The Proposed New Regulation A for Fundraising

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Title IV of the Jumpstart Our Business Startup (JOBS) Act mandated changes to the moribund Regulation A offering process. That law raised the bar from $5 million to $50 million and prodded the SEC into making changes. The SEC issued the proposed rule with enough interesting treats that it may be worth exploring. The SEC is treating it like an IPO-lite as opposed to the wary eye cast on private placements.

The proposal splits Regulation A offerings into two baskets. Tier 1 offerings can be for up to $5 million a year. Tier 2 offerings can be for up to $50 million per year. By stepping up to Tier 2, the company’s financial statements must be audited and company must file semiannual reports and updates similar to public company reporting.

The part the SEC got right is that Tier 2 offerings would be exempt from state registration. The existing Regulation A’s failure to preempt the state blue sky laws is a major reason it is not used. I don’t see why the SEC would even bother with an offering type that does not preempt state blue sky laws. Tier 1 offerings under Regulation will likely continue unused.

The real nasty part is that investors are limited to purchasing no more than 10% of an investor’s net worth or annual income. That’s a big red flag. However, the SEC took the smart approach and did not turn that into a compliance requirement. The company needs to make investors aware of the 10% restriction, but can rely on a representation from the purchaser. The investor does not have to disclose personal information to verify compliance.

The proposal makes Regulation A a quirky middle ground to private placements and public offerings.

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Compliance Bricks and Mortar for December 20

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

SEC Enforcement Statistics: A Work in Progress? by Thomas O. Gorman in SEC Actions

The SEC released Enforcement Division statistics for government Fiscal Year 2013 along with a table and chart listing the number of actions filed each year as well as the amount of disgorgement and penalties ordered. The SEC Press Release states also states that in the last fiscal year the program obtained a record $3.4 billion in “monetary sanctions against wrong doers.” That amount is 22% higher than fiscal 2011 when the agency brought a record number of enforcement actions.

How These 5 Dirtbags Radically Advanced Your Digital Rights by David Kravets in Wired.com’s Threat Level

Bad facts make bad law, as the legal saw goes. But it cuts both ways: Sometimes bad people make good law. Consider the following exhibits: a cocaine dealer, a child pornographer, a purveyor of suspect penis-enlargement pills, and two accused hackers. The courtroom challenges they brought resulted in rulings that dramatically expanded your rights, from helping to keep your email and whereabouts private to reducing gadget searches at the U.S. border and limiting the legal definition of unlawful hacking.

Jan. 8 Webcast: SEC Enforcement – Key Developments in 2013 in Securities Docket

In this webcast analyzing key developments in SEC enforcement, our panel will discuss notable events from 2013 and emerging issues for 2014.

Hedge Fund Advisers’ Systemic Risk Disclosures in Bankruptcy by Wulf Kaal in The CLS Blue Sky Blog

The significant increase of hedge fund participation in the bankruptcy process, among other factors, resulted in an increased emphasis in the literature on the role of hedge funds in bankruptcy. Scholars, practitioners, and members of the federal bankruptcy bench voiced concern over hedge funds’ hidden agendas and offsetting positions, hedge funds’ attempts to manipulate the negotiation and reorganization process, and their seeking control of the debtor at the expense of other stakeholders. Because of their perceived detrimental impact on the bankruptcy process, some commentators have labeled distressed hedge fund investors as “vultures.” Others emphasize the liquidity provided by hedge funds and the corresponding enhancement of the restructuring process.

Volker Rule and Real Estate Funds

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Five regulatory agencies adopted the final rules that implement the Volcker Rule, a provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act. It’s a big, complicated, ugly rule that will drive compliance officers at banks crazy trying to implement. Have fun reading all 964 pages. The text of the regulations themselves only run on for 70 of those pages

From the position of a private fund sponsor there is one section to pay particular attention to. Subpart C of the Volker Rule prohibits banks from owning or sponsoring a “covered fund”. That definition comes from section 13(h)(2) of the Bank Holding Company Act and is any entity that would be an investment company, but for the exclusions under sections 3(c)(1) and 3(c)(7) of the Investment Company Act. That picks up hedge funds and private equity funds. It will also likely pickup real estate funds whose managers registered as investment advisers.

