Investment Management

Posted on Monday, May 8 2017 at 10:38 am by

General Solicitations of Certain Regulation D “Private” Securities Offerings:  SEC Affirms Zero-Tolerance Policy.

By Paul Foley and John I. Sanders

On March 29, 2017, the Securities and Exchange Commission (the “SEC”) issued a noteworthy opinion in In re KCD Financial Inc.,[i] a review of a FINRA disciplinary action.[ii]  While the opinion affirmed FINRA’s disciplinary action,[iii] it also affirmed the SEC’s zero-tolerance policy regarding general solicitations made in the course of certain Regulation D offerings.  Those relying on or contemplating relying on Regulation D exemptions from registration should review the SEC’s opinion.

Factual Background

KCD Financial, Inc. (“KCD”) is an independent broker-dealer.[iv]  In 2011, KCD signed an agreement with one of its affiliates (“Westmount”) under which it would solicit accredited investors for a particular private fund (the “Fund”) sponsored by Westmount.[v]  Westmount did not plan to register the offering.  Westmount instead planned to rely on a Rule 506(b) exemption from registration.[vi]

Prior to KCD selling any interest in the Fund, Westmount issued a press release describing the Fund.[vii]  Two Dallas newspapers published articles based on the press release and made the articles available on their respective public websites.[viii]  One of those newspaper articles was then posted on a public website belonging to a Westmount affiliate.[ix]  Westmount’s outside counsel informed Westmount that the newspaper articles constituted general solicitations, which are prohibited in Rule 506(b) offerings.[x]

After KCD and Westmount officers were told that the articles were general solicitations prohibited under Rule 506(b), they did not end the offering, register the securities, or seek to rely on an alternative exemption.  Instead, KCD’s CCO and Westmount’s Vice President of Capital Markets instructed the representatives to sell interests in the Fund only to (i) those with an existing relationship to KCD or Westmount and (ii) accredited investors who had not learned of the offering through the general solicitations.[xi]  Under those guidelines, at least one person was refused an opportunity to purchase interests in the Fund.[xii]

During a FINRA examination of KCD, the examiner found that the newspaper article about the offering had not been removed from a Westmount-affiliated website.[xiii]  Subsequently, FINRA filed a complaint against KCD alleging that the firm’s registered representatives sold securities that were unregistered and not qualified for an exemption from registration, thereby violating FINRA Rule 2010.[xiv]  FINRA also alleged that KCD failed to reasonably supervise the offering, thereby violating FINRA Rule 3010.[xv]  FINRA’s Hearing Panel found that KCD violated those rules.[xvi]  FINRA censured KCD and imposed a fine of $73,000.[xvii]  The National Adjudicatory Counsel affirmed FINRA’s decision.[xviii]  KCD then requested an SEC review.[xix]

SEC Review

KCD admitted that the Fund interests it offered were not registered, but argued that offers were made pursuant to Rule 506(b).[xx]  The SEC rejected KCD’s contention,[xxi] finding that where a party relying on the Rule 506(b) exemption makes a general solicitation, the exemption then is unavailable “regardless of the number of accredited investors or the knowledge and experience of the purchasers who were not accredited investors.”[xxii]  In this context, whether purchasers were accredited or had prior relationships with KCD and Westmount was “irrelevant to whether or not the newspaper articles constituted a general solicitation” and precluded reliance on Rule 506(b).[xxiii]

KCD also argued, assuming the newspaper articles constituted general solicitations, it could still rely on a Rule 506(b) exemption because “KCD did not generally solicit any of the actual investors in the [Westmount] Fund.”[xxiv]  This argument confused the notion of what is prohibited under Rule 506(b).  It is making an offer by general solicitation which precludes reliance on a Rule 506(b) exemption.[xxv]  Whether a sale results directly from the general solicitation is irrelevant.[xxvi]

Practical Implications

The SEC’s opinion affirms its view that exemptions from registration in securities offerings are narrowly construed and must be adhered to strictly.[xxvii]  Where, as here, the exemption prohibits a general solicitation, any general solicitation forever forfeits the issuer’s ability to rely on the exemption in making the offering (i.e., the toothpaste cannot go back into the tube).

