Category: Fundraising

Participating Bad Actors and Private Funds

bad actor

The SEC staff issued new Compliance & Disclosure Interpretations relating to Rule 506(d), the new bad actor rule. Under the rule, an issuer may not rely on the Rule 506 exemption if the issuer or any other person covered by rule has a relevant disqualifying event that occurred on or after September 23, 2013 (the effective date of the rule 506).

It’s a tricky rule, mandated by Dodd-Frank. Conceptually, I agree that the law should not permit bad guys to participate in private offerings of securities. The devil is in the details.

One murky item was what it meant to “participate” in the offering. For a big placement agent or brokerage, it’s easy to wall someone off. But how does that work from the perspective of the issuer? The SEC offered two new answers to questions about “participation.”

Question 260.18

Question: Does the term “participating” include persons whose sole involvement with a Rule 506 offering is as members of a compensated solicitor’s deal or transaction committee that is responsible for approving such compensated solicitor’s participation in the offering?

Answer: No.

Question 260.19

Participation in an offering is not limited to solicitation of investors. Examples of participation in an offering include participation or involvement in due diligence activities or the preparation of offering materials (including analyst reports used to solicit investors), providing structuring or other advice to the issuer in connection with the offering, and communicating with the issuer, prospective investors or other offering participants about the offering. To constitute participation for purposes of the rule, such activities must be more than transitory or incidental. Administrative functions, such as opening brokerage accounts, wiring funds, and bookkeeping activities, would generally not be deemed to be participating in the offering.

Those question are clearly addressed to placement agents and brokers, not to issuers.

So who is “participating” in the offering at a fund manager?

The rule explicitly covers the fund manager. But the fund manager is rarely an individual.

The rule explicitly covers “any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with such sale of securities.” That would cover the marketing group, if any of them are getting paid a commission. Of course that raises the other issuer of whether the marketing group is subject to broker-dealer registration.

The rule also includes any “general partner or managing member of any such investment manager.” Those are legal terms and could be avoided by the organizational structure and titles granted to the manager’s principals. But I would include the principal owners of the fund manager.

Then the rule moves down the next rung and includes “any director, executive officer or other officer participating in the offering of any such investment manager”.  The SEC release clearly said that merely being an officer, does not bring you into the scope of the rule’s disqualification. An “officer” test based solely on job title would be unduly burdensome and overly restrictive.

Participation in an offering would have to be more than transitory or incidental involvement, and could include activities such as participation or involvement in due diligence activities, involvement in the preparation of disclosure documents, and communication with the issuer, prospective investors or other offering participants.

That brings the marketing group clearly back into the rule because is communicates with prospective investors.

I have trouble with “preparation of disclosure documents.” Lots of people in the organization help to prepare the disclosure documents and are involved in due diligence activities.

I was hoping the SEC’s new interpretations would help narrow the scope of those covered by the rule at the fund manager. But they do not.

References:

The Upcoming Changes to the Accredited Investor Standard

Monopoly man

Section 413 of the Dodd-Frank Act requires the Securities and Exchange Commission to review the accredited investor definition by July 21, 2014, the fourth anniversary of President Obama’s signing of the  law. In a letter to Congressman Scott Garrett, SEC Chair Mary Jo White said that the Commission staff has begun a comprehensive review of the accredited investor definition. The letter was specifically a response to questions from Congressman Garrett.

I have no doubt that the current definition of accredited investor using income or net worth for individuals excludes people who should not be excluded from private securities offerings. I also have no doubt that it also allows in people who are not financially sophisticated enough to analyze the investment opportunity. For example, the SEC Commissioners fail the income test based on their salaries as commissioners. (I have no doubt they meet the net worth test.)

I do like the clear line drawn by the standard. I also like that a company can use reasonable belief to rely on questionnaire submitted by the investor to prove its accredited investor standard.

The new standards imposed by the SEC to verify accredited investor status under the permitted general solicitation are causing many to avoid that option. Few individuals are going to want to supply tax returns or W-2s to make an investment opportunity.

In reading the questions asked by Congressman Garrett it seems clear to me that he wants the definition expanded to create a larger pool of potential investors.

The GAO report on the accredited investor standard highlights net worth as the most important measure of an investor for private placements.  The report has some great analysis of potential changes to the standard.

The deadline is still months away, but I expect there will be significant changes to the definition.

References:

Is Your Fund Name Misleading?

