Tag: Regulation D

Felons and Fund Managers

Most private funds rely on a Rule 506 exemption under Regulation D to sell their limited partnership interests to investors. A new SEC rule amending Rule 506 should catch the eye of private fund compliance officers. The concept it fairly straight-forward: felons should not be allowed to take advantage of the private offering exemptions.

Dodd-Frank

Section 926 of Dodd-Frank requires the SEC to adopt rules disqualifying an offering from reliance on Rule 506 of Regulation D when certain felons or other “bad actors” are involved in the offering. Rule 506 is the most widely claimed exemption under Regulation D. For the 12 month period ended September 30, 2010 the Commission received 17,292 initial filings for offerings under Regulation D, of those 16,027 claimed a Rule 506 exemption.

What types of felonies?

The  proposal is not for all felonies, just those related to the securities industry. So you could be a convicted Under the proposed rule, a “disqualifying event” would include:

  • Criminal convictions in connection with the purchase or sale of a security, making of a false filing with the SEC or arising out of the conduct of certain types of financial intermediaries. The criminal conviction would have to have occurred within 10 years of the proposed sale of securities (or five years, in the case of the issuer and its predecessors and affiliated issuers).
  • Court injunctions and restraining orders in connection with the purchase or sale of a security, making of a false filing with the SEC or arising out of the conduct of certain types of financial intermediaries. The injunction or restraining order would have to have occurred within five years of the proposed sale of securities.
  • Final orders from state securities, insurance, banking, savings association or credit union regulators, federal banking agencies or the National Credit Union Administration that bar the issuer from:
    • associating with a regulated entity.
    • Engaging in the business of securities, insurance or banking.
    • Engaging in savings association or credit union activities.
  • Or orders that are based on fraudulent, manipulative or deceptive conduct and are issued within 10 years before the proposed sale of securities.
  • Certain Commission disciplinary orders relating to brokers, dealers, municipal securities dealers, investment companies and investment advisers and their associated persons, which would be disqualifying for as long as the order is in effect;
  • Suspension or expulsion from membership in a “self-regulatory organization” or from association with an SRO member, which would be disqualifying for the period of suspension or expulsion;
  • Commission stop orders and orders suspending the Regulation A exemption issued within five years before the proposed sale of securities; and
  • U.S. Postal Service false representation orders issued within five years before the proposed sale of securities.

Who is covered?

The proposed rule would cover

  • the issuer (i.e. the fund)
  • its predecessors and affiliated issuers
  • Directors, officers, general partners and managing members of the issuer.
  • 10 percent beneficial owners and promoters of the issuer (i.e. the fund manager).
  • Persons compensated for soliciting investors
  • the general partners, directors, officers and managing members of any compensated solicitor (i.e. employees of your placement agents).

The rule is bit fuzzy on how this would apply to fund manager, since it is not legally the issuer. Under the investment advisers registration you already need to disclose criminal activity. That disclosure is broader than what is proposed under the new rule. This is just disclosure, not a bar from use of the offering exemption.

Reasonable Care Exception

The proposed rule would provide an exception from disqualification when the issuer can show it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed.

Paragraph (c)(1) of this section shall not apply:

(i) Upon a showing of good cause and without prejudice to any other action by the Commission, if the Commission determines that it is not necessary under the circumstances that an exemption be denied; or

(ii) If the issuer establishes that it did not know, and in the exercise of reasonable care could not have known, that a disqualification existed under paragraph (c)(1) of this section.

Instruction to paragraph (c)(2)(ii). An issuer will not be able to establish that it has exercised reasonable care unless it has made factual inquiry into whether any disqualifications exist. The nature and scope of the requisite inquiry will vary based on the circumstances of the issuer and the other offering participants.

Here is where compliance steps in. The rule has no explicit record-keeping, reporting or disclosure requirements. But if you want make sure you can take advantage of the “reasonable care exception” you will need to keep records.  It looks like we will need a new form for employees to fill out asking for a disclosure of events under the rule. It also looks like you will need to run criminal background checks on your principals and key employees.

