Facebook may alter the privacy settings on private funds, perhaps influencing the SEC to change the required distribution of information about private funds and the companies in which they invest from "Friends Only" to "Everyone." As we report below, the SEC is considering whether "special purpose vehicles" (i.e., private funds such as hedge funds and private equity funds) are being used to circumvent beneficial ownership rules. Specifically, the SEC is considering whether companies should be required to "look through" a private fund investment (i.e., count the investors in the private fund as shareholders of the company) in determining whether to require the company to register under the Securities Exchange Act of 1934.

The foundation of the private fund and private equity industries are the general exemptions from the costly registration requirements of the securities law. Congress and the SEC have generally included such exemptions under the theory that private funds, and investors in private funds, are not the type of investors that the securities laws were designed to protect. For instance, private funds are typically exempted from the definition of "investment company," and therefore exempt from the registration requirements of the Investment Company Act of 1940, under Section 3(c)(1) or 3(c)(7). In general terms, Section 3(c)(1) exempts private funds with less than 100 investors and Section 3(c)(7) exempts private funds whose investors are qualified purchasers (i.e., high net worth individuals and institutional investors). If a private fund were not exempted from the definition of "investment company" it would be required to register under the Investment Company Act in the same manner as a mutual fund, and would be subject to the same disclosure and reporting requirements.

An offering of interests in a private fund, or a limited offering of securities by a company to a private fund, is typically exempt from registration under the Securities Act of 1933 because it is made in accordance with Regulation D. Among other things, Rule 506 of Regulation D states that an issuer of securities may not use general solicitation or advertising to market the securities and that it may sell its securities to an unlimited number of accredited investors (and up to 35 other purchasers) that have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment. If the offering of securities were not made in accordance with Regulation D, the issuer also would be required to register its interests under the Securities Act.

Under Section 12(g) of the Securities Exchange Act of 1934, a company is required to register under the Exchange Act if it has total assets in excess of $10 million and a class of equity securities held of record by 500 or more persons. Registration under the Exchange Act would subject the company to significant annual and periodic reporting requirements (i.e., 10-K, 10-Q and 8-K's). Therefore, a company such as Facebook, which does not wish to be subject to the Exchange Act reporting requirements, takes steps to ensure that no class of equity securities is held of record by 500 or more persons. In determining whether a class of equity securities is held of record by 500 or more persons, Rule 12g5-1(a)(2) under the Exchange Act states that securities identified as held of record by a corporation, a partnership or trust (which would include a private fund) shall be included as so held by one person. In other words, the company is not forced to "look through" the private fund to count each investor of the private fund as a shareholder of the company.

Were the SEC to determine that it was appropriate to "look through" a private fund investment for purposes of the Exchange Act, the results would significantly burden the private fund industry and chill private investment, with little or no marginal protection to the investing public. Using the proposed investment in Facebook by a private fund sponsored by Goldman Sachs as an example, it is important to remember that the investors in the Goldman Sachs entity are investing in a private fund, they are not investing in Facebook. When they invest in the Goldman Sachs private fund, they are accepting the associated credit risks and reduced transparency of an investment in the private fund, as compared with a direct investment in Facebook. When they receive their account statement, it will contain the financial statements and results of the private fund, not of Facebook. The investors in the Goldman Sachs entity also are high net worth clients, who presumably do not need the protection of the securities laws. The private fund itself that is investing in Facebook is doing so with the knowledge that Facebook is not a registered company and is willing to accept the attendant risks and reduced disclosure. It seems to be an unusual result if the registration status of Facebook could be triggered by the actions of Goldman Sachs. It seems burdensome to hold a company responsible for "looking through" each of its shareholders and to permit a single shareholder to trigger a company's registration by holding company stock in a partnership vehicle.

Similarly, it seems incongruous to apply Section 12(g) to private funds in any event. For instance, if under the Securities Act, a private fund is permitted to sell its interests to a theoretically unlimited number of knowledgeable and experienced accredited investors, and under the Investment Company Act is permitted to have a theoretically unlimited number of investors that are qualified purchasers, then there would seem to be no marginal benefit to such investors by requiring registration under the Exchange Act upon the arbitrary 501st investor purchasing an interest in the private fund.

We will continue to monitor developments in this case and provide a status update with any new developments.