You_Can_Call_Me_Al

Last week, the SEC’s Division of Investment Management released a guidance update that focuses on funds that use a name that “suggests safety or protection from loss.” The IM Guidance Update is a shot across the bow, warning a fund to considering changing its name if it exposes investors to “market, credit, or other risks.”

Every investment fund has exposures to “market, credit or other risks”, so the Guidance presumably applies to every fund. That means your fund name should not suggest “safety or protection from loss.”

The Guidance points to two bad words: “protected” and “guaranteed.”

The Guidance states that the agency has recently asked some managers to change the names of their funds.

We have made these requests because we believe that, in practice, investors sometimes focus on a fund’s name to determine the fund’s investments and risks, either because the name sometimes appears without the clarifying prospectus disclosures (e.g. , in advertisements) or because of the prominence of a fund’s name or for other reasons.

Funds that managed volatility by investing a portion of the fund’s assets in cash, short-term fixed income instruments, short positions on exchange-traded futures, or other investments had included the term “protected” in their name. The SEC was rightly concerned that “protected” only meant partly protected. Similarly, some funds had entered into shortfall guarantees to protect a fund’s downside. That protection may not have covered a 100% of the loss. Of course the protection is only as good as the credit of the company providing the coverage.

References:

You Got Questions About 506(c) – The SEC Has Answers

sec-seal

The new Rule 506(c) is a big substantive change on how private placements can be run. That leaves many, including me, with a lot of questions. The Securities and Exchange Commission just posted a series of new questions and answers on the new rule. Most of the answers are expected confirmations, but there are a few surprises.

Question 260.05 If you switch a pre-rule offering to new Rule 506(c) offering, do you need to file an amendment to From D. YES.

Question 260.06 If you take reasonable steps to verify that all investors are accredited, but after the sale you find out that an investor did not meet the standard. The SEC says that’s okay as long you took reasonable steps and had a reasonable belief.

Here was a surprise.

Question 260.07 All of your investors are accredited investors, but you didn’t take reasonable steps to verify that they were accredited. The SEC says that you failed the exemption. “The verification requirement in Rule 506(c) is separate from and independent of the requirement that sales be limited to accredited investors.”

The other item for fund managers to take a look at is Question 260.10 regarding existing investors. The SEC makes it clear that the exemption for existing investors in the non-exclusive list of verification methods only apples to the same issuer. So you can’t rely on this exemption when raising a new fund.

Another small surprise is that the SEC will allow you to retreat from a 506(c) offering back to a 506(b) offering. Question 260.11 makes it clear that as long as you did not engage in general solicitation you can amend the Form D to change the exemption. And vice-versa. Question 260.12 explicitly allows an offering to switch from 506(b) to 506(c). Many people I talked to thought you could make switch, but it’s good to hear it explicitly form the SEC.

The Confusing Analysis of Whether You Are An Accredited Investor

accredited investors

There are few commentators who think the current definition of “accredited investor” is a particularly good definition for individuals who should be investing in private placements of securities. Basing the standard on income and net worth does give you a perspective that the person could withstand the potential loss of investment. The definition has become even more important as the ban on general solicitation and advertising has been lifted. That’s going to leave a lot of potential investors and a lot of companies seeking capital trying to figure it out.

The income test of $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year, provides an interesting model. It’s reasonably verified with tax returns. Although I suspect few investors will want to turn over their tax returns to potential investment targets.

There is some uncertainty about the meaning of “spouse” for same-sex couples, given the Windsor decision that struck down the Defense of Marriage Act.

A humorous aspect of the income test is that the SEC Commissioners’ salaries are less than $200,000. Therefore, they each fail the accredited investor income test, unless a spouse is earning at least $150,000.

The asset test is even more difficult because assets now exclude the value of the home. Except if the mortgage balance is higher than the value of the home, then the negative value of the home is included in the asset test.

Of course the first problem is figuring out the value of your home and comparing it to the mortgage balance. I like that Zillow says my house is worth more than my mortgage, but is that an authoritative source for use in an accredited investor analysis?

Then the SEC also requires an home equity advance or mortgage increase in the prior sixty days to be a liability in calculating net worth, even if it does not put the house underwater. During the comment period, a concern was raised that an unscrupulous actor could convince grandma to mortgage her home, converting equity into cash that earns her the accredited investor standard.

The biggest problem is proving net worth to meet the accredited investor standard. You need to prove how much your house is worth, the mortgage balance, the timing of the mortgage origination, the timing of any home equity draws, all of your liabilities, and lastly your assets. merely producing a bank statement showing $1 million in cash in the bank is not enough to have take “reasonable steps” to conclude that a person is an “accredited investor.’

