Category: Financial Services Law

My Mother Wants to Invest in My Startup: Raising Funds With Non-Accredited Investors

Emerging companies are filled with potential, and the entrepreneurs running them have countless great ideas that may one day change the world. These owners typically fund their startup companies with money from their own pockets at first. But eventually, as the company grows, the company needs more capital to fuel that growth. This is when entrepreneurs often turn to outside sources for funds. It may seem innocuous to ask family and friends to contribute to your growing, high-potential business. Of course, they want to support you and the work you are doing.

But don’t be too quick to accept money from your biggest fans. The securities laws in the United States regulate capital raising, and entrepreneurs need to know how to raise funds within the boundaries of the securities laws before taking money from anyone, including family and friends, so as to avoid potential issues after taking that much-needed capital.

Under United States securities laws, and the securities laws of each individual state (or “blue sky” laws), offers and sales of securities have to be either registered or exempt from registration. Generally, registered offerings are too cost prohibitive for startup companies. This means a startup needs to issue securities pursuant to an exemption from registration. The most widely available and used exemptions depend entirely or mostly on limiting the offering to only “accredited” investors, but not every entrepreneur has a rich aunt or uncle in the family who qualifies as an accredited investor. Some exemptions permit offering to non-accredited investors, but depend on those investors still being  “sophisticated.” An investor can qualify as a non-accredited but “sophisticated” investor if the investor, either alone or with a “purchaser representative,” (as defined by the SEC) has sufficient knowledge and experience in financial and business matters to be capable of evaluating the merits and risks of the prospective investment. While your mother and best friend and second cousin may be very smart and may even run their own businesses, they may lack the sophistication the SEC requires to satisfy exemption requirements. Determining whether to include non-accredited investors, whether sophisticated or not, in the offering at the outset is important because it will affect which exemptions from registration are available for the offering and on what basis.

A brief description of some of the more typical exemptions that contemplate inclusion of non-accredited investors in the offering is below. Depending on which exemption is used, the cost and time it takes to get to the offering may vary dramatically.

Regulation Crowdfunding

Regulation Crowdfunding came about via the Jumpstart Our Business Startups Act of 2012, more commonly referred to as the “JOBS Act.” Regulation Crowdfunding is similar to the popular platform Kickstarter except, instead of giving out a t-shirt to investors, the entity raising capital can give out equity. A capital raise through Regulation Crowdfunding must meet the following requirements, among others:

  1. all transactions must take place through a registered broker-dealer or an online, SEC-registered funding platform;
  2. the company can raise a maximum aggregate amount of $5 million in a 12-month period;
  3. non-accredited investors may invest in the offering, but the amounts in which they can invest are limited; and
  4. the company must disclose certain information by filing a Form C with the SEC.

Generally, securities issued through Regulation Crowdfunding may not be resold for at least one year. An offering under Regulation Crowdfunding is not subject to state securities regulations.

Although non-accredited investors can invest in a Regulation Crowdfunding offering, the amount of securities that can be sold to a non-accredited investor is limited:

  • If the investor’s annual income or net worth is less than $107,000, the investor can invest the greater of $2,200 or 5 percent of the greater of the investor’s annual income or net worth.
  • If the investor’s annual income or net worth is equal to or greater than $107,000, the investor can invest 10 percent of the greater of the investor’s annual income or net worth, not to exceed an amount invested of $107,000.

Accredited investors may invest an unlimited amount in an offering under Regulation Crowdfunding (subject to the maximum amount a company can raise each year).

While the ability to raise a respectable amount of capital from any investor may seem appealing, there are some negatives to consider when thinking of conducting an offering pursuant to Regulation Crowdfunding. First, the Form C that is required to be filed at the outset of the offering requires the company to disclose a significant amount of information. A higher information requirement almost always leads to higher legal and other advisor costs. Second, the company must make annual filings, which include either audited financial statements or financial statements certified by the company’s principal executive officer. Finally, the company has no control over who actually invests. When it comes time to sell the company, the lack of relationship with a potentially large portion of investors may lead to challenges. And if the company is not as successful as planned, these investors could be prime plaintiffs in a securities action.

Regulation D

Regulation D of the Securities Act of 1933, as amended (the “Securities Act”) sets forth safe harbors providing for exemption from registration under Section 4(a)(2) of the Securities Act. Some of these safe harbors are available even if offering to non-accredited investors, including Rule 504 and Rule 506(b) of Regulation D.

Rule 504

Under Rule 504, a company can offer to sell up to $10,000,000 of securities in a 12-month period. A company utilizing this exemption may not be a reporting company, an investment company, or a blank check company. The company may use general solicitation so long as certain state securities disclosure conditions are met, and securities generally may be sold to non-accredited investors, depending on state law. Because Rule 504 does not pre-empt state law, a company issuing securities pursuant to Rule 504 must comply with state securities laws, in addition to the federal securities laws, which requires the issuer to qualify or register the offering in every state in which the company plans to offer the securities, or requires the issuance to be subject to an exemption. Compliance with state securities laws is time-consuming and costly, especially if the company is issuing securities in multiple states.

Rule 506(b)

Under Rule 506(b), a company can raise an unlimited amount of capital and can sell securities to an unlimited number of accredited investors. A company also can sell securities to up to 35 non-accredited but sophisticated investors. However, selling to non-accredited investors, no matter how sophisticated they are, requires the company to provide substantially more disclosure, including financial statements, to such non-accredited investors. A higher information requirement almost always leads to higher legal and other advisor costs. The company also must make itself available to answer questions from non-accredited investors. Rule 506(b) also prohibits the use of general solicitation in an offering.

Regulation A

Another product of the JOBS Act, the amended version of Regulation A (referred to herein as simply “Regulation A”) is sometimes referred to as a “mini public offering.” Companies may sell securities to investors under two tiers, each of which has different requirements. Under either tier, the company must file with the SEC an offering statement on Form 1-A, which must be qualified by the SEC before the company may take any funds from investors. Before the SEC qualifies the offering, the SEC will review and provide comments to the company’s Form 1-A, and the company will have to amend the Form 1-A based on the SEC’s comments to the SEC’s satisfaction.

Tier 1

  • A company can raise up to $20 million in a 12-month period.
  • The company must include in its disclosure documents financial statements that have been reviewed by an independent accounting firm.
  • There is no individual investment limit.
  • The company must file a Form 1-Z exit report.

Tier 2

  • A company can raise up to $75 million in a 12-month period.
  • The company must include in its disclosure documents financial statements that have been audited by an independent accounting firm.
  • Investors in a Tier 2 Regulation A offering that are not accredited investors are subject to an investment limit equal to 10 percent of the greater of the investor’s annual income or net worth if the investor is a natural person or 10 percent of the greater of the investor’s annual revenue or net assets if the investor is not a natural person.
  • The company is required to file with the SEC annual reports on Form 1-K, with audited financial statements, semiannual reports on Form 1-SA, current reports on Form 1-U, and an exit report on Form 1-Z.

A company selling securities under Regulation A may use general solicitation, though any general solicitation before the Form 1-A has been filed must comply with the requirements for “test the waters” communications. An offering conducted under Tier 1 is subject to state blue sky laws, but an offering under Tier 2 is not. Securities sold in reliance on Regulation A are not restricted securities, meaning they generally can be freely resold, subject to applicable state blue sky laws. As mentioned above, complying with state blue sky laws is time-consuming and costly.

Other registration exemptions may be available in specific situations that allow offering to non-accredited investors, but the above are the most readily available. As the process and requirements for qualifying for any of these exemptions makes clear, raising money from your mother is not as simple as accepting a check. Always have a plan on how and to whom you are offering securities before you start taking money. Meeting the requirements of an exemption that allows offering securities to a non-accredited investor is typically time-consuming, complicated, and costly because of the disclosure requirements.