Those making exempt offerings in reliance on Rule 504,[xxviii] Rule 505,[xxix] and Rule 506(b)[xxx] should review their sales practices in light of the KCD opinion.  In reviewing practices, issuers should look beyond the obvious means of making a general solicitation (e.g., a press release that is published by a widely-circulated newspaper).  Websites and social media accounts of those participating in the offerings are equally capable of precluding use of a valuable registration exemption.

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

[i] In re KCD Financial, Inc., SEC Release No. 34-80340 (March 29, 2017), available at www.sec.gov/litigation/opinions/2017/34-80340.pdf (hereinafter, SEC Opinion).

[ii] In re KCD Financial, Inc., FINRA Complaint No. 2011025851501 (Aug. 3, 2016), available at http:www.finra.com (hereinafter, FINRA Opinion).

[iii] SEC Opinion, supra note 1, at p. 1.

[iv] Id., at p. 2.

[v] Id.

[vi] Id.

[vii] Id, at p. 3.

[viii] Id.

[ix] Id. at p. 4.

[x] Id.

[xi] Id.

[xii] Id.

[xiii] Id.

[xiv] Id.

[xv] Id.

[xvi] FINRA Opinion, supra note 2, at p. 4.

[xvii] Id.

[xviii] Id.

[xix] Id.

[xx] SEC Opinion, supra note 1, at 2.

[xxi] Id.

[xxii] Id. at 7.

[xxiii] Id. at 9.

[xxiv] Id at 10.

[xxv] Id.

[xxvi] Id. at 11

[xxvii] Id. at 7.

[xxviii] 17 CFR 230.504 (2017).

[xxix] 17 CFR 230.505 (2017).

[xxx] 17 CFR 230.506(b) (2017).

Posted on , May 8 2017 at 9:59 am by

SEC Amends Crowdfunding Rules

By Paul Foley and John I. Sanders

Under the Jumpstart our Business Startups Acts of 2012 (the “JOBS Act”), the Securities and Exchange Commission (the “SEC”) adopted rules allowing for securities-based crowdfunding in 2015.[i]  The JOBS Act required the SEC to adjust dollar limits placed on the amount that could be invested or raised through securities-based crowdfunding at least every five years to account for inflation.[ii]  On April 5, 2017, the SEC issued a final rule adjusting those limits for the first time.[iii]  We encourage those interested in issuing securities through a securities-based crowdfunding offering to review the final rule and call us with any questions you may have.

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

[i] SEC, Release No. 33-9974 (Oct. 9, 2015), available at https://www.sec.gov/rules/final/2015/33-9974.pdf.

[ii] Id. at 15.

[iii] SEC, Release No.33-10332 (April 5, 2017), available at https://www.sec.gov/rules/final/2017/33-10332.pdf.

Posted on Wednesday, April 19 2017 at 8:48 am by

SEC Issues Guidance to Robo-Advisers

Robo-advisers are a fast-growing segment of the investment advisory industry.  In fact, they now account for an estimated $71.5 billion in assets under management.[1]  In response to their explosive growth, the SEC has made robo-advisers an examination priority[2] and has issued regulatory guidance to them.[3]  The SEC’s guidance is summarized below.

  • Disclosures to potential clients should explain the: (i) robo-adviser’s business model and how it differs from traditional investment adviser models; and (ii) limitations in the scope of the robo-adviser’s services.[4]  The robo-adviser should also consider whether its delivery of the disclosures is clear and conspicuous enough to be effective in the context of the relationship, which may be entirely web-based.[5]
  • Questionnaires used to gather client information should be designed to obtain sufficient information to support the robo-adviser’s suitability obligation.[6] Where the client can select investments other than those the adviser recommends, the robo-adviser should provide commentary supporting its recommendations.[7]
  • Internal compliance programs should address the unique aspects of the robo-adviser business model, including limited human interaction and heightened cybersecurity risks.[8]

Advisers who have replaced or supplemented their advisory services with robo-adviser technology in recent years may have questions after reviewing the SEC’s guidance.  Please feel free to contact us with any questions you may have.