You can review the ridiculousness of the asset test in a new investor bulletin from the SEC: Investor Bulletin: Accredited Investors (.pdf) SEC Pub. No. 158.

John Smith fails the test because he took an additional draw on the home equity line in the past sixty days. But in two months he once again becomes an accredited investor. He did nothing but wait and his financial situation did not change. But two months later he can be an angel investor and invest in a start-up company.

James Lee fails the test because his house is $100,000 underwater and pulls him $80,000 short of the accredited investor standard. But as soon as Zillow makes a good positive update, he becomes an accredited investor. He did nothing but wait for the real estate market to recover. But then he can invest in a hedge fund.

References:

Investor Bulletin: Accredited Investors (.pdf) SEC Pub. No. 158

Voluntarily Submit Your Private Placement Advertisements to the SEC

sec-seal
In a head-scratching move, the Securities and Exchange Commission has created a portal for you to voluntarily submit general solicitation materials for private placements. With Rule 506(c) now in effect, companies are free to advertise their private placements of securities, so long as the company takes reasonable steps to ensure that investors are accredited investors.

When the SEC issued Rule 506(c), it also proposed a new rule that would require a company to submit its general solicitation and advertising materials. That new rule, along with several others proposed at the same time, are controversial.

I assume that the SEC portal is set up to take submissions if required at some point at the future. I’m not sure why any company would voluntarily submit materials. I’m scratch my head even harder because there is no field to identify the issuer soliciting for investors. That would seem to limit the utility of the submission.

Perhaps the portal is intended for Whistleblowers? But there is statement and link to direct submission involving possible violations of the securities laws to the TCR portal.

Perhaps the SEC merely had its IT group put together the portal in anticipation of the proposed rule becoming effective? Perhaps.

References:

Voluntary Submission of General Solicitation Materials Used in Rule 506(c) Offerings

The New Era of Public Private-Placements

half-price advertisement

The Securities and Exchange Commission’s new Rule 506(c) goes into effect today, lifting the ban on general solicitation and advertising. Fund managers, start-ups, and established companies can make public, their private placements of securities. That is both a good thing and a bad thing.

It’s good because start-ups can now pitch their products to potential consumers and for investments by investors. Demo days are no longer operating in a shadowy area that may violate the rule on private placements. Private fund managers can now advertise their brand, much as mutual fund companies can advertise. Private fund managers can speak to the press so that their coverage is no longer incorrect.

It’s bad because once you advertise, you have to take “reasonable steps to verify” that you should have a “reasonable belief” that an investor is an accredited investor. For individuals, it may mean that an issuer would ask for tax returns or certified financial statements. I think most individuals will resist that request. So a start-up that is seeking individual investors may actually handicap its ability to attract investors by engaging in general solicitation or advertising.

It’s also bad for securities regulators. If a regulator could see information on what should be a private placement, the regulator knows its a bad private placement. By the old definition of private placement, the regulator should not be able to see the information because its private. Either the company made a bad mistake or there’s fraud involved. In the new era of public private-placements, regulators will have little insight into the nature of the private offering.

At some point the regulators will have access to the Form D filing that provides a basic set of information about the public private-placement. But that does not need to be filed until 15 days after the first sale of securities.

In an attempt to fix the loss of the red flag, the SEC proposed some additional rules to help with investor protection. I, and many others, feel the proposed rules are more likely to impede private fundraising more than protect investors.

The better solution would have been to improve the poor definition of “general solicitation and advertising.” There were many things that clearly fit into the definition and many things that clearly fell outside of the definition. If the SEC had just carved out a few more items (see the “good” above), private placements would not be in their current turmoil.

But it was not up to the SEC. It was a Congressional mandate in the JOBS Act that swept aside the ban. It was Congress who imposed the investor verification requirement.

The good news is that the old private placement regime is still in place. As long as you don’t engage in general advertisement or solicitation, in other words have a private private-placement, you don’t have to engage in the messy investor verification process.

The New Rule 506(d) and Bad Actors

baD BOYS

At its latest meeting, the Securities and Exchange Commission approve the rule that lifted the ban on general solicitation and advertising for certain private placements. The SEC also adopted the new rule that disqualifies felons and other bad actors from participating in certain securities offerings. The first rule was mandated by the JOBS Act. The “bad actor” rule was mandated by Dodd-Frank.

