Filing Private Fund Private Placement Memoranda with FINRA

Starting on December 3, 2012, FINRA members must file 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. Placement agents for private funds will likely be FINRA members and subject to this rule.

FINRA Rule 5123 is part of FINRA’s approach to increase oversight and investor protection in private placements. FINRA established standards on disclosure, use of proceeds and a filing requirement for private placements issued by a member firm or a control entity in Rule 5122. FINRA also has previously provided guidance on the scope of a firm’s responsibility to conduct a reasonable investigation of private placement issuers in Regulatory Notice 10-22.

However, the rule has some big exemptions. The following private placements are exempt from the requirements of this Rule:

(1) offerings sold by the member or person associated with the member solely
to any one or more of the following:

(A) institutional accounts, as defined in Rule 4512(c);
(B) qualified purchasers, as defined in Section 2(a)(51)(A) of the Investment Company Act;
(C) qualified institutional buyers, as defined in Securities Act Rule 144A;
(D) investment companies, as defined in Section 3 of the Investment Company Act;
(E) an entity composed exclusively of qualified institutional buyers, as defined in Securities Act Rule 144A;
(F) banks, as defined in Section 3(a)(2) of the Securities Act;
(G) employees and affiliates, as defined in Rule 5121, of the issuer;
(H) knowledgeable employees as defined in Investment Company Act Rule 3c-5;
(I) eligible contract participants, as defined in Section 3(a)(65) of the Exchange Act; and
(J) accredited investors described in Securities Act Rule 501(a)(1), (2), (3) or (7).

That list is likely going to mean that private fund offering will not be subject to the rule as long as they exclude non-accredited investors from the offering. Or at least exclude the placement agent from soliciting non-accredited investors. Given the likely lifting of the ban on general solicitation for private funds that exclude non-accredited investors this rule is likely to further limit the access of non-accredited investors to private funds.

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Compliance Bits and Pieces for October 19

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

Frankenstein, Lance Armstrong and FCPA/Bribery Act Compliance by Tom Fox

So how does Frankenstein relate to compliance and ethics? Exhibit A for today is my fellow Texan Lance Armstrong. Yesterday, in the FCPA Blog I wrote about Armstrong and ethical values in the context of engaging in conduct which is so unethical, that you would be embarrassed to tell your children about it. Today I want to focus on some other aspects of Armstrong. Should he be analogized to Dr. Frankenstein, the Monster, or perhaps both?

Schapiro SEC Reign Nears End With Rescue Mission Not Done by Joshua Gallu and Robert Schmidt in Bloomberg

It’s not surprising that Schapiro’s frustrations boiled over that August evening. She has told friends that the late nights and almost constant policy battles have left her exhausted and eager to depart after the November election. Admirers and critics agree Schapiro rescued the agency from the threat of extinction when she was appointed by President Barack Obama four years ago. Still, she hasn’t fulfilled her mission — to overcome the SEC’s image as a failed watchdog by punishing those who steered the financial system toward disaster and by proving regulators can head off future breakdowns.

SEC Examinations of Investment Advisers – Highlights of IAA 2012 Boston Compliance Workshop in Compliance Avenue

At an Investment Adviser Association (IAA) 2012 Compliance Workshop in Boston yesterday, IAA legal staff, law firm attorneys and Securities Exchange Commission (SEC) staff, including a regional representative from the SEC’s Office of Compliance Inspections and Examinations, discussed current developments in SEC exams, including current inspection priorities and issues for advisers to consider. As noted by each speaker from the SEC, their statements are their own views and not necessarily those of the SEC.

This post provides highlights of the discussions about 2012 SEC examinations, the new SEC “presence” examinations for newly-registered investment advisers and the anticipated focus of SEC investment adviser examinations in 2013.

Caution Advised for Newly Registered Advisers a client alert from Pepper Hamilton LLP

In addition, the SEC examination staff has indicated that meeting with the firm’s “leadership” during an examination is likely to be of special importance. The SEC examination staff views effective risk governance as including the following three essential lines of defense, which are in turn supported by senior management and the board of directors or the principal owners of the firm:

(1) The business is the first line of defense responsible for taking, managing and supervising risk effectively and in accordance with laws, regulations and the risk appetite set by the board and senior management of the whole organization.

