Skip to main content

Regulatory Alert: New Reporting Requirements under the Corporate Transparency Act

The Corporate Transparency Act (CTA), enacted as part of the National Defense Authorization Act of 2021, went into effect on January 1, 2024. The CTA is intended to increase corporate transparency and prevent bad actors from using “shell” companies to conduct illegal activities. Under the CTA, domestic and foreign “reporting companies” are required to submit beneficial ownership information (BOI) reports to the U.S. Treasury Department’s Financial Crimes Enforcement Network (FinCEN). The BOI reports are a significant new disclosure requirement for affected companies—please review the information below to determine whether the reporting requirements apply to your company.

What is a reporting company?

A “reporting company” includes (i) domestic corporations, limited liability companies, or other entities formed with a secretary of state or similar office; and (ii) foreign corporations, limited liability companies, or other entities registered to do business in any U.S. state. Notwithstanding the broad definition of a reporting company, there are currently 23 types of entities that are exempted from filing BOI reports.[1] Notably for our clients, the list of exempt entities includes the following: (i) SEC-registered investment advisers (SEC RIA); (ii) venture capital fund advisers that are exempt reporting advisers under Section 203(l) of the Investment Advisers Act of 1940 (Advisers Act); (iii) CFTC-registered commodity pool operator and commodity trading advisors and (iv) pooled investment vehicles (PIVs) operated or advised by an exempt adviser.

Note that state-registered investment advisers, unregistered investment advisers, “private fund advisers” that are exempt reporting advisers under Section 203(m) of the Advisers Act, and PIVs operated or advised by one of the foregoing entities are currently not exempt from the BOI report filing requirements. However, certain affiliates of an exempt entity—e.g., “relying advisers” of an SEC RIA and subsidiaries controlled or wholly owned by an SEC RIA—may also qualify for exemption under specific circumstances.

BOI report disclosure requirements and determining who is a beneficial owner?

BOI reports must include certain information regarding the reporting company and its beneficial owners. A “beneficial owner” is any individual who, directly or indirectly, either (i) exercises substantial control over a reporting company; or (ii) owns or controls at least 25% of the ownership interests of the reporting company. For each beneficial owner, the BOI report must include the individual’s legal name, date of birth, current address and a copy of the individual’s passport or driver’s license.

Whether an individual has “substantial control” of a reporting company depends on the power the individual exercises over the company. For example, an individual is deemed to have substantial control of a reporting company if he or she directs, determines, or has substantial influence over important decisions made by the company. In addition, any senior officer is deemed to have substantial control over a reporting company. The term “senior officer” means any individual holding the position or exercising the authority of a president, chief financial officer, general counsel, chief executive officer, chief operating officer, or any other officer, regardless of official title, who performs a similar function.

Who is a company applicant?

For each entity, there are one or two company applicants: (i) the individual who directly files the document that creates, or first registers, the reporting company; and (ii) the individual who is primarily responsible for directing or controlling the filing of the relevant document (if different). Notably, company applicants formed before January 1, 2024 are not required to disclose their company applicants.

What are the BOI report filing deadlines?

There are three different BOI report filing deadlines, depending on the date a reporting company was created or registered to do business in the U.S.:

  1. Reporting companies created or registered to do business prior to January 1, 2024, must file an initial BOI report by January 1, 2025.
  2. Reporting companies created or registered to do business on or after January 1, 2024, and before January 1, 2025, must file an initial BOI report within 90 calendar days from the date each such company was created or registered to do business.
  3. Reporting companies created or registered to do business on or after January 1, 2025, must file an initial BOI report within 30 calendar days from the date each such company was created or registered to do business.

What are the requirements for updating BOI reports?

Reporting companies must file updated BOI reports within 30 days of (i) any change to the information reported; or (ii) becoming aware that any information reported is inaccurate. For private fund managers, a key change to monitor will be the obligation to file an updated BOI report any time the fund adds a beneficial owner (e.g., each time a limited partner obtains an ownership interest of 25% or more of the fund).

Overall, the CTA represents a significant new reporting requirement for affected companies. We are advising our clients to review the CTA and the BOI report requirements closely to determine whether they must report to FinCEN. As always, feel free to reach out to us should you have any questions.


[1] Full list of exempt entities: securities reporting issuer, governmental authority, bank, credit union, depository institution holding company, money services business, broker or dealer in securities, securities exchange or clearing agency, other Exchange Act registered agency, investment company or investment adviser, venture capital fund adviser, insurance company, state-licensed insurance producer, Commodity Exchange Act registered entity, accounting firms, public utility, financial market utility, pooled investment vehicle, tax-exempt entity, entity assisting a tax-exempt entity, large operating company, subsidiary of certain exempt entities, and inactive entity. Specific criteria apply.

Regulatory Alert: SEC Adopts New Rules for Private Fund Advisers

On August 23, 2023, the U.S. Securities and Exchange Commission (“SEC”) adopted new rules under the Investment Advisers Act of 1940 (“Advisers Act”) applicable to both SEC-registered and unregistered private fund advisers (“Rules”). Among other requirements, the Rules require registered private fund advisers to provide investors with quarterly statements and yearly audited financial statements. In addition, the Rules place restrictions on the ability of both registered and unregistered private fund advisers to give preferential treatment to certain investors. Below is a summary of the provisions under the Rules that we consider to be the most noteworthy. 

Quarterly Statement and Audit Requirements

The Rules require registered private fund advisers to present investors with quarterly statements detailing the fund’s performance, fees, expenses and any other compensation paid to the adviser (or its related persons) by the fund or the fund’s portfolio companies. While the current SEC custody rules require registered investment advisers with custody of client assets to provide quarterly account statements to clients, private fund advisers are exempt from this requirement if they distribute annual audited financial statements to fund investors. Although it’s customary for private funds to provide at least quarterly reports to investors, registered private fund advisers should nonetheless confirm that their current reporting procedures comply with the Rules. The SEC will require compliance with the quarterly statement provision within 18 months after the Rules become effective.[1]

Under the current SEC custody rules, registered private fund advisers are generally required to either distribute audited financial statements to investors or be subject to an annual surprise examination. The Rules effectively eliminate the surprise examination option and require all registered advisers of private funds to distribute audited financial statements to investors at the end of each fiscal year.  Despite the available options under the custody rule, private funds typically elect to distribute audited statements to investors; as such, we do not expect the annual audit requirement under the Rules to impact the current practices of most registered private fund advisers. Like the quarterly statement rule, the SEC will require compliance within 18 months after the Rules become effective.

Preferential Treatment

The Rules prohibit both registered and unregistered private fund advisers from providing certain preferential treatment to investors regarding redemption and information rights. Further, the Rules require additional disclosures when funds provide other preferential terms to investors. These provisions will significantly affect an adviser’s ability to enter into side letter agreements with investors.

In the case of redemptions, advisers will no longer be permitted to provide preferential redemption rights to certain investors that the adviser reasonably expects to have a material, negative effect on other investors. As an example, the SEC discussed how allowing an investor to redeem early may leave a fund with fewer liquid assets to use when satisfying future redemption requests for other investors.

The Rules provide for two exceptions to the preferential redemption rights prohibition: (i) redemptions required by applicable laws (i.e., if needed to comply with pay-to-play laws) and (ii) preferential redemption rights afforded to all current and future investors.  For example, a fund is still permitted to have separate share classes with different redemption rights provided that each share class is available to all investors. However, the separate share classes must be available without qualification and not contingent on investment amount, affiliation to the adviser, etc.

Additionally, the Rules prohibit private fund advisers from providing preferential information rights regarding portfolio holdings or exposures to certain investors if the adviser reasonably expects such preferential treatment to have a material, negative effect on the other investors. According to the SEC, selective disclosure of portfolio holdings could allow certain investors to profit or avoid losses at the expense of other investors without access to such additional information. The SEC also pointed to issues in funds with preferential redemption rights where investors could withdraw capital and “front-run” the fund.

Finally, the Rules require private fund advisers to disclose other types of preferential treatment arrangements to current and potential investors. Specifically, advisers must disclose all preferential treatment related to any material economic terms prior to an investor’s investment.  Advisers must also provide investors with annual disclosures of all other preferential treatment arrangements provided to investors since the prior notice. The first notice must be provided (i) for a closed-end fund, as soon as reasonably practicable following the end of the fund’s fundraising period; and (ii) for an open-end fund, as soon as reasonably practicable following the investor’s investment in the fund.

Managers with $1.5 billion or more in private fund assets under management are required to comply with the preferential treatment rule within 12 months of the effective date. All other advisers are required to comply with the rule within 18 months of the effective date. Notably, the preferential treatment prohibitions will not be applied retroactively to governing agreements that were in effect prior to the compliance date and would need to be amended to comply with the Rules. In contrast, no such “legacy status” will be granted with respect to the preferential treatment disclosure requirements under the Rules.

Overall, we believe the preferential treatment portions of the Rules are the headliner. Side letters with preferential terms for certain investors are a longstanding hallmark of operating and investing in private funds—eliminating much of the practice will recalibrate the power dynamics between fund sponsors and certain investors and likely have far-reaching effects upon the entire industry. In the near term, advisers with existing preferential terms in place will need to work with legal counsel to ensure they comply with the new disclosure requirements under the Rules. We will be closely monitoring how the private fund industry adapts to the Rules over the coming months. Please feel free to reach out to us should you have any questions.


[1] The Rules will become effective within 60 days of publication in the federal register.

Ripple and Terraform: A Securities Law Framework for Crypto Begins to Take Shape

There has been a flurry of crypto enforcement news recently, including the Securities and Exchange Commission (“SEC”) suing two major crypto exchanges, Coinbase, Inc. and Binance Holdings Ltd. (“Binance”). The Coinbase and Binance lawsuits represent an existential threat to centralized crypto exchanges that, in part, hinges on whether tokens sold in secondary markets are securities. At the same time, two conflicting rulings last month in the SEC’s ongoing lawsuits against Ripple Labs, Inc. (“Ripple”) and Terraform Labs Pte Ltd. (“Terraform”) provide a possible framework for determining when a digital asset is a security.

Ripple

On July 13, 2023, Judge Analisa Torres of the U.S. District Court for the Southern District of New York (“SDNY”) issued a summary judgment ruling regarding sales of Ripple’s token, XRP. Judge Torres issued a split ruling, finding that direct sales of XRP to institutional investors were a securities offering whereas “programmatic sales” to retail investors on digital asset exchanges were not. Judge Torres’ decision came down to whether XRP qualified as an “investment contract”—a type of security—under federal securities laws. The court, applying a three-pronged test first established by the Supreme Court in SEC v. W.J. Howey Co., defined an investment contract as:

a contract, transaction or scheme whereby a person (i) invests money; (ii) in a common enterprise; and (iii) is led to expect profits solely from the efforts of the promoter or a third party.

Although the court analyzed four types of XRP distributions under the Howey test, the first two are most relevant here: (i) sales of XRP made directly to institutional investors; and (ii) programmatic sales of XRP on digital asset exchanges. Judge Torres found that the initial sale of XRP to institutional investors met all three prongs of the Howey test. Notably, she found that Ripple’s marketing efforts caused the institutional investors to believe that their capital would be used to improve the XRP ecosystem and thereby increase the token’s value. In contrast, Judge Torres found that the programmatic sales of XRP on digital asset exchanges to retail investors failed the third prong of the Howey test because the investors could not have known whether they were purchasing XRP from Ripple.[1]

Huge win for crypto. Hoorah! But wait….

Terraform

Several days later, on July 31, 2023, Judge Jed Rakoff—also from the SDNY—denied Terraform’s motion to dismiss, finding that the SEC adequately pled that sales of Terraform’s UST, LUNA and MIR tokens (collectively, the “Terraform Tokens”) are securities. In determining whether the Terraform Tokens are investment contracts and, in turn, securities, Judge Rakoff applied the Howey test and found that Terraform had “embarked on a public campaign to encourage both retail and institutional investors to buy their crypto-assets by touting the profitability of the crypto-assets and the managerial and technical skills that would allow the defendants to maximize returns on the investors’ coins.”

Judge Rakoff went on to expressly rebuke the Ripple decision:

[t]he Court declines to draw a distinction between these coins based on their manner of sale, such that coins sold directly to institutional investors are considered securities and those sold through secondary market transactions to retail investors are not. In doing so, the Court rejects the approach recently adopted by [Judge Torres].

He added:

Howey makes no such distinction between purchasers. And it makes good sense that it did not. That a purchaser bought the coins directly from the defendants or, instead, in a secondary re-sale transaction has no impact on whether a reasonable individual would objectively view the defendants’ actions and statements as evincing a promise of profits based on their efforts.

A few days later, on August 9, 2023, the SEC announced it will seek an interlocutory appeal of Judge Torres’ decision regarding the programmatic sales of XRP.

Takeaways

Although the SDNY’s decision in Ripple has limited precedential value and the SEC’s appeal was expected, it marked the first significant judicial pushback to the SEC’s perceived “crypto regulation through enforcement” campaign. If Judge Torres’ analysis were adopted as a judicial framework for applying the Howey test to digital assets, the SEC would be hamstrung in enforcement actions against certain token issuers and exchanges. Many commentators were quick to cite the decision as bullish for the prospects of Coinbase and Binance.

However, the Ripple framework never quite made sense, and the Terraform decision throws several gallons of cold water on it. The divergence between the Ripple and Terraform rulings ultimately comes down to Judge Rakoff’s refusal to draw a distinction between direct sales to institutional investors and secondary market sales to retail investors. This seems right—asserting that a reasonable retail investor would not have seen or understood Ripple’s public marketing campaign is dubious. Further, Judge Rakoff’s approach is better aligned with protecting retail investors, a core policy objective of existing securities laws.

Some additional notes:

  • Judge Rakoff agreed with Judge Torres that digital assets are not de facto securities. This is correct. There are myriad examples of cryptocurrencies that are not part of an investment scheme (e.g., certain gaming tokens) or are sufficiently decentralized to not qualify as an investment contract under the Howey test (e.g., BTC).
  • Neither court addressed the crypto elephant in the room: Can a token initially issued as an investment contract become sufficiently decentralized to “evolve” into a utility token? (Or, in the case of ETH, can a token evolve from an investment contract to a sufficiently decentralized utility token and then potentially back to an investment contract with the launch of Ethereum 2.0 and its proof of stake system. Simple stuff.)
  • The inconsistency between these rulings—along with the dizzying logic of the previous note—underscores the need for legislative clarity to fill the regulatory gaps in applying US securities laws to digital assets. Although a recent House bill that would expand the CFTC’s oversight of digital assets has gained traction, it is not expected to clear the Senate.
  • There are legitimate criticisms of the SEC’s public posturing with respect to crypto and its unwillingness to engage with industry participants. However, those are topics for another post. Our analysis here is limited to applying current US securities laws to the sale of tokens as a means for raising capital for development.

In light of the Ripple and Terraform rulings, we see the following framework emerging for sales of digital assets:

  • The Howey test should be applied on a transaction-by-transaction basis, but also: If tokens are initially sold in a manner that constitutes an investment contract—and in a manner in which the tokens have equity-like characteristics—sales on an exchange or other secondary market will continue to qualify as investment contracts (on a transaction-by-transaction basis) unless the token evolves into a utility token. This approach begs the question of when a token originally sold as an investment contract can become sufficiently decentralized to no longer be considered a security, but it still supports the SEC’s position that tokens issued as a means for raising capital for development are generally securities.
  • Put another way: If we think of certain tokens as equity+ (digital assets with equity-like characteristics plus the added use of blockchain functionality), it doesn’t make sense for those tokens to fall outside the scope of US securities laws simply because they contain an additional layer of use. However, it does make sense that “equity+ tokens” could become sufficiently decentralized to evolve into utility tokens. Maybe the next court will tackle the “sufficiently decentralized” question.

We are closely monitoring both cases along with the broader US regulatory environment for digital assets. Please feel free to reach out to us should you have any questions.


[1] While declining to address whether secondary market sales of XRP constitute investment contracts, the court seemed to imply as much by reasoning that the programmatic sales were not investment contracts because the retail investors “stood in the same shoes as a secondary market purchaser who did not know to whom or what it was paying money.”

Client Alert—Coinbase and Binance Lawsuits

On June 6, 2023, the U.S. Securities and Exchange Commission (“SEC”) brought a five-count civil complaint in New York federal court against Coinbase Inc. (“Coinbase”). The complaint alleges that Coinbase operates as an unregistered broker, exchange and clearing agency. The SEC asserts that Coinbase’s failure to register “deprive[s] investors of significant protections, including inspection by the SEC, recordkeeping requirements, and safeguards against conflicts of interest, among others.”

According to the SEC’s complaint, Coinbase lists at least 13 “crypto asset securities”[1] on its platform and offers a “staking-as-a-service” product. Earlier this year, the SEC charged Kraken with failing to register its staking-as-a-service product; Kraken settled the case and shut down its staking investment program in the United States.

