Bruce Karpati, the Chief of the SEC Enforcement Division’s Asset Management Unit, held a Q&A session entitled “Private Equity Enforcement Concerns” at the Private Equity International Conference held in New York on January 23, 2013. He addressed private equity firm activities of concern, how the SEC is tracking those activities, and ways firms can avoid getting into trouble. [Read more...]
SEC Enforcement Division’s Asset Management Unit’s Chief Anticipates Increase in Private Equity Enforcement
February 14, 2013 By Leave a Comment
SEC Enforcement Division’s Asset Management Unit Chief Reveals New Priorities in Regulation of Private Funds
January 9, 2013 By Leave a Comment
Bruce Karpati, Chief of the SEC Enforcement Division’s Asset Management Unit, gave a speech entitled “Enforcement Priorities in the Alternative Space” on December 18, 2012. The recently established 75-member Asset Management Unit (AMU) is dedicated to investigating investment advisers, investment companies, hedge funds, mutual funds, and private equity funds making up the “alternative space” referred to in the speech’s title. Karpati addressed current enforcement priorities, touching upon, among other topics, the AMU’s enhanced expertise, investor risks, and how the hedge fund operating model incentivizes misconduct. As outlined in Karpati’s speech, the AMU’s current priorities indicate that, while traditionally hedge funds and private equity funds were lightly regulated, this will likely no longer be the case.
The loose regulation of private funds is the result of the assumed sophistication of the investors involved, the burgeoning market, increased industry specialization, and regulatory changes mean that unsophisticated investors are increasingly investing in private funds and even sophisticated investors are often unable to evaluate the risks involved in their investment. Unsophisticated investors are increasingly exposed to hedge funds indirectly through pensions, endowments, foundations, and other retirement plans. The increasing retail nature of hedge funds has encouraged wealthy but unsophisticated investors to invest directly, and the upcoming elimination of the prohibition on general solicitation and advertising will expose a much broader pool of investors to what previously would have been private offerings. In addition, alternative investment vehicles often involve complicated investments that create significant opportunity for fraud, even when investors are relatively sophisticated. Finally, smaller hedge fund advisers — where most hedge fund fraud occurs — are exempt from registration under federal securities laws. As a result, they may not have effective compliance policies, are not subject to inspection by the SEC, and are not required to comply with SEC advertising rules for investment advisers. Karpati highlighted the AMU’s concern that unregistered advisers may fail to limit offerings to accredited investors or fail to abide by other restrictions placed on registered advisers.
Karpati went on to discuss how the hedge fund operating model itself gives rise to conflicts of interest and incentives to commit fraud. First, hedge fund managers are compensated by both management fees and performance fees, so they often have an incentive to overvalue assets or engage in riskier strategies. Hedge fund managers also face considerable pressures to yield high returns. Finally, it is easy for fund advisers to engage in related party transactions or give favored treatment to certain investors through preferential redemptions or side letters.
While the SEC previously focused on enforcement of the various rules and regulations governing investment advisers, such as violations of registration and disclosure requirements and failure to adopt and enforce compliance procedures, the AMU’s new priorities, as outlined by Karpati, cover the more amorphous area of an adviser’s ethical obligations to investors and clients. There are many ways that federal securities laws govern such ethical obligations, but two of the most significant are: (i) the Investment Advisers Act of 1940 places a fiduciary duty on investment advisers to their clients and (ii) the anti-fraud provisions of Investment Advisers Act and other securities laws places a duty of disclosure of conflicts of interest to investors. Karpati stated that fund managers must guard against all incentives — even unconscious — that might cause them to provide advice that is not disinterested. It is possible to commit a violation of these laws even if the breach does not actually intend to injure a client. In addition, an adviser can violate the law even if a client does not suffer actual injury.
To effectively carry out enforcement against these kinds of violations, the personnel conducting an SEC examination will need to operate on a more sophisticated level than merely trying to check off a list of requirements that the adviser was required to meet. Karpati revealed that the AMU has hired former industry professionals such as hedge fund managers, private equity analysts, and due diligence professionals. These experts have implemented certain risk-based analytic initiatives utilizing data analysis and designated risk criteria to identify individuals or firms that could be engaged in specific types of misconduct. One such initiative is the “Aberrational Performance Inquiry,” which targets hedge fund performance returns that seem too good to be true. Together with the Division of Risk, Strategy, and Financial Innovation and the Office of Compliance Inspections and Examinations (OCIE), the AMU’s experts analyze performance data of thousands of hedge fund advisers and identify possible misconduct. This initiative has so far yielded seven enforcement actions against hedge fund advisory firms and managers for improper use of fund assets, fraudulent valuations, misrepresenting fund returns, failure to disclose related party transactions, and other misconduct. Another risk analytic initiative is the “Private Equity Initiative,” which seeks to uncover private equity fund advisers that pose a higher risk for certain misconduct, such as improperly failing to liquidate assets or misrepresenting the value of holdings to investors.
