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

Norm Champ, Deputy Director, Office of Compliance Inspections and Examinations at the SEC, gave his insghts as to the SEC’s plans to examine hedge fund sponsors who were required to newly register as investment advisers under the Dodd-Frank Act.

According to Mr. Champ, the SEC strategy for these new registrants will include:

  • an initial phase of industry outreach and education,
  •  followed by a coordinated series of examinations of a significant percentage of the new registrants that will focus on the highest risk areas of their business and help the SEC to risk rate the new registrants, and
  • culminating in the publication of a series of “after action” reports, reporting to the industry on the broad issues, risks, and themes identified during the course of the examinations.

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

 

The Federal Reserve Board, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation issued final supervisory guidance regarding stress-testing practices at banking organizations with total consolidated assets of more than $10 billion.

The guidance does not implement the stress testing requirements in the Dodd-Frank Wall Street Reform and Consumer Protection Act  or in the Federal Reserve Board’s capital plan rule that apply to certain companies, as those requirements have been or are being implemented through separate proposals by the respective agencies. However, the agencies expect that banking organizations with total consolidated assets of more than $10 billion would follow the principles set forth in the guidance–as well as other relevant supervisory guidance–when conducting stress testing in accordance with the Dodd-Frank Act, the capital plan rule, and other statutory or regulatory requirements.

The federal banking agencies also issued a joint statement to clarify expectations for stress testing by community banks–banks, savings associations, and bank and savings and loan holding companies with $10 billion or less in total assets. The Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of Currency clarified that community banks are not required or expected to conduct the types of stress testing required of larger organizations.

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 CFPM, outlined rules it is considering that would simplify mortgage points and fees and bring greater transparency to the mortgage loan origination market. These rules, which the CFPB expects to propose this summer and finalize by January 2013, are meant to make it easier for consumers to understand mortgage costs and compare loans so they can choose the best deal.

The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act places certain restrictions on the points and fees offered with most mortgages. The CFPB is considering proposals that would:

  • Require an Interest-Rate Reduction When Consumers Elect to Pay Discount Points
  • Require Lenders to Offer Consumers a No-Discount-Point Loan Option
  • Ban Origination Charges that Vary with the Size of the Loan

In 2010, the Federal Reserve Board issued a rule that prohibits loan originators from directing consumers into higher priced loans because they could earn more money. The Dodd-Frank Act requires the CFPB to issue rules as well. The proposals the CFPB is considering would reaffirm the Board’s rule, which bans the practice of varying loan originator compensation based on interest rates or certain other loan terms. The CFPB’s proposal would also clarify certain issues in the existing rule that have created industry confusion.

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 released answers to frequently asked questions about the use of intermediaries pursuant to Title III of the JOBS Act, which can be individually cited as the Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012, or the CROWDFUND Act.  The CROWDFUND Act creates a new exemption from Section 5 of the Securities Act for so-called “crowdfunded” offerings, provided that the offerings meet certain requirements.  Before heading to the SEC’s FAQs, here are some more basic FAQs about the CROWDFUND Act for the uninitiated:

What are “intermediaries” and why do they matter?

In order to take advantage of the new exemption, an offering must comply with several requirements.  One of those requirements is that the offering must be conducted through an “intermediary” that is either a registered broker or a registered funding portal.

What do the terms “crowdfunded” and “crowdfunding” mean?

A crowdfunded offering, for purposes of the CROWDFUND Act, means a transaction in which (1) an issuer raises no more than $1 million in the aggregate from sales of securities (including securities sold in the preceding 12 months), (2) investors are subject to limitations on their maximum investment, and (3) the issuer complies with a number of other more technical requirements that we won’t discuss here.  Investments by individuals with less than $100,000 in annual income or net worth are limited to the greater of $2,000 or 5 percent of income or net worth.  For individuals with greater than $100,000 in income or net worth, the limit is 10% of income or net worth, with a ceiling of $100,000.

What is a “funding portal”?

