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In a press release yesterday, the CFTC issued an exemptive letter, CFTC Letter No. 14-116, providing relief from certain provisions of CFTC Regulations 4.7(b) and 4.13(a)(3) that restrict marketing to the public.  The exemptive relief was issued to make CFTC Regulations 4.7(b) and 4.13(a)(3) consistent with SEC Rule 506(c) of Reg. D and Rule 144A, which were amended by the Jumpstart Our Business Startups Act (JOBS Act), to permit general solicitation or advertising subject to certain limitations.

Generally, the JOBS Act adopted SEC Rule 506(c) to permit an issuer, subject to the conditions of the rule, to engage in general solicitation or general advertising when offering and selling securities, and amended SEC Rule 144A to permit the use of general solicitation, subject to the limitations of the rule, when securities are sold to qualified institutional buyers (“QIBs”) or to purchasers that the seller reasonably believes are QIBs.  Prior to the CFTC’s exemptive relief, commodity pool operators (“CPOs”) relying on CFTC Regulations 4.7(b) and 4.13(a)(3) were not able to use general solicitation under Rule 506(c) or Rule 144A, as the CFTC exemptions prohibited general solicitation.

The new relief from provisions in CFTC Regulations 4.7(b) and 4.13(a)(3) is subject to the following conditions:

  1. The exemptive relief is strictly limited to CPOs who are 506(c) Issuers or CPOs using 144A Resellers.
  2. CPOs claiming the exemptive relief must file a notice with the Division.  The notice of claim of exemptive relief must:
  • State the name, business address, and main business telephone number of the CPO claiming the relief;
  • State the name of the pool(s) for which the claim is being filed;
  • State whether the CPO claiming relief is a 506(c) Issuer or is using one or more 144A Resellers;
  • Specify whether the CPO intends to rely on the exemptive relief pursuant to Regulation 4.7(b) or 4.13(a)(3), with respect to the listed pool(s);

 i.      If relying on Regulation 4.7(b), represent that the CPO meets the conditions
of the exemption, other than that provision’s requirements that the offering be
exempt pursuant to section 4(a)(2) of the 33 Act and be offered solely to QEPs,
such that the CPO meets the remaining conditions and is still required to sell
the participations of its pool(s) to QEPs;
ii.       If relying on Regulation 4.13(a)(3), represent that the CPO meets the
conditions of the exemption, other than that provision’s prohibition against
marketing to the public;

  • Be signed by the CPO; and
  • Be filed with the Division via email using the email address dsionoaction@cftc.gov and stating “JOBS Act Marketing Relief” in the subject line of such email.
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China imposes controls on the inflow and outflow of foreign exchange. Given the involvement of State Administration of Foreign Exchange and various other governmental agencies in the process, repatriating funds from China can be a trap for the unwary. Foreign investors should familiarize themselves with the approval requirements and procedures.

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The relentless attention being paid to cyber-attacks is driving companies to increase cyber security budgets and purchases. In turn, this has led institutional investors and asset managers to see potentially massive returns associated with companies in the cyber security market. Indeed a number of companies that have gone public have had phenomenal success, and the constantly morphing nature of cyber-attacks means that purchasing trends are not likely to slow down any time soon.

However, it is critical to keep in mind that just as cyber security capabilities can be a very attractive component in evaluating a potential investment; it also could lead to potentially negative consequences. Ignorance of some key legal and policy considerations could lead to an improper assessment of the value/future earnings potential of technology investments. These considerations are true regardless of whether or not the technology or service has a core “security” component.

Below are some key issues to consider when making cyber security investment decisions:

