Category: Investment

What to Do Now With Your CARES Act PPP Loan

A Warning

Those who have obtained Paycheck Protection Program (PPP) loans (or have applied or been approved for such loans but not yet received the loan proceeds) have been warned by the U.S. federal government to make sure that they, in fact, qualify for the loans. Secretary Mnuchin exonerated lenders who processed the loans and warned that it is the borrowers themselves who sign the application and make the relevant certifications who face potential criminal action for false certifications. Borrowers have now been given a grace period until May 7, 2020, to repay loans they may have obtained “based on a misunderstanding or misapplication of the required certification standard.” This short — now less than one-week — period gives PPP loan borrowers very little time to act and is aggravated by the ambiguity of applicable regulatory and other guidance as discussed below.

Thinking About What to Do

Borrowers are, and should be, asking, “what do we do about our PPP loan?” They are doing so in a unique moment. Indeed, a former member of a Congressional oversight board following the last financial crisis opined in the Wall Street Journal: “[B]orrower beware! Businesses with flexibility should seriously consider to what extent accepting the terms of federal loans or other support may be a Faustian bargain. The ultimate cost may dramatically outweigh the temporary gain.” Understanding the issues that inform the answer to this question, unfortunately, involves some detailed analysis as discussed below.

Broad Loan Availability Initially Heralded and Broad CARES Act Approach

The signing into law of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act)on March 27, 2020, was heralded as a critical response to the COVID-19 economic crisis. The PPP loan program was enacted to make $349 billion of loan funds broadly available to qualifying businesses so that those businesses could keep their employees employed. In fact, following enactment, the federal government repeatedly encouraged businesses to apply for (and lenders to quickly process) PPP loans. Even as late as April 15, 2020, Secretary Mnuchin announced that “[w]e want every eligible small business to participate and get the resources they need.” In order to broaden its reach, the CARES Act affirmatively took action to cut back eligibility restrictions in the existing Small Business Administration (SBA) loan program through which PPP loans are administered, including:

  • suspending the requirement that borrowers must not be able to obtain credit elsewhere;
  • repealing the requirement that liquid owners contribute capital alongside an SBA loan;
  • creating a presumption that loan applicants were adversely impacted by COVID-19; and
  • reducing the breadth of the complex affiliation rules.

The SBA itself even published guidance allowing borrowers to restructure their governance arrangements to qualify for a loan.

A Continuing Changing Landscape; Making a Decision to Keep a PPP Loan

Since the passage of the CARES Act, the landscape has continued to evolve — sometimes daily — with ongoing guidance from the SBA and Treasury, whether in the form of Interim Final Rules (immediately effective upon publication in the Federal Register without first soliciting public comment due to the emergency nature of the situation), FAQ guidance from the SBA with new questions and answers added frequently over the past month, or mere public statements by public officials. Through the end of April — just a month into the CARES Act — seven formal Interim Final Rules for the CARES Act have been issued and 12 updates to the SBA’s FAQs on the PPP have been published. It has been difficult to find clear guidance and sure footing, even before the most recent government warnings.

A Sudden Shift in Approach

On April 23, 2020, after significant press reporting and commentary on those participating in the PPP loans, the SBA and Treasury Secretary abruptly shifted course with the publication of a new FAQ (Question 31) stating that the certification each borrower makes in its application that “[c]urrent economic uncertainty makes this loan request necessary to support the ongoing operations of the Applicant” must be made “in good faith, taking into account their current business activity and their ability to access other sources of liquidity sufficient to support their ongoing operations in a manner that is not significantly detrimental to the business” (emphasis supplied). As to specific examples where certification might raise questions or get a closer look, an April 23 FAQ highlighted large public companies and an April 24 Interim Final Rule highlighted Private Equity (PE) portfolio companies. On April 28, Secretary Mnuchin made public comments promising audits of all loan amounts over $2 million, and then — also on April 28 — the SBA updated its FAQs twice to highlight this new certification interpretation as also applicable to private companies and to formalize the $2 million audit threshold requirement. In other words, virtually all borrowers must be cognizant of the certification that they made in their loan application.

What Does the Certification Mean?

Unfortunately, there is no real guidance as to what this certification means. However, one thing is certain — this certification and the question of access to “other sources of liquidity” will be judged in retrospect. It is anyone’s guess how long the “look back” risk will exist. Our experience is that these kinds of after-the-fact examinations have a long life. In this respect, a borrower may legitimately ask how it knows if it has access to liquidity — must a public company try to test the capital markets; must a PE fund owner consider drawing down on undrawn commitments or fund level credit agreements to fund a highly distressed portfolio company; will VC-backed companies be judged poorly in this context if their investors have large amounts of so-called “dry powder” to invest; and will private business owners have to evaluate their own wealth, liquidity positions, and borrowing capacity? These are all questions that have no ready answer through current SBA rules or guidance. The fact that the CARES Act “suspended” the normal requirement that a borrower be unable to obtain credit elsewhere and repealed the requirement of liquid owners to contribute capital has simply not been reconciled with the SBA’s new scrutiny on available liquidity, as the Treasury and SBA have leaned hard into the statutory certification requirement that any loan request must be “necessary.” Borrowers and applicants would be excused from asking what it means for the SBA to require liquidity that is not “significantly detrimental to the business.” Does that mean “significantly detrimental” to the current business owners (whether public company stockholders, PE or VC fund investors, or the owners of private businesses themselves) in terms of dilution or the like, or does this important phrase instead mean just what it says — such alternative available liquidity is not “significantly detrimental to the business” itself (e.g., financing that the business cannot make “work“ for any real period of time and which damages the business as a going concern)? Again, the SBA and Treasury have provided no clear answers.

The Other Key Certification Issue:

As borrowers evaluate their options to return loans before the expiration of the safe harbor on May 7, 2020, they must also focus on compliance with the SBA “affiliation” rules. The affiliation rules are complex and directly impact the question of who may apply for a PPP loan. This is because the way in which the CARES Act defines eligible borrowers largely turns on the number of employees involved, and an applicant must generally (under applicable regulatory guidance and rules, but subject to certain waivers set forth in the CARES Act itself) apply the SBA’s affiliation rules to aggregate its own number of employees with that of all of its affiliates. Thus, the application of the SBA’s affiliation rules is critically important to an applicant’s ability to make another certification in each PPP loan application: that “the Applicant is eligible to receive a loan under the rules in effect at the time this application is submitted that have been issued by the Small Business Administration (SBA) implementing the Paycheck Protection Program ….” So, in addition to the question of necessity for the PPP loan and alternate sources of liquidity, borrowers must ensure that they have considered the application of the affiliation rules (unless otherwise waived) in deciding whether to keep SBA loans.

Who Is an Affiliate Under the CARES Act?

According to the SBA, affiliate status for purposes of determining the number of employees of a business concern for PPP loans works as follows:

  • “Concerns and entities are affiliates of each other when one controls or has the power to control the other, or a third party or parties controls or has the power to control both”;
  • “It does not matter whether control is exercised, so long as the power to control exists. Affiliation under any of the circumstances described [in 13 C.F.R. § 121.301(f)] is sufficient to establish affiliation” for applicants for the PPP; and
  • There are four general bases of affiliation that the SBA will consider when determining the size of an applicant: (1) affiliation based on ownership; (2) affiliation arising under stock options, convertible securities, and agreements to merge; (3) affiliation based on management; and (4) affiliation based on identity of interest.

As noted, these affiliation rules are both subtle and complex. Interestingly, even Congress did not seem to get the affiliation rules quite right in the CARES Act. In this regard, there are two SBA-related affiliation rules — rules set forth in 13 C.F.R. § 121.103 (Section 103) and rules set forth in 13 C.F.R. § 121.301 (Section 301). When Congress exempted certain business concerns from the affiliation rules for the PPP, it did so under the Section 103 rules. Yet, according to the SBA April 3 Interim Final Rule, it is, in fact, the Section 301 rules that govern affiliation for the PPP loan program (though the SBA explained that it would, consistent with the Congressional Section 103 waiver, also make that waiver applicable for Section 301).

Uncertainty in Application

As questions have arisen under these affiliation tests, borrowers who relied on them in submitting their application would be well advised to “double check” their analysis with appropriate counsel given the heightened scrutiny that will most certainly be applied in retrospective audits of PPP loan recipients. And, it is not just the application of the four bases of control that have given rise to questions of how the affiliation rules work, but the actual language of the CARES Act itself. In this regard, while the CARES Act clearly waives affiliation rules for “any business concern with not more than 500 employees that, as of the date on which the loan is disbursed, is assigned a North American Industry Classification System [(NAICS)] code beginning with 72,” the CARES Act itself has a separate and more expansive provision for NAICS code 72 companies allowing for more than 500 aggregate employees and which provides: “During the covered period, any business concern that employs not more than 500 employees per physical location of the business concern and that is assigned a North American Industry Classification System code beginning with 72 at the time of disbursal shall be eligible to receive a covered loan.” This seems to be clear and self-executing language. Indeed, both applicable House and Senate publicly available explanations of the CARES Act suggest as much, explaining that a qualifying borrower is “Any business concern that employs not more than 500 employees per physical location of the business concern and that is assigned a North American Industry Classification System code beginning with 72, for which the affiliation rules are waived” (emphasis supplied). But, nowhere has the SBA specifically addressed the question of how these two specific NAICS code 72 provisions of the CARES Act are to be applied in conjunction with one another. Even the SBA FAQs seem to intentionally avoid addressing this issue head-on, leaving borrowers at risk for after-the-fact second-guessing.

The Criminal Issue

Secretary Mnuchin referenced criminal liability for a reason. During the past two decades, for every major crisis this country has witnessed, from the Financial Crisis to Hurricane Katrina, high levels of fraud were identified and addressed post-crisis. From the experience gained in prior disasters, the Department of Justice and other enforcers are well aware that fraud may occur under the CARES Act as well. They almost certainly realize that a strong way to prevent such fraud is to take an early, aggressive stance against misconduct. We would predict that U.S. law enforcement will seek to make extreme examples of the individuals who exploited COVID-19-related government assistance improperly and precluded the assistance from helping those actually in need.

The underlying criminal issues relating to PPP loans are relatively straightforward. The loan application itself makes clear that applicants are required to state they qualify, and advises that there are criminal penalties for knowingly making false certifications. Each applicant, by signing the loan application, makes the following statements:
I further certify that the information provided in this application and the information provided in all supporting documents and forms is true and accurate in all material respects. I understand that knowingly making a false statement to obtain a guaranteed loan from SBA is punishable under the law, including under 18 USC 1001 and 3571 by imprisonment of not more than five years and/or a fine of up to $250,000; under 15 USC 645 by imprisonment of not more than two years and/or a fine of not more than $5,000; and, if submitted to a federally insured institution, under 18 USC 1014 by imprisonment of not more than thirty years and/or a fine of not more than $1,000,000.

This certification is essentially the same certification generally applicable to forms and information required by a bank or the government that involve applications for loans, grants or other financial assistance. The certification provides that if you knowingly mislead or lie on the application, you have committed a felony. However, the one completing such an application should endeavor in good faith to provide correct information. This means not simply guessing or blindly answering to expedite processing of the loan application or superficially making the certifications in question. In short, if you mislead in order to receive a PPP loan or lie to receive forgiveness, there is a material risk that the government will believe a felony has been committed.

As stated above, because of the intense pressure to protect the integrity of the PPP loan program and to deter widespread fraud, government enforcers may well use additional criminal statutes to prevent fraud on the United States and the banks. PPP-related prosecutions may involve the usual bank fraud, wire fraud and other common financial fraud statutes. These specific laws all have the common requisite element of deceit. Further, the government will clearly feel free to use whatever remedies possible to recover ill-gotten PPP money and assess related fines to make the U.S. taxpayers whole through various civil enforcement remedies. To avoid such criminal consequences, borrowers need to exercise their best efforts to provide the government with accurate information. There is no criminal liability for mistakes or inadvertent omissions, but when actions are judged retrospectively, trying to prove a lack of intent is not a situation any borrower would want to face. Of course, possible criminal prosecution is not the only redress or negative consequence that wrongful borrowers may face. There are, for example, civil penalties and actions that can be pursued by regulatory or government authorities, qui tam actions, and possible stockholder or equity holders claims against boards or managers, not to mention the potential negative press.

