Articles Tagged with Hedge Funds

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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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As we have previously reported, the Securities and Exchange Commission (“SEC”) has taken a significantly heightened interest in whether people who engage in certain promotional activities on behalf of issuers of securities should be subject to regulation as a broker dealer.  The David Blass speech of April 5, 2013 put hedge fund general partners on notice that certain sales practices undertaken by hedge fund personnel may require registration as a broker dealer.  The SEC has recently followed up this guidance with enforcement action.

On May 15, 2014, the SEC  charged a Tiburon, California based securities salesman for selling millions of dollars in oil-and-gas investments without being registered with the SEC as a broker-dealer or associated with a registered broker-dealer.  The defendant, Behrooz Sarafraz, agreed to settle the SEC charges by paying disgorgement of his commissions, prejudgment interest, and a penalty for a total of more than $22 million.

According to the SEC’s complaint filed in federal court in San Francisco, Sarafraz acted as the primary salesman on behalf of TVC Opus I Drilling Program LP and Tri-Valley Corporation, which were based in Bakersfield, California.   From February 2002 to April 2010, these companies raised more than $140 million for their oil-and-gas drilling venture.  While Sarafraz was raising money for these entities, he was not associated with any broker-dealer registered with the SEC.  The SEC also alleged that Sarafraz worked full-time locating investors for the Opus and Tri-Valley oil-and-gas ventures.  He described the investment program to investors and recommended they purchase Opus partnership interests or securities of Tri-Valley and its affiliated entities.  In return, Sarafraz received commissions that ranged from seven to 17 percent of the sales proceeds that he and members of a sales network generated.  The SEC alleges that Opus and Tri-Valley paid Sarafraz approximately $18.3 million in sales commissions.  He paid approximately $1.9 million to others as referral fees and kept the remaining $16.4 million for himself.

For the two companies for which Sarafraz raised money, this could be just the beginning of the process.  If investors have lost money or would otherwise seek to unwind these transactions, it is possible that the investors could sue the companies and Sarafrax for rescission.  Typically, in a rescission recovery case, the plaintiffs who purchased through the unregistered broker can receive the higher of the current market price of the price that they originally paid for the securities.  Hedge funds and other private companies that use solicitors should take note.

The SEC also charged New York-based Rafferty Capital Markets with illegally facilitating trades for another firm that was not registered as a broker-dealer as required under the federal securities laws.  According to the SEC’s order instituting settled administrative proceedings, Rafferty agreed to serve as the broker-dealer of record in name only for approximately 100 trades in asset-backed securities that were actually introduced by the unregistered firm.  While Rafferty held the necessary licenses and processed the trades, it was the unregistered firm that managed the business.  Five of the firm’s employees became registered representatives with Rafferty but they performed their work in the offices of the unregistered firm, which retained sole authority over their trading decisions and determined their compensation.  Rafferty had no involvement in the trading or compensation decisions while the registered representatives executed the trades through Rafferty’s systems on behalf of the unregistered firm.  Based on the agreement, Rafferty kept 15 percent of the compensation generated by these trades and sent the remaining balance to the unregistered firm.

The SEC’s order found that Rafferty willfully violated Federal securities laws and also willfully aided and abetted and caused the unregistered broker-dealer’s violation of the registration provisions of the Securities Exchange Act.  Rafferty consented to a cease-and-desist order that censures the firm and requires the disgorgement of $637,615 as well as payment of $82,011 in prejudgment interest and a $130,000 penalty.  This case should serve as a cautionary tale for hedge fund and other private fund managers that seek to hire sales people who construct sham arrangements with a broker dealer in order to appear to be in compliance with the broker dealer registration provisions.  Expect more of these types of action from the SEC in the near future.

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Written by: Ildiko Duckor

The California Commissioner of Business Oversight (“Commissioner”) recently amended California’s custody rule 10 C.C.R. Section 260.237 (the “New Custody Rule”).  The New Custody Rule will be effective on April 1, 2014.

All investment advisers licensed or required to be licensed in California must comply with the New Custody Rule.  California Exempt Reporting Advisers are not affected.

