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.

Sources:

PERE CFO Forum 2013

IMG_1217[1]

I spent most of yesterday in New York at PERE’s CFO Forum. I came to speak about the evolution and revolution of regulation in the private equity real estate industry. I thought I would share a few items.

The opening panel focused on the changing role of the Chief Financial Officer. A big change is the avalanche of regulations and business requirements. Compliance is expensive when you add together the direct costs, the indirect costs, and the lost opportunity costs. It’s a cost of doing business.

Fund managers are fiduciaries. Exceed your investors expectations.

There is the rise of the new “F” words: FATCA, FIRPTA, FBAR, and FCPA.

The second panel focused on valuations. They put forth three items to focus on during valuations: consistency, transparency, and independence. You should have a consistency in the process, regardless of product type or geography.

Transparency allows someone to see good work product to get to the final fair value. As with third grade math, it’s not just about getting the right answer, it’s also about showing your work.

Independence is important to show that the decision makers are not influenced by other factors in trying to reach fair value. A person compensated based on an increase in fair value should not sit on the valuation committee.

As markets recovered from the 2008 financial panic we entered an era of price discovery. Nobody was quite sure where pricing would be post-crisis. With rising interest rates, we may be entering a new phase of price discovery.

The third panel was on tax reform and tax policy developments. There is a general sense in Washington that there could be a major tax code reform. As a result some changes are being held up based on the possibility of becoming part of a larger piece of legislation.

  • Carried interest remains under attack. The latest is the Cut Loopholes Act S. 268.
  • Rate equalization would likely reduce the disparate treatment between capital gains and ordinary income.
  • Business interest expense could be reduced to avoid the tax incentive in favor of leverage over equity.
  • FIRPTA is being found to discourage inbound investments in real estate. One proposed reform is the Real Estate Jobs and Investment Act S. 1181 that would repeal IRS Notice 2007-55.
  • Entity choice and pass through legislation would impose corporate taxation on “large” pass through entities.
  • Like-kind exchanges could be tightened to limit the deferral to direct swaps and application of a stricter standard of “like.”

My panel was on regulation: evolution or revolution for real estate.

According to some informal polls, most of the audience had registered last year as a result of Dodd-Frank. A few had been registered prior and a few were not registered.

As much as we are dealing with dramatic changes in the regulatory environment, the Securities and Exchange Commission is dealing with a dramatic change in their oversight of investment advisers. Dodd-Frank moved thousands of small retail investment advisers from the SEC to state registration. In exchange, the SEC got lots more hedge fund, private equity  funds, and real estate funds. The SEC has as much to learn about private fund operations as we do to learn about SEC oversight.

 

Update: Real Estate Investment Fraud or Securities Fraud?

Looks like a great investment?
Looks like a great investment?

Back in September, the SEC announced an asset freeze against Western Financial Planning Corporation and its principal Louis Schooler for a $50 million real estate fraud. That caught my eye because the SEC has little jurisdiction over real estate. The structure of the real estate investments went a long way to try to be not securities. I assumed the defendants would start out of the gate by arguing that the interests were not securities. That turned out to be true. But a California federal judge rejected the argument that the land investments didn’t count as securities.

Attorneys for Schooler had filed a motion to dismiss the suit and argued that the interests Schooler sold to investors were general partnership interests. Schooler argued that the general partnership interests were entitlements to land, rather than traditional securities. Without a characterization as securities, Schooler’s alleged failure to disclose material facts to investors would be outside the SEC’s enforcement authority.

Judge Gonzalo P. Curiel laid out the three factor test from Williamson v. Tucker for whether a general partnership is an investment contract, and therefore a security:

A GP is an investment contract—and thus a security—if one of the following factors is present:

(1) the general partnership agreement leaves so little in the hands of the partners that the arrangement in fact distributes power as would a limited partnership;

(2) the partners are so inexperienced and unknowledgeable in the general partnership business affairs that they are incapable of intelligently exercising their partnership powers; or

(3) the partners are so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that they cannot replace the manager of the enterprise or otherwise exercise meaningful partnership or venture powers.

Judge Curiel found that the interests satisfied the second and third tests.

I don’t think this makes every real estate partnership interest a security. But it is a very fact dependent analysis. As you get more investors in the partnership and complicate the structure and management, the investment starts looking more like a security than a real estate investment.