The Rule also explicitly pulls in some commodity pools. There is some fine print there to focus on. Those real estate fund managers that didn’t register as investment advisers, but did file as commodity pool operators may be stuck with the Volker Rule. It’s tough to figure out what the agencies are trying to grab, but my best guess is that the rule applies if the fund relies on a 4.7 exemption, but may not apply if the fund relies on the 4.13 exemption.

The Rule does allow for a small ownership interest, as long as it does not exceed 3% of the total value of the total number or value of the outstanding ownership in the fund. (See Section 12(a)(2)(ii)(A).) From the bank’s perspective, it cannot have more than 3% of its Tier 1 capital in covered funds.

As for a real estate fund, it may still be able to be exempted from the restrictions under the Volcker Rule. It would have to rely on the nebulous section 3(c)(5)(c) exemption under the Investment Company Act. The fund may also have to limit its use of interest rate derivatives to stay outside the definition of a “commodity pool” under the Commodity Exchange Act.

The end result for real estate funds is likely minimal. Clearly the big investment bank-sponsored funds will go away. Bu that has been happening for the past few years. Just look at the PERE Charts to see those funds dropping down and off the list. They will continue to be sellers and not buyers. It does look like separate accounts and other types of real estate investments may be permitted for banks.

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Criminal Background Checks for IA Reps in Massachusetts

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There is a new requirement for Investment Advisers Representatives in Massachusetts. Beginning on January 1, 2014 each applicant for registration as an investment adviser representative in Massachusetts will be required to submit a Criminal Offender Record Information (“CORI”) acknowledgement form.

The Secretary of State published proposed changes to the Investment Adviser regulations in March. The changes are effective on January 1, 2014.

The CORI acknowledgement form will be made available in fillable .pdf format on the Division’s website at the URL http://www.sec.state.ma.us/sct/sctcori/cori.htm and is a required component of a complete application. But the IARD system won’t take the form so the completed and executed CORI acknowledgement form has to be filed by e-mail submission to the address [email protected].

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Private Fund Is Sanctioned for Valuation Issues

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The Securities and Exchange Commission brought another case out of its Aberrational Performance Inquiry initiative in the Enforcement Division’s Asset Management Unit. That initiative identifies funds with suspicious returns and flags performance that is inconsistent with a fund’s investment strategy or other benchmarks forms a basis for further investigation and scrutiny. The initiative nabbed GLG Partners for overstating its stake in an emerging market coal mining company.

This case’s headline caught my attention because it’s a challenge of a hard-to-value asset.  A private equity stake in a company is a Level 3 asset that can’t be determined by outside data sources. I would expect that a fund that used a thoughtful process and could justify its assumptions in a valuation should not have the value challenged by the SEC.

For private funds, valuation is a key area of focus for the SEC. I’ve heard from examiners that they are looking for consistent valuation process with justified assumptions for hard to value asset.

GLG appears to have a few red flags on its valuation that would raise questions. GLG bought the 25% stake in Sibanthracite for $210 million March 20, 2008. Just 11 days later, GLG wrote up the value to $425 million on March 31. That’s a big jump in value.

The asset stayed at the $425 million valuation until December 2010. That’s a long time for an asset to stay at the same value. According to the SEC order, there was a failure in GLG’s process to determine the fair value of the investment.

I hope one of the reasons that the action was taken was because of the resulting impact the valuation failure had on the management fees earned by GLG. The inflated valuation resulted in GLG earning extra management and administration fees of about $7.8 million.

GLG was a hedge fund and earned its management based on valuation. That is unlike the private equity fund model where the fund does not typically earn a management on an increased valuation, but instead earns a promote on a realized value.

The investment happened just before the financial crisis in the fall of 2008 and the improper valuation occurred during the turmoil of 2009 and 2010. According to news reports, GLG created a side pocket for the Sibanthracite holding, limiting investors’ ability to redeem from the fund.

The SEC also piled on and faulted GLG for improper statements of AUM on its Form ADV filings.

The reports are not clear on how GLG came to the attention of the SEC. The press release credits the Aberrational Performance Inquiry initiative. I’m skeptical that GLG was flagged for over-performance when the investment was not subject to market pricing. Perhaps the Aberrational Performance Inquiry initiative it just running all of the cases where there are valuation issues.

