Developments in Securities Regulation, Corporate Governance, Capital Markets, M&A and Other Topics of Interest. MORE

The SEC Division of Investment Management has provided guidance regarding the application of the exemption from investment adviser registration available to an investment adviser that advises solely one or more “venture capital funds” as defined in Rule 203(l)-1 of the Advisers Act (the “VC Exemption”).

The guidance clarifies, among other things:

  • Venture capital advisers may have multiple private funds participating in any given portfolio company investment. For example, two venture capital funds with the same adviser (or advisers that are “related persons”) may each invest in the same portfolio company. They may do so through a single intermediate holding company that is not wholly owned by either of the funds, but rather is wholly owned by the two funds collectively. The Division will not object if an intermediate holding company is wholly owned collectively by more than one venture capital fund advised by the same investment adviser (or its related persons).
  • Venture capital advisers will often accommodate U.S. tax-exempt and non-U.S. investors by forming an alternative investment vehicle (“AIV”) that is separate from the venture capital fund and that will elect to be taxed as a corporation. The Division will not object if an adviser relying on the VC Exemption disregards alternative investment vehicles when determining whether it can meet the requirements of the VC Exemption provided that the AIV is formed solely to address investors’ tax, legal or regulatory concerns and such AIV is not intended to circumvent the VC Exemption’s general limitation on investing in other investment vehicles.
  • The guidance discusses investments acquired by the adviser during fund raising and later transferred to a venture capital fund, referred to as “Warehoused Investments.” The Division will not object to an adviser treating a Warehoused Investment as if it were acquired directly from the qualifying portfolio company for purposes of the definition of “venture capital fund” under Rule 203(l)-1 of the Advisers Act provided that: (i) the Warehoused Investment is initially acquired by the adviser (or a person wholly owned and controlled by the adviser) directly from a qualifying portfolio company solely for the purpose of acquiring the investment for a prospective venture capital fund that is actively fundraising; and (ii) the terms of the Warehoused Investment are fully disclosed to each investor in the venture capital fund prior to each investor committing to invest in the fund.
  • The Division also gives guidance on the use of “side funds” and, at the end of a fund’s life, liquidating trusts.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

When implementing SEC Exchange Act Rule 10C-1 regarding the independence of compensation committee members, Nasdaq adopted a prohibition on the receipt of compensatory fees by compensation committee members, which is the same standard applicable to audit committee members under Nasdaq’s listing rules and Rule 10A-3 under the Exchange Act.

Over the past few months, however, Nasdaq has received feedback from listed companies and others that the prohibition on compensatory fees creates a burden on issuers at a time when regulatory burdens are higher than ever before.  For example, there are companies in some industries (e.g., the energy and banking industries) where it is common to have directors who do a de minimis amount of business with the issuer and would, therefore, be ineligible to serve on the compensation committee under the Nasdaq rules.  These companies may have difficulty recruiting a sufficient number of eligible directors to serve on their boards, given the different requirements for board, audit committee and compensation committee composition.

After weighing these comments, Nasdaq has proposed to remove the prohibition on the receipt of compensatory fees by compensation committee members. Nasdaq proposes to state instead that in affirmatively determining the independence of any director who will serve on the compensation committee, a company’s board must consider the source of compensation of the director, including any consulting, advisory or other compensatory fee paid by the company to the director.

In IM-5605-6, Nasdaq also proposes to state that when considering the sources of a director’s compensation in determining independence for purposes of compensation committee service, the board should consider whether the director receives compensation from any person or entity that would impair the director’s ability to make independent judgments about the company’s executive compensation.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

The Consumer Financial Protection Bureau, or CFPB, has issued a report entitled “Understanding the Effects of Certain Deposit Regulations on Financial Institutions’ Operations: Findings on Relative Costs for Systems, Personnel, and Processes at Seven Institutions.” The report is a step by the CFPB to collect and evaluate information on the benefits, costs, and impacts of certain deposit regulations.

Among other things, the study found the two smallest institutions included in the study had in-scope compliance costs of about 4% and 6%, respectively, of their estimated total retail deposit operating expense. The five largest study participants incurred costs to comply with the same regulations roughly equal to 1% to 2% of their estimated total retail deposit operating expenses.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

The SEC has adopted rules prohibiting “bad actors” from using Rule 506 after September 23, 2013 (the effective date of the rules), or if prohibited conduct occurred prior to the effective date of the rules, the prohibition will not apply if disclosure of the past prohibited conduct is made to investors a reasonable amount of time prior to the sale of securities. Since public companies often rely on Rule 506 for financing transactions, it seems logical that many would want to update their D&O questionnaires for the bad actor provisions to ensure that the 506 exemption is available going forward and to cure through disclosure past prohibited conduct by the applicable covered persons.