  • Cyber security matters in every investment
    • It is a simple fact that every company faces cyber threats. Multiple studies have  demonstrated that essentially every company has been or is currently subject to cyber-attack and that most if not all have already been successfully penetrated at least once. This leads to a key consideration: every company’s cyber security posture should be considered when making investment decisions. For example, a company selling information technology that is less prone to cyber-attacks should be viewed as a better investment than competitors who pay little to no attention to how their products can be breached.
  • Cybercrime is cheap
    • The cost of conducting cyber-attacks is depressingly cheap: $2/hour to overload and shutdown websites, $30 to test whether malware will penetrate standard anti-virus systems, and $5,000 for an attack using newly designed methods to exploit previously undiscovered flaws. Indeed it is now so cheap to create malware that the majority of malicious programs are only used once – thereby defeating many existing cyber security systems which are designed to recognize existing threats. This all adds up to a cost/benefit analysis that is irresistible for cyber-attackers, and essentially guarantees that the pace and sophistication of attacks will not let up any time soon.
  • Cyber security should be in the company’s DNA
    • Whether a company is offering a service or a technology, a critical factor to consider is its approach to security. Companies that consider security a key functionality that needs to be integrated from the start of the design process are far more likely to go to market with an offering that has higher degree of security. Security as an afterthought is just that – an afterthought. Weaving security into the DNA of a service or technology will be extremely helpful in decreasing security risks. Just remember though that no security program or process is flawless, and no one should expect perfection.
  • Is there a nation-state problem?
    • An R&D or manufacturing connection to countries known for conducting large-scale cyber espionage causes heartburn for companies and governments alike. Too many instances have occurred where buying items from companies owned by or operated in problem nation states have resulted in cyber-attacks. In some cases, Federal agencies are prohibited from buying IT systems from companies with connections to specific governments. Investors and managers need to stay abreast of problem countries, and also examine whether the product or service has a connection to such countries. Failure to do so can lead to investments in companies that have limited market potential.
  • Do your homework and forensic analyses
    • There’s nothing like buying a trade secret only to find out it really isn’t a secret. Before investing in any company, conduct due diligence to determine how good the security of the company is and whether IP or trade secret information has been compromised.
  • If the government cares, so should you
    • The Federal government is stepping up its requirements regarding cyber security in procurements. That means that all federal contractors (not just defense contractors) are going to have to increase their internal cyber security programs if they want to win government contracts. Failure to have a good cyber security program could lead to lost contracts, and thus decreased growth. 
  • Words matter
    • Companies have been too lax in negotiating terms that explicitly set forth security expectations for IT products as well as who will be liable should there be a breach/attack. Judicious reviews of terms and conditions can help avoid liability following a cyber-attack. For example, companies should not accept boilerplate language regarding the following of “industry standards” or “best practices” with respect to cyber security. Instead, specific obligations and benchmarks need to be agreed upon before signing any agreement. Further agreements should be drafted to that make clear that security measures are the obligation of the other party. That way the investor has set up a stronger argument for recovering losses as well as shifting liability away from itself.
  • Insurance isn’t everything
    • Companies may be tempted to think that if a company has a cyber-insurance policy, they are protected in the event of a cyber-attack. The reality is that there is an enormous chasm between buying coverage and having claims paid. Cyber policies are increasingly being written and interpreted to cover fewer types of attacks, and so do not be tempted to think that cyber insurance can fully protect an investment.
  • SAFETY Act
    • Under the Support Anti-Terrorism by Fostering Effective Technologies Act (SAFETY Act), cyber security services, policies, and technology providers are all eligible to receive either a damages cap or immunity from liability claims. The SAFETY Act also protects cyber security buyers, as they cannot be sued for using SAFETY Act approved items. Possessing SAFETY Act protections should be considered a positive sign and indicative of potential earnings growth.

There is no doubt about it; cyber risks are here to stay. Addressing those risks should be a core component of any business or investment strategy, because even if “today’s problem” is solved the introduction of new technologies will just mean a new threat vector for adversaries to exploit.

It is not all doom and gloom, however. Paying attention to cyber security trends and doing some simple due diligence will go far in minimizing digital risks. Make no mistake: defenses will always be incomplete and successful attacks will happen. However, with the right processes and approach, the bad outcomes can be minimized and investments will be protected.

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At the Intersection of Faith and Illiteracy.

In what may have been one of the more interesting weeks this year for SEC enforcement actions, the Enforcement Division brought a number of actions last week, several of which will make you wonder if the warnings that we issued when the JOBS Act was passed are not coming to pass.  Although none of these actions are based on 506(c) reliance, they do suggest that as capital finally starts to seek new opportunities outside the mainstream, it is necessary for investors to evaluate investment opportunities very carefully in order to avoid the scam artists who, like Jesse James, go where the money is.

On July 31, 2014, the SEC filed fraud charges and sought emergency relief against Thomas J. Lawler of Snellville, Georgia, a self-proclaimed minister, and his company, Freedom Foundation USA LLC for fraudulently offering and selling fictitious securities.  With all due respect to Siskel and Ebert, this case is not to be missed.  I laughed, I cried, if you only read one enforcement action this year, it has to be this one.