The complaint against Coinbase came one day after the SEC brought action against Binance Holdings Ltd. and its affiliates (“Binance”) for also operating as an unregistered broker, exchange and clearing agency. In addition, the SEC charged Binance with failing to restrict U.S. investors from accessing Binance.com and misleading investors concerning the existence of market surveillance and controls to prevent manipulative trading on an affiliated Binance website. The SEC also charged Binance’s founder and chief executive, Changpeng Zhao, with deliberately and secretly trying to evade US laws.

While the respective lawsuits against Coinbase and Binance largely overlap in terms of legal issues, the complaint against Coinbase notably lacks the allegations of fraud and mismanagement found throughout the Binance complaint. That may be one silver lining; a pivotal lawsuit involving the largest US-based crypto exchange—without the distraction of fraud charges—may provide the best opportunity to date for clear guidance regarding the application of existing US securities laws to crypto assets.

These cases also serve as a backdrop for any potential legislative action. Near-term legislative action appears unlikely, however, despite House members releasing a crypto regulation discussion draft last week. For now, the SEC appears to be intent on regulating crypto assets it deems securities through enforcement. We advise all industry participants to monitor these cases closely and proceed accordingly. For crypto fund managers and investors, we recommend identifying any potential liquidity risks resulting from exposure to targeted exchanges or tokens deemed to be unregistered securities by the SEC.

As always, please feel free to reach out to us if you have any questions.

[1] The Coinbase complaint lists 13 cryptocurrencies as securities: SOL, ADA, MATIC, FIL, SAND, AXS, CHZ, FLOW, ICP, NEAR, VGX, DASH and NEXO.

2023 SEC Exam Priorities: Key Takeaways for Investment Managers

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.

 

SEC Proposes Amendments to Custody Rule and Targets Digital Assets

On February 15, 2023, the SEC released Rule 223-1 (the “Safeguarding Rule”) under the Investment Advisers Act of 1940 (the “Advisers Act”), proposing amendments to Advisers Act Rule 206(4)-2 (the “Custody Rule”). The Safeguarding Rule would greatly broaden the reach of the Custody Rule and captures a wide range of assets, including digital assets, real estate, loans, and other emerging asset classes, in addition to physical assets. Should the proposal be adopted in its current form, it will significantly impact how registered investment advisers manage and protect their clients’ assets.

Below is a brief overview of some of the more notable changes under the Safeguarding Rule.

      I. Minimum Custodial Protections

The Safeguarding Rule, among other things, outlines minimum custodial protections which would require an adviser to enter into a written agreement with qualified custodians to provide fundamental protections. The proposed requirements are “designed to serve as guardrails” and do not prescribe specific procedures. Some changes include:

  • the Custody Rule would be expanded to apply to all client assets held in advisory accounts, not just client “funds and securities,” explicitly including digital assets;
  • advisers with custody of client assets would be required to maintain them with a qualified custodian. The qualified custodian must have “possession or control” of client assets and participate in any change of beneficial ownership of the client’s assets;
  • a qualified custodian should indemnify an advisory client when its negligence, recklessness or willful misconduct results in that client’s loss;
  • a qualified custodian should clearly identify an advisory client’s assets and segregate them from the custodian’s proprietary assets;
  • the client’s assets should remain free of liens in favor of a qualified custodian unless authorized in writing by the client;
  • the exception for “privately offered securities” would be rescinded in favor of a new exception from the requirement to maintain certain assets with a qualified custodian, provided that the adviser meets certain conditions; and
  • a custodial agreement would need to reflect an adviser’s agreed-upon level of authority to effect transactions in the advisory client’s account.

      II. Qualified Custodian

There are not material changes to what types of entities could serve as qualified custodians, though there are additional compliance requirements. Banks or savings associations (including trust companies); registered broker-dealers; registered futures commission merchants; and certain types of foreign financial institutions may serve as qualified custodians. Foreign financial institutions would need to meet additional qualification requirements not currently part of Rule 206(4)-2. In addition, the Safeguarding Rule would require that a qualifying bank or savings association hold client assets in an account that is designed to protect the assets from creditors or in the event of insolvency. Specifically, the qualifying bank or savings institution must maintain the client’s assets in an account in which assets are easily identifiable and clearly segregated from the bank’s assets. The Safeguarding Rule also expands the criteria specifically required of foreign financial institutions that seek to qualify as custodians.

      III. Digital Asset Implications

The Safeguarding Rule extensively addresses digital assets. Some significant implications for advisers that deal with digital assets:

  • Digital assets are in scope. In the Safeguarding Rule, the SEC asserts that the present Custody Rule covers digital assets. The SEC does not elaborate or analyze why digital assets are considered “funds,” as opposed to other types of property.
  • Possession or control. The requirement for qualified custodians to have “possession or control” of client assets may pose challenges for custodians of digital assets. It’s difficult to prove exclusive possession or control of digital assets due to their unique characteristics. However, the Safeguarding Rule allows for flexibility in demonstrating “possession or control” by permitting situations where the custodian is necessary to change the ownership of the asset. For instance, a “qualified custodian would have possession or control of a digital asset if it generates and maintains private keys for the wallets holding advisory client digital assets in a manner such that the adviser is unable to change beneficial ownership of the digital asset without the custodian’s involvement.”
  • Digital asset trading platforms. The SEC acknowledges that the requirement for qualified custodians to have “possession or control” of client assets while the investment adviser has custody presents a challenge for advisers trading on digital asset platforms that require prefunding. If the trading platform is not a qualified custodian, it would violate both the current Custody Rule and the Safeguarding Rule. However, the SEC points out that not all digital asset trading involves prefunding, and some trades occur on noncustodial decentralized platforms and Alternative Trading Systems (“ATSs”).

      IV. Form ADV amendments.

The Safeguarding Rule includes updates to recordkeeping requirements for advisers and changes to Form ADV regarding custody-related data that the Commission, its staff and the public can access. The proposed changes to Item 9 reporting requirements include more information on the basis of custody of client assets, qualified custodians responsible for maintaining client assets and independent public accountants engaged for surprise examinations or financial statement audits of private funds.

      V. Compliance transition.

Under the Safeguarding Rule, advisers with over $1 billion in regulatory assets under management (“RAUM”) would be required to comply with the rule within one year of the rule’s effective date, while advisers with less than $1 billion in RAUM would have 18 months to comply the rule.

The comment period will be open for 60 days following publication of the proposing release in the Federal Register.

Key Takeaways:

  • The SEC proposed the Safeguarding Rule, which expands the Custody Rule under the Advisers Act to include all client assets, including digital assets.
  • Advisers with custody of client assets would be required to maintain them with a qualified custodian who indemnifies clients in case of loss, clearly identifies and segregates client assets from proprietary assets, and maintains them in a separate account designed to protect them from creditors or insolvency.
  • Banks, broker-dealers, futures commission merchants, and certain foreign financial institutions may serve as qualified custodians, but they must comply with additional qualification requirements and criteria. Custodians may have to segregate digital assets into dedicated accounts to ensure their safekeeping, preventing the mixing of assets with the adviser’s or related parties’ assets.
  • The Safeguarding Rule extensively addresses digital assets and acknowledges that they are in scope. The requirement for custodians to have “possession or control” of digital assets may pose challenges for custodians, but the rule allows flexibility in demonstrating “possession or control” and includes provisions for digital asset trading platforms.
  • The Safeguarding Rule includes updates to recordkeeping requirements for advisers and changes to Form ADV regarding custody-related data that the Commission, its staff and the public can access.
  • Advisers with over $1 billion in AUM would have to comply with the new rule within one year of its adoption, while smaller advisers would have 18 months to comply.

Year-End Client Letter

As we turn the page on 2022, we would like to highlight the following legal, regulatory and business matters that may affect you or your clients heading into the new year. As always, feel free to reach out to us should you have any questions.

Investment Advisers and Exempt Reporting AdvisersAnnual Amendment of Form ADV. Each registered investment adviser (RIA) and exempt reporting adviser (ERA) must file an annual updated amendment to its Form ADV. The annual amendment must be filed within 90 days of the adviser’s fiscal year-end.

Each RIA should also provide to each client an updated Form ADV Part 2A brochure and a summary of material changes to the brochure, if any (or simply a summary of material changes, if any, accompanied by an offer to provide the updated brochure).

Investment Adviser Registration Depository (IARD) Renewal Fees. Annual renewal fees for Securities and Exchange Commission (SEC) and state RIAs, as well as SEC ERAs, are due to the IARD by December 12, 2022.  Please visit www.iard.com for more information.

Form PF. An investment adviser must file Form PF if it (i) is registered or required to be registered with the SEC; (ii) advises one or more private funds; and (iii) has at least $150 million in private fund assets under management. Investment advisers must file Form PF on an annual basis within 120 days of the fund’s fiscal year-end.

Form 13H Amendments. All large traders that have made a Form 13H filing with the SEC are required to submit an annual filing within 45 days of the end of each calendar year.

SEC Matters

New SEC Investment Adviser Marketing Rules are Now in Full Effect. The SEC’s new marketing rules took effect on November 4, 2022. As of that date, RIAs are no longer permitted to choose to comply with the previous advertising and cash solicitation rules.

Broadly, the new marketing rules include updates to (i) the definition of an advertisement; (ii) generally prohibited advertising practices; (iii) the parameters for including testimonials, endorsements and third-party ratings; and (iv) the parameters for including performance results. The SEC also amended the books and records rules to require investment advisers to maintain records of certain advertisements, as well as amended Form ADV to require advisers to disclose their marketing practices.

On September 19, 2022, the SEC released guidance regarding how examinations will focus on the new marketing rules. Specific areas of review will include whether advisers have (i) adopted and implemented written policies and procedures designed to prevent violations of the new rules; (ii) a reasonable basis for believing they can substantiate material statements of fact in advertisements; (iii) complied with the new rules regarding performance advertising; and (iv) followed the amendments to the books and records requirements and accurately completed the new portion of Form ADV relating to the marketing rules.

The new portion of Form ADV was added to Item 5 of Part 1A.

SEC Proposes Significant Changes in Private Fund Regulation. On February 9, 2022, the SEC proposed new rules and regulations under the Investment Advisers Act of 1940 applicable to both SEC-registered and unregistered private fund advisers. The intent of the proposed rules is to require fund managers “to provide transparency to their investors regarding the full cost of investing in private funds and the performance of such private funds.”

See our full blog post with a summary of the proposed rules here. Generally, the proposed rules require annual audits and quarterly statements for RIAs (in lieu of the surprise examination option) and prohibit certain activities for SEC-registered and unregistered private fund advisers. Notably, one of the proposed prohibited practices involves the use of side letters that provide select fund investors with favorable terms. Under the proposed rules, these side letters would need to be disclosed to all prospective and current investors. The initial comment period for the proposed rules was set to end on April 25, 2022. The SEC later extended the comment period to June 13, 2022.

SEC Proposes Amendments to Form PF. On August 10, 2022 the SEC proposed amendments to Form PF in an effort to bolster the Financial Stability Oversight Council’s ability to assess systemic risk along with the SEC’s regulatory authority over fund managers and its investor protection efforts. Generally, the proposed amendments seek to (i) enhance reporting by large hedge fund advisers on qualifying hedge funds; (ii) enhance reporting on basic information about advisers and the private funds they advise; (iii) enhance reporting concerning hedge funds; (iv) amend how advisers report complex structures; and (v) remove aggregate reporting for large hedge fund advisers.

Notable to the digital asset space, the proposed amendments add a new sub-asset class for digital assets and include a definition for the term “digital asset.” The SEC specifically requested comments with respect to how digital assets should be categorized and disclosed. The comment period ended on October 11, 2022.

SEC Charges Advisory Firms for Custody Rule and ADV Violations. On September 9, 2022, the SEC issued a press release detailing charges against multiple investment advisers for failing to comply with SEC custody rules and/or failing to update the status of their audited financial statements on Form ADV. The firms ultimately agreed to pay civil penalties totaling more than $1 million. In detailing the charges, the SEC re-emphasized that RIAs managing private funds should ensure they are distributing audited financial statements to investors in a timely manner and updating their Form ADVs when audited financial statements are received. Specifically, the SEC noted that if an RIA checks “Report Not Yet Received” under Part 1A, Schedule D, Section 7.B.23 of its Form ADV, it must promptly file an amendment when the report is available. ERAs should also keep this in mind to the extent their funds are subject to an annual audit.

The charges follow an SEC settlement with another registered adviser in March for failing to maintain adequate policies and procedures regarding the custody rule and failing to deliver audited statements in a timely manner. RIAs managing private funds should review their policies and procedures to confirm they are currently compliant.

SEC Proposes New Requirements for Outsourced Services. On October 26, 2022, the SEC proposed new rules for RIAs that prohibit outsourcing certain functions without appropriate due diligence and monitoring of the service providers. The proposed rules apply to “covered functions,” which are functions or services that (i) are “necessary to provide advisory services in compliance with the Federal securities laws”; and (ii) “if not performed or performed negligently, would be reasonably likely to cause a material negative impact on the adviser’s clients or on the adviser’s ability to provide investment advisory services.” The proposed rules outline the due diligence procedures required before retaining a service provider to perform a “covered function” and require advisers to obtain reasonable assurances that third-party recordkeepers meet certain enumerated standards regarding their recordkeeping procedures. The SEC is currently accepting comments regarding the proposed rules until December 27, 2022.

Commodity Trading Advisors and Commodity Pool Operators

Annual Reaffirmation of CPO Exemption. Commodity pool operators (CPOs) and commodity trading advisors (CTAs) relying on an exemption from registration with the Commodity Futures Trading Commission (CFTC) are required to reaffirm their exemption eligibility within 60 days of the calendar year-end.

Forms CPO-PQR and CTA-PR. Registered CPOs and CTAs must file Form CPO-PQR and Form CTA-PR, respectively, using the NFA’s EasyFile system. Registered CPOs must file Form CPO-PQR on a quarterly basis within 60 days of the quarters ending in March, June and September, as well as within 90 days of the calendar year-end. Registered CTAs must file Form CTA-PR on a quarterly basis within 45 days of each quarter-end.

Advisers that are dually registered with the SEC and the CFTC may satisfy certain Form CPO-PQR filing requirements by filing Form PF by the Form CPO-PQR deadline.

CPO and CTA Annual Report Updates. Registered CPOs—including CPOs utilizing the CFTC Regulation 4.7 exemption—must distribute an Annual Report to each participant in each pool that they operate, as well as submit a copy of the Annual Report and key financial balances to the National Futures Association (NFA), within 90 days of the pool’s fiscal year-end. An independent certified public accountant must certify the Annual Report.

CPOs should also check the date of the most recent disclosure document of each pool they operate. CPOs are generally prohibited from soliciting clients with a disclosure document that has not been updated within the past 12 months.

CFTC and NFA Matters

CFTC Releases Enforcement Results for 2022. On October 20, 2022, the CFTC released its annual enforcement results for the fiscal year 2022. In total, the CFTC obtained orders imposing over $2.5 billion in payments and filed 82 enforcement actions. Notably, 18 of the CFTC actions involved digital assets. The digital asset-related actions largely involved either unregistered exchange activity or untrue/misleading statements made in connection with digital assets. The CFTC has general authority over most digital asset derivative transactions and has broad anti-fraud authority over spot digital asset transactions. The CFTC’s Division of Enforcement has a task force specifically dedicated to digital assets, and we expect to see the CFTC continue to prioritize bringing regulatory actions in the digital assets space.

CFTC Finds DAO Liable as an Unincorporated Association. On September 22, 2022, the CFTC filed an enforcement action in the U.S. District Court for the Northern District of California charging a decentralized autonomous organization (DAO) with illegally offering retail commodity transactions in digital assets. The CFTC alleged the DAO solicited customers for its software protocol that allowed users “to open leveraged positions whose ultimate value was determined by the price difference between two digital assets from the time the position was established to the time it was closed.” The CFTC classified these transactions as retail commodity transactions that were unlawful since they did not take place on a designated contract market.

The founders of the protocol transferred the protocol from a limited liability company to the DAO and then touted the DAO’s ability to avoid regulation. However, the CFTC stated that the DAO and its members should nevertheless be liable based on the existence of the DAO as an unincorporated association. The CFTC also filed an enforcement action against the original LLC and its founders. Significantly, the enforcement action and order demonstrate the CFTC’s willingness to go after DAOs and their participants. Fund managers should keep this regulatory risk in mind when investing in decentralized finance (DeFi) projects involving DAOs.

Digital Assets Matters

FTX Fallout. On November 11, 2022, FTX Trading Ltd. and its affiliates (FTX) filed for Chapter 11 bankruptcy protection in Delaware. The bankruptcy sent shockwaves through the crypto industry not seen since the Mt. Gox collapse in 2014. We are actively working with our clients impacted by FTX’s collapse to develop appropriate responses, from both a legal and a business operations standpoint. Although the collapse is a repeat of financial fraud as old as time rather than an indictment of blockchain technology and decentralization (it is arguably the opposite), it does shine a light on the need for clearer regulation. We continue to expect the SEC to emerge as the leading regulator of crypto exchanges and tokens and are monitoring potential legislative responses from Congress. Although there appears to be bipartisan support for certain reforms such as separating custody from trading platforms, unique challenges remain such as how to prevent non-US exchanges that may fall outside the US regulatory regime from interacting with US customers.

