Category: Investment

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.

Article By:

 of

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.

Article By:

SEC Staff Meets with IRS to Discuss Tax Implications of a Floating Net Asset Value (NAV)

GK_Logo_Full-Color (CMYK)

SEC staff recently met with staff members of the IRS to discuss the tax implications of adopting a floating net asset value (NAV) for money market funds. The discussion centered on the tax treatment of small gains and losses for investors in money market funds, and the IRS reportedly told the SEC there is limited flexibility in interpreting current tax law. A floating NAV could require individual and institutional investors to regard every money market fund transaction as a potentially taxable event.

Investors would have to determine how to match purchases and redemptions for purposes of calculating gains, losses and share cost basis. The SEC reached out to the IRS as it continues to consider measures, including a floating NAV, to enable money market funds to better withstand severe market disruptions.

For additional discussion of money market reform, please see “SEC Debates on Money Market Reforms Continue” in our January 2013 and October 2012 updates.

Sources: John D. Hawke, Jr., Economic Consequences of Proposals to Require Money Market Funds to ‘Float’ Their NAV, SEC Comment Letter File No. 4-619, November 2, 2012; Christopher Condon and Dave Michaels, SEC Said to Discuss Floating NAV for Money Funds with IRS, Bloomberg, March 7, 2013; Joe Morris, SEC Sounding Out IRS on Floating NAV, Ignites, March 7, 2013.

 of

U.S. Commodity Futures Trading Commission (CFTC) Grants No-Action Relief for End Users from Swap Reporting Requirements

SchiffHardin-logo_4c_LLP_www

On April 9, 2013, the Division of Market Oversight of the U.S. Commodity Futures Trading Commission (CFTC) issued a no-action letter delaying the swap reporting compliance deadlines for end users and other swap counterparties that are not swap dealers or major swap participants (non-SD/MSP counterparties).  The relief provided to market participants is effective immediately.

The CFTC had issued regulations setting forth various reporting requirements for swap transactions (Part 43 — real-time reporting for swap transactions, Part 45 — transactional data reporting to a registered swap data repository, and Part 46 — historical swap data reporting) of the CFTC’s regulations. The rules had established a deadline of April 10, 2013 for swap counterparties that are not swap dealers or major swap participants (non SD/MSP counterparties). Citing implementation concerns involving technological and operational capabilities, a number of market participants requested that the Division of Market Oversight provide a six-month extension of the compliance deadline.  The CFTC’s April 9 no-action  letter does not grant the full six-month extension requested, but provides certain time-limited no action relief to nonSD/MSP swap counterparties as described below.

1.          No-Action Relief for Reporting of Interest Rate and Credit Swaps

The letter extends no-action relief for end users’ interest and credit swaps reporting untilJuly 1, 2013.  However, non SD/MSP swap counterparties that are “financial entities,” as defined in Section 2(h)(7)(C), must comply with reporting requirements under Part 43 and 45 on April 10, 2013.

2.         No-Action Relief for Reporting of Equity, Foreign Exchange and other Commodity Swaps

The no-action relief for end users who engage in swaps in other asset classes (e.g., equity, foreign exchange, and other commodities) is extended until August 19, 2013.  For non-SD/MSP swap counterparties that are “financial entities,” as defined in Section 2(h)(7)(C), the no-action relief extends until May 29, 2013.

3.         No-Action Relief for Historical Swap Data Reporting Under Part 46

The letter also extends no-action relief to end users’ Part 46 historical swap data reporting for all swap asset classes until October 31, 2013.  For non SD/MSP swap counterparties that are “financial entities,” as defined in Section 2(h)(7)(C), the Part 46 no-action relief extends until September 30, 2013.  Any pre-enactment or transition swap entered into prior to 12:01 a.m. on April 10, 2013 is reportable as a historical swap.

4.         Compliance Date for Recordkeeping Obligations has not been Extended

The letter also confirms that the no-action relief provided for reporting requirements doesnot impact any Dodd-Frank-related recordkeeping obligations applicable to SDs, MSPs or end users.  Thus, for historical swaps, end users must maintain records under the Part 46 rules for any such swaps entered into prior to April 10, 2013.   With respect to swaps entered into on or after April 10, end users must maintain records under the Part 43 and 45 rules, and obtain a CFTC Interim Compliant Identifier for this purpose by April 10, 2013.