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

 

[1] Daisy Maxey, Spotlight on Robo Advisers’ Returns, Wall Street Journal (Nov. 1, 2016), https://www.wsj.com/articles/spotlight-on-robo-advisers-returns-1478018429.

[2] SEC, National Exam Program Examination Priorities for 2017 (Jan. 13, 2017), www.sec.gov/about/offices/ocie/national-examination-program-priorities-2017.pdf.

[3] SEC, IM Guidance Update No. 2017-02 (Feb. 2017), www.sec.gov/im-guidance-2017-02.pdf.

[4] Id.

[5] Id.

[6] Id.

[7] Id.

[8] Id.

Posted on Thursday, March 2 2017 at 3:13 pm by

Department of Labor Set to Eliminate the Fiduciary Rule

On March 2, 2017, the DOL proposed to extend the applicability date of the Department of Labor (“DOL”) Conflict of Interest Rule (the “Fiduciary Rule”) from April 10, 2017 for 60 days.[1]  The proposal states that the extension will make it possible for the DOL to take additional steps (e.g., propose rescission of the Fiduciary Rule) without the Fiduciary Rule becoming applicable.[2]  The DOL states that this approach is being taken so that “advisers, investors and other stakeholders would be spared the risk and expense of facing two major changes in regulatory environment.”[3]  This delay follows the Presidential Memorandum, sent by President Trump on February 3, 2017, that directed the DOL to examine whether the Fiduciary Rule would “adversely affect the ability of Americans to gain access to retirement information and financial advice.”[4]  Considering the language contained in the Presidential Memorandum and the text of DOL’s release, we do not believe the Fiduciary Rule is long for this world.

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

[1] Department of Labor,  Conflict of Interest Rule – Retirement Investment Advice; Proposed Rule; Extension of Applicability Date (March 1, 2017), available at https://www.dol.gov/agencies/ebsa/laws-and-regulations/rules-and-regulations/completed-rulemaking/1210-AB32-2.

[2] Id.

[3] Id.

[4] Id.  The DOL was instructed to consider the following three questions in the course of its examination:  (1) whether the anticipated applicability of the final rule has harmed or is likely to harm investors due to a reduction of Americans’ access to certain retirement savings offerings, retirement product structures, retirement savings information, or related financial advice; (2) whether the anticipated applicability of the final rule has resulted in dislocations or disruptions within the retirement services industry that may adversely affect investors or retirees; and (3) whether the final rule is likely to cause an increase in litigation, and an increase in the prices that investors and retirees must pay to gain access to retirement services.  President Trump directed that if the DOL makes an affirmative determination as to any of the three inquiries or otherwise finds the Fiduciary Rule is incompatible with President Trump’s desire “to empower Americans to make their own financial decisions,” then the DOL is to publish for notice and comment rulemaking a proposal to revise or rescind the Fiduciary Rule.

Posted on Friday, December 16 2016 at 11:51 am by

7 Securities Law and Regulatory Changes Likely to be Considered During the Trump Administration

By Paul Foley and John Sanders

On November 8, 2016, political power in United States shifted in an unexpected and unprecedented way.  As of January 20, 2017, Republicans will hold the White House and both Houses of Congress.[1]  President-elect Donald Trump will also have the opportunity to appoint two SEC Commissioners and a new Chair.[2]  He and his party will have the ability to reshape securities law and regulation.  As this was unanticipated, there was little discussion before the election as to what it would mean for securities law and regulation.  We believe the following seven issues are likely to be part of the discussion in the weeks and months ahead.

