Investment Fund Law Blog - Legal News Updates for Investment Fund Managers & Investors : Pillsbury Winthrop Shaw Pittman LLP

Written by:  Jay Gould

On April 8, 2013, we reviewed a recent speech by David Blass, the Chief Counsel of the Division of Trading and Markets of the Securities and Exchange Commission (the “SEC”), in which Mr. Blass provided his views on whether certain investment fund managers might be operating in a way that would require registration as a broker dealer.  For hedge fund managers, the problem typically arises in the context of paying internal sales people based on the amount of capital raised.  As we noted, the widespread misreading or abuse of Rule 3a4-1, the issuer’s exemption safe harbor on which so many hedge fund managers rely, is now clearly on the SEC’s radar. 

But there are other ways to become entangled in broker dealer registration requirements that many private equity funds (and some hedge funds) will also need to consider.  The SEC staff is aware that advisers to some private funds, such as managers of private equity funds executing a leverage buyout strategy, may collect fees other than advisory fees, some of which look suspiciously like brokerage commissions.  It is not uncommon for a fund manager to direct the payment of fees by a portfolio company of the fund to one of its affiliates in connection with the acquisition, disposition (including an initial public offering), or recapitalization of the portfolio company.  These fees are often described as compensating the fund manager or its affiliated company, or personnel for “investment banking activity,” including negotiating transactions, identifying and soliciting purchasers or sellers of the securities of the company, or structuring transactions.  These are typical investment banking activities for which registration as a broker dealer is required.

Perhaps through its presence exams, the SEC staff recognizes that the practice of charging these transaction fees is fairly common among certain private equity fund managers.  Blass suggested that if the payment of these investment banking type fees were used to offset the management fee, then a valid argument could be made that no separate brokerage compensation was generated.  However, the industry argument that the receipt of such fees by the general partner of the fund should be viewed as the same person as the fund, so there are no transactions for the account of others was not an argument that the SEC staff appeared ready to endorse.  As long as the fee is paid to someone other than the fund for the types of activities described above, then the general partner or its affiliate would need to go through the analysis as to why broker dealer registration is not required.  The private equity fund bar has also advanced the policy argument that requiring private equity fund managers to register as broker dealers serves no useful purpose.  This policy argument that advocates the position that the SEC should exempt certain firms and not others for the same conduct, as attractive as it might be for managers of private equity funds, is a total non-starter from the regulator’s perspective.  The SEC staff will remain fixated on the type of activity and the fees generated from that activity when attempting to determine whether registration is required. 

Particularly among private equity fund managers, many of which have not had a history of being a regulated entity, this violation of the broker dealer registration requirement is not viewed as a serious matter because “everyone else is doing it.”  But the SEC is putting private equity on notice that this is an area that the staff will focus on in examinations and will eventually bring enforcement action.  In addition to being subject to sanctions by the SEC, another possible consequence of acting as an unregistered broker-dealer is the potential right to rescission by investors.  A transaction that is intermediated by an inappropriately unregistered broker-dealer could potentially be rendered void.  A purchaser of securities would typically seek to void a transaction if the price had moved against him, leaving the fund manager scrambling to make up the difference between the sales price and the value at rescission.   Private equity fund managers and those hedge fund managers that conduct similar activities should give greater attention to this issue for which the SEC staff has provided fair warning. 

Written by:  Sarah A. Good and Jessica R. Bogo

A Financial Industry Regulatory Authority (“FINRA”) hearing panel held that FINRA’s own rules prohibiting judicial class action waivers in broker-dealer customer arbitration agreements are preempted by the Federal Arbitration Act and unenforceable. Once this decision becomes final, it will likely change the landscape of broker-dealer arbitrations. Many other broker-dealers will adopt a judicial class action waiver in their customer arbitration agreements and end decades of securities class action lawsuits, which generally provide little benefit to class members.

