Category: Fundraising

I’m an NFL Owner

Sort of.

The Green Bay Packers want to expand Lambeau Field by 6,700 seats, add new gates and new video boards. To finance the improvements, the team ownership decided to sell additional stock in the ownership corporation. Since the Kraft family is unlikely to be selling the Patriots anytime soon, I was willing to part with some football loyalty and some cash to get my own piece of the NFL pie.

Unlike the rest of the National Football League franchises, the Green Bay Packers franchise is owned by non-profit, community-based organization, Green Bay Packers, Inc. The corporation is required to be nonprofit sharing and that no shareholder may receive any dividend or pecuniary profit by virtue of being a shareholder in the corporation. Any increase in value or operating profits and any proceeds upon liquidation of the corporation will go to community programs, charitable causes or other similar causes. If you add in limitations in stock ownership and transfer restrictions, it’s virtually impossible for anyone to recoup the amount initially paid to acquire the stock. That makes it a completely non-economic investment.

Is it a security?

Here is what the offering document says:

Because the Corporation believes Common Stock is not considered “stock” for securities laws purposes, it believes offerees and purchasers of Common Stock will not receive the protection of federal, state or international securities laws with respect to the offering or sale of Common Stock. In particular, Common Stock will not be registered under the Securities Act of 1933, as amended, or any state or international securities laws. The Common Stock will not be approved by the Securities and Exchange Commission or any state or international regulatory authority nor will the
Securities and Exchange Commission or any state or international regulatory authority approve the Offering or the terms of the Offering.

Under the Howey definition of an investment contract, you need (1) a common enterprise and (2) to depend “solely” for its success on the efforts of others. Certainly, the Packers’ stock meets those two prongs. The third prong is an expectation of profits. That is not true. However the definition of “security” in the Securities Exchange Act of 1934 includes “any note, stock, treasury stock…” The interests in the Packers are clearly stock and seem to fall into the definition of security.

What do you get?

A certificate:

The certificate is designed in the timeless tradition of classic stock certificates. The 12 inch by 8 inch certificate is printed on exquisite paper using a classic engraved steel plate process. It features an artistic representation of heritage. The record of your ownership will be secure, and you will be able to display your ownership with pride.

Is this Crowdfunding?

This is the current state of crowdfunding. You can’t offer securities without going through the registration process or finding an exemption. But you can still raise funds from a large group of people. Just don’t offer a share of the profits or stock. That’s how the kickstarter crowdfunding platform works. You get an over-priced product or a t-shirt or some other token of appreciation. As a backer, you do not have visions of early retirement because you just bought a piece of ownership in a multi-million dollar idea.

A Packers’ alternative would be to have merely offered a certificate of appreciation or tufts of grass from Lambeau field. But they offered the ability to say “I’m an NFL owner.”

I’m supporting a multi-million dollar idea. On Any Given Sunday, any team in the NFL can beat another. A team from tiny Green Bay, Wisconsin can still generate the revenue to field a competitive team and win the Super-Bowl.

I still prefer that the Patriots win the Super Bowl.

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New Financial Legislation Takes Another Step

Four bills made their way through the Capital Markets and Government Sponsored Enterprises Subcommittee of the House Financial Services Committee last week and this week were approved by the full  Financial Services Committee .

The Congress had to throw in some attacks against the Securities and Exchange Commission.
“We cannot wait for the SEC to act when millions of Americans are out of work and small businesses can’t access capital because of outdated regulations.  Small business accounts for the majority of new jobs created in the U.S.  The Committee took action today and passed common-sense ideas that will promote jobs,” said Financial Services Chairman Spencer Bachus. “Capital formation is essential for a robust economy. The bills approved today provide the modernized regulatory environment that is needed to help small businesses create jobs.”
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Lifting the Ban on General Solicitation

From a  securities compliance perspective, when you  see an advertisement or an email seeking capital for an investment opportunity there is most likely a problem. Now there is a bill in Congress that would change that view.

When selling a security, you need to register the security or find an appropriate exemption from registration. Most likely a private fund or an entrepreneur would try to fall under one of the exemptions under Regulation D. If the company is seeking over $1,000,000 they are prohibited from offering to sell the securities “by any form of general solicitation or general advertising“. Before asking someone to make an investment, you need to have a preexisting, substantive relationship.

“The types of relationships with offerees that may be important in establishing a general solicitation has not taken place are those that would enable the issuer (or a person acting on its behalf) to be aware of the financial circumstances or sophistication of the person with whom the relationship exists or that otherwise are of some substance and duration.” Mineral Lands Research & Marketing Corp., S.E.C. No-Action Letter, 1985 WL 55694 (Dec. 4 1985).