A “funding portal” is defined as a crowdfunding intermediary that does not (1) offer investment advice, (2) solicit sales or offers, (3) pay compensation based on sales of securities, (4) hold or handle investor funds, or (5) engage in other activities that the SEC may prohibit by rule.  In other words, a funding portal is limited to facilitating the matching of investors with issuers.  Funding portals will still need to register with both the SEC and FINRA and must comply with a number of other requirements discussed in the SEC’s FAQs, but funding portals need not register as brokers.

When will the crowdfunding exemption become available to issuers?

The SEC is directed to adopt rules implementing the CROWDFUND Act within 270 days of its enactment, which would be January 1, 2013.  However, as we’ve seen, the SEC doesn’t always meet statutory deadlines.

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

The ripple effect of the JOBS Act is beginning to show as the NYSE has proposed to adjust its listing qualification standards to reflect that emerging growth companies, or ECGs,  under the JOBS Act only need to present two years of audited financial statements.

In its rule filings the NYSE notes that its initial listing standards s require listing applicants to meet theapplicable financial criteria over a period of three fiscal years. As the staff of the NYSE bases its determination as to a company’s compliance with the financial initial listing standards only on publicly available audited financial data, an EGC which availed itself of the right to file only two years of audited financial data as part of its initial public offering registration statement or subsequent registration statements would be unable to qualify for listing under those particular financial listing standards. The NYSE proposes to amend the initial financial listing standards in Sections 102.01C and 103.01B to permit an EGC to meet the applicable standard on the basis of the two years of audited financial data actually reported, rather than the three years of financial data that would otherwise be required.

The proposed amendment would only be applicable to EGCs that actually avail themselves of their ability to report only two years of audited financial information. Under the proposed amendments, EGCs would still be required to meet the same aggregate financial requirements, but would be required to do so over a two-year period rather than a three-year period, if they have availed themselves of the JOBS Act provision allowing EGCs to file only two years of audited financial statements.

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

The CFTC has announced a proposed rulemaking schedule.  Some of the highlights include:

  • The end-user exemption and other matters related to mandatory clearing are scheduled for June 2012
  • A proposed response to the MF Global collapse related to segregation and bankruptcy is scheduled for Fall 2012
  • Final rules for margin and capital for non-banks is scheduled for Fall 2012

The CFTC describes the foregoing dates as the “earliest potential date for consideration.”

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

Jill Radloff and I recently gave a presentation at a CLE session in Minneapolis, Minnesota on the JOBS Act and Other SEC and Dodd-Frank developments.  We covered:

  • The repeal of the ban on general solicitations in Rule 506 offerings
  • Changes to the definition of accredited investor mandated by the Dodd-Frank Act
  • “Bad actor” disqualifications for Rule 506 offerings
  • Changes to the Exchange Act registration thresholds
  • The ability of the SEC to promulgate a new exemption from registration under so called Regulation A+
  • The IPO on-ramp provisions of the JOBS Act for emerging growth companies
  • Crowdfunding
  • How the conflict mineral provisions of the Dodd-Frank Act will affect private companies
  • The business conduct standards for swap dealers
  • Special board approvals that will be required for public companies to rely on the end user exception for uncleared swaps

You can find our written materials here and our PowerPoint presentation here.

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

High profile groups have begun to submit comments on the JOBS Act to try and steer rulemaking in the correct direction.

The Federal Regulation of Securities Committee, Business Law Section, of the American Bar Association noted:

  • The proposed rules or the accompanying release should reflect the existing definition of “accredited investor” that includes a reasonable belief standard – and nothing more onerous, such as an absolute verification.
  • In setting forth the reasonable steps to be taken to verify that purchasers of the securities offered by means of general solicitation or general advertisement in Rule 506 offerings are accredited investors, the proposed rules should reflect current custom and practice.  Here they are saying the standard subscription agreement should be enough to verify accredited investor status unless the issuer has knowledge otherwise.
  • The group correctly noted that Rule 144A only applies to resales.  However, the investment banks that are initial purchasers in the 144A transactions acquire the securities from the issuer in a Section 4(2) private placement, which is not a Rule 506 offering.  For the elimination on general solicitation to be of help in 144A issuance transactions, the SEC needs to provide by rule that the use of general solicitations in the 144A transaction does not destroy the initial placement using the 4(2) exemption.

