Category: Fundraising

The New Advertising Rule for Private Funds and Investment Advisers Is Still Sitting

As an early Christmas present, the Securities and Exchange Commission approved a new marketing rule on December 22, 2020. This was after a vote on the rule was suddenly canceled at an open meeting the week prior.

Now we are two months after approval of the rule, but it hasn’t yet been published in the Federal Register. So it’s not effective yet and the long runway for compliance has not been laid out.

What’s going on?

The Biden administration imposed a regulatory freeze. It’s not legally binding on Securities and Exchange Commission. Perhaps the SEC is embracing the freeze even though its not required.

In connection with the new Marketing Rule the SEC stated that it was reviewing the 60 years of guidance and no-action letters that have governing marketing under the old advertising rule. Perhaps the erasure of that guidance will be part of the final publication.

Otherwise, the SEC is giving us time to re-read the new Marketing Rule and thinking about the roadmap.

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Performance Advertising and the Funds That Weren’t There

Eric Malley decided that buying buy hundreds of luxury Manhattan residences on the cheap and leasing them to corporate tenants would be a great way to make money. He would let others in on his plan as investors. He created MG Capital Management Residential Fund III and raised $23 million from about 60 investors. It seemed successful enough that he launched a follow up Fund IV that raised $35 million.

You may be asking yourself: What about Fund I and Fund II?

The marketing materials for Fund III and Fund IV described very successful predecessor funds. In the Fund III PPM the outcome was described as

Fund I:
(1) raised $350 million of investor capital;
(2) earned a gross return on investment (ROI) of 38.99% and a net ROI of 30.81% during its six-year investment term from 2007 through 2013;
(3) outperformed the S&P 500 Index by 4.5-to-1; and
(4) sold its 74-property portfolio to two buyers for $750 million

and

Fund II:
(1) raised $55 million of investor capital in only 30 days; and
(2) achieved an average gross ROI of 38.06%,
cumulative unrealized gains on equity of 154.55%, and
a gross investment multiple of 2.55x.

In the complaint filed by the Securities and Exchange Commission, there is no evidence that these funds existed. Nor is there any evidence that MG controlled the $1.8 billion portfolio of real estate supposedly owned by the funds.

As for the Fund III and Fund IV, well, they did not perform well. According to the SEC complaint, Fund IV “earned $1.6 million in rent and incurred operating expenses of $8.3 million, resulting in net operating losses of approximately $6.7 million” and “$4.7 million in unrealized losses on portfolio investments, bringing Fund IV’s total net loss to approximately $11.4 million.”

As you might expect, MG is accused of illegally siphoning money from the funds. The SEC claims that (1) MG retained cash rebates from the sellers of the properties purchased by the funds and (2) charged the fund for unearned brokerage fees.

MG Capital and its principal Eric C. Malley are subject to civil charges by the SEC, criminal charges by the Department of Justice, and civil suits by investors. We haven’t heard their side of the story. Take the information above as a clear statement of what you should not do.

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Changes to the Definition of Accredited Investor

The Securities and Exchange Commission made some small changes to the definition of “accredited investor” last week. The changes had been first proposed last December.

The definition of “accredited investor” is at the nexus of the Securities and Exchange Commission’s missions: (1) to protect investors, (2) to maintain fair, orderly, and efficient markets, and (3) to facilitate capital formation.  If you’re an accredited investor you have access to private offerings. That enables capital formation. Private offerings are not subject to review by the SEC so they have fewer protections in place for investors. The commissioners were split on their votes to approve the changes.

Lots of arguments around the accredited investor definition are about an investor’s ability to assess risk in making the investment. I’ve long argued that the risk with a private placement is not the risk of loss, but the risk of liquidity. Some private placements are very risky and some are not. All private placements are less liquid than publicly traded securities. Tesla is at a crazy price right now, but you can sell and exit out of your position in minutes. You may not be able to exit from a private placement position for years.

The big news in the changes in the definition are the items that are missing. There were no changes to the wealth or income levels for qualification. Those levels have been unchanged for decades, broadening the pool of accredited investors with inflation.

The changes to the definition really just make some small expansions.

The SEC added a new category to the definition that permits qualification based on certain professional certifications, designations or credentials.  In conjunction with the changes, the SEC designated holders in good standing of the Series 7, Series 65, and Series 82 licenses as accredited investors. These are deemed as individuals with an ability to assess risk.

