Category: Fundraising

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.

The New Rule 506(d) and Bad Actors

baD BOYS

At its latest meeting, the Securities and Exchange Commission approve the rule that lifted the ban on general solicitation and advertising for certain private placements. The SEC also adopted the new rule that disqualifies felons and other bad actors from participating in certain securities offerings. The first rule was mandated by the JOBS Act. The “bad actor” rule was mandated by Dodd-Frank.

The bad actor rule makes private placements a bit harder and will require private funds and companies to do more homework in connection with the fundraising. That’s because an issuer cannot rely on the Rule 506 exemption if the issuer or any other person covered by the rule had a “bad actor disqualification.”

I think the starting point is who is covered by the rule. The rule applies to

  • The issuer, including its predecessors and affiliates
  • Directors, executive officers, general partners, and managing members of the issuer
  • Any other officer participating in the offering
  • Anyone who holds 20% or more of the outstanding voting equity securities
  • Investment managers and principals of pooled investment funds
  • Any general partner or managing member, director, executive officer or other officer participating in the offering of a fund sponsor
  • Solicitors paid to sell the securities investors as well as the general partners, directors, officers, managing members or other officer participating in the offering

For fund managers registered with the SEC the employees affected are a narrower group than those in Item 11 on Form ADV. That part of the Form ADV disclosure applies to all employees, other than employees performing only clerical, administrative, support or similar functions. Plus the Form ADV includes all of the officers, partners, directors, and certain affiliates.

The big difference is the 20% threshold for ownership in the company. For startups, that would likely pull some angel investors into the “actor” category.

It’s not clear what to do if the 20% investor is an entity. The rule does not seem to cover that circumstance. I suppose that if Bernie Madoff set up Scumbag Bernie Investor LLC to invest in the fund that would be a mere facade to hide his ownership. If the entity has multiple owners and officers it seems that a single “bad actor” inside the investor should not taint the whole entity.

The other fuzzy item is “officers participating in the offering.” The SEC had declined to merely use job title as the defining line. That would have included everyone who had the title of vice president.

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.

I’m not sure how I feel about that guidance. A lot of people end up reviewing the Private Placement Memorandum.

Of those relevant actors to determine if they were bad, they need to have been involved in a “disqualifying event” which includes:

  • Criminal convictions in connection with financial fraud.
  • Subject to an order of judgement that limits involvement in the securities industry.
  • Subject to an order of judgement that limits involvement in the banking industry
  • Subject to an order of judgement from the CFTC.
  • Subject to a US Postal Service false representation order.

The actual list is much more convoluted, long, and unwieldy. That means putting together a questionnaire will be difficult. For private fund adviser, it does not match up squarely with the Form ADV disclosures and is not as clearly written as the Form ADV disclosures.

The default would be to put together a questionnaire and just use the text of Rule 505(d). I’m not sure it’s comprehensible by a non-lawyer. Actually, I’m not sure it’s easily comprehensible by a lawyer. I just added it to my questionnaire for Form ADV, making it extend to four pages.

The next question is how much diligence you need to conduct to determine if one of your “actors” is a “bad actor”? The rule requires the issuer to exercise “reasonable care.” Which in “light of the circumstances, the issuer made a factual inquiry into whether a disqualification exists.”

That’s the kind of fuzziness that keeps a compliance officer up at night.

Fortunately, the SEC offers some color to the “reasonable care” in the release.

For example, we anticipate that issuers will have an in-depth knowledge of their own executive officers and other officers participating in securities offerings gained through the hiring process and in the course of the employment relationship, and in such circumstances, further steps may not be required in connection with a particular offering.

So the questionnaire approach should work for employees, unless you have some suspicion that an employee has been up to no good.

What about for investors?

Factual inquiry by means of questionnaires or certifications, perhaps accompanied by contractual representations, covenants and undertakings, may be sufficient in some circumstances, particularly if there is no information or other indicators suggesting bad actor involvement.

That’s enough to let me fall asleep at night. Maybe I’ll need just a little bourbon to take the edge off.

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What to Make of the New Rule 509

509

While I was waiting to see what surprises the Securities and Exchange Commission had included in the rule lifting the ban on general solicitation and advertising for private placements, the SEC slipped in an unexpected surprise. The SEC is proposing a new Rule 509.