In the release the SEC said: “The steps required would vary with the circumstances, but we anticipate may include such steps as making appropriate inquiry of covered persons and reviewing information on publicly available databases.”

Comments

This is still a proposed rule, but time is short. Under Dodd-Frank, the disqualification rules need to be in place by July 21, 2011. There is time to Submit Comments.

Sources:

Is the SEC Going to Reform Advertising Rules?

Advertising and corporate communications is a rough area for compliance when used in capital formation. The rules are restrictive, not always intuitive, often vague, and in direct opposition to the revenue-hungry side of the company.

Last week, the House Committee on Oversight and Government Reform heard testimony on “how securities regulations have harmed public and private capital formation in the United States.”

“Economists now estimate that the market for underwritten initial public offerings in the U.S. have plummeted from an annual average of 530 during the 1990s to about 126 since 2001. Meanwhile, the number of companies listed on the major American exchanges peaked in 1997 at more than 7,000. Today, there are approximately 4,000. Furthermore, private capital formation in the U.S. is increasingly difficult, as demonstrated by Facebook’s recent decision to issue its high-profile private offering to foreign investors but not Americans.”

Since I’m in the private equity sector, I care more about the limitations placed on private capital formation. SEC Chairman re-stated the justification for the ban on general advertising under Regulation D.

“The ban was designed to ensure that those who would benefit from the safeguards of registration are not solicited in connection with a private offering.”

“I recognize that some continue to identify the general solicitation ban as a significant impediment to capital raising for small businesses. I also understand that some believe that the ban may be unnecessary because those who do not purchase the offered security would not be harmed by the solicitation that occurs. At the same time, the general solicitation ban is supported by others on the grounds that it helps prevent securities fraud by making it more difficult for fraudsters to attract investors or unscrupulous issuers to condition the market. We need to balance these considerations as we move forward in analyzing this issue.”

Barry Silbert, CEO of Second Market phrased it nicely:

It should not matter that non-accredited individuals know that unregistered securities are available for sale. No one prohibits car manufacturers from advertising, even though children under the legal driving age are viewing the advertisements. The general solicitations prohibition unnecessarily limits the pool of potential investors, thereby restricting companies’ ability to raise capital to fuel growth.

Chairman Shapiro said the SEC staff is looking at the offering rules and whether the general solicitation ban should be revisited. Given all of the rule-making from Dodd-Frank, it’s hard to imagine that the SEC will find the bandwidth to revisit the rule in the near future.

Sources:

Image is Reaching for Blue Skies by Kelvin Tan
CC BY 2.0

The Changing Standard for an Accredited Investor

As financial reform has made its way through Congress there have been several proposed changes to the standard of what it takes to be an accredited investor.

In 1982, the SEC prescribed the standard in Rule 501 of Regulation D:

5. Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his purchase exceeds $1,000,000;

6. Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;

The Senate version of the bill would have increased both amounts. If you use the CPI index, the amounts would more than double.

Although the bill has not passed yet, but it looks like the accredited investor standard is going to change. Section 413 of the bill is Adjusting the Accredited Investor Standard.

The net worth standard will stay at $1 million for at least the next four years, but the value of the primary residence will be excluded from net worth. Otherwise the SEC will be tasked with a review of the definition of “accredited investor” and has a clean slate to develop its own definition. The SEC can revisit the definition every four years. The only standard is that the definition be “appropriate for the protection of investors, in the public interest, and in light of the economy.”

Looking into my crystal ball, I expect the SEC to adjust the income standards based on inflation. That would put them at around $459,000 if single and $688,000 if married. I would also expect the standard to include some sort investment expertise and knowledge standard. Having a big pile of cash or a big paycheck will likely no longer be the only standard.  At least that’s my guess.