1. Dodd-Frank Act – Volcker Rule

The Volcker Rule, a 900-plus-page rule adopted in December 2013, was intended to limit proprietary trading by banks.[3]  Championed by former Federal Reserve Chairman Paul Volcker, the rule was a last-minute addition to the 2010 Dodd-Frank Act.  For years, it stalled as regulators and commentators tried to distinguish between speculation (deemed bad) from investment (deemed good).  Few believe that the regulators were successful in properly drawing this distinction.[4]  Making the rule more susceptible to criticism, many experts have determined the rule “would have done nothing to mitigate [the Great Recession,] the worst financial crisis since the Great Depression.”[5]

President-elect Trump’s nominee for Secretary of the Treasury has promised “strip back” elements of the Dodd-Frank Act, including the Volcker Rule.[6]  If the new administration is dedicated to repealing the Volcker Rule, something that isn’t quite clear,[7] repealing it won’t be easy.  Legislative action would likely require bipartisan support in the Senate.[8]  Eliminating the rule through agency rule making, like adopting the rule, would require coordination between multiple independent agencies,[9] an opportunity for public comment,[10] and time.[11]  The easier (but less permanent) solution is for the new President to appoint agency heads who will interpret the rule differently or deemphasize its enforcement.[12]  The discussion of whether, and how, to repeal the Volcker Rule should be followed closely.

2. Delegated Authority for Enforcement

In 2009, the SEC delegated authority to the Director of Enforcement to open formal orders of investigation of persons and entities.[13]  The Director of Enforcement then took the unprecedented step of sub-delegating authority to Regional Directors, Associate Directors, and Specialized Unit Chiefs.[14]  The delegation supports Chair White’s “broken windows” approach by which deficiencies and misconduct of every size and nature are addressed.[15]  This approach has resulted in a record number of enforcement proceedings.[16]  However, many commentators have raised concerns about the ease with which proceedings can be brought and subpoenas issued and whether enforcement is now less effective because it is uncoordinated.[17]  If the new administration wishes to end the delegation, it can appoint SEC Commissioners and a Chair that will withdraw the delegation with an order[18] not subject to the lengthy formal rule making process.[19]

3. Fiduciary Rule

The Department of Labor (the “DOL”) finalized the so-called “Fiduciary Rule” in April 2016 and announced it would go into effect in April 2017.[20]  According to the DOL, investors lose billions of dollars in fees each year because their advisors are not acting in their best interests.[21]  The goal of the Fiduciary Rule, therefore, is to “stop advisers from putting their own interests in earning high commissions and fees over clients’ interests in obtaining the best investments at the lowest prices.”[22]  However, the net effect of the rule is unclear.  Among the potential negative effects of the rule are investors losing access to competent advice,[23] skyrocketing costs for affected accounts,[24] decreases of 25 to 50% in annuities sales,[25] and unnecessary corporate restructuring.[26]

If lawsuits aimed at preventing the rule from going into effect fail, those who advocate repealing the rule will find the job challenging.  First, the rule isn’t within the reach of the Congressional Review Act[27] and isn’t likely to be suspended by the Secretary of Labor who oversaw its creation.[28]  That means a lengthy formal rule making process would be required to repeal the rule.[29]  It is uncertain whether this is an effort the investment advisory industry would welcome after spending the past year working toward compliance, which included spinning off business units[30] changing long-standing pricing models,[31] and jettisoning certain clients.[32]

4. Consolidated Audit Trail

In 2010, as the SEC and CFTC attempted to trace the root cause of the Flash Crash, it became abundantly clear that the financial market regulators were ill-equipped to police modern markets.  Out of this realization came the idea for the Consolidated Audit Trail (the “CAT”).[33]  CAT is conceptualized as a market-wide system that tracks equity and option trades.[34]  It would help in both investigations and monitoring.  Proving manipulation and fraud, as well as identifying systemic risk, should become easier with CAT in place.  However, despite years of work, “a fully baked, centralized trail is still years away.”[35]  Given the benefits of an operational CAT to each of the SEC’s mandates, including maintaining the investor confidence that drives investment into our public markets, getting it up and running may be a priority.  However, many commentators argue that CAT would be a hacker’s dream.[36]  The new administration will signal its where it stands on CAT with its appointment of SEC commissioners and Chair.

