Thursday, October 2, 2014

Let's Make a Deal: Regulating Deal-Makers on Wall Street, Main Street and in Silicon Valley in the Crowdfunding Era (Summary of 14 Articles)


By Jim Verdonik
I'm an attorney with Ward and Smith PA.  I also write a column about business and law for American Business Journals , have authored multiple books and teach an eLearning course for entrepreneurs.

You can reach me at JFV@WardandSmith.com.
Or you can check out my eLearning course at www.YouTube.com/eLearnSuccess
or read my newspaper articles at


This article provides a quick summary of 14 articles I recently wrote about securities laws that regulate Deal-Makers:
·         Venture Capital Managers
·         Investment Bankers
·         Business Brokers and Other M & A specialists
·         Finders
·         Real Estate Developers
·         And the newest members of the dealer-makers club: people who operate technology platforms that showcase companies that are raising money and Social Media consultants who attract potential investors to offerings.

The articles focus on the ongoing struggle between Wall Street, Silicon Valley and Main Street to control different parts of the deal-making world and why the SEC is favoring Wall Street at the expense of both Main Street and Silicon Valley Deal-Makers.  This raises the question: When is "investor protection" simply a tool for protecting Wall Street from competition?
In this struggle for Deal-Making domination, the specific services you provide and the types of fees you charge matter.  Small changes in your business model can affect what you are allowed to do.
We'll focus on SEC positions that make it more difficult for small to medium size businesses to raise capital and what steps Deal-Makers should take to capitalize on regulatory and technology change to better serve this market.  In this process, we'll analyze:
  • The traditional regulatory framework for brokers in private placements, including recent SEC efforts to expand the list of people who have to register as brokers.
  • Court cases that define how unregistered finders should operate to position themselves to win against the SEC.  What services can unregistered finders safely provide?  What fees can unregistered finders safely charge?
  • The exemption Section 201 (c) of the JOBS Act created for unregistered intermediaries in Rule 506 offerings and how the SEC's interpretation of the limited scope of this exemption is depriving investors of important tools investors need.
  • How to make a living in the "crowd."  The economics of crowdfunding portal operators dictated by SEC rules.  What services can portal operators provide?  What fees can portal operators charge?  How will the crowdfunding rules adversely affect both companies raising capital and investors who want to use crowdfunding portals?
  • Proposals to provide exemptions that will free unregistered finders to play more active roles in private placement transactions.
  • How to comply with a new M & A brokers exemption from registration for business brokers and others who help sell entire businesses.
  • The rise of online venture capital in the form of single purpose venture capital investment and buy-out funds as deal-makers switch from being agents to principals and how the Investment Advisers Act (which for decades has had limited impact) is becoming more important to Deal-Makers.  Why raise one fund that invests in ten companies when you can set up ten funds to invest in ten companies, especially now that technology can speed the capital raising process?
  • The role Social Media consultants play on the capital raising team.
  • A reminder that state laws still regulate brokers and investment advisers.
All these issues are related; because they all affect Deal-Makers, but not all issues affect all Deal-Makers.
To help you focus on the issues that are most important to you and your business, we've created a table that briefly describes each article.  Click on the links in the table to find the full articles.

