Category: Fundraising

What’s Next For Private Funds Now that the SEC has Lifted the Ban on General Solicitation

SEC Seal 2

On Wednesday, the Securities and Exchange Commission adopted a new rule that will allow private funds to advertise. (Perhaps “private fund” is not the right label anymore.) Of course it’s not as simple as merely removing the word “not” and allowing public advertising of private placements.

The new rule creates a new option. It creates a public private placement. A fund manager or company can publicly advertise the offering so long as all purchasers of the securities are accredited investors and the issuer takes reasonable steps to verify that such purchasers are accredited investors

The existing option is still viable that operates under the regulatory regime as it existed before 10:00 am yesterday. I suppose it’s a private private placement.

One concern I had was how a public private placement under the new Rule 506(c) would affect a private fund under its Section 3(c)1 or 3(c)7 exemption under the Investment Company Act. Private funds are precluded from relying on either of these two exemptions if they make a public offering of their securities. The SEC explicitly addressed this concern.

As we stated in the Proposing Release and reaffirm here, the effect of Section 201(b) is to permit private funds to engage in general solicitation in compliance with new Rule 506(c) without losing either of the exclusions under the Investment Company Act.(page 48 of Release 33-9415)

Another concern was whether the SEC was eliminating the “reasonable belief” standard that an investor is accredited under the new Rule 506(c) offerings. The SEC specifically addressed this concern.

We note that the definition of accredited investor remains unchanged with the enactment of the JOBS Act and includes persons that come within any of the listed categories of accredited investors, as well as persons that the issuer reasonably believes come within any such category.

My last concern was what it meant to take “reasonable steps to verify” that investors are accredited. The SEC stuck with its principles-based approach, but did provide four non-exlusive methods for verifying accredited investor status for individuals.

The principles-based approach requires you to take an “objective determination … in the context of the particular facts and circumstances.” That’s a bit messy. I was hoping the SEC would explicitly state that a minimum investment of $1 million would be enough. If the investor has $1 million, then the investor has $1 million of net worth and meets the accredited investor threshold. The SEC states that the minimum investment is a highly relevant factor.

The SEC expresses some concern that the cash investment could be financed by the issuer or a third party. Those are legitimate concerns given the potential for fraud by shady operators who would hide behind such a bright line test. But it does cause me a headache.

Clearly there will need to be some additional recordkeeping when it comes to a public offering of a private placement.

The SEC also passed a rule banning “bad actors” from having a substantial role in a private placement, regardless of whether it is public or private. I’ll take a closer look at that one later.

Lastly, the SEC is proposing changes to the Form D required to filed with a private placement. There are many changes in that rule. More than I expected.

  • the filing of a Form D no later than 15 calendar days in advance of the first use of general solicitation in a Rule 506(c) offering;
  • the filing of a closing Form D amendment within 30 calendar days after the termination of a Rule 506 offering; and
  • additional information on Form D about the offering

In addition, the rule is proposing a new disclosure on advertising materials in public private placements. The new rule 509 will require all issuers to include: (i) legends in any written general solicitation materials used in a Rule 506(c) offering; and (ii) additional disclosures for private funds if such materials include performance data.

The SEC is also proposing amendments to Rule 156 under the Securities Act that would extend the guidance contained in the rule to the sales literature of private funds.

There is a lot to digest. Looks like my weekend will be spent reading SEC releases and rules.

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DOMA, the SEC, and the Accredited Investor

us supreme court and compliance

The US Supreme Court ruled on same sex marriages and removed the broad federal definition of marriage that applies to over a thousand laws and regulations. Decision in US v. Windsor (.pdf) One of those regulations is from the Securities and Exchange Commission and affects fundraising for private funds and other private placements.

One of the standards for private placements of securities is that an investor generally needs to meet the definition of “accredited investor.” For an individual that means a (1) net worth, excluding the primary residence, of $1 million, or (2) annual income in excess of $200,000 in each of the two most recent years or joint income with a spouse in excess of $300,000.