The bad actor rule makes private placements a bit harder and will require private funds and companies to do more homework in connection with the fundraising. That’s because an issuer cannot rely on the Rule 506 exemption if the issuer or any other person covered by the rule had a “bad actor disqualification.”

I think the starting point is who is covered by the rule. The rule applies to

  • The issuer, including its predecessors and affiliates
  • Directors, executive officers, general partners, and managing members of the issuer
  • Any other officer participating in the offering
  • Anyone who holds 20% or more of the outstanding voting equity securities
  • Investment managers and principals of pooled investment funds
  • Any general partner or managing member, director, executive officer or other officer participating in the offering of a fund sponsor
  • Solicitors paid to sell the securities investors as well as the general partners, directors, officers, managing members or other officer participating in the offering

For fund managers registered with the SEC the employees affected are a narrower group than those in Item 11 on Form ADV. That part of the Form ADV disclosure applies to all employees, other than employees performing only clerical, administrative, support or similar functions. Plus the Form ADV includes all of the officers, partners, directors, and certain affiliates.

The big difference is the 20% threshold for ownership in the company. For startups, that would likely pull some angel investors into the “actor” category.

It’s not clear what to do if the 20% investor is an entity. The rule does not seem to cover that circumstance. I suppose that if Bernie Madoff set up Scumbag Bernie Investor LLC to invest in the fund that would be a mere facade to hide his ownership. If the entity has multiple owners and officers it seems that a single “bad actor” inside the investor should not taint the whole entity.

The other fuzzy item is “officers participating in the offering.” The SEC had declined to merely use job title as the defining line. That would have included everyone who had the title of vice president.

Participation in an offering would have to be more than transitory or incidental involvement, and could include activities such as participation or involvement in due diligence activities, involvement in the preparation of disclosure documents, and communication with the issuer, prospective investors or other offering participants.

I’m not sure how I feel about that guidance. A lot of people end up reviewing the Private Placement Memorandum.

Of those relevant actors to determine if they were bad, they need to have been involved in a “disqualifying event” which includes:

  • Criminal convictions in connection with financial fraud.
  • Subject to an order of judgement that limits involvement in the securities industry.
  • Subject to an order of judgement that limits involvement in the banking industry
  • Subject to an order of judgement from the CFTC.
  • Subject to a US Postal Service false representation order.

The actual list is much more convoluted, long, and unwieldy. That means putting together a questionnaire will be difficult. For private fund adviser, it does not match up squarely with the Form ADV disclosures and is not as clearly written as the Form ADV disclosures.

The default would be to put together a questionnaire and just use the text of Rule 505(d). I’m not sure it’s comprehensible by a non-lawyer. Actually, I’m not sure it’s easily comprehensible by a lawyer. I just added it to my questionnaire for Form ADV, making it extend to four pages.

The next question is how much diligence you need to conduct to determine if one of your “actors” is a “bad actor”? The rule requires the issuer to exercise “reasonable care.” Which in “light of the circumstances, the issuer made a factual inquiry into whether a disqualification exists.”

That’s the kind of fuzziness that keeps a compliance officer up at night.

Fortunately, the SEC offers some color to the “reasonable care” in the release.

For example, we anticipate that issuers will have an in-depth knowledge of their own executive officers and other officers participating in securities offerings gained through the hiring process and in the course of the employment relationship, and in such circumstances, further steps may not be required in connection with a particular offering.

So the questionnaire approach should work for employees, unless you have some suspicion that an employee has been up to no good.

What about for investors?

Factual inquiry by means of questionnaires or certifications, perhaps accompanied by contractual representations, covenants and undertakings, may be sufficient in some circumstances, particularly if there is no information or other indicators suggesting bad actor involvement.

That’s enough to let me fall asleep at night. Maybe I’ll need just a little bourbon to take the edge off.

Sources:

What to Make of the New Rule 509

509

While I was waiting to see what surprises the Securities and Exchange Commission had included in the rule lifting the ban on general solicitation and advertising for private placements, the SEC slipped in an unexpected surprise. The SEC is proposing a new Rule 509.

Rule 509 would require disclosures on “any written communication that constitutes a general solicitation or general advertising.”

(1) The securities may be sold only to “accredited investors,” which for natural persons are investors who meet certain minimum annual income or net worth thresholds;

(2) The securities are being offered in reliance on an exemption from the registration requirements of the Securities Act and are not required to comply with specific disclosure requirements that apply to registration under the Securities Act;

(3) The Commission has not passed upon the merits of or given its approval to the securities, the terms of the offering, or the accuracy or completeness of any offering materials;

(4) The securities are subject to legal restrictions on transfer and resale and investors should not assume they will be able to resell their securities;

(5) Investing in securities involves risk, and investors should be able to bear the loss of their investment.