SEC Scales Up Crypto Enforcement Team. On May 3, 2022, the SEC announced it was nearly doubling its Crypto Assets and Cyber Unit in its Division of Enforcement from 30 to 50 dedicated positions. The expanded Crypto Assets and Cyber Unit is tasked with focusing on securities law violations related to crypto asset offerings, exchanges and lending products, as well as DeFi platforms, non-fungible tokens (NFTs) and stablecoins. The expansion of the SEC’s crypto enforcement arm is consistent with SEC Chair Gary Gensler’s sustained push to establish the SEC as crypto’s chief regulator of the asset class.

DOJ Charges Former OpenSea Employee in First Digital Asset Insider Trading Scheme. On June 1, 2022, the US Attorney’s Office for the Southern District of New York and the Federal Bureau of Investigation announced charges against a former product manager at OpenSea, the world’s largest NFT marketplace, for a scheme to commit insider trading. The OpenSea employee allegedly used confidential information regarding which NFTs were going to be featured on OpenSea’s homepage to invest ahead of the announcements. Interestingly, the DOJ elected to sidestep the issue of whether the underlying NFTs were securities by charging the defendant with wire fraud and money laundering.

SEC Charges Former Coinbase Manager with Insider Trading. On July 21, 2022, the SEC announced insider trading charges against a former Coinbase product manager and others for trading ahead of multiple announcements regarding tokens that were being added to the Coinbase trading platform. The SEC appeared to use the charges to regulate through enforcement by explicitly noting that many of the underlying tokens are securities. While the SEC has previously identified tokens as securities, those charges typically involved direct enforcement actions against an issuer. As SEC Division of Enforcement Director Gurbir Grewal noted, the case highlights the SEC’s focus on treating many tokens as securities regardless of label.

SEC Charges Influencer for Touting Token. On October 3, 2022, the SEC announced charges against Kim Kardashian for touting EthereumMax tokens on her Instagram account without disclosing that she was paid $250,000 to publish the post. Ms. Kardashian agreed to settle the charges, cooperate with the SEC’s ongoing investigation and pay $1.26 million in penalties, disgorgement and interest. In addition to reinforcing the SEC’s position that many tokens are securities offerings subject to federal securities laws, the charges and settlement were a highly publicized warning to celebrities and influencers to avoid promoting tokens on their social media accounts without disclosing compensation received from the token issuer.

Additional Compliance Matters

Verification of New Issues Status. Fund managers must conduct an annual verification of each account to ensure investors are eligible to participate in initial public offerings or new issues pursuant to FINRA Rules 5130 and 5131. While the initial verification requires affirmative representations by account holders, FINRA allows subsequent verifications to be completed using negative consent letters.

Annual Audited Financial Statements. RIAs that manage private funds are generally required to distribute audited financial statements to each fund investor within 120 days of each year-end.

Annual Compliance Review. RIAs should review their compliance program annually. The annual review should evaluate, at a minimum, the firm’s Code of Ethics, privacy policy, marketing policies, recordkeeping procedures, the Business Continuity plan, trading restrictions, trading practices, conflicts of interest, ERISA disclosures and compliance violation procedures.

Each RIA must also provide its investors with a copy of its privacy policy on an annual basis, even if no changes have been made to the privacy policy.

Form D Annual Amendments.  Form D filings for funds maintaining continuous offerings must be amended annually, on or before the anniversary of the Form D filing or the filing of the most recent amendment. When amending Form D, the fund should review the entire form and ensure all information is up to date.

Blue Sky Filings.  Fund managers should review their state blue sky filings to ensure they have met any applicable state renewal requirements.

If you require assistance with any of the above items, please do not hesitate to contact Kevin Cott at kevin@cottlawgroup.com. As always, we appreciate your continued business and support. From all of us at Cott Law Group, we wish you a happy and healthy New Year.

Proposed Rule Changes for Private Fund Advisers

On February 9, 2022, the Securities and Exchange Commission (SEC) proposed new rules (Proposed Rules) under the Investment Advisers Act of 1940 (Advisers Act) that, if adopted, would significantly impact private fund advisers. Below is a high-level summary of the Proposed Rules and their potential impact on affected advisers.

Annual Audit Requirement

The Proposed Rules would require SEC-registered advisers to obtain annual audited financial statements for each private fund they advise. Fund auditors would also be required to promptly notify the SEC if a modified opinion is issued or the auditor’s engagement is terminated.

Notably, the audit requirement under the Proposed Rules is a separate and distinct requirement from custody requirements pursuant to Rule 206(4)-2 under the Advisers Act, i.e. the Proposed Rules do not permit advisers to elect a surprise examination in lieu of an audit.

Quarterly Statements

Under the Proposed Rules, SEC-registered advisers would be required to provide quarterly account statements to investors in each private fund they advise. The statements would need to be presented in a standardized format that includes a “detailed accounting” of specific fee and expense disclosures, portfolio investment compensation paid to the adviser or its affiliates, standardized fund performance information based on the type of fund (i.e. “liquid” vs. “illiquid”), etc. The statements would need to be provided within 45 days of the end of each calendar quarter.

Prohibited Activities

The Proposed Rules would prohibit both SEC-registered and unregistered advisers from certain activities with respect to private funds, including the following:

  • Providing preferential treatment to certain investors via side letter agreements (Side Letters) with respect to redemption rights or access to information regarding portfolio holdings or exposures, if the adviser reasonably expects such preferential treatment would have a material, negative effect on other investors (although not outright prohibited, certain other preferential terms—including fee discounts and additional investment rights—would need to be disclosed in writing to prospective and current investors);
  • Reducing clawbacks of carried interest paid to the adviser to be net of taxes;
  • Reimbursing, indemnifying or limiting the liability of the adviser for breaches of fiduciary duties, willful misfeasance, bad faith, recklessness or negligence in providing services to a private fund;
  • Charging private funds for accelerated monitoring fees, costs related to examinations or investigations of the advisers or adviser regulatory and compliance costs;
  • Borrowing funds from a private fund; and
  • Allocating costs related to portfolio investments held by multiple funds and/or co-investment vehicles on a non-pro rata basis.

With respect to the prohibited activities in connection with Side Letters, the lack of a “grandfathering” provision would be uniquely challenging for existing advisers affected by the Proposed Rules; such advisers would effectively have to choose between complying with the Proposed Rules or breaching a previously granted Side Letter provision.

A public comment period regarding the Proposed Rules will remain open for 60 days following publication on the SEC website or 30 days following publication in the Federal Register, whichever is longer. The Proposed Rules would mark a landmark shift in SEC regulation of private fund advisers, and we will continue to monitor any related developments. Should you have any questions regarding this alert or the Proposed Rules in general, feel free to contact Kevin Cott at kevin@cottlawgroup.com.

Year-End Client Letter

As we turn the page on 2021, we would like to highlight the following legal, regulatory and business matters that may affect you or your clients heading into the new year. As always, feel free to reach out to us should you have any questions.

Investment Advisers and Exempt Reporting Advisers

Annual Amendment of Form ADV. Each registered investment adviser (RIA) and exempt reporting adviser (ERA) must file an annual updated amendment to its Form ADV. The annual amendment must be filed within 90 days of the adviser’s fiscal year-end.

Each RIA should also provide to each client an updated Form ADV Part 2A brochure and a summary of material changes to the brochure, if any (or simply a summary of material changes, if any, accompanied by an offer to provide the updated brochure).

Investment Adviser Registration Depository (IARD) Renewal Fees. Annual renewal fees for Securities and Exchange Commission (SEC) and state RIAs, as well as SEC ERAs, were due to the IARD by December 13, 2021.  Please visit www.iard.com for more information.

Form PF. An investment adviser must file Form PF if it (i) is registered or required to be registered with the SEC; (ii) advises one or more private funds; and (iii) has at least $150 million in private fund assets under management. Investment advisers must file Form PF on an annual basis within 120 days of the fund’s fiscal year-end.

Form 13H Amendments. All large traders who have made a Form 13H filing with the SEC are required to submit an annual filing within 45 days of the end of each calendar year.

New Rules for New York Investment Adviser Representatives. Prior to February 1, 2021, New York did not require investment adviser representatives, principals, supervisors or solicitors (IARs) to register with the state. Effective as of February 1, 2021, IARs representing a New York RIA or SEC RIA with a New York place of business are required to register. Absent a waiver, IARs must either pass the Series 65 exam or a combination of the Series 7 and Series 66 exams within 2 years prior to filing for registration. IARs were generally required to register by August 31, 2021, absent certain exemptions.

SEC Matters

SEC Increases Qualified Client Thresholds. On June 17, 2021, the SEC adopted amendments to the definition of “qualified client” under the Securities Act of 1933. The amendments increased the dollar amount thresholds for the “assets-under-management” test and the “net worth” test, respectively, from $1 million to $1.1 million and from $2.1 million to $2.2 million. Adjustments to the net worth and assets-under-management thresholds are made every five years to account for inflation.

The amendments became effective on August 16, 2021, and do not apply retroactively to contractual relationships entered prior to the effective date. Advisers to separately managed accounts and/or private funds relying on Section 3(c)(1) of the Investment Company Act of 1940 should review and update their investment advisory contracts and/or offering documents to reflect the new thresholds. Further details regarding the amendments can be found here.

SEC Adopts Modernized Marketing Rule for Investment Advisers. On December 22, 2020, the SEC adopted amendments to Rule 206(4)-1 under the Advisers Act to create a single, consolidated rule (Marketing Rule) that replaced separate advertising and cash solicitation rules. The Marketing Rule represents a significant overhaul of adviser marketing rules with a stated goal of shifting to “principles-based provisions designed to accommodate the continual evolution and interplay of technology and advice.” Among other changes, the Marketing Rule: (i) expands the scope of which communications, materials and activities are considered “advertisements”; (ii) replaces the per se violations of the Advisers Act with a more flexible, principles-based approach (potentially granting advisers the ability to use marketing materials in certain circumstances that include specific recommendations, testimonials, third-party ratings, etc.); and (iii) allows the use of hyperlinks and layered disclosures under certain conditions.

Advisers should reevaluate all methods by which they currently communicate with current and prospective clients, including their current marketing materials, solicitation arrangements, recordkeeping practices and social media policies. The Marketing Rule became effective on May 4, 2021, but advisers have until November 4, 2022, to comply with the new rule. More information regarding the Marketing Rule and the current transition period can be found here.

Commodity Trading Advisors and Commodity Pool Operators

Annual Reaffirmation of CPO Exemption. Commodity pool operators (CPOs) and commodity trading advisors (CTAs) relying on an exemption from registration with the Commodity Futures Trading Commission (CFTC) are required to reaffirm their exemption eligibility within 60 days of the calendar year-end.

Forms CPO-PQR and CTA-PR. Registered CPOs and CTAs must file Form CPO-PQR and Form CTA-PR, respectively, using the NFA’s EasyFile system. Registered CPOs must file Form CPO-PQR on a quarterly basis within 60 days of the quarters ending in March, June, and September, and within 90 days of the calendar year-end. Registered CTAs must file Form CTA-PR on a quarterly basis within 45 days of each quarter-end.

Advisers that are dually registered with the SEC and the CFTC may satisfy certain Form CPO-PQR filing requirements when they file Form PF. In order to take advantage of this, such advisers must file Form PF by the Form CPO-PQR deadline.

CPO and CTA Annual Report Updates. Registered CPOs, including CPOs utilizing the CFTC Regulation 4.7 exemption, must distribute an Annual Report to each participant in each pool that they operate, as well as submit a copy of the Annual Report and key financial balances to the National Futures Association (NFA), within 90 days of the pool’s fiscal year-end. An independent certified public accountant must certify the Annual Report.

CPOs should also check the date of the most recent disclosure document of each pool they operate. CPOs are generally prohibited from soliciting clients with a disclosure document that is more than 12 months old.

CFTC and NFA Matters

Changes to Form CPO-PQR. As of the March 31, 2021, reporting date, the CFTC has revised and streamlined Form CPO-PQR. The revised Form CPO-PQR now has one schedule (Schedule A), and all reporting CPOs must file the revised Form CPO-PQR every quarter, regardless of size. The CFTC has also attempted to make the form more user-friendly.

CFTC Establishes Climate Risk Unit. On March 17, 2021, Acting CFTC Chairman Rostin Behnam announced the establishment of the Climate Risk Unit (CRU). The CRU will assess the efficacy of derivatives products in addressing climate-related risks in the financial system. As part of its mission, the CRU will represent the CFTC in industry discussions to reduce carbon emissions worldwide. The CRU also intends to facilitate dialogue regarding emerging climate risks, aid in the development of new “net-zero” products, support development of climate-related market risk data and evaluate effectiveness of other tools in accelerating products and services that promote climate-friendly practices.

New Notice Requirements for CPOs. Effective as of June 30, 2021, CPOs are subject to newly adopted NFA Compliance Rule 2-50 (Rule 2-50). Rule 2-50 requires CPOs to report the following occurrences to the NFA with respect to each commodity pool they operate: (i) the inability to fulfill its obligations to investors or an unplanned liquidation of the pool; (ii) the inability to meet margin calls; (iii) the inability to make redemptions in accordance with subscription agreements; (iv) freezing redemptions in preparation for ceasing operations; and (v) receiving notice from a counterparty that the pool is in default. All pools operated by a CPO—including pools relying on the CFTC Regulation 4.13(a)(3) de minimis exemption—are subject to Rule 2-50. The NFA released Interpretive Notice 9080 to provide examples of when notice is not required (e.g., if a CPO reasonably expects to meet the margin call within the time prescribed by its Futures Commission Merchant (FCM)).

NFA Updates Branch Office Inspection Requirement and Physical Examination Requirement. In light of the pandemic, the NFA released a notice to allow Members who were temporarily working from home to exempt their home office from the definition of a “branch office.” The notice, released in March 2021, was made permanent starting September 23, 2021. In NFA Interpretive Notice 9002, the definition of a “branch office” was revised to exclude “any location where one or more associated persons (APs) from the same household live or rent/lease (e.g., a shared or co-workspace).”

The exemption for home offices was not the only change caused by the pandemic. Through the end of 2021, Members are allowed to conduct their annual inspection of each branch office remotely. While the annual inspection is still required, the ability to do so virtually is in line with current public health policies. The NFA will also allow Members to conduct virtual inspections of branch offices in 2022, if appropriate given applicable risks.

Financial Industry Regulatory Authority (FINRA) Matters

FINRA Amends Rules 5122 and 5123 to Include Retail Communications. Effective October 1, 2021, FINRA amended Rules 5122 and 5123 to expand the filing requirements of broker dealers. Under the previous versions of the rules, member firms were required to file any private placement memorandum (PPM), term sheet or other offering documents used in connection with a private placement offering. Under the amended rules, such firms are also required to file any “retail communications” used in connection with private placement offerings (e.g., pitchbooks, slide presentations, fact sheets). The amended rules effectively formalize a common practice—most broker dealers have historically filed such retail communications simultaneously alongside the required PPMs or term sheets.

Digital Assets Matters

El Salvador Adopts Bitcoin as Legal Tender. On September 7, 2021, EL Salvador became the first country to adopt Bitcoin as legal tender. With the change, each company in El Salvador became required to accept Bitcoin as payment, and each citizen was gifted $30 in Bitcoin for utilizing the government’s e-wallet. President Nayib Bukele hoped the adoption of Bitcoin would stimulate the country’s economy in part by reducing transaction costs and increasing efficiency in international transactions. El Salvador remains the only country to adopt such a policy.

Rulemaking Petition Sent to SEC on Non-Fungible Tokens (NFTs). On April 12, 2021, Arkonis Capital, a registered broker dealer, submitted a rulemaking petition to the SEC requesting guidance on NFTs. In the petition, Arkonis posits scenarios under which an NFT may be deemed a “security”. They also argue that if an NFT relates to an existing asset and is marketed as a collectible with a public assurance of authenticity on the blockchain, it should not be considered a security.

Arkonis further states that should the SEC deem an NFT to be a security, the platform facilitating the sale and/or trading of such NFT could be required to register with the SEC as an exchange. Given these regulatory implications, Arkonis petitioned the SEC to publish guidance regarding when an NFT is a security and the resulting registration requirements. As of December 2021, the SEC has not released the requested guidance.

SEC Chair Gensler Discusses the Regulation of Cryptocurrency Under Existing Authorities. On September 14, 2021, Gary Gensler, the SEC Chair, testified before the Senate Banking Committee regarding the SEC’s authority to regulate the cryptocurrency market. During the testimony, Gensler responded to questions about gaps in the current regulatory regime by stating the SEC and the CFTC have “a great deal of authority” with regard to digital assets and “a great deal of clarity” in determining which digital assets meet the definition of a security. The gaps, he clarified, exist in the coordination amongst the different regulatory agencies—specifically, the SEC, the CFTC and the banking agencies.