In a thoughtful 48-page decision, a FINRA hearing panel on Thursday, February 21, 2013 followed the U.S. Supreme Court’s holding in AT&T Mobility LLC v. Concepcion, 131 S.Ct. 1740 (2011) (“Concepcion”) and held that FINRA Rules prohibiting broker-dealers from adopting judicial class-action waivers in customer arbitration agreements are unenforceable and preempted by the Federal Arbitration Act (“FAA”). For more background on Concepcion and recent California litigation post-Concepcion, please see our prior client alerts including, “Recent Maverick Ruling in CA Appellate Court Finds Concepcion Does Not Overrule Gentry.”

The decision arises from a Complaint filed on February 1, 2012 by FINRA’s Department of Enforcement against Charles Schwab & Co., Inc. (“Schwab”). In September 2011, Schwab added a provision to its pre- dispute arbitration agreements requiring customers to “waive any right to bring a class action, or any type of representative action” against Schwab or any related third party “in court.” The Complaint alleged that the waiver violated FINRA’s Rules prohibiting self-regulatory organizations (“SROs”) from adopting pre-dispute arbitration agreements that prohibited customers from filing judicial class actions.

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Written by:  Jay Gould

The Securities and Exchange Commission (the “SEC”) recently charged and entered into consent decrees with four India-based brokerage firms for providing brokerage services to U.S. investors without being registered as broker dealers under the U.S. securities laws.  This otherwise mildly interesting enforcement action by the SEC should serve as a cautionary tale to hedge fund managers based outside the U.S. that seek to raise capital from U.S. investors, as well as U.S. fund managers that seek to sell their fund shares in foreign countries.

Many non-U.S.-based fund managers seek to raise money from U.S. investors due to the large amounts of available capital in this country and the relative willingness of U.S. investors to consider managers from foreign jurisdictions.  However, visiting potential U.S. investors or sending fund marketing materials into the U.S. without complying with the U.S. broker dealer rules could result in a fate similar to that suffered by the four Indian brokerage firms that were sanctioned and fined by the SEC. In order to avoid an enforcement proceeding, non-U.S. fund managers should retain a properly registered U.S. brokerage firm to sell the fund’s securities, enter into a “chaperoning” arrangement with a U.S. broker or register a subsidiary as a broker-dealer in the U.S.  

Whether prudent or not, most U.S.-based fund managers rely on Rule 3a4-1, the so-called “issuers exemption,” under the Securities Exchange Act of 1934 (the “1934 Act”) in order to avoid either registering the general partner or an affiliate of the fund as a broker, or retaining an unrelated broker to sell the fund’s interests.  But when U.S. fund managers travel outside the U.S. to gauge interest or solicit potential investors, the U.S. rules are not applicable.  Each country has its own regulatory scheme, and fund managers are well advised to understand what is permitted and prohibited in each country before visiting each country at the risk of being the subject of a new episode of “Locked Up Abroad.”  Indeed, certain countries impose criminal sanctions for offering securities if the offeror is not properly authorized to do so.

The Investment Fund Law Blog boldly predicts that the SEC will one day soon re-visit the industry’s expansive interpretation of the “issuer’s exemption” and the result will not be pleasant for the private funds industry.

So what did these Indian brokerage firms do to incur the wrath of the SEC?  The activities that these firms engaged in included:

• Buying and selling Indian securities on Indian stock exchanges on behalf of U.S. investors;
• Managing public offerings for Indian issuers in which shares were sold to U.S. investors;
• Soliciting U.S. investors by email, phone calls, and in-person meetings between Indian issuers and U.S. investors;
• Engaging in commission sharing agreements with U.S. registered broker-dealers, in which the firms provided research to U.S. investors in exchange for commission income;
• Organizing and sponsoring conferences in the U.S. bringing together representatives of Indian issuers and U.S. investors; and
• Sending firm employees to the U.S. to meet with U.S. investors and attend corporate road shows.

Many of these activities no doubt sound hauntingly familiar to U.S.-based fund managers that travel abroad for the purpose of raising capital.  All four firms were censured and ordered to pay a combined total of more than $1.8 million in disgorgements and prejudgment interest, but no civil penalties were imposed due to the firms’ cooperation with the SEC.  The firms have all submitted settlement offers, without admitting or denying any wrongdoing.

The SEC’s press release on the matter can be found here. 

