Month: April 2013

Private Equity Funds in the Hot Seat

Debevoise & Plimpton LLP

Debevoise & Plimpton LLP put on an excellent seminar focused on enforcement actions against private equity funds.

Moderator:
Kenneth J. Berman

Speakers:
Eric R. Dinallo
Robert B. Kaplan
Shannon Rose Selden

Each fund manager is designated with a risk rating by the Securities and Exchange Commission. The Form ADV filing gives the SEC the background to assign that rating for a likelihood to be in compliance or out-of-compliance with regulatory requirements.

Registration gives the SEC the ability to just show up and ask for information. Prior to registration, the SEC would have needed a subpoena. The goal of the presence exams is to visit 25% – 50% of the new registrants over the next 2 years. The exams seems to more heavily weighted towards private equity than hedge funds. Perhaps because many hedge funds had been registered before and the SEC is more familiar with the risks with hedge funds.

Examination Priorities:

Exam Priorities in 2013 for Investment Advisers
– Conflicts of Interest Related to Compensation Arrangements
– Conflicts of Interest Related to Allocation of Investment Opportunities
– Marketing/Performance

“Presence” Exam Priorities
– Marketing
– Portfolio Management
– Conflicts of Interest
– Safety of Client Assets
– Valuation

Enforcement Priorities
• Marketing/Performance
• Valuation
• Conflicts of Interest
• Allocation of Expenses
• Fee Arrangements & Calculations
• Waterfall & Carry Distribution Calculations
• “Zombie Funds”

Marketing Cases:

• In re Oppenheimer Asset Mgmt. Inc., et al, (March 11, 2013)
• In re Ranieri Partners LLC and Donald W. Phillips (March 8, 2013) and In re Stephens (March 8, 2013)
• In re Advanced Equities, Inc. (Sept. 18, 2012)

Valuation
• In re Oppenheimer Asset Mgmt. Inc. (March 11, 2013)
• SEC v. Brantley Capital Mgmt., LLC et al. (Sep. 28, 2010)
• In re KCAP Financial, Inc., (Nov. 28, 2012)
• SEC v. Yorkville Advisors (Oct. 17, 2012)

Conflicts of Interest
• In re Crisp (Aug. 30, 2012) (Self-Dealing)
• SEC v. Resources Planning Group Inc. (Nov. 23, 2012) (Misuse of Client Funds)

Fees & Expenses

• In re Pinkas (Feb. 15, 2012) (Allocation of expenses)
• SEC v. Onyx Capital Advisors, LLC (April 22, 2010) (Improper Fee Arrangements)

State versus Federal Enforcement

States still have the ability to enforce anti-fraud laws against investment advisers and private funds. Just because you are exempt from state registration, you are not exempt from state enforcement.

Ranieri

Highlighted the Ranieri case where a finder stepped over the line and acted as a placement agent. The SEC not only brought an action against the finder, but also against the fund firm and its principal. The SEC seemed especially annoyed that the finder had been barred from acting as a broker.

Are You Systemically Important?

too_big_to_fail_poster

One of the catchphrases that came out of the 2008 financial crisis was “too big to fail.” It’s a great concept, but hard to define in a meaningful way. Many think that there is no private company that should not be allowed to fail. Dodd-Frank created a concept of systemically important, trying to create additional oversight for “financial companies” that could be too big to fail.

The trick was trying to define a “financial company.” Many companies use derivatives to hedge their business risks. Many big manufacturing companies use hedging to limit exposure to commodities they use. Companies with overseas operation use foreign exchange derivatives to hedge currency risks. The tough part was drawing the line.

The Federal Reserve Board on Wednesday announced approval of a final rule that establishes the requirements for determining when a company is “predominantly engaged in financial activities.” The requirements will be used by the Financial Stability Oversight Council when it considers the potential designation of a nonbank financial company for consolidated supervision by the Federal Reserve.

The final rule defines the terms “predominantly engaged in financial activities”, “significant nonbank financial company” and “significant bank holding company.” The FSOC must consider the extent and nature of the company’s transactions and relationships with other significant nonbank financial companies and significant bank holding companies. If designated, those nonbank financial companies will be required to submit reports to the Federal Reserve, the FSOC, and the Federal Deposit Insurance Corporation on the company’s credit exposure to other significant nonbank financial companies and significant bank holding companies as well as the credit exposure of such significant entities to the company. Consistent with the proposal, a firm will be considered significant if it has $50 billion or more in total consolidated assets or has been designated by the FSOC as systemically important.

Sources:

The SEC and Social Media

social-media-expert

Netflix chief executive Reed Hastings got into trouble on July 3, 2012 when he used his personal Facebook page to announce that Netflix had more than one billion hours of online viewing in June. That trouble came from an SEC rule implemented in August of 2000: Regulation FD. That rule was implemented to stop the egregious practice of some companies delivering company news to select recipients ahead of a general announcement. Those select recipients would be able to make money from getting the news ahead of time and trading on the upcoming stock movement.

