Category: Fundraising

506(c) Enforcement Actions

Although I had a lot of hope that the changing of private placement advertising restrictions by the Securities and Exchange Commission would remove potential foot-faults from the fundraising process, the end result proved challenging. Now it appears that the SEC is on the brink of challenging firms that took at advantage of the loosened restrictions.

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Given the enormous restrictions on being a company with publicly listed securities, private placements have been a vibrant form of raising capital. Although deemed more “risky”, to me that is a poor label without a further discussion of risk. The risk is liquidity, not risk of loss. A huge portion of the private placement market is by firms that provide no more risk than a publicly listed company. There is also capital being raised by start-ups and riskier companies. The common factor is not the risk of loss. The common factor is the investor’s limited ability to sell the security. If the investor needs liquidity, the investor will have limited options.

The main concern of the SEC in passing Rule 506(c) was be the increase in fraud. So far, we have not seen the enforcement actions to back up that fear.

However, the use of advertising under 506(c) for a private placement has been limited. From 2013, when 506(c) became effective, through 2015, there were $2,800 billion in offerings under 506(b) and only $71 billion in offerings for 506(c).

It seems like enforcement proceedings are in process for some firms that abused Rule 506(c). SEC Chair Mary Jo White stated that the SEC has some open investigations. Over the next few months perhaps those become public.

The failure of Rule 506(c) is that it was coupled with a proposed rulemaking that would dramatically change the landscape of private placements. We have not heard anything more on that rulemaking. It’s specter still haunts Rule 506(c) offerings.

I think Rule 506(c) is more than what most fund managers wanted for changes in advertising. Fund managers wanted some safe harbors for advertising to avoid foot-faults. Fund managers want to able to participate in league tables, talk to the press and talk at conferences without the fear that an inadvertent slip of the tongue would wreck havoc on a fundraising. I encountered no fund managers who were interested in media campaigns as part of a fundraising.

It looks like we may get more insight into the SEC’s view of Rule 506(c) when the enforcement actions are announced.

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Compliance and the Presidential Candidates

With the New Hampshire primary complete, the field of presidential candidates will continue to become smaller. Some of those dropping out may lower their expectations to Vice President or go back to their day jobs. Registered investment advisers have to worry about those day jobs when it comes to campaign donations.

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Under SEC Rule 206(4)-5, investment advisors are limited in their ability to give campaign contributions to political candidates who can directly or indirectly influence the hiring of an investment advisor by a government-sponsored investment entity. A campaign contribution in violation of the rule means the investment advisor can not collect fees from the applicable government-sponsored investor for two years. The rule applies to registered investment advisors and fund managers that had been exempt under the now-repealed, private fund manager exemption.

The president of the United States is not an office that can directly or indirectly influence the hiring of an investment advisor, so that position is not one that is limited by the SEC Rule. However, you also need to look at the candidate’s current office to see if that position is one that is limited.

Two of the remaining national candidates hold state offices: John Kasich and Chris Christie. They are both subject to SEC Rule 206(4)-5 because they appoint members to the state pension fund board in their states.

It’s not clear how the addition of a state governor (or other politician subject to  Rule 206(4)-5) would affect past donations.

These are just the national candidates. As points out on his blog, there are dozens of candidates on the state primary ballots with over forty on California’s List of Generally Recognized Presidential Candidates for California Primary.

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Another Pay-to-Play Case

There are few among us who think the high cost of getting elected and fundraising that it requires is good for American politics. The SEC took a moral high ground and passed Rule 206(4)-5. That rule effectively prohibits investment managers from making political contributions to politicians who control pension money, other than small token amounts. The SEC brought another pay-to-play case last week for egregious behavior. State Street was charged with funneling campaign contributions to a state treasury official.

Politician: Holding Out a Stack of Money

When I first saw this case I thought it would be a Rule 206(4)-5 case since State Street is a big money manager. In this circumstance, the relationship was a custodial relationship and outside the Advisers Act.