Gensler also testified in October before the House Committee on Financial Services regarding cryptocurrency regulation. When asked about whether certain cryptocurrencies are securities, Gensler declined to comment on any specific token and reiterated that any token that passes the Howey Test is a security. Specifically, he stated “[T]he securities laws are quite clear. If you’re raising money from somebody else, and the investing public has a reasonable anticipation of profits based on the efforts of others, that fits within the securities law.”

First Bitcoin Futures ETF Launches. On October 18, 2021, ProShares launched the Bitcoin Strategy ETF, the first Bitcoin-focused exchange traded fund listed on a national exchange. Trading under “BITO”, the fund does not directly invest in Bitcoin but provides exposure to Bitcoin futures contracts. As of November 11, 2021, BITO had net assets of over $1.4 billion. Two other national Bitcoin futures ETFs launched shortly after the launch of BITO.

SEC Rejects Spot Bitcoin ETF. On November 12, 2021, the SEC rejected a proposed rule change to list shares of the VanEck Bitcoin Trust on the Cboe BZX Exchange. In its rejection, the SEC stated that the exchange did not meet its burden as a national securities exchange under the Securities Exchange Act of 1934 “to prevent fraudulent and manipulative acts and practices” and “to protect investors and the public interest.” The ruling is consistent with past statements from SEC Chair Gensler and other SEC actions demonstrating a preference for Bitcoin futures ETFs over spot Bitcoin ETFs.

Coinbase Files for Futures and Derivatives Trading. On September 16, 2021, Coinbase confirmed that it filed an application with the NFA to register as an FCM. As an FCM, Coinbase would be able to offer cryptocurrency futures and derivatives trading to U.S. persons on its platform. The application is still pending.

Ripple Lawsuit. In December 2020, the SEC sued Ripple Labs Inc. and two of its executives for allegedly conducting a $1.3 billion unregistered securities offering for XRP, its token. The SEC claims that XRP is a security because it was distributed by Ripple in a centralized manner and represents an investment in the company. Ripple disputes these claims, asserting that the SEC failed to release proper guidance on digital asset regulation and is attempting to utilize an outdated regulatory scheme on a novel industry. The Ripple case is ongoing, and its outcome could significantly affect the digital asset industry in the U.S.

SEC Fines Poloniex for Operating Unregistered Digital Asset Exchange. On August 9, 2021, the SEC announced that Poloniex LLC agreed to pay more than $10 million to settle charges of operating an unregistered digital asset exchange. The order states that Poloniex’s platform facilitated buying and selling digital assets, including digital assets that met the definition of a security. While operating the exchange, Poloniex instituted an internal review mechanism where it determined how likely certain digital assets were to be deemed securities. However, the SEC stated that Poloniex offered the ability to trade digital assets that were at “medium risk” under Poloniex’s policy and, as a result, certain digital assets meeting the definition of a security were available to trade on the platform.  This case reinforces the SEC’s authority over the digital asset industry, but the SEC did not go into detail on which specific digital assets met the definition of a security. 

CFTC Fines Kraken for Offering Margin Trading in the U.S. On September 28, 2021, the CFTC issued an order settling charges against Payward Ventures, Inc. d/b/a Kraken for illegally offering margined retail commodity transactions in digital assets and failing to register as an FCM. From June 2020 to July 2021, Kraken allowed customers to purchase digital assets (including Bitcoin) using margin. The CFTC found that “actual delivery” of the underlying assets did not occur, meaning the transactions met the definition of “retail commodity transactions.” Such transactions fall under the CFTC’s jurisdiction and are treated similarly to traditional futures contracts. The CFTC found the transactions to be unlawful because they did not take place on a designated contract market and Kraken acted as an unregistered FCM by soliciting and accepting the transactions.

BitMEX Moves All Operations Offshore as Remedial Measures in CFTC Action. On August 10, 2021, the CFTC announced that a U.S. district court entered a consent order against five companies that operated the BitMEX cryptocurrency derivatives trading platform. The order required BitMEX to pay a $100 million civil monetary penalty. As part of its remedial measures, BitMEX no longer maintains any substantive operations or business functions in the U.S. BitMEX also certified to the CFTC that anyone located in the U.S. is prohibited from accessing the platform. BitMEX’s remedial measures places it in line with other platforms offering digital asset derivative transactions solely outside the U.S.

Additional Compliance Matters

Verification of New Issues Status. Fund managers must conduct an annual verification of each account to ensure investors are eligible to participate in initial public offerings or new issues pursuant to FINRA Rules 5130 and 5131. While the initial verification requires affirmative representations by account holders, FINRA allows subsequent verifications to be completed using negative consent letters.

Annual Audited Financial Statements. RIAs that manage private funds are generally required to distribute audited financial statements to each fund investor within 120 days of each year-end.

Annual Compliance Review. RIAs should review their compliance program annually. The annual review should evaluate, at a minimum, the firm’s Code of Ethics, privacy policy, marketing policies, recordkeeping procedures, the Business Continuity plan, trading restrictions, trading practices, conflicts of interest, ERISA disclosures and compliance violation procedures.

Each RIA must also provide its investors with a copy of its privacy policy on an annual basis, even if no changes have been made to the privacy policy.

Form D Annual Amendments.  Form D filings for funds maintaining continuous offerings must be amended annually, on or before the anniversary of the Form D filing or the filing of the most recent amendment. When amending Form D, the fund must update the entire form.

Blue Sky Filings.  Fund managers should review their state blue sky filings to ensure they have met any applicable state renewal requirements. Note that issuers selling securities in New York in reliance on an exemption under Regulation D are required to file Form D and pay related filing fees through the Electronic Filing Depository. As of February 1, 2021, New York does not accept any Form 99 submissions and no longer requires issuers to file a notarized Form U-2.

Regulatory Alert: SEC Expands Definition of Accredited Investor

On August 26, 2020, the U.S. Securities and Exchange Commission (“SEC”) adopted amendments to the definition of “accredited investor” under the Securities Act of 1933. As previously covered, the amendments expand the definition of an accredited investor in an effort to more effectively identify institutional and individual investors that have the knowledge and expertise to participate in private capital markets. Notably, the updated definition of an accredited investor will allow more investors to participate in hedge funds and other alternative investment funds by adding new categories of qualifying natural persons and entities. The amendments became effective on December 8, 2020 and can be viewed here.

Below is a summary of key changes to the definition of an accredited investor included in the amendments:

  1. Credentialed Individuals. Individuals may now qualify as accredited investors based on certain professional certifications, designations or credentials. Initially, the SEC designated the Series 7, Series 65 and Series 82 licenses as qualifying credentials. The SEC may add other qualifying credentials pursuant to future orders.
  2. Knowledgeable Employees. “Knowledgeable employees”, as defined in Rule 3c-5(a)(4) under the Investment Company Act of 1940 (“Company Act”), of private investment funds will be deemed accredited investors when making investments in such funds. Notably, expanding the definition of an accredited investor to include knowledgeable employees will allow funds with assets of $5 million or less to permit such employees to invest in the funds without jeopardizing the fund’s status as an accredited investor (i.e., an entity in which all equity owners are accredited investors).
  3. Additional Entities. An accredited investor now includes SEC- and state-registered investment advisers, exempt reporting advisers, rural business investment companies and limited liability companies with more than $5 million in assets. The new definition also adds a category for any entity, including Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries, that (i) own “investments,” as defined in Rule 2a51-1(b) under the Company Act, in excess of $5 million; and (ii) that was not formed for the specific purpose of investing in the securities offered.
  4. Family Offices. Certain “family offices” with at least $5 million in assets under management and their “family clients,” as each term is defined under the Investment Advisers Act of 1940, will now qualify as accredited investors.
  5. Spousal Equivalents. Spousal equivalents may now pool their finances for the purpose of qualifying as accredited investors. The SEC specifically noted that spousal assets do not need to be held jointly to be included in the pooled finances calculation.

Private investment funds and other issuers that currently rely on Regulation D of the Securities Act to offer securities to investors should work with legal counsel to amend their subscription documents and offering materials to reflect the updated definition of an accredited investor. If you have any questions regarding the amendments to the accredited investor definition, please do not hesitate to contact Kevin Cott at kevin@cottlawgroup.com.

SEC Approves Modernizing Amendments to Accredited Investor Definition

On August 26, 2020, the U.S. Securities and Exchange Commission (the “SEC”) adopted amendments to the definition of “accredited investor” under the Securities Act of 1933 (the “Act”). The SEC proposed the amendments on December 18, 2019 in an effort to more effectively identify institutional and individual investors that have the knowledge and expertise to participate in private capital markets. Ultimately, the updated definition allows more investors to participate in private offerings by adding new categories of natural persons and entities that may qualify as accredited investors.

The SEC’s press release on the amendments and the full text of the final rule can be found here.  In addition, our previous blog post discussing the proposed amendments in detail can be found here.

Below is a summary of the amendments to the accredited investor definition as provided by the SEC. The amendments are set to become effective 60 days after publication in the Federal Register.

The amendments to the accredited investor definition in Rule 501(a) of the Act:

  1. Add a new category to the definition that permits natural persons to qualify as accredited investors based on certain professional certifications, designations or credentials or other credentials issued by an accredited educational institution, which the SEC may designate from time to time by order. In conjunction with the adoption of the amendments, the SEC designated by order holders in good standing of the Series 7, Series 65, and Series 82 licenses as qualifying natural persons.  This approach provides the SEC with flexibility to reevaluate or add certifications, designations, or credentials in the future.  Members of the public may wish to propose for the SEC’s consideration additional certifications, designations or credentials that satisfy the attributes set out in the new rule;
  2. Include as accredited investors, with respect to investments in a private fund, natural persons who are “knowledgeable employees” of the fund;
  3. Clarify that limited liability companies with $5 million in assets may be accredited investors and add SEC- and state-registered investment advisers, exempt reporting advisers, and rural business investment companies (RBICs) to the list of entities that may qualify;
  4. Add a new category for any entity, including Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries, that own “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered;
  5. Add “family offices” with at least $5 million in assets under management and their “family clients,” as each term is defined under the Investment Advisers Act; and
  6. Add the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors.

If you have any questions regarding the amendments to the accredited investor definition, please do not hesitate to contact Kevin Cott at kevin@cottlawgroup.com.

SEC Proposes Updates to Accredited Investor Definition

On December 18, 2019, the U.S. Securities and Exchange Commission (the “SEC”) issued a press release highlighting proposed amendments to the definition of an “accredited investor” under the Securities Act of 1933 (the “Act”). We expect private fund managers to embrace the proposed changes, as the amendments seek to permit more investors to participate in private capital markets by including new categories of qualifying natural persons and entities and solidifying previous interpretive positions held by the SEC. Below is a short summary of the notable proposed additions to the definition. The SEC’s full press release and the complete proposal can be found here.

  1. Professional Certificates and Knowledgeable Employees of a Fund

The proposed definition will add two new categories applicable to individual investors. First, the new definition will allow natural persons who hold professional certifications to be considered accredited investors regardless of their financial condition. The SEC states in the proposal that it expects this category will initially include holders of Series 7, 65, or 82 licenses but mentions holders of other degrees and certifications (CFA, CPA, MBA) as possible inclusions as well.

Second, the new definition will include a specific carve out for “knowledgeable employees” of a private fund. The carve out will be similar to the current category for directors, executive officers, or general partners of the issuer but will apply more broadly to include knowledgeable employees as currently defined in Rule 3c-5 of the Act.

  1. Registered Investment Advisors, RBICs, and LLCs

While the current definition of accredited investor includes various entity types, the SEC is seeking to add three additional entity types that it feels are sophisticated enough to be considered accredited. Specifically, the SEC is proposing to add state and SEC registered investment advisers, approved rural business investment companies (as defined in the Consolidated Farm and Rural Development Act), and certain limited liability companies.

The inclusion of certain LLCs is of particular note because the current definition does not specifically refer to LLCs. Under the new definition, the SEC will add LLCs to the list of entities that are considered accredited as long as they have total assets in excess of $5 million and were not formed for the specific purpose of acquiring the securities being offered.

  1. Certain Family Offices and Family Clients

The SEC is also proposing a new category of accredited investors that includes any “family office” with at least $5 million in assets under management and its “family clients,” as those terms are defined under the Advisers Act. The SEC is also proposing that the family office must not be formed for the specific purpose of acquiring the securities offered and that the family office be directed by a person with the requisite knowledge and experience in financial and business matters to ensure the family office is capable of evaluating the merits and risks of the prospective investment.

As justification for the addition, the SEC believes that these family offices have the minimum amount of assets under management to sustain the risk of loss and that the additional requirements will safeguard against improper reliance. The SEC generally expects all family offices to be accredited under the new definition.

  1. Entities Owning at Least $5 Million in Investments

In addition to including the enumerated entities above, the SEC is also proposing a catch-all category that will allow any entity owning investments in excess of $5 million that is not formed for the specific purpose of acquiring the securities being offered to be deemed accredited. This new category is meant to include all existing entity forms not already contemplated by the current definition, such as Indian tribes or governmental bodies.

  1. Codification of SEC Interpretations of the Current Rule

As part of the proposed definition, the SEC is codifying certain existing interpretations of the current definition. Of note, the SEC will codify two important interpretations applying to entities owned solely by accredited investors and individuals pooling combining finances with spousal equivalents.

The current definition of accredited investor includes any entity in which all the equity owners are accredited investors. However, the definition does not state whether one should look through any underlying entities that are not natural persons. Consistent with the SEC’s existing interpretation of the current definition, the proposed definition specifically states that one may look through any equity owners that are entities to the ultimate natural person owners.

The current definition allows “spouses” to pool together their finances to meet the relevant thresholds. However, the definition does not explicitly extend to spousal equivalents such as domestic partnerships or civil unions. Consistent with its current interpretation, the SEC is proposing this amendment because it sees no reason to distinguish between these types of relationships and believes that the new definition will remove any unnecessary barriers to investment opportunities for spousal equivalents.

Private Lending Funds: When is a note a security?




With significant growth in the hard money lending industry in recent years, many sponsors of private lending funds have requested guidance regarding whether the underlying loans and other debt instruments in such funds are considered “securities” under the Securities Act of 1933 (“Securities Act”), the Investment Company Act of 1940 (“ICA”) and the Investment Advisers Act of 1940 (“Advisers Act”) (collectively, “Acts”).  Below is a general overview of what types of notes fall under the purview of the Acts.

Each of the Acts contains an identical definition of what constitutes a security, including “any note” and “evidence of indebtedness.” A common misconception is that all investment instruments are similarly categorized for the purposes of the Securities Act, the ICA and the Advisers Act. However, the SEC and the Supreme Court have taken the position that the scope of the term “security” varies under each Act. Because the Acts are generally targeted toward separate entities and intended to achieve different objectives, instruments deemed not to be securities for purposes of one Act may be regarded by the SEC as securities for the purposes of another Act. Ultimately, whether the underlying loans purchased or originated by a private lending fund are deemed securities can have far-reaching impacts on the fund and its sponsor, including investment adviser registration requirements for the sponsor and the number of investors that can be admitted to the fund.

Securities Act of 1933

For the purposes of the Securities Act, the Supreme Court held in Reves v. Ernst & Young that every note is presumed to be a security, but that presumption can be rebutted by showing that the note bears a strong resemblance to a judicially crafted list of notes that are presumed not to be securities. Included in this list of non-securities are:

  1. note delivered in consumer financing
  2. note secured by a mortgage on a home
  3. short-term note secured by a lien on a small business or some of its assets
  4. note evidencing a character loan to a bank customer
  5. short-term note secured by an assignment of accounts receivable
  6. note which formalizes an open-account debt incurred in the ordinary course of business

While the Supreme Court did not elaborate on the scope of each of these categories, it did adopt a “family resemblance” test which is a purpose-based approach to determining whether an investment instrument closely resembles one of the judicially-crafted family of instruments that are not considered securities. The family resemblance test asks the following questions to assist in making the determination if the context and purpose of an instrument closely resembles a category of notes from the list:

  1. Is the purpose of the debt transaction to raise money for the general use of a business enterprise or to finance substantial investments and is the purchaser motivated primarily by the profit the notes are expected to generate for the business?
  2. Does the issuer’s plan of distribution seek to establish some form of common trading in the notes, either for speculative or investment purposes?
  3. Is there a reasonable public expectation that the instruments should be treated as “securities”?
  4. Is there some mitigating factor such as the existence of another regulatory scheme that sufficiently protects investors, thereby rendering strict application of securities laws unnecessary?

Based on the judicially crafted family of notes, particularly the first two examples, and the family resemblance test, it is likely that the Supreme Court would hold that hard money loans backed by mortgages, for example, would not be considered securities.