The SEC’s complaint filed in U.S. District Court for the Northern District of Georgia alleged that, since as early as 2004, the defendants  Lawler and Freedom Foundation offered investors the opportunity to eliminate their debts and collect lucrative profits through the purchase of so called “administrative remedies” (“ARs”).  Defendants told potential investors that every individual had funds established for them in an account at birth — where, by whom, and in what amount the supposed account is established are details Lawler does not provide.  Defendants further told potential investors that the investors therefore did not owe their creditors for mortgage and other debts, and that Freedom Foundation would use its unique and proprietary process to create the ARs, which would eliminate the investors’ debt and provide a lucrative financial return.  Does the Wesley Snipes tax case come to mind?

The SEC alleged that defendants told potential investors that a $1,000 AR would cancel the investor’s debt and return $325,000 to the investor, while a $10,000 investment would supposedly entitle the investor to receive $1 million when the AR funded.  Freedom Foundation claimed it would fund the ARs through a mysterious process involving a Papal decree.  What could possibly go wrong there?  The SEC claims that Lawler sold approximately 2,000 ARs over ten years to investors throughout the country and that he was actively soliciting additional investors.  This is not exactly one per minute, but it is impressive.  And, as shocking as this may sound, the SEC found that not one investor in this scheme received any of the promised returns.

Freedom Club targeted our most ignorant and vulnerable citizens through an internet presentation that was designed to prey on the uninformed and easily swayed.  Let’s hope that the SEC is not successful in shutting down the Freedom Club website before you have the opportunity to check it out: http://www.freedomclubusa.com/.  Admit it, this case does raise the question of whether anyone who would fall for this scam should be allowed to handle money at all…ever.

Chief Compliance Officer/General Counsel Takes the Fall.

You may recall that we recently wrote about attorneys who seem to escape scrutiny by the SEC when they participate in illegal activities.  There is an administrative remedy against attorneys who facilitate or promote wrongdoing, but the SEC has been slow to target ethically challenged attorneys.  Well, wait no longer.  Last month, a judgment was entered by consent against the general counsel and chief compliance officer of an investment adviser who was found to have aided and abetted fiduciary violations of the firm’s principal in the misappropriation of hedge fund client assets in contravention of the offering documents of the fund.  What is the take away here?  If you are a Chief Compliance Officer, I believe you know the answer to that one.

See, Securities and Exchange Commission v. Weston Capital Asset Management, LLC, et al., Civil Action Number 14-CV-80823-COHN, in the United States District Court for the Southern District of Florida.

Criminal Referrals Catching On.

Robert G. Bard was sentenced on July 31 by a U.S. District Court in Pennsylvania. Bard had been found guilty by a jury and convicted of 21 counts of securities fraud, mail fraud, wire fraud, bank fraud, and making false statements for defrauding his investment advisory clients between December 2004 and August 2009.  The court sentenced Bard to 262 months imprisonment and ordered him to pay $4.2 million in restitution to 66 victims.  If you do the math, this comes out to right around $200,000 per year sentence.

The criminal case arose out of the same facts that were the subject of a civil injunctive action filed by the SEC in 2009. The Commission’s complaint alleged that defendant Bard, an investment adviser, and his solely-owned company Vision Specialist Group LLC had violated the federal securities laws through fraudulent misrepresentations regarding client investments, account performance and advisory fees, and by Bard’s creation of false client account statements, forgery of client documents.

In a follow-on administrative proceeding to the SEC’s civil court action, an administrative law judge barred Bard from the securities industry in an initial decision.

Elder Abuse also Brings Criminal Action.

The SEC also brought charges against a broker based in Roanoke, Va., for allegedly defrauding elderly customers, including some who are legally blind, by stealing their funds for her personal use and falsifying their account statements to cover up her fraud.

According to the SEC’s complaint, Donna Jessee Tucker siphoned $730,289 from elderly customers and used the money to pay for such personal expenses as vacations, vehicles, clothes, and a country club membership.  Tucker ensured that the customers received their monthly account statements electronically, knowing that they were unable or unwilling to access their statements in that format. The SEC further alleges that Tucker engaged in unauthorized trading and other financial transactions while making misrepresentations to customers about their investment accounts and forging brokerage, banking, and other documents.

