Category: Fundraising

The SEC Shuts Down Another Illegal Crowdfunding Site

eureeca-logo

Kickstarter has shown the world that crowdfunding is a viable option for funding great ideas. Because of US securities laws, the funding arrangement on that platform cannot be for an equity interest. That’s selling securities and that practice is subject to decades of protections built to protect consumers.  The JOBS Act opened the possibility of equity crowdfunding sites for the masses, but the implementation is still hung up in SEC rulemaking.

That has not stopped internet entrepreneurs from firing up crowdfunding sites. There are ways to do so legally, but there are lots of regulatory and operational landmines that need to be navigated.

Of course, it’s very easy to set up an illegal crowdfunding site. Eureeca.com did that and subjected itself to the wrath of the SEC.

Eureeca.com’s approach was to make international investments available for crowdfunding. From looking at the funding proposals on the site, most seem to be coming out of the Middle East and North Africa. Since I see the proposals and can seemingly participate, Eureeca.com subjected itself to the jurisdiction of the SEC.

The website is a general solicitation for securities purchases. None of the securities are registered. Eureeca.com is not making any attempt to limit participants to accredited investors and is not taking steps to verify that investors are accredited investors. That would allow it to use the new Rule 506(c) exemption for public private placements.

The SEC wrath was a charge of failing to register as a broker-dealer.

According to the SEC order, three US investors put $20,000 into four offerings. That resulted in a $25,000 fine and new big disclaimer on the site:

The securities and services on the Eureeca platform are not being offered in the USA or to U.S. persons. For further information please read our FAQs.

If the offerings were in the US, the SEC would also be able to interfere with the private placements as violations, but the issuers are outside the reach of the SEC. I’m not familiar with the securities laws in the foreign jurisdictions, but I would guess that Eureeca.com is violating the securities laws in many other countries.

The SEC will continue to bring the hammer down on crowdfunding sites. The SEC worried about consumer protection and fraud in this area. I think they are right to concerned.

Sources:

The SEC Still Hates Intrastate Crowdfunding

Icon of Money in the Hand on Rusty Warning Sign.

One of the exemptions from registering a securities offering is if the offering is limited to one state. Some crowdfunding advocates latched onto this exemption and have been pushing for single state crowdfunding at the state legislatures. On April 10, 2014, the SEC issued a Compliance and Disclosure Interpretation on intrastate crowdfunding offerings. The interpretation was overly restrictive.

The SEC said at the time that you can’t use a third-party portal website for an intrastate securities offerings. “Use of the Internet would not be incompatible with a claim of exemption under Rule 147 if the portal implements adequate measures so that offers of securities are made only to persons resident in the relevant state or territory.” In reading that, the SEC waved a big regulatory “NO” finger at using third party sites.

The SEC just retreated slightly from that position, but proved that the SEC does not understand how the internet works. In Question 141.05, published on October 2, the SEC seems to be a bit more lenient when it comes a company using its own website. The SEC acknowledges that a website advertises the company, but could also advertise a securities offering. “Although whether a particular communication is an “offer” of securities will depend on all of the facts and circumstances…”

If the company does make the existence of an investment opportunity available on an unrestricted website, that could be considered a violation of the intrastate exemption. The SEC offers up the solution that a company “could implement technological measures to limit communications that are offers only to those persons whose Internet Protocol, or IP, address originates from a particular state or territory and prevent any offers to be made to persons whose IP address originates in other states or territories. ”

The location of an IP address does not necessarily equate to your state of residence.  It may not even equate to where you at the moment you are accessing the internet. One of the great values of the internet is that is defies and defeats physical borders.

 The SEC’s solution is short-sighted and poorly thought out.

Sources:

Narrowing the Safe Harbors

narrow safe harbor compliance

The Securities and Exchange Commission rolled out the accredited investor verification requirement and made it principle-based for purposes of Rule 506(c). You have to take reasonable steps to verify that an investor meets the accredited investor standard. In the same release it created four non-exclusive safe harbors that would deemed to be taking “reasonable steps.”  The SEC recently released six new Compliance and Disclosure Interpretations on the verification of prospective investors as accredited investors.

One safe-harbor method is to review the IRS filings for the two most recent years. That seems straightforward. Just deliver me the two latest tax filings. But the SEC has made that safe harbor nearly  impossible to navigate during the first part of a calendar year. In Question 260.35, the SEC takes a very strict view of the safe harbor. The filings must be for the two most recent years. So if you were to use that safe harbor in 2014, the issuer must get the 2013 and 2012 tax filings.

For most potential investors this safe harbor is inaccessible in January and may extend further into the year depending on when the investor files his or her tax return. I’ve filed an extension for the past few years and don’t get my taxes done until August. I couldn’t prove myself to be an accredited investor using the safe harbor until that point in the calendar year.

