Author: Kevin Cott

Earlier this year, the Examination Division (“Division”) of the Securities and Exchange Commission (“SEC”) published its 2023 examination priorities (the “Report”). The Division publishes these priorities annually to provide industry insights and highlight areas it believes present possible risks to investors. The Report is based on the Division’s observations from those examinations, as well as conversations with stakeholders within the SEC, their counterparts at other regulatory agencies, and market participants.

This year, the SEC will prioritize several key areas, including: (1) recently adopted rules for investment advisers and investment companies; (2) standards of conduct for broker-dealers and investment advisers; (3) ESG investing; (4) information security and operational resiliency; and (5) emerging technologies and crypto-assets.

New Investment Adviser and Investment Company Rule–Marketing Rule

The Division will focus on Rule 206(4)-1 of the Investment Advisers Act of 1940 (the “Marketing Rule”) and assess whether registered investment advisers (“RIAs”) have adopted and implemented written policies and procedures to prevent violations by the advisers and their supervised persons. Additionally, the Division will review whether RIAs have complied with substantive requirements of the Marketing Rule (e.g., whether firms can substantiate material statements of facts and meet requirements regarding performance advertising, testimonials, endorsements and third-party ratings). The Division will also concentrate on new rules applicable to investment companies, including the Derivatives Rule (Investment Company Act Rule 18f-4) and Fair Valuation Rule (Investment Company Act Rule 2a-5).

Investment Advisers to Private Funds

Next, the Division plans to conduct reviews focusing on advisers’ fiduciary duties and risk management. The Division intends to emphasize compliance programs, fees and expenses, custody, the Marketing Rule, conflicts of interest and the use of alternative data. Private fund advisers’ portfolio strategies, risk management, and investment recommendations and allocations will also be reviewed, with particular emphasis on conflicts and disclosures around these areas. The Division states that it will focus on private funds that have “specific risk characteristics”, such as being (1) highly leveraged; (2) managed along with business development companies (3) private equity funds using affiliates to provide services to portfolio companies and fund clients; (4) owning hard to value assets (e.g., crypto, commercial real estate); (5) invested in or sponsoring a SPAC; or (6) involved in adviser-led restructurings.

Environmental, Social, and Governance (“ESG”) Investing

The Division will continue to focus on ESG-related advisory services and fund offerings to ensure they are operating in accordance with their disclosures. This includes assessing whether ESG products are properly labeled and whether recommendations to retail investors are made in their best interests.

Information Security and Operational Resiliency

The Division will also prioritize cybersecurity risks in 2023, given the elevated risk environment due to larger market events, geopolitical concerns and the proliferation of cybersecurity attacks. The Division will focus on advisers’ policies and procedures, governance practices, and response to cyber-related incidents, including ransomware attacks. It will also review compliance with Regulations S-P and S-ID and examine practices to prevent account intrusions and safeguard customer records and information, including personally identifiable information. The Division will pay particular attention to the cybersecurity issues associated with the use of third-party vendors, unauthorized use of third-party providers, and operational resiliency planning for systemically significant registrants.

Additionally, the Division will review broker-dealers’ and RIAs’ practices to prevent interruptions to mission-critical services and to protect investor information, records and assets. It will assess whether policies and procedures are reasonably designed to safeguard customer records and information and whether the location of such records has been properly disclosed to the SEC. The focus will also include reviewing whether there has been unauthorized use of third-party providers, particularly for transition assistance when departing RIA personnel attempt to migrate client information to another firm.

Crypto Assets and Emerging Financial Technologies

Lastly, the Division will examine broker-dealers and RIAs that offer new products and services, including crypto assets and emerging financial technology, such as robo-advisers and online brokerage services. The Division will focus on whether market participants involved with crypto or crypto-related assets met their respective standards of care, and whether their compliance, disclosure, and risk management practices are updated and enhanced regularly.

These examinations will focus on first time registrants offering crypto or crypto-related assets, as well as broker-dealers and RIAs that employ digital engagement practices. The Division will assess whether these practices are consistent with investor disclosures, represent fair and accurate information, and consider the risks associated with these practices, especially for vulnerable investors such as seniors.

The SEC’s Office of Compliance Inspections and Examinations (“OCIE”) recently issued a risk alert concerning compliance issues with Rule 206(4)-1) of the Investment Advisers Act of 1940 (the “Advertising Rule”). The Advertising Rule is frequently a point of emphasis during OCIE examinations of investment advisers, as well as examinations by state-level agencies.  The SEC outlined six frequently-encountered compliance issues for investment advisers as they relate to the Advertising Rule:

1. Misleading Performance Results: OCIE identified two primary culprits of misleading performance results findings: improper performance reporting and inadequate disclosures. OCIE highlighted instances of improper performance reporting where advisers failed to deduct advisory fees from performance results. OCIE also identified inadequate disclosures where advisers failed to disclose (i) limitations of benchmark comparisons and (ii) material information in hypothetical and back-tested performance results.
2. Misleading One-on-One Presentations: OCIE noted that some advisers failed to include material disclosures in one-on-one presentations to potential investors.
3. Misleading Claims of Compliance with Voluntary Performance Standards: OCIE discussed misstating compliance with non-mandatory actions such as compliance with recognized performance standards or compliance with certain levels of cybersecurity. Advisers typically run into this issue when they use a non-customized compliance manual template.
4. Cherry-Picked Profitable Selections: OCIE warned against the use of advertising past, specific recommendations of an adviser without publishing a list of all recommendations by the adviser over the last year or other disclosures as required by the Advertising Rule.
5. Misleading Selection of Recommendations: OCIE noted advisers failed to properly disclose past specific investment recommendations associated with a particular investment strategy in compliance with the Advertising Rule and SEC no-action letters.
6. Compliance Policies and Procedures: OCIE specifically addressed advisers that failed to have or implement policies and procedures for the review and approval of advertising materials prior to dissemination; determining the parameters of performance calculations; and confirming the accuracy of performance results in complying with the Advertising Rule.

The SEC also highlighted compliance issues regarding advisers touting awards, rankings, and/or professional designations in marketing materials.  OCIE noted the following issues:

1. Misleading Use of Third-Party Rankings or Awards: Advisers failed to disclose material information related to rankings and awards and/or simply provided false or misleading statement to the public. This included submitting false or misleading information in award applications; publishing stale or outdated ranking information; and/or failing to disclose material award selection criteria and/or the fact that the adviser paid a fee to distribute the results of the survey or award.
2. Misleading Use of Professional Designation: Advisers made false or misleading disclosures in Form ADV Part 2B Brochure Supplements. Specifically, some advisers displayed outdated or unearned professional designations.
3. Testimonials: Advisers published statements of clients on social media, firm websites, and social media in violation of the Advertising Rule on testimonial publication.

The SEC has long-focused on compliance with the Advertising Rule, and OCIE continues to examine and penalize advisers that do not follow its substantive and disclosure requirements. Advisers should have policies and procedures in place to review and approve all advertisements and statements made to current and prospective clients, whether by outside counsel or a compliance officer. Feel free to reach out to us if you have any questions about compliance with the Advertising Rule.

In our last update concerning Regulation A, we discussed the SEC’s revamp of Regulation A, referred to as Regulation A+. Regulation A was originally intended to act as a middle ground between private placement offerings and registered public offerings. However, Regulation A was rarely used due to the high cost of compliance relative to the amount of capital that could be raised under it. Instead, most issuers gravitated towards private placement under Rule 506 of Regulation D, which permits an unlimited amount of capital to be raised with relative ease.

Regulation A+ allows issuers to raise up to $50 million, compared to a $5 million cap under the original framework. Regulation A+ went live on June 19, 2015, and last month the SEC released a report summarizing the impact of Regulation A+ during the first 16 months (June 19, 2015 through October 31, 2016) since the amendments became effective. Although it is too early to draw any long-term conclusions from the SEC’s report, Regulation A+ appears to be a much more popular offering than its predecessor.

To recap, Regulation A+ is divided into two tiers. Tier 1 Offerings allow issuers to raise up to $20 million during any 12-month period, subject to SEC and state regulatory authority review. Tier 2 Offerings allow issuers to raise up to $50 million during any 12-month period, subject to SEC review. While offerings in both tiers require an extensive review process, Tier 2 offerings are subject to additional requirements, including providing audited financials; filing annual, semiannual, and current event reports; and a cap on sales to non-accredited investors (no more than 10% of the greater of the investor’s annual income or net worth).

For the purposes of this post, offerings that have been submitted to the SEC and/or state regulatory authority are considered “Filed.” Offerings that have completed SEC and/or state regulatory authority review and are approved to solicit and sell to the public are considered “Qualified.” These are the major takeaways from the first 16 months of Regulation A+:

Size

• There were 147 filings seeking up to of $2.6 billion in financing. Issuers filed 72 Tier 1 Offerings, and 75 Tier 2 Offerings. Tier 1 Offerings accounted for $700 million in the total offering amount, while Tier 2 Offerings constituted the remaining $1.9 billion.
• Of those 147 filings, the SEC and/or state regulatory authority qualified a total of 81 offerings seeking up to $1.5 billion. The SEC and state regulatory authorities qualified 33 Tier 1 Offerings, and the SEC qualified 48 Tier 2 Offerings.
• The average and median offering amount for Tier 1 Offerings was $10 million and $6 million, respectively. The average and median offering amount for Tier 2 Offerings was $26 million and $20 million, respectively.

Characteristics of the Offerings

• Issuers offered equity (as opposed to debt or other types of securities) in 87% of all offerings.
• Only 10% of all qualified offerings (None in Tier 1 and 17% in Tier 2) utilized an underwriter, and only 36% of all qualified offerings (18% in Tier 1 and 48% in Tier 2) utilized an intermediary.
• The median number of states in a Tier 1 offering was 4, and the median number of states in a Tier 2 offering was 50.
• Approximately 10% of all qualified offerings involved sales by existing and affiliate (a person who directly or indirectly controls the issuer i.e. executive officer, director, or a substantial shareholder) shareholders.
• The median and average number of days it took the SEC and state regulatory authorities to qualify a Tier 1 offering was 68 and 93 days, respectively. The median and average number of days it took the SEC to qualify a Tier 2 offering was 104 and 121 days, respectively.

