Category: Fundraising

More Political Contribution Problems

There is too much money in a politics. I understand the Securities and Exchange Commission’s desire to purge political contributions from the investment adviser business for state and local government money. But I’ve never been a fan of Rule 206(4)-5, the pay-to-play rule. It’s continuing to ensnare companies in ways that highlight problems with the rule and the very low limits in the rule.

One recent case is that of PNC Capital Advisors. One its employees in business development made a $1000 campaign contribution to John Kasich’s presidential campaign. Kasich was the governor of Ohio and able to appoint trustees to the Ohio state pension funds. That made Kasich an “Official” under the rule and firm had some Ohio state pension money under management.

As I had pointed out, only two out of the twenty-two the major candidates for the last presidential election were subject to the campaign contribution limit because they held state offices: John Kasich and Chris Christie. The rule obviously creates an unnecessary distortion in political campaigns. Adding Pence, the Governor of Indiana to the ticket caused another what do we do moment.

In PNC’s case, the employee had been listed by PNC as a “covered associate” and was in the process of being promoted when PNC discovered the campaign contribution. However, the employee was not responsible for the Ohio account. At no time had the employee been involved in soliciting the Ohio plans, and had never communicated with the Ohio plans. The Contributor had never solicited any other state or local Ohio government entity. The Contributor had never made presentations for, or met with, any representatives of the Ohio plans or with any other Ohio government entities, or supervised any person who met with any of the Ohio plans or other Ohio government entity. If promoted, the Contributor will neither meet with any Ohio government entities personally, nor supervise any person who solicits investment advisory services business from Ohio government entities.

The employee failed to disclose the contribution because he was focused the office Kasich was running for, President, and failed to realize that the rule applied to the current office as well. The PNC compliance group found the contribution in the process of running checks in connection with a promotion. A promotion that is now on hold and has been for 2017.

The SEC order prohibits the employee from soliciting government funds for several months. PNC was allowed to keep the two year worth of fees. $700,000 of fees was at risk for that $1000 contribution.

That was a $1000 contribution in a campaign in which Kasich raised over $19 million.

BlackRock had a similar problem with the Kasich campaign. One of its employees wrote a check for $2700 to the Kasich campaign. The employee was in the ETF division, but since he was on the global executive committee, he fell into the definition of “covered associate.”

Similar to PNC, that employee had never solicited government entities for investment advisory business that is covered under the Rule. To the extent the Contributor has personally solicited business from any government entities, it was exclusively for direct investments in RICs that are outside the scope of the Rule. He has never attended, or otherwise participated in, any meetings, discussions, or any other communications in which a solicitation of covered investment advisory business has taken place.

Blackrock’s compliance group found the donation while conducting a routine compliance review.

Here is a list of other exemptions granted. These were identified in the PNC application and BlackRock application.

  • Davidson Kempner Capital Management LLC, Investment Advisers Act Release Nos. IA-3693 (October 17, 2013) (notice) and IA-3715 (November 13, 2013) (order)
  • Ares Real Estate Management Holdings, LLC, Investment Advisers Act Release Nos. IA-3957 (October 22, 2014) (notice) and IA-3969 (November 18, 2014) ( order);
  • Crestview Advisors, LLC, Investment Advisers Act Release Nos. IA-3987 (December 19, 2014) (notice) and IA-3997 (January 14, 2015)(order);
  • T. Rowe Price Associates, Inc., and T. Rowe Price International Ltd., Investment Advisers Release Nos. IA-4046 (March 12, 2015) (notice) and IA-4508 (April 8, 2015)(order);
  • Crescent Capital Group, LP, Investment Advisers Release Nos. IA-4140 (July 14, 2015) (notice) and IA-4172 (August 14, 2015) (order);
  • Starwood Capital Group Management, LLC, Investment Advisers Act Release Nos. IA-4182 (August 26, 2015)(notice) and IA-4203 (September 22, 2015) (order);
  • Fidelity Management & Research Company and FMR Co., Inc., Investment Advisers Release Nos. IA-4220 (October 8, 2015) (notice) and IA-4254 (November 3, 2015) (order);
  • Brookfield Asset Management Private Institutional Capital Adviser US, LLC et. al., Investment Advisers Act Release Nos. IA-4337 (February 22, 2016) (notice) and IA-4355 (March 21, 2016) (order);
  • Angelo, Gordon & Co., LP, Investment Advisers Release Nos. IA-4418 (June 10, 2016)(notice) and IA-4444 (July 6, 2016) ( order);
  • Brown Advisory LLC, Investment Advisers Act Release Nos. IA-4605 (January 10, 2017) (notice) and IA-4642 (February 7, 2017) (order)