5. Pay Ratio Disclosures

The Dodd-Frank Act instructed the SEC to adopt a rule requiring each publicly traded company to disclose “the ratio of the compensation of its chief executive officer (CEO) to the median compensation of its employees.”[37]  The ratio would appear in registration statements, proxy and information statements, and annual reports that call for executive compensation disclosure.[38]  This seemingly simple calculation may “actually entail herculean bookkeeping for large, diverse companies.”[39]

The compliance date for the pay ration rule is January 1, 2017.[40]  Once the new Congress and SEC commissioners are in place, authorities should consider whether the rule serves any of the SEC’s three mandates: protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation.[41]  If the rule is deemed inappropriate under those mandates, Congress may amend the Dodd-Frank Act and instruct the SEC to engage in a formal rule making process aimed at repealing the rule.  If the rule is deemed appropriate, or the political will to repeal the rule is lacking, it may remain in place with the SEC allowing companies “substantial flexibility in determining the pay ratio.”[42]

6. Political Contributions Disclosures

In 2011, a group of college professors argued that the Supreme Court’s Citizens United[43] ruling necessitated an SEC rule requiring public companies to disclose their political expenditures.[44]  The SEC received more than 1 million public comments – a record.[45]  Yet, the SEC did not act.  Senator Elizabeth Warren, less than a month before the recent election, openly urged President Obama to remove SEC Chair Mary Jo White for refusing “to develop a political spending disclosure rule despite her clear authority to do so.”[46]  This was perhaps a bit unfair.  Not only was the SEC restricted by law from working on the rule at that time,[47] but the rule has faced tremendous opposition.[48]  Business groups and Republicans have long argued that “a company’s political contributions are not related to its financial performance and that the disclosures are unnecessary.”[49]  A Republican Congress or appointments to the SEC may find 2017 is an ideal time to revisit this issue.

7. Liquidity Risk Management

On October 13, 2016, the SEC announced that it had finalized a rule that would require open-ended investment companies to develop liquidity risk management programs and make additional disclosures related to liquidity.[50]  The rule, among other things, requires an investment company’s board of directors to adopt a formal plan for managing liquidity risk and make disclosures classifying fund investments into one of four categories according to liquidity.[51]  In a letter to the SEC supporting the rule, Senator Sherrod Brown cited several sources for the proposition that the fund industry was growing and offering investments in less-liquid assets.[52]  Tellingly, Senator Brown cited widely-available public sources such as Barron’s and Bloomberg articles.[53]  If the public has access to multiple news stories about liquidity risk, risk disclosures in regulatory filings, and lists of fund holdings online, it is fair to ask whether the rule carries a benefit to investors along with its cost.  If the determination is made the costs of this rule substantially outweigh the benefits, then the SEC may engage in a formal rule making process to repeal the rule.

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

[1] Richard Cowan and Susan Cornwell, Republicans Defend Grip on U.S. Congress as Trump Wins Presidency, Reuters (Nov. 9, 2016), http://www.reuters.com/article/us-usa-election-congress-idUSKBN13317Z.

[2] Mark Shoeff Jr., Where Donald Trump Stands on Top Financial Adviser Issues, Investment News (Nov. 9, 2016), http://www.investmentnews.com/article/20161109/FREE/161109909/where-donald-trump-stands-on-top-financial-adviser-issues.

[3] SEC, Final Rule: Prohibitions and Restrictions on Proprietary Trading and Certain Interests In, and Relationships With, Hedge Funds and Private Equity Funds (Dec. 10, 2013), https://www.sec.gov/rules/final/2013/bhca-1.pdf.

[4] The Volcker Ambiguity, The Wall Street Journal (Dec. 11, 2013), http://online.wsj.com/news/articles/SB10001424052702304744304579250393935144268.

[5] Ben Steil, Beyond the Volcker Rule: A Better Approach to Financial Reform, Council on Foreign Relations (April 2012), http://www.cfr.org/financial-crises/beyond-volcker-rule-better-approach-financial-reform/p27894.

[6] Jacob M. Schlesinger, Trump Treasury Choice Steven Mnuchin Vows to ‘Strip Back’ Dodd-Frank, The Wall Street Journal (Nov. 30, 2016), http://www.wsj.com/articles/trump-treasury-choice-steven-mnuchin-vows-to-strip-back-dodd-frank-1480513188.

