Posted on Thursday, December 15 2016 at 9:28 am by

Supreme Court Confirms Expansive View of Insider Trading

By Paul Foley, Clay Wheeler, and John Sanders

Perhaps the most serious charge that could be leveled against a reader of this blog is that of being engaged in or associated with “insider trading.”  The allegation alone is enough to derail or end a promising career.  Successful compliance requires an understanding of the law and your obligations under it.  In light of recent developments regarding insider trading, including the first Supreme Court decision to address the crime in 20 years,[1] we encourage you to read this article in its entirety and contact us with any questions you may have.

Insider Trading:  The Tradition

Section 10(b) of the Securities Exchange Act of 1934[2] and Rule 10b-5[3] promulgated thereunder prohibit insider trading.  The basic elements of insider trading are:  (i) engaging in a securities transaction, (ii) while in possession of material, non-public information, (iii) in violation of a duty to refrain from doing so.

The paradigm case discussing the so-called “classical” theory of insider trading is Chiarella v. U.S.[4]  In Chiarella, an employee of a publishing firm was charged with insider trading after using advance notice of a takeover bid to trade.  Chiarella’s conviction was reversed by the Supreme Court after the Court focused on the requirement of a duty running from the trader to the shareholders of the corporate entity “owning” the material, non-public information.  Thus, a successful prosecution under the classical theory usually involves a corporate insider trading in shares of his or her employer while in possession of material, non-public information (e.g., advance notice of a merger).

After Chiarella, an important development in the law has been the extension of liability to persons who receive tips from insiders, i.e., individuals whose duty to refrain from trading is derived or inherited from the corporate insider’s duty.  Thus, not only may insiders be liable for insider trading under rule 10b-5, but those to whom they pass tips, either directly (tippees) or through others (remote tippees) may be liable if they trade on such tips.  Because tippee and remote tippee liability is more difficult to grasp and more likely to affect our readers, this article will primarily, but not exclusively, focus on individuals in those circumstances.

In a pattern that has repeated itself over the years, courts broadened the scope of insider trading by developing a second, “complementary”[5] theory of insider trading – the “misappropriation” theory.  This theory “targets person[s] who are not corporate insiders but to whom material non-public information has been entrusted in confidence and who breach a fiduciary duty to the source of the information to gain personal profit in the securities market.”[6]  The seminal case in the articulation of the misappropriation theory is U.S. v. O’Hagan.  In O’Hagan, a partner at a large law firm (but not ours) obtained and traded on information given to attorneys in the firm who were representing a client in a tender offer.  The Supreme Court held that “A person who trades in securities for personal profit, using confidential information misappropriated in breach of a fiduciary duty to the source of the information, may be held liable for violating § 10(b) and Rule 10b-5.”[7]  In practical terms, under the misappropriation theory, individuals who come into possession of material, non-public information while providing services to corporate clients, such as the attorney in O’Hagan [8] may be held liable.

Joining Chiarella and O’Hagan in making up the traditional core of insider trading law is Dirks v. SEC.[9]  In Dirks, the Supreme Court attempted to set a limit on the scope of insider trading.[10]  Dirks was a securities analyst who learned from a former insurance company insider that the company was committing fraud and was on the verge of financial ruin.[11]  Dirks investigated and disclosed this information to several people, including a reporter and clients who traded on the information.[12]  Dirks was held liable for insider trading, but appealed.[13]  The overturning of Dirks’s liability centered on the fact that the corporate insider had disclosed the fraud to Dirks purely by a desire to expose the fraud, rather than to obtain any financial or other personal benefit.  The Court held:

In determining whether a tippee is under an obligation to disclose or abstain, it is necessary to determine whether the insider’s “tip” constituted a breach of the insider’s fiduciary duty.  Whether disclosure is a breach of duty depends in large part on the personal benefit the insider receives as a result of the disclosure.  Absent an improper purpose, there is no breach of duty to stockholders.  And absent a breach by the insider, there is no derivative breach.[14]

Furthermore, Dirks introduced the idea that a tippee has to be actually aware of the tipper’s breach or presented with sufficient facts so that the tippee will be deemed aware.  In this way, Dirks created a “personal benefit” element related to the tipper.  After Dirks, prosecutors were generally confident they could prove this benefit existed as long as there was a quid pro quo or a moderately close relationship between tipper and tippee.

Newman:  A Disruption

Chiarella, O’Hagan, and Dirks guided the law of insider trading largely uninterrupted for nearly 20 years.  Then came a decision from the Second Circuit, the so-called “Mother Court”[15] of securities law, but an underling of the Supreme Court, called U.S. v. Newman.[16]

Newman involved a hedge fund portfolio manager who was part of an information-sharing cohort of analysts and portfolio managers.[17]  By the time Newman received the tip, he was “four levels removed from the insider tippers,” (i.e., a remote tippee).[18]  The tippers were insiders at technology companies who had provided information to what the court termed “casual acquaintances,” who in turn passed those tips on.  Citing Dirks repeatedly for support, the U.S. 2nd Circuit Court of Appeals emphasized that government must prove the tipper received “a personal benefit” and that the tippee knew of that benefit.[19]

In Newman, the Second Circuit concluded that “the mere fact of friendship” was insufficient to give rise to the required personal benefit to the tipper.  Instead, the court required “proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.”  Despite the fact that the 2nd Circuit cited its adherence to Dirks in overturning Newman’s conviction, it was clear to all that by raising the bar for the evidence required to meet the Dirks “personal benefit” requirement, the opinion suggested a serious new limitation on insider trading law.  Moreover, the prosecutors were denied a rehearing en banc and a Supreme Court writ of certiorari.  This meant Newman would remain law in the most significant federal circuit for securities law until further notice.

