Category: SEC News

Stealing Private Equity Investment Opportunities

Private equity transactions are not outside the scope of enforcement by the Securities and Exchange Commission. The SEC filed a case against a former principal of an investment adviser that manages private equity funds. The charge is that he “usurped …[a] lucrative investment opportunity in a private company.” At this point, the SEC has only filed for a cease and desist order and has not proven the allegations against Matthew Crisp.

Crisp worked for Adams Street Partners, a private equity firm registered with the SEC as an investment adviser. In 2006 and 2007, Adams Street was looking at investing in TicketsNow. Crisp was assigned as the lead sponsor of the possible investment. They decided to go ahead, but the investment was greater that their typical investment amount so Crisp decided to syndicate a portion of the committed investment.

Crisp decided to create his own investment fund and take a portion of the  syndication. Adams Street contends that Crisp was not authorized to syndicate the investment to his own fund. He also increased the size of his fund’s allocation.

The SEC contends that the resulting decrease in the size of the Adams Street’s collective investment in TicketsNow was a misappropriation of a lucrative investment opportunity that should have gone to Adams Street. The SEC alleges that Crisp did not disclose his involvement to Adams Street. That would include failing to report the involvement on his periodic compliance disclosures. Failure to disclose such information was a violation of the Adam Street’s fiduciary duties and of it’s policies.

It turned out to be a good investment because TicketsNow was sold to a competitor a year later.The investment tripled their invested capital.

The SEC alleges that this was not a single instance of malfeasance. They claim that Crisp tried again with an investment in Sherman’s Travel. He took a syndication in that investment in his own investment fund.

Adams Street discovered the problem and, after conducting an internal investigation, terminated Crisp. Thy also took the next step and self-reported the matter to the SEC.

The SEC alleges that Crisp violated Sections 206(1), 206(2), and 206(4) of the Advisers Act. They extend this through Rule 206(4)-8 which prohibits fraudulent activity by advisers to pooled investment vehicles with respect to investors or prospective investors.

In the alternative, the SEC contends that Crisp aided and abetted Adams Street’s violation of Sections 206(1), 206(2), and 206(4) of the Advisers Act, extended through Rule 206(4)-8.

Further, the SEC alleges that pursuant to the actions outlined above, Crisp willfully violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder.

The cease and desist proceeding is being instituted to determine whether the allegations noted are true and what remedial action is appropriate. Crisp already returned a large portion of his returns to Adams Street.

As more private equity fund managers are going to be registered with SEC in the next six months, I found this case to be an interesting example of SEC enforcement in the industry. Assuming that Crisp actually did what the SEC alleges, such activity should be a violation of the firm’s conduct policy and a violation of it’s funds’ partnership agreements. Investors generally will impose a contractual obligation on the fund manager to not divert investment opportunities to employees and principals of the fund manager.

So how does SEC enforcement help in this area? I suppose it adds the scare factor of a government investigation on top of losing your job and professional reputation.

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Robbery Not Allowed is by Anders Sandberg

Conflicts of Interest and Securitizations

The Big Short highlighted some of the difficulties of taking an investment position in a real estate downturn. The situation was taken a step further with Goldman Sachs’ help in putting together mortgage backed securities with the primary purpose of helping a client take an investment position that the securities will default. It turned out very well for Goldman’s client and terrible for the purchasers of the securities.

Section 621 of the Dodd-Frank Wall Street Reform and Consumer Protection Act prohibits an underwriter, placement agent, initial purchaser, or sponsor, or any affiliate or subsidiary of any such entity, of an asset-backed security from engaging in a transaction that would involve or result in certain material conflicts of interest. It then leaves it up to the Securities and Exchange Commission to issue rules for the purpose of implementing this new prohibition.

The SEC published a proposed rule at its Open Meeting on Sept. 19, 2011: Prohibition against Conflicts of Interest in Certain Securitization (.pdf).

The proposed rule could — if certain conditions are otherwise met — prohibit a firm from packaging Asset Backed Securities, selling them to an investor, and subsequently shorting the Asset Backed Securities to potentially profit at the same time as the investor would incur losses.

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The SEC Overhaul

On July 11, 2011, the President issued Executive Order 13579, “Regulation and Independent Regulatory Agencies,” which states that independent regulatory agencies should promote the goals set forth in Executive Order 13563 of January 18, 2011 that applies to executive agencies. He is asking the SEC, CFTC and other independent agencies to focus on a regulatory system that protects “public health, welfare, safety, and our environment while promoting economic growth, innovation, competitiveness, and job creation.” The Securities and Exchange Commission responded to Executive Order 13579 by inviting “interested members of the public to submit comments to assist the Commission in considering the development of a plan for the retrospective review of its regulations.”

