Category: Fundraising

Filing Private Fund Private Placement Memoranda with FINRA

Starting on December 3, 2012, FINRA members must file a copy of any private placement memorandum, term sheet or other offering document the firm used within 15 calendar days of the date of the sale. Placement agents for private funds will likely be FINRA members and subject to this rule.

FINRA Rule 5123 is part of FINRA’s approach to increase oversight and investor protection in private placements. FINRA established standards on disclosure, use of proceeds and a filing requirement for private placements issued by a member firm or a control entity in Rule 5122. FINRA also has previously provided guidance on the scope of a firm’s responsibility to conduct a reasonable investigation of private placement issuers in Regulatory Notice 10-22.

However, the rule has some big exemptions. The following private placements are exempt from the requirements of this Rule:

(1) offerings sold by the member or person associated with the member solely
to any one or more of the following:

(A) institutional accounts, as defined in Rule 4512(c);
(B) qualified purchasers, as defined in Section 2(a)(51)(A) of the Investment Company Act;
(C) qualified institutional buyers, as defined in Securities Act Rule 144A;
(D) investment companies, as defined in Section 3 of the Investment Company Act;
(E) an entity composed exclusively of qualified institutional buyers, as defined in Securities Act Rule 144A;
(F) banks, as defined in Section 3(a)(2) of the Securities Act;
(G) employees and affiliates, as defined in Rule 5121, of the issuer;
(H) knowledgeable employees as defined in Investment Company Act Rule 3c-5;
(I) eligible contract participants, as defined in Section 3(a)(65) of the Exchange Act; and
(J) accredited investors described in Securities Act Rule 501(a)(1), (2), (3) or (7).

That list is likely going to mean that private fund offering will not be subject to the rule as long as they exclude non-accredited investors from the offering. Or at least exclude the placement agent from soliciting non-accredited investors. Given the likely lifting of the ban on general solicitation for private funds that exclude non-accredited investors this rule is likely to further limit the access of non-accredited investors to private funds.

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SEC Brings a Pay-to-Play Action

The Securities and Exchange Commission filed a “pay-to-play” case against Goldman Sachs and one of its former investment bankers, Neil M.M. Morrison. The SEC alleges that Goldman and Morrison made undisclosed campaign contributions to then-Massachusetts state treasurer Timothy P. Cahill while he was a candidate for governor.

The case was brought under the Municipal Securities Rule on pay-to-play: MSRB Rule G-37. The SEC’s investment adviser/private fund rule on pay to play, Rule 206(4)-5, is based closely on that MSRB rule.

The SEC’s order found that Goldman Sachs did not disclose any of the contributions on MSRB forms and did not  keep records of the contributions in violation of MSRB rules.

Goldman Sachs agreed to settle the charges by paying $7,558,942 in disgorgement, $670,033 in prejudgment interest, and a $3.75 million penalty. This is the largest fine ever imposed by the SEC for Municipal Securities Rulemaking Board pay-to-play violations. The SEC’s case against Morrison continues.

According to the SEC’s order against Goldman Sachs, Morrison worked in the firm’s Boston office and solicited underwriting business from the Massachusetts treasurer’s office beginning in July 2008. Morrison was substantially engaged in working on Cahill’s political campaigns. Before joining Goldman Sachs, between January 2003 and June 2007, Morrison was employed by the Massachusetts Treasurer’s Office, which included positions as the first deputy treasurer, chief of staff and assistant treasurer, reporting directly to Cahill.

Morrison participated extensively in Cahill’s gubernatorial campaign, often during working hours from his Goldman Sachs office, and used Goldman Sachs resources (such as phones, e-mail and office space). The SEC claims that Morrison’s use of Goldman Sachs work time and resources for campaign activities constituted valuable in-kind campaign contributions to Cahill that were attributable to Goldman Sachs and disqualified the firm from engaging in municipal underwriting business with certain Massachusetts municipal issuers for two years after the contributions.

While Morrison was an employee and working on the Cahill campaign, Goldman Sachs participated in 30 prohibited underwritings with Massachusetts issuers and earned more than $7.5 million in underwriting fees.