Just as enforcing standards of fiduciary duty and the duty to disclose conflicts of interest requires SEC enforcement personnel to think on a more sophisticated level, complying with these requirements will also require investment advisers and fund managers to consider their compliance practices on a more sophisticated level. Merely following bright line rules many no longer be enough.
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© 2013 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
The SEC (Finally) Issues a Preliminary Rule for Repeal of the Regulation D General Solicitation Requirements
August 30, 2012 By Leave a Comment
Yesterday, the SEC finally released its proposed rule to amend Rule 506 of Regulation D to eliminate the general solicitation prohibition for private placement offerings. As I’ve discussed in a previous post, the SEC’s continued delays in issuing this rule has resulted in considerable frustration among the entrepreneurial community and in Congress.
While the SEC has finally released its proposed rule, this does not mean that startups and other companies looking to conduct private placements can begin to use the newly revised Regulation D to conduct private placements via public advertising. The SEC only issued a proposed rule, which means that the change will not be effective until after the SEC has received comments and possibly revised the rule further. That said, after a quick read of the proposed rule, here are the highlights:
The JOBS Act provides that the use of general solicitation is only permitted in offerings in which all investors are accredited investors. Some commenters were concerned that the wording of this provision implied that in order for a private placement offering conducted with a general solicitation to have a valid exemption, all investors must actually be accredited. If this were true, then even an inadvertent error could result in a complete loss of the exemption. However, since the definition of an accredited investor includes anyone that the issuer reasonably believes would otherwise qualify as an accredited investor, this should not be an issue. Indeed, the SEC has taken this position as well. Thus, if any issuer reasonably believes that an investor would qualify as an accredited investor, then the fact that that investor later turns out not to be accredited investor would not cause a complete loss of the exemption.
Another concern that some observers had was that the new rule would not extend to private funds. The reason for this is that private funds must be exempt not only from Securities Act registration, but also from registration under the Investment Company Act of 1940. The two main exemptions that private funds rely upon to be exempt from this law both require that the fund not make any public offering of securities. Fortunately, the SEC has taken the position that if a fund issues its interests pursuant to the revised Rule 506, then the fund would not be deemed to be engaging in a public offering and the fund would still be exempt from registration under the Investment Company Act.
One issue that was frequently brought up in the lead up to the proposing of this rule was whether issuers could continue to rely on Rule 506 as it currently stands. The new Rule 506 requires issuers to take “reasonable steps to verify” that their investors are indeed accredited investors, whereas the current Rule 506 contains not such requirement.[1] Current practice is simply to obtain a representation from the investor certifying that he or she qualifies as an accredited investor. So, can an issuer continue to rely on such a representation and simply not engage in any general solicitation? The answer is yes; the SEC has preserved the existing Rule 506, which will be called Rule 506(b) and the new rule allowing general solicitation will be called Rule 506(c).
While the preceding three points will come as a relief to many within the entrepreneurial and private fund management communities, the fact is that the SEC provided little specific guidance as to what constitutes “reasonable steps” to verify an investor is accredited. When the JOBS Act was passed, many speculated as to what this would mean precisely and hopes that the SEC could provide some degree of clarity. Unfortunately, from the rule proposed yesterday, it appears that the SEC will not be providing any clarity. The proposed rule simply parrots the wording of the JOBS Act, without elaborating at all. However the commentary to the rule does provide some degree of guidance, albeit not particularly specific guidance. The commentary merely states that the “particular facts and circumstances of each purchaser” governs what would constitute reasonable steps. The examples provided are far beyond the scope of this post, but it is sufficient to say that issuers will have no bright-line rule to protect them. One of the primary benefits of using Rule 506 is that is a safe harbor, which allows issuers to know with reasonable certainty that their offering is exempt from registration under the Securities Act. I’m not entirely sure that the new Rule 506(c) will give issuers that level of comfort. When qualification for the exemption is reliant upon individual facts and circumstances, it takes away a lot of the certainty that issuers desire when issuing securities. That said, from reading the commentary, it does not appear that the SEC has established a particularly high standard for what constitutes “reasonable steps.” It doesn’t mandate taking any particular action (such as obtaining tax returns or other financial statements) and issuers can rely on third-parties, such as accountants, lawyers, and broker-dealers, to provide verification.
These are simply my initial impressions based upon my first reading of the rule, and of course, the final rule may end up being somewhat or very different from the proposed rule. Some of these ambiguities I’ve just described may end up getting clarified in the final rule.
Footnotes
[1] Of course, if an investor does not fit within one of the objective categories of persons who are accredited, the issuer must at least have a “reasonable belief” that they do otherwise qualify.
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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
The SEC Increases the Net Worth Requirement of the Definition of “Qualified Client” Impacting Both Registered and Some Unregistered Private Fund Managers
February 23, 2012 By Leave a Comment
Private fund managers who are registered with the SEC are required to follow federal regulations on performance compensation. Generally, if a registered fund manager desires to collect fees based on fund performance (such at the typical 20% carried interest), then each investor in the fund must be a “qualified client.” Prior to the passage of the Dodd-Frank Act, a qualified client was defined as either (i) an individual or company that immediately after investing into the fund has at least $ 750,000 under the management of the fund manager or (ii) an individual or company that has a new worth of $1.5 Million or more or qualifies as a “qualified purchaser.”[1] The Dodd-Frank Act required that the SEC update these two thresholds for inflation, which it did, effective September 19, 2011. It updated the thresholds to $1 Million and $2 Million respectively.
