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By Joseph T. Lynyak III and Rodney R. Peck

This Alert analyzes steps that officers and directors of bank and non-bank financial companies and their holding companies and affiliates can take to address personal liability for alleged breaches of duty to manage and supervise a financial company’s operations, allegations which are being made in an increasing number by federal and state regulatory agencies, including the federal banking agencies and the U.S. Consumer Financial Protection Bureau (CFPB).

On December 10, 2012, a California jury returned a verdict of $169 million in a case brought by the FDIC against three former IndyMac Bancorp Inc. executives after determining that those officers were negligent in making loans to homebuilders by continuing to push for growth in loan production without proper regard for creditworthiness and market conditions. Soon thereafter, the former CEO of IndyMac Bank agreed to pay $1 million from his personal assets in addition to available insurance proceeds to settle another FDIC claim related to the failure of IndyMac Bank. In an unrelated yet problematic series of developments, the newly formed CFPB recently assessed civil money penalties against three holding companies for aggressive marketing practices in an aggregate amount exceeding $500 million.

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Written by: Jeffrey Stern and Anthony H. Schouten

The Commodity Futures Trading Commission has issued new “know your customer” and external business conduct rules to give effect to certain provisions of Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Under these rules, major dealers in swaps and derivatives (“Swap Dealers”) will be required to, among other things, conduct diligence on counterparties, verify their status as “eligible contract participants” and ensure that swap recommendations are suitable for them. In addition, these rules impose heightened duties on Swap Dealers that trade with employee benefit plans subject to Title I of the Employee Retirement Income Security Act of 1974, governmental plans as defined in ERISA Section 3, endowments, state and federal agencies, and other protected counterparties (“Special Entities”).

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The NFA recently issued a notice entitled “Guidance on the Annual Affirmation Requirement for those Entities that are currently operating under an exemption or exclusion from CPO or CTA registration.”  As of February 2012, each person claiming an exemption or exclusion from CPO registration under CFTC Regulation 4.5, 4.13(a)(1), 4.13(a)(2), 4.13(a)(3), 4.13(a)(5) or an exemption from CTA registration under 4.14(a)(8) is required to annually affirm the exemption or exclusion upon which it relies.  The annual notice affirming the exemption or exclusion is due within 60 days of the calendar year end.  The first notice is due for the calendar year ending December 31, 2012.  The required affirmation must be filed electronically on the NFA’s Exemption System.  A full version of the NFA notice along with FAQs regarding the annual affirmation requirement is available here.

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Written by:  Jay Gould

The Securities and Exchange Commission (the “SEC”) recently charged and entered into consent decrees with four India-based brokerage firms for providing brokerage services to U.S. investors without being registered as broker dealers under the U.S. securities laws.  This otherwise mildly interesting enforcement action by the SEC should serve as a cautionary tale to hedge fund managers based outside the U.S. that seek to raise capital from U.S. investors, as well as U.S. fund managers that seek to sell their fund shares in foreign countries.

Many non-U.S.-based fund managers seek to raise money from U.S. investors due to the large amounts of available capital in this country and the relative willingness of U.S. investors to consider managers from foreign jurisdictions.  However, visiting potential U.S. investors or sending fund marketing materials into the U.S. without complying with the U.S. broker dealer rules could result in a fate similar to that suffered by the four Indian brokerage firms that were sanctioned and fined by the SEC. In order to avoid an enforcement proceeding, non-U.S. fund managers should retain a properly registered U.S. brokerage firm to sell the fund’s securities, enter into a “chaperoning” arrangement with a U.S. broker or register a subsidiary as a broker-dealer in the U.S.  

Whether prudent or not, most U.S.-based fund managers rely on Rule 3a4-1, the so-called “issuers exemption,” under the Securities Exchange Act of 1934 (the “1934 Act”) in order to avoid either registering the general partner or an affiliate of the fund as a broker, or retaining an unrelated broker to sell the fund’s interests.  But when U.S. fund managers travel outside the U.S. to gauge interest or solicit potential investors, the U.S. rules are not applicable.  Each country has its own regulatory scheme, and fund managers are well advised to understand what is permitted and prohibited in each country before visiting each country at the risk of being the subject of a new episode of “Locked Up Abroad.”  Indeed, certain countries impose criminal sanctions for offering securities if the offeror is not properly authorized to do so.

The Investment Fund Law Blog boldly predicts that the SEC will one day soon re-visit the industry’s expansive interpretation of the “issuer’s exemption” and the result will not be pleasant for the private funds industry.

