Category: Fundraising

Hypothetical Backtested Performance

Yesterday’s post on faking returns made me think about the use of theoretical models and the ability of an investment adviser or fund manager to use hypothetical performance instead of actual performance. The real use of performance figures is in advertising, so the SEC’s rules on advertising are the key focus. (I don’t see how hypothetical performance works on reports to investors, unless you’re Bernie Madoff.)

Backtesting involves the use of theoretical performance developed by applying a particular investment strategy to historical financial data. You’re more likely to see it for a quantitative or formula-based strategy than anything else. The backtested results show investment decisions that theoretically would have been made had the given strategy been employed during the particular past period of time. However, backtesting does not involve actual market risk or client money.

The SEC rules do not explicitly address model performance. You would have to look at IA Rule 206(4)-1 (a)(5) which prohibits any advertisement that “contains any untrue statement of a material fact, or which is otherwise false or misleading.” Backtesting is going to start from a position as being highly suspect since it’s not based on actual events.

The adviser will need to disclose that there are inherent limitations on the data derived from the retroactive application of a model developed with the benefit of hindsight. The adviser needs to disclose the reasons why actual results may differ. See In re Market Timing Systems, Inc. et al., SEC Release No. IA-2047

One of the problems with backtesting is whether the securities and trades that would be used going forward were available in past. This is a particular problem when using synthetic products or derivatives. Of course, the advertised performance must reflect the deduction of advisory fees, brokerage or other commissions, and any other expenses that a client would have paid.

The most obvious need in using a theoretical model is that adviser needs to disclose that the performance was derived from the retroactive application of a model developed with the benefit of hindsight and not with real money at stake. See In re Schield Management Company et al., SEC Release No. IA-1872

The SEC has indicated that labeling backtested returns as “hypothetical”, “pro-forma”, or that “actual results were available upon request” in and of itself, is insufficient to satisfy the disclosure requirement. (see In re Schield Management Company et al., SEC Release No. IA-1872  and In re LBS Capital Management, Inc., SEC Release No. IA-1644) It  fails “to convey fully the inherent limitations of the data derived from the retroactive application of a model developed with the benefit of hindsight.” The disclosures need to be robust enough to dispel the misleading suggestion that the advertised performance represented actual trading.

There are no set rules, so you need to look toward enforcement actions to see what actions the SEC found to be egregious.

In re Patricia Owen-Michel, SEC Release No. IA-1584 (Sept. 27, 1996)

In the enforcement case against Patricia Owen-Michael, the SEC sanctioned the president of an investment adviser for allegedly circulating misleading advertisements that used a computer-based statistical model to select stocks and mutual funds and to generate trading signals. The adviser’s advertisements included charts and graphs depicting hypothetical performance of an investment model applied retroactively. The SEC alleged that the various charts and graphs depicting hypothetical performance of the model failed to disclose:

  • That the adviser only began offering the given service after the performance period depicted by the advertisement;
  • That the advertised performance results do not represent the results of actual trading but were achieved by means of the retroactive application of a model designed with the benefit of hindsight;
  • All material economic and market factors that might have had an impact on the adviser’s decision making when using the model to manage actual client accounts;

In re Schield Management Company et al., SEC Release No. IA-1872 (May 31, 2000)

In the 2000 case against Schield Management, the SEC alleged that the firm distributed materially false and misleading advertisements because it combined the pre-implementation data with performance data from periods following Schield’s implementation of the relevant trading strategies. One chart showed that the Schield’s model consistently outperformed the S&P 500 index without disclosing that Schield’s actual implementation of the strategy actually underperformed the S&P 500 index. The advertisements also failed to disclose that it applied materially different trading rules in calculating the performance of the strategy before and after the actual implementation of the strategy.

According to the SEC, Schield published advertisements that materially overstated their performance because they failed to deduct the full management fee and other fees earned by the firm from the performance results. On a cumulative basis, this had the effect of overstating the performance of the strategy by more than thirteen percent. The firm also included performance numbers that were calculated erroneously.