© 2021 Varnum LLP
For more articles on startups, visit the NLRSecurities & SEC section.

Lawsuit Loans: Are the Pros Worth the Cons?

The lawsuit loan industry is loaning plaintiffs more than $100 million in the United States each year, but at what price to the injured and their loved ones?

This type of funding is also known as a lawsuit cash advance, lawsuit funding, settlement funding, and pre-settlement funding. No matter what you call it, having the ability to take out a cash advance against a pending settlement has helped thousands of people to cover their costs during the litigation process. That doesn’t mean it’s without its risks.

Lawsuit loans are typically funded by hedge funds, private investors, or banks that are willing to loan money to plaintiffs with the promise of a hefty return on their investment. Critics of lawsuit loans have pointed out that the legal standards other types of lenders are bound to do not apply to this type of lending, since it is largely unregulated in most states.

The business of lending to plaintiffs arose over the last decade, part of a trend in which banks, hedge funds, and private investors are putting money into other people’s lawsuits. But the industry, which now lends plaintiffs more than $100 million a year, remains unregulated in most states, free to ignore laws that protect people who borrow from most other kinds of lenders.

Why People Take Out Lawsuit Loans

According to a 2019 survey by Charles Schwab, 59% of Americans are one paycheck away from homelessness. This situation certainly hasn’t improved now that the country has been in the grip of a pandemic for the past year. Many people are already struggling to make ends meet, and an accident could quickly put the average person in dire financial straits.

When someone is injured in an accident that was caused by another party’s negligence, they may lose their ability to work, either temporarily or permanently. This can quickly push a family that was barely making it over the financial brink and into a never-ending cycle of late notices, collection calls, and eviction notices.

Before there is any discussion about whether or not the pros of a lawsuit are worth the cons, we must consider the fact that this is not solely a theoretical discussion about whether or not certain types of lending are predatory in nature or whether or not there is enough regulation. The pros and cons of lawsuit loans must be considered against the real-life financial consequences a particular plaintiff may be facing during their lawsuit before a judgment can be made.

The Benefits of Lawsuit Loans

There are plenty of benefits to taking advantage of pre-settlement funding, especially if you’re a plaintiff who is in a financial bind. The biggest of these benefits, of course, is being able to have food in your refrigerator, functioning utilities, and a roof over your head while you’re out of work and struggling to recover from an accident. But the benefits go beyond basic survival needs.

Insurance companies often pressure the victims of injury accidents to settle for an unfair amount because they know they are in a bad situation and looking for an immediate solution. They may drag the settlement process out hoping the plaintiff will cave in out of financial necessity. In addition to this, personal injury attorneys may also feel pressured into covering their clients’ expenses during the claims process. This can be a tremendous expense.

One of the benefits of lawsuit loans that plaintiffs appreciate most is in some types of funding, such as pre-settlement funding, you will not be required to repay the loans if your case fails to settle or get a court award. This, of course, is only a benefit if you are certain the type of funding you are signing up for does not require repayment. It is critical that any plaintiff clearly understands the terms of the financing before they sign any agreements.

The Drawbacks of Lawsuit Loans

The main disadvantage of lawsuit loans is the cost. While it is true that an attorney may be able to get a much larger settlement if the plaintiff can afford to hang in there throughout negotiations, many accident victims and their families are still shocked when the final bill comes in.

This is only a drawback if you aren’t well-informed about what the interest rate will be and what that figure may look like in relation to your estimated settlement. It can also become a drawback if you take a larger lawsuit loan than you need. However, if you only take what is needed and you are realistic about what your settlement will look like after you’ve paid the interest, settlement funding can keep you afloat during this difficult time.

Another disadvantage of lawsuit loans is the fact that you may not qualify, especially if the lender does not require you to pay the loan back if your case isn’t successful. These lenders are taking a huge risk, so in order to qualify for settlement funding your case must be likely to reach a favorable conclusion for the injured party.

What Borrowers and Their Attorneys Need to Know

Lawsuit loans can mean the difference between seeing that justice is done and being further victimized by insurance corporations that put profits before human lives. They can also send a plaintiff into sticker shock and leave them feeling angry if they don’t do their homework and understand what they’re getting into before they sign on the dotted line.

When you’re looking for a lender, whether for yourself or for a client, be sure to choose a lawsuit loan provider who believes in complete transparency throughout the process. If a lender won’t work with you on a personal level to make sure you clearly understand the terms of the loan, it’s better to take your business elsewhere.

So, are the pros of lawsuit loans worth the cons? The answer is…it depends on the plaintiff’s situation. If you or your client can make it through the lawsuit without accepting funding, it’s probably your best option to do so. However, if you’re struggling and there’s no end in sight, you may find that the drawbacks of settlement funding are well worth the advantages.

© 2021 High Rise Financial LLC

ARTICLE BY Melissa J. Fleming of High Rise Financial LLC
For more articles on lawsuit loans, visit the NLR Financial Institutions & Banking section.

CFPB Suit Against Student Loan Trusts Dismissed

On March 26, 2021, Judge Maryellen Noreika of the U.S. District Court for the District of Delaware dismissed a lawsuit brought by the Consumer Financial Protection Bureau (“CFPB”) in Consumer Financial Protection Bureau v. The National Collegiate Master Student Loan Trusts,1 finding, inter alia, that the CFPB’s suit was constitutionally defective due to the CFPB’s untimely attempt to ratify the prosecution of the litigation in the wake of the Supreme Court’s decision in Seila Law LLC v. Consumer Financial Protection Bureau.  This case has been closely watched by many participants in the structured finance industry, because the litigants had disputed over the question of whether the trusts at issue in the litigation are “covered persons” liable under the Consumer Financial Protection Act despite their status as passive securitization trust entities—a question that has important and wide-reaching implications for the structured finance markets.

Background

The National Collegiate Student Loan Trusts (the “Trusts”) hold more than 800,000 private student loans through 15 different Delaware statutory trusts created between 2001 and 2007, totaling approximately $12 billion.  The loans originally were made to students by private banks.  The Trusts provided financing for the student loans by selling notes to investors in securitization transactions.  The Trusts also provided for the servicing of and collection on those student loans by engaging third-party servicers.  However, the Trusts themselves are passive special purpose entities lacking employees or internal management; instead, to operate, the Trusts relied on various interlocking trust-related agreements with multiple third-party service providers to—among other things—administer each of the Trusts, determine the relative priority of economic interests in the Trusts, and service the Trusts’ loans.

On September 4, 2014, the CPFB issued a civil investigative demand (“CID”) to each of the Trusts for information concerning thousands of allegedly illegal student loan debt collection lawsuits used to collect on defaulted loans held by the Trusts.  On May 9, 2016, the CFPB alerted the Trusts to the fact that the CFPB was considering initiating enforcement proceedings against the Trusts based on the collection lawsuits through a Notice and Opportunity to Respond and Advice (“NORA”).  A few weeks later, the law firm McCarter & English, LLP (“McCarter”), purporting to represent the Trusts, submitted a NORA response to the CFPB.  McCarter and the CFPB then proceeded to negotiate a Proposed Consent Judgment to resolve the CFPB’s investigation of the Trusts.

The Litigation

On September 18, 2017, the CFPB filed suit against the Trusts in Delaware federal court (the “Court”), alleging that the Trusts had violated the Consumer Financial Protection Act of 2010 (the “CFPA”) by engaging in unfair and deceptive practices in connection with their servicing and collection of student loans.  Although the CFPB acknowledged that the Trusts had no employees and that the alleged misconduct resulted from actions taken by the Trusts’ servicers and sub-servicers in the course of their debt collection activities—rather than any actions taken by the Trusts themselves—the CFPB nonetheless named only  the Trusts as defendants.  On the same day, the CFPB also filed a motion to approve the Proposed Consent Judgment negotiated with McCarter.