Before you get too excited and submit a comment about repealing your most hated SEC rule, the SEC’s comment request is only for general comments on what the scope and elements on the development of a plan for retrospective review of existing significant regulations. So it’s just comments on the plan to review existing regulations.

1. What factors should the Commission consider in selecting and prioritizing rules for review?
2. How often should the Commission review existing rules?
3. Should different rules be reviewed at different intervals? If so, which categories of rules should be reviewed more or less frequently, and on what basis?
4. To what extent does relevant data exist that the Commission should consider in selecting and prioritizing rules for review and in reviewing rules, and how should the Commission assess such data in these processes? To what extent should these processes include reviewing financial economic literature or conducting empirical studies? How can our review processes obtain and consider data and analyses that address the benefits of our rules in preventing fraud or other harms to our financial markets and in otherwise protecting investors?
5. What can the Commission do to modify, streamline, or expand its regulatory review processes?
6. How should the Commission improve public outreach and increase public participation in the rulemaking process?
7. Is there any other information that the Commission should consider in developing and implementing a preliminary plan for retrospective review of regulations?

The Commission is not soliciting comment in this notice on specific existing Commission rules to be considered for review. Hopefully, that will come soon.

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The SEC, “Spousal Equivalents” and the Family Office

The SEC now recognizes “spousal equivalents” defined as “cohabitants occupying a relationship generally equivalent to that of a spouse.” Before wondering if the federal government is making big strides, keep in mind that this recognition is limited to the new Family Office Rule (.pdf).

Dodd-Frank created a new exemption for Family Offices. Previously they typically operated under the 15 clients rule that was repealed by Dodd-Frank or a private ruling from the SEC. Dodd-Frank left it up to the SEC to define a “family office.”

Rule 202(a)(11)(G)-1 contains three general conditions to fitting into the Family Office Exemption. First, the family offices may only provide advice about securities to certain “family clients.” Second, family clients must wholly own the family office and family members and/or family entities must control the family office. Third, a family office cannot hold itself out to the public as an investment adviser.

Th rule inevitably leads to a definition of “family.” Too narrow and many family offices would be excluded. Too broad and every investor will find an ancestor from the Mayflower. The SEC decided on a 10 generation limit.

The rule treats lineal descendants and their spouses, spousal equivalents, stepchildren, adopted children, foster children and persons who were minors when another family member became their legal guardian as family members.

I think it was bold move of the SEC to include spousal equivalents. They brush aside the Defense of Marriage Act argument: Because the term “spouse” is not defined in the rule and a “spousal equivalent” is identified as a category of person, separate and distinct from a “spouse,” that meets the definition of a “family member”….  DOMA provides that in “determining the meaning of any Act of Congress, or of any ruling, regulation, or interpretation of the various administrative bureaus and agencies of the United States…the word ‘spouse’ refers only to a person of the opposite sex who is a husband or wife.” 1 U.S.C. 7.

The failure of a family office to be able to meet the conditions of the new rule will not preclude the office from providing services to family members. But, the family office will need to find another exemption, register under the Advisers Act or seek an exemptive order from the SEC.

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The image is the Spousal Equivalent Badge available from Zazzle.

SEC Extends Deadline and Adopts Rules for Advisers and Private Funds

At an open meeting on June 22, the Securities and Exchange Commission adopted new rules under the Investment Advisers Act of 1940 aimed at investment advisers, private fund managers, venture capital funds, and family offices.

Based on the statements at the meeting, there will be three new rules would:

Delay Registration Deadline and a New Form ADV. The new registration/reporting deadline for new Advisers Act registrants and “exempt reporting advisers” will be March 30, 2012. Previously exempt private advisers, particularly those to hedge funds and private equity funds, will not be required to register until March 30, 2012. All advisers will be required to make a filing in the first quarter of 2012. Those previously registered advisers who no longer qualify for SEC registration will be required to withdraw by June 28, 2012.

The SEC staff pointed out that 2012 is a leap year, so the 90 day deadline is March 30 instead of March 31 in 2012.