In re LBS Capital Management, Inc., SEC Release No. IA-1644 (July 18, 1997)

In the case against LBS Capital Management, Inc., the SEC sanctioned an investment adviser who had developed a mutual fund timing and selection service by using historical financial data, but failed to “disclose with sufficeint prominence or detail that the advertised results … did not represent the results of actual trading using client assets”.

The advertisement disclosed in a footnote that the performance results were “pro-forma,” that “model” performance was “no guarantee of future results,” that the timing service “ went live” in January 1994, and that “actual results” were “available upon request.”

The SEC found that the footnote disclosure was inadequate under the  facts and circumstances.  Citing In the Matter of Jesse Rosenbaum (IA Release No. 913, May 17, 1984), the SEC pounded on the table and stated that a misleading statement in an advertisement cannot be “cured by the disclaimers buried in the [smaller print] text [of the advertisement].”

The SEC also noted that the advertisement was distributed to the adviser’s existing and prospective retail clients “without regard for their investment sophistication or acumen.” Using the facts and circumstances test, the SEC used the standard of an unskilled and unsophisticated investor.

In re Market Timing Systems, Inc. et al., SEC Release No. IA-2047 (Aug. 28, 2002)

In the case against Market Timing Systems, the SEC alleged that Market Timing Systems, Inc. promoted returns for its model of over 70% for a 13 year time period. However, the advertisements did not disclose that the performance results were hypothetical and were generated by the retroactive application of the mode. The advertisements with 13 years of performance were distributed in 1999 and Market Timing did not begin business until 1998.

One point in this case clarifies the problem with using hypothetical models. The actual performance of client accounts during its first quarter of operations was materially less than the model’s hypothetical results for the same period.

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How Popular is Regulation D Fund Raising?

 

With the passage of the Jumpstart Our Business Startups Act, it makes sense to look at the regulations around capital formation and see how they affect the ability of companies to raise capital and how they chose to do so. Of course larger economic effects may outsize the influence of the choices.

The SEC’s Division of Risk, Strategy and Financial Innovation published a report on capital raising using Regulation D. (.pdf) The Division looked at Form D filings from January 2009 to March 2011.

The most startling aspect of the report is that the SEC has only been collecting Reg D filings in a machine-readable form since March, 2009. There are decades worth of data sitting in paper format. The other flaw is that the Reg D filings do not require a filing as to the final dollar amount of securities sold through the offering. Although the SEC has very exact information about publicly available securities, it only has estimates of private offerings.

Some key findings:

  • In 2010, Reg D offerings surpassed debt offerings as the dominant offering method in terms of aggregate amount of capital raised in the U.S.: $905 billion.
  • The average Reg D offering is $30 million, but the median Reg D offering is modest in size: approximately $1 million.
  • Public issuances fell by 11% from 2009 to 2010 while private issuances increased by 31% over the same period.

I also found it interesting to compare this report’s findings with a recent article published in the Business Lawyer: The Wreck of Regulation D: The Unintended (and Bad) Outcomes for the SEC’s Crown Jewel Exemptions by Rutheford B. Campbell, Jr. The two studies cover different time frames and the SEC excludes some types of filings, but there are some startling differences.

The SEC found that 55% of the offerings were under Rule 506. Campbell found that 94% of the offerings were under Rule 506. The biggest problem is that Rule 504 and Rule 505 offerings are subject to state blue-sky laws. Campbell’s argument is that the failure to preempt state regulation pushes more issuers into the tougher requirements of Rule 506, even though the fundraising totals are small enough to fit under Rule 504 or Rule 505. That still with the ban on general solicitation and advertising under Rule 506.

Both found that very few non-accredited investors purchased securities through the Reg D offerings. The SEC found that 90% of the offering had no non-accredited investors, with average amount of 0.1 non-accredited investors and a median of 0. Campbell merely used a sample, but similarly found that the vast majority of offering were limited to accredited investors.

The SEC study emphasizes that Reg D offerings are the opposite of crowdfunding. The median number of investors in an offering is 4, with almost 90% of the offerings involving 30 or fewer investors and 99% of offerings having fewer than 155 investors.

