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

We recently passed the first rolling 12-month period for determining which entities will surpass the CFTC’s de minimis swap dealing levels and thus be “swap dealers” under the Dodd-Frank Act. So, who are they?

The National Futures Association maintains an up-to-date registry of swap dealers and major swap participants, along with their respective CFTC registration statuses. The registry shows that there are currently 94 companies with provisional or pending registration as swap dealers. Almost all of the companies are large banking or financial services companies and their affiliates, including Goldman Sachs, JP Morgan, Citibank, Bank of America, Merrill Lynch, Credit Suisse, and others.

However, three large energy/physical commodity companies are also registered as swap dealers: BP Energy Company, Shell Trading Risk Management LLC, and Cargill Incorporated. The CFTC recently approved a “limited purpose swap dealer designation” for Cargill and its affiliate, Cargill Financial Service International, Inc.–the first time such a designation has been granted. Pursuant to the order, the Cargill affiliates will be treated as swap dealers with respect to swap activities engaged in through Cargill’s “Cargill Risk Management Business Unit” and as non-swap dealers with respect to all other swap activities.

The NFA registry shows that just 2 companies—Cournot Financial Products LLC and MBIA Insurance Corporation—are registered as major swap participants.

Dodd-Frank Amendments to Master Agreements with Swap Dealer Counterparties

Swap Dealers are subject to comprehensive regulation under the Dodd-Frank Act. As a result, they must obtain certain representations from their counterparties and otherwise ensure that their swap transactions with counterparties satisfy the CFTC’s swap dealer regulations. The International Swaps and Derivatives Association (ISDA) has published two protocols—the ISDA August 2012 DF Protocol and the ISDA March 2013 DF Protocol—to address many of these swap dealer requirements. Approximately 11,000 companies have adhered to these protocols, showing their wide adoption. The protocols may be incorporated into existing master agreements (the ISDA and any other master swap agreement in place between matched counterparties) by: (1) “adhering” to the protocol through submission of an adherence letter and payment of $500 to ISDA and (2) exchange of questionnaires with counterparties. This may be done via an online system provided by ISDA/Markit.

Alternatively, the operative “Supplement” portion of each protocol may be incorporated into individually designated master agreements by an executed amendment. The International Energy Credit Association (IECA) has published amending agreements designed to incorporate the August 2012 and March 2013 ISDA DF Supplements into designated master agreements, with minor modifications that arguably make the Supplements friendlier to end users. IECA has also published a “Dodd-Frank Act Representations and Reporting Amending Agreement” that is a convenient means of obtaining mutual representations and assigning the swap reporting responsibility between two end user counterparties for Dodd-Frank compliance purposes.

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

The SEC has settled an administrative action with the managing member of a fund of private equity funds.  In an examination the SEC staff learned that the  manager was violating the custody rule (Rule 206(4)-2 under the Investment Advisers Act) because  the manager did not have a reasonable basis for believing that a qualified custodian was sending quarterly statements to private equity investors members and the manager had not arranged for annual surprise exams of the fund’s assets. Alternatively, the manager had not arranged for the funds financial statements to be audited annually and distributed to the funds investors.

In addition, Rule 206(4)-7 under the Advisers Act – requires investment advisers registered with the SEC to:

  • adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act and rules adopted under the Act;
  • review at least annually the adequacy of the policies and procedures and the effectiveness of their implementation; and
  • designate a Chief Compliance Officer, who is a supervised person, responsible for administering the policies and procedures.

The SEC alleged the manager’s policies and procedures were not reasonably designed to prevent violations of the custody rule. The firm’s compliance manual did not acknowledge that the manager had custody over the fund’s assets. Thus, it had no written policies and procedures to ensure that it met the requirements of the custody rule regarding the fund’s assets. The manager also failed to conduct annual reviews of its compliance policies and procedures and the effectiveness of their  implementation and failed to institute a documented process to identify potential compliance risks and conflicts of interest.

The SEC also alleged the manager’s Form ADV contained untrue statements of material fact. Although the manager had custody of the fund’s assets, the manager stated in its Forms ADV that it did not maintain custody of client assets or securities.

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

Rule 205-3 issued under the Investment Advisers Act of 1940, or the Advisers Act, provides an exemption from section 205(a)(1) of the Advisers Act, which prohibits an investment adviser from entering into an investment advisory contract that provides for compensation to the adviser on the basis of a share of capital gains upon or capital appreciation of the client’s funds.  An investment adviser may charge such a fee under rule 205-3 if the client—including investors in certain private funds—is a “qualified client” as defined in the rule. An investor is a qualified client if, among other ways to qualify, the investor, “immediately after entering into the contract has at least $1,000,000 under the management of the investment adviser.”

The SEC has been asked whether advisers may aggregate the investments of certain investors when determining whether the investors are qualified clients as defined in rule 205-3.  In these cases the related investment advisers that comprise a firm collectively advise two or more different private funds, each with its own investors. When determining if an investor is a qualified client as defined in rule 205-3 and is therefore eligible to be charged performance-based compensation, firms have asked whether they may aggregate the investor’s investments in all of the private funds advised by the related investment advisers that comprise the firm. An investor may have invested less than $1,000,000 in any one private fund, but more than $1,000,000 collectively in the private funds advised by the related investment advisers that comprise the firm. In this situation, consistent with the operation of a single advisory business as described in the no-action letter to the American Bar Association, the staff would not object if the firm aggregated the investor’s investments in all of the private funds advised by the related investment advisers that comprise the Firm when determining if the investor has at least $1,000,000 “under the management of the investment adviser,” and thus is a qualified client as defined in rule 205-3.