Sources:

Updated pdf file with text of the Private Fund Investment Advisers Registration Act of 2010

Image: three horsemen of the apocalypse, greenspan, et al by daveeza

Dodd Bill, Private Placements and Accredited Investors

I previously wrote about how the Restoring American Financial Stability Act being tossed around in the Senate could affect private investment funds by changing the definition of accredited investor and altering the process for a Regulation D private placement.

It looks like much of that is going to be wiped out of the bill. Senate Amendment 4056, proposed by Senator Bond, was passed by a voice vote.

The amendment directs the SEC to adjust the net worth needed to attain accredited investor status to $1,000,000, excluding the value of the primary residence. Within the period of four years after enactment, however, the net worth standard must be $1,000,000, excluding the value of the primary residence. The proposal would give the SEC the power to adjust the the definition of “accredited investor” every four years.

Senate Amendment 4056 also removed the 120 review period for private placements.

I have found Senate process for dealing with financial reform bill to be incredibly opaque and fast moving. There have been almost 400 amendments proposed since the bill was submitted last month, with the text of most of the amendments not being available until after vote has taken place.

Sources:

FINRA Guidance on Private Placements

finra

The Financial Industry Regulatory Authority released Regulatory Notice 10-22 reminding registered firms about their obligations regarding suitability, disclosures and other requirements for selling private placements to customers.

A Broker-Dealer that recommends a security is under a duty to conduct a reasonable investigation concerning that security and the issuer’s representations about it. This is true regardless of the type of security. The “reasonable” standard for the investigation depends on many factors including the nature of the recommendation, the role of the broker-dealer in the transaction, its knowledge of and relationship to the issuer, and the issuer itself.

NASD Rule 2310 requires a broker-dealer to have reasonable grounds to believe that a recommendation to purchase, sell or exchange a security is suitable for the customer. That means they must have a reasonable basis to to determine that the recommendation is suitable for at least some investors. Then they have to determine that it is suitable for the specific customer.

The fact that an investor meets the net worth or income test for being an accredited investor is only one factor to be considered in the course of a complete suitability analysis. In a Regulation D offering the broker-dealer should, at a minimum, conduct a reasonable investigation concerning:

  • the issuer and its management;
  • the business prospects of the issuer;
  • the assets held by or to be acquired by the issuer;
  • the claims being made; and
  • the intended use of proceeds of the offering

Although the “reasonable investigation” must be tailored to each private placement, the regulatory notice provides a list of best practices gathered from member firms.

A. Issuer and Management. Reasonable investigations of the issuer and its management concerning the issuer’s
history and management’s background and qualifications to conduct the business might include:

  • Examining the issuer’s governing documents, including any charter, bylaws and partnership agreement, noting particularly the amount of its authorized stock and any restriction on its activities. If the issuer is a corporation, a BD might determine whether it has perpetual existence.
  • Examining historical financial statements of the issuer and its affiliates, with particular focus, if available, on financial statements that have been audited by an independent certified public accountant and auditor letters to management.
  • Looking for any trends indicated by the financial statements.
  • Inquiring about the business of affiliates of the issuer and the extent to which any cash needs or other expectations for the affiliate might affect the business prospects of the issuer.
  • Inquiring about internal audit controls of the issuer.
  • Contacting customers and suppliers regarding their dealing with the issuer.
  • Reviewing the issuer’s contracts, leases, mortgages, financing arrangements, contractual arrangements between the issuer and its management, employment agreements and stock option plans.
  • Inquiring about past securities offerings by the issuer and the degree of their success while keeping in mind that simply because a certain product or sponsor historically met obligations to investors, there are no guarantees that it will continue to do so, particularly if the issuer has been dependent on continuously raising new capital. This inquiry could be especially important for any blind pool or blank-check offering.
  • Inquiring about pending litigation of the issuer or its affiliates.
  • Inquiring about previous or potential regulatory or disciplinary problems of the issuer. A BD might make a credit check of the issuer.
  • Making reasonable inquiries concerning the issuer’s management. A BD might inquire about such issues as the expertise of management for the issuer’s business and the extent to which management has changed or is expected to change. For example, a BD might inquire about any regulatory or disciplinary history on the part of management and any loans or other transactions between the issuer or its affiliates and members of management that might be inappropriate or might otherwise affect the issuer’s business.
  • Inquiring about the forms and amount of management compensation, who determines the compensation and the extent to which the forms of compensation could present serious conflicts of interest. A BD might make similar inquiries concerning the qualifications and integrity of any board of directors or similar body of the issuer.
  • Inquiring about the length of time that the issuer has been in business and whether the focus of its business is expected to change.

