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Know the Rules on Private Placement Variable Product Sales

Just because a product is offered in a private placement does not mean that the suitability requirements of the federal securities laws can be ignored.

Judith A. Hasenauer, 11/07/2013

In this last article of our series on private placement variable products we will discuss some of the rules applicable to the sale of such products in the United States. Like the registered counterpart, private placement variable products are subject to the same three basic laws: tax law, federal securities law, and state insurance law. Because of the nature of the rules we will be discussing, this article is more technical and detailed than we usually prepare.

We have heard on more than one occasion that because the product under consideration was being offered on a private placement basis, the federal tax laws applicable somehow were different--for example, Internal Revenue Code (IRC) Section 817(h) (the diversification requirements) was not applicable. The IRC, and the regulations thereunder, are agnostic as to whether the product is registered with the Securities and Exchange Commission or offered on a private placement basis. In fact, the identical rules would apply whether the product was offered onshore or offshore. Therefore, regardless of the manner of the offering, the IRC sections appropriate for the type of product offered must be complied with.

There are a number of federal securities laws that come into play when a variable product is being offered, including the Securities Act of 1933 ('33 Act), Securities Exchange Act of 1934, the Investment Company Act of 1940 ('40 Act), and the rules and regulations of FINRA. Although an in-depth analysis of how all of these affect variable products is not possible in the limited space we have, we would like to at least touch upon the more important aspects.

The basic principle of the concept of private placement is that the product (any product, whether it be a variable product or a security offering) is being offered to a limited group of persons who have the knowledge, financial experience, and net worth such that they do not need the consumer protections provided by these securities laws. Before we examine the details of the requirements, we want to set out a guiding principle of private placement transactions: Before you recommend purchasing a security on a private placement basis, you should make sure that your client not only has the net worth to sustain a significant loss of capital but also fully understands all of the risks involved. This is not an either/or situation.

When an issuer, in our case here the insurance company, desires to offer a security on a registered basis, it will register the security with the SEC and engage the services of an underwriter (a registered broker-dealer). Such a broker-dealer and the selling broker-dealers are responsible for ascertaining whether the offer and sale complies with the federal securities laws. The issuer has little or no involvement in the sales process. When an issuer chooses to offer a security on a private placement basis, in addition to any duties imposed on the selling broker-dealer, the issuer has a duty to make sure that purchasers meet the necessary purchaser qualifications.

There are differing sets of rules that govern purchaser qualifications for private placement variable products under the '33 Act: Regulation D and the exempted transactions (Section 4(a)(2)) provisions. All variable insurance products are offered in conjunction with a separate account established by the insurance company. Such separate accounts are either registered, or must be exempt from such registration, under the '40 Act.

One of the difficulties people sometimes have in understanding exactly what the rules require for eligibility of prospective purchasers is that the definitions between the '33 Act and '40 Act are not completely harmonized.

Section 4(2) of the '33 Act simply provides that transactions by an issuer not involving any public offering are exempt from registration. Regulation D (or as most people refer to it, "Reg D") is a set of rules promulgated under the '33 Act. It is captioned as, "Rules governing the limited offer and sale of securities without registration under the Securities Act of 1933." Reg D is intended as a safe harbor rule, which means that an issuer's failure to fully satisfy the conditions of one of the rules under Reg D does not raise any presumption that the exemption provided by 4(a)(2) is not available. Thus, you will see issuers craft purchaser qualification requirements that are appropriate for their offerings but not necessarily consistent with other offerings by other issuers.

Judith A. Hasenauer, JD, CLU, is an attorney with the law firm of Blazzard & Hasenauer, P.C. She devotes her practice exclusively to the financial services industry, providing consulting on the development and regulatory clearance of products, compliance issues, distribution issues and related matters, such as advisory activities and industry initiatives.

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar.

The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.

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