What’s clear is that capital raised in private offering under Regulation D rivals the capital raised in public offering.

It does leave you questioning why Congress felt the need to remove the ban on general solicitation and advertising on private offering to accredited investors under the JOBS Act. It looks like private offerings are raising lots of capital.

It seems clear to me that the private capital market is poorly understood by the Securities and Exchange Commission and poorly understood by Congress. There needs to be better data and better studies.

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Will Private Funds Be Excluded?

Title II of the Jumpstart Our Business Startups Act directs the SEC to lift the ban on general solicitation and advertising under Rule 506 of Regulation D. That rule creates a safe harbor that deems the covered transactions to not involve any public offering within the meaning of section 4(2) of the Securities Act.

However, private funds also have to deal with the restriction in the Investment Company Act that also limits public offerings. Under the exclusions in 3(c)1 and 3(c)7 the fund must be an issuer “which is not making and does not presently propose to make a public offering of its securities”. Historically, the SEC has interpreted the meaning of “public offering” to be the same between the two acts. So not being a public offering under Rule 506 meant the offering was not public under the Investment Company Act.

For real estate fund managers relying on the 3(c)5 exclusion, there is no ban on a public offering in that exclusion.

The JOBS Act requires the SEC to revise its rule, so we don’t know exactly how the changes to Rule 506 will work. It’s possible that the SEC will limit the changes to the Securities Act and not open general advertising to funds under 3(c)1 and 3(c)7 who are required to be private.

However, Section 201(b) of the JOBS Act contains this:

(b) CONSISTENCY IN INTERPRETATION.—Section 4 of the Securities Act of 1933 (15 U.S.C. 77d) is amended—

(1) by striking ‘‘The provisions of section 5’’ and inserting

‘‘(a) The provisions of section 5’’; and

(2) by adding at the end the following:

‘‘(b) Offers and sales exempt under section 230.506 of title 17, Code of Federal Regulations (as revised pursuant to section 201 of the Jumpstart Our Business Startups Act) shall not be deemed public offerings under the Federal securities laws as a result of general advertising or general solicitation.’’.

(My emphasis)

I assume the Investment Company Act is part of the “Federal securities laws.” I suppose you could argue that the Investment Advisers Act and the Investment Company Act operate separately from the Securities Act and the Exchange Act. That would be a tough argument for the SEC to make. The SEC could explicitly not include 3(c)1 and 3(c)7 under the changes to Rule 506.

That would seem unlikely. Take a look at the SEC’s own website “Researching the Federal Securities Laws Through the SEC Website” where it lists the Investment Company Act and Investment Advisers Act as part of the federal securities laws.

More likely would be the SEC issuing a rule with no mention of 3(c)1 and 3(c)7 or the Investment Company Act. That might leave practitioners a bit nervous about the gap.

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Crowdfunding the Crowdfunders

With President Obama set to sign the Jumpstart Our Business Startups Act on Thursday, it seems the race is on to create a crowdfunding portal and to start making money. Crowdfunding has been around for a long time and the use of a crowdfunding portal dates back several years. Now there is a crowdfunding accreditation program and a trade association.

Crowdsourcing.org has launched the Crowdfunding Accreditation for Platform Standards program to promote the adoption of best practices. Eight platforms have obtained the green ribbon since the program started on March 21:

PleaseFund.Us
Crowdcube
Crowdfunder 
Grow Venture Community
GreenUnite
HelpersUnite
SymBid
Fundrazr

David Marlett announced the formation of the National Crowdfunding Association, “the professional organization of all companies and individuals with an interest in crowdfunding. The NCFA is charged with “supporting, educating and protecting the American crowdfunding industry.” According to the press release, over “fifty companies and individuals dedicated to the nascent crowdfunding industry came together to form the association.

Mr. Marlett claims to have launched the first crowdfunding agency on March 21, 2012 and is now the executive director of the National Crowdfunding Association. They even have twitter accounts, Facebook pages, and blogs. (Does that make it real?)

Over on the transcedant Quora, questions keep coming on Crowdfunding: Crowdfunding will explode after the JOBS Act passes. How can I invest in a crowdfunding site?

My original thought on crowdfunding was a line from Groucho Marx, “Please accept my resignation. I don’t care to belong to any club that will have me as a member.” if these investments and opportunities are so good, why hasn’t a professional investor delivered the funding? Why would the company want my $1,000? Maybe they are not that good? Maybe they are inexperienced? Maybe they are just looking to make a quick buck?

In looking at the race to create crowdfunding portals and associations of portals I have the same concerns. There are plenty of existing sites and existing companies that could easily choose to dominate the marketplace, if they so choose. The Securities and Exchange Commission has to craft a regulatory structure to deal with the CROWDFUND Act. That will take months.

For now it seems there will be tussle for attention in the space. The megaphones are out. There will be losses.

Steps to Determine if an Investor is Accredited

Private funds will be able to advertise and solicit for investor, provided all of the investors are “accredited investors.” The will dramatically change the way capital raising for private funds operates.

The drawback is the loss of 35 non-accredited investors in the fund. That exception has been eliminated. Funds will need to wait until the Securities and Exchange Commission issues the rules under Section 201 of the JOBS Act.

Part of those rules may be a mandated approach to determine if someone is an accredited investor.

“Such rules shall require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission.”

The SEC may take the opportunity to mandate an approach to validate an investor’s financial standing. As with most regulations, it could clear up uncertainty or create a paperwork headache (or both).

Will you need a copy of an investor’s W-2? A certified financial statement? Those are reasonable requests. However it would create much more personal information that would need to be safeguarded by the fund sponsor.

There is the possibility that the mandated approach would also address the requirements to determine if an investor is “qualified client” under the Investment Advisers Act or a “qualified purchaser” under the Investment Company Act.

We will have to wait and see what comes out of 100 F Street.

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Next Steps for the JOBS Act

The Jumpstart Our Business Startups Act, as amended by the Senate, was voted on by the House of Representatives yesterday and passed 380 to 41. That makes it a very bi-partisan bill, even though all 41 “Nays” were Democrats. If I remember my Schoolhouse Rocks song correctly, it’s up to the President to sign it or veto it.

The White House has already expressed support for the concept of crowdfunding. I expect President Obama will sign it into law very soon. He may actually have signed it by the time you are reading this.

As with the big Dodd-Frank law of 2010 that increased regulatory oversight, this law that decreases the regulatory burden tasks the Securities and Exchange Commission with many tasks. There are several studies and rulemakings thrown at the SEC. (I didn’t see any budget increase to go along with these tasks.)

The one I’m most focused on is in Title II-Access to Capital for Job Creators. Section 201(a) requires the SEC to

“revise its rules issued in section 230.506 of title 17, Code of Federal Regulations, to provide that the prohibition against general solicitation or general advertising contained in section 230.502(c) of such title shall not apply to offers and sales of securities made pursuant to section 230.506, provided that all purchasers of the securities are accredited investors.”

The law gives the SEC 90 days to make the revision.  WWSECD? (What Will the SEC Do?)

The SEC could simply insert the new language into Rule 506. It’s exactly what Congress demanded. However, the SEC could provide some clarity and other restrictions around the advertising. There could be rules about record-keeping or submission of advertisements. The SEC still has its ant-fraud mandate so it could impose other requirements. Some of the SEC commissioners have already spoken out against the law. But given the short timeframe, I doubt the SEC will do anything except insert the new language.

However, the SEC does need to act before the late-night TV advertisements begin. There may be some regulatory limbo if the SEC does not enact the revision by the end of the 90 day period. Why would the SEC pick this fight with Congress? Get ready for a new wave of advertisements for unregistered securities starting this summer. But you can only buy them if you are an accredited investor.

The SEC will have to study the “tick rule” to determine if penny increments are too small for the new category of emerging companies under Title I of the JOBS Act: Reopening American Capital Markets to Emerging Growth Companies. Section106 tasks the SEC with this study. I guess Congress thinks the trading on public companies with less reporting on executive compensation, lesser financial reporting obligations, and less auditing would trade differently than companies that meet the more exacting standards of a public company. Of course this is just for small companies, with less than $1 billion in gross revenues. (When did a billion get to be so small?)  I’m sure the brokerage houses would love to see a bigger spread on the tick.

Title I also tasks the SEC with a review of Regulation S-K. Section 108 gives the SEC 180 days to study how to streamline the registration process.

Title IV-Small Company Formation expands the Regulation A exemption allowing a more streamlined approach for smaller issues. The limit is raised from $5 million to $50 million. (When did $50 million get to be so small?) The Comptroller General gets tasked with study of the state blue sky laws on Regulation A offerings.

Title V- Private Company Growth and Flexibility Act, or as I call it the let’s not make Facebook go public section. It raised the 12(g)(1)(A) standard from 500 shareholders to 2,000 or 500 who are not accredited.  Section 503 tasks the SEC with revising the definition of “held of record” and safe harbor provisions for employee compensation.  The SEC also look at its authority to enforce Rule 12g5-1 and report its recommendation back to Congress.

Title VI-Capital Expansion makes a shareholder increase for banks and bank holding companies and gives the SEC a year to issue final regulations to implement the changes.

Title VII makes the SEC tell people about the JOBS Act.

The Securities and Exchange Commission shall provide online information and conduct outreach to inform small and medium sized businesses, women owned businesses, veteran owned businesses, and minority owned businesses of the changes made by this Act.

I expect we will see a new web page or domain from the SEC on the JOBS Act.

Those are not very sexy changes and probably leave you scratching your head about why Congress would pass these changes and do so very quickly. It leaves me curious as well. Many of the SEC commissioners took that rare action of publicly stating their opposition to the law. The state regulatory association stated:

Election-year politics have blinded Congress and the White House to the unintended consequences of the JOBS Act, which while well intentioned, could do little more than open the floodgates to investment fraud.

I suppose it was election year politics. And good marketing. The bill sponsors were able to give it the acronym JOBS, even though the bill has little to do directly with jobs. The sponsors have draped small businesses with the flag of job creators and opening the floodgates of capital to them will allow them to grow and re-create the millions of jobs lost in 2008-2009.

There was also the sexy piece of the JOBS Act that I have not mentioned, Title III-CROWDFUND. It’s designed to enable aspiring entrepreneurs to access capital using the internet to gather small dollar investments from would-be investors across America. William Carleton has done a great job of covering the crowdfunding aspect of the law.

Don’t expect Kickstarter to start offering equity funding any time soon. The SEC has 270 days to enact the rules around crowfunding and regulation of funding portals.

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Lifting the Ban on General Solicitation and General Advertising

On Thursday afternoon, the US Senate passed the Jumpstart Our Business Startups Act, a bill designed to make it easier for small companies to raise capital. The centerpiece of the legislation is the crowdfunding provision. However, the Senate passed an amendment to that section of the legislation. That means the Senate version and the House version of the law are different. It’s up to the House to pass the Senate version, or meet in conference to find a compromise.

The Senate did not change Title II of the legislation. Those sections eviscerate the long-standing prohibition on general advertisement and general solicitation of investors. Amendments to Title II were proposed, but were shot down.

It seems like the House is willing pass the Senate version of the legislation and the President is willing to sign it. That means one of the biggest limitations to fundraising for private funds is likely to be erased. It will take a few months after the passage of the law for the SEC to change the regulations in Rule 506.

As early as this summer, the marketing opportunities for private funds will dramatically increase. Maybe that’s a fair trade for having to register as an investment adviser with the SEC.

Here is the text of the bill:

TITLE II—ACCESS TO CAPITAL FOR JOB CREATORS

SEC. 201. MODIFICATION OF EXEMPTION

(a) MODIFICATION OF RULES.— (1) Not later than 90 days after the date of the enactment of this Act, the Securities and Exchange Commission shall revise its rules issued in section 230.506 of title 17, Code of Federal Regulations, to provide that the prohibition against general solicitation or general advertising contained in section 230.502(c) of such title shall not apply to offers and sales of securities made pursuant to section 230.506, provided that all purchasers of the securities are accredited investors. Such rules shall require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission. Section 230.506 of title 17, Code of Federal Regulations, as revised pursuant to this section, shall continue to be treated as a regulation issued under section 4(2) of the Securities Act of 1933 (15 U.S.C. 77d(2)).

(2) Not later than 90 days after the date of enactment of this Act, the Securities and Exchange Commission shall revise subsection (d)(1) of section 230.144A of title 17, Code of Federal Regulations, to provide that securities sold under such revised exemption may be offered to persons other than qualfied institutional buyers, including by means of general solicitation or general advertising, provided that securities are sold only to persons that the seller and any person acting on behalf of the seller reasonably believe is a qualified institutional buyer.

How Do State Regulators Really Feel About the JOBS Act?

The House of Representatives recently voted to pass The Jumpstart Our Business Startups (JOBS) Act (H.R. 3606), a collection of several bills focused on barriers to capital formation. I’m focused on the bill because of mostly because of the Access to Capital for Job Creators section that would override the ban on general solicitation and advertising under Regulation D.

I welcome some sensible changes to Regulation D because I find the ban a bit vague as part of the fundraising process. Private fund managers could use guidance from the SEC on what is allowed and what is prohibited by the ban.

On the other hand, knowing the general ban exists makes it easy to dismiss scams and spam spinning tales of possible investment opportunities. That unsolicited message is either a straight-up scam or a naive entrepreneur who thinks they can operate without competent advice. Either way you can easily dismiss the opportunity.

Another provision of the JOBS Act that I found interesting is the Private Company Flexibility and Growth Act. The main purpose is to raise the thresholds under Section 12(g)(1)(A) of the Exchange Act. Currently under that provision, private companies with more than 500 shareholders and a big stream of revenue effectively have to become public companies. That shareholder limit forced Google into going public and most recently is forcing Facebook to go public.

The centerpiece of the JOBS Act is the new crowdfunding platform. Currently, platforms like Kickstarter are prohibited from offering equity. Project sponsors have to ask for donations, offer schwag, or pre-sell products. All of which seems to work very well.

Commentators like William Carleton think the concept of crowdfunding will be great for entrepreneurs. The Wall Street Journal has a point-counterpoint this morning on crowdfunding:

Like most stuff coming out of Congress, even if the concept is good I think Congress is likely to screw up the drafting of the law.

That is my view of the JOBS Act. Most of the concepts are good, but the execution is poor. I think Congress is missing the balance between investor protection and access to capital. That opinion is shared by the North American Securities Administrators Association. Here is a snippet from an editorial by Jack E. Herstein, president of NASAA:

The most jobs this cleverly named bill may create are jobs for fraudsters, like the Nigerian scammers, penny-stock pitchers and Ponzi schemers already lurking behind the Internet to cloak their schemes.

The Senate is mulling over their version of these bills where it seems to have bi-partisan support. President Obama has also thrown his support to some of the concepts in the JOBS Act. It seem likely that something will pass. According to Talking Points Memo it looks like Senate Majority Leader Harry Reid is willing to trade support for the JOBS Act for approval of some judicial nominees.

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Crowdsourcing the Crowdfunding Exemption

There is a growing movement to create a new crowdfunding regime for raising capital. The models seem to draw inspiration from Kickstarter, a platform to fund creative projects. I say that because each time I see a draft bill it talks about an internet-based intermediary as part of the exemption.

President Obama endorsed the idea of a crowdfunding exemption. That has lead to three bills in Congress, plus a proposal being generated by NASAA as a state-run alternative.

President Obama cheered for crowdfunding as part of the American Jobs Act unveiling. The statement talks about the millions raised through Kickstarter in the form of donations. That’s not exactly right. The offering is sometimes a pure donation, but more often is linked to a product in development.

The Entrepreneur Access to Capital Act (H.R. 2930) permits “crowdfunding” to finance new businesses by allowing companies to accept and pool donations up to $5 million without registering with the SEC. It would limit individual investments to the lesser of $10,000 or 10% of an investor’s annual income. An amendment requiring a notice filing with the SEC was rejected as was an amendment that would have barred felons from being involved.

NASSA is putting together a model exemption for use at the state level. The various state level regulators are trying to craft this model.

The Democratizing Access to Captial Act (S.1791) was introduced by Senator Scott Brown. This bill is being supported by the Wefunders, who is in the business of being a platform for capital crowdfunding. Unlike Kickstarter, it’s only open to accredited investors.

Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2011 (S. 1970) was  introduced by Senator Merkley. This bill has the right acronym.

What they all have in common is some cap on the total funds that can be raised and a cap on how much someone can invest.

I’m all for making it easier for entrepreneurs to have easier access to capital. The registration and legal limits on capital-raising deter lots of projects. However, they also vet projects. To some extent, excluding the unworthy. It also tends to deter lots of worthy projects.

I like the project crowdfunding at Kickstarter. There is no expectation of riches, other than whatever trinket or completed example of the project they promise to you in exchange for your funding. I have no concerns about the dilution of shares, executive compensation, ratchets, and follow-up rounds.

Capital crowdfunding should be an interesting experiment. I predict it will create lots of new jobs and fund lots of interesting projects.

I also expect that it will be suspect to fraud. I expect that there will be many disappointed small investors who expected to reap fortunes, instead being stuck with worthless shares in failed companies or companies that existed only to funnel cash to fraudsters.  The extent of that fraud will depend on how well Congress crafts a crowdfunding bill. I expect they will come up short.

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New York City “Pay-to-Play” Law is Upheld

The U.S. Court of Appeals for the Second Circuit upheld a New York City “pay-to-play” law against various constitutional challenges: Ognibene v. Parkes. The Pay to play law is in Local Law 34 and it:

  1. Lowers the caps applicable to campaign contributions from parties that have “business dealings” with New York City
    • to $400 (otherwise $4,950 applies to contributors not within the purview of the Law) for candidates for city-wide offices,
    • to $320 (otherwise $3,850) for candidates for borough offices, and
    • to $250 (otherwise $2,750) for candidates for city council,
  2. Prohibits public matching for contributions from the Affected Persons, and
  3. extends a ban on contributions from corporations to apply to partnerships, LLCs, and LLPs.

“Business dealings” include, among other things, “contracts for investment of pension funds” and transactions with “lobbyists”.

The plaintiffs in Ognibeneh include Republican Party members, the New York State Conservative Party, lobbyists, and other business interests. They challenged the Law as a violation of the First Amendment, the Fourteenth Amendment, and the Voting Rights Act. They lost in the district court and made this appeal. In affirming the district court’s decision, the Second Circuit considered whether the aforementioned provisions of the Law were “closely drawn to address a sufficiently important state interest” and found that each was sufficiently closely-drawn.

The Second Circuit agreed with the district court that the “doing business” contribution limits are “closely drawn” because combating corruption and the public perception of corruption is a sufficiently important justification for placing limits on donations to a candidate. The court draws a distinction from restrictions on independent corporate campaign expenditures which were struck down in Citizens United as overly burdensome limitations on speech.

The court was not persuaded that actual “evidence of recent scandals” was needed to justify the contribution limits. “[T]o require evidence of actual scandals for contribution limits would conflate the interest in preventing actual corruption with the separate interest in preventing apparent corruption.” Finding “no doubt that the threat of corruption or its appearance is heightened when contributors have business dealings with the City” and citing studies by the City Council on the issue, the court held that it is “reasonable and appropriate” to place additional limitations on contributions by Affected Persons.

The court drew another distinguish between the Green Party case in Connecticut and this law. The Connecticut law challenged in Green Party put in place a total ban on contributions, as opposed to mere limits.  However, “if the appearance of corruption is particularly strong due to recent scandals, therefore, a ban may be appropriate.”

Of course, pay-to-play laws are not unique to New York City. The SEC’s Rule 206(4)-5 enacted a similar limit on campaign contributions. Anyone challenging the SEC rule would have to look at this case and realize the SEC rule would like stand up to court scrutiny.

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Image is New York City celebrating the surrender of Japan. They threw anything and kissed anybody in Times Square., 08/14/1945 from the US National Archives