Article By:

of

Second Circuit Bars Criminal Defendant from Accessing Assets Frozen by Regulators

Katten Muchin

The US Court of Appeals for the Second Circuit recently upheld a district court’s refusal to release nearly $4 million in assets frozen by the Securities and Exchange Commission and the Commodity Futures Trading Commission to help a defendant fund his criminal defense.

Stephen Walsh, a defendant in a criminal fraud case, had requested the release of $3.7 million in assets stemming from the sale of a house that had been seized by regulators in a parallel civil enforcement action. In denying Walsh’s motion to access the frozen funds, the US District Court for the Southern District of New York found that the government had shown probable cause that the proceeds had been tainted by defendant’s fraud, and were therefore subject to forfeiture. Though Walsh and his wife had purchased the home in question using funds unrelated to the fraud, Walsh ultimately acquired title to the home pursuant to a divorce settlement in exchange for a $12.5 million distributive award paid to his wife, at least $6 million of which, according to the court, was traceable to the fraud.

Agreeing with the District Court, the Second Circuit found that although the house itself was not a fungible asset, it was “an asset purchased with” the tainted funds from the marital estate by operation of the divorce agreement and affirmed the denial of defendant’s request. Further, since Walsh’s assets did not exceed $6 million at the time of his arrest, under the Second Circuit’s “drugs-in, first-out” approach, all of his assets became traceable to the fraud.

U.S. v. Stephen Walsh, No. 12-2383-cr (2d Cir. Apr. 2, 2013).

 of

Private Equity Fund Is Not a “Trade or Business” Under ERISA

An article, Private Equity Fund Is Not a “Trade or Business” Under ERISA, written by Stanley F. Lechner of Morgan, Lewis & Bockius LLP was recently featured in The National Law Review:

Morgan Lewis logo

 

District court decision refutes 2007 Pension Benefit Guaranty Corporation opinion letter and could provide potential clarity to private equity firms and private equity funds in determining how to structure their investments.

In a significant ruling that directly refutes a controversial 2007 opinion by the Pension Benefit Guaranty Corporation (PBGC) Appeals Board, the U.S. District Court for the District of Massachusetts held in Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pension Fund that a private equity fund is not a “trade or business” under the Employee Retirement Income Security Act (ERISA) and therefore is not jointly and severally liable for millions of dollars in pension withdrawal liability incurred by a portfolio company in which the private equity fund had a substantial investment.[1] This ruling, if followed by other courts, will provide considerable clarity and relief to private equity funds that carefully structure their portfolios.

The Sun Capital Case

In Sun Capital, two private equity funds (Sun Fund III and Sun Fund IV) invested in a manufacturing company in 2006 through an affiliated subsidiary and obtained a 30% and 70% ownership interest, respectively, in the company. Two years after their investment, the company withdrew from a multiemployer pension plan in which it had participated and filed for protection under chapter 11 of the Bankruptcy Code. The pension fund assessed the company with withdrawal liability under section 4203 of ERISA in the amount of $4.5 million. In addition, the pension fund asserted that the two private equity funds were a joint venture or partnership under common control with the bankrupt company and thus were jointly and severally liable for the company’s withdrawal liability.

In response to the pension fund’s assessment, the private equity funds filed a lawsuit in federal district court in Massachusetts, seeking a declaratory judgment that, among other things, they were not an “employer” under section 4001(b)(1) of ERISA that could be liable for the bankrupt company’s pension withdrawal liability because they were neither (1) a “trade or business” nor (2) under “common control” with the bankrupt company.

Summary Judgment for the Private Equity Funds

After receiving cross-motions for summary judgment, the district court granted the private equity funds’ motion for summary judgment. In a lengthy and detailed written opinion, the court made three significant rulings.

First, the court held that the private equity funds were passive investors and not “trades or businesses” under common control with the bankrupt company and thus were not jointly and severally liable for the company’s withdrawal liability. In so holding, the court rejected a 2007 opinion letter of the PBGC Appeals Board, which had held that a private equity fund that owned a 96% interest in a company was a trade or business and was jointly and severally liable for unfunded employee benefit liabilities when the company’s single-employer pension plan terminated.

