On July 15, 2019, the staff of the Securities and Exchange Commission (SEC) and the North American Securities Administrators Association (NASAA) issued a joint statement summarizing federal and state securities law considerations that may be applicable to “qualified opportunity funds” (QOFs), which are pooled investment funds established to reinvest gains in designated opportunity zones. The Tax Cuts and Jobs Act, enacted in December 2017, offers significant tax incentives for long-term investments in economically distressed areas designated as “qualified opportunity zones” (QOZs). The QOZ tax incentive program is designed to stimulate capital investment in and economic development of economically depressed areas, and the Treasury Department has designated over 8,700 QOZs nationwide. The statement issued by the SEC and NASAA provides an overview of federal and state securities laws and regulations that may be relevant in structuring and operating QOFs. Notably, the statement does not alter existing laws or regulations.
Interests in QOFs Are Most Likely “Securities”
QOFs are defined as “any investment vehicle which is organized as a corporation or a partnership for the purpose of investing in qualified opportunity zone property.” Interests in QOFs generally are considered “securities” and therefore, most QOFs will need to comply with federal and applicable state securities laws.
Under the Securities Act of 1933, as amended (Securities Act), in offering and selling securities, issuers must either register the securities offering with the U.S. Securities and Exchange Commission (SEC) or qualify for a valid exemption from registration. The most common exemption from federal securities law registration provisions relied upon by issuers is provided by Regulation D promulgated under Section 4(a)(2) of the Securities Act, particularly Rule 506. Rule 506 provides an exemption from federal securities laws registration provisions for issuers raising an unlimited amount of money who are selling securities to an unlimited number of accredited investors (and up to 35 additional sophisticated investors if the required disclosures are provided) and which comply with the other requirements of this exemption. Other securities law exemptions which may be available to QOF issuers include a small offering exemption under Rule 504 under Regulation D, the intrastate offering exemption in Securities Act Rules 147 and 147A, the small offering exemption under Regulation A and the Regulation Crowdfunding exemption under the Securities Act.
Issuers offering securities in QOF offerings also may be subject to the securities laws in the states in which securities are offered or sold to investors, but qualified offerings made under Regulation D at the federal level are subject to federal securities law pre-emption of state law registration provisions. Issuers relying on certain federal securities law registration exemptions generally will need to make a notice filing with the applicable states and pay a fee.
Persons Soliciting Investors in QOF Offerings May Need to Register as “Brokers”
Any person who solicits or refers investors in connection with an offering of QOF securities may be considered a “broker” and must consider applicable federal and state broker-dealer registration requirements. A “broker” is generally defined as a person who is engaged in the business of effecting securities transactions for the account of others, and each such person must be registered as a broker-dealer under federal securities laws, or have a valid exemption or exception from registration.
Whether an individual is a “broker” for a QOF securities offering depends on the specific facts and circumstances, but generally the SEC takes a broad view of who constitutes a “broker.” Some of the circumstances that the SEC and courts have identified as indicating that an individual is acting as a broker include: marketing securities, soliciting investors to purchase or sell securities, assisting in the potential purchase of securities, screening investors, negotiating purchases and sales of securities between investors and the issuer, handling investor funds or securities, and assisting in evaluating the merits of any investment. Whether an individual is acting as a broker depends on the totality of the facts and circumstances and not all factors need to be present.
Perhaps the most significant indication that a person is acting as a broker is that the individual receives compensation based upon the outcome or the size of a securities offering, so called “transaction-based” compensation. The presence of transaction-based compensation is a strong indication that the person engaging in this activity should be registered as a broker-dealer (or have an available exemption or exception).
Under federal law and regulations, persons employed by the issuer who market and solicit potential investors in a QOF offering will be exempt from broker-dealer registration, provided that the individual has other substantial duties at the issuer not related to transactions in securities. Again, one significant consideration will be whether the individual is receiving transaction-based compensation or sales commissions based on sales of securities. Persons who may be considered “brokers” also must review applicable state broker-dealer registration requirements to determine whether state registration is required or whether there is an available exemption or exception available.
QOFs May Be “Investment Companies” Subject to Federal And/Or State Registration Requirements
QOFs are pooled investment vehicles through which investors invest in QOZs and may qualify as an “investment company” under federal securities laws. The Investment Company Act of 1940, as amended (Investment Company Act) defines an “investment company” as an issuer which:
QOF issuers that fall within this definition must either register as an investment company under the Investment Company Act and subject themselves to substantial federal regulation and oversight, or have a valid exemption or exception from these registration provisions.
Several exclusions from the definition of an “investment company” are available to QOF issuers. Most commonly, issuers rely on the exclusion provided by Section 3(c)(1) of the Investment Company Act, for an issuer with outstanding securities that are beneficially owned by not more than 100 persons and which is not making and does not presently propose to make a public offering of securities. Another exclusion from the definition of an “investment company” is provided by Section 3(c)(5)(C) of the Investment Company Act, which exempts issuers not engaged in the business of issuing redeemable securities and primarily engaged in purchasing or otherwise acquiring mortgages or other liens on and interests in real estate. QOF issuers that have more than 100 investors also may be able to rely on the exemption provided by Section 3(c)(7) of the Investment Company Act, which provides an exemption from registration under the Investment Company Act for funds that restrict investment to “qualified purchasers.” “Qualified purchasers” under the Investment Company Act generally are individuals or businesses with more than $5 million in investments or entities that are owned exclusively by qualified purchasers.
Persons Advising QOFs May Be Subject To Regulation Under the Investment Advisers Act and Comparable State Laws
The SEC/NASAA statement also reminds QOF issuers that persons advising QOFs may be considered “investment advisers” subject to compliance with the federal Investment Advisers Act of 1940 (Advisers Act) or comparable state securities laws. The Advisers Act defines an “investment adviser” as “any person who for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of the securities or as to the advisability of investing in, purchasing or selling securities.” Individuals who qualify as an investment adviser generally must register as such, unless there is an available exemption or exemption. State securities laws also have comparable definitions and registration provisions.
The tax incentives provided by the opportunity zone program in the Tax Cuts and Jobs Act adopted in December 2017 offer investors the possibility of receiving significant tax benefits when investing gains in QOFs. But QOFs must consider and comply with a wide variety of significant federal and state securities laws and regulations. Developers and investment management firms seeking to form, structure and operate QOFs should seek advice of capable tax and securities law counsel.