Representative Kevin McCarthy (R-CA) introduced the Access to Capital for Job Creators Act (HR 2940) which require the Securities and Exchange Commission to revise its rules to permit general solicitation in offerings under Rule 506 of Regulation D.

In my view, I don’t think there should be an elimination of the ban on general advertising and general solicitation. That would just expose large segments of the population to potential securities fraud. Currently, ads for investment opportunities are red flags for state and federal regulators.

However, I do think it needs to a little easier for entrepreneurs to raise capital. The SEC should offer some better guidance on the limitation. They could also offer some programs and safe harbors. I assume the SEC is waiting for someone to approach them with examples. They continue to be too underfunded and too understaffed to be proactive.

Will the Access to Capital for Job Creators Act be enacted? I doubt that it would pass in its current form. It takes away some investor protection and warning system for securities regulators. That would seem a bad position when the country is stealing trying to recover from the massive losses of 2008.

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Crowdsourcing the Purchase of a Beer Company

Some beer lovers who were fans of Pabst Blue Ribbon heard that its parent company, the Pabst Brewing Co., was up for sale. The previous owner had died, leaving it to a charitable trust. Charities couldn’t hold on to the asset so they had to sell it.

The beer lovers were a few hundred million dollars short on the purchase price. This is the 21st Century, so they decide to create a website, buyabeercompany.com, to crowdsource the purchase price. They even set up a Twitter account and Facebook page. Each investor would receive a “crowdsourced certificate of ownership,” as well as beer of a value equal to the amount invested.

Those of you with even a vague understanding of securities laws will see that this will not end well.

The fundraising effort was relatively successful. They elicited $14.75 million in pledges during their first few weeks. Apparently, they eventually raised $200 million in pledges from more than 5 million pledgors.

That was not enough money to purchase the company, but it was enough to get in trouble with the Securities and Exchange Commission.

Under Section 5(c) of the Securities Act, it’s unlawful to offer to sell a security unless it is registered with the SEC or there is an applicable exemption. There is no exemption for beer lovers.

From the SEC Administrative Order, it sounds like the beer lovers thought that by merely asking for pledges to eventually buy the company they were not offering securities for sale. The SEC disagreed and pointed to Section 2(a)(3) of the Securities Act that defines “offer to sell” as “every attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value.”

So how does Kickstarter not violate Securities Law? Those projects involve selling a product, not selling securities. I pledged for a trebuchette project on Kickstarter. I get two of the Trebuchettes; I don’t get an interest in the company making the product.

I suppose the beer lovers could merely have pre-sold cases of PBR to raise capital. But if you think the securities laws are tough to deal with, try dealing with interstate liquor sales.

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Is the SEC Going to Reform Advertising Rules?

Advertising and corporate communications is a rough area for compliance when used in capital formation. The rules are restrictive, not always intuitive, often vague, and in direct opposition to the revenue-hungry side of the company.

Last week, the House Committee on Oversight and Government Reform heard testimony on “how securities regulations have harmed public and private capital formation in the United States.”

“Economists now estimate that the market for underwritten initial public offerings in the U.S. have plummeted from an annual average of 530 during the 1990s to about 126 since 2001. Meanwhile, the number of companies listed on the major American exchanges peaked in 1997 at more than 7,000. Today, there are approximately 4,000. Furthermore, private capital formation in the U.S. is increasingly difficult, as demonstrated by Facebook’s recent decision to issue its high-profile private offering to foreign investors but not Americans.”

Since I’m in the private equity sector, I care more about the limitations placed on private capital formation. SEC Chairman re-stated the justification for the ban on general advertising under Regulation D.

“The ban was designed to ensure that those who would benefit from the safeguards of registration are not solicited in connection with a private offering.”

“I recognize that some continue to identify the general solicitation ban as a significant impediment to capital raising for small businesses. I also understand that some believe that the ban may be unnecessary because those who do not purchase the offered security would not be harmed by the solicitation that occurs. At the same time, the general solicitation ban is supported by others on the grounds that it helps prevent securities fraud by making it more difficult for fraudsters to attract investors or unscrupulous issuers to condition the market. We need to balance these considerations as we move forward in analyzing this issue.”

Barry Silbert, CEO of Second Market phrased it nicely:

It should not matter that non-accredited individuals know that unregistered securities are available for sale. No one prohibits car manufacturers from advertising, even though children under the legal driving age are viewing the advertisements. The general solicitations prohibition unnecessarily limits the pool of potential investors, thereby restricting companies’ ability to raise capital to fuel growth.