(2) Key support functions, such as compliance and ethics or risk management, are the second line of defense. They need to have adequate resources, independence, standing and authority to implement effective programs and objectively monitor and escalate risk issues.

(3) Internal audit is the third line of defense and is responsible for providing independent verification and assurance that controls are in place and operating effectively.

FDIC Insurance End May Spark Money-Market Turbulence, Pimco Says by Liz Capo McCormick in Bloomberg

A potential flood of cash into the U.S. money markets if unlimited Federal Deposit Insurance Corp. coverage is allowed to lapse in December is creating investor concern and may lower short-term interest rates, according Pacific Investment Management Co. An emergency 2008 government provision providing unlimited insurance on certain bank accounts during the U.S. financial crisis to help prevent sudden withdrawals will expire at the end of the year unless Congress extends it. There is about $1.4 trillion sitting in banks’ non-interest-bearing transactions accounts holding more than $250,000, the previous insurance ceiling, which would become uninsured in January if Congress doesn’t act, FDIC data show.

Aberrational Performance Inquiry of Nabs Another Private Fund Manager

The SEC has once again claimed that its Aberrational Performance Inquiry has identified another miscreant. Once again, I’m skeptical that the SEC is actually using “proprietary risk analytics” to identify hedge funds with suspicious returns.

The SEC alleges that Yorkville Advisors overstated the value of the assets in its funds to improve marketability and increase fees. According to the SEC complaint, the failure was two-pronged: one of misstatements and a second failure to follow the funds’ own policies and procedures on valuation. Yorkville denies the charges. Yorkville claims to have maintained “robust control procedures” to ensure that assets were valued properly, including having two former SEC enforcement lawyers as members of Yorkville’s valuation committee.

The lesson from the complaint is to follow your own policies and procedures when it comes to valuation and don’t hide information from your auditors.

According to the SEC press release, this is the seventh case arising from the “SEC’s Aberrational Performance Inquiry, an initiative by the Enforcement Division’s Asset Management Unit that uses proprietary risk analytics to identify hedge funds with suspicious returns.” I have seen four other cases, but I’m not sure I can identify the other two cases.

Robert Khuzami, the Director of the Division of Enforcement for the SEC revealed an investigative initiative concerning hedge funds during Congressional testimony in March, 2011.  The Aberrational Performance Inquiry program is now focusing on hedge funds that outperform “market indexes by 3% and [are] doing it on a steady basis.”  Khuzami referred to such performance as “aberrational,” and stated that Enforcement is “canvassing all hedge funds” for such “aberrational performance.

Yorkville disclosed that the SEC started looking at it in August, 2009. That’s almost two years before the Aberrational Performance Inquiry program was announced and only six months after Khuzami joined the SEC. That timing leaves me skeptical that the Aberrational Performance Inquiry program discovered the issues with Yorkville. In addition, Yorkville made investments in equities and debt so there is not a good index to benchmark the funds’ performance to determine if it is “aberrational.”

I have no doubt that the SEC is looking closer at the performance of private funds to see if the performance numbers make sense given the markets and a fund’s investment strategy. That is a direct result of the aberrations in Madoff’s performance.  And I have no doubt that there is group in the SEC looking at performance and worked on the Yorkville case.

And I have no doubt that the SEC is taking a closer at private equity funds and hedge funds. At a minimum, the SEC has a window into these fund now that fund managers have registered with the SEC.

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A CFTC Exemption for Private Equity Funds

The CFTC is going to dramatically expand its realm through the one-two punch of gaining regulatory control over non-securities derivatives and the removal of a widely used exemption. (With the release of REITs from the definition of “commodity pool” perhaps the CFTC is loosening its grip.) Fortunately, there is another exemption that most private equity funds will be able to utilize. But it requires some math.