Form ADV is going to change. No surprise. Under the amended adviser registration form, advisers to private funds will have to provide:

  • Basic organizational and operational information about each fund they manage, such as the type of private fund that it is (e.g., hedge fund, private equity fund, or liquidity fund), general information about the size and ownership of the fund, general fund data, and the adviser’s services to the fund.
  • Identification of five categories of “gatekeepers” that perform critical roles for advisers and the private funds they manage (i.e., auditors, prime brokers, custodians, administrators and marketers).
  • More information about conflicting or potential conflicting relationships.

Define Venture Capital Funds. Under the definition, a venture capital fund is a private fund that:

  • Invests primarily in “qualifying investments” (generally, private, operating companies that do not distribute proceeds from debt financings in exchange for the fund’s investment in the company); may invest in a “basket” of non-qualifying investments of up to 20 percent of its committed capital; and may hold certain short-term investments.
  • Is not leveraged except for a minimal amount on a short-term basis. Borrowing is limited in time as well.
  • Does not offer redemption rights to its investors.
  • Represents itself to investors as pursuing a venture capital strategy.
  • Is not registered under the Investment Company Act.

There will be a rule on grandfathering substantially as proposed in November, with the three conditions that the fund had been represented to be a “venture capital fund,” that the first closing was prior to December 31, 2010 and that no new capital commitments are made after July 21, 2011.

The new category of venture capital fund advisers and other “exempt reporting advisers” will file portions of Part 1 of Form ADV. Commissioner Schapiro noted that there was no current intention to subject exempt reporting advisers to routine examinations, while also noting that the SEC retains the authority to examine those advisers in its discretion. The Staff noted that the Form ADV will include a uniform calculation for “assets under management.”

Family Office Exemption. This exemption should be consistent with no-action relief previously provided and the proposed rule. It sounds like there will be some expansion to address a broader universe of permitted family clients and ta longer transition period (through December 31, 2013) for the termination of relationships with charitable entities that were not exclusively funded by the family.

These rules will have completed most of the rulemaking required under Title IV of Dodd-Frank, the Private Fund Investment Advisers Registration Act.

My printer is still cranking out the text of the new rules and I need to dive deeper into the details.

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Sometimes You Get Stuck and Can’t Get Out

Finally, the SEC is going to take some action today on the regulation of investment advisers, venture capital funds, and private fund managers.

For years, they’ve been trying to get regulatory control of private funds. Now they are going to get it.

Do they really want it?

Sometimes what you want to do is not a good a choice. As a case in point, I give you a kitten crawling inside a hamster ball.

Sure it’s cute. But you end up with a pissed-off kitten.

The Open Meeting for June 22 is all about the Investment Advisers Act.

Agenda:

Item 1: The Commission will consider whether to adopt new rules and rule amendments under the Investment Advisers Act of 1940 to implement provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act. These rules and rule amendments are designed to give effect to provisions of Title IV of the Dodd-Frank Act that, among other things, increase the statutory threshold for registration of investment advisers with the Commission, require advisers to hedge funds and other private funds to register with the Commission, and address reporting by certain investment advisers that are exempt from registration.

Item 2: The Commission will consider whether to adopt rules that would implement new exemptions from the registration requirements of the Investment Advisers Act of 1940 for advisers to venture capital funds and advisers with less than $150 million in private fund assets under management in the United States. These exemptions were enacted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The new rules also would clarify the meaning of certain terms included in a new exemption for foreign private advisers.

Item 3: The Commission will consider whether to adopt a rule defining “family offices” that will be excluded from the definition of an investment adviser under the Investment Advisers Act of 1940.

The word I’ve heard is that the July 21, 2011 deadline will be extended to March 31, 2012.

Be Mindful of Compliance Costs

That story is title does not come from me; it’s a quote from  Commissioner Troy A. Paredes of the Securities and Exchange Commission.

We cannot simply focus on the costs and benefits of a single rule change on a stand-alone basis. It is the totality of the regulatory infrastructure that impacts the private sector. As part of this analysis, we need to be mindful of compliance costs. It is costly for firms to comply with the regulatory obligations they confront both in terms of out-of-pocket expenditures, as well as the opportunity cost of the time and effort of personnel that could have been directed toward other productive endeavors. Indeed, the compliance burden on investment advisers has increased of late due to, for example, the need to comply with the new “pay-to-play” rule restricting political contributions; the recent amendments to Part 2 of Form ADV concerning the preparation and delivery of a “brochure” and “brochure supplements” to advisory clients; and the recent amendments to the custody rule.