A fundamental difference between the legal reasoning of the court in the Sun Capital case compared to the reasoning of the PBGC in the 2007 opinion is the extent to which the actions of the private equity funds’ general partners were attributed to the private equity fund. In the PBGC opinion, the Appeals Board concluded that the private equity fund was not a “passive investor” because its agent, the fund’s general partner, was actively involved in the business activity of the company in which it invested and exercised control over the management of the company. In contrast, the court in Sun Capital stated that the PBGC Appeals Board “misunderstood the law of agency” and “incorrectly attributed the activity of the general partner to the investment fund.”[2]

Second, in responding to what the court described as a “creative” but unpersuasive argument by the pension fund, the court concluded that the private equity funds did not incur partnership liability due to the fact that they were both members in the affiliated Delaware limited liability company (LLC) that the funds created to serve as the fund’s investment vehicle in purchasing the manufacturing company. Applying Delaware state law, the court stated that the private equity funds, as members of an LLC, were not personally liable for the liabilities of the LLC. Therefore, the court concluded that, even if the LLC bore any responsibility for the bankrupt company’s withdrawal liability, the private equity funds were not jointly and severally liable for such liability.

Third, the court held that, even though each of the private equity funds limited its investment in the manufacturing company to less than 80% (i.e., 30% for Fund III and 70% for Fund IV) in part to “minimize their exposure to potential future withdrawal liability,” this did not subject the private equity funds to withdrawal liability under the “evade or avoid” provisions of section 4212(c) of ERISA.[3] Under section 4212(c) of ERISA, withdrawal liability could be incurred by an entity that engages in a transaction if “a principal purpose of [the] transaction is to evade or avoid liability” from a multiemployer pension plan. In so ruling, the court stated that the private equity funds had legitimate business reasons for limiting their investments to under 80% each and that it was not clear to the court that Congress intended the “evade or avoid” provisions of ERISA to apply to outside investors such as private equity funds.

Legal Context for the Court’s Ruling

Due to the distressed condition of many single-employer and multiemployer pension plans, the PBGC and many multiemployer pension plans are pursuing claims against solvent entities to satisfy unfunded benefit liabilities. For example, if a company files for bankruptcy and terminates its defined benefit pension plan, the PBGC generally will take over the plan and may file claims against the company’s corporate parents, affiliates, or investment funds that had a controlling interest in the company, or the PBGC will pursue claims against alleged alter egos, successor employers, or others for the unfunded benefit liabilities of the plan that the bankrupt company cannot satisfy.

Similarly, if a company contributes to a multiemployer pension plan and, for whatever reason, withdraws from the plan, the withdrawing company will be assessed “withdrawal liability” if the plan has unfunded vested benefits. In general, withdrawal liability consists of the employer’s pro rata share of any unfunded vested benefit liability of the multiemployer pension plan. If the withdrawing company is financially unable to pay the assessed withdrawal liability, the multiemployer plan may file claims against solvent entities pursuant to various legal theories, such as controlled group liability or successor liability, or may challenge transactions that have a principal purpose of “evading or avoiding” withdrawal liability.

Under ERISA, liability for unfunded or underfunded employee benefit plans is not limited to the employer that sponsors a single-employer plan and is not limited to the employer that contributes to a multiemployer pension plan. Instead, ERISA liability extends to all members of the employer’s “controlled group.” Members of an employer’s controlled group generally include those “trades or businesses” that are under “common control” with the employer. In parent-subsidiary controlled groups, for example, the parent company must own at least 80% of the subsidiary to be part of the controlled group. Under ERISA, being part of an employer’s controlled group is significant because all members of the controlled group are jointly and severally liable for the employee benefit liabilities that the company owes to an ERISA-covered plan.

Private Investment Funds as “Trades or Businesses”

Historically, private investment funds were not considered to be part of an employer’s controlled group because they were not considered to be a “trade or business.” Past rulings generally have supported the conclusion that a passive investment, such as through a private equity fund, is not a trade or business and therefore cannot be considered part of a controlled group.[4]

In 2007, however, the Appeals Board of the PBGC issued a contrary opinion, concluding a private equity fund that invested in a company that eventually failed was a “trade or business” and therefore was jointly and severally liable for the unfunded employee benefit liabilities of the company’s defined benefit pension plan, which was terminated by the PBGC. Although the 2007 PBGC opinion letter was disputed by many practitioners, it was endorsed by at least one court.[5]

The Palladium Capital Case

In Palladium Capital, a related group of companies participated in two multiemployer pension plans. The companies became insolvent, filed for bankruptcy, withdrew from the multiemployer pension plans, and were assessed more than $13 million in withdrawal liability. Unable to collect the withdrawal liability from the defunct companies, the pension plans initiated litigation against three private equity limited partnerships and a private equity firm that acted as an advisor to the limited partnerships. The three limited partnerships collectively owned more than 80% of the unrestricted shares of the defunct companies, although no single limited partnership owned more than 57%.