B. Issuer’s Business Prospects. Reasonable investigations of the issuer’s business prospects, and the relationship of those prospects to the proposed price of the securities being offered, might include:

  • Inquiring about the viability of any patent or other intellectual property rights held by the issuer.
  • Inquiring about the industry in which the issuer conducts its business, the prospects for that industry, any existing or potential regulatory restrictions on that business and the competitive position of the issuer.
  • Requesting any business plan, business model or other description of the business intentions of the issuer and its management and their expectations for the business, and analyzing management’s assumptions upon which any business forecast is based. A BD might test models with information from representative assets to validate projected returns, break-even points and similar information provided to investors.
  • Requesting financial models used to generate projections or targeted returns.
  • Maintaining in the BD’s files a summary of the analysis that was performed on financial models provided by the issuer that detail the results of any stress tests performed on the issuer’s assumptions and projections.

C. Issuer’s Assets. Reasonable investigations of the quality of the assets and facilities of the issuer might include:

  • Visiting and inspecting a sample of the issuer’s assets and facilities to determine whether the value of assets reflected in the financial statements is reasonable and that management’s assertions concerning the condition of the issuer’s physical plants and the adequacy of its equipment are accurate.
  • Carefully examining any geological, land use, engineering or other reports by third-party experts that may raise red flags.
  • Obtaining, with respect to energy development and exploration programs, expert opinions from engineers, geologists and others are necessary as a basis for determining the suitability of the investment prior to recommending the security to investors.

“An increase in investor complaints regarding private placements, as well as SEC actions halting sales of certain private placement offerings, led FINRA to launch a nationwide initiative that involves active examinations and investigations of broker-dealers engaged in retail sales of private placement interests,” said FINRA Chairman and CEO Rick Ketchum.

Sources

Accredited Investors under the Restoring American Financial Stability Act

Senator Dodd

One of the surprises in the Restoring American Financial Stability Act of 2010 is that it proposes to raise the standard for being an accredited investor. Section 412 of the bill would require the SEC to increase the dollar thresholds to be qualified as an accredited investor. Section 413 would require the GAO to study the appropriate criteria.

The current standards come from Section 2(a)15 of the Securities Act of 1933

ii. any person who, on the basis of such factors as financial sophistication, net worth, knowledge, and experience in financial matters, or amount of assets under management qualifies as an accredited investor under rules and regulations which the Commission shall prescribe.

In 1982, the SEC prescribed the standard in Rule 501 of Regulation D:

5. Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his purchase exceeds $1,000,000;

6. Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;

If you adjust for inflation from 1982, those levels could increase to $459,000 if single and $688,000 if married, with the net worth requirement becoming $2.29 million. The bill is not clear on what to use as an inflation index. I used the Consumer Price Index for All Urban Consumers (CPI-U) comparing March 1981 (94.5) to February 2010 (216.741).

The Private Fund Investment Advisers Registration Act passed by the House in the Wall Street Reform and Consumer Protection Act of 2009 (H.R.4173) required the SEC to start increasing the asset levels. The Dodd bill (still not in the Thomas system) takes the issue on more forcefully.

The result is that there will be fewer investors for private investment funds. Under and , you are limited to 35 non-accredited investors in a private fund offering, with an unlimited number of accredited investors.

