Kirschner Update: Leveraged Loans are Not Securities

The Second Circuit put the leveraged loan market at ease and ruled that those notes are not securities. The Court had asked the Securities and Exchange Commission to offer its opinion on whether they were securities and the SEC declined to do so.

The Second Circuit followed the four factors of the Reeves “family resemblance” test.

1) “[T]he motivations that would prompt a reasonable seller and buyer to enter into” the transaction;
2) “[T]he plan of distribution of the instrument”;
3) “[T]he reasonable expectations of the investing public”; and
4) “[W]hether some factor such as the existence of another regulatory scheme significantly reduces the risk of the instrument, thereby rendering application of the Securities Acts unnecessary.”

The court found that the company and the note purchasers had different motivations. The company was entering into a commercial transaction. The note purchasers may have been motivated for investment.

Even though there ended up being lots of note purchasers, the distribution was controlled and not made available to the general public.

The court found that the note purchasers should have expected the notes to be treated as loans and not investments in the company.

Finally, the court found that there was some regulatory guidance and the loans were secured by a perfected interest in the company’s assets.

The court found that the notes had a family resemblance to loans issued by banks for commercial purposes. Therefore they are not securities.

The result of the decision is that the note purchasers can’t bring fraud claims under the state securities laws, which would have given them an additional remedy. In end, it was a lot of worrying, with no change in the law. It does stand as a reminder to focus on structuring loan transactions and documents to make sure you hit the points of the Reeves test.

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The Private Fund Rule Is Coming

The Securities and Exchange Commission has set the agenda for its August 23 meeting.

ITEM 2: Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews

OFFICE: Division of Investment Management

STAFF: William A. Birdthistle, Sarah G. ten Siethoff, Melissa Harke, Marc Mehrespand, Tom Strumpf, Robert Holowka, Shane Cox, Neema Nassiri

The Commission will consider whether to adopt rules and amendments under the Investment Advisers Act of 1940 (“Advisers Act”) for private fund advisers and whether to adopt amendments to the compliance rule under the Advisers Act.

It would be really unusual for the rule to not be adopted if its on the agenda. The question is “what will be in the final rule?”

The proposed rule in second quarter of 2022 had proposals that could be very problematic:

  • Limitations on indemnification for private fund advisers
  • Limitations on clawbacks for taxes
  • Limitations on different treatment for different investors
  • Standards for fee and expense disclosure
  • Not allowing existing contractual arrangement to continue if they differ from the rule requirements

The proposed rule was a kitchen sink of items with no unifying theme, other than to try to make private funds more like mutual funds without the liquidity. The rule could have a profound impact on the private fund industry.

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ABA Amends Rule on Client Due Diligence

The American Bar Association House of Delegates adopted a resolution that strengthens a lawyer’s obligation to decide before accepting or maintaining representation whether a client seeks to use the lawyer’s services to further a crime or fraud. This is part of an effort to alleviate concerns about the use of lawyers to facilitate money laundering and other financial crimes.

Kevin Shepherd, the ABA’s Treasurer, said that the U.S. Treasury Department had informed him that a failure to pass the resolution would cause the agency to take immediate regulatory action and to lobby for legislation imposing additional obligations on lawyers.

A few months ago Robert Wise, a New York lawyer, plead guilty to criminal charges stemming from payments he made for Russian oligarch Viktor Vekselberg, to maintain six properties in New York and Florida owned by the Russian billionaire in violation of sanctions.

The resolution adds a new inquiry requirement for lawyers under the ABA Model Rule of Professional Conduct:

(a) A lawyer shall inquire into and assess the facts and circumstances of each representation to determine whether the lawyer may accept or continue the representation. Except as stated in paragraph (c), a lawyer shall not represent a client or, where representation has commenced, shall withdraw from the representation of a client if:

…. (4) the client or prospective client seeks to use or persists in using the lawyer’s services to commit or further a crime or fraud, despite the lawyer’s discussion pursuant to Rules 1.2(d) and 1.4(a)(5) regarding the limitations on the lawyer assisting with the proposed conduct.