Characteristics of the Issuer

• The median total assets for qualified Tier 1 and Tier 2 Offerings was $100k and $200k, respectively. The average total assets for qualified Tier 1 Offerings was $104.7 million and $61.9 for qualified Tier 2 Offerings.
• 62% of all issuers with qualified offerings (61% Tier 1 and 64% Tier 2) had no revenues. All Tier 1 issuers and 89% of Tier 2 issuers had revenues of less than $1 million.
• Issuers with qualified offerings had a median of 3 employees and an average of 29 employees.
• 37% of all issuers were in finance, insurance, and real estate, 27% were in other business services, and 22% operated in Manufacturing.
• California led the way with 36% of all offerings, followed by Florida and Texas at 14% and 10%, respectively.

An immediate takeaway from this data is that Regulation A+ appears to be more popular than its predecessor. In the 12 months prior to the enactment of Regulation A+ (June 19, 2014 through June 18, 2015), there were approximately 51 Regulation A filings seeking to raise approximately $159 million. Adjusting for the length of the SEC’s study, one would expect a 16-month period to include approximately 70 filings seeking around $218 million. Instead, over the last 16 months we saw a two-fold increase in projected filings, and an almost $2.4 billion increase in offering amount.

From this data, we can also see that Tier 2 offerings were qualified at a higher rate (64% vs. 46% for Tier 1), but took longer to qualify on average than Tier 1 Offerings (121 days vs. 93 days). The study does not provide insight into what could cause this discrepancy between tiers. The discrepancy could be purely due to timing issues in the study or it could have another underlying cause; it will be interesting to measure these factors as Regulation A+ matures as an offering option.

This information also demonstrates the speculative nature of Regulation A+ offerings thus far. The clear majority of issuers offered equity instead of debt, presumably to avoid short-term expense obligations. Also, relatively few issuers utilized an underwriter or intermediary, apart from 48% of Tier 2 offerors that used an intermediary. This is understandable given the fact that most of the issuers have relatively few assets, a limited amount of debt, little to no revenues, and a small number of employees. Although this data shows the speculative downside of Regulation A+ (90% of all offerings were sold on a best effort basis), it also shows a major advantage of utilizing Regulation A+: small, startup companies with promising futures can raise up to $50 million without having to incur the costs and obligations of retaining an underwriter or intermediary, not to mention the avoided regulatory burden.

It is too early to determine whether Regulation A+ will be a success. Tier 1 and Tier 2 Offerings are only obligated to provide complete information about sales after the termination or completion of an offering. Of the available information, the SEC estimates that 20 issuers have raised approximately a combined $190 million, and 11 issuers have reported zero proceeds. Due to reporting time frames, these numbers are likely substantially understated. We will keep you posted on future updates regarding Regulation A+.

Feel free to reach out to us if you have any question or if you think that Regulation A+ could be a viable option for your investment offering.

On October 30, 2015, the Securities and Exchange Commission (SEC) adopted the final rules implementing Title III of the Jumpstart Our Business Startups Act (JOBS Act), known as “crowdfunding.” These rules take effect on May 16, 2016. As that deadline approaches, companies, investors and intermediaries seeking to take advantage of these rules must prepare themselves to assure full compliance.

The new rules are designed to help small companies raise capital and allow non-accredited investors to participate in venture capitalism—something historically left only to accredited investors. Because investors participating in crowdfunding are expected to have a lower level of financial sophistication, the rules provide safeguards through certain limitations on companies, investors and intermediaries. In short, the rules broadly do the following:

1. Cap the amount of money an issuer can raise through crowdfunding in a year
2. Limit the amount investors can contribute to crowdfunding in a year
3. Impose specific and general disclosure requirements on issuers
4. Create a regulatory framework for the broker-dealers and funding portals that facilitate crowdfunding

New Developments

The final crowdfunding rules are mostly in-line with the rules proposed by the SEC last year. However, below are some notable differences between the proposed and final rules.

1. Exception for Audited Statements. First-time issuers may elect a one-time exception to the requirement that they provide audited financial statements for an offering greater than $500,000. Instead, the rules allow the issuer to submit statements reviewed by an independent public accountant. Presumably, this exception will help small companies seeking only an initial investment of capital by reducing up-front transaction costs.
2. Exception to Annual Reporting Obligation. An issuer need not comply with the annual reporting requirements if either (1) the issuer has filed at least one annual report and it has fewer than 300 holders of record, or (2) the issuer has filed annual reports for at least the three most recent years and it has total assets of $10 million or less. Again, these exceptions help reduce some of the administrative costs of crowdfunding.
3. Intermediary Compensation. Issuers may pay intermediaries in stock, instead of cash. They may report compensation paid as either a dollar value or percentage of the offering amount and may use a good faith estimate if the parties are unable to identify an exact amount at the time of filing the offering statement on Form C.
4. Intermediary Selectivity. Intermediaries may use their discretion in determining whether to let an issuer use their platforms. This should allow intermediaries to better screen issuers and create more targeted crowdfunding platforms.
5. Disclosure Obligations. Issuers must disclose any material information necessary in order to make the statements made not misleading. This modification places an affirmative obligation on issuers to correct any statements that were or became misleading after they were made.
6. Tax Return Disclosure. Issuers need not provide copies of their federal income tax returns when conducting offerings of $100,000 or less. Instead, they need only provide the issuer’s amount of total income, taxable income and total tax as set forth in its filed tax returns with the principal executive officer’s certification.

The remainder of this post summarizes the crowdfunding framework, including the relevant changes to the final rules, so that investors, intermediaries and start-up companies can prepare for the new crowdfunding rules to take effect in May.

I. RULES PERTAINING TO ISSUERS

Eligibility

All companies other than those listed below are eligible to use Regulation Crowdfunding.

• Non-U.S. companies
• Publicly traded companies
• Blank check companies and special purchase acquisition companies
• Certain investment companies[1]
• Companies disqualified by the Regulation Crowdfunding provisions (e.g. bad actors)
• Companies that have failed to file their annual report required by Regulation Crowdfunding for the past two years

Annual Limit on Capital Raised

One of the biggest limitations imposed by the rules on crowdfunding is the limit on capital raised each year. Specifically, issuers may raise a maximum aggregate amount of $1 million through crowdfunding offerings on a 12-month rolling basis. Other non-crowdfunding capital raising options do not count toward this limit. The offering cap includes offering expenses and intermediary fees. Some critics argue that this limit is too low for the cost and time companies will have to spend working out the limitations.

Issuer Disclosure Statements

• Initial Offering Statement. Issuers must comply with various disclosure requirements and file certain information with the SEC in connection with a crowdfunding offering, including an offering statement on Form C. Generally, an issuer must disclose information about company management, financial structure and condition, an assessment of the specific and general risks of the investment, and a reasonably detailed description of the offering including (1) the purpose and intended use of the proceeds of the offering, (2) the price of the securities to the public or the method for determining the price, (3) the target offering amount, (4) whether the target amount may grow, (5) the deadline to reach the target amount, and (6) updates on efforts to reach the target amount at specified benchmarks.

Issuers must also provide financial statements prepared in accordance with U.S. GAAP for the issuer’s two most recent fiscal years. Based on the proposed amount of the offering, issuers may elect varying levels of review. If the issuer seeks to raise $100,000 or less, the issuer’s principal executive officer may certify the statements to be true and complete in all material respects. If the issuer seeks to raise more than $100,000 but not in excess of $500,000, an independent public accountant must review the statements. If the issuer seeks to raise more than $500,000, an independent public accountant must audit the statements, except that first-time issuers may instead provide reviewed financial statements.

• Annual Reporting Requirements. Issuers must provide an annual report containing financial statements certified true and complete in all material respects by the issuer’s principal executive officer and any other information similar to what the issuer included in its offering statement on Form C.

Companies must continue to issue annual statements until the company (1) liquidates or dissolves, (2) goes public, (3) no longer has any shareholders who originally purchased securities in their crowdfunding offering, (4) files at least three annual reports and has total assets that do not exceed $10 million, or (5) files at least one annual report and has fewer than 300 holders of record.

• Material Information Requirement. In addition to the specifically enumerated disclosure requirements, the rules require disclosure of any material information necessary to make any statements made, in light of the circumstances under which they were made, not misleading. In other words, companies must correct any statements that become misleading due to a later development in the business.

II. RULES PERTAINING TO INVESTORS

Limitations on Amount Contributed by Investors

The SEC distinguishes between accredited and non-accredited investors, defining the former as one whose net worth is greater than $1 million (excluding a primary residence) or whose annual income in each of the two most recent years is greater than $200,000 ($300,000 for married couples). Accredited investors are not restricted as to how much they can invest in start-ups. In contrast, Regulation Crowdfunding allows non-accredited investors to contribute lesser amounts to crowdfunded start-ups based on their income and net worth. The rules subdivide non-accredited investors into two categories: (1) investors with a net worth or annual income less than $100,000, and (2) investors with a net worth and annual income greater than $100,000.

• Investors with Annual Income or Net Worth Below $100,000. Investors who fall into the first non-accredited category are limited in the amount they can invest annually through crowdfunding by the greater of $2,000 or 5% of the lesser of their annual income or net worth.

• Investors with Annual Income and Net Worth Above $100,000. Investors who fall into the second non-accredited category are limited in the amount they can invest annually through crowdfunding only to the extent that the investment does not exceed 10% of the lesser of their annual income or net worth up to $100,000.

Resale Limitations

Investors who purchase securities in a crowdfunding offering may not resell those securities within one year of their initial issuance other than to (1) an accredited investor, (2) third parties in a registered offering, (3) an investor’s family member, or (4) the issuer.

III. RULES PERTAINING TO INTERMEDIARIES

Issuers must conduct every crowdfunding offering through an intermediary, also known as a “platform.” These platforms must register as either broker-dealers or funding portals. Companies must conduct each crowdfunding offering through a single intermediary. While platforms may accept issuers’ securities as compensation for services, the directors and officers of an intermediary may not hold any securities of an issuer on their portal.