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

Yesterday, the CFTC voted to approve a new position limits rule that resembles the agency’s previous short-lived rule (vacated and now abandoned after court challenge), albeit with certain significant changes.

Affected Contracts

The position limits will apply to 28 core futures contracts in physical commodities and their “economically equivalent” futures, options, and swaps. The 28 contracts include 19 agricultural contracts, 5 metal contracts, and the following four energy contracts:

(1) NYMEX Henry Hub Natural Gas (NG);
(2) NYMEX Light Sweet Crude Oil (CL);
(3) NYMEX RBOB Gasoline (RB); and
(4) NYMEX NY Harbor ULSD (HO).

The CFTC provided new clarification that a swap may be considered “economically equivalent” to a futures contract when it is:

(1) a “look-alike” contract
(2) a contract with a reference price based on “only the combination of at least one referenced contract price and one or more prices in the same or substantially the same commodity as that underlying the relevant core referenced futures contract, provided that such a contract is not a locational basis swap”;
(3) an intercommodity spread contract with two reference price components, one or both of which are based on referenced contracts; or
(4) a contract priced at a fixed differential to a core referenced futures contract.

Spot-Month Limits

Spot-month position limits will generally be set at 25% of estimated deliverable supply, applied separately to physical-delivery and cash-settled contracts in the same commodity. Traders with only cash-settled positions in a commodity in the spot month may be eligible for an exemption allowing them to hold up to five-times the level of the normal cash-settled limit. Initial spot-month limits will be based on limit levels currently in place at designated contract markets (DCMs) or on estimates of deliverable supply in a commodity submitted by a DCM. Subsequent levels will be adjusted at least every two years and will be based on deliverable supply.

Non-Spot-Month Limits

Non-spot-month position limits (applied to positions in all contract months combined or in a single contract month outside of the spot month) will be set at 10% of the contract’s first 25,000 contracts of open interest plus 2.5 percent of any open interest beyond that. Open interest will be based on the sum of open interest in futures and cleared and uncleared swaps. Initial non-spot-month position limits will be based on open interest in futures and swaps that are significant price discovery contracts. Subsequent levels will be adjusted at least every two years based on referenced contract open interest for a calendar year.

Bona Fide Hedge Exemptions

As before, bona fide hedge positions will be exempt from the position limits. However, statements by Commissioners O’Malia and Wetjen indicate that the bona fide hedge exemption for anticipatory hedges has been narrowed significantly and that the Section 1.47 process for seeking exemptions for non-enumerated hedges has been eliminated. These important aspects of the rule are sure to draw significant attention from end users who rely on the hedge exemption with respect to their own positions or are concerned about the effects of the position limits rule on market liquidity.

Aggregation of Positions Across Affiliates

The CFTC also released the text of its companion “aggregation” rule to the position limits rule, which is similar to its previous aggregation proposals. Subject to certain exemptions, the rule requires “all positions in accounts for which any person . . . controls trading or holds a 10 percent or greater ownership or equity interest” to be aggregated with the positions held and trading done by such person.

Exemptions from aggregation are available with respect to:

(1) Limited partners, limited members, shareholders or other similar types of pool participants holding 10 percent or greater ownership in a pool, subject to certain further requirements.

(2) Entities in which a person holds between a 10 percent and 50 percent ownership or equity interest, provided that such person and the owned entity: (A) do not have knowledge of the trading decisions of the other; (B) trade pursuant to separately developed and independent trading systems; (C) have and enforce written procedures to preclude each from having knowledge of, gaining access to, or receiving data about, trades of the other; (D) do not share employees that control the trading decisions of either; and (E) do not have risk management systems that permit the sharing of trades or trading strategy.

(3) Entities in which a person holds greater than 50 percent ownership, as long as the entity is not required to be consolidated on the person’s financial statements under GAAP, requirements (A) through (E) above are met, and certain certifications are made, subject to the approval of the CFTC.

(4) Subject to additional requirements: futures commission merchants, independent account controllers, underwriters, broker-dealers, persons for which the sharing of information associated with aggregation would create a reasonable risk of violation of other law, and higher-tier entities with respect to an owned entity that has already filed a notice of exemption.

In general, persons seeking to take advantage of these exemptions from the aggregation requirement must file a notice with the CFTC.

Impact of the Rule

The position limits rule has not been published yet, but is expected to allow for a 60-day comment period and to become effective 60 days after approval and publication in its final form. The rule is expected to provide an additional exemption for good faith pre-existing positions. The CFTC estimates that the rule will affect 400 traders, not taking into account the number for traders eligible for the various exemptions. This is estimated to include 148 traders with respect to spot-month position limits in referenced energy contracts and 11 with respect to non-spot month position limits in referenced energy contracts.

Check dodd-frank.com frequently for updated information regarding the Dodd-Frank Act.