However, within days of the CFPB’s initiation of the lawsuit, multiple parties associated with the Trusts intervened in the litigation to argue against the entry of the Proposed Consent Judgment.  The intervenors expressed concern that the entry of the Proposed Consent Judgment would impermissibly impair or rewrite their respective contractual obligations as set forth in the agreements underlying the Trusts.  After discovery, on May 31, 2020, the Court denied the CFPB’s motion to approve the Proposed Consent Judgement, holding that McCarter lacked authority to execute the Proposed Consent Judgment pursuant to terms of the agreements governing the Trusts and Delaware law.

On June 29, 2020, in another lawsuit involving the CFPB, the United States Supreme Court held in Seila Law LLC v. Consumer Financial Protection Bureau that the CFPB’s structure violated the Constitution’s separation of powers.2  Specifically, the Supreme Court held that “an independent agency led by a single Director and vested with significant executive power” has “no basis in history and no place in our constitutional structure,”3 and that the statutory restriction on the President’s authority to remove the CFPB’s Director only for “inefficiency, neglect, or malfeasance” violated the separation of powers.4  The Supreme Court then concluded that the proper remedy was to sever the removal restriction, and ultimately allowed the CFPB to stand.  The Supreme Court also noted that an enforcement action that the CFPB had filed to enforce a CID while its structure was unconstitutional may nonetheless be enforceable if it was later successfully ratified by an acting director of the CFPB who was removable at will by the President.  If not so ratified, however, the enforcement action must be dismissed.

Around the time the Supreme Court issued its decision in Seila Law, various intervenors were briefing multiple motions to dismiss the CFPB’s complaint against the Trusts.  One subset of intervenors—Ambac Assurance Corporation, the Pennsylvania Higher Education Assistance Agency, and the Wilmington Trust Company5 (collectively, “Ambac”)—argued, inter alia, that: (i) the Supreme Court’s decision in Seila Law required dismissal of the CFPB’s complaint because the CFPB’s ratification of the litigation against the Trusts was untimely, and (ii) the Court lacked subject matter jurisdiction over its asserted claims because the Trusts are not “covered persons” as required under the CFPA.  Another intervenor, Transworld Systems, Inc.6 (“TSI”) also argued that the CFPB’s complaint merited dismissal for lack of subject matter jurisdiction as well.

The Court’s Holding

Subject Matter Jurisdiction

The Court held that it possessed the requisite subject matter jurisdiction to decide the CFPB’s claims, and rejected the contention that a showing of whether the Trusts are “covered persons” is a jurisdictional requirement under the CFPA.  To determine whether a restriction—such as the term “covered persons”—is jurisdictional, the Court looked to “whether Congress has clearly stated that the rule is jurisdictional.”7  “[A]bsent such a clear statement,” courts “should treat the restriction as nonjurisdictional.”8

The Court then examined the CFPA, observing that there is no clear statement in the CFPA’s jurisdictional grant that “covered persons” is required.  The Court noted that only one section of the CFPA addresses the issue of subject matter jurisdiction, and that section granted jurisdiction over “an action or adjudication proceeding brought under Federal consumer law” with no mention of “covered persons” whatsoever.9

While the Court agreed that the term “covered persons” appeared multiple times throughout the CFPA, it pointed out that none of the sections where “covered persons” appeared mentioned jurisdiction.

Enforcement Authority

In light of the Supreme Court’s holding in Seila Law, the Court granted Ambac’s motion to dismiss the CFPB’s complaint due to the CFPB’s lack of enforcement authority as a result of its untimely ratification of the litigation.

As an initial matter, the Court observed that there was no question that the CFPB initiated the enforcement action against the Trusts at a time when its structure violated the constitutional separation of powers.  The task facing the Court, then, would be to determine (i) whether that constitutional defect has been cured by ratification, or (ii) whether dismissal of the suit is required.  Under the applicable Third Circuit precedent, there are three general requirements for ratification of previously-unauthorized action by an agency: (1) “the ratifier must, at the time of ratification, still have the authority to take the action to be ratified”; (2) “the ratifier must have full knowledge of the decision to be ratified”; and (3) “the ratifier must make a detached and considered affirmation of the earlier decision.”10  Here, the parties’ dispute centered around the first requirement.

Under the first requirement, the Court noted that “it is essential that the party ratifying should be able not merely to do the act ratified at the time the act was done, but also at the time the ratification was made.”11  On July 9, 2020, the CFPB’s then-Director, Kathy Kraninger, had ratified the decision to initiate the CFPB’s litigation against the Trusts a few weeks after the Supreme Court’s decision in Seila Law.  The Court held that Director Kraninger’s ratification was ineffective, because (i) an enforcement action arising from alleged CFPA violations must be brought no later than three years after the date of discovery of the violation to which the action relates,12 (ii) ratification is ineffective when it takes place after the relevant statute of limitations has expired, and (iii) the CFPB clearly had discovery of the Trusts’ alleged CFPA violations more than three years before the ratification date, i.e., before July 9, 2017.  Thus, Director Kraninger’s ratification of the CFPB’s decision to file suit against the Trusts failed to cure the constitutional defects raised by Seila Law, and the CFPB’s complaint—initially filed by a CFPB director unconstitutionally insulated from removal—could not be enforced.

In so holding, the Court rejected the CFPB’s argument that the timeliness requirements for ratification were satisfied because the CFPB had brought the original suit within the applicable limitations period.  The Court likewise rejected the CFPB’s request to equitably toll the statute of limitations for ratification, because the CFPB “could not identify a single act that it took to preserve its rights in this case in anticipation of the constitutional challenges that could have reasonably ended with an unfavorable ruling from the Supreme Court.”13

Key Takeaways

The securitization industry has operated for decades on the premise that agreements governing securitization transactions provide that transaction parties are responsible for their own malfeasance and, barring special circumstances, will not be held accountable for the misconduct of other parties to the transaction.  A decision holding that passive securitization entities like the Trusts are “covered persons” under the CFPA—and thus potentially responsible for the actions of their third-party service providers—would undermine the certainty of contract terms that undergirds the success of the structured finance industry, with grave implications for the heathy functioning of the industry.  While the substantive question of whether passive securitization entities like the Trusts could indeed be “covered persons” and held accountable for the actions of their third-party service providers remains to be answered for another day, the Court did observe that it “harbor[ed] some doubt” that the plain language of the CFPA extended to passive statutory trusts,14 and expressed skepticism as to whether the CFPB could successfully replead in a manner that would successfully cure the deficiencies in its original complaint.

1   2021 WL 1169029, at *3 (D. Del. Mar. 26, 2021).

2   140 S.Ct. 2183, 2197 (June 29, 2020).  For a detailed discussion on Seila Law, please see our July 2, 2020 Clients & Friends Memo, “Seila Law LLC v. Consumer Financial Protection Bureau: Has the Supreme Court Tamed or Empowered the CFPB?”, available at https://www.cadwalader.com/resources/clients-friends-memos/seila-law-llc-v-consumer-financial-protection-bureau-has-the-supreme-court-tamed-or-empowered-the-cfpb.

3   Id. at 2201.

4   Id. at 2197.

5   Ambac Assurance Corporation provided financial guarantee insurance with respect to securities in over half of the Trusts.  The Pennsylvania Higher Education Assistance Agency is the Primary Servicer for the Trusts, while the Wilmington Trust Company is the Trusts’ Owner Trustee.