(6) For private funds: the securities offered are not subject to the protections of the Investment Company Act.

These are not a big deal by themselves. I already have some variation of these lined up for pitchbooks and marketing materials. Given that we have no better definition of what constitutes “general solicitation and advertising” I expect we’ll see these in all materials.

The other requirement is a disclosure for performance data used by private funds.

  • the performance data represents past performance.
  • past performance does not guarantee future results.
  • current performance may be lower or higher than the performance data presented.
  • the private fund is not required by law to follow any standard methodology when calculating and representing performance data.
  • the performance of the private fund may not be directly comparable to the performance of other funds.
  • a telephone number or a website where an investor may obtain current performance data.

Again, I don’t think any of these are a big deal. I think that private fund managers will merely need to adjust their disclosures pages to include this information.

The new Rule 509 also requires that performance data must be of the most practicable date and you must disclose the period for which performance is presented.

The mutual fund industry was concerned about the advertising for hedge funds alongside the highly regulated advertising for mutual funds. Clearly, the SEC is trying to level the playing field.  Mutual funds are limited in what they can do. I suspect they were concerned that hedge funds would be able to make more wild claims and not have to spew out the legal disclaimers that take up a big chunk of mutual fund advertising.

Lastly, if the performance presentation does not include the deduction of fees and expenses, the private fund must disclose that the presentation does not reflect the deduction of fees and expenses and that if such fees and expenses had been deducted, performance may be lower than presented.

I suspect this one is designed to scoop up the venture capital funds that managed to escape the investment adviser registration requirement under Dodd-Frank. Funds with registered fund managers already have to present net returns.

Rule 509 is merely proposed so it could be changed. But I doubt we will see any changes. The SEC will want to keep a tight lid on private fund advertising. I expect this rule will be ready to go shortly after advertising is permitted.

I don’t find anything particularly objectionable in Rule 509. The SEC clearly states in the release that failure to comply will not result in loss of the 506(c) offering.

However, a failure to comply that results in a enforcement action could lead to a ban under the new Rule 507(a). It’s not a footfault; it requires an action by the SEC or the courts. I suspect a examiner seeing a mistake will not blow up the private placement unless the examiner refers it to enforcement and enforcement decides to bring charges.

The other hook is a proposed change to Rule 156 under the Securities Act that would make it apply to private funds. More that later.

Buckets of Money

buckets of money

Radio personality Raymond J. Lucia, Sr. got in trouble with the SEC. An administrative law judge made it official and issued an initial decision in the case. Lucia will barred from associating with any investment adviser, broker or dealer, the investment adviser registrations for him and his firm are revoked, and is stuck with a $50,000 penalty against him and a $250,000 penalty against his former IA firm.

Judge Elliot’s decision found that that firm had violated the investment adviser antifraud statutes and that Lucia had aided and abetted the firm’s violations. “Judge Elliot’s initial decision vindicates the Division of Enforcement’s original position that Lucia and RJLC misled the investors who attended their seminars by claiming that the Buckets of Money strategy had been successfully backtested when in fact it had not been,” said Michele Wein Layne, Director of the SEC’s Los Angeles Regional Office.

It’s not over yet. Lucia and RJLC have 21 days from the date of the decision to appeal the decision. I suspect they will appeal.

The SEC found four flaws in Lucia’s performance marketing, with the misleading application of:

  1. historical inflation rates
  2. investment adviser fee impact
  3. returns on Real Estate Investment Trust (REIT) securities, and
  4. reallocation of assets.

The biggest problem cited by the judge was the backtesting use of REITs in the fictional portfolios that went back to 1966. Lucia used an assumed dividend rate of 7%, but is alleged to have failed to disclose that it was an assumed rate. Another problem was using non-traded REITs in the backtest when non-traded REITs were not available during that period. The last problem was that Lucia failed to disclose the illiquidity of non-traded REITs.

Looking at the administrative order it seems that these deficiencies could have been fixed with proper disclosure. Maybe not fixed, but would have reduced the likelihood of the SEC bringing charges and an adverse decision.

One interesting carve-out by the judge was an exclusion of Lucia’s slideshows from the definition of written communications under Rule 206(4)-1(b). The SEC did not show that the slideshow was printed out and distributed.

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