Written by: Jay Gould and Peter Chess

The Financial Industry Regulatory Authority (“FINRA”) released new guidance last month regarding new FINRA Rule 2111 (the “Suitability Rule”), which requires a broker-dealer to have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through reasonable diligence by the broker-dealer.  The Suitability Rule codifies and clarifies the three main suitability obligations that previously had been discussed largely in case law:

• Reasonable-basis suitability.  A broker must perform reasonable diligence to understand the nature of the recommended security or investment strategy involving a security or securities, as well as the potential risks and rewards, and determine whether the recommendation is suitable for at least some investors based on that understanding.
• Customer-specific suitability.  A broker must have a reasonable basis to believe that a recommendation of a security or investment strategy involving a security or securities is suitable for the particular customer based on the customer’s investment profile.
• Quantitative suitability.  A broker who has control over a customer account must have a reasonable basis to believe that a series of recommended securities transactions are not excessive.

In general, the Suitability Rule retains the core features of the previous National Association of Securities Dealers (“NASD”) suitability rule, NASD Rule 2310.  However, the new Suitability Rule imposes broader obligations on firms regarding recommendations of investment strategies.  Existing guidance and interpretations regarding suitability obligations continue to apply to the extent that they are not inconsistent with the new rule.  The guidance provided by FINRA on the Suitability Rule includes the following:

• The suitability requirement that a broker make only those recommendations that are consistent with the customer’s best interests prohibits a broker from placing their interests ahead of the customer’s interests.
• The customer’s investment profile is critical to the assessment of the suitability of a particular recommendation.
• The recently passed Jumpstart Our Business Startups Act (the “JOBS Act”) does not affect the suitability obligations regarding private placements, including those private placements made in reliance on the JOBS Act’s elimination of the prohibition on general solicitation.
• The term “investment strategy” is to be interpreted broadly and would apply to cases where the strategy results in a securities transaction or even mentions a specific security.
• The extent to which a firm needs to document its suitability analysis depends on an assessment of the customer’s investment profile and the complexity of the recommended security or investment strategy.
• Although the reasonableness of a firm’s effort to perform “reasonable diligence” will depend on the facts and circumstances, asking a customer for the information ordinarily will suffice.

The institutional-customer exemption under NASD Rule 2130 and its definition of “institutional customer” has been replaced with the more common definition of “institutional account.”  In addition, the new institutional-customer exemption focuses on whether (1) a broker has a reasonable basis to believe the institutional customer is capable of evaluating risks independently and (2) the institutional customer affirmatively indicates that it is exercising independent judgment (a new requirement).

Written by: Jay B. Gould and Peter Chess

On April 18, 2012, the Securities and Exchange Commission (“SEC”) and the Commodity Futures Trading Commission (“CFTC”) voted to adopt rules defining “swap dealer,” “security-based swap dealer,” “major swap participant,” and “major security-based swap participant,” among other terms, as mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”).  The Dodd-Frank Act assigns to the SEC the regulatory authority for security-based swaps[1] and assigns to the CFTC the regulatory authority for swaps. 

Under the adopted rules, the definitions are as follows:

A swap dealer is defined as any person who:

• Holds itself out as a dealer in swaps;
• Makes a market in swaps;
• Regularly enters into swaps with counterparties as an ordinary course of business for its own account; or
• Engages in activity causing itself to be commonly known in the trade as a dealer or market maker in swaps.

The definition of security-based swap dealer tracks the definition of swap dealer, with “security-based swap” inserted where “swap” appears.

A major swap participant is a person that satisfies any one of the three parts of the definition:

• A person that maintains a “substantial position” in any of the major swap categories, excluding positions held for hedging or mitigating commercial risk and positions maintained by certain employee benefit plans for hedging or mitigating risks in the operation of the plan.
• A person whose outstanding swaps create “substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets.”
• Any “financial entity” that is “highly leveraged relative to the amount of capital such entity holds and that is not subject to capital requirements established by an appropriate Federal banking agency” and that maintains a “substantial position” in any of the major swap categories.

The definition of major security-based swap participant tracks the definition of major swap participant with “security based-swap” inserted where “swap” appears.