The Managed Funds Association, an advocacy group for hedge funds, also submitted a useful comment letter:

  • Hedge funds are permitted to makes sales of securities to “knowledgeable employees” (as set forth in Rule 3(c)(5)) but still maintain their exemptions from registration under the Investment Company Act.  Accordingly, the group recommends that the SEC amend the definition of “accredited investor” to include those individuals who meet the definition of “knowledgeable employee” in Rule 3c-5 under the Investment Company Act so that hedge funds will be able to make general solicitations under the JOBS Act.
  • Section 206 and Rule 206(4)-1 of the Investment Advisers Act place restrictions on advertisements by registered investment advisers.  The group believes uncertainty remains as to the scope and application of these limitations to private fund advisers and urges the SEC to permit greater disclosure of information related to registered or exempt private fund managers in advertising materials.
  • The group notes that 3(c)(7) funds, which only sell securities to “qualified purchasers,” will now be able to have more than 499 investors as a result of changes to the Exchange Act registration thresholds implemented by the JOBS Act. Section 504 of the JOBS Act directs the Commission to review whether additional tools are needed to enforce the anti-evasion provision in Rule 12g5-1 under the Exchange Act, and provide its findings to Congress. The Managed Funds Association believes the necessary enforcement provisions are in place for hedge funds, because hedge funds that rely on Section 3(c)(7) are already subject to a similar anti-evasion provision in Rule 2a51-3 under the Investment Company Act, which deems a company formed for the specific purpose of investing in a 3(c)(7) fund to be a qualified purchaser only if each beneficial owner of the company’s securities is a qualified purchaser.

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 approved an interpretive notice of the MSRB under which underwriters of municipal securities will be required to disclose to their state and local government clients risks about complex financial transactions, potential conflicts of interest, and compensation received from third-party providers of derivatives and investments.

Some of the principles covered by the new regulations include:

  • An underwriter is required to provide robust disclosures as to its role, its compensation and any actual or potential material conflicts of interest.
  • All representations made by underwriters to state and local governments must be truthful and accurate and may not misrepresent or omit material facts.
  • Underwriters of municipal bond issues that recommend complex municipal securities transactions or products are required to disclose all material financial risks and characteristics, incentives and conflicts of interest regarding the transactions or products.
  • An underwriter’s duty to have a reasonable basis for the representations it makes to a state or local government extends to representations made in connection with the preparation by the state or local government of its disclosure documents.
  • The duty to treat state and local governments fairly includes an implied representation that the price an underwriter pays to a state or local government is fair and reasonable, taking into consideration all relevant factors.
  • Underwriters are required to disclose potential conflicts of interest, including the existence of third-party payments, values, or credits made or received, profit-sharing arrangements with investors, and the issuance or purchase of credit default swaps for which the underlying reference is the state or local government whose securities are being underwritten.
  • Underwriters are reminded not to disregard the state and local governments’ rules for retail order periods by accepting or placing orders that do not satisfy the state and local governments’ definitions of “retail.”

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

Carlo V. di Florio, who is the Director of the  Office of Compliance Inspections and Examinations at the SEC recently gave his views as to key points the SEC will consider in the examination process of sponsors of private equity groups who are registered with the SEC and other matters.

Data

Mr. di Florio began by outlining the data profile of new private equity registrants:

  • There are now close to 4000 IAs that manage one or more private funds registered with the Commission, of which 34 per cent have registered since the effective date of the Dodd-Frank Act.
  • 32 per cent of all advisers that register with the SEC report that they advise at least one private fund.
  • Of the roughly 4000 registered private fund advisers, 7 per cent are domiciled in a foreign country (the UK is the most significant).
  • Registered private fund advisers report that they advise nearly 31,000 private funds with total assets of $8 trillion (16% of total assets managed by all registered advisers).
  • Based on available information, of the 50 largest hedge fund advisers in the world, 48 are now registered with the Commission. Fourteen of these are new registrants.
  • Of the 50 largest private equity funds in the world, 37 are now registered with the Commission. 18 of these are new registrants.