Article Number
DESCRIPTION
1
This article discusses public policy issues related to Deal-Makers.  We describe how the SEC's policy of applying broker-dealer rules too broadly, limits competition, harms the economy, preserves Too Big to Fail Investment Banks, deprives growth companies of capital and limits the choices investors have.
2
Who Are You Calling "Broker"? Why the SEC Casts Too Broad a Net. http://jimverdonikintersection.blogspot.com/2014/09/who-are-you-calling-broker-why-sec.html
This article describes the SEC's position about who is required to register as a broker.  We discuss the three key issues the Securities Exchange Act says must be present before you have to register as a broker and how the SEC often ignores the statute.
3
Courts vs SEC:  Why Do Some Courts Disagree with the SEC's Broad Rules About Who Has to Register as a Broker? http://jimverdonikintersection.blogspot.com/2014/09/courts-vs-sec-why-do-some-courts.html
This article describes the principles courts have used to decide that the SEC's interpretation of the broker registration requirements of the Securities Exchange Act is too broad and how unregistered finders should conduct their business to fall within the court decisions that favor unregistered finders.
4
Section 201 (c) of the JOBS Act: New Exemption from Broker Registration in Rule 506 Offerings and SEC's Narrow Interpretation of Exemption http://jimverdonikintersection.blogspot.com/2014/09/section-201-c-of-jobs-act-new-exemption.html
This article describes the exemptions from registration as a broker the JOBS Act created in 2012 for all Rule 506 private placement offerings and why the SEC opposes this exemption and limits the fees you can charge for services.  The JOBS Act exemption applies to both operators of digital platforms that connect issuers and potential investors and some activities of unregistered finders in traditional offerings that don't use the Internet.  Exempted services include due diligence services and providing standard investment forms and technology and media based listing-introduction services.  Co-investing in investment transactions is also an exempted activity.
5
Section 201 (c) of the JOBS Act:  Uniform Media Broker Exemption Rules For Internet, Radio, Television, Newspapers and Telephones in Rule 506 Offerings
This article discusses how the broker registration exemption created by the JOBS Act applies to people who operate a wide range of media and technology tools used to reach investors in any Rule 506 offering.  Rules about services and fees for services should be uniform for all media and technology tools (including Internet, Radio, Television, Newspapers and Telephones), which undermines the SEC's initial pronouncements about what fees Internet platform operators can charge.
6
Section 201 (c) JOBS Act: What Services and Fees Can Exempt Platforms and Finders Provide and Charge in Rule 506 Offerings? http://jimverdonikintersection.blogspot.com/2014/09/section-201-c-jobs-act-fees-and-scope.html
This article discusses why the SEC's narrow interpretation of the activities and fees for listing-introduction services, due diligence and providing investment form documents that the JOBS Act exempts is inconsistent with both the statute and common practices in many private placements.
7
Tough Time Making a Living in the Crowd: What Services Crowdfunding Platform Operators Allowed to Prove and What Fees Can They Charge? http://jimverdonikintersection.blogspot.com/2014_09_01_archive.html
This article discusses why the Crowdfunding rules' tight limits on the fees Crowdfunding portal operators will be able to charge and the tools they will be able to provide investors to identify investment opportunities will cause both businesses raising capital and investors to choose Rule 506 offering platforms over Crowdfunding portals.
8
This article discusses an SEC letter (issued in 2014) that explains the conditions business brokers and other finders have to meet to be exempt from registering as a broker when they sell a business.
9
Salesmen vs. Matchmakers: What do Deal Makers Do?  And How Should that Drive Securities Regulations? http://jimverdonikintersection.blogspot.com/2014/10/salesmen-vs-matchmakers-what-do-deal.html
This article explains the value many finders bring to transactions that go beyond just acting as sales people and why the functions finders perform in deals that are too small for most registered brokers justify expanded exemptions from registration for finders.
10
Proposed Finders Exemptions in Capital Raising Deals:  If M & A Brokers are Exempt from Registration, Why Are Capital Raising Finders not Exempt? http://jimverdonikintersection.blogspot.com/2014/10/proposed-finders-exemptions-in-capital.html
This article discusses several exemptions for finders in capital raising transactions proposed by the American Bar Association and others.
11
Do Issuers and Issuer Employees and Contractors Have to Register as Brokers or Dealers? http://jimverdonikintersection.blogspot.com/2014/10/do-issuers-and-issuer-employees-and.html
This article discusses the exemption from the broker-dealer registration requirements of the Securities Exchange Act that issuers of securities and their employees rely on and circumstance in which these exemptions can be lost.
12
Special Purpose Entities: The Rise of Online Single Purpose Venture Capital Investment and Buyout Funds  http://jimverdonikintersection.blogspot.com/2014/10/special-purpose-entities-rise-of-online.html
This article discusses a business model finders can use that does not require them to register as a broker-dealer.  Single purpose venture capital funds can be formed for each investment transaction.  Instead of collecting a commission for closing the investment, the manager who organizes the fund can receive a carried interest in profits and an annual management fee like traditional venture capital funds that invest in many different companies.  The article discusses the exemption available from requirements to register as an investment adviser and raises the question: Why raise one fund that invests in ten companies when you can set up ten funds to invest in ten companies, especially now that technology can speed the capital raising process?
13
New Deal-Makers: Social Media Digital Marketing Consultants Find their Place in Securities Offerings http://jimverdonikintersection.blogspot.com/2014/10/new-deal-makers-social-media-digital.html
This article discusses the roles Social Media marketing consultants can play in Internet based Rule 506 offerings and how they should operate to avoid being required to register as a broker-dealer under the Securities Exchange Act.  Where is the line between lead generation and regulated sales activities for Social Media marketing consultants?
14
State Regulation of Deal Makers: Offering, Broker-Dealer and Investment Adviser Laws http://jimverdonikintersection.blogspot.com/2014/10/state-regulation-of-deal-makers.html
This article describes state laws that govern brokers and investment advisers and how to navigate these state requirements.