The deputy treasurer of a state pension fund arranged for illicit political contributions and improper payoffs through a fundraiser/lobbyist for State Street.

According to the SEC’s complaint against the fundraiser/lobbyist, Robert Crowe, he met the state official’s demand for campaign contributions by illegally filtering cash through his personal bank account and reimbursing individuals for contributions made in their own names. Crowe made additional illicit campaign contributions in response to the official’s threats that State Street would lose the business.

The State Street employee who headed it’s public funds group was also charged for participating in the pay-to-play scheme. According to the complaint against Vincent DeBaggis, he arranged for payments through a strawman as lobbying services, knowing that a large portion of that fee would be going to the state official. The lobbying agreement called for a success fee if the state pension funds became clients of State Street. DeBaggis’ conduct was in violation of State Street’s Standard of Conduct.

“Pension fund contracts cannot be obtained on the basis of illicit political contributions and improper payoffs,” said Andrew J. Ceresney, Director of the SEC’s Enforcement Division. “DeBaggis corruptly influenced the steering of pension fund custody contracts to State Street through bribes and campaign donations.”

The state official, Amer Ahmad, has already been convicted of misconduct and is currently in federal prison.

This case was more egregious than the first case the SEC brought against a Philadelphia firm for making a $2000 contribution, with no showing that it was designed to buy influence.

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SEC Takes a Look at the “accredited investor” definition

The Securities and Exchange Commission left a new Report on the Review of the Definition of “Accredited Investor” as an early Christmas present under your compliance tree. [Feel free to replace Christmas with New Years or the year end celebration of your choice.] We will need to keep an eye on what happens with this report.

 

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The accredited investor definition falls right into battle zone of the SEC where it needs to balance capital formation on one side and investor protection on the other. I expect there will a Festivus feats of strength contest to see who wins the battle over the definition.

Section 413(b)(2)(A) of Dodd-Frank requires the SEC to study the accredited investor definition every four years.  This is the first study. It’s not a SEC inspired review, but one mandated by Congress.

SEC Chair Mary Jo White encourages “investors, companies and other market participants to provide comments as public input will be very valuable as the Commission considers the definition.” The report considers alternative approaches to defining “accredited investor,” provides staff recommendations for potential updates and modifications to the existing definition and analyzes the impact potential approaches may have on the pool of accredited investors.

Few people think that the current income and net worth tests for an accredited investor have much to do with the ability to judge the risks of a private investment. Of course, it also does not mean that non-accredited investors can judge a publicly listed security either.

But the current tests do offer a bright-line than makes it easy toe evaluate a potential investor’s eligibility to participate in the offering.

“Clarity and certainty in the accredited investor definition foster greater confidence in unregistered markets and ultimately could reduce the cost of capital, thereby promoting increased capital formation, particularly for small businesses.”

Given that Regulation D offerings still raise more money than registered offerings, you have to wonder if Congress and the SEC have made it more palatable to stay private.

As for private placements being more risky than registered investments, I will disagree. They may be more or less risky on whether the investment will produce a return. The risk is not in the return. The risk is one of liquidity. A private placement by Exxon may not be any more risky than the public stock. The risk is that there is no market to resell the security. If you suddenly need the cash back from the investment you may have no ability to get it until a liquidation event.

Here are the two groups of recommendations from the Report:

The Commission should revise the financial thresholds requirements for natural persons to qualify as accredited investors and the list-based approach for entities to qualify as accredited investors. The Commission could consider the following approaches to address concerns with how the current definition identifies accredited investor natural persons and entities:

  • Leave the current income and net worth thresholds in place, subject to investment limitations.
  • Create new, additional inflation-adjusted income and net worth thresholds that are not subject to investment limitations.
  • Index all financial thresholds for inflation on a going-forward basis.
  • Permit spousal equivalents to pool their finances for purposes of qualifying as accredited investors.
  • Revise the definition as it applies to entities by replacing the $5 million assets test with a $5 million investments test and including all entities rather than specifically enumerated types of entities.
  • Grandfather issuers’ existing investors that are accredited investors under the current definition with respect to future offerings of their securities.