Due Diligence Requirements 

Intermediaries are responsible for a certain amount of due diligence on their part. First, they must run background checks on an issuer’s officers, directors and 20% beneficial holders. They must deny access to their platform for any issuer they reasonably believe is subject to any of the bad actor disqualification provisions of Regulation Crowdfunding. Second, they need a reasonable basis for believing that issuers complied with all requirements of Regulation Crowdfunding and employ accurate methods for record keeping. Finally, they must have a reasonable basis for believing investors on their portals satisfy the investment limits established by Regulation Crowdfunding. Intermediaries may reasonably rely on the representations of issuers and investors, unless they have any reason to question the reliability of those representations.

IV. LIABILITY CONSIDERATIONS

Both issuers and intermediaries will likely have liability for materially misleading statements and omissions in an issuer’s offering statement. Not surprisingly, an issuer of crowdfunded securities is liable to a purchaser if the issuer makes an untrue statement of a material fact or omits to state a material fact. The SEC specifically declined to exempt intermediaries from liability, noting that it will likely consider intermediaries an “issuer” in this context. Intermediaries will likely bake this cost of liability uncertainty into the transaction fee, which may further negate some of the monetary benefits of crowdfunding.

[1] A company cannot crowdfund a fund to invest in other crowdfunded opportunities. Each offering must include a business plan for which the underlying purpose must be a bonafide business and not an investment vehicle.

When we last wrote about Regulation A, the SEC had released its proposed rules amending the securities registration exemption to expand its availability to larger offerings. On March 25, 2015, the SEC adopted its final rules amending Regulation A. The final rules are substantially similar in form to the proposed rules, and the amendments will become effective 60 days after publication in the Federal Register.

As background, Regulation A is a longstanding exemption under the Securities Act of 1933 that, until recently, permitted unregistered public offerings of up to $5mm of securities during any 12-month period. Regulation A was intended to bridge the gap between private placement offerings and registered public offerings, but it failed to gain traction due to the high cost of compliance relative to the amount of capital that could be raised under it. Issuers instead gravitated towards private placements under Rule 506 of Regulation D, which permits an unlimited amount of capital to be raised with relative ease.

In recent years, however, there has been a groundswell to amend Regulation A to raise the dollar threshold and make it a more viable option to issuers looking to conduct a limited public offering. Unlike a private placement offering, securities sold in a Regulation A offering are not considered “restricted securities” under Securities Act Rule 144 and are freely transferrable by non-affiliates of the issuer. The amended Regulation A under the final rules – commonly referred to as “Regulation A+” – is a welcome expansion and modernization of the exemption that abandons the $5mm cap in favor of a two-tiered offering structure:

(1) Tier 1 – offerings of securities of up to $20mm during any 12-month period, with not more than $6mm in offers by selling security-holders that are affiliates of the issuer; and
(2) Tier 2 – offerings of securities of up to $50mm during any 12-month period, with not more than $15mm in offers by selling security-holders that are affiliates of the issuer.

For offerings of up to $20mm, issuers may elect whether to proceed under Tier I or Tier II, subject to eligibility, disclosure and reporting requirements. All Regulation A+ issuers are still required to file an extensive offering statement on Form 1-A, which is subject to SEC staff review and comment.

Issuers conducting Tier II offerings are subject to additional requirements, including:

(1) Providing audited financial statements;
(2) Filing annual, semiannual and current event reports; and
(3) A cap on the amount of securities non-accredited investors may purchase (no more than 10% of the greater of the investor’s annual income or net worth)

In contrast to Rule 506 offerings, issuers utilizing Regulation A+ may sell securities to an unlimited number of non-accredited investors. Notably, the final rules also preempt state securities law registration and qualification requirements (i.e. “Blue Sky” laws) for securities offered to “qualified purchasers,” which effectively covers all offerees in Tier 2 offerings but does not cover offerees in Tier 1 offerings. As such, Tier 1 offerings will be subject to both Regulation A and state registration and qualification requirements. Some states have pushed back against the Tier 2 preemption, with Montana and Massachusetts both going so far as filing petitions in federal court challenging the SEC’s authority to preempt state law.

Regardless of how the court challenges play out, it will be interesting to see whether Regulation A+ catches on with smaller companies in need of outside capital. We expect most issuers will continue to rely predominantly on Rule 506 under Regulation D for outside capital, but that Regulation A+ may gain traction among issuers looking to gradually transition to a registered public offering.

Please feel free to contact us if you have any questions regarding this post.

While the comprehensive set of crowdfunding regulations (“Regulation Crowdfunding”) proposed by the Securities and Exchange Commission (“SEC”) pursuant to Title III of the JOBS Act remain pending, several states have begun to take the matter of equity crowdfunding into their own hands. Texas is the most recent state to take the initiative on crowdfunding. As the second most populous state in the United States, Texas would grant companies using the crowdfunding exemption access to a broad base of potential investors.

Made effective on November 17, 2014, Texas’ crowdfunding exemption is based on the intrastate offering exemption of the Securities Act of 1933 and SEC Rule 147. Because of this, only Texas based companies meeting certain criteria may use the offering exemption, and only Texas residents may invest in those offerings. Beyond being limited to Texas companies and investors, many provisions of the Texas crowdfunding exemption will be familiar to those who have been following the SEC’s Regulation Crowdfunding (including the use of crowdfunding portals and the $1 million raising cap).

Texas’ crowdfunding exemption addresses and imposes a number of limitations on Issuers, Investors, and Dealers/Portals—each to be discussed in turn.

Issuers

As an initial matter, any company wishing to use the crowdfunding exemption must be organized in the state of Texas and must maintain its principal office in Texas. Companies that pass these two initial hurdles must then demonstrate: (i) at least 80% of the company’s gross revenue during its most recent fiscal year is derived from the operation of a business in Texas; (ii) at least 80% of the company’s assets at the end of its most recent semiannual period prior to the offering are located in Texas; and (iii) the company will use at least 80% of the net offering proceeds in connection with the operation of its business within Texas. (Excluded from using the exemption are “bad actors,” investment companies, and SEC reporting companies.)

The exemption then requirements companies to make a number of disclosures when registering to become an issuer. Companies must disclose, among other information, (a) a general description of its business, (b) its management and major stockholders, (c) how the offering proceeds will be used, and (d) financial information. Notably the financial information does not need to be audited, it simply must be certified as true by the principal executive officer. (But if the issuer does have audited financials for any of the previous three years, those must be disclosed.)

Once all of the Texas residency requirements have been satisfied and all of the necessary disclosures made, companies may then issue securities through the crowdfunding exemption. Companies are limited to raising no more than $1 million in any 12-month period—the same cap imposed by the SEC’s Regulation Crowdfunding.

Investors

Investors in these offerings are limited to Texas residents. As will be described below, it is the responsibility of the dealer/crowdfunding portal to verify an investor’s Texas residency. Non-accredited investors are limited to investing a maximum of $5,000 in any offering, while accredited investors (as defined in SEC Rule 501) are not limited to any particular amount. Unlike the SEC’s Regulation Crowdfunding, investors are not otherwise limited by net worth or annual income.

Dealers/Portals

Any offer or sale of securities by an issuer must be made through a registered dealer or registered crowdfunding portal. It is the responsibility of the dealer/portal to verify investor residency before allowing investors to view available offerings. Residency is verified through such identification as a Texas driver license, Texas voter registration card or property tax records.

Conclusion

The Texas’ crowdfunding exemption, like the seven other states with similar exemptions, is hampered by the fact it is based on the intrastate offering exemption. As such, companies using these crowdfunding exemptions are limited in both their access to investors as well as their communications about the offering. The SEC’s Regulation Crowdfunding is supposed to address and solve these problems, but it is unknown when the SEC will issue its final rules and what form exactly they will come in.

Please feel free to contact us for more information on which states currently allow equity crowdfunding and the state-by-state rules for conducting such an offering.

Over the past few years the jurisdictional interplay between the Securities and Exchange Commission (“SEC”) and the Commodity Futures Trading Commission (“CFTC”) has been significantly overhauled. One question we continue to receive from clients on this front is the potential regulatory implications under both agencies of investing or trading in swap transactions. In that regard, below is a general overview of the regulation of swaps.

The CFTC and the SEC jointly approved final rules on August 13, 2012 regarding the definition and regulation of what are generally known as “swaps.” Swaps have been categorized into four types: (1) swaps, (2) security-based swaps, (3) mixed swaps, and (4) security-based swap agreements. (Swaps and security-based swaps are the most common.) Under this framework, the CFTC regulates swaps, the SEC regulates security-based swaps, the two commissions jointly regulate mixed swaps, and the SEC has antifraud authority over the CFTC regulated security-based swap agreements.

“Swaps” are generally derivative products that reference such things as interest rates, exchange rates, commodities, or foreign exchange/currencies.

“Security-based swaps” are generally derivative products that reference single securities, single loans, or narrow-based securities indexes (indexes containing 9 or less securities).

Persons who fall within the definition of “swap dealers” must register with the CFTC, while persons who fall within the definition of “security-based swap dealers” must register with the SEC, though each commission provides registration exemptions. A dealer is generally one does one of the following four activities for swaps or security-based swaps: (1) holds itself out as a dealer; (2) makes a market; (3) regularly enters into transactions with counterparties in the regular course of business for its own account; or (4) engages in any activity causing the person to be commonly known as a dealer.

Excluded from the definition of any of the four types of swaps are “equity options” (any put, call, straddle, option, or privilege on any security, CD, or group/index of securities that is subject to the ’33 and ’34 Acts), certain consumer and commercial transactions (e.g., insurance products, loans—subject to certain requirements), physically settled nonfinancial commodity forwards (when both parities to the forward have a bona fide intent to make or take delivery), and security forwards (either the purchase or sale of securities on a fixed or contingent basis or sales of securities for deferred delivery that will be physically delivered).