The commentary is very direct

[1] Paragraph (a) imposes an obligation on a lawyer to inquire into and assess the facts and circumstances of the representation before accepting it. The obligation imposed by Paragraph (a) continues throughout the representation. A change in the facts and circumstances relating to the representation may trigger a lawyer’s need to make further inquiry and assessment. For example, a client traditionally uses a lawyer to acquire local real estate through the use of domestic limited liability companies, with financing from a local bank. The same client then asks the lawyer to create a multi-tier corporate structure, formed in another state to acquire property in a third jurisdiction, and requests to route the transaction’s funding through the lawyer’s trust account. Another example is when, during the course of a representation, a new party is named or a new entity becomes involved.

We’ve seen the actions FinCEN have taken against title insurance companies under the Real Estate Geographical Targeting Orders.

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Charging the Gatekeeper

The SEC charged EIA All Weather Alpha Fund and its investment adviser, Andrew Middlebrooks, for fraud last year. The SEC alleged that Middlebrooks misrepresented the Fund’s performance in order to retain current investors and to induce new investors. The Adviser directed the creation of and approved an inflated NAV for the Fund with false and misleading performance results. The Fund provided investors with statements showing positive returns in the investors’ accounts and purported Fund gains from trading. In reality, the purported gains reflected in the investor statements were false. The Fund had actually lost money.

Normally, you would have expected a fund auditor to pick up on the problem. One of the claims against Middlebrooks and the Fund is that they falsely claimed the Fund had an auditor.

In the past, the SEC has shown its willingness to go after gatekeepers who missed obvious red flags in a fraud, in addition to the fraudster. The obvious target in this case would have been the auditor. The SEC claimed that Middlebrooks fabricated the financial statements and an audit report.

The SEC turned to the fund administrator for culpability. To be honest, I was a bit surprised to hear that there was a fund administrator. Based on the SEC order, it looks like the fund administrator failed to catch the red flags.

The agreement between the Fund and Theorem Fund Services required the fund to appoint an independent auditor to conduct an audit of the fund. At the onboarding in early January 2018, Theorem relied on a representation of the Fund. At year end of 2018, Theorem found out that no auditor had been engaged. That started the process of Theorem ending its services. By then, the damage had been done.

Over the course of 2018 Theorem was responsible for calculating the Fund’s NAV monthly. Theorem did what it was supposed to do and used the trading statements to calculate the NAV. The big failure happened in March 2018 when the fund lost $342,000. Rather than record the loss on the Fund, Middlebrooks decided to treat the loss as a “receivable” from the fund manager. The result would be no reduction of the Fund’s NAV. This treatment of losses as a receivable continued through 2018 and Theorem published investor statements that didn’t show the losses.

As a result of this “weird treatment,” the Fund’s performance for July 2018 since inception was positive 148.39%. The true result was a negative 63.9%.

Obviously the treatment of the loss as a receivable is “weird.” I suppose its possible that a fund could structure a loan from the manager to the fund to cover losses. That would need to be disclosed in the financial statements and creates a whole set of conflicts and compliance issues. Blackstone offered a guaranteed return to an investor in BREIT earlier this year.

Here, there was no disclosure. There was actually no receivable. There was no provision in the fund documents to allow a loan and no note or documentation to evidence the loan resulting in the receivable. Theorem just accepted that the Fund’s word that it was legally liable to reimburse the losses. (They were not.)

In January 2019, the fund switched trading platforms. Theorem at that time required disclosure of the receivable and a plan for its repayment to investors. The Fund did not do so and Theorem terminated the arrangement.

Theorem still provided investor statements with the bogus receivable until the termination was effective 30 days later.

The question I have is “who turned in the Fund and Middlebrooks?” It could have been Theorem. But the charging documents make no mention of Theorem’s cooperation. I think it’s more likely to have been a disgruntled investor.

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Are Syndicated Loans Securities?

Notes are securities and loans are not securities. Simple enough. Except, our financial system doesn’t operate in such a black and white manner. Syndicated loans kind of fall in the middle.