These all look technical violations with no evidence that there were weaknesses in policies or an intent to influence. The rule is just too broad, with dollar limits that are too low.

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Celebrity Endorsements of ICOs and other Securities

With BitCoin breaking through the $10,000 barrier and growing interest in the uses of the underlying blockchain technology, everyone is looking to cash in using virtual currency. As with an IPO, the goal of investors in an Initial Coin Offering is get in early and cheap before the market takes the price up. The Securities and Exchange Commission warned sponsors that ICOs look a lot like a securities offerings and need to comply with securities laws.

It turns out that ICO sponsors are violating SEC rules and FTC rules.

Looking forward to participating in the new @cobinhood Token! ZERO fee trading! #CryptoCurrency#BitCoin#ETH – https://t.co/1XFiosn22Spic.twitter.com/A7es0C2Rxr
— Jamie Foxx (@iamjamiefoxx) September 18, 2017

Looking forward to participating in the new @LydianCoinLtdToken! #ThisIsNotAnAd #CryptoCurrency #BitCoin #ETH #BlockChainpic.twitter.com/a8kT9eHEko
— Paris Hilton (@ParisHilton) September 3, 2017

The SEC warned that celebrity endorsements of securities need to disclose the nature, source, and amount of any compensation paid, directly or indirectly, by the company in exchange for the endorsement.  (Obviously, that is hard to do in the 140 280 characters of Twitter.) A failure to disclose this information is a violation of the anti-touting provisions of the federal securities laws. That also potentially pulls the celebrity endorser into possible anti-fraud provisions of the securities laws

There are the advertising rules from the Federal Trade Commission that also require disclosure of payment for endorsements. The FTC Guidelines make it clear that celebrities must disclose their relationships with advertisers when making endorsements outside the context of traditional ads, such as on social media.

Ms. Hilton’s endorsement of Lydian Coin was deleted after Forbes reporters uncovered the checkered legal past of the founder of Lydian Coin.

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Best Practices for Presenting Model and Hypothetical Performance

These are my notes from an ACA Compliance Webcast on this subject. I’m sure you can find a replay on the ACA website.

There were three great presenters:

  • Alicia Hyde, Partner, ACA Performance Services
  • Mike Sonnenburg, CIPM, Managing Director, ACA Performance Services
  • Kim Daly, Managing Director, ACA Compliance Group

Definitions

The first topic was what these terms mean:

Model–A list of investments and transactions for an investment strategy that are not actually held by the portfolio but can be backtested over historical periods and/or run contemporaneously. Model portfolios are typically constructed using individual securities (stocks and bonds), ETFs, pooled funds, or other investment products. Also known as a paper portfolio, a policy portfolio, or a target portfolio.

Hypothetical–Performance of a model or synthetic portfolio (i.e., non-actual performance). Hypothetical performance can be ex-post and/or ex-ante.

Backtested–Ex-post testing of an investment model to see how it would have performed historically. Backtesting attempts to demonstrate how an investment strategy, constructed with the benefit of hindsight, would have performed as if it had been implemented historically.

Simulated –Same as backtested; non-actual performance and can be ex-post or ex-ante.

Theoretical–Same as backtested; non-actual performance and can be ex-post or ex-ante.

Ex-ante–Projected future performance. Ex-ante performance is non-actual and, as such, is hypothetical.

Ex-post –Performance over historic (after the fact)periods. Ex-post may be non-actual or actual performance.

Contemporaneous (Live) Model–Performance derived from a live, or contemporaneous model, where investment decisions occur in real time. Live model performance is still considered non-actual.