One attorney called Newman “a well-deserved generational setback for the Government.”[20]  The predicted effect of Newman was that the government would be forced to prove that someone charged with insider trading knew that she was trading on non-public, material information and that “the tipper’s goal in disclosing information is to obtain money, property, or something of tangible value.”[21]  This heightened burden led to the reversal of more than a dozen insider trading convictions,[22] and pending cases were dropped.[23]

Salman:  The Expansive View of Insider Trading Strikes Back

Newman’s holding concerning what qualifies as a personal benefit to the tipper was reversed last week when the Supreme Court issued its opinion in Salman v. United States.[24]  Before the Supreme Court issued its opinion, in Salman, only the most ardent securities law gurus followed the case.  So, some background may be helpful.  Salman was convicted after trading on material, non-public information received from a friend, who had received the information from Salman’s brother-in-law.  Thus, Salman was prosecuted as a remote tippee.  He argued that he could not “be held liable as a tippee because the tipper (his brother-in-law, who worked on M&A matters at an investment bank) did not personally receive money or property in exchange for the tips.”[25]

In a strong rebuke, the Supreme Court held, “To the extent that the Second Circuit in Newman held that the tipper must also receive something of a “pecuniary or similarly valuable nature” in exchange for a gift to a trading relative, that rule is inconsistent with Dirks.[26]  Justice Alito succinctly explained “a tippee’s liability for trading on inside information hinges on whether the tipper breached a fiduciary duty” and that duty is breached “when the tipper discloses the inside information for a personal benefit.”[27]  Such a personal benefit can be inferred where the tip is made “to a trading relative or friend.”[28]

Why Salman Matters

By allowing a generous inference of a benefit to the tipper based on a personal relationship alone, the Supreme Court in Salman reestablished the old order of things – an expansive scope for insider trading prosecutions.  We understand that investment advisers are more likely than others to come into contact with corporate insiders, as well as those with whom corporate insiders speak in confidence.  You know these individuals as professionals, former schoolmates, and even friends and family members.  In discussing your work, it is quite possible that non-public, material information may be intentionally or inadvertently tipped to you.  Your livelihood and liberty may depend on how well you understand your legal obligations when that happens.  Fortunately, when you have questions about the rules regarding insider trading, we’re here to assist.

 

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s New York and Winston-Salem offices. Clay Wheeler is a partner in Kilpatrick’s Raleigh and Winston-Salem officesJohn Sanders is an associate based in the firm’s Winston-Salem office.

 

[1] Greg Stohr and Patricia Hurtado, The Supreme Court Will Hear Its First Insider-Trading Case in 20 Years, Bloomberg (Oct. 4, 2016), https://www.bloomberg.com/politics/articles/2016-10-04/wall-street-watching-as-u-s-high-court-tackles-insider-trading.

[2] 15 U.S.C. 78j (2016).

[3] 17 CFR 270.10b-5 (2016).

[4] Chiarella v. U.S., 445 U.S. 222 (1980).

[5] U.S. v. O’Hagan, 521 U.S. 642, 643 (1997).

[6] SEC v. Obus, 693 F.3d 276, 284 (2d Cir. 2012).

[7] O’Hagan, at 642.

[8] Id.

[9] Dirks v. SEC, 463 U.S. 646 (1983).

[10] Id. at 646.

[11] Id.

[12] Id.

[13] Id.

[14] Id. at 647.

[15] James D. Zirin, American Bar Association, The Mother Court: A.K.A., the Southern District Court of New York, http://www.americanbar.org/publications/tyl/topics/legal-history/the-mother-court-aka-southern-district-court-new-york.html

[16] U.S. v. Newman, 773 F.3d 438 (2d Cir. 2014)

[17] Id. at 443.

[18] Id.

[19] Id. at 450.

[20] Jon Eisenberg, How the United States v. Newman Changes the Law, Harvard Law School Forum on Corporate Governance and Financial Regulation (May 3, 2015), https://corpgov.law.harvard.edu/2015/05/03/how-united-states-v-newman-changes-the-law/.

[21] Salman v. U.S., available at https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=2&ved=0ahUKEwihloXYvu_QAhVBjpAKHflsCIIQFggjMAE&url=https%3A%2F%2Fwww.supremecourt.gov%2Fopinions%2F16pdf%2F15-628_m6ho.pdf&usg=AFQjCNGY28IXIk-a-h-Nuvi5EXSHC6XW6g&sig2=Ydo5oy44CzIMDuCxjMluzA&bvm=bv.141320020,d.eWE (The opinion presents and rejects this argument from Salman before stating that the rule from Newman is inconsistent with precedent)

[22] Greg Stohr and Patricia Hurtado, The Supreme Court Will Hear Its First Insider-Trading Case in 20 Years, Bloomberg (Oct. 4, 2016), https://www.bloomberg.com/politics/articles/2016-10-04/wall-street-watching-as-u-s-high-court-tackles-insider-trading.

[23] Patricia Hurtado, SAC Capital’s Steinberg Gets Insider Trading Charges Dropped, Bloomberg (Oct. 23, 2015), https://www.bloomberg.com/news/articles/2015-10-22/u-s-drops-charges-against-sac-capital-s-michael-steinberg.

[24] Salman, supra note 21.

[25] Id.

[26] Id.

[27] Id.

[28] Id.

Posted on Thursday, November 10 2016 at 2:03 pm by

Revised Form ADV: What CCOs Need to Know

By Paul Foley and John Sanders of Kilpatrick Townsend & Stockton

On Aug. 25, 2016, the Securities and Exchange Commission adopted final rules intended to update and enhance the disclosure requirements promulgated under the Investment Advisers Act of 1940—primarily by revising Form ADV. The final rules, which became effective on October 31, 2016 and have a compliance date of Oct. 1, 2017, are substantial and wide-ranging, and chief compliance officers should take note both of their provisions and the potential implementation issues they raise.

INCREASE IN SMA DISCLOSURES

Among the most significant amendments to Form ADV are those related to the disclosure of assets held in separately managed accounts. Advisers will now be required to disclose the approximate percentage of SMA assets that are invested in 12 broad asset categories, including exchange-traded equity securities, U.S. government bonds and derivatives.

This classification requirement presents a practical concern as certain SMA assets may not fit squarely within a single category. The SEC will allow advisers to use their own classification methodology for such assets, “so long as their methodologies are consistently applied and consistent with information the advisers report internally.” But what sounds like well-intentioned deference may not be as beneficial to advisers as it seems. In fact, it may trap unwary advisers, leaving them unable to change internal classification methodologies later.

Perhaps more surprisingly, the new SMA disclosure requirements may be of marginal utility with respect to SMAs holding significant interests in funds, such as exchange-traded funds, mutual funds, hedge funds and private equity funds. Indeed, despite the wide variations among fund asset allocations, the amendments only require advisers to disclose the amount of fund assets held in SMAs. Advisers are expressly told not to look through such funds with respect to the underlying exposure to the various asset categories.