In Sum – This Much is Clear – Double Check, Document and Be Careful Either Way

It would not be surprising or unreasonable for business owners to ask how they are supposed to act with any comfort as to PPP loans given all the uncertainty noted above, with the Treasury Secretary highlighting criminal penalties in relation to improper applications, and with a new “safe harbor” loan “give back” period running only until May 7. It also would not be surprising to see those borrowers who can find a way to make it without the PPP loan decide to return PPP loan proceeds (or not accept funds that have been approved but not yet been received) — even when they have been truly harmed by the COVID-19 pandemic, even when they have always intended to use the loan to keep employees paid exactly as intended by the CARES Act, and even when they believe they qualify for the PPP loan. What is clear from all of the above is that not much is truly clear with respect to the eligibility criteria and certification requirements for PPP loans. What also seems clear — including from the most recent SBA rules issued April 30 stating that the maximum loan amount for a related corporate group will be limited to $20 million — is that loans (even big loans) for qualifying firms are legitimate.

Some Practical Points

Finally, those borrowers who ultimately elect to keep their loans should strongly consider working with counsel to create a contemporaneous, written record to support their certifications or their current decisions to keep those loans based on the certifications that were made at the time of the loan application. There are two key inquiries. First, the borrower should review compliance with the affiliation rules to support the eligibility certification. Second, the borrower should review support for its “necessity” certification, considering (for example) the following questions:

  • What were the specific facts and circumstances showing that the applicant bore financial hardship and faced material economic uncertainty?
  • Did the applicant consider its ability to access capital, including conducting discussions with those who were in a position to provide capital such as the applicant’s current lender(s) and equity holders?
  • Did the applicant prepare a forecast projecting its liquidity position and effect on the operations of not obtaining a PPP loan and that would demonstrate that the loan was necessary to support the ongoing operations of the borrower? Alternatively, did the borrower conduct any other financial review in connection with such certification?

Best practices would then have the foregoing crisply documented and reviewed and approved by the borrower’s board or other governing body. The written record should demonstrate that a bona fide, good-faith effort was undertaken to support the certifications truthfully. If this exercise cannot produce a defensible written record, then the prudent decision may be to return the loan proceeds, ideally before elapse of the grace period for doing so.

Authored by: Trevor J. Chaplick, Peter H. Lieberman & Nathan J. Muyskens  of Greenberg Traurig, LLP

 

©2020 Greenberg Traurig, LLP. All rights reserved.

Modernization at Last: Insight to the Newly Published EB-5 Modernization Rules … Now the Race is On …

On July 23, 2019, United States Citizenship and Immigration Services’ (USCIS) regulations to update the Immigrant Investor Program were published in the Federal Register. The new EB-5 Immigrant Investor Program Modernization rules (New Rules) amend the historic Department of Homeland Security (DHS) regulations governing the employment-based, fifth preference (EB-5) immigrant investor classification and associated regional centers to reflect statutory changes and modernize the EB-5 program. The New Rules are creating quite a buzz in the EB-5 community with good reason. Of particular note, the New Rules modify the EB-5 program by:

  • Increasing the required minimum investment amounts;

  • Providing the long-awaited priority date retention to EB-5 investors in certain cases;

  • Amending targeted employment area (TEA) designation criteria;

  • Centralizing TEA determination;

  • Clarifying USCIS procedures for the removal of conditions on permanent residence fulfilment;

  • Providing for periodic minimum investment increases henceforth; and

  • Implementing a myriad other amendments.

The New Rules are effective 120 days from publication, which is November 21, 2019. The effective date of the New Rules presupposes that Congress will extend the EB-5 Program’s current sunset date of September 30, 2019. USCIS clarified that it will adjudicate investors, who file a Form I-526 petition before November 21, 2019, under the current EB-5 program rules. Now the race is on to initiate and complete investments by the effective date.

The “New” EB-5 Program: A Closer Look at Certain Changes.

Increased Minimum Investment. To account for inflation since the commencement of the EB-5 Program, the New Rules increase the minimum investment amount per investor to participate to $900,000 (from $500,000) if the project is located in a TEA or to $1.8 million (from $1 million) if not in a TEA. This increased amount commences on November 21, 2019. For many this is good news as the minimum investment amount increase is substantially lower than DHS’ initial proposal to increase to $1.35 million. To further adjust for inflation, the New Rules provide for periodic increases henceforth to the minimum investment every five years. USCIS proposes that this fixed schedule will create “predictability and consistency” by allowing EB-5 participants to plan accordingly.

TEA Determination. The amendments to TEA’s determination procedures that commence on and after November 21, 2019, are a hot topic. The biggest change in the New Rules is the abolishment of state sovereignty in the TEA determination process. No longer will the state in which the project is located determine TEA qualification. USCIS, which operates under DHS, will review and determine the designation of high-unemployment TEAs. EB-5 program stakeholders believe this change alone will dramatically limit the number of projects that qualify as a TEA, which could lead to an obsolescence of the EB-5 program. Also of note, the New Rules provide that any city or town with a population of 20,000 or more, whether inside or outside of a metropolitan statistical area, may qualify as a TEA henceforth. The New Rule also provides that a TEA may consist of a census tract or contiguous census tracts in which the new commercial enterprise (NCE) is principally doing business if the NCE is located in more than one census tract, and the weighted average of the unemployment rate for the tract or tracts is at least 150% of the national average. The applicability of TEA status to rural areas remains unchanged. Thus, only projects in metropolitan areas are at risk of no longer qualifying as a TEA under the New Rules after November 20, 2019.

DHS supports these steps with the position that the New Rules will ensure consistency in TEA adjudications by directing investment to areas most in need and increase the consistency of how high-unemployment areas are defined in the program. Of note, the New Rules do not include any preference for rural and urban distressed areas, notwithstanding the proposals for visa set-asides for such project. In addition, the New Rules do not integrate TEA determination with the new qualified opportunity zone designations under the 2017 Tax Cuts and Job Creation Act. These provisions might be addressed legislatively by Congress as part of a reauthorization bill this year. Some EB-5 stakeholders believe that Congress might overrule the New Rules in part (i.e., regarding the minimum investment amount and TEA changes) plus enact additional modernization rules such as authorizing additional visas, etc.

Priority Date Retention. For many years, both Congress and USCIS have recognized the value of a modification to the EB-5 Program to permit EB-5 investors to retain their visa priority date if they are required to amend their EB-5 petition for reasons unrelated to their own doing. The New Rules will allow EB-5 investors to use the priority date of a previously approved EB-5 petition. If and when an investor needs to file a new EB-5 petition, they can now retain the priority date of the previously approved petition, subject to certain exceptions.

An EB-5 immigrant petition’s priority date is normally the date on which the petition was properly filed. In general, when demand exceeds supply for a particular visa category, an earlier priority date is more advantageous. DHS will allow an EB-5 immigrant petitioner to use the priority date for a subsequently filed petition for the same classification for which the petitioner qualifies (unless the petition is revoked for material error, fraud or willful misrepresentation). We note that the New Rules allow an EB-5 petitioner to retain the priority date from an approved Form I-526 petition for a subsequently filed Form I-526 on or after November 21, 2019.

Removal of Conditions on Permanent Residence. The New Rules clarify that derivative family members must file their own Form I-829 to remove conditions on their permanent residence if they are not included in the principal petitioner’s I-829 petition. In addition, the New Rules streamline the adjudication process for removing conditions by providing flexibility in interview locations.

What happens next?

Until November 21, 2019, foreign investors, regional centers, developers and job-creating entities can rely on the existing rules. We urge those considering participation in the EB-5 program who desire to be grandfathered under the current law and the minimum investment amount of $500,000 to invest as soon as possible. As discussed above, if a project’s location in the market no longer qualifies as a TEA, then the minimum investment amount increases to $1.8 million, not just to $900,000. Accordingly, we recommend amending offering documents to include a discussion of the additional risks caused by the New Rules; principal among them is the potential inability to raise funds after November 21.

Regarding future viability of the EB-5 program, the increased investment amount may cause foreign investors to look to other United States programs, such as the L-1 and EB-1, as multinational executive or may look to the immigrant investor programs in other countries with a lower investment amount than the United States.[1]

[1] https://www.eb5investors.com/eb5-basics/international-immigrant-investor-programs

© Polsinelli PC, Polsinelli LLP in California
Article by Debbie A. Klis of Polsinelli PC.
For more on EB-5 immigration developments, see the National Law Review Immigration Law page.

New Rules Offer Clarity On China’s Outbound M&A Crackdown

On August 18, 2017, China’s State Council issued guidelines clarifying rules passed a year ago by the State Administration of Foreign Exchange (SAFE) limiting outbound investments as cover-up to move money out of China.

The new guidelines provide different policies for Chinese companies’ investment overseas, broadly dividing overseas investment into three categories:

  • investments in “real estate, hotels, entertainment, sport clubs, [and] outdated industries” are restricted;

  • investments in sectors that could “jeopardize China’s national interest and security, including output of unauthorized core military technology and products” and investments in gambling and pornography are prohibited; and

  • investments in establishing R&D centers abroad and in sectors like high-tech and advanced manufacturing enterprises that could boost China’s Belt and Road Initiative, and investments that would benefit Chinese products and technology will be encouraged by Chinese outbound regulators.

These guidelines are new and we have to wait and see how they will be interpreted and implemented by regulators. Still, there may be reasons to believe they will have a net positive effect on the China-U.S. M&A market. The new guidelines bring about greater certainty to buyers, lenders and targets on whether a deal will get approved by Chinese regulators.

The volume and size of Chinese outbound M&A is already on an upward trajectory in the second quarter of 2017, as buyers are already getting more acclimated to SAFE rules announced at the end of 2016 restricting the outflow of Chinese capital. Chinese buyers completed 94 deals totaling $36 billion in Q2, compared to the 74 deals totaling $12 billion in Q1. The current Chinese outbound M&A trend, coupled with greater certainty under the new guidelines, is likely to result in more Chinese outbound M&A deals during the last quarter of 2017, as well as in 2018.

This post was written by Shang Kong & Zhu Julie Lee of Foley & Lardner LLP © 2017

For more legal analysis go to The National Law Review

EB-5 Visas: A Source of Funding for US Businesses But Not Without Risk

Poyner Spruill

China’s wealthy investors are known for seeking secure havens for their money overseas.  In addition to being considered a secure environment for their money, the US offers the EB-5 program providing the investor and his or her immediate family with permanent US residence, known as getting “green cards” in return for making an investment.

Basically, in return for an investment of either $500,000 or $1,000,000, which can be shown to the satisfaction of the US Citizenship and Immigration Services to create 10 US jobs per investment over a two year period, the investor and his family get green cards.  Since it started in 1990, the EB-5 visa program has brought approximately $6.7 billion to the US and has created 95,000 jobs.  In fact, the EB-5 visa program was not very popular until the 2008 financial crisis when traditional sources of financing became more difficult to obtain.  Since then, numerous businesses have attempted to use the EB-5 program to raise money.  For example, Vermont’s Trapp Family Lodge of “Sound of Music” fame advertises that it seeks EB-5 investors to open a beer hall and renovate its existing resort facilities.

There are two distinct EB-5 routes — the Basic Program and the Regional Center Pilot Program. Both programs require that the immigrant make a capital investment of either $500,000 or $1,000,000 (depending on whether the investment is in a Targeted Employment Area [TEA]) in a new commercial enterprise located within the United States.  A TEA is defined by law as “a rural area or an area that has experienced high unemployment of at least 150% of the national average.”  The new commercial enterprise must create or preserve 10 full-time jobs for qualifying US workers within two years (or under certain circumstances, within a reasonable time after the two year period) of the immigrant investor’s admission to the US as a Conditional Permanent Resident.

Entrepreneurs across the nation have set up regional centers for foreign investment to market local EB-5 projects to investors.  There are over 230 such regional centers, some of which are state-run  like Vermont’s Jay Peak. The flexibility offered by a regional center is attractive to both the investor and developer since the investor does not have to play a role in the company. With a direct EB-5 investment, the investor must have some sort of “managerial” function.  Seeing a lucrative opportunity when connecting an investor with regional centers, an industry has sprung up, particularly in China, to connect US businesses with potential investors. These go-betweens charge the regional center as much as $175,000 per investor for making the introduction.

Some projects have not produced the requisite number of jobs that would prompt US immigration authorities to withhold green cards – resulting in exposure to lawsuits from the investor against the developer or regional center that has solicited the investment.  Approximately 31 investors, 15 from China, filed a federal lawsuit alleging the only thing they had to show for a $15.5 million investment was an undeveloped plot of land across the Mississippi River from New Orleans.  In San Bruno, California, three Chinese investors alleged in a lawsuit filed last year that they lost $3 million when an EB-5 developer disappeared with his associates concocted a story about his death.

In contrast, the Marriot and Hilton hotel chains have successfully solicited and obtained EB-5 investment funds to build new hotels; Sony Pictures Entertainment and Warner Brothers have used the EB-5 program to raise funds for film projects; and the new home of the NBA’s Brooklyn Nets, Barclay Center, was funded through EB-5 investment.

Even if successful, EB-5 visa approval has become much slower due to suspicion of fraud and developers’ inaccurate estimate of creating 10 jobs per investor.  With the economic downturn, the USCIS has hired economists and securities lawyers to review EB-5 applications. Now showing it that it means business, the Securities Exchange Commission has filed its first lawsuit against an EB-5 project alleging that the promoters of a Chicago hotel and convention center project fraudulently sold more than $145 million in securities and collected $11 million in administrative fees from over 250 Chinese investors.

The Canadian government has decided recently to halt its immigrant investor program due to the number of Chinese applications.  This has left Chinese investors potentially turning their attention to the US equivalent as they seek a financially and politically stable haven for themselves and their families.

Article By:

Jennifer G. Parser
Of:
Poyner Spruill LLP

FINRA (Financial Industry Regulatory Authority) Issues New Rules on Securities Borrowing, Customer Protection and Callable Securities

Katten Muchin

 

On December 4, 2013 the Securities and Exchange Commission approved rules proposed by the Financial Industry Regulatory Authority regarding securities loans and borrowings, permissible use of customers’ securities, and callable securities. For securities loans and borrowings, Financial Industry Regulatory Authority proposed new Rule 4314, which requires a member firm acting as an agent in a securities lending or borrowing transaction to disclose its capacity as agent. The rule aims to clarify whether parties are acting as principals or agents when entering into security lending or borrowing agreements. When member firms loan securities to or borrow securities from a counterparty acting in an agency capacity, the rule requires the member firm to maintain books and records to reflect the details of the transaction with the agent and each principal on whose behalf the agent is acting as well as the details of the transaction. The rule allows a member firm that is a party to a loan or borrowing agreement with another member firm to liquidate the transaction whenever the other party becomes subject to one of the specified liquidation conditions. Additionally, no member firm can lend or borrow any security to or from any person that is not a member of FINRA, including any customer, except pursuant to a written agreement. Each member firm subject to Securities Exchange Act Rule 15c3-3 that borrows fully paid or excess margin securities from a customer must comply with the Securities Exchange Act Rule 15c3-3 requirements for a written agreement between the borrowing member firm and lending customer.

FINRA also adopted new Rule 4330 regarding the permissible use of customers’ securities. The rule prohibits a member firm from lending securities held on margin for a customer that are eligible to be pledged or loaned unless the member firm first obtains written authorization from the customer permitting the lending arrangement. The rule also requires a member firm that borrows fully paid or excess margin securities carried for a customer account to comply with Securities Exchange Act Rule 15c3-3, provide notices to customers in compliance with Securities Exchange Act Section 15(e), and notify FINRA at least 30 days prior to the borrowing. Before any member firm engages in a securities borrowing transaction with a customer, the rule requires the member firm to have reasonable grounds for believing that the customer’s loan of securities is appropriate for its financial situation and needs and that the member firm provide certain disclosures to the customer in writing. A FINRA member firm is also required to keep books and records evidencing compliance with these rules.

Finally, FINRA adopted new Rule 4340 to clarify requirements applicable to callable securities. The rule requires each member firm with possession or control of a callable security, in the event of a partial redemption or call, to identify such securities and establish an impartial lottery system to allocate the securities among its customers. The member firm must also provide written notice, which may be electronic, to new customers opening an account and to all customers once a year that describes how customers may access the allocation procedures on the member firm’s website or obtain hard copies upon request. The rule prohibits a member firm from allocating securities to its own or an associated person’s account during a redemption until all other customers’ positions have been satisfied. This prohibition applies only when the redemption is offered on terms favorable to the called parties. When on unfavorable terms, a member firm cannot exclude its positions or those of its associated persons from the redemption.

The proposed rules with links to amendments, comments, and the approval order may be accessed here.

 

Article by:

 
Of:
 

A Giant Leap: EU-China Bilateral Investment Treaty Negotiations to Be Launched Formally

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Negotiations for a bilateral investment treaty between the European Union and China are expected to be formally launched during the EU-China Summit next week. Though the launch would be just the first step in a long negotiation process, it would also be a giant leap for upgrading the investment relationship between the EU and China.

On 24 October 2013, the fourth meeting of the EU-China High Level Economic and Trade Dialogue was held in Brussels.  Among other points, the most recent talk between the world’s two biggest traders reaffirmed the willingness to formally launch negotiations for a bilateral investment treaty (BIT) during the EU-China Summit to be held in Beijing later this month.

This move is significant for several reasons.

  • There is huge potential for investment flow between the European Union and China.

According to provisional Eurostat data, in 2012 Chinese investments into the EU(27) amounted to €3.5 billion, and only accounted for 2.2 per cent of total foreign direct investment (FDI) flowing into the EU. By contrast, in the same year EU firms invested €9.9 billion in China, accounting for approximately 11.4 per cent of all China’s inward FDI. It is worth noting that the EU’s outward FDI to China only accounted for 2.4 per cent of total outbound investment flowing from the EU to the rest of world in 2012. By contrast, bilateral trade in goods and services is more than €1 billion per day.

  • The existing BITs between China and EU Member States are to be upgraded.

China signed its first BIT with Sweden in 1982, and currently has similar arrangements with each and every EU Member State (except Ireland).  However, these BITs were negotiated and executed in the past 30 years, during which China went through substantial changes in all aspects of society, including a significant increase in outbound investment.  Some of the BITs were updated to reflect such changes, e.g., the China-Netherlands BIT was amended to include national treatment in 2001.

Overall, the EU-China BIT will not be a simple compilation of the existing BITs between China and EU Member States, but an upgrade of the investment relationship between them.

  • The negotiation of a EU-China BIT is likely to be a long process.

The negotiation of a BIT between two giant economic entities is likely to be a long process.  For example, the China-US BIT negotiation is still in its preliminary stage more than 30 years after both parties opened the dialogue in 1980.  The China-Canada agreement took 18 years and went through 22 rounds of formal negotiations.

The difficulties of these negotiations must not be underestimated.  The EU-China BIT will go further than the existing bilateral agreements with individual Member States.  The EU negotiators are keen to include provisions on market access, including access to services, and on intellectual property.  The negotiation process is likely to be complicated by calls from the European Parliament to include provisions on fundamental rights and values (social, environmental, consumer, etc.).

From a procedural point of view, this will be the first trade agreement negotiated by the EU since the assignment of trade and investment agreements to the exclusive competence of the EU under the Lisbon Treaty.  This gives the European Parliament a key role to play in approving any final agreement.

In sum, if both parties formally launch the negotiations in November, it will be a small step in the negotiation process, but a giant leap for upgrading the investment relationship between EU and China.

If EU industry has concerns about obstacles to FDI in China, including discrimination and absence of mutual treatment, it is not too late to raise them with the Directorate General for Trade of the European Commission.

Article by:

Philip Bentley, QC

Frank Schoneveld

Bryan Fu

Of:

McDermott Will & Emery

Investment Management Legal and Regulatory Update – October 2013

GK_Logo_Full-Color (CMYK)

SEC Issues Guidance Update for Investment Companies that Invest in Commodity Interests and Announces New Risk and Examinations Office

The staff of the Division of Investment Management has issued a Guidance Update that summarizes the views of the Division regarding disclosure and compliance matters relevant to funds that invest in commodity interests. The staff also announced the creation of a Risk and Examinations Office within the Division of Investment Management that will accompany the SEC’s Office of Compliance Inspections and Examinations (OCIE) on exam visits.

Disclosure of Derivatives and Associated Risks. Any principal investment strategies disclosure related to derivatives should be tailored specifically to how a fund expects to be managed and should address those strategies that the fund expects to be the most important means of achieving its objectives and that it also anticipates will have a significant effect on its performance. In determining the appropriate disclosure, a fund should consider the degree of economic exposure the derivatives create, in addition to the amount invested in the derivatives strategy. This disclosure also should describe the purpose that the derivatives are intended to serve in the portfolio (e.g., hedging, speculation, or as a substitute for investing in conventional securities), and the extent to which derivatives are expected to be used. Additionally, the disclosure concerning the principal risks of the fund should similarly be tailored to the types of derivatives used by the fund, the extent of their use, and the purpose for using derivatives transactions.

Prior Performance Presentation. A newly registered fund that invests in commodity interests and that includes in its registration statement information concerning the performance of private accounts or other funds managed by the fund’s adviser is responsible for ensuring that such information is not materially misleading. Specifically, a fund that includes the performance of other funds or private accounts should generally include the performance of all other funds and private accounts that have investment objectives, policies, and strategies substantially similar to those of the fund.

Legend Requirement. Rule 481 under the Securities Act requires a fund to provide a legend on the outside front cover page that indicates that the SEC has not approved or disapproved of the securities or passed upon the accuracy or adequacy of the disclosure in the prospectus and that any contrary representation is a criminal offense. The staff will not object if a fund that invests in commodity interests includes in the legend language that also indicates that the CFTC has not approved or disapproved of the securities or passed upon the accuracy or adequacy of the disclosure in the prospectus.

Compliance and Risk Management. Day-to-day responsibility for managing a fund’s portfolio, including any commodity interests and their associated risks, rests with the fund’s investment adviser. In addition, the fund’s board generally oversees the adviser’s risk management activities as part of the board’s oversight of the adviser’s management of the fund. The staff expects that funds and their advisers would adopt policies and procedures that address, among other things, consistency of fund portfolio management with disclosed investment objectives and policies, strategies, and risks.

Each fund should have in place policies and procedures that are sufficient to address the accuracy of disclosures made about the fund’s use of derivatives, including commodity interests, and associated risks, as well as consistency of the fund’s investments in these derivatives with the fund’s investment objectives. For example, these policies and procedures should be reasonably designed to prevent material misstatements about a fund’s use of derivatives, including commodity interests, and the associated risks.

New Risk and Examinations Office. The update notes that a Risk and Examinations Office has recently been created within the Division of Investment Management to analyze and monitor the risk management activities of investment advisers, investment companies, the investment management industry and new products. The group will work closely with OCIE to make onsite visits to investment management firms.

Source: SEC Division of Investment Management Guidance, August 2013, 2013-05.

SEC Approves Registration Rules for Municipal Advisors

State and local governments that issue municipal bonds frequently rely on advisors to help them decide how and when to issue the securities and how to invest proceeds from the sales. Prior to passage of the Dodd-Frank Act in 2010, municipal advisors were not required to register with the SEC. This left many municipalities relying on advice from unregulated advisors. After the Dodd-Frank Act became law, the SEC established a temporary registration regime for municipal advisors that prohibited any municipal advisor from providing advice to, or soliciting, municipal entities or other covered persons without being registered. More than 1,100 municipal advisors have since registered with the SEC. The SEC recently adopted final rules that establish a permanent registration regime for municipal advisors.