The Commissioner was giving a speech to the Hedge Fund Regulation and Current Developments symposium at the Center for Law, Economics & Finance at the The George Washington University Law School on June 8.

There was lots of blame thrown at the hedge fund industry after the financial crisis of 2008 with very little data to support the accusations.  Commissioner Parades also addressed this point:

Regulatory decision making should be supported by data, to the extent available, and economic analysis. This is particularly important to stress insofar as the SEC is concerned, because the SEC is an agency that traditionally has overwhelmingly been comprised of lawyers. Empirical analysis must be much more central to decision making at the SEC than has been the case.

Commissioner Parades is just one of five commissioners, so his position is not necessarily a controlling influence. But it’s still good to see that at least part of the SEC is focusing on there being better regulatory, not just more regulatory control

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Finally, Some SEC Action on the July 21 Deadline for Fund Managers

If you’re a private fund manager you have been worried about the looming July 21 deadline for registration. Given the 45 day review period, the filing deadline was June 6. That came and went without the SEC having the rules in place for registration. Sure, the SEC commissioners and staff have been saying the plan to extend the deadline. But, still no extension.

Looking ahead to June 22, it looks like the SEC will finally take up the formal action. The Open Meeting for June 22 is all about the Investment Advisers Act.

Agenda:

Item 1: The Commission will consider whether to adopt new rules and rule amendments under the Investment Advisers Act of 1940 to implement provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act. These rules and rule amendments are designed to give effect to provisions of Title IV of the Dodd-Frank Act that, among other things, increase the statutory threshold for registration of investment advisers with the Commission, require advisers to hedge funds and other private funds to register with the Commission, and address reporting by certain investment advisers that are exempt from registration.

Item 2: The Commission will consider whether to adopt rules that would implement new exemptions from the registration requirements of the Investment Advisers Act of 1940 for advisers to venture capital funds and advisers with less than $150 million in private fund assets under management in the United States. These exemptions were enacted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The new rules also would clarify the meaning of certain terms included in a new exemption for foreign private advisers.

Item 3: The Commission will consider whether to adopt a rule defining “family offices” that will be excluded from the definition of an investment adviser under the Investment Advisers Act of 1940.

Hopefully, they won’t change their mind about extending the deadline.

Felons and Fund Managers

Most private funds rely on a Rule 506 exemption under Regulation D to sell their limited partnership interests to investors. A new SEC rule amending Rule 506 should catch the eye of private fund compliance officers. The concept it fairly straight-forward: felons should not be allowed to take advantage of the private offering exemptions.

Dodd-Frank

Section 926 of Dodd-Frank requires the SEC to adopt rules disqualifying an offering from reliance on Rule 506 of Regulation D when certain felons or other “bad actors” are involved in the offering. Rule 506 is the most widely claimed exemption under Regulation D. For the 12 month period ended September 30, 2010 the Commission received 17,292 initial filings for offerings under Regulation D, of those 16,027 claimed a Rule 506 exemption.

What types of felonies?

The  proposal is not for all felonies, just those related to the securities industry. So you could be a convicted Under the proposed rule, a “disqualifying event” would include:

  • Criminal convictions in connection with the purchase or sale of a security, making of a false filing with the SEC or arising out of the conduct of certain types of financial intermediaries. The criminal conviction would have to have occurred within 10 years of the proposed sale of securities (or five years, in the case of the issuer and its predecessors and affiliated issuers).
  • Court injunctions and restraining orders in connection with the purchase or sale of a security, making of a false filing with the SEC or arising out of the conduct of certain types of financial intermediaries. The injunction or restraining order would have to have occurred within five years of the proposed sale of securities.
  • Final orders from state securities, insurance, banking, savings association or credit union regulators, federal banking agencies or the National Credit Union Administration that bar the issuer from:
    • associating with a regulated entity.
    • Engaging in the business of securities, insurance or banking.
    • Engaging in savings association or credit union activities.
  • Or orders that are based on fraudulent, manipulative or deceptive conduct and are issued within 10 years before the proposed sale of securities.
  • Certain Commission disciplinary orders relating to brokers, dealers, municipal securities dealers, investment companies and investment advisers and their associated persons, which would be disqualifying for as long as the order is in effect;
  • Suspension or expulsion from membership in a “self-regulatory organization” or from association with an SRO member, which would be disqualifying for the period of suspension or expulsion;
  • Commission stop orders and orders suspending the Regulation A exemption issued within five years before the proposed sale of securities; and
  • U.S. Postal Service false representation orders issued within five years before the proposed sale of securities.