In a parallel action, the U.S. Attorney’s Office for the Western District of Virginia announced criminal charges against Tucker.

The above cited actions represent just some of the more interesting enforcement actions brought by the SEC and the Department of Justice in recent days.  The full list is more extensive.

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The U.S. House of Representatives took a major positive step towards increasing the nation’s cyber security posture today when, on a voice vote, it passed H.R. 3696, the “National Cybersecurity and Critical Infrastructure Protection Act.”

The NCCIP bill, co-sponsored by House Homeland Security Chairman Mike McCaul, Ranking Member Bennie G. Thompson, Subcommittee Chair Patrick Meehan, and Subcommittee Ranking Member Yvette Clarke, clarifies a number of roles and responsibilities of the Department of Homeland Security (DHS), and it also strengthens key public/private partnerships.

One of the most interesting and potentially helpful elements of the NCCIP bill is in Title II, Section 202. There, the House approved additional language to be inserted into the Support Anti-Terrorism by Fostering Technologies Act of 2002 (the SAFETY Act). The language would add the term “qualifying cyber incident” to the SAFETY Act, thereby making it perfectly clear that cyber attacks unconnected to “acts of terrorism” may trigger – at the discretion of the Secretary of Homeland Security – the liability protections offered by the SAFETY Act.

READ MORE…

Read this article and additional publications at pillsburylaw.com/publications-and-presentations.

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The Securities and Exchange Commission (SEC) yesterday adopted a series of amendments to the rules that govern money market funds.  The most controversial of these amendments will require institutional prime and tax-exempt money market funds to maintain a floating net asset value (NAV) and will allow the boards of institutional and retail prime and tax-exempt money market funds to impose liquidity fees and to suspend redemptions temporarily if the funds’ weekly liquid assets fall below a certain threshold.  Funds will have two years to comply with these amendments.

Retail and government funds will be not subject to the floating NAV requirement.  A retail fund is defined as a fund that has policies and procedures reasonably designed to limit all beneficial owners to natural persons.  A government fund is defined as a fund that invests 99.5% of its assets in cash and government securities.  Floating NAVs will be rounded to the fourth decimal place.  In conjunction with the SEC amendments, the Treasury Department and the Internal Revenue Service proposed rules providing a simplified tax accounting method to track gains and losses on floating NAV money market funds and providing relief from the wash sale rules.

If a money market fund’s weekly liquid assets fall below 30% of its total assets, a fund board would be permitted to impose a liquidity fee of up to 2% on redemptions and to suspend redemptions (impose a “gate”) for up to 10 business days.  If the liquid assets fall below 10%, the fund would be required to impose a liquidity fee of 1%, unless the fund board determines that a lower or higher fee (ranging from no fee to a 2% fee) would be in the best interest of the fund.  Government funds would not be subject to these requirements, but could voluntarily opt into them if previously disclosed to investors.

Concern has been expressed that the floating NAV requirement will impose new costs on money market funds, prompt institutional investors to shift cash to government funds, bank deposits and unregulated funds, and impair the short-term funding of businesses and governments.  Concern has also been expressed that the liquidity fee and gate requirements will trigger runs.

The SEC at the same time adopted less controversial amendments to the diversification, disclosure and stress testing requirements for money market funds, as well as to the reporting requirements for money market funds and for private funds that operate like money market funds.  In addition, it reproposed amendments to remove references to credit ratings in the rules and forms relating to money market funds.

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The Securities and Exchange Commission (the “SEC”) charged Kevin McGrath, a partner at a New York investor relations firm with insider trading.  According to the SEC complaint, McGrath allegedly received confidential information from clients in order to prepare press releases.  The SEC discovered McGrath used non-public information from two different clients to buy or sell such clients’ securities for his personal benefit.

While high dollar insider trading cases are common news, this case involves profits of a mere $11,776.  The financial penalties were similarly small and McGrath settled the case with a disgorgement of $11,776, interest of $1,492 and a penalty of $11,776, in addition to a prohibition on trading in any client security.  Those with access to insider information should see this case as a reminder that no instance of insider trading will be ignored by the SEC.