Registered municipal advisors will also likely be subject to additional new regulation from the Municipal Securities Rulemaking Board (MSRB). In September 2011, the MSRB withdrew several rule proposals pertaining to municipal advisors pending adoption by the SEC of a permanent registration regime for municipal advisors. Among the proposals was a rule regulating political contributions by municipal advisors. The MSRB had previously indicated that it would resubmit the withdrawn rule proposals once a final definition of the term “municipal advisor” was adopted by the SEC.

Proposed Rule

In 2010, the SEC proposed a rule governing the permanent registration process. The proposal defined “municipal advisor” broadly and would have required municipal advisor registration of appointed board members of municipalities and people providing investment advice on all public funds. The SEC received more than 1,000 comment letters on the proposal, most of which raised concerns about the broad reach of the proposal.

Final Rule

The final rule requires a municipal advisor to register with the SEC if it:

  • provides advice on the issuance of municipal securities or about certain “investment strategies” or municipal derivatives; or
  • undertakes a solicitation of a municipal entity or obligated person.

The rule clarifies who is and is not a “municipal advisor” and offers guidance on when a person is providing “advice” for purposes of the municipal advisor definition. The rule exempts employees and appointed officials of municipal entities from registration and limits the type of “investment strategies” that will result in municipal advisor status. Additionally, instead of the proposed approach that would have required individuals associated with registered municipal advisory firms to register separately, the final rule requires firms to furnish information about these individuals.

Defined Terms

Advice. A person is providing “advice” to a municipal entity or an “obligated person” based on all of the relevant facts and circumstances, including whether the advice:

  • involves a recommendation to a municipal entity;
  • is particularized to the specific needs of a municipal entity; or
  • relates to municipal financial products or the issuance of municipal securities.

Advice, however, does not include providing certain general information.

An “obligated person” is an entity such as a non-profit university or non-profit hospital that borrows the proceeds from a municipal securities offering and is obligated by contract or other arrangement to repay all or some portion of the amount borrowed.

Investment Strategies. A person providing advice to a municipal entity or an “obligated person” with respect to “investment strategies” only has to register if such advice relates to:

  • the investment of proceeds of municipal securities;
  • the investment of municipal escrow funds; or
  • municipal derivatives.

Exemptions from the Municipal Advisor Definition

The following persons conducting the specified activities would not be required to register as a municipal advisor:

Registered Investment Advisers. Registered investment advisers and associated persons do not have to register if they provide investment advice in their capacities as registered investment advisers, such as providing advice regarding the investment of the proceeds of municipal securities or municipal escrow investments.

This exemption does not apply to advice on the structure, timing, and terms of issues of municipal securities or municipal derivatives. The SEC considers advice in these areas as outside the focus of investment adviser regulation.

Independent Registered Municipal Advisor. Persons who provide advice in circumstances in which a municipal entity has an independent registered municipal advisor with respect to the same aspects of a municipal financial product or issuance of municipal securities do not have to register, provided that certain requirements are met and certain disclosures are made.

Banks. Banks do not have to register to the extent they provide advice on certain identified banking products and services, such as investments held in deposit accounts, extensions of credit, funds held in a sweep account or investments made by a bank acting in the capacity of bond indenture trustee or similar capacity.

This exemption does not apply to banks that engage in other municipal advisory activities, such as providing advice on the issuance of municipal securities or municipal derivatives, in part because municipal derivatives were a source of significant losses by municipalities in the financial crisis.

Underwriters. Brokers, dealers and municipal securities dealers serving as underwriters do not have to register if their advisory activities involve the structure, timing and terms of a particular issue of municipal securities.

Registered Commodity Trading Advisor. Registered commodity trading advisors and their associated persons do not have to register if the advice they provide relates to swaps.

Swap Dealers. Registered swap dealers do not have to register as municipal advisors if they provide advice with respect to swaps in circumstances in which a municipal entity is represented by an independent advisor.

Public Officials and Employees. Public officials do not have to register to the extent that they are acting within the scope of their official capacity. This exemption addresses an unintended consequence of the proposed rule that generated significant public comment and created the impression that public officials and municipal employees would be covered if they provided “internal” advice.

This exemption covers persons serving as members of a governing body, an advisory board, a committee, or acting in a similar official capacity as an official of a municipal entity or an obligated person. For instance, it covers:

  • members of a city council, whether elected or appointed, who act in their official capacity; and
  • members of a board of trustees of a public or private non-profit university acting in their official capacity, where the university is an obligated person by virtue of borrowing proceeds of municipal bonds issued by a state governmental educational authority.

Similarly, this exemption covers employees of a municipal entity or an obligated person to the extent that they act within the scope of their employment.

Attorneys. Attorneys do not have to register if they are providing legal advice or traditional legal services with respect to the issuance of municipal securities or municipal financial products.

This exemption does not apply to advice that is primarily financial in nature or to an attorney representing himself or herself as a financial advisor or financial expert on municipal advisory activities.

Accountants. Accountants do not have to register if they are providing accounting services that include audit or other attest services, preparation of financial statements, or issuance of letters for underwriters.

Registration Forms

The final rule requires municipal advisory firms to file the following through EDGAR:

  • Form MA to register as a municipal advisor; and
  • Form MA-I for each individual associated with the firm who engages in municipal advisory activities.

The temporary registration regime will remain in place until December 31, 2014. The new rule requires municipal advisors to register on a staggered basis beginning July 1, 2014. The expiration date of the temporary rules will be extended in order to allow municipal advisors to continue to remain temporarily registered during the staggered compliance period.

Sources: SEC Approves Registration Rules for Municipal Advisors, SEC Press Release 2013-185 (September 18, 2013); Registration of Municipal Advisors, SEC Release No. 34-70462 (September 18, 2013).

SEC Eliminates the Prohibition on General Solicitation and General Advertising in Certain Private Offerings to Accredited Investors

As we reported in our July Client Alert, the SEC amended Regulation D to implement a Jumpstart Our Business Startups Act (JOBS Act) requirement to lift the ban on general solicitation and general advertising for certain private offerings.

JOBS Act

Congress passed the JOBS Act in 2012, which directed the SEC to remove the prohibition against general solicitation and general advertising for securities offerings relying on Rule 506, provided that sales are limited to accredited investors and an issuer takes reasonable steps to verify that all purchasers are accredited investors.

While issuers will be able to widely solicit and advertise for potential investors, the JOBS Act required the SEC to adopt rules that “require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission.” In other words, there is no restriction on who an issuer can solicit, but an issuer faces restrictions on who is permitted to purchase its securities.

Rule 506(c)

The addition of 506(c) to the existing Rule 506 permits issuers, including hedge funds and other private funds, to use general solicitation and general advertising to offer their securities provided that:

  • all purchasers of the securities are accredited investors (as defined in Rule 501);
  • the issuer takes reasonable steps to verify that the investors are accredited investors;
  • all other conditions of the Rule 506 exemption are met; and
  • Form D is completed and the box is checked indicating that Rule 506(c) is being relied upon.

Verification of Accredited Investor Status

Under the new rules, the issuer will need to take reasonable steps to verify that each investor is accredited. Whether the steps taken are “reasonable” will be a principles-based determination by the issuer, in the context of the particular facts and circumstances of each purchaser and transaction. The SEC noted that the issuer should consider the nature of the purchaser and the amount and type of information that the issuer has about the purchaser; the nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering; and the terms of the offering, such as a minimum investment amount.

In response to comments received with respect to the SEC’s original rule proposal, the amendment to Rule 506 also includes a non-exclusive list of methods that issuers may use to verify that purchasers are accredited investors. The methods described in the final rule include the following:

  • Verification of Income. Review IRS forms filed for last two years and obtain a written representation of expected income for the current year.
  • Verification of Net Worth. Review documentation related to assets (bank and brokerage statements, CDs and independent appraisal reports) and liabilities (credit reports).
  • Third Party Verification. Obtain a written confirmation that a person is an accredited investor from a broker-dealer, investment adviser, attorney or CPA.
  • Existing Accredited Security Holder. For any investor who invested in an issuer’s prior Rule 506 offering as an accredited investor and remains an investor, obtain a written certification (at the time of a Rule 506(c) sale) that he or she still qualifies as an accredited investor.

Preservation of Existing Rule

The existing provisions of Rule 506 as a separate exemption are not affected by the final rule. Issuers conducting Rule 506 offerings without the use of general solicitation or general advertising can continue to conduct securities offerings in the same manner and aren’t subject to the new verification rule.

Form D

In connection with these changes, Form D has been amended to require issuers to indicate whether they are relying on 506(c), which permits general solicitation and advertising in a Rule 506 offering.

The rule amendments became effective September 23, 2013.

Sources: SEC Approves JOBS Act Requirement to Lift General Solicitation Ban, Commission Also Adopts Rule to Disqualify Bad Actors from Certain Offerings and Proposes Rules to Enable SEC to Monitor New Market and Bolster Investor Protections, SEC Press Release 2013-124 (July 10, 2013); Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, SEC Release No. IA-3624 (July 10, 2013).

SEC Adopts Rule to Disqualify “Bad Actors” from Rule 506 Offerings

The SEC recently approved amendments to Rule 506 to set forth the “bad actor” (commonly known as “bad boy”) provisions that could disqualify issuers from relying on the rule. The Dodd-Frank Act directed the SEC to adopt the amendments in order to prevent issuers from relying on the Rule 506 safe harbor if certain “bad actors” were involved in the offering.

As required by the Dodd-Frank Act, the SEC approved disqualifications under Rule 506 that are substantially similar to the disqualifications found in other securities regulations. Persons covered by the bad boy provisions include: issuers; directors, executive officers, other officers participating in the offering, general partners or managing members of issuers; beneficial owners of 20% or more of the issuer’s voting equity securities; investment managers to an issuer that is a pooled investment fund and directors, executive officers, other officers participating in the offering, general partners or managing members of the investment manager; promoters connected with the issuer; persons compensated for soliciting investors as well as the directors, officers, general partners or managing members of any compensated solicitor. The disqualifying events include:

  • securities-related criminal convictions;
  • securities-related court injunctions and restraining orders;
  • final orders of a state securities commission, state insurance commission, state or federal bank, savings association or credit union regulator or the CFTC barring an individual from association with regulated entities or from engaging in securities, insurance or banking business or finding a violation of any law pertaining to fraudulent, manipulative or deceptive conduct;
  • SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment advisers and investment companies and their associated persons;
  • SEC cease-and-desist orders related to violations of certain anti-fraud provisions and registration requirements of the federal securities laws;
  • suspension or expulsion from membership in, or suspension or bar from associating with a member of, a securities self-regulatory organization; and
  • SEC stop orders pertaining to the filing of a registration statement or the suspension of an exemption.

Reasonable Care Exception. Under this exception, an issuer would not lose the benefit of the Rule 506 safe harbor if it can show that it did not know and, in the exercise of reasonable care, could not have known that a covered person with a disqualifying event participated in the offering.

Disclosure of Pre-Existing Disqualifying Events. Disqualification applies only for disqualifying events that occur after September 23, 2013, the effective date of this rule. Matters that existed before the effective date of the rule and would otherwise be disqualifying are subject to a mandatory disclosure requirement to investors.

Sources: SEC Approves JOBS Act Requirement to Lift General Solicitation Ban, Commission Also Adopts Rule to Disqualify Bad Actors from Certain Offerings and Proposes Rules to Enable SEC to Monitor New Market and Bolster Investor Protections, SEC Press Release 2013-124 (July 10, 2013); Disqualification of Felons and Other Bad Actors from Rule 506 Offerings, SEC Release No. 33-9414 (July 10, 2013).

SEC Proposes Amendments to Private Offering Rules (Regulation D and Form D)

In partial response to the many comments that the SEC received with respect to its proposed JOBS Act amendments to Rule 506, the SEC recently proposed the following amendments to the private offering rules.

Advance Notice of Sale. Under the proposal, issuers that intend to engage in general solicitation as part of a Rule 506 offering would be required to file the Form D at least 15 calendar days before engaging in general solicitation for the offering. Also, within 30 days of completing an offering, issuers would be required to update the information contained in the Form D and indicate that the offering has ended.