The Securities Act diverges from the ICA and the Advisers Act by including exceptions to the definition of securities.  For example, the Securities Act states that any note with a maturity date of less than nine months is presumed not to be a security. However, the ICA and the Advisers Act do not contain such a presumption. Therefore, under the Securities Act, notes with a term of less than nine months are presumed not to be securities, whereas under the ICA and the Advisers Act, such notes must overcome a presumption that they are securities in order to be exempt from the regulations of those Acts. The various notes that are presumed not to be securities under the Securities Act demonstrates the narrower scope of the definition of securities under the Securities Act than that of the ICA and Advisers Act.

Investment Company Act of 1940

Hard money loans are lending instruments in which a lender offers funds to a borrower in exchange for a promissory note secured by the borrower’s assets, typically real estate. It has been established that all promissory notes are securities under the ICA. Because the Supreme Court issued the list of non-security notes based on its interpretation of the Securities Act, we cannot be certain whether the Supreme Court or the SEC would hold this list of notes to be securities under the ICA or the Advisers Act.

Additionally, promissory notes with a maturity date of less than nine months do not contain the presumption that they are not securities under the ICA. Therefore, promissory notes of any term can be deemed securities and the fund issuing promissory notes may be subject to the ICA.

Assuming hard money loans are deemed securities under the ICA, a private lending fund can be structured in a way that exempts it from being considered an investment company under Sections 3(c)(1), 3(c)(7) or 3(c)(5) of the ICA.

Section 3(c)(1) of the ICA provides an exemption from the definition of an investment company for private offerings “whose outstanding securities (other than short-term paper) are beneficially owned by not more than 100 persons.” Essentially, to avoid being considered an investment company, the lending fund can be offered to no more than 100 persons, accredited or non-accredited, and comply with advertising restrictions, such as not advertising details of the fund to the public. Section 3(c)(7) also provides an exemption for private funds and requires that the outstanding securities are owned exclusively by “qualified purchasers.”

Section 3(c)(5) of the ICA offers an exemption to registration for issuers primarily engaged in acquiring mortgages and similar real estate interests. Specifically, Section 3(c)(5)(C) provides that “any person who is primarily engaged in purchasing or otherwise acquiring mortgages and other liens on and interests in real estate” is not an investment company. Therefore, a lender of hard money loans backed by mortgages would likely not be subject to the ICA. This exemption is often the most utilized by lending funds because it does not impose other restrictions, such as investor type or count limits and advertising rules.

However, for a lender to qualify for the 3(c)(5)(C) exemption, they cannot issue redeemable securities, face-amount certificates of the installment type, or periodic payment plan certificates. Because a lender cannot issue redeemable securities under this exemption, the lender must be structured as a closed-end fund to qualify for the exemption. The lender must also satisfy the “Asset Composition Test.” The Asset Composition Test requires:

  1. at least 55% of its assets consist of “mortgages and other liens on and interests in real estate” (called “qualifying interests”) and the remaining 45% of its assets consist primarily of “real estate-type interests”;
  2. at least 80% of its total assets consist of qualifying interests and real estate-type interests; and
  3. no more than 20% of its total assets consist of assets that have no relationship to real estate.

Investment Advisers Act of 1940

While the SEC has not issued formal guidance as to whether it would take a similar position as it does with the ICA with respect to the Advisers Act and default to all promissory notes being deemed securities, the Bureau of National Affairs has stated that because of the investment characteristics that exist when loans are pooled together or when advice about loan investments is given, loans either are or may be treated as securities under the ICA and the Advisers Act.

If hard money loans and similar investment instruments were to be deemed securities under the Advisers Act, the sponsor may need to register as an investment adviser with the SEC or the appropriate state securities bureau, depending on a variety of factors. Registering as an investment adviser can impose significant regulatory burdens on a lender, including disclosure of all material facts and conflicts of interest, prohibitions against the lender acting as principal for its own account, limitations on advertising, safeguarding the client’s collateral, record examinations, etc.

Ultimately, whether private investment lenders are subject to the Acts depends on the structure and the purpose of the instruments, the availability of exemptions from being deemed an investment company and / or an investment adviser and the purpose for which the SEC is evaluating the loans. Because the definition of a security under each of the Acts varies, fund sponsors must be mindful of how the underlying loans will be structured on the front end of launching a private lending fund and should consult qualified legal counsel to confirm compliance with applicable securities laws.

US Treasury Report: Potential Implications for Private Placements, Exempt Offerings and Finders

The U.S. Department of the Treasury released a report this month outlining issues and recommendations in U.S. Capital Markets that the Treasury hopes will promote economic growth while maintaining investor protection. The Treasury report discussed measures that may facilitate the public offering and IPO process, as well as steps that could potentially facilitate capital raising for private placements (Regulation D) and other exempt offerings (Regulation CF and Regulation A+) associated with the JOBS Act. The following is a summary of the Treasury’s discussion on private placements and exempt offerings.

Regulation A+

The Treasury report focused its discussion of Regulation A+ on Tier II, which allows issuers to raise up to $50 million in what some may consider a “mini IPO” due to reduced disclosure and ongoing reporting requirements (we have a more in depth discussion of Regulation A+ here and here). The Treasury report provided three recommendations to Tier II of Regulation A+.

First, the Treasury recommended expanding Regulation A+ to Exchange Act reporting companies. Current, publicly traded companies are prohibited from utilizing Regulation A+ and must utilize other exemptions such as Regulation D to raise capital outside of traditional public offerings. The Treasury stated expanding Regulation A+ to Exchange Act reporting companies could provide public companies with lower-cost means of raising capital as well as increase awareness of Regulation A+ availability.

Second, in an effort to increase liquidity in the secondary market, the Treasury recommended that state securities regulators update regulations to facilitate secondary market trading of Tier 2 securities, or, alternatively, that the SEC use its authority to preempt state registration requirements for Tier II offerings. Currently, federal securities laws do not impose trading restrictions for Tier 2 securities. State securities laws, however, may prohibit secondary market transactions that do not comply with state-level registration requirements. Tier II offerings are already exempt from state blue sky registration requirements, and it is the Treasury’s position that eliminating state-specific secondary market requirements would increase the marketability and liquidity of Regulation A+ offerings.

Finally, the Treasury recommended the Tier II offering limit be increased to $75 million. The Treasury cited the Financial Choice Act that passed in the House for policy rationale. The Treasury stated and increase in the Tier II amount to $75 million would reduce costs associated with raising capital for private companies.

Regulation CF

The Treasury outlined concerns with the relative complexity and costs associated with using Regulation CF (discussed here and here) as opposed to simply conducting a private placement. The Treasury stated that the overall difficulty and cost associated with a Regulation CF offering may result in less-attractive companies pursuing funding from less sophisticated investors, who may not have the expertise to evaluate the investments. The Treasury recommended five primary changes to Regulation CF.

1. Allow single-purpose crowdfunding vehicles advised by a RIA that could potentially have a lead investor conduct due diligence, pool assets of other investors, and receive carried interest compensation;
2. Allow accredited investors to invest an unlimited amount of capital;
3. Change investment limits to the greater of 5% or 10% annual income or net worth from the lesser test currently imposed;
4. Raise the maximum revenue requirement for Regulation CF issuers to $100 million to $25 million; and
5. Raise the limit on offering amount to $5 million (currently $1 million) to lower offering costs per dollar raised.

Regulation D

The Treasury allocated a significant portion of its report to maintaining the efficacy of private capital markets, but only provided two recommendations for Regulation D. The Treasury’s recommendations focused on expanded access to private placements.

First, the Treasury recommended expanding the definition of an accredited investor. It is the Treasury’s position that an accredited investor could be broadened to include any investor who is advised on the merits of making a Regulation D investment by a fiduciary (such as a federal or state RIA). The Treasury also proposed including financial professionals, such as investment adviser and broker-dealer representatives, in the definition of an accredited investor.

Second, the Treasury recommended reviewing the provisions in the Securities Act and Investment Company Act that restrict unaccredited investors from investing in private funds containing Rule 506 offerings. The Treasury bolstered its position by stating unaccredited investors could further diversify investment portfolios through access to a well-diversified portfolio of private placements.

Finders Regulatory Structure

The Treasury also included a recommendation regarding finders. Currently, firms and individuals are generally required to register with the SEC, FINRA, and any relevant states in order to receive transaction-based compensation in connection with effecting a securities transaction. Thus, finders that are unaffiliated with a broker-dealer are likely operating in an unlicensed capacity. The Treasury recommended the SEC, FINRA, and states propose a new “broker-dealer lite” regulatory scheme for finders and other intermediaries that assist small companies with capital formation.

Final Thoughts

The Treasury’s report emphasized removing regulations imposed by federal and state securities regulatory authorities and SROs. Practically speaking, many of the Treasury’s proposals have a very small likelihood of fully coming to fruition (such as recommending all states ease Regulation A+ secondary market requirements and/or offer broker-dealer lite). However, some of the Treasury’s recommendations may be able to gain traction or have already been explored by federal regulators (i.e. expanding the definition of accredited investors to financial professionals was original the SEC’s idea).

Given the Treasury’s lack of jurisdiction over securities-related policy and rules, it will be up to federal and state regulators and legislative bodies to enact the Treasury’s recommended policies. The Treasury’s report does, however, provide us some insight into the current administration’s priorities in capital market regulation.

SEC Risk Alert: Advertising Compliance Issues for Investment Advisers

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.

DOL Fiduciary Rule: Impact on Hedge Fund Managers

Background

On June 9, 2017, the Department of Labor (“DOL”) effected a new regulation  expanding the definition of a “fiduciary” under the Employee Retirement Income Security Act of 1974 (“ERISA”) and Section 4975 of the Internal Revenue Code of 1986 (“Code”) (the “Fiduciary Rule”). Prior to the publication of the Fiduciary Rule, investment managers of private funds could effectively avoid designation as an ERISA fiduciary by limiting the aggregate investment in a fund by ERISA-covered plans and Individual Retirement Accounts (collectively, “Benefit Plans”) to less than 25% of the fund’s total assets under management (“AUM”).

While the 25% AUM exemption is still in place at the fund level, the Fiduciary Rule creates a new set of circumstances under which a fund manager could be deemed a fiduciary as a result of providing investment advice to a Benefit Plan in connection with the Benefit Plan’s “decision to invest” or to “maintain an investment” in a fund. Under the new rule, fund managers that make recommendations to Benefit Plans regarding the advisability of a particular investment or management decision are considered fiduciaries. The Fiduciary Rule defines recommendation as “a communication that, based on its content, context and presentation, would reasonably be viewed as a suggestion that the advice recipient engage in or refrain from taking a particular course of action.”

What does this mean for Fund Managers?

Due to the broad definition of the term recommendation, this means that fund managers may become subject to ERISA fiduciary obligations simply by communicating with a Benefit Plan investor regarding its decision to invest in or withdraw from a fund, including the decision to maintain or increase an investment in a fund. The Fiduciary Rule does provide some examples of communications that would not be considered investment recommendations, such as general circulation newsletters, remarks and presentations at speeches and conferences, general market data, and performance reports. In contrast, if a fund manager were to recommend a particular fund (including any fund in which it manages), discuss withdrawal or reallocation of funds, or tailor advice to a particular Benefit Plan, such communication would likely be deemed investment advice and subject the manager to ERISA fiduciary obligations.

Safe Harbor

The Fiduciary Rule contains a key safe harbor for Benefit Plan transactions conducted through independent fiduciaries with financial expertise (the “Safe Harbor”). Specifically, fund managers will not be classified as ERISA fiduciaries if:

  1. The fund manager provides the above-described recommendations to an independent fiduciary;
  2. The fund manager knows and receives assurances that the independent fiduciary (i) has the responsibility to act as fiduciary for the Benefit Plan and (ii) appropriate experience and knowledge to do so;
  3. The fund manager discloses to the independent fiduciary that the manager is (i) not undertaking to provide impartial investment advice and (ii) not giving advice in a fiduciary capacity; and
  4. The fund manager receives no compensation in connection with the investor’s decision to invest in the fund.

For the purposes of the Safe Harbor, the Fiduciary Rule defines independent fiduciaries as:

  1. A U.S. regulated and supervised bank;
  2. A U.S. qualified insurance carrier;
  3. A federal or state investment adviser;
  4. A registered broker-dealer; or
  5. An independent fiduciary that holds, manages, or controls assets of at least $50 million.

Options for Fund Managers

Fund managers with mostly larger, institutional clients may elect to solely accept funds from Benefit Plans represented by an expert fiduciary. While this would prevent these fund managers from receiving compensation in connection with the transaction (i.e. investment management fee or finder’s fee), it would still allow the collection of management fees and performance allocations on fund assets. We advise fund managers that solely elect to accept expertly managed Benefits Plans to update their offering documents to include (i) disclosures that the fund manager is not acting as a fiduciary and (ii) representations from each Benefit Plan investor that contain sufficient information to establish the transaction qualifies for the Safe Harbor.

Fund managers that elect to accept non-expertly managed Benefit Plans, however, should take precautions to ensure no advice is given to make or maintain an investment in a fund.  Fund managers that provide such advice may be classified as fiduciaries of these non-expertly managed Benefit Plans, which would subject any management fee and performance allocation to scrutiny under the prohibited transactions provision of Section 4975 of the Code, primarily involving fiduciary conflict of interest issues.  With these considerations in mind, we advise fund managers that elect to accept non-expertly managed Benefit Plans (such as self-directed IRA and 401(k) plans and small ERISA Plans) to do the following:

  1. Assess whether current Benefit Plan investors fall under the Safe Harbor or another exemption. Investments made by Benefits Plans of the owners of a fund manager and “friends and family” investors would not be subject to the Fiduciary Rule if the investors are not paying fees to the fund manager and not subject to a performance allocation.
  2. Review all marketing and communication material to current or prospective investors to ensure that communications could not be perceived as a recommendation to invest maintain an investment in the fund.
  3. Attach or incorporate disclosures into the offering documents that the fund manager is not acting as a fiduciary and that nothing in the offering documents should be construed as ERISA fiduciary investment advice.

While fund managers may elect to take the above-listed precautions, given the uncertainty of how the DOL will enforce the Fiduciary Rule, the wisest option may be to refrain from taking on new Benefit Plan investors and/or taking additional contributions from existing Benefit Plan investors that are not represented by an expert fiduciary. The above-steps are general guidelines, and fund managers that elect to continue to accept capital from non-expertly managed Benefit plans should have their offering and marketing materials reviewed by qualified counsel to ensure the materials do not contain any information that could be deemed an investment recommendation. Even fund managers that solely elect to accept capital from expertly managed Benefit Plans should consult counsel to ensure the terms of the Safe Harbor are met with respect to each Benefit Plan investor.

Future of the Fiduciary Rule

Although the rule has already gone into effect with relaxed oversight, the DOL issued a temporary enforcement policy stating it will not take enforcement action against persons working diligently and in good faith until January 1, 2018. While the DOL has indicated it will not overturn the Fiduciary Rule without legal cause, it has also stated it will continue its review of the Fiduciary Rule during this transitional period. The current administration has voiced strong opposition to the Fiduciary Rule, and the proposed Financial CHOICE Act, which recently passed in the House, could potentially repeal the Fiduciary Rule (although the Act has not garnered much traction in the Senate).

We will continue to closely monitor developments regarding the Fiduciary Rule. In the meantime, feel free to reach out to us if you have any questions concerning the Fiduciary Rule or need assistance updating existing fund subscription documents to address the new rule.

Cryptocurrency Fund Managers: SEC Update

On Tuesday evening the SEC issued a significant report for cryptocurrency fund managers, announcing its determination that blockchain tokens offered and sold by an organization called The DAO were securities, subject to federal regulation. In its report, the SEC analyzed whether The DAO, Slock.it UG (a German corporation), Slock.it UG’s co-founders, and any intermediaries that brokered transactions violated federal securities laws through the issuance of DAO Tokens. Although the SEC ultimately elected not to bring charges or make specific findings regarding the transactions in connection with the issuance of DAO tokens, the SEC provided a cautionary report to all individuals and entities involved with future and past Initial Coin Offerings (ICOs), including cryptocurrency fund managers. Below is a brief background of the emergence of cryptocurrencies and ICOs, a securities analysis framework for ICOs moving forward, and finally our guidance regarding how certain virtual currency participants—particularly cryptocurrency fund managers—should proceed in light of the SEC’s report.

Understanding the terms

Blockchain: Blockchain is an emerging piece of technology that generally serves as a distributed electronic ledger—similar to a database of stored information—that is spread out and maintained by multiple individuals in a network of computers. Blockchain networks utilize cryptography and encryption methods to secure, process, and verify transactions that occur on the blockchain network. Virtual currencies (such as Bitcoin, Ethereum, and Litecoin) utilize blockchain technology to create and verify transactions that occur between users of the virtual currency.

Virtual Currencies (also labeled cryptocurrencies): Virtual currency is a digital representation of value that is issued and controlled by its developers, and used and accepted among the members of a specific (virtual) community. Unlike regular money, it is not issued by a central bank or other banking authority and is therefore called unregulated, decentralized and relying on a system of trust; this trust is typically accomplished through the use of cryptographic methods in blockchain technology. Many virtual currencies are convertible and can be exchanged to “real” money like the US Dollars.

Virtual Tokens or Coins: Virtual tokens or coins are typically units of value for virtual currencies. While virtual tokens or coins may represent other rights such as the right to utilize a product, virtual tokens or coins can often represent a financial interest in an entity or product; the latter potentially constituting a security.

Understanding the ICO

In an ICO, a company or other entity creates specialized virtual coins or tokens that it later distributes using blockchain technology. Individuals and entities that purchase these virtual coins or tokens typically exchange virtual currencies such as Bitcoin or Ether for the ICO company’s virtual coins or tokens. The capital raised in an ICO may go towards funding of a digital program, software, or other project. The virtual tokens or coins issued in an ICO can potentially be utilized by purchasers to access the digital platform, software, or contribute to the project in some capacity.

Where promoters and cryptocurrency fund managers may run afoul of federal securities laws is in situations where the ICO involves a return on investment or an interest in the company. For example, a startup company could potentially raise capital through an ICO; in lieu of issuing stock to investors, it could conduct an ICO and distribute virtual coins or tokens to investors, promising a share of future profits. Investors–including cryptocurrency fund managers–could then sell and purchase the virtual tokens or coins of the ICO for virtual currency or fiat currency (U.S. dollars) via virtual currency exchanges, thus creating a secondary market for the virtual coins or tokens of the ICO.

After the SECs release, the virtual coins or tokens that the company distributed would likely be considered securities subject to federal regulation. In addition, cryptocurrency fund managers purchasing such coins or tokens would need to comply with relevant Investment Adviser Act and Investment Company Act provisions and the virtual currency exchanges would likely be required to register as broker-dealers to avoid violation of federal securities laws.

Securities Analysis

In the SEC’s report, the SEC refrained from laying down concrete rules regarding whether any given ICO constitutes a securities offering. Instead, the Commission stated “[w]hether or not a particular transaction involves the offer and sale of a security— regardless of the terminology used—will depend on the facts and circumstances, including the economic realities of the transaction.” If the facts and circumstances of an ICO constitute the offer and sale of a security, the issuers and promoters of the ICO “must comply with the federal securities laws, including the requirement to register with the Commission or to qualify for an exemption from the registration requirements of the federal securities laws.”

While the facts and circumstances standard does not provide a concrete test, entities looking to conduct an ICO may utilize the securities analysis provided by Coinbase, the first regulated Bitcoin exchange in the United States, to obtain a preliminary understanding of whether a particular ICO may constitute the offer or sale of securities. Based on the Howey Test for whether an arrangement involves an investment contract, the securities analysis can be distilled to the following:

Blockchain tokens with one or more of the following rights are not likely to meet the definition of a security:

1. Rights to program, develop or create features for the system or to “mine” coins or tokens that are embedded in the system;
2. Rights to access or license the system;
3. Rights to charge a toll for such access or license;
4. Rights to contribute labor or effort to the system;
5. Rights to use the system and its outputs;
6. Rights to sell the products of the system; and
7. Rights to vote on additions to or deletions from the system in terms of features and functionality

Conversely, blockchain tokens that provide one or more of the following rights are likely to constitute a security:

1. Ownership interest in a legal entity, including a general partnership;
2. Equity interest;
3. Share of profits and/or losses, or assets and/or liabilities;
4. Status as a creditor or lender;
5. Claim in bankruptcy as equity interest holder or creditor;
6. Holder of a repayment obligation from the system or the legal entity issuer of the Blockchain Token; and
7. A feature allowing the holder to convert a non-security Blockchain Token into a Blockchain Token or instrument with one or more investment interests, or granting the holder an option to purchase one or more investment interests

Conclusions

While the SEC elected to not pursue charges against any individuals or entities that participated in The DAO ICO, this latest development signifies the SEC’s intent to assert its authority to regulate the digital asset and ICO market. Issuers intending on conducting an ICO and exchanges intending on brokering transactions involving virtual coins or tokens will need to consult qualified legal counsel prior to doing so. In addition, U.S. purchasers–including cryptocurrency fund managers–will need to consult qualified legal counsel concerning possible securities implications prior to doing so, including whether to register as an investment adviser and compliance with the Investment Company Act if planning on allocating investor funds toward ICOs and/or other virtual coin or token tractions.

We will continue to update you on further developments concerning blockchain networks, virtual currencies and ICOs. Given that the SEC has determined that an ICO’s status as a security will be decided on a case-by-case basis depending on the underlying facts and circumstances, we advise cryptocurrency fund managers to seek counsel before venturing into the virtual currency space. Please feel free to reach out to us if you have any additional questions about virtual currencies or the SEC’s report.

Regulation CF Update

Last Year, we discussed the SEC’s most recent attempt to implement Title III of the Jumpstart Our Business Startups Act (JOBS Act) through the establishment of a new rule, Regulation Crowdfunding (Regulation CF). Regulation CF became effective on May 16, 2016, and this February the SEC released a white paper outlining Regulation CF offerings initiated in the first six months (May 16, 2016-December 31, 2016).

To recap, Regulation CF allows issuers to raise up to $1 million over a 12-month period from individual investors. Issuers that utilize Regulation CF are required to utilize a funding portal or broker-dealer. Additionally, there are limits to the amount each individual investor can invest. Over a 12-month trailing period, investors with an annual income or net worth of less than $100,000 may invest, among all securities offered under Regulation CF, the greater of (i) $2,000 or (ii) 5% of the lesser of their annual income or net worth. Over a 12-month trailing period, investors with an annual income and net worth of at least $100,000 may invest, among all securities offered under Regulation CF, the lesser of (i) 10% of their annual income and (ii) 10% of their net worth.

From May 15, 2016 through December 31, 2016, there were 163 unique offerings (on a Form C) seeking a target amount of $18 million. While most of the 163 offerings are still ongoing, as of December 31, 2016, 28 offerings filed documents signifying completion (on a Form C-U). Those 28 offerings raised approximately $8 million. Here are additional takeaways from the first six months of Regulation CF:

Characteristics of the Offering

• The average offering set a target of $110,000. The median amount was $53,000.
• Of the 28 offerings that filed a Form C-U, issuers raised an average of $290,000 and a median amount of $171,000 for a total of $8.1 million.
• The average target duration for an offering was 4.5 months.
• Issuers offered equity in 36% of the offerings; debt in 20% of the offerings; and other security types such as units, convertibles, simple arrangements for revenue sharing (SAFEs), and other revenue sharing and membership interests in 44% of all offerings.

Issuer Characteristics

• The average issuer age was 28.7 months (18 months median). 21% of all issuers were incorporated less than three months before initiating an offering.
• Issuers had a median of three employees.
• The median issuer had $43,000 in assets and an average of $210,000 in assets, although 21% of all issuers had no assets.
• The median issuer had $0 in revenue. 60% of all issuers were pre-revenue.
• The average net loss of the most recent fiscal year was $147,900, and only 9% of all issuers generated positive income in their most recent fiscal year.
• The average debt/asset ratio was 5.2; the median was 0.7.

Intermediary Characteristics

• 21 intermediaries participated in Regulation CF offerings (13 funding portals and 8 broker-dealers)
• The top 5 intermediaries (Wefunder Portal LLC, StartEngine Capital LLC, Trucrowd Inc., Nextseed Us LLC, and Dreamfunded Marketplace LLC) constituted 71% of all offerings.
• The average fee as a percent of proceeds for funding portals was 5.1% and the median was 5%. The average fee as a percent of proceeds for broker-dealers was 7.7% and the median was 7%.
• Funding portals took a financial interest in 16% of their offerings. Funding portals took an average 2.4% financial interest in issuers, while broker-dealers took an average financial interest of 5.2%.

Regulation CF appears to be a fairly popular method of raising funds. Issuers utilized Regulation CF in 163 unique offerings in its first six months, compared to Regulation A+’s 147 offerings in its first 16 months. Given the average target amount is $110,000, and the average target offering timetable is 4.5 months, it appears that issuers are electing to utilize Regulation CF for quick access to relatively small amounts of capital.

From the data, we can see that the typical issuer fits into the definition of a startup company. The typical Regulation CF issuer has been in business for less than three years, zero revenue, little to no assets, few employees and moderate amounts of debt. Given the relatively low cost of raising funds (~5-7% intermediary fees), Regulation CF might be the cheapest or most effective method of raising capital until these small, up-and-coming companies can begin to generate revenue.

It will take quite some time to determine the success or failure of Regulation CF. From May 15, 2016 through December 31, 2016, 28 of the 163 offerings filed completion documents, reporting approximately $8 million in raised capital. We will continue to monitor the capital raising activity of Regulation CF as well as the outcome for the issuers that conduct offerings pursuant to Regulation CF.

Please feel free to reach out to us if you have any additional questions or if you think that Regulation CF could be a viable option for your investment offering.

Hedge Fund Marketing Practices: Checking in on Rule 506(c)

The overwhelming majority of hedge funds and private equity funds rely on an exemption from registration found in Rule 506 under Regulation D of the Securities Act. Prior to September 2013, Rule 506 was restrictive in that it required hedge fund managers to establish a pre-existing relationship with investors and placed a firm prohibition on general solicitation and advertising practices.

As we have previously written regarding hedge fund advertising rules, in September 2013 the SEC expanded Rule 506 to include an alternative exempt offering framework. Under new Rule 506(c), issuers may engage in general solicitation and advertising practices when offering securities, provided that all purchasers of the securities are verified (more below) accredited investors. Under the expanded Rule 506 framework, issuers have the option to continue to rely on the original Rule 506 exemption—now found under Rule 506(b)—which still prohibits general solicitation and advertising practices.

Although the establishment of Rule 506(c) removed the general solicitation and advertising prohibition—effectively freeing fund managers to advertise hedge fund offerings through television, newspapers, websites, etc.—relatively few issuers have opted to take advantage of it. In January 2016, SEC Chair Mary Jo White stated that from September 2013 through late 2015, 506(c) offerings only had a $71 billion market as opposed to the $2.8 trillion market for 506(b) offerings. This is likely due in part to the heightened verification requirement of Rule 506(c); whereas Rule 506(b) allows potential investors to self-certify their accredited status, Rule 506(c) requires that issuers take “reasonable steps” to verify the accredited status of each investor. Rule 506(c) sets out three primary methods of verification:

Income: Issuers can review any I.R.S. form that reports the investor’s income for the two most recent years. This includes, but is not limited to, Form W-2, Form 1099, Schedule K-1 to Form 1065, and Form 1040. In addition to I.R.S. forms stating the investor’s income for the two most recent years, an investor must make written representation that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor.

Net Worth: Issuers can review documentation dated within the prior three months to determine whether an investor meets the requisite net worth to qualify as an accredited investor. For assets, issuers can review bank statements, brokerage statements, certificates of deposits, tax assessments, and other appraisal reports by third parties. With respect to liabilities, issuers can utilize a consumer report from a nationwide consumer reporting agency.

Professional Verification: Issuers can obtain written confirmation from persons or entities that have taken reasonable steps to verify the investor is an accredited investor within the prior three months and has determined that the investor is an accredited investor. This includes a registered broker-dealer; an investment adviser in good standing with the SEC; a licensed attorney in good standing under his or his jurisdiction; or a CPA who is registered and in good standing under the laws of the place of his or her residence or principal office.

Although the above-listed safeguards will apply to most new purchasers, the SEC also included a safeguard for issuers that obtain a written certification from an accredited investor who purchased securities pursuant to 506(b) from the issuer prior to September 23, 2013, if that same issuer conducts a Rule 506(c) offering at a later date.

While the heightened verification requirement of Rule 506(c) does require more effort and due diligence on behalf of the issuer, the ability to publicly advertise may help issuers raise additional capital. Rule 506(c) provides the above-listed safe harbors, but the SEC has indicated issuers may be able to satisfy verification obligations through other means. In addition, there has been a rise in independent, third-party verifiers that are willing to conduct accredited investor status verification and certification for issuers in accordance with the Rules.

Please feel free to contact us if you have any questions regarding exempt offerings under Rule 506(c) or other aspects of Regulation D.

Regulation A+ Update

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.

Guest Post: SEC to Examine Compliance with Whistleblower Provisions

As even casual followers of SEC enforcement actions are aware, whistleblower provisions under Dodd-Frank remain a hot-button topic among investment advisers and the investing public in general–the SEC awarded over $57 million to 13 whistleblowers during the 2016 fiscal year, which is more than in all previous years combined. In light of a recent risk alert on the subject issued by the SEC, below is a guest post by Todd Kaplan of Cloudbreak Compliance Group, LLC (“Cloudbreak”), re-posted here with Cloudbreak’s permission. Cloudbreak is a boutique consulting firm that provides fund managers with regulatory compliance support. For more information regarding Cloudbreak’s services, please see their contact information below the post.  

SEC to Examine Compliance with Whistleblower Provisions

On October 24, 2016, the Securities and Exchange Commission (the “SEC”) issued a Risk Alert stating that it is examining advisers’ compliance with key whistleblower provisions under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Whistleblower Provisions”).

As part of this initiative, the SEC will focus on a variety of documents to assess whether they violate the Whistleblower Provisions, including Compliance Manuals, Codes of Ethics, employment agreements and severance agreements.  In particular, the SEC is seeking any provisions that:  (a) purport to limit the types of information that an employee may convey to the SEC or other authorities, and (b) require departing employees to waive their rights to any individual monetary recovery in connection with reporting information to the government.  The Risk Alert highlights certain provisions that may cause concern, including those that:

  • Require an employee to represent that he or she has not assisted in any investigation involving the adviser;
  • Prohibit any and all disclosures of confidential information, without any exception for voluntary communications with the SEC concerning possible securities laws violations;
  • Require an employee to notify and/or obtain consent from the adviser prior to disclosing confidential information, without any exception for voluntary communications with the SEC concerning possible securities laws violations; or
  • Purport to permit disclosures of confidential information only as required by law, without any exception for voluntary communications with the SEC concerning possible securities laws violations.

In light of the Risk Alert, advisers may wish to ensure that they have adopted policies and procedures to comply with the Whistleblower Provisions.

Advisers may also wish to review their Compliance Manuals, Codes of Ethics, employment agreements, severance agreements and any other documents imposing confidentiality obligations on employees to determine whether they contain any provisions that are inconsistent with the Whistleblower Provisions.  Potential remedial actions could include:

  • Revising documents on a going-forward basis to make it clear that nothing contained in them prohibits employees/former employees from voluntarily communicating with the SEC or other authorities regarding possible violations of law or from recovering a SEC whistleblower award;
  • Providing general notice to employees, or notice to employees who signed restrictive agreements, of their right to contact the SEC or other authorities; and
  • Contacting former employees who signed severance agreements to inform them that the company does not prohibit them from communicating with the SEC or seeking a whistleblower award.

For more information regarding Cloudbreak Compliance Group, LLC, please visit their website or contact Todd Kaplan at todd@cloudbreakcompliance.com.


Legal Disclaimer: Cloudbreak is a compliance consulting firm and does not provide legal advice.  This guest post contains general information only.  Cloudbreak is not, by means of this guest post, rendering professional advice or services.  Before making any decision or taking any action that might affect your business, you should consult with your legal counsel and other qualified professional advisers.  This guest post is presented without any warranty or representation as to its accuracy or completeness.  Cloudbreak assumes no responsibility to update this guest post based on events after its publication.

 

Intrastate Crowdfunding Update

On October 26, 2016, the Securities and Exchange Commission (“SEC”) adopted final rules regarding intrastate crowdfunding offerings. The final rules amend Securities Act Rule 147 to update the safe harbor protections under Section 3(a)(11) of the Securities Act, so that issuers may continue to use state law exemptions that are conditioned upon compliance with both Section 3(a)(11) and Rule 147.

As background, the Jumpstart Our Business Startups (“JOBS”) Act was signed into law in 2012, but the SEC did not adopt final rules implementing Title III of the JOBS Act until October 30, 2015. During this regulatory limbo, many states—including Georgia (see below)—decided to jump start the process by enacting their own legislation permitting intrastate offerings in reliance upon the federal exemption.

Each company relying on the federal intrastate offering exemption must (i) be organized in the state where it is offering the securities; (ii) carry out a significant amount of its business in that state; and (iii) make the particular offer and sale of securities only to residents of that state. The issuing company is also responsible for ensuring that securities offered under the intrastate exemption are neither sold to any out-of-state residents nor resold to residents of other states with a certain time-period (typically nine months). Beyond that, the SEC is effectively deferring to the states to oversee intrastate crowdfunding offerings.

With that in mind, all participating states require issuers to do one of the following:

  • register their intrastate securities offering with that state’s securities commission; or
  • qualify for an exemption from state registration.

Although registering securities offerings at the state level is not as costly and onerous as registering securities offerings with the SEC, it can still be a burden. The intrastate crowdfunding exemption can therefore be a useful tool for local businesses looking to raise limited capital from local investors in a cost-effective and timely manner.