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Private equity firms were put on notice last year that they may be subject to registration as broker dealers when David Blass, head of the Division of Markets and Trading at the Securities and Exchange Commission (“SEC”), provided his insights at an industry conference.  Since that time, the SEC has published their examination priorities list, which included the presence exams of new registrants, a portion of which would review that status of private equity fund managers under the broker dealer rules.  Following up on this warning to the industry, the SEC has also targeted unregistered brokers for enforcement action.

Recently, at a speech in front of another industry group, Mr. Blass provided further guidance on how a private equity firm might structure its compensation arrangements in order to avoid the need to register as a broker dealer.  Consistent with the advice that Pillsbury has been providing private fund clients for many years, Mr. Blass warned against paying “transaction based” compensation and further suggested that if a private fund employee has “an overall mix of functions,” and sales is one aspect of those duties, it is less likely that the SEC staff would view such an arrangement as one that would require broker dealer registration.  An employee of a private fund manager would not be prohibited from being compensated on the overall success of the firm, and certainly sales of fund securities contribute to that overall success.  But tying compensation to assets raised looks like the traditional broker dealer compensation and should be avoided.

Mr. Blass indicated that the SEC is close to finalizing guidance on issues connected to private fund manager employee compensation.  However, the SEC staff has further to go before providing guidelines to the industry on the broker dealer registration issues posed by deal fees that private equity firms sometimes collect on transactions.  It is unlikely that Mr. Blass will see his initiatives through to completion, as he will soon be joining the staff of the Investment Company Institute where he will one day lobby against his former positions.

If you would like additional background on how the private fund managers came to find themselves in the gray zone of broker dealer registration as a result of paying their employees for performance, you may want to re-visit this article.

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In a move that should place securities lawyers and their clients on notice, Commissioner Kara Stein of the Securities and Exchange Commission (“SEC”) recently indicated that lawyers may become targets of SEC enforcement actions when a registrant has been poorly advised by its attorney and the result of that advice ends up harming investors or violating regulatory standards.  The SEC has the ability to sanction, fine and bar attorneys and accountants from practicing before the SEC pursuant to SEC Rules of Practice 102(e).  As a practical matter, a bar pursuant to Rule102(e) precludes an attorney or an accountant from representing a regulated entity, such as an investment adviser or broker dealer, in any further dealings with the SEC or otherwise.

Several years ago, before he retired, I asked Gene Gohlke, then the acting head of the SEC’s Office of Compliance, Inspections and Examinations, why it was that the SEC brought Rule 102(e) proceedings against accountants, but rarely against attorneys.  “Lawyers are different,” was the answer I received.  And that has been the approach  of the SEC for quite some time, only bringing proceedings to bar attorneys in the most obvious and egregious cases.  My question to Mr. Gohlke was prompted by what I saw as questionable legal advice from certain “boutique” law firms that were providing not just aggressive advice, but simply incorrect advice.  You may recall that before the relatively recent Mayer Brown no-action letter, hedge fund managers were being advised that they could hire third party marketers that were not registered as broker dealers through “solicitation agreements” pursuant to Rule 206(4)-3 under the Investment Advisers Act of 1940.  This position, which was advocated by every former real estate or anti-trust  lawyer turned hedge fund lawyer, was flatly wrong, but generally embraced by fund managers.  When the SEC finally caught on that some fund managers were hiring unregistered broker dealers, Bob Plaze, then associate director of the Division of Investment Management of the SEC, somewhat famously quipped that if fund managers had been interpreting the Dana letter to allow such activity, they had been interpreting it wrong.

Additionally, in his recent speech, David Blass put fund managers on notice that they have been misinterpreting the scope of the “issuer’s exemption,” Rule 3a4-1 under the Securities Exchange Act of 1934.  Fund managers are now on notice that they need to either hire third party brokers, or pay their internal employees based on something other than the amount of capital raised on behalf of the fund.  This also grew out of a misunderstanding of that rule by the aggressive and misinformed section of the securities bar.  There are many other examples, such as relying on the “issuer’s exemption” when the fund is organized as a unit trust, rather than a partnership or exempted company (don’t do it), misinterpretation of what constitutes permissible use of soft dollars within the safe harbor Section 28(e), operation of the custody rule, execution of short sales, and many more.  When the SEC finds deficiencies in a fund management organization, it is typically the fund manager that suffers the consequences, not the attorney that advised the fund management company.