Based on the specific facts of the case, and relying in part on the PBGC’s 2007 opinion, the U.S. District Court for the Eastern District of Michigan denied the parties’ cross-motions for summary judgment. Among other things, the court stated that there were material facts in dispute over whether the three limited partnerships acted as a joint venture or partnership regarding their portfolio investments, whether the limited partnerships were passive investors or “investment plus” investors that actively and regularly exerted power and control over the financial and managerial activities of the portfolio companies, and whether the limited partnerships and their financial advisor were alter egos of the companies and jointly liable for the assessed withdrawal liability. Because there were genuine issues of material fact regarding each of these issues, the court denied each party’s motion for summary judgment.

Significance of the Sun Capital Decision

In concluding that a private equity fund is not a “trade or business,” the Sun Capital decision directly refutes the 2007 PBGC opinion letter and its reasoning. If the Sun Capital decision is followed by other courts, it will provide welcome clarity to private equity firms and private equity funds in determining how to structure their investments. Among other things, both private equity funds and defined benefit pension plans would benefit from knowing whether or under what circumstances a fund’s passive investment in a portfolio company can constitute a “trade or business” thus subjecting the private equity fund to potential controlled group liability. Similarly, both private equity firms and private equity funds need to know whether a court will attribute to the private equity fund the actions of a general partner or financial or management advisors in determining whether the investment fund is sufficiently and actively involved in the operations and management of a portfolio company to be considered a “trade or business.”

The Sun Capital decision was rendered, as noted above, against a backdrop in which the PBGC and underfunded pension plans are becoming more aggressive in pursuing new theories of liability against various solvent entities to collect substantial sums that are owed to the employee benefit plans by insolvent and bankrupt companies. Until the law becomes more developed and clear regarding the various theories of liability that are now being asserted against private equity funds investing in portfolio companies that are exposed to substantial employee benefits liability, it would be prudent for private equity firms and investment funds to do the following:

  • Structure carefully their operations and investment vehicles.
  • Be cautious in determining whether any particular fund should acquire a controlling interest in a portfolio company that faces substantial unfunded pension liability.
  • Ensure that the private equity fund is a passive investor and does not exercise “investment plus” power and influence over the operations and management of its portfolio companies.
  • Conduct thorough due diligence into the potential employee benefits liability of a portfolio company, including “hidden” liabilities, such as withdrawal liability, that generally do not appear on corporate balance sheets and financial statements.
  • Be aware of the risks in structuring a transaction in which an important objective is to elude withdrawal liability.

Similarly, until the law becomes more developed and clear, multiemployer pension plans may wish to devote particular attention to the nature and structure of both strategic and financial owners of the businesses that contribute to their plans and should weigh and balance the risks to which they are exposed by different ownership approaches.

[1]. Sun Capital Partners III, LP v. New England Teamsters & Trucking Indus. Pension Fund, No. 10-10921-DPW, 2012 WL 5197117 (D. Mass. Oct. 18, 2012), available here.

[2]. Sun Capital, slip op. at 17.

[3]. Id. at 29-30.

[4]. See e.g., Whipple v. Comm’r., 373 U.S. 193, 202 (1963).

[5]. See, e.g., Bd. of Trs., Sheet Metal Workers’ Nat’l Pension Fund v. Palladium Equity Partners, LLC (Palladium Capital), 722 F. Supp. 2d 854 (E.D. Mich. 2010).

Copyright © 2012 by Morgan, Lewis & Bockius LLP

Foundational Issues for Angel Investors

Michael Best Logo

The angel investment community in Wisconsin has been growing steadily for several years now, and given the limited availability of professional venture capital in the state this is good news. My purpose today is to offer some of the newer and prospective angel investors in our state some ideas they should think about in terms of what they want to get out of their angel investing activities, and some of the things they should consider in terms of accomplishing those goals. As in all of my blogs, the focus is on high impact angel entrepreneurship and investing.

Realistic Objectives. Most angels, while looking to make some money, also have other objectives, ranging from keeping busy to “giving back” to other entrepreneurs, to supporting regional economic development. That is all good, because with the odd exception that proves the rule, high impact angel investors generally don’t generate the kinds of returns that professional seed/early stage venture capital investors generate. Still, even if your core objective is not about financial returns, it is a big mistake to invest in any deal that does not pass the blush test as a financial investment. Take marginally more risk than a professional investor playing with other folks’ money might take, and pay a modest premium for the honor; but never invest in a deal, or on terms, that don’t make sense as an investment. If you do, you won’t be doing yourself, your community or the entrepreneur any favors. And you probably won’t have much fun, either.

