The private placement memorandum’s evolving role in the expanding market for global capital
January 2019 | EXPERT BRIEFING | FINANCE & INVESTMENT
Private equity (PE) markets are flourishing. Investor confidence looks to be on the uptick in the aftermath of the 2008 global financial crisis that was partly triggered by the failure to accurately evaluate the risks of certain investments. One could say that PE is apparently experiencing a golden age – certainly one that is interesting and which could be captured in the adage ‘may you live in interesting times’.
A broad range of industries and businesses are being transformed by technological advancements like artificial intelligence (AI), blockchain, computer technology, the internet, and more. Given these breakthroughs, many investors are taking advantage and sinking their money into new and innovative – but often untested – private ventures.
Professional advisers to this latest generation of entrepreneurs may be more wary of the attendant risks and more prudent about disclosing them. Increasingly, executives and their advisers are employing a special disclosure document known among lawyers and investment bankers as a private placement memorandum (PPM). Companies looking to raise capital in a private offering, including their officers, managers and advisers, would benefit from knowing the key purposes, parts and potential advantages of a PPM in the current investment climate.
A PPM is similar to a business plan, but more detailed and focused on legal issues. The PPM is not a new legal tool. Rather, it has a long history originating in Anglo-Saxon law, specifically in US securities law. The PPM consists of two main documents. Firstly, a subscription agreement, which sees the issuing company offer securities to a group of investors for acceptance or non-acceptance. And second, the memorandum, which delineates, in an objective tone, facts that are material to the investment decision, including the terms of the offering, the nature of the business and industry, the company’s strategy and, importantly, all material risks to the investors.
Because the disclosure of risks is so critical, much time and attention is spent drafting that section of the PPM. Regardless of industry, whether it is entertainment, healthcare, real estate, manufacturing or data cloud storage – investors need to be informed of factors that could potentially lead to a loss of their investment. The fact that the issuer is making no guarantees as to investors’ returns should be a consistent theme in the document.
The ‘risks factors’ section of a PPM is typically separately captioned and follows other key components of a PPM, including: (i) a cover page identifying the fund and its senior managers; (ii) legends indicating the securities being offered are privately placed and unregistered; (iii) a ‘term sheet’ setting forth essential conditions like the minimum investment amount, priority of distributions, and investor remedies; (iv) the ‘investment objective and strategy’, summarising senior management’s investment rationale; and (v) descriptions of accompanying agreements between the company, its managers and service providers. Other documents include an investor suitability questionnaire and the company’s organisational documents which, depending on the company’s goals, may be a corporation’s charter, a partnership’s agreement or an LLC’s operating agreement.
The benefits of a PPM are manifold. It serves as a marketing tool, giving investors valuable information. It makes capital easier and less expensive. And, the PPM’s robust disclosures fulfil a key prerequisite to obtaining certain exemptions from some securities regulations. Structuring a PPM to accomplish these objectives is the domain of a skilled and experienced lawyer.
In the US, a PPM is a by-product of the country’s 1933 Securities Act and the 1934 Securities Exchange Act – both Acts premised on the assumption that investors can evaluate the merits of a security if they are provided with the accurate and complete information about the issuer and the particular security being offered. Under the 1933 Act, an offer or sale of a security or membership interest constitutes an “offering” of securities that must be registered with the Securities and Exchange Commission (SEC) and state authorities, unless the offering satisfies the prerequisites of several exemptions, notably Regulation D and A of the 1933 Act. Regulation D, embodied in rules 504 and 506, targets “accredited investors”, but also allows issuers to raise funds from unaccredited investors subject to various limitations and the requirement they receive extensive factual disclosures about the issuer and the investment. Regulation A+ requires a level of disclosure comparable to a formal registration statement (i.e., a prospectus) for a public offering of securities. Accordingly, issuers must prepare an extensive PPM in order to rely on Regulation A+.
Unless an offering meets a particular exemption, the issuer must formally register and file a prospectus with the SEC for public disclosure. Failure to do so results in civil liability. The civil liability provisions of US securities laws impose strict disclosure requirements on issuers and provide aggrieved buyers of securities with several express and implied causes of actions if they suffer harm as a result of relying upon an inaccurate or incomplete financial statement. While some of these liability provisions do not apply if the particular offering is exempt from registration, several key liability provisions continue to apply – a key caveat often prompting and necessitating a PPM.