6   TSI is a sub-servicer responsible for the collection of the Trusts’ delinquent loans.

7   Nat’l Collegiate Master Student Loan Tr. at *3 (citing Sebelius v. Auburn Reg’l Med. Ctr., 568 U.S. 145, 153 (2013)).

8   Id.

9   See 12 U.S.C. § 5565(a)(1).

10  Nat’l Collegiate Master Student Loan Tr. at *4 (quoting Advanced Disposal Serv. E., Inc. v. Nat’l Labor Relations Bd., 820 F.3d 592, 602 (3d Cir. 2016)).

11  Id. (quoting Advanced Disposal, 820 F.3d at 603) (emphasis in original).

12  12 U.S.C. § 5564(g)(1).

13  Nat’l Collegiate Master Student Loan Tr. at 7.

14  Id. at 3.

© Copyright 2020 Cadwalader, Wickersham & Taft LLP

ARTICLE BY Ellen Holloman,  Neil J. Weidner,  Cheryl D. Barnes
Rachel Rodman, Scott A. Cammarn and Ailsa Chau of
Cadwalader, Wickersham & Taft LLP

For more articles on the CFPB, visit the NLR Financial Institutions & Banking section.

Fraud in Subscription Credit Facilities

Recent press coverage has brought to light allegations of fraud in relation to a subscription credit facility made available to a fund managed by a Florida-based private equity fund manager, JES Global Capital. The allegations claim that one of the managers of JES forged subscription agreements totaling $85 million from two institutions, as well as bank records showing wire transfers from those institutions. An audit letter attesting to the financial health of the fund was also said to be falsified by the manager. The investigation remains ongoing, with the accused manager having been arrested and facing up to 30 years in prison for wire fraud and aggravated identity theft.

How are subscription credit facilities susceptible to fraud?

The case has led to questions about the due diligence processes in the subscription credit facility market. Subscription credit facilities are secured by the unfunded capital commitments of the investors in the fund, the right of the fund to receive capital contributions from such investors and the right of the fund to call capital. In addition, a pledge of the bank account into which the capital is deposited is also typically required. Subscription credit facility lenders conduct due diligence on the fund (as well as its manager) and the investors in the fund, but the key link between the two is the documentation which evidences the investors’ commitments to contribute capital to the fund following the issuance of drawdown notices. Such commitments are documented by subscription agreements or deeds of adherence, whereby each investor agrees to be bound by the fund’s limited partnership agreement and commits to contribute capital up to the amount set out in such documentation. Due diligence reviews are focused on the contents of the contractual framework (i.e. who are the investors, what are their commitments and are there circumstances in which they are not required to honor capital calls) and whether they appear on their face to be enforceable. However, there are limitations around the extent to which a lender can be confident that an investor is committed to a fund through document review alone.

What are the implications when an investor’s commitment to the fund has been forged?

The amount of credit that a lender is willing to extend to a fund is dependent on the amount of the fund’s unfunded capital commitments. It is not clear from the JES case whether the forged commitments were the only commitments to the fund or, alternatively, whether the fund has genuine investors with an actual pool of unfunded capital commitments. Assuming the fund does include genuine investors, by forging investor commitments totaling $85 million, the apparent pool of unfunded capital commitments would be inflated and the amount the lender was willing to advance would be artificially increased.

In the JES case, the key question is who ultimately bears responsibility for repayment of the fund’s debt. If there are genuine investors in the fund, then under typical documentation such investors will be obligated for the debt of the fund on a pro rata basis up to the amount of their unfunded capital commitments. This would depend on the exact wording of the fund’s limited partnership agreement, but it is not unusual for investors to be required to fund drawdown notices without set-off, counterclaim or defense. We expect the lender would have the ability to enforce its pledge and take its own steps to issue drawdown notices to investors to recover the outstanding debt.

On the other hand, if there are no genuine investors (and no amounts available in the pledged bank accounts), the lender is likely to be in an unsecured position vis-à-vis the fund, but may be able to take steps as an unsecured creditor to seek recovery of the debt. This would depend on the extent to which the fund had assets available to meet such debts and/or whether a trustee in bankruptcy could seek to clawback any payments as preferential or fraudulent transfers in an insolvency process. Further, as the general partner of a fund is liable for the fund’s debts, a lender could also attempt to recover from the general partner (although we would typically not expect the general partner to have substantial assets).

How can subscription credit facility lenders mitigate the risk of fraud?

Following the JES case, we expect that lenders will place greater importance on investor due diligence. Given the potential shortcomings in contractual due diligence, this may lead to the adoption of additional due diligence practices. As a practical matter, fund managers may start to see lenders take some of the following additional steps (some of which we already see on some deals but which are not universal and often resisted by fund managers):

  • Requiring letters or acknowledgements to be provided by investors to the lender. Such letters are not generally required by a number of key lenders in the subscription credit facility market, except where lending to funds with concentrated investor bases. Requiring such letters does not eliminate the chance of fraud entirely given that typically the fund manager would be the one liaising with investors to obtain letters or acknowledgements.
  • Requiring notices to be sent to investors informing them of the grant of security. This is standard in European deals given the requirement to give notice to perfect security, but there are differences in approach as to timing and methodology. In US deals, notices are not usually required except for investors in certain jurisdictions, in particular Cayman feeder funds.
  • Requiring evidence that investors have already funded at least one capital call or a specified percentage of their aggregate commitment to the fund before the fund is able to draw under the credit facility. This not only ensures that investors have “skin in the game” before the lender advances funds, but also gives the lender the opportunity to verify bank records. Where the fund’s bank accounts are held with the lender, the verification process is straightforward. However, as demonstrated by the JES case, where this is not the case and the lender relies on the fund to merely provide copies of bank statements of third-party bank accounts, there is still potential for forgery.
  • Spot checks by lenders making direct contact with investors. We aren’t aware of the extent to which spot checks currently take place, but the JES case may lead to lenders considering such checks as part of their due diligence.

Despite the above options open to subscription credit facility lenders, the closest a lender could come to eliminating the risk of fraud would be to make contact with each investor directly to confirm its commitment to the fund as part of the initial due diligence process. Even then, it is possible to envision extreme scenarios where a fraudulent fund manager supplies false contact details and impersonates the investor during the verification process. However, the more additional checks that are built into the due diligence process, the greater the likelihood of detecting fraud before loans are advanced, and the greater the deterrent effect on potential fraudsters. Fund managers may therefore see an increase in lenders employing more rigorous steps in their due diligence processes, with an increased focus on direct contact with investors. On its face, this direct contact is likely to be unappealing to fund managers from an investor relations perspective.

What is the likely fallout from the JES case?

No financial product is completely immune to fraud, and the fact that this is only the second major reported case in the subscription credit facility market suggests that this should not be a cause for panic. Understandably, lenders will be reviewing their due diligence processes and, we expect, requiring additional due diligence, particularly when looking to underwrite new business with a fund or its manager where the lender has no prior existing relationship. It would not be surprising if lenders applied greater pressure on fund managers to maintain the pledged bank account with the lender to assist in the verification steps outlined above (we already see some banks incorporate a soft obligation to do so, but it is not a widespread requirement). The ability of funds with very concentrated investor bases to obtain a subscription credit facility (which is already rare) may become more difficult. Further, investors may begin to take a closer look at the borrowing powers in fund documentation and the circumstances in which they are obligated to fund capital calls to repay fund indebtedness. The fallout from the JES case remains to be seen, but suggestions of increased pricing or requirements to completely overhaul processes on subscription credit facilities appear premature. We will provide further updates as the case develops and the market responds.