 

If you would like to learn more, you can reach me at JFV@WardandSmith.com.
Or you can check out my eLearning course at www.YouTube.com/eLearnSuccess
or read my newspaper articles at
http://www.bizjournals.com/triangle/search/results/_author/Jim+Verdonik?q=%22Jim+Verdonik%22&title=


 


 

Wednesday, October 1, 2014

State Regulation of Deal Makers: Offering, Broker-Dealer and Investment Adviser Laws (Article 14 in a series of 14 articles about Deal-Makers)


By Jim Verdonik
I'm an attorney with Ward and Smith PA. I also write a column about business and law for American Business Journals , have authored multiple books and teach an eLearning course for entrepreneurs. You can reach me at JFV@WardandSmith.com.
Or you can check out my eLearning course at www.YouTube.com/eLearnSuccess or purchase my books http://www.amazon.com/Jim-Verdonik/e/B0040GUBRW
or read my newspaper articles at
This article is one of 14 articles in a series of articles about Deal-Makers called:
LET'S MAKE A DEAL: REGULATING DEAL-MAKERS ON WALL STREET, MAIN STREET AND IN SILICON VALLEY IN THE CROWDFUNDING ERA
Most people focus on the SEC when we talk about broker-dealer registration, investment adviser regulation and exemptions from registrations for securities offerings.

But we would be remiss if we fail to deal with the roles states play.

States require registration and otherwise regulate:

  • Securities offerings.
  • Broker-dealers
  • Investment advisers.
  • Certain people who work for broker-dealers and investment advisers.
Each state has its own combination of exemptions and regulations, but state securities administrators meet regularly to try to adopt rules that embody common general principles.

Since complying with 50 sets of securities rules are burdensome to people in the securities business without adding much additional protections for investors, Federal law sometimes pre-empts state laws.

Securities Offerings Exemptions

Let's talk about state exemptions for offerings of securities from registration of offers and sales of securities for two reasons.

·         First, because state laws about exemptions often drive the choices people make about what Federal offer exemption they use for their offering.  One reason why over 90% of private placements use SEC Rule 506 is because Section 18 of the Securities Act includes securities sold under Rule 506 in the definition of "Covered Securities.  Covered securities are exempt from state laws that require you to submit offering materials to state securities regulators for review before you offer or sell securities in a state.  State pre-offering or pre-sale review requirements added substantial time and expense to the offering process.  People often had to comply with state laws before they knew whether there were any actual investors in a state.  While some comments received from state securities regulators added useful disclosures for investors, much time was wasted dealing with comments on disclosure documents that added little protection for investors.  A Rule 506 offering, however, allows you to wait until after you sell securities in a state and then file a notice that you sold securities in that state.  States maintain these post-closing filing requirements primarily to collect filing fees.

  • Many state exemptions from registration of securities offerings are conditioned on the issuer not paying unlicensed brokers a commission for sales in that state.  If you paid an unlicensed broker a commission, investors could demand a refund even if no fraud was involved in the offering.  This automatic loss of state offering exemptions in many states created issues liability issues for using unregistered finders.  What was initially a problem for unregistered finders became a problem for issuers.  By choosing to use Rule 506, the state exemptions were unnecessary.  Using Rule 506 does not totally negate issuer liability for using unregistered finders.  Paying an unregistered broker may be a material fact that should be disclosed to investors.  The SEC's position is that it is always a material fact, but one can argue that disclose that the commission is being paid is material, but the identities or unregistered status is not material.
Broker-Dealer Registration

State securities laws generally mimic the language of the Exchange Act by defining a broker or a dealer as "any person engaged in the business of effecting transactions in securities for the account of others or for his own account."