Section 3 of the Defense of Marriage Act mandated that the word “spouse” refer only to a person of the opposite sex who is a husband or a wife.” 1 U.S.C. § 7 (1997)

Less than 10 years ago, the Massachusetts Supreme Judicial Court went through a laundry list of legal rights that couples enjoy once they are married. In the landmark Goodridge decision, that court decided that “spouse” should not be limited to a man and a woman. It affects a broad spectrum of rights granted by the government to people who are married.

The US Supreme Court decided that Section 3 of the Defense of Marriage Act is unconstitutional. Therefore, the accredited investor definition’s use of the word “spouse” is no longer restricted by DOMA to a person of the opposite sex who is a husband or a wife.

In the states that allow same-sex marriage, an issuer should now be able to allow a same-sex married couple to combine their income to meet the standard. I don’t think the SEC needs to take any action for this to happen.

In states that allow civil unions, the answer is a bit murkier and depends on the rights granted under state law. The civil union law would need to deem the two participants to be “spouses.” That is exactly what Illinois did in its civil union law:

“Party to a civil union” means a person who has established a civil union pursuant to this Act. “Party to a civil union” means, and shall be included in, any definition or use of the terms “spouse”, “family”, “immediate family”, “dependent”, “next of kin”, and other terms that denote the spousal relationship, as those terms are used throughout the law. SB1716

What is even murkier is a married couple who move to a state that does not recognize same sex marriage. Are they still “spouses” if not recognized by their state of residence? Justice Scalia raises this issue in his dissent.

Whether you agreed with DOMA or not, it made a very bright line test for “spouse”. That line is now more complicated for determining if a potential investor is an “accredited investor.”

This may become even more complicated when the SEC finally issues the regulation that lifts the ban on general solicitation and advertising. The new regulation will require a firm to take reasonable steps to determine that an investor is accredited if it wants to engage in general advertisement or solicitation. It will be interesting to see if the SEC includes something on this issue.

Given the SEC’s huge rulemaking backlog, I doubt they will make a separate statement on same-sex marriages under securities law. The SEC could tuck something into the advertising rule since it is already in the works. Perhaps the SEC was waiting for the Windsor case to be decided.

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Image of the US Supreme Court by OZinOH

Same Sex Marriage and Accredited Investors

Compliance, the SEC and the Supreme Court

The US Supreme Court is likely to come out shortly with its ruling on same sex marriages. The ruling may have an impact on fundraising for private funds and other private placements.

One of the standards for private placements of securities is that the investors generally need to meet the definition of “accredited investors.” For individuals that means a (1) net worth, excluding the primary residence, of $1 million, or (2) annual income in excess of $200,000 in each of the two most recent years or joint income with a spouse in excess of $300,000.

That word “spouse” is the one being addressed by the Supreme Court.  Section 3 of the Defense of Marriage Act (DOMA) states that in determining the meaning of “any ruling, regulation, or interpretation of the various administrative bureaus and agencies of the United States,…the word ‘spouse’ refers only to a person of the opposite sex who is a husband or a wife.” (1 U.S.C. § 7 (1997)

William Carleton picked up on the wrinkle in Rule 506 that same-sex marriages were not treated equally for purposes of the accredited investor standard.

Here in my home state of Massachusetts, “spouse” is not limited to a man and a woman. In the landmark Goodridge decision that made same-sex marriage legal, the Massachusetts Supreme Judicial Court went through a laundry list of legal rights that couples enjoy once they are married. Those were rights not available not available to same-sex couples.

You can add the accredited investor standard to that big pile of legal rights.

The accredited investor concept was included in Regulation D “based on the presumption that accredited investors can fend for themselves without the protections afforded by registration.” I’m not sure how gender plays a role in determining the financial ability of a couple. But currently it does.

What happens if the Supreme Court strikes down the DOMA restriction? I assume the SEC will not do anything and let the term “spouse” sit in the definition. They have enough political landmines to deal with, I don’t see the SEC jumping out with a rulemaking embrace of same-sex marriage when it still has not yet removed the ban on general advertising or issued rules on crowdfunding.

That will leave it up to the issuers, the fund managers, the start-up companies, and their lawyers to wrestle with the definition of “spouse.” I expect a few intrepid offerings will get an extra investor or two. I expect many conservative issuers will wait for more guidance from the SEC.