CFTC Regulation 4.13(a)(3) contains a “De Minimis Exemption.” To take advantage of the exemption a fund must satisfy these requirements:

  1.  The Funds is exempt from registration under the Securities Act of 1933 and offered without marketing to the public in the U.S.
  2.  The CPO has a reasonable belief that investors are “accredited investors”, “knowledgeable employees” or “qualified eligible persons”.
  3. The fund discloses to each prospective investor in the Commodity Pool that the CPO is exempt from registration under the De Minimis Exemption and therefore, unlike a registered CPO, is not required to deliver a disclosure document or a certified annual report to investors.
  4. File an initial notice of claim with the National Futures Association, and renew on an annual basis.
  5. One of two trading tests must be met:
  • 5% cost: the aggregate initial margin, premiums, and required minimum security deposit for retail forex transactions required to establish commodity interest positions (including securities futures positions), determined at the time the most recent position was established, will not exceed 5 percent of the liquidation value of the pool’s portfolio, after taking into account unrealized profits and unrealized losses on any such positions it has entered into; or
  • 100% value: the aggregate net notional value of such positions, determined at the time the most recent position was established, does not exceed 100 percent of the liquidation value of the pool’s portfolio, after taking into account unrealized profits and unrealized losses on any such positions it has entered into.

What’s not clear to me is how portfolio companies and subsidiaries fit into the tests. I assume you would treat a wholly-owned subsidiary as you would treat fund -level activity. At some point the fund’s ownership in an entity should remove it from being part of the fund level calculation. I just have not dived deep enough into the CFTC world to figure out where that threshold is.

For private equity funds and real estate funds, the 100% test may be close depending on the type of leverage used and the risk mitigation used. However, the 5% cost should be easy. Interest rate swaps and foreign exchange hedge are usually very cheap, less than 5% of the nominal value of the hedge.

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REITs and the CFTC

Dodd-Frank’s Title VII is likely to sweep a bunch of private equity fund operators under the CFTC’s registration requirement. The CFTC stated that a single interest rate swap or foreign exchange hedge could drag the fund manager into the definition of “Commodity Pool Operator” (7 USC §1a(10) and have to register with the CFTC. The National Association of Real Estate Investment Trusts was also concerned the equity REITs that use interest rate hedges could be considered a commodity pool.

The CFTC released an interpretative letter releasing REITs from the grasps of the CFTC. The CFTC agrees with the NAREIT position that REITs are operating companies and are therefore not commodity pools.

But will this interpretative letter help real estate private equity funds? Most real estate private equity funds have a REIT somewhere in their structure, so the letter offers some benefit.

The CFTC notes that equity REITs are, in part, operating companies because they engage in substantial management and operational function. (Check for real estate funds.)

Equity REITs use derivatives is limited to supporting its primary focus on real estate ownership and operation. (Check for real estate funds.)

The CFTC list three criteria for this relief:

  • The REIT primarily derives its income from the ownership and management of real estate and uses derivatives for the limited purpose of “mitigat[ing] their exposure to changes in interest rates or fluctuations in currency”;
  • The REIT is operated so as to comply with all of the requirements of a REIT election under the Internal Revenue Code, including 26 U.S.C. §856(c)(2) (the 75 percent test) and 26 U.S.C. §856(c)(3) (the 95 percent test); and
  • The REIT has identified itself as an equity REIT in Item G of its last U.S. income tax return on Form 1120-REIT and continues to qualify as such, or, if the REIT has not yet filed its first tax filing with the Internal Revenue Service, the REIT has stated its intention to do so to its participants and effectuates its stated intention.

I’m not yet sure if this gets a real estate fund all the way out of CFTC registration. I think there will be more to come.

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First the SEC, Now the CFTC

The Dodd-Frank Wall Street Reform and Consumer Protection Act is getting ready to land its second regulatory punch to private equity funds. The first was the registration requirement with the Securities and Exchange Commission. The second is the upcoming registration requirement with the Commodities Futures Trading Commission.

Two recent developments pull fund managers into the CFTC’s world. The first is the inclusion of interest rate and foreign exchange swap transactions into the regulatory oversight of the CFTC. That’s part of the Dodd-Frank regulation of derivatives. The second is the repeal of a popular exemption from registration. That exemption was available for funds that were limited to investors that were accredited investors and qualified eligible persons. That exemption will cease to be available after December 31, 2012.

