Year: 2011

What is a Venture Capital Fund?

For me, venture capital has always been a fuzzy term. They generally invest in start-ups and provide early stage capital for their growth. As a company progresses through later rounds of funding, that definition does not seem to work that well. For example, would you label the latest rounds of funding in Facebook as “venture capital”?

The other problem for a venture capital fund is that liquidity events for their portfolio companies may leave them holding valuable chunks of publicly traded stock or mature private company securities, leaving their capitalization.

Until recently, an exact definition was not needed. Venture capital fund managers could operate across a spectrum of business models, depending on what limitations they promised to their fund investors.

Now, the Securities and Exchange Commission has required a more precise definition. Venture Capital fund managers can take advantage of an exemption from registration under the Investment Advisers Act. This exemption is not available for the rest of the private equity world of investment managers.

The SEC published the final definition under a new Rule 203(l)-1

A venture capital fund is any private fund that:

(1) Represents to investors and potential investors that it pursues a venture capital strategy;

(2) Immediately after the acquisition of any asset, other than qualifying investments or short-term holdings, holds no more than 20 percent of the amount of the fund‘s aggregate capital contributions and uncalled committed capital in assets (other than short-term holdings) that are not qualifying investments, valued at cost or fair value, consistently applied by the fund;

(3) Does not borrow, issue debt obligations, provide guarantees or otherwise incur leverage, in excess of 15 percent of the private fund‘s aggregate capital contributions and uncalled committed capital, and any such borrowing, indebtedness, guarantee or leverage is for a non-renewable term of no longer than 120 calendar days, except that any guarantee by the private fund of a qualifying portfolio company‘s obligations up to the amount of the value of the private fund‘s investment in the qualifying portfolio company is not subject to the 120 calendar day limit;

(4) Only issues securities the terms of which do not provide a holder with any right, except in extraordinary circumstances, to withdraw, redeem or require the repurchase of such securities but may entitle holders to receive distributions made to all holders pro rata; and

(5) Is not registered under section 8 of the Investment Company Act of 1940 (15 U.S.C. 80a-8), and has not elected to be treated as a business development company pursuant to section 54 of that Act (15 U.S.C. 80a-53).

They piece of the definition is the term “qualifying investments.”

Qualifying investment means:

(i) An equity security issued by a qualifying portfolio company that has been acquired directly by the private fund from the qualifying portfolio company;

(ii) Any equity security issued by a qualifying portfolio company in exchange for an equity security issued by the qualifying portfolio company described in paragraph (c)(3)(i) of this section; or

(iii) Any equity security issued by a company of which a qualifying portfolio company is a majority-owned subsidiary, as defined in section 2(a)(24) of the Investment Company Act of 1940 (15 U.S.C. 80a-2(a)(24)), or a predecessor, and is acquired by the private fund in exchange for an equity security described in paragraph (c)(3)(i) or (c)(3)(ii) of this section.

Qualifying portfolio company means any company that:

(i) At the time of any investment by the private fund, is not reporting or foreign traded and does not control, is not controlled by or under common control with another company, directly or indirectly, that is reporting or foreign traded;

(ii) Does not borrow or issue debt obligations in connection with the private fund‘s investment in such company and distribute to the private fund the proceeds of such borrowing or issuance in exchange for the private fund‘s investment; and

(iii) Is not an investment company, a private fund, an issuer that would be an investment company but for the exemption provided by § 270.3a-7 of this chapter, or a commodity pool.

The big limitation throughout the definition is on the debt limitation.

Many funds use a subscription credit facility secured by the uncalled capital commitments. This gives them quicker access to cash for investments. Then the facility is paid down after capital is called. The use of a credit facility also allows the capital calls to be spread out and can be used to give fund investors more lead time to pull together their own cash. It seems this new rule will severly limit the ability of a venture capital fund to use a subscription credit facility.