According to the complaint, this seems like an egregious violation of the pay-to-play rules. It does highlight that items beyond cash contributions could be considered a “contribution” under the pay-to-play rule.

We would not consider a donation of time by an individual to be a contribution, provided the adviser has not solicited the individual’s efforts and the adviser’s resources, such as office space and telephones, are not used….

A covered associate’s donation of his or her time generally would not be viewed as a contribution if such volunteering were to occur during non-work hours, if the covered associate were using vacation time, or if the adviser is not otherwise paying the employee’s salary

Sec Release IA-3403 page 46 and footnote 157 (.pdf)

From a compliance perspective, the question is how to value the use of time in the office, email, and phone usage. I suppose you can add up long distance charges. For employees you can use their hourly rate to determine time spent.  For Morrison, it appears that even using a very conservative measurement  of his time and the Goldman resources, the value would be many times in excess of the $250 limit under the MSRB rule. (The SEC limit is $350 if you can vote for the person.)

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Senate Races and SEC Limits on Political Contributions

Last year a new rule from the Securities and Exchange Commission went into effect that limited the ability of investment advisers and private fund managers to make political campaign contributions. The purpose was to prevent some illicit pay-to-play activity by government officials who control government sponsored investment funds. With the close of the national political conventions and selection of the Republican and Democratic tickets, it’s clear how the pay-to-play rule for investment advisers will affect the presidential fund-raising.

It won’t.

Let’s take a look at Congress and see how  Rule 206(4)-5 affects campaign contributions for some of the currently competitive Senate races.

Connecticut

Chris Murphy is currently a member of the US House of Representatives. Therefore, donations to him would not be limited by the rule.

Linda McMahon does not currently hold a political office. She was the former CEO of World Wrestling Entertainment. Therefore, donations to her would not be limited by the rule.

Indiana

Joe Donnelly is a member of the U.S. House of Representatives. Therefore, donations to him would not be limited by the rule.

Richard Mourdock is the current  State Treasurer of Indiana. That position raises a red flag and requires further research. The Treasurer or his nominee serves on the Board of Trustees of the Indiana Public Retirement System, the state’s largest pension system. If your firm want access to those government investment funds, you will need to limit donations to Mr. Mourdock.

Massachusetts

Scott Brown is the incumbent Senator. Therefore, donations to Mr. Brown would not be limited by the rule.

Elizabeth Warren is a professor at Harvard and does not currently hold a political office. Therefore, donations to her would not be limited by the rule.

Missouri

Claire McCaskill is the incumbent Senator. Therefore, donations to her would not be limited by the rule.

Todd Akin is a Republican member of the United States House of Representatives. Therefore, donations to him would not be limited by the rule.

Montana

Jon Tester is the incumbent Senator seeking reelection. Therefore, donations to him would not be limited by the rule.

Denny Rehberg is currently a member of the US House of Representatives. Therefore, donations to him would not be limited by the rule.

Nevada

Shelley Berkley is a member of the United States House of Representatives. Therefore, donations to her would not be limited by the rule.

Dean Heller is the incumbent Senator. Therefore, donations to him would not be limited by the rule.

North Dakota

Heidi Heitkamp is a former Attorney General, but does not currently hold a political office. Therefore, donations to her would not be limited by the rule.

Rick Berg is a member of the United States House of Representatives. Therefore, donations to him would not be limited by the rule.

Ohio

Sherrod Brown is the incumbent Senator. Therefore, donations to Mr. Brown would not be limited by the rule.

Josh Mandel is the current Treasurer of Ohio. Donations to Mr. Mandel are limited by the rule. The Treasurer appoints members to the state retirement system boards who select investment and investment advisers.

Virginia

Tim Kaine is a former Governor of Virginia. Therefore, donations to him would not be subject to the rule. If he was still the sitting governor, donations to him would have been limited.

George Allen is also a former Governor of Virginia and was a former US Senator from Virginia. Therefore, donations to him would not be subject to the rule. If he was still the sitting governor, donations to him would have been limited.