Title VII (the “Derivatives Act”) of Dodd-Frank creates a new framework for regulating derivatives. Securities derivatives get SEC oversight, but non-securities derivatives get CFTC oversight.

Under the Commodity Exchange Act, as amended by the Derivatives Act, swaps are now considered “commodity interests” and need to be considered when determining whether an entity is a “commodity pool” and whether the operator or adviser to the entity is a Commodity Pool Operator or Commodity Trading Advisor.

  • A “Commodity Pool” is “any investment trust, syndicate, or similar form of enterprise operated for the purpose of trading in commodity interests, including any… commodity for future delivery, security futures product, or swap. . .””
  • A “Commodity Pool Operator” (a “CPO”) is any person “engaged in a business that is of the nature of a commodity pool…and who, in connection therewith, solicits, accepts or receives from others, funds, securities or property. . .for the purpose of trading in commodity interests, including any… commodity for future delivery, security futures product or swap. . .”
  • A “Commodity Trading Advisor” (a “CTA”) is any person “who, for compensation or profit, engages in the business of advising others. . . as to the value of or advisability of trading in… any contract of sale of a commodity for future delivery, security futures product, or swap . . .””

I don’t think most private equity funds would consider themselves to be “trading” in commodity interests. However, the CFTC release indicates that entering into a single commodity interest transaction would be sufficient to cause a fund to be a Commodity Pool. So, a fund that enters into a single interest rate hedge could be treated as a Commodity Pool and the adviser of the fund would have to register as a CPO or CTA, or establish an available exemption.

I would guess that the CFTC will have a few thousand new registrants by the end of the year. Fortunately, there is another exemption that should allow many funds to avoid the full regulatory oversight of the CFTC. More on that later.

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Cycling and Compliance

During the summer of 2001, Mrs. Doug was stuck on the couch recovering from knee surgery. She stumbled across the coverage of the Tour de France, and especially Lance Armstrong, on the Outdoor Life Network. We were hooked, and ever since have been glued to the television during July to watch the beauty and competition of the Tour de France.

The US Postal Service team was a well run dynamo helping to support Lance Armstrong during his dominance of the race for seven years. It was clear that Mr. Armstrong trained harder and was more focused on winning than any of his competitors. Unfortunately, the evidence has become almost overwhelming that the US Postal Service team was involved in doping, including Mr. Armstrong.

Any fan of professional cycling knows that there is long history of drug abuse in the peleton. Many Tour de France riders had been subject to disciplinary action for doping. Only three of the podium finishers in the Tour de France from 1996 through 2005 have not been directly tied to likely doping through admission, sanctions, public investigation or exceeding the UCI hematocrit threshold.  The sole exceptions were Bobby Julich – third place in 1998, Fernando Escartin – third place in 1999, and Mr. Armstrong.

I always thought Mr. Armstrong was above this. After all, he fought cancer. He looked death in the eye and said he was not ready yet. There were rumors that Mr. Armstrong was doping. Most of those came from other rides with a grudge against him or were otherwise relatively unreliable.

The US Anti-Doping Agency released its report implicating the riders of the US Postal Service Team in wide spread doping. My heart was broken when two of my favorite riders George Hincapie and Levi Leipheimer admitted to doping.

Because of my love for the sport, the contributions I feel I have made to it, and the amount the sport of cycling has given to me over the years, it is extremely difficult today to acknowledge that during a part of my career I used banned substances. Early in my professional career, it became clear to me that, given the widespread use of performance enhancing drugs by cyclists at the top of the profession, it was not possible to compete at the highest level without them. I deeply regret that choice and sincerely apologize to my family, teammates and fans.

George Hincapie

The cycling team had a culture of doping, set with tone from the top to push your body with medical treatment to improve performance. I’m still sorting through the extensive material to find direct evidence of Mr. Armstrong’s doping. So far the evidence is fairly light about his use. However, the evidence of the USPS team’s acceptance of doping is overwhelming.