The SEC issued its report on the investigation of Mr. Hastings and determined not to pursue an enforcement action against him. The SEC publicly released its Report of Investigation to help provide some guidance on the use of social media for public company disclosure.

Personally, I thought Mr. Hastings made a bad decision in using his personal Facebook page to make a company announcement. The information had already been released, but in more technical releases. His personal Facebook page did have 200,000 friends who could see the news, but it was still gated and not available to the general public in a broad and non-exclusionary manner. It was a poor choice, but not one that should subject him or the company to an enforcement action.

Regulation FD is written to be platform neutral. You can release “important” company information as long as it available to everyone at the same time. It applies equally to press releases, company websites, Twitter, Facebook, or the big rock in front of your headquarters.

The key for correct distribution is to let people know where the news will be distributed. You could argue that Steve Jobs’ annual display of the latest gadget from Apple is a distribution channel that everyone knows about. A company could carve company announcements into the stone in front of its headquarters if it so chose.

Mr. Hastings foot-fault was that Netflix had not previously used his personal page as a platform for releasing company news. In early December 2012, Hastings stated for the public record that

“we [Netflix] don’t currently use Facebook and other social media to get material information to investors; we usually get that information out in our extensive investor letters, press releases and SEC filings.”

Hastings errant Facebook post was probably not “important” enough and the Facebook page was probably just public enough that the SEC thought it could not win an enforcement action. I’m sure Hastings and Facebook paid quite a bit in legal fees to address the repercussions of that errant post.

It’s not big news that the SEC has embraced social media. The SEC merely reminded companies that they need to go through the Regulation FD analysis when using social media platforms. The SEC embraced social media a long time ago.

I think Facebook is terrible primary platform for important corporate disclosures. It lacks the workflow and content management tools that any corporate communication professional would want to have. The same is even more so with Twitter. It’s hard to do much with 140 characters, except direct the reader to another website.

To de-emphasize the importance of the SEC guidance, it’s not even released as SEC guidance, a risk alert, or other typical SEC regulatory rulings. It merely restates what Regulation FD says and drops in the word Facebook. Too many social media specialists will merely read the headline.

Even Facebook does not use Facebook for company announcements. This announcement will not change that. Maybe Facebook will see the potential for including content management and compliance tools that will allow companies to embrace Facebook and be in compliance with securities laws.

Sources:

Fund Investing and Crowdfunding

fc-logo

As the Securities and Exchange Commission has been dragging its feet on new crowdfunding regulations, companies are finding a way to crowdfund using the current rules. The biggest challenge is dealing with the broker-dealer registration requirements. If you sell securities on a transaction basis, you are likelya broker-dealer and need to deal with the registration requirements.  The other limitation is dealing with the current ban on general solicitation and advertising.

One company that appears to be successfully employing a crowdfunding  strategy is Solar Mosaic. The company is selling interests directly in its own projects so it avoids the broker-dealer requirements. It uses a Rule 504 exemption instead of Rule 506 exemption under Regulation D. Rule 504 exempt offerings are not subject to the ban on advertising that impedes Rule 506 offerings, but are subject to a $1 million limit on capital raised. I even invested a small amount of cash in a Solar Mosaic project.

I have seen a few other platforms, like Circle Up, that partner with a broker-dealer. Effectively, the web crowdfunding platform sits on top of the broker-dealer’s regulatory platform.

The latest crowdfunding approach to catch my eye is FundersClub. They even obtained a no-action letter from the Securities and Exchange Commission blessing their approach. (I should disclose that Mrs. Doug works at the law firm that requested the no-action letter.)

FundersClub acts as a venture capital fund manager and registered as a venture capital fund manager with California. It starts a separate private fund for each company that it funds.

The compensation it tricky. According to the SEC no-action letter and the FundersClub FAQ, the company charges an administrative fee to cover out of pocket costs. None of that fee goes to salaries or personnel. That lack of transaction compensation and operations was enough to keep the company away from broker-dealer registration.

FundersClub does take a promote on the performance of the investment fund. It has a long road ahead for compensation to come in, but is aligned with the investors.

I decided to try out the platform. Signing up is straightforward.

As for vetting users as accredited investors, the platform does a better job than others. It asks for your income, joint income and net worth. Other platforms just have a check button exactly tied to the right answers for those questions. With FundersClub, you need to know your income or know the right answers to be accredited.

It does have one simple check for knowledge:

By checking this box, you represent that you have such knowledge and experience in financial and business matters that you are capable of evaluating the merits and risks of investment opportunities in private companies generally, and you are able to bear the economic risk of such investments including the risk of complete loss.

After passing the entrance hurdle, there are several investment opportunities in the works.

The current regulatory environment for crowdfunding is tricky, but navigable for accredited investors. Non-accredited investors are left out, so maybe crowdfunding is not the right term. I’m skeptical that the JOBS Act mandate for new crowdfunding regulations is going to truly open the floodgates to non-accredited investors.

Sources:

UPDATED: To clean up more than my usual collection of typos.