Month: August 2013

Top Social Media Enforcement Issues in the Securities Industry

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Broker-dealers and investment advisers are finding access to client through social networks and providing new marketing opportunities. But they also pose the challenge of making it harder for the firms to supervise, review, maintain, and protect the information. The Securities and Exchange Commission and FINRA are struggling to keep the regulatory requirements up to date and protective as the social networks change rapidly.

In their article, “The Social Network Unhinged: #TopSocialMediaEnforcementIssuesintheSecuritiesIndustry,” which appeared in the June 2013 issue of Banking & Financial Services Policy Report, Sutherland attorneys Brian L. Rubin and Caroline A.Crenshaw review recent social media enforcement actions brought by the SEC and FINRA and discuss challenges facing the securities industry as it continues on the Internet.

The authors track the evolution from the early days of email to today.  They also dive into cyber-security.

 

Updated Guidance on the Custody Rule for Private Funds

Barnum and Bailey Limited Stock Certificate

The Securities and Exchange Commission has provided some updated guidance on the Custody Rule for private funds. It has sometimes been tricky for private funds to comply with Rule 206(4)-2.

The custody rule deems it to be a fraudulent, deceptive or manipulative act, practice or course of business for an adviser to have custody of client funds or securities unless a qualified custodian maintains those funds and securities in a separate account for each client under that client’s name. The custody rule provides an exception from the custodian requirement for a fund in the case of certain privately offered securities it holds, provided the fund’s financial statements are audited.

“Privately offered securities” are defined as securities that are: (A) acquired from the issuer in a transaction or chain of transactions not involving a public offering; (B) uncertificated, and ownership thereof is recorded only on the books of the issuer or its transfer agent in the name of the client; and (C) transferable only with the prior consent of the issuer or holders of the outstanding securities of the issuer.

This has posed a challenge for real estate fund managers and private equity fund managers that happen to have an entity that is certificated. For example, if the real estate fund has a REIT subsidiary, it may have issued stock certificates as a matter of practice. The Custody Rule would mandate that the fund hire a qualified custodian to hold that single REIT stock certificate. That custody relationship is expensive and provides little (no?) protection to fund investors.

The Investment Management Division issued an update that provides a great deal of relief.

The Division created a new category of securities for purposes of the custody rule: “private stock certificates.” These are non-transferable stock certificates or “certificated” LLC interests that were obtained in a private placement. These fail to meet the definition of “privately offered securities” because they are certificated.

“The Division would not object if an adviser does not maintain private stock certificates
with a qualified custodian, provided that:
  1.  the client is a pooled investment vehicle that is subject to a financial statement audit in accordance with paragraph (b)(4) of the custody rule;
  2. the private stock certificate can only be used to effect a transfer or to otherwise facilitate a change in beneficial ownership of the security with the prior consent of the issuer or holders of the outstanding securities of the issuer;
  3. ownership of the security is recorded on the books of the issuer or its transfer agent in the name of the client;
  4. the private stock certificate contains a legend restricting transfer; and
  5. the private stock certificate is appropriately safeguarded by the adviser and can be replaced upon loss or destruction.”

That is fantastic news.

Even better, the update adds some clarity to partnership agreements:

Partnership agreements, subscription agreements and LLC agreements are not certificates under Rule 206(4)-2(b)(2)(B) and the securities represented by such documents are privately offered securities provided they meet the other elements of Rule 206(4)-2(b)(2).

I know a few fund advisers that took a very conservative position on the Custody Rule and were shipping partnership agreements their custodians. It looks like that is not required by the Custody Rule.

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Compliance Bricks and Mortar for August 2

Bricks 6

These are some of the compliance-related stories that recently caught my attention.

At SAC, Rules Compliance With an ‘Edge’ by James B. Stewart in the New York Times

Whatever else might be said about SAC’s compliance program, the bottom line is that it failed. Whether that failure can be attributed to Mr. Cohen or his top compliance officials remains to be seen. But Mr. Pitt, for one, came away from his visit to the firm unimpressed. “My sense was that it was a check-the-box mentality, not a serious commitment,” Mr. Pitt told me.

The Indictment of S.A.C. Capital Advisors: Where Was The Auditor? by Francine McKenna in re: The Auditors

Looks like investors can’t count on “independent” auditors like PwC, which was also MF Global’s “independent” auditor, to spot illegal activity either.

Sun Capital Court Ruling Threatens Structure of Private Equity by Victor Fleischer in Dealbook

Last week, the United States Court of Appeals for the First Circuit issued a ruling that will make it harder for private equity funds to walk away from the unfunded pension liabilities of companies they have bought if the company goes bankrupt.

Specifically, the court ruled that one of Sun Capital’s private equity funds was “not merely a ‘passive’ investor” but actively involved in the operations of Scott Brass Inc., a portfolio company that went bankrupt in 2008. The case was brought by the New England Teamsters and Trucking Industry Pension Fund.

Avoiding five potential traps in “new” Rule 506 offerings by David C. Scileppi in Securities Edge

The removal of the ban is a huge change in the way private offerings may be conducted and welcome relief to the thousands of issuers each year who have tapped out their “friends and family,” but yet are too small to attract private equity funds.  With these new changes, however, bring challenges in making sure you conduct a “new” Rule 506 offering (a/k/a Rule 506(c) offering) correctly.

So, with the caveat that best practices are still being developed for Rule 506(c) offerings and issuers and attorneys are still parsing through the new rules, here are five potential pitfalls to avoid: ….

Criminal Forfeiture and SAC Capital by David Smyth and Wes Camden in Cady Bar the Door

But in the event of a conviction, the criminal case does have at least one prominent feature that the SEC’s case does not: the prospect of a massive criminal forfeiture of assets gained by any criminal conduct.  In addition to the indictment, prosecutors filed a civil forfeiture complaint for what it alleges is money laundering activity by the defendants.  The Wall Street Journal reported on Thursday that the government will seek forfeiture of around $10 billion, “according to a person familiar with the matter.”

Employee Criminal History and 506(d)

baD BOYSThe bad actor rule in the new Rule 506(d) 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.”

An issue arises when you ask about criminal history. It’s been decades since I had to fill out a job application, but I remember the question asking if you are a convicted felon. That allows employer to quickly discard job applications filed by convicted criminals. A few states have felt that this is discriminatory and have enacted limitations on asking whether a job applicant has a criminal history.

This conflicts with the Rule 506(d) requirement that you exercise reasonable care in determining whether a covered employee is a bad actor. Some states limit your ability to run a criminal background inquiry and some limit your ability to even ask whether a prospective employee has a criminal background.

A shotgun approach will not work.

Most of these state laws allow you to eventually ask the criminal background question. If you are subject to 506(d) you need to ask the question, it can’t be one of the first questions.

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