Category: Fundraising

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.

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Filing Form D and General Solicitation

soap box

One of the current issues around a fund manager or company from using advertising as part of its private placement fundraising is the proposed changes to filing requirements for Form D.

Few people I have spoken with actually want to use general solicitation like bulk emails, newspaper ads, or web ads. But they do want to be able to mention fundraising at industry events, advertise the fund manager as a brand, and talk to the media. All of those could be considered general advertising and solicitation or could come close to the line. The SEC has not created a bright line test for when an announcement becomes general and endangers a private placement.

Many people embraced the lifting of the ban on general solicitation and advertising because the fund manager or company could avoid the advertising foot fault of private placement.

The requirement that a firm take reasonable steps to determine if potential investor is accredited is one impediment. For funds with large minimum investment requirements and mostly institutional investors, it’s probably less of an impediment.

The foot-faults under the proposed rule are even greater.

For instance, the proposed rule would require filing of Form D before a general advertisement or solicitation begins. That’s a problem when it’s not clear whether an activity falls under those terms. It’s also a problem if the terms of the offering change over the course of the pre-sale marketing period. Often, a private fund’s terms are not complete during the initial marketing phase.

Even worse, the proposed rule imposes a draconian ban on the use of private placements if you failed to file the Form D before the activity that would be considered general advertising and solicitation.

I agree that not requiring the filing until 15 days after the first sale is not the best method to provide information to investors or regulators. I think the better position is to require the filing 15 days before the first sale.

The proposed rule 510T would also require filing the materials used in general solicitation and advertisements with the SEC. Again, with those terms not well defined it’s hard to know if you have violated the rule. If the materials escape and get published in the media, you’ve potentially blown the private placement and the filing requirement with no ability to cure.

According to Jim Hamilton’s World of Securities Regulation, seven Senators have urged the SEC to adopt the proposed rules to help state securities regulators. Broc Romanek in theCorporateCounsel.net notes that SEC Commissioner Aguilar has weighed in supporting the proposed rules as necessary for investor protection.

Fund managers may be intrigued by the lifting of advertising requirements, they are more likely to cause a foot-fault than staying under the existing private placement regime.

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How Not to Use Twitter as a Fund Manager

Navigator Money Management

The Securities and Exchange Commission charged Mark A. Grimaldi and his firm, Navigator Money Management, with making false claims through Twitter, newsletters, and other communications about the success of their investment advice and a mutual fund they manage. Grimaldi and Navigator were using social media and widely disseminated newsletters to cherry-pick information and make misleading claims about their success in an effort to attract more business.

The Investment Advisers Act’s main thrust is to not be fraudulent, deceptive or misleading. When it comes to the restrictions on advertising, the rules can get complicated.

Grimaldi co-founded The Money Navigator and it had more than 60,000 subscribers by the end of 2011. He used it in part to promote the performance of his various investment financial advise platforms. He stretched the truth and the SEC caught him.

Based on the order, the SEC came in for a exam and poured through the publication looking for advertising rule violations and found some.

Mark Grimaldi manages Sector Rotation (NAVFX),” which “was ranked number 1 out of 375 World Allocation funds tracked by Morningstar. Sector Rotation produced an average annual return of 10.25% from August 31, 2002, to October 31, 2011, vs. 5.47% for the S&P 500 Index, according to Morningstar.”

The ranked #1 and nearly doubling the S&P index must stand out as problematic. The #1 ranking was from October 2010 to October 2011. It was ranked lower before that time frame. I read the copy as saying it was #1 from 2002 to 2011.

It’s tough to claim a 10.25% return from 2002 to 2009 when the fund did not exist prior to December 2009. The return is based on a hypothetical return published in The Money Navigator, not actually put to work. Plus, Grimaldi did not work at The Money Navigator until 2004.

That kind of stretching the truth is even more problematic when you edit the statements down to the 140 characters used in Twitter:

the April issue of the Money Navigator will give you an inside look of how I doubled the S&P500 the last 10 years w/o using low cost funds”

“[m]y cap app model has DOUBLED the S&P 500 the last 10 years.”