So what did these Indian brokerage firms do to incur the wrath of the SEC?  The activities that these firms engaged in included:

  • Buying and selling Indian securities on Indian stock exchanges on behalf of U.S. investors;
  • Managing public offerings for Indian issuers in which shares were sold to U.S. investors;
  • Soliciting U.S. investors by email, phone calls, and in-person meetings between Indian issuers and U.S. investors;
  • Engaging in commission sharing agreements with U.S. registered broker-dealers, in which the firms provided research to U.S. investors in exchange for commission income;
  • Organizing and sponsoring conferences in the U.S. bringing together representatives of Indian issuers and U.S. investors; and
  • Sending firm employees to the U.S. to meet with U.S. investors and attend corporate road shows.

Many of these activities no doubt sound hauntingly familiar to U.S.-based fund managers that travel abroad for the purpose of raising capital.  All four firms were censured and ordered to pay a combined total of more than $1.8 million in disgorgements and prejudgment interest, but no civil penalties were imposed due to the firms’ cooperation with the SEC.  The firms have all submitted settlement offers, without admitting or denying any wrongdoing.

The SEC’s press release on the matter can be found here. 

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By Peter J. Hunt, Susan P. Serota, Matthew C. Ryan1

In welcome news for private equity (“PE”) funds, a recent district court opinion determined that two PE funds and their bankrupt portfolio company were not a “controlled group” and thus the PE funds were not responsible for pension liabilities at the portfolio company. The decision, Sun Capital Partners III, LP v. New England Teamsters and Trucking Industry Pension Fund, explicitly rejected a prior Pension Benefit Guaranty Corporation (“PBGC”) ruling on the same question and illuminated best practices for structuring future PE fund investments.

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Under current gift tax law, any individual may make a gift of up to $5.12 million this year to the individual’s children, grandchildren and other beneficiaries without paying gift tax.  Any gift in excess of that amount is taxed at a historically-low 35%.  Unless Congress acts to extend (in whole or part) this benefit, created under the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, the gift exemption will decrease to $1 million on January 1, 2013.  Any gift in excess of $1 million will thereafter be taxed at up to 55%.  Fund managers and other financial services professionals who have significant estates should consult their tax and estate planning professionals immediately to take advantage of this enormous opportunity.  Many fund managers are making gifts of carried interests to “dynasty trusts” created in states that permit trusts to continue in perpetuity, where the gift may be held for the benefit of future generations without being reduced by estate or other transfer taxes at each generation.  Pillsbury’s latest Advisory addresses this topic in detail; you can find the Advisory at www.pillsburylaw.com/publications.

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Written by:  Jay B. Gould, Michael Wu and Peter Chess

Note: Pillsbury and KPMG, along with the California Hedge Fund Association, will be sponsoring a “Managers Only” event on the JOBS Act and the new world of “general solicitation” for Funds on June 14.

The Jumpstart Our Business Startups Act (the “JOBS Act” or the “Act”), signed into law by President Obama on April 5, 2012, seeks to encourage economic growth through the easing of certain restrictions on capital formation and by improving access to capital.  The JOBS Act contains a number of provisions that will directly impact private funds and their general partners, managers and sponsors.  Below is a summary of the Act’s provisions that directly affect private funds, including ongoing requirements for funds that at this time do not appear to be affected by the Act.

Section 4 of the Securities Act.  The JOBS Act amends Section 4 of the Securities Act of 1933, as amended (“Securities Act”), so that offers and sales exempt under Rule 506 of Regulation D will not be deemed public offerings as a result of general advertising or general solicitation.  Private funds relying on the exception in Section 3(c)(1) (“3(c)(1) Fund”) of the Investment Company Act of 1940, as amended (“Investment Company Act”), will be able to continue to avail themselves of this exception so long as all of their investors are accredited investors, as defined in Rule 501 of Regulation D (“Accredited Investors”).  We expect that private funds relying on the exception in 3(c)(7) (“3(c)(7) Fund”) of the Investment Company Act will obtain the greatest benefit from the JOBS Act, as these funds, which accept only “qualified purchasers,” as defined in Section 2(a)(51) of the Investment Company Act, may now have up to 2000 investors (as discussed below) before they would be required to register as a public reporting company under the Securities Exchange Act of 1934, as amended (“Exchange Act”).  3(c)(1) Funds will continue to be limited to 99 investors, although a fund manager may organize and offer both a 3(c)(1) Fund and a 3(c)(7) Fund with the same investment objective and strategies without the two funds being subject to “integration” under the Securities Act.

General Solicitation and General Advertising.  The JOBS Act requires the Securities and Exchange Commission (“SEC”) to amend Regulation D under the Securities Act to eliminate the prohibition on general solicitation and general advertising for offerings under Rule 506, provided that all purchasers are Accredited Investors.  The Act mandates that the SEC implement rule amendments ninety days after the enactment of the Act, or by July 4, 2012.

It is unlikely that the SEC will be able to meet this deadline given the requirement to provide public notice and comment prior to adopting any final rules; accordingly, these rule amendments are expected to be adopted by the fall with very little transition period.  Although the Act leaves little in the way of discretion to the SEC in the rulemaking process there are two areas in which the SEC may seek to provide substantive guidance.  The SEC is required to amend Regulation D such that any issuers relying on Rule 506 must take reasonable steps to verify that purchasers are Accredited Investors.  Some observers believe that the SEC may require issuers that avail themselves of the general advertising provisions to obtain sufficient financial information from prospective purchasers so that the “accredited status” of such investors can be more precisely determined.  This could take the form of requiring all such issuers to obtain an income statement or verified financial statement from investors.  The other area in which the SEC may attempt to provide additional oversight is with respect to the offering of private fund interests through broker-dealers. 

Brokers and Dealers.  The JOBS Act provides that with regard to securities offered and sold under Rule 506 and subject to certain conditions, registration as a broker or dealer under Section 15(a)(1) of the Exchange Act will not be required for certain persons solely because of the performance of specific functions.[1]  This exemption from registration is available only if such persons: (i) receive no compensation in connection with the purchase and sale of the securities; (ii) do not have possession of customer funds or securities in connection with the purchase and sale of securities; and (iii) are not subject to statutory disqualification (sometimes referred to as “bad boy” provisions).  Although it is uncertain at this time, the SEC may take this opportunity to require private funds that avail themselves of the ability to advertise generally to conduct all offers and sales of their fund interests through a registered broker-dealer.  The SEC realizes that as a result of the fast moving and innovative private funds industry, the regulator lost control of Regulation D as well as the “issuer’s exemption” in Rule 3a4-1 under the Exchange Act, the exemption that fund managers rely upon to offer their securities directly to purchasers.  It is not clear that Rule 3a4-1 was ever intended for this purpose, and the SEC may take this opportunity to clarify how offers and sales are conducted generally by private fund managers.

Record Holders.  The JOBS Act increases from 500 to 2,000 the number of record holders of equity securities an issuer may have before the issuer is required to register under Section 12(g) of the Exchange Act, so long as the number of non-Accredited Investors does not exceed 499.  3(c)(1) Funds will be unable to have any non-Accredited Investors if they want to employ general advertising even though, under Regulation D rules that predate the JOBS Act, sales could be made to up to 35 non-Accredited Investors (with no general solicitation).  There is an outstanding question as to whether the SEC will “grandfather” in existing non-Accredited Investors in 3(c)(1) Funds, or if perhaps some form of Rule 506 will survive whereby sales to non-Accredited Investors will be permissible if no general solicitation takes place.      

Continuing Restrictions and Obligations.  Although the JOBS Act will potentially ease the burdens presented by capital raising for private funds, the following should be noted: 

  • Private fund offerings pursuant to Rule 506 will continue to be subject to the anti-fraud provisions of federal and state securities laws and the restrictions on advertising found in the Investment Advisers Act of 1940, as amended (“Advisers Act”).  For example, Rule 206(4)-1 of the Advisers Act (the advertising rule) and its general prohibition against advertisements that are false and misleading still necessitates compliance.  Managers of private funds that advertise generally must understand the advertising rules against “testimonials” in their public marketing materials.  To be “liked” on Facebook or similarly endorsed on other social networking sites would likely be considered to be an illegal testimonial by the SEC which could result in and administrative action accompanied by fines and penalties.   
  • Private funds should continue to rely on the guidance provided in the Clover Capital Management, Inc. SEC no-action letter and the subsequent line of letters when contemplating activities such as performance presentations by following practices so as not to present misleading performance results.  Further, private funds should continue to comply with Rule 206(4)-8 of the Advisers Act and its prohibition on making untrue statements or omitting material facts or otherwise engaging in fraudulent, deceptive or manipulative conduct regarding interactions with investors in pooled investment vehicles.  To the extent a private fund manager avails itself of the ability to advertise past performance, special care will need to be taken to ensure that all documents are consistent and performance information is presented in a manner that is complete and accurate.
  • Private funds should consider and continue to comply with advertising and disclosure rules as applicable to registered advisers and members of the Financial Industry Regulatory Authority (“FINRA”).  FINRA rules also apply to broker-dealers acting as placement agents or intermediaries in Rule 506 transactions.  Private funds making use of exemptions from registration under the Advisers Act and/or the Investment Company Act must continue to comply with the restrictions set forth in such exemptions.  For example, although the JOBS Act provides that offers and sales exempt from registration under Rule 506 will not be deemed public offerings by virtue of the use of general advertising and general solicitation, 3(c)(1) Funds must not exceed the one hundred beneficial owner limit.