Please feel free to contact us if you have any questions regarding this post.

Overview of Regulation A

On December 18, 2013, the SEC proposed rules to amend Regulation A, pursuant to Title IV of the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”). Regulation A, adopted as a rule in 1936, was meant to assist small businesses with capital formation under the then-newly created securities regulatory regime. The Regulation A securities registration exemption was meant to be a middle ground between private placement financings and a full-blown public securities offering.

In practice, however, Regulation A is rarely used. According to the recent proposed rules release, the SEC noted in the time period of 2009–2012 Regulation A was only used in 19 offerings, raising approximately $73 million. During the same time period, however, Regulation D was used in 27,500 offerings of up to $5 million (the statutory limit for Regulation A offerings), raising approximately $25 billion

Two longstanding criticism of Regulation A have contributed to its non-use: (1) the cost of an offering relative to the amount capable of being raised, and (2) the necessity of complying with state blue sky laws in each state where the offering is conducted. While Regulation A offerings are supposed to be “mini-registrations” compared to a public offering’s registration statement, they still involve a number of costs and must be qualified by the SEC before a sale can be made. Despite being qualified by the SEC, the issuer must then comply with the blue sky laws of every state in which it intends to offer its securities for sale. This entire process is expensive and time consuming, and therefore arguably not worth using considering companies can only raise a maximum of $5 million per year through Regulation A.

Fixing Regulation A: Regulation A+

The changes brought about by Title IV of the JOBS Act and its resultant proposed rules are widely known as “Regulation A+.” Regulation A+ attempts to address the criticisms of Regulation A and resuscitate its use through a number of significant changes. As an initial matter, offerings under Regulation A+ are organized into two tiers: Tier I is for offerings of $5 million and under, and Tier II is for offerings of up to $50 million. Tier I offerings maintain Regulation A as it was pre-JOBS Act, while Tier II offerings contain the new changes. Issuers elect which tier they wish to use for their offering.

Regulation A+ retains many of the beneficial characteristics of Regulation A, such as allowing issuers to: (i) submit a scaled-down offering statement to the SEC for validation before sales of securities can be made in lieu of the full registration statement required of public offerings; (ii) “test the waters” for market interest before submitting an offering statement; (iii) publicly offer securities for sale; (iv) generally advertise and solicit; (v) accept non-accredited investors; and (vi) permit investors to resell their securities without restriction.

Proposed Changes

The proposed changes of Regulations A+ are meant to address the primary criticisms of Regulation A: the low issuance cap of $5 million and the high cost of complying with state blue sky laws. The most significant changes of Regulation A+ are: (1) raising the issuance cap to $50 million, and (2) federal preemption of state blue sky laws—i.e., issuers electing to use Tier II of Regulation A+ will only be required to receive SEC validation, eliminating the need to comply with state blue sky laws.

Yet with these changes Regulation A+ imposes three notable checks to balance the interest of fostering capital formation by companies against the interest of maintaining investor protections. First, the issuers must provide enhanced offering disclosures with audited financial statements (which is still less stringent than a full registration statement), annual and semiannual reports, as well as ongoing reporting of certain significant events. Second, certain categories of issuers are excluded from using Regulation A+, including “bad actor” issuers, development stage companies, and issuers registered under the Investment Company Act of 1940. Third, investors are limited to investing the greater of 10% of their net worth or net income into a Regulation A+ offering per year.

Conclusion

Like the proposed rules for equity crowdfunding, Regulation A+ is simply a set of proposed rules at this point (although raising the issuance cap to $50 million is mandated by Congress in the JOBS Act, so that will not be changing). As with any expansive change to securities regulation, Regulation A+ has received its share of challenges, particularly with respect to the proposed federal preemption of state blue sky laws, so it is unclear how closely the final rules will reflect the proposed rules. The comment period on the proposed rules closed earlier this year, but there is still no sign of when the final rules will be issued.

Please feel free to contact us if you have any questions regarding the status of Regulation A+ or how you might be able to utilize it in the future.

Overview

The Foreign Account Tax Compliance Act (“FATCA”) – part of the Hiring Incentives to Restore Employment Act – introduced a number of new withholding and reporting rules to address tax evasion by U.S. citizens and companies. The rules affect foreign financial institutions (“FFIs”), including, but not limited to, brokerage firms, hedge funds, and other pooled investment vehicles.

FATCA compels FFIs to report to the Internal Revenue Service (“IRS”) on an annual basis regarding their “U.S. accounts” (discussed below). Because the IRS cannot directly tax foreign entities, FATCA induces FFIs to comply with these new regulations by imposing a 30% withholding tax on certain categories of U.S. derived payments to FFIs that fail to comply with FATCA’s disclosure and reporting requirements.

FFIs can comply with FATCA in one of two ways: either (1) register with and sign an FFI Agreement with the IRS, or (2) be organized in a country that has signed an Intergovernmental Agreement (an “IGA”) with the U.S. Under an IGA, an FFI must still register with the IRS, but otherwise is simply required to comply with its local jurisdiction’s rules for the implementation of FATCA, rather than the FFI Agreement requirements. (Importantly for investment managers and hedge funds, both the Cayman Islands and the British Virgin Islands have signed IGAs with the U.S.) FFIs that are in compliance with FATCA are termed “Participating FFIs,” while noncompliant FFIs are termed “Nonparticipating FFIs.”

FATCA’s Disclosure and Reporting Obligations

Participating FFIs need to identify a responsible officer in the FATCA registration system that will sign and verify compliance with FATCA’s withholding and reporting rules. This officer is responsible for ensuring that the Participating FFI completes the following tasks:

• Obtain information about each of its account holders from which it can determine if an account is a U.S. account;
• Observe required verification and due diligence procedures for the identification of U.S. accounts;
• File an annual report with the IRS providing information about each of its U.S. accounts;
• Withhold FATCA tax from withholdable payments and “foreign pass-through payments” to Recalcitrant Account Holders (defined below) and Nonparticipating FFIs;
• Comply with any IRS requests for further information with respect to its U.S. accounts; and
• If foreign law would prevent the disclosure of any such information, secure a waiver of the foreign law prohibition from the owner of the U.S. account or, failing receipt of such a waiver, close the U.S. account.

An account holder that fails to provide the required information, documentation, or waivers to a requesting FFI is termed a “Recalcitrant Account Holder.”

The New FATCA Withholding Tax

The U.S. derived payments to FFIs subject to the new 30% withholding tax include (1) interest, dividends and other similar passive income, which are referred to as fixed and determinable annual or periodical income (termed “FDAP income”), and (2) gross proceeds from the sale or other disposition of any property that can produce interest or dividends (i.e., securities). The 30% withholding tax applies to the gross proceeds of each sale (it does not take the disposed of asset’s tax basis into consideration).

FATCA requires U.S. payors and Participating FFIs to withhold the 30% rate from payments due to nonparticipating FFIs—both FFIs that have not registered and/or signed an FFI Agreement with the IRS and FFIs that are not in compliance with their local jurisdiction’s IGA. Moreover, even Participating FFIs are required to withhold the tax on certain pass-through payments to Recalcitrant Account Owners (as described above).

FATCA Definitions

Identifying which accounts are “U.S. accounts” requires an FFI to look-through its accounts to the actual owners of those accounts. A “U.S. account” is defined as any “financial account” held by any one or more “specified U.S. persons” or “U.S. owned foreign entities.” A financial account includes any debt or equity interest in an FFI (other than publicly traded interests).

A “specified U.S. person” generally is any U.S. person other than publicly traded corporations and their affiliates, tax-exempt organizations, governments, banks, regulated investment companies and common trust funds. A “U.S. owned foreign entity,” is any foreign entity with one or more “substantial U.S. owners.”

A “substantial U.S. owner” generally is defined as the holder of more than a 10% interest but there is an exception for investment funds. In the case of investment funds, any U.S. owner will be deemed to be a substantial U.S. owner and as a consequence the fund is considered a U.S. owned foreign entity.

Offshore Fund Application

Subject to an exception, an offshore hedge fund that is comprised of foreign investors and/or tax-exempt U.S. investors is excluded from FATCA disclosure and reporting. The exception occurs if the foreign investor is an investment fund with at least one U.S. owner. The existence of even a single U.S. owner will render the foreign investment fund a “U.S. owned foreign entity” and cause its interest in an offshore hedge fund to be a “U.S. account.” As a consequence of having a U.S. account, the offshore hedge fund becomes subject to FATCA disclosure and reporting.

Moving Forward

The deadline for FFIs within countries that have signed an IGA with the U.S. is December 31, 2014, while the deadline for FFIs required to sign FFI Agreements passed on June 30, 2014. However, regardless of the deadline, all FFIs should begin the due diligence procedures and standards contained in the proposed regulations. This includes developing questionnaires for existing investors and revised investor subscription documentation that will solicit the information about those investors and their actual owners as required by FATCA. Additionally, such funds should review and modify, if necessary, their documents to ensure they require investors to cooperate with the funds’ efforts to comply with FATCA.

Fund managers should speak and work with their tax advisers and legal counsel to properly address the changes imposed by FATCA.

When we last wrote on the new rules permitting equity crowdfunding, the comment period had recently closed. To date, however, there is no sign of when the final rules will be issued or what changes (if any) will be made from the proposed rules. Additionally, a recent event has made investors even more eager for the final crowdfunding rules to be implemented. On March 25, 2014, Facebook Inc. agreed to acquire Oculus VR Inc., the maker of a virtual-reality headset, for $2 billion in cash and stock.[1] Oculus was founded in 2012 and used Kickstarter to fund its first round of investment, raising over $2.4 million. Because Kickstarter is not an “equity crowdfunding” platform, those first “investors” in Oculus did not receive a single cent of the $2 billion purchase price paid by Facebook.[2]

This is the type of situation the crowdfunding rules were designed to address. As will be described, though, the proposed rules would not have allowed Oculus to raise the amount it did, and likely would be deficient for the fundraising needs of many other companies. Because of this problem, among other shortcomings, members of Congress have proposed legislation to remedy the situation.