According to a statement by Commissioner O’Malia today, the CFTC has voted to dismiss its appeal of the federal district court decision striking down the CFTC’s 2011 position limits rule. The Commission has an open meeting scheduled for November 5 to propose a new position limits rule. Commissioner O’Malia had harsh criticism regarding the taxpayer dollars wasted in pursuing the “dual-track approach” of appealing dismissal of the old rule while preparing a new rule for nearly twelve months. The new position limits rule, expected to provide for a 60-day comment period, will likely be the subject of great interest and continued controversy.

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

FINRA has proposed rules and related forms for crowdfunding portals. The proposal, which reflects the rules recently proposed by the SEC, would implement in FINRA’s rules the provisions of the JOBS Act.  FINRA believes it has streamlined the proposed rules to the extent possible to reflect the limited scope of activity permitted by funding portals while also maintaining investor protection.

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.

The SEC has proposed new Regulation Crowdfunding  to implement the requirements of Title III of the JOBS Act.  Regulation Crowdfunding would prescribe rules governing the offer and sale of securities under new Section 4(a)(6) of the Securities Act of 1933. The proposal also provides a framework for the regulation of registered funding portals and brokers that issuers are required to use as intermediaries in the offer and sale of securities in reliance on Section 4(a)(6).

I.          CROWDFUNDING EXEMPTION

Limitation on Capital Raised

The exemption from registration provided by Section 4(a)(6) is available to a U.S. issuer provided that “the aggregate amount sold to all investors by the issuer, including any amount sold in reliance on the exemption provided under [Section 4(a)(6)] during the 12-month period preceding the date of such transaction, is not more than $1,000,000.  Capital raised through means other than the crowdfunding exemption is not counted towards the $1,000,000 maximum.

The SEC believes that an offering made in reliance on Section 4(a)(6) should not be integrated with another exempt offering made by the issuer, provided that each offering complies with the requirements of the applicable exemption that is being relied upon for the particular offering. An issuer could complete an offering made in reliance on Section 4(a)(6) that occurs simultaneously with, or is preceded or followed by, another exempt offering. An issuer conducting a concurrent exempt offering for which general solicitation is not permitted, however, would need to be satisfied that purchasers in that offering were not solicited by means of the offering made in reliance on Section 4(a)(6).  Similarly, any concurrent exempt offering for which general solicitation is permitted could not include an advertisement of the terms of an offering made in reliance on Section 4(a)(6) that would not be permitted under Section 4(a)(6) and the proposed rules.

Investment Limitation

Under Section 4(a)(6)(B), the aggregate amount sold to any investor by an issuer, including any amount sold in reliance on the exemption during the 12-month period preceding the date of such transaction, cannot exceed:

  • the greater of $2,000 or 5 percent of the annual income or net worth of such investor, as applicable, if either the annual income or the net worth of the investor is less than $100,000; and
  • 10 percent of the annual income or net worth of such investor, as applicable, not to exceed a maximum aggregate amount sold of $100,000, if either the annual income or net worth of the investor is equal to or more than $100,000.

There is a glitch in the drafting of the statute because the language “if either the annual income or net worth of the investor is equal to or more than $100,000” can cause both limitations to be applicable.  The SEC believes that the appropriate approach to the investment limit provision is to provide for an overall investment limit of $100,000, but within that overall limit, to provide for a “greater of” limitation based on annual income and net worth. Under the proposed rules, therefore, if both annual income and net worth are less than $100,000, then a limit of $2,000 or 5 percent of annual income or net worth, whichever is greater, would apply. If either annual income or net worth exceeds $100,000, then a limit of 10 percent of annual income or net worth, whichever is greater, but not to exceed $100,000, would apply.

The proposed rules require a natural person’s annual income and net worth to be calculated in accordance with the SEC’s rules for determining accredited investor status.  The proposed rules would clarify that an investor’s annual income and net worth may be calculated jointly with the income and net worth of the investor’s spouse.

The proposal allows an issuer to rely on efforts that an intermediary takes in order to determine that the aggregate amount of securities purchased by an investor will not cause the investor to exceed the investor limits, provided that the issuer does not have knowledge that the investor had exceeded, or would exceed, the investor limits as a result of purchasing securities in the issuer’s offering.

Transactions Conducted Through an Intermediary

Under Section 4(a)(6)(C), a transaction in reliance on Section 4(a)(6) must be “conducted through a broker or funding portal that complies with the requirements of [S]ection 4A(a).” The rules require an issuer to use only one intermediary because:

  • The SEC believes a central tenet of the concept of crowdfunding is presenting members of the crowd with an idea or business so members of the crowd can share information and evaluate the idea or business. Allowing an issuer to conduct a single offering or simultaneous offerings in reliance on Section 4(a)(6) through more than one intermediary would diminish the ability of the members of the crowd to effectively share information, because essentially, there would be multiple “crowds.”
  • Because practices among intermediaries may differ, were multiple intermediaries to conduct a single offering or simultaneous offerings, this could result in significant differences among such offerings.
  • Allowing an issuer to conduct an offering using more than one intermediary would make it more difficult for intermediaries to determine whether an issuer is exceeding the $1 million aggregate offering limit.