Wisconsin

Tammy Baldwin is currently a member of the US House of Representatives. Therefore, donations to her would not be limited by the rule.

Tommy Thompson was a former governor of Wisconsin, but does not currently hold a political office. Therefore, donations to him would not be subject to the rule. If he was still the sitting governor, donations to him would have been limited.

Also keep in mind that contributions to state and local political parties are also limited by the rule.

Even if the contributions to a particular candidate are not limited by the rule, an investment adviser is still required to keep a record of all campaign contributions.

Senate Map is from Real Clear Politics

The Vice President and SEC’s Pay to Play Rule

Now that the Democratic and Republican conventions have ended and the presidential tickets are final, we can look at how the SEC’s new rule on political contributions will affect the November election. It won’t.

Early in the Republican contest for the nomination, Rick Perry was on the watch list under Rule 206(4)-5. Since he could directly or indirectly control several state pension funds in the State of Texas, contributions to Governor Perry would be subject to the rule. That means limiting contributions to $350.

It’s clear how the rule worked for Presidential nominees. It was not clear to me how the rule would work with the vice presidential candidates. The office itself does not control a government pension fund. But you need to look to the candidates current office as well under the Rule.

If Mr. Romney had selected a sitting governor, such as New Jersey’s Chris Christie, the SEC rule would have limited political contributions to the Republican ticket. In most states, Governors appoint board members for the state pension funds. It’s not clear whether that nomination would have tainted past contributions to the Republican campaign.

With Mitt Romney’s selection of Paul Ryan as his vice presidential running mate, we don’t have to look for the answer yet. Mr. Ryan is an incumbent U.S. Congressman and is not associated with selecting advisers or investments for a government pension fund.

Based on a quick glance of the other tickets, it looks like the pay-to-play rule does not apply to most of the other political parties looking to grab a few votes in November.

The Libertarian Party is on the ballot in most states. It’s candidates Former Governor Gary Johnson (New Mexico) and
Former Superior Court Judge Jim Gray (California) do not currently hold political office.

The Green Party weaved its way through the ballot process and managed to get on the ballot in about half of the states. Neither Dr. Jill Stein (Massachusetts) nor Cheri Honkala (Pennsylvania) currently hold political office.

I’m a bit confused by the ballot of the Party of Socialism and Liberation. Their presidential candidate, Peta Lindsay, and their vice presidential candidate, Yari Osorio, are both under the Constitution’s mandated minimum age for their respective offices. In addition Mr Osorio is foreign born, making him further ineligible to hold the office.

I have no comment on Rosanne Barr’s presidential campaign.

506(c) and General Solicitation and Advertising in Securities Offerings

Section 201(a)(1) of the Jumpstart Our Business Startups Act (the “JOBS Act”) directs the Securities and Exchange Commission to amend Rule 506 of Regulation D. Congress wants to permit general solicitation or general advertising in offerings made under Rule 506, provided that all purchasers of the securities are accredited investors. With one caveat: the issuer must take reasonable steps to verify that purchasers of the securities are accredited investors. After some delays, the SEC has finally published a proposed rule to implement the Congressional mandate.

After waiting all summer for a proposed rule, the SEC decided to finally take action during my vacation. And on the day I promised to take my kids to Story Land. My review of the rule and commentary would have to wait until my kids had their fill of Cinderella and the Bamboo Chutes.

Thanks to William Carleton’s live blog and a review of speeches, I could see that the five commissioners were not in full agreement about the rule or the procedure for adopting the rule. Commissioner Gallagher was in favor of the proposed rules, but wanted it to be an interim final rule. Commissioner Aguilar thought the proposed rules did not go far enough in protecting investors. In the end, that may not mean much.

As expected, the removal of the general solicitation and public offering prohibitions, comes with a few caveats.

Does Not Remove Ban

I found it interesting that the SEC chose to create a new regulatory scheme, rather than merely eliminate the ban. The proposed rule includes a new Rule 506(c) that permits general solicitation and advertising provided all investors are accredited and the issuer takes reasonable steps to verify that they are accredited. 506(b) stays in place allowing an issuer to have up to 35 sophisticated, but non-accredited investors, provided there is not general solicitation or advertising, but does not have to take reasonable steps to verify the investors’ status.

“Take reasonable steps to verify”

The SEC did not do what many feared would be the worst result under the JOBS Act. The proposed rule does not impose any specific requirement to verify that an investor meets the standard of an accredited investor. “Whether the steps taken are “reasonable” would be an objective determination, based on the particular facts and circumstances of each transaction.”

To some extent that seems okay. In the private equity fund model we have a particular concern that a potential investor will be able meet a capital call. It should just mean having to document the diligence process.

However, the SEC did strike one common aspect of fundraising practice.

[W]e do not believe that an issuer would have taken reasonable steps to verify accredited investor status if it required only that a person check a box in a questionnaire or sign a form, absent other information about the purchaser indicating accredited investor status.

Offering documents will need to be changed.

A Non-Accredited Investor Sneaks In

The language of the JOBS Act made some, including me, nervous that if a non-accredited investor could sneak into an offering and blow up the exemption. A person of limited means really wanted to be an investor, lied on the questionnaire, but passed through the reasonable steps taken by the issuer to verify status. Fortunately, the SEC took that position that the issuer would not lose the ability to rely on the Rule 506(c) exemption, so long as the issuer took reasonable steps to verify that the purchaser was an accredited investor and had a reasonable belief that such purchaser was an accredited investor.

Changes to Form D

In addition, to the new 506(c) the SEC is proposing to amend Form D. The notice filing with the SEC would have a check box to indicate whether an offering is being conducted pursuant to the proposed Rule 506(c) that would permit general solicitation.

Blessing for Private Funds

Private funds typically rely on the Rule 506 safe harbor to raise funds without having to register under the Securities Act. Private funds were also restricted under Section 3(c)(1) and Section 3(c)(7) of the Investment Company Act from making a public offering of securities. Historically, the SEC has considered rule 506 transactions to be non-public offerings. But would the SEC change that position given its hostility towards the JOBS Act?

Thankfully, the answer is no.

We believe the effect of Section 201(b) is to permit privately offered funds to make a general solicitation under amended Rule 506 without losing either of the exclusions under the Investment Company Act.

Comments

Now there is 30 comment period. I’m just guessing, but I’d be surprised to see changes to the proposed rule. I think the benefit of the comment period will be to add some additional commentary around the “reasonable steps to verify” standard.

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What Does FINRA Think About Crowdfunding?

The crowdfunding provisions in Title III of the JOBS Act provide an exemption from registration under the Securities Act of 1933 for securities offered by through crowdfunding, provided the numerous requirements are met. An intermediary that seeks to engage in crowdfunding must be registered as a broker-dealer or a funding portal. I expect many people are looking at what the regulatory requirements are going to be for this new type of entity. The JOBS Act also requires that a funding portal be a member of an applicable SRO, but limits the examination and enforcement authority of the SRO over registered funding portals to rules “written specifically for registered funding portals.”

FINRA issued Regulatory Notice 12-34 soliciting public comment on the appropriate scope of FINRA rules that should apply to member firms engaging in crowdfunding activities, either as funding portals or as brokers.

Commenters are encouraged to identify the types of requirements that should apply to registered funding portals, taking into account the relatively limited scope of activities by a registered funding portal permitted under the JOBS Act. Comments are particularly requested about possible rules concerning supervision, advertising, anti-money laundering, fraud and manipulation, and just and equitable principles of trade.

I think would-be crowdfunding portal developers are going to have a hard time dealing with the know-your-customer rules required in setting up an account.

Would established firms set up crowdfunding portals. FINRA is clearly anticipating that some of its member firms will do so. And why not? I’m sure a brokerage firm could view a crowdfunding portal as a minor league, allowing them to farm prospects for bigger alternative investments.

FINRA is already looking at potential conflicts.

FINRA also requests comment on whether engaging in crowdfunding might present special conflicts or concerns for a broker-dealer, such as might arise if a registered representative were to recommend that a customer visit the firm’s crowdfunding site.

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The Rebirth of Regulation A Offerings

The Jumpstart Our Business Startups Act requires the Securities and Exchange Commission to amend Regulation A, raising the threshold for use of that exemption from $5 million to $50 million. From the numbers I’ve seen, Regulation A was rarely used as a source of raising capital. It seemed strange that it was included in the JOBS Act. But there were many strange things in the JOBS Act.

Section 402 of the JOBS ACT required the GAO to study the impact of state securities laws on Regulation A offerings. The GAO released its study: Factors That May Affect Trends in Regulation A Offerings.

The report confirmed the lack of use of Regulation A in capital raising. The number of Regulation A offerings filed with the SEC decreased from 116 in 1997 to 19 in 2011. Similarly, the number of qualified offerings dropped from 57 in 1998 to 1 in 2011.

The big difference is that Regulation A offerings are still subject to state securities laws. In contrast, Rule 506 offerings under Regulation D are not subject to the state securities law.

To contrast, there were 15,500 initial Regulation D offerings for up to $5 million in 2010 and 2011, compared to the 8 qualified Regulation A offerings during the same period.

One aspect of a Regulation A offering compared to a Regulation D offering is that it is subject to review, comment, and qualification by the SEC. According to the GAO report 20% of Regulation A filings were abandoned during the SEC comment process.

Another aspect of Regulation A is that the securities’ sales are not limited to accredited investors. So there is a larger pool of potential investors.

On the state side of the process, all states conduct a similar disclosure review as the SEC. Apparently some states will also engage in a merit review to determine if potential investors are getting a good deal. According to the report, businesses are generally advised by legal counsel to avoid Regulation A offerings in states that have a merit review.

So where does this leave Regulation A offerings in the new world of capital formation after the JOBS Act? I would guess in the same place. The big advantage of Reg A offerings over Reg D offering is that they can be sold to non-accredited investors. That comes with a lot of cost and lost time to go through the review process. I would guess that the new crowdfunding offering would be a more attractive alternative to reaching non-accredited investors. Of course, the regulations on crowdfunding do not yet exist and the mandatory equity crowdfunding portals do not yet exist.

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Pay to Play and Cash Solicitations

The Securities and Exchange Commission extended the date by which registered investment advisers must comply with the ban on third-party solicitation in Rule 206(4)-5 under the Investment Advisers Act. The SEC is extending the compliance date in order to ensure an orderly transition. Since solicitors will need to registered as an investment adviser or a broker/dealer or a municipal advisor.

Part of the rule was reliant on FINRA coming up with a rule to meet the requirements under the definition of “registered person” in 206(4)-5(f)(9)(ii)(B) for broker-dealers. FINRA has not done that yet. (Isn’t FINRA supposed to be more effective than the SEC?)

It’s not just FINRA, the the Municipal Securities Rulemaking Board has not finished its rules for municipal advisers under 206(4)-5(f)(9)(iii).

My IACCP symposium also raised the limitations in Rule 206(4)-3. That rule prohibits the use of solicitors in fundraising unless certain requirements are met. The rule specifically refers to “clients” with no further elaboration. For a private fund, that raises the distinction between the fund as a client and the fund investors as limited partners in the fund.

Fortunately, there is an interpretative letter ruling on the topic

We believe that Rule 206(4)-3 generally does not apply to a registered investment adviser’s cash payment to a person solely to compensate that person for soliciting investors or prospective investors for, or referring investors or prospective investors to, an investment pool managed by the adviser.

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Skin in the Game

Limited partners prefer that a private fund manager have an equity stake in the fund.  In the past, the general partner had to put in equity to make sure the fund qualified as a partnership under tax law. The change in the tax law categorization by the check-the box regulations removed the multipart test to determine if an entity should receive partnership or corporate tax treatment. That effectively ending the tax driven decision that the general partner have a significant ownership interest in the partnership.

A secondary benefit from the general partner’s equity stake was that the fund manager’s economic interest was better aligned with the limited partners’ interests. If the fund took a loss, the general partner also experienced the loss.

A recent SEC case focused on a fund manager’s false claim of having “skin in the game.” Quantek Asset Management represented to prospective investors that its principals had invested their own money in the private funds. Quantek, Bullick Capital, Javier Guerra, and Ralph Patino each settled the charges, but without admitting or denying the findings. I’m treating the findings as true for educational purposes, hoping to find some lessons from this SEC enforcement.

The Alternative Investment Management Association’s standard Illustrative Questionnaire for Due Diligence Review of Hedge Fund Managers asked two questions about “skin in the game”:

  1. What is the total amount invested by the principals/management in the fund and other investment vehicles managed pari passu with the fund?
  2. Has the management reduced its personal investment?

In December 2006, Quantek answered question with $13 million. In later questionnaires that amount was reduced to $10 million, then in June 2007 it went down to $10 million, and in December 2007 fell to $7 million. In each instance the answer to question 2 was “no”.

The SEC says that the correct answer to question 1 was always zero. The principals had not invested any capital in the funds. In their defense, Quantek claims a misunderstanding that they thought some unrelated investments should have been credited as being made pari passu with the funds.  Quantek finally got the amount right in June 2009 when it finally answered no to question 1.  By this point, Quantek had obtained almost $1 billion in assets under management.

In addition to the due diligence questionnaires, Quantek also entered into side letters that limited the ability of the principals to reduce their fund ownership by more than 20%. Such a provision does not make any sense if the principals do not have any fund ownership.

In addition, the SEC found two other areas of failure. Quantek misled investors about certain related-party loans made by the fund to affiliates of Guerra and Bulltick. Second, Quantek  repeatedly failed to follow the robust investment approval process it had described to investors in the fund. Quantek concealed this deficiency by providing investors with backdated and misleading investment approval memoranda signed by Guerra and other Quantek principals.

Quantek and Guerra agreed jointly to pay more than $2.2 million in disgorgement and pre-judgment interest, and to pay financial penalties of $375,000 and $150,000 respectively. Bulltick agreed to pay a penalty of $300,000, and Patino agreed to a penalty of $50,000.Guerra consented to a five-year securities industry bar. Patino consented to a securities industry bar of one year.

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Image of the Petronas Towers is by Magnus Manske

Gathering Information on Your Private Fund Investors

One item that I picked up from PEI’s recent Private Fund Compliance Conference is the new way you need gather information about investors in your private fund for Form PF. I put Form PF to the side because my filing is not required until next year. However, there is a key March 31, 2012 date in the Adopting Release for Form PF (.pdf).

In Section 1b, Item B. Question 16 (.pdf)Form PF  asks the manager to “specify the approximate percentage of the reporting fund’s equity that is beneficially owned” by the listed category of investors. You need to file Form PF if you listed private funds in your Form ADV.

The catch in the instruction is:

With respect to beneficial interests outstanding prior to March 31, 2012, that have not been transferred on or after that date, you may respond to this question using good faith estimates based on data currently available to you.
(my emphasis)

If you are fundraising now, it looks like you need to make sure your subscription documents require the investor to self-select their designation. I suppose you also need to do some diligence to make sure the selection is correct.

Even if you’re not fundraising, you need to address this change for any transfers in a private fund after March 31, 2012.

The analysis for which sections of Form PF you need to fill out is a bit complicated. But every private fund needs to fill out Section 16 and answer the question about the beneficial ownership of the fund. Every private fund needs to start gathering information about their investors using this data scheme:

(a) Individuals that are United States persons (including their trusts);
(b) Individuals that are not United States persons (including their trusts);
(c) Broker-dealers;
(d) Insurance companies;
(e) Investment companies registered with the SEC;
(f) Private funds;
(g) Non-profits;
(h) Pension plans (excluding governmental pension plans);
(i) Banking or thrift institutions (proprietary);
(j) State or municipal government entities (excluding governmental pension plans);
(k) State or municipal government pension plans;
(l) Sovereign wealth funds and foreign official institutions; or
(m) Investors that are not United States persons and about which the foregoing beneficial ownership information is not known and cannot reasonably be obtained because the beneficial interest is held through a chain involving one or more third-party intermediaries.
(n) Other

 

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