Author: Doug Cornelius

You can find out more about Doug on the About Doug page

Individuals as Qualified Purchasers

To pull the pieces together, private funds are exempt from the Investment Company Act under Section 3(c)(1) or Section 3(c)(7). Under (1) the fund is limited to 100 investors. Under (7), there is no limit on the number of investors, but the investors have to be “Qualified Purchasers.”

The definition of “qualified purchaser” in Section 2(51)(A) includes individuals as

(i) any natural person … who owns not less than $5,000,000 in investments, as defined by the Commission;

Which leads us to seeking out the definition of “investments” for purposes of the “qualified purchaser” definition. That was published by a SEC rule-making in 1997 and can be found in Section 270.2a51-1(b).

The first issue to tackle is marriage or spousal equivalent.

The rule provides that, in determining whether a natural person is a qualified purchaser, the person may include in the amount of his or her investments any investments held jointly with the person’s spouse (“Joint Investments”). Thus, a person who owns $3 million of investments individually and $2 million of Joint Investments would be a qualified purchaser. The spouse also would be a qualified purchaser if he or she owned, individually, an additional $3 million of investments.

A married couple investing jointly can include their joint assets. If only one spouse is investing, that spouse can use the assets in his or her own name and the joint assets to reach $5 million.

For individuals there are six items that can be considered investments.

  1. Securities, as defined in section 2(a)(1) of the Securities Act of 1933. Excluded are securities in a company controlled by the person, unless that company is (i) an investment company or one of the exclusions from the definition, (ii) a company with publicly traded securities, or (iii) showing at least $50 million in shareholders’ equity on its financial statements.
  2. Real estate held for investment purposes. That excludes your principal residence, your vacation home and the office you work in.
  3. Commodity interests held for investment purposes. That means you have to be primarily in the business of trading commodity interests.
  4. Physical commodities held for investment purposes. That means you have to be in business of trading commodities. Your Babe Ruth baseball card is not going to count unless your business is trading baseball cards.
  5. Financial contracts held for investment purposes that fall outside the definition of securities.
  6. Cash and cash equivalents held for investment purposes. That’s going to exclude your checking account, but you can probably include your savings account.

Add that stuff together if its in the person’s name or held jointly. If it adds up to $5 million. That person is a “qualified purchaser.” You just have to have a reasonable belief that the person is a qualified purchaser.

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Suspicious Activity Reporting

The Securities and Exchange Commission’s Division of Examinations released a Risk Alert on Compliance Issues Related to Suspicious Activity Monitoring and Reporting at Broker-Dealers. While it spent most of the publication laying out the vague requirements of reporting suspicious activity, it took a sharp turn and listed six types of activities that the SEC would consider suspicious activity that should be reported.

  1. Large deposits of low-priced securities, followed by the near-immediate liquidations of those securities and then wiring out the proceeds.
  2. Patterns of trading activity common to several customers including, but not limited to, the sales of large quantities of low-priced securities of multiple issuers by the customers.
  3. Trading in thinly traded, low-priced securities that resulted in sudden spikes in price or that represented most, if not all, of the securities’ daily trading volumes.
  4. Trading in the stock of issuers that were shell companies or had been subject to trading suspensions or whose affiliates, officers, or other insiders had a history of securities law violations.
  5. Questionable background of customers such as the fact that they were the subject of criminal, civil, or regulatory actions relating to, among other things, securities law violations.
  6. Trading in the stock of issuers for which over-the-counter stock quotation systems had published warnings because the issuers had ceased to comply with their SEC financial reporting obligations or for which the firms relied on a “freely tradeable” legal opinion that was inconsistent with publicly available information.

I found this to be a great reference list.

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SPAC, SMACK, SHAQ?

SPACs are the current tulips of the markets. Everyone wants a piece of one. Celebrities are joining the rush. As noted in the title, Shaq has one. Actually Shaq is on his second SPAC.

Almost 250 SPAC IPOs were completed in 2020, raising total gross proceeds of approximately $75 billion That was about half of the number of IPOs and half of the capital raised in IPOs.

There are lots or reasons for companies to become liquid and raise capital through a SPAC. There is certainty in pricing. Private company founders and their backers don’t have to spend months worried about how much capital will be raised in an IPO. They negotiate the capital raise with the SPAC executives.

The downside is that the private company may not have been through the compliance wringer to make sure it’s ready for the rigors of being a public company.

The SEC is catching up and has released a series of statements and policy notices about SPACs. The Division of Corporate Finance pointed out that these newly crafted public companies have to focus on their books and records and their financial controls. The public SPACs have to meet these standards. But since they are just sitting on a pile of cash, their controls can be very simple. It’s really the controls of the acquired company that will be in operation.

A public statement by the SEC’s Chief Accountant also pointed to the financial controls, governance, and audit controls that creates faith in the public markets.

One item that the SEC has started to focus on is the treatment of the warrants involved in the SPAC combination. The reason that sponsors are jumping on the SPAC bandwagon is the promote granted to the SPAC organizers in the form of warrants.