The lack of a look-through mechanism means that the SEC and current and potential advisory clients may garner little information from the new disclosure requirements. This is particularly true with respect to advisers that primarily use funds in SMAs.

For example, if nearly all of an adviser’s SMA assets are invested in funds, the new disclosure requirements will provide almost no meaningful insight regarding the risk, diversification or strategies used by the adviser in SMAs. This issue will only grow more pronounced as advisers increasingly use ETFs and other fund-based strategies.

UMBRELLA REGISTRATION

Another noteworthy amendment to Form ADV tries to make umbrella registration more efficient. The SEC first allowed umbrella registration through no-action letter guidance in response to the new adviser registration requirements set forth in the Dodd-Frank Act. Today, around 743 filing advisers and 2,587 relying advisers are using umbrella registrations. The SEC believes this represents nearly all advisers entitled to use umbrella registration.

With umbrella registration already in extensive use, the true effect of these amendments is to codify the conditions that must be met before it can be employed. According to the SEC, this was done “to limit eligibility for umbrella registration to groups of private fund advisers that operate as a single advisory business.”

The Commission received a number of comment letters regarding umbrella registration that favored relaxing the requirements. Specifically, some objected to the condition that the filing adviser and relying advisers operate under a single code of ethics and a single set of written policies and procedures administered by a single CCO. But the SEC did not alter its position.

The agency’s focus on limiting the applicability of umbrella registration did not address a surprisingly popular practice whereby one or more advisers under common control, but organized as distinct entities, avoid registration entirely. In such circumstances, advisers specifically do not meet the requirements for umbrella registration and each adviser tries to rely on its own exemption from registration. This seems like a missed opportunity by the SEC to address a practice that one could argue is simply doing indirectly what is prohibited from being done directly.

SOCIAL MEDIA DISCLOSURE

Nestled among the amendments that will impact advisers immediately is one that, although somewhat significant today, will likely become even more important over time. Form ADV now requires disclosure of the adviser’s social media accounts and the address of each of the adviser’s social media pages. The SEC plans to use this information to prepare for examinations of advisers and compare information that advisers disseminate across different platforms.

We anticipate that SEC examiners will have heightened interest in advisers’ use of social media. Moreover, we believe this additional disclosure will lead to significantly more deficiencies and, potentially, enforcement related to the adviser recordkeeping and performance marketing rules.

CLARIFYING AMENDMENT AND TECHNICAL CHANGES

In addition to the changes discussed above, the SEC has made numerous amendments designed to clarify Form ADV and its instructions. Although the clarifying and technical amendments are too numerous to cover adequately here, an overview of the changes to Item 7, which the SEC revised significantly, provides an illustrative example.

Item 7.A., which requires advisers to disclose whether their related persons fall within certain financial industry categories, will now state that advisers need not disclose that some of their employees perform investment advisory functions or are registered representatives of a broker/dealer, since this information is reported elsewhere in Form ADV.

In a similar vein, Item 7.B asks whether an adviser serves as an adviser to a private fund and Section 7.B.(1) is where further information is provided. The SEC has added an explanation that Section 7.B.(1) of Schedule D should not be completed for a fund if another registered adviser or SEC-exempt reporting adviser reports the information. These amendments are likely to improve the overall quality of disclosure in Form ADV by making it more consistent among advisers.

BOOKS AND RECORD RULES

The SEC has also amended Rule 204-2, the books and records rule, under the Advisers Act. Rule 204-2(a)(16), which at present requires advisers to maintain records supporting performance claims in communications that are distributed to 10 or more persons, will now require records to be maintained for any performance claims distributed to any person.

In addition, Rule 204-2(a)(7) will now require advisers to maintain originals of all written communications received and copies of all written communications sent by an adviser relating to the performance or rate of return of any managed accounts or other securities recommendations. We believe these amendments to the books and records rule will have a limited impact on advisers because most advisers already maintain this information.

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s New York office. John Sanders is an associate based in the firm’s Winston-Salem, North Carolina office.

Posted on Friday, October 14 2016 at 1:05 pm by

SEC Reports on Fiscal Year 2016 Enforcement Actions

On October 12, 2016, the Securities and Exchange Commission (the SEC), announced its enforcement results for the 2016 fiscal year.[1]  For all but the most dedicated followers of the SEC’s recent uptick in enforcement activities, the results are eye opening.

The Numbers

In 2016, the SEC filed a record 868 enforcement actions against a wide-range of actors.[2]  This represents a jump of over 7.5% from 2015 and 15% from 2014.[3]  The Wall Street Journal linked the record-breaking year to SEC Chair Mary Jo White’s “broken windows” strategy of pursuing “the smallest legal violations” as well as the serious, headline-grabbing frauds.[4]  The effect, Chair White says, “makes you feel like we are everywhere.”[5]

Not only was the SEC able to increase the number of enforcement actions filed in 2016, it also was successful in obtaining over $4 Billion in disgorgements and penalties through favorable orders, settlements, and judgements.[6]

Insider Trading

Several of the highlighted enforcement actions for the year involve a point of perpetual emphasis for the SEC: insider trading.[7]  In 2016, nearly 10% of all enforcement actions brought were related to insider trading.  Several of those stemmed from what the SEC described as “complex insider trading rings” uncovered through “innovative uses of data and analytics.”[8]

One illustration of a complex insider trading ring involves two hedge fund managers and a former government official.[9]  The former government official allegedly used deception, concealing his role as a hedge fund consultant, to obtain confidential information about upcoming approvals of generic drug applications from former colleagues at the Food and Drug Administration.[10]  The SEC alleged that one of the hedge fund managers made unlawful profits of nearly $32 million by insider trading on tips he received from the scheme.[11]

Investment Advisers

The SEC also revealed that investment advisers were a primary target of SEC enforcement actions in 2016.[12]  In fact, nearly 20% of enforcement actions brought during the year, were brought against investment advisers and investment companies.[13]  This was another SEC record.[14]

Those who have been following the SEC under Chair White are not surprised by the surge in enforcement actions against investment advisers.[15]  Chair White has moved examiners from the broker-dealer unit to the investment adviser unit of the Office of Compliance Inspections and Examinations in recent years.[16]  Chair White has directed the enlarged staff to examine issues that generate conflicts of interest, such as cybersecurity policies and financial incentives.[17]

In a special section of the press release, the SEC highlighted some of its enforcements actions against advisers.[18]  Among the highlights are eight actions related to private equity fund advisers.[19]  Some of the entities and individuals involved are giants in the private equity industry:  Blackstone Group,[20] Fenway Partners,[21] and WL Ross & Co.[22]  Each paid fines related to its failure to adequately disclose certain fee arrangements.