Although the statute does not expressly require it, the SEC believes that in enacting Section 4(a)(6)(C), Congress contemplated that crowdfunding transactions made in reliance on Section 4(a)(6) and activities associated with these transactions would occur over the Internet or other similar electronic medium that is accessible to the public.  The SEC believes that an “online-only” requirement enables the public to access offering information and share information publicly in a way that will allow members of the crowd to decide whether or not to participate in the offering and fund the business or idea.  The proposed rules require that an intermediary, in a transaction involving the offer or sale of securities in reliance on Section 4(a)(6), effect such transactions exclusively through an intermediary’s platform.  The SEC proposes to define the term “platform” to mean an Internet website or other similar electronic medium through which a registered broker or a registered funding portal acts as an intermediary in a transaction involving the offer or sale of securities in reliance on Section 4(a)(6).

These following issuers are excluded from relying on the crowdfunding exemption:

  • Issuers not organized under the laws of a state or territory of the United States or the District of Columbia;
  • issuers that are subject to Exchange Act reporting requirements;
  • investment companies as defined in the Investment Company Act or companies that are excluded from the definition of investment company under Section 3(b) or 3(c) of the Investment Company Act;
  • any issuer that has sold securities in reliance on Section 4(a)(6) if the issuer has not filed with the Commission and provided to investors, to the extent required, the ongoing annual reports required by Regulation Crowdfunding during the two years immediately preceding the filing of the required new offering statement;
  • issuers subject to the “bad boy” disqualifiers in Section 302(d) of the JOBS Act; and
  • any issuer that has no specific business plan or has indicated that its business plan is to engage in a merger or acquisition with an unidentified company or companies.

II.        FILING AND DISCLOSURE REQUIREMENTS FOR ISSUERS

Prohibitions Applicable to the Issuer

Proposed Regulation Crowdfunding places several restrictions on issuer conduct in connection with a crowdfunded offering relating to advertising and promotion of the offering and its terms.

Prohibition on Advertising Terms of the Offering

Under the proposed rules, an issuer would be prohibited from advertising an offering pursuant to Section 4(a)(6), except that the issuer would be permitted to distribute a notice that includes only the following information with respect to the offering:

  • A statement that the issuer is conducting an offering, the name of the intermediary, and a link to the intermediary’s offering
  • The amount of securities offered, the nature of the securities, the price of the securities, and the closing date for the offering
  • The name, address, phone number, and website of the issuer, the e-mail address of a representative of the issuer, and a brief factual description of the issuer’s business.

Although the content of these notices is restricted, the proposed rules do not restrict the means by which the notices may be distributed.  Further, the issuer is free to communicate with the public about other aspects of its business during the pendency of a Section 4(a)(6) offering as long as the issuer does not disclose any information about the offering other than the information permitted on notices. The rules also permit direct communication between the issuer and potential investors about the offering, including while the offering is ongoing, provided that the communications occur through the intermediary’s platform and the issuer identifies itself as the issuer in all such communications.

Disclosure of Promoter Compensation

The proposed rules prohibit issuers from agreeing to compensate any person for promoting Section 4(a)(6) other than through the communication channels associated with the intermediary’s platform unless the promotion is limited to distributing notices that merely direct the recipient to the funding platform (as discussed above).   An issuer is permitted to compensate a person for promoting an offering through the communication channels of the intermediary’s platform, but only if the issuer also takes reasonable steps to ensure that, with every promotional communication, the promoter clearly discloses the past and prospective receipt of compensation from the issuer.  This rule applies not only third party promoters, but also to employees or shareholders of the issuer and any other person that undertake promotional activities on behalf of the issuer through the intermediary’s platform.

Form C and Filing Requirements

The rules propose a new Form C (with several variations) that would be used by issuers in Sectyion 4(a)(6) offerings to file the required information and disclosures with the SEC and to provide the information to the applicable intermediary.

Form C: Offering Statement

The initial disclosure regarding the offering would be filed on Form C, and the issuer would fulfill its filing obligations by filing Form C: Offering Statement with the SEC, providing the intermediary with a copy of the filing, and directing investors to the filing on the intermediary’s platform through a posting on the issuer’s website or by e-mail notification.  The specific disclosure requirements of Form C are discussed in detail below.

Form C-A: Amendments to the Offering Statement

Form C filings can be amended by filing Form C-A with the SEC.  Issuers may amend their Form C filings to account for changes in offering information, and issuers must amend their Form C filings to reflect any material changes in the offering terms or disclosures previously provided to investors.  The SEC considers a material change to be one involving information with respect to which there is a substantial likelihood that a reasonable investor would consider it important in deciding whether or not to purchase the offered securities, under the facts and circumstances.  Examples of material changes include changes to the financial condition of the issuer, changes to the intended use of proceeds of the offering, and determination of the final price of the securities being offered if only the methodology for determining the final offering price has previously been disclosed.

If there is a material change, the issuer will be required to check a box on Form C-A indicating that there has been a material change and that the issuer will not accept any investment from investors who have previously committed to purchase securities in the offering unless the investors reconfirm their commitment in light of the material change.

Form C-U: Progress Updates

Under the proposed rules, issuers would be required to file with the SEC (and provide to the intermediary and potential investors) periodic updates on the progress of the offering on new Form C-U filed via the EDGAR system.  Updates would be required within five days after (i) the issuer has received commitments for 50% of the offering amount, (ii) the issuer has received commitments for 100% of the offering amount; (iii) the issuer intends to accept subscriptions in excess of the offering amount; and (iv) the issuer has closed on proceeds of the offering.