One of the biggest criticisms of the proposed crowdfunding rules has been the high cost of completing an issuance. The SEC performed a cost/benefit analysis detailing the estimated costs of raising money via crowdfunding under the proposed rules. The SEC considered three cost elements involved with crowdfunding issuances: (1) the success fee (the amount paid to intermediaries for facilitating the transaction); (2) the compliance costs (related to the preparation and filing of forms both before and after the fundraising transaction); and (3) the cost of a Certified Public Accountant review or audit.

According to a summary of the SEC’s cost/benefit analysis, it is estimated that issuances under $100,000.00 will consume on the low-end 12.9% of the money raised; for issuances over $100,000.00 but less than $500,000.00, the low-end cost could drop to 7.96%; and for issuances from $500,000.00 to $1 million, the low-end cost could drop to 7.66%.[3] (For reference, the SEC estimated the average sales commission for Regulation D offerings of up to $1 million to be 6.5%.)[4]

Because of the high potential cost of crowdfunding issuances and the relatively low $1 million cap, among other issues, members of Congress have proposed legislation to address the proposed regulations’ shortcomings. The bill, entitled the Equity Crowdfunding Improvement Act of 2014 (H.R. 4564), was proposed on May 6, 2014.[5] The bill repeals and replaces the problematic provisions of Title III of the JOBS Act as currently enacted. There are five significant changes proposed by the bill:

First, corporations would be allowed to raise significantly more capital under the crowdfunding exemption. (Note: the bill expressly limits its availability to entities organized as corporations at the time the securities are issued.)

• Under the proposed rules, there are three issuance tiers under the crowdfunding exemption with corresponding issuer obligations: first, for issuances of up to $100,000.00, tax returns and unaudited financial statements of the issuer must be filed with the SEC; second, for issuances of $100,000.00 to $500,000.00, an independent accountant must review the issuer’s financial statements; and third, for issuances of $500,000.00 to $1 million, the issuer’s financial statements must be audited.
• The bill expands the first tier to cover issuances up to $500,000.00; the second tier would cover issuances of $500,000.00 to $3 million; while the third tier would cover issuances of $3 million to $5 million.

This change would allow corporations to raise more capital while spreading the costs of an issuance over a larger amount of capital. Under the proposed rules, Oculus would not have been able to raise the full $2.4 million it received on Kickstarter, whereas the bill would have both allowed Oculus to raise that amount and do so without requiring audited financial statements.

Second, the bill eliminates a number of the filing burdens placed on issuers both before and after an offering. In particular, issuers will no longer be required to describe their current financial condition and the intended use of the offering proceeds before the offering, or be required to issue ongoing annual reports on the results of the issuer’s operations after the offering.

Third, individuals would be allowed to invest more money in corporations through the crowdfunding exemption.

• Under the proposed rules, the maximum amount individuals can invest through the crowdfunding exemption is the greater of $2,000 or 5% of such individual’s annual income in one year, if both annual income and net worth are below $100,000.00; or if either annual income or net worth are above $100,000.00, then the maximum becomes the greater of 10% of net worth or annual income, with a cap of $100,000.00.
• The bill raises the maximum amount individuals can invest is raised to the simple formula of the greater of $5,000 (adjusted for inflation annually), or 10% of the investor’s annual income or net worth.

Fourth, the bill eliminates a number of burdens placed on the intermediaries between issuers and investors. (As an initial matter all references to “funding portals” have been removed and replaced with simply “intermediary,” yet most of the requirements remain the same with a few exceptions detailed here.) Intermediaries would no longer be required to provide Investor Education Materials, or require investors to positively affirm that they understand they can lose their entire investment. Additionally, intermediaries would be allowed to “curate” issuer offerings. Under the proposed regulations, any attempt by a Funding Portal to be selective as to which issuers can use its services (even attempts to screen out questionable issuers) is considered by the regulations as offering “investment advice” and, as a consequence, is prohibited. The proposed bill would allow curation of offerings by excluding an intermediary’s curation of issuer offerings from the definition of “investment advice.”

Fifth, the bill would exclude crowdfunding investors from being counted as shareholders of record for the purposes of the shareholder cap under the Securities Exchange Act of 1934. This change prevents crowdfunding issuers from triggering some of the reporting obligations imposed on companies if they have more than a certain number of investors.

While the bill addresses many of the criticisms leveled at the proposed rules, it is unclear what chance of success it has of being enacted. As for the proposed rules, while it is unknown when they will become finalized or what changes (if any) will be made to them, it is expected that the final rules will be similar to the proposed rules—with all of its shortcomings. Until the rules are finalized, issuers can continue to use the traditional methods of fundraising as well as other recently altered exemptions (specifically Regulation D and Regulation A+ offerings, respectively).

[1] http://online.wsj.com/news/articles/SB10001424052702303949704579461812019189626

[2] http://blogs.wsj.com/digits/2014/03/25/aug-1-2012-when-oculus-asked-for-donations/

[3] http://venturebeat.com/2014/01/02/it-might-cost-you-39k-to-crowdfund-100k-under-the-secs-new-rules/

[4] http://www.sec.gov/rules/proposed/2013/33-9470.pdf FN 828

[5] https://www.govtrack.us/congress/bills/113/hr4564/text

Background

On July 10, 2013, the SEC approved Rule 506(c) in compliance with the Jumpstart Our Business Startups Act (the “JOBS Act”) to permit, to an extent, general solicitation and general advertising for certain Regulation D offerings (previously addressed here).  However, thus far Rule 506(c) has been rarely used in the marketplace, with many commentators attributing the lackluster response to the rule’s limited scope. Most notably, Rule 506(c) was in conflict with commonly claimed Commodity Futures Trading Commission (“CFTC”) exemptions found under Rules 4.13(a)(3)[1] and 4.7[2] due to the additional restrictions imposed with respect to such exemptions on marketing  exempt pools to the public.

However, the CFTC’s Division of Swap Dealer and Intermediary Oversight (“DSIO”) recently issued a letter harmonizing CFTC Rules 4.13(a)(3) and 4.7 with SEC Rule 506(c), thereby removing a roadblock to a CPO’s use of Rule 506(c).

The DSIO’s exemptive relief includes the following:

• For exemptions filed under CFTC Rule 4.13(a)(3), relief from the requirement that securities be “offered and sold without marketing to the public”;

• For reporting relief filed under CFTC Rule 4.7, relief from the requirements that (1) an offering be exempt pursuant to Section 4(a)(2) of the Security Act and (2) that securities be offered solely to qualified eligible persons (“QEPs”).

When does the relief take effect?

The exemptive relief is effectively immediately. However, the exemptive relief is intended as an interim fix and its provisions can be modified or revoked at the DSIO’s discretion.

What is the scope of the relief?

Relief is limited to CPOs conducting 506(c) offerings of CPOs and CPOs using 144A Resellers (i.e. entities reselling securities in reliance on a Rule 144A exemption). As such, it does not extend to other Regulation D, Regulation A or Section 4(a)(2) offerings.

Is the relief self-executing?

No. CPOs (both registered and exempt) must file notice with the DSIO verifying compliance with the substantive conditions of the relief.  The notice should include, among other things, the CPO’s basic contact information, as well as specify whether the CPO intends to rely on the exemptive relief pursuant to Regulation 4.7(b) or 4.13(a)(3).

Is verification required for Investment Advisers?

Yes. The final rules require managers who opt into 506(c) general solicitation and general advertising to take reasonable steps to insure that all investors meet the accredited investor standard. While managers must establish their own verification process, the SEC lists two approaches to verification—(1) “principles- based” approached to verification using surrounding facts and circumstance, e.g. nature of the investor and size of the investment, or (2) specific examples of documentation that will provide sufficient verification that individuals meet the accredited investor test.

Conclusion

The CFTC’s exemptive relief extends the reach of Rule 506(c) to some CPOs claiming CFTC exemptions under Regulation 4.7 and 4.13(a)(3), provided the CPOs comply with applicable conditions of such relief (e.g. notice filing and investor verification).

Please feel free to contact us if you have any questions regarding the status of the JOBS Act or its potential impact on CPO marketing activities.

As final rules permitting equity-based crowdfunding draw near, we have seen issuers and market intermediaries ramp up efforts to develop platforms able to take advantage of the imminent rule changes. Consider SolarCity, for example, the largest installer of rooftop solar systems in the US. Recently SolarCity purchased Common Assets, a startup financial technology company, to develop a funding portal to crowdfund SolarCity’s ambitious growth projections. SolarCity, like many other rapidly growing companies, is seeking alternative methods to raise capital at cheaper rates. The JOBS Act contained many provisions to allow such alternative methods, including enhanced securities registration exemptions and an equity crowdfunding framework. Almost two years since the JOBS Act was signed into law, the SEC has sought comment on proposed rules to allow crowdfunding of up to $1 million using funding portals. However, it remains to be seen how SolarCity and similarly situated companies will ultimately choose to utilize the new rules.

Title III of the JOBS Act, known separately as the Capital Raising Online While Deterring Fraud and Unethical Non–Disclosure Act of 2012, defines and contains the framework for the new equity crowdfunding regulatory scheme. The framework contains two main components: 1) a new exemption for securities issuances of up to $1 million with significant differences from other small issuance exemptions; and 2) a new brokering entity labeled a “funding portal” that is less regulated than traditional broker-dealers. Title III is not deemed effective until the SEC adopts the proposed rules fleshing out the new framework. Although the comment period on these rules closed on February 4, 2014, the rules may not be adopted for many months afterward as some finer points get hashed out. Thus far commentary has been divided as to whether the rules are too restrictive of crowdfunding in an attempt to provide investor safety or too lenient in an attempt to allow more opportunities to raise capital. Because of the split in thought, it seems likely that the rules as proposed may end up very similar to the final adopted rules.