The SEC also brought an enforcement action against three AIG affiliates which earned fees for steering clients into share classes of mutual funds that charged 12b-1 fees when the clients were eligible for share classes that did not charge such fees. In a release announcing the settlement of those claims, the SEC warned that “investment advisers must be vigilant about conflicts of interest when selecting mutual fund share classes.”[23]  This mix of actions against investment advisers is an example of how the SEC’s broken windows approach creates the appearance of comprehensive enforcement.

New Tools

In reviewing the results of this record-setting year, industry participants should note what the SEC credits for its success. Chair Mary Jo White states that the SEC is “using new data analytics to uncover fraud, enhancing [the SEC’s] ability to litigate tough cases, and expanding the playbook bringing novel and significant actions to better protect investors and our markets.”[24]

Analytical technology is something that the SEC has been developing for several years.[25]  The Market Information Data Analytics System (MIDAS), introduced in 2013, gives the SEC greater ability to reconstruct market data time-stamped to the micro-second.[26]  Efforts to build the Consolidated Order Trail are still ongoing.[27]  However, once that is on-line, the SEC should become even better at selecting and winning enforcement actions.

Conclusion

It is understandable if securities professionals reading these results do, in fact, feel that the SEC is everywhere these days. These results should trigger a recommitment to regulatory compliance that includes doing the little things right.  We’re here to help.

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s New York and Winston-Salem offices. John Sanders is an associate in the firm’s Winston-Salem office.

[1] SEC, SEC Announces Enforcement Results for FY 2016 (Oct. 12, 2016), https://www.sec.gov/news/pressrelease/2016-212.html.

[2] Id.

[3] Jean Eaglesham, WALL ST. J., SEC Breaks Record for Number of Enforcement Cases (Oct. 11, 2016), http://www.wsj.com/articles/sec-on-track-to-break-record-for-number-of-enforcement-cases-1476198436.

[4] Id.

[5] Id.

[6] Id.

[7] Thomas O. Gorman, LEXIS NEXIS, Priorities for the SEC’s Enforcement Division (March 23, 2015), https://www.lexisnexis.com/legalnewsroom/securities/b/securities/archive/2015/03/23/priorities-for-the-sec-s-enforcement-division.aspx.

[8] SEC, supra note 1.

[9] Id.

[10] Jonathan Stempel, REUTERS, Visium’s Valvani Charged With Insider Trading (June 16, 2016), http://www.reuters.com/article/us-usa-fraud-insidertrading-idUSKCN0Z11TB.

[11] SEC, supra note 1.

[12] Id.

[13] Id.

[14] Eaglesham, supra note 3.

[15] Kenneth Corbin, FINANCIAL PLANNING, SEC Brings Record Number of Enforcement Actions Against Advisers (Oct. 12, 2016), http://www.financial-planning.com/news/sec-brings-record-number-of-enforcement-actions-against-advisers.

[16] Id.

[17] Id.

[18] SEC, supra note 1.

[19] Id.

[20] SEC, Blackstone Charged With Disclosure Failures (Oct. 7, 2015), https://www.sec.gov/news/pressrelease/2015-235.html.

[21] SEC, SEC Charges Private Equity Firm and Four Executives With Failing to Disclose Conflicts of Interest (Nov. 3, 2015), https://www.sec.gov/news/pressrelease/2015-250.html.

[22] CNBC, SEC Fines Wilbur Ross’ Firm $2.3 Million Over Fees (Aug. 25, 2016), http://www.cnbc.com/2016/08/25/sec-fines-wilbur-ross-firm-23-million-over-fees.html.

[23] SEC, AIG Affiliates Charged With Mutual Fund Shares Conflicts (March 14, 2016), https://www.sec.gov/news/pressrelease/2016-52.html.

[24] SEC, supra note 1.

[25] Elisse Walter, Chairman, SEC, Harnessing Tomorrow’s Technology for Today’s Investors and Markets (Feb. 19, 2013), https://www.sec.gov/News/Speech/Detail/Speech/1365171492300.

[26] SEC, MIDAS: Market Information Data Analytics System, https://www.sec.gov/marketstructure/midas.html.

[27] Rob Tricchinelli, BLOOMBERG BNA, SEC Releases Consolidated Audit Trail Plan (April 28, 2016), http://www.bna.com/sec-releases-consolidated-n57982070430/.

Posted on Friday, February 28 2014 at 9:32 pm by

SEC Provides No-Action Relief for M&A Brokers

On January 31, the staff of the Securities and Exchange Commission (“SEC”) issued a no-action letter (“No-Action Letter”) [1] permitting an “M&A Broker”, under certain circumstances, to facilitate mergers, acquisitions, business sales, and business combinations (together, “M&A Transactions”) in connection with the transfer of ownership of a “privately-held company” (any company that does not have any class of securities registered, or required to be registered, with the SEC under Section 12 of the Securities Exchange Act of 1934 and is not required to file periodic information, documents, or reports under Section 15(d) of the Exchange Act) without the M&A Broker registering as a broker-dealer under section 15(b) of the Exchange Act. The specific terms and conditions in the No-Action Letter are outlined below.

While the details of the definition of M&A Broker are complicated, the No-Action Letter has caught the securities industry by surprise. The No-Action Letter provides a potential exemption from SEC broker-dealer registration for many M&A industry consultants commonly referred to as “business brokers”, even if they are paid “finders” or “success” fees for securities-based M&A transactions between privately-held companies. In particular, the No-Action Letter permits an M&A Broker [2] to (i) advertise a privately-held company for sale with information such as the description of the business, general location, and price range, (ii) participate in the negotiations of the M&A Transaction, (iii) advise the parties to issue securities, or otherwise to effect the transfer of the business by means of securities, or assess the value of any securities sold, and (iv) receive transaction-based or other compensation, without registering as a broker-dealer with the SEC.