However, the standard of review for the motion to dismiss is a based on an assumption that the SEC’s factual allegations are true and are viewed in the light most favorable to the SEC. If the case proceeds, the SEC will need to prove the allegations.

According to the SEC complaint, Schooler was marking up the price paid for the land investments. The aggregate price paid for investors in the land ownership was far in excess of the purchase price paid by Western. In one case the investors contributed $1.85 million for an undeveloped parcel of land in Stead, Nevada that had a fair market value of $355,000. A second issue was that Western was publishing investment brochures that hyped the value of the land and seemed to be marking the value improperly.

Sources:

Enjoy Independence Day

When in the Course of human events, it becomes necessary for one people to dissolve the political bands which have connected them with another, and to assume among the powers of the earth, the separate and equal station to which the Laws of Nature and of Nature’s God entitle them, a decent respect to the opinions of mankind requires that they should declare the causes which impel them to the separation.

We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness.

I’m focused on the “pursuit of happiness” clause and taking a few days off.

declaration of independence

Failing to Disclose a Lack of Control

DALLAS TNT 7.jpg

Whenever I think of oil and gas syndications, I think of Dallas and J.R. Ewing. You can get screwed over in the wiggle of one of Larry Hagman’s luxurious eyebrows. The SEC’s complaint against Infinity Exploration for securities fraud in connection with oil and gas wells still caught my attention.

The first question is whether the interests would be securities or real estate. The SEC complaint focused on two offerings: Matagorda and New Mexico 10. Both were pooled investment vehicles. Infinity will have to battle its own statement. The PPMs for the investments both state that the offering consists of “securities” and that the investments are being offered pursuant to Regulation D.

One of the main charges is that Infinity mischaracterized what the pooled investment vehicles owned. The PPMs stated that the investment objective was to acquire, own, and deal with the prospect and that Infinity would perform drilling, testing and operations of the well. The SEC charges that Infinity was merely raising funds to invest in a joint venture with another firm and that Infinity would not be in a control position. The PPMs never disclosed that investors were purchasing an interest in an entity that would merely hold interests in another joint venture. The SEC also lays out a long list of other false or misleading statements in the PPMs.

Assuming the SEC view is correct, the lesson is to properly disclose the nature of the investments when fund raising. Real estate often has several layers of ownership and control. The key is to properly disclose those layers and how your investment fits into the mix.

The second big failure is that Infinity mischaracterized the use of proceeds. The PPM said that 80% would go to pay well-related costs, and the balance to administrative and overhead costs. The SEC charges that the 80% went to the third party joint venture partner who was actually doing the well work and Infinity kept the 20% as a commission.

It all fell apart when the joint venture partner went belly up. One investor had put in $37,500 with promises of immediate income and return of 100% of principal within a year. He ended up with a grand total of $667 in revenue. That is less than the annual grooming cost was for the late Larry Hagman’s eyebrows.

Sources:

Compliance Bricks and Mortar for June 28

bricks 20

These are some of the compliance-related stories that recently caught my attention.

Performance Fantasies Lead to SEC Enforcement Action by Jay B. Gould in Pillsbury’s Investment Fund Law Blog

For fund managers and investment advisers, there are a number of takeaways from the D’Amato case. First, when back tested or hypothetical “performance” is used in marketing materials, full and accurate disclosure must be made to investors and potential investors. The methodology used must be sound and records must be kept. Similarly, with respect to actual performance, calculations must be accurate and verifiable and must be presented in a context that does not make otherwise accurate information misleading in any material way. Fund managers, in particular, should not dismiss the D’Amato case because it occurred in the context of mutual funds and more “retail” type investors. The SEC and state regulators are willing to go back and look at past marketing presentations for inflated or inaccurate claims, all of which are required to kept as part of an adviser’s books and records.

Some Thoughts on What Makes a Good CCO by Tom Fox

There are several prominent commentators who frequently discuss the role a Chief Compliance Officer (CCO). One such commentator is Donna Boehme, who regularly writes articles, speaks about, and even tweets on this subject. But what type of mindset does a CCO need to be successful? What are some of the skills? I thought about those questions when I read three very different articles on unrelated topics recently.