The proposed rules closely follow and elaborate on the JOBS Act by creating an exemption from registration for issuers of under $1 million in aggregate during a 12-month period, provided such issuers comply with certain criteria. All issuers must disclose basic information such as the legal status, physical address, names of directors and officers, and the business plan of the issuer. For issuances of up to $100,000.00, tax returns and unaudited financial statements of the issuer must be filed with the SEC. For issuances of $100,000.00 to $500,000.00, an independent accountant must review the financial statements. For issuances of $500,000.00 to $1 million, the financial statements must be audited. Other filings required of all issuers include the capital structure of the issuer and the details of the planned offering, such as pricing, risk factors, and intended use of the funds raised. Post-issuance reporting requirements parallel the filing requirements. Additionally, advertising and solicitation by the issuer is banned, although notice directing potential offerees to a broker or funding portal is allowed.

Certain restrictions disqualify issuers from using the crowdfunding exemption. First, bad actor provisions follow those applied to other registration exemptions. Second, issuers that have already issued registered securities may not utilize the crowdfunding exemption. Third, certain types of investment, acquisition and blank check companies are not allowed to raise money using the crowdfunding exemption.

The JOBS Act also restricts the amount of investment by individual investors in securities offered under the crowdfunding exemption. The proposed rules closely follow the outline of the statute, but clarify that the maximum investment by individuals is $2,000.00 or 5% of such individual’s annual income in one year, whichever is greater, if both annual income and net worth are below $100,000.00. If either annual income or net worth is above $100,000.00, up to 10% of the greater of annual income or net worth may be invested, up to a maximum of $100,000.00. Net worth is calculated in the same manner as the determination of accredited investor status. Annual income and net worth may be determined on an individual or joint basis in the case of married persons. Additionally, issuers may rely on intermediaries to ensure that investors don’t surpass investment caps.

Issuers wishing to take advantage of the crowdfunding exemption are required to sell securities through an intermediary. This intermediary can include traditional brokers or newly defined funding portals. The JOBS Act permits funding portals to be exempt from the same registration requirements as brokers, but they must still belong to a national securities association (likely FINRA). Funding portals are also much more limited in scope and role than traditional brokers; they are restricted from soliciting orders, holding or managing investor funds, or offering investment advice. Only one offering and one intermediary may be used at any one time. Additionally, entities under common control will be considered a single issuer.

Under these basic guidelines it seems unlikely that most growing companies will be able to raise enough capital to finance ambitious growth. Fortunately, the SEC has proposed that the crowdfunding exemption can be used in addition to other registration exemptions, without altering the validity of the exemptions. With the recent alterations to other exemptions (specifically Regulation D and Regulation A+ offerings), the greatest challenge may be finding counsel to help navigate the new landscape.

On July 10, 2013, the Securities and Exchange Commission (“SEC”) approved final rules pursuant to the Jumpstart our Business Startups Act (“JOBS Act”) that remove the ban on general solicitation and advertising practices for certain private offerings made in reliance on Rule 506 under Regulation D of the Securities Act. After taking nearly a year to implement the originally proposed rule amendments, the SEC’s final rules will become effective on September 23, 2013. As previously discussed (see here, here, here and here), the removal of the general solicitation and advertising ban is a watershed event that will significantly alter the capital-raising landscape for private fund managers going forward.

Amendments to Rule 506 and Rule 144A to Eliminate the General Solicitation and Advertising Ban

Under new Rule 506(c), issuers may engage in general solicitation and general advertising practices when offering securities, provided that:

1)      All purchasers of the securities are accredited investors; and

2)      The issuer takes reasonable steps to verify that the purchasers of the securities are accredited investors.

Defining what constitutes “reasonable steps to verify” accredited investors will be the crux of the new rules. In response to heavy criticism to the proposed rule amendments, the SEC included the following verification methods in Rule 506(c) (though not exclusive, the list provides a helpful guideline to managers relying on the new rules):

1)      Documentation of income, such as a review of the investor’s income tax returns for the previous two years;

2)      Documentation of net worth, such as a review of the investor’s bank or brokerage statements;

3)      Third-party verification from a broker-dealer, certified public accountant, licensed attorney, etc.; and

4)      Reliance on written verification from an existing investor who invested in the underlying Rule 506 offering prior to the new rules taking effect.

Note that issuers also have the option to continue to rely on the original Rule 506 exemption instead (now found under Rule 506(b)), which still prohibits general solicitation and advertising practices. However, in contrast to Rule 506(c), Rule 506(b) allows issuers to accept up to thirty-five (35) non-accredited investors in the offering. For many start-up and emerging managers, the decision whether to launch as a Rule 506(b) or a Rule 506(c) offering will ultimately hinge on the tradeoff between utilizing general solicitation and advertising practices versus retaining the flexibility to accept investments from certain non-accredited family members and friends.

The SEC also adopted amendments to Rule 144A under the Securities Act which will allow issuers to offer securities to persons other than qualified institutional buyers (“QIBs”), including by means of general solicitation and advertising practices, provided the securities are only sold to investors the issuer reasonably believes are QIBs.

“Bad Actor” Disqualification

The SEC also approved final rules that disqualify issuers from utilizing the Rule 506 exemption if certain felons and other “bad actors” are involved in the offering. In contrast to the originally proposed rules, disqualifications will apply only for triggering events that occur after the effective date of the new rule (subject to mandatory disclosures).

Proposed Form D Amendments

Finally, the SEC proposed rules for comment regarding changes to Form D filing requirements and additional content distributed pursuant to Rule 506 offerings. Form D will be revised to require issuers to check a box indicating whether they are relying on Rule 506(c) for the underlying offering. The proposed rules would also require issuers that intend to rely on Rule 506(c) to file Form D no later than 15 days before engaging in general solicitation or advertising practices (currently an issuer must file a Form D within 15 days after the first sale of securities in the offering).

Conclusion

Issuers will only be able to opt-in to Rule 506(c) and utilize general solicitation and advertising practices if they take reasonable steps to verify that all investors are accredited. Note that fund managers may choose to continue an offering that commenced prior to the effective date of the final rules as either a Rule 506(b) or a Rule 506(c) offering, despite the offering not previously having been in compliance with Rule 506(c). However, fund managers electing to opt-in to Rule 506(c) will need to take appropriate action to confirm compliance with the new rules going forward, including modifying existing offering documents, updating record-keeping and due diligence procedures, etc., as well as amending Form D filings accordingly.

Please feel free to contact us if you have any questions regarding the status of the JOBS Act or its potential impact on hedge fund marketing activities.

In the wake of the 2010 Flash Crash, which saw the Dow plunge nearly 9% in roughly five minutes, several political and regulatory officials in the United States and Europe called for a “financial transaction tax” (“FTT”)[1] to discourage high frequency trading. While the likelihood of the United States or the European Union implementing a FTT in the near future is extremely low, countries inside the European Union are eyeing a FTT as a means to create tax revenue.

A FTT is an extremely small tax assessed every time an entity engages in a bond, stock, or currency trade, or any other similar transaction. Generally, the tax would amount to a 10-25 cent tax per 100 dollars. Ostensibly, the tax would reduce speculation in financial markets.

The European Union has proposed the idea, but remains nowhere near promulgating or implementing a FTT through an international agreement. Ten countries have expressed support for the proposal, but several – most notably Great Britain[2] – remain vehemently opposed to it. As succinctly noted in the EU proposal, “[T]he principle of harmonised tax on financial transactions will not receive unanimous support within the Council in the foreseeable future.”[3]

On October 12, 2012, several member states proposed “enhanced cooperation” between countries regarding implementing a FTT.[4] Enhanced cooperation is a procedural mechanism to allow a subset of EU members to enact a policy proposal without running afoul of the EU.[5] However, it remains unclear whether FTT proponents plan to adopt the EU Commission proposal as-is or modify it to make the FTT more palatable to skeptical Eurozone countries.

Since implementation on an EU-wide level remains unlikely, some countries inside the European Union are taking action. France recently passed a very limited transaction tax on trading French-issued shares when the issuer’s market capitalization exceeds €1 billion.[6] Italy stated that it plans to pass a FTT, as well, and Spain has been a vocal supporter of an EU-wide FTT.[7]

These recent adoptions can be thought of as these countries dipping their toes in before taking the plunge. France’s FTT exempts market makers, only applies to 110 French companies and is riddled with exemptions for sophisticated investors.[8] Italy has not promulgated its own FTT yet; whether Italy opts for a “soft” FTT or the far more encompassing EU proposal remains to be seen.[9]

But what about the United States? The US is even less likely to pass a FTT. Representatives have introduced a bill implementing some form of a FTT ten times in the past four years; none of them have garnered significant support. Additionally, Congress has queued up a full plate of financial regulation for the time being. Agencies are still struggling to delineate their boundaries and figure out the rules required by a post-Dodd-Frank regulatory environment.

While a FTT would certainly alter investment strategies and capital allocation, high frequency trading strategies should remain viable for the foreseeable future. For planning purposes, it may be prudent to apply France’s FTT to other countries inside the Eurozone to assess the viability of the investor’s strategy in case of a tax shift.

As part of its initiative to increase oversight of investment advisers pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”), the Securities and Exchange Commission (“SEC”) recently released a memorandum outlining increased scrutiny for newly registered advisers[1] through “Presence Exams.”[2]

Presence Exams are “focused, risk-based” reviews of newly registered advisers under the Investment Advisers Act of 1940. Though the SEC has not finalized the content, methodology, or length of Presence Exams, the SEC has indicated such exams will focus on traditionally “high risk” areas in investment advising, including conflicts of interest, marketing, valuation, portfolio management and asset security.

The Presence Exam initiative has three distinct phases: Engagement, Examination and Reporting. Each phase will generally conform to the following goals:

Engagement

• Inform newly registered advisers about their obligations under applicable regulation.
• Publish materials assisting advisers with compliance, including staff letters, risk alerts, no-action letters and special studies.
• Focus on providing senior advisers with a forum to address compliance issues and learn about effective compliance practices.