What is “having custody?”

Holding or having authority to obtain possession of client funds or securities, for example:

  • Possession of client funds or securities unless received inadvertently and returned to the sender promptly.
  • Any arrangement (such as a general power of attorney) that authorizes you to withdraw client funds or securities maintained with a custodian by instructing the custodian.
  • Any capacity with authority to access to client funds or securities (such as general partner of a limited partnership, managing member of a limited liability company or trustee of a trust).

If you “have custody” of assets.

  • Qualified Custodian.  You must maintain those assets with a “qualified custodian” such as a bank, trustee, or prime broker.
  • Notice on ADV.  You must notify the Commissioner on your ADV that you have or may have custody.
  • Notice to Clients*. You must notify your client in writing of the custodian’s name and address, and the manner in which the assets are maintained, and any changes to this information.
  • Quarterly Custodian’s Account Statement*.  You must reasonably ascertain that the custodian sends quarterly account statements with specific information to each client (for example, by being cc-d on electronic statements the custodian sends).
  • Surprise Exam*.  You must retain a CPA (by written agreement) to have an annual “surprise exam” of client assets, and report the examination and any resignation of the CPA on your ADV.
  • Internal Control Report.  If you or your affiliate serves as the qualified custodian:
    • The CPA firm conducting the surprise exam must be registered with and subject to examination by the PCAOB.
    • You must obtain an annual internal control report with specified content.
  • Exceptions.  There are certain exceptions from some of the New Custody Rule’s requirements for mutual fund shares, certain private securities, and for advisers that “have custody” only because they deduct fees (if certain conditions are also satisfied).

Fund Managers’ Obligations.

If you are a general partner of an investment limited partnership or a managing member of a limited liability company (or are in a similar position with respect to a pooled fund vehicle):

  • Quarterly Investor Account Statement.  You must send to all fund investors quarterly account statements showing:
    • the total amount of all additions to and withdrawals from the fund,
    • a listing of all additions to and withdrawals from the fund by an investor,
    • the opening and closing value of the fund at the end of the quarter,
    • the total value of an investor’s interest in the fund at the end of the quarter, and
    • a listing of securities positions on the closing date of the statement pursuant to FASB Accounting Standards Codification 946-210-50-4 through 6.
  • Independent Expense Verification*.  You must retain (by written agreement) an independent accountant or attorney obligated to act in your investors’ best interests and send him/her all invoices or receipts with details regarding calculations, so the independent person can:
    • review all fees, expenses and withdrawals from the fund,
    • determine that payments conform to the fund agreement, and
    • forward to the custodian approval for payments of the invoices.
  • Audited Fund Exceptions*.  You need not comply with the following requirements:  Notice to Clients, Quarterly Custodian’s Account Statement, Surprise Exam and Independent Expense Verification; if:
    • Your fund is audited annually, in accordance with GAAP, by an independent CPA registered with and subject to examination by the PCAOB.
    • The audited financials are distributed to all investors and the Commissioner within 120 days of the end of the fund’s fiscal year.
    • A final liquidation audit is performed, in accordance with GAAP, upon the fund’s liquidation, and the audited financials are distributed to investors and the Commissioner promptly upon completion of the audit.
    • The independent CPA is required by agreement to notify the Commissioner on Form ADV if it resigns or is terminated.
    • You notify the Commissioner that you intend to use the audit exception route.

For further details and interpretation of the intricacies of the New Custody Rule as they apply to you, please contact your Pillsbury Investment Funds and Investment Management team member.

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Written by:  Jay B. Gould and Jessica M. Brown

The Securities and Exchange Commission’s (“SEC”) Office of Compliance Inspections and Examinations released a “Risk Alert” on January 28, 2014, which focuses on the due diligence investment advisers perform in alternative investments[1] and managers for their clients. After observing an increasing trend in advisers recommending alternative investments to their clients, the SEC examined a group of SEC-registered investment advisers, who collectively manage more than $2 trillion. The purpose of the examination and the Risk Alert is to review how the advisers perform due diligence, utilize investment teams to review fund structures and complex investment strategies, and identify, control and disclose conflicts of interest.