For private funds, there is an application of the “knowledgeable employee” definition over to accredited investor status. The SEC established Rule 3C-5 to allow “knowledgeable employees” to invest in their company’s private fund without having to be a “qualified purchaser”. The rule also exempts these knowledgeable employees from the 100 investor limit under the Section 3(c)(1) exemption from the Investment Company Act. However, the knowledgeable employee had to separately qualify as an accredited investor. This rule change covers that gap.

In act of progressive politics, the SEC added the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors.

“The term spousal equivalent shall mean a cohabitant occupying a relationship generally equivalent to that of a spouse.”

There were additional marginal expansions for some investment entities.

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Proposed Regulation of “Finders” in New York

The New York Attorney General has been keeping busy. Yesterday it was a lawsuit against the National Rifle Association. There are the previous lawsuits against the Trump Foundation and the Trump Organization. I missed the April announcement of proposed changes to some of the securities regulations in New York.

One caught my eye and caught the eye of Goodwin Procter lawyers Peter W. LaVigne, Nicholas J. Losurdo, and Jana Steenholdt. New York is stepping into the gray area of regulating finders.

Finders are not quite brokers and not quite investment advisers. They don’t give financial advice. They just have a big rolodex and want it to generate some revenue.

As pointed out by the Goodwin lawyers, the classic case is in the Paul Anka No-action letter. (Yes, the crooner.) He ended up connected with ownership syndicate trying to finance the newly formed Ottawa Senators hockey team. Anka was from Ottawa and was rooting for his home team, but didn’t want to do so for free. He would hand over his rolodex but wanted a cut of the money coming in. Anka also had good lawyers and they asked the Securities and Exchange Commission to bless the arrangement.

Mr. Anka did not:

  • participate in any negotiations between the Senators and any potential investors,
  • make any recommendations to them regarding an investment in the Senators,
  • participate in any advertisement, endorsement, or general solicitation for the investment,
  • participate, in the preparation of any materials relating to the sale or purchase of the investment
  • distribute the materials to any potential investor,
  • perform any independent analysis of the sale,
  • engage in any “due diligence” activities,
  • assist in or provide financing for the investment,
  • provide any advice relating to the valuation of or the financial advisability of such an investment.

He simply let the hockey club contact the people in his rolodex.

New York is interested in finders who did a bit more than Mr. Anka. The proposed definition of a “Solicitor”:

a person who as part of a regular business, engages in the business of providing investment advice to the limited extent that such person receives compensation for introducing a prospective investor or investors to an investment adviser or federally covered investment adviser…

Solicitors are subject to the same registration and examination requirements as investment advisers, and principals and representatives of solicitors are subject to the same registration and examination requirements as investment adviser representatives…

Mr. Anka probably falls outside that definition. He wasn’t in the regular business of making introductions. It may hit many organizations that are in that business.

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Private Fund Takes a Broadside Hit for Misleading Marketing

When using a track record in marketing materials, compliance officers will focus on the numbers and how they are used to portray prior results. The Securities and Exchange Commission will also scrutinize these results when they inevitably stop by to exam registered fund managers.

Keeping the track record straight is even more difficult for a new firm. Inevitably the principals will want to market their successful investment activity at the legacy firm.

Old Ironsides Energy ran into this problem when marketing its Old Ironsides Energy II fund.

The Securities and Exchange Commission charged the firm with using misleading marketing materials that mischaracterized a large, legacy investment with strong, positive returns. Old Ironsides identified it as an early stage “direct drilling investment” over which Old Ironsides had
direct management in partnership with project operators in its legacy portfolio. However the investment was better characterized as in interest in a private fund advised by a third party.

As you might expect, the private fund’s returns were really good. Also, Old Ironsides Fund II would not be investing in private funds.

It’s not that Old Ironsides couldn’t include that private fund in its returns. It needed to better describe that investment so that potential investors could understand it.

I found it strange that the SEC also include a charge that Old Ironsides failed to implement its policies and procedures. The P&Ps included a provision that:

“prohibited the use of performance results in Old Ironsides’ marketing materials that were false or misleading, including any misleading depictions of investment performance in both form and content leading to direct or indirect implications or inferences arising out of the context of the marketing materials.”

The SEC found that the marketing materials were misleading so the P&Ps were not followed. Is the SEC trying to say that a firm should not have language like that in its P&Ps? Or is just another charge the SEC can pile on when ti finds something it doesn’t like?

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Proposed Harmonization of Exempt Securities Offerings

In what proposes to be a big change in private placements, the Securities and Exchange Commission issued a set of proposed amendments that “provide a more rational framework, eliminate complexity and increase access to capital while preserving and enhancing important investor protections.”

Offering and Investment Limits. The Commission proposed revisions to the current offering and investment limits for certain exemptions.