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Compliance Bricks and Mortar for December 13

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

How Financial Institutions May Benefit from Changes to the Rule Against Perpetuities by Reid K.Weisbord in the CLS Blue Sky Blog

Now that most jurisdictions have repealed or abrogated the Rule Against Perpetuities, estate planning practitioners have started to consider whether a trust created to comply with the Rule could, after the Rule’s repeal, be extended in perpetuity to provide for future generations of the settlor’s descendants. In my forthcoming article, Trust Term Extension, I examine the issue of whether trust law doctrines would permit this type of modification. In particular, the article focuses on the trust law doctrines of equitable deviation and modification to achieve the settlor’s tax objectives.

An SEC Investigation Can Be A Bad Day, But It Can Get Worse by Thomas O. Gorman in SEC Actions

Becoming involved with an SEC investigation is a bad day for any company and its executives. There are things that can be done to make it better. There are also ways to make it worse, much worse. Executives at Vitesse Semiconductor Corporation, when face with a possible option backdating investigation, are an example of how to make it worse.

For Bitcoin, Square Peg Meets Round Hole Under the Law by Peter J. Henning in Dealbook

There is a Wild West quality to Bitcoin, created out of a libertarian bent that connotes a world beyond government regulation. Like any currency, it carries with it a degree of anonymity, much as the phrase “cash is an orphan” signals that money can be largely untraceable once put into circulation. More than ordinary cash, though, Bitcoin operates largely outside the current banking system, making it even more difficult to trace transactions.

An important real-world conflict of interest experiment in Conflict of Interest Blog

The results of this real-world experiment powerfully demonstrate the impact on the ethicality of conduct that financial incentives can have – even on the judgment of individuals who, by virtue of their professional norms, are supposed to be resistant to COIs.

Senator Levin Urges SEC to Toughen Proposed Monitoring of Reg. D Post Ending of General Solicitation Ban in Jim Hamilton’s World of Securities Regulation

Senator Carl Levin (D-MI) said that the SEC’s proposal to monitor concerns over permitting issuers to engage in general solicitation under Rule 506 pursuant to the JOBS Act do not go far enough to protect investors from fraudulent offerings on what the Senator called “the soon-to-be “Wild West” that now exists under the final Rule 506. In a letter to the SEC, he urged the Commission to further enhance the proposal to ensure that investors in Rule 506(c) offerings are provided with full disclosure information and that such investors are actually accredited investors as required by Congress.

Participating Bad Actors and Private Funds

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The SEC staff issued new Compliance & Disclosure Interpretations relating to Rule 506(d), the new bad actor rule. Under the rule, an issuer may not rely on the Rule 506 exemption if the issuer or any other person covered by rule has a relevant disqualifying event that occurred on or after September 23, 2013 (the effective date of the rule 506).

It’s a tricky rule, mandated by Dodd-Frank. Conceptually, I agree that the law should not permit bad guys to participate in private offerings of securities. The devil is in the details.

One murky item was what it meant to “participate” in the offering. For a big placement agent or brokerage, it’s easy to wall someone off. But how does that work from the perspective of the issuer? The SEC offered two new answers to questions about “participation.”

Question 260.18

Question: Does the term “participating” include persons whose sole involvement with a Rule 506 offering is as members of a compensated solicitor’s deal or transaction committee that is responsible for approving such compensated solicitor’s participation in the offering?

Answer: No.

Question 260.19

Participation in an offering is not limited to solicitation of investors. Examples of participation in an offering include participation or involvement in due diligence activities or the preparation of offering materials (including analyst reports used to solicit investors), providing structuring or other advice to the issuer in connection with the offering, and communicating with the issuer, prospective investors or other offering participants about the offering. To constitute participation for purposes of the rule, such activities must be more than transitory or incidental. Administrative functions, such as opening brokerage accounts, wiring funds, and bookkeeping activities, would generally not be deemed to be participating in the offering.

Those question are clearly addressed to placement agents and brokers, not to issuers.

So who is “participating” in the offering at a fund manager?

The rule explicitly covers the fund manager. But the fund manager is rarely an individual.

The rule explicitly covers “any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with such sale of securities.” That would cover the marketing group, if any of them are getting paid a commission. Of course that raises the other issuer of whether the marketing group is subject to broker-dealer registration.

The rule also includes any “general partner or managing member of any such investment manager.” Those are legal terms and could be avoided by the organizational structure and titles granted to the manager’s principals. But I would include the principal owners of the fund manager.

