Month: April 2014

Can a Vending Machine Be a Security?

virtual concierge and compliance

The Securities and Exchange Commission brought charges against Joseph Signore and Paul Lewis Schumack, II in connection with an alleged investment fraud concerning the sales and marketing of a “Virtual Concierge” machine. The machine looks like an ATM, but carries advertising and can print tickets and coupons. It looks shady, but a machine alone is not a security. Does the SEC have jurisdiction?

According to the SEC complaint, Signore and Schumack offered two investment options. The first is the aggressive option. The investor is responsible for placing the machine. The second option is the passive option where the investor makes an investment and lets the company do the work in exchange for a guaranteed payment of $300 per month.

Under the passive option, the investment arrangement could be considered an “investment contract” under the definition of a security. I assume the court will use some derivation of the Howey case to determine if there is an investment contract, and look at whether there is

  1. an investment of money,
  2. a common enterprise,
  3. a reasonable expectation of profits, and
  4. a reliance on the entrepreneurial or managerial efforts of others.

I would guess that the aggressive option would not meet the test. But the passive option is likely to meet the test. The virtual concierge investors pay $3500, do nothing, and get $300 per month. It sounds like the investors are relying on the managerial efforts of others to generate profits.

The virtual concierge contractual arrangement sounds a lot like the orange grove investment in Howey. The actual investment is in real estate or a tangible good. But the investment is wrapped with a management contract that turns the investment into a passive investment that is likely to meet the definition of an “investment contract.”

From the criminal complaint, it sounds like Schumack and Signore were very good at convincing people to make the investment. A confidential witness states that they sold approximately 16,000 units. However, the company was only able to place 46 machines.

Of course, this story is based solely on the government’s accusations and the defendants have not had an opportunity to respond the charges. The story caught my eye as part of my continuing to quest to define a “security.”

References:

The SEC Has Seen Your Private Equity Fees And Is Not Happy With Them

money penny

According to a story in Bloomberg, the Securities and Exchange Commission has examined about 400 private equity firms and found that more than half have charged “unjustified fees and expenses without notifying investors”. The editor decided to change the headline from “unjustified” to “bogus”.

Fees and expenses charged by a fund manager to investors in the fund is always a conflict. The manager is taking cash from the limited partners.

The first question is whether the fees and expenses are adequately disclosed in the private placement memorandum or the partnership agreement. Most funds give the manager broad discretion to charge expenses for managing the investments to the investors in the fund. I have a hard time believing that over 50% of fund managers are charging expenses that are not permitted by the fund documents.

The story used “unjustified” when disclosing what the “person with knowledge of the SEC’s findings” stated about the fees. That may be more about the SEC not being happy with the fees charged, not necessarily that the fund manager is not legally entitled to the fees.

The second issue to think about with fees is whether the fees distort behavior. Certainly, a fund manager could be tempted to operate its private equity investments in a way that maximizes its fee revenue. That may cause the manager to make decisions that are in its best interest and not necessarily in the best interest of the fund investors. If a fund manager earns a fee for raising additional debt for a portfolio company, but not for raising additional equity. You might think the fund manager would be inclined to more often raise debt instead of equity.

To counter that inclination, private fund mangers earn the best returns by deliver great returns to their investors. Most managers earn a carry, taking an extra piece of the profit for good returns to investors. Taking a fee in the short term would hurt the long term, bigger return.

Compliance has a role to monitor fees to make sure they comply with the disclosures and legal agreements. It also has a role to monitor whether the nature of the additional fees distorts behavior in a way that could be perceived as adverse to investors.

The story mentions three types of bogus fees:

  1. miscalculating fees,
  2. improperly collecting money from companies in their portfolio and
  3. using the fund’s assets to cover their own expenses

One is failing to comply with the documents. Two is a potential disclosure failure. Although, the SEC may be expecting more specific disclosure than exists in the fund documents. Three may be a difference of opinion by the SEC over what should be a fund expense and what should be a management company expense.

As for expenses, the story mentions the Clean Energy Capital case where the SEC has accused the fund manager of grossly over-allocating expenses to the fund instead of the management company.