Form C-AR: Ongoing Annual Reporting Obligations

An issuer that sells securities in a crowdfunded offering will be required to file an annual report with the SEC on Form C-AR and to make that annual report available to investors by posting the report on the issuer’s website.  The annual report will be due no later than 120 days after the end of the most recent fiscal year, and must include information similar to the information provided in the initial Form C filing for a crowdfunded offering (including financial statements meeting the requirements of a Section 4(a)(6) offering), except that the annual report will not include information that is specific to an offering of securities.

Form C-TR: Termination of Reporting

The annual report obligation would continue until (i) the issuer becomes an Exchange Act reporting company, (ii) all of the securities issued in crowdfunded transactions are redeemed or purchased by another party, or (iii) the issuer liquidates or dissolves its business.

When an issuer is no longer subject to the ongoing reporting obligations, it will be required to file a Form C-TR: Termination of Reporting, which will serve as a notice to the SEC and investors that it is no longer required to provide the annual reports on Form C-AR.

Required Disclosures of Offering Information

The following sections discuss information that would be required to be disclosed by an issuer on Form C pursuant to the proposed rules.

Basic Issuer Information; Officers and Directors

The issuer would be required to disclose basic information about its identify and status, including its name, legal status, form of organization, date and jurisdiction of organization, and physical and website addresses, the current number of employees of the issuer, and the SEC file number and CRD number of the intermediary being used for the Section 4(a)(6) offering and the amount being paid to that intermediary in connection with the offering (including any referral or other fees).

The issuer would also be required to disclose information about its directors and officers,

defined to include the president, vice president, secretary, treasurer or principal financial officer, comptroller or principal accounting officers, and any person who routinely performs corresponding functions for the issuer.

For officers and directors, the issuer would need to disclose each individual’s name, positions held with the issuer, duration in those positions, and business experience (including principal occupation) during the last three years.  For officers, the issuer would need to disclose whether the officer has been employed by another employer and the name and principal business of that employer.  Since similar disclosures by issuers are required for the prior five years in connection with registered offerings and offerings under Regulation A, the SEC sees this disclosure relating to only the prior three years as an accommodation to startups relying on the crowdfunding rules.

Certain 20% Beneficial Owners

The issuer would be required to disclose the names of each shareholder who owns 20% or more of the issuer’s outstanding voting equity securities, calculated by voting power as of the most recent practicable date.  In coming up with this formulation, the SEC is resolving some ambiguity in the JOBS Act in favor of startups; the JOBS Act arguably could require disclosure of holders of 20% or more of each class of an issuer’s securities.  The SEC also believes that making the date of calculation flexible (“as of the most recent practicable date”) is to the benefit of issuers and ensures that issuers are not subject to more stringent calculation requirements than those applicable to issuers in registered offerings.

Business Plan and Use of Proceeds

The SEC is proposing a flexible approach to the required disclosures of a business plan and intended use of offering proceeds.  While a business plan is required, the form and content of the business plan has not been prescribed, and the SEC has indicated that the business plan can be tailored to fit the stage of the business.  In the use of proceeds disclosure, the SEC is requiring disclosure that is reasonably detailed under the circumstances. The proposing release provides several examples of the type of disclosure that would be appropriate under the circumstances, stating, for example, that “If an issuer does not have definitive plans for the proceeds, but instead has identified a range of possible uses, then the issuer should identify and describe each probable use and factors impacting the selection of each particular use.”

Target offering Amount and Deadlines

If an issuer will accept investments beyond the targeted offering amount, under the proposed rules it must disclose this fact in its Form C filing, along with a statement of the maximum amount the issuer will accept under any circumstances and a description of how the oversubscribed securities would be allocated among investors.

Form C would also require clear disclosures regarding offering closing procedures, the circumstances under which an investor could cancel their investment, and the circumstances under which the issuer could close the offering early.  These disclosures must include the following required information:

  • Investors can cancel their investment up to 48 hours prior to the deadline identified in the offering materials, but if an investor does not cancel the investment, then their funds will be released to the issuer upon closing;
  • The intermediary will notify investors when the target offering amount has been met, and if the target offering amount is not met then no securities will be sold and all funds will be returned to investors;
  • If the target offering amount is met prior to the deadline identified in the offering materials, the issuer must provide five days advance notice before closing the offering early; and
  • If an investor does not reconfirm the investment commitment after a material change is made to the offering and disclosed on Form C-A, the investment will be cancelled and the issuer must return the funds to the investor.

Ownership and Capital Structure

Under the proposed rules, issuers would be required to include detailed information regarding the issuer’s ownership and capital structure in the Form C filing, including:

  • Descriptions of the characteristics of each class of securities of the issuer, including the securities being offered, and a description of the difference between the different classes of securities, with an emphasis on voting rights and the way the rights of the securities being offered can be modified or limited;
  • Descriptions of the material terms of any indebtedness of the issuer;
  • A description of how the exercise of the rights held by principal shareholders could affect purchasers of the offered securities;
  • The name and ownership level of 20% beneficial holders
  • Descriptions of certain related party transactions among the issuer and any officer, director, promoter, or 20% beneficial owner, or any immediate family member of any of the foregoing, if the related party transaction was in excess of five percent of the amount the issuer has raised through crowdfunded offerings in the trailing twelve months including the amount proposed to be raised in the current offering;
  • Disclosure of all exempt offerings conducted by the issuer within the last three years, including the date of each offering, the exemption relied upon, the amount raised, the type and amount of securities sold, and the use of proceeds;
  • A description of how the offered securities are being valued and examples of how securities may be valued in the future, including in subsequent corporate actions;
  • Disclosure of the risks associated with minority ownership and corporate actions such as additional issuances of shares, repurchases by the issuer, transactions with related parties, and a stock or asset sale by the issuer;
  • Legends regarding the risks of investing in a crowdfunding transaction generally and the ongoing reporting obligations of the issuer, including details about how those reports can be obtained
  • Discussion of risk factors that make an investment in the issuer risky or speculative; and
  • A description of the restrictions on transfer of the offered securities.

Discussion of Financial Condition and Financial Disclosures

Discussion of Financial Condition

All issuers would be required to submit to the SEC, the relevant intermediary, and potential investors a description of their financial condition under the proposed rules.  The description of financial condition would be similar to the MD&A discussion required of Exchange Act reporting companies under Item 303 of Regulation S-K.  The description of the issuer’s financial condition would need to include a discussion of historical results of operation, liquidity and capital resources, the proceeds of the offering and other pending sources of capital, and how the current available and anticipated capital relates to the viability of the issuer’s business.

Financial Disclosures

In all cases, the required financial disclosure under the proposed rules must include a complete set of financial statements (balance sheet, income statement, statement of cash flows, and statement of changes in owners’ equity) prepared in accordance with GAAP and a discussion of any material changes to the issuer’s financial condition since the date of the financial statements.  The level of certification or review required of the financial statements varies depending on the aggregate amount (i) offered by the issuer in the current offering (including any oversubscriptions that will be accepted by the issuer), and (ii) offered and sold by the issuer in a crowdfunded offering in the prior twelve months (referred to here as the “aggregate offering amount”).

If the aggregate offering amount is $100,000 or less, the issuer would only need to provide tax returns (with personal information such as social security numbers redacted) for the most recently completed year and financial statements that are certified by the issuer’s principal executive officer as true and complete in all material respects on a form proposed by the SEC.

If the aggregate offering amount is greater than $100,000 but not more than $500,000, the issuer would need to provide financial statements that have been reviewed by an independent public accountant, using the independence standards set forth in Rule 2-01 of Regulation S-X.  The review would need to be based on the American Institute of Certified Public Accountants (AICPA) standards.  A copy the independent public accountant’s review report would be included in the disclosures to the SEC, the intermediary, and potential investors.

If the aggregate offering amount is more than $500,000, the issuer would be required to provide financial statements that have been audited by an independent public accountant (again, using the Regulation S-X independence standards).  The audit could be conducted either using the AICPA standards or the Public Company Accounting Oversight Board (PCAOB) standards.  A copy of the audit report would need to be included in the disclosures to the SEC, the intermediary, and potential investors.  An issuer that received an adverse audit opinion or a disclaimer of opinion would be disqualified from engaging in a Section 4(a)(6) offering.

III.       REQUIREMENTS FOR CROWDFUNDING INTERMEDIARIES

As mentioned above, Section 4(a)(6)(C) requires crowdfunding offerings to be conducted through a broker or funding portal that complies with Section 4A(a).  A funding portal is defined as any broker acting as an intermediary in a transaction involving the offer or sale of securities for the account of others, solely pursuant to Securities Act Section 4(a)(6), that does not: (1) offer investment advice or recommendations; (2) solicit purchases, sales or offers to buy the securities offered or displayed on its platform or portal; (3) compensate employees, agents or other person for such solicitation or based on the sale of securities displayed or referenced on its platform or portal; (4) hold, manage, possess or otherwise handle investor funds or securities; or (5) engage in such other activities as the Commission, by rule, determines appropriate.  In addition to the foregoing limitations, below is a summary of various requirements placed upon these crowdfunding intermediaries under Section 4A(a) and the proposed rules.

SEC Registration and FINRA Membership

Each crowdfunding intermediary must be registered with the SEC as a broker or funding portal. Under the proposal, a crowdfunding intermediary must register as a broker under Section 15(b) of the Exchange Act or as a funding portal under Securities Act Section 4A(a)(1) and proposed Rule 400 of Regulation Crowdfunding.  The proposal sets out a process and form (Form Funding Portal) for funding portal registration.  Additionally, each intermediary will be required to be a member of FINRA (or any subsequent national securities association) before acting as an intermediary.

Financial Interests

The directors, officers and partners of an intermediary are prohibited from having any financial interest in an issuer using their services. The proposal extends this prohibition to the intermediary itself, and also prohibits any of these parties from receiving a financial interest in an issuer as compensation for services related to an offering of the issuer’s securities. The proposed rules interpret “any financial interest in an issuer,” to mean a direct or indirect ownership of, or economic interest in, any class of the issuer’s securities.