The Commission should revise the accredited investor definition to allow individuals to qualify as accredited investors based on other measures of sophistication. The Commission could consider the following approaches to identify individuals who could qualify as accredited investors based on criteria other than income and net worth:

  • Permit individuals with a minimum amount of investments to qualify as accredited investors.
  • Permit individuals with certain professional credentials to qualify as accredited investors.
  • Permit individuals with experience investing in exempt offerings to qualify as accredited investors.
  • Permit knowledgeable employees of private funds to qualify as accredited investors for investments in their employer’s funds.
  • Permit individuals who pass an accredited investor examination to qualify as accredited investors.

Personally, I think some increase in the income and asset tests are okay if it also includes an ability for an investor to prove financial sophistication to gain access to private offerings.

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Wrapped Gifts Under Tree is by Jimmie
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On line portals for fundraising

As part of the updates on private placements, the Securities and Exchange Commission granted a no-action letter to Citizen VC, an online venture capital firm. The main question was whether the firm was creating “substantive, pre-existing relationships” with prospective investors through its website. The firm wanted to avoid a result that its offers & sales under Rule 506(b) would be considered general solicitation or general advertising under Rule 502(c) of Regulation D.

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For CitizenVC the first step is a generic online “accredited investor” questionnaire.

That moves into the “relationship establishment period.” During that period CitizensVC may

  1. Contact the prospective investor by telephone to discuss the prospective investor’s investing experience and sophistication, investment goals and strategies, financial suitability, risk awareness, and other topics designed to assist CitizenVC in understanding the investor’s sophistication
  2. Send an introductory email to the prospective investor.
  3. Contact the prospective investor online to answer questions they may have about CitizenVC, the Site, and potential investments.
  4. Utilize third party credit reporting services to confirm the prospective investor’s identity, and to gather additional financial information and credit history information to support the prospective investor’s suitability.
  5. Encourage the prospective investor to explore the Site and ask questions about the Manager’s investment strategy, philosophy, and objectives.
  6. Generally foster interactions both online and offline between the prospective investor and CitizenVC.

Maybe it’s just me, but only 1 and 3 seem particularly meaningful and substantive. But the rest don’t hurt. Apparently it is enough to create a “substantive, pre-existing relationship” once the potential member is admitted as a member. A prospective Member is not presented with any investment opportunity when being qualified to join the platform.

I found it more meaningful that the minimum capital investment requirement is not less than $50,000 per deal. That means they are not targeting small investors.

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Updates on Private Placements

One of the troubling aspects of private placements is trying to draw the line between public advertising for the business and public advertising for selling securities. This aspect is even more apparent for private equity funds and real estate funds that want to tout their deals without jeopardizing their fundraising. The Securities and Exchange Commission offered some updated guidance.

private placement

The SEC published The 11 Securities Act Rules Compliance and Disclosure Interpretations that provide guidance on “general solicitation” under Rule 502(c)

Question 256.24 What information can an issuer widely disseminate about itself without contravening Rule 502(c)?

Answer: Information not involving an offer of securities may be disseminated widely without violating Rule 502(c). For example, factual business information that does not condition the public mind or arouse public interest in a securities offering is not an offer and may be disseminated widely. Information that involves an offer of securities through any form of general solicitation would contravene Rule 502(c). [August 6, 2015].

Which of course leads to the next question:

Question 256.25: What is factual business information?

Answer: What constitutes factual business information depends on the facts and circumstances. Factual business information typically is limited to information about the issuer, its business, financial condition, products, services, or advertisement of such products or services, provided the information is not presented in such a manner as to constitute an offer of the issuer’s securities. Factual business information generally does not include predictions, projections, forecasts or opinions with respect to valuation of a security, nor for a continuously offered fund would it include information about past performance of the fund. (Release No. 33-5180). [August 6, 2015]

Not deep guidance, but it’s still guidance.

Questions 256.26 through 256.33 offer insight into the pre-existing, substantive relationship you need to avoid general solicitation.