Chairman Shapiro said the SEC staff is looking at the offering rules and whether the general solicitation ban should be revisited. Given all of the rule-making from Dodd-Frank, it’s hard to imagine that the SEC will find the bandwidth to revisit the rule in the near future.

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Image is Reaching for Blue Skies by Kelvin Tan
CC BY 2.0

Turning Your PowerPoint into an Advertisement

Once a fund manager is registered, Rule 206(4)-1 imposes additional restrictions on advertising that the SEC has determined would be fraudulent deceptive or manipulative. That means public presentations could be considered an advertisement.

First I want to look back at the definition of an “advertisement” for purposes of the rule. An advertisement for purposes of the rule 206(4)-1 is:

“[A]ny notice, circular, letter or other written communication addressed to more than one person, or any notice or other announcement in any publication or by radio or television, which offers (1) any analysis, report, or publication concerning securities, or which is to be used in making any determination as to when to buy or sell any security, or which security to buy or sell, or (2) any graph, chart, formula, or other device to be used in making any determination as to when to buy or sell any security, or which security to buy or sell, or (3) any other investment advisory service with regard to securities.”

In meeting with potential investors, invariably, someone will pull out a Powerpoint presentation to discuss the fund manager, their past performance, and future business plan. In looking at the definition of advertisement, a purely oral presentation would not be an advertisement. One the projector lights up, the presentation starts moving into the realm of an advertisement.

The final straw is leaving a copy of the presentation behind. Now the presentation is clearly a “written communication.”

And don’t forget about the requirements of Regulation D regarding advertising and disclosure requirements for privately-offered securities.

Fees and Performance Results for Advisers and Fund Managers

Section 206 of the Investment Advisers Act prohibits fraud, deception or manipulation, regardless of whether the fund manager is registered. Once registered, Rule 206(4)-1 imposes additional restrictions on advertising that the SEC has determined would be fraudulent, deceptive or manipulative.

The first item on the list of fraudulent, deceptive or manipulative practices is testimonials, which I wrote about earlier. The second item in the advertising rule is a prohibition on using past performance in an advertisement, subject to some limitations. I also wrote about that last week.

One of the controversial standards when using performance results is that they must be shown net of fees.

In a 1986 No Action Letter to Clover Management the SEC said it was their view that “Rule 206(4)-1(a)(5) prohibits an advertisement that: … (2) Includes model or actual results that do not reflect the deduction of advisory fees, brokerage or other commissions, and any other expenses that a client would have paid or actually paid; ”

Can you just include a description of your fees? No.

[B]ecause advertisements typically present adviser performance results over a number of
years, narrative disclosure of the existence and range of advisory fees, in our view, would
not be an adequate substitute for deducting advisory fees because of the compounding
effect on performance figures that occurs if advisory fees are not deducted. In our view it is
inappropriate to require a reader to calculate the compounding effect of the undeducted
expenses on the advertised performance figures. Investment Company Institute No Action Letter (1987)

But you can include gross returns, as long as they are side-by-side with net of fees results. See Association of Investment Management and Research (1996). Both the net and gross performance figures need to be presented in an equally prominent manner. The “advertisement” must contain sufficient disclosure to ensure that the performance figures are not misleading. For example, when showing a performance figure gross of fees there should be a disclaimer that the figures do not reflect the payment of investment advisory fees and other expenses.

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Performance Results in Fund Brochures

Section 206 of the Investment Advisers Act prohibits fraud, deception or manipulation, regardless of whether the fund manager is registered. Once registered, Rule 206(4)-1 imposes additional restrictions on advertising that the SEC has determined would be fraudulent, deceptive or manipulative.

The first item on the list of fraudulent, deceptive or manipulative practices is testimonials, which I wrote about earlier.

The second item in the advertising rule is prohibition on using past performance in an advertisement, subject to some qualification:

206(4)-1(a)(2): Which refers, directly or indirectly, to past specific recommendations of such investment adviser which were or would have been profitable to any person:

Provided, however, That this shall not prohibit an advertisement which sets out or offers to furnish a list of all recommendations made by such investment adviser within the immediately preceding period of not less than one year if such advertisement, and such list if it is furnished separately:

(i) State the name of each such security recommended, the date and nature of each such recommendation (e.g., whether to buy, sell or hold), the market price at that time, the price at which the recommendation was to be acted upon, and the market price of each such security as of the most recent practicable date, and

(ii) contain the following cautionary legend on the first page thereof in print or type as large as the largest print or type used in the body or text thereof: “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”

Of course, all advertising is still subject to the prohibition on advertising that is otherwise false or misleading in Rule 206(4)-1(a)(5).The SEC has adopted a facts-and-circumstances test to determine whether the use of performance results is false or misleading.