Fraud Reduction Measures

Under the proposed rules, the intermediary must take  measures to reduce the risk of fraud in crowdfunding offerings, by requiring intermediaries to:

  • have a reasonable basis to believe a crowdfunding issuer is in compliance with relevant regulations (the proposed rules would permit intermediaries to reasonably rely on representations of the issuer, absent knowledge or other information or indications that the representations are not true)
  • have a reasonable basis to believe the issuer has established a means to keep accurate records of the holders of its securities (for example, use of a direct registration system, legends on certificates or use of a registered transfer agent, although none of these are required); the intermediary may rely on an issuer’s representations concerning the means it has established to satisfy this requirement, unless the intermediary has reason to question the reliability of the representations.
  • deny access to an issuer or offering if the intermediary believes it presents a potential risk of fraud or if the issuer or any of its officers, director or 20% beneficial owners is subject to disqualification under the proposed rules. The proposal requires an intermediary to conduct certain background and regulatory checks on issuers and such related parties.
  • If such disqualifying information becomes known to the intermediary after the fact, the intermediary must promptly remove the offering from its platform, cancel the offering and return all funds to investors.

Education Materials

The proposed rules would require the intermediary to deliver to investors, at account opening, educational materials that are in plain language and otherwise designed to communicate effectively specified information. The proposed rules would require the materials to include:

  • the process for the offer, purchase and issuance of securities through the intermediary;
  • the risks associated with investing in securities offered and sold in reliance on Section 4(a)(6);
  • the types of securities that may be offered on the intermediary’s platform and the risks associated with each type of security, including the risk of having limited voting power as a result of dilution;
  • the restrictions on the resale of securities offered and sold in reliance on Section 4(a)(6);
  • the types of information that an issuer is required to provide in annual reports, the frequency of the delivery of that information, and the possibility that the issuer’s obligation to file annual reports may terminate in the future;
  • the limitations on the amounts investors may invest, as set forth in Section 4(a)(6)(B);
  • the circumstances in which the issuer may cancel an investment commitment;
  • the limitations on an investor’s right to cancel an investment commitment;
  • the need for the investor to consider whether investing in a security offered and sold in reliance on Section 4(a)(6) is appropriate for him or her; and
  • that following completion of an offering, there may or may not be any ongoing relationship between the issuer and intermediary.

Investor Limits

Each intermediary will be required to ensure no investor exceeds the investment limits. The proposed rules would allow an intermediary to rely on an investor’s representations about its income and net worth and total crowdfunding investments made in the last 12 months.

Investor’s Right to Cancel

The intermediary must allow investors to cancel their investment commitments.  Under the proposed rules, investors must be given an unconditional right to cancel their commitment for any reason until 48 hours before the deadline identified in the issuer’s offering materials. The proposed rules set forth a procedure for issuers to close an offering earlier than the deadline when it reaches its target funding amount before that time, subject to detailed conditions and notice periods.  Upon making material changes to an offering or terminating an offering, additional notice and reconfirmation or cancellation requirements would apply.

Communication Channels

The proposed rules will require intermediaries to provide communication channels to permit discussions among investors and between investors and the issuer about offerings on the platform, with detailed requirements of these channels set forth in the rules.

ATS / Secondary Market Transactions

Under the proposed rules, facilitating crowdfunded transactions alone would not require an intermediary to register as an exchange or as an alternative trading system (i.e., registration as a broker-dealer subject to Regulation ATS). To the extent that an intermediary facilitates secondary market activity in securities issued in reliance on Section 4(a)(6), the intermediary would be required to register as an exchange or as an alternative trading system if it met the criteria in Exchange Act Rule 3b-16.  The SEC noted that a funding portal, by definition, is limited to acting as an intermediary in transactions involving the offer or sale of securities for the account of others solely pursuant to Section 4(a)(6), which are primary issuances of securities. Thus, a funding portal could not effect secondary market transactions in securities.

Associated Persons

The proposed rules apply to the associated persons of funding portals as well in many instances, and would define the term “person associated with a funding portal or associated person of a funding portal” to mean any partner, officer, director or manager of a funding portal (or any person occupying a similar status or performing similar functions), any person directly or indirectly controlling or controlled by a funding portal, or any employee of a funding portal, but would exclude any persons whose functions are solely clerical or ministerial.  FINRA currently provides licensing and qualification requirements for associated persons of brokers. While the SEC is not  proposing any such requirement for persons associated with a funding portal, FINRA (or any other registered national securities association) could propose such requirements, as well as requirements dealing with supervision of funding portal personnel and appropriate compliance structures.

IV.  ADDITIONAL REQUIREMENTS ON FUNDING PORTALS

Registration

Securities Act Section 4A(a)(1) requires that an intermediary facilitating a transaction made in reliance on Section 4(a)(6) register with the SEC as a broker or a funding portal. A funding portal would register with the Commission by filing a form with information consistent with, but less extensive than, the information required for broker-dealers on Form BD.  The new form will be called Form Funding Portal.

The funding portal’s registration would become effective the later of:

  • 30 calendar days after the date that the registration is received by the Commission; or
  • the date the funding portal is approved for membership in FINRA or any other registered national securities association.