Synthetic Portfolio–The ex-post combination of actual portfolio returns. For example, taking an actual equity portfolio and combining it with an actual fixed income portfolio to create a synthetic balanced portfolio. The underlying performance is that of actual portfolios, but they are synthetically combined according to a prescribed asset allocation. Synthetic performance is considered to be hypothetical performance.

The Law

The main limitation is section 206 that prohibits you from being fraudulent, deceptive or manipulative. That has been further extrapolated by the SEC in Rule 206(4)-1, the advertising rule. That rule has been further elaborated in the Clover No Action Letter.

All of this has been heightened by the F-Squared cases that failed to properly disclose that the adviser and the firms that used its services were not based on actual performance.

Presenting Model Performance

  1. Model portfolio performance must not be presented in a false or misleading manner.
  2. Model performance should not be linked to actual performance.
  3. ‘White-labeling’ third party model performance requires sufficient due diligence.
  4. Model portfolio performance must include specific, accurate, and robust disclosures.

Model Performance Disclosures

Disclosures should address these items:

  • 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
  • Any material changes to the conditions, objectives, or investment strategies of the model portfolio during the time period portrayed and, if so, the effect of any such change on the results portrayed
  • As applicable, that the adviser’s clients had investment results materially different from the results portrayed in the model

Include the following disclosures:

  1. The results do not represent the results of actual trading using client assets but were achieved by means of the retroactive application of a model that was designed with the benefit of hindsight.
  2. The returns should not be considered indicative of the skill of the adviser
  3. The client may experience a loss.
  4. The results may not reflect the impact that any material market or economic factors might have had on the adviser’s use of the back-tested model if the model had been used during the period to actually manage client assets.
  5. The adviser, during the period in question, was not managing money at all, or according to the strategy depicted.
  6. The back-testing is for a strategy that the client accounts will follow or, if not, what difference there will be.

You can show projected returns

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Most Frequent Advertising Rule Compliance Issues

It looks like the Securities and Exchange Commission has been taking a close look at advertising by investment advisers. The Office of Compliance Inspections and Examinations issued a risk alert on The Most Frequent Advertising Rule Compliance Issues Identified in OCIE Examinations of Investment Advisers.

I didn’t see any surprises in the alert.

  • Advisers presented performance results without deducting advisory fees.
  • Advertisements that compared results to a benchmark but did not include disclosures about the limitations inherent in such comparisons, including instances where, for example, an advertisement did not disclose that the advertised strategy materially differed from the composition of the benchmark to which it was compared.
  • Advertisements that contained hypothetical and backtested performance results, but did not explain how these returns were derived.
  • Advertised performance results complied with a certain voluntary performance standard, when it was not clear to staff that the performance results in fact adhered to the performance standard’s guidelines. (i.e. GIPS compliance)
  • Advertisements that staff believe contain cherry-picked stock selections
  • Disclosure of past specific investment recommendations
    that may have been misleading because they included only certain, and not all, recommendations, in order to illustrate a particular investment strategy, and they did not meet the conditions set forth in Subsection (a)(2) of the Advertising Rule. In addition, they did not satisfy the representations upon which IM staff based certain no-action assurances as provided in the TCW Group and Franklin no-action letters.
  • Advertisements that referred to advisers receiving high rankings in various publications, but those publications were issued several years prior, and the rankings were no longer applicable.
  • References to professional designations that have lapsed or that did not
    explain the minimum qualifications required to attain such designations.
  • Statements of clients attesting to their services or otherwise endorsing the adviser that may be prohibited testimonials.

The only tidbit of information is that OCIE conducted a “Touting Initiative” in 2016. The focus was to examine the adequacy of disclosures that advisers provided to their clients when touting awards, promoting ranking lists, or identifying professional designations  in their marketing materials.

OCIE launched the Touting Initiative because of the “regularity with which staff encounters advisers that advertise these accolades without disclosing material facts about them.”