Your traditional loan is a single lender who holds and controls the debt. Notes and bonds get issued into a more fungible format to more than one investor, with control centralized with a trustee or loan administrator. There are lots of different structures on the notes and bond side of the spectrum.

Syndicated loans involve a group of lenders. Typically it’s a smaller group of lenders and they have some amount of control, collectively, over the administration of the loan.

There a fight in the Second Circuit in Kirschner v. JP Morgan Chase Bank on whether a particular syndicated loan issuance was a security. There is enough uncertainty that the court asked the Securities and Exchange Commission to offer its opinion. A few days ago, the SEC declined to do so.

While we are used to a discussion of the Howey test when talking about securities, it’s important to note that it is focused on the definition of an “investment contract.” There is a whole other line of cases on the “loan” versus “note” definition lead by the Reves v. Ernst & Young case which established the “family resemblance test.”

The analysis is whether the note in question is like any of these notes that are not securities:

  1. the note delivered in consumer financing,
  2. the note secured by a mortgage on a home,
  3. the short term note secured by a lien on a small business or some of its assets,
  4. the note evidencing a ‘character’ loan to a bank customer,
  5. short-term notes secured by an assignment of accounts receivable, or
  6. a note which simply formalizes an open-account debt incurred in the ordinary course of business (particularly if, as in the case of the customer of a broker, it is collateralized [… and]
  7. notes evidencing loans by commercial banks for current operations.

In determining whether the note in question has a family resemblance to one of the seven, there are four factors to consider:

  1. The motivation of seller and buyer – If the seller’s motivation is to raise money for his/her business and the buyer’s motivation is to earn profits, then the note is likely a security.  Even if the note is not necessarily characteristic of a security, if the investor reasonably expected that they were buying a security, and would be protected by the accompanying securities laws, then its more likely to be a security.
  2. The plan of distribution of the note – If the note instrument is being offered and sold to a broad segment or the general public for investment purposes, it is a security.
  3. The reasonable expectations of the investing public – If the investors think that the securities laws and their anti-fraud provisions apply to the note, then it’s more likely to be a security.
  4. Alternative regulatory regime – Is there another regulatory scheme, like banking regulation, that applies to the note, then its less likely to be a security.

The case as hand involves a $1.775 billion syndicated loan to Millennium Laboratories. As you might expect, Millennium defaulted. The loan participants are suing the loan syndicator to try get some additional recovery. The district court ruled that the syndicated loan interests were not securities and the loan participants appealed to the Second Circuit.

As mentioned above, the Second Circuit is mulling over the appeal and asked the SEC to opine on the treatment of this loan syndication. The SEC’s failure to say that the syndicated loan interests are not securities has created a bit of a panic in the syndicate loan markets.

We’ll keep an eye out for this decision.

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The One with the Girlfriend’s Laptop

The Securities and Exchange Commission actually uses the term “romantic partner”, not girlfriend in this complaint. I guess the SEC doesn’t want to impose labels on the relationship. Based on this case, I assume the relationship is over. The COVID pandemic was hard on a lot of relationships with couples isolated at home. Stealing information from your “romantic partner” seems likely to end the relationship.

That’s just what Steven Teixeira did. While working at home during the pandemic, Teixeira would access her laptop while she was out of the room or outside their Queens apartment.

She was an executive assistant at an investment bank. She was responsible for scheduling meetings of the investment bank’s valuation and fairness committees concerning potential transactions involving the investment bank’s clients. She had access to material nonpublic information relating to dozens of the investment bank’s transactions.

Teixeira had a friend who knew a guy who was a stock trader, Jordan Meadow. The three met and Teixeira offered up his access to the information to Meadow. The three plotted an insider trading scheme, with Meadow offering to buy Teixeira and the third friend Rolex watches. Teixeira and Meadows began trading on the flow of transaction information that Teixeira was snooping from his romantic partner’s laptop.

Their aggressive trading caught the attention of the regulators and Meadow’s compliance department. The scheme came to an end in January 2023 when the romantic partner returned to working in the office rather than from home.

Teixeira pled guilty in a cooperation agreement. The DOJ and SEC are pursuing more serious charges against Meadow.

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Ripple is Sometimes a Security (?)

The big challenge with crypto is how it fits into regulatory schemes that were drafted almost a century a go. Add in the politically driven split between the regulation of commodities by the CFTC and the regulation of securities by the SEC and you get a mess. Slap in the variable structures used by crypto issuers when selling crypto tokens and you get a tangled mess.

This challenge just got messier with the recent decision in the case of the Securities and Exchange Commission v Ripple Labs.

The definition of a “security” includes an “investment contract.” The meaning behind that term was established in the 1946 case of the SEC v. W.J. Howey. The decision created a three prong test:

(1) invests his money (2) in a common enterprise and (3) is led to expect profits solely from the efforts of the promoter or a third party.

Bitcoin largely falls outside the definition. You don’t expect a dividend on Bitcoin. You’re investing for the rise in price alone. There is no meaningful company behind it trying to find a way to make a profit. Bitcoin is more like a commodity.

Some will argue a currency. But currencies are used as a store of value to buy things. I don’t think Bitcoin is being used to buy many legal goods.

Ripple Labs comes along and sells the XRP token to generate cash to build out the Ripple platforms, some of which will use the XRP token. The facts are a bit murky about whether the XRP coin holders would get some of the profit from the Ripple platforms.

The court looked first at the past sales of XRP tokens directly to institutional buyers and decisively finds that the XRP tokens are securities. “When the value of XRP rose, all Institutional Buyers profited in proportion to their XRP holdings.” (page 18)

For some weird reason, the court then finds that indirect sales and sales on exchanges are not investment contracts. Since they were blind bid/ask transactions, the buyers didn’t know if the money was going to Ripple or to a secondary seller.

So institutional buyers get more protection than retail buyers under the court’s reasoning. That seems to be the opposite approach of the protective regulatory approach of the SEC.

That also seems weird in the reality of exchanges for “securities.” An investment would be a security if it’s bought directly from the issuer and possibly not a security if it’s purchased from a secondary seller.

Under the court’s decision, crypto is looking very good. Sales of “investment contracts” to institutional investors can rely on the private placement regime. Sales to retail investors through an exchange would not be an investment contract.

Weird result. The product’s status as a security is dependent on how it’s sold. Doesn’t sound right to me. I assume the SEC will appeal this result. I think this will just be a temporary win for Crypto.

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The One with Insider Trading, Pharma and the Police Chief

Joseph Dupont was a senior executive at Alexion Pharmaceuticals and reserve officer with the Dighton police force. (Dighton’s most notable attraction is Dighton Rock, covered in petroglyphs.) Dupont worked on Alexion’s acquisition of Portola Pharmaceuticals.

Dupont knew he couldn’t trade in the stock of Portola with all of the inside information he had. But that apparently didn’t stop him from leaking the information to his buddy, Shawn Cronin, who was a sergeant on the Dighton police force. (He has since become Chief.) Cronin then told two other mutual buddies, Stanley Kaplan and Jarett Mendoza. Kaplan then told a colleague, Paul Feldman, who spread the information even further.

The SEC Complaint and US Attorney Indictment have some compelling facts. Dupont had Alexion meeting to hammer out the details of the acquisition on April 8. That night Dupont had a long conversation with Cronin. Cronin texted Kaplan that night:

“Good evening, sir. If you need something to take your mind off of the everyday battle, remember that stock I told you about? Good time to buy.”

Cronin then opened a new brokerage account and placed an order to buy shares in Portola. Kaplan did the same. They continued to buy more shares in the following weeks.

The criminal indictment has a bunch of incriminating messages among the defendants:

“I need more inside information.”
“Knowing of a buyout or an news beforehand is gol[d].”
“Let’s hope our golden goose will continue laying golden eggs!”

When the acquisition was announced the stock price of Portola jumped 130%.