While the Risk Alert focuses on the narrow market segment of advisers who recommend to their clients discretionary investments in alternative investments managed by outside advisers/managers, the recommendations and due diligence practices can serve as practical guidance for all investment advisers and fund managers.

Observations

The SEC notes four primary trends in the due diligence that advisers perform on alternative investments and their managers:

  1. Position-level transparency and client risk mitigation
  2. Use of third parties to supplement and validate information provided by managers
  3. Quantitative analyses and risk measures on the investment and managers
  4. Enhancing and expanding due diligence teams and policies

Warning Indicators

The SEC notes a number of red flags that advisers find with respect to managers that warrant additional due diligence. These warning signs include:

  • managers who refuse transparency requests;
  • performance returns that conflict with factors known to be associated with the manager’s strategy;
  • unclear investment and research process;
  • lack of a sufficient control environment and separation of duties between the business and investment units;
  • portfolio holdings that conflict with a purported strategy;
  • insufficiently knowledgeable personnel to carry out the strategy intended to be implemented;
  • changes in manager investment style;
  • investments that are overly complex or opaque;
  • lack of third-party administrator;
  • inexperienced auditor;
  • repeated changes in service providers;
  • unfavorable background check results;
  • discovery of undisclosed conflicts of interest;
  • insufficient compliance or operational programs; and
  • lack of sufficient fair valuation process.

Advisers should review whether their due diligence process identifies these warning indicators and whether there are additional warning indicators they should consider to meet their fiduciary obligations. 

Adviser Compliance Practices

The SEC identifies the areas in which they found material deficiencies or control weaknesses with the investment advisers. Based on the deficiencies the SEC identifies, advisers who recommend alternative investments should ensure:

  • the due diligence policies and procedures for alternative investments/managers are reviewed annually;
  • disclosures made to clients do not deviate from actual practices, are consistent with fiduciary principles and describe any notable exceptions to the adviser’s typical due diligence process;
  • marketing materials are not misleading or unsubstantiated regarding the scope and depth of the due diligence process;
  • due diligence processes are written policies that contain sufficient detail and require adequate documentation; and
  • if responsibilities are delegated to third-party service providers, periodic reviews of those service providers’ adherence to their agreements.

Conclusion

The SEC reminds advisers that they are fiduciaries and must act in the best interest of their clients. In order to meet their fiduciary obligations when selecting alternative investments for clients, an adviser must evaluate whether such investment meets the client’s investment objectives and is consistent with the strategies and principles of investment presented to the adviser by the manager.

While the Risk Alert focuses on a narrow market segment of advisers, the recommendations and due diligence practices have a broader application. Any SEC-registered adviser, exempt reporting adviser or state-registered adviser can review their own operational due diligence policies and procedures to see if they can be bolstered by incorporating any of the recommendations contained in the Risk Alert. Further, managers of alternative investments should consider whether any of their practices or policies are included in the list of warning indicators and make the changes necessary to smoothly pass an adviser’s due diligence process.

[1] Included in the SEC’s definition of “alternative investments” are hedge funds, private equity funds, venture capital funds, real estate funds, funds of private funds, and other private funds.

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Pillsbury was recently recognized for the second time as the “Best Onshore Law Firm – Hedge Fund Start-Ups” at the 2013 HFMWeek U.S. Hedge Fund Service Awards in New York City. This marks the fifth consecutive year Pillsbury has been honored by HFMWeek for its service to the hedge fund community. Pillsbury also won the HFMWeek Award for “Best Onshore Law Firm – Client Service” in 2009, 2010 and 2011.

The awards were established to recognize organizations that have outperformed their peers through the volatility of the last year, by demonstrating exceptional customer service or innovative product development. Winners are determined by a panel of independent industry experts who look at a combination of quantitative and qualitative measures.

Partner Jay Gould, leader of Pillsbury’s Investment Funds & Investment Management practice team, accepted the award on behalf of the Investment Funds & Investment Management team.

“HFMWeek’s recognition of Pillsbury and our work for clients organizing new investment advisers and offering new funds is even more meaningful because these are pivotal days for the industry, which faces relentless competition, global economic uncertainty and entirely new regulatory controls—particularly here in the U.S.,” Gould said. “This award reflects the understanding by both investors and fund managers that new hedge fund managers need to partner with the very best in class legal team in order to be and remain competitive in today’s highly scrutinized markets.”

HFMWeek serves the international hedge fund community, covering all aspects of operating a successful hedge fund. Pillsbury prevailed over top U.S. firms that also practice in the funds management area.

The team posts analysis of legal and business issues at Pillsbury’s Investment Fund Law Blog.

About Pillsbury Winthrop Shaw Pittman LLP

Pillsbury is a full-service law firm with an industry focus on energy & natural resources, financial services including financial institutions, real estate & construction, and technology. Based in the world’s major financial, technology and energy centers, Pillsbury counsels clients on global business, regulatory and litigation matters. We work in multidisciplinary teams that allow us to understand our clients’ objectives, anticipate trends and bring a 360-degree perspective to complex business and legal issues—helping clients to take greater advantage of new opportunities, meet and exceed their objectives and better mitigate risk. This collaborative work style helps produce the results our clients seek.

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This article was published by Business in Canada and is reprinted here with permission.

Business in Canada recently had the opportunity to interview Richard Taglianetti, a giant in the hedge fund universe who has raised millions of dollars for start-up managers over the course of his career. At present, Richard serves as the senior managing director of hedge funds at Corinthian Partners, where he connects institutional investors on both sides of the Atlantic with emerging managers who have logical, scalable processes and strong track records, to boot.

During the interview, we discussed the challenges facing the Canadian hedge fund industry and why its size pales in comparison to the United States and the United Kingdom. Consider this: the population of United States is roughly ten times that of Canada, but its hedge fund managers oversee roughly 45 times the assets. At the end of 2012, Canadian hedge funds managed about $35 billion while their counterparts in the United States had a cumulative AUM of over $1.5 trillion. In light of this vast discrepancy, Richard concluded that “there’s definitely something holding the Canadian hedge fund industry back.”

Shortly thereafter, Richard was kind enough to follow up with Business in Canada, sending an email in which he outlined a few things that are inhibiting the growth of hedge funds in the Great White North.

  • Underperformance

As Richard previously told us, “Performance is a magnet for assets.”  Unfortunately, in 2012, Canadian hedge funds did more to repel than attract investors.  As a whole, the industry gave back 5 percent last year, far underperforming the TSX, which advanced by 4 percent.

  • The End Of The Commodities Supercycle

Before ‘tapering’ became part of Wall Street’s lexicon, investors were rebalancing their portfolios in accordance with the notion that the commodities supercycle was drawing to a close.  Richard believes this development had a particularly deleterious effect on resource-focused managers in Canada.

  • The Cost Of Accessing FundSERV

FundSERV is an online hub that connects and facilitates transactions between funds, distributors, and intermediaries. Membership in this network doesn’t come cheap.  According to Richard, these costs unduly burden smaller managers, which reduces the size of the pool of managers in Canada. In addition, this restricts a hedge fund’s access to high net worth investors, who provide the vital money needed for expansion.

Richard is quite open to working with Canadian managers, saying, “If there was a team in Canada that is performing, I would love to talk to them.”  But after 13 years of putting out global searches for managers, only a handful of Canadians have answered his call. 

Author: BiC Editorial Board

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Written by:  Jessica Brown

On July 25, 2013, the Securities and Exchange Commission’s (“SEC”) Division of Investment Management released its first annual report to Congress, as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), regarding how it used private fund data collected from investment advisers on Form PF. Dodd-Frank gave the SEC authority to require registered investment advisers to file reports and maintain records regarding the funds they advise. The SEC adopted Form PF in 2011 as the mechanism through which registered advisers must provide this information to the SEC.

Although it acknowledges that the intent of the Dodd-Frank provision was to provide data for the Financial Stability Oversight Council (“FSOC”) to assess systemic risk, the SEC is using the data to support its own regulatory programs as well.  