In particular, the SEC noted the following regarding M&A Brokers:

  • M&A Brokers may not have the ability to bind a party to an M&A Transaction.
  • M&A Brokers may not directly, or indirectly through any of its affiliates, provide financing for an M&A Transaction.
  • M&A Brokers may not have custody, control, or possession of or otherwise handle funds or securities issued or exchanged in connection with an M&A Transaction or other securities transaction for the account of others.
  • M&A Transactions may not involve a public offering, but instead must be conducted in compliance with an applicable exemption from registration under the Securities Act of 1933.
  • No party to any M&A Transaction may be a “shell company”,[3] other than a “business combination related shell company”.[4]
  • M&A Brokers representing both buyers and sellers must provide clear written disclosure as to the parties represented and obtain written consent from both parties to the joint representation. In addition, an M&A Broker facilitating an M&A Transaction with a group of buyers may do so only if the group is formed without the assistance of the M&A Broker.
  • The buyer, or group of buyers, in any M&A Transaction must, upon completion of the M&A Transaction, control and actively operate the company or the business conducted with the assets of the business.[5]
  • No M&A Transaction may result in the transfer of interests to a passive buyer or group of passive buyers.
  • Any securities received by the buyer or M&A Broker in an M&A Transaction will be restricted securities within the meaning of Rule 144(a)(3) under the Securities Act because the securities would have been issued in a transaction not involving a public offering.
  • M&A Brokers and each officer, director or employee of an M&A Broker: (i) cannot have been barred from association with a broker­dealer by the SEC, any state or any self-regulatory organization; and (ii) may not be suspended from association with a broker-dealer.

Future Considerations

The No-Action Letter is a welcome step towards clarifying the registration requirements for M&A Brokers; however, it remains to be seen what, if any, effect it will have on determinations under state securities laws and their varied definitions of “brokers”, “dealers” and “finders”. Although it is reasonable to assume that states that have adopted laws similar to federal law in this area may likewise adopt the interpretation presented in the No-Action Letter, only time will tell if this proves to be the case. We also recommend that individuals and companies looking to rely on the No-Action Letter to avoid SEC broker-dealer registration carefully consider the No-Action Letter’s requirements for transactions to fit under its parameters (namely, the requirements that qualifying transactions involve a buyer that will take voting control, assume executive officer or management positions or otherwise have the power to exert control over the seller after the transaction). Additionally, we note that the No-Action Letter does not address continuing issues regarding broker-dealer registration of private equity fund advisers that receive deal-based fees, who likely would not be able to comply with the M&A Broker definition. Nevertheless, the No-Action Letter’s stark departure from the SEC’s historical position that transaction-based compensation is the “hallmark of broker-dealer activity” is a positive step towards addressing, at the federal level, at least some of these issues.

For more information on the No-Action Letter, please contact any member of the Investment Management Team.


[1] SEC No-Action Letter re: M&A Brokers, dated January 31, 2014. A copy of the No-Action Letter is available here.

[2] An “M&A Broker” is defined in the No-Action Letter as a person engaged in the business of effecting securities transactions solely in connection with the transfer of ownership and control of a privately-held company (defined below) through the purchase, sale, exchange, issuance, repurchase, or redemption of, or a business combination involving, securities or assets of the company, to a buyer that will actively operate the company or its assets, whether through the power to elect officers and approve budgets or by service as an executive or other executive manager, among other things.

[3] A “shell” company is defined in the No-Action Letter as a company that: (1) has no or nominal operations; and (2) has: (i) no or nominal assets; (ii) assets consisting solely of cash and cash equivalents; or (iii) assets consisting of any amount of cash and cash equivalents and nominal other assets. In this context, a going concern need not be profitable, and could even be emerging from bankruptcy, so long as it has actually been conducting business, including soliciting or effecting business transactions or engaging in research and development activities.

[4] A “business combination related shell company” is defined in the No-Action Letter as a shell company (as defined in Rule 405 of the Securities Act) that is (1) formed by an entity that is not a shell company solely for the purpose of changing the corporate domicile of that entity solely within the United States or (2) formed by an entity defined in Securities Act Rule 165(f) among one or more entities other than the shell company, none of which is a shell company.

[5] A buyer, or group of buyers collectively, would have the necessary control if it has the power, directly or indirectly, to direct the management or policies of a company, whether through ownership of securities, by contract, or otherwise. The necessary control will be presumed to exist if, upon completion of the transaction, the buyer or group of buyers has the right to vote 25% or more of a class of voting securities; has the power to sell or direct the sale of 25% or more of a class of voting securities; or in the case of a partnership or limited liability company, has the right to receive upon dissolution or has contributed 25% or more of the capital. In addition, the buyer, or group of buyers, must actively operate the company or the business conducted with the assets of the company.

 

 

Posted on Wednesday, January 15 2014 at 8:58 pm by

SEC Releases 2014 Exam Priorities

On January 9, 2014, the Securities and Exchange Commission (the “SEC”) announced its 2014 examination priorities (the “Exam Priorities”) as part of the SEC’s National Examination Program (the “NEP”) to foster communication with both investors and registered entities. The Exam Priorities are a “road map” for how investment advisers, funds, broker-dealers and others in the asset management industry will be reviewed by the SEC’s exam staff in the year ahead. The Exam Priorities describe multiple levels of NEP initiatives, including NEP-wide initiatives and “program area-specific initiatives” (e.g., initiatives that focus on investment advisers or broker-dealers).