The SEC’s solution is to switch to the principles-based approach by reviewing the two most recent available years and getting written representations from the potential investor that:

(i) an Internal Revenue Service form that reports the purchaser’s income for the recently completed year is not available,
(ii) specify the amount of income the purchaser received for the recently completed year and that such amount reached the level needed to qualify as an accredited investor, and
(iii) the purchaser has a reasonable expectation of reaching the requisite income level for the current year.

The SEC is clearly making it hard to navigate the investor verification requirement. It seems to laying mines around the entrances to the safe harbor.

Sources:

Image is US Navy 060628-N-4776G-144 The Nimitz-class aircraft carrier USS Ronald Reagan (CVN 76) navigates its way through the narrow strait that make up the inlet to Pearl Harbor for a port visit.jpg

 

Don’t Lie About Being GIPS Compliant

GIPS logo

The Global Investment Performance Standards (GIPS) attempts to be a set of standardized, industry-wide principles that guide investment firms on how to calculate and present their investment results to prospective clients. An SEC-registered investment adviser touting that it is GIPS Compliant in advertising, moves GIPS from an accounting concern to a regulatory concern.

ZPR Investment Management made that mistake. The firm and its principal were hammered with penalties for the violations. Zavanelli is barred from the industry and must pay a $660,000 fine for its advertising that falsely claimed GIPS compliance.

It’s a big penalty for an advertising failure.

It was interesting to see that Zavanelli used some international operations and tried, unsuccessfully, to keep those separate from the US operations. The reason, according to an email found during the SEC investigation was to keep the communication away from the “prying eyes of the SEC Monster.” In the decision, the Administrative Law Judge details the combative nature of Mr. Zavanelli during the hearing. That lead the ALJ to the finding that he acted willfully and with scienter.

Sources:

International Regulatory Landscape For Private Funds

private fund compliance forum

These are my live notes from PEI’s Private Fund Compliance Forum.

They are likely to be incoherent and full of typos.

AIFMD is a difficult topic.

Transitional regime. It’s just about over; it expires at the end of July 2014. They don’t work in France. They work well in the UK. Germany is in the middle. For an upcoming fund, it may be better to start marketing now to take advantage of the transitional rules.

The rules are different for non-EU funds and managers than for EU-based ones.

How does co-investment work in the “marketing” definition for AIFMD. It’s possible to set up a co-investment policy and procedure that shoehorns it into reverse solicitation.

One panelists view on the criteria to make reverse solicitation work:

  1. Talking to institutional investors
  2. Talking to investors that you have some previous relationship with
  3. Keep to a minimum number of investors. (A handful of investors)
  4. Don’t do it in France

After the transition period, you may still have a runway to close. Don’t let it go beyond the end of the summer. Get contact and some communication during the transition period.

Soft marketing. You don’t want to register if you won’t have any investors in that country. Pitchbooks may not be marketing. It’s better if you have not completed the PPM or have not yet had a first closing. You need a fund to be in existence before you can register.

Depositories in Germany and Denmark is more than a custodian. It is intrusive and will check the investments. The marketplace for depositories is still developing.

Registration is expensive; Who will pay for it? Management company? All investors? Just EU investors? Country by country allocation?

There is no single solution for all EU countries. It is a patchwork.

AIFMD enforcement is coming from a country’s regulatory authority. Failure to register is a criminal offense. If you need a legal opinion on compliance, a fund’s legal counsel may force registration or stricter compliance.

Not AIFMD:

  • Joint venture
  • Managed account – single investor fund
  • Co-investments- The UK has specifically stated as such (other countries may take a different view)

The panel moved on to corruption and compared the FCPA to the UK’s Bribery Act. The UK’s version is stricter so it’s better to set any anti-corruption policies to the stricter UK requirements.

For private equity firms, it is possible that the bribery actions in a portfolio company could be passed through, putting liability on the fund manager. The UK enforcers are prepared to bring an action even where the nexus to the UK is tenuous.

 

Congress Tries to Fix the JOBS Act

house financial services

I’m still surprised that the Jumpstart Our Business Startups Act flew through Congress two years ago. It’s surprising to see bi-partisan support for anything. Unfortunately, the law was flawed and has accomplished little that it set out to accomplish.

The Title III Crowdfunding law was wildly hailed as monumentally changing the way small businesses could raise capital. However, the law was deeply (fatally?) flawed. The law handed the Securities an impossible framework to craft regulatory control. The SEC has not produced the new regulations because of the deep flaws in the law. That fact is clearly acknowledged in a recent legislative cover memo. Plus there is a titanic clash between the consumer protection and capital formation goals of the the SEC.