Additional Information about the Issuer and the Offering. Under the proposal, issuers would be required to provide additional information such as:

  • types of general solicitation used;
  • methods used to verify accredited investor status;
  • publicly available website;
  • controlling persons;
  • industry group;
  • asset size;
  • breakdown of investor types (accredited/non-accredited and natural person/entity) and amounts invested; and
  • breakdown of use of proceeds.

Disqualification. Under the proposal, an issuer would be disqualified from using the Rule 506 exemption in any new offering if the issuer or its affiliates did not comply with the Form D filing requirements in a Rule 506 offering.

Legends and Disclosures. Under the proposal, issuers would be required to include certain legends or cautionary statements in any written general solicitation materials used in a Rule 506 offering. The legends would be intended to inform potential investors that the offering is limited to accredited investors and that certain potential risks may be associated with such offerings.

In addition, if the issuer is a private fund and includes information about past performance in its written general solicitation materials, it would be required to provide additional information in the materials to highlight the limitations on the usefulness of this type of information. The issuer also would need to highlight the difficulty of comparing this information with past performance information of other funds. The proposal also requests public comment on whether other manner and content restrictions should apply to written general solicitation materials used by private funds.

Submission of Written General Solicitation Materials to the SEC. Under the proposal, issuers would be required to submit written general solicitation materials to the SEC through an intake page on the SEC website. Materials submitted in this manner would not be available to the general public. As proposed, this requirement would be temporary, expiring after two years.

Guidance to Private Funds about Misleading Statements. In its current form, Rule 156 under the Securities Act provides guidance on when information in mutual fund sales literature could be fraudulent or misleading for purposes of the federal securities laws. Under the proposal, the rule would be amended to apply to the sales literature of private funds.

Comments on the proposal originally were due on September 23, 2013. However, “in light of the public interest,” the SEC re-opened the comment period until October 30, 2013.

Sources: SEC Approves JOBS Act Requirement to Lift General Solicitation Ban, Commission Also Adopts Rule to Disqualify Bad Actors from Certain Offerings and Proposes Rules to Enable SEC to Monitor New Market and Bolster Investor Protections, SEC Press Release 2013-124 (July 10, 2013); Amendments to Regulation D, Form D and Rule 156, SEC Release No. IC-30595 (July 10, 2013).

SEC Charges Investment Adviser for Misleading Fund Board About Algorithmic Trading Ability

The SEC charged an investment adviser and its former owner for misleading a mutual fund’s board of directors about the firm’s ability to conduct algorithmic currency trading so the board would approve the adviser’s contract to manage the fund.

The case arises out of an initiative by the SEC Enforcement Division’s Asset Management Unit to focus on the “15(c) process” – a reference to Section 15(c) of the Investment Company Act that requires a fund’s board to annually evaluate the fund’s advisory agreements. Advisers must provide the board with truthful information necessary to make that evaluation.

“It is critical that investment advisers provide truthful information to the directors of the registered funds they advise,” said Julie M. Riewe, Co-Chief of SEC Enforcement Division’s Asset Management Unit. “Both boards and advisers have fiduciary duties that must be fulfilled to ensure that a fund’s investors are not harmed.”

The SEC’s Enforcement Division alleged that Chariot Advisors LLC and Elliott L. Shifman misled the fund’s board about the nature, extent, and quality of services that the firm could provide. In two presentations before the board, Shifman misrepresented that his firm would implement the fund’s investment strategy by using a portion of the fund’s assets to engage in algorithmic currency trading. Chariot fund’s initial investment objective was to achieve absolute positive returns in all market cycles by investing approximately 80% of the fund’s assets under management in short-term fixed income securities, and using the remaining 20% to engage in algorithmic currency trading.

According to the SEC’s order instituting administrative proceedings, Chariot Advisors did not have an algorithm capable of conducting such currency trading. This was particularly significant because in the absence of an operating history the directors focused instead on Chariot Advisors’ reliance on models when the board evaluated the advisory contract. Even though Shifman believed that the fund’s currency trading needed to achieve a 25 to 30% return to succeed, Shifman allegedly did not disclose to the board that Chariot Advisors had no algorithm or model capable of achieving such a return.

The SEC alleges that for at least the first two months after the fund was launched, Chariot Advisors did not use an algorithm model to perform the fund’s currency trading as represented to the board, but instead hired an individual trader who was allowed to use discretion on trade selection and execution. According to the order, the trader used a technical analysis, rules-based approach for trading that combined market indicators with her own intuition.

The SEC further alleges that the misconduct by Shifman and Chariot Advisors caused misrepresentations and omissions in the Chariot fund’s registration statement and prospectus filed with the SEC and viewed by investors.

A hearing will be scheduled before an administrative law judge to determine whether the allegations contained in the order are true and whether any remedial sanctions are appropriate.

Sources: SEC Charges North Carolina-Based Investment Adviser for Misleading Fund Board About Algorithmic Trading Ability, SEC Press Release 2013-162 (August 21, 2013); In the Matter of Chariot Advisors, LLC and Elliott L. Shifman, Investment Company Act Release No. 30655 (August 21, 2013).

Article By:

of

Private Placement of Alternative Investment Funds in the European Union (EU): Changing Regulatory Landscape

GT Law

I. Overview

The European Commission’s Alternative Investment Fund Managers Directive (“AIFMD”) was designed to establish a unified framework throughout the EU for regulating previously unregulated Alternative Investment Funds (“AIF”).

The AIFMD is effective as per July 22, 2013. The AIFMD, as any other EU directive, however needs to be transposed into European Union members’ national laws before it will actually have effect. Moreover, the AIFMD leaves the member states with the flexibility to make their own choices on certain aspects. This concerns also the private placement of units in AIF´s.

In preparation for its enforcement by the individual EU member states, this memorandum will discuss the AIFMD’s effect on non-EU managers of AIFs (“AIFM”) marketing non-EU AIFs within the EU.  The memorandum will first give a broad overview of some of the AIFMD’s measures significant for non-EU AIFMs, followed by a table summarizing how the private placement of AIF´s in the major capital markets of the EU is affected the AIFMD.

It should be noted that prior to July 22, 2013, the marketing of AIF´s in EU member states already required an individual analysis for each member state. For the time being not much has changed in this respect but marketing unregulated funds to selected non retail investors has certainly become more complex due to the AIFMD. Also these distributions may no longer be expected to remain of relatively little interest to securities regulators and fund managers may therefore be required to strengthen their compliance efforts in this area.

II. Regulatory Target – AIF Managers

The AIFMD seeks to regulate a set of previously unregulated AIFs, namely, “all collective investment undertakings that are not regulated under the Undertakings for Collective Investment in Transferable Securities (UCITS) Directive.”  These include hedge funds, private equity funds, commodity funds, and real estate funds, among others.

Rather than regulating AIFs directly, however, the AIFMD regulates AIFMs—that is, entities providing either risk or portfolio management to an AIF.  According to the AIFMD, each AIF may only have a single entity as its manager.

The AIFMD applies to AIFMs that are: (1) themselves established in the EU (“EU AIFM”); (2) AIFMs that are not established in an EU country (“non-EU AIFM”), but that manage and market AIFs established in the EU (“EU AIF”); or (3) non-EU AIFMs that market AIFs that are not established in a EU country (“non-EU AIF”) within an EU jurisdiction.

This memo principally deals with the third category, non-EU AIFMs that market non-EU AIFs in the EU.

III. Exemption – Small AIFs

Pursuant to the AIFMD, AIFMs that manage small funds are exempt from the full rigor of the AIFMD regulatory regime.  A lighter regulatory regime is applicable to these AIFMs.

The AIFMD defines AIFMs that manage small funds as either: (1) an AIFM with aggregate assets under management not exceeding € 500 million, where the AIFs are not leveraged, and the investors do not have redemption rights for the first five years after their investment; or (2) an AIFM with aggregate assets under management not exceeding € 100 million.

AIFMs of smaller funds are largely exempted from the AIFMD, and will only be subject to registration, and limited reporting requirements.

IV. Marketing – Definition

As previously discussed, the AIFMD applies to non-EU AIFMs marketing non-EU AIFs in one or more EU jurisdictions.

The AIFMD defines marketing as “a direct or indirect offering or placement at the initiative of the AIFM or on behalf of the AIFM of units or shares of an AIF it manages to or with investors domiciled or with a registered office in the Union.”  This marketing definition does not include reverse solicitation, where the investor initiates the investment, and the investment is not at the AIFM’s direct or indirect initiative.

Thus, for example, if an EU investor initiated an investment in a U.S. AIF, managed by a U.S. AIFM, the U.S. AIFM and AIF would be unaffected by the AIFMD.  The AIFMD would only apply to U.S. AIFMs managing U.S. AIFs, if the U.S. AIFM solicited investment in the EU.

V. Regulating Non-EU AIFMs – National Private Placement Regimes

The AIFMD is designed to phase out national private placement regimes, creating a unified regulatory regime throughout the EU.  However, the AIFMD is scheduled to come into force in stages.

Between July 22, 2013, and 2018 (at the earliest), non-EU AIFMs will be able to market their non-EU AIFs in an EU jurisdiction (“EU Target Jurisdiction”) subject to the national private placement regimes applicable in that EU jurisdiction.

Thus for example, a U.S. AIFM marketing a U.S. AIF in the UK will be able to do so subject to the UK’s private placement regime.

VI. Regulating Non-EU AIFMs – Additional AIFMD Requirements

As explained, through 2018, the AIFMD will largely permit non-EU AIFMs to market non-EU AIFs subject to the private placement regime in the EU Target Jurisdiction.

However, the AIFMD does include three additional requirements for the non-EU AIFMD to be able to take advantage of the EU Target Jurisdiction’s private placement regime.  These include, specific disclosure and reporting requirements, cooperation agreements, and exclusion of AIFs and AIFMs established in certain countries.  Each of these will be discussed in turn.

a. Applicable AIFMD Reporting Requirements

By its terms, the AIFMD will require even non-EU AIFMs marketing non-EU AIFs pursuant to national private placement regimes to comply with certain AIFMD provisions concerning annual reports, disclosures to investors, periodic reporting to regulators, and acquisition of control over EU companies.

A non-EU AIFM will thus be required to make available: (1) an annual report for each non-EU AIF that it markets in the EU; (2) information relevant to potential investors, as well as changes in material information previously disclosed; (3) regular reports to the national regulator in the EU Target Jurisdiction; and (4) disclosure information to a listed or unlisted EU company over which the non-EU AIFM acquires control.

b. Cooperation Agreements

For non-EU AIFMs to be able to market their non-EU AIFs in an EU jurisdiction, the AIFMD requires that there be cooperation agreements in place between the regulator in the non-AIFM’s home jurisdiction, and the EU Target Jurisdiction.

ESMA has negotiated memoranda of understanding (“MOU”) with 34 regulators in a variety of jurisdictions.  These include regulators in Albania, Australia, Bermuda, Brazil, the British Virgin Islands, Canada (the provincial regulators of Alberta, Quebec and Ontario as well as the Superintendent of Financial Institutions), the Cayman Islands, Dubai, Guernsey, Hong Kong (Hong Kong Monetary Authority and Securities and Futures Commission), India, the Isle of Man, Israel, Jersey, Kenya, Malaysia’s Labuan Financial Services Authority, Mauritius, Montenegro, Morocco, Pakistan, Serbia, Singapore, Switzerland, Tanzania, Thailand, the United Arab Emirates and the United States (Federal Reserve Board, Office of the Comptroller of the Currency and Securities and Exchange Commission).

These MOUs, however, are insufficient to permit non-EU AIFMs to market their non-EU AIFs in any EU jurisdiction.  Rather, the EU Target Country must have a separate cooperation agreement with the regulator in the non-EU AIFM’s home jurisdiction (presumably these separate cooperation agreements will be based on the MOUs negotiated by ESMA).