NEP-Wide Initiatives

Some of the more significant NEP-wide initiatives include the following:

  • Fraud Detection and Prevention. This initiative focuses on the NEP’s use of quantitative and qualitative tools and techniques to identify market participants engaged in fraudulent or unethical behavior.
  • Corporate Governance, Conflicts of Interest, and Enterprise Risk Management. This initiative is designed to: (i) evaluate firms’ control environment and “tone at the top,” (ii) understand firms’ approach to conflict and risk management, and (iii) initiate a dialogue on key risks and regulatory requirements.
  • Technology. This initiative focuses on firms’ governance and use of technology, including operational capability, market access, information security and preparedness to respond to sudden malfunctions and system outages.
  • Dual Registrants. This initiative derives from concern that the convergence among broker-dealer and investment adviser activity creates a significant risk. Accordingly, the NEP will examine conflicts of interest, impacts to investors from different supervisory structures and legal standards of conduct related to dual registrants’ and their representatives’ provision of brokerage and investment advisory services.
  • New Laws and Regulation. This initiative focuses on general solicitation practices and verification of accredited investor status under newly adopted Rule 506(c) for Regulation D offerings. The NEP will also focus on compliance with regulatory requirements for crowdfunding compliance as these new rules become effective.

Program Area-Specific Initiatives

The Exam Priorities’ program area-specific initiatives are further categorized into “core risks”, generally selected based on issues identified in recently conducted examinations; “new and emerging issues and initiatives”, which the SEC generally believes pose increased risks due to changes in the industry; and “policy topics”, which generally represent areas of focus because the SEC is seeking to better understand them.

Some of the more significant area-specific initiatives for investment advisers/investment companies and broker-dealers include the following:

 A. Investment Adviser/Investment Company Program

Core Risks

Safety of Assets and Custody. This initiative focuses on non-compliance with Rule 206(4)-2 under the Advisers Act (“Custody Rule”). Examiners will pay particular attention to those instances where advisers fail to realize they have custody and therefore fail to comply with requirements of the Custody Rule.

Conflicts of Interest Inherent in Certain Investment Adviser Business Models. This initiative focuses on conflicts of interest inherent in an adviser’s business model, including matters related to compensation and investment allocations.

Marketing/Performance. This initiative considers the accuracy and completeness of advisers’ claims about their investment objectives and performance, especially in connection with newly effective rules adopted under the Jumpstart Our Business Startups (“JOBS”) Act.

New and Emerging Issues and Initiatives Never-Before Examined Advisers. This initiative involves focused, risk-based examinations of advisers that have been registered for more than three years but have not yet been examined under the NEP. The staff will also continue the use of shorter Presence Exams for newly registered advisers, which focus on key areas of marketing, portfolio management, conflicts of interest, safety of client assets and valuation.

Wrap Fee Programs. This initiative focuses on assessing whether wrap fee program advisers are fulfilling their fiduciary and contractual obligations to clients.

Quantitative Trading Models. This initiative involves examining investment advisers with substantial reliance on quantitative portfolio management and trading strategies to assess, among other things, whether these firms have adopted and implemented compliance policies and procedures tailored to the performance and maintenance of their proprietary models.

Payments for Distribution in Guise. This initiative involves review of the variety of payments made by advisers and mutual funds to distributors and intermediaries, the adequacy of disclosure made to fund boards about these payments and boards’ oversight of the same.

Fixed Income Investment Companies. This initiative focuses on risks associated with a changing interest rate environment and the impact this may have on bond funds and related disclosures of risks to investors.

Policy Topics. Policy Topics discussed in the Exam Priorities include a focus on “alternative” investment companies (i.e., mutual funds with certain hedge fund-like strategies) and securities lending arrangements.

B. Broker-Dealer Exam Program  

Some of the Core Risks for Broker-Dealers discussed in the Exam Priorities are as follows: 

Sales Practices/Fraud. This initiative focuses on detecting and preventing fraud and other violations in connection with sales practices to retail investors. 

Supervision. This initiative considers broker-dealers’ supervision of: (i) independent contractors and financial advisors in “remote” locations and large branch offices, (ii) registered representatives with significant disciplinary histories, and (iii) private securities transactions. 

Trading. This initiative involves broker-dealers’ market access controls related to, among other things, erroneous orders, the use of technology (with a focus on algorithmic and high frequency trading), information leakage, and cyber security. 

* * * * * * * 

This description of the Exam Priorities is not exhaustive. In addition, while the NEP expects to allocate significant resources throughout 2014 to the examination of the issues described herein and the other issues identified in the Exam Priorities, the NEP will conduct additional examinations in 2014 focused on risks, issues and policy matters that are not discussed or identified in the Exam Priorities. 

The Exam Priorities can be found here.

Posted on Tuesday, September 18 2012 at 11:30 pm by

SEC Issues Proposed Rules Regarding Elimination of General Solicitation Ban

The Securities and Exchange Commission (the “SEC”) has issued proposed rules that would permit certain forms of “general solicitation” in private offerings made in reliance on Rule 506 of Regulation D or Rule 144A under the Securities Act of 1933 (the “Securities Act”).  

Rule 506 Offerings

Rule 506 of Regulation D provides a non-exclusive safe harbor that permits the sale of securities in private placements to certain persons, including purchasers who the issuer reasonably believes are accredited investors and up to 35 other purchasers subject to certain conditions.  In addition, offerings made pursuant to Rule 506 are not subject to any state securities registration requirements.  Currently, Rule 506 prohibits any form of general solicitation or general advertising in connection with a sale of securities under Rule 506.

The JOBS Act directed the SEC to amend Rule 506 by July 4, 2012, to permit general solicitation or general advertising in Rule 506 offerings, provided the only purchasers of the securities are accredited investors.

The proposed rules would permit general advertisements in connection with Rule 506 offerings if the issuer takes “reasonable steps to verify that the purchasers of the securities are accredited investors” and “all purchasers of securities must be accredited investors, either because they come within one of the enumerated categories of persons that qualify as accredited investors or the issuer reasonably believes that they do, at the time of the sale of the securities”.  However, issuers that do not engage in a general solicitation may to continue to adhere to Rule 506 as it currently exists and sell to up to 35 non-accredited investors if general solicitation is not employed.

While the proposed rules require issuers to take “reasonable steps” to verify that purchasers of the securities are accredited investors, they do not specify the methods necessary to satisfy this requirement.  The SEC specifically avoided providing specifics in order to provide sufficient flexibility to accommodate different types of transactions and changes in market practices and to avoid the market giving unnecessary weight to any factors the SEC may have otherwise provided.  It should be recognized, however, that this approach by the SEC is likely to create uncertainty among issuers as to what steps will be sufficient to comply with the proposed rules.  