Examination

• Select advisers for review and examine one or more high-risk areas associated with fund management.
  • The SEC has not indicated how advisers will be selected, how the SEC will determine which high-risk area(s) to examine, how long the review will last, or when Presence Exams will begin.
  • Additionally, the SEC has not clarified when a newly registered adviser is no longer eligible for a Presence Exam.
• At the end of each Presence Exam, send the applicable adviser a letter finding no deficiencies, highlighting deficiencies, or referring the adviser to the SEC’s Enforcement Division or another regulator if the Presence Exam uncovered serious deficiencies.

Reporting

• The SEC will report its observations to the public, likely focusing on areas where new advisers consistently ran afoul of existing regulation.

Presence Exams represent an additional regulatory requirement that formerly exempt advisers must meet to stay in the SEC’s good graces. Although we are reluctant to draw specific conclusions without additional information from the SEC, one general theme seems true: The Presence Exam will be another manifestation of Dodd-Frank’s focus on having the SEC take a more active role in requiring presumptive evidence of propriety from advisers to private funds.

Additional general information about the SEC’s new compliance initiatives can be found at the Office of Compliance and Inspection’s information on the National Examination Program at http://www.sec.gov/about/offices/ocie.shtml.

Please feel free to contact us should you have any questions regarding Presence Exams or related compliance matters.

As mandated by Congress pursuant to Section 201 of the Jumpstart our Business Startups Act (“JOBS Act”), the Securities and Exchange Commission (“SEC”) recently released its proposed rules to eliminate the prohibition against general solicitation and advertising in connection with offerings and sales pursuant to Rule 506 under Regulation D of the Securities Act. The removal of the general solicitation and advertising ban is conditioned upon issuers taking “reasonable steps” to ensure that only accredited investors participate in the underlying offerings. As always, the devil is in the details: Defining precisely what entails such reasonable steps was the brunt of the directive tasked of the SEC. By effectively punting its primary directive, the SEC appears to have opened the door to Congress reframing the scope of the mandate entirely.

As previously discussed, the SEC failed to provide firm guidance regarding the steps an issuer must take to ensure an investor is accredited. Instead, the SEC vaguely notes in its proposed release that issuers are to consider the facts and circumstances of the transactions, rationalizing that adopting specific verification methods “would be impractical and potentially ineffective in light of the numerous ways in which a purchaser can qualify as an accredited investor.” The SEC further notes that proposing such methods could be overly burdensome in some cases and ineffective in others.

In response, Senator Carl Levin (D-MI) sent a terse letter to the SEC, reprimanding the SEC for drafting a proposed rule that “provides no certainty to issuers and fails to establish methods sufficient to ensure that only accredited investors participate in the offerings.” He further notes that it was made clear that “self-certification” of accredited investors is inadequate, suggesting that the SEC’s proposed rules need to require common-sense documentation and/or verification practices and procedures.

Of potentially greater consequence to the hedge fund community, however, is Senator Levin’s surprising pivot at the close of the letter, in which he insists that the SEC not only failed to meet its statutory directive, but also misconstrued the scope of the mandate in applying it to private investment vehicles. In relevant part:

Congress 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.

Distinguishing between operational businesses and private investment vehicles in the context of removing the general solicitation ban would mark a major shift in tone and direction, potentially reframing and limiting the reach of the JOBS Act within the hedge fund community. If Senator Levin’s interpretation is carried through and adopted by the SEC in its final rules, fund managers may not be granted the broad array of capital raising options that, just a few weeks ago, appeared imminent.

We will continue to monitor the situation closely as we await the SEC’s final rules. Please feel free to contact us if you have any questions regarding the status of the JOBS Act or its potential impact on hedge fund marketing activities.

As previously discussed here and here, on April 5, 2012, President Obama signed into law the Jumpstart our Business Startups Act (“JOBS Act”). Notably, the JOBS Act tasks the Securities and Exchange Commission (“SEC”) with removing the prohibition against general solicitation and general advertising in offerings and sales pursuant to Rule 506 under Regulation D of the Securities Act, provided that all of the purchasers of such securities are accredited investors. After missing its initial deadline, last week the SEC finally released its long-awaited proposed rules to eliminate the general solicitation and advertising ban.

Under the proposed rules, fund managers conducting Rule 506 offerings would be permitted to use general solicitation and general advertising to market the underlying securities, provided that: (1) the issuer takes reasonable steps to verify that the investors are accredited investors; and (2) all investors are accredited investors, because either (i) they come within one of the categories of persons who are accredited investors under existing Rule 501 or (ii) the issuer reasonably believes that they meet the categories at the time of the sale of the securities.

In determining the reasonableness of the steps that an issuer has taken to verify that a purchaser is an accredited investor, the proposing release somewhat vaguely explains that issuers are to consider the facts and circumstances of the transactions. This includes, among other things, the following factors:

• The type of purchaser and the type of accredited investor that the purchaser claims to be.
• The amount and type of information that the issuer has about the purchaser.
• The nature of the offering, meaning:
  • The manner in which the purchaser was solicited to participate in the offering.
  • The terms of the offering, such as a minimum investment amount.

The SEC’s proposing release rationalizes that adopting specific verification methods that an issuer might use “would be impractical and potentially ineffective in light of the numerous ways in which a purchaser can qualify as an accredited investor.” The SEC further notes that proposing such methods could be overly burdensome in some cases and ineffective in others. However, fund managers and other interested parties will likely find this approach lacking; there has been considerable speculation leading up to the proposed rules as to how the SEC would address the verification process, as well as the impact the change would have on investor certification practices, but the SEC appears to have effectively punted here. This leaves issuers in a state of limbo regarding what constitutes “reasonable steps” to verify accredited investors. As such, until the SEC provides further clarification, managers relying on the new exemption are advised to err on the side of caution by requiring as much information from qualifying investors as the issuer can reasonably request. It will be interesting to see if the SEC provides any further guidance regarding verification methods in the final rules.

It also remains to be seen whether the SEC will restrict certain types of advertising with respect to issuers relying on the new exemption; it is likely that, as issuers begin to engage in general solicitation and general advertising activities, the rules and surrounding interpretations will be further refined in response to common practices.

Notably, the proposed rules would preserve the existing portions of Rule 506 as a separate available exemption, allowing issuers who elect to conduct Rule 506 offerings without the use of general solicitation and general advertising to avoid becoming subject to the new verification rules.

It is also important to note that fund managers cannot rely on the new rules yet; this week’s released rules are proposed rules only and will not take effect until the SEC takes comments and releases final rules, which may differ materially from the proposed rules outlined above.

Please feel free to contact us if you have any questions regarding the status of the JOBS Act or its potential impact on hedge fund marketing activities.

(Note: This post was originally circulated on August 1, 2012.)

As previously discussed, on April 5, 2012 President Obama signed into law the Jumpstart our Business Startups Act (“JOBS Act”), marking a dramatic shift in the private fund marketing landscape. Notably, the JOBS Act tasks the Securities and Exchange Commission (“SEC”) with removing the prohibition against general solicitation and general advertising in offerings and sales pursuant to Rule 506 under Regulation D of the Securities Act, provided that all of the purchasers of such securities are accredited investors. As such, the JOBS Act will ultimately provide fund managers with a broad array of capital raising opportunities previously unavailable to them.

The JOBS Act established a 90 day deadline for the SEC to release new rules eliminating the general solicitation and advertising ban. However, as expected, the SEC failed to meet the July 4, 2012 deadline (on June 28, 2012 SEC Chair Mary Schapiro testified to Congress that the deadline was unrealistic; the SEC has since announced that it will consider rules to eliminate the ban during its August 22, 2012 open meeting).

With the final rules still in limbo, fund managers are advised to exercise caution with respect to hedge fund marketing practices and avoid “jumping the gun” in anticipation of the forthcoming changes. For example, the use of email blasts, social media, non-password protected website content, etc., should still be considered prohibited marketing activities in connection with a Rule 506 offering.

Furthermore, as a means of additional investor protection, the SEC is expected to adopt certain rules requiring fund managers to reasonably verify that potential investors are accredited (marking a significant departure from the current standard, which only requires issuers to reasonably believe that investors are accredited). However, it remains unclear what specific steps fund managers will be required to take to “verify” qualifying investors, as well as whether the new rules will address the ramifications of continuing to admit non-accredited investors, grandfathering provisions, the anti-fraud provisions of the Securities Act, etc.

Upon release of the SEC’s final rules, fund managers should not only receive clarification as to what constitutes permissible marketing activities and their investor verification obligations, but should also have a clearer idea of the hedge fund marketing landscape in general going forward. In the interim, fund managers should continue to operate under the existing framework and err on the side of caution.

Please feel free to contact us if you have any questions regarding the status of the JOBS Act or its potential impact on hedge fund marketing activities.

We were recently interviewed by Mercenary Trader regarding our thoughts on the JOBS Act and its potential impact on the overall hedge fund community (we have been tracking the development of the proposed legislation since late 2011). Pending the release of final SEC rules implementing the changes, the legislation will significantly alter the hedge fund marketing landscape going forward, particularly with regard to small- and mid-sized fund managers. Notably, the JOBS Act eliminates the ban on general solicitation and general advertising of private fund interests under Regulation D in connection with sales to accredited investors, thereby granting hedge fund managers a broad array of capital raising options previously unavailable to them.

The full interview can be found here. Mercenary Trader is a popular market research and online forum for investment managers and traders, run by professional traders. For more information regarding Mercenary Trader, please take a moment to check out their website.

Please contact us if you have any questions regarding the JOBS Act and its expected impact on fund marketing activities.

As previously discussed, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”) significantly altered the jurisdictional boundaries between federal and state registration of investment advisers.  Although most advisers seem to be familiar with the adjusted registration thresholds, there is still some general confusion regarding the new registration exemptions, as well as which firms must report to the Securities and Exchange Commission (“SEC”) as Exempt Reporting Advisers (“ERAs”).  To help clarify, below is a brief overview of the updated registration requirements, primary exemptions from registration and ERA filing requirements.

Post-Dodd-Frank Investment Adviser Registration Thresholds

• Advisers with assets under management (“AUM”) of at least $100 million must register with the SEC, provided that advisers solely to private funds are generally not required to register with the SEC until reaching AUM of at least $150 million.  The new rules implement a transitional exemption allowing such advisers until March 30, 2012 to register.