© 2020 Proskauer Rose LLP.
ARTICLE BY Ron D. Franklin, Jinyoung Joo and Cameron A. Roper of  Proskauer Rose LLP

Three Critical Questions That Will (Hopefully) be Answered by the SEC’s Lawsuit against Ripple

Late last year, the SEC filed a litigated action in the U.S. District Court for the Southern District of New York against Ripple Labs Inc. and two of its executive officers (collectively, “Ripple”), alleging that Ripple raised over $1.3 billion in unregistered offerings of the digital asset known as XRP. Ripple opted not to file a motion to dismiss the complaint, and based on recent filings it appears that the parties do not believe a pre-trial settlement is likely. The SEC’s complaint alleges that, beginning in 2013, Ripple raised funds through the sales of XRP in unregistered securities offerings to investors in the U.S. and abroad. Ripple also allegedly exchanged billions of XRP units for non-cash consideration, including labor and market-making services. The SEC’s complaint also named as defendants two executives of Ripple who allegedly effected personal, unregistered sales of XRP totaling approximately $600 million. According to the SEC, during all of this, Ripple failed to register its offers and sales of XRP, or satisfy any exemption from registration, in violation of Section 5 of the Securities Act of 1933.

The SEC’s case rests on the proposition that XRP is a security – if it is not, the SEC lacks jurisdiction. In SEC v. Howey, the Supreme Court provided a framework for determining whether certain assets are “investment contracts,” and therefore, are securities (Section 3(a)(10) of the Securities Act defines the term “security” to include an “investment contract”). In what is now known as the “Howey Test,” the Court explained that an asset is a security if it represents an investment in a common enterprise with the expectation of profits derived solely from the efforts of others. In its complaint, the SEC argues that XRP is a security because investors who purchased XRP anticipated that profits would be dependent upon Ripple’s efforts to manage and develop the market for XRP. Ripple has disputed the SEC’s allegations, arguing that XRP is a “fully functioning currency that offers a better alternative to Bitcoin.”

The Ripple case raises three very important questions regarding digital assets, and may provide a vehicle for the SEC or the court to offer answers to those questions:

  1. When does a digital asset transition from a security to a currency (or something else)? At one end of the spectrum, the SEC has made it clear that it views almost any initial coin offering (ICO) to involve the offer of securities. At the other end, there is Ether, which today relies on a distributed ledger without a centralized administrator. In 2018, then Director of the SEC’s Division of Corporation Finance, William Hinman, stated publicly that “putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions.” XRP probably falls somewhere in between those two extremes. Because of that, this case may present a unique opportunity for the SEC or the court to shed further light on how and where to draw the line between a security and a currency.
  2. How will President Biden’s administration approach digital assets? Under Chairman Clayton’s leadership, the SEC took a deliberate approach towards digital assets and, as reflected by the Ripple case, was not hesitant to bring enforcement actions in this space. President Biden has nominated Gary Gensler to the be the next SEC Chair. For the past few years, Mr. Gensler has been a Professor at MIT, teaching courses on blockchain and crypto assets. He will almost certainly have strong views on how the SEC should approach digital assets. As this litigation progresses, we may gain some insight into those views.
  3. How should disgorgement be calculated for a violation of Section 5 (and only Section 5) after the Supreme Court’s decision last year in Liu? In the Ripple case, the SEC has alleged that the company raised over $1.3 billion from sales of XRP, and the two individual defendants sold approximately $600 million of XRP. In the past, the SEC has often argued that all proceeds of an offering made in violation of Section 5 were subject to disgorgement as ill-gotten gains. In Liu, however, the Supreme Court explained that courts should deduct “legitimate expenses” when calculating disgorgement. The Ripple case could provide the SEC or the court the opportunity to explain how to calculate legitimate expenses, particularly in this case, where there are no allegations that the company or executives engaged in fraud, and it looks like the company will be able show substantial expenses from operating its business and the executives will be able to show that they provided legitimate employment services to Ripple.

Hopefully, the Ripple case will provide answers to one or more of these questions. Stay tuned.

© 2020 Proskauer Rose LLP.
For more, visit the NLR Securities & SEC section.

Second Draw Paycheck Protection Program Loans: Answers to Employers’ Frequently Asked Questions

The Consolidated Appropriations Act (CAA), 2021 includes a provision that modified and extended the Small Business Administration’s (SBA) Paycheck Protection Program (PPP). Specifically, Section 311 of the Additional Coronavirus Response and Relief provisions of the CAA provides for PPP second draw loans for eligible businesses. Employers seeking a PPP loan may apply through March 31, 2021. Below are answers to some key questions regarding second draw PPP loans.

Question 1. What are some key distinctions between first and second draw PPP loans?

Answer 1. Second draw PPP loans are intentionally narrower and smaller in terms of eligibility and amount. In order to be eligible, businesses must be able to demonstrate that they experienced a 25 percent reduction in gross receipts in a 2020 calendar quarter compared to the same quarter in 2019. While first draw PPP loans were capped at $10 million per borrower based on payroll costs in 2019, second draw PPP loans have a maximum of $2 million per borrower based on payroll costs in either 2019 or 2020. Additionally, first draw PPP loans were subject to a $20 million maximum for businesses that were part of a single corporate group, but second draw loans are subject to a $4 million maximum.

Q2. What employer missteps may impact forgiveness for PPP loans?

A2. A common mistake is not looking at the loan forgiveness application or their own data until after the conclusion of the “covered period.” This may limit a borrower’s ability to implement strategies that take advantage of the various safe harbors or exceptions to rules that reduce the amount of the loan that may be forgiven.

Another common mistake occurs when borrowers do not maintain PPP loan records in a centralized location, which may cause them to scramble to collect the information needed when they are completing the loan forgiveness application. In some instances, employers may not be able to find documents to substantiate unique situations, such as bona fide offers to rehire terminated employees that were refused or employee requests for reduced hours.

Q3. What steps might employers take to aid in managing the requirements for loan forgiveness?

A3. Borrowers may want to start contemplating loan forgiveness before they receive their loan disbursements. For example, in order to properly account for these funds, consider setting up a separate bank account to receive the PPP loan distribution. This step will streamline a borrower’s ability to track how each dollar of the loan is spent.

Borrowers may also want to contact their vendors shortly after receiving their loans to determine what type of reporting features may be available to help them document the permitted payroll and non-payroll costs during the covered period. Many vendors are producing standardized PPP loan reports that facilitate a borrower’s ability to complete the loan forgiveness application.

Q4. Are there any special considerations in the PPP loan process?

A4. In an effort to provide targeted relief to businesses that have been hardest hit by the pandemic, there are special rules in place for determining eligibility and the maximum amount of the PPP loans for borrowers that are in the hotel or restaurant industries (those with an NAICS code beginning with 72).

Borrowers that receive a loan in excess of $2 million are subject to a higher level of scrutiny and review following submission of their loan forgiveness applications. In addition to a mandatory SBA audit, such borrowers also need to complete an additional loan necessity questionnaire on SBA Form 3508 or 3509 (depending on their for-profit status).

© 2020, Ogletree, Deakins, Nash, Smoak & Stewart, P.C., All Rights Reserved.

ARTICLE BY Michael K. Mahoney of Ogletree, Deakins, Nash, Smoak & Stewart, P.C.
For more, visit the NLR Coronavirus News section.

White House Issues PPP Reforms

Today, the White House announced several reforms to the PPP Program aimed at targeting funds to the smallest businesses and those that have been left behind in previous relief efforts.