Sources:

Defining An Accredited Investor

bull investor

One of the key rules for private investment funds is that their investors generally need to be “accredited investors.” This is the gateway to an exemption from the registration requirement under the federal securities laws.

The exemption is generally targeted so that experienced investors with significant financial resources and their own advisers are in less need of the Securities and Exchange Commission’s regulatory protection. In theory, they can protect themselves better than the SEC could protect them.

Who qualifies as an accredited investor? The answer is spelled out in Rule 501 of Regulation D:

  • Any bank as defined in section 3(a)(2) of the Act, or any savings and loan association or other institution as defined in section 3(a)(5)(A) of the Act whether acting in its individual or fiduciary capacity;
  • Any broker or dealer registered pursuant to section 15 of the Securities Exchange Act of 1934; any insurance company as defined in section 2(a)(13) of the Act;
  • Any investment company registered under the Investment Company Act of 1940 or a business development company as defined in section 2(a)(48) of that Act;
  • Any Small Business Investment Company licensed by the U.S. Small Business Administration under section 301(c) or (d) of the Small Business Investment Act of 1958;
  • Any plan established and maintained by a state, its political subdivisions, or any agency or instrumentality of a state or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5,000,000;
  • Any employee benefit plan within the meaning of the Employee Retirement Income Security Act of 1974 if the investment decision is made by a plan fiduciary, as defined in section 3(21) of such act, which is either a bank, savings and loan association, insurance company, or registered investment adviser, or if the employee benefit plan has total assets in excess of $5,000,000 or, if a self-directed plan, with investment decisions made solely by persons that are accredited investors
  • Any private business development company as defined in section 202(a)(22) of the Investment Advisers Act of 1940
  • Any charitable organization, corporation, or partnership with assets exceeding $5 million (not formed for the specific purpose of acquiring the securities offered);
  • Any director, executive officer, or general partner of the company selling the securities;
  • Any natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase;
  • Any natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year;
  • Any trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes
  • Any entity in which all of the equity owners are accredited investors.

In addition to the definition of accredited investor, you also need to understand how accredited investor status relates to the common exemptions from the registration requirements of the federal securities law.

Rule 504 permits allows a business to sell up to $1 million in securities during a 12 month period to an unlimited number of non-accredited investors. Additionally, Rule 504 does not require the issuer to provide any specific disclosure to the investors, regardless of whether they are accredited.

Rule 505 allows a business to sell up to $5 million in securities during a 12 month period to an unlimited number of accredited investors, and up to 35 non-accredited investors. The disclosure requirements when selling to non-accredited investors are significantly more difficult to meet and are very similar to the disclosures required in a public offering.

Rule 506 allows a business to raise an unlimited amount of capital via the sale of securities to an unlimited number of accredited investors and up to 35 non-accredited investors. In addition to the disclosure requirements for Rule 505, any non-accredited investors must also meet a “sophistication” standard, either themselves or through a qualified  representative. The status of an investor as “sophisticated” is a high standard. Investors who are merely knowledgeable about the particular industry are not necessarily sophisticated. They must have such knowledge and experience in financial and business matters that they are capable of evaluating the merits and risks of the prospective investment.

References:

The SEC’s Office of Inspector General and Form D

sec-oig

The SEC’s Office of Inspector General has released its Semiannual Report to Congress (.pdf). I started off looking at how the OIG feels about the new Form D for securities sold under the Regulation D exemption: “Based on our review of Form D, we determined that certain revisions should be made to the form to better ensure that potential investors are not misled by information in a form filing and to further clarify the information that is reported on the form.” [Page 32]

Fund Raising Publicity

1903 stock certificate of the Baltimore and Ohio Railroad

Under the U.S. securities laws, it is important for private investment funds to avoid engaging in a “general solicitation” or “general advertising” prior to and during fund raising. The key to private investment funds and the private offering of interests in the funds is that they are “private.”