You can add on two more failure. If you state a specific recommendation you need to disclose all of the recommendations within the past year. When showing past performance you need disclaimer that it should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list under Rule 206(4)-1(a)(2)

You should read the order as way to test your knowledge of the advertising rules. I bet that Mr. Grimaldi also understands them better now.

 

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The Proposed New Regulation A for Fundraising

A+

Title IV of the Jumpstart Our Business Startup (JOBS) Act mandated changes to the moribund Regulation A offering process. That law raised the bar from $5 million to $50 million and prodded the SEC into making changes. The SEC issued the proposed rule with enough interesting treats that it may be worth exploring. The SEC is treating it like an IPO-lite as opposed to the wary eye cast on private placements.

The proposal splits Regulation A offerings into two baskets. Tier 1 offerings can be for up to $5 million a year. Tier 2 offerings can be for up to $50 million per year. By stepping up to Tier 2, the company’s financial statements must be audited and company must file semiannual reports and updates similar to public company reporting.

The part the SEC got right is that Tier 2 offerings would be exempt from state registration. The existing Regulation A’s failure to preempt the state blue sky laws is a major reason it is not used. I don’t see why the SEC would even bother with an offering type that does not preempt state blue sky laws. Tier 1 offerings under Regulation will likely continue unused.

The real nasty part is that investors are limited to purchasing no more than 10% of an investor’s net worth or annual income. That’s a big red flag. However, the SEC took the smart approach and did not turn that into a compliance requirement. The company needs to make investors aware of the 10% restriction, but can rely on a representation from the purchaser. The investor does not have to disclose personal information to verify compliance.

The proposal makes Regulation A a quirky middle ground to private placements and public offerings.

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Participating Bad Actors and Private Funds

bad actor

The SEC staff issued new Compliance & Disclosure Interpretations relating to Rule 506(d), the new bad actor rule. Under the rule, an issuer may not rely on the Rule 506 exemption if the issuer or any other person covered by rule has a relevant disqualifying event that occurred on or after September 23, 2013 (the effective date of the rule 506).

It’s a tricky rule, mandated by Dodd-Frank. Conceptually, I agree that the law should not permit bad guys to participate in private offerings of securities. The devil is in the details.

One murky item was what it meant to “participate” in the offering. For a big placement agent or brokerage, it’s easy to wall someone off. But how does that work from the perspective of the issuer? The SEC offered two new answers to questions about “participation.”

Question 260.18

Question: Does the term “participating” include persons whose sole involvement with a Rule 506 offering is as members of a compensated solicitor’s deal or transaction committee that is responsible for approving such compensated solicitor’s participation in the offering?

Answer: No.

Question 260.19

Participation in an offering is not limited to solicitation of investors. Examples of participation in an offering include participation or involvement in due diligence activities or the preparation of offering materials (including analyst reports used to solicit investors), providing structuring or other advice to the issuer in connection with the offering, and communicating with the issuer, prospective investors or other offering participants about the offering. To constitute participation for purposes of the rule, such activities must be more than transitory or incidental. Administrative functions, such as opening brokerage accounts, wiring funds, and bookkeeping activities, would generally not be deemed to be participating in the offering.

Those question are clearly addressed to placement agents and brokers, not to issuers.

So who is “participating” in the offering at a fund manager?

The rule explicitly covers the fund manager. But the fund manager is rarely an individual.

The rule explicitly covers “any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with such sale of securities.” That would cover the marketing group, if any of them are getting paid a commission. Of course that raises the other issuer of whether the marketing group is subject to broker-dealer registration.

The rule also includes any “general partner or managing member of any such investment manager.” Those are legal terms and could be avoided by the organizational structure and titles granted to the manager’s principals. But I would include the principal owners of the fund manager.

Then the rule moves down the next rung and includes “any director, executive officer or other officer participating in the offering of any such investment manager”.  The SEC release clearly said that merely being an officer, does not bring you into the scope of the rule’s disqualification. An “officer” test based solely on job title would be unduly burdensome and overly restrictive.

Participation in an offering would have to be more than transitory or incidental involvement, and could include activities such as participation or involvement in due diligence activities, involvement in the preparation of disclosure documents, and communication with the issuer, prospective investors or other offering participants.

