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

We previously reported that there was proposed legislation making its way through the Minnesota legislature that contained a number of amendments to the securities laws relating to investment advisers and applying a new layer of regulation for investment adviser representatives.  After receiving input from a number of constituencies, the committees involved have offered changes to the proposed legislation.  A copy of the full as-revised proposed legislation is not yet available, but here is a summary of the most recent changes to the proposed legislation.

Three types of changes can be briefly summarized: 1) changes that do not affect the concept of the new legislation but are only intended to clarify; 2) the elimination of duplicative definitions; and 3) the elimination of provisions requiring the payment of fees in connection with investment adviser representative registration.

The House bill had stricken “investment adviser representative” from the list of persons who are excluded from the definition of “investment adviser.”  Since this would have had the unintended consequence of subjecting investment adviser representatives to all of the provisions of Chapter 80A applicable to investment advisers, the stricken language was reinstated. 

Current law exempts investment advisers from the registration statutes if their only clients in Minnesota are certain defined subsets of persons.  A new change will eliminate institutional investors from this list.  As a result, investment advisers (and newly defined investment adviser representatives) whose only clients in Minnesota are institutional investors will not be exempt from registration.  In addition, the item “any other person exempted by rule adopted or order issued under this chapter” was eliminated from the list of persons exempt from investment adviser (and now investment adviser representative) registration.

The new legislation provides that an investment adviser to a private fund (other than a venture capital fund) is exempt from the state investment adviser registration requirements if it’s only clients are certain specified types of 3(c)(1) funds (“qualified clients”) which are defined in new 80A.58(c)(1).  A change to the new legislation now includes a grandfathering provision that makes this exemption available for an investment adviser to a private fund (other than a venture capital fund) that has one or more beneficial owners who are not qualified clients, provided that the fund existed prior to the effective date of the new legislation, the fund ceases to accept beneficial owners who are not “qualified clients,” and the investment adviser provides certain specified disclosures and audited financial statements to all beneficial owners of the fund.

Section 80A.66 currently contains record keeping and financial reporting requirements for investment advisers and broker-dealers.  The proposed legislation added new subsections relating to record keeping and financial reporting requirements applicable to investment advisers to private funds.  The proposed legislation also contained a provision giving the administrator the ability to amend existing rules if “the requirements of this section [and related rules] do not fully comport with the existing provisions of federal law.”  This grant of authority to the administrator has been removed in the most current form of the proposed legislation.

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

The SEC has granted AngelList relief on accepting transaction based compensation for crowd funding, exempting it from the broker-dealer rules.  A couple days ago, the SEC granted relief to thefundersclub.com.  Makes you kind of wonder what is going to happen next. 

These holes in the broker-dealer-rules are big enough to drive a truck through.  Since they are based on granting the crowd funding site a carried interest, they will cost founders a lot of money.  FINRA registered broker-dealers might charge 6% plus some warrants, not a 20% carried interest.  Founders should be saying “Ouch.”

To provide persepctive, a crowd funding platform may have to register with FINRA as a broker-dealer if it accepts commissions or their equivalent from the sale of securities because that makes the crowd funding site a broker-dealer.  Otherwise stated, when a crowd funding site collects money from investors or the issuer, it has to be sure it is not transaction based compensation which makes it a broker dealer, requiring FINRA registration. The crowd funding sites always collect money sometime, and hence the requests for no-action relief.

For those of you interested, in this paper we examined the perils of dealing with unregistered broker-dealers such as other crowd funding sites that may be broker dealers and the consequences, along with other ground rules for raising money for start-ups.

Note in this case AngelList represents it was going to register with the SEC as an investment advisor, but that is different from registering with FINRA as a broker-dealer.  Among other things, this distinguishes thefundersclub.com, which represents it is exempt from registration as an investment advisor as a venture capital advisor under the Dodd-Frank Act.

AngelList Advisors proposes to offer investors two investment models in which to invest in an Investment Vehicle on its platform: one is called an “Angel Followed Deal” and the other is an “Angel Advised Deal.” In an Angel Followed Deal, the Lead Angel will not be required to take an active role with respect to advising the Investment Vehicle or the Portfolio Company, and may not even be aware that it is being “followed” by the other Investors. In an Angel Advised Deal, the Lead Angel will be aware that it is being followed; and will agree to take an active role in identifying the investment opportunity, leading negotiations with the Portfolio Company, and providing (or offering to provide) significant managerial assistance and financial guidance to the Portfolio Company. AngelList represented that the Lead Angel will not provide investment advice to the Portfolio Company, AngelList Advisors or Investors, unless it is appropriately registered as an investment adviser with the SEC or a state securities authority, or is properly exempt from registration as an investment adviser.