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Image – Multiple sources across the internet. Let me know if you are the original creator

Compliance Bits and Pieces for August 19

Here are some recent compliance related stories that caught my attention:

ABA Journal Seeks ‘Blawg 100′ Nominees

The editors of the ABA Journal are gearing up to select their annual list of the 100 best legal blogs, the Blawg 100. And they are seeking suggestions of blogs they should include. “Tell us about a blawg—not your own—that you read regularly and think other lawyers should know about,” they ask.

To nominate a law blog you think should be included, go to the Blawg 100 Amici page and submit it to the editors.

Breach Notification Obligations In All 50 States? by Kristen J. Mathews in Proskauer’s Privacy Law Blog

Did you know there are breach notification obligations in all 50 states (effective 9/2012), even though only 46 states have adopted them? How could that be, you ask? Because Texas said so. (Does that surprise you?)

Texas recently amended its breach notification law so that its consumer notification obligations apply not only to residents of Texas, but to any individual whose sensitive personal information was, or is reasonably believed to have been, acquired by an unauthorized person. Texas’s amended law (H.B. 300) specifically requires notification of data breaches to residents of states that have not enacted their own law requiring such notification (that is, Alabama, Kentucky, New Mexico and South Dakota).

Fair Valuation of Assets under Management Is Key Element of SEC Regime for Hedge Fund and Private Fund Advisers in Jim Hamilton’s World of Securities Regulation

Acting on a Dodd-Frank mandate, the SEC adopted regulations requiring that hedge fund and private fund advisers with $150 million assets under management register with the Commission. Given the $150 million asserts under management trigger for registration, the fair valuation of a fund’s assets is a critical element of the new regime. The SEC said in Adopting Release No. IA-3222 that hedge fund and private fund advisers must determine the amount of their assets under management based on the market value of those assets, or the fair value of those assets where market value is unavailable. They must calculate the assets on a gross basis, that is, without deducting liabilities, such as accrued fees and expenses or the amount of any borrowing. If a fund does not have an internal capability for valuing illiquid assets, the SEC expects it to obtain pricing or valuation services from an outside administrator or other service provider.

Former FrontPoint Manager Pleads Guilty to Insider Trading by Azam Ahmed in Dealbook

The portfolio manager, Joseph F. Skowron, known as Chip, admitted before a federal judge in Manhattan that he had avoided $30 million in losses by trading on tips leaked by a consultant for an expert network about the results of a clinical drug trial. He also admitted that he and the consultant, Dr. Yves Benhamou, had agreed to mislead the Securities and Exchange Commission about their actions. Mr. Skowron faces as much as five years in prison for the one count of conspiracy to commit securities fraud and obstruct justice and will pay a $5 million fine.

Is the SEC Covering Up Wall Street Crimes? by Matt Taibbi in Rolling Stone

Flynn discovered a directive on the enforcement division’s internal website ordering staff to destroy “any records obtained in connection” with closed MUIs. The directive appeared to violate federal law, which gives responsibility for maintaining and destroying all records to the National Archives and Records Administration. Over a decade earlier, in fact, the SEC had struck a deal with NARA stipulating that investigative records were to be maintained for 25 years – and that if any files were to be destroyed after that, the shredding was to be done by NARA, not the SEC.

But Flynn soon learned that the records for thousands of preliminary investigations no longer existed. In his letter to Congress, Flynn estimates that the practice of destroying MUIs had begun as early as 1993, and has resulted in at least 9,000 case files being destroyed.

Matt Taibbi Thinks It’s “Orwellian” For the Government Not To Keep Records On You Just Because You Haven’t Done Anything Wrong by Matt Levine in Dealbreaker

Matt Taibbi may actually be right that it breaks the law – he has, on occasion, been right about facts in the world, though it’s often a coincidence. Here he suggests that some SEC staffers were worried about personal criminal liability for not archiving records of preliminary inquiries, which sounds a little far-fetched but possible. And there are some more interesting accusations here – including some suggestive coincidences where SEC enforcement execs squashed investigations and then left for the firms that were being investigated. But we were always under the impression that the trouble with Big Brother was too much all-pervading surveillance, not too little.

