Month: September 2013

The Confusing Analysis of Whether You Are An Accredited Investor

accredited investors

There are few commentators who think the current definition of “accredited investor” is a particularly good definition for individuals who should be investing in private placements of securities. Basing the standard on income and net worth does give you a perspective that the person could withstand the potential loss of investment. The definition has become even more important as the ban on general solicitation and advertising has been lifted. That’s going to leave a lot of potential investors and a lot of companies seeking capital trying to figure it out.

The income test of $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year, provides an interesting model. It’s reasonably verified with tax returns. Although I suspect few investors will want to turn over their tax returns to potential investment targets.

There is some uncertainty about the meaning of “spouse” for same-sex couples, given the Windsor decision that struck down the Defense of Marriage Act.

A humorous aspect of the income test is that the SEC Commissioners’ salaries are less than $200,000. Therefore, they each fail the accredited investor income test, unless a spouse is earning at least $150,000.

The asset test is even more difficult because assets now exclude the value of the home. Except if the mortgage balance is higher than the value of the home, then the negative value of the home is included in the asset test.

Of course the first problem is figuring out the value of your home and comparing it to the mortgage balance. I like that Zillow says my house is worth more than my mortgage, but is that an authoritative source for use in an accredited investor analysis?

Then the SEC also requires an home equity advance or mortgage increase in the prior sixty days to be a liability in calculating net worth, even if it does not put the house underwater. During the comment period, a concern was raised that an unscrupulous actor could convince grandma to mortgage her home, converting equity into cash that earns her the accredited investor standard.

The biggest problem is proving net worth to meet the accredited investor standard. You need to prove how much your house is worth, the mortgage balance, the timing of the mortgage origination, the timing of any home equity draws, all of your liabilities, and lastly your assets. merely producing a bank statement showing $1 million in cash in the bank is not enough to have take “reasonable steps” to conclude that a person is an “accredited investor.’

You can review the ridiculousness of the asset test in a new investor bulletin from the SEC: Investor Bulletin: Accredited Investors (.pdf) SEC Pub. No. 158.

John Smith fails the test because he took an additional draw on the home equity line in the past sixty days. But in two months he once again becomes an accredited investor. He did nothing but wait and his financial situation did not change. But two months later he can be an angel investor and invest in a start-up company.

James Lee fails the test because his house is $100,000 underwater and pulls him $80,000 short of the accredited investor standard. But as soon as Zillow makes a good positive update, he becomes an accredited investor. He did nothing but wait for the real estate market to recover. But then he can invest in a hedge fund.

References:

Investor Bulletin: Accredited Investors (.pdf) SEC Pub. No. 158

Compliance Bricks and Mortar – Solicitation and Advertising Edition

bricks for sale

On Monday, the new SEC Rule 506(c) became effective, lifting the ban on general solicitation and advertising, creating a new era of public private-placements. These are some of the stories on the effect of the new the rule that caught my attention.

Pros and Cons of General Solicitation by Joe Wallin in Startup Law Blog

Well, ok. In the old days, you couldn’t generally solicit or generally advertise your securities offerings. You had to work pre-existing contact to pre-existing contact. You were not supposed to stand up on a stage at an industry conference and say, ‘We are raising $500,000 in Series A at $1.00 a share. Please see me and I’d love to talk to you about it.’ In fact, this was illegal. It was also illegal to blog or Tweet or use Facebook to try to raise money. Many people broke the rules. Some got in a lot of trouble.”

Angel investing: The walls come tumbling down by William Carleton in Geekwire

Some angel group leaders have been advising companies to not go there. Some angels are taking the position that they will not be investing in any deals that involve general solicitation or general advertising. The reps and warranties are already being written: “Company has not engaged in general solicitation and is not otherwise subject to Rule 506(c) . . . .” Access to many angel group meetings and demo events is being tightened up, in an effort to preserve the availability of the old rule, now known as Rule 506(b), which very much remains a viable option. (Kudos to the SEC for having the foresight to preserve the old rule in parallel with the new.)

Small Businesses Take Fundraising Public Small Businesses Take Fundraising Public by Angus Loten in the Wall Street Journal

Douglas Penman, for instance, says he is planning to make T-shirts promoting investment opportunities in his San Francisco startup, Nukotoys Inc., which makes children’s educational trading cards for mobile devices. He’s hoping to have the T-shirts worn by skyscraper window washers, to catch the eye of wealthy executives inside. The company, launched in 2010, is looking to raise $2 million to expand its user base, he says.