Who is covered?

The proposed rule would cover

  • the issuer (i.e. the fund)
  • its predecessors and affiliated issuers
  • Directors, officers, general partners and managing members of the issuer.
  • 10 percent beneficial owners and promoters of the issuer (i.e. the fund manager).
  • Persons compensated for soliciting investors
  • the general partners, directors, officers and managing members of any compensated solicitor (i.e. employees of your placement agents).

The rule is bit fuzzy on how this would apply to fund manager, since it is not legally the issuer. Under the investment advisers registration you already need to disclose criminal activity. That disclosure is broader than what is proposed under the new rule. This is just disclosure, not a bar from use of the offering exemption.

Reasonable Care Exception

The proposed rule would provide an exception from disqualification when the issuer can show it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed.

Paragraph (c)(1) of this section shall not apply:

(i) Upon a showing of good cause and without prejudice to any other action by the Commission, if the Commission determines that it is not necessary under the circumstances that an exemption be denied; or

(ii) If the issuer establishes that it did not know, and in the exercise of reasonable care could not have known, that a disqualification existed under paragraph (c)(1) of this section.

Instruction to paragraph (c)(2)(ii). An issuer will not be able to establish that it has exercised reasonable care unless it has made factual inquiry into whether any disqualifications exist. The nature and scope of the requisite inquiry will vary based on the circumstances of the issuer and the other offering participants.

Here is where compliance steps in. The rule has no explicit record-keeping, reporting or disclosure requirements. But if you want make sure you can take advantage of the “reasonable care exception” you will need to keep records.  It looks like we will need a new form for employees to fill out asking for a disclosure of events under the rule. It also looks like you will need to run criminal background checks on your principals and key employees.

In the release the SEC said: “The steps required would vary with the circumstances, but we anticipate may include such steps as making appropriate inquiry of covered persons and reviewing information on publicly available databases.”

Comments

This is still a proposed rule, but time is short. Under Dodd-Frank, the disqualification rules need to be in place by July 21, 2011. There is time to Submit Comments.

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Learning Lessons From Gaffken & Barriger

I read through an occasional SEC complaint looking for lessons to be learned. Those involving real estate funds particularly catch my eye. I found the complaint against Lloyd V. Barriger (.pdf) and his management of his Gaffken & Barriger Fund to be full of lessons.

I don’t have any independent facts and am accepting the complaint at face value. Barringer has not settled with the SEC so I’m sure he has a different view of the events and disagrees with some of the statements. In large part it looks like he was trying to make it through the collapse of the housing market and the liquidity crunch of 2007 & 2008 by stretching his funds and his investments. Ultimately, his fund could not hold out any longer and collapsed.

“In the midst of the credit crisis, Barriger chose to lie about the solvency and liquidity of his fund rather than admit the somber truth of a collapsing business,” said George Canellos, Director of the SEC’s New York Regional Office. “He continued to solicit new investor funds based on the same misrepresentations up until the day before the fund collapsed.”

Gaffken & Barriger started off by investing in microcap securities. Then it, like many investors, was lured by the outsized returns of the real estate in 1998. Effective August 1,2005, the Fund’s stated purpose was “investing, holding, and trading in real estate, real estate loans, real estate securities, other securities and other financial instruments and rights thereto[.]” According to the PPM, the Fund’s primary strategy was “hard money lending”making high interest short-term bridge loans to real estate developers.

As you might guess with hindsight, the fund started experiencing higher delinquencies in 2005 and started experiencing losses. I would guess that he started stretching the truth hoping his investments would bounce back, only be trapped into bigger lies as the losses grew instead of decreasing.

I found it interesting that the SEC focused on the preferred returns to the limited partners in the fund. This is a practice that is common in many real estate funds. Investors often get a preferred return and the sponsor gets an over-sized portion of the profit above that return. I think the SEC got caught up in the tax allocations of the fund and took it as a bad fact. I’m not sure that warranted.

Another lesson to take away is that Dodd-Frank will not do anything to prevent this type of fraud. Given the size of Gaffken & Barriger it would not be SEC registered, but would be state registered. The SEC would still be able to investigate, but would not be the examiner.

That is a common theme I have noticed in SEC complaints against investment advisers and fund managers. They are mostly below the $100 million threshold for SEC registration. These troublemakers will need to be caught by state examiners. The SEC may be able to come riding in on its white horse to round up the bad guys, but will not be in a position to make an early intervention to prevent the fraud.

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