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Report on Access to Capital and Market Liquidity

Many people seem to think that the new commissioner of the Securities and Exchange Commission, Jay Clayton, is likely to focus more on capital formation issues than the previous commissioner. The recent report on Access to Capital and Market Liquidity from the SEC’s Division of Economic and Risk Analysis caught my attention.

From the signing of Dodd-Frank in 2010 through the end of 2016, the DERA notes $20.20 trillion in capital formation, of which $8.8 trillion was raised through registered offerings, and $11.38 trillion was raised through unregistered offerings. More money is being raised through private placements, than through public offerings. From 2012 to 2016 the amount raised was 26% greater. From 2009 through 2011 it was only 21.6% greater.

That data should be a caution to regulators who want to make changes to Regulation D and the “accredited investor” standard.

“When combined, the capital raised through Regulation D and Rule 144A offerings in a year is consistently larger than the total capital raised via registered equity and debt offerings. Most Regulation D offerings (over 66%) include equity securities; by contrast, in the Rule 144A market, the vast majority of issuers are financial institutions and over 99% of securities are debt securities.”

The report also looks at the new public private-placement offerings under 506(c). Only 3% of the capital raised under Regulation D since rule 506(c) went into effect has been through issuances claiming the 506(c) exemption. The report also noted that the average amount raised in a 506(c) offering is only half of that raised in Rule 506(b) offering, $13 million to $26 million. “Overall, it is not clear whether offerings under Rule 506(c) are indicative of new capital formation or a reallocation from other offering types.”

What is one of the reasons for a private placement over a public offering? It seems cheaper.

“Nonfinancial issuers paid on average about 6% in total fees for Regulation D offerings in 2009-2016. In comparison, a company going public pays an average gross spread of 7% to its IPO underwriters, while a reporting company raising equity through a follow-on (seasoned) equity offering pays an average gross spread of about 5.4%.”

There is a lot more detail in the report. More than I’m ready to digest (or want to digest).

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A Classic Example of a General Solicitation Failure

The SEC opinion in KCD Financial Inc. (SEC Opinion 34-80340, March 29, 2017) affirms a fine and disciplinary action against KCD for selling securities in a private placement when no exemption from registration was available under Rule 506. The KCD opinion makes clear that you can’t fix the general solicitation failure by then only selling only to people had a prior relationship with issuer.

The action is against KCD, a broker-dealer, for selling the unregistered securities of Westmount Realty Finance’s WRF Distressed Residential Fund 2011. The offering’s PPM stated that the securities were being made in reliance on an exemption from the registration requirements of the Securities Act and that interests in the Fund were being offered only to persons who were accredited investors as set forth in Regulation D. In 2011, that meant no general solicitation or advertising.

Westmount screwed up and issued a press release that ended up being published in two local newspapers. Westmount screwed up even further by linking to those newspaper articles from Westmount’s website.

As long ago as 1964, [the SEC] has held that the statutory definition of “offer to sell” included “any communication which is designed to procure orders for a security,” and that even a communication that did not on its face refer to a particular offering could nonetheless constitute an offer as long as it was “designed to awaken an interest” in the security. [Gearhart & Otis, Inc., Exchange Act Release No. 7329, 1964 SEC LEXIS 513, at *59 (June 2, 1964), aff’d on other grounds, 348 F.2d 798 (D.C. Cir. 1965)]

The articles reported that “Dallas-based Westmount Realty Finance LLC announced Tuesday that it launched a $10 million real estate fund to acquire bank-owned residential properties and nonperforming, discounted residential loans.” (Yes, the article is still visible online.) That seems to clearly be general solicitation.

The argument from KCD was that it did not generally solicit any of the actual investors in the WRF Fund. When prospective new investors called, KCD asked if they had seen the article. If yes, they were not allowed to invest.

This argument was rejected. Once you engage in a general solicitation in violation of Rule 502(c), the Rule 506 exemption is not available for any subsequent sales of the securities regardless of limiting the sales only to investors who did not see the general solicitation. SEC guidance in 1983 pointed out that soliciting people with a pre-existing relationship and had reasonably believed that the recipients had the knowledge and experience in financial and business matters that he or she was capable of evaluating the merits and risks of the prospective investment is not general solicitation. “The mere fact that a solicitation is directed only to accredited investors will not mean that the solicitation is in compliance with Rule 502(c). Rule 502(c) relates to the nature of the offering not the nature of the offerees.”