Report on Investment Adviser’s Use of Social Media in Massachusetts

Social Media used by Investment Advisers

There is a growing trend in the financial services industry to use social media sites for outreach to existing as well as potential customers. Noticing this trend, the Securities Division of The Office of the Secretary of the Commonwealth surveyed investment advisers registered and doing business within the Commonwealth of Massachusetts. The purpose of the survey is to determine the scope of investment advisers’ use of social media, and what, if any, record retention and supervisory procedures have been implemented or utilized by those advisers. Empirical evidence is good to have.

The Division forwarded the social media survey to 576 investment advisers registered with the Division and located in the Commonwealth and 79% of advisers have responded.

  • 44% of investment advisers used some form of social media
  • Of those not using, 10% expect to use it in the next year
  • A majority of investment advisers using social media fall within the 42-62 age bracket

The Survey also suggests that some advisers do not have policies relating to the retention or supervision of social media content, are not retaining social media content, and do not supervise the use of social media content.

  • 69% of advisers using social media claimed to not have written record retention policies related to the retention of social media content
  • 57% also did not retain all content posted on social media websites maintained (directly or indirectly), by the firm.

It should not come as  surprise that the Division concluded that additional regulatory guidance concerning the use of social media would be appropriate. We have already seen enforcement at the national level for the abuse of social media. I expect the states will be on board soon and including a review of social media as part of their examination and review process.

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Germany, Sub-Prime Mortgage Backed Securities, and Scatology

Michael Lewis continues his around the world tour of the 2008 financial crisis from the view of Germany: It’s the Economy, Dummkopf!. The story in the September issue of Vanity Fair seems to be all about excrement. We heard that there were big chunks of the mortgage securities business that were terrible. There is the famous email describing the Timberwolf as on sh*tty deal.

Lewis did great job offering some insight from Ireland, Greece, the Iceland. In this story he seems distractedby feces and Nazis. The biggest insight I took away was:

At bottom, he [Dirk Röthig, of the German financial institution IKB] says, the Germans were blind to the possibility that the Americans were playing the game by something other than the official rules. The Germans took the rules at their face value: they looked into the history of triple-A-rated bonds and accepted the official story that triple-A-rated bonds were completely risk-free.

IKB and many of the other German banks thought they were getting a good return on the mortgage-back securities with little risk, but were actually getting a sh*tty deal. I get it. But I think he belabors the metaphor.

Michael Lewis could write about the economics of a paper bag and I’m sure it would be interesting story to read. In fact, I paid for a subscription to Vanity Fair just because of his articles. This one came up a bit short. Maybe he just thought the underlying story was not interesting enough so he spiced it up with lots of stories about German scatology. He layers in some Jewish alienation in Germany for some spice in his the discussion of feces.

It’s the Economy, Dummkopf! is still worth reading and still offers a few great insights into the 2008 financial crisis.

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When is Real Estate a Security?

Fee simple ownership of the “bricks and mortar” of real estate is not a securities transaction. “The offer of real estate as such, without any collateral arrangements with the seller or others, does not involve the offer of a security.” As you move further away from that model, you move closer and closer to the ownership a security than the ownership of real estate. The line between the two is not a bright line. One of the latest cases to address the difference is Salameh v. Tarsadia Hotels 2011 U.S. Dist. LEXIS 30375, on appeal to the Ninth Circuit.

One of the seminal cases is SEC v. W.J. Howey Co., 328 U.S. 293 (1946). That case involved an offering of units of a citrus grove development, coupled with a contract for cultivating, marketing, and remitting the net proceeds to the investor. They held that it was an offering of an “investment contract” within the meaning of that term as used in the provision of § 2(1) of the Securities Act of 1933 defining “security” as including any “investment contract,” and was therefore subject to the registration requirements of the Securities Act.

Even though decades have passed, the line is bit a clearer, but still muddy as the Salameh case illustrates. The developer of the Hard Rock Hotel in San Diego used a condominium- hotel ownership structure to help provide capital.  The purchase/investment turned out to be a bad one, so they sued the developer.