Online Platforms Give the First Public Look at Private Equity by Paul Spinrad in PBS’s Mediashift

A major change in federal securities regulations takes effect this week, and many people are wondering how it will turn out. It’s now legal — with the proper filings and for the first time in over 80 years — for businesses to publicly advertise for investors. Proponents hope that this change will spur entrepreneurship, job creation and innovation nationwide, particularly in areas outside of the typical startup hotspot cities. Detractors fear that the regs will provide a new mechanism for fraudsters to scam retirees and others out of their wealth. Either way, the system known as “private equity” won’t always be so private anymore — and as of Monday morning, several online platforms discussed below are giving the public its first look at the formerly secret world of startup investing.

General Solicitation Brings Startups Capital, Risks by Evelyn M. Rusli and Andrew Ackerman in WSJ.com’s Digits

“The government is doubling down on the idea that accredited investors can fend for themselves,” said William Carleton, a Seattle-based startup lawyer.

ERA’s demo day: “This is not a general solicitation” by Erin Griffith in PandoDaily

However, as I predicted, the pitches conspicuously left off a crucial piece. Up until this week, most demo day speeches end with something like “We’re raising $750,000 in seed funding and we already have a third of it committed from top-tier angel investors.”

But today the demos very carefully avoided that. “If you’re interested in changing the way the world books its wedding bands (or sells its used clothing, or buys its farm machinery or whatever), talk to us afterwards,” the founders declared. No fundraising, no dollar signs, no explicit asks.

How General Solicitation Will Change Private Equity And Venture Capital Forever by Ryan Caldbeck in Forbes.com

According to public filings from SEC.gov, in 2012 there were over 30,000 Reg D offerings. Collectively, they raised $1.3 trillion. About $1.1 trillion is related to financial services and pooled investment funds- i.e. hedge funds, private equity funds and similar groups raising money. The remainder spans industries from agriculture to telecom. All 30,000 of those offerings took place in a ‘silent’ offering, with no mention of the capital raise in public. The result was both inefficient, and costly for investors and the issuers.

Voluntarily Submit Your Private Placement Advertisements to the SEC

sec-seal
In a head-scratching move, the Securities and Exchange Commission has created a portal for you to voluntarily submit general solicitation materials for private placements. With Rule 506(c) now in effect, companies are free to advertise their private placements of securities, so long as the company takes reasonable steps to ensure that investors are accredited investors.

When the SEC issued Rule 506(c), it also proposed a new rule that would require a company to submit its general solicitation and advertising materials. That new rule, along with several others proposed at the same time, are controversial.

I assume that the SEC portal is set up to take submissions if required at some point at the future. I’m not sure why any company would voluntarily submit materials. I’m scratch my head even harder because there is no field to identify the issuer soliciting for investors. That would seem to limit the utility of the submission.

Perhaps the portal is intended for Whistleblowers? But there is statement and link to direct submission involving possible violations of the securities laws to the TCR portal.

Perhaps the SEC merely had its IT group put together the portal in anticipation of the proposed rule becoming effective? Perhaps.

References:

Voluntary Submission of General Solicitation Materials Used in Rule 506(c) Offerings

The New Era of Public Private-Placements

half-price advertisement

The Securities and Exchange Commission’s new Rule 506(c) goes into effect today, lifting the ban on general solicitation and advertising. Fund managers, start-ups, and established companies can make public, their private placements of securities. That is both a good thing and a bad thing.

It’s good because start-ups can now pitch their products to potential consumers and for investments by investors. Demo days are no longer operating in a shadowy area that may violate the rule on private placements. Private fund managers can now advertise their brand, much as mutual fund companies can advertise. Private fund managers can speak to the press so that their coverage is no longer incorrect.

It’s bad because once you advertise, you have to take “reasonable steps to verify” that you should have a “reasonable belief” that an investor is an accredited investor. For individuals, it may mean that an issuer would ask for tax returns or certified financial statements. I think most individuals will resist that request. So a start-up that is seeking individual investors may actually handicap its ability to attract investors by engaging in general solicitation or advertising.

It’s also bad for securities regulators. If a regulator could see information on what should be a private placement, the regulator knows its a bad private placement. By the old definition of private placement, the regulator should not be able to see the information because its private. Either the company made a bad mistake or there’s fraud involved. In the new era of public private-placements, regulators will have little insight into the nature of the private offering.