Thus, for example, for a U.S. AIFM to be able to market its U.S. AIF in the UK, the UK’s Financial Conduct Authority must have a cooperation agreement with the United States’ Securities and Exchange Commission.

c. Exclusion of Non-Cooperative Country or Territory

Finally, pursuant to the AIFMD, to be able to market based on the EU Target Country’s private placement regime, neither the non-EU AIFM nor the non-EU AIF may be considered a country considered a “Non-Cooperative Country or Territory,” by the Financial Action Task Force on anti-money laundering, and terrorist financing.

In sum, through 2018, non-EU AIFMs may market their non-EU AIFs in EU jurisdictions according to the relevant EU Target Jurisdiction’s private placement regime, subject to a few additional AIFMD requirements.

VII. The AIFMD in Each EU Jurisdiction

The above discussion outlines the AIFMD’s general requirements pertaining to non-EU AIFMs marketing non-EU AIFs.

However, because to take effect the AIFMD must be transposed into the national law of each EU jurisdiction, and because through 2018 the AIFMD largely relies on national private placement rules to regulate non-EU AIFMs, there is bound to be substantial variation in the AIFMD’s application across EU jurisdictions.

The table below details relevant aspects of the AIFMD’s application in each of the EU jurisdictions (plus Norway, and Switzerland).  Supplementing the memorandum, the table serves as a basic guide for the AIFMD’s application to non-EU AIFMs seeking to market their non-EU AIFs in each of the EU jurisdictions.  The chart includes, for each country, whether it has transposed the AIFMD on time (“On time” / “Not on time”), an overview of the private placement regime, relevant reporting requirements, transitional provisions, and a list of the countries with which a cooperation agreement is in place.

Because some of the EU countries have yet to transpose the AIFMD, or have not completed the transposition, and cooperation agreement process we will indicate on the outline where completion of the process is pending.

BELGIUM

  • AIFMD Transposition
    • Not on time
  • Private Placement Regime
    • At present, AIFMs must be registered locally, and are subject to a minimum investment amount of € 250,000.
  • Relevant Reporting Requirements – Pending
  • Transitional Provisions – Pending
  • Cooperation Agreements with non-EU Countries – Pending

DENMARK

  • AIFMD Transposition
    • Not on time.
  • Private Placement Regime
    • Denmark permits marketing to a maximum of 8 offerees, and requires that a non-EU AIFM be licensed in its member state of reference.1
  • Relevant Reporting Requirements
    • Non-EU AIFs licensed in another EU jurisdiction pursuant to AIFM regulations must submit additional documentation to the Danish FSA, including operating and managing plans, and contact information.
  • Transitional Provisions
    • Transitional provisions will permit non-EU AIFMs to market AIFs under Denmark’s current private placement regime until at least July 22, 2014 (provided that the AIFMs commenced marketing prior to the transposition date of July 22, 2013).
  • Cooperation Agreements with non-EU Countries – Pending

FINLAND

  • AIFMD Transposition
    • Not on time.
  • Private Placement Regime
    • Finland’s private placement regime permits AIFMs to market only to “professional” clients.
  • Relevant Reporting Requirements – Pending
  • Transitional Provisions
    • The AIFMD is not expected to apply to non-EU AIFMs until 2015.
    • Transitional rules have been proposed (although not yet adopted) permitting AIFMs to market pursuant to existing private placement rules, provided that the AIFMs can show that they have made a good faith effort to comply with AIFMD.
  • Cooperation Agreements with non-EU Countries – Pending

FRANCE

  • AIFMD Transposition
    • On time.
  • Private Placement Regime
    • Under its present private placement regime, France does not permit AIFMs to actively solicit investment.
  • Relevant Reporting Requirements – Pending
  • Transitional Provisions
    • It appears that a transitional period will apply until 22 July 2014, during which all French AIFMs will be able to continue marketing and / or managing any AIFs in France on the pre-AIFMD basis (for example by using reverse solicitation).
    • Other AIFMs (whether EU but outside France or non-EU) would, therefore, need to be authorized.
  • Cooperation Agreements with non-EU Countries – Pending

GERMANY

  • AIFMD Transposition
    • On time.
  • Private Placement Regime
    • Under the new German private placement regime, non-EU AIFMs may market to professional investors, subject to requirements.
    • To market in Germany, the non-EU AIFM must appoint an independent entity to act as a depositary (as defined in the AIFMD), and notify BaFin, Germany’s markets regulator, of the appointed depository’s identity.
  • Relevant Reporting Requirements
    • Notifying BaFin of its intention to market in Germany, and include an application with a comprehensive list of information and documents.  BaFin will have up to two months to review, and decide upon the application.
    • Making certain initial and ongoing investor disclosures.
    • Complying with reporting requirements to BaFin.
  • Transitional Provisions
    • Non-EU AIFMs that marketed funds in Germany by prior to the AIFMD’s July 22, 2013 effective date (“previously marketed funds”) will be permitted to continue marketing those previously marketed funds under existing private placement rules until July 21, 2014.
  • Cooperation Agreements with non-EU Countries – Pending

IRELAND

  • AIFMD Transposition
    • On time.
  • Private Placement Regime
    • Under Ireland’s private placement regime, non-EU AIFMs will be able to market in Ireland without restrictions additional to those of the AIFMD, discussed above.
  • Relevant Reporting Requirements
    • Ireland will only require that the non-EU AIFMs comply with the AIFMD’s reporting requirements for non-EU AIFMs discussed above.
  • Transitional Provisions
    • Non-EU AIFMs managing qualified investor alternative investment funds (“QIAIF”), as defined under the relevant Irish provisions, which were authorized prior to the July 22, 2013 transposition date will not be required to be AIFMD compliant until July 22, 2015.
    • Non-EU AIFMs managing QIAIFs authorized after July 22, 2013 will have two years from the QIAIF’s launch date to become AIFMD compliant.
  • Cooperation Agreements with non-EU Countries – Pending

ITALY

  • AIFMD Transposition
    • Not on time.
  • Private Placement Regime
    • Under Italy’s current private placement regime, which it seems will be available to non-EU AIFMs through 2015, AIFMs may market only to “expert” investors.
  • Relevant Reporting Requirements
    • Currently, AIFMs must disclose their balance sheets, certain administrative documents, and financial reports regarding their managers’ activities.
  • Transitional Provisions – Pending
  • Cooperation Agreements with non-EU Countries – Pending

LUXEMBOURG

  • AIFMD Transposition
    • On time.
  • Private Placement Regime
    • Through 2018, Luxembourg will permit small and non-EU AIFMs to market pursuant to its private placement regime.
  • Relevant Reporting Requirements
    • Luxembourg imposes certain transparency requirements on AIFMs, including disclosure of an AIFM’s net asset value, and disclosures upon gaining control of an EU company.
  • Transitional Provisions
    • Beginning on July 22, 2014, in addition to complying with Luxembourg’s private placement regime, non-EU AIFMs will be required to comply with the third country provisions of the AIFMD.
  • Cooperation Agreements with non-EU Countries
    • Luxembourg signed cooperation agreements with all 34 of the regulators that entered into MOUs with ESMA.

THE NETHERLANDS

  • AIFMD Transposition
    • On time.
  • Private Placement Regime
    • Netherlands will permit certain AIFMs to market pursuant to its private placement regime provided offerings are: (1) to less than 150 persons; (2) units have an individual nominal value of at least EUR 100,000 or consist of a package of units with at value of at least EUR 100,000; or (3) offered to professional investors only.
    • Non-EU AIFMs are exempted for offerings to qualified investors only if the AIFM is not domiciled in a non cooperative country under FATF rules and the Dutch regulator and the foreign regulator entered into a MOU.
    • AIFMs licensed by the relevant securities regulators in the USA, Jersey and Guernsey may offer to any investor under a license recognition regime.
  • Relevant Reporting Requirements
    • Notification to Netherlands Financial Markets Authority and reporting of investments, risk positions and investment strategy of AIF to Dutch Central Bank.
  • Transitional Provisions
    • Several grandfathering provisions for non-EU AIF’s that stopped marketing prior to 22 July 2013.
  • Cooperation Agreements with non-EU Countries – Pending

POLAND

  • AIFMD Transposition
    • Not on time.
  • Private Placement Regime
    • So far, the Polish regulator has not published an AIFMD transposition regulation.
    • However, under the existing private placement regime, non-EU AIFs that wish to market its units in Poland may do so if:
      • The units are qualified as equity or debt securities under their respective governing law; and
      • The units are offered under the “private placement” regime, meaning a nonpublic offer to sell securities to no more than 149 identified investors
  • Relevant Reporting Requirements – Pending
  • Transitional Provisions
    • As mentioned above, the Polish regulator has not made an official announcement concerning AIFMS transposition.
  • However, a representative of the Polish regulator recently indicated in an interview that:
    • AIFMs currently marketing AIFs in Poland will have two years to determine whether they fall within the regulations of the AIFD; and
    • If so, the AIFMs will be required to become AIFMD compliant within the two-year period.
  • Cooperation Agreements with non-EU Countries – Pending

SPAIN

  • AIFMD Transposition
    • Not on time.
  • Private Placement Regime
    • Currently, no private placement regime is available, and it in not anticipated that a private placement regime will be made available in the implementation of the AIFMD.
    • Under proposed rules, registration with, and authorization from the Spanish regulator is required for non-EU AIFMs to market non-EU AIFs to professional investors only in Spain.
    • Authorization to market may be denied if:
      • The non-EU AIF’s home state applies discriminatory marketing rules against Spanish AIFs;
      • The non-EU AIF provides insufficient assurance of compliance with Spanish law, or insufficient protection of Spanish investors; or
      • The non-EU AIFs will disrupt competition in the Spanish AIF market.
  • Relevant Reporting Requirements – Pending
  • Transitional Provisions – Pending
  • Cooperation Agreements with non-EU Countries – Pending

SWEDEN

  • AIFMD Transposition
    • Not on time.
  • Private Placement Regime
    • At present, there is no private placement regime for marketing AIFs in Sweden.
    • Many AIFs, simply fall outside the scope of Sweden’s regulations, and may market freely in Sweden
    • Other AIFs affected by Sweden’s regulation may only be marketed by a Swedish AIFM, or an AIFM regulated in another EU country.
    • It is unclear whether non-EU AIFMs will be able to continue to market freely after the AIFMD comes into force, or whether they will be prevented from marketing in Sweden altogether
  • Relevant Reporting Requirements – Pending
  • Transitional Provisions – Pending
  • Cooperation Agreements with non-EU Countries – Pending

UNITED KINGDOM

  • AIFMD Transposition
    • On time.
  • Private Placement Regime
    • Provided that an AIF has been marketed by the non-EU AIFM prior to July 22, 2013 in an EEA jurisdiction, the non-EU AIFM will be able to continue to market the funds under the UK’s private placement regime until July 21, 2014 without complying with the requirements of the AIFMD.
    • For new funds marketed from July 22, 2013, the non-EU AIFM will need to comply with the reporting requirements of the AIFMD set out below.
  • Relevant Reporting Requirements
    • Prior to marketing in the UK, an AIFM must give the FCA written notification of its intention to do so.
    • In the notification, the AIFM must affirm that it is responsible for complying with the relevant AIFMD requirements, and that these relevant requirements have been satisfied.
    • Once it has submitted the notification to the FCA, the AIFM may begin marketing—it need not wait for the FCA’s approval.
    • Additionally, the AIFM is subject to disclosure requirements, including:
      • Ensuring that investor disclosure in fund marketing materials meets the disclosure and transparency requirements set out in the directive;
      • Reporting either annually or semi-annually to the FCA proscribed information; and
      • Submitting and publishing an annual report for each AIF that the AIFM manages or markets.
  • Transitional Provisions
    • The non-EU AIFMs that marketed any AIF in the EU prior to the AIFMD’s July 22, 2013 effective date will be permitted to market AIFs in the UK under the pre-AIFMD rules until July 21, 2014.
    • Non-EU AIFMs taking advantage of the transitional provision may do so irrespective of whether or not the FSA has cooperation agreements in place
  • Cooperation Agreements with non-EU Countries
    • The UK signed cooperation agreements with all 34 of the regulators that entered into MOUs with ESMA.