The proposed rules instead provide that whether the steps taken are “reasonable” would be an objective determination, based on the particular facts and circumstances of each transaction.  The proposed rules do, however, provide that an issuer should consider the following factors when evaluating the reasonableness of the steps taken to verify that a purchaser is an accredited investor:

  • the nature of the purchaser and the type of accredited investor that the purchaser claims to be;
  • the amount and type of information that the issuer has about the purchaser; and
  • the nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount.

With regard to the last factor, the proposed rules indicate that an issuer that solicits new investors through a website accessible to the general public or through a widely disseminated email or social media solicitation would likely be obligated to take greater measures to verify accredited investor status than an issuer that solicits new investors from a database of pre-screened accredited investors created and maintained by a reasonably reliable third party, such as a registered broker-dealer.  In the case of website offerings, the SEC does not believe that an issuer would have taken reasonable steps to verify accredited investor status if it required only that a person check a box in a questionnaire or sign a form, absent other information about the purchaser indicating accredited investor status.  In the case of a widely disseminated email or social media solicitation, the SEC believes that an issuer would be entitled to rely on a third party that has verified a person’s status as an accredited investor, provided that the issuer has a reasonable basis to rely on such third-party verification.  Additionally, the SEC also believes that a purchaser’s ability to meet a high minimum investment amount could be relevant to whether an issuer’s verification steps would be reasonable.  For example, the ability of a purchaser to satisfy a minimum investment amount requirement that is sufficiently high such that only accredited investors could reasonably be expected to meet it, with a direct cash investment that is not financed by the issuer or by any other third party, could be taken into consideration in verifying accredited investor status.

Regardless of the particular steps taken, issuers will need to retain adequate records that document the steps taken to verify that a purchaser was an accredited investor.  Any issuer claiming an exemption from the registration requirements of Section 5 has the burden of showing that it is entitled to that exemption.  However, if a person who does not meet the criteria for any category of accredited investor purchases securities in a Rule 506(c) offering, we believe that the issuer would not lose the ability to rely on the proposed Rule 506(c) exemption for that offering, so long as the issuer took reasonable steps to verify that the purchaser was an accredited investor and had a reasonable belief that such purchaser was an accredited investor.

Effect on Sections 3(c)(1) and 3(c)(7) under the Investment Company Act

Privately offered funds, such as hedge funds, venture capital funds and private equity funds, typically rely on Section 4(a)(2) and the Rule 506 safe harbor to offer and sell their interests without registration under the Securities Act.  In addition, privately offered funds generally rely on exclusions from the definition of “investment company” under Section 3(c)(1) and Section 3(c)(7) the Investment Company Act, which enables them to be excluded from the regulatory provisions of that Act.  Privately offered funds are precluded, however, from relying on either of these two exclusions if they make a public offering of their securities.  The proposed rules provide that SEC believes the effect of the proposed rules is to permit privately offered funds to make a general solicitation without losing either of the exclusions under the Investment Company Act.

Amendment to Rule 144A

Rule 144A provides a non-exclusive safe harbor exemption from the registration requirements of the Securities Act for resales of certain “restricted securities” to qualified institutional buyers (“QIBs”).  In order for a transaction to come within existing Rule 144A, a seller must have a reasonable basis for believing that the offeree or purchaser is a QIB and must take reasonable steps to ensure that the purchaser is aware that the seller may rely on Rule 144A.  The proposed rules revise Rule 144A to provide that securities sold pursuant to Rule 144A may be offered to persons other than QIBs, including by means of general solicitation, provided that securities are sold only to persons that the seller and any person acting on behalf of the seller reasonably believe is a QIB.  Under the proposed rules, resales of securities pursuant to Rule 144A could be conducted using general solicitation, so long as the purchasers are limited to QIBs.

If you have any questions regarding the matters addressed above, please contact us.

Posted on Sunday, July 1 2012 at 9:01 am by

SEC Staff Member Speaks on the SEC’s Approach to Examining Newly-Registered Private Equity Advisers

Carlo di Florio, Director of the Office of Compliance Inspections and Examinations (“OCIE”) at the SEC, recently addressed the Private Equity International Private Fund Compliance Forum and answered various questions regarding how the SEC will prepare for and examine the nearly 4,000 newly-registered private fund advisers that registered with the SEC as a result of the recent deadline under the Dodd-Frank Act.  Some of the highlights of Mr. di Florio’s speech follow.

Mr. di Florio described how OCIE’s National Examination Program (“NEP”) attempts to manage and mitigate risks presented by private equity funds, as well as large hedge funds, through a three-fold examination strategy.  First, the NEP will have a phase of industry outreach and education.  Next, there will be coordinated examinations of a large percentage of new registrants, focusing on high-risk areas of their business.  Finally, the NEP will publish a series of “after-action” reports on themes and issues identified.

Mr. di Florio indicated that one of the focuses of the NEP is to educate investment advisers regarding compliance, including adopting and implementing written policies and procedures, designating a Chief Compliance Officer (“CCO”), maintaining certain books and records, filing annual updates of Form ADV, ensuring that advertising complies with regulatory rules and implementing a code of ethics.  He also noted that NEP’s purpose includes strengthening OCIE’s communications with senior management of private equity firms in order to assess the corporate culture set at the top of the organization’s, senior management’s and firm principal’s support for CCOs, firms’ approaches to enterprise-wide risk management and identification of industry-wide risks.

To identify which candidates to select for examination, the NEP will seek to identify firms and practices that present the greatest risk.  Mr. di Florio gave examples of basic risk characteristics that the NEP would be likely to track, including material changes in business activities, changes in key personnel, the regulatory history of the firm and anomalies in key metrics such as fee or performance information.

Mr. di Florio recommends that, in order to avoid attracting NEP attention and potential examination, firms should be proactive about identifying conflicts and remediating those conflicts with strong policies.  Furthermore, he commented that firms should also place importance on creating a firm-wide ethical culture.  In the case of an examination, a firm should possess strong records and know how to readily access data, document ongoing monitoring and testing of policies and procedures, and be forthcoming about problems.

If a firm is selected for examination, Mr. di Florio noted that the examination itself will generally focus on three key inquiries:  Is the firm’s process for identifying and assessing potential problems and conflicts of interest effective?  Is that process likely to identify new problems and conflicts that may occur as the future unfolds?  How effective and well-managed are the firm’s policies and procedures, as well as its process for creating and adapting those policies and procedures, in addressing potential problems and conflicts?

