SEC Clears the Way For Intra-State Crowdfunding

Most states have passed crowdfunding laws. One of the barriers has been the breadth of the federal preemption of interstate securities transactions. To be intra-state, and therefore out of the jurisdiction of the Securities and Exchange Commission, the investors and the company doing the fundraising needed to all be in the same state. The problem is the widespread use of Delaware as a state of organization. That puts the company in Delaware, while the operations and investors are in another state.

Crowdfunding

It was good to see states experimenting with crowdfunding. The SEC regulations of equity crowdfunding have proven to be difficult. Now the SEC has cleared the way for a broader definition of intra-state.

For example, the Massachusetts crowdfunding regulation, 950 CMR 14.402(B)(13)(o), required the issuer to have its principal place of business in Massachusetts and to be formed in Massachusetts.

The adopted a new Rule 147A  and amendments to Rule 147 to address the crowdfunding limitations. The SEC had adopted Rule 147 in 1974 as a safe harbor to a statutory intrastate exemption under Section 3(a)(11) of the Securities Act of 1933.

The new Rule 147A has changed the requirement so that the issuer merely has to have its “principal place of business” in that state and satisfy at least one “doing business” requirement to demonstrate the in-state nature of the issuer’s business.

Of course, the SEC does not make intra-state crowdfunding legal. It’s subject to state regulatory requirements. Massachusetts, and most states, will need to revise their crowdfunding laws to open up to these broader rules.

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CCO Needs To Be a Jack of All Trades

Andrew Donahue, the Chief of Staff of the Securities and Exchange Commission gave a speech earlier this month to the National Society of Compliance Professionals National Conference. He was attempting to share his thoughts on the current and future challenges that compliance professionals in the financial services area face.

He envisions that CCOs will need to be a “jack of all trades with access to a wide array of skillsets.”

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In the past, compliance merely required an expertise in the applicable laws and regulations.

Now it requires expertise in technology, operations, market, risk, and auditing. Firms are changing rapidly, and markets are rapidly evolving and regulations are only getting more voluminous. Mr. Donahue points out that staying up to date is one of the biggest challenges for complaince professionals.

“It is critical that you make it a priority to develop the necessary technical expertise, keep up with changing market dynamics, fully appreciate all of the firm’s businesses and follow regulatory developments and their impact on your firm and its operations.”

I fear that Mr. Donahue should remember, and compliance professionals shoudl strive to avoid, the second half of the phrase: Jack of all trades and master of none.

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Co-Investments and the SEC

Last year, regulators from the Securities and Exchange Commission raised concern about co-investments. The statements were vague about what was bothering the regulators.

Co-investments allow a private equity to lower its exposure to an investment and give others an opportunity to invest along side the fund at a discounted rate. It can be an opportunity to lure investors into the fund by granting them preferential treatment to co-investments. This would lower the effective management fee costs the investor pays to the manager.

Many fund investor are interested, but its hard to spread the opportunities equally out to all of those interested. Splitting the co-investment equally will result in opportunities being so small per investor that it’s not worth the time, effort and money.

The biggest concern for fund managers is execution. It takes a great deal of effort to put the capital stack together for an acquisition. The fund manager needs a potential co-investor to be able to act quickly and decisively.

From the SEC’s perspective, I assume examiners would not be happy to find fund managers dangling the possibility of co-investments as an incentive for an investor to commit to the fund and then not actually offering co-investments to that investor.

Fund managers need to be honest with investors and let them know where they stand in line for co-investments. If a fund manager has offered priority co-investment rights to certain investors, the manager disclose this.

The other concern of regulators and one which should be a concern is allocating deal costs. If the deal goes ahead, co-investors should pay their portion of the deal costs. Last year, the SEC raised concerns about broken deal costs when co-investments are used on a regular basis. The SEC felt that not all of the broken deal costs should be paid by the fund when co-investments were a routine part of the investing strategy.

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When Does A Stock Picking Contest Turn Into a Derivative

Forcerank’s premise was simple: “fantasy sports for stocks”.

Forcerank runs mobile phone games where players predict the order in which stocks would perform relative to each other.  In its original form, if a player did well he or she won points and could some receive a cash prize. Forcerank kept 10 percent of the entry fees.

The gaming is a ruse to collect data. Forcerank iss looking to obtain data about market expectations that it hopes to sell to hedge funds and other investors.

forcerank

It seems clear to me that Forcerank was concerned about the gambling aspect of the app. There was a provision in the rules the stated the Forcerank contest was a “skill based” contest. If it were not skill-based (i.e luck) then it would be gambling. You pay an entry fee and if you win you get a prize. If winning is based on luck it’s gambling.