In this first report to Congress, the SEC indicated that is has been focused on the Form PF electronic filing system, resolving technical issues with security and data collection, guiding Form PF filers through the new form and system, establishing protocols for internal access and protection of data, and providing the FSOC with access to the data. Various divisions of the SEC have begun to use the Form PF data to assist with monitoring, identifying and examining investment advisers and private funds. The SEC also plans to provide non-proprietary Form PF data about large hedge funds to the International Organization of Securities Commission for its report on the global hedge fund market.

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Written by:  Jay B. Gould and Jessica Brown

On July 10, 2013, the Securities and Exchange Commission (“SEC”) voted to lift the ban on general solicitation and advertising by private funds (and other private company issuers) as mandated by Congress in the Jumpstart Our Business Startups Act (“JOBS Act”). In addition to lifting the ban on general solicitation, the SEC approved a disqualification rule that will prospectively prohibit any felon or “bad actor” from relying on Rule 506 exemptions. Finally, the SEC voted to propose amendments to the current private offering rules.

I.          New Rule 506(c) 

Summary

Rule 506(c), as adopted by the SEC, permits private issuers to use general solicitation and general advertising when making a securities offering, provided the issuer only sells to accredited investors.[1] Issuers must take affirmative and reasonable steps to verify that each investor is accredited under the Rule 501 definition, and cannot simply rely upon a representation from the investor.

Verification Rule

The burden now shifts to private fund managers to determine “reasonableness” when making a determination of an investor’s accredited status. In response to comments it received, the SEC has provided some ideas an issuer can consider when determining its verification procedures. The non-exclusive, non-required verification methods published by the SEC include: (i) review federal tax forms, (ii) confirm net worth through documentation, or (iii) obtain written confirmation from a registered broker-dealer, registered investment adviser, licensed attorney in good standing, or registered CPA.  Accordingly, private fund managers will be able to rely upon certain third parties to make a determination of accreditation.

Current Rule 506 Exemptions

Rule 506(c) does not modify or repeal any of the current Rule 506 exemptions and issuers may still rely on those exemptions as written.   Therefore, private fund managers that do not see the value in advertising or soliciting to the public, or find the conditions of the new rules too onerous, may continue under the current private offering regime and will remain subject to all of the same restrictions on communications with the public to which they are currently subject. 

Form D

The current Form D filing document will be amended to include a “check-the-box” option to designate if the issuer is relying on the new Rule 506(c) in its present offering.  For those private funds and other issuers that do intend to generally advertise, the SEC has proposed that a Form D would need to be filed with the SEC 15 days in advance of the offering and again within 30 days after the offering closes.  It is proposed that an issuer that fails to make these filings would be prohibited from using the public advertising rules in the future.

II.        Rule 144A

Similar to the changes to Rule 506, under the new rules, securities sold pursuant to Rule 144A may be “offered” to investors other than qualified institutional buyers, because information about such offerings would be made public by way of general advertising, but the securities may only be sold to investors the seller reasonably believes to be qualified institutional buyers.[2]

III.       Felons and “Bad Actors” Disqualification

The SEC unanimously adopted a rule that disqualifies certain felons and “bad actors” from relying on any Rule 506 exemption.[3] This disqualification will be effective sixty days after the publication of the final rules in the Federal Register. 

The SEC identified a number of events that would disqualify an issuer from relying on Rule 506, such as securities-related criminal convictions, court injunctions and restraining orders, final orders from regulators and agencies, certain SEC disciplinary orders, anti-fraud or registration-related cease-and-desist orders from the SEC, SEC stop orders, suspension or expulsion from membership or association with a self-regulated organization, or recent U.S. Postal Service false representation orders. 

However, much to the consternation of the lone dissenting Commissioner Luis Aguilar, this provision will not bar persons who have committed financial and other crimes in the past.  It will only bar such bad actors on a going forward basis. Presumably, the fact that a principal of an issuer is a convicted felon would be a material fact that would be required to appear in the offering materials of the issuer, and for private funds, this information would, in most cases, get picked up in the Form ADV of the fund manager.