Public companies are currently required to make disclosure about directors’ and officers’ prior  criminal convictions, securities law violations and other matters in proxy statements pursuant to Item 401(f) of Form S-K.  While similar to many of the “bad actor” events, Item 401(f) was separately drafted at a different time.  The result is two parallel sets of background questions drafted in separate styles that are similar enough to be repetitive but dissimilar enough to be difficult to combine in a way that makes sense.

One way to update D&O questionnaires is to just paste the bad actor questions after the 401(f) questions.  It is a valid choice and may be the easiest way to go, and easier to monitor for annual updates.  However it results in one set of questions regarding a seemingly loosely related and arbitrary series of events for 401(f) being followed by another set of questions regarding another seemingly loosely related and arbitrary series of events for Rule 506, the cumulative effective of which is to make it look like all of the events are posted in random order.

The other way to do it is to try and group similar Item 401(f) events with similar Rule 506 events, or better yet combine and consolidate related questions.  While easily said, it is difficult to execute.  Since both rules aggregate multiple, highly specific events within a single question, this approach results, as we have tried to implement it, in probably more questions being asked, albeit in maybe a more understandable format.

You can find a sample of both forms of updates that we have prepared here.  We have posted the Word version (or at least tried).  Whatever approach you choose, we suggest the questionnaire be given not only to current officers and directors, but potential officers and directors, and present and potential security holders and others that could potentially trip the “bad actor” rules.

If you have any ideas, suggestions for improvements, or corrections, please forward them to stephen.quinlivan@leonard.com.

We have also updated our Preliminary 2014 Proxy Checklist which you can find here.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

Some issuers who are required to progress far enough down the conflict minerals decision tree may be unable, after performing due diligence, to determine whether conflict minerals in relevant products financed or benefitted armed groups.  While such issuers will still be required to file a conflict minerals report, for a period of time those issuers will be able to describe their products as “DRC conflict undeterminable.”  Under the conflict minerals rules, issuers that use the “DRC conflict undeterminable” designation will not be required to include an independent private sector audit in their conflict minerals report.  However, if the “DRC conflict undeterminable” designation is used, issuers will be required to provide a description of the products, the facilities used to process the necessary conflict minerals in those products, if known, the country of origin of the necessary conflict minerals in those products, if known, and the efforts to determine the mine or location of origin with the greatest possible specificity.

The purpose of the “DRC conflict undeterminable” designation is to:

  • Allow time for viable tracking systems to be put in place and avoid a de-facto embargo on conflict minerals from the DRC and other covered countries
  • Lead to more accurate disclosure, as the alternative would be to state the products have not been found to be “DRC conflict free”
  • Avoid the situation in which virtually all issuers would describe their products as having not been found to be “DRC conflict free” simply because they could not determine the origin of their conflict minerals

As the due date for the first conflict minerals report approaches, many issuers may greet the use of the “DRC conflicts undeterminable” designation with a sigh of relief.  However, as pointed out in this blog by The Elm Consulting Group, the ability to use the designation may be accompanied by many perplexing questions, such as “Is the “Undeterminable” status negated if a company has reasonable information about the sourcing status of only one metal in a product, or is “Undeterminable” linked to knowledge of all the conflict minerals in a product?”  Issuers are therefore urged to think carefully and monitor regulatory developments.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

The staff of the Office of Credit Ratings of the SEC has submitted a study  under Section 939C  of the Dodd-Frank Wall Street Reform and Consumer Protection Act to the Committee on Banking, Housing, and Urban Affairs of the U.S. Senate and the Committee on Financial Services of the U.S. House of Representatives.

The report is divided into Part One and Part Two. Part One, including Sections I through V, describes the study  required by Section 939C on the independence of nationally recognized statistical rating organizations, or NRSROs, and how such independence affects ratings issued by the NRSROs; describes the annual examinations of NRSROs; identifies the current NRSROs; and reviews the U.S. and foreign regulatory backdrop for the provision of ancillary services by the credit rating industry and conflicts of interest with respect thereto.