Their claim was that a series of documents, including the Purchase Contract, the Unit Maintenance and Operations Agreement, and the Rental Management Agreement turned the ownership into a “security” and not the mere ownership of real estate. Since the securities were not registered, they could seek rescission. In this case, the ownership and control issues were not just split into separate documents, some of the documents were entered into at significantly different times.

The issues are not that new. The Securities and Exchange Commission noted the problem as far back as 1973 when it issued Release No. 33-5347 which had guidelines on the applicability of federal securities laws to the sales of condominiums and units of real estate development.

The investors/purchaser lost the court case.  The court The case is now under appeal and there are numerous other issues involved in the case so we may not any new insight on when an investment in real estate becomes an investment in a security.

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A Weekend of Whistleblowing

Friday marked the effective date of the SEC’s Whistlelower Rule. Lucky whistleblowers can now cash in with bounties of up to 30% of the government’s recovery when cases involve in excess of $1 million. The question I have is whether there was spike in tips submitted over the weekend?

The SEC is trying to make it easy. They rolled out a fancy new website:

Submit a tip:

To qualify for an award under the Whistleblower Program, you must submit information regarding possible securities law violations to the Commission in one of the following ways:

SEC Office of the Whistleblower
100 F Street NE
Mail Stop 5971
Washington, DC 20549
Fax: (703) 813-9322

Please note that if you choose to submit your information anonymously, i.e., without providing your identity or contact information, you must be represented by, and provide contact information for, an attorney in connection with your submission in order to be eligible for an award.

After years of the government pushing for companies to beef up internal compliance and use hotlines to report problems, Congress opened a big barn door for people to go around internal systems. I suppose they think more people like Harry Markopolos will step up and prevent the next Madoff, or Enron, or Worldcom.

Sure, the rewards can be limited for bypassing internal reporting. But people will see the dollar signs. Inevitably there will be some sketchy lawyer advertisements encouraging you get in contact with them so they can help you qualify for the whistleblower bounty.

I suppose it’s too much to expect a big change instantly. I will be interested to see if the new rule has any impact.

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Image: Qiqi Green Whistle 8-16-09 3 by Steven Depolo
CC BY 2.0

Compliance Bits and Pieces for August 12

These are some compliance-related stories that recently caught my eye:

United Breaks Guitars: Lesson Learned for Companies and Whistleblowers by Tom Fox

The authors break their analysis down into two components, which I believe relate to the compliance context. The first is to understand what would drive an employee to go outside the internal reporting process? It is usually due to what the employee feels is a sense of betrayal. That is the employee has made a compliant in good faith but either nothing happens or nothing seems to happen. After the internal compliant has been initiated it must be triaged based on its severity. Just as a battlefield or hospital triage, the more serious a complaint, the quicker it should be investigated and resolved.

FSA seeks views on new regulatory guide: Financial Crime: a guide for firms

The Financial Services Authority recently published “CP11/12: Financial crime: a guide for firms“ seeking views on the FSA proposal for a new regulatory guide, Financial Crime: a guide for firms including bribery and corruption.

Dilbert.com

Remind People to Do the Right Thing

Dan Ariely continues to find small, easy ways to change behavior. This time it was his students running the experiment instead of him. Two students sent an email to everyone in the class that included a link to a website that was supposed to contain the answers to a past year’s final exam.

In half of the emails they included this statement:

P.S. I don’t know if this is cheating or not, but here’s a section of the University’s Honor Code that might be pertinent. Use your own judgment:

“Obtaining documents that grant an unfair advantage to an individual is not allowed”

Using Google Analytics, the students tracked how many people from each group visited the website with the answers. Overall, about 69% of the class visited. However, when the message included the reminder about the honor code, only 41% accessed the website.

Of course 41% is a big number. So the honor code message did not prevent cheating. But it did cause a big drop from 69%.