AngelList Advisors represented that it will not receive a commission or management fee as compensation for its advisory services, but will be entitled to receive compensation (i.e., carried interest), as described in each Investment Vehicle’s offering documents. This compensation would be equal to a portion of the increase in value, if any, of the investment as calculated at the termination of the investment in the Investment Vehicle. Under the Angel Advised Deals, the Investment Vehicle will also provide the Lead Angel with compensation based on the overall profitability of the Investment Vehicle.  AngelList also stated that AngelList Advisors may, upon distribution of the Investment Vehicle’s assets, be entitled to recoup any initial expenses it paid in the formation ofthe Investment Vehicle.

Let’s thank the SEC for their advice on these two matters which will undoubtedly lead to capital formation for small businesses.  But a piece really missing is we need SEC guidance on whether these models constitute a general solicitation, destroying the private offering exemption.

In the meantime, what are practitioners to think?  These entities broadly advertise their wares on the internet, and the SEC must be aware of that.  When will the SEC (hopefully) state this is not a general solicitation?

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

 

Thefundersclub.com operates a really cool website.  The publicly available page advertises “The best way to invest in startups. Insider access to pre-vetted startups. Low minimum investment sizes. Free membership. Join today.”  Another publicly available page states “Investments are made in venture funds set up for the startups, and therefore, the minimum check sizes are 10-20 times smaller than typical angel investments – $1K-$5K typically, vs. $25K-$100K.” It’s a little hard to tell though whether the site is operational or in test mode, but I wasn’t going to part with money to find out. Footnote 19 to the incoming SEC letter says the first multi-company fund has closed, though, and single fund companies are possible.

You would almost think it was illegal, but the SEC just issued a no action letter. A little further clicking indicates you have to certify you are an accredited investor before working your way into the site.

The no action letter doesn’t address general solicitation issues, but instead addresses whether the fundersclub is a broker dealer.  They don’t earn commissions on the sale of securities, but apparently do take a carried interest. The carried interest only pays out if a fund returns its capital contributions.  They also don’t propose to take a management fee.  The SEC apparently blesses the argument that thefundersclub.com only receives money if they are successful in creating value.  Or otherwise stated, traditional investment adviser compensation is not transaction based compensation earned by a broker-dealer.

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

The CFPB has released a bulletin explaining its belief that certain lenders that offer auto loans through dealerships are responsible for unlawful, discriminatory pricing. According to the CFPB, potentially discriminatory markups in auto lending may result in tens of millions of dollars in consumer harm each year, and the bulletin provides guidance to indirect auto lenders within the CFPB’s jurisdiction on how to address fair lending risk.

It’s not a black and white area.  As some have pointed out,  the CFPB does not regulate, supervise or have the authority to investigate or initiate enforcement actions against auto dealers.  Nonetheless, we predict headaches for auto dealers.

But the CFPB explains the problem like this: When consumers finance automobile purchases from an auto dealership, the dealer often facilitates indirect financing through a third party lender. The dealer plays a valuable role by originating the loan and finding financing sources. In this indirect auto financing process, the lender usually provides the dealer with an interest rate that the lender will accept for a given consumer.

Further, according to the CFPB, indirect auto lenders often allow the dealer to charge the consumer an interest rate that is costlier for the consumer than the rate the lender gave the dealer. This increase in rate is typically called “dealer markup.” The lender shares part of the revenue from that increased interest rate with the dealer. As a result, markups generate compensation for dealers while frequently giving them the discretion to charge consumers different rates regardless of consumer creditworthiness. Lender policies that provide dealers with this type of discretion increase the risk of pricing disparities among consumers based on race, national origin, and potentially other prohibited bases.

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

The CFTC’s Division of Clearing and Risk has issued a no-action letter that provides relief from required clearing for a limited set of “stub swaps” that remain after the partial novation or partial termination of an original swap that was not required to be cleared because it was executed prior to an applicable compliance date for required clearing.

The Division will not recommend that the Commission take enforcement action against any person for failing to clear stub swaps resulting from partial novations or partial terminations, provided that the original swaps were executed prior to the date on which the counterparties must begin complying with the clearing requirement. Both the original swaps and stub swaps, and the related partial novations and terminations, must meet certain conditions specified in the letter.

The no-action relief is subject to, among others, the following conditions:

  • the original swap must not have been cleared;
  • the original swap was executed prior to an applicable compliance date for required clearing;
  • the partial novation or termination may reduce only the notional amount of the original swap, with all other terms of the stub swap remaining unchanged; and
  • the records relating to the original swap are amended solely to reflect the reduced notional amount of the swap.