The key reforms are as follows:

  • 14-Day Exclusivity Period. From February 24 – March 10 only businesses with fewer than 20 employees can apply for PPP.
  • Revisions of Loan Calculation Formula. The loan calculation formula for sole proprietors, independent contractors, and self-employed individuals will be revised to offer more relief. Additionally, $1 billion will be set aside for businesses in this category without employees located in low- and moderate-income areas.
  • Removal of Restrictions on Eligibility.
    • Businesses with at least 20% owned by individuals who have committed a felony within the last year (except for financial-assistance related fraud) are now eligible for PPP, unless the applicant or owner is incarcerated at the time of the application.
    • Restrictions on eligibility for businesses with at least 20% owned by individuals who are delinquent on federal student loans will be removed.
  • Clarification of Non-Citizen, Lawful U.S Resident Eligibility. The SBA will issue clarifying guidance that holders of Individual Taxpayer Identification Numbers (“ITINs”) may access PPP if otherwise eligible.

The full White House briefing can be found here. SBA guidance on these matters will be forthcoming.

© Polsinelli PC, Polsinelli LLP in California

ARTICLE BY Philip G. Feigen and Sara C. Ainsworth of Polsinelli PC
For more, visit the NLR Coronavirus News section.

Rupture Rapture: Should the GameStop?

GameStop, a company described on January 26, 2021, in the Wall Street Journal as a “moribund mall retailer” that sold electronic games, but not very many with the closing of malls as a result of the growth of e-commerce, and even fewer after the shutdowns of non-essential shopping stores due to COVID, has seen its stock (listed on the New York Stock Exchange) share price rise in the last year from a low of $2.57 to $483.00. Almost all of that gain has occurred since Friday, January 22, 2021. What business development caused this? The simple answer to that question is NONE.

Rupture Rapture

Value and pricing have always been a part of capital markets. According to Aristotle in “The Politics” (Book I, Section 1259a) Thales of Miletus (c. 624 – c.548 BC) the pre-Socratic Greek mathematician, astronomer, and philosopher from Miletus in Ionia (now the Southwestern part of Turkey) had been taunted about the uselessness of philosophy, as he was quite poor. But Thales recognized from his astronomical studies in that 6th century BCE year, that although it was still winter, there would be a “bumper” crop of olives. He raised a small sum of money and made deposits on all the olive presses in Miletus and the surrounding area. When the crop came in he controlled the presses and let them out (in the face of great demand) at prices he set, thereby making a substantial profit. Thales had “cornered” the market for olive presses; he set the pricing and he acted to prove that philosophers could be wealthy. So, his motives were both to accumulate wealth and status.

These two human needs: the desire for wealth and the desire for recognition have been the principal motivations across human history for certain market events. In the Golden Age in the Netherlands in the 17th century, the ownership of beautiful tulips was the indicator of status, as by 1637 the price for some bulbs reached ten times the average annual income. This phenomenon was the basis for the Scottish journalist, Charles MacKay’s famed book (seen as the first socio/psychological study of market behavior) “Extraordinary Popular Delusions and the Madness of Crowds.” In 1711, a joint-stock company was organized in London to deal with British national debt and, after a 1713 grant of monopoly power, to supply slaves to the Caribbean islands where sugar cane was grown. That company (formally known as The Governor and Company of the merchants of Great Britain trading to the South Seas and other parts of America, and for the encouragement of the Fishery; and informally as The South Sea Company) began to deal in government debt arising from the War of Spanish Succession. Almost all the war expense was privately financed and, indeed, even the Bank of England was a private company. Seed capital was raised with a lottery and by 1719, shares were offered to the public. Gripped with speculative frenzy the share price rose from L 128 in January 1720 to a peak of almost L 1000 by summer, as everyone who was anyone fought to buy shares for fear of missing out on the expected great wealth. In the subsequent collapse, millions of pounds were lost, including as much as L 22,000 by Sir Isaac Newton who famously wrote: “I can calculate the movement of the stars, but not the madness of men.” The collapse of the South Sea Bubble led to the passage in 1720 of the Bubble Act which prohibited the formation of a joint-stock company without a royal charter.

In the United States, one of its first financial crises (after the success of Alexander Hamilton in nationalizing the debt after the victory against Great Britain and Washington’s resolution of the 1791-1794 Whiskey Rebellion) was the Panic of 1837, when speculative lending for land purchases in what is now the Midwest coincided with a sharp drop in cotton prices, and the real estate bubble burst. The real estate speculators had been seeking wealth and prestige that were presumed to flow with land ownership. This probably was the cause of Martin Van Buren, being a one-term president, as he was seen as slow to attempt to stabilize the market. After the recovery from 1837 and the chaos and death of the Civil War 1861-1865, America embarked on a Gilded Age in the 1870s and 1880s, the time of great industrial growth, especially in railroads (the Golden Spike was driven in Provo, Utah in 1869 to create transcontinental rail connections), and the rise of the so-called Robber Barons. Then, in 1890, the wheat crop in Argentina (whose international financial agent was the British firm, Baring Brothers) failed along with a political coup in Buenos Aires caused European investors (brought in by Baring Brothers) facing losses to trade in their investments in American stocks and holdings of dollars for physical gold. The resulting Panic of 1893 saw the collapse of over 500 banks and the bankruptcies of the Union Pacific, the Northern Pacific, and the Atchison, Topeka & Santa Fe Railroads. Unemployment reached 25% in Pennsylvania, 35% in New York, and 45% in Michigan. All this followed from what turned out to be a less than wise series of investment decisions by persons seeking wealth and with its position.

Once again in 1906, some very wealthy New Yorkers sought to increase their wealth by cornering the market on the stock of United Copper Company. Their effort was financed by loans from a number of New York City banks, led by borrowings from Knickerbocker Trust Company, New York’s third-largest bank. Also in 1906, Congress passed the Hepburn Act which created the Interstate Commerce Commission (“ICC”) to regulate railroad operations, including pricing. As the ICC assumed its activities, the prices of railroad company stocks fell. When the effort to corner the stock in United Copper failed in October 1907 the prices of shares traded on the NYSE plummeted 50% over three weeks from their 1906 highs. This was the so-called Knickerbocker Crisis (also known as the Panic of 1907), which caused the financial system to freeze until J.P. Morgan single-handedly organized the New York banks to save the American financial system. His success and the concern that there might not always be someone of his stature and wealth to “save the day” led to the passage in 1913 of the Federal Reserve Act and the creation of the Board of Governors of the Federal Reserve System (the “Fed”). Once again speculating investors had been seeking increased wealth and market power, and the prestige that comes with them.

After World War I, the United States breathed a collective sigh of relief as the country enjoyed an explosion of pent-up demand that led to the wealthy excesses of the “Roaring Twenties” so well captured in the works of F. Scott Fitzgerald. The Dow Jones Industrial Average increased six-fold from August 1921 until September 1929, and the Fed’s warning in March 1929 of excessive speculation went largely unheeded. It was said that even shoeshine boys and cab drivers were buying stock expecting (and hoping) to get rich. Some of this was also driven by a fear of losing out on great opportunities. As the famed international economist, Charles Kindleberger, has observed “There is nothing as disturbing to one’s well-being and judgment as to see a friend get rich. Unless it is to see a non-friend get rich.” The excessive speculation ended in the Crash in October 1929 and the onset of the Depression. This, in turn, led to the New Deal and the enactment, among many other pieces of Federal legislation, of the Glass-Steagall Act of 1933 (separating commercial banks from investment banks), the Securities Act of 1933, and the Securities and Exchange Act of 1934 (which created the Securities and Exchange Commission (“SEC”)).

After the United States recovered from the Depression, with the assistance of the economic necessity brought on by World War II, the economy once again began to hum as the Eisenhower administration promised “Peace, Progress, and Prosperity.” Despite the continuing Cold War America was thriving, and with that came waves of technological innovation, so that in the 1960s almost any company which ended in “tronics” as in “electronics” was seen as a winner. Once again investors drove up the prices of the so-called “Nifty Fifty;” companies whose stock would always gain at market price. Frequently, investors were disappointed. Then by 1994, some very bright men, including two Nobel Laureates, started Long-Term Capital Management (“LTCM”), which used computer algorithms to create portfolios using stocks and options. After achieving stunning returns for three years in 1998, LTCM lost $4.6 billion in four months as a result of the Russian financial crisis which had not been factored into their computations. The stock market fell precipitously and the American (and indeed, the world), the financial system almost came “unglued.” The Fed organized a rescue by raising $3.6 billion from 14 of the largest banks in the world. LTCM was liquidated in 2000, just in time to observe the famed “Dot.Com Bubble” burst in March 2000, after stocks traded on NASDAQ rose 400% from 1995 prices. Once again, investors chasing wealth and prestige, fearful of losing out on the “hot new thing” of Internet companies “rushed in where angels feared to tred.”

In a financial collapse, redux brought on by the “irrational exuberance” about homeownership and home speculation the worldwide Great Recession of 2007-2008 so graphically captured in the book and movie “The Big Short” brought bankruptcy and ruin to many who had sought wealth and prestige. People who could not afford the debt payments were allowed to borrow money to buy houses, the lending banks were not terribly concerned because Wall Street investment bankers had invented a way to package and resell mortgage loans in engineered pieces to institutions and to individual investors. Because they were pieces of mortgage loans they were seen as very secure and were in fact rated that way by the major rating agencies, When the bubble burst with the collapse of investment banks Bear, Stearns, and Lehman Brothers, the near bankruptcy of American International Group, the failure of Washington Mutual Saving Bank and Wachovia, the receiverships for Fannie Mae and Freddie Mac, and the regulatory enforced takeover of Merrill Lynch, unemployment soared and the United States Government, including the Fed, had to pump billions into the economy to stabilize it. The Great Recession also resulted in the passage of the Dodd-Frank Act, which added material constraints on many aspects of the financial system. Once again persons striving for the wealth associated with homeownership and the accompanying sense of belonging, along with bankers and service people eager to obtain outsized returns drove behavior, which in hindsight, turned out to be an extraordinary chain of bad decisions.

Even in the well-recognized market frauds using so-called “Pump and Dump” schemes, the motives are to obtain wealth. The fraud promoter selects a stock and issues all kinds of positive (not factually based) news and opinions aimed at getting investors to push up the price of the stock for fear of losing out on a “good thing.” Then, when the price is high enough the promoter “dumps” the shares on the enticed, eager, and unsuspecting, public. This type of fraud typically has involved “boiler rooms” and was graphically captured in the 2000 film of the same name. One of the most “famous” of these “boiler room” firms was Stratton Oakmont, whose co-founder, Jordan Belfort, turned his resulting criminal conviction into the basis for the Academy Award-nominated film, “The Wolf of Wall Street.” Here again, the outsized desire for riches and prestige led to very bad results.

Should the GameStop?

So what did/do the investors in GameStop (and a few other stocks) see that lures them into driving its price and the prices of some other companies unbelievably high? Since the March 2020 onset of the COVID pandemic actions by the Fed and Congressional legislation have pumped extraordinary amounts of money into the economy, much of it into the hands of individuals. As a result of the pandemic, much of the nation’s economy has been in a shut-down mode for ten months. The amount of sporting events has been greatly reduced and only a few fans in a few venues are allowed to attend in person. Travel other than by personal auto or private jet is quite a challenge, and there are NO cruises. On the other hand, casinos and on-line gaming have seen rapidly growing use as people try to overcome the boredom and sense of confinement brought on by the various shutdown orders. At the same time a Romanian immigrant, Vlad Tenev, and his co-founder started Robinhood Capital Management, a stock brokerage that reportedly allows one to buy and sell securities, including options without fees. Trading is done electronically and is apparently strongly embraced by younger investors. Indeed, one market commentator (Jim Cramer of CNBC’s “Mad Money”) has dubbed the many new retail investors using Robinhood and other inexpensive trading platforms the “Merry Men.” This all is occurring in a time of tremendous growth and use of social media, including the ability to “organize” so-called “flash mobs” and even the January 6, 2021, attack on the U.S. Capitol. MacKay’s observations about “the Madness of Crowds” may be particularly relevant to any attempt to understand these phenomena.

We know from statements on Twitter and text messages received by commentators on CNBC’s “Squawk Box” as well as those quoted in the Wall Street Journal that many if not most of the “investors” driving up the price of GameStop and the other companies involved are not interested in making money. They have been “organized” into the equivalent of a “flash mob” by statements on the Wall Street Bets sub-platform on the media platform sponsored by Reddit, a recently formed social media company. What drives them is learning that hedge funds that specialize in taking short positions in stock have sold billions of dollars worth of stock in these companies, where the hedge funds (often owned and controlled by billionaires) do not own the stock. Short selling is a gamble that the price of a stock will decline, and when the stock is not owned (a so-called “naked short”) the funds can lose billions if the price instead rises. Short selling does serve as an effective check on pricing exuberance. Apparently quite a number of the so-called “Reddit Mob” members had lost money when investments they made (e.g., reputedly in Nikola Corp., Wirecard AG, and Valeant Pharmaceuticals International, Inc., to name a few) when the stock of those chosen investments declined in value after short-sellers took their positions and published investment reports explaining why they thought the stock was overpriced. The “Reddit Mob” with the time, boredom, money, and participatory technological skills had collective anger and a sense of having been taken advantage of by billionaires who looked down on Mob members. They “organized” a series of what is known as a “Short Squeeze” to break or bankrupt the short-sellers. According to David Kostin of Goldman, Sachs & Company, Inc., in a February 1, 2021, report this is the biggest “Short Squeeze” in 25 years. And they have succeeded: one fund, Melvin Capital, reportedly sold out of its GameStop short position, taking a loss of 53% of its asset value (over $3 billion). Melvin Capital only survived after a capital infusion from two other funds, Citadel Capital Management, which lost 3% of its value, and Point 72, which lost 10% of its asset value. Citadel happens also to be an investor in Robinhood. Another short seller, Andrew Left’s Citron Research, announced that after 20 years of short investing and publishing opinions on shortable companies will do so no longer due to the threats of physical violence to him and to his family members, which the FBI is reportedly now investigating.

When Robinhood suspended the ability to trade stocks in 13 companies including GameStop on Thursday, January 28, 2021, its clients went wild, multiple class-action suits have reportedly been filed, and at least one person, David Portnoy of the online gambling company Bar Stools, accused Robinhood of “kowtowing” to the demands of a hedge fund (namely Citadel). In fact, it appears that Robinhood had a potential liquidity problem. Broker-dealers (“BDs”) like Robinhood, do not close the trades they handle. That is done by clearing firms, the most significant of which is the Depository Trust Company (“DTC”). DTC and other clearing firms require BDs to post cash collateral (cash or Treasuries, etc.) against the risk that transactions do not close. The amount required to be posted depends on several factors, including the price of a stock; the volume of trades in that stock; and the rate of price increase or decrease in the short run. DTC required Robinhood to put up substantial additional cash collateral in order to continue trading GameStop and other affected securities. Other BDs faced similar requirements. In the case of Robinhood, it reportedly raised $1 billion overnight and reopened trading in those stocks on Thursday the 2r, although with some limitations on permitted volume. However, the anger and outrage are more than evident, including caustic criticism from Rush Limbaugh (quoted in the New York Post), and Senators Elizabeth Warren and Ted Cruz. As of Monday, February 1, 2021, Robinhood has reduced the number of stocks still subject to trading limits to eight.