Rule 509 would require disclosures on “any written communication that constitutes a general solicitation or general advertising.”

(1) The securities may be sold only to “accredited investors,” which for natural persons are investors who meet certain minimum annual income or net worth thresholds;

(2) The securities are being offered in reliance on an exemption from the registration requirements of the Securities Act and are not required to comply with specific disclosure requirements that apply to registration under the Securities Act;

(3) The Commission has not passed upon the merits of or given its approval to the securities, the terms of the offering, or the accuracy or completeness of any offering materials;

(4) The securities are subject to legal restrictions on transfer and resale and investors should not assume they will be able to resell their securities;

(5) Investing in securities involves risk, and investors should be able to bear the loss of their investment.

(6) For private funds: the securities offered are not subject to the protections of the Investment Company Act.

These are not a big deal by themselves. I already have some variation of these lined up for pitchbooks and marketing materials. Given that we have no better definition of what constitutes “general solicitation and advertising” I expect we’ll see these in all materials.

The other requirement is a disclosure for performance data used by private funds.

  • the performance data represents past performance.
  • past performance does not guarantee future results.
  • current performance may be lower or higher than the performance data presented.
  • the private fund is not required by law to follow any standard methodology when calculating and representing performance data.
  • the performance of the private fund may not be directly comparable to the performance of other funds.
  • a telephone number or a website where an investor may obtain current performance data.

Again, I don’t think any of these are a big deal. I think that private fund managers will merely need to adjust their disclosures pages to include this information.

The new Rule 509 also requires that performance data must be of the most practicable date and you must disclose the period for which performance is presented.

The mutual fund industry was concerned about the advertising for hedge funds alongside the highly regulated advertising for mutual funds. Clearly, the SEC is trying to level the playing field.  Mutual funds are limited in what they can do. I suspect they were concerned that hedge funds would be able to make more wild claims and not have to spew out the legal disclaimers that take up a big chunk of mutual fund advertising.

Lastly, if the performance presentation does not include the deduction of fees and expenses, the private fund must disclose that the presentation does not reflect the deduction of fees and expenses and that if such fees and expenses had been deducted, performance may be lower than presented.

I suspect this one is designed to scoop up the venture capital funds that managed to escape the investment adviser registration requirement under Dodd-Frank. Funds with registered fund managers already have to present net returns.

Rule 509 is merely proposed so it could be changed. But I doubt we will see any changes. The SEC will want to keep a tight lid on private fund advertising. I expect this rule will be ready to go shortly after advertising is permitted.

I don’t find anything particularly objectionable in Rule 509. The SEC clearly states in the release that failure to comply will not result in loss of the 506(c) offering.

However, a failure to comply that results in a enforcement action could lead to a ban under the new Rule 507(a). It’s not a footfault; it requires an action by the SEC or the courts. I suspect a examiner seeing a mistake will not blow up the private placement unless the examiner refers it to enforcement and enforcement decides to bring charges.

The other hook is a proposed change to Rule 156 under the Securities Act that would make it apply to private funds. More that later.

Buckets of Money

buckets of money

Radio personality Raymond J. Lucia, Sr. got in trouble with the SEC. An administrative law judge made it official and issued an initial decision in the case. Lucia will barred from associating with any investment adviser, broker or dealer, the investment adviser registrations for him and his firm are revoked, and is stuck with a $50,000 penalty against him and a $250,000 penalty against his former IA firm.

Judge Elliot’s decision found that that firm had violated the investment adviser antifraud statutes and that Lucia had aided and abetted the firm’s violations. “Judge Elliot’s initial decision vindicates the Division of Enforcement’s original position that Lucia and RJLC misled the investors who attended their seminars by claiming that the Buckets of Money strategy had been successfully backtested when in fact it had not been,” said Michele Wein Layne, Director of the SEC’s Los Angeles Regional Office.

It’s not over yet. Lucia and RJLC have 21 days from the date of the decision to appeal the decision. I suspect they will appeal.

The SEC found four flaws in Lucia’s performance marketing, with the misleading application of:

  1. historical inflation rates
  2. investment adviser fee impact
  3. returns on Real Estate Investment Trust (REIT) securities, and
  4. reallocation of assets.