Part Two of the report, including Sections VI through X, includes an overview of the ancillary services provided by the NRSROs and the potential conflicts of interest involved; reviews, on an entity-by-entity basis, the details of the ancillary services provided by the NRSROs and the applicable policies and procedures which have been publicly disclosed by the NRSROs; describes certain self-enforcement measures taken by NRSROs with respect to such policies and procedures; describes the results of relevant essential findings from recent annual NRSRO examinations; considers comparable conflicts of interest; and offers related conclusions and recommendations.

The report concludes by noting the essential findings (which are limited in number) in the NRSRO exam reports relating to certain NRSROs’ management of conflicts of interest involving ancillary services do not suggest that NRSROs generally have been unable to manage such conflicts of interest through their existing policies and procedures. Accordingly, at this time, the SEC staff does not believe that it is warranted to recommend to the SEC changes to the rules on an NRSRO’s providing ancillary services to issuers for which it also provides a rating.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

 

 

On November 6, 2013, the Commodity Futures Trading Commission filed suit against Donald R. Wilson and his company, DRW Investments, for “banging the close” and “spoofing” the IDEX USD Three-Month Interest Rate Swap Futures Contract (the “Three-Month Contract”) from January 2011 through August 2011. See CFTC Banging the Close and Spoofing pdf.

DRW Investments took a $350 million bilateral position in the Three-Month Contract. In taking that position, they believed that the contract was undervalued—that its value would rise. It did not. At that point, according to the suit, Wilson and DRW “took matters into their own hands.”  CFTC Suit at 3

Understanding the alleged manipulative conduct, requires understanding that (1) the method for valuing the Three Month Contract was dependent on bids during a pre-set 15-Minute PM Settlement Period [between 2:45 p.m. and 3:00 p.m. ET] and (2) in the absence of activity during this Settlement Period, values would default to prevailing interest rates, so-called Corresponding Rates. According to the suit, “the methodology [for determining value] was dependent upon various data including bids and offers for the Three-Month Contract that were electronically placed by market participants on the NFX [NASDAQ OMX Futures Exchange] to the extent that any [bids or offers] were placed or pending during preset 15-minute, PM Settlement Period each day….If no bids or offers were electronically placed or pending during the time period, then, for many of the contracts it listed, IDCH [International Derivatives Clearinghouse] would generally default to setting its daily settlement rates, i.e., the IDEX curve [the daily settlement rates of the Three-Month Contract for various maturities] to be same as the prevailing interest rates in corresponding bilateral interest markets specified in the IDCH’s [International Derivatives Clearinghouse] (“Corresponding Rate(s)”).  CFTC Suit at 2-3.

According to the CFTC, to prevent prices from defaulting to the Corresponding Rates (and to increase their profits from values higher than the Corresponding Rates), Wilson and DRW “banged the close” and “spoofed” the 15-minute PM Settlement Period from January 2011 to August 2011.  They “banged the close” by repeatedly placing bids [nearly 60% of the bids and on 13 days all their bids] during the Settlement Period.

They “spoofed” by entering into those bids with no intent of consummating those transactions. According to the CFTC, DRW cancelled those bids after prices were set during the Settlement Period so that “DRW would [not] have to actually enter into a futures contract and pay the higher rates that it bid.” Id. “In fact,” according to the CFTC, “none of DRW’s electronic bids were accepted or “hit” to consummate an actual transaction.  Yet, all of its bids during the PM Settlement Period pushed the Three-Month Contract settlement prices higher than they would have been in the absence of DRW’s bids.” Id.

At least two red flags got the attention of the CFTC.

  1. An illiquid market.  According to one DRW trader, the Three Month Contract was the “ultimate of illiquid products.”  CFTC Suit at 20.
  2. Activity inconsistent with a prior period.  According to the CFTC, DRW did not have the capacity to place the bids on the NFX directly and so on January 21, 2011, they hired Sky Road LLC.  According to the CFTC suit, DRW “had no business purpose for retaining Sky Road other than to carry out the manipulative scheme.” CFTC Suit at 16.

In commenting on the suit, acting CFTC Enforcement Director Gretchen Lowe, said, “Traders cannot engage in manipulative acts to affect the price of futures contracts to achieve their desired profits, regardless of the so-called motive [apparently a reference to DRW protecting a position.]   Today’s action demonstrates that the Commission [the CFTC] will vigorously prosecute such cases to protect the integrity of the markets.”