Advertising

Private equity groups will be able to engage in advertising during their fund raising cycle once the SEC deletes the prohibition on general solicitation during Rule 506 offerings as required by the JOBS Act.  Mr. di Florio noted the “advertising rule” prohibits advertisements by investment advisers that are false or misleading advertising or contain any untrue statements of material fact. Advertising, like all statements made to clients or prospective clients, is subject to the general prohibition on fraud under section 206 of the Advisers Act as well as other anti-fraud provisions under the federal securities laws. In addition to specific regulatory requirements, SEC staff has also indicated its view that, if you advertise performance data, the firm should disclose all material facts necessary to avoid any unwarranted inferences.

Risks

Mr. di Florio discussed some of the risk areas regarding private equity that might be considered during an examination:

  • What is the fund strategy? Does the fund control portfolio companies or hold only minority positions? Is the strategy to invest with other firms or alone? Does strategy make general sense? Are investments in easily understandable companies?
  • How clear are investor disclosures around ancillary fees (particularly those charged to portfolio companies), management fee offsets and allocation of expenses? How robust are the processes to ensure compliance with those disclosures?
  • Does the firm have a complicated set of diverse products? If so, how are inter-product conflicts managed? These conflicts can arise, for instance, from two products investing in different parts of a deal’s capital structure or products competing for deal allocation.
  • What risks are posed by the life cycle of the funds? For example, for funds approaching the end of their life fund raising may be necessary, in which case risks related to claims about the fund’s track record and valuation should be in focus. Conversely, a “Zombie” adviser who is unlikely to raise additional capital may be motivated to extract value from its current holdings, in which case risks related to fees, expenses and liquidity would come into focus. For a fund at the beginning of its life cycle, deal allocations between investment vehicles, or other types of favoritism might be a greater focus of concern.
  • How sophisticated and reliable are the processes used by the fund? Is the valuation process robust, fair and transparent? Are there strong processes for compliance with the fund’s agreements and formation documents? Are compliance and other key risk management and back office functions sufficiently staffed? What is the quality of investor communications? What is the quality of processes to ensure conflict resolution in disputes with or among investors?
  • What is the overall attitude of management towards the examination process, its compliance obligations, and towards risk management generally, compared to its peers?

Conflicts

From the examinations of private equity firms that the SEC has conducted to date, Mr. di Florio described a number of conflicts they have noted:

  • The profitability of the management company is obviously an important concern for private equity general partners and this creates an incentive to maximize fees and minimize expenses. The SEC has seen instances where expenses that should have been paid by the management company were pushed to the funds and have also seen instances where questionable fees were charged to portfolio companies. In addition, the same manager may be incentivized to be opaque with fee disclosures for fear that fund investors may not see extra fees as being in their best interest and to pursue larger deals which can absorb more fees. The adviser negotiates more favorable discounts with vendors for itself than it does for the fund;
  • The adviser favors side-by-side funds and preferred separate accounts by shifting certain expenses to its less favored funds;
  • The adviser puts one or more of the funds that it manages into both equity and debt of a company, which traditionally have conflicting interests, especially during initial pricing and restructuring situations;
  • One or more of a private equity firm’s portfolio companies may hire a related party to the adviser to perform consulting or investment banking services. This type of conflict may be remediated through strong disclosures, but the SEC has seen instances where disclosures were not very robust;
  • Conflicts between different business lines, where there may be the potential for confidential information to be improperly shared. The traditional means of remediating these types of conflicts is to maintain effective information barriers, but the SEC has seen weaknesses in private funds’ practices. For example, the SEC has have observed instances of weak or nonexistent controls where the public and private sides of the adviser’s business hold meetings or telephone conversations regarding an issuer about which the private side has confidential information, or poor physical security during business hours over the adviser’s office space such that employees of unrelated financial firms that have offices in the same building could gain access to the adviser’s offices.

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