It seems that doping was widespread, but has since decreased since 2008. Jonathan Vaughters, a former USPS rider and self-admitted doper, offers decreased riding times as evidence of doping.

  • L’Alpe D’Huez
    • Fastest: 22.43 kph, 1,900 vertical meters per hour by Marco Pantani in 1997
    • Fastest since 2008: 19.98 kph, 1,670 vertical meters per hour by Carlos Sastre in 2008
  • Plateau De Beille
    • Fastest: 22 kph, 1,812 vertical meters per hour by Marco Pantani in 1998
    • Fastest since 2008: 20.57 kph, 1,678 vertical meters per hour by Jelle Vandenert in 2011
  • Fastest Grand Tour Climbing Rate
    • Fastest: 1,769 vertical meters per hour by Roberto Heras in 2004’s Vuelta a Espana
    • Fastest since 2008: 1,682 vertical meters per hour by Bradley Wiggins in 2012’s Tour de France

The data shows a 10% drop in average fastest times. This correlates to the 10% drop in hemoglobin rates reported by UCI doctors from 2007 until 2010.

Perhaps that still leaves us with Mr. Armstrong as the greatest rider of his time. He was competing against dopers, while probably doping himself. The playing field was level for the elite riders. It was just a medically elevated playing field.

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The New SEC Presence Exams


The Securities and Exchange Commission has started it Presence Exams process. I have copies of letters from the New York Regional Office and the Boston Regional Office. The Presence Exams is part of an initiative to conduct “focused, risk-based examinations of investment advisers to private funds that recently registered with the commission.”

The SEC has broken the Presence Exams initiative into three phases: Engagement, Examination, and Reporting. This matches up with the preview offered by Carlo di Florio at PEI’s Private Fund Compliance Forum.

I assume the letters are part of the engagement phase. They include a long list of reference materials about the Investment Advisers Act and compliance.

The SEC has broken the examination phase into 5 higher risk areas for review:

  • marketing
  • portfolio management
  • conflicts of interest
  • safety of client assets
  • valuation

I assume the other regional offices have sent out the same letter. Please let me know if your firm has received one and if it’s different from the New York or Boston letters. You can leave a comment or email to [email protected].

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Royalty Is Not Always a Foreign Official

I’m not quite sure how royalty works in various parts of the world. From the latest FCPA Opinion release, the parties to a business deal also did not fully understand. The proposed business relationship has some serious red flags so I’m not surprised the parties requested the opinion. According to the release, submission for a release was part of the contract.

The requestor was going to make payments to a member of the country’s royal family. (Red flag – But a key issue is whether he is Foreign Official.) The Royal Family Member was going to lobby his home country’s embassy to engage the requestor as the country’s lobbyist in the United States. (Lobbying the government = another red flag) The Royal Family Member would be working on a commission for 20% of what requestor receives for business. (red flag) The Royal Family Member can also identify other opportunities for the Requestor in the foreign country subject to a separate engagement. (red flag)

The whole opinion hinges on the definition of “Foreign Official” under the FCPA and whether the Royal Member falls under that definition. The FCPA defines a “foreign official” as

any officer or employee of a foreign government or any department, agency, or instrumentality thereof, . . . or any person acting in an official capacity for or on behalf of any such government or department, agency, or instrumentality . . . .

15 U.S.C. § 78dd-2(h)(2)(A)

The Department of Justice looks to FCPA Opinion Release 10-03 and United States v. Carson, et al., No. 09-cr-00077 (C.D. Cal. 2011) and distills the factors in those sources to three factors to determine whether a member of a royal family is a “foreign official”:

(i) how much control or influence the individual has over the levers of governmental power, execution, administration, finances, and the like;

(ii) whether a foreign government characterizes an individual or entity as having governmental power; and

(iii) whether and under what circumstances an individual (or entity) may act on behalf of, or bind, a government.