Most state statutes, however, create specific exclusions to specific classes of people and entities, including business brokers, issuers engaged in certain transactions and people who assist issuers in certain exempt transactions. 

We should note, however, that even if the issuer is selling a "covered security" in a Rule 506 offering such that the offering is exempt from state pre-sale review by reason of Federal law, a person who is compensated for soliciting investors in the offering, may be deemed to be a broker-or a dealer. 

As discussed in article (2) of this series of articles, paying an unregistered broker or dealer may cause loss of the Rule 506 exemption and might constitute fraud under both state and Federal law.

Finally, many states require individual sales people associated with brokers to register with the state even if the entity they work for is not required to register.

Investment Adviser Registration

In article (12) of this series of articles, we discussed single purpose venture capital funds and buy-out funds and how the Federal Investment Advisers Act applies to them.

Now, let's discuss how state law and Federal law interact with one another.  Federal law deals with three categories of advisers based on the amount of assets they manage:

  • Less than $25 million
  • $425 to $100 million
  • $100 million or more
Federal law precludes anyone registering as an investment adviser if they manage less than $25 million, unless the state where the adviser has its principal office and place of business has not enacted a statute that regulates investment advisers.  Being regulated can be something less than being required to register.  States often prohibit fraud and other practices even if the adviser is exempt from registration.

If the adviser manages between $25 million to $100 million of assets, the adviser is not allowed to register with the SEC, if the adviser is registered (or is required to register) with the state where it has its principal office and place of business and the adviser is subject to examination by the state regulator.

At $100 million or more assets, the adviser must register with the SEC, unless an exemption from registration applies.

This means that if an adviser that manages less than $25 million of assets is exempt from state registration, there is no requirement to register at either the state or Federal level.

The most common registration exemption for advisers under Federal law was that advisers who had 14 or fewer clients did not need to register, if they did not hold themselves out to the public as an investment adviser.  This Federal exemption from registration was repealed by the Dodd-Frank Act, but many states continue to have this exemption from registration. 

Traditionally, the Federal rule was that investors in funds are not counted as "clients" of the manager of the investment fund for purposes of the 14 or fewer clients exemption.  Only the fund itself was considered a client.  In 2004 the SEC changed this rule to count fund investors as clients, but the SEC's rule was declared invalid by the DC Court of Appeals in the 2006 Goldstein case.  Consequently, for purposes of most states laws you count each fund as a client not each investor in a fund.

It is likely that states will eventually follow the Federal government's lead in abolishing the 14 or fewer exemption.  This is likely to occur faster in states where the exemption is contained in a rule issued by a securities administrator, but take longer where the exemption is included in a state statute.

Another common exemption from registration is for managers of "business development companies."  Some venture capital finds fall within the definition of "business development company."  Other venture capital funds do not qualify.

Section 222 (d) of the Investment advisers Act also provides a uniform exemption from state registration, unless the adviser:

·         Has a place of business in the state.

·         Or during the preceding 12 months the adviser has had six or more "clients" who are residents of that state.

Because advisers usually have great flexibility in choosing where its investment funds are located, most advisers to funds should be able to avoid registration in most states.

Other common state exemptions from registration or exclusions from the definition of investment adviser include persons who do not hold themselves out to be investment advisers.

Combining Federal and State Exemptions

In article (12) of this series of articles, we discuss investment funds that are special purpose entities formed to invest in a single specific business. 

The focus of some state laws on the number of clients or funds and the focus of Federal exemptions in the types of investments of the types of investors creates a target for a registration free zone where:

·         Total assets of all funds an adviser manages is less than $25 million, which would provide exemption from registration under Section 203A (a) of the Investment Advisers Act, and the adviser manages14 or fewer investment funds or another state exemption described above.

·         Total assets of all funds an adviser manages is less than $150 million and all investors are Qualified Investors, which would provide exemption from registration under  the Investment Advisers Act, and the adviser manages14 or fewer investment funds or another state exemption described above.