A “substantive” relationship is one in which the issuer (or a person acting on its behalf) has sufficient information to evaluate, and does, in fact, evaluate, a prospective offeree’s financial circumstances and sophistication, in determining his or her status as an accredited or sophisticated investor. Self-certification alone (by checking a box) without any other knowledge of a person’s financial circumstances or sophistication is not sufficient to form a “substantive” relationship.

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What is a “Voting Equity Security” under the Bad Actor Rule?

When the Securities and Exchange Commission adopted Rule 506(d), it did not define “voting equity securities.” That left many fund managers having to take an aggressive approach on compliance with the “bad actor rule.” The SEC has provided some additional clarity.

Vote

I have to admit that I did not pay much attention to the recent rule release for Regulation A. I’m skeptical that it’s a particularly useful fundraising tool for funds. Also, Regulation recently came under siege from state securities regulators.

It turns out that the SEC buried some clarification about Rule 506(d) in the release for the updated Regulation A. If you don’t want to read all 450+ pages of the rule release, just turn to page 203 for the discussion of the change.

The SEC has reconsidered its initial interpretation as it applies to the bad actor rule in 506(d) and created a bright-line test. (As a compliance professional, I like bright-line tests.)

Previously the SEC consider securities as voting equity securities if:

“securityholders have or share the ability, either currently or on a contingent basis, to control or significantly influence the management and policies of the issuer through the exercise of a voting right.”

I think most people looked at this and said if you have or could possibly have 20% of anything in the company, you fall within the bad actor rule. The SEC decided this interpretation was too broad and wanted a definition that would “facilitate compliance.”

The new definition:

In this regard, we believe that such a term should include only those voting equity securities which, by their terms, currently entitle the holder to vote for the election of directors. In other words, we believe the term should be read to denote securities having a right to vote that are presently exercisable. Additionally, while the ability to control or significantly influence the management or policies of the issuer may be derived in part from the power to vote for the election of directors, in order to dispel any uncertainty as to the scope of our interpretation, we believe the term “voting equity securities” should be interpreted based on the present right to vote for the election of directors, irrespective of the existence of control or significant influence.

That is a great change, making the definition more narrow. A great change that is limited to investment vehicles formed as corporations.

Of course, the SEC flubbed and used the term “directors” in this definition. That leaves fund compliance professionals scratching their heads as to how this interpretation applies to a private fund, which is typically organized as a limited partnership.

I think you have to ignore it. You can argue that a right of limited partners to remove the general partner without fault is the equivalent to the right to elect a director of a corporation. I’m just not sure you win that argument. It certainly make the bright line test much more blurry.

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Vote by Theresa Thompson
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Massachusetts Adopts Crowdfunding

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Add Massachusetts to the growing list of states that are sidestepping the unusable federal crowdfunding alternative.

“The Crowdfunding Exemption is designed to foster job creation by helping small and early-stage Massachusetts companies find investors and gain greater access to capital with fewer restrictions. The exemption is also intended to provide necessary investor protections by requiring key disclosures, and by making the exemption unavailable to bad actors that have violated the securities laws or committed financial fraud.”

The federal crowdfunding provisions in the Jumpstart Our Business Startups Act of 2012 was supposed to be a panacea for crowdfunding. But the final language of the law was amended at the last minute. The Securities and Exchange Commission was vocally opposed to it, but issued proposed regulations in October 2013 to implement the exemption. The SEC received about 300 written comments to the proposed regulations, but there is no sign that the final regulations will come out any time soon. The Federal crowdfunding regime will not be effective until the SEC issues those regulations. Even then, the regime is likely to be unwieldy.

A May 1, 2014 Wall Street Journal article, entitled “Frustration Rises Over Crowdfunding Rules,” describes efforts in the U.S. Congress to amend the JOBS Act even before the federal regime takes effect. However, many states have decided that crowdfunding is worth trying and are not waiting for the SEC.

The new Massachusetts crowdfunding regime is limited to $1 million a year, which can be increased to $2 million with audited financial statements. The company must set a fundraising minimum and must keep funds in escrow at a Massachusetts bank until it reaches the target.

The investment amount limitations are a bit messy. For those with net worth and income of less than $100,000, an investment is limited to the greater of $2000 or 5% of annual income or net worth. For the wealthier, it can go up to 10% of income or net worth. The Massachusetts regulation looks to the SEC accredited investor standard for calculating those amounts (i.e. exclude the home).

There is a limitation on form. The business must be formed under Massachusetts law, have its principal place of business in Massachusetts and authorized to do business in Massachusetts. It’s too bad the regime excludes the Delaware formed organizations from crowdfunding. That limits future growth of the company. Bigger money investors will want a Delaware entity for the certainty under the Delaware corporate laws for protection of their shareholder rights.

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Real Estate Crowdfunding

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Real estate investing has a long history of crowdfunding. Prior to the 1986 changes to the tax code, there was a large syndication business for getting investors into real estate. Although the investment was usually more for the tax breaks involved instead of income and capital appreciation.

With the surge of product crowdfunding through sites like Kickstarter, the regulatory changes for equity crowdfunding from the SEC, and state-level implementation of crowdfunding, investors and sponsors are once again looking to crowdfunding for real estate. Currently, it’s largely limited to accredited investors due to SEC limits or limited to state specific projects and investors.

Goodwin Procter put together a publication full of real estate crowdfunding articles: A Guide to Real Estate Crowdfunding Today.

The guide hits one major theme: crowdfunding is new and there are few success stories. No one site has been very successful at pulling investors and meaningful projects together.

Real estate investing is capital-intensive. It should be a natural area for crowdfunding. The big concern is fees. The crowdfunding platforms I’ve looked at are expensive. It’s expensive for the sponsor and its expensive for the investor.

The other concern is execution. To purchase or sell real estate, you need to decide quickly on the best deals and convince the other side that you can close. If you are buying a property and sourcing the capital with crowdfunding, there is the possibility that you won’t raise the money and not be able to close. You would have to include the successful crowdfunding as a closing condition, or have a backup source of more expensive capital to cover the failed crowdfunding. As a real estate seller, why would you accept an offer contingent on crowdfunding?

The alternative is that the crowdfunded real estate is already warehoused with the sponsor and is looking to lay off some of the equity or fund capital improvements. The sponsor is looking to crowdfunding as a cheaper source of capital or a quicker source of capital. So far, crowdfunding does not seem cheaper or faster than other sources of capital. And if other sources of capital are not interested in the investment, perhaps that is an indication of the investment’s quality.

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Pay to Pour

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Massachusetts regulators have launched an investigation into whether providers are paying for access. In this case, it’s about beer, not political donations. Pay-to-play is illegal under Massachusetts and federal liquor control laws.

The restrictions date back to the end of Prohibition, to keep large breweries from dominating the market. Small breweries have to compete for limited space at the bar. This is not true for the grocery store where non-alcohol manufacturers routinely pay a slotting fee for access to the supermarket shelves.

A local craft brewing company executive aired his grievances on Twitter, and complained that two restaurants would not serve his beer because he would not buy a beer line. The response, in part, was

“I personally don’t even know you, never asked you for a damn thing, never intend to ask you for a damn thing and will not serve your inferior product. ” 

From compliance perspective it looks like the Massachusetts law must hinge on the word “substantial”

No licensee shall give or permit to be given money or any other thing of substantial value in any effort to induce any person to persuade or influence any other person to purchase, or contract for the purchase of any particular brand or kind of alcoholic beverages, or to persuade or influence any person to refrain from purchasing, or contracting for the purchase of any particular brand or kind of alcoholic beverages.

Whenever I go into a bar or liquor store, I see plenty of signs and other items that have clearly been given to the retailer. I guess the glowing Budweiser sign is not “substantial.” The accusations are for payments or merchandise on a grander scale.

Does it matter? Is this a regulation that helps the economics for a consumer?

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