Month: October 2016

SEC Clears the Way For Intra-State Crowdfunding

Most states have passed crowdfunding laws. One of the barriers has been the breadth of the federal preemption of interstate securities transactions. To be intra-state, and therefore out of the jurisdiction of the Securities and Exchange Commission, the investors and the company doing the fundraising needed to all be in the same state. The problem is the widespread use of Delaware as a state of organization. That puts the company in Delaware, while the operations and investors are in another state.

Crowdfunding

It was good to see states experimenting with crowdfunding. The SEC regulations of equity crowdfunding have proven to be difficult. Now the SEC has cleared the way for a broader definition of intra-state.

For example, the Massachusetts crowdfunding regulation, 950 CMR 14.402(B)(13)(o), required the issuer to have its principal place of business in Massachusetts and to be formed in Massachusetts.

The adopted a new Rule 147A  and amendments to Rule 147 to address the crowdfunding limitations. The SEC had adopted Rule 147 in 1974 as a safe harbor to a statutory intrastate exemption under Section 3(a)(11) of the Securities Act of 1933.

The new Rule 147A has changed the requirement so that the issuer merely has to have its “principal place of business” in that state and satisfy at least one “doing business” requirement to demonstrate the in-state nature of the issuer’s business.

Of course, the SEC does not make intra-state crowdfunding legal. It’s subject to state regulatory requirements. Massachusetts, and most states, will need to revise their crowdfunding laws to open up to these broader rules.

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Crowdfunding is by Rocio Lara
CC BY SA

CCO Needs To Be a Jack of All Trades

Andrew Donahue, the Chief of Staff of the Securities and Exchange Commission gave a speech earlier this month to the National Society of Compliance Professionals National Conference. He was attempting to share his thoughts on the current and future challenges that compliance professionals in the financial services area face.

He envisions that CCOs will need to be a “jack of all trades with access to a wide array of skillsets.”

jack-of-trades-bigest-swiss-army-knife

In the past, compliance merely required an expertise in the applicable laws and regulations.

Now it requires expertise in technology, operations, market, risk, and auditing. Firms are changing rapidly, and markets are rapidly evolving and regulations are only getting more voluminous. Mr. Donahue points out that staying up to date is one of the biggest challenges for complaince professionals.

“It is critical that you make it a priority to develop the necessary technical expertise, keep up with changing market dynamics, fully appreciate all of the firm’s businesses and follow regulatory developments and their impact on your firm and its operations.”

I fear that Mr. Donahue should remember, and compliance professionals shoudl strive to avoid, the second half of the phrase: Jack of all trades and master of none.

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Co-Investments and the SEC

Last year, regulators from the Securities and Exchange Commission raised concern about co-investments. The statements were vague about what was bothering the regulators.

Co-investments allow a private equity to lower its exposure to an investment and give others an opportunity to invest along side the fund at a discounted rate. It can be an opportunity to lure investors into the fund by granting them preferential treatment to co-investments. This would lower the effective management fee costs the investor pays to the manager.

Many fund investor are interested, but its hard to spread the opportunities equally out to all of those interested. Splitting the co-investment equally will result in opportunities being so small per investor that it’s not worth the time, effort and money.

The biggest concern for fund managers is execution. It takes a great deal of effort to put the capital stack together for an acquisition. The fund manager needs a potential co-investor to be able to act quickly and decisively.

From the SEC’s perspective, I assume examiners would not be happy to find fund managers dangling the possibility of co-investments as an incentive for an investor to commit to the fund and then not actually offering co-investments to that investor.

Fund managers need to be honest with investors and let them know where they stand in line for co-investments. If a fund manager has offered priority co-investment rights to certain investors, the manager disclose this.

The other concern of regulators and one which should be a concern is allocating deal costs. If the deal goes ahead, co-investors should pay their portion of the deal costs. Last year, the SEC raised concerns about broken deal costs when co-investments are used on a regular basis. The SEC felt that not all of the broken deal costs should be paid by the fund when co-investments were a routine part of the investing strategy.

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When Does A Stock Picking Contest Turn Into a Derivative

Forcerank’s premise was simple: “fantasy sports for stocks”.

Forcerank runs mobile phone games where players predict the order in which stocks would perform relative to each other.  In its original form, if a player did well he or she won points and could some receive a cash prize. Forcerank kept 10 percent of the entry fees.