[7] Emily Stephenson, Trump Calls for ‘21st century’ Glass-Steagall Banking Law, Reuters (Oct. 26, 2016), http://www.reuters.com/article/us-usa-election-trump-banks-idUSKCN12Q2WA.

[8] Ryan Tracy and John Carney, How to Kill the Volcker Rule? Don’t Enforce it, The Wall Street Journal (Nov. 28, 2016), http://www.wsj.com/articles/how-to-kill-the-volcker-rule-dont-enforce-it-1480329002.

[9] Id.

[10] 5 U.S.C. 553 (2016), available at https://www.law.cornell.edu/uscode/text/5/553 (Outlining the process for rule making, as defined in 5 U.S.C. 551 (2016)).

[11] Tracy and Carney, supra note 8.

[12] Id.

[13] SEC, Final Rule: Delegation of Authority to Director of Division of Enforcement (Aug. 5, 2009), https://www.sec.gov/rules/final/2009/34-60448.pdf.

[14] Bradley J. Bondi, A Questionable Delegation of Authority: Did the SEC Go Too Far When It Delegated Authority to the Division of Enforcement to Initiate an Investigation?, Center for Financial Stability (Sept. 20, 2016), http://centerforfinancialstability.org/wp/2016/09/20/a-questionable-delegation-of-authority-did-the-sec-go-too-far-when-it-delegated-authority-to-the-division-of-enforcement-to-initiate-an-investigation/

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

[16] Id.

[17] Bondi, supra note 14.

[18] 17 CFR 200.30-4 (2016), available at https://www.law.cornell.edu/cfr/text/17/200.30-4.

[19] 5 U.S.C. 553(a)(2) (2016), available at https://www.law.cornell.edu/uscode/text/5/553.

[20] Department of Labor, Final Rule: Conflict of Interest Rule (April 8, 2016), https://www.dol.gov/agencies/ebsa/laws-and-regulations/rules-and-regulations/completed-rulemaking/1210-AB32-2.

[21] Id.

[22] Liz Skinner, Figuring Out Fiduciary: Now Comes the Hard Part, Investment News (May 9, 2016), http://www.investmentnews.com/article/20160509/FEATURE/160509939/the-dol-fiduciary-rule-will-forever-change-financial-advice-and-the.

[23] Robert Litan & Hal Singer, Obama’s Big Idea for Small Savers: ‘Robo’ Financial Advice, The Wall Street Journal (July 21, 2015), http://www.wsj.com/articles/obamas-big-idea-for-small-savers-robo-financial-advice-1437521976.

[24] Jed Morowitz & Mason Braswell, Exclusive: Merrill to End Commission-Based Retirement Business on Retail Accounts, AdvisorHub (Oct. 6, 2016), http://advisorhub.com/exclusive-merrill-end-commission-based-retirement-business-retail-accounts/.

[25] Skinner, supra note 22.

[26] Christine Idzelis, Sale of AIG Advisor Group May Signal Wave of Mergers Ahead, Investment News (Jan. 29, 2016), http://www.investmentnews.com/article/20160129/FREE/160129906/sale-of-aig-advisor-group-may-signal-wave-of-mergers-ahead.

[27] 5 U.S.C. 801 (2016), available at https://www.law.cornell.edu/uscode/text/5/801.

[28] Aaron Back, Eliminating Obama’s Fiduciary Rule Easier Said Than Done, The Wall Street Journal (Dec. 5, 2016), http://www.wsj.com/articles/eliminating-obamas-fiduciary-rule-easier-said-than-done-1480976385.

[29] 5 U.S.C. 553 (2016), available at https://www.law.cornell.edu/uscode/text/5/553 (Outlining the process for rule making, as defined in 5 U.S.C. 551 (2016)).

[30] Greg Iacurci, Insurance Based Broker-Dealers Plan to Use BICE Under DOL Fiduciary Rule, Investment News (July 7, 2016), http://www.investmentnews.com/article/20160707/FREE/160709959/insurance-based-broker-dealers-plan-to-use-bice-under-dol-fiduciary.