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Placement Agents and the SEC Inquiry of Private Fund Broker Dealer Requirements

money penny

Broker-dealer regulation in connection with the sale of private fund interests has become a focus of SEC inquiry. The David Blass speech on private funds and broker-dealer registration highlights the issue. If you have internal marketing people who are getting paid transaction based compensation for selling fund interests, there may be an issue. Even if you don’t pay a commission-like compensation to dedicated internal marketing people you may have a problem.

The big problem with having your internal marketing people re-cast as broker-dealers is that if they are not registered, your fund investors could have a rescission right. One way to deal with the broker-dealer issue is to use a third-party placement agent. Then, the fund manager would not need as much internal marketing manpower. The fund could rely on the placement agent’s broker-dealer registration.

But the SEC started a witch hunt against placement agents in 2009 when it threatened to ban the use of placement agents when dealing with government pension plans. That put fund managers on the defensive when dealing with placement agents. Individual states began instituting their own bans on placement agents. Many investors raised a red flag for compliance issues when a placement agent was involved in a fundraising.

Placement agents had to give some thought as to how they operated their businesses given that they are precluded from acting as an agent when dealing with the big dollars of pension plans.

Of course, many fund managers bulked up their internal marketing groups to deal with the lesser assistance they would get from placement agents. Now the SEC is going after those groups. Unfortunately, the SEC is being very inconsistent on how it wants private funds with savvy investors to operate now that they are under the stricter scrutiny of the SEC.

AIFMD in the UK

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HM Treasury has published its response to its first consultation on the transposition of the Alternative Investment Fund Managers Directive (“AIFMD”) in the United Kingdom. The main thrust of the AIFMD will not hit Europe for a few years, but in the meantime there will be more uniform limitations on private placements in the European Union starting on July 22, 2013. Unfortunately, all of the EU countries are scrambling to get the new regulatory regimes in place. “Scrambling” may imply more activity than is really happening.

The United Kingdom has moved a step closer and published revised draft regulations under the AIFMD (.pdf). The good news is that the UK is proposing to provide a year of transition so that the requirements under the AIFMD for private placements won’t come into full effect until July 2014.

The draft regulations propose replacing the registration process for non-EU managers seeking to market their funds under the U.K. private placement regime with a simple notification procedure. You certify your compliance with the AIFMD. That way the fund manager does not have to wait for the approval of the Financial Conduct Authority before undertaking marketing.

That registration requirement is trouble under the AIFMD. Effectively, you need to go through the registration process and wait for approval before marketing in that EU country. There is no private placement passport. Of course, it may turn out that you end up with no investors in that country.

Now we need the other member countries of the EU to move forward so that European investors don’t get excluded from investment opportunities when the end of July comes around.

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FINRA Issues Regulatory Notice on Communications Regarding Real Estate Investments

finra

FINRA issued Regulatory Notice 13-18 on compliance with the communications with the public rule concerning communications about unlisted REITS and other real estate investments.  Among other things, FINRA is concerned about the use of pictures of real property in the marketing materials.

FINRA Rule 2210 regulates broker-dealer communications with the public. Clearly, based on the Regulatory Notice, FINRA is concerned about disclosures and marketing when it comes to private real estate. The Regulatory is focused on private REITs and direct participation plans, not private equity real estate. However, the guidance may be applicable to a placement agent involved in fundraising.

It was the limitation on pictures that caught my attention. One of the unique aspects of real estate funds is that you can show pictures of the investments. There is little guidance on how you need to treat the pictures or whether the pictures could be considered misleading. So the FINRA Regualtory Notice caught my eye.

Communications for a new program often include photographs or other images of properties owned by investments managed by the program’s sponsor that are similar to properties the program expects to purchase. In order to be clear that investors will not acquire an interest in the pictured property, prominent text must accompany each depiction explaining that the property is owned by an investment managed by the sponsor and not the program. Once the real estate program has acquired a portfolio, the communication may include depictions of properties that are limited to investments owned by the program.

That’s not much of a help. You can’t include pictures of non-fund properties unless you disclose that they are owned by a different fund.

Ensuring compliance in your marketing and solicitation procedures

PEI PFC Forum 2013

These are my notes from the Private Fund Compliance Forum 2013.

Paula Bosco, Managing Director, Chief Regulatory Counsel & CCO, New Mountain Capital, LLC
Abrielle Rosenthal, Senior Principal & Senior Compliance Counsel, TowerBrook Capital Partners L.P.

The JOBS Act is going to change things. We just don’t know when or how. However, most people think it will just reduce risks associated with speaking at conferences and speaking to the press.  A poll of the audience showed only 6% would advertise widely, 34% would advertise in small institutional circles, and 60% would not change their marketing practices.

You want to make sure you define terms like Gross IRR and return on equity.  Of course, all gross numbers must be accompanied by net numbers.

You want your footnotes to be at least 8pt, otherwise its unreadable.

You want every statement in the materials to have a source and to be backed by data. You especially need to have the supporting data for past performance numbers.

You can treat communications to current investors communicating current fund performance as not being marketing materials. The danger is that the materials get delivered to a prospective investor as part of the marketing pitch.

Be sure to be consistent across the Form ADV and responses to DDQs and other marketing materials.

The session turned to the big, ugly, hairy gorilla known as AIFMD. If you are not actively marketing in Europe and don’t have any Europe fund operations then you probably don’t have to worry about AIFMD.

However, there are three areas that may still trigger AIFMD: co-investments, secondary transfers, and equity structures.

If you are allowing co-investments from European investors that could trigger AIFMD. If an investor sells an interest to a European investor it may trigger AIFMD.

Local laws on lobbying and pay-to-play can be time consuming.

Remember that the anti-fraud rules apply to all communications, not just marketing. You can never be misleading.

Fund Investing and Crowdfunding

fc-logo

As the Securities and Exchange Commission has been dragging its feet on new crowdfunding regulations, companies are finding a way to crowdfund using the current rules. The biggest challenge is dealing with the broker-dealer registration requirements. If you sell securities on a transaction basis, you are likelya broker-dealer and need to deal with the registration requirements.  The other limitation is dealing with the current ban on general solicitation and advertising.

One company that appears to be successfully employing a crowdfunding  strategy is Solar Mosaic. The company is selling interests directly in its own projects so it avoids the broker-dealer requirements. It uses a Rule 504 exemption instead of Rule 506 exemption under Regulation D. Rule 504 exempt offerings are not subject to the ban on advertising that impedes Rule 506 offerings, but are subject to a $1 million limit on capital raised. I even invested a small amount of cash in a Solar Mosaic project.

I have seen a few other platforms, like Circle Up, that partner with a broker-dealer. Effectively, the web crowdfunding platform sits on top of the broker-dealer’s regulatory platform.

The latest crowdfunding approach to catch my eye is FundersClub. They even obtained a no-action letter from the Securities and Exchange Commission blessing their approach. (I should disclose that Mrs. Doug works at the law firm that requested the no-action letter.)

FundersClub acts as a venture capital fund manager and registered as a venture capital fund manager with California. It starts a separate private fund for each company that it funds.

The compensation it tricky. According to the SEC no-action letter and the FundersClub FAQ, the company charges an administrative fee to cover out of pocket costs. None of that fee goes to salaries or personnel. That lack of transaction compensation and operations was enough to keep the company away from broker-dealer registration.

FundersClub does take a promote on the performance of the investment fund. It has a long road ahead for compensation to come in, but is aligned with the investors.

I decided to try out the platform. Signing up is straightforward.

As for vetting users as accredited investors, the platform does a better job than others. It asks for your income, joint income and net worth. Other platforms just have a check button exactly tied to the right answers for those questions. With FundersClub, you need to know your income or know the right answers to be accredited.

It does have one simple check for knowledge:

By checking this box, you represent that you have such knowledge and experience in financial and business matters that you are capable of evaluating the merits and risks of investment opportunities in private companies generally, and you are able to bear the economic risk of such investments including the risk of complete loss.

After passing the entrance hurdle, there are several investment opportunities in the works.