[W]e believe the use of model or actual results in an advertisement would be false or misleading under Rule 206(4)-1(a)(5) if it implies, or a reader would infer from it, something about the adviser’s competence or about future investment results that would not be true had the advertisement included all material facts. Any adviser using such an advertisement must ensure that the advertisement discloses all material facts concerning the model or actual results so as to avoid these unwarranted implications or inferences. Because of the factual nature of the determination, the staff, as a matter of policy, does not review any specific advertisements. Clover Capital Management, Inc. 1986 No Action Letter

A facts-and-circumstances test is not one that helps a compliance officer sleep at night. That means judgment calls and disagreements with management on what can be included and how it can be included.

There are many SEC no action letters out setting some lines in the sand. A 1986 No Action Letter to Clover Management lays out a series practices that are bad for disclosing model and actual results:

(1) Fails to disclose the effect of material market or economic conditions on the results portrayed (e.g., an advertisement stating that the accounts of the adviser’s clients appreciated in the value 25% without disclosing that the market generally appreciated 40% during the same period);

(2) Includes model or actual results that do not reflect the deduction of advisory fees, brokerage or other commissions, and any other expenses that a client would have paid or actually paid;

(3) Fails to disclose whether and to what extent the results portrayed reflect the reinvestment of dividends and other earnings;

(4) Suggests or makes claims about the potential for profit without also disclosing the possibility of loss;

(5) Compares model or actual results to an index without disclosing all material facts relevant to the comparison (e.g. an advertisement that compares model results to an index without disclosing that the volatility of the index is materially different from that of the model portfolio);

(6) Fails to disclose any material conditions, objectives, or investment strategies used to obtain the results portrayed (e.g., the model portfolio contains equity stocks that are managed with a view towards capital appreciation);

(7) Fails to disclose prominently the limitations inherent in model results, particularly the fact that such results do not represent actual trading and that they may not reflect the impact that material economic and market factors might have had on the adviser’s decision-making if the adviser were actually managing clients’ money;

(8) Fails to disclose, if applicable, that the conditions, objectives, or investment strategies of the model portfolio changed materially during the time period portrayed in the advertisement and, if so, the effect of any such change on the results portrayed;

(9) Fails to disclose, if applicable, that any of the securities contained in, or the investment strategies followed with respect to, the model portfolio do not relate, or only partially relate, to the type of advisory services currently offered by the adviser (e.g., the model includes some types of securities that the adviser no longer recommends for its clients);

(10) Fails to disclose, if applicable, that the adviser’s clients had investment results materially different from the results portrayed in the model;

(11) [for actual results] Fails to disclose prominently, if applicable, that the results portrayed relate only to a select group of the adviser’s clients, the basis on which the selection was made, and the effect of this practice on the results portrayed, if material.

The other important thing to keep in mind when deciding to use performance results is that you must keep all of the accounts, books, internal working papers and other records necessary to demonstrate the calculation of the performance results. SEC Rule 204-2(a)(16)

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Ratings and Fund Managers

Investment advisers, and therefore fund managers once they register as investment advisers, are limited in how they advertise. Section 206 of the Investment Advisers Act already prohibits fraud, deception or manipulation, regardless of whether the fund manager is registered. Once registered, Rule 206(4)-1 imposes additional restrictions on advertising that the SEC has determined would be fraudulent deceptive or manipulative.

The first item on the list of restrictions is testimonials. This prohibition reflects the concern that the experience of one customer is not necessarily typical of the experience for all customers.

To some extent this also covers third party ratings since they are relying on the testimonials of clients. If you have a good rating you may want to include that rating as part of your fundraising materials. That means you are indirectly including a testimonial in your advertising and are staring squarely at the prohibitions in the advertising rule.

However, the SEC has recognized that the distribution of unbiased third-party ratings may not be fraudulent. In a 1982 No Action Letter to New York Investors Group, Inc., the SEC allowed the investment adviser to include an article from a financial publication that “lauds the Company/ and or the Company president’s success in picking stocks that do well under both favorable and unfavorable market conditions.”

The SEC ruled that “an article by an unbiased-third party concerning an investment adviser’s performance, however, is not a testimonial unless it includes a statement of a customer’s experience or endorsement. ” While clarifying that the article is not a testimonial, it is still an advertisement.