To its credit, Georgia was an intrastate crowdfunding pioneer. In 2011, Georgia became the second state (after Kansas) to enact an intrastate crowdfunding exemption when it enacted the Invest Georgia Exemption (“IGE”). Initially, Georgia-based companies could raise up to $1 million through the IGE; however, in October of 2015 Georgia increased the cap to $5 million to address issuer concerns regarding the usefulness of the exemption.

Companies relying on the IGE must meet the following requirements:

  • The issuer is a for-profit business entity formed in Georgia and registered with the Secretary of State;
  • The transaction qualifies for the federal exemption for intrastate offerings in Section 3(a)(11);
  • The issuer raises no more than $5 million from Georgia resident investors; and
  • The issuer accepts no more than $10,000 from each non-accredited investor.

Additionally, an issuer must file a notice—called a “Form GA-1”—with the state securities commissioner before the use of “general solicitation” or the 25th sale of the security, whichever occurs first. The notice must contain the names and addresses of the following persons:

  • The issuer;
  • All persons involved in the offer or sale of securities on behalf of the issuer; and
  • The bank or other depository institution in which investor funds will be deposited.

Each state intrastate exemption is unique. State exemptions may vary with respect to the cap on the amount that can be raised, the amount allowed from each non-accredited investor, the number of non-accredited investors allowed per security offering, whether the security must be offered on an equity crowdfunding portal, etc. To ensure compliance with current intrastate exemptions, we strongly suggest contacting an attorney familiar with these types of offerings.

As always, feel free to contact us should you have any questions regarding this post.

Year-End Compliance Alert for Investment Managers

As we approach the final quarter of 2016, we would like to take this opportunity to remind you of the following legal, regulatory and compliance obligations that may apply to certain investment managers heading into 2017.

Investment Advisers and Exempt Reporting Advisers

Annual Amendment of Form ADV.  Each registered investment adviser (“RIA”) and exempt reporting adviser (“ERA”) must file an annual updating amendment to its Form ADV. The annual amendment must be filed within 90 days of the adviser’s fiscal year-end.

Each RIA must also provide to each client an updated Form ADV Part 2A brochure and a summary of material changes to the brochure, if any (or simply a summary of material changes, if any, accompanied by an offer to provide the updated brochure).

Form PF. An investment adviser must file Form PF if it is registered or is required to be registered with the Securities and Exchange Commission (“SEC”), advises one or more private funds and has at least $150 million in private fund assets under management. Investment advisers must file Form PF on an annual basis within 120 days of the fund’s fiscal year-end.

Investment Adviser Registration Depository (“IARD”) Renewal Fees. Annual renewal fees for SEC and state registered investment advisers as well as SEC ERAs are due to the IARD by December 16, 2016.  Please visit www.iard.com for more information, fee schedules and payment options.

Commodity Pool Operators and Commodity Trading Advisors

Annual Reaffirmation of CPO Exemption. Commodity pool operators (“CPOs”) and commodity trading advisors (“CTAs”) relying on an exemption from registering with the Commodity Futures Trading Commission (“CFTC”) are required to reaffirm their exemption eligibility within 60 days of the calendar year-end.

Forms CPO-PQR and CTA-PR. Registered CPOs and CTAs must file Forms CPO-PQR and CTA-PR, respectively, using the NFA’s EasyFile system. Registered CPOs must file Form CPO-PQR on a quarterly basis within 60 days of the quarters ending in March, June, and September and within 90 days of the calendar year-end. Registered CTAs must file Form CTA-PR on a quarterly basis within 45 days of each quarter-end.

Advisers that are dually registered with the SEC and CFTC may satisfy certain Form CPO-PQR filing requirements when they file Form PF. In order to take advantage of this, the adviser must file Form PF by its Form CPO-PQR deadline.

CPO and CTA Annual Updates. Registered CPOs must distribute an Annual Report to each participant in each pool that it operates, as well as submit a copy of the Annual Report and key financial balances from it to the National Futures Association (“NFA”), within 90 days of the pool’s fiscal year-end. An independent certified public accountant must certify the Annual Report.

Additionally, CPOs and CTAs must prepare and file with the NFA an Annual Questionnaire and Annual Registration Update and pay their NFA membership dues and fees.

Additional Regulatory and Compliance Matters

Verification of New Issues Status.  Fund managers need to conduct an annual verification of each account to ensure investors are eligible to participate in initial public offerings or new issues pursuant to FINRA Rules 5130 and 5131. While the initial verification requires affirmative representations by account holders, FINRA allows subsequent verifications to be completed through the use of negative consent letters.

Annual Privacy Policy Notice.  Each registered investment adviser must provide it investors with a copy of its privacy policy on an annual basis, even if no changes have been made to the privacy policy.

Form D Annual Amendments.  Form D filings for funds maintaining continuous offerings must be amended annually, on or before the anniversary of the Form D filing or the filing of the most recent amendment.  When amending Form D, the fund must update the entire form.

Blue Sky Filings.  Fund managers should review their state blue sky filings to ensure they have met any renewal requirements.

SEC Increase to Qualified Client Threshold Reminder.  On June 14, 2016, the SEC issued an order increasing the dollar amount of the net worth threshold in Rule 205-3 under the Investment Advisers Act of 1940 from $2,000,000 to $2,100,000. Rule 205-3 provides an exemption from the prohibition on performance-based compensation where the client entering into the advisory contract is a “qualified client’ as defined in the rule. As a result, SEC registered investment advisers and certain state registered and exempt advisers subject to the qualified client requirement will need to consult with counsel and update their advisory agreements and fund offering documents prior to the effective date.

Alert: SEC Increases Qualified Client Threshold

On June 14, 2016, the Securities and Exchange Commission (“SEC”) issued an order (“Order”) increasing the dollar amount of the net worth threshold in Rule 205-3 under the Investment Advisers Act of 1940 from $2,000,000 to $2,100,000. Rule 205-3 provides an exemption from the prohibition on performance-based compensation where the client entering into the advisory contract is a “qualified client’ as defined in the rule. Effective August 15, 2016, revised Rule 205-3 will define a “qualified client” as a person that:

• has at least $1,000,000 under the management of the investment adviser immediately after entering into the contract; or
• the investment adviser reasonably believes, immediately prior to entering into the contract, either (i) has a net worth (together, in the case of a natural person, with assets held jointly with a spouse) of more than $2,100,000 or (ii) is a qualified purchaser as defined in section 2(a)(51)(A) of the Investment Company Act of 1940.

Advisers should be relieved to know that the increase in the net worth threshold is not retroactive (i.e. an advisory agreement or subscription agreement for a private investment fund entered into prior to the August 15, 2016 effective date should not be affected by the modification to the qualified client threshold). However, advisory agreements or subscription agreements entered on or after the effective date will be subject to the new threshold.

As a result, SEC registered investment advisers and certain state registered and exempt advisers subject to the qualified client requirement will need to consult with counsel and update their advisory agreements and fund offering documents prior to the effective date. Please do not hesitate to contact us should you have any questions or need assistance making the required updates.

A copy of the Order is available at: https://www.sec.gov/rules/other/2016/ia-4421.pdf.

Regulation Crowdfunding Takes Effect on May 16, 2016

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.

Year-End Compliance Alert for Investment Managers

With 2015 coming to a close, we would like to take this opportunity to remind you of key legal, regulatory and compliance obligations that may apply to you or your clients heading into 2016. As always, please contact us should you have any questions or require assistance with respect to any of the following matters.

Investment Advisers and Exempt Reporting Advisers

Annual Amendment of Form ADV.  Each registered investment adviser (“RIA”) and exempt reporting adviser (“ERA”) must file an annual updating amendment to its Form ADV. The annual amendment must be filed within 90 days of the adviser’s fiscal year end.

Each RIA must also provide to each client an updated Form ADV Part 2A brochure and a summary of material changes to the brochure, if any (or simply a summary of material changes, if any, accompanied by an offer to provide the updated brochure).

Form PF. An investment adviser must file Form PF if it is registered or is required to be registered with the SEC, advises one or more private funds, and has at least $150 million in private fund assets under management. Investment advisers must file Form PF on an annual basis within 120 days of the fund’s fiscal year end.

Commodity Pool Operators and Commodity Trading Advisors

Annual Reaffirmation of CPO Exemption. Commodity pool operators (“CPOs”) and commodity trading advisors (“CTAs”) relying on an exemption from registering with the Commodity Futures Trading Commission (“CFTC”) are required to reaffirm their exemption eligibility within 60 days of the calendar year end.

Forms CPO-PQR and CTA-PR. Registered CPOs and CTAs must file Forms CPO-PQR and CTA-PR, respectively, using the NFA’s EasyFile system. Registered CPOs must file Form CPO-PQR on a quarterly basis within 60 days of the quarters ending in March, June, and September and within 90 days of the calendar year end. Registered CTAs must file Form CTA-PR on a quarterly basis within 45 days of each quarter’s end.

Advisers that are dually registered with the SEC and CFTC may satisfy certain Form CPO-PQR filing requirements when they file Form PF. In order to take advantage of this, the adviser must file Form PF by its Form CPO-PQR deadline.

CPO and CTA Annual Updates. Registered CPOs must distribute an Annual Report to each participant in each pool that it operates, as well as submit a copy of the Annual Report and key financial balances from it to the National Futures Association (“NFA”), within 90 days of the pool’s fiscal year end. An independent CPA must certify the Annual Report.

Additionally, CPOs and CTAs must prepare and file with the NFA an Annual Questionnaire and Annual Registration Update and pay their NFA membership dues and fees.

Additional Compliance Matters

Verification of New Issues Status.  Fund managers need to conduct an annual verification of each account to ensure investors are eligible to participate in initial public offerings or new issues pursuant to FINRA Rules 5130 and 5131. While the initial verification requires affirmative representations by account holders, FINRA allows subsequent verifications to be completed through the use of negative consent letters.

Annual Privacy Policy Notice.  Each registered investment adviser must provide it investors with a copy of its privacy policy on an annual basis, even if no changes have been made to the privacy policy.

Form D Annual Amendments.  Form D filings for funds maintaining continuous offerings must be amended annually, on or before the anniversary of the Form D filing or the filing of the most recent amendment.  When amending Form D, the fund must update the entire form.

Blue Sky Filings.  Fund managers should review their state blue sky filings to ensure they have met any renewal requirements.

Investment Adviser Registration Depository (IARD) Renewal Fees. Annual renewal fees for SEC and state registered investment advisers as well as SEC exempt reporting advisers are due to the IARD by December 12, 2015.  Please visit www.iard.com for more information, fee schedules and payment options.

Please feel free to contact us should you have any questions or require assistance with respect to any of the aforementioned items.

Regulation A+ Update: Final Rules

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.

Texas Passes Crowdfunding Exemption

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.

Year-End Compliance Alert

With 2014 coming to a close, we would like to take this opportunity to remind you of key legal, regulatory and compliance obligations that may apply to you as you transition into 2015.

Investment Advisers and Exempt Reporting Advisers

Annual Amendment of Form ADV.  Each registered investment adviser (“RIA”) and exempt reporting adviser (“ERA”) must file an annual updating amendment to its Form ADV. The annual amendment must be filed within 90 days of the adviser’s fiscal year end.

Each RIA must also provide to each client an updated Form ADV Part 2A brochure and a summary of material changes to the brochure, if any (or simply a summary of material changes, if any, accompanied by an offer to provide the updated brochure).

Form PF. An investment adviser must file Form PF if it is registered or is required to be registered with the SEC, advises one or more private funds, and has at least $150 million in private fund assets under management. Investment advisers must file Form PF on an annual basis within 120 days of the fund’s fiscal year end.

Commodity Pool Operators and Commodity Trading Advisors

Annual Reaffirmation of CPO Exemption. Commodity pool operators (“CPOs”) and commodity trading advisors (“CTAs”) relying on an exemption from registering with the Commodity Futures Trading Commission (“CFTC”) are required to reaffirm their exemption eligibility within 60 days of the calendar year end.

Forms CPO-PQR and CTA-PR. Registered CPOs and CTAs must file Forms CPO-PQR and CTA-PR, respectively, using the NFA’s EasyFile system. Registered CPOs must file Form CPO-PQR on a quarterly basis within 60 days of the quarters ending in March, June, and September and within 90 days of the calendar year end. Registered CTAs must file Form CTA-PR on a quarterly basis within 45 days of each quarter’s end.

Advisers that are dually registered with the SEC and CFTC may satisfy certain Form CPO-PQR filing requirements when they file Form PF. In order to take advantage of this, the adviser must file Form PF by its Form CPO-PQR deadline.

CPO and CTA Annual Updates. Registered CPOs must distribute an Annual Report to each participant in each pool that it operates, as well as submit a copy of the Annual Report and key financial balances from it to the National Futures Association (“NFA”), within 90 days of the pool’s fiscal year end. An independent CPA must certify the Annual Report.

Additionally, CPOs and CTAs must prepare and file with the NFA an Annual Questionnaire and Annual Registration Update and pay their NFA membership dues and fees.

Additional Compliance Matters

Verification of New Issues Status.  Fund managers need to conduct an annual verification of each account to ensure investors are eligible to participate in initial public offerings or new issues pursuant to FINRA Rules 5130 and 5131. While the initial verification requires affirmative representations by account holders, FINRA allows subsequent verifications to be completed through the use of negative consent letters.

Annual Privacy Policy Notice.  Each registered investment adviser must provide it investors with a copy of its privacy policy on an annual basis, even if no changes have been made to the privacy policy.

Form D Annual Amendments.  Form D filings for funds maintaining continuous offerings must be amended annually, on or before the anniversary of the Form D filing or the filing of the most recent amendment.  When amending Form D, the fund must update the entire form.

Blue Sky Filings.  Fund managers should review their state blue sky filings to ensure they have met any renewal requirements.

Investment Adviser Registration Depository (IARD) Renewal Fees. Annual renewal fees for SEC and state registered investment advisers as well as SEC exempt reporting advisers were due to the IARD by December 12, 2014.  Please visit www.iard.com for more information, fee schedules and payment options.

Please feel free to contact us should you have any questions or require assistance with respect to any of the aforementioned items.

General Overview of Swap Transactions

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.

Regulation A+

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.

FATCA Update

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.

JOBS Act Update: The Equity Crowdfunding Improvement Act of 2014

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

JOBS Act Update: CFTC Grants Exemptive Relief Permitting General Solicitation and Advertising

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.



[1]  Provides CTFC registration exemption for CPOs who operate pools meeting certain enumerated “de minimis” requirements

 

[2] Provides exemption from certain of the disclosure, reporting and recordkeeping requirements applicable to registered CPOs)

 

JOBS Act Update: Proposed Crowdfunding Rules Nearer to Adoption

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.

Jobs Act Update: SEC Approves Final Rules Removing the General Solicitation and Advertising Ban for Private Offerings

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.

California: An Illustrative Example of Dodd-Frank’s Impact upon Investment Advisers at the State Level

Although most investment advisers are aware of the adjusted thresholds for federal and state registration under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”), one of the ongoing challenges for advisers is complying with registration requirements at the state level, especially as state regulators scramble to recalibrate their investment adviser laws to better comport with federal law. Each state presents its own unique, evolving set of registration requirements and available exemptions from registration to advisers prohibited from registering with the Securities and Exchange Commission (“SEC”) (generally advisers with less than $100 million in assets under management (“AUM”)) and with a place of business in the state. With that in mind, it is especially important in the post-Dodd-Frank regulatory environment that advisers remain informed and up-to-date with respect to applicable state requirements.

Take California, for example. Prior to Dodd-Frank, California-based advisers avoided registration by a state analogue to a federal exemption. The exemption allowed a private advisor that did not hold itself out to the public as an investment adviser and had fewer than fifteen clients in the preceding twelve months to avoid registration, provided that the advisor had at least $25 million in AUM. Dodd-Frank repealed the federal exemption, which led to a state-level abandonment of the exemption, as well. Many states, including California, sought to create a replacement rule to exempt private funds from registration. On August 27, 2012 the California Department of Corporations (“CDC”) adopted a new exemption from the state’s investment adviser registration requirements for advisers to only “qualified private funds.”[1]

Qualifying private funds include any fund relying on the exemptions from registration found in Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940, as amended, as well as venture capital funds.[2] The adviser seeking exemption must only manage qualifying funds; any non-qualifying funds or managed accounts prevent the adviser from seeking exemption under the private fund exemption.

Additionally, private funds must be owned entirely by accredited investors and provide audited annual reports by an independent accountant. Further, a private fund adviser may only rely on the exemption if:

  • neither the adviser nor its advisory affiliates have any “bad actor” disqualifications;
  • the adviser files a truncated Form ADV for exempt reporting advisers with the CDC; and
  • the adviser pays the required registration and annual renewal fees.

In addition, an investment advisers relying on a now-defunct exemption is grandfathered in to the foregoing exemption provided that the adviser stops selling interests in applicable funds to non-accredited investors, does not charge performance fees to subsequent non-qualified clients, and complies with all relevant registration and reporting requirements.

Keep in mind that the foregoing analysis is a high-level overview of the new exemption and its impact upon affected advisers only. For a more comprehensive analysis of updated investment adviser laws and their potential impact on your firm – whether based in California or another affected state – please feel free to contact us for a free consultation.