That brings the marketing group clearly back into the rule because is communicates with prospective investors.

I have trouble with “preparation of disclosure documents.” Lots of people in the organization help to prepare the disclosure documents and are involved in due diligence activities.

I was hoping the SEC’s new interpretations would help narrow the scope of those covered by the rule at the fund manager. But they do not.

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The Upcoming Changes to the Accredited Investor Standard

Monopoly man

Section 413 of the Dodd-Frank Act requires the Securities and Exchange Commission to review the accredited investor definition by July 21, 2014, the fourth anniversary of President Obama’s signing of the  law. In a letter to Congressman Scott Garrett, SEC Chair Mary Jo White said that the Commission staff has begun a comprehensive review of the accredited investor definition. The letter was specifically a response to questions from Congressman Garrett.

I have no doubt that the current definition of accredited investor using income or net worth for individuals excludes people who should not be excluded from private securities offerings. I also have no doubt that it also allows in people who are not financially sophisticated enough to analyze the investment opportunity. For example, the SEC Commissioners fail the income test based on their salaries as commissioners. (I have no doubt they meet the net worth test.)

I do like the clear line drawn by the standard. I also like that a company can use reasonable belief to rely on questionnaire submitted by the investor to prove its accredited investor standard.

The new standards imposed by the SEC to verify accredited investor status under the permitted general solicitation are causing many to avoid that option. Few individuals are going to want to supply tax returns or W-2s to make an investment opportunity.

In reading the questions asked by Congressman Garrett it seems clear to me that he wants the definition expanded to create a larger pool of potential investors.

The GAO report on the accredited investor standard highlights net worth as the most important measure of an investor for private placements.  The report has some great analysis of potential changes to the standard.

The deadline is still months away, but I expect there will be significant changes to the definition.

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Is Your Fund Name Misleading?

You_Can_Call_Me_Al

Last week, the SEC’s Division of Investment Management released a guidance update that focuses on funds that use a name that “suggests safety or protection from loss.” The IM Guidance Update is a shot across the bow, warning a fund to considering changing its name if it exposes investors to “market, credit, or other risks.”

Every investment fund has exposures to “market, credit or other risks”, so the Guidance presumably applies to every fund. That means your fund name should not suggest “safety or protection from loss.”

The Guidance points to two bad words: “protected” and “guaranteed.”

The Guidance states that the agency has recently asked some managers to change the names of their funds.

We have made these requests because we believe that, in practice, investors sometimes focus on a fund’s name to determine the fund’s investments and risks, either because the name sometimes appears without the clarifying prospectus disclosures (e.g. , in advertisements) or because of the prominence of a fund’s name or for other reasons.

Funds that managed volatility by investing a portion of the fund’s assets in cash, short-term fixed income instruments, short positions on exchange-traded futures, or other investments had included the term “protected” in their name. The SEC was rightly concerned that “protected” only meant partly protected. Similarly, some funds had entered into shortfall guarantees to protect a fund’s downside. That protection may not have covered a 100% of the loss. Of course the protection is only as good as the credit of the company providing the coverage.

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You Got Questions About 506(c) – The SEC Has Answers

sec-seal

The new Rule 506(c) is a big substantive change on how private placements can be run. That leaves many, including me, with a lot of questions. The Securities and Exchange Commission just posted a series of new questions and answers on the new rule. Most of the answers are expected confirmations, but there are a few surprises.

Question 260.05 If you switch a pre-rule offering to new Rule 506(c) offering, do you need to file an amendment to From D. YES.

Question 260.06 If you take reasonable steps to verify that all investors are accredited, but after the sale you find out that an investor did not meet the standard. The SEC says that’s okay as long you took reasonable steps and had a reasonable belief.

Here was a surprise.

Question 260.07 All of your investors are accredited investors, but you didn’t take reasonable steps to verify that they were accredited. The SEC says that you failed the exemption. “The verification requirement in Rule 506(c) is separate from and independent of the requirement that sales be limited to accredited investors.”

The other item for fund managers to take a look at is Question 260.10 regarding existing investors. The SEC makes it clear that the exemption for existing investors in the non-exclusive list of verification methods only apples to the same issuer. So you can’t rely on this exemption when raising a new fund.