But with the SEC now identifying attorneys as key “gatekeepers,” all of that could change.  Commissioner Stein is “troubled greatly” by enforcement cases where the lawyers that gave advice on the transaction and prepared and reviewed disclosures that were relied upon by investors are not held accountable.  The Commissioner identified that when lawyers do provide bad advice, or effectively serve to assist fraud, their involvement is used as a shield against liability, both for themselves and for others.  The problem has been surfaced by the SEC, now we will see how and against whom enforcement action is taken in order to make an example for the industry.

What does this mean for fund managers?  First, fund managers need to recognize that “forum shopping” is dangerous.  You can always find a lawyer somewhere that is complacent, desperate, or unethical enough to tell the fund manager whatever they want to hear.  This is a short term folly and can only lead to a bad result in the longer term.  Second, the market has changed substantially since the heady days of 2002-2007.  It is no longer just the overworked and understaffed regulators with which fund managers need to concern themselves.  Investor sophistication in the due diligence area has increased substantially and now endowments, family offices and ultra-high net worth investors want to understand that the fund manager has made good decisions with respect to their service providers and has not opted for a low-end option that the fund manager can dominate and control.  Particularly for start-up fund managers that have essentially one shot at executing on a successful offering, the choice of an administrator that has no FATCA solution, or a lawyer that is unknown or not respected, can kill the offering before it ever gets started.  As attorneys, we recognize that competition in the asset management business is fierce and raising assets has rarely been more difficult; however, this is a business that is built on trust and confidence.  Fund managers need to demonstrate with every decision they make; they are motivated by the best interests of their investing clients.

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On May 16, 2014, a federal court in Florida entered an Order finding in favor of the Commodity Futures Trading Commission (CFTC) following a trial against four Hunter Wise related companies and their owners on charges that they had fraudulently misrepresented the nature of precious metals transactions that resulted in millions of dollars in customer losses.

Hunter Wise was found to have orchestrated a multi-level marketing scheme in which so-called retail dealers served a sales function for Hunter Wise, soliciting customer accounts. The dealers advertised and claimed that they sold physical metals, including gold, silver, platinum, palladium, and copper, to retail customers on a financed basis and forwarded customer funds to Hunter Wise, whose identity was not disclosed to the customers.  Using deceptive marketing materials provided to them by Hunter Wise, the dealers claimed to arrange loans for the purchase of physical metals and advised customers that their physical metals would be stored in a secure depository.  Customers were then charged “exorbitant interest” on the purported loans and storage fees for the metal they thought they had purchased.  In fact, neither Hunter Wise nor any of the dealers purchased any physical metals, arranged actual loans for their customers to purchase physical metals, or stored physical metals for any customers participating in their retail commodity transactions.  Over 90 percent of the retail customers lost money.

Hunter Wise Commodities, LLC, Hunter Wise Services, LLC, Hunter Wise Credit, LLC, and Hunter Wise Trading, LLC and the individuals running the companies, have been ordered to pay, jointly and severally, $52.6 million in restitution to the defrauded customers and to pay a civil monetary penalty, jointly and severally, of $55.4 million, the maximum provided by law.  The CFTC charged Hunter Wise, its principals, and other related parties in December 2012.  The Court found that the principals of Hunter Wise knowingly defrauded more than 3,200 retail customers for more than 16 months, between July 2011 and February 2013, and engaged in fraudulent conduct that was “repeated, callous and blatant.”

In considering the appropriate penalties, the Court noted that the fraudulent scheme was “egregious and recurrent” and “calculated to deceive retail customers.” The Court held that the likelihood of future violations was “strong” given that Hunter Wise principals did not acknowledge any wrongdoing.  Further, the “systematic and pervasive nature” of the fraud necessitated full restitution for all customers who lost money between July 16, 2011 and February 25, 2013.

This case follows a CFTC “Precious Metals Fraud Advisory” alert issued in January of 2012 in which the CFTC indicated that it was aware of an increase in the number of companies offering customers the opportunity to buy or invest in precious metals.  The CFTC’s Consumer Fraud Advisory specifically warned that frequently companies do not purchase any physical metals for the customer, but instead simply keep the customer’s funds.  The Consumer Fraud Advisory further cautioned consumers that leveraged commodity transactions are unlawful unless executed on a regulated exchange.