The biggest problem cited by the judge was the backtesting use of REITs in the fictional portfolios that went back to 1966. Lucia used an assumed dividend rate of 7%, but is alleged to have failed to disclose that it was an assumed rate. Another problem was using non-traded REITs in the backtest when non-traded REITs were not available during that period. The last problem was that Lucia failed to disclose the illiquidity of non-traded REITs.

Looking at the administrative order it seems that these deficiencies could have been fixed with proper disclosure. Maybe not fixed, but would have reduced the likelihood of the SEC bringing charges and an adverse decision.

One interesting carve-out by the judge was an exclusion of Lucia’s slideshows from the definition of written communications under Rule 206(4)-1(b). The SEC did not show that the slideshow was printed out and distributed.

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What’s Next For Private Funds Now that the SEC has Lifted the Ban on General Solicitation

SEC Seal 2

On Wednesday, the Securities and Exchange Commission adopted a new rule that will allow private funds to advertise. (Perhaps “private fund” is not the right label anymore.) Of course it’s not as simple as merely removing the word “not” and allowing public advertising of private placements.

The new rule creates a new option. It creates a public private placement. A fund manager or company can publicly advertise the offering so long as all purchasers of the securities are accredited investors and the issuer takes reasonable steps to verify that such purchasers are accredited investors

The existing option is still viable that operates under the regulatory regime as it existed before 10:00 am yesterday. I suppose it’s a private private placement.

One concern I had was how a public private placement under the new Rule 506(c) would affect a private fund under its Section 3(c)1 or 3(c)7 exemption under the Investment Company Act. Private funds are precluded from relying on either of these two exemptions if they make a public offering of their securities. The SEC explicitly addressed this concern.

As we stated in the Proposing Release and reaffirm here, the effect of Section 201(b) is to permit private funds to engage in general solicitation in compliance with new Rule 506(c) without losing either of the exclusions under the Investment Company Act.(page 48 of Release 33-9415)

Another concern was whether the SEC was eliminating the “reasonable belief” standard that an investor is accredited under the new Rule 506(c) offerings. The SEC specifically addressed this concern.

We note that the definition of accredited investor remains unchanged with the enactment of the JOBS Act and includes persons that come within any of the listed categories of accredited investors, as well as persons that the issuer reasonably believes come within any such category.

My last concern was what it meant to take “reasonable steps to verify” that investors are accredited. The SEC stuck with its principles-based approach, but did provide four non-exlusive methods for verifying accredited investor status for individuals.

The principles-based approach requires you to take an “objective determination … in the context of the particular facts and circumstances.” That’s a bit messy. I was hoping the SEC would explicitly state that a minimum investment of $1 million would be enough. If the investor has $1 million, then the investor has $1 million of net worth and meets the accredited investor threshold. The SEC states that the minimum investment is a highly relevant factor.

The SEC expresses some concern that the cash investment could be financed by the issuer or a third party. Those are legitimate concerns given the potential for fraud by shady operators who would hide behind such a bright line test. But it does cause me a headache.

Clearly there will need to be some additional recordkeeping when it comes to a public offering of a private placement.

The SEC also passed a rule banning “bad actors” from having a substantial role in a private placement, regardless of whether it is public or private. I’ll take a closer look at that one later.

Lastly, the SEC is proposing changes to the Form D required to filed with a private placement. There are many changes in that rule. More than I expected.

  • the filing of a Form D no later than 15 calendar days in advance of the first use of general solicitation in a Rule 506(c) offering;
  • the filing of a closing Form D amendment within 30 calendar days after the termination of a Rule 506 offering; and
  • additional information on Form D about the offering

In addition, the rule is proposing a new disclosure on advertising materials in public private placements. The new rule 509 will require all issuers to include: (i) legends in any written general solicitation materials used in a Rule 506(c) offering; and (ii) additional disclosures for private funds if such materials include performance data.

The SEC is also proposing amendments to Rule 156 under the Securities Act that would extend the guidance contained in the rule to the sales literature of private funds.

There is a lot to digest. Looks like my weekend will be spent reading SEC releases and rules.

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DOMA, the SEC, and the Accredited Investor

us supreme court and compliance

The US Supreme Court ruled on same sex marriages and removed the broad federal definition of marriage that applies to over a thousand laws and regulations. Decision in US v. Windsor (.pdf) One of those regulations is from the Securities and Exchange Commission and affects fundraising for private funds and other private placements.

One of the standards for private placements of securities is that an investor generally needs to meet the definition of “accredited investor.” For an individual that means a (1) net worth, excluding the primary residence, of $1 million, or (2) annual income in excess of $200,000 in each of the two most recent years or joint income with a spouse in excess of $300,000.

Section 3 of the Defense of Marriage Act mandated that the word “spouse” refer only to a person of the opposite sex who is a husband or a wife.” 1 U.S.C. § 7 (1997)

Less than 10 years ago, the Massachusetts Supreme Judicial Court went through a laundry list of legal rights that couples enjoy once they are married. In the landmark Goodridge decision, that court decided that “spouse” should not be limited to a man and a woman. It affects a broad spectrum of rights granted by the government to people who are married.

The US Supreme Court decided that Section 3 of the Defense of Marriage Act is unconstitutional. Therefore, the accredited investor definition’s use of the word “spouse” is no longer restricted by DOMA to a person of the opposite sex who is a husband or a wife.

In the states that allow same-sex marriage, an issuer should now be able to allow a same-sex married couple to combine their income to meet the standard. I don’t think the SEC needs to take any action for this to happen.

In states that allow civil unions, the answer is a bit murkier and depends on the rights granted under state law. The civil union law would need to deem the two participants to be “spouses.” That is exactly what Illinois did in its civil union law:

“Party to a civil union” means a person who has established a civil union pursuant to this Act. “Party to a civil union” means, and shall be included in, any definition or use of the terms “spouse”, “family”, “immediate family”, “dependent”, “next of kin”, and other terms that denote the spousal relationship, as those terms are used throughout the law. SB1716

What is even murkier is a married couple who move to a state that does not recognize same sex marriage. Are they still “spouses” if not recognized by their state of residence? Justice Scalia raises this issue in his dissent.

Whether you agreed with DOMA or not, it made a very bright line test for “spouse”. That line is now more complicated for determining if a potential investor is an “accredited investor.”

This may become even more complicated when the SEC finally issues the regulation that lifts the ban on general solicitation and advertising. The new regulation will require a firm to take reasonable steps to determine that an investor is accredited if it wants to engage in general advertisement or solicitation. It will be interesting to see if the SEC includes something on this issue.

Given the SEC’s huge rulemaking backlog, I doubt they will make a separate statement on same-sex marriages under securities law. The SEC could tuck something into the advertising rule since it is already in the works. Perhaps the SEC was waiting for the Windsor case to be decided.

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Image of the US Supreme Court by OZinOH

Same Sex Marriage and Accredited Investors

Compliance, the SEC and the Supreme Court

The US Supreme Court is likely to come out shortly with its ruling on same sex marriages. The ruling may have an impact on fundraising for private funds and other private placements.

One of the standards for private placements of securities is that the investors generally need to meet the definition of “accredited investors.” For individuals that means a (1) net worth, excluding the primary residence, of $1 million, or (2) annual income in excess of $200,000 in each of the two most recent years or joint income with a spouse in excess of $300,000.

That word “spouse” is the one being addressed by the Supreme Court.  Section 3 of the Defense of Marriage Act (DOMA) states that in determining the meaning of “any ruling, regulation, or interpretation of the various administrative bureaus and agencies of the United States,…the word ‘spouse’ refers only to a person of the opposite sex who is a husband or a wife.” (1 U.S.C. § 7 (1997)

William Carleton picked up on the wrinkle in Rule 506 that same-sex marriages were not treated equally for purposes of the accredited investor standard.

Here in my home state of Massachusetts, “spouse” is not limited to a man and a woman. In the landmark Goodridge decision that made same-sex marriage legal, the Massachusetts Supreme Judicial Court went through a laundry list of legal rights that couples enjoy once they are married. Those were rights not available not available to same-sex couples.

You can add the accredited investor standard to that big pile of legal rights.

The accredited investor concept was included in Regulation D “based on the presumption that accredited investors can fend for themselves without the protections afforded by registration.” I’m not sure how gender plays a role in determining the financial ability of a couple. But currently it does.

What happens if the Supreme Court strikes down the DOMA restriction? I assume the SEC will not do anything and let the term “spouse” sit in the definition. They have enough political landmines to deal with, I don’t see the SEC jumping out with a rulemaking embrace of same-sex marriage when it still has not yet removed the ban on general advertising or issued rules on crowdfunding.

That will leave it up to the issuers, the fund managers, the start-up companies, and their lawyers to wrestle with the definition of “spouse.” I expect a few intrepid offerings will get an extra investor or two. I expect many conservative issuers will wait for more guidance from the SEC.

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Placement Agents and the SEC Inquiry of Private Fund Broker Dealer Requirements

money penny

Broker-dealer regulation in connection with the sale of private fund interests has become a focus of SEC inquiry. The David Blass speech on private funds and broker-dealer registration highlights the issue. If you have internal marketing people who are getting paid transaction based compensation for selling fund interests, there may be an issue. Even if you don’t pay a commission-like compensation to dedicated internal marketing people you may have a problem.

The big problem with having your internal marketing people re-cast as broker-dealers is that if they are not registered, your fund investors could have a rescission right. One way to deal with the broker-dealer issue is to use a third-party placement agent. Then, the fund manager would not need as much internal marketing manpower. The fund could rely on the placement agent’s broker-dealer registration.

But the SEC started a witch hunt against placement agents in 2009 when it threatened to ban the use of placement agents when dealing with government pension plans. That put fund managers on the defensive when dealing with placement agents. Individual states began instituting their own bans on placement agents. Many investors raised a red flag for compliance issues when a placement agent was involved in a fundraising.

Placement agents had to give some thought as to how they operated their businesses given that they are precluded from acting as an agent when dealing with the big dollars of pension plans.

Of course, many fund managers bulked up their internal marketing groups to deal with the lesser assistance they would get from placement agents. Now the SEC is going after those groups. Unfortunately, the SEC is being very inconsistent on how it wants private funds with savvy investors to operate now that they are under the stricter scrutiny of the SEC.

AIFMD in the UK

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HM Treasury has published its response to its first consultation on the transposition of the Alternative Investment Fund Managers Directive (“AIFMD”) in the United Kingdom. The main thrust of the AIFMD will not hit Europe for a few years, but in the meantime there will be more uniform limitations on private placements in the European Union starting on July 22, 2013. Unfortunately, all of the EU countries are scrambling to get the new regulatory regimes in place. “Scrambling” may imply more activity than is really happening.

The United Kingdom has moved a step closer and published revised draft regulations under the AIFMD (.pdf). The good news is that the UK is proposing to provide a year of transition so that the requirements under the AIFMD for private placements won’t come into full effect until July 2014.

The draft regulations propose replacing the registration process for non-EU managers seeking to market their funds under the U.K. private placement regime with a simple notification procedure. You certify your compliance with the AIFMD. That way the fund manager does not have to wait for the approval of the Financial Conduct Authority before undertaking marketing.

That registration requirement is trouble under the AIFMD. Effectively, you need to go through the registration process and wait for approval before marketing in that EU country. There is no private placement passport. Of course, it may turn out that you end up with no investors in that country.

Now we need the other member countries of the EU to move forward so that European investors don’t get excluded from investment opportunities when the end of July comes around.

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FINRA Issues Regulatory Notice on Communications Regarding Real Estate Investments

finra

FINRA issued Regulatory Notice 13-18 on compliance with the communications with the public rule concerning communications about unlisted REITS and other real estate investments.  Among other things, FINRA is concerned about the use of pictures of real property in the marketing materials.

FINRA Rule 2210 regulates broker-dealer communications with the public. Clearly, based on the Regulatory Notice, FINRA is concerned about disclosures and marketing when it comes to private real estate. The Regulatory is focused on private REITs and direct participation plans, not private equity real estate. However, the guidance may be applicable to a placement agent involved in fundraising.

It was the limitation on pictures that caught my attention. One of the unique aspects of real estate funds is that you can show pictures of the investments. There is little guidance on how you need to treat the pictures or whether the pictures could be considered misleading. So the FINRA Regualtory Notice caught my eye.

Communications for a new program often include photographs or other images of properties owned by investments managed by the program’s sponsor that are similar to properties the program expects to purchase. In order to be clear that investors will not acquire an interest in the pictured property, prominent text must accompany each depiction explaining that the property is owned by an investment managed by the sponsor and not the program. Once the real estate program has acquired a portfolio, the communication may include depictions of properties that are limited to investments owned by the program.

That’s not much of a help. You can’t include pictures of non-fund properties unless you disclose that they are owned by a different fund.