IV.       What Happens Next

Timing

The effective date of Rule 506(c) and the disqualification rule is 60 days following the date the rule is published in the Federal Register. For an ongoing offering under Rule 506 that began before the effective date of Rule 506(c), the issuer may elect to continue the offering after the effective date in accordance with the requirements of either the current Regulation D rule or new Rule 506(c), which permits general solicitation and advertising.  Accordingly, if an issuer chooses to continue its offering under Rule 506(c), any general solicitations that take place after the effective date, will not impact the exempt status of offers and sales that took place prior to the effective date in reliance on Rule 506(b).

What Funds Can Do Now

After the effective date of Rule 506(c), private funds that are not otherwise disqualified from using the Rule 506 exemptions may begin advertising and soliciting generally. An issuer that chooses to advertise or solicit generally must put policies and procedures in place to ensure that reasonable steps are taken to verify that each purchaser is accredited and that no sales are made to non-accredited investors.

Limitations, CFTC Considerations and Fund Advertising

Since February 2012, when the Commodity Futures Trading Commission (“CFTC”) rescinded Rule 4.13(a)(4), most private funds have relied upon the de minimus exemption of Rule 4.13(a)(3) in order to be exempt from CFTC registration. Other funds that trade futures or other instruments that are subject to CFTC oversight above the de minimus threshold, avail themselves of the “registration lite” exemption in Rule 4.7, pursuant to which all fund investors must be “qualified eligible persons.”  However, both of these exemptions require that the fund securities must be offered and sold without any marketing to the public in the United States.  Therefore, until the CFTC acts to amend these exemptive rules on which many private fund managers rely, none of these private funds will be able to use the general solicitation provisions of new Rule 506(c).  The Managed Funds Association submitted an outline of proposed rule amendments to the CFTC that would harmonize the CFTC rules with the SEC’s JOBS Act rules, but it is uncertain when the CFTC will act on this matter.

For a discussion of these provisions, see this discussion on Bloomberg. 

Proposed Amendments to Regulation D, Form D and Rule 156

In connection with the approval of Rule 506(c), the SEC proposed amendments to Regulation D, Form D and Rule 156 under the Securities Act. These proposed “investor protection” amendments are intended to enhance the SEC’s ability to evaluate market changes, the nature of advertising used by issuers, the steps taken by the issuer to verify that all investors were accredited and the intended use of the proceeds of the sale. It is likely that these provisions will soon become part of the new Form D and be applicable to private fund managers that advertise or solicit to the public. 

Finally, fund managers and their compliance officers should familiarize themselves with the requirements of Rule 156, as it appears likely that this anti-fraud rule will soon apply to the sales literature and advertising produced by hedge fund and private equity funds.

Questions regarding new Rule 506(c), the CFTC rules, Rule 156 and other implications regarding this recent SEC action should be directed to your Pillsbury attorney contact.

 

[1] Rule 501 of Regulation D defines an individual as an “accredited investor” if they have individual net worth, or joint net worth with the person’s spouse, in excess of $1 million at the time of the purchase, excluding the value of the primary residence of such person, or 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.

[2] Rule 144A defines “qualified institutional buyers” as certain institutions that own and invest at least $100 million in securities of issuers that are unaffiliated with the institutions, banks and financial institutions must also have a net worth in excess of $25 million. A registered broker-dealer qualifies if it owns and invests on a discretionary basis over $10 million in securities of issuers that are unaffiliated with the broker-dealer. 

[3] An issuer will be disqualified from relying on Rule 506 exemptions if any “covered person” has had a “disqualifying event.” The rule defines “covered persons” as: (i) the issuer, (ii) the issuer’s predecessors and affiliated issuers, (iii) directors and certain officers, general partners and managing members of the issuer, (iv) 20 percent beneficial owners of the issuer, (v) promoters, (vi) investment managers and principals of pooled investment funds, and (vii) persons compensated for soliciting investors as well as the general partners, directors, officers, and managing members of any compensated solicitor.