The gaming is a ruse to collect data. Forcerank iss looking to obtain data about market expectations that it hopes to sell to hedge funds and other investors.

forcerank

It seems clear to me that Forcerank was concerned about the gambling aspect of the app. There was a provision in the rules the stated the Forcerank contest was a “skill based” contest. If it were not skill-based (i.e luck) then it would be gambling. You pay an entry fee and if you win you get a prize. If winning is based on luck it’s gambling.

The Securities and Exchange Commission looked at the Forcerank contest in a different light.

Dodd-Frank gave the SEC new powers to regulate security-based swaps.

The Commodity Exchange Act defines the term “swap”:

“[T]he term ‘swap’ [includes] any agreement, contract, or transaction—… (ii) that provides for any purchase, sale, payment, or delivery (other than a dividend on an equity security) that is dependent on the occurrence, nonoccurrence, or the extent of the occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence[.]”

That’s a very broad definition. It was a definition that the SEC applied to the Forcerank contests.

[E]ach Forcerank entry was a swap because each participant paid to enter into an agreement with Forcerank LLC that provided for the payment of points and, in certain cases, cash. Those payments were dependent upon the occurrence, or the extent of the occurrence, of an event or contingency (i.e., the player’s predictions about the price performance of individual securities being compared to actual performance and the player’s aggregate points being compared to other players). Such event or contingency was “associated with a potential financial, economic or commercial consequence” because it was calculated by measuring the change in the market price of an individual security over a period of time and comparing that change to an identical metric based on the market price of other individual securities.

I find this an interesting roadblock to stock-picking contests.

I looked at the Forcerank website and downloaded the app. There is no longer an entry fee and there are no cash prizes. That removes it from the definition of “derivative”. It also removes the incentive to enter the contest and the revenue stream from Forcerank.

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The SEC’s Pay-to-Play Rule and California Labor Law

Keith Bishop chimed in on Campaign Contributions and the SEC in the context of California law: Pay-To-Play Meets The California Labor Code at the California Corporate & Securities Law blog.

He point to  California Labor Code:

Section 1101.
No employer shall make, adopt, or enforce any rule, regulation, or policy:

(a) Forbidding or preventing employees from engaging or participating in politics or from becoming candidates for public office.
(b) Controlling or directing, or tending to control or direct the political activities or affiliations of employees.

Section 1102.
No employer shall coerce or influence or attempt to coerce or influence his employees through or by means of threat of discharge or loss of employment to adopt or follow or refrain from adopting or following any particular course or line of political action or political activity.

Obviously there is some conflict from the face of the code with SEC Rule 206(4)-5 that limits certain employees of registered investment advisers from making campaign contributions to certain elected officials.

You may disagree with the rulings, but political campaign contributions are considered political activities. The SEC rule therefore limits political activities.

That puts the CCO of a registered investment adviser in a precarious position. On the one hand, violating the SEC rule could result in the loss of a great deal of money for the adviser.  On the other hand the CCO’s policy may be violation of California law.

Mr. Bishop cites Couch v. Morgan Stanley & Co., a 2016 federal court decision that looked at those sections of the California Labor Code. That court found that it was okay to fire someone for legitimate, non-political reason even though the underlying action was related to political activity. In that case, Mr. Couch was elected to the county board of supervisors. Morgan Stanley told him he could not hold both jobs based on time constraints.

I suppose that helps a bit. The limit on campaign contributions is set by a federal agency, not an employer made rule. It’s not the employer imposed rule. The rule is non-political in that, on its face, it does not apply to a political position, but to a political office.

One problem is the perception cast by advisers who want to do business with Indiana. They are telling their employees that donations to the Republican presidential candidates are limited, but there are no limits on the other candidates. It’s to meet the standards of the rule, but comes across as very political.

Of course that does leave the problem of how to implement the rule and Goldman Sachs’ implementation of the rule. Goldman banned contributions. That seems to be more than required by the federal rule and could be seen as unduly limiting the employee’s activities.

I know many advisers have taken the same position as Goldman Sachs and banned all political contributions by all employees. The intricacies of the SEC rule make anything more tough to manage. Others have pointed out that such a position may be in conflict with California law. Thanks to Mr. Bishop for pointing out the law on the issue.