References:

What Are the Implications of the SEC’s New Private Fund Exam Unit

SEC Seal 2

Greg Roumeliotis and Sarah N. Lynch are reporting in Reuters that the Securities and Exchange Commission has formed a new group dedicated to the exam of private equity and hedge funds. This new private fund unit will be co-chaired by Igor Rozenblit and Marc Wyatt. Rozenblit is coming from the asset management unit of the SEC’s enforcement division and is a former private equity professional. Wyatt joined the SEC in 2012 as a private funds examiner and formerly worked for hedge funds.

Based on the private fund managers I have spoken with that have been subject to a SEC exam, nearly all have found that the examiners knew little about private equity, real estate, or more exotic hedge funds. Examiners’ knowledge seems mostly limited to retail investment advisers, mutual fund advisers, and basic hedge funds.

I assume the new unit will be largely focused on education. I’ve heard Rozenblit speak and he certainly understands how private equity works and where enforcement should focus. I think he will offer great insight for examiners.

Assuming this story is true, I expect there will be significant changes to the exam process for private fund managers. The document request letters have often been a poor fit for private equity funds. Some even show a complete misunderstanding of how a private equity fund operates. That leads to lots of time wasted by examiners and fund managers subject to examination.

References:

Compliance Bricks and Mortar for April 4

bricks 15

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

Small Banks Look to Sell as Rules Bite by Michael Rappaport in the Wall Street Journal

In a period when low interest rates are squeezing small banks, the costs of adhering to new regulations are taking a toll. Executives from at least a half-dozen small banks that have agreed to be acquired in recent months said the increasing regulatory burden was a factor in their decisions.

Just How Binding Are SEC Statements In An Adopting Release? by Keith Paul Bishop in California Corporate and Securities Law

The really important question is what is the legal effect, if any, of preambles to rules?  One might argue that since a preamble is not subject to notice and comment, it is not legally binding under the Administrative Procedure Act (5 U.S.C. § 551 et seq.).  However, the Ninth Circuit Court of Appeals held earlier this week that an administrative law judge could consider the regulatory preamble.  Peabody Coal Co. v. Dir., Office of Workers’ Comp. Programs, 2014 U.S. App. LEXIS 5996 (9th Cir. Apr. 1, 2014).

Paul Ryan’s Plan for the SEC: Slash & Burn by Broc Romanek in TheCorporateCounsel.net

Not sure why Rep. Paul Ryan chose the SEC as an example of a federal agency with “duplication, hidden subsidies, and large bureaucracies” in his budget plan released yesterday, but he did. This is the 4th year in a row that Ryan has proposed a plan – but the first time he has focused on the SEC specifically. Remember that the SEC is not only deficit neutral and doesn’t count against the new-fangled Congressional budget caps, but is an independent agency that brings in more money to the US Treasury than it costs. Ryan’s proposal doesn’t specify exactly how much he would cut from the SEC (rather there are budget cuts for a group of agencies as a whole on pages 38-39).

Michael Lewis’s flawed new book by Felix Salmon

I’m halfway through the new Michael Lewis book – the one that has been turned into not only a breathless 60 Minutes segment but also a long excerpt in the New York Times Magazine. Like all Michael Lewis books, it’s written with great clarity and fluency: you’re not going to have any trouble turning the pages. And, like all Michael Lewis books, it’s at heart a narrative about a person — in this case, Brad Katsuyama, the founder of a small new stock exchange called IEX.

Dear Virginia: Do better by Jessica Tillipman in The FCPA Blog

Last summer, I wrote a series for the FCPA Blog about Virginia’s “Shamefully Inadequate Ethics Laws” (see here, here and here). I was not alone in criticizing what has been deemed one of the least effective ethics regimes in the country.

Accredited Investor Verification

rich accredited investor

When Congress imposed a lifting of the ban on advertisements for private placements, it also imposed a mandate that the fundraiser “take reasonable steps to verify that purchasers of the securities are accredited investors.” The methods for verification were to be determined by the Securities and Exchange Commission.

The SEC, to its credit, did not impose impose strict methods for verification. It largely decided to allow fundraisers to use a principles-based approach. The SEC did include four non-exclusive safe harbors for verification.

Congress thought that lifting the ban would invigorate fundraising. But funds and companies have been reluctant to use it. According to a speech by Keith Higgins, only 10% of private placements have used the Rule 506(c) methods. Since September 2013, there were 900 offerings that raised $10 billion under Rule 506(c). But there were over 9,200 offerings that raised $233 billion under the old Rule 506(b) regime.

With the verification requirement, the outcome and backlash has been that fundraisers should only use one of the four methods. That of course, is silly. It’s safe, but overly cautious. The SEC did specifically state that reliance on an investor’s self-answered questionnaire alone is not taking reasonable steps. You will need to look at your potential investor and find out some additional information.

That investigation adds time and and energy. For private equity funds, it’s probably a step that should be taken anyhow. Investor defaults on capital calls is a bad thing. You want to make sure that your potential investor will be able to make the contributions over course of the expected timeline of capital calls. That’s a bit different than a one time contribution to a hedge fund or private company investment.

Minimum investment goes a long way to meeting the reasonable steps. If an investor is making a $1 million investment then presumably the investor has the $1 million new worth which is the accredited investor baseline test. The SEC did not specifically endorse this standard. The concern is that the investor may have borrowed the money to make the investment. The SEC is clearly worried about shady operators getting little old ladies to mortgage their homes to make risky investments.

For me, the biggest concern is the overhang of the proposed changes to Regulation D that were put up for comment at the same time the SEC lifted the ban. That injects too much uncertainty into the fundraising process. The SEC stated that there will likely be a grace period and some transitional relief. But its hard to plan a fundraising that could take 12 months with that kind of uncertainty.

I was interested in using Rule 506(c) because of the uncertainties around the definition of general solicitation and advertising. It would be great to eliminate potential foot-faults. I could sleep better at night, not worrying about whether an employee would mention fundraising at an industry event. The company could respond to media requests and could correct misinformation in the media about the fundraising.

But the SEC has left too much uncertainty in the process to fully embrace a Rule 506(c) offering.

References:

The SEC Endorses Yelp for Investment Advisers

yelp

Investment Advisers and the Securities and Exchange Commission have been struggling with the use of social media. Advisers see it as a way to communicate with clients and potential clients. The SEC sees it as an area ripe for fraud. Both are right.

The SEC has stuck fast to rules on advertisements when it comes to social media. The SEC does not care if the social media sites cannot meet the control and record-keeping standards. The SEC does not care if it’s hard to meet the standards. Clearly, the SEC is focused on investor protection in this area. The features of social media sites keep changing so it’s hard to keep the features in line with the SEC requirements.

But the SEC listens to the complaints and keeps releasing guidance in this area. The SEC released Investment Management Guidance 2014-4 that provides some additional guidance on the intersections of testimonial and social media sites.

Rule 206(4)-1(a)(1) prohibits the use of testimonials in an investment adviser’s advertisements. The SEC considers the publication of testimonials to be inherently misleading because “they emphasize the comments and activities favorable to the investment adviser and ignore those which are unfavorable”.

The SEC did make an exception for third party rankings. See DALBAR.

The new guidance merely points investment advisers to the prior guidance on testimonials and tries to add some context to the use of social media sites. I think most advisers will not find much good news in the guidance.

In looking through the questions and answers I only see Yelp and its copycat sites being allowed by the guidance. I assume many thought the guidance would be an endorsement of Facebook pages, but that feature seems to fall outside the acceptable areas allowed by the guidance.

A Facebook page is controlled by the publisher (the adviser) and is therefore not an independent site. The SEC requires the social media site to be independent. Others may see some wiggle room in allowing ratings on a Facebook page for investment advisers. I think you need to be very cautious because the feature and controls on Facebook pages change rapidly and inconsistently.

That leaves Yelp and its copycats that rate businesses. I already see a few ratings of investment advisers in Boston.

The Guidance points out that recommendations posted by the adviser or its employees are strictly prohibited. Similarly, an adviser can’t pay for recommendations or offer discounts to clients to post commentary.

References: