Month: July 2013

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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Fund Advertising Edition of Compliance Bricks and Mortar

buy a brick 1

The SEC released the final rule lifting the ban on general solicitation and advertising for private placements. Here is a collection of stories on that topic.

SEC Adopts JOBS Act Title II Rules by Dave Lynn in Corporate Counsel.net

July 4th fireworks came a week late to 100 F Street yesterday, as the SEC adopted the changes to Rule 506 of Regulation D mandated by Title II of the JOBS Act, in what was sometimes a contentious open meeting. The changes to Rule 506–permitting the use of general solicitation and general advertising in a Rule 506 offering provided that the issuer takes reasonable steps to verify that purchasers are accredited investors–were over a year late, and generated a good bit of comment and criticism.

SEC releases final rule allowing general advertising for certain private offerings by Usha Rodrigues in The Conglomerate

What exactly are “reasonable steps?” There’s the rub. The final rules track the proposed ones closely, save that the agency heeded the pleas of many, myself included, to articulate some concrete methods as to what constitutes a “reasonable step.” I asked for a safe harbor, but the SEC declined to go so far.

Get Ready for the SkyBridge Capital Holiday Bowl! by David Smyth in Cady Bar the Door

I am actually sort of fascinated to see what the upshot will be.  It will allow all manner of advertising by hedge funds in all manner of venues.  I suspect you will see hedge funds all over Google, newspapers and magazines, and even on the Twitter.  Anthony Scaramucci, of SkyBridge Capital, makes no bonesabout his plans for this liberation.  As he said last year, “I am hellbent on creating a global brand and the only way to do that is through advertising.”  At a more mundane level, other private fund managers who want to give interviews to, say, Barron’s or the Wall Street Journal will be able to do so now without fear that their comments will be construed as generally soliciting investors for their funds.

Facilitating General Solicitation at the Expense of Investors by Luis A. Aguilar, Commissioner, U.S. Securities and Exchange Commission

It is without doubt the responsibility of the Commission to implement Section 201 of the JOBS Act. It is equally without doubt that this responsibility cannot be separated from the Commission’s duty to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. Congress established the Commission as the independent agency with the expertise and authority to administer the federal securities laws. By statute, the Commission has the power to make, amend, and rescind the rules and regulations needed from time to time to carry out the provisions of such laws.

SEC Approves JOBS Act Requirement to Lift General Solicitation Ban

Commission Also Adopts Rule to Disqualify Bad Actors from Certain Offerings and Proposes Rules to Enable SEC to Monitor New Market and Bolster Investor Protections

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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PERE CFO Forum 2013

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I spent most of yesterday in New York at PERE’s CFO Forum. I came to speak about the evolution and revolution of regulation in the private equity real estate industry. I thought I would share a few items.

The opening panel focused on the changing role of the Chief Financial Officer. A big change is the avalanche of regulations and business requirements. Compliance is expensive when you add together the direct costs, the indirect costs, and the lost opportunity costs. It’s a cost of doing business.

Fund managers are fiduciaries. Exceed your investors expectations.

There is the rise of the new “F” words: FATCA, FIRPTA, FBAR, and FCPA.

The second panel focused on valuations. They put forth three items to focus on during valuations: consistency, transparency, and independence. You should have a consistency in the process, regardless of product type or geography.

Transparency allows someone to see good work product to get to the final fair value. As with third grade math, it’s not just about getting the right answer, it’s also about showing your work.

Independence is important to show that the decision makers are not influenced by other factors in trying to reach fair value. A person compensated based on an increase in fair value should not sit on the valuation committee.

As markets recovered from the 2008 financial panic we entered an era of price discovery. Nobody was quite sure where pricing would be post-crisis. With rising interest rates, we may be entering a new phase of price discovery.

The third panel was on tax reform and tax policy developments. There is a general sense in Washington that there could be a major tax code reform. As a result some changes are being held up based on the possibility of becoming part of a larger piece of legislation.

  • Carried interest remains under attack. The latest is the Cut Loopholes Act S. 268.
  • Rate equalization would likely reduce the disparate treatment between capital gains and ordinary income.
  • Business interest expense could be reduced to avoid the tax incentive in favor of leverage over equity.
  • FIRPTA is being found to discourage inbound investments in real estate. One proposed reform is the Real Estate Jobs and Investment Act S. 1181 that would repeal IRS Notice 2007-55.
  • Entity choice and pass through legislation would impose corporate taxation on “large” pass through entities.
  • Like-kind exchanges could be tightened to limit the deferral to direct swaps and application of a stricter standard of “like.”

My panel was on regulation: evolution or revolution for real estate.

According to some informal polls, most of the audience had registered last year as a result of Dodd-Frank. A few had been registered prior and a few were not registered.

As much as we are dealing with dramatic changes in the regulatory environment, the Securities and Exchange Commission is dealing with a dramatic change in their oversight of investment advisers. Dodd-Frank moved thousands of small retail investment advisers from the SEC to state registration. In exchange, the SEC got lots more hedge fund, private equity  funds, and real estate funds. The SEC has as much to learn about private fund operations as we do to learn about SEC oversight.

 

Update: Real Estate Investment Fraud or Securities Fraud?

Looks like a great investment?
Looks like a great investment?

Back in September, the SEC announced an asset freeze against Western Financial Planning Corporation and its principal Louis Schooler for a $50 million real estate fraud. That caught my eye because the SEC has little jurisdiction over real estate. The structure of the real estate investments went a long way to try to be not securities. I assumed the defendants would start out of the gate by arguing that the interests were not securities. That turned out to be true. But a California federal judge rejected the argument that the land investments didn’t count as securities.

Attorneys for Schooler had filed a motion to dismiss the suit and argued that the interests Schooler sold to investors were general partnership interests. Schooler argued that the general partnership interests were entitlements to land, rather than traditional securities. Without a characterization as securities, Schooler’s alleged failure to disclose material facts to investors would be outside the SEC’s enforcement authority.

Judge Gonzalo P. Curiel laid out the three factor test from Williamson v. Tucker for whether a general partnership is an investment contract, and therefore a security:

A GP is an investment contract—and thus a security—if one of the following factors is present:

(1) the general partnership agreement leaves so little in the hands of the partners that the arrangement in fact distributes power as would a limited partnership;

(2) the partners are so inexperienced and unknowledgeable in the general partnership business affairs that they are incapable of intelligently exercising their partnership powers; or

(3) the partners are so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that they cannot replace the manager of the enterprise or otherwise exercise meaningful partnership or venture powers.

Judge Curiel found that the interests satisfied the second and third tests.

I don’t think this makes every real estate partnership interest a security. But it is a very fact dependent analysis. As you get more investors in the partnership and complicate the structure and management, the investment starts looking more like a security than a real estate investment.

However, the standard of review for the motion to dismiss is a based on an assumption that the SEC’s factual allegations are true and are viewed in the light most favorable to the SEC. If the case proceeds, the SEC will need to prove the allegations.

According to the SEC complaint, Schooler was marking up the price paid for the land investments. The aggregate price paid for investors in the land ownership was far in excess of the purchase price paid by Western. In one case the investors contributed $1.85 million for an undeveloped parcel of land in Stead, Nevada that had a fair market value of $355,000. A second issue was that Western was publishing investment brochures that hyped the value of the land and seemed to be marking the value improperly.

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Enjoy Independence Day

When in the Course of human events, it becomes necessary for one people to dissolve the political bands which have connected them with another, and to assume among the powers of the earth, the separate and equal station to which the Laws of Nature and of Nature’s God entitle them, a decent respect to the opinions of mankind requires that they should declare the causes which impel them to the separation.

We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness.

I’m focused on the “pursuit of happiness” clause and taking a few days off.

declaration of independence

Failing to Disclose a Lack of Control

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Whenever I think of oil and gas syndications, I think of Dallas and J.R. Ewing. You can get screwed over in the wiggle of one of Larry Hagman’s luxurious eyebrows. The SEC’s complaint against Infinity Exploration for securities fraud in connection with oil and gas wells still caught my attention.

The first question is whether the interests would be securities or real estate. The SEC complaint focused on two offerings: Matagorda and New Mexico 10. Both were pooled investment vehicles. Infinity will have to battle its own statement. The PPMs for the investments both state that the offering consists of “securities” and that the investments are being offered pursuant to Regulation D.

One of the main charges is that Infinity mischaracterized what the pooled investment vehicles owned. The PPMs stated that the investment objective was to acquire, own, and deal with the prospect and that Infinity would perform drilling, testing and operations of the well. The SEC charges that Infinity was merely raising funds to invest in a joint venture with another firm and that Infinity would not be in a control position. The PPMs never disclosed that investors were purchasing an interest in an entity that would merely hold interests in another joint venture. The SEC also lays out a long list of other false or misleading statements in the PPMs.

Assuming the SEC view is correct, the lesson is to properly disclose the nature of the investments when fund raising. Real estate often has several layers of ownership and control. The key is to properly disclose those layers and how your investment fits into the mix.

The second big failure is that Infinity mischaracterized the use of proceeds. The PPM said that 80% would go to pay well-related costs, and the balance to administrative and overhead costs. The SEC charges that the 80% went to the third party joint venture partner who was actually doing the well work and Infinity kept the 20% as a commission.

It all fell apart when the joint venture partner went belly up. One investor had put in $37,500 with promises of immediate income and return of 100% of principal within a year. He ended up with a grand total of $667 in revenue. That is less than the annual grooming cost was for the late Larry Hagman’s eyebrows.

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