For Regulation A:
– raise the maximum offering amount under Tier 2 of Regulation A from $50 million to $75 million; and
– raise the maximum offering amount for secondary sales under Tier 2 of Regulation A from $15 million to $22.5 million.

For Regulation Crowdfunding:
– raise the offering limit in Regulation Crowdfunding from $1.07 million to $5 million;
– amend the investment limits for investors in Regulation Crowdfunding offerings by: not applying any investment limits to accredited investors; and revising the calculation method for investment limits for non-accredited investors to allow them to rely on the greater of their annual income or net worth when calculating the limit on how much they can invest.

For Rule 504 of Regulation D:
– raise the maximum offering amount from $5 million to $10 million.

Integration:

The current Securities Act integration framework for determining whether multiple securities transactions should be considered part of the same offering is proposed to be revised with four new safe harbor. This would be particularly useful in private fund offerings. One is strict 30-day separation between the offerings.

General Solicitation:

Demo days and similar events would be exempt from “general solicitation” restrictions.

Accredited investor verification:

The amendments would change the financial information that must be provided to non-accredited investors in Rule 506(b) private placements to align with the financial information that issuers must provide to investors in Regulation A offerings.

There would be new items to the non-exclusive list of verification methods in Rule 506(c) public-private placements.

It’s just a proposed rule. You have two months to review and provide comments.

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The One Who Thought He Was Above the Law

The headlines for a case against Steven Seagal just write themselves. We was charged by the SEC for violating the anti-touting provisions of the securities laws for putting his celebrity girth behind Bitcoiin2Gen, in an initial coin offering.

The coin launched at about $0.60 in February 2019 and is not just about worthless. As near as I can tell, the selling point of this coin to BitCoin is that it has an extra “i.”

I have some sympathy for Mr. Seagal. He may have thought he was merely hawking some scam coin and not realized he was touting a security. Of course that’s the big problem with coin offerings. Promoters claim they are not securities, but the SEC thinks they are.

The SEC points out that the Bitcoiin offering was was well after the SEC’s DAO report that warned companies about the intersection of ICOs and securities laws. Just because you say it’s not a security over and over again, it does not make it true.

Mr. Seagal was to be paid $250,000 in cash and $750,000 in the Bitcoiins. Although, according to the SEC order, he only ended up with $157,000 in his pocket. That must be a nice supplement to his unpaid position as a special Russian representative to promote humanitarian ties between Russia and the United States.

As a Buddhist, Zen teacher, and healer, Steven lives by the principles that the development of the physical self is essential to protect the spiritual man. He believes that what he does in his life is about leading people into contemplation to wake them up and enlighten them in some manner. These are precisely the objectives of the Bitcoiin2Gen to empower the community by providing a decentralized P2P payment system with its own wallet, mining ecosystem and robust blockchain platform without the need of any third party.

https://bitcoiin2gen.pr.co/163919-zen-master-steven-seagal-has-become-the-brand-ambassador-of-bitcoiin2gen?reheat_cache=1

Mr. Seagal was not the first celebrity to get tagged by the SEC for promoting coin offerings. Professional boxer Floyd Mayweather Jr. and music producer DJ Khaled disgorged their promoter fees and paid penalties in November 2018.

Mr. Seagal accepted the order without admitting or denying the charges. That give the SEC the right to play the Nico Toscani quote: “You guys think you’re above the law. Well, you ain’t above mine.”

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Proposed Changes to Accredited Investor Definition

On Wednesday, the Securities and Exchange Commission proposed changes to the definition of “Accredited Investor” under Regulation D. The reason for the changes is to open the private market to a broader group of individual and institutional investors.

For those hoping for a dramatic change in how to determine accredited investor, you’ll be disappointed. The change eats at the edges and covers a few small openings.

The key to the accredited investor definition is that it limits who can invest in a private placement under Rule 506. If you don’t meet the accredited investor standard you can’t invest.

One expansion is to allow certain credentialed people to be automatically included as an accredited investor. The initial credentials are for registered representatives who have Series 7, 65 or 82 license. The rule notes that there are over 700,000 people who hold those designations, but has no data on how many of these were not previously qualified.

For private funds, there is an application of the “knowledgeable employee” definition over to accredited investor status. The SEC established Rule 3C-5 to allow “knowledgeable employees” to invest in their company’s private fund without having to be a qualified purchaser. The rule also exempts these knowledgeable employees from the 100 investor limit under the Section 3(c)(1) exemption from the Investment Company Act. However, currently the knowledgeable employee still has to be an accredited investor. This rule change will cover that gap.