Assuring the private nature of an offering means that not only the issuer, but any party acting on its behalf, must refrain from generally soliciting potential purchaser. This means that a fund and its agents (which includes all management, personnel, placement agents,attorneys, accountants and other representatives) must be careful during the fund raising period not to make statements to the general public with regard to an investment in a fund.

Rule 502(c) of Regulation D states the limitation as “neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising, including, but not limited to, the following:

1. Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and

2. Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising. . . “

If a fund or its agents make statements that could be viewed as a “general advertising” or “general solicitation”, the SEC could impose a “cooling-off period.” This would typically mean a cessation of all fundraising and a moratorium on fund closings for a period of several months. A “general solicitation” could also trigger registration of the fund sponsor or the fund under the Advisers Act or the Investment Company Act.

The SEC has indicated that it believes that the following actions violate Rule 502(c):

1. Mass mailings

2. Speaking to the media about a solicitation when funding or investment matters are discussed, whether such speech is directed at current fundraising efforts or deemed to be an attempt to “condition the market” by making reference to the success or attractive return of previous investments.

3. Print, radio and television advertisements or solicitations regarding funding or investment matters

4. Tombstone advertising (an ad which does no more than give the barest of information) is held by SEC staff to “condition the market” for the securities and therefore constituted an offer even though the tombstone did not specifically mention the transaction in question.

Rule 502(c) prohibits general solicitation or general advertisement that occurs in connection with a Regulation D securities offering. This is to separate typical company advertising if a company advertises with no intention to “offer or sell the securities of the issuer” then such advertising should not violate rule 502(c).

The image is a 1903 stock certificate of the Baltimore and Ohio Railroad in the public domain and available on Wikimedia Commons.

Bits and Pieces on Compliance

Here are a few stories and items that caught my eye this week, but I have not had time to build-out to a full post: The FCPA Enforcement Report of the First Quarter of 2009 from The FCPA Blog

We count seven Foreign Corrupt Practices Act enforcement actions since the start of the year, including indictments, pleas and settlements, along with one newly disclosed investigation. Four of the enforcement actions involve individuals, and four relate to KBR. By this time last year, there had been just a couple of new enforcement actions (2008 finished with eleven organizations and twenty-six individuals being either charged with new FCPA offenses, settling enforcement actions, or having charges amended, reinstated or affirmed). Here’s this year’s rundown so far: . . .

Profiles in Power: The 20 most influential general counsel in America from the National Law Journal

In this inaugural publication of The National Law Journal’s Most Influential General Counsel, we have highlighted 20 attorneys whose leadership has proven strong — and even creative — during the turmoil in the legal industry.

OIG Recommends Action on Reg D Issues, Form D Changes from Melissa Klein Aguilar of The Filing Cabinet

The Securities and Exchange Commission should take steps to better ensure compliance with Regulation D, to act when it finds non-compliance, and should make better use of Form D information. That’s according to a March 31 report by the SEC’s Office of Inspector General, which reviewed Corporation Finance’s process for assessing whether companies appropriately use Reg D, the rule that allows exemptions from federal registration under the Securities Act of 1933 for limited offerings of securities.

Mass. Regulator Accuses Madoff Feeder Fund of “Fraud” by Kevin LaCroix of The D&O Diary

In an April 1, 2009 administrative complaint (here), Massachusetts Secretary of the Commonwealth William Francis Galvin accused Madoff feeder fund Fairfield Greenwich Advisors and its Bermuda affiliate of “complete disregard of its fiduciary duties to its investors” and of “flagrant recurring misrepresentations” that “rise to the level of fraud.”

Landmark Agreements Clear Path for Government New Media

Answering President Obama’s call to increase citizen participation in government, the U.S. General Services Administration is making it easier for federal agencies to use new media while meeting their legal requirements. For the past six months, a coalition of agencies led by GSA has been working with new media providers to develop terms of service that can be agreed to by federal agencies. The new agreements resolve any legal concerns found in many standard terms and conditions that pose problems for federal agencies, such as liability limits, endorsements, freedom of information, and governing law.

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