Another small surprise is that the SEC will allow you to retreat from a 506(c) offering back to a 506(b) offering. Question 260.11 makes it clear that as long as you did not engage in general solicitation you can amend the Form D to change the exemption. And vice-versa. Question 260.12 explicitly allows an offering to switch from 506(b) to 506(c). Many people I talked to thought you could make switch, but it’s good to hear it explicitly form the SEC.

The Confusing Analysis of Whether You Are An Accredited Investor

accredited investors

There are few commentators who think the current definition of “accredited investor” is a particularly good definition for individuals who should be investing in private placements of securities. Basing the standard on income and net worth does give you a perspective that the person could withstand the potential loss of investment. The definition has become even more important as the ban on general solicitation and advertising has been lifted. That’s going to leave a lot of potential investors and a lot of companies seeking capital trying to figure it out.

The income test of $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year, provides an interesting model. It’s reasonably verified with tax returns. Although I suspect few investors will want to turn over their tax returns to potential investment targets.

There is some uncertainty about the meaning of “spouse” for same-sex couples, given the Windsor decision that struck down the Defense of Marriage Act.

A humorous aspect of the income test is that the SEC Commissioners’ salaries are less than $200,000. Therefore, they each fail the accredited investor income test, unless a spouse is earning at least $150,000.

The asset test is even more difficult because assets now exclude the value of the home. Except if the mortgage balance is higher than the value of the home, then the negative value of the home is included in the asset test.

Of course the first problem is figuring out the value of your home and comparing it to the mortgage balance. I like that Zillow says my house is worth more than my mortgage, but is that an authoritative source for use in an accredited investor analysis?

Then the SEC also requires an home equity advance or mortgage increase in the prior sixty days to be a liability in calculating net worth, even if it does not put the house underwater. During the comment period, a concern was raised that an unscrupulous actor could convince grandma to mortgage her home, converting equity into cash that earns her the accredited investor standard.

The biggest problem is proving net worth to meet the accredited investor standard. You need to prove how much your house is worth, the mortgage balance, the timing of the mortgage origination, the timing of any home equity draws, all of your liabilities, and lastly your assets. merely producing a bank statement showing $1 million in cash in the bank is not enough to have take “reasonable steps” to conclude that a person is an “accredited investor.’

You can review the ridiculousness of the asset test in a new investor bulletin from the SEC: Investor Bulletin: Accredited Investors (.pdf) SEC Pub. No. 158.

John Smith fails the test because he took an additional draw on the home equity line in the past sixty days. But in two months he once again becomes an accredited investor. He did nothing but wait and his financial situation did not change. But two months later he can be an angel investor and invest in a start-up company.

James Lee fails the test because his house is $100,000 underwater and pulls him $80,000 short of the accredited investor standard. But as soon as Zillow makes a good positive update, he becomes an accredited investor. He did nothing but wait for the real estate market to recover. But then he can invest in a hedge fund.

References:

Investor Bulletin: Accredited Investors (.pdf) SEC Pub. No. 158

Voluntarily Submit Your Private Placement Advertisements to the SEC

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In a head-scratching move, the Securities and Exchange Commission has created a portal for you to voluntarily submit general solicitation materials for private placements. With Rule 506(c) now in effect, companies are free to advertise their private placements of securities, so long as the company takes reasonable steps to ensure that investors are accredited investors.

When the SEC issued Rule 506(c), it also proposed a new rule that would require a company to submit its general solicitation and advertising materials. That new rule, along with several others proposed at the same time, are controversial.

I assume that the SEC portal is set up to take submissions if required at some point at the future. I’m not sure why any company would voluntarily submit materials. I’m scratch my head even harder because there is no field to identify the issuer soliciting for investors. That would seem to limit the utility of the submission.

Perhaps the portal is intended for Whistleblowers? But there is statement and link to direct submission involving possible violations of the securities laws to the TCR portal.

Perhaps the SEC merely had its IT group put together the portal in anticipation of the proposed rule becoming effective? Perhaps.

References:

Voluntary Submission of General Solicitation Materials Used in Rule 506(c) Offerings