The newly adopted rules contain further definitions for the terms “substantial position,” “hedging or mitigating commercial risk,” “substantial counterparty exposure,” “financial entity,” “highly leveraged,” and “eligible contract participant.”  In addition, the adopting release provides interpretative guidance on the definitions of swap dealer and security-based swap dealer, and the CFTC provides further details on the exclusion for swaps in connection with originating a loan, the exclusion of certain hedging swaps and the exclusion of swaps between affiliates.  Finally, the new rules call for a de minimis exemption from the definition of swap dealer and security-based swap dealer wherein a person who engages in a de minimis amount of swap or security-based swap dealing will be exempt from the respective definition.  

The SEC and the CFTC adopted the new rules under joint rulemaking, and the SEC rules become effective 60 days after the date of publication in the Federal Register, although dealers and major participants will not have to register with the SEC until the dates that will be provided in the SEC’s final rules for the registration of dealers and major participants.  The CFTC must adopt further rules defining the term “swap,” and swap dealers and major swap participants will need to register by the later of July 16, 2012, or 60 days after the publication of CFTC rules defining “swap.”

The full text of the SEC press release and fact sheet is available here.  The full text of the CFTC release is available here.

[1]               Security-based swaps are broadly defined as swaps based on (i) a single security, (ii) a loan, (iii) a narrow-based group or index of securities, or (iv) events relating to a single issuer or issuers of securities in a narrow-based security index. 

Written by Jay Gould

On October 18, 2011, the SEC released a notice of FINRA’s filing of Proposed Rule 5123 (the “Proposed Rule”) which would require FINRA members and associated persons to: 1) provide to investors disclosure documents in connection with private placements prior to sale and 2) file with FINRA such disclosure documents within 15 days after the date of first sale and any subsequent amendments.  These proposed changes would significantly affect fund managers who offer or sell their funds that are exempt from registration pursuant to Section 3(c)(1) of the Investment Company Act through third party marketers, nearly all of which are required to be registered as broker-dealers.

Pre-sale requirement to provide disclosure documents to investors

The Proposed Rule would require FINRA members and associated persons that offer or sell private placements or participate in the preparation of private placement memoranda (“PPM”), term sheets or other disclosure documents in connection with such private placements, to provide such disclosure documents to investors prior to sale.  The disclosure documents must describe the anticipated use of offering proceeds, the amount and type of offering expenses, and the amount and type of offering compensation.  Much of this information is currently captured in the Form D filing that most fund managers file with the SEC, but under the Proposed Rule, would go directly to investors in connection with the sale of fund interests.

As a practical matter, this likely means increased scrutiny of hedge fund and other private fund offerings by FINRA, as well as the likelihood that third party marketers that sell on behalf of hedge funds may request greater or more enhanced indemnification from fund managers in the placement agency agreement between the third party marketer and the fund manager.  Accordingly, fund managers who use third party marketers to market their funds must keep their fund documents updated, taking into account all changes to fund strategies, material performance issues (to the extent applicable), regulatory changes and management personnel changes, to name a few.      

Post-sale requirement to notice file with FINRA

The Proposed Rule would also require each FINRA member and associated person to notice file with FINRA by filing the PPM, term sheet or other disclosure documents no later than 15 days after the date of first sale.  In addition, any amendments to such disclosure documents or disclosures required by the Proposed Rule would have to be filed no later than 15 days after such documents are provided to any investor or prospective investor.  To the extent these documents are provided to investors, they would also be subject to the strict liability standard of Rule 206(4)-8 under the Investment Advisers Act to which all fund managers are already subject.  Accordingly, fund managers must be careful to keep all of their documents current under the materiality standards of state and Federal securities laws.

Offerings Exempted from the Proposed Rule

The Proposed Rule would exempt several types of private placements including offerings sold only to any one or more of the following purchasers: 

•  institutional accounts, as defined in NASD Rule 3110(c)(4);
• qualified purchasers, as defined in Section 2(a)(51)(A) of the Investment Company Act;  (Accordingly, 3(c)(7) funds would be exempt from the Proposed Rule.)
• qualified institutional buyers, as defined in Securities Act Rule 144A;
• investment companies, as defined in Section 3 of the Investment Company Act;
• an entity composed exclusively of qualified institutional buyers, as defined in Securities Act Rule 144A;
• banks, as defined in Section 3(a)(2) of the Securities Act; and
• employees and affiliates of the issuer.