Some of this has gone away since the SEC changed the general solicitation rules. Most firms do not want to check the box that says they engaged in general solicitation, fearing it will create greater SEC scrutiny.

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Changes to the Accredited Investor Standard?

The Securities and Exchange Commission has three mandates: (1) protect investors, (2) maintain fair, orderly, and efficient markets, and (3) facilitate capital formation. Regulation of private securities transaction through the accredited investor standard falls squarely in the conflict between these mandates.

The general statement about why certain investors can invest in securities subject to less regulatory oversight is that they are able to handle the risk. The standard for handling risk is the accredited investor standard and it’s based on tests of income or net worth. In theory, if you had a certain amount of money you could handle the risk.

The existing thresholds for an accredited investor were created in the 1980s. The big change was Dodd-Frank that excluded primary residence from the net worth calculation. The income and net worth test are not pegged to inflation and therefore have become more inclusionary over the past decades.

Last week, Acting Chairman Michael S. Piwowar quoted William Graham Sumner’s Forgotten Man in adding his view of securities regulation. He gave his view on accredit investors:

“Distinguishing investors who can fend for themselves from those who cannot is a line-drawing exercise fraught with peril. The Commission did just that in 1982 when it adopted Regulation D, dividing the world of private offering investors into two categories: those persons accorded the privileged status of “accredited investor” and those who are not.”

Here he steps into a fallacy. Or at least what I believe is a fallacy. He tags private placements as “high-risk, high-return securities available only to the Davos jet-set.”

First, the tests for accredited investor are not so high that you need to be in the Davos Jet-set.

Second, private placements are not all high-risk, high-return investments.

Perhaps the SEC is suffering from a lack of data on private placements. Private placements are investments that the issuer can sell to a smaller group of investors without having to go through the cost of a public offering.

Congressional mandates, SEC regulation, and shareholder lawsuits have made being a public company less attractive. There are additional costs and risks with allowing your securities to trade publicly. Until a few weeks ago, a public company had to worry about [the resource extraction rule conflict materials in its supply chain] and how to calculate the pay ratio between the CEO and its workers.

The risk for private placements is really not the loss of capital. It’s loss of liquidity.

Private placements have limited opportunities for investors to achieve liquidity. That generally means a long hold period. If the investor needs cash, the investor will have to look for other holdings to sell to get that liquidity. Private placements do not have a market for resale, so the investor needs to find a willing buyer in secondary sale process or wait for the liquidity event, if one ever comes.

Using income and net worth tests make sense because of the liquidity risk associated with private placements. The accredited investor will more likely have the income or capital to address the liquidity.

Within the world of private placements there are very risk investments and low risk investments when looking at an investors likely return of capital.

For example look at hedge funds, they may be more or less risky than a mutual fund depending on the investing style. As an investor, you have limited opportunities to receive back your investment and any returns. Most hedge limits have significant notice periods for redemption and often limited redemption to a few times each year for investors to get their hands on cash.

There seems to be a lot of focus on the high-risk early stage investing associate with private placements. Those are only good investments if you can make lots of them. You see something like 5% of startups making money and rest essentially going to zero. Assuming those odds, you need to make 20 investments. The accredited investor standard ends up being low if you just focus on those risky investments and ignore the more plentiful lower risk investments.

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What We Learned About The Pay to Play Rules After The Election

CCOs did not sleep well for one. Monitoring employee contributions to political candidates is difficult. The political contributions do not originate from the firm, so there is no accounting control that you can put in place.

You can’t ban political contribution if you have an office in California. California labor law seems to make such a ban illegal.

You also risk a non-employee spouse making a donation in the name of both. Or you may think less of giving a donation to personal friend or friend of friend running for office.

That makes it easy to trip over the rule with a $500 donation. That happened to Pershing Square. Maybe.

An analyst gave a contribution to a failed candidate for the Governor of Massachusetts. The Governor appoints board members to the state pension fund. That pension fund was a client of Pershing Square.

But the candidate in question failed to garner support at the state convention and never made it onto the ballot. No voter ever had the opportunity to vote for this candidate.

It is not clear if the analyst was a “covered associate” under the rule. He occasionally participated in client meetings to discuss Pershing Square’s strategy and approach. But it does not look like his activities should be considered soliciting investments under Rule 206(4)-5.

Plus, the contribution was made after the state pension fund had already committed to the investment with Pershing Square. The contribution was made in 2013 and the state pension fund had made its investments in 2011 and 2012.

Once again we see that the breadth of the SEC pay to play rule is implicating actions that seem far removed from trying to buy influence. Pershing Square is having expend tremendous resources to avoid Rule 206(4)-5’s draconian penalty of forfeiting two year’s worth of management fees.

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Gun Jumping

I began exploring the difference between advertising the soup and advertising the securities in yesterday’s post. That is, I looking for distinction between a private equity firm advertising in relation to its portfolio companies or real estate holdings, and advertising its performance as an investment adviser. Portfolio company advertising is outside the legal framework under the Investment Advisers Act restrictions on advertising.

half-price advertisement

I thought the gun-jumping rules under the Securities Act might provide a useful framework to help determine whether an ad is about the soup or about the securities.

The default would seem to be that any advertising by a firm could be considered an advertisement for the firm’s securities, depending on the facts and circumstance. The SEC has explained that

“the publication of information and publicity efforts, made in advance of a proposed financing which have the effect of conditioning the public mind or arousing public interest in the issuer or in its securities constitutes an offer . . .” Guidelines for the Release of Information by Issuers Whose Securities are in Registration, Release No. 33-5180 (Aug. 16, 1971) [36 FR 16506]

In the 2005 Securities Offering Reform, the SEC created safe harbors under Rule 168 and Rule 169 for factual business information, which included advertisements or information about a firm’s products or services. These rule reinforce the ability to advertise about the portfolio company or real estate as long as its not an advertisement about the investment adviser.

It would seem that a portfolio company’s advertisements that do not mention its private equity owner are perfectly okay. Once the private equity manager is mentioned, you need to make sure the advertisement is focused on the portfolio company and not the success of the registered private equity fund manager.

It’s harder to put this in the context of a registered real estate fund manager. Tenants have a keen interest in the owner of the real estate. They want to know that the landlord has the financial resources to keep the building running and to live up to its obligations under the lease.

There is surely a distinction to be made between a real estate fund manager as an operator of real estate and as an investment adviser. I’m still looking for some guidance.

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SEC Clears the Way For Intra-State Crowdfunding

Most states have passed crowdfunding laws. One of the barriers has been the breadth of the federal preemption of interstate securities transactions. To be intra-state, and therefore out of the jurisdiction of the Securities and Exchange Commission, the investors and the company doing the fundraising needed to all be in the same state. The problem is the widespread use of Delaware as a state of organization. That puts the company in Delaware, while the operations and investors are in another state.

Crowdfunding

It was good to see states experimenting with crowdfunding. The SEC regulations of equity crowdfunding have proven to be difficult. Now the SEC has cleared the way for a broader definition of intra-state.

For example, the Massachusetts crowdfunding regulation, 950 CMR 14.402(B)(13)(o), required the issuer to have its principal place of business in Massachusetts and to be formed in Massachusetts.

The adopted a new Rule 147A  and amendments to Rule 147 to address the crowdfunding limitations. The SEC had adopted Rule 147 in 1974 as a safe harbor to a statutory intrastate exemption under Section 3(a)(11) of the Securities Act of 1933.

The new Rule 147A has changed the requirement so that the issuer merely has to have its “principal place of business” in that state and satisfy at least one “doing business” requirement to demonstrate the in-state nature of the issuer’s business.

Of course, the SEC does not make intra-state crowdfunding legal. It’s subject to state regulatory requirements. Massachusetts, and most states, will need to revise their crowdfunding laws to open up to these broader rules.

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Crowdfunding is by Rocio Lara
CC BY SA