The Securities and Exchange Commission last week began privately telling accountants that warrants, which are issued to early investors in the deals, might not be considered equity instruments, according to people familiar with the matter.

It’s the special sauce that has helped lubricate the SPAC engine. It’s not a bubble in valuation. It’s a bubble in method.

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Form ADV FAQ Comes a Little Late

Most investment advisers filed their form ADVs last week, before the March 31 filing deadline. That didn’t stop the Securities and Exchange Commission from publishing a new FAQ about Form ADV on April 6. Hopefully you got it right.

There has been some questions about office locations that need to be disclosed on Form ADV during the pandemic. The general thought was that temporarily working from home during the pandemic didn’t need to be disclosed. Was that the right approach?

Let’s see…

Q: My firm has employees who are temporarily conducting investment advisory business from a temporary location other than their usual place of business (their homes, for example) as part of the firm’s business continuity plan due to circumstances related to coronavirus disease 2019 (COVID-19). Item 1.F of Part 1A requires information about a firm’s principal office and place of business. Section 1.F of Schedule D requires information about “each office, other than your principal office and place of business, at which you conduct investment advisory business.” Is my firm required to update either Item 1.F of Part 1A or Section 1.F of Schedule D in order to list the temporary teleworking addresses of its employees?

A: No. As long as the employees are temporarily teleworking as part of the firm’s business continuity plan due to circumstances related to coronavirus disease 2019 (COVID-19), staff would not recommend enforcement action if the firm does not update either Item 1.F of Part 1A or Section 1.F of Schedule D in order to list the temporary teleworking addresses. For purposes of this FAQ, “temporarily teleworking” includes prolonged plans to telework, provided that the firm maintains a physical office location. (Updated April 6, 2021)

Marketing Rule FAQs

The Securities and Exchange Commission finally published the new Marketing Rule for investment advisers. Based on the publication date, it becomes effective on May 4. The compliance date is November 4, 2022. A frequently asked question is whether you can slowly wade into the standards of the new rule or do you have to do a full belly-flop.

Apparently, that question has become frequent enough that the SEC published a response. The answer is the full belly-flop.

“An adviser may choose to comply with the amended marketing rule in its entirety any time starting on the effective date, May 4th, 2021. Until an adviser transitions to the amended marketing rule, the adviser would continue to comply with the previous advertising and cash solicitation rules and look to the staff’s positions under those rules. The staff believes an adviser may not cease complying with the previous advertising rule and instead comply with the amended marketing rule but still rely on the previous cash solicitation rule. “

https://www.sec.gov/investment/marketing-faq

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Bad Investments and Overcharging

Douglas Elstun failed his clients in two ways. He over charged them and he put them into inappropriate investments.  

Mr. Elstun invested some of his clients’ money in daily leveraged ETFs, which deliver multiples of short-term performance of a stock index. He also invested some clients in inverse ETFs which are designed to deliver the opposite performance of a market index in the short term. If these sound complex, you’re right. A FINRA regulatory notice said:  

“[The ETFs] are highly complex financial  instruments that are typically designed to achieve their stated objectives on a daily basis.” … “[The ETFs] are typically unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.” 

Mr. Elstun used a buy and hold strategy for his clients with these complex ETFs, resulting in millions of dollars in losses. He either didn’t understand the ETFs because he portrayed them as hedges against a market downturn, or he was making misleading statements to his clients.  

Mr. Elstun also overcharged his clients. Even though several advisory agreements stated that he was only entitled to a fee of 1%, he started charging 1.25%. The SEC charged him with falsifying revised agreements. 

In addition to wrongfully increasing the rate, Mr. Elstun also wrongfully expanded the base of assets to apply the rate. For certain clients he included equity in houses, other real estate and vehicles that the clients purchased.  

Mr. Elstun is still contesting the charges so we only have the SEC’s side to rely upon.

Making sure investment advice is appropriate for a particular client is a key compliance role. Any good compliance review should have shown that a long term hold in those ETFs was bad advice. As you might expect, Mr. Elstun was also the CCO of the firm.

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How to do a Fundraising Incorrectly

Ettro Capital developed real estate. It’s principal, Peter Ettro must have thought that using a private fund to raise some of the capital to finance the investments would be a good idea. He raised over $4 million from 13 investors in ECM Opportunity Fund. The problem is that he made some big fundraising mistakes.

The first category of mistakes was lying to prospective investors.

From April through October 2017, Ettro claimed that the Fund’s net return since inception ranged from as low as 26.4% to as high as 56%, its blended net return since inception exceeded 20%, its realized yield was 18.67%, and its total return was 43.67%. In truth, the fund didn’t have any returns until November 2017 and it wasn’t that good.

Ettro send another investor a description of the projects the fund had in its portfolio. It listed two completed projects that had gained over $900,000 and six projects in progress. It left out a third completed project that had lost over $1.1 million.

Ettro also inflated the size of the portfolio, claiming to invested in over $50 million of real estate projects. The truth was closer to $1.5 million.

The second category of problems was engaging in general solicitation.