NORWAY2

  • Private Placement Regime
    • At present, Norway does not permit soliciting investment in AIFs.
  • Relevant Reporting Requirements – Pending
  • Transitional Provisions – Pending
  • Cooperation Agreements with EU Countries – Pending

SWITZERLAND

  • Private Placement Regime
    • Non-EU AIFMs may market through the Swiss private placement regime without any additional regulation, approval, or license requirement or the investor is:
      • A License financial institution;
      • A regulated insurance institution; or
      • An investor that has concluded a written discretionary asset management agreement with a licensed financial institution, or a financial intermediary, provided that information is provided to the investor through the financial institution, or intermediary, and that the financial intermediary is:
        • Regulated by anti-money laundering regulation;
        • Governed by the code of conduct employed by a specific self-regulatory body recognized by the Swiss regulator; and
        • Compliant with the recognized standards of the self-regulatory body.
  • Relevant Reporting Requirements – Pending
  • Transitional Provisions
    • Non-Swiss AIFMs have until March 1, 2015 to:
      • Appoint a Swizz representative, and a Swiss paying agent; and
      • Comply with all relevant regulations.
    • Non-Swiss AIFMs that have yet to be subject to Swiss regulation must:
      • Contact, and register with the Swiss regulator by September 1, 2013; and
      • If not sufficiently licensed in their home country, apply for a license by March 1, 2015.
    • Cooperation Agreements with EU Countries – Pending

1 An AIFM’s member state of reference (“MSR”) is the member state where the marketing of most of the AIF takes place.  So, for example if a U.S. AIFM markets in Denmark, and Denmark is the Member State of Reference, then the Danish FSA must issue the U.S. AIFM a license prior to commencement of the U.S. AIFM’s marketing activities in Denmark.

2 Norway, and Switzerland are non-EU countries of interest.  Because they are not part of the EU, they are not required to transpose the AIFMD.

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What the SEC’s Elimination of the Prohibition on General Solicitation for Rule 506 Offerings Means to the EB-5 Community

Sheppard Mullin 2012

As we previously reported, on July 10, 2013, the SEC adopted the amendments required under the JOBS Act to Rule 506 that would permit issuers to use broad-based marketing methods such as the Internet, social media, email campaigns, television advertising and seminars open to the general public.  These types of methods are referred to in U.S. securities laws as “general solicitation,” and they have until now been prohibited in most offerings of securities that are not registered with the SEC. This is an important development to the EB-5 community because EB-5 offerings very often rely on Rule 506 as an exemption from offering registration requirements.

In addition, the SEC amended Rule 506 to disqualify felons and other “bad actors” from being able to rely on Rule 506.  This is also an important development for the EB-5 community, which has developed a heightened sensitivity to the potential for fraud in the wake of the Chicago Convention Center project.

Please note that these new rules are not yet effective.  See “When do the new rules become effective?” below.

Overview

Companies intending to raise capital through the sale of securities in or from the United States must either register the securities offering with the SEC or rely on an exemption from registration.   Failure to assure an available exemption for unregistered securities can result in civil and criminal penalties for the participants in the offering and rescission rights in favor of the investors.

For EB-5 programs, a widely used exemption from registration is Rule 506 of Regulation D, under which an issuer may raise an unlimited amount of capital from an unlimited number of “accredited investors” and up to 35 non-accredited investors.  Historically, this exemption has prohibited general solicitation or advertising in connection with the offering, including publicly available web sites, social media, email campaigns, television advertising and seminars open to the general public.

The other commonly used exemption, Regulation S, has been less restrictive on general solicitation, but is not available for investors already present in the United States and does not preempt state securities law registration/exemption obligations, which often prohibit general solicitation.  Rule 506 does preempt such state laws (except as to notice filings and filing fees).  For many EB-5 programs and investors, there is no available exemption other than Rule 506 that does not also prohibit general solicitation.

In connection with the passage by Congress of the Jumpstart Our Business Startups (JOBS) Act in April 2012, Congress directed the SEC to remove the prohibition on general solicitation or general advertising for securities offerings relying on Rule 506, provided that sales are limited to accredited investors only and that the issuer takes reasonable steps to verify that all purchasers of the securities meet the requirements for accredited investors. The SEC initially proposed a rule to implement these changes in August 2012, but did not pass final rules on the changes to Rule 506 until now.

What changes were made to Rule 506?

The final rule adds a new Rule 506(c), which permits issuers (that is, the partnerships or other organizations actually issuing partnership interests and the like in exchange for EB-5 capital) to use general solicitation and general advertising  for the offer their securities, provided that:

  • All purchasers of the securities are accredited investors as defined under Rule 501; and
  • The issuer takes “reasonable steps” to verify that the purchasers are all accredited investors.

Who is an accredited investor?

Under Rule 501 of Regulation D, a natural person qualifies as an “accredited investor” if he or she is either:

  • An individual net worth (or joint net worth with a spouse) that exceeds $1 million at the time of the purchase, excluding the value of a primary residence; or
  • An individual annual income of at least $200,000 for each of the two most recent years (or a joint annual income with a spouse of at least $300,000 for those years), and a reasonable expectation of the same level of income in the current year.

What are reasonable steps to verify that an investor is accredited?

What steps are reasonable will be an objective determination by the issuer (or those acting on its behalf), in the context of the particular facts and circumstances of each purchaser and transaction.  The SEC indicates that among the factors that issuers should consider under this facts and circumstances analysis are:

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

The final rule provides a non-exclusive list of methods that issuers may use to satisfy the verification requirement for purchasers who are natural persons, including:

  • For the income test, reviewing copies of any IRS form that reports the income of the purchaser for the two most recent years and obtaining a written representation that the purchaser will likely continue to earn the necessary income in the current year.
  • For the net worth test, reviewing one or more of the following types of documentation dated within the prior three months and obtaining a written representation from the purchaser that all liabilities necessary to make a determination of net worth have been disclosed:
    • With respect to assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments, and appraisal reports issued by independent third parties; and
    • With respect to liabilities: a consumer report from at least one of the nationwide consumer reporting agencies;
  • As an alternative to either of the above, an issuer may receive a written confirmation from a registered broker-dealer, SEC-registered investment adviser, licensed attorney, or certified public accountant that it has taken reasonable steps within the prior three months to verify the purchaser’s accredited status.

Simply relying on a representation from the purchaser, or merely checking a box on an accredited investor questionnaire, will not meet the requirement for objective verification. EB-5 Regional Centers should consider this carefully if they intend to make “accredited investor” determinations.

What actions must an issuer take to rely on the new exemption?

Issuers selling securities under Regulation D using general solicitation must file a Form D. The final rule amends the Form D to add a separate box for issuers to check if they are claiming the new Rule 506 exemption and engaging in general solicitation or general advertising. An issuer is currently required to file Form D within 15 days of the first sale of securities in an offering, but the SEC promulgated proposed rules to require an earlier filing.  See “Are there any other changes contemplated for Rule 506?” below.

Will the new rule affect other Rule 506 offerings that do not use general solicitation?

Not directly. The existing provisions of Rule 506 remain available as an exemption. This means that an issuer conducting a Rule 506 offering without using general solicitation or advertising is not required to perform the additional verification steps.

Who is excluded from using the Rule 506 exemption?

Under the new rule regarding “bad actors” required by the Dodd-Frank Act, an issuer cannot rely on a Rule 506 exemption (including the existing Rule 506 exemption) if the issuer or any other person covered by the rule has had a “disqualifying event.”  The persons covered by the rule are the issuer, including its predecessors and affiliated issuers, as well as:

  • Directors and certain officers, general partners, and managing members of the issuer;
  • 20% beneficial owners of the issuer;
  • Promoters;
  • Investment managers and principals of pooled investment funds; and
  • People compensated for soliciting investors as well as the general partners, directors, officers, and managing members of any compensated solicitor.

What is a “disqualifying event?”

A “disqualifying event” includes:

  • Felony and misdemeanor criminal convictions in connection with the purchase or sale of a security, making of a false filing with the SEC or arising out of the conduct of certain types of financial intermediaries. The criminal conviction must have occurred within 10 years of the proposed sale of securities (or five years in the case of the issuer and its predecessors and affiliated issuers).
  • Court injunctions or restraining orders in connection with the purchase or sale of a security, making of a false filing with the SEC, or arising out of the conduct of certain types of financial intermediaries. The injunction or restraining order must have occurred within five years of the proposed sale of securities.
  • Final orders from certain regulatory authorities that:
    • bar the issuer from associating with a regulated entity, engaging in the business of securities, insurance or banking, or engaging in savings association or credit union activities, or
    • are based on fraudulent, manipulative, or deceptive conduct and were issued within 10 years of the proposed sale of securities.
  • Certain SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment companies, and investment advisers and their associated persons.
  • SEC cease-and-desist orders related to violations of certain anti-fraud provisions and registration requirements of the federal securities laws.
  • Suspension or expulsion from membership in or association with a self-regulatory organization (such as FINRA, the membership organization for broker-dealers).
  • U.S. Postal Service false representation orders issued within five years before the proposed sale of securities.

What disqualifying events apply?

Only disqualifying events that occur after the effective date of the new rule will disqualify an issuer from relying on Rule 506. However, matters that existed before the effective date of the rule and would otherwise be disqualifying must be disclosed to investors.

Are there exceptions to the disqualification?

Yes. An exception from disqualification exists when the issuer can that show it did not know and, in the exercise of reasonable care, could not have known that a covered person with a disqualifying event participated in the offering.  The SEC can also grant a waiver of the disqualification upon a showing of good cause.

When do the new rules become effective?

Both rule amendments will become effective 60 days after publication in the Federal Register.  Publication normally occurs within two weeks after final rules are adopted.

Are there any other changes contemplated for Rule 506?

In connection with the foregoing final rules, the SEC separately published for comment a proposed rule change intended to enhance the SEC’s ability to assess developments in the private placement market based on the new rules regarding general solicitation. This proposal would require issuers to provide additional information to the SEC, including:

  • identification of the issuer’s website;
  • expanded information about the issuer;
  • information about the offered securities;
  • the types of investors in the offering;
  • the use of proceeds from the offering;
  • information on the types of general solicitation used; and
  • the methods used to verify the accredited investor status of investors.

Though this proposed rules is not specifically directed to EB-5 offerings, the SEC could use such information to enhance the monitoring it is already doing of EB-5 programs.

The proposed rule would also require issuers that intend to engage in general solicitation as part of a Rule 506 offering to file the Form D at least 15 calendar days before engaging in general solicitation for the offering. Then, within 30 days of completing the offering, the issuer would be required to update the information contained in the Form D and indicate that the offering had ended.

The proposed rule has a 60-day comment period.

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Investment Regulation Update – April 2013

GT Law

The Investment Regulation Update is a periodic publication providing key regulatory and compliance information relevant to broker-dealers, investment advisers, private funds, registered investment companies and their independent boards, commodity trading advisers, commodity pool operators, futures commission merchants, major swap participants, structured product sponsors and financial institutions.

This Update includes the following topics:

  • SEC Adopts Rules to Help Protect Investors from Identity Theft
  • Increased Attention to Broker-Dealer Registration in the Private Fund World
  • SEC Issues Guidance Update on Social Media Filings By Investment Companies
  • AIFMD — Effect on U.S. Fund Managers
  • SEC Announces 2013 Examination Priorities
  • Reminder — Upcoming Form PF Filing Deadline
  • Reminder — Upcoming Dodd-Frank Protocol Adherence Deadline
  • Are you a Lobbyist?
  • Recent Events

SEC Adopts Rules to Help Protect Investors from Identity Theft

On April 10, 2013, SEC Chairman Mary Jo White’s official first day on the job, the SEC, jointly with the CFTC, adopted rules and guidelines requiring broker-dealers, mutual funds, investment advisers and certain other regulated entities that meet the definition of “financial institution” or “creditor” under the Fair Credit Reporting Act (FCRA) to adopt and implement written identity theft prevention programs designed to detect, prevent and mitigate identify theft in connection with certain accounts. Rather than prescribing specific policies and procedures, the rules require entities to determine which red flags are relevant to their business and the covered accounts that they manage to allow the entities to respond and adapt to new forms of identity theft and the attendant risks as they arise. The rules also include guidelines to assist entities subject to the rules in the formulation and maintenance of the required programs, including guidelines on identifying and detecting red flags and methods for administering the program. The rules also establish special requirements for any credit and debit card issuers subject to the SEC or CFTC’s enforcement authority to assess the validity of notifications of changes of address under certain circumstances. Chairman White stated, “These rules are a common-sense response to the growing threat of identity theft to all Americans who invest, save or borrow money.” The final rules will become effective 30 days after date of publication in the Federal Register and the compliance date will be six months thereafter.