Title II demanded a lifting of the ban on general solicitation. Congress added a caveat that the company raising the capital take reasonable steps to ascertain that the investor is an accredited investor. That’s a bad hurdle, but not insurmountable. However, the SEC’s consumer protection goal produced a nasty set of proposed regulations that has scared off many firms from taking advantage of the new possibilities for advertising and solicitation.

Congress is trying to fix the problem. There is a hearing today on three bills that offer technical fixes to the JOBS Act.

The first is rebuilding of the Crowdfunding platform. This bill repeals the old law and replaces it with a modified version of the original House bill proposed by Rep. McHenry.

The second is an improvement to the oft-forgotten Regulation A exempted offerings. The proposal would raise the offering amount to 10 million and makes a few other tweaks.

The third blows up the SEC’s proposed regulatory changes to Form D and otherwise makes advertising and solicitation more palatable for private offerings.

Hearing entitled “Legislative Proposals to Enhance Capital Formation for Small and Emerging Growth Companies, Part II”
Thursday, May 1, 2014 9:30 AM in 2128 Rayburn HOB

Witnesses:

  • Mr. Benjamin Miller, Co-Founder, Fundrise
  • Ms. Annemarie Tierney, Executive Vice President and General Counsel, SecondMarket
  • Mr. William Beatty, Director of Securities, Securities Division, Washington State Department of Financial Institutions
  • Mr. Jeff Lynn, Chief Executive Officer, Seedrs Limited

These are well-thought out changes that would improve capital formation. I fear that the House Financial Services Committee has become too partisan to effectively legislate.

Accredited Investor Verification

rich accredited investor

When Congress imposed a lifting of the ban on advertisements for private placements, it also imposed a mandate that the fundraiser “take reasonable steps to verify that purchasers of the securities are accredited investors.” The methods for verification were to be determined by the Securities and Exchange Commission.

The SEC, to its credit, did not impose impose strict methods for verification. It largely decided to allow fundraisers to use a principles-based approach. The SEC did include four non-exclusive safe harbors for verification.

Congress thought that lifting the ban would invigorate fundraising. But funds and companies have been reluctant to use it. According to a speech by Keith Higgins, only 10% of private placements have used the Rule 506(c) methods. Since September 2013, there were 900 offerings that raised $10 billion under Rule 506(c). But there were over 9,200 offerings that raised $233 billion under the old Rule 506(b) regime.

With the verification requirement, the outcome and backlash has been that fundraisers should only use one of the four methods. That of course, is silly. It’s safe, but overly cautious. The SEC did specifically state that reliance on an investor’s self-answered questionnaire alone is not taking reasonable steps. You will need to look at your potential investor and find out some additional information.

That investigation adds time and and energy. For private equity funds, it’s probably a step that should be taken anyhow. Investor defaults on capital calls is a bad thing. You want to make sure that your potential investor will be able to make the contributions over course of the expected timeline of capital calls. That’s a bit different than a one time contribution to a hedge fund or private company investment.

Minimum investment goes a long way to meeting the reasonable steps. If an investor is making a $1 million investment then presumably the investor has the $1 million new worth which is the accredited investor baseline test. The SEC did not specifically endorse this standard. The concern is that the investor may have borrowed the money to make the investment. The SEC is clearly worried about shady operators getting little old ladies to mortgage their homes to make risky investments.

For me, the biggest concern is the overhang of the proposed changes to Regulation D that were put up for comment at the same time the SEC lifted the ban. That injects too much uncertainty into the fundraising process. The SEC stated that there will likely be a grace period and some transitional relief. But its hard to plan a fundraising that could take 12 months with that kind of uncertainty.

I was interested in using Rule 506(c) because of the uncertainties around the definition of general solicitation and advertising. It would be great to eliminate potential foot-faults. I could sleep better at night, not worrying about whether an employee would mention fundraising at an industry event. The company could respond to media requests and could correct misinformation in the media about the fundraising.

But the SEC has left too much uncertainty in the process to fully embrace a Rule 506(c) offering.

References:

Filing Form D and General Solicitation

soap box

One of the current issues around a fund manager or company from using advertising as part of its private placement fundraising is the proposed changes to filing requirements for Form D.

Few people I have spoken with actually want to use general solicitation like bulk emails, newspaper ads, or web ads. But they do want to be able to mention fundraising at industry events, advertise the fund manager as a brand, and talk to the media. All of those could be considered general advertising and solicitation or could come close to the line. The SEC has not created a bright line test for when an announcement becomes general and endangers a private placement.

Many people embraced the lifting of the ban on general solicitation and advertising because the fund manager or company could avoid the advertising foot fault of private placement.

The requirement that a firm take reasonable steps to determine if potential investor is accredited is one impediment. For funds with large minimum investment requirements and mostly institutional investors, it’s probably less of an impediment.

The foot-faults under the proposed rule are even greater.

