The Downside to Advertisement Restrictions

Going back over my notes in search of guidance on when advertising for a private equity firm is advertising restricted under the Investment Advisers Act and when it is advertising for the firm’s products and services, I’m left uncertain.
half-price advertisement

I was hoping that the gun jumping interpretations would offer some meaningful guidance. So far, I have not found much hope.

My concerns arose from some second-hand rumors about what the Securities and Exchange Commission has been attacking during examinations of private equity firms and real estate firms that are registered as investment advisers. One story was about a fund manager having to take down references to a real estate industry award on the firm’s website. The award sounded like one focused on real estate operations. Using my earlier standard, the award sounded like an award for making good soup not for having good securities.

That leaves real estate fund managers registered as investment advisers at a competitive disadvantage to real estate sponsors who are not registered as investment advisers. The public real estate companies have some guidance under Rule 168 and Rule 169 as to what is advertisement.

Registered real estate fund managers may have to operate in a gray area trying to decide when an advertisement is about the real estate soup. Otherwise they risk the vagaries of an SEC examiner deciding an advertisement violates the Investment Advisers Act.

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Gun Jumping

I began exploring the difference between advertising the soup and advertising the securities in yesterday’s post. That is, I looking for distinction between a private equity firm advertising in relation to its portfolio companies or real estate holdings, and advertising its performance as an investment adviser. Portfolio company advertising is outside the legal framework under the Investment Advisers Act restrictions on advertising.

half-price advertisement

I thought the gun-jumping rules under the Securities Act might provide a useful framework to help determine whether an ad is about the soup or about the securities.

The default would seem to be that any advertising by a firm could be considered an advertisement for the firm’s securities, depending on the facts and circumstance. The SEC has explained that

“the publication of information and publicity efforts, made in advance of a proposed financing which have the effect of conditioning the public mind or arousing public interest in the issuer or in its securities constitutes an offer . . .” Guidelines for the Release of Information by Issuers Whose Securities are in Registration, Release No. 33-5180 (Aug. 16, 1971) [36 FR 16506]

In the 2005 Securities Offering Reform, the SEC created safe harbors under Rule 168 and Rule 169 for factual business information, which included advertisements or information about a firm’s products or services. These rule reinforce the ability to advertise about the portfolio company or real estate as long as its not an advertisement about the investment adviser.

It would seem that a portfolio company’s advertisements that do not mention its private equity owner are perfectly okay. Once the private equity manager is mentioned, you need to make sure the advertisement is focused on the portfolio company and not the success of the registered private equity fund manager.

It’s harder to put this in the context of a registered real estate fund manager. Tenants have a keen interest in the owner of the real estate. They want to know that the landlord has the financial resources to keep the building running and to live up to its obligations under the lease.

There is surely a distinction to be made between a real estate fund manager as an operator of real estate and as an investment adviser. I’m still looking for some guidance.

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Publicity for Private Equity Funds

While looking through the various restrictions on advertising for investment advisers, I was  struck by how they fail to address the operations of private equity funds. The Securities and Exchange Commission effectively banned advertising by investment advisers for decades. As reality came, the SEC relented, subject to strict restrictions. In this post-Dodd-Frank world with private equity funds, the advertising restrictions are tough to navigate for private equity funds and their portfolio companies.

half-price advertisement

Private equity funds are dealing with two different regulatory schemes. The restrictions under the Investment Advisers Act apply all the time, while the restrictions under the Securities Act will apply during fundraising.

The issue is drawing the line between advertising for the fund manager and advertising for the portfolio company. The same is true for private equity real estate funds, in which case the real estate asset is the portfolio company.

A soup company should be able to advertise its soup. This should be true regardless of its ownership structure, whether it is a public company, a private company, or owned by a private equity fund. The soup company can only advertise securities issued by the company in accordance with the securities laws.

I have not found much in the Investment Advisers Act to address this circumstance. That the ownership of the soup company is controlled by an firm regulated under the Investment Advisers Act should not affect its ability to advertise soup.

If the soup is real estate, the firm should be able to advertise its buildings. The ownership structure of real estate should not affect its ability to let the general public that the building is for sale, that space is available or that some new renovations have transformed the building.

The problem begins when you try to draw the line between an advertising for the soup and an advertising for the securities. It’s not a bright line. I’m sure you can imagine ads all along the line going from soup to securities.

That has lead me to look at the SEC limitations around gun-jumping. Under Section 5(c) of the Securities Act, it’s unlawful to make solicitations or offers for the sale of securities prior to the filing of a registration statement. There is a large body of law on what constitutes pre-filing publicity. This is a large body of law in which I have no expertise.