For partial novations, the relief is also subject to the condition that the novated swap (assuming it is entered into after an applicable compliance date and is within one of the classes of swaps determined by the Commission to be required to be cleared) is submitted for clearing pursuant to section 2(h)(1)(A) of the CEA and part 50 of the Commission’s regulations. This is consistent with the Commission’s statement in the clearing requirement final rulemaking that the clearing requirement applies to all new swaps, as well as changes in the ownership of a swap, including assignment, novation, exchange, transfer, or conveyance.

The relief is limited to partial novations and partial terminations and does not apply to circumstances where the original counterparties enter into and book a new swap that fully or partially offsets the risk of an existing uncleared swap and thereby achieve a similar economic result to a full termination, a partial novation, or a partial termination. All new swaps that are subject to required clearing under part 50 of the Commission’s regulations, including those that partially or fully offset the risk of original swaps, must be submitted for clearing, unless an exception or exemption under part 50 of the Commission’s regulations applies.

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

The Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency have issued joint supervisory guidance on leveraged lending.  It remains to be seen how this guidance may affect private equity groups and acquisition financing.  According to the Wall Street Journal, Wall Street sold a record $78 billion of leveraged loans in February alone, citing statistics of S&P Capital IQ LCD. The surge of deals was 10% higher than the pre-crisis record of $71 billion issued in February 2007.

According to the regulators, before the financial crisis, the volume of leveraged credit transactions grew tremendously and participation by non-regulated investors willing to accept looser terms increased. While leveraged lending declined during the crisis, volumes have since increased and prudent underwriting practices have deteriorated. The regulators believe some debt agreements have included features that weaken lender protection by excluding meaningful maintenance covenants and including other features that can limit lenders’ recourse in the event of weakened borrower performance. In addition, capital and repayment structures for some transactions, whether originated to hold or to distribute, have been aggressive. The regulators also believe management information systems at some institutions have proven less than satisfactory in accurately aggregating exposures on a timely basis.

The guidance focuses attention on several key areas, including the following:

  • Establishing a sound risk-management framework: The agencies expect that management and the board of directors identify the institution’s risk appetite for leveraged finance, establish appropriate credit limits, and ensure prudent oversight and approval processes.
  • Underwriting standards: An institution’s underwriting standards should clearly define expectations for cash flow capacity, amortization, covenant protection, collateral controls, and the underlying business premise for each transaction, and should consider whether the borrower’s capital structure is sustainable, regardless of whether the transaction is underwritten to hold or to distribute.
  • Valuation standards: An institution’s standards should concentrate on the importance of sound methods in the determination and periodic revalidation of enterprise value.

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

Since the beginning of 2013, the CFTC has required certain market participants to report their interest rate and credit index swap trades to a swap data repository, or SDR.   CFTC Commissioner Scott D. O’Malia recently outlined problems with this effort.  According to Mr. Omalia:

  • The data submitted to SDRs and, in turn, to the CFTC is not usable in its current form. The problem is so bad that CFTC staff have indicated that they currently cannot find the London Whale in the current data files.
  • In a rush to promulgate the reporting rules, the Commission failed to specify the data format reporting parties must use when sending their swaps to SDRs. In other words, the Commission told the industry what information to report, but didn’t specify which language to use. This has become a serious problem. As it turned out, each reporting party has its own internal nomenclature that is used to compile its swap data.
  • The end result is that even when market participants submit the correct data to SDRs, the language received from each reporting party is different. In addition, data is being recorded inconsistently from one dealer to another. It means that for each category of swap identified by the 70+ reporting swap dealers, those swaps will be reported in 70+ different data formats because each swap dealer has its own proprietary data format it uses in its internal systems. Now multiply that number by the number of different fields the rules require market participants to report.
  • Aside from the need to receive more uniform data, the Commission must significantly improve its own IT capability. The Commission now receives data on thousands of swaps each day. So far, however, none of our computer programs load this data without crashing. This would seem odd with such a seemingly small number of trades. The problem is that for each swap, the reporting rules require over one thousand data fields of information. This would be bad enough if we actually needed all of this data. We don’t. Many of the data fields we currently receive are not even populated.
  • Until this is fixed, nobody should be under the illusion that promulgation of the reporting rules will enhance the Commission’s surveillance capabilities.

I guess we can write all the laws we want but can’t make computers work.

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

The Division of Market Oversight, or DMO, and Office of Data and Technology, or ODT of the CFTC have issued an advisory reminding all swap counterparties of the imminent April 10, 2013, deadline for each counterparty to obtain a legal entity identifier, or LEI, currently known as a CFTC Interim Compliant Identifier or CICI.