Rule 206(4)-5(a)(1) under the Investment Advisers Act prohibits a registered investment adviser from providing investment advisory services for compensation to a government entity within two years after a contribution to an official of the government entity is made by the investment adviser or any covered associate of the investment adviser.  This is the so called “pay-to-play” rule.  Rule 206(4)-5(e) provides that the SEC may exempt an investment adviser from the prohibition under Rule 206(4)-5(a)(1) upon consideration of several factors.

An adviser to a hedge fund applied for an exemption on October 16, 2012 as a result of a campaign contribution to a public official, and an amended and restated application was filed on July 5, 2013.  The contribution to which the application for exemption related occurred in May 2011.

The adviser stated the violation was inadvertent and represented it had taken extensive steps to implement additional compliance procedures.  The violation was discovered by the adviser through routine compliance testing.

An escrow account was established.   All fees paid from the clients’ capital accounts in the hedge fund for the two-year period beginning on May 22, 2011 were paid into the escrow account while the application was pending.

On November 13, 2013, an exemption from Rule 206(4)-5(a)(1) under the Advisers Act was granted.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

Congress is working to reconcile differing versions of legislation to implement an Obama Administration deal with Mexico to develop oil and gas resources in the Gulf of Mexico.  Three Democratic lawmakers recently wrote Senate Majority Leader Harry Reid and urged him to reject any efforts to include language that would exempt companies from the disclosure requirements under Section 1504 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.  According to the lawmakers, the House version of the implementing legislation, H.R. 1613, contains a provision that would exempt companies operating under the U.S.-Mexico pact from complying with Section 1504 of Dodd-Frank.

The United States District Court for the District of Columbia previously vacated the SEC resource extraction disclosure rules.  It is believed the SEC is working on new rules to propose.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

In a November 15, 2013 letter to Representative Scott Garrett (Chairman of the Subcommittee on Capital Markets and Government-Sponsored Enterprises for the House Financial Services Committee), SEC Chair Mary Jo White described potential changes to the accredited investor definition and factors that will be considered by the SEC in its comprehensive review of the accredited investor definition.  Ms. White’s letter was in response to an October 30th letter from Mr. Garrett that had posed a number of questions relating to the SEC’s plans with respect to its review of the accredited investor definition, which is required by Section 413(b)(2)(A) of the Dodd-Frank Act.  The Wall Street Journal has a good article up that provides some additional background and context for this letter and the ongoing back and forth between the SEC and Congress.

In responding to Mr. Garrett’s questions, Ms. White did not offer many specifics, but did indicate that the SEC is considering all aspects of the accredited investor definition.  Ms. White’s letter states that the SEC is examining:

  • whether the existing net worth and income tests are appropriate measures that should continue to be used (presumably this also includes consideration of whether and how the net worth and income thresholds could or should be adjusted);
  • whether financial professionals, such as registered investment advisers, consultants, brokers, traders, portfolio managers, analysts, compliance staff, legal counsel, and regulators should be considered accredited investors without regard to net worth;
  • whether individuals with certain educational backgrounds focused on business, economics, and finance should be considered accredited investors without regard to net worth;
  • whether an expanded pool of accredited investors would help provide liquidity in private placement investments and thereby reduce the risk profile of those investments;
  • whether reliance on a qualified broker or registered investment adviser should enable ordinary investors to participate in private placements; and
  • whether reducing the pool of accredited investors would harm U.S. GDP.

It appears that Ms. White agrees in principle with several assertions underlying Mr. Garrett’s questions.  For example, Ms. White agrees that the inclusion of more financially sophisticated investors in private offerings (regardless of whether the investors are “large or small”) would improve the extent to which private offerings are scrutinized by investors generally. 

Ms. White is also open to the idea that certain professional certifications and educational backgrounds may be useful proxies for financial sophistication, such as CPA or CFA designations, securities licenses, and degrees in business, finance, accounting, or economics. Ms. White also noted, however, that the SEC has already received comments expressing concern as to whether academic background alone is an appropriate measure for determining accredited investor status.

Ms. White also cautioned that alteration of the accredited investor criteria may not necessarily result in a substantial increase in the pool of accredited investors due to overlap between those who meet the existing tests and those who might meet any new or changed tests.

The letter concludes by noting that the SEC is in the process of complying with Mr. Garrett’s request that it produce all communications between the SEC and the GAO relating to accredited investor matters over the last 18 months.

For other information on the JOBS Act, see JOBS Act and Other Securities Law Essentials for Growing Companies.

Check jobs-act-info.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.