Investments by Private Equity Funds: Legal and Regulatory Matters

May 24, 2017

Just as establishing a private equity fund comes with a myriad of legal and regulatory issues, so does its investment and operating phase. Aside from the regulation of capital raising under the Securities Act of 1933, and conduct and registration requirements under the Investment Advisers Act of 1940, a private equity fund may face a complex set of laws, regulations, customs and practices when making investments, some of which are unique to private equity investments – and some of which may be unique to the investee or its industry. Seward & Kissel attorneys routinely act as fund counsel in private equity investments and advise clients in the negotiation and documentation of the terms of these transactions.

This summary outlines certain key legal and regulatory issues to be considered by private equity funds when making investments in both public and private companies.

U.S. Anti-Trust Laws. Generally, if a proposed investment would cause the value of the total investment in the investee to exceed a dollar threshold (currently $80.8 million), the fund and its affiliates may (absent an exemption) be required to make an advance notification filing with the U.S. Federal Trade Commission and U.S. Department of Justice under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, which implicates FTC or DOJ review. Such review could, in some circumstances, result in delays and/or failure to obtain approval.

Regulated Industries. Investments in certain industries (such as banking, securities brokerage and insurance) may be prohibited or limited to a fixed percentage of the voting securities. In some cases, notification to, or approval by, a regulator may be required. Other industries may have ownership requirements or limitations related to citizenship or residency.

State Law Fiduciary Duties. Nominee directors, and in some cases the fund as having selected a nominee director, will be subject to fiduciary duties and related liability under the laws of the jurisdiction of incorporation or formation of the investee entity.

SEC Filing Requirements and Resale Restrictions. Depending on levels of beneficial ownership of the investee’s voting stock, the fund and certain equity holders and controlling persons may be deemed affiliates or insiders of the investee, implicating a potentially complex regime of filing requirements and trading limitations, including certain limitations on resales under the Securities Act of 1933. For investees that are or become publicly traded companies, beneficial ownership and transaction reporting under Section 13 and 16 of the Securities Exchange Act of 1934, as well as Section 16 related “short-swing” profits law and rules may be implicated. Blackout periods and other trading restrictions of the investee’s own compliance procedures may apply in certain circumstances. In addition, at the time of the investment and certain other times, the fund and management personnel may obtain material nonpublic information about the investee, which could impose resale restrictions.

U.S. Foreign Corrupt Practices Act. The Foreign Corrupt Practices Act, or the FCPA, is designed to prevent U.S. and U.S.-connected companies from engaging in activities that are in the nature of bribes to foreign governments and governmental facilities to gain a business advantage. Investee entities may be conducting business in violation of the FCPA which can, in certain circumstances, be imputed to the fund and certain controlling persons. Also, the investee entity may be deemed a governmental entity itself, which could affect the propriety of the investment depending upon facts and circumstances. Other countries have similar anti-corruption laws, including the United Kingdom. Anytime you are contemplating an investment in a foreign entity, either directly or indirectly, careful due diligence should be performed to ensure FCPA compliance.

Trade Sanctions and Embargoes. The U.S. Office of Foreign Assets Control or OFAC regulates trading with countries for which the U.S. has implemented trade restrictions, sanctions and embargoes, whether by statute or rulemaking. Investee entities may be conducting business in violation of U.S. federal law and OFAC rules, which can, in certain circumstances, be imputed to the fund and certain controlling persons. Foreign countries, including the EU, have similar regulatory regimes. It is important to understand the risks associated with investing in particular regions of the world, and a thorough due diligence process should be conducted when evaluating an investment opportunity.

United States Taxes. The nature of the investee entity, its jurisdiction and status, may cause tax effects to the fund that could subject it and its equity holders to U.S. federal and state taxation. For example, if the investee is treated as a partnership or a corporation for U.S. federal income tax purposes, non-U.S. investors in the fund may be required to file a U.S. federal income tax return, and U.S. tax-exempt investors may realize ‘unrelated business taxable income,’ or UBTI, from the investment. Also, both the fund and its U.S. taxable investors may be subject to tax return filing and payment obligations in the various states in which the investee does business.

Foreign Taxes. The nature of the investee entity, its jurisdiction and status, may cause tax effects to the fund that could subject it and its equity holders to foreign taxation. For example, certain payments made by foreign companies may be subject to withholding taxes; and the tax treatment of businesses (i.e., whether active or passive) and of varying types of transactions will differ based on the tax treatment of the entity, the nature of its business, and levels of control that could be deemed to exist from the investment. Also, tax agreements and treaties between and among countries, including the U.S., may affect the types and amounts of reporting and filing obligations in foreign jurisdictions and foreign taxes payable, as well as funds flow restrictions.

ERISA Matters. When making an investment where 80% or more of the investee company is owned by the fund or a related group of funds, the fund may be liable for any unfunded pension liability or multiemployer pension withdrawal liability of the investee company. These liabilities can be substantial and should be addressed before any acquisition of 80% or more or an investee company.

Investment Funds. If the investee is a private investment vehicle, it is important to ascertain that it has a valid exemption from the definition of an “investment company” under the Investment Company Act of 1940. Also, when investing in a fund that is a registered investment company under the Investment Company Act of 1940, certain investment thresholds and limitations should be considered.

If you would like more information concerning these matters, contact your Seward & Kissel attorney.