From a qualitative perspective, the replies to the email message indicated that those who received the honor code message were often upset and offended. And those that did not see the code were generally thankful.

Again, Ariely shows the powers of reminders when it comes to instilling ethical behavior.

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Laundering the Proceeds of Corruption

The FCPA and the Bribery Act focus mostly on the giver of the bribe. On the other hand, the recipients of the bribes need to deal with the cash to also avoid being caught. Like all criminals, they either shove cash into their mattresses or find a way to launder the money to get it back into the financial system. The Financial Action Task Force recently released a study on the links between corruption and money laundering: Laundering the proceeds of corruption (.pdf – 54 pages).

In running an anti-money laundering program you realize that politically-exposed persons are a potential danger to your firm. More people have noticed the potential dangers in light of the regime upheavals in North Africa and the Middle East. Funds associated with the current regime are being frozen and seized across the world. If one is your investor, you’re going to be tied up in legal headaches for years.

I suppose the money is tantalizing. The FATF report cites an estimate of $50 billion of proceeds from corruption. That’s a lot of cash to launder and big mattresses.

There are many different ways to get the cash flowing:

  • In the Green-Bangkok film festival FCPA case, the bribes were paid simply by means of the wire transfer of funds from US-based accounts, where the promoters were located, into offshore accounts in third countries maintained by family members of the PEP. The bribes never passed through Thailand.
  • Joseph Estrada, then the President of the Philippines, often received cash or check payments from gambling operators in exchange for their protection from arrest or law enforcement activities. This money was simply deposited into domestic accounts in the name of a fictional person or in corporate vehicles.
  • In the case of the bribery of US Congressman Randall Cunningham, who was a senior legislator with significant control over military expenditures, a military contractor bribed him both by checks to a corporation controlled by Cunningham, but also by agreeing to purchase real estate owned by Cunningham at a vastly inflated price.
  • Pavel Lazarenko, former Prime Minister of Ukraine, regularly required entities that wished to do business in Ukraine to split equally the profits of the enterprise with him. These businesses would transfer a share of ownership to Lazarenko associates, and money would be wired from the victim companies to offshore accounts controlled by Lazarenko.
  • Vladimiro Montesinos, Peruvian President Fujimori‘s security advisor, used shell corporations to disguise and move money illegally obtained through defense contracts with the Peruvian government, involving several corporate vehicles in a number of jurisdictions with each vehicle holding bank accounts in yet other jurisdictions.

In the United States, the Financial Crimes Enforcement Network, Treasury’s financial intelligence unit has been trying to impose anti-money laundering obligations on private funds for years. I still take the position that private equity funds are not an attractive target for money laundering, given their illiquidity and the long length of time it takes to see cash returned.

Nonetheless, fund managers should be vigilant to find out where their investors’ money comes from.

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Compliance and Liar’s Poker

Michael Lewis has written some great stuff on our most recent financial crisis: The Big Short, Iceland’s Meltdown, Greece and Corruption, and Popping the Irish Bubble. This was not his first rodeo. Lewis had a brief career in finance working as a London-based bond salesman for Solomon Brothers during the mid eighties. His finance career came to crashing halt in 1988 just after the big stock market crash of 1987. He tells his tales of finance and the excesses of Wall Street in Liar’s Poker.

Lewis covers the birth of the mortgage securitization market and trading of mortgages at Solomon Brothers. The firm dominated the market for a few years. They helped shepherd through the regulatory changes and convinced the bankers at S&Ls to buy and sell their mortgages. They essentially created greater liquidity in the American housing market. This would grow tremendously over the next twenty years, leading to the events Lewis later documents in The Big Short.

As a young, inexperienced, and mostly incompetent bond salesman, Lewis mostly screws his customers selling them bad products. But it was good for Solomon Brothers. It was good for his wallet. Wall Street greed is on full display.

It’s eerie reading this book, realizing that it was not 2008, but 1986. The book is not as good as The Big Short, but is still a very good book. I think it’s important to look back to make sure we don’t keep making the same mistakes.