At some point the regulators will have access to the Form D filing that provides a basic set of information about the public private-placement. But that does not need to be filed until 15 days after the first sale of securities.

In an attempt to fix the loss of the red flag, the SEC proposed some additional rules to help with investor protection. I, and many others, feel the proposed rules are more likely to impede private fundraising more than protect investors.

The better solution would have been to improve the poor definition of “general solicitation and advertising.” There were many things that clearly fit into the definition and many things that clearly fell outside of the definition. If the SEC had just carved out a few more items (see the “good” above), private placements would not be in their current turmoil.

But it was not up to the SEC. It was a Congressional mandate in the JOBS Act that swept aside the ban. It was Congress who imposed the investor verification requirement.

The good news is that the old private placement regime is still in place. As long as you don’t engage in general advertisement or solicitation, in other words have a private private-placement, you don’t have to engage in the messy investor verification process.

Compliance Bricks and Mortar for September 20

 

MontelibrettiPalazzoBarberini bricks

These are some of the compliance-related stories that recently caught my attention.

An entrepreneur who, come September 23, will not be tweeting for investors by William Carleton

And not for concern that SEC proposed rules would impose pre-filing, information filing and other requirements. No, he was looking only at that “price” 506(c), the actual final rule that becomes effective next week, exacts: verification of the accredited status of all purchasers.

“From my point of view,” he told me, “the wealthier a person or family is, the less likely they’re going to give you any kind of information about their finances.”

The Red Baron and Leading in Compliance by Tom Fox

I thought about those fanciful flights of Snoopy vs. The Red Baron when I considered the compliance implications found in this past weekend’s Corner Office Section of the New York Times (NYT), where Adam Bryant interviewed Bob Moritz, chairman and senior partner of PricewaterhouseCoopers LLP (PwC), in an article entitled “Want to Learn about Diversity? Become a Foreigner”. In this article Bryant detailed several leadership lessons that Moritz had experienced over the years which I thought had quite a bit of application to the compliance practitioner.

10 Common Questions Regarding General Solicitation by Joe Wallin in the Startup Law Blog

On September 23, 2013, startups are going to be able to generally solicit their securities offerings under Rule 506(c) of Regulation D.

There are a couple of catches.

This Picture Is Worth 471 Words (More or Less) by Keith Paul Bishop in California Corporate & Securities Law

Monday is the big day for the SEC’s “Bad Actor” and “General Solicitation” rule amendments.   I’ve previously observed that many are likely to find the Bad Actor amendments to be bad rules when it comes to compliance.  Today’s blog is devoted to just one interpretational problem with the Bad Actor amendments.

Don’t get too excited about JPMorgan’s admissions to the SEC by Alison Frankel in Bloomberg

But if you look closely at what JPMorgan actually admitted, you’ll see that the SEC settlement won’t be of much use to shareholders in the class action. Don’t misunderstand me: JPMorgan is extremely unlikely to escape from the private shareholder case without paying a lot of money. That’s not because of the SEC settlement, however. As I’ll explain, the bank’s lawyers did a very good job of tailoring JPMorgan’s admissions to the SEC to minimize their impact in the class action. In fact, I suspect that future SEC defendants are going to look at the JPMorgan settlement as a model for how to quench regulators’ thirst for blood without spilling a drop in parallel shareholder litigation.

Twitter announces its IPO in a tweet by Robert C. White Jr. in Securities Edge

In its IPO filing process Twitter took advantage of one of the key available provisions of the JOBS Act. Section 6(e) of the Securities Act allows an “emerging growth company” to file an IPO registration statement on a confidential basis. This provision is designed to give the company and the SEC time to identify and work through potential problem areas or issues before investors see any information. It also allows companies to keep material nonpublic information confidential until late in the SEC review process. If the company decides not to proceed with its IPO, it has avoided the public disclosure of this information. If the company and the SEC can work out these problems and issues satisfactorily, the registration statement (amended as necessary) eventually becomes available to the public and the IPO process goes forward. This should make the registration process very quick and efficient after it emerges from the initial SEC review.

Yet Another Rule to Discourage Companies From Going Public

sec-seal

There has always been a tension between regulating the capital markets to protect the public and making capital formation more efficient. While I was focusing on Tuesday’s meeting SEC Advisory Committee on Small and Emerging Companies discussing changes to private placements, the SEC passed another rule that smacks public companies. Now public companies need to start worrying about the ratio of the CEO’s compensation to the median compensation of all employees.