Increased Attention to Broker-Dealer Registration in the Private Fund World

The role of unregistered persons in the sale of interests in privately placed investment funds is an area of great interest for the SEC and the subject of recent enforcement actions. On March 8, 2013, the SEC filed and settled charges against a private fund manager, Ranieri Partners, LLC, one of the manager’s senior executives and an external marketing consultant regarding the consultant’s failure to register as a broker-dealer. The Ranieri Partners enforcement actions are especially interesting for two reasons: (i) there were no allegations of fraud and (ii) the private fund manager and former senior executive, in addition to the consultant, were charged.

On April 5, 2013, David Blass, the Chief Counsel to the SEC’s Division of Trading and Markets, addressed a subcommittee of the American Bar Association. His remarks have been posted on the SEC website. Mr. Blass referenced a speech by the former Director of the Division of Investment Management, who expressed concern that some participants in the private fund industry may be inappropriately claiming to rely on exemptions or interpretive guidance to avoid broker-dealer registration.

In addition, Mr. Blass noted Securities Exchange Act Rule 3a4-1’s safe harbor for certain associated persons of an issuer generally is not or cannot be used by private fund advisers. He suggested that private fund managers should consider how they raise capital and whether they are soliciting securities transactions, but he did acknowledge that a key factor in determining whether someone must register as a broker-dealer is the presence of transaction-based compensation. The Chief Counsel also raised the question of whether receiving transaction-based fees in connection with the sale of portfolio companies’ required broker-dealer registration. He suggested that private fund managers may receive fees additional to advisory fees that could require broker-dealer registration, e.g., fees for investment banking activity.

On a related note, in two recent “no-action” letters, the SEC has established fairly clear rules regarding how Internet funding network sponsors may operate without being required to register as broker-dealers. On March 26 and 28, 2013, the SEC’s Division of Trading and Markets addressed this narrow, fact-specific issue in response to requests from FundersClub Inc. and AngelList LLC seeking assurances that their online investment matchmaking activities would not result in enforcement action by the SEC. The April 10, 2013 GT Alert—SEC Clarifies Position on Unregistered Broker-Dealer Sponsors of Internet Funding Networks is availablehere.

SEC Issues Guidance Update on Social Media Filings by Investment Companies

On March 15, 2013, the SEC published guidance from the Division of Investment Management (IM Guidance) to clarify the obligations of mutual funds and other investment companies to seek review of materials posted on their social media sites. This report stems from the SEC’s awareness of many mutual funds and other investment companies unnecessarily including real-time electronic materials posted on their social media sites (interactive content) with their Financial Industry Regulatory Authority filings (FINRA). In determining whether a communication needs to be filed, the content, context, and presentation of the communication and the underlying substantive information transmitted to the social media user and consideration of any other facts and circumstances are all taken into account, such as whether the communication is merely a response to a request or inquiry from the social media user or is forwarding previously-filed content. The IM Guidance offers examples of interactive content that should or should not be filed with FINRA. The IM Guidance is the first in a series of updates to offer the SEC’s views on emerging legal issues and to provide transparency and enhance compliance with federal securities laws and regulations. You may find a link to the SEC Press Release and IM Guidance here.

On a related note, on April 2, 2013, the SEC released a report of an investigation regarding whether the use of social media to disclose nonpublic material information violates Regulation FD. The SEC has indicated that, in light of evolving communication technologies and habits, the use of social media to announce corporate developments may be acceptable; however, public companies must exercise caution and undertake careful preparation if they wish to disseminate information through non-traditional means. The April 5, 2013 GT Alert—Social Media May Satisfy Regulation FD But Not Without Risk and Preparation by Ira Rosner is available here.

AIFMD – Effect on U.S. Fund Managers

New European Union legislation that regulates alternative asset managers who manage or market funds within the EU comes into force on July 22, 2013. The Alternative Investment Fund Managers Directive (AIFMD) will have a significant impact on U.S. fund managers if they actively fundraise in Europe after July 21, 2013 (or if they manage EU-domiciled fund vehicles). Historically, U.S. private equity firms raising capital in Europe have relied on private placement regimes that essentially allowed marketing to institutions and high net worth investors. Beginning July 22, 2013, U.S. fund managers may continue to rely on private placement regimes in those EU jurisdictions that continue to operate them; however, they will now be under an obligation to meet certain reporting requirements and rules set out in the AIFMD relating to:

  • transparency and disclosure, and
  • rules in relation to the acquisition of EU portfolio companies.

The transparency and disclosure rules require, for the most part, the disclosure of information typically found in a PPM; however, additional items are likely to be required such as the disclosure of preferential terms to particular investors and level of professional indemnity cover. The rules also require reports to be made to the regulator in each jurisdiction in which the fund has been marketed. The reports will need to include audited financials, a description of the fund’s activities, details of remuneration and carried interest paid, and details of changes to material disclosures. Acquisitions of EU portfolio companies also lead to reporting obligations on purchase – an annual report – and a rule against “asset stripping” for 24 months after the acquisition of control. Firms with less than €500 million in assets under management are exempt from the reporting requirements and reverse solicitation is potentially an option, as the directive does not prevent an EU institution from contacting the U.S. fund manager, but in practice it may be difficult to apply systematically.  Fund managers may choose to register in the EU on a voluntary basis from late 2015. This will allow marketing across all EU member states on the basis of a single registration. However, registration will come with a significant compliance burden. If you plan to market in the EU after July 23, 2013, ensure that you review your marketing materials, evaluate your likely reporting obligations and consider how the portfolio company acquisition rules are likely to impact your transactions.

SEC Announces 2013 Examination Priorities

On February 21, 2013 the SEC’s National Examination Program (NEP) published its examination priorities for 2013. The examination priorities address issues market-wide, as well as issues relating to particular business models and organizations. Market-wide priorities include fraud detection and prevention, corporate governance and enterprise risk management, conflicts of interest, and technology controls.  Priorities in specific program areas include: (i) for investment advisers and investment companies, presence exams for newly registered private fund advisers, and payments by advisers and funds to entities that distribute mutual funds; (ii) for broker-dealers, sales practices and fraud, and compliance with the new market access rule; (iii)for market oversight, risk-based examinations of securities exchanges and FINRA, and order-type assessment; and (iv) for clearing and settlement, transfer agent exams, timely turnaround of items and transfers, accurate recordkeeping, and safeguarding of assets, and; (iv) for clearing agencies, designated as systemically important, conduct annual examinations as required by the Dodd-Frank Act. The priority list is not exhaustive. Importantly, priorities may be adjusted throughout the year and the NEP will conduct additional examinations focused on risks, issues, and policy matters that are not addressed by the release.

Reminder—Upcoming Form PF Filing Deadline

SEC registered investment advisers who manage at least $150 million in private fund assets with a December 31st fiscal year end should be well underway in preparing their submissions for the approaching April 30, 2013 deadline. Filings must be made through the Private Fund Reporting Depository (PFRD) filing system managed by the Financial Industry Regulatory Authority (FINRA). As a reminder, advisers to three types of funds must file on Form PF: hedge funds, liquidity funds and private equity funds. Hedge funds are generally defined as a private fund that has the ability to pay a performance fee to its adviser, borrow in excess of a certain amount or sell assets short. Liquidity funds are defined as a private fund seeking to generate income by investing in short-term securities while maintaining a stable net asset value for investors. Private equity funds are defined in the negative as not a hedge fund, liquidity fund, real estate fund, securitized asset fund or venture capital fund and does not generally provide investors with redemption rights. When classifying its funds, advisers should carefully read the fund’s offering documents and definitions on Form PF and should seek assistance of counsel. Particularly, we have seen the broad definition of hedge fund cause a fund considered a private equity fund by industry-standards to be a hedge fund for purposes of Form PF, thus subjecting the fund to more expansive reporting requirements. As is the case with filing Form ADV through IARD, the $150 Form PF filing fee is paid through the same IARD Daily Account and must be funded in advance of the filing. FINRA recently updated their PFRD System FAQs. The SEC has also posted new Form PF FAQs, which should be referred to for upcoming filings.

Reminder — Upcoming Dodd-Frank Protocol Adherence Deadline

All entities, including private funds, engaged in swap transactions must adhere to the ISDA Dodd-Frank Protocol no later than May 1, 2013 in order to engage in new swap transactions on or after May 1. Adherence to the Dodd-Frank Protocol will result in an entity’s ISDA swap documentation being amended to incorporate the business conduct rules that are applicable to swap dealers under Dodd-Frank.  Adherence to the Protocol involves filling out a questionnaire to ascertain an entity’s status under Dodd-Frank (e.g., pension plan, hedge fund and corporate end-user).  Further information on adherence to the Protocol can be obtained at ISDA’s website by clicking here.

Are you a lobbyist?

Over the last decade, many state and municipal governments have enacted new laws regarding how businesses may interact with government officials. These laws often establish new rules expanding the activities that are deemed to be “lobbying,” who is required to be registered as a lobbyist and what information must be publicly disclosed. Approximately half of the states, and countless municipalities, now define lobbying to include attempts to influence government decisions regarding procurement contracts – including contracts for investment advisors and placement agents – and impose steep penalties for companies that fail to register and disclose their “lobbying” activities and expenditures. Although some lobbying laws include exceptions for communications that occur as part of a competitive bidding process, the rules are inconsistent and not always clear. For example, although New York City’s lobbying law long included procurement lobbying, in 2010 the City’s Corporation Counsel and the City Clerk issued letters warning businesses that “activities by placement agents and other persons who attempt to influence determinations of the boards of trustees by the City’s . . . pension funds” are likely to be considered lobbying activity that requires registration and disclosure. Similarly, California’s lobbying law was expanded in 2011 to expressly include persons acting as “placement agents” in connection with investments made by California retirement systems, or otherwise seek to influence investment by local public retirement plans. Greenberg Traurig’s Investment Regulation Group, in conjunction with our Political Law Compliance team, is available to assist clients with questions regarding how to navigate increasingly complex lobby compliance laws and rules across the country and beyond. GT has a broad range of experience in advising to some of the world’s leading corporations, lobbying firms, public officials and others who seek to navigate lobbying and campaign finance laws.

Recent Events

On April 18, 2013, GT hosted the seminar, “The Far Reaching Impact of FATCA Across Borders and Across Industries” as both a webinar and live program in NY and Miami. The seminar explored the latest FATCA regulations and key intergovernmental agreements as well as their applications to a variety of industries. Click here to view the presentation.

On April 10, 2013, GT sponsored Artisan Business Group’s EB-5 Finance seminar at our NYC office. The program exposed participants to a unique alternative financing opportunity for projects that lend themselves to the EB-5 immigrant investor program and featured several GT speakers, including Steve Anapoell and Genna Garver, Co-Chair of the Investment Regulation Group, who provided a securities law update and considerations in the EB-5 area. Guest speakers included Jeff Carr from EPR, Phil Cohen from the EB-5 Resource Center, and Reid Thomas from NES Financial.

On April 2, 2013, GT co-hosted a Global Compliance seminar with Dun & Bradstreet on Foreign Corrupt Practices Act (FCPA) issues. The program included an overview of the FCPA, with a specific emphasis on the Department of Justice’s recently released Resource Guide to the FCPAand recent enforcement activities. A link to the Resource Guide can be found here.

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