• Advisers with AUM between $25 million and $100 million (“mid-sized advisers) must register in the state in which they maintain their principal office and place of business, subject to certain exceptions (e.g., New York based mid-sized advisers will need to register with the SEC or report as an ERA, if eligible).

• Advisers with AUM of less than $25 million are prohibited from registering with the SEC (unless based in Wyoming), but may be required to register in the state in which they maintain their principal office and place of business.

Exemptions from SEC Registration

• Private Fund Adviser Exemption – Advisers that solely advise private funds and have AUM of less than $150 million are exempt from registration.

• Foreign Private Adviser Exemption – Advisers that (i) have no place of business in the U.S.; (ii) have, combined, less than 15 U.S. clients and investors in private funds; (iii) have aggregate AUM attributable to U.S. clients and investors in private funds of less than $25 million; and (iv) do not hold themselves out generally to the U.S. public as investment advisers, are exempt from registration.

• Venture Capital Exemption – Advisors that solely advise venture capital funds are exempt from registration.  A “venture capital fund” is defined as a private fund that: (i) holds no more than 20 percent of the fund’s capital commitments in non-qualifying investments (i.e. “qualifying portfolio companies” directly acquired by the fund); (ii) does not borrow or otherwise incur leverage (other than limited short-term borrowing); (iii) does not offer its investors redemption rights other than in extraordinary circumstances; (iv) represents itself as pursuing a venture capital strategy; and (v) is not registered under the Investment Company Act of 1940 and has not elected to be treated as a business development company.

• Family Office Exemption – family offices, defined as companies that (i) have no clients other than “family clients”; (ii) are wholly owned by family clients and are exclusively controlled by one or more family members and (iii) do not hold themselves out to the public as investment advisers, are exempt from registration.

Exempt Reporting Advisers

• Advisers relying on the Private Fund Adviser Exemption or the Venture Capital Exemption are considered ERAs, and, as such, will be required to prepare and file Form ADV Part 1A with the SEC by March 30, 2012, as well as comply with certain other reporting and recordkeeping requirements.  Note that whether an adviser is considered an ERA will also depend upon where the adviser is located, and that advisers qualifying as ERAs may still be required to register in the state in which they maintain their principal office and place of business.

As state securities commissioners rush to amend their respective investment adviser registration requirements in response to the final SEC rules, it is especially important that advisers consult qualified legal counsel to assure compliance with the evolving regulatory landscape.

Please contact us if you have any questions regarding the new registration requirements or would like to discuss the potential impact of the new requirements upon your firm.

In early November, the House of Representatives passed four bills aimed to help small companies raise capital.  The legislation received overwhelming bipartisan support, in large part due to legislators’ framing of the package as pro-jobs creation.

Of note, the package includes H.R. 2940, the Access to Capital for Job Creators Act (“Job Creators Act”), which was passed on November 3^rd by a vote of 413 to 11.  If enacted in its current form, the Job Creators Act would be a game-changer for private funds relying on exemption from registration under Section 4(2) of the Securities Act of 1933 (“Securities Act”).

Most private funds avoid registering their securities with the U.S. Securities and Exchange Commission (“SEC”) by relying on Section 4(2) and the “safe harbor” exemption found in Rule 506 under Regulation D of the Securities Act.  Rule 506 allows companies to raise an unlimited amount of capital provided the underlying securities are not marketed through any form of general solicitation or general advertising.  As such, managers of hedge funds and other private investment vehicles are generally prohibited from marketing such funds to potential investors with whom they do not have a preexisting relationship.

The Job Creators Act would remove the prohibition against general solicitation or general advertising of non-publicly traded securities, thereby permitting managers of hedge funds and other private offerings to publicly market such interests and raise capital from prospective investors regardless of whether a preexisting relationship exists.  If enacted, the highly restrictive capital raising rules for private offerings would be upended in one fell swoop.  Fund managers would effectively be able to target qualified investors through direct advertising, publicly available websites, offline and online forums that bring together investors with funds seeking additional capital, etc.  This would mark a significant shift in the securities regulation landscape.

The capital formation relief is balanced by enhanced investor protection; notably, the prohibition against general solicitation or general advertising of interests in private offerings is eliminated, provided that all purchasers of such securities are accredited investors.  This would effectively discontinue the practice of offering interests in private funds to certain non-accredited investors possessing the requisite sophistication and investment experience to invest in a hedge fund or other private offering.  Further, the Job Creators Act directs the SEC to adopt regulations requiring issuers utilizing general solicitation or general advertising to verify that all investors are accredited (as opposed to relying on investor self-certification, as currently permitted).

Considering the current political climate and momentum behind the legislation package, the Job Creators Act could be enacted swiftly over the next few months.  We will be monitoring the progress of the Job Creators Act closely and keep you apprised of any developments.

In the interim, the text of H.R. 290 can be found here.

Please contact us if you have any questions regarding H.R. 290 or its potential impact on private offerings.

Each issuer of securities relying on an exemption from registration pursuant to Regulation D under the Securities Act of 1933 must file Form D with the Securities and Exchange Commission (“SEC”), as well as each state in which the issuer accepts an investor.  Form D is required with respect to any private offering, including interests in hedge funds.

As required by the SEC, Form D should be filed no later than 15 calendar days after the “date of first sale” of securities in the offering.  Most states also require a Form D notice filing within 15 calendar days after the date of first sale pursuant to their respective “Blue Sky” laws.  However, certain states (e.g., New York) require a pre-filing instead; Form D pre-filings must be submitted before any sales occur within the state.

The SEC Electronic Data Gathering, Analysis, and Retrieval system (“EDGAR”) website includes an electronic version of Form D. In order to file Form D, you will need to first complete a Form ID through EDGAR.  This document must be notarized, so be sure to print and sign it in the presence of a notary.  You may then scan the document as a PDF, upload it to EDGAR, create a passphrase and submit the Form ID.  Be sure to write down the passphrase, as well as save a copy of the Form ID Application Acknowledgement page for future reference.  Once you have received your EDGAR confirmation email with your new ID and CIK Number, you may log in on the Form D portion of EDGAR and begin completing Form D.

Form D requires basic information regarding the principal place of business, related persons and type of industry of the private offering.  Other sections require the calculation of revenue, sales compensation (if any), the number of investors and gross proceeds.  Form D must be signed and submitted to the SEC electronically. Most states will require a copy of Form D with either an electronic or, in some cases, an original signature.

Annual amendments to Form D must be filed with the SEC every year on or before the anniversary of the most recently filed notice.  Some states also require annual amendment filings.  Form D can be found here for reference: http://www.sec.gov/about/forms/formd.pdf.

Issuers of private offerings should always consult with a qualified hedge fund attorney prior to the date of first sale to confirm that Form D is timely filed with the appropriate federal and state agencies.

Please contact us if you would like assistance with Form D and/or Blue Sky notice filings or have any questions regarding the process in general.

As part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”), Congress passed the Private Fund Investment Advisers Registration Act of 2010 (“Act”).  The Securities and Exchange Commission (“SEC”) recently adopted rules to implement the Act that will significantly impact many private fund managers.  Notably, the Act eliminates the “private adviser exemption” and adjusts the jurisdictional boundaries between federal and state regulation of investment advisers.  Under the new regulatory framework, investment advisers with assets under management (“AUM”) of (i) $100 million or more will generally be required to register with the SEC (advisers to solely private funds with AUM of less than $150 million are exempt from registration); (ii) between $25 million and $100 million will generally be required to register at the state level (if the adviser’s home state does not require registration or examination, the advisor will be required to register with the SEC); and (iii) $25 million and under will generally be required to register at the state level (subject to exemption).

The SEC also implemented changes to the reporting, disclosure and record keeping requirements of investment advisers.  The new rules include significant changes to Form ADV and to the reporting requirements of registered investment advisers regarding private funds, as well as requiring a new category of advisers – exempt reporting advisers – to file the SEC’s new Form ADV, Part 1A.

Both existing and newly formed advisers are strongly encouraged to consult with qualified legal counsel to determine how the new regulatory framework will affect their respective registration statuses.  For further reference, below is a general overview of the registration process.

• Manually complete entitlement forms: In order to register as an investment adviser, the first step is to complete the entitlement forms that can be found in the Investment Adviser Registration Depository (“IARD”) entitlement packet. It is important that each manager select the form appropriate to its filing requirements.

• Pay all applicable fees, such as the IARD firm system processing fee, firm state registration fees, investment adviser representative system processing fees, investment adviser representative state registration filing fees, etc.

• Complete Form ADV Part I: Form ADV Part I is available within the IARD system, and includes basic identification questions as well as a list of disclosure questions regarding each investment adviser. The purpose of completing this form is to ensure that the investment adviser’s information is publicly available through the IARD website.

• Complete Form ADV Part II: Form ADV Part II is no longer completed in checkbox format; it now must be completed as a written firm brochure, including all required written supplemental brochures, as an exhibit to Part I that all clients and potential clients will receive. The firm brochure should be a brief overview of the firm’s business practices. Each supplemental brochure should provide further explanation of the answers in each investment adviser’s Form ADV Part I.

• Form U4: Form U4 can also be found in the IARD system and must be completed for all investment adviser representatives.  For state registered investment advisers, each investment adviser representative will be subject to certain proficiency requirements.  It varies by state, but typically all representatives must pass either the Series 65 exam or the Series 66 exam and the Series 7 exam (however, many states waive the proficiency requirements with respect to representatives who possess certain industry certifications, such as CFPs and CFAs).   

In addition to the steps above, each adviser’s hedge fund attorney should help prepare an appropriate investment management agreement for the adviser and develop appropriate compliance infrastructure, as required on a state-by-state basis.

The investment adviser registration process varies in length for each state – and even within states for different advisers depending on the adviser’s responsiveness, the assigned examiner, etc. – but can generally be completed within six weeks.  SEC registrations tend to be more streamlined and can typically be completed within four weeks or less.

Please contact us for a free consultation if you have any questions regarding the investment adviser registration process.