Some market participants and Alexis Ohanian, co-founder of Reddit, have asserted that this is all a result of “democratizing” the capital markets and net positive for the future. A report in the weekend edition of Wall Street Journal, for Saturday and Sunday, January 30-31, 2021, identified a 34-year-old former Massachusetts Mutual Life Insurance Co., marketing employee as the on-line “influencer” who triggered the interest in GameStop. He reportedly began buying GameStop shares at about $5 each in July 2019, seeing a chance that it might gain in profits through better use of e-commerce. But as he talked up his ideas on internet chat rooms, including Wall Street Bets, other “investors” joined in.  This in turn provoked short-selling hedge funds to enter the fray. The hedge funds were gambling that GameStop had little “real” value above $5.00 per share so that they would profit when the market price returned to its July 2019 level. This enraged the “Reddit Mob” and through constant use of social media, they formed an investment bloc, albeit without objective structure.

American capital markets have since the beginning of economic studies relied on the self-control imposed on individuals by their own self-interest. That was and is the notion behind the idea of “The Invisible Hand” in Adam Smith’s “The Wealth of Nations.” Almost all of the regulations applicable to the capital markets rely on creating costs (both economic and reputational) for violations that generally deter misbehavior. Indeed, that fundamental precept is reflected in the cost/benefit analysis required as part of any new regulatory proposal. But the “Reddit Mob” is apparently NOT price-sensitive; i.e., they say that they do not care if they lose every dollar they spend, as long as the short sellers are routed. As Christopher Mims wrote in the weekend edition of the Wall Street Journal of Saturday/Sunday, January 30-31, 2021 (page B 4) “The Wall Street Bets members …are [an example of] what philosophers call “closed epistemic systems,” worldviews that are unaffected by the information that contradicts them. Its confirmation bias on steroids. It’s also the logic of a cult.” Those characteristics present an urgent need to reevaluate the traditional regulatory approach. There are some things that can readily be done, probably without legislation;

  • Greater transparency of short position sizes and holders, more immediately available (as is already the case in European markets)
  • Limitations on how much of a company’s stock can be shorted, even in a “naked short” to a maximum of the total or some percentage of the total number of shares outstanding (in some cases short-sellers have shorted more shares than exist)
  • Limitations and/or prohibitions on the use of options to increase the impact on pricing
  • Limit or end the ability to buy selected stocks on margin
  • Greater authority of regulators and/or exchanges to suspend the trading ability of specific shareholders, in addition to the authority to suspend trading in specific securities

Beyond these, new constraints need to be designed and implemented to constrain “Reddit Mob” attacks anywhere in the market. Under the 1968 Williams Act amendments to the Securities and Exchange Act of 1934, as amended, a person OR GROUP acting in concert who acquires 5% or more of the stock of a public company, must file disclosure documents with the SEC including an indication of intentions. In antitrust law, the concept of “conscious parallelism” is well-recognized as a basis for finding a “conspiracy in restraint of trade.” One wonders whether the SEC might espouse a similar view with respect to the “Reddit Mob,” such that their parallel (yet collective) actions might allow regulatory sanctions for actions that would be seen as suspect if done by a single individual. The SEC did issue a statement on Friday, January 29, 2021, which said (in part):

The Commission is closely monitoring and evaluating the extreme price volatility of certain stocks’ trading prices over the past several days. …[E}xtreme price volatility has the potential to expose investors to rapid and severe losses and undermine market confidence.

Nietzsche warned, beware the attack of the sheep, (here organized on social media and seeking the rapture of revenge). Let us hope that the SEC will yet be the Good Shepherd.

©2020 Norris McLaughlin P.A., All Rights Reserved
ARTICLE BY Peter D. Hutcheon of Norris McLaughlin P.A.
For more, visit the NLR Securities & SEC section.

Shining a Spotlight on ESG Disclosures in the Biden Administration

In a period where almost nothing seems certain, it is inevitable that ESG issues will be on the front of the incoming SEC Chair’s mind. Jay Clayton, who resigned as SEC Chairman in December 2020, has urged that one-size-fits-all metrics for environmental disclosures aren’t appropriate given the varied impacts of climate change on different industries. However, President-elect Biden has made clear that climate change will be a high priority for his administration: he has vowed to rejoin the Paris Climate Agreement on his first day of office. Thus, the five-member SEC, where three seats are controlled by the President’s party, can be expected to make ESG disclosures a high priority.

Investors are also in part to thank (or blame) for the growing significance of ESG topics in public disclosures. An SEC advisory committee that advocates for investors urged last May that the SEC establish disclosure policies regarding ESG topics, arguing that investors want reliable information on these matters before making investment and voting decisions. And in its 2019 “Statement on the Purpose of a Corporation,” even the Business Roundtable—a former champion of “shareholder primacy”—agreed that the purpose of corporations is to promote “an economy that serves all Americans.” While this document has been criticized for not providing more palpable sustainability goals, Rep. Joe Kennedy (D-Mass.) called it “a welcome step toward a more moral capitalism” and the U.S. Chamber of Commerce said it “agreed wholeheartedly with the renewed focus.” With the changing of the guard at the SEC, all signs point in the direction of further steps toward “moral capitalism” in the months to come.

© 2020 Proskauer Rose LLP.

ARTICLE BY Erica T. Jones of Proskauer Rose LLP
For more, visit the NLR Securities & SEC section.

Mixed-Status Families to Finally Receive Stimulus Checks

Last week, Congress passed the $900 billion coronavirus relief package that was signed into law by President Donald Trump on December 27, 2020. In this package, the U.S. government will allow mixed-status households to receive stimulus checks. In mixed-status families, at least one member of the household must have a Social Security number (SSN). These families were denied stimulus checks in the first round of payments offered in late March this year.

Who Can Expect Stimulus Checks?

United States citizens and legal permanent residents (green card holders) will receive $600 in direct aid, even if they previously filed their taxes jointly with an undocumented spouse. An additional $600 checks will be sent for each dependent child. The new compromise is also retroactive to the mixed-status families where at least one household member has an SSN. These families will receive checks for $1,200 per household and $500 per child as previously allocated by the CARES Act.

Individuals with an adjusted gross income higher than $75,000 in 2019, heads of household who earned more than $112,500, and couples who made $150,000 will not be eligible for the checks. Undocumented immigrants and other non-citizens who do not have an SSN and file individual tax returns are ineligible for aid. U.S. Citizen children will not receive this aid at least one parent has an SSN.

Many undocumented immigrants and some non-citizens are ineligible for Social Security Numbers. They use government-issued Individual Taxpayer Identification Numbers (ITIN) to pay taxes. Deferred Action for Childhood Arrivals (DACA) and Temporary Protected Status (TPS) beneficiaries have Social Security Numbers.

Reactions to the Coronavirus Relief Package

“It was unfair and absurd that millions of taxpayers in need of assistance to feed their families, many in the immigrant community with U.S. citizen children and working on the frontlines, were previously denied access to these survival funds,” said Senate Democratic Leader Chuck Schumer. “I am pleased we were able to extend this economic lifeline to additional families in need.”

“Given there are 5.5 million immigrants working at the front lines of this crisis as essential workers, Congress should provide protection to all tax filers in the U.S regardless of immigration status,” Kerri Talbot, the Director of Federal Advocacy at The Immigration Hub, a lobbying group, said in a statement.

The nonprofit Migration Policy Institute estimated that 14.4 million people in mixed-status families were excluded from relief. This included 5.1 million who are either citizens or green cardholders. Specifically, the figure includes 1.4 million spouses and 3.7 million children who are citizens or legal residents.

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