·         The adviser uses the venture capital fund exemption for funds that have an unlimited amount of assets in reliance on Section 203 (l) of the Investment Advisers Act and the adviser manages14 or fewer investment funds or another state exemption described above.

Fitting within this registration free zone will present different challenges depending on an adviser's business model.

Some of these special purpose entities are formed by people who want to do a single deal.  Other people business model requires the managers to form a new entity for each of an ongoing series of investments in multiple issuers.  Some of these multiple deal entities call themselves "online venture capital funds."

Certainly, most managers who want to do "one off" deals or a deal every couple of years can fit within the exemption provisions we discuss above for the states and within the Federal exemptions we discuss in article (13).  Managers who want to churn out a steady stream of SPE deals will have greater challenges avoiding Federal and state registration.

The part of the registration free zone described above that relates to managers of private funds that have 99 or fewer investors and less than $150 million of assets is in the process of being cut back by state regulators.  Proposed NASAA model rule would require state registration of all advisers who advise private funds with assets under $150 million that are exempt from the definition of investment company under the Investment Company Act by reason of Section 3 (c) (1), unless all the fund's owners are qualified investors.  This provision would cover advisers to most venture capital funds, unless the adviser is also exempt from registration under Section 203 (m) of the Investment Advisers Act.

Shifting Management Responsibilities and Ownership Interests

One way to deal with the state issues may be to resign from managing duties as the number of entities grows.  This might be accomplished by having ownership vest over an agreed number of years and then not being active in some deals to make room for other deals.  Groups of managers may be able to allocate management duties while still sharing the upside gains of the investment entities.

For the most part, both Federal and state regulation depends the nature of the services an individual provides to determine whether someone is providing investment advice, not on ownership.  Before employing such programs to manage the number of entities managed and the dollar amount of investments managed, however, advisers should consult with their lawyers about beneficial ownership rules that might cause an owner to be deemed to be an adviser even if the owner no longer actively managers a fund..

Rules that Apply to Exempt Investment Advisers

As we discuss in article (12) of this series of articles, some SEC rules apply to investment advisers who are exempt from the registration requirements of the Investment Advisers Act. 

Fund managers should be careful to understand what state rules may apply to investment advisers who are exempt from registration or to persons who are excluded from the definition of investment adviser under state laws, but who perform activities governed by state statutes.  For example, many state statutes apply to any person who accepts compensation for providing advice even of that person is excluded from the definition of investment adviser or is exempt from registration as an investment adviser.

If the manager of a venture capital fund is permitted to register with the SEC under the Investment Advisers Act of 1940 because of the amount of assets it manages, but qualifies for the venture capital fund exemption from registration afforded by Section 203 (l), the venture fund manager must file a Form ADV with the SEC and amend the form ADV not less often than annually. 

Therefore, a manager of one or more single purpose venture capital funds should value the assets it manages for all funds each year to determine whether the manager exceeds the threshold for state regulation and falls within Federal regulation.  Likewise, fund managers who manage less than $100 million of assets should monitor changes in state laws about investment advisers, which may affect their Federal registration requirements.

The SEC also has the right to inspect records of investment advisers who are exempt from registration and the exempt advisers must comply with anti-fraud and conflict of interest rules.

The same rules apply to managers of "private funds" with under $150 million of assets, which qualify for the exemption from registration afforded by Section 203 (m) of the Investment Advisers Act of 1940.

If you would like to learn more, you can reach me at JFV@WardandSmith.com.
Or you can check out my eLearning course at www.YouTube.com/eLearnSuccess
or read my newspaper articles at



 

New Deal-Makers: Social Media Digital Marketing Consultants Find their Place in Securities Offerings (Article 13 in a series of 14 articles about Deal-Makers)


By Jim Verdonik

I'm an attorney with Ward and Smith PA. I also write a column about business and law for American Business Journals , have authored multiple books and teach an eLearning course for entrepreneurs. You can reach me at JFV@WardandSmith.com.
Or you can check out my eLearning course at www.YouTube.com/eLearnSuccess
or read my newspaper articles at


This article is one of 14 articles in a series of articles about Deal-Makers called:

LET'S MAKE A DEAL: REGULATING DEAL-MAKERS ON WALL STREET, MAIN STREET AND IN SILICON VALLEY IN THE CROWDFUNDING ERA

For many years you could easily predict the team of people who would be working together on a securities  offering. 