The current regulatory environment for crowdfunding is tricky, but navigable for accredited investors. Non-accredited investors are left out, so maybe crowdfunding is not the right term. I’m skeptical that the JOBS Act mandate for new crowdfunding regulations is going to truly open the floodgates to non-accredited investors.

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UPDATED: To clean up more than my usual collection of typos.

File Your Fund’s PPM With FINRA?

finra

FINRA Rule 5123 requires each FINRA member firm that sells securities in a private placement, subject to certain exemptions, to file with FINRA a copy of any private placement memorandum, term sheet or other offering document the firm used within 15 calendar days of the date of the sale, or indicate that it did not use any such offering documents. If you are using a placement agent to help with fundraising, the placement agent will be subject to the FINRA rules. Then the fundraising is potential subject to the FINRA disclosure, unless if falls into an exemption. The exemptions for a private fund split the world into two.

For funds exempt under Section 3(c)(7) of the Investment Company Act, all of the buyers will be “qualified purchasers.” Rule 5123 has an exemption for the filing requirement for offerings sold to qualified purchasers.[5123(b)(1)(B)]

For funds using the Section 3(c)(1) exemption, the analysis in not as clean. Rule 5123 has an exemption for the filing requirement for offerings sold to some types of accredited investors. [5123(b)(1)(J)] It leaves out items 6 and 7 in the definition of accredited investor.

A fundraising triggers the filing requirement if you sell to natural persons who are accredited investors, but don’t meet the standard of qualified purchaser.

In talking with a placement agent, they are including representations that the offering will be a 3(c)(7) offering so that they are protected from having to make the FINRA filing.

How to Do Everything Wrong in a Securities Offering

first choice investment

I first looked at the First Choice Investments action by the Securities and Exchange Commission because it involved a real estate investment company. I thought it would be another to case to help me explore ““. Instead I found a train wreck, at least if what the SEC alleges is true. The company was selling high-yield notes that could be converted to shares in the company. This was a real estate based investment, but the company was not selling real estate interests. There is no argument that the company was selling securities.

In the SEC complaint, First Choice is accused of misusing funds and misleading advertising. The misuse of funds comes across as standard corporate fraud, raising cash for one purpose but pocketing it for your own compensation and outside uses.

The advertising and promotion was blatantly in violation of securities laws and shows some of the concerns of crowdfunding and removing the ban on general advertising.

Right on the public webpage, First Choice offers a 10% return paid quarterly and touts that First — Choice is about to go public shortly. With the ban on general advertising, there is a big red flag on this company’s web page.  First Choice is advertising the securities offering. Also, according to the SEC complaint, First Choice was cold calling potential investors. So they are violating both the general advertising and general solicitation restrictions currently in place for Regulation D Rule 506 offerings.

Also targeted in the complaint is an affiliated company, Acorp Development. It was offering $5 million of equity. It decided to put the SEC logo on its investor’s lounge with a link to its Form D filing. You should not use the SEC logo in a way that indicates something is approved by the SEC.

The Investor Presentation is a strange mix of concepts, questionable math, and false promises. After a handful of case studies, the presentation shows the pro forma returns for an investment, showing a target cap rate of 13.41%. All of the preceding case studies had lower cap rates.

The First Choice “Investor Principal Protection” caught my as incredibly strange. Somehow through a consulting agreement, Goldberg-Goldberg offers an “Investment Enhancement Program” that provides an “assured return of investment during the high risk stage of the business.” I scratch my head wondering how a consulting agreement is supposed to offer investor principal protection.

The First Choice notes state that they can be converted to equity. But with no formula for conversion, the windfall touted by First Choice would seem to be non-existent.

In a world where non-accredited investors should be shielded from private offerings, the First Choice materials are full of red flags that should make any reasonably savvy investor walk away. However, First Choice was still able to raise $3 million. The public availability of information is a red flag to regulators that the company is operating outside the bounds of the securities laws.

Post-repeal of the advertising ban and the post-enactment of equity crowdfunding, this types of fraudulent offering may be more common and more public. Hopefully, the SEC can find the right balance to limit the ability of bad actors that play in the securities offering playground.

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