Now, the SEC has issued an additional order further increasing the net worth threshold to $2 Million excluding the value of the investors primary residence, similar to the change that was made last year to the net worth threshold component of the definition of “accredited investor.” Like the exclusion from net worth of a primary residence in the accredited investor definition, the exclusion from the net worth threshold of the qualified client definition has a number of wrinkles:
- If the primary residence is encumbered by any mortgage indebtedness, then the investor can exclude that mortgage indebtedness as a liability up to the estimated fair market value of the home. If the home is “underwater” and the indebtedness exceeds the value of the home, then the investor must count the excess as a liability.
- If the mortgage indebtedness on an investor’s home increased within the 60 days prior to the investor’s execution of the subscription agreement, then the amount by which the indebtedness increased must be counted as debt. Essentially, this prevents a potential investor from taking out a line of credit on their home right before investing and artificially increasing their net worth for the purposes of this regulation.
This change may have a significant effect on what investors a fund manager can accept if the fund manager is a registered investment adviser. In addition, while on paper, this change does not affect fund managers that are not registered with the SEC, many states’ securities regulators are requiring, as a condition to being exempt with own their states’ registration requirements, that a fund manager only accept qualified clients. So these regulations have the ability to affect unregistered fund managers as well. They will come into effect 90 days after their publication in the Federal Register.
Footnote
[1] A “qualified purchaser” is defined roughly as a person with at least $5 Million in investment assets or a company with at least $25 Million in investment assets.
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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
Should private funds be exempt from the ban on general solicitation?
January 26, 2012 By Leave a Comment
The Managed Funds Association recently submitted a comment letter to the Securities and Exchange Commission dated January 6, 2012 requesting the SEC to amend Rule 502(c) of Regulation D to exempt private funds, such as hedge funds, private equity funds, and venture capital funds, from the ban on general solicitation and advertising under Regulation D.
Currently under existing law, private funds cannot engage in any “general solicitation” or “general advertising” in connection with offers and sales of interests in their funds. This prohibits funds from engaging in any public advertising and communications about their securities offerings and requires a “substantial pre-existing relationship” between the issuer and any offeree. In its letter, the MFA makes the case that changes in the securities markets and technology have rendered the general solicitation restrictions of Regulation D, enacted 30 years ago, outdated. In addition, the MFA argues that the vagueness over what constitutes a general solicitation, combined with the severe penalties for even an inadvertent violation creates legal uncertainly for private funds, which inhibits capital formation. It also makes the argument that allowing general solicitations for private fund offerings will increase transparency of funds, because they will be able to publicly publish their returns.
If the MFA proposal were to be adopted, private funds would be able to engage in public communications and offering activity while remaining in compliance with Regulation D and corresponding sections of the Investment Company Act that exempt private funds from investment company registration if they do not engage in a public offering. This would certainly ease some of the compliance burdens on private funds.
One question that must be asked is why should this exemption from the general solicitation requirement apply only to private funds? Why shouldn’t it apply to any Regulation D offering? The MFA’s letter doesn’t really answer this point, though it does make a few arguments in favor of the change that would generally only apply to private funds. For instance, it argues that the restriction creates an aura of secrecy that causes people not familiar with securities laws to make negative inferences about the hedge fund industry. This is certainly true; though how much harm this actually causes the hedge fund industry is up for debate. It seems to me that if we’ve decided that the ban on general solicitation is outdated, then it should be repealed outright, rather than just repealed for certain industries.[1]
Another thought I had while reviewing the letter is that the MFA makes a much better case for exempting so-called “3(c)(7)” funds rather than “3(c)(1) funds.” 3(c)(7) funds are limited to qualified purchasers who must have over $5 million in investment assets (if an individual) or $25 million in investment (if an institution). Given that there are relatively few qualified purchasers, repealing the ban on general solicitation only for offerings targeted towards qualified purchasers would not likely cause the inundation of investment offers we are likely to see if this was opened up to all accredited investors.
Therefore, in my view, the best reform that could be instituted right now would be to allow general solicitation for any private offering that is offered solely to qualified purchasers (regardless of whether the offering is for a private fund or some other kind of entity). I also propose that one additional condition on being exempt from the general solicitation ban would be that the issuer would be required to document proof of the qualified purchaser’s status by obtaining financial records (rather than now where the investor can simply represent that he or she is a qualified purchaser). Such an approach, in my view, may be the best way to balance the needs of capital formation with investor protection.
Footnotes
[1] In fact there is a bill circulating through Congress right now that does repeal the ban on general solicitation for Regulation D private placements. What comes of it remains to be seen.
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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