The capital raising team included two or more of the "usual suspects":

·         The issuer's officers.
·         Lawyers.
·         Investment bankers or finders.
·         Financial consultants.
·         Accountants.

With the rise of Internet as the most cost efficient tool to sell most products and services and changes in securities laws that permit advertising and general solicitations in SEC Rule 506(c) private placements and crowdfunding securities offerings, new players are becoming increasingly important to the securities offering team – Social Media marketing consultants.

Before we explore the roles Social Media consultants can play in securities offerings without violating securities laws, we should remind the old players that they need to adapt what they traditionally have done to the new sales tools the new players are bringing to the table.  The old payers know how to talk with one another.  They know what roles they each play, what roles others play and where they need to coordinate their efforts. 

 The old payers will have to adapt to do the same with Social Media consultants.  Change is coming quicker that some people think.  Already, business people are referring to crowdfunding "campaigns" instead of "offerings."  The old team members will have to adapt quickly to fit new "campaigns" into regulatory boxes built for "offerings." 

Old team members won’t be effective in their jobs, if they just say no to everything.  "Campaigns" will have to combine new ways of communicating with established principles of anti-fraud compliance.

For example, lawyers will have to learn how to review and revise Social Media communications to ensure compliance with anti-fraud rules without destroying effective communication.  Investment bankers will have to learn how to pick up the ball to sell the offering to leads generated by the Social Media team.  It will take time for these players to learn how to dance with one another.  Initially, it won’t be pretty.  Expect a few toes to be stepped on during the learning process.

The offering team will initially focus on the anti-fraud rules and offering exemptions of the Securities Act of 1933.  That's the primary statute that regulates securities offerings.  But the Securities Act isn't the only regulatory driver.

The learning process will go much smoother, if everyone on the team understands how broker-dealer and investment adviser rules shape what Social Media consultants are allowed to do and what they cannot do without registering either as a broker-dealer under Section 15 (a) (1) of the Securities Exchange Act of 1934 or as an investment adviser under the Investment Advisers Act of 1940 and the state counterparts of these laws.

Now, let's examine how the broker-dealer registration provisions of Section 15 (a) (1) of the Securities Exchange Act and the investment adviser registration provisions of the Investment Advisers Act are likely to shape the roles Internet and Social Media consultants will likely play in securities offerings.

In this examination we will focus on:

      ·         The fees Social Media consultants can charge.

·         The activities Social Media consultants can perform without being deemed ot be making "recommendations" or providing "investment advice."

The securities compliance challenges Social Media consultants will face will depend in large part on how hands on the consultants become in the Social Media campaign.  Consultants who merely advise issuers and train issuer employees to implement the campaign will have a relatively easy compliance task.  Consultants who become more hands on by implementing the campaign, including interacting online with potential investors, face greater risks that they will cross the line into activity that requires them to register.

 

Special Purpose Entities: The Rise of Online Single Purpose Venture Capital Investment and Buyout Funds (Article 12 in a series of 14 articles about Deal-Makers)


 
By Jim Verdonik
I'm an attorney with Ward and Smith PA. I also write a column about business and law for American Business Journals , have authored multiple books and teach an eLearning course for entrepreneurs. You can reach me at JFV@WardandSmith.com.
Or you can check out my eLearning course at www.YouTube.com/eLearnSuccess
or read my newspaper articles at
This article is one of 14 articles in a series of articles about Deal-Makers called:
LET'S MAKE A DEAL: REGULATING DEAL-MAKERS ON WALL STREET, MAIN STREET AND IN SILICON VALLEY IN THE CROWDFUNDING ERA
In article (11) of this series of articles, we examined "dealers" and why most issuers do not have to register as either a "broker" or as a "dealer" under Section 15 (a) (1) of the Exchange Act.

There are many kinds of issuers.  Most issuers are not in the securities business.  They sell securities to raise capital to conduct businesses that have nothing to do with buying or selling securities.  What distinguishes investment funds like venture capital, private equity and hedge funds is that such investment funds are issuers that use the money they raise to purchase and eventually re-sell securities, entire businesses, real estate and other investments.