I think it’s a silly rule that will do nothing except fire up shareholder activists and further discourage companies from going public.

At least this rule is not the fault of the Securities and Exchange Commission. Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act mandated this rule. Blame Congress, not the SEC.

(b) ADDITIONAL DISCLOSURE REQUIREMENTS.—

(1) IN GENERAL.—The Commission shall amend section 229.402 of title 17, Code of Federal Regulations, to require each issuer to disclose in any filing of the issuer described in section 229.10(a) of title 17, Code of Federal Regulations (or any successor thereto)—

(A) the median of the annual total compensation of all employees of the issuer, except the chief executive officer (or any equivalent position) of the issuer;

(B) the annual total compensation of the chief executive officer (or any equivalent position) of the issuer; and

(C) the ratio of the amount described in subparagraph (A) to the amount described in subparagraph (B).

There is an exception for Emerging Growth Companies from the rule. Yet another benefit to grabbing this status under the JOBS Act.

The SEC did not mandate any particular methodology for the calculation. This rule will be a big challenge for bigger companies and multi-national companies.

I also wonder if there will be a math problem with companies using “average” instead of “median.” Surely, at least one company will put someone in charge of the calculation that does not know the difference.

References:

The Fall of Fredrick Douglas Scott

frederick d scott

Fredrick Douglas Scott was named one of Ebony magazine’s “Top 30 under 30”, claiming to be the youngest African-American to found a hedge fund. In April 23, 2012, his company, ACI Capital Group, filed a Form ADV showing $3.7 billion in assets under management.

It was a lie and Mr. Scott is a thief.

Perhaps the SEC should have noticed the red flag when ACI’s AUM increased dramatically to $3.7 billion. One month earlier, ACI had filed a Form ADV with $100 million in assets under management.

According to the SEC complaint, the $3.7 billion consisted of  illiquid foreign bonds, rights to real property in the Republic of Cameroon and Guadalajara, Mexico, and a Honduran mine. The complaint, among many charges, contains a charge of violation of Section 203A of the Investment Advisers Act for registering with the SEC instead of the state regulators since he actually had less than $25 million in assets under management.

Of course it is up to the SEC to prove the charges. However, Mr. Scott already plead guilty to wire fraud conspiracy to steal over $1 million from investors and lying to official from the SEC.

“Fredrick Douglas Scott admitted that he used ACI Capital to steal his clients’ investments and fund his own lavish lifestyle. Rather than the historic figure he presented to the media, Scott stands revealed as a common thief who lied his way into his investors’ pockets and then continued his web of lies when confronted by the SEC. Scott has now been brought to justice for lying, cheating, and stealing for his own personal financial gain.”
United States Attorney Loretta E. Lynch.

References:

Unraveled: The Fall of Marc Dreier

Unraveled and Compliance

Had it not been for Bernie Madoff, Marc Dreier would likely have been the most notorious fraudster of recent memory. The press coverage was stolen away from Mr. Dreier’s $3/4 billion scam by the billions Madoff stole. But Dreier’s theft was much more brazen and a lot crazier.

Over the weekend, between shuttling the kids to activities, mowing the lawn, and football, I managed to watch Unraveled. It tells the Dreier story and interviews him during the 60 days between the day he plead guilty and his sentencing hearing.

Trapped in his gilded cage, an Upper East side apartment with breathtaking views, Dreier struggles with his uncertain future. He knows he will be in prison for a long time. The prosecution wants over 100 years and he is asking for 12 years. He is hoping that he will be imprisoned close enough to Manhattan that his family could visit more often. And he is hoping his sentence will offer some hope that he could live long enough to once again be free.

The movie offers a great deal of insight into the mind of fraudster and the motivations to start criminal activity.

Dreier was an ambitious lawyer, with dreams of running a big law firm. He has an outsized ego and wanted to drape himself with expensive things that showed success: expensive art, expensive cars, mingling with celebrities, and big donations to charity. His rapidly expanding law firm was sucking in capital and all of those expensive things were… expensive.

Dreier wanted to be perceived as being successful and wanted others to recognize his success.

Dreier had drained his credit and was desperate for another $1 million. So desperate that he created a fictitious note from one of his clients and found a buyer. He thought he could invest the cash in his law firm and create enough income that he could pay back the note. A year later when the note matured, he didn’t have the capital and needed to roll it over. And he needed more capital. So he faked a bigger note. This steamrolled over the next few years enough that he ended up with $740 million in stolen cash.