The evolving regulatory environment can be challenging for PPM drafters. The attitudes and concerns of securities regulators vary from jurisdiction to jurisdiction, impacting regulations and their effect on issuers. For example, in the US, although the PPM is delivered within the context of a private placement, the legal standard that determines whether disclosure is adequate is essentially the same ‘materiality’ standard that applies to a registered public offering filed with the SEC. Accordingly, a PPM should include disclosures on material business topics, executive compensation, managers’ qualifications and governance matters – anything that would be material to the decision to invest. However, unlike some European countries, US securities laws do not generally deem material – and thus do not require – disclosures on sustainability-related matters like the environmental impact of the issuer’s operations, future environmental events or impacts or the general effects of such ongoing matters like climate change.
Nonetheless, issuers and PPM drafters should be aware of emerging regulatory issues. For example, they should know how regulators are dealing with the use of cryptocurrencies in initial coin offerings (ICOs) to raise capital. Some countries, such as China, have already banned them. Others have expressed official hostility toward these high-risk offerings. Although top SEC officials have stated that ICOs may constitute an “offering of securities”, the US has not banned ICOs as a method of raising capital. The disclosure and risk factors regarding ICOs in any jurisdiction should, in all prudence, be detailed and extensive, in light of the uncertainties as to where the law will eventually land.
But securities laws and regulations are just one side of the coin. One of the most important changes in the art and science of PPM preparation is the description of risks. We offer some general guidelines in rethinking these provisions. First, ‘risk factors’ should be limited to those that are specific to the issuer. Securities regulators, including the SEC, have made it clear that vague, generic and general boilerplate provisions will do little to protect the issuer and its controlling officers from legal liability. Second, risk disclosures should be organised in a manner reflecting their relative importance. A common method is to discuss them in the following order: company-specific risks, industry-specific risks, and risks inherent in the type of security or derivative being issued.
Company-specific risks should always be customised and are likely to vary widely depending on the circumstances. Company-specific disclosures should detail things like the company’s short or non-existent operating history, ongoing litigation, potential acquisitions, debt being carried, liquidity factors and the inexperience of current management.
Industry-specific risks should also be customised. They may encompass economic and environmental conditions, labour costs and shortages, price fluctuations or tariffs on raw materials and increased costs associated with new forms of regulation. The European Union’s sweeping General Data Protection Regulation (GDPR), which became effective on 25 May 2018, is a prime example of an industry-specific risk.
Risks specific to the type of security or derivative being issued will typically explain the substantive and differing tax treatment of debt and equity securities and the risk that ‘debt’ may be recharacterised as ‘equity’ or vice versa. It is crucial to work closely with experienced securities and tax attorneys in drafting these provisions. If debt securities are issued, the PPM’s Risk Factors should explain whether the debt is subordinated or unsecured, and delineate the investors’ relative rights to cash distributions (or contributions) in the event of a complete liquidation. If equity securities are issued, the PPM should explain the classes of stock, the respective rights of shareholders, the rights to dividends and risks of share dilution. It is also important to disclose the special risks faced by minority shareholders. Contingent debt instruments raise special tax risks that should probably be explained in the standalone tax disclosures section of the PPM.
No PPM could possibly disclose, let alone explain, to each investor all possible tax risks and reporting requirements associated with an investment. However, the PPM should give investors a reasonable idea of the associated tax exposures, not be misleading and advise them to seek their own, independent tax counsel before investing.
The risks of tax exposures that should be properly disclosed will depend on whether the prospective pool of investors are accredited or unaccredited, domestic or foreign, individuals or business entities and if entities the type of organisation (e.g., partnerships, trusts, pension funds, tax exempts, etc.). Tax disclosures will also depend on the type of business and underlying investment, the location of investment property and whether the issuer is conducting a trade or business in the country where it is organised, which could be imputed to the investors. Given all these factors, boilerplate tax provisions will not suffice. Rather, they must be customised, both to the pool of offerees and to the rapidly changing tax laws relevant to the offering. In fact, the PPM may very well need to be updated as the tax laws, domestic and foreign, change.
The use of PPM’s as a disclosure tool, while not new, is becoming more popular in private capital markets in the US, in jurisdictions such as France with the government’s pro-investment policies in the start-up sector and in Luxembourg – and all this with good reason.
Pamela A. Fuller is a tax attorney and Alan S. Gutterman is senior corporate counsel at Royse Law Firm P.C., and Sara Mansuri is a corporate lawyer. Ms Fuller can be contacted by email: email@example.com. Mr Gutterman can be contacted on +1 (650) 813 9700 or by email: firstname.lastname@example.org. Ms Mansuri can be contacted on +1 (347) 945 8730 or by email: email@example.com.
© Financier Worldwide
Pamela A. Fuller and Alan S. Gutterman
Royse Law Firm P.C.