All of this suspicious trading caught the attention of the regulators after the merger and launched an inquiry. Alexion was forced to ask its employees whether they knew any of the names on the list of suspicious traders. Cronin lied and said he didn’t know any, even though Cronin, Kaplan and Mendoza were on the list.

The gains they made:

  • Cronin – $72,000
  • Mendoza – $39,000
  • Kaplan – $472,000
  • Feldman – $1.73 million (He put the most money in)

All are facing disgorgement of the gains, civil penalties and significant jail time. Mendoza has already plead guilty.

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SEC’s Regulatory Agenda

The Securities and Exchange Commission has published the Spring update to its agency rule list: Agency Rule List – Spring 2023 Securities and Exchange Commission. While none of this is carved in stone it does give us some sense of what the SEC is working on, what it has given up on, and when things may come out.

The first item on my mind is the proposed Private Fund Rule. That was first proposed in the first quarter of 2022 with a Buffet of Private Fund Regulations piled into one proposed rule. I have heard little about what end up in the rule. It’s still on the agenda and has a proposed final action in October 2023.

Cybersecurity for investment advisers is also still on the agenda. This was another of the first quarter 2022 rulemaking. My biggest concern is that the rule would likely make a cyber breach a fraud violation. Seems like that’s a problem given that the US government is noting a widespread cyberattack today: US government agencies hit in global cyberattack. Nonetheless, the rule still on the agenda and has a proposed final action in October 2023.

Outsourcing by investment advisers remains on the agenda. Any final action is pushed off to April 2024. I think the SEC is struggling with how to scope the rule.

“A covered function is defined in the proposed rule as a function or service that is necessary for the adviser to provide its investment advisory services in compliance with the Federal securities laws, and that, if not performed or performed negligently, would be reasonably likely to cause a material negative impact on the adviser’s clients or on the adviser’s ability to provide investment advisory services.”

If I hire a bad elevator contractor for my private real estate fund’s assets and all the elevators stop working, I think that makes it a “covered function” that would be subject to the proposed rule.

The new Safeguarding Advisory Client Assets rule looks like it its on the fast track. It was just published in the first quarter of 2023 and is scheduled for final action in October 2023. That rule is targeting at killing crypto. In the process, it’s taking a sledgehammer to all alternative investments.

It looks like we’ve got three big regulatory changes coming out this fall. Sounds like we should rest up this summer to get ready.

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New Risk Alert on the Marketing Rule

The Division of Examination released a risk alert on additional areas of emphasis during examinations focused on the new Marketing Rule (Rule 206(4)1): Examinations Focused on Additional Areas of the Adviser Marketing Rule. This is identified as a follow up to the September 19, 2022, Risk Alert describing the initial areas of review related to examining advisers for compliance with the Marketing Rule: Examinations Focused on the New Investment Adviser Marketing Rule.

The new areas of focus are:

  1. Testimonials and Endorsements
  2. Third-Party Ratings
  3. Form ADV

Testimonials and Endorsements

The focus seems to be just on the key compliance areas. You need to make sure you have good disclosures about whether the person is an actual client/investor, whether the person is compensated and any material conflicts of interest.

I’m seeing placement agents struggling with how to disclose their role in the marketing and fundraising. They all have good disclosures and procedures. I assume there will some move towards standardization in the industry.

Third-Party Ratings

Compliance needs to keep a close eye on these and the substance behind them. The Risk Alert makes it clear that the SEC wants the time frame to be clear, who did the rating and whether there was any compensation.

An interesting note is that the SEC wants to see that the:

“adviser has a reasonable basis for believing that such questionnaire or survey is structured to make it equally easy for a participant to provide favorable and unfavorable responses, and is not designed or prepared to produce any predetermined result.”

Form ADV

The SEC wants to make sure you are checking the right boxes in the new Form ADV questions regarding marketing. Not much substance here, just easy for the SEC to review and grade. I assume the examiners have seen a bunch of advisers who checked the wrong boxes.

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Back from a hiatus on the blog. I thought it prudent to shut down during an examination. The end result was just fine. Exams are just nerve-wracking.