Such investment funds have to comply with the Securities Act when they sell securities to raise capital just like other issuers.  But investment funds also have to comply with other securities laws, because their primary business involves securities.  That means we have to deal with special securities issues whenever we deal with investment funds and the people who manage or advise investment funds.  These issues include:

·         How do we apply the broker-dealer rules we have been discussing to these investment funds?

·         How do other laws like the Investment Company Act and the Investment Advisers Act apply to these investment fund deal makers?

·         How are the JOBS Act, other regulatory reforms and technology changing the role of investment funds and their advisers, managers and general partners?

·         In particular, how are special purpose entities that are organized to make a single investment or to purchase a single business becoming more powerful players by using technology to change the deal-making world and what regulations apply to their activities?

·         If anyone can organize an investment fund, can issuers be proactive in helping someone to organize an investment fund that is dedicated to investing in the securities of that issuer?

·         How can issuers use these changes to their advantage by taking an active role in organizing an investment fund to do their transaction?

·         How can unregistered finders reduce their regulatory risks and expenses by changing their roles from being an agent to being a principal in securities transactions by organizing and managing special purpose investment funds that invest in or purchase one business?

·         What legal issues do special purpose investment funds that invest in or purchase one business have to navigate?

Broker-Dealer Registration Issues for Investment Funds

The first regulatory issues are what the words "for the account of others" mean and what benefits you are permitted to derive from a securities transaction when you are acting for the account of others or for your own account.

All of the exemptions from requirements to register as a broker we discussed in earlier articles in this series of articles deal with the issues of:

  • The fees you can charge, if you act as an agent or provide other services in connection with the offer, purchase or sale of securities?
  • What services are you allowed to provide to issuers and investors?
Let's review the general rules about compensation we have discussed:

  • You cannot charge a "success fee" in connection with the sale of securities, unless you are a registered broker, unless you rely on court cases that say that introducing investors to issuers is not the same as "effecting transactions" in securities. 
  • Sometimes other transaction based compensation that is not a "success fee" can trigger broker registration requirements, if the services you provide constitute "effecting transactions" in securities. 
Now, let's discuss the roles people play when they earn fees.

Success fees are paid to agents for arranging a transaction between two or more principals – usually the principals are an issuer of securities and one or more investors.  To be an agent, you do not have to have the power to make decisions.  Most brokers in private placements and other investment transactions act as advisers and do not have discretionary power to act on behalf the principals.  Essentially, being an agent means that you provide services.

But, what if you are not an "agent" at all?  What if you don't provide services?  What if you are a principal in the deal?  What if you are making decisions about how you will invest the money of an investment fund of which you are a part owner?  Do broker registration rules apply to people and entities that invest in securities and the people who manage the purchasers who are not paid a fee by issuers that sell securities?

Investment Funds and Their Managers

Now, let's compare the roles investment funds and their managers play and the benefits they receive more closely match issuers and the owners of issuers who engage in a business other than investing in securities or are the roles and benefits of investment funds and their managers more like the roles brokers play and the benefits brokers receive.

·         Transaction Roles:  Like issuers, investment funds and their managers make decisions and exchange cash for securities.  They do not provide advice to other participants in the securities transaction or act as an agent like brokers do.

·         Post-Transaction Roles.  Like issuers, investment funds and their managers are beginning a relationship with the other party to the securities transaction – the issuer.  The investment fund and its manager do not walk away from the relationship like a broker does.  The relationship lasts as long as the investment fund owns the issuer's securities.  The investment fund's managers often serve on the issuer's Board of Directors or otherwise provide advice or assistance to the issuer to help increase the investment's value.

·         Transaction Benefits:  The investment fund's managers usually earn nothing or very little, unless the securities they purchase appreciate in value.  The people who manage investment funds usually earn a carried interest (a percentage of the investment fund's future profits, if any, from the investment) and may collect periodic management fees (usually a small percentage of the investment fund's value).  Management fees are usually large enough to pay expenses and salaries, but are usually small enough that they do not constitute the manager's primary economic benefit if the investment is a success.  The carried interest is worthless, if the deal does not make money for investors.  This gives investment fund managers a vested interest in making the deal work for all the investors.  The fund mangers' upside interest is also usually a long-term proposition - especially if the investment is in an issuer whose securities are not publicly traded.  Unlike a broker-dealer, investment fund managers do not usually walk away from the closing table with an immediate profit.