[1] The full revision text is available at http://www.corp.ca.gov/Regulations/Licensees/1811B.pdf.

[2] Jason Wallace, IA brief: California broadens scope of private-adviser exemption, Reuters, Sept. 12 2012; available at http://blogs.reuters.com/financial-regulatory-forum/2012/09/12/ia-brief-california-broadens-scope-of-private-adviser-exemption/

Financial Transaction Tax

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.



[1] A FTT is also commonly known as a “Tobin tax” after the economist who put forward a contemporary justification for its existence.

[2] Interestingly, Great Britain actually has a transaction tax called the “stamp tax.” Any transfer of a “stock or marketable security” is subject to the tax, subject to certain caveats. See Section 4.7 at http://www.hmrc.gov.uk/so/manual.pdf.

[3] EU Proposed Council Decision: available at http://ec.europa.eu/taxation_customs/resources/documents/taxation/com_2012_631_en.pdf.

[4] EU Proposed Council Decision: available at http://ec.europa.eu/taxation_customs/resources/documents/taxation/com_2012_631_en.pdf.

[5] A helpful analogy may be to consider the state/federal dynamic in the United States. On issues where the federal government has not decisively spoken, like gay marriage rights, states are free to enact their own policies to the extent they do not contradict federal law.

[6] See Ernst & Young FTT Implications Report: available at http://www.ey.com/Publication/vwLUAssets/Financial_Transaction_Tax_implications_for_banks/$FILE/FTT_flyer_01.pdf.

[7] See Crowe Horwath: The Expected Italian Financial Transaction Tax: available at http://www.crowehorwath.net/uploadedFiles/IT/news/121109%20FTT%20Alert(1).pdf; European Voice, Italy and Spain Back Financial Transaction Tax, available at http://www.europeanvoice.com/article/2012/october/italy-and-spain-back-financial-transaction-tax/75333.aspx.

[8] See Ernst & Young FTT Implications Report: available at http://www.ey.com/Publication/vwLUAssets/Financial_Transaction_Tax_implications_for_banks/$FILE/FTT_flyer_01.pdf.

[9] Compare France’s recent FTT with the EU proposal’s scope. EU Executive Summary of the Impact Assessment of a Financial Transaction Tax, Section 7.1-3: available at http://ec.europa.eu/taxation_customs/resources/documents/taxation/other_taxes/financial_sector/summ_impact_assesmt_en.pdf.

Presence Exams

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.



[1] Newly registered advisers are advisers that registered with the SEC after Dodd-Frank’s effective date: July 21, 2011.

[2] See the SEC General Letter introducing the Presence Exam (“General Letter”): http://www.sec.gov/about/offices/ocie/letter-presence-exams.pdf.

JOBS Act Update: Senator Levin Throws a Curve

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.

JOBS Act Update: SEC Releases Proposed Rules

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.

JOBS Act update

(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.

JOBS Act Interview

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.

Investment Adviser Registration Requirements in 2012

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.

Access to Capital for Job Creators Act

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 3rd 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.

Form PF

As part of the ongoing effort to provide greater transparency to the investment management industry in the wake of the financial crisis of 2008, earlier this year the Securities and Exchange Commission (“SEC”) and the Commodity Futures Trading Commission (“CFTC”) proposed Rule 204(b)-1 under the Investment Advisers Act of 1940.  Significantly, Rule 204(b)-1 requires SEC registered investment advisers to report information about private funds on newly developed Form PF, marking a major sea change in the regulatory oversight of hedge funds and other private investment funds.

On October 26, 2011, the SEC voted to adopt the version of Rule 204(b)-1 summarized below (the CFTC is expected to vote on the rule shortly, after which a jointly approved final rule can be released).  Due to intense lobbying from hedge fund advocacy groups, several important concessions are reflected in the current version of the rule.

Initial reports on Form PF will be required in two stages: (1) Advisers with $5 billion or more in assets under management (“AUM”) must file the initial form within 60 days of the quarter ending June 30, 2012; and (2) advisers with AUM of $150 million or more but less than $5 billion must file the initial form within 60 to 120 days of the end of 2012.

Form PF will be filed with the SEC through the Financial Industry Regulatory Authority (“FINRA”), the largest independent regulator for all securities firms doing business in the U.S. and the operator of the Investment Adviser Registration Depository (“IARD”).  FINRA will impose a $150 filing fee for each Form PF annual/quarterly update.

We will provide further analysis of the final rule once it has been released.  In the interim, managers of private funds are encouraged to begin familiarizing themselves with Form PF in preparation for the rule’s implementation.  Proposed Form PF can be found here.  Although smaller fund advisers will initially be unaffected by the enhanced reporting requirements of Form PF, such managers should be mindful of the increased transparency initiative nonetheless, especially as states continue to track changes in federal securities laws at the state level.

Please contact us if you have any questions regarding Form PF or its potential impact on fund managers.

Regulation D

Hedge funds are typically structured as private placements in order to avoid registering their interests under the Securities Act of 1933 (“Securities Act”).  In particular, Section 4(2) of the Securities Act exempts from registration transactions not involving any public offering.  However, the availability of the Section 4(2) exemption is subjective and, at times, ambiguous.  To better clarify the availability of the Section 4(2) exemption, the Securities and Exchange Commission (“SEC”) adopted Regulation D (“Reg D”), a collection of certain safe harbor exemptions from registration of private offerings that effectively serve as the backbone of the “private placement exemption.”

Reg D provides three alternative safe harbors in Rules 504, 505, and 506; however, Rule 506 is generally the most relevant exemption for private funds, as it allows funds to offer securities without regard to the dollar amount of the offering. Below is a brief description of Rules 501 through 506.

Rule 501 – Definitions and Terms Used in Regulation D

Rule 501 provides definitions of certain terms found in Rules 502 to 508, most notably the definition of an “accredited investor.”

Rule 502 – General Conditions to Be Met

Rule 502 details the conditions private funds must meet to qualify for a Reg D exemption, including integration issues, information requirements and limitations on resale.  However, the most relevant condition for fund managers is typically the limitation on the manner of the offering, which prohibits any form of general solicitation or general advertising of the underlying securities.  The solicitation and advertising restrictions are an integral aspect of all Reg D offerings, and should be discussed in detail with a qualified hedge fund attorney prior to marketing the fund.

Rule 503 – Filing of Notice of Sales

Rule 503 requires a private fund relying on Reg D to file a notice of sale on Form D with the SEC within fifteen days after the first sale of an interest in the fund.  Although states cannot require a private fund to register its Rule 506 offering with them, states can require notice filings (typically a copy of Form D) and associated filing fees under applicable Blue Sky laws.

Rule 504 – Exemption for Limited Offers and Sales of Securities Not Exceeding $1,000,000

Rule 504 provides an exemption for the offer and sale of up to $1,000,000 of securities over any 12-month period.  Rule 504 applies primarily to certain intrastate offerings.

Rule 505 – Exemption for Limited Offers and Sales of Securities Not Exceeding $5,000,000

Rule 505 provides an exemption for the offer and sale of up to $5,000,000 of securities over any 12-month period. Issuers may sell securities to an unlimited number of accredited investors plus no more than 35 non-accredited investors.

Rule 506 – Exemption for Limited Offers and Sales Without Regard to Dollar Amount of Offering

Rule 506 provides an exemption for the offer and sale of securities without regard to the dollar amount of the offering. For this reason, the vast majority of hedge funds and private equity funds rely on the Rule 506 exemption from registration.  Rule 506 is similar to Rule 505 in that funds may issue securities to an unlimited number of accredited investors and up to 35 non-accredited investors. Often referred to as the “sophistication” element, Rule 506 requires non-accredited investors to have “such knowledge and experience in financial and business matters that [they are] capable of evaluating the merits and risks of the prospective investment.”

Please contact us for a free consultation if you have any questions regarding Regulation D or starting a fund in general.

Commodity Pool Operator and Commodity Trading Advisor Registrations

Pursuant to the Commodity Exchange Act (“CEA”), advisers who utilize futures contracts, options on futures or retail off-exchange forex contracts in their trading programs are generally required to register as a commodity pool operator (“CPO”) and/or commodity trading advisor (“CTA”), as appropriate, unless they qualify for an available exemption from registration.  This article provides a general overview of the CPO/CTA registration process.

A CPO is an individual or organization which operates and solicits funds for a commodity pool, including a hedge fund that trades futures contracts, options on futures or retail off-exchange forex contracts.  A CTA is more broadly defined to include an individual or organization which, for compensation or profit, advises others as to the value of or the advisability of buying or selling futures contracts, options on futures or retail off-exchange forex contracts.  In other words, a CPO is most always also a CTA by definition, whereas an individual or organization may be a CTA and not a CPO.  The key distinction is whether the adviser manages a pooled investment vehicle.

(Note: Prior to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”), off-exchange retail forex was excluded from the jurisdiction of the Commodity Futures Trading Commission (“CFTC”).  However, in large part prompted by Dodd-Frank, the CFTC published final rules on August 30th, 2010 effectively making off-exchange retail forex markets subject to regulation by the CFTC and National Futures Association (“NFA”).  Advisers to funds and/or separate managed accounts who utilize forex trading and have not become registered CPOs and/or CTAs (or filed an available exemption) could be subject to significant sanctions, and should consult a qualified hedge fund attorney immediately to begin undertaking appropriate compliance measures.)

All registered CPOs and CTAs who manage or exercise discretion over customer accounts must be Members of NFA.  In addition, all CPO/CTA registrants are required to file the following:

  • A completed online Form 7-R;
  • A non-refundable $200 application fee; and
  • Membership dues (if applicable) of $750.

CPO/CTA registrants must also file applications for its Principals and Associated Persons that include the following:

  • A completed online Form 8-R;
  • Fingerprint cards;
  • Proficiency requirements (generally, a passing score on the Series 3 exam); and
  • A non-refundable $85 application fee for each Principal and Associated Person.

Lastly, all CPO/CTA registrants engaged in retail off-exchange forex are also required to:

  • Apply to become a forex firm by completing online Form 7-R; and
  • Have at least one Principal that is also an approved Forex Associated Person.

Please contact us for a free consultation if you have any questions regarding the CPO/CTA registration process.

Form D

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.

Investment Adviser Registration

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.

State Blue Sky Regulation

At the federal level, sales of securities are subject to the Securities Act of 1933 (“Securities Act”) and the SEC rules enacted thereunder.  Sales of securities are also regulated at the individual state level under state securities laws, often called “Blue Sky” laws.  Each state’s respective Blue Sky laws apply to offers and sales of securities within the state.

Although states are prohibited from requiring the registration of securities exempt from registration under the Securities Act, states may require issuers of securities to make notice filings concerning the securities they sell.  These required notice filings, often called “Blue Sky Notice Filings,” inform each state’s securities division of the type of business being conducted (directly or indirectly) within the state.  Hedge funds must make a Blue Sky Notice Filing in each state in which one of its investors resides.  In most cases, Blue Sky Notice Filings must be made with respect to a fund within fifteen days of the date of first sale within each state.  New York, a notable exception, requires that a Blue Sky “pre-filing” be made before any securities are sold within the state.

Before making a Blue Sky Notice Filing on your behalf, most hedge fund attorneys will require that you provide them with the following: 1) each investor’s name; 2) each investor’s state of residence; 3) the amount of each investor’s investment(s); and 4) the date of first sale within each state.

Blue Sky Notice Filings can be an extensive and complicated process, especially since each state imposes its own requirements and fees.  For reference, below are the respective Blue Sky Notice Filing fees and form requirements for each state as of the date of this post:

Alabama

Filing Fee: $300

Required Form(s): Manual Form D

Alaska

Filing Fee: $600-$1,100

Required Form(s): Electronic Form D

Arizona

Filing Fee: $250

Required Form(s): Electronic Form D

California

Filing Fee: $300

Required Form(s): Electronic Form D, Form U-2

Colorado

Filing Fee: $75

Required Form(s): Electronic Form D with original signature

Connecticut

Filing Fee: $150

Required Form(s): Electronic or Manual Form D

Delaware

Filing Fee: None

Required Form(s): Electronic Form D, Form U-2

Florida

*No Blue Sky Notice Filing Required*

Georgia

Filing Fee: $250

Required Form(s): Electronic Form D, Form U-2

Hawaii

Filing Fee: $100

Required Form(s): Electronic or Manual Form D, Form U-2

Idaho

Filing Fee: $50

Required Form(s): Electronic Form D, Form U-2

Illinois

Filing Fee: $100

Required Form(s): Electronic Form D

Indiana

Filing Fee: None

Required Form(s): Manual Form D

Iowa

Filing Fee: $100

Required Form(s): Electronic Form D, Form U-2

Kansas

Filing Fee: $250

Required Form(s): Electronic or Manual Form D

Kentucky

Filing Fee: $250

Required Form(s): Electronic Form D, Form U-2

Louisiana

Filing Fee: $300

Required Form(s): Electronic Form D, Form U-2

Maine

Filing Fee: $300

Required Form(s): Electronic Form D, Form U-2

Maryland

Filing Fee: $100

Required Form(s): Electronic Form D, Form U-2

Michigan

Filing Fee: $100

Required Form(s): Electronic Form D

Minnesota

Filing Fee: $100 +

Required Form(s): Electronic Form D, Form U-2

Mississippi

Filing Fee: $300

Required Form(s): Electronic or Manual Form D, Form U-2

Missouri

Filing Fee: $100

Required Form(s): Electronic Form D

Montana

Filing Fee: $200 +

Required Form(s): Electronic Form D, Form U-2

Nebraska

Filing Fee: $200

Required Form(s): Electronic Form D

Nevada

Filing Fee: $500

Required Form(s): Electronic or Manual Form D

New Hampshire

Filing Fee: $500

Required Form(s): Form

New Mexico

Filing Fee: $350

Required Form(s): Electronic Form D with authentication email, Form U-2

New York

Filing Fee: $1,200 (NYS Dept. of Law), $35 & $150 (Department of State)

Note: Must be paid with 3 separate checks

Required Form(s): Electronic Form D, Form U-2 (one original, one copy)

North Carolina

Filing Fee: $350

Required Form(s): Electronic Form D

North Dakota

Filing Fee: $100

Required Form(s): Electronic Form D

Ohio

Filing Fee: $100

Required Form(s): Electronic Form D, Form U-2

Oklahoma

Filing Fee: $250

Required Form(s): Electronic Form D, Form U-2

Oregon

Filing Fee: $250

Required Form(s): Electronic Form D

Rhode Island

Filing Fee: $300

Required Form(s): Electronic Form D, Form U-2

South Carolina

Filing Fee: $300

Required Form(s): Electronic Form D

South Dakota

Filing Fee: $250

Required Form(s): Electronic Form D

Tennessee

Filing Fee: $500

Required Form(s): Electronic Form D

Texas

Filing Fee: up to $500

Required Form(s): Electronic Form D

Utah

Filing Fee: $100

Required Form(s): Electronic or Manual Form D with original signature

Vermont

Filing Fee: $600

Required Form(s): Electronic Form D, Form U-2

Virginia

Filing Fee: $250

Required Form(s): Electronic or Manual Form D

Washington

Filing Fee: $300

Required Form(s): Electronic Form D

West Virginia

Filing Fee: $125

Required Form(s): Electronic Form D, Form U-2

Wisconsin

Filing Fee: $200

Required Form(s): Electronic Form D

Wyoming

Filing Fee: $200

Required Form(s): Electronic Form D with original signature underneath electronic signature

 

Please contact us if you would like assistance with your fund’s Blue Sky Notice Filings or have any questions regarding the process in general.

SEC Order Raises Performance Fee Thresholds

On July 12, 2011, the Securities and Exchange Commission (“SEC”) approved an order (“Order”) increasing the dollar amount thresholds necessary for an investor to qualify as a “qualified client” under Rule 205-3 under the Investment Advisers Act of 1940 (“Advisers Act”).  A “qualified client” is currently defined under Rule 205-3 as an investor that (i) has at least $750,000 in assets under management with the investment adviser or (ii) has a net worth of more than $1.5 million.  The Order carries out a requirement of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) to adjust the respective thresholds for inflation.

Effective September 19, 2011, the assets under management requirement will be increased to $1 million and the net worth requirement will be increased to $2 million.  SEC registered investment advisers (and many state registered investment advisers) are precluded from charging performance-based compensation to investors that are not qualified clients.  As such, the increased thresholds will significantly inhibit the ability of affected advisers to charge performance-based compensation to certain investors.

Advisers affected by the Order should contact qualified legal counsel immediately to confirm compliance with the increased thresholds and assure that all subscription agreements and investment management agreements are updated accordingly.  Absent further guidance from the SEC, we do not currently believe that existing investors with an affected adviser will need to be recertified as qualified clients, provided such investors do not contribute additional capital to the adviser after September 19, 2011.

The Order can be read in its entirety here.

If you have any questions regarding this alert or related matters, please contact us today.