The proposed rules would require, as a condition of registration, that a funding portal have in place, and thereafter maintain for the duration of such registration, a fidelity bond that:

  • has a minimum coverage of $100,000;
  • covers any associated person of the funding portal unless otherwise excepted in the rules set forth by FINRA or any other registered national securities association of which it is a member; and
  • meets any other applicable requirements, as set forth by FINRA or any other registered national securities association of which it is a member.

Exemption from Broker Dealer Registration

The JOBS Act directs the SEC to exempt a registered funding portal from the requirement to register as a broker or dealer under Exchange Act Section 15(a), subject to certain conditions.  But for the exemption from registration Congress directed, a funding portal would be required to register as a broker under the Exchange Act.  The obligations imposed under the JOBS Act on an entity acting as an intermediary in a crowdfunding transaction would bring that entity within the definition of “broker” under Exchange Act Section 3(a)(4). A funding portal would be “effecting transactions in securities for the account of others” by, among other things, ensuring that investors comply with the conditions of Securities Act Section 4A(a)(4) and (8), making the securities available for purchase through the funding portal, and ensuring the proper transfer of funds and securities as required by Securities Act Section 4A(a)(7). In addition, a funding portal’s receipt of compensation linked to the successful completion of the offering also would be indicative of acting as a broker in connection with these transactions.

The proposed rule exempts an intermediary that is registered as a funding portal from the requirement to register as a broker-dealer. However the proposed rules require that a funding portal permit the examination and inspection of all of its business and business operations that relate to its activities as a funding portal, such as its premises, systems, platforms and records, by representatives of the SEC, and of the national securities association of which the funding portal is a member.

V.        OTHER PROVISIONS

Restrictions on Resales

The proposed rules track the JOBS Act and provide that securities issued in reliance on Section 4(a)(6) may not be transferred by the purchaser for one year after the date of purchase, except when transferred:

  • to the issuer of the securities;
  • to an accredited investor;
  • as part of an offering registered with the SEC;
  • to a family member of the purchaser or the equivalent, or
  • in connection with the death or divorce of the purchaser.

Exemption from Section 12(g)

The JOBS Act requires the SEC to exempt securities issued under Section 4(a)(6) from the registration requirements of the Exchange Act.  Proposed Rule 12g-6 provides that securities issued pursuant to an offering made under Section 4(a)(6) would be permanently exempted from the record holder count under Section 12(g). An issuer seeking to exclude a person from the record holder count would have the responsibility for demonstrating that the securities held by the person were initially issued in an offering made under Section 4(a)(6).

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.

On October 24, 2013, the CFTC Enforcement Division announced its 2013 fiscal year results – 82 filed enforcement actions and record fines of $1.7 billion ($1.5 billion in civil penalties and $200 million in restitution and disgorgement.) The 82 enforcement actions in 2013 brought the total number of enforcement actions over the past three years to 283, nearly double the amount over the three years prior. Go here to read the CFTC news release.

The CFTC brought:

  • Three actions against auditing firms for failing to either (i) follow Generally Accepted Accounting Standards, (ii) safeguard customer assets or (iii) have the requisite knowledge and experience to audit future commission merchants or any entity holding customer segregated accounts;
  • Four actions against companies for failing to diligently supervise employees that either (i) lost significant amounts of money, (ii) employed a trading system that gave the company a pricing advantage over (and harmed) its retail customers, (iii) allowed an account to acquire a significant option position that the account owners could not afford or (iv) ignored warning signs that clients were being procured through fraudulent means; and
  • Six actions using new Dodd-Frank authority that prohibits either (i) disruptive trading, specifically spoofing (bidding or offering with intent to cancel before execution) and (ii) making false statements during CFTC investigations.

Commenting on the results, CFTC Enforcement Director David Meister, who is leaving at the end of the month, said, “As we have begun to enforce our new Dodd-Frank authority on top of the laws that have been on the books for decades, the cases we bring and the sanctions we have obtained reflect the Division’s unwavering commitment to protect market participants and promote market integrity.

 

 

The United States District Court for the Southern District of New York recently dismissed a case with prejudice by an employee whistleblower that lived in Taiwan.  The court stated there is no evidence that Congress intended the ant-retaliation provisions of Dodd-Frank to apply extraterritorially.

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 sanctioned three investment advisory firms for repeatedly ignoring problems with their compliance programs.

The enforcement actions arise from the agency’s Compliance Program Initiative, which targets firms that have been previously warned by SEC examiners about compliance deficiencies but failed to effectively act upon those warnings.  Had the problems been addressed, the firms could have prevented their eventual securities law violations.  The SEC Enforcement Division’s Asset Management Unit has coordinated with examiners to bring several cases since the initiative began two years ago.

Andrew Bowden, director of the SEC’s National Exam Program, said, “After SEC examiners identified significant deficiencies, these firms did little or nothing to address them by the next examination.  Firms must fix deficiencies identified by our examiners.”

For instance, the SEC’s order against a firm referred to as MPM and its owners finds that they failed to correct ongoing compliance violations at the firm despite prior warnings from SEC examiners.  In particular, they failed to complete annual compliance reviews in 2006 and 2009 and made misleading statements on MPM’s website and investor brochure.  For instance, one location on MPM’s website misleadingly represented that the firm had more than $600 million in assets.  However, on its Form ADV filing to the SEC during that same time period, it reported that the firm’s assets under management were $359 million or less.

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