So, if unregistered deal makers want to earn a long-term success fee, they could form a limited liability company or other entity to purchase a business or to invest in a capital‑raising offering.  Then, the limited liability company could raise capital to buy the business or invest.  In that case, the deal maker who manages the buyer would then be a principal instead of an agent.

Neither the investment fund nor the investment fund's manager would be required to register as a broker-dealer under Section 15 (a) (1) of the Exchange Act.

Competition Between Blind Pool Funds and Brokers

Now, let's focus on project finance and single purpose investment funds and how they differ from other investment funds.

Most investment funds we are familiar with invest in pools of securities.  Because the contents of the pool are unknown at the time investors invest in the pool, we call them "blind pools."  For example, a venture capital fund might invest in the securities of a dozen or two dozen securities over the course of a ten-year period.  The venture fund's managers might tell investors that they intend to focus investments on one or more industries, or on investments in a specific geographic area or on investments in businesses that have reached a specified size or stage of development, but investors do not know the specific businesses the investment fund will invest in when they write checks to invest in the blind pool investment fund. 

The managers of investment fund blind pools and registered brokers often compete with one another for the business of institutional investors and high net worth individuals.  Investing in a blind pool is not the only way to achieve diversification.  Brokers could provide investors with the diversification investment funds offer by selling investors offerings from multiple issuers.  The primary difference is that with a blind pool the investor makes one investment decision instead of multiple investment decisions when they buy investments in multiple issuers from brokers.

Project Finance and Single Purpose Investment Funds

So far, most of the things we have discussed about investment funds would apply to both blind pools and special purpose entities. 

Some of the people who invest in investment funds are institutional money managers who owe fiduciary duties to their clients, because they invest other peoples' money - like pension funds and insurance companies.  How is investing in a "blind pool" consistent with anyone's "fiduciary duties?"

What motivates people (especially fiduciaries) to invest in "bind pools?"

Blind pools are usually sold based on the reputations of the investment fund's managers.  If the managers have managed other funds in the past, the ROI they earned for investors in their prior funds is usually used to sell new funds to investors.  This historic ROI is used despite the fact that the SEC requires disclosure to investors that "past performance in not a guaranty of future results."  Like many things the SEC requires people to tell investors, investors routinely ignore these warnings about past performance and future results.

What business strategies do most "blind pools" pursue?  Most blind pools tell investors that their investment is safer than investing in a specific identified issuer, because the investment fund's managers will:

·         Diversify risk across a number of unknown businesses in the portfolio.

·         Be able to capitalize on good investment opportunities by being able to invest quickly instead of trying to sell investors on each portfolio company.

·         Add value to portfolio companies through advice and management.

·         Retain money for follow on rounds in portfolio companies.

This is an efficient system for the managers of blind pools.  The investment fund managers have a lot of investment discretion and the managers spend less time raising money, because in one offering they usually raise all the money they need for five or more years.  But let's compare blind pools and single purpose investment funds from the perspective of investors. 

Remember the investors?  Securities laws are supposed to protect investors while investors try to achieve their investment goals.  So, the important questions are how do special purpose entities compare to blind pool investment funds:

  • In promoting investor ROI goals?
  • Increasing or decreasing investor risk?
  • Increasing or decreasing investor management and transaction costs? 
The primary difference between doing specific project financing and raising a pool of money in advance to invest in a dozen portfolio companies over time is that investors lose the diversification of an investment pool like a traditional venture, hedge or private equity fund.  But single purpose investment transactions offer investors other advantages in exchange for not providing diversification:

·         Investors can invest in a "pure play."

·         Investors know what they are investing in.

·         Investors are not required to commit large amounts of capital over long periods of time without knowing when the capital will be invested.

·         Investors receive more detailed disclosures when they are not investing in a blind pool, because a single purpose fund knows more about what it is investing in or purchasing.

Given these advantages to investors, the SEC should have no legitimate interest in squelching the growth of this type of special purpose entity investment vehicle by placing unnecessary road blocks in the way of special purpose entities competing with blind pools for investors.