This royal family member:

  1. has no official or unofficial title or role in the Foreign Country’s government
  2. has no official or unofficial power over any aspect of the Foreign Country’s governmental decision-making process, executive function, administration, finance
  3. has no direct or indirect power to award the business the Requestor seeks
  4. cannot, by virtue of his membership in the royal family, ascend to a governmental position
  5. has no benefits or privileges because of his status as a Royal Family Member
  6. has no relationship—personal, professional, or familial—with the decision-makers in the Foreign Country’s Embassy and the Foreign Country’s government who will decide whether to award the business

As the FCPA Professor Mike Koehler points out, this opinion procedure release creates more uncertainty in the definition of a foreign official. Past advice has focused on the purpose of the payments and not just the mere status of the official. The Carson decision looks to the entity to determine if it is a government organization.

The facts and circumstances about the royal family member sound unique to me. (Again, pointing out that I don’t understand how the various royal family members related to their home countries.) We don’t know the foreign country based on the opinion release. It would seem based on points 4 and 5 that the royal family is largely ceremonial in the country and not in a position of power in the government. Otherwise, the royal family itself would be foreign government instrumentality.

There is new guidance expected this month from the DOJ and SEC that is meant to consolidate the advice given on the FCPA. Perhaps that will help clear up some of the confusion over who is a foreign official.

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Image is the Crown of Rus-Ukrania by Alexandr Synytsa

Whistleblower Only Has to Believe There is Something Wrong

Whistleblower rights are growing stronger. The recent award of a reward in excess of $100 million to a whistleblower will certainly attract those looking for financial reward. Dodd-Frank not only increased the chances of getting a reward, it also provided broader rights to employees and the courts are starting to rule strongly in favor of employees. A recent ruling highlights the new legal world of whistleblowers.

An employee wrote a letter to the Securities and Exchange Commission and reported that the company had failed to submit its 2009 amendment to the pension plan to its board of directors for approval and had failed to file its amendment with the SEC. The employee, Richard Kramer, was a human resources officer and member of the pension plan committee. Kramer had also told the company that there needed to be three member of the committee, not just the two in place at that time.

Kramer argues that as a result of his complaints, the company disciplined him, reduced his responsibilities, and eventually fired him.

The Dodd-Frank Act provides this protection against whistleblower retaliation:

No employer may discharge, demote, suspend, threaten, harass, directly or indirectly, or in any other manner discriminate against, a whistleblower in the terms and conditions of employment because of any lawful act done by the whistleblower —

(i) in providing information to the Commission in accordance with this section;
(ii) in initiating, testifying in, or assisting in any investigation or judicial or administrative action of the Commission based upon or related to such information; or
(iii) in making disclosures that are required or protected under the Sarbanes-Oxley Act of 2002, the Securities Exchange Act of 1934, including section 10A(m) of such Act, and any other law, rule, or regulation subject to the jurisdiction of the Commission.

A “whistleblower” is defined as “any individual who provides, or 2 or more individuals acting jointly who provide, information relating to a violation of the securities laws to the Commission, in a manner established, by rule or regulation, by the Commission.” 15 U.S.C. § 78u-6(a)(6)

The company first argues that Kramer is not a whsitleblower because he did not us the SEC’s new method of reporting on Form TCR. Mailing a regular letter is insufficient. The court did not believe that it is unambiguously clear that the Dodd-Frank Act’s whistleblower retaliation provision is limited to those individuals who have provided information relating to a securities violation to the SEC, and have done so in a manner established by the SEC. In the court’s view, the company’s interpretation would dramatically narrow the available protections available to potential whistleblowers. I suspect that the use of Form TCR will be required for whistleblower payouts, but not required for retaliation claims.

The company that argued that it had filed the form with the SEC on the date of the 2009 amendment to the plan. There was no securities law violation.

The court noted that in order to qualify for whistleblower protection the employee need only demonstrate that he reasonably believed there had been a violation. There need not be an actual violation of securities laws. The court found that the employee may have reasonably believed the company to be committing violations of SEC rules or regulations.

The ruling was just on the motion to dismiss and amend claims, so it is not over. It does appear to be the first Dodd-Frank whistleblower claim to survive a motion to dismiss in federal court.  I expect it will not be the last.

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