It’s All About Deal Flow. Consistently successful angel investors share a critical trait with their consistently successful venture capital cousins: great deal flow. That is, they get the “pick of the crop” of available deals. So, as a new angel, how do you get access to the best deals?

Good angel deal flow is almost always a result of a solid value added investment proposition. That is, angels that bring something valuable to their portfolio companies beyond capital almost always have better deal flow than those who don’t. Maybe you have great connections with downstream investors. Or maybe you are a great management coach with deep industry knowledge and networks. Whatever. As a new angel investor, if you want to get quality deal flow – the sine qua non of successful angel investing – you must establish and deliver a value proposition for entrepreneurs over and above writing a check.

Find a Good Niche. Angel investing and investors come in a bewildering array of flavors. Some angels are lone wolves, while others run better in packs. Some have very specific industry preferences, while others may focus on investment/business stage. These choices should, of course, reflect the value add investment proposition of the particular angel. They should also reflect a variety of other factors. For example, rational angel investing, as rational venture capital investing, is based on diversifying investments across a portfolio of deals. Ten is the “rule of thumb” but you should consider five a minimum portfolio objective. Well, if you have $500k, and you want to make at least five investments, you either need to limit your per company investment to $100k (and that, typically, in multiple tranches) or you need to find a pack to join to leverage your personal capital pool. The size of the capital base also impacts whether you will look to be a leader in the angel round, or a follower – which in turn will impact how much say you will have (in the strict follower case, little or none) in setting the terms of the deal. If you find yourself in a pack, consider whether you want to be a committed fund – that is, a fund with pool of available capital committed – or a “pass the hat” operation, where each member of the pack makes their own investment decision. (All other things equal, entrepreneurs – here is that deal flow issue again – prefer committed capital funds, with or without side cars, to pass the hat funds.) Finally, consider what your time horizon is. If you want to see customer validation sooner rather than later, stay away from most early stage biotech deals, for example, even if they otherwise fit your criteria.

Learn the Rules Before You Break Them. Whatever your objectives are, do yourself, entrepreneurs, other angels and downstream investors a favor: don’t try to tell the repeat players already in the business how to go about the business. While there is always room for improvement (well, almost always) the “conventional rules” of angel investing in terms of deal terms are conventional for a reason: they more or less work, and they are more or less easy/cost-effective to implement (assuming both sides have experienced counsel). If as a newer angel you want to do something materially different from the industry norm with the terms of a deal, be ready to explain just what the problem with more traditional terms is in the specific instance – and why your tweaks won’t complicate raising downstream capital. If you are honest about this, you will most likely never propose terms that are materially different from the conventional wisdom.

A Final Thought. The “big four” risk factors in deal due diligence are team, market, technology and financing. A word to the wise: twenty-five years in and around the venture capital, high impact entrepreneurship, and angel investing world has taught me one lesson above all others: the most important factor in success is the team. If you are not good at, and serious about, team due diligence, find another angel who is, and don’t write a check without her.

© MICHAEL BEST & FRIEDRICH LLP

Recent Case Suggests How Private Equity Funds Can Protect Against Unfunded Pension Liabilities of Portfolio Companies

The National Law Review recently published an article, Recent Case Suggests How Private Equity Funds Can Protect Against Unfunded Pension Liabilities of Portfolio Companies, written by Joseph S. Adams, Laurence R. Bronska, Nancy S. Gerrie, Andrew C. Liazos, and Maureen O’Brien of McDermott Will & Emery:

McDermott Will & Emery

A significant objective for a private equity (PE) fund when making an investment is to avoid exposing itself to portfolio company liabilities.  Generally, corporate law would protect the purchaser of a controlling interest in an acquired corporation against portfolio company liabilities as long as the acquired company is operated independently of the purchaser.  However, special considerations apply under theEmployee Retirement Income Security Act (ERISA), the federal law that governs employee benefit plans.  ERISA makes all members of a controlled group liable on a joint and several basis for any pension-related liabilities of single employer and multi-employer pension plans.  The Pension Benefit Guaranty Corporation (PBGC), the federal agency responsible for overseeing these pension plans, has been aggressive in broadly interpreting what is a “controlled group” for this purpose and in pursuing PE funds for pension liabilities incurred by portfolio companies.  But a recent case out of the U.S. District Court for the District of Massachusetts signals that courts may not agree with the PBGC’s broad assessment of pension liability for PE funds.

In a recently decided case, Sun Capital Partners III L.P. v. New England Teamsters and Trucking Industry Pension Fund, D. Mass., No. 1:10-cv-10921-DPW, 10/18/12, the U.S. District Court for the District of Massachusetts became the first court to reject a multi-employer pension plan’s attempt to rely on PBGC precedent to assess a PE fund with a portfolio company’s unfunded pension liabilities.  While this likely is not the last word on this subject, the Sun Capital Partners case offers a roadmap for how a PE fund may take a position to avoid controlled group liability for single employer and multi-employer pension liability.

Background

Title IV of ERISA imposes joint and several liability with respect to a broad array of pension liabilities, including an employer’s minimum funding contributions to a single employer pension plan, unfunded pension liabilities upon plan termination, PBGC premium payments and withdrawal liability under a multi-employer pension plan.  Under ERISA, joint and several liability applies to any entity under common control with the employer sponsoring the pension plan.

  • The definition of “common control” is interpreted under federal tax rules that are applicable to tax-qualified plans under Section 414 of the Internal Revenue Code (the Code).
  • These Internal Revenue Service (IRS) regulations have long provided that entities are under common control if they are “trades or businesses” that share common ownership of 80 percent or more (by vote or value).
  • In the 1987 case of Commissioner v. Groetzinger, the Supreme Court of the United States established a test for when an activity constitutes a “trade or business” for these purposes.  Under Groetzinger, for a person to be engaged in a trade or business, the primary purpose of the activity must be income or profit, and the activity must be performed with continuity and regularity.

In 2007, the PBGC issued an opinion (PBGC Appeals Board opinion dated September 26, 2007) finding that a PE fund was engaged in a trade or business.  According to the PBGC, the PE fund subject to the opinion was engaged in a “trade or business” because it had a stated purpose of creating a profit; provided investment services; and had a general partner that received management fees, a carried interest and consulting fees (i.e., the PE funds did not receive just investment income as a passive investor similar to an individual investor).  The PBGC stated that this activity was regular and continuous because of the size of the PE fund and its profits.

The Sun Capital Decision

In the Sun Capital Partners case, the court determined that the one-time investment of capital by a PE fund into a portfolio company was a passive investment and did not result in the PE funds engaging in a trade or business.  The investment was structured such that the portfolio company was owned by two PE funds in a 70/30 split.  Each PE fund had a general partner, and each general partner had a management company that performed consulting and advisory services.  The PE funds, as shareholders, could appoint members of the board of directors of the portfolio company.

In its decision, the court determined that receipt of non-investment compensation in the form of consulting, management or advisory fees and carried interest by the management companies and the general partners could not be attributable to the PE funds.  The non-investment income was a result of a contractual relationship between the management companies, the general partners and the portfolio company.  The court found that the receipt of this non-investment income did not mean that the PE funds themselves were engaged in the full range of the general partners’ activities.  The PE funds themselves did not perform any consulting, advising or management services, and did not have employees, own any office space, or make or sell any goods.  In fact, on tax returns, the PE funds reported only capital gains and dividends, both sources of investment income.  Further, the court held that the ability of the PE funds to appoint the board of directors of the portfolio company did not mean that the funds were engaged in a trade or business, because such appointments were made in the PE funds’ capacity as shareholders of the portfolio company.  The court also noted that the fact that the same persons signed the management agreements representing both sides of the contract was not persuasive evidence of engaging in a trade or business, since officers of different entities can sign in different capacities.

The court in the Sun Capital Partners case expressly considered and declined to rely on the 2007 PBGC opinion.  Importantly, the court held that the 2007 PBGC opinion had misapplied the theory of agency and incorrectly imputed the management companies’ or general partners’ actions to the PE funds.  In addition, the court held that, as a matter of law, the PBGC had misapplied the Groetzinger test and other relevant tax law precedent.

Finally, the court determined that the structuring of the PE funds’ investment in the portfolio company (using multiple funds each owning less than 80 percent of the portfolio company) did not violate ERISA provisions allowing certain transactions to be undone if they were undertaken to evade or avoid ERISA liabilities.  Although the PE funds admitted that one of the reasons that the investment was structured to be two funds with a 70/30 split was in order to minimize pension liability risk, the court found that ERISA’s evade-or-avoid provisions did not apply in this context, because such provisions were meant to apply to sellers rather than first-time investors.  Indeed, as the court noted, if the investment was undone and the controlled group determined without regard to the investment as contemplated under ERISA, the PE funds would still not be liable.  Thus, application of the evade-or-avoid provisions did not make sense in this context.

Implications

Most importantly, this decision provides support for the widely held position that a PE fund is not engaged in trade or business and cannot be determined to be under common control with its portfolio companies under Code Section 414.  Under this interpretation, no PE fund could be held liable for withdrawal liability under a multi-employer pension plan, or unfunded benefits liabilities upon termination of a single employer plan (or minimum funding or contractually required ongoing contributions to such plans), because PE funds are not engaged in a trade or business.  Further, if the PE fund cannot be held liable, then the chain of ownership between portfolio companies held by the same private equity fund is also broken.  This decision also provides significant leverage to negotiate with the PBGC or a multi-employer pension fund should a PE fund be defending itself against the PBGC or multi-employer pension fund for pension liability claims.

In order to avail themselves of the benefits of this decision, PE funds should evaluate their operations and contractual relationships to determine if such operations and relationships are comparable to those outlined by the court in the Sun Capital Partners case.  In addition, PE funds may wish, when possible, to structure future investments across multiple funds with each fund owning less than 80 percent of the portfolio company in order to minimize risk of pension liability.

On November 2, 2012, the multi-employer pension fund appealed the decision in the Sun Capital Partners case to the U.S. Court of Appeals for the First Circuit.

© 2012 McDermott Will & Emery

Are You Waffling About Crowd Funding Internet Sites?

Last weekend, at the wedding of a law school classmate, I received a box of pre-packaged, gluten-free, vegan waffle mix as the wedding favor.  A little odd, I thought…until I learned that the product was developed and produced by the groom!  Quite intrigued, I set about learning from the other wedding guests how the groom funded and developed the product.  As it turns out, he obtained funding using Kickstarter.

I had already heard of Kickstarter through the Internet and media, but did not know much about how it actually worked.  Kickstarter is one of several Internet sites that allows for “crowd funding.”  On Kickstarter, there are “Project Creators” who seek to raise money to fund their projects, and “Project Backers” who pledge money to the Creators in support of their projects.

The concept of crowd funding is still relatively new, and the legal implications and regulations related to this activity are evolving.  The lawyer in me could not help but ask questions – questions that anyone interested in using Kickstarter or any similar crowd funding site should consider:

  • What are the tax consequences for a Creator that receives funding through this platform?
  • Is a Backer protected from Creator fraud or misrepresentations?
  • Is there any recourse for a Backer when a Creator does not follow-through with its project, despite reaching its funding goal?
  • What kind of copyright and trademark considerations should a Creator investigate before launching a project?

Although crowd funding Internet sites like Kickstarter open the door for average people to support or obtain funding for interesting projects, users should still investigate the terms of use, limits of liability, or other fine print from the sites themselves.  Further, users may wish to consult with attorneys and tax professionals about the potential risks and benefits of utilizing these sites to determine if it is the best choice for them.

As for me, until I come up with a creative project idea, I am just going to sit back and enjoy the waffles.

© Copyright 2012 Dickinson Wright PLLC

Derivatives Use by Public Companies – A Primer and Review of Key Issues

The Public Companies Group of Schiff Hardin LLP recently had an article regarding Derivatives published in The National Law Review:

Over the last several decades, the use of derivatives as a tool to mitigate and control risk has expanded significantly. Despite well-publicized abuses involving derivatives, the efficacy of derivatives as a means of managing economic and other forms of risk remains widely accepted. The evolving mix of users of derivatives in the last ten years has also impacted the derivatives landscape. Traditionally, commercial hedgers such as processors, mills and large corporations used derivatives to manage risks; today, while commercial hedgers remain active,much of the increase in volume in derivatives is attributable to non-traditional end-users, such as public companies, which have been active users of derivatives, most notably interest rate and foreign currency hedging instruments.

This article provides a brief primer on the various uses of derivatives, including the use of derivatives by public companies to manage risks. It also addresses a number of questions arising out of the Dodd-Frank Act, which provides a new level of regulation over derivatives.

1. What is a Derivative?

Put simply, a derivative is a contract whose value is based upon (or derived from) the value of something else. Virtually every derivative, from the most complex to the most mundane, falls within this definition. The “something else,” which is often referred to as the “underlying” or the “commodity,” can be a security (e.g., a share of company stock or a U.S. Treasury note), a commodity (e.g., gold, soybeans or cattle), an index (e.g., the S&P 500 index), a reference rate (e.g., LIBOR), or virtually anything else to which a value can be assigned and validated. As long as the value of the contract is based on or “derived” from the value of something else, the contract is a derivative.

2. Types of Derivatives

Conceptually, derivatives take many different forms. At the highest and broadest level, there are two types of derivatives: (1) exchange-traded derivatives, and (2) over-the-counter, or “OTC,” derivatives, which are not traded an exchange.

Exchange-traded derivatives include futures, options on futures, security futures and listed equity options. OTC derivatives are privately negotiated contracts conducted almost entirely between institutions on a principal-to-principal basis and designed to permit customers to adjust individual risk positions with greater precision. OTC derivatives include swaps, options, forwards and hybrids of these instruments.

3. Dodd-Frank Act

In July 2010, President Obama signed into law the Dodd-Frank Act. Title VII of the Dodd-Frank Act imposes a new regulatory regime on OTC derivativesand the market for those derivatives. The primary regulators are the Commodity Futures Trading Commission (“CFTC”) for “swaps” and the SEC for “security-based swaps.” Subject to certain exceptions, [1] the term “swap” is broadly defined to include most types of products now known as OTC derivatives, including interest rate, currency, credit default and energy swaps. “Security-based swap” is a much narrower category of transactions based on a single security or loan or a “narrow-based security index” (as defined under the Commodity Exchange Act or “CEA”).

The CFTC’s general directive from Congress under the Dodd-Frank Act is to cause as many swaps as possible to be cleared by central clearing entities in order to reduce “systemic risk” to the financial markets, and to have as many swaps as possible traded on CFTC-regulated exchanges, or on or through other CFTC-regulated entities, in order to increase transparency in the markets. The Dodd-Frank Act thus makes it unlawful for a person to enter into a swap without complying with the Commodity Exchange Act and the rules published by the CFTC.

Fortunately, most public company users of derivatives can make use of an exemption under the Dodd-Frank Act. Under Title VII, an “end user” generally means a company that is not a “financial entity” and that uses derivatives to hedge or mitigate commercial risk. The concept is intended to include industrial corporations and other non-financial enterprises that use swaps on interest rates, foreign currencies, energy, commodities and other derivatives, as appropriate to their businesses, to hedge their business risks. A so-called “end-user exemption” from the clearing and exchange trading requirements is generally available to counterparties that (1) are not financial entities, (2) are hedging their own commercial risks and (3) notify the CFTC or SEC, as applicable, how they generally meet their financial obligations associated with entering into uncleared swaps. A public company that relies on the exemption is also required to obtain the approval of its board of directors or other governing body.

4. Use of Derivatives by Public Companies

As end-users, public companies often use derivatives to manage various risks associated with running a large enterprise, including interest rate, foreign currency and commodity risk. According to a recent study, 29 of the 30 companies that comprise the Dow Jones Industrial Average (DJIA) use derivatives. Similarly, a study has found that two-thirds of companies with sales of more than $2 billion use OTC derivatives and more than half of all companies that have sales between $500 million and $2 billion are “very active” in derivatives markets.

Further, the International Swaps and Derivatives Association conducted a survey on the use of derivatives by Fortune Global 500 companies and found that 94% of these companies use derivatives to manage business and macroeconomic risks. According to the survey, the most widely used instruments were foreign exchange and interest rate derivatives. Many industries reported participation at rates greater than 90%, including financial companies (98%), basic materials companies (97%), technology companies (95%), and health care, industrial goods and utilities (92%).

Public companies typically use derivatives to manage interest rate risk and foreign currency risk and to minimize accounting earnings volatility and the present value of their tax liabilities. A company, for instance, may use derivatives to offset increases in the price of commodities it uses in manufacturing or its other operations. Further, large public companies borrow and lend substantial amounts in credit markets. In doing so, they are exposed to significant interest rate risk — they face substantial risk that the fair values or cash flows of interest sensitive assets or liabilities will change if interest rates increase or decrease. These companies also have significant international operations. As a result, they are also exposed to exchange rate risk — the risk that changes in foreign currency exchange rates will negatively impact the profitability of their international businesses. To reduce these risks, companies enter into interest rate and foreign currency swaps, forwards and futures as a hedge against potential exposures.

As a result of the Dodd-Frank Act’s regulation of derivatives, a number of questions arise that public companies must consider (and revisit often as the regulatory landscape changes):

  • What are the implications of having our swaps — which were previously unregulated — executed on a regulated exchange or facility and cleared through a regulated clearinghouse?
  • How do we assure compliance with Section 723(b) of the Dodd-Frank Act, which provