Category: Fundraising

The One Who Thought He Was Above the Law

The headlines for a case against Steven Seagal just write themselves. We was charged by the SEC for violating the anti-touting provisions of the securities laws for putting his celebrity girth behind Bitcoiin2Gen, in an initial coin offering.

The coin launched at about $0.60 in February 2019 and is not just about worthless. As near as I can tell, the selling point of this coin to BitCoin is that it has an extra “i.”

I have some sympathy for Mr. Seagal. He may have thought he was merely hawking some scam coin and not realized he was touting a security. Of course that’s the big problem with coin offerings. Promoters claim they are not securities, but the SEC thinks they are.

The SEC points out that the Bitcoiin offering was was well after the SEC’s DAO report that warned companies about the intersection of ICOs and securities laws. Just because you say it’s not a security over and over again, it does not make it true.

Mr. Seagal was to be paid $250,000 in cash and $750,000 in the Bitcoiins. Although, according to the SEC order, he only ended up with $157,000 in his pocket. That must be a nice supplement to his unpaid position as a special Russian representative to promote humanitarian ties between Russia and the United States.

As a Buddhist, Zen teacher, and healer, Steven lives by the principles that the development of the physical self is essential to protect the spiritual man. He believes that what he does in his life is about leading people into contemplation to wake them up and enlighten them in some manner. These are precisely the objectives of the Bitcoiin2Gen to empower the community by providing a decentralized P2P payment system with its own wallet, mining ecosystem and robust blockchain platform without the need of any third party.

https://bitcoiin2gen.pr.co/163919-zen-master-steven-seagal-has-become-the-brand-ambassador-of-bitcoiin2gen?reheat_cache=1

Mr. Seagal was not the first celebrity to get tagged by the SEC for promoting coin offerings. Professional boxer Floyd Mayweather Jr. and music producer DJ Khaled disgorged their promoter fees and paid penalties in November 2018.

Mr. Seagal accepted the order without admitting or denying the charges. That give the SEC the right to play the Nico Toscani quote: “You guys think you’re above the law. Well, you ain’t above mine.”

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Proposed Changes to Accredited Investor Definition

On Wednesday, the Securities and Exchange Commission proposed changes to the definition of “Accredited Investor” under Regulation D. The reason for the changes is to open the private market to a broader group of individual and institutional investors.

For those hoping for a dramatic change in how to determine accredited investor, you’ll be disappointed. The change eats at the edges and covers a few small openings.

The key to the accredited investor definition is that it limits who can invest in a private placement under Rule 506. If you don’t meet the accredited investor standard you can’t invest.

One expansion is to allow certain credentialed people to be automatically included as an accredited investor. The initial credentials are for registered representatives who have Series 7, 65 or 82 license. The rule notes that there are over 700,000 people who hold those designations, but has no data on how many of these were not previously qualified.

For private funds, there is an application of the “knowledgeable employee” definition over to accredited investor status. The SEC established Rule 3C-5 to allow “knowledgeable employees” to invest in their company’s private fund without having to be a qualified purchaser. The rule also exempts these knowledgeable employees from the 100 investor limit under the Section 3(c)(1) exemption from the Investment Company Act. However, currently the knowledgeable employee still has to be an accredited investor. This rule change will cover that gap.

Commissioner Jackson was opposed to the expansion. He is concerned about the lack of investor protection. He thought there was a lack of analysis in the release. In one instance he cites that the use of brokers expected to protect investors under the proposal. However, the data he looked at found that there was higher instance of fraud when brokers were involved. No vote.

Commissioner Peirce found the current bright-line tests of income and net worth are too simplistic, keeping out qualified people and allowing in more that may not be qualified. She also noted that the geographic disparities in cost of living results in lower salaries and therefore a geographic disparity in accredited investors. Yes vote.

Commissioner Roisman pointed out that he is not currently an accredited investor and would not qualify under the proposed changes. He stated that the definition should be broader. He is also concerned about the lack of investor protections. Yes vote

Commissioner Lee found the changes merely go to expanded the pool of private investors without the data on fraud. She is concerned that the current net worth and income levels are not indexed to inflation, expanding the pool of investors who could enter into private transactions without the protections of the public markets. No vote.

Chairman Clayton noted that there is a consensus that the current definition is less than satisfactory. Yes vote.

Once published, the proposal will be open for comments for 60 days.

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SEC Proposes to Modernize the Advertising Rules for Investment Advisers

I had my coffee ready and headphones on to listen to Tuesday morning’s Securities and Exchange Commission open meeting for Item 3: “Investment Adviser Advertisements; Compensation for Solicitations.” After cancelling a appointment to watch it, I discovered that Item 3 had been taken off the meeting agenda. The SEC voted on Monday to propose amendments to modernize the rules under the Investment Advisers Act addressing investment adviser advertisements and payments to solicitors.

The proposed rule would replace Rule 206(4)-1, first adopted in 1961. It will be a dramatically different approach to advertising restrictions.

Specifically, we are proposing a restructured and more tailored rule that: (i) modifies the definition of “advertisement” to be more “evergreen” in light of ever-changing technology; (ii) replaces the current four per se prohibitions with a set of principles that are reasonably designed to prevent fraudulent or misleading conduct and practices; (iii) provides certain additional restrictions and conditions on testimonials, endorsements, and third-party ratings; and (iv) includes tailored requirements for the presentation of performance results, based on an advertisement’s intended audience. The proposed rule also would require internal review and approval of most advertisements and require each adviser to report additional information regarding its advertising practices in its Form ADV.

In addition to modifying the advertising rule, the SEC is including a revision to the cash solicitation rule, Rule 206(4)-3. The premise of that rule was to male sure clients were aware that paid solicitors have a conflict of interest.

We are proposing to expand the rule to apply to the solicitation of current and prospective investors in any private fund, rather than only to “clients” (including prospective clients) of the investment adviser. Our proposal would require solicitor disclosure to investors, which alerts investors to the effect of this compensation on the solicitor’s incentive in making the referral. In addition, we are proposing changes to eliminate: (i) the requirement that solicitors provide the client with the adviser’s Form ADV brochure; and (ii) the explicit reminders of advisers’ requirements under the Act’s special rule for solicitation of government entity clients and their fiduciary and other legal obligations. Our proposal would also eliminate the requirement that an adviser obtain a signed and dated acknowledgment from the client that the client has received the solicitor’s disclosure, and instead would afford advisers the flexibility in developing their own policies and procedures to ascertain whether the solicitor has complied with the rule’s required written agreement.

There is a lot to digest in the 500 pages of the release. Since it appears the Commissioners all agreed to proposed rules, this is likely to be very close to final rule.

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Form SHL: Report by U.S. Funds on Foreign Ownership

Hopefully, if this form filing is applicable to your firm, you’ve already sent it in. It’s due on August 30. The penalty for failing to submit the form is a civil penalty of not less than $2,500 and not more than $25,000.

The form is required if your firm was the recipient of a mailing of the form or if you have more than $100 million in foreign investors in your fund.

The filing is part of a mandatory survey conducted under the authority of the International Investment and Trade in Services Survey Act (22 U.S.C. 3101) and Executive Order 11961 of January 19, 1977. The Act specifies that the authority to secure current information on international investment, including (but not limited to) such information as may be necessary for computing and analyzing the balance of payments accounts and the international investment position of the United States.

This report collects information on securities issued by U.S.-residents that are owned by foreign residents, including U.S. equities (including shares in funds), U.S. short-term debt securities (including selected money market instruments), U.S. long-term debt securities, and U.S. asset-backed debt securities.

The standard includes foreign ownership of private funds. Often foreign investors use blockers of domestic subsidiaries to invest. The form’s instructions indicate that you can use the standard of whether the investor gave you a W-8 instead of a W-9 to determine that the investors is “foreign.”

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Harmonization of Securities Offering Exemptions

or all you ever wanted to know about private placements

The Securities and Exchange Commission is stepping into the meeting point of its mandates by looking to “simplify, harmonize, and improve” the framework for private placements. The SEC is looking to expand investment opportunities while balancing investor protections and the promotion of capital formation.

The 200+page release provides a summary of the various private placement regimes in one handy guide. As Chairman Clayton noted, its an “elaborate patchwork.”

Note that twice as much capital is raised from private placement than capital raised through registered offerings. On page 16, the SEC notes:

In 2018, registered offerings accounted for $1.4 trillion of new capital compared to approximately $2.9 trillion that we estimate was raised through exempt offering channels.

Exemption2018 Amount Raised
Rule 506(b) of Regulation D $1,500 billion
Rule 506(c) of Regulation D $ 211 billion
Regulation A: Tier 1 $ 0.061 billion
Regulation A: Tier 2 $ 0.675 billion
Rule 504 of Regulation D $ 2 billion
Regulation Crowdfunding; Section 4(a)(6) $0.055 billion
Other exempt offering$1,200 billion

This has been true for at least the past decade, despite the elaborate patchwork. 506(b) offerings alone exceeded registered offerings last year.

As I’ve said in the past, private placement investments are not necessarily more risky than investments in registered offerings. The risk is one of liquidity. There is no market to buy or sell the investment so there is no ready exit.

If you had invested in Uber prior to the public offering, you had little choice but to sit and wait for a liquidity event. Now, you can liquidate your Uber position the same day.

The Concept Release is a great document to summarize the various ways to raise money privately, with the pros, cons and limitations of each.

The SEC has limited abilities to make wholesale changes. Many of the exemptions are driven by statute and would take Congressional approval. Nothing is passing in the Congress right now.

The SEC can make some changes around Regulation D that could be useful. The SEC should be careful that it does not disrupt the most widely used way to raise capital.

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We Select Best-in-Class… of those that pay us

Deutsche Bank marketed a robust, independent due diligence process to identify, evaluate, and select best-in-class asset managers.  But failed to disclose that it only recommended hedge funds that shared their management fees with the bank.

DB disclosed that it might receive revenue sharing and actually disclosed the amount it received in the subscription agreement. DB can recommend only its own products to its clients, as long as there is good disclosure.

However, the SEC felt that DB did not have good disclosure. The marketing for the fund failed to disclose that it was only recommending funds that agreed to pay a kickback to DB. 

The SEC has been focusing on these “retrocessions.”  What is interesting about this case is that the bank was not a registered adviser or broker-dealer. The bank was charged with violating the Securities Act’s anti-fraud provisions (17(a)(2)).

This is not the first time this has happened. JP Morgan paid a $267 million settlement to the SEC in 2016. The bank was investigated for steering high-net-worth clients toward its own proprietary investment funds that could cost more rather than those managed by other institutions.

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Pre-existing, Substantive Relationships and General Solicitation

As cryptocurrency issuance declines, the Securities and Exchange Commission is continuing to clean out the fraud, mis-steps, and foolishness of coin promoters. These actions have carried over to the services and investment managers involved in coin offerings.

Usman Majeed wanted to make his money by running a fund that invests in cryptocurrency. He ran into the same mistakes and ignorance of the securities laws that coin promoters stumble over. His platform was Mutual Coin Fund, with an approach that is “purely quantitative and involves algorithmic trading with intense backtesting…” and develops “new trading strategies involving artificial intelligence and machine learning through neural networks.”

That sounds like a lot of the same gobbley-gook for a crypto-fund offering that you hear for a coin offering.

That aside, he still managed to raise over $500,000 from investors from August 2017 to May 2018. Then managed to lose 62% of it by March 2019.

From the SEC order, it sounds like enforcement decided to focus on the marketing failure. Mr. Majeed and the fund didn’t have a pre-existing, substantive relationship with the investors. The fund engaged in general solicitation through its website and media interviews.

The fund could have engaged in general solicitation if it checked the 506(c) box on its Form D. But it checked the 506(b) box.

Of course, with 506(c) the fund would have needed to take reasonable steps to confirm that investors were accredited investors. But at least one investor was not accredited according to the SEC order.

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Failure to Launch Means Cancellation

The SEC cancelled the adviser registration of an internet investment adviser because it never launched its website.  

Kevin Ajenifuja registered his firms with the SEC by filing its Form ADV on May 28, 2015. He stated the eligibility for registration was because the firm was an “Internet Investment Adviser.”

Internet investment advisers typically are not eligible to register with the SEC. They do not manage the assets of their clients and therefore do not meet the statutory threshold for registration with the SEC. That would mean they would have to register in the states where they do business. For an internet investment adviser that would mean as a practical matter having to register in all 50 states. The SEC passed the internet adviser exception to fix this problem in 2003.