Paul Weiss discusses ISDA’s March 2013 Dodd-Frank Protocol by Manuel Frey in The CLS Blue Sky Blog

Since the effectiveness of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”), the Commodity Futures Trading Commission (the “CFTC”) has finalized many of the rules that implement the detailed regulatory regime outlined by the Dodd-Frank Act. A number of these rules require market participants to update their swap trading documentation to comply with this new regulatory regime. This client alert outlines coverage and adherence mechanisms of the ISDA March 2013 Dodd-Frank Protocol (the “March Protocol”), the newest installment of ISDA’s well-tested mechanism aimed at facilitating the multilateral and standardized amendment of swap trading documentation.

Why Do Family Firms Thrive? by Chris MacDonald in the Business Ethics Blog

The family in question may have not just a strong position in terms of the stock it holds; they may also bear the name that’s emblazoned on the company letterhead. And the company’s origins and evolution may be intimately bound up with the family’s own history. This adds up to considerable influence. Is that influence a good or a bad thing? In principle, at least, there’s a worry that the family’s influence might not always work in the interests of other shareholders. And this worry is exacerbated by the fact that family-controlled companies often don’t stick to widely-acknowledged best practices in terms of corporate governance.

Crisis Chronicles: 300 Years of Financial Crises (1620–1920) by James Narron and David Skeie in Liberty Street Economics

The Kipper und Wipperzeit is the common name for the economic crisis caused by the rapid debasement of subsidiary, or small-denomination, coin by Holy Roman Empire states in their efforts to finance the Thirty Years’ War (1618–48). In a 1991 article, Charles Kindleberger—author of the earlier work Manias, Panics and Crashes and originally a Fed economist—offered a fascinating account of the causes and consequences of the 1619–23 crisis. Kipper refers to coin clipping and Wipperzeit refers to a see-saw (an allusion to the counterbalance scales used to weigh species coin). Despite the clever name, two forms of debasement actually fueled the crisis.

 

Brick Wall by Aaron Smith

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.

Sources:

Image of the US Supreme Court by OZinOH

LRN’s 2013 Ethics & Compliance Leadership Survey Report

lrn logo

LRN’s has published its 2013 Ethics & Compliance Leadership Survey Report. This sixth annual Ethics & Compliance Leadership Survey Report provides guidance and specific recommendations on critical risks and challenges. The report is based on a survey of more than 180 ethics and compliance leaders from across industries and geographies.

This year’s report has a new metric: the Program Effectiveness Index (PEI). The US Sentencing Guidelines, the UK Bribery Act, regulators, and law enforcement all talk about having an effective compliance program. LRN looks at three major roles to address the Program Effectiveness Index:

  1. a network of corporate controls
  2. facilitator of business operations in regulated contexts
  3. promotion of ethical conduct and culture

At first I was startled to see the Program Effectiveness Index measured on a scale from 0-1. I forgot about decimal points for a moment. In its survey, LRN reports an average PEI score of  0.71, with the scores distributed across a typical bell curve. The highest score was a 0.98 and the lowest was a 0.23.

The report highlights five attributes that distinguish the most effective ethics and compliance programs from the least:

  1. Celebration of acts of ethical leadership
  2. Adapting program to changing business needs
  3. Focus on employees as a key element of risk assessment
  4. Access to and support of senior management
  5. Management’s use of risk data in decision-making

The survey respondents consisted of 11% financial services and 10% insurance, with the rest covering a broad spectrum of industries. The report does not dovetail neatly with the needs of a private fund manager.  Of course it is always useful to see what others are doing with their programs, not just your peers.

Small Business Capital Access and Job Preservation Act

Capitol Hill

Congress, or at least the the House Financial Services Committee, is proposing some relief for private equity funds. The Committee approved the Small Business Capital Access and Job Preservation Act, along with three other pieces of legislation.

The bill would exempt private equity fund managers from the registration and reporting requirements of the Investment Adviser Act. The big hurdle in the bill for the exemption is that the fund has not borrowed a principal amount in excess of twice its invested capital commitments.

That’s a terrible standard. In the early days of a fund, it may draw down on its subscription line of credit for fees and expenses before it invests its first dollar in a transaction. That means the fund will have borrowed more than twice its “invested” capital. Many private equity funds would not be able to pass this test. Dropping the word “invested” would make the exemption useful.

The other big hurdle missing in the bill is the definition of private equity. The bill leaves it up to the Securities and Exchange Commission to define a private equity fund for purposes of the bill. The bill gives the SEC 6 months to craft the definition.

The bill is notable, but I suspect it has little chance of becoming law.


Sources: