Articles Tagged with Jobs Act

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The SEC’s final crowdfunding rules, which are largely consistent with the proposed rules, provide broader access to capital for startups and small businesses, though concerns over cumbersome disclosure and regulatory requirements persist.

On October 30, 2015, the Securities and Exchange Commission (SEC) voted to adopt final rules implementing Title III of the Jumpstart Our Business Startups Act (JOBS Act), known as “crowdfunding”. The final rules, to be codified as “Regulation Crowdfunding” in furtherance of Section 4(a)(6) of the Securities Act of 1933, are expected to become effective in May 2016. A copy of the final rules can be found here.

Regulation Crowdfunding will allow smaller, non-public U.S. companies to raise up to $1 million in any 12-month period by selling securities over the Internet (including through apps and other technologies) to individual investors who are not required to meet any sophistication or wealth standards, but will be subject to relatively small investment limits.

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On October 30, 2015, the Securities and Exchange Commission (SEC) adopted Regulation Crowdfunding. The final rule permits companies to offer and sell securities through crowdfunding. The “Regulation Crowdfunding Exemption” is created under Section 4(a)(6), Title III of the JOBS Act.

The key features of the final rules

  1. Permit individuals to purchase securities in crowdfunding offerings subject to certain limits:
    • A company is permitted to raise a maximum aggregate amount of $1 million through crowdfunding offerings in a 12-month period.
    • Individuals are permitted, over a 12-month period, to invest in the aggregate across all crowdfunding offerings up to:
      • The greater of $2,000 or 5% of the lesser of their annual income or net worth, if either their annual income or net worth is less than $100,000.
      • 10% of the lesser of their annual income or net worth, if both their annual income and net worth are equal to or more than $100,000.
    • The aggregate amount of securities sold to an investor through all crowdfunding offerings may not exceed $100,000.
  1. Require companies to disclose certain information about their business and securities offering and to file an annual report with the SEC and provide it to investors.
  2. Create regulatory framework for the broker-dealers and funding portals that facilitate the crowdfunding transactions. A funding portal is required to register with the SEC and become a FINRA member. A company relying on the Regulation Crowdfunding Exemption is required to conduct its offering exclusively through one intermediary platform at a time.

In addition, the SEC is proposing to amend the existing Securities Act Rule 147 and Rule 504. Rule 147 would be amended to, among other things, permit companies to raise money from investors within their state (intrastate offering) without registering the offers and sales with the SEC. Rule 504 would be amended to increase the aggregate amount of securities that may be offered and sold in any 12-month period from $1 million to $5 million. Bad actor disqualification would also apply in Rule 504 offerings.

A full copy of the final rules is available HERE.

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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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Written by: Jay B. Gould

On October 23, 2013, the Securities and Exchange Commission (“SEC”) voted unanimously to propose rules under the JOBS Act to permit companies to offer and sell securities through crowdfunding.

Crowdfunding describes an evolving method of raising capital that has been used outside of the securities arena to raise funds through the Internet for a variety of projects, products or artistic endeavors. Crowdfunding has generally not been used as a means to offer and sell securities because offering a share of the financial returns or profits from business activities would likely trigger the registration provisions of the federal securities laws relating to the offer or sale of securities.

Title III of the JOBS Act created an exemption under the securities laws so that this type of funding method can also be used to offer and sell securities without registration. The JOBS Act established the framework for a regulatory structure for this funding method. It also created a new entity – a funding portal – to allow Internet-based platforms or intermediaries to facilitate the offer and sale of securities without having to register with the SEC as brokers. Crowdfunding should not be confused with rules that were recently adopted under Regulation D that permits issuers of securities of private companies to engage in general solicitation or public advertising related to the sales of such securities.

The intent of the JOBS Act was to make it easier for startups and small businesses to raise capital from a wide range of potential investors and provide additional investment opportunities for investors. Critics, led by consumer groups and state securities administrators, have been critical of both the Regulation D amendments regarding general solicitation, as well as the crowdfunding provisions, as opening the floodgates for fraudster to prey on the financially unsophisticated. Accordingly, the challenge for the SEC is to establish a regulatory structure that both permits small companies and entrepreneurs to access investors in an efficient manner, while protecting the investors from scam artists.

Proposed Rules
The proposed rules would among other things permit individuals to invest subject to certain thresholds, limit the amount of money a company can raise, require companies to disclose certain information about their offers, and create a regulatory framework for the intermediaries that would facilitate the crowdfunding transactions.

Under the proposed rules:

  • A company would be able to raise a maximum aggregate amount of $1 million through crowdfunding offerings in a 12-month period.
  • Investors, over the course of a 12-month period, would be permitted to invest up to:

$2,000 or 5 percent of their annual income or net worth, whichever is greater, if both their annual income and net worth are less than $100,000.

10 percent of their annual income or net worth, whichever is greater, if either their annual income or net worth is equal to or more than $100,000. During the 12-month period, these investors would not be able to purchase more than $100,000 of securities through crowdfunding.

Certain companies would not be eligible to use the crowdfunding exemption. Ineligible companies include non-U.S. companies, companies that already are SEC reporting companies, certain investment companies (such as hedge funds), companies that are disqualified under the proposed disqualification rules, companies that have failed to comply with the annual reporting requirements in the proposed rules, and companies that have no specific business plan or have indicated their business plan is to engage in a merger or acquisition with an unidentified company or companies.

Securities purchased in a crowdfunding transaction cannot be resold for a 12-month period. Holders of these securities would not count toward the threshold that requires a company to register with the SEC under Section 12(g) of the Securities Exchange Act of 1934.

Disclosure by Companies
The proposed rules would require companies conducting a crowdfunding offering to file certain information with the SEC, provide it to investors and the relevant intermediary facilitating the crowdfunding offering, and make it available to potential investors.

In its offering documents, among the things the company would be required to disclose are:

  • Information about officers and directors as well as owners of 20 percent or more of the company.
  • A description of the company’s business and the use of proceeds from the offering.
  • The price to the public of the securities being offered, the target offering amount, the deadline to reach the target offering amount, and whether the company will accept investments in excess of the target offering amount.
  • Certain related-party transactions.
  • A description of the financial condition of the company.
  • Financial statements of the company that, depending on the amount offered and sold during a 12-month period, would have to be accompanied by a copy of the company’s tax returns or reviewed or audited by an independent public accountant or auditor.

Companies would be required to amend the offering document to reflect material changes and provide updates on the company’s progress toward reaching the target offering amount.

Companies relying on the crowdfunding exemption to offer and sell securities would be required to file an annual report with the SEC and provide it to investors.

Crowdfunding Platforms
Title III of the JOBS Act requires that crowdfunding transactions take place through an SEC-registered intermediary, either a broker-dealer or a funding portal. Under the proposed rules, the offerings would be conducted exclusively online through a platform operated by a registered broker or a funding portal, which is a new type of SEC registrant.

The proposed rules would require these intermediaries to:

  • Provide investors with educational materials.
  • Take measures to reduce the risk of fraud.
  • Make available information about the issuer and the offering.
  • Provide communication channels to permit discussions about offerings on the platform.
  • Facilitate the offer and sale of crowdfunded securities.

The proposed rules would prohibit funding portals from:

  • Offering investment advice or making recommendations.
  • Soliciting purchases, sales or offers to buy securities offered or displayed on its website.
  • Imposing certain restrictions on compensating people for solicitations.
  • Holding, possessing, or handling investor funds or securities.

The proposed rules would provide a safe harbor under which funding portals can engage in certain activities consistent with these restrictions.

What’s Next?
The SEC will take public comments on the proposed rules for 90 days, after which it will review the comments and determine whether to adopt the proposed rules. Depending upon the tone and substance of the comments, the SEC may move quickly to adopt the rules as proposed, adopt the rules with certain modifications based on the comments, or re-propose the rule for additional public comment. Anxious market participants should not expect to start offering their crowdfunding securities.

Follow @Investment_Law on Twitter.

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Written by: Jay B. Gould

On September 23, 2013, the JOBS Act rules that roll back the 80 year old ban on the use of general advertising and public solicitation by issuers of unregistered securities will be a reality. At least it will be a reality for fund managers that do not rely on an exemption from the Commodity Futures Trading Commission. Private funds managers will decide over time whether they would like to avail themselves of the new rules, which will allow them to post performance numbers on their websites, talk openly about their funds on CNBC and Bloomberg, sponsor NASCAR events, and just generally be more open and transparent about their businesses. The responsibilities associated with these new rights are the requirements that the fund manager verify the accredited status of each investor, refrain from committing financial fraud, and file a revised Form D to indicate that the fund is following the new rules. Whether to use these new rules will be a tough call for many fund managers as they consider whether greater transparency provides a benefit for their specific business model. Hedge funds have often avoided the glare of public scrutiny, but the trade-off of building a more recognizable brand and more easily reaching potential investors could provide motivation for some fund managers to give these new rules a try.

But what happens if a fund manager is initially enamored of the new rules and decides to advertise generally, but later changes his mind? Can a fund manager go back to the old “pre-existing, substantial relationship” days, and how do you do that once the fund has been “generally offered” to the public? This could happen for any number of reasons. Perhaps the most prevalent would be that the manager reaches capacity in the fund in either assets, such as a quant fund, or investor slots, which would more likely be the case for a fund that relies on Section 3(c)(1) for its exemption from investment company registration. A fund manager in one of these situations may have originally liked the idea of generally advertising, but subsequently finds public solicitation of limited utility and not worth the potential added scrutiny from regulators and market participants.

If a fund commences an offering pursuant to Rule 506(c) using general solicitation, and later wants to go back and use the old rules, (i.e., rule 506(b)), the issue is one of integration. Rule 506(b) prohibits general solicitation; accordingly, the only way to stop using the public offering rules once a fund manager has done so, would be to wait a period of time so the rule 506(c) offering is not integrated with the rule 506(b) offering. Rule 502(a) of Regulation D provides for a safe harbor from integration so long as the selling effort of the earlier offering ceases for six months, and the fund does not commence a subsequent offering for 6 months after completion of the earlier offering. Therefore, a fund manager would need to cease the offering, file the Form D to indicate that the offering is over, and wait six months before commencing the “private” offering. A new Form D would need to be filed for the private offering under Rule 506(b) once that offering commences.

There is another way whereby fund managers could go straight from the public offering to the private offering without the six month cooling off period. It is possible that a fund manager could use the five factor test safe harbor of Rule 502(a) to avoid integration and commence a new private offering immediately. For most hedge fund managers, this would be fairly tough test to meet. The five factors that a fund would need to consider are as follows:

(a) Whether the sales are part of a single plan of financing;
(b) Whether the sales involve issuance of the same class of securities;
(c) Whether the sales have been made at or about the same time;
(d) Whether the same type of consideration is being received; and
(e) Whether the sales are made for the same general purpose.

In order to meet the requirements of the five factor test, the fund seeking to avoid integration would need to offer a different class of shares/interests, for a different investment purposes, with different terms and conditions. For many hedge fund managers, this will be a difficult standard to meet. So the bottom line here appears to be that you can put Humpty Dumpty back together again, he will just need six months in intensive care.

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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.

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This article was published by CounselWorks and is reprinted here with permission.

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April 12, 2013

Dear Friends,

Yesterday, the SEC testified before Congress providing an update on the implementation of the JOBS Act. Regarding the implementation of the lift on the prohibition against general solicitation, the SEC said its staff are “developing recommendations for the Commission’s consideration as how to best move forward.”

The JOBS Act passed in April 2012 and a rule for this provision has yet to be finalized.  “The longer we wait for action by the regulators, the more our engines of economic growth will continue to simply tread water, or worse yet starve, for lack of opportunity,” said Congressman David Schweikert (R-Ariz), a participant in CounselWorks’ 2012 SummerTime Summit and Chairman of the House Small Business subcommittee on regulations.

Please click here for a link to the SEC’s testimony and click here for a link to the transcripts and video of the full hearing.

Please feel free to contact us with any questions at (212) 867-0200 or e-mail us at info@counselworksllc.com

Thank you,

CounselWorks

 

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On February 21, 2013, the Staff of the Securities and Exchange Commission (the “Staff” and the “SEC,” respectively) published its 2013 priorities for the National Examination Program (“NEP”) in order to provide registrants with the opportunity to bring their organizations into compliance with the areas that are perceived by the Staff to have heightened risk.  The NEP examines all regulated entities, such as investment advisers and investment companies, broker dealers, transfer agents and self-regulatory organizations, and exchanges.  This article will focus only on the NEP priorities pertaining to the investment advisers and investment companies program (“IA-ICs”)

As a general matter, the Staff is concerned with fraud detection and prevention, corporate governance and enterprise risk management, conflicts of interest, and the use and implications of technology.  The 2013 NEP priorities, viewed in tandem with the “Presence Exam” initiative that was announced by the SEC in October 2012, makes it abundantly clear that the Staff will focus on the approximately 2000 investment advisers that are newly registered as a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd Frank”).

The Staff intends to focus its attention on the areas set forth below.   