A year and a half later, in September 2016, the SEC contacted Mr. Ajenifuja because it thought he should withdraw the registration. He was still developing the website. The SEC said he should he withdraw and apparently he said he would do so.

The SEC gave notice in December 2016 that it intended to cancel the registration. Ajenifuja challenged the cancellation and had a hearing a year and half later in April 2018. He apparently still did not have an operational interactive website.

Mr. Ajenifuja argued that the internet adviser exception allows a grace period for development. In the adopting release the SEC “recognized the need for internet investment advisers to register with the Commission early in their development and testing phase in order to obtain venture capital.” Further that “many of these advisers may not even be fully operational 120 days after the registration has been granted.”

The SEC conceded that an internet adviser may be allowed some leeway beyond 120 days. However, there is no explicit grace period after the 120 days. The SEC would consider an extension based on facts and circumstances. Clearly, the SEC is looking for a firm to “reasonably expect to have a fully functional interactive website within a relatively short period” to prevent de-registration.

This decision may be the first time that SEC has said that internet advisers may get more than 120 days to launch so long as they can demonstrate significant progress. 

Unfortunately for Mr. Ajenifuja, the SEC found that three years was too long to still not have an operational website.

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Do Private Equity Funds Manipulate Reported Returns?

Some do, and it backfires.

In a working paper by Gregory W. Brown, Oleg R. Gredil, and Steven N. Kaplan they studied cash flows and NAV reports for a sample of 2,071 buyout and venture funds. The study was motivated by the potential incentive for fund managers to exaggerate performance to attract investors to a follow-on fund. They looked for evidence consistent with funds manipulating their self-reported net asset values around the time commitments are raised for a next fund.

The results of this analysis suggest that exaggerated NAVs are associated with lower probability of raising a follow-on fund. When they examined performance of funds that are unsuccessful at raising a follow-on fund, they observed clear evidence of performance reversals toward the end of fund life that is consistent with investors seeing through attempts of performance manipulation. Furthermore, they saw that conservative reporting and credible signaling (via distributing capital back to investors) have, on average, stronger effects on fundraising-odds than market-adjusted performance. The results were similar for both buyout and venture funds.

The study concludes that top-performing fund managers may try to safeguard their long-term reputation from bad luck by reporting conservative NAVs.  They are more likely to do this when it does not jeopardize their high relative performance rank. Correspondingly, limited partners punish fund managers for the appearance of overstated performance by not providing capital to subsequent funds.

The findings corroborate the evidence in another study that private equity fundraising outcomes are largely determined by sophisticated counterparties.

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When Your Model Doesn’t Work

Don’t sell it if it doesn’t work right.

That’s an easy lesson learned by Aegon USA, its CIO and Director of New Initiatives. Unfortunately, they were a subadvisor to Transamerica, who had to pay the biggest fine out of the bunch.

Transamerica offered, sold and managed quantitative-model-based mutual funds, variable life insurance investment portfolios, variable annuity investment portfolios and separately managed accounts, which were marketed as “managed using a proprietary quant model” and promised that these quantitative techniques were “emotionless,” “model driven” and “model-supported” and provided descriptions of how the quantitative models were to have operated.

Unfortunately, the models didn’t work as intended and Transamerica didn’t look at them close enough to confirm that the models worked and didn’t disclose the risks with the models.

Aegon had developed the models in 2010. The person who developed the model was an analyst who recently earned his MBA, had no experience in portfolio management, had no formal training in financial modeling, and no training in developing quantitative models for use in managing investment strategies. Aegon and Transamerica named a senior manager as the portfolio manager even though the analyst was the sole architect of the model. That analyst was so significant to the product that internal audit attribute “key person risk” to him.

To its credit, internal audit found that Aegon did not have a process in place to validate its models or conduct peer reviews. Unfortunately, this was after Aegon had launched ten versions of the product. A high level peer review found glaring errors. Those were fixed, but the models were not subject to formal validation until 2013.

During the summer of 2013, Aegon determined that its allocation models contained material errors. For example, Aegon found that the model contained “numerous errors in logic, methodology, and basic math” and concluded that these errors rendered it to “not be fit for purpose.”

In the end, they were pushing a product that didn’t work the way they said it would and oversold the experience behind the product.

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