The more detailed discussion about the use of ratings is in a 1998 No Action Letter to DALBAR, Inc. The company conducted a survey to measure the effectiveness of investment advisers and their representatives.  Based on the survey, DALBAR would assign a numerical ranking. Since the investment adviser was paying for the survey, presumably they would want to publish a good result to attract more clients. That means the ratings would be part of an advertisement.

The SEC said that the DALBAR rating is a testimonial because the rating carries an implicit statement of clients’ experiences. The DALBAR rating is testimonial, made indirectly.

But the SEC turns around and and blesses the DALBAR rating, granting the sought after “we would not recommend enforcement action.” The SEC lists these factors:

  • DALBAR rating does not emphasize the favorable client responses or ignore the unfavorable responses.
  • The rating represents all or a statistically significant sample of an adviser’s clients.
  • The client questionnaire has not been prepared to produce any pre-determined results.
  • The client questionnaire makes it easy for a client to give negative or positive responses.
  • DALBAR does not perform any subjective analysis of the survey results, but merely assigns numerical ratings after averaging client responses.
  • DALBAR is not affiliated with any advisers.
  • DALBAR charges a uniform fee, paid in advance.
  • Survey results clearly identify the percentage of survey participants who received each designation and the total number of survey participants.

While the SEC blesses the DALBAR rating system, they took the opportunity to point out that an adviser’s use of the rating in their advertisement materials could still be a violation of Section 206(4) and Rule 206(4)-1(a)(5). The SEC provided some guidance that advisers should consider when using a DALBAR or similar rating:

1. Whether the advertisement discloses the criteria on which the rating was based;

2. Whether an adviser or IAR advertises any favorable rating without disclosing any facts that the adviser or IAR knows would call into question the validity of the rating or the appropriateness of advertising the rating (e.g., the adviser or IAR knows that it has been the subject of numerous client complaints relating to the rating category or in areas not included in the survey);

3. Whether an adviser or IAR advertises any favorable rating without also disclosing any unfavorable rating of the adviser or IAR (or the adviser that employs the IAR);

4. Whether the advertisement states or implies that an adviser or IAR was the top-rated adviser or IAR in a category when it was not rated first in that category;

5. Whether, in disclosing an adviser’s or IAR’s rating or designation , the advertisement clearly and prominently discloses the category for which the rating was calculated or designation determined, the number of advisers or IARs surveyed in that category, and the percentage of advisers or IARs that received that rating or designation;

6. Whether the advertisement discloses that the rating may not be representative of any one client’s experience because the rating reflects an average of all, or a sample of all, of the experiences of the adviser’s or IAR’s clients;

7. Whether the advertisement discloses that the rating is not indicative of the adviser’s or IAR’s future performance; and

8. Whether the advertisement discloses prominently who created and conducted the survey, and that advisers and IARs paid a fee to participate in the survey.

If you are using third-party ratings as part of your fundraising materials, DALBAR presents you with a laundry list of things you can and cannot do with those ratings.
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Client Lists and Private Fund Managers

Section 206 of the Investment Advisers Act prohibits fraud, deception or manipulation, regardless of whether the fund manager is registered. Once registered, Rule 206(4)-1 imposes additional restrictions on advertising that the SEC has determined would be fraudulent deceptive or manipulative.

The first item on the list of restrictions is testimonials. This prohibition reflects the concern that the experience of one customer is not necessarily typical of the experience for all customers.

Merely including a list of client names is not a testimonial, but could still be considered fraudulent. You can see that in the example of Reservoir Capital Management. Reservoir provided prospective clients a client list, which Reservoir described as “representative,” that consisted of the names of eight institutional investors. In the SEC’s view this created the impression that a substantial portion of Reservoir’s client base was institutional clients. The truth was that no more than fifteen percent of Reservoir’s assets under management were assets of institutional clients.

A list of all clients would unlikely to be considered a testimonial in violation of the rule. Once you start producing a partial list, the SEC gets considered that the inclusion or exclusion of clients on the list could be fraudulent or manipulative.

The SEC offered some additional guidance on including a partial list of clients in a 1993 No Action Letter to Denver Investment Adviser Associates. They came up with three conditions that need to be satisfied:

1. You can’t use performance based criteria in determining which clients to include in the list

2. The client list has a disclaimer similar to this: “It is not known whether the listed clients approve or disapprove of the adviser or the advisory services provided.

3. The client list includes a statement disclosing the objective criteria used to determine which clients to include in the list.

For a fund manager, the funds are the clients. However, I could easily see how this limitation could be taken the next step to investors in the funds.

Also keep in mind that the fact that a particular customer or consumer is a client could be considers nonpublic personal information, making it subject to Regulation S-P. Several states prohibit an investment adviser from disclosing a client’s identity
without consent.

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