Then the rule moves down the next rung and includes “any director, executive officer or other officer participating in the offering of any such investment manager”.  The SEC release clearly said that merely being an officer, does not bring you into the scope of the rule’s disqualification. An “officer” test based solely on job title would be unduly burdensome and overly restrictive.

Participation in an offering would have to be more than transitory or incidental involvement, and could include activities such as participation or involvement in due diligence activities, involvement in the preparation of disclosure documents, and communication with the issuer, prospective investors or other offering participants.

That brings the marketing group clearly back into the rule because is communicates with prospective investors.

I have trouble with “preparation of disclosure documents.” Lots of people in the organization help to prepare the disclosure documents and are involved in due diligence activities.

I was hoping the SEC’s new interpretations would help narrow the scope of those covered by the rule at the fund manager. But they do not.

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Snow Shoveling and Compliance

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A winter storm has been hitting big chunks of the United States over the last few days. For me, in Boston, it’s just a small accumulation. That’s enough to cause a nuisance and snarl the morning commute.

For me, one test of compliance is snow shoveling. Did my neighbors shovel their sidewalks so people can pass safely?

I live in a neighborhood where there are lots of walkers. The elementary school is just down the street and most kids walk to school. Many people in the neighborhood walk to the nearby bus stops and train station for their commute into Boston. Property owners should clear their sidewalks. It’s the right thing to do.

Of course, being in the suburbs many people just drive everywhere. They think the strip of concrete between their house and the street is merely a place to put the barrels on trash-day. That potentially endangers pedestrians who may be forced into the street or may slip and fall on the uncleared sidewalk.

My town has contemplated enactment of shoveling ordinance, making it an offense if your sidewalk is not shoveled within 24 hours after the end of the storm. The ordinance would turn an ethics issue into a compliance issue.

What do you shovel first, your driveway or your sidewalk? What’s more important to you? To your neighbors?

Compliance Bricks and Mortar for December 6

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

When blowing the whistle is a conflict of interest in Conflicts of Interest Blog

Employees generally owe duties of loyalty to their companies (at least under US law), but for some time whistleblowing has not seen as a breach of such duty. This was the underpinning of an important Supreme Court case thirty years ago – Dirks v SEC – which held that an employee who told a securities analyst about a fraud at the employee’s company had not breached a fiduciary duty to the company (and hence under applicable law the securities analyst could not be prosecuted for insider trading based on this disclosure). But not all duties of loyalty are the same, and lawyers (and other professionals) are typically seen as having a stronger duty in this area than are employees in general.

When Good People Do Bad Things by Peter J. Henning in DealBook

That is the conundrum of many white-collar crime cases: successful business people act in ways that put careers and personal fortunes at risk for seemingly modest gains, and sometimes the misconduct benefits their company but themselves only indirectly.

SEC CustodyFest Vol. 2: Electric Boogaloo by David Smyth in Cady Bar the Door

I know you’ve been eagerly awaiting the return of SEC CustodyFest. Let’s turn to the second matter brought by the SEC on October 28th: Further Lane Asset Management. This case actually did not revolve around the investment adviser custody rule; other issues were at play as well.

Hedge-fund ‘Fight Club’ traded illegal tips instead of punches by Bloomberg in CTpost.com

The hedge-fund analysts vacationed together in the Hamptons, gambled in Las Vegas and adopted a creed that parodied the rules in the Brad Pitt film “Fight Club.” Instead of trading punches, they traded illegal tips that allowed their portfolio managers to reap tens of millions of dollars in profit. Having pleaded guilty to insider trading, four of the men are now set to be witnesses against SAC Capital Advisors fund manager Michael Steinberg.

Notes for building a chart comparing crowdfunding exemptions by William Carleton

On the working theory that more states are going to establish investment crowdfunding exemptions, I’m thinking it makes sense to start building a chart to compare them all. And to compare state exemptions against the prospective federal exemption under Title III of the JOBS Act.

AML: A Corporate Governance Issue by Wilmer Hale (.pdf) in the Banking Law Journal

Bank Secrecy Act (“BSA”) was passed, there is no doubt those efforts have picked up intensity in recent years and that this increased focus will continue. Indeed, the comptroller of the currency has said that “[i]n the wake of the financial crisis, too many banks inappropriately cut staffing and spending for BSA and anti-money laundering compliance as austerity measures.”