Commissioner Jackson was opposed to the expansion. He is concerned about the lack of investor protection. He thought there was a lack of analysis in the release. In one instance he cites that the use of brokers expected to protect investors under the proposal. However, the data he looked at found that there was higher instance of fraud when brokers were involved. No vote.

Commissioner Peirce found the current bright-line tests of income and net worth are too simplistic, keeping out qualified people and allowing in more that may not be qualified. She also noted that the geographic disparities in cost of living results in lower salaries and therefore a geographic disparity in accredited investors. Yes vote.

Commissioner Roisman pointed out that he is not currently an accredited investor and would not qualify under the proposed changes. He stated that the definition should be broader. He is also concerned about the lack of investor protections. Yes vote

Commissioner Lee found the changes merely go to expanded the pool of private investors without the data on fraud. She is concerned that the current net worth and income levels are not indexed to inflation, expanding the pool of investors who could enter into private transactions without the protections of the public markets. No vote.

Chairman Clayton noted that there is a consensus that the current definition is less than satisfactory. Yes vote.

Once published, the proposal will be open for comments for 60 days.

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SEC Proposes to Modernize the Advertising Rules for Investment Advisers

I had my coffee ready and headphones on to listen to Tuesday morning’s Securities and Exchange Commission open meeting for Item 3: “Investment Adviser Advertisements; Compensation for Solicitations.” After cancelling a appointment to watch it, I discovered that Item 3 had been taken off the meeting agenda. The SEC voted on Monday to propose amendments to modernize the rules under the Investment Advisers Act addressing investment adviser advertisements and payments to solicitors.

The proposed rule would replace Rule 206(4)-1, first adopted in 1961. It will be a dramatically different approach to advertising restrictions.

Specifically, we are proposing a restructured and more tailored rule that: (i) modifies the definition of “advertisement” to be more “evergreen” in light of ever-changing technology; (ii) replaces the current four per se prohibitions with a set of principles that are reasonably designed to prevent fraudulent or misleading conduct and practices; (iii) provides certain additional restrictions and conditions on testimonials, endorsements, and third-party ratings; and (iv) includes tailored requirements for the presentation of performance results, based on an advertisement’s intended audience. The proposed rule also would require internal review and approval of most advertisements and require each adviser to report additional information regarding its advertising practices in its Form ADV.

In addition to modifying the advertising rule, the SEC is including a revision to the cash solicitation rule, Rule 206(4)-3. The premise of that rule was to male sure clients were aware that paid solicitors have a conflict of interest.

We are proposing to expand the rule to apply to the solicitation of current and prospective investors in any private fund, rather than only to “clients” (including prospective clients) of the investment adviser. Our proposal would require solicitor disclosure to investors, which alerts investors to the effect of this compensation on the solicitor’s incentive in making the referral. In addition, we are proposing changes to eliminate: (i) the requirement that solicitors provide the client with the adviser’s Form ADV brochure; and (ii) the explicit reminders of advisers’ requirements under the Act’s special rule for solicitation of government entity clients and their fiduciary and other legal obligations. Our proposal would also eliminate the requirement that an adviser obtain a signed and dated acknowledgment from the client that the client has received the solicitor’s disclosure, and instead would afford advisers the flexibility in developing their own policies and procedures to ascertain whether the solicitor has complied with the rule’s required written agreement.

There is a lot to digest in the 500 pages of the release. Since it appears the Commissioners all agreed to proposed rules, this is likely to be very close to final rule.

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Form SHL: Report by U.S. Funds on Foreign Ownership

Hopefully, if this form filing is applicable to your firm, you’ve already sent it in. It’s due on August 30. The penalty for failing to submit the form is a civil penalty of not less than $2,500 and not more than $25,000.

The form is required if your firm was the recipient of a mailing of the form or if you have more than $100 million in foreign investors in your fund.

The filing is part of a mandatory survey conducted under the authority of the International Investment and Trade in Services Survey Act (22 U.S.C. 3101) and Executive Order 11961 of January 19, 1977. The Act specifies that the authority to secure current information on international investment, including (but not limited to) such information as may be necessary for computing and analyzing the balance of payments accounts and the international investment position of the United States.

This report collects information on securities issued by U.S.-residents that are owned by foreign residents, including U.S. equities (including shares in funds), U.S. short-term debt securities (including selected money market instruments), U.S. long-term debt securities, and U.S. asset-backed debt securities.

The standard includes foreign ownership of private funds. Often foreign investors use blockers of domestic subsidiaries to invest. The form’s instructions indicate that you can use the standard of whether the investor gave you a W-8 instead of a W-9 to determine that the investors is “foreign.”

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