I plan to spend the next few days exploring the area of gun-jumping to see if I can find some ways to determine when a private equity firm is advertising the soup or advertising the securities.

Veterans Day Compliance Bricks and Mortar

Please remember to those who have served in the armed forces for the sacrifices they have made.

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

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Donald Trump’s Transition Team: We Will ‘Dismantle’ Dodd-Frank in the Wall Street Journal

The brief note on Mr. Trump’s new website marked the first time since Tuesday’s election that the president-elect addressed financial regulatory policy. The statement was consistent with Mr. Trump’s campaign trail rhetoric, blaming the Obama administration’s signature response to the financial crisis for a tepid economy and promising to “replace it with new policies to encourage economic growth and job creation,” but providing few details. [More…]

When Compliance Counsel Speaks, CCOs Should Listen by Tom Fox in FCPA Compliance & Ethics

I was recently having breakfast with a colleague and we were discussing the Department of Justice’s (DOJ) Compliance Counsel Hui Chen and what we believe to be the positive impact she has had on the compliance community, compliance programs and the role of the Chief Compliance Officer (CCO). I told him about some of her public remarks about what constitutes an effective compliance program.  [More…]

Five Post-Election Points for CCOs to Ponder by Matt Kelly in Radical Compliance

Well, the American people, in their endless wisdom or lack thereof, elected Donald Trump to the White House and gave us a Congress even more deeply divided than before.

The post-mortems on what happened last night and what it means for the country will be many, and last for months. Compliance officers can get started with a few items that should be on your radar screen today.

Key Lawmakers are gone, or busy [More…]

Here’s How the SEC Is Using Big Data to Catch Insider Trading in Reuters

Formed in 2010, the Analysis and Detection Center of the SEC’s Market Abuse Unit culls through billions of rows of trading data going back 15 years to identify individuals who have made repeated, well-timed trades ahead of corporate news.

The new strategy is starting to show results, enabling the SEC to launch nine insider trading cases, around 7% of cases the agency brought since 2014 against people who trade on confidential corporate information.  [More…]

 

Gatekeeper Failure for a Taking Management Fees in Advance

Steven Burrill was using his venture capital fund as a persona piggy bank and the fund’s auditor failed to do anything when it saw the red flags. Now the auditor partner is subject to charges by the Securities and Exchange Commission.

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Private funds typically take management fees in advance. That is not unusual or illegal. SEC filings for registered investment advisers specifically contemplate it. Item 18 in Form ADV Part 2A requires additional disclosures that must be made if you take prepayment of more than $1200 in fees per client six months or more in advance. Most private funds take management fees quarterly in advance to “keep the lights on.”

But Burrill started taking fees earlier than allowed under the fund documents. Eventually, Burrill took more in advance fees than could be expected to earn over the life of the fund. The SEC brought charges against Burrill and he agreed to repay the fees and pay a fine.

As the SEC has done with several other cases, the SEC brought charges against a gatekeeper who failed to act.

Adrian D. Beamish was the audit partner with PricewaterhouseCoopers LLP for the Burrill engagement. According to the SEC order:

From 2009 through 2011, Burrill characterized the payments as advances on future management fees that he would earn through the provision of future management services as the fund’s manager. The payments were made many months—and even years—before the fees were to be earned. In each of these three years, Beamish failed to inquire whether Burrill had the authority to take the unusual payments, nor did he scrutinize the rationale for the payments, which Burrill needed to pay his own personal expenses and to fund his other businesses. Significantly, in conducting the yearend 2012 audit, Beamish learned that the advanced management fee payments that had been paid greatly exceeded any potential future management fee obligations the fund might owe.

The prepaid management fees were almost $5 million at the end of 2009, over $9 million in 2010 and over $13 million by the end of 2011.

“Had Beamish made appropriate inquiries as required by professional standards, his audit team would have likely discovered that the fees advanced to the General Partner had been used for the business operations of affiliated Burrill entities, such as Burrill Securities LLC, and to pay for Burrill’s own personal expenses.”

The SEC charges that Beamish failed to exercise professional care mandated by the accounting standards. According to the SEC, he failed as a gatekeeper.

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What Now? Trump Presidency and Compliance

While votes are still being counted, it’s clear that the Clinton Firewall in Michigan and Wisconsin did not hold. Get used to saying “President Trump.” The other story is that Republicans held the Senate, leaving Congress in the hands of the Mitch McConnell and Paul Ryan. That means some aspect of the Republican platform will start going through the legislative system in January. What will that mean for compliance?

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The Clinton loss was a compliance failure. Clinton failed to implement policies and procedures to address the conflict of interests between the Clinton Foundation and her role in government. There was the appearance of charitable donations being made to influence government action. (If not actual influence-peddling.) Anyone familiar with the FCPA would know that charitable donations to influence government action in a foreign country will put you in the crosshairs of enforcement for an FCPA violation.

Clinton had a cybersecurity failure, or at least the appearance of a failure. Her emails ended up on the computer of an accused pedophile.

As a result, America elected Mr. Trump.

He has clearly stated policies on isolationism, pulling away from free trade and limiting immigration. That was the bedrock of his campaign. America has its version of Brexit.

Mr. Trump has not been clear on what his plan is for domestic policy. That seems to be a more generic Republican agenda. We need to look more toward Mr. Ryan’s plans and Mr. McConnell’s plans.

Expect de-regulation. All three have made calls for repeal of Dodd-Frank. I don’t expect it will be a simple repeal. I think compliance professional can expect a wholesale reversal in some areas. Many of us will be tearing up policies and procedures and starting over.

For private funds, there have been several bills in the House to remove or lessen the registration requirements. Those died in the Senate. It’s not clear if they died because Senate leaders did not like the changes or didn’t want to bother with the legislative effort knowing they would be vetoed by the President.

I expect Mary Jo White will step down as Chair of the Securities and Exchange Commission. That will leave three vacancies to be filled by the new President. There is a chance that the current candidates are approved during the lame duck session. I would not take that bet. I’m skeptical that Mr. McConnell will let Obama implement anything during the lame duck session.

January will be busy in Congress as the old bills are dusted off and run through committee to get on the floor of the House. New bills will come together quickly. Compliance professionals will need to pay close attention. Change is coming.

Privcap – Game Change Real Estate 2016

What better way to spend November 2 than in Chicago with the enthusiasm of the Cubs winning game 6 the night before the conference and the historic World Series win that night. I was in the windy city for Privcap Game Change conference for real estate in 2016.

privcap

The conference was largely focused on real estate industry trends and markets. That is outside of my expertise and are topics that I do not address in my stories. I’m sharing a few of those notes, but I don’t necessarily endorse them and my firm does not necessarily endorse them.

I spoke on a panel on GP Operations in the Age of SEC Compliance. We repeated the session twice for rotating breakout sessions. There was quite a lot of discussion about the pros and cons of registering with the SEC as an investment adviser. One attendee earlier in the day remembered a time in the 1980s when an SEC office kicked out the real estate advisers from registration. Investors had asked them to register. The SEC told them not to.

That is the driving force for real estate fund managers to register today: investor expectations. Real estate funds are in a gray area of the registration requirement. Congress used a odd definition to define “private funds.” There appear to be fund managers getting advice letters from their law firms that they are not subject to registration.

There was a lot of talk about the fee cases being brought by the SEC against fund managers. I pointed out that those cases are independent of registration. The SEC cases are based on the anti-fraud provisions (section 206) that are not limited to registered investment advisers.

The opening session of the conference was peering into the crystal ball and prognosticating on the near future for real estate. Is a recession coming? How defensive should your investing be? The last real estate slump was caused by debt run amok and before that oversupply. Fundamentals are still pretty good in most sectors and most markets. Low interests have a big effect and there is uncertainty about when and how quickly interest rates may rise. Our current stage of global central bank policy is in uncharted territory: long period of low interest rates, negative interest rates, running out of debt to buy.

The second session focused on changes to the industrial sector, in particular the light industrial sector with the Fourth Industrial Revolution.

The First Industrial Revolution used water and steam power to mechanize production. The Second used electric power to create mass production. The Third used electronics and information technology to automate production. Now a Fourth Industrial Revolution is building on the Third, the digital revolution that has been occurring since the middle of the last century. It is characterized by a fusion of technologies that is blurring the lines between the physical, digital, and biological spheres.

One focus is the “last mile” of e-commerce. These are new users in the space. They need more light industrial space than bricks and mortar retailers. Faster delivery times means more e-commerce facilities close to more population centers. The facilities have much more automation than traditional warehouses.

The third panel focused on what private real estate investment managers can learn from public market REITs. They do have a correlation with the broader market trends. That may change now that REITs have been split off from the financial sector to their own sector. REITs have more volatility than private real estate in part because the private side marks values only quarterly.

A session on LP-GP relations noted that real estate allocations were down in 2015. The biggest fund managers are taking the bulk of the allocations. Some things that are “no-go” from an LP’s perspective are the lack of key man provisions, devotion of time and deal-by-deal waterfalls. Look at other relationships with LPs to see if it an inducement to take other actions that may not be beneficial to the main fund.

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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Crowdfunding is by Rocio Lara
CC BY SA

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.”

jack-of-trades-bigest-swiss-army-knife

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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