Foreign Private Advisers.  A “foreign private adviser” that qualifies for the exemption from registration under the Advisers Act is an adviser that has no place of business in the U.S., fewer than 15 U.S. clients, less than $25 million attributable to U.S. clients and does not hold itself out generally to the public in the U.S. as an investment adviser.  The SEC in the past has construed certain types of advertising, including information available on websites, as an example of an adviser holding itself out to the public in the U.S. as an investment adviser.  Given the increased freedom for advertising under the JOBS Act, the SEC may look more closely at advisers taking advantage of the foreign private adviser exemption and whether any activities that could be construed as advertising may violate the terms of the exemption.

Regulation S.  Regulation S under the Securities Act, the safe harbor from registration for offshore sales of securities to non-U.S. persons, does not allow for “directed selling efforts” in the U.S.  It remains to be seen if general solicitation or advertising in connection with the amendments to Regulation D will be seen as “directed selling efforts” under Regulation S and whether the SEC will clarify how this will affect the potential use of Regulation S in connection with offerings under Rule 506.

 State Blue Sky Laws.  Many private funds have relied on self-executing exemptions in certain states in order to avoid filings and/or fees required under applicable state statutes or rules.  These self-executing exemptions are commonly conditioned on a prohibition on general solicitation or general advertising.  Private funds employing general solicitation and/or advertising in reliance on the amended Rule 506 should note the mechanics of such Blue Sky laws of the states where securities are being offered and sold and comply accordingly.

[1]   This applies to persons that: (a) maintain a platform or mechanism that permits the offer, sale, purchase, or negotiation of or with respect to securities, or permits general solicitations, general advertisements, or similar or related activities by issuers of such securities, whether online, in person, or through any other means; (b) co-invest in such securities; or (c) provide ancillary services with respect to such securities.

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by Joseph J. Kaufman

New guidance outlines key rules for the new confidential review option for initial public offerings by emerging growth companies in the United States. 

The Jumpstart Our Business Startups Act (also known as the JOBS Act) became a U.S. federal law on April 5, 2012 and immediately authorized a confidential submission option for registered securities offerings in the United States by emerging growth companies (EGCs). The U.S. Securities and Exchange Commission (SEC)’s Division of Corporation Finance staff promptly announced its procedure for accepting confidential draft registration statements using this option. The staff has also given written and oral guidance on a number of relevant frequently asked questions. This alert explains the background and expected benefits of the confidential submission option and reviews the SEC staff guidance.

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By: Louis A. Bevilacqua, Joseph R. Tiano, Jr., David S. Baxter, Ali Panjwani and K. Brian Joe

On April 5, 2012, President Obama signed into law the Jumpstart Our Business Startups Act (JOBS Act), a bill with widespread bipartisan support and assembled from a combination of legislative initiatives introduced throughout 2011 targeting smaller companies and focusing on cheaper capital raising and job creation. We discuss the key provisions of the JOBS Act and their impact on these companies and securities offerings.

The Jumpstart Our Business Startups Act (JOBS Act) is a consolidation of several bills introduced throughout 20111 with the goal of making it easier for smaller companies to raise money and lessen their regulatory burden while doing so. The House of Representatives passed the JOBS Act on March 8 by a vote of 390-23, and the Senate passed the same bill, with one amendment, on March 22 by a vote of 73-26. The Senate amendment offered a more restrictive take on the House bill’s provisions dealing with the increasingly popular grass-roots financing method known as crowdfunding. On reconsideration of the bill with the Senate amendment, the JOBS Act passed the House by a vote of 380-41 on March 27, and President Obama signed it into law on April 5. The JOBS Act is one of the most comprehensive pieces of legislation in recent years to be specifically targeted at developing companies. This Alert summarizes the most important provisions of the JOBS Act and the implications of those provisions.

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Written by Jay Gould, Michael Wu and Peter Chess

The Commodity Futures Trading Commission (the “CFTC”) recently amended its registration rules regarding Commodity Pool Operators (“CPOs”) and Commodity Trading Advisors (“CTAs”), which will require many general partners and managers of private investment funds that previously relied on an exemption from registration to now register with the CFTC.  After a public comment period in which the industry overwhelmingly supported the continuation of these exemptions, the CFTC decided to rescind the CPO exemption under CFTC Rule 4.13(a)(4) and amend the CPO exemption under CFTC Rule 4.13(a)(3).  Rule 4.13(a)(4) previously exempted private pools from registering as a CPO with the CFTC for funds offered only to institutional qualified eligible purchasers (“QEPs”) and natural persons who meet QEP requirements that hold more than a de minimis amount of commodity interests.

The CFTC’s amendment did not change the application of CFTC Rule 4.13(a)(3) to a fund of a hedge fund (“Fund of Funds”).  However, due to the repeal of these exemptions, many of the general partners or managers of a Fund of Funds’ underlying funds may be required to register as CPOs, thereby requiring registration of the Fund of Funds manager.  The CFTC has provided guidance with respect to when a Fund of Funds manager may continue to rely upon an exemption from registration as a CPO.  We have summarized these circumstances below:     

  • If a fund (i) allocates a Fund of Fund’s assets to one or more underlying funds, which do not satisfy the trading limits of CFTC Rule 4.13(a)(3)[1] (“Trading Limits”) and each of which is operated by a registered CPO, and (ii) does not allocate the Fund of Fund’s assets directly to commodity interest trading, that fund may only rely on Section 4.13(a)(3) if the Fund of Funds itself satisfies the Trading Limits.
  • If a fund (i) allocates a Fund of Fund’s assets to one or more underlying funds, each having a CPO who is either (a) exempt under CFTC Rule 4.13(a)(3) or (b) a registered CPO that complies with the Trading Limits, and (ii) does not allocate the Fund of Fund’s assets directly to commodity interest trading, that fund may rely on Section 4.13(a)(3).
  • If a fund (i) allocates a Fund of Fund’s assets to one or more underlying funds, each of which satisfies the Trading Limits, and (ii) does not allocate the Fund of Fund’s assets directly to commodity interest trading, that fund may multiply the percentage restriction applicable to each underlying fund by the percentage of the Fund of Fund’s allocation of assets to such underlying fund, to determine whether that fund may rely on Section 4.13(a)(3).
  • If a fund (i) allocates the Fund of Fund’s assets to one or more underlying funds, and it has actual knowledge of the Trading Limits of the underlying funds (e.g., where the underlying funds or their CPOs are affiliated with a fund), and (ii) does not allocate the Fund of Fund’s assets directly to commodity interest trading, that fund may aggregate the commodity interest positions across the underlying funds to determine compliance with the Trading Limits and whether or not that fund may rely on CFTC Rule 4.13(a)(3). 
  • If a fund (i) allocates no more than 50% of the Fund of Fund’s assets to underlying funds that trade commodity interests (regardless of the level of trading engaged by such underlying funds), and (ii) does not allocate the Fund of Fund’s assets directly to commodity interest trading, that fund may rely on CFTC Rule 4.13(a)(3).

The CFTC amended Section 4.13(a)(3) to address how to calculate the notional value of swaps and how to net swaps.  In addition, the CFTC will now require a CPO relying on Section 4.13(a)(3) to submit an annual notice to the National Futures Association affirming its ability to continue relying on the exemption.  If a CPO cannot affirm its ability to do so, the CPO will be required to withdraw the exemption and, if necessary, apply for registration as such.

For additional information on whether these rule amendments will require you to register as a CPO or CTA, or whether the CFTC guidance or another exemption might provide a further exemption from registration, please contact your Pillsbury Investment Funds Attorney.

[1]   CFTC Rule 4.13(a)(3) requires that at all times either: (a) the aggregate initial margin and premiums required to establish commodity interest positions does not exceed five percent of the liquidation value of the Fund’s investment portfolio; or (b) the aggregate net notional value of the Fund’s commodity interest positions does not exceed one-hundred percent of the liquidation value of the Fund’s investment portfolio.