[31] Id.

[32] Andrew Welsch, Raymond James follows Morgan’s Lead in Keeping Commissions Under Fiduciary, OnWallStreet (Oct. 27, 2016), http://www.onwallstreet.com/news/raymond-james-follows-morgans-lead-in-keeping-commissions-under-dol; See also Robert Powell, New Rules Force Financial Advisers to do What’s Best for their Clients, USA Today (April 6, 2016), http://www.usatoday.com/story/money/columnist/powell/2016/04/06/investors-new-fiduciary-rule-protection/82661384/.

[33] SEC, Final Rule: Consolidated Trail (July 18, 2012), https://www.sec.gov/rules/final/2012/34-67457.pdf.

[34] Nick Fera, What New Developments in the Consolidated Audit Trail Spell for Broker-Dealer Compliance, The Street (June 13, 2016), https://www.thestreet.com/story/13604582/1/what-new-developments-in-the-consolidated-audit-trail-spell-for-broker-dealer-compliance.html.

[35] Id.

[36] Dave Michaels, SEC Approves Consolidated Audit Trail to Detect Market Manipulation, Wall Street Journal (Nov. 15, 2016), http://www.wsj.com/articles/sec-to-vote-on-consolidated-audit-trail-to-detect-market-manipulation-1479240411.

[37] SEC, SEC Adopts Rule for Pay Ratio Disclosure (Aug. 5, 2015), https://www.sec.gov/news/pressrelease/2015-160.html.

[38] Id.

[39] Richard Levick, The Pay Ratio Rule:  Businesses Face Unprecedented Executive Pay Disclosure Burden (Feb. 9, 2016), http://www.forbes.com/sites/richardlevick/2016/02/09/the-pay-ratio-rule-businesses-face-unprecedented-executive-pay-disclosure-burden/#a044585cf077.

[40] SEC, Final Rule: Pay Ratio Disclosure (Aug. 5, 2015),  https://www.sec.gov/news/pressrelease/2015-160.html.

[41] SEC, What We Do, https://www.sec.gov/about/whatwedo.shtml.

[42] SEC, SEC Adopts Rule for Pay Ratio Disclosure (Aug. 5, 2015), https://www.sec.gov/news/pressrelease/2015-160.html.

[43] Citizens United v. Federal Election Com’n, 558 U.S. 310 (2010).

[44] Committee of Corporate Political Spending, Rulemaking Petition to SEC (Aug 3, 2011), available at https://www.sec.gov/rules/petitions/2011/petn4-637.pdf.

[45] Ranee Merle and Jim Tankersley, Elizabeth Warren Urges President Obama to Remove the Head of the SEC, The Washington Post (Oct. 14, 2016), https://www.washingtonpost.com/news/wonk/wp/2016/10/14/elizabeth-warren-asks-president-obama-to-remove-the-head-of-the-sec/.

[46] Id.

[47] Pub. L. No. 114-113, 129 Stat. 3030 (2016), available at https://www.congress.gov/bill/114th-congress/house-bill/2029/text (stating that no funds made available under the Consolidated Appropriations Act would “be used by the [SEC] to finalize, issue, or implement any rule, regulation, or order regarding the disclosure of political contributions.”)

[48] Andrew Ackerman, Elizabeth Warren to Obama: Fire SEC Chief Mary Jo White, The Wall Street Journal,  (Oct. 14, 2016), http://www.wsj.com/articles/elizabeth-warren-to-obama-fire-sec-chief-mary-jo-white-1476439200.

[49] Merle and Tankersley, supra note 45.

[50] SEC, Final Rule: Investment Company Liquidity Risk Management Programs (Oct. 13, 2016), https://www.sec.gov/rules/final/2016/33-10233.pdf.

[51] Id.

[52] Letter from U.S. Senator Sherrod Brown to SEC Chair Mary Jo White (July 6, 2016), available at https://www.sec.gov/comments/s7-24-15/s72415-247.pdf.

[53] Id.

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, 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.

 

 

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