Dreier used one of his real estate company clients as the front. He knew enough about its business that he could make financial statements that were credible enough. He felt that this client owed him. Dreier had been sanctioned by a judge for being too aggressive. Dreier felt the client should have spoken out in favor of him, but instead stayed silent. Dreier repaid that perceived betrayal by having that company be the one issuing Dreier’s fake notes.

If you have any interest in financial fraud or compliance, it’s worth 90 minutes of your time to watch the movie. It’s currently streaming on Netflix.

Compliance Bricks and Mortar for September 13

These are some of the compliance-related stories that recently caught my attention

Embattled J.P. Morgan Bulks Up Oversight by Monica Langley and Dan Fitzpatrick in the Wall Street Journal

J.P. Morgan Chase & Co., facing a host of regulatory and legal woes, plans to spend an additional $4 billion and commit 5,000 extra employees this year to clean up its risk and compliance problems, according to people close to the bank.

As part of a companywide effort, the bank is spending an additional $1.5 billion on managing risk and complying with regulations, including a 30% increase in risk-control staffing, these people said. In addition, it expects to add $2.5 billion to its litigation reserves in the second half of the year, these people said.

The 506(c) Seed Financing Blues by William Carleton

I know I can’t just take from any Joe
Investment in my fledgling startup co.

But come the 23rd this month, I hear,
It’s dope to advertise with brazen cheer

My need for funds. The only legal catch:
My purchasers must be accreds. (Well, natch.)

FCPA Compliance and Ethics Report: The weekly report on all things compliance related by Tom Fox

The FCPA Compliance and Ethics Report, Episode 3 Videoblog

SEC Names Paul Levenson as Director of Boston Regional Office

Mr. Levenson joins the SEC from the U.S. Attorney’s Office for the District of Massachusetts, where he is an Assistant U.S. Attorney and Chief of the Economic Crimes Unit that is responsible for investigations and prosecutions of financial crimes. Mr. Levenson has successfully coordinated many criminal investigations with the SEC’s Division of Enforcement during his tenure in the U.S. Attorney’s Office. He will begin working at the SEC in late October.

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Image is Germany Luebeck townhall bricks (detail) by Arnold Paul
http://commons.wikimedia.org/wiki/File:Germany_Luebeck_townhall_bricks_%28detail%29.JPG

cc by sa

There Is No Secret International Market for Prime Bank Investments

scams

If someone approaches you about investing in a Prime Bank investment program, walk away. Do not give them your time or money. It’s a scam.

There is an undercurrent of distrust in the financial markets, thinking that the big players have some secret way to make massive amounts of money with no risk. What better way to prey on this distrust that to hook a gullible target into investing alongside these players in this dark, international market.

The fraudsters have an air of secrecy and promise extraordinary returns to leverage the acquisition of prime bank instruments. For some reason, these prime banks sell notes at greatly reduced prices to quickly and secretly raise capital.

The SEC recently shut down one of this scams. Unfortunately, the fraudsters managed to lure in 45 investors and $3.6 million of their cash. The fraudsters added a new wrinkle to the scam by promising to keep the investors’ cash in an attorney’s escrow account until the attorney received proof that the bank had received a stand-by letter of credit which the investors were leasing from a European banking group.

“Leasing” a standby letter of credit?!?

Even after falling for that, there was the lure of a respectable attorney holding their cash. Unfortunately, the Securities and Exchange Commission claims that the attorney, Bernard H. Butts, was in on the scam. (It’s up to the SEC to prove his guilt.)

Interestingly, Butts himself had apparently fallen for an investment scam. According to news report, he had apparently “invested” with Jason Meyer who held out no-risk investments in Mexican historic bonds, tropical timber and fantasy Ecuadorean gold mines. Meyer had claimed that Butts’ initial investment was performing well and arranged to have $1 million of profit wired back. Instead, Butts doubled down and reinvested that cash. Then he sent another $1 million for more investments. Meyer was fraudster. Butts lost nearly all of that cash.

What motivated Butts to get involved in the prime bank scam? Maybe he had learned techniques from Meyer. Maybe he was desperately trying to get back some of the cash he had lost. Maybe he was duped into acting as escrow agent and didn’t realize there was a scam going on again.

But we can learn from this. There is no such thing as a lucrative market for prime bank investments.

References: