Category: Investment Choice

FINRA Guidance on Private Placements

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The Financial Industry Regulatory Authority released Regulatory Notice 10-22 reminding registered firms about their obligations regarding suitability, disclosures and other requirements for selling private placements to customers.

A Broker-Dealer that recommends a security is under a duty to conduct a reasonable investigation concerning that security and the issuer’s representations about it. This is true regardless of the type of security. The “reasonable” standard for the investigation depends on many factors including the nature of the recommendation, the role of the broker-dealer in the transaction, its knowledge of and relationship to the issuer, and the issuer itself.

NASD Rule 2310 requires a broker-dealer to have reasonable grounds to believe that a recommendation to purchase, sell or exchange a security is suitable for the customer. That means they must have a reasonable basis to to determine that the recommendation is suitable for at least some investors. Then they have to determine that it is suitable for the specific customer.

The fact that an investor meets the net worth or income test for being an accredited investor is only one factor to be considered in the course of a complete suitability analysis. In a Regulation D offering the broker-dealer should, at a minimum, conduct a reasonable investigation concerning:

  • the issuer and its management;
  • the business prospects of the issuer;
  • the assets held by or to be acquired by the issuer;
  • the claims being made; and
  • the intended use of proceeds of the offering

Although the “reasonable investigation” must be tailored to each private placement, the regulatory notice provides a list of best practices gathered from member firms.

A. Issuer and Management. Reasonable investigations of the issuer and its management concerning the issuer’s
history and management’s background and qualifications to conduct the business might include:

  • Examining the issuer’s governing documents, including any charter, bylaws and partnership agreement, noting particularly the amount of its authorized stock and any restriction on its activities. If the issuer is a corporation, a BD might determine whether it has perpetual existence.
  • Examining historical financial statements of the issuer and its affiliates, with particular focus, if available, on financial statements that have been audited by an independent certified public accountant and auditor letters to management.
  • Looking for any trends indicated by the financial statements.
  • Inquiring about the business of affiliates of the issuer and the extent to which any cash needs or other expectations for the affiliate might affect the business prospects of the issuer.
  • Inquiring about internal audit controls of the issuer.
  • Contacting customers and suppliers regarding their dealing with the issuer.
  • Reviewing the issuer’s contracts, leases, mortgages, financing arrangements, contractual arrangements between the issuer and its management, employment agreements and stock option plans.
  • Inquiring about past securities offerings by the issuer and the degree of their success while keeping in mind that simply because a certain product or sponsor historically met obligations to investors, there are no guarantees that it will continue to do so, particularly if the issuer has been dependent on continuously raising new capital. This inquiry could be especially important for any blind pool or blank-check offering.
  • Inquiring about pending litigation of the issuer or its affiliates.
  • Inquiring about previous or potential regulatory or disciplinary problems of the issuer. A BD might make a credit check of the issuer.
  • Making reasonable inquiries concerning the issuer’s management. A BD might inquire about such issues as the expertise of management for the issuer’s business and the extent to which management has changed or is expected to change. For example, a BD might inquire about any regulatory or disciplinary history on the part of management and any loans or other transactions between the issuer or its affiliates and members of management that might be inappropriate or might otherwise affect the issuer’s business.
  • Inquiring about the forms and amount of management compensation, who determines the compensation and the extent to which the forms of compensation could present serious conflicts of interest. A BD might make similar inquiries concerning the qualifications and integrity of any board of directors or similar body of the issuer.
  • Inquiring about the length of time that the issuer has been in business and whether the focus of its business is expected to change.

B. Issuer’s Business Prospects. Reasonable investigations of the issuer’s business prospects, and the relationship of those prospects to the proposed price of the securities being offered, might include:

  • Inquiring about the viability of any patent or other intellectual property rights held by the issuer.
  • Inquiring about the industry in which the issuer conducts its business, the prospects for that industry, any existing or potential regulatory restrictions on that business and the competitive position of the issuer.
  • Requesting any business plan, business model or other description of the business intentions of the issuer and its management and their expectations for the business, and analyzing management’s assumptions upon which any business forecast is based. A BD might test models with information from representative assets to validate projected returns, break-even points and similar information provided to investors.
  • Requesting financial models used to generate projections or targeted returns.
  • Maintaining in the BD’s files a summary of the analysis that was performed on financial models provided by the issuer that detail the results of any stress tests performed on the issuer’s assumptions and projections.

C. Issuer’s Assets. Reasonable investigations of the quality of the assets and facilities of the issuer might include:

  • Visiting and inspecting a sample of the issuer’s assets and facilities to determine whether the value of assets reflected in the financial statements is reasonable and that management’s assertions concerning the condition of the issuer’s physical plants and the adequacy of its equipment are accurate.
  • Carefully examining any geological, land use, engineering or other reports by third-party experts that may raise red flags.
  • Obtaining, with respect to energy development and exploration programs, expert opinions from engineers, geologists and others are necessary as a basis for determining the suitability of the investment prior to recommending the security to investors.

“An increase in investor complaints regarding private placements, as well as SEC actions halting sales of certain private placement offerings, led FINRA to launch a nationwide initiative that involves active examinations and investigations of broker-dealers engaged in retail sales of private placement interests,” said FINRA Chairman and CEO Rick Ketchum.

Sources

Should You Invest in Ethical Companies?

2010 World’s Most Ethical Companies

Yesterday, I was excited to see that the World’s Most Ethical Companies for 2010 had outperformed the S&P 500. Ethisphere went back five years and charted the performance. They found a 53% return for the 2010 class of companies, compared to a 4% return in the S&P.

The hindsight of looking back on the performance is great. It’s telling me that I should have bought stock in those companies five years ago. We all know that hindsight is 20/20. I was curious to see if inclusion on the list is an indicator of future performance.

Should I run out and buy the companies on the 2010 list?

I decided to go back and check the performance of the companies on the first edition of Ethisphere’s list: 2007 World’s Most Ethical Companies.

Great news for ethical investing

The group of public companies on Ethisphere’s 2007 World’s Most Ethical Companies dramatically outperformed the broader market.

If you bought one share in each of the 52 companies on June 1, 2007, you would have realized a -6.34% return. In comparison, the S&P 500 had a -19.57% return and the Dow Jones Industrial Average had  a -15.80% return.

If you bought $100 worth of shares in each of the companies instead of 1 share each, your return drops to -9.83%. The difference is due almost entirely to the presence of Google and its lofty share price. (I used the Berkshire Hathaway B shares because the astronomical price of the Berkshire Hathaway A shares would have dwarfed the one share results.)

Methodology

I used SPY SPDRs, an index fund that tracks the S&P 500, and the SPDR DIAs, an index fund that tracks the Dow Jones Industrial Average.

There are 52 stocks on Ethisphere’s 2007 list that were public companies then and now. Two other companies on the list were public, but went private: Sun Microsystems and Bright Horizons. I omitted those two. There were another 38 companies that were private or whose shares were only available on foreign exchanges. I also omitted those 38 from my calculations.

I used the adjusted close price from Yahoo’s historical prices for the 52 companies, SPY and DIA shares, which adjusts the close price for dividends and splits.

Here is the spreadsheet with the underlying values: http://spreadsheets.google.com/pub?key=t5Tg37_FEqFq71zqApUq0Pw&output=html. Feel free to double-check my math or challenge my methodology.

What does it mean?

I own some of the shares on the list, so I’m well aware that almost as many companies underperformed. (After all, it is an average return.) Eighteen of the 52 companies performed worse than the SPY shares. There does not seem to be a clustering of returns or any one big or gain in the group of 52. It seems to me that these ethical companies, as a group, just outperform the broader market.

If I had more time, I might go back to the 2008 list and the 2009 list to see how those companies have done over a shorter term.

Accidental Securities Underwriter

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So you made almost $1 million on selling penny stocks through the pink sheets on $75,000. Nice pay day. Then the SEC makes you give it all back.

This is the sad tale of Rodney Schoemann, a professional stock market trader.

Schoemann had previous purchased some restricted shares in Stinger Systems, Inc. that were marked “RESTRICTED” on their face. He apparently thought the company was worth investing in, so he asked to purchase 100,000 unrestricted shares from one of the company’s insiders. Schoemann paid the insider at the company $0.75 per share, which were not marked with a restriction. He later deposited the shares with his broker and sold them to the public.

Unfortunately, those 100,000 were not registered and that insider was in control of the issuer.

An administrative law judge found that Schoemann violated Sections 5(a) and 5(c) of the Securities Act of 1933 in November 2004 by offering and selling the securities of Stinger Systems, Inc.when no registration statement was filed or in effect for those securities and no exemption from registration was available.

Securities Act Section 5(a) prohibits any person, directly or indirectly, from selling a security in interstate commerce unless a registration statement is in effect as to the offer and sale of that security or there is an applicable exemption from the registration requirements. Securities Act Section 5(c) prohibits the offer or sale of a security unless a registration statement as to such security has been filed with the Commission, or an exemption is available.

Schoenmann argued that he was not an underwriter. But individual investors may be deemed “underwriters” within the statutory meaning of that term if they act as links in a chain of securities transactions from issuers or control persons to the public.

Section 2 of the Securities Act has this definition:

The term “underwriter” means any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security, or participates or has a direct or indirect participation in any such undertaking, or participates or has a participation in the direct or indirect underwriting of any such undertaking; but such term shall not include a person whose interest is limited to a commission from an underwriter or dealer not in excess of the usual and customary distributors’ or sellers’ commission. As used in this paragraph the term “issuer” shall include, in addition to an issuer, any person directly or indirectly controlling or controlled by the issuer, or any person under direct or indirect common control with the issuer.

From the testimony, both Shoemann and the insider thought the shares were freely transferable. The insider did not think he was a control person and Shoemann never inquired the insider to see if he was control person.

Shoemann did see a legal opinion that shares in Stinger Systems, Inc. were freely tradeable. This opinion was submitted to the transfer agent and the Pink Sheets. Advice of counsel is not a defense, since it merely goes to the question of scienter.

A showing of scienter is not required to establish a violation of Section 5. There is strict liability.

The last test was whether Shoemann had purchased the shares for distribution. This test involves intent. Since Shoemann sold all 100,000 shares in the two weeks after he purchased them, he would have a hard arguing that he did not intend to distribute them. So Schoemann served as a link in a chain of transactions where securities moved from the issuer to the public, and in doing so, served as an underwriter.

The deal made financial for Shoemann, but he failed to realize the legal background on the shares. The SEC made him disgorge his $967,901 ($1,042,901 in gross proceeds, minus Schoemann’s initial $75,000 purchase price) from his “violative sales” of Stinger stock. In addition to the disgorgement of profits, he has to pay prejudgment interest of $335,370.98.

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The fi360 Fiduciary Score Methodology

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The fi360 Fiduciary Score is a quantitative evaluation of how well a fund meets a minimum set of due diligence criteria. The score can quickly help identify a list of Mutual Funds and Exchange Traded Funds that are worth further research in your selection process. You can also use the score as part of your ongoing monitoring process since it can highlight funds with potential deficiencies.

If you are an investment adviser, you need to conduct your diligence on the investment choices you distribute. As we saw in the Hennessee Group administrative action, if you promote your diligence program you have to actually follow that program. [Failure to Conduct Diligence Can Lead to SEC Sanctions]

The fi360 scoring system weights a fund’s standing in relation to thresholds in nine areas. The more points, the worse the fund choice. Zero is good and 100 indicates significant shortfalls. The nine areas for scoring:

  • regulatory oversight;
  • track record;
  • assets in the fund;
  • stability of the organization;
  • composition consistent with asset class;
  • style consistency;
  • expense ratio/fees relative to peers;
  • risk-adjusted performance relative to peers; and
  • performance relative to peers.

Fi360 offers investment fiduciary education, practice management, and support. They also offer training and certification for investment fiduciary professionals.

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Credit Rating Agency Reform

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Last week the Securities and Exchange Commission held a roundtable on the credit agencies to consider a range of ideas to get tougher on them. Securities and Exchange Commission Chairman Mary Schapiro lead the discussion and pointed out that “rating agency performance in the area of mortgage-backed securities backed by residential subprime loans, and the collateralized debt obligations linked to such securities has shaken investor confidence to its core.” The SEC has exclusive authority over rating agency registration and qualifications as a result of the Credit Rating Agency Reform Act of 2006.

There seems to be a conflict of interest when the fee for the rating agency is paid by the issuer of the debt instead of the investor who is relying on the rating. This issued-paid model accounts for 98% of the ratings.

The rating agencies are are faced with lots of litigation over their  ratings of mortgage-back securities. One of their defense tactics is that their ratings are “opinions” and are protected by the First Amendment. That would probably mean having to prove actual malice and not just making a false statement. If the ratings are found to be more of a private commercial transaction then it is less likely that the First Amendment would apply.

One thing that has struck me as odd about the ratings is that they give the same designation to company debt as they do to structured products. It seems to me that there is a big difference between (1) the bonds issued by GE, payable from GE’s revenues and (2) the bonds issued out of a fixed pool of assets like Mortgage-Back Securities.

There are only a few dozen companies that have AAA ratings on their debt. These companies are actively managed looking for the long term success of the company. There are many variables, making the rating process more complicated.

On the other hand, the structured finance products are not actively managed. You have a bunch of income coming in and you structure that income flow into tranches. The default rate is governed by the quality of the assets and the larger economy’s effect on the cash flow from those assets. The rating process is complicated in a different way because you need to look at the variables that may affect the performance and how they may be correlated. I wrote before on how the rating agencies got this wrong: The Risk Management Formula That Killed Wall Street.

Maybe its time to break the ratings into separate categories so that investors will not be mistaken into thinking that a AAA rated mortgaged back security has less chance of a default than ExxonMobil.

What do you think?

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N.Y. Comptroller Bans Placement Agents for State Pension Fund

State Comptroller Thomas P. DiNapoli today announced he has banned the involvement of placement agents, paid intermediaries and registered lobbyists in investments with the New York State Common Retirement Fund (CRF). The ban includes entities “compensated on a flat fee, a contingent fee or any other basis.”

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Guidance Concerning the National Security Review Conducted by the Committee on Foreign Investment in the United States

On December 8, the Committee on Committee on Foreign Investment in the United States published a notice in the Federal Register of that provides guidance to U.S. businesses and foreign persons that are parties to transactions that are covered by section 721 of the Defense Production Act of 1950, as amended by the Foreign Investment and National Security Act of 2007, and the regulations at 31 CFR part 800.

Section 721 requires CFIUS to review covered transactions notified to it ‘‘to determine the effects of the transaction[s] on the national security of the United States,’’ but does not define ‘‘national security,’’ other than to note that the term includes issues relating to homeland security. Instead, section 721 provides an illustrative list of factors, listed below, for CFIUS to consider.

This notice provides examples and insight into what types of transaction could trigger a CFIUS review.

CFIUS notes that a just because a transaction presents national security considerations does not mean that CFIUS will necessarily determine that the transaction poses national security risk.

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Implementation of Foreign Investment and National Security Act

Davis Polk & Wardwell attorneys Margaret M. Ayres and Jeanine P. McGuinness prepared a memorandum entitled FINSA Final Regulations (.pdf) discussing the final regulations issued by the U.S. Department of the Treasury to implement the Foreign Investment and National Security Act of 2007. That law amended the 1988 “Exon-Florio” statute and made significant changes to the scope of review and process for evaluating foreign acquisitions of U.S. businesses for national security risks. The regulations also codify recent improvements to the practices of the Committee on Foreign Investment in the United States.

The new regulations include the concept of a “covered transaction” and give additional guidance on key terms, including “control.”

A “covered transaction” is a transaction that could result in control of a U.S. businesss by a foreign person.

“Transaction” is broadly defined [§800.224] to include acquisitions, mergers, joint ventures and long term leases.

“U.S. Business” is also broadly defined [§800.226] to include any entity engaged in interstate commerce in the U.S. For real estate that excluded raw land and equipment. If contracts go along with the assets, then you could have a U.S. Business. Although raw land is excluded a leased building probably would be a U.S. business.

“Control” is broadly defined [§800.204] to give the CFIUS broad discretion. A list of minority shareholder protections are listed in §800.204(c) as not in themselves conferring control. This list is fairly short compared to most minority shareholder protections. There is another relatively safe harbor in §800.302(b) that a transaction with a foreign person holding 10% or less of the voting interest and holding that interest solely for passive investment will not be a covered transaction.

The final regulations were published in the Federal Register on November 21 and will become effective on December 22, 2008.

Comments on CFIUS

Over at Sheppard Mullin’s Government Contracts Blog, Lucantonio N. Salvi put together a summary of comments to the draft CFIUS regulations: Comments On Proposed CFIUS Rules Range From Cautious Praise To Outright Criticism.

[T]he U.S. Department of the Treasury published on April 21, 2008 proposed rules designed to strengthen the process by which the Committee on Foreign Investment in the United States (“CFIUS”) reviews and approves certain business transactions involving foreign investment. The proposed rules were issued under the Foreign Investment and National Security Act of 2007, Pub. L. No. 110-49 (“FINSA”), which requires a more intense CFIUS process that allows the government more discretion in investigating and altering business transactions that may impact national security. The U.S. Department of the Treasury invited comments on the proposed rules through June 9, 2008. Now that the comment period is over, we thought it might be worthwhile to see what types of comments were received. Not surprisingly, it is a mixed bag.

The final regulations are now ready for publishing in the Federal Register and will go into afect thirty days after publication.

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