In addition, the Rule would exempt the following types of offerings:

• offerings of exempted securities, as defined by Section 3(a)(12) of the Exchange Act;
• offerings made pursuant to Securities Act Rule 144A or SEC Regulation S;
• offerings of exempt securities with short term maturities under Section 3(a)(3) of the Securities Act;
• offerings of subordinated loans under Exchange Act Rule 15c3-1, Appendix D;
• offerings of “variable contracts” as defined in Rule 2320(b)(2);
• offerings of modified guaranteed annuity contracts and modified guaranteed life insurance policies, as referenced in Rule 5110(b)(8)(E);
• offerings of non-convertible debt or preferred securities by issuers that meet the eligibility criteria for incorporation by reference in Forms S-3 and F-3;
• offerings of securities issued in conversions, stock splits and restructuring transactions that are executed by an already existing investor without the need for additional consideration or investments on the part of the investor;
• offerings of securities of a commodity pool operated by a commodity pool operator as defined under Section 1a(11) of the Commodity Exchange Act; and
• offerings filed with FINRA under Rules 2310, 5110, 5121 and 5122.

Confidential treatment

Documents and information filed with FINRA pursuant to the Proposed Rule would be given confidential treatment.  FINRA would use such documents and information solely for the purpose of determining compliance with FINRA rules or other applicable regulatory purposes.  In addition, FINRA would afford confidential treatment to any comment or similar letters by FINRA and thus could not be discoverable by a litigant through a legal action.

A full text of the SEC Notice and Proposed Rule is available here.

Written by Michael Wu

The SEC has adopted a new rule pursuant to Section 13(h) of the Securities Exchange Act of 1934 requiring large traders to register with the SEC and imposing reporting requirements on their broker-dealers. 

In her speech on July 26, 2011, SEC Chairman Mary L. Shapiro said, “[t]his new rule…would significantly bolster our ability to oversee the U.S. securities markets by allowing the Commission to promptly and efficiently identify significant market participants on a cross-market basis, collect data on their trading activity, reconstruct market events, conduct investigations and, as appropriate, bring enforcement matters.” 

Under the rule, large traders are required to register with the SEC using a new form, Form 13H.  Upon registration, each large trader is issued a unique large trader identification number (LTID).  Large traders are required to provide such LTID to their broker-dealers.  In addition, the rule imposes recordkeeping, reporting and limited monitoring requirements on certain registered broker-dealers through whom large traders execute their transactions. 

A large trader is defined as a person whose transactions in exchange-listed securities equal or exceed 2 million shares or $20 million during any calendar day, or 20 million shares or $200 million during any calendar month.

A full text of the final rule is available here.

Written by Michael Wu

On December 15, 2010, FINRA Rule 3270 became effective.  FINRA Rule 3270 requires each registered representative of a broker-dealer to provide it with prior written notice of an outside business activity.  FINRA Rule 3270, which replaced NASD Rule 3030 and NYSE Rule 346, specifically identifies the types of activities that would be subject to the rule and requires registered representatives to disclose to the broker-dealer whenever he or she intends to serve as an employee, independent contractor, sole proprietor, officer, director or partner of another entity, or will be compensated, or reasonably expects to be compensated, from another entity in connection with any business activity outside the scope of such individual’s relationship with the broker-dealer.  Passive investments and activities subject to NASD Rule 3040 (i.e., the private securities transaction rule) are exempt from the requirements under FINRA Rule 3270.

Upon receipt of notice of an outside business activity from a registered representative, a broker-dealer must determine whether the proposed activity would (i) interfere with such registered representative’s responsibilities to the broker-dealer and/or its clients or (ii) be viewed by clients or the public as part of the broker-dealer's business.  Based on such analysis, the broker-dealer may impose specific limits or conditions on such activity or prohibit such activity.  The broker-dealer must document the review process of each written notice received and keep appropriate records.  If a registered representative was actively engaged in an outside business activity prior to December 15, 2010, the broker-dealer must review such activity in accordance with FINRA Rule 3270 by June 15, 2011.