The Securities and Exchange Commission looked at the Forcerank contest in a different light.

Dodd-Frank gave the SEC new powers to regulate security-based swaps.

The Commodity Exchange Act defines the term “swap”:

“[T]he term ‘swap’ [includes] any agreement, contract, or transaction—… (ii) that provides for any purchase, sale, payment, or delivery (other than a dividend on an equity security) that is dependent on the occurrence, nonoccurrence, or the extent of the occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence[.]”

That’s a very broad definition. It was a definition that the SEC applied to the Forcerank contests.

[E]ach Forcerank entry was a swap because each participant paid to enter into an agreement with Forcerank LLC that provided for the payment of points and, in certain cases, cash. Those payments were dependent upon the occurrence, or the extent of the occurrence, of an event or contingency (i.e., the player’s predictions about the price performance of individual securities being compared to actual performance and the player’s aggregate points being compared to other players). Such event or contingency was “associated with a potential financial, economic or commercial consequence” because it was calculated by measuring the change in the market price of an individual security over a period of time and comparing that change to an identical metric based on the market price of other individual securities.

I find this an interesting roadblock to stock-picking contests.

I looked at the Forcerank website and downloaded the app. There is no longer an entry fee and there are no cash prizes. That removes it from the definition of “derivative”. It also removes the incentive to enter the contest and the revenue stream from Forcerank.

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The SEC’s Pay-to-Play Rule and California Labor Law

Keith Bishop chimed in on Campaign Contributions and the SEC in the context of California law: Pay-To-Play Meets The California Labor Code at the California Corporate & Securities Law blog.

He point to  California Labor Code:

Section 1101.
No employer shall make, adopt, or enforce any rule, regulation, or policy:

(a) Forbidding or preventing employees from engaging or participating in politics or from becoming candidates for public office.
(b) Controlling or directing, or tending to control or direct the political activities or affiliations of employees.

Section 1102.
No employer shall coerce or influence or attempt to coerce or influence his employees through or by means of threat of discharge or loss of employment to adopt or follow or refrain from adopting or following any particular course or line of political action or political activity.

Obviously there is some conflict from the face of the code with SEC Rule 206(4)-5 that limits certain employees of registered investment advisers from making campaign contributions to certain elected officials.

You may disagree with the rulings, but political campaign contributions are considered political activities. The SEC rule therefore limits political activities.

That puts the CCO of a registered investment adviser in a precarious position. On the one hand, violating the SEC rule could result in the loss of a great deal of money for the adviser.  On the other hand the CCO’s policy may be violation of California law.

Mr. Bishop cites Couch v. Morgan Stanley & Co., a 2016 federal court decision that looked at those sections of the California Labor Code. That court found that it was okay to fire someone for legitimate, non-political reason even though the underlying action was related to political activity. In that case, Mr. Couch was elected to the county board of supervisors. Morgan Stanley told him he could not hold both jobs based on time constraints.

I suppose that helps a bit. The limit on campaign contributions is set by a federal agency, not an employer made rule. It’s not the employer imposed rule. The rule is non-political in that, on its face, it does not apply to a political position, but to a political office.

One problem is the perception cast by advisers who want to do business with Indiana. They are telling their employees that donations to the Republican presidential candidates are limited, but there are no limits on the other candidates. It’s to meet the standards of the rule, but comes across as very political.

Of course that does leave the problem of how to implement the rule and Goldman Sachs’ implementation of the rule. Goldman banned contributions. That seems to be more than required by the federal rule and could be seen as unduly limiting the employee’s activities.

I know many advisers have taken the same position as Goldman Sachs and banned all political contributions by all employees. The intricacies of the SEC rule make anything more tough to manage. Others have pointed out that such a position may be in conflict with California law. Thanks to Mr. Bishop for pointing out the law on the issue.

Post Debate Campaign Contributions and the SEC

With the first of the presidential debates over, I thought it would be a good time to refresh myself on the SEC’s limits on political campaign donations by investment advisers. SEC Rule 206(4)-5 was put in place to limit political influence on government pension plan investment choices.

candidates

Under the rule:

1. All political campaign contributions should be reported.
2. Employees can contribute up to $150 to any candidate.
3. Employees can contribute a larger amount to certain candidates after checking make sure it does not violate the SEC rule.

Number three is the tricky part.

SEC regulations limit the ability of certain employees at an investment adviser from donating to candidates who could influence the decision-making of a state or local government retirement plans if you want that plan as a fee paying client.