New and Emerging Issues.

The Staff believes that new and emerging risks related to IA-ICs include the following:

  • New Registrants.  The vast majority of the approximately 2,000 new investment adviser registrants are advisers to hedge funds or private equity funds that have never been registered, regulated, or examined by the SEC.  The Presence Exam initiative, which is a coordinated national examination initiative, is designed to establish a meaningful “presence” with these newly registered advisers.  The Presence Exam initiative is expected to operate for approximately two years and consists of four phases: (i) engagement with the new registrants; (ii) examination of a substantial percentage of the new registrants; (iii) analysis of the examination findings; and (iv) preparation of a report to the industry on the findings.  The Presence Exam initiative will not preclude the SEC from bringing enforcement actions against newly registered advisers.  The Staff will give a higher priority to private fund advisers that it believes present a greater risk to investors relative to the rest of the registrant population or where there are indicia of fraud or other serious wrongdoing.  We expect to see the SEC bring enforcement actions against private equity and hedge fund managers for issues related to valuations, calculation of performance-related compensation and communications to investors that describe valuations and performance-related compensation.
  • Dually Registered IA/BD.  Due to the continued convergence in the investment adviser and broker-dealer industry, the Staff will continue to expand coordinated and joint examinations with the broker dealer examination program of dually registered firms and distinct broker-dealer and investment advisory businesses that share common financial professionals.  It is not uncommon for a financial professional to conduct a brokerage business through a registered broker-dealer that the financial professional does not own or control and to conduct investment advisory business through a registered investment adviser that the financial professional owns and controls, but that is not overseen by the broker-dealer.  This business model presents many potential conflicts of interest.  Among other things, the Staff will review how financial professionals and firms satisfy their suitability obligations when determining whether to recommend brokerage or advisory accounts, the financial incentives for making such recommendations, and whether all conflicts of interest are fully and accurately disclosed.
  • “Alternative” Investment Companies.    The NEP will also focus on the growing use of alternative and hedge fund investment strategies in registered open-end funds, exchange-traded funds (“ETFs”), and variable annuity structures.  The Staff intends to assess whether: (i) leverage, liquidity and valuation policies and practices comply with regulations; (ii) boards, compliance personnel, and back-offices are staffed, funded, and empowered to handle the new strategies; and (iii) the funds are being marketed to investors in compliance with regulations.
  • Payments for Distribution In Disguise.    The Staff will also examine the wide variety of payments made by advisers and funds to distributors and intermediaries, the adequacy of disclosure made to fund boards about these payments, and boards’ oversight of the same.  With respect to private funds, the Staff will examine payments to finders or other unregistered intermediaries that may be conducting a broker dealer business without being registered as such.  Payments made pursuant to the Cash Solicitation Rule will also be a focus of private fund payment arrangements.

Ongoing Risks.

The Staff anticipates that the ongoing risks selected as focus areas for IA-ICs in 2013 will include:

  • Safety of Assets.  The Staff has indicated that recent examinations of investment advisers have found a high frequency of issues regarding the custody and safety of client assets under the Investment Advisers Act of 1940 (“Advisers Act”) Rule 206(4)-2 (the “Custody Rule”).   The staff will focus on issues such as whether advisers are: (i) appropriately recognizing situations in which they have custody as defined in the Custody Rule; (ii) complying with the Custody Rule’s “surprise exam” requirement; (iii) satisfying the Custody Rule’s “qualified custodian” provision; and (iv) following the terms of the exception to the independent verification requirements for pooled investment vehicles.  Many private equity funds and fund of funds have been slow to adopt policies and procedures that comply with the Custody Rule.
  • Conflicts of Interest Related to Compensation Arrangements.  The Staff expects to review financial and other records to identify undisclosed compensation arrangements and the conflicts of interest that they present.  These activities may include undisclosed fee or solicitation arrangements, referral arrangements (particularly to affiliated entities), and receipt of payment for services allegedly provided to third parties. For example, some advisers that place client assets with particular funds or fund platforms are, in return, paid “client servicing fees” by such funds and fund platforms. Such arrangements present a material conflict of interest that must be fully and clearly disclosed to clients.  These types of compensation arrangements are commonplace among private equity fund advisers, many of which have just recently registered.  In fact, many private equity funds have compensation arrangements that the Staff believes requires broker dealer registration.  We believe that the Staff will make this point quite clearly by bringing enforcement actions against certain private equity fund general partners for engaging in unregistered broker dealer activity.  Enforcement actions are viewed as an effective way to get the message across to an industry that has long ignored this particular issue.
  • Marketing/Performance.  Marketing and performance advertising is viewed by the Staff as an inherently high-risk area, particularly among private funds that are not necessarily subject to an industry standard for the calculation of investment returns.  Aberrational performance of certain registrants and funds can be an indicator of fraudulent or weak valuation procedures or practices.  The Staff will also focus on the accuracy of advertised performance, including hypothetical and back-tested performance, the assumptions or methodology utilized, and related disclosures and compliance with record keeping requirements.   The Staff is starting to think about how the anticipated changes in advertising practices related to the JOBS Act will affect their reviews regarding registrants’ use of general solicitations to promote private funds.  Whether private funds will be permitted to advertise performance under the JOBS Act rules remains to be seen.  Certainly, there have been loud and influential voices that advocated for the position that the SEC should continue to study performance advertising by private funds before allowing it in the adoption of the highly anticipated rules.
  • Conflicts of Interest Related to Allocation of Investment Opportunities.  Advisers managing accounts that do not pay performance fees (e.g., most mutual funds), side-by-side with accounts that pay performance-based fees (e.g., most hedge funds) face potential conflicts of interest.  The Staff will attempt to verify that the registrant has controls in place to monitor the side-by-side management of its performance-based fee accounts and non-performance-based fee accounts with similar investment objectives, especially if the same portfolio manager is responsible for making investment decisions for both kinds of client accounts or funds.  For certain types of strategies, such as credit strategies, where one fund may be permitted to invest in all securities in the capital structure, whereas other funds may be limited in what they can purchase by credit quality or otherwise, these potential conflicts of interest are particularly acute.  Fund managers must have policies in place that account for these potential conflicts, manage the conflicts and document the investment resolution.
  • Fund Governance.  The Staff will continue to focus on the “tone at the top” when assessing compliance programs.  The Staff will seek to confirm that advisers are making full and accurate disclosures to fund boards and that fund directors are conducting reasonable reviews of such information in connection with contract approvals, oversight of service providers, valuation of fund assets, and assessment of expenses or viability.  Chief Compliance Officers will want to make sure that those items that are required to be undertaken in the compliance manual actually occur as stated and scheduled.

Policy Topics.

The staff anticipates that the policy topics for IA-ICs will include:

  • Money Market Funds.  The SEC continues to delude itself regarding the regulation of money market funds.  This once sleepy and relatively benign product is now the pillar of the commercial paper market and functions like and deserves the regulation of a banking product.  But the SEC, and the mutual fund trade organization, are loathe to cede authority to banking regulators for this “dollar per share”  product.  Accordingly, the SEC will continue to try to find ways for thinly capitalized advisers to offer and manage  money market funds by requiring money market funds to periodically stress test their ability to maintain a stable share price based on hypothetical events, such as changes in short-term interest rates, increased redemptions, downgrades and defaults, and changes in spreads from selected benchmarks (i.e., basically, all of the market events that have proven fatal to money market funds in the past and which will be so again as long as these funds remain fundamentally flawed).
  • Compliance with Exemptive Orders.  The staff will focus on compliance with previously granted exemptive orders, such as those related to registered closed-end funds and managed distribution plans, employee securities companies, ETFs and the use of custom baskets, and those granted to fund advisers and their affiliates permitting them to engage in co-investment opportunities with the funds.  Exemptive orders are typically granted pursuant to a number of well-developed conditions with which the registrant promises to adhere.  The market timing and late trading scandals of 2003 illustrated that once a registrant has obtained an exemptive order, it may or may not abide by all of the conditions of that order.
  • Compliance with the Pay to Play Rule.  To prevent advisers from obtaining business from government entities in return for political “contributions” (i.e., engaging in pay to play practices), the SEC recently adopted and subsequently amended, a pay to play rule. The Staff will review for compliance in this area, as well as assess the practical application of the rule.  Advisers should be aware that most states have their own pay to play rules and many of them have penalties that are far more onerous than the SEC’s rule.

We will continue to monitor this and other new developments and provide our clients with up to date analysis of the rules and regulations that may affect their businesses.