In the advisory, DMO and ODT suggest two immediate steps to ensure compliance with CICI requirements. One, each swap counterparty should visit www.ciciutility.org, check its CICI status, and self-register for a CICI or self-certify its third-party-registered CICI if that is needed. Two, swap dealers should contact each of their counterparties regarding CICIs, and remind them to obtain a CICI before the April 10 deadline if they have not already done so.

According to the advisory this means that all swap counterparties, even those that are not swap dealers or major swap participants, and even those not required to report swap data, must obtain a CICI before April 10, 2013. In addition, each entity must maintain its own CICI after it is issued, keeping its reference data current and accurate, and re-certifying the record at appropriate intervals.

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

On Friday, the United States Court of Appeals for the District of Columbia Circuit told the Federal Energy Regulatory Commission (FERC) that the Commodity Futures Trading Commission (CFTC) has exclusive jurisdiction over manipulative conduct in natural gas futures markets, even if that conduct impacts FERC jurisdictional gas markets. See Brian Hunter v. Federal Energy Regulatory Commission, Case No. 11-1477.

FERC penalized Brian Hunter, a futures trader for the now-defunct Amaranth Advisors, $30 million for engaging in manipulative conduct in the natural gas market. But the manipulative conduct did not involve a FERC jurisdictional transaction. It involved future transactions—over which CFTC has day-to-day jurisdiction, not FERC. FERC had claimed, however, that because Mr. Hunter’s manipulation affected the price in FERC-regulated natural gas markets, it could exercise jurisdiction over manipulation in the futures markets.

The court quickly disabused FERC of that notion—only five weeks passed from oral argument to decision—saying that the CFTC has “exclusive jurisdiction … with respect to accounts, agreements[,]….and transactions involving contracts of sale of a commodity for future delivery, traded or executed on a CFTC-regulated exchange.” Therefore, the court concluded that the CFTC has exclusive jurisdiction over manipulation of natural gas futures contracts and that the Energy Policy Act of 2005 did not repeal that exclusive jurisdiction—not explicitly and certainly not implicitly.

In so ruling, the court rejected FERC’s argument that when there is manipulation in one market that directly or indirectly affects the other market (in this case manipulation in CFTC regulated futures market affecting FERC regulated gas markets) both agencies have an enforcement role. As a result of this ruling, FERC will only be able to utilize its enforcement authority to penalize market participants for manipulative conduct in FERC jurisdictional transactions, not transactions in other markets (futures here), even when the manipulative conduct in those other markets might impact a FERC jurisdictional market.

With the jurisdictional dispute now resolved, the CFTC will likely restart its suspended enforcement action against Hunter.

Check Dodd-Frank.com frequently for updated information on the Dodd-Frank Act, the JOBS Act, and other important matters regarding regulation of derivatives and securities.

There is a bill working its way through the Minnesota state legislature that amends chapter 80A of the Minnesota Statutes to, among other things, implement investment adviser registration for investment advisers whose only clients are private funds.

Minnesota law currently includes an exemption from registration as an investment adviser for investment advisers whose only clients are accredited investors.  The proposed legislation removes this exemption and includes an additional category of advisers exempt from state registration – “private fund advisers.”  Understanding this change requires knowledge of a number of new defined terms under Minnesota law, such as:

  • 3(c)(1) fund: a qualifying private fund eligible for exclusion from the definition of an “investment company” under section 3(c)(1) of the Investment Company Act of 1940.
  • Private fund: an issuer that would be an investment company as defined in Section 3 of the Investment Company Act of 1940 but for section 3(c)(1) or 3(c)(7) of that act.
  • Private fund adviser:  an investment adviser whose only clients are private funds that meet the “qualifying private fund” definition included in SEC Rule 203(m)-1.
  • Venture capital fund: a private fund that meets the definition of a venture capital fund in SEC Rule 203(1)-1.

The new legislation contains additional requirements for a subset of private fund advisers – namely, those private fund advisers who advise at least one “3(c)(1) fund that is not a venture capital fund.”   This subset of private fund advisers must:

  • Besides venture capital funds, advise only 3(c)(1) funds whose outstanding securities (other than short-term paper) are owned only by persons who would meet the definition of a qualified client under SEC Rule 205-3 at the time the securities are purchased from the issuer;
  • At the time of purchase, make additional disclosures in writing to each beneficial owner of a 3(c)(1) fund that is not a venture capital fund; and
  • Obtain annual audited financial statements of each 3(c)(1) fund that is not a venture capital fund and deliver a copy to each beneficial owner of the fund.

The new legislation also require state registered investment advisers to keep the same records that are required of exempt reporting advisers at the federal level, and to file that information with the state.  In addition, the legislation spells minimum record keeping requirements with respect to private funds.

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