The full address by Mr. di Florio is available here.

Posted on Friday, June 15 2012 at 8:15 pm by

SEC Approves Amended FINRA Rule 5123 on Private Placement of Securities

On June 7, 2012, the Securities and Exchange Commission (the “SEC”) approved a revised version of Financial Industry Regulatory Authority (“FINRA”) Rule 5123 (“Rule 5123”) on an accelerated basis. The new rule will marginally increase the reporting burdens on FINRA member firms that sell certain private placements to certain classes of accredited investors. The effective date for Rule 5123 has not yet been determined.

Under revised Rule 5123, FINRA member firms that sell a security in a nonpublic offering are required to:

(1)  submit to FINRA a copy of any existing offering document, including Private Placement Memoranda, term sheets, or other offering documents, used in connection with a private placement within 15 calendar days of the date of the first sale, in addition to any material amendments to documents that were previously-filed; or

(2)  indicate to FINRA that no such offering documents were used in connection with such sale.

FINRA will use the information gathered from Rule 5123 filings to aid in the detection and prevention of fraud and to assist with the identification of problematic terms and conditions found in private placement offering documents. All documents filed pursuant to Rule 5123 will receive confidential treatment and will only be used for the purpose of determining compliance with FINRA rules and other relevant regulatory purposes.

Various exemptions from the Rule 5123 filing requirements are available depending on the type of offering and the type of purchasers that are involved. We encourage all FINRA member firms to carefully review the requirements and exemptions contained in the SEC order granting accelerated approval of FINRA Rule 5123 (the “Rule 5123 Order”).

The Rule 5123 Order is available by clicking here.

Posted on Wednesday, June 6 2012 at 9:16 am by

Form PF Filing Deadlines Rapidly Approaching

As most private fund investment advisers have heard, the SEC and the Commodity Futures Trading Commission (“CFTC”) adopted new rules under the Commodity Exchange Act (“CEA”) and the Investment Advisers Act of 1940 that require Form PF filings by private fund advisers. The new Form PF filing requirement applies to SEC-registered investment advisers, as well as CFTC-registered commodity pool operators (“CPOs”) and commodity trading advisors (“CTAs”). The information collected by Form PF is designed to assist the Financial Stability Oversight Council, created under the Dodd-Frank Act, in its assessment of systemic risk in the U.S. financial system and the private fund industry. The initial filing date for Form PF is quickly approaching for certain private fund advisers, such as “large liquidity fund advisers” and “large hedge fund advisers”. Below is a breakdown of requirements and filing dates for each classification of private fund advisers.

Who must file a Form PF?
An investment adviser must file Form PF if it: (1) is registered or required to register with the SEC; (2) advises one or more private funds; and (3) had at least $150 million in regulatory Assets Under Management (“AUM”) attributable to private funds as of the end of its most recently completed fiscal year. These conditions also apply to CPOs and CTAs that manage any commodity pool that is a “private fund.”

What information is required on Form PF?
The amount and type of information required on Form PF varies based on both the size of the adviser and the types of funds managed. All private fund advisers are required to complete Sections 1a and 1b. Additionally, Section 1c must be completed by hedge fund advisers for each hedge fund they advise. Most Form PF filers or “smaller advisers” (i.e., advisers who had greater than $150 million in private fund AUM, but less than a “large” threshold at the end of the most recently completed fiscal year) will only need to complete Sections 1a and 1b of Form PF, which covers basic information dealing with the adviser’s identity and AUM. However, three types of “Large Private Fund Advisers” are required to complete additional sections:

  • Section 2 of Form PF: Large hedge fund advisers (i.e., advisers who had at least $1.5 billion in hedge fund AUM as of the end of any month during the prior fiscal quarter) must complete Section 2. This section requires additional information regarding the hedge funds these advisers manage.
  • Section 3 of Form PF: Large liquidity fund advisers (i.e., advisers who manage one or more liquidity funds and who had at least $1 billion in combined liquidity fund and registered money market fund assets as of the end of any month in the prior fiscal quarter) must compete Section 3 of Form PF. Section 3 requires information concerning funds valuation, valuation methodology, liquidity and certain identified positions.
  • Section 4 of Form PF: Large private equity fund advisers (i.e., advisers who had at least $2 billion in private equity fund AUM as of the last day of the most recent fiscal year) must complete Section 4. This section requires information dealing with the private equity fund’s activities, portfolio companies and certain creditors.

When are the reporting deadlines, compliance dates, and initial filing dates for Form PF?
Reporting deadlines, compliance dates and initial filing dates vary depending on the type and size of private fund advisers. Large liquidity fund advisers, large hedge fund advisers and large private equity fund advisers have rapidly approaching deadlines. These private fund advisers all have a compliance date of June 15, 2012. Other notable and upcoming deadlines are the initial filing dates for large liquidity fund advisers and large hedge fund advisers, which are July 15, 2012 and August 29, 2012, respectively. Other types of private fund advisers have later reporting deadlines and filing dates.

What is the reporting frequency of Form PF?
Large liquidity fund advisers and large hedge fund advisers must file Form PF quarterly, while large private equity fund advisers and smaller advisers are only required to file Form PF annually.

The CFTC and the SEC’s Joint Final Rules regarding the reporting of Form PF are available here.

Posted on Wednesday, May 30 2012 at 7:53 pm by

Recent Retirement Plan Fee Disclosures Now Required

The first disclosures by fiduciaries, registered investment advisers and certain other service providers to retirement plans under section 408(b)(2) of ERISA (the “408(b)(2) Disclosures”) are due on July 1, 2012. The 408(b)(2) Disclosures apply to service providers (including investment advisers) to retirement plans subject to the fiduciary provisions of ERISA, which include most 401(k) plans and pension plans, and generally require disclosures regarding services provided to, and fees payable by, retirement plans. Service providers who do not comply with the 408(b)(2) Disclosures may be subject to penalties by the Department of Labor. For more information, see the DOL’s fact sheet on the 408(b)(2) Disclosures, available here.

Subscribe to Kilpatrick Townsend's Legal Alerts to help you stay current of new and noteworthy legal issues that may affect your business.