Ettro had filed a Form D for the fundraising and checked the “Rule 506(b)” box. That makes it a private offering and prohibits general solicitation and general advertising. Ettro made the fundraising material available on a website. THat included target returns and investor testimonials that all visitors could access.

Ettro tried to fix the problem by filing an amendment to Form D, switching to the “Rule 506(c)” box. That public-private offering allows general solicitation. The big requirement is that you have to take steps to verify the accredited investor status of your investors. Ettro had not done so. At least one investor was not accredited.

Ettro voluntarily returned the management fees back to the fund investors and has to pay a $60,000 fine to the SEC.

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Got Thoughts on Form PF or Private Fund Registration Requirements?

The Securities and Exchange Commission published a list of rules to be reviewed pursuant to the Regulatory Flexibility Act. The publication invites comments on whether the rules should be amended or continued without change. Two items caught my attention.

The first is Form PF. It was adopted in October 2011. The second is the registration requirement imposed on private funds and other Dodd-Frank requirement. That rule and rule amendments was adopted in June 2011.

Does this mean changes are coming?

The Regulatory Flexibility Act (5 U.S.C. 601-612) requires an agency to review its rules that have a significant economic impact upon a substantial number of small entities within ten years of the publication of such rules as final rules. 5 U.S.C. 610(a). The purpose of the review is “to determine whether such rules should be continued without change, or should be amended or rescinded . . . to minimize any significant economic impact of the rules upon a substantial number of such small entities.”

The SEC notes that there were no comments on its initial Regulatory Flexibility Analysis for either rule.

The publication of these opening for comments seems like a pro forma step by the SEC to comply with the Regulatory Flexibility Act and not movement to make regulatory changes. But if the SEC gets comments, maybe it will think about making changes. The link to leave comments is on this page: https://www.sec.gov/rules/other.htm.

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Ignoring Iranian Red Flags

There are a few places around the world that you know you can’t do business with. Iran and North Korea have very strict limitations. If it pops up that your business partner wants to ship your products to one of these countries, it’s time to get legal and compliance on the phone before you agree to that sale.

UniControl, Inc., a manufacturer of process controls, airflow pressure switches, boiler controls, and other instrumentation, based in Ohio ran into this problem and violated the Iranian Transactions and Sanctions
Regulations.

From 2013 to 2017, UniControl exported 21 shipments of air pressure switches, valued at $687,189,
to European company that were subsequently reexported the shipments to Iran. U.S. Department of the Treasury’s Office of Foreign Assets Control took action against UniControl because it failed to take appropriate steps in response to multiple warning signs that its goods were being reexported to Iran.

Early in their relationship, one of these European trade partners told UniControl that it had a significant market for UniControl’s goods in Iran and inquired whether UniControl could serve as a supplier. UniControl rightfully said “no.” It otherwise didn’t take any steps to ensure the re-shipment to Iran would not actually happen.

UniControl really screwed up when it entered into a sales representative agreement with a European trade partner that explicitly listed Iran as a target for sales. UniControl employees met with the partner at a trade conference and met with Iranian nationals at the partner’s booth.

The last step was a request from the trade partner to remove the “Made in the USA” label from the products. “The European trade partner explained that the Iranian end-user may have problems with the stated origin of the products.” The company engaged outside counsel to figure out how much trouble it was in. Sadly, it still sent some of the shipments.

What saved the company was largely self-reporting the problem and investing in a more robust compliance program.

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Subscription Credit Facility Fraud

Lots of private equity funds use a line of credit to fund acquisitions. It’s quicker to draw on the line than to call equity from investors. That line of credit is secured by the capital commitments to the private equity fund. Later the private equity fund calls the capital for the acquisition and pays down the line of credit. According to a criminal complaint a private equity fund manager is accused of forging subscription documents and an audit letter to get a line of credit.

JES Global was registered with the Securities and Exchange Commission as an Exempt Reporting Adviser. Its principal, Elliot Smerling, committed blatant fraud. It may have future implication for private funds and the work that will go into setting up a credit facility.

Elliot Smerling had an empire of private equity funds and reportedly lived a lavish lifestyle, with homes in Florida, New York and Brazil with a collection of luxury cars. Smerling is accused of committing fraud to keep his complex financial operation afloat, according to the criminal charges.

He set up a credit facility with Silicon Valley Bank for one of his funds. He handed the bank two subscription agreements. One purported a $45 million commitment from a New York University endowment and a second purported to be $40 million from an investment manager. The criminal complaint did not identify the two purported investors. Smerling is also accused of submitting a forged audit letter and a falsified bank statement showing a wire transfers from the purported investors.

According to the criminal complaint, Smerling produced fake documents. The University endowment has no record of the document or the wire and the signature does not match the CIO of the endowment. The investment manager has no record of the document or the wire and the signature does not match. The audit firm named on the audit letter was not engaged by Smerling or the fund. The address on the letterhead of the audit letter is an address that the firm has not operated at for several years.

This is the first time that I’ve heard of subscription facility fraud. I expect that there may be changes to the lending process

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