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Written by: Louis A. Bevilacqua

On January 10, 2013 the Financial Industry Regulatory Authority (“FINRA”) issued a voluntary Interim Form for funding portals (the “Interim Form”). The Interim Form is designed for prospective crowdfunding portals under the Jumpstart our Business Startups Act (the “JOBS Act”), which was enacted on April 5, 2012. Title III of the JOBS Act, which relates to crowdfunding, requires the Securities and Exchange Commission (the “SEC”) and FINRA to promulgate rules before crowdfunding portals can commence operations. The Interim Form permits companies that intend to become funding portals under Title III of the JOBS Act to voluntarily submit to FINRA information regarding their business. FINRA expects that the information received will help it develop rules specific to crowdfunding portals.

CONTINUE READING…

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Written by:  Jay Gould

When can private fund managers start posting performance numbers on their websites and sponsoring the Super Bowl?  Not yet, according to Senator Carl Levin (D-MI) in letters dated October 5,2012 and October 12, 2012, (the “Levin Letters”) rebuking the SEC for having missed the point of the legislation in the SEC rulemaking process.  As you recall, on August 29, 2012, the SEC proposed rules pursuant to Section 201 of the Jumpstart our Business Startups Act (“JOBS Act”) that, if adopted in final form, would allow private issuers, including private funds, to generally solicit and advertise as long as the investors are all “accredited investors.” 

Of most importance to hedge fund and private equity fund managers that have been anticipating a more relaxed and flexible approach of communicating with the public and soliciting new investors, the Levin Letters flatly accuse the SEC of failing to grasp the scope of the JOBS Act in applying it to private investment vehicles.  According to Levin, the SEC should “distinguish between issuers that engage in operational businesses and those that are merely investment vehicles.”  The October 12 letter further advises the SEC that  “[c]ongress did not contemplate removing the general solicitation ban – without retaining any limitations on forms of solicitation – for private investment vehicles.  Indeed, no argument was made during the debate of the bill that the objective was to ease the capital aggregation process for private investment vehicles.  The words “hedge fund,” “private fund,” or “investment vehicle” were not used either during the committee or floor debate in the House of Representatives. Nor did the Senate engage in any debate relating to removing these advertising and marketing restrictions completely from private investment vehicles.” 

According to the Levin staffer who is responsible for this area of the Senator’s legislative initiatives, we should no longer expect that the SEC will adopt the rules as proposed.  The SEC must propose new rules that more accurately reflect the intent of Congress and not simply abdicate regulatory authority over the use of general advertising and solicitation by private funds, the Investment Fund Law Blog was told by Levin’s office.    

This SEC mulligan may very well put back into play many of the criticisms of the JOBS Act that were expressed in the comment period after the JOBS Act was first signed into law.  As you may recall, on May 21, 2012, the Investment Company Institute (the “ICI”) submitted a comment letter to the SEC regarding Section 201 of the JOBS Act in which the ICI encouraged the SEC to, among other things, adopt advertising rules for private funds that are at least as restrictive as those that apply to registered mutual funds, raise the income and net worth standards in the definition of “accredited investor,” and prohibit or limit performance advertising by hedge funds until the SEC has studied the implications of such advertising for 60 years.  In a follow up letter to the SEC on August 17, 2012, the ICI, citing press reports and rumors, implored the SEC to not adopt “interim rules” pursuant to Section 201.  Rather, the ICI suggested, full notice and comment should be employed in this rulemaking process so that the SEC might fully observe its fundamental mandate to protect investors.  It should be noted that the SEC began accepting public comments on all aspects of the JOBS Act shortly after the legislation became law on April 5, 2012.  The law itself requires the SEC to adopt rules pursuant to Section 201 within 90 days of the signing of the legislation, a time frame that, quite obviously, was not met. 

The Levin Letters further admonished the SEC to establish “methods” for determining whether an investor meets the “accredited investor” standard.  The rule proposal provided only that an  issuer must take “reasonable steps” to determine accredited status, and provided significant flexibility for issuers to determine the appropriate level of due diligence in order to verify status.  The Levin Letters requested that the SEC go back to the drafting table and come up with a new proposal that requires “common sense” documentation and/or verification practices and procedures.  If, as Levin’s office suggests, the SEC does re-propose rules as a result of this criticism, it could result in issuers being required to follow definitive verification standards, such as obtaining an income statement, balance sheet, or bank or brokerage statements from investors. 

It is possible that the last chapter of the JOBS Act rules regarding general solicitation may not yet be written.  In the meantime, private fund managers should continue observing the current ban on general solicitation and advertising and put on hold those plans to post their performance returns on the back of Serena Williams’ tennis togs.