You need to figure out which employees are subject to the rule. That’s what led to Goldman Sachs banning all contributions by the firm’s partners. The rule is unclear on which employees of an adviser are subject to the limitation. It’s clear that the very top and fundraisers are included. It’s clear that administrative staff are excluded. Then there are a lot employees in the grey area.

Then you need to figure out which political offices actually influence the decision-making of state or local pension funds. In most states that is the political offices appoint officers or trustees to the state fund’s board. Generally, that sweeps up the governor and treasurer. Good luck figuring out how that works with local boards.

You get really tough ones like Pennsylvania State Employees’ Retirement System. Two members are appointed by the President Pro Tempore of the Pennsylvania Senate and two members are appointed by the Speaker of the Pennsylvania House of Representatives. Those positions are voted on by the Senators and Representatives, not the general public. So I think every state Senator and Representative in Pennsylvania is affected by this rule since any of them could end up in that position.

Back to the major party presidential candidates and the Rule’s impact:

Clinton – Kaine: Neither of them are in an office that would be limited by the SEC rule.

Trump-Pence: Because Mr. Pence is the governor of Indiana, contributions to this campaign are limited by the SEC.

For those of you looking further down the ballot:

Johnson-Weld (Libertarian Party): Neither is currently in an elected office so contributions are not limited. Both were governors and would have been limited in those offices.

Stein-Baraka (Green Party): Neither is currently in an elected office so contributions are not limited.

Castle-Bradley (Constitution Party): Neither is currently in an elected office so contributions are not limited.

The effect of SEC Rule 206(4)-5 is to limit donations to the Trump campaign. CCOs across the country are telling their employees they can contribute fully to the Clinton-Kaine ticket but are limited in donating to the Trump-Pence ticket.

Personal Benefit in Insider Trading

While Mr. Cooperman was accused of making millions on insider trading. Sheren Tsai made $23,914.41 on her illegal trades. The relatively small amount of the gains caught my eye in the press release, but a particular line in the pleadings made me think it was worth highlighting.

Ms. Tsai was (is?) in a romantic relationship with Colin Whelehan.  Both worked at different investment advisory firms. Mr. Whelehan was involved in a significant corporate event. He told this material non-public information to Ms. Tsai. She bought stock in the target company and made the above-mentioned $23,914.41 in profits.

The pleading that caught my eye was the statement about personal benefit:

“25. As a result of his tip, Whelehan received a personal benefit in the form ova gift to his closest personal friend, his live-in girlfriend and romantic partner, Tsai.”

Clearly, the SEC is trying to sort the law out in the post-Newman world.

Then there is the insider trading catch.

Ms. Tsai’s compliance group noticed the trades in her account. Clearly it looked strange to have the purchase so close to the announcement and spike in price. Most insider trading platforms will flag that trade.

The compliance group also had Ms. Tsai’s emails. Mr. Whelehan had sent an email from his work email to her work email  writing in part:

“one of Apollo’s portfolio companies would be buying out ADT.”

Ms. Tsai later sent a message using her work email

“So when is it [target’s stock price] going to BOUNCE”

Both had compliance training and knew about insider trading. They are caught as about red-handed as you can get for insider trading.

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Is Cooperman The New Cuban?

The Securities and Exchange Commission brought charges against Mark Cuban for insider trading. The SEC claimed he was an insider based his status as a big shareholder in the company or that he had agreed to not trade on material non-public information disclosed to him.

The SEC brought charges against Leon Cooperman for trading on material non-public information. The SEC is alleging that Cooperman used his status as a big shareholder in Altas Pipeline Partners to obtain confidential details about an upcoming company transaction.

According to the SEC complaint, an executive at Atlas Pipeline shared confidential information with Cooperman believing he would keep in confidential and not trade on that information. That seems a lot like the Cuban facts.

The SEC alleges that the Cooperman explicitly agreed to not use the information to trade. Going back to the Cuban case, he never agreed to keep the information confidential.

The trading activity outlined in the SEC order shows Cooperman making a huge bet on Atlas Pipeline. At one point his activity was 95% of the daily volume of trading on a set of Atlas Pipeline call options.

It looks there was a parallel action of criminal charges. But the Newman case from the Second U.S. Circuit Court of Appeals sets a standard that a recipient of an inside tip must know the confidential information came from an insider and that the insider disclosed the information for a personal benefit.

The Salman case is before the Supreme Court and is looking at the Newman standard for criminal insider trading.  If that standard is upheld, it seems unlikely that Cooperman would be in an orange jumpsuit. According to reports, the DOJ has suspended its investigation into Cooperman until the Salman case is decided.

The civil charges from the SEC is based on misappropriation so it does not need to prove that the tippee received a benefit.

It seems like the case will hinge on the credibility of the Atlas Pipeline executive. That executive is not named in the complaint.

Assuming the SEC case passes the credibility standard, it will need to prove the legal standard that Cooperman’s trading should be illegal.

Given the recent history of the SEC bringing cases in front of its own administrative judges, this case was filed in federal district court.

I see two likely reasons. Cooperman demanded this venue in exchange for agreeing to the tolling of the statue of limitations. (The trading happened in 2010.) Or, the SEC is looking to set legal precedent.

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Compliance Bricks and Mortar for September 23

We have passed the Autumnal equinox and are heading into the dark nights of winter. Maybe some of these of compliance-related stories will keep you awake during the longer nights.

Bricks Boston 1

Why Don’t General Counsels Stop Corporate Crime? by Sureyya Burcu Avci and H. Nejat Seyhun in the HLS Forum on Corporate Governance and Financial Regulation

Evidence shows that in spite of these reforms enacted in SOX and explicit provisions and responsibilities given to corporate attorneys, most of the whistle-blowing in case of corporate fraud comes from employees (17%), non-financial market regulators (13%), and media (13%). [3] Clearly absent from this list are top in-house corporate counsels (GCs). In this paper, we investigate the potential reasons for the failure of corporate counsels to report and prevent corporate crime. [More…]

Ex-official at SEC says whistleblowers do crucial work by Gretchen Morgenson

McKessy said that whistleblowers under the SEC’s program had prospered because the SEC guaranteed anonymity to those who come forward. “The SEC’s devotion to maintaining the confidentiality of whistleblowers is the biggest factor in the program’s success,” he said. [More…]

SEC delivering on promise to scrutinize private equity firms by Todd Ehret, Regulatory Intelligence in Reuters

Assets under management by PE managers grew to $700 billion in 2000 thanks to the technology and dot-com boom. They have now swelled to more than $4.2 trillion according to the 2016 Preqin Private Equity Report. This tremendous growth in assets now dwarfs total hedge fund assets of approximately $2.8 trillion.

This industry largely went unregulated until the passage of the Dodd-Frank Act in 2010 which required PE and hedge fund managers to register by 2012. Two recently settled enforcement actions involving prominent PE firms added to the growing list of PE managers tripped up by the U.S. Securities and Exchange Commission’s (SEC) probe into PE firms. This, along with a handful of other expensive SEC settlements, and prominent public warnings by regulators to the industry are noteworthy and prompted our review below. We also highlight the top areas of concern and offer some suggestions. [More…]

Andrew Weissmann On The FCPA – It Is “Very Easy For The People At The DOJ And SEC To Basically Impose A Tax For Doing Business” In Certain Countries by the FCPA Professor

FCPA Professor was the first to highlight the seeming irony when vocal FCPA enforcement critic and reform advocate Andrew Weissmann was selected to head the DOJ’s fraud section in January 2015 and how Weissmann should have stayed true to his former self when unveiling the DOJ’s “FCPA Pilot Program” in April 2016.

Weissmann’s prior positions on the FCPA are nicely captured in a 2010 panel event in which he speaks at great length regarding various aspects of the FCPA. [More…]

 

Auditor Independence Enforcement Actions

The Securities and Exchange Commission announced its first enforcement actions for auditor independence failures. I expect your auditors may have a bunch of new restrictions and questionnaires when it is time for the annual audit.

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The SEC announced two separate enforcement actions, both involving Ernst & Young.

In one case, Gregory S. Bednar got too cozy with a audit client’s CFO. Bednar and the CFO stayed overnight at each other’s homes, took family trips together and they exchanged hundreds of personal messages.

In the other case, Pamela Hartford violated the auditor independence rule by having a romantic relationship with an executive at an audit client.

According to the SEC’s orders, Ernst & Young required audit engagement teams to follow certain procedures to assess their independence. They asked employees if they had family, employment, or financial relationships with audit clients that could raise independence concerns.  The SEC says that is not enough. Apparently the SEC is expecting a broader question about “non-familial close personal relationships” that could impair the audit firm’s independence.

Ernst & Young’s independence policies “recognized that a non-familial close personal relationship between an engagement team member and a client employee in an accounting or financial reporting oversight role could present an independence problem”.  But the firm had no procedures to identify those relationships and whether a relationship could jeopardize independence.

I expect that audit firms are going to broaden their independence questionnaires. I expect some of the questions and responses could be quite awkward.

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