For instance, the proposed rule would require filing of Form D before a general advertisement or solicitation begins. That’s a problem when it’s not clear whether an activity falls under those terms. It’s also a problem if the terms of the offering change over the course of the pre-sale marketing period. Often, a private fund’s terms are not complete during the initial marketing phase.

Even worse, the proposed rule imposes a draconian ban on the use of private placements if you failed to file the Form D before the activity that would be considered general advertising and solicitation.

I agree that not requiring the filing until 15 days after the first sale is not the best method to provide information to investors or regulators. I think the better position is to require the filing 15 days before the first sale.

The proposed rule 510T would also require filing the materials used in general solicitation and advertisements with the SEC. Again, with those terms not well defined it’s hard to know if you have violated the rule. If the materials escape and get published in the media, you’ve potentially blown the private placement and the filing requirement with no ability to cure.

According to Jim Hamilton’s World of Securities Regulation, seven Senators have urged the SEC to adopt the proposed rules to help state securities regulators. Broc Romanek in theCorporateCounsel.net notes that SEC Commissioner Aguilar has weighed in supporting the proposed rules as necessary for investor protection.

Fund managers may be intrigued by the lifting of advertising requirements, they are more likely to cause a foot-fault than staying under the existing private placement regime.

References:

 

 

 

How Not to Use Twitter as a Fund Manager

Navigator Money Management

The Securities and Exchange Commission charged Mark A. Grimaldi and his firm, Navigator Money Management, with making false claims through Twitter, newsletters, and other communications about the success of their investment advice and a mutual fund they manage. Grimaldi and Navigator were using social media and widely disseminated newsletters to cherry-pick information and make misleading claims about their success in an effort to attract more business.

The Investment Advisers Act’s main thrust is to not be fraudulent, deceptive or misleading. When it comes to the restrictions on advertising, the rules can get complicated.

Grimaldi co-founded The Money Navigator and it had more than 60,000 subscribers by the end of 2011. He used it in part to promote the performance of his various investment financial advise platforms. He stretched the truth and the SEC caught him.

Based on the order, the SEC came in for a exam and poured through the publication looking for advertising rule violations and found some.

Mark Grimaldi manages Sector Rotation (NAVFX),” which “was ranked number 1 out of 375 World Allocation funds tracked by Morningstar. Sector Rotation produced an average annual return of 10.25% from August 31, 2002, to October 31, 2011, vs. 5.47% for the S&P 500 Index, according to Morningstar.”

The ranked #1 and nearly doubling the S&P index must stand out as problematic. The #1 ranking was from October 2010 to October 2011. It was ranked lower before that time frame. I read the copy as saying it was #1 from 2002 to 2011.

It’s tough to claim a 10.25% return from 2002 to 2009 when the fund did not exist prior to December 2009. The return is based on a hypothetical return published in The Money Navigator, not actually put to work. Plus, Grimaldi did not work at The Money Navigator until 2004.

That kind of stretching the truth is even more problematic when you edit the statements down to the 140 characters used in Twitter:

the April issue of the Money Navigator will give you an inside look of how I doubled the S&P500 the last 10 years w/o using low cost funds”

“[m]y cap app model has DOUBLED the S&P 500 the last 10 years.”

You can add on two more failure. If you state a specific recommendation you need to disclose all of the recommendations within the past year. When showing past performance you need disclaimer that 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 under Rule 206(4)-1(a)(2)

You should read the order as way to test your knowledge of the advertising rules. I bet that Mr. Grimaldi also understands them better now.

 

References:

The Proposed New Regulation A for Fundraising

A+

Title IV of the Jumpstart Our Business Startup (JOBS) Act mandated changes to the moribund Regulation A offering process. That law raised the bar from $5 million to $50 million and prodded the SEC into making changes. The SEC issued the proposed rule with enough interesting treats that it may be worth exploring. The SEC is treating it like an IPO-lite as opposed to the wary eye cast on private placements.

The proposal splits Regulation A offerings into two baskets. Tier 1 offerings can be for up to $5 million a year. Tier 2 offerings can be for up to $50 million per year. By stepping up to Tier 2, the company’s financial statements must be audited and company must file semiannual reports and updates similar to public company reporting.

The part the SEC got right is that Tier 2 offerings would be exempt from state registration. The existing Regulation A’s failure to preempt the state blue sky laws is a major reason it is not used. I don’t see why the SEC would even bother with an offering type that does not preempt state blue sky laws. Tier 1 offerings under Regulation will likely continue unused.

The real nasty part is that investors are limited to purchasing no more than 10% of an investor’s net worth or annual income. That’s a big red flag. However, the SEC took the smart approach and did not turn that into a compliance requirement. The company needs to make investors aware of the 10% restriction, but can rely on a representation from the purchaser. The investor does not have to disclose personal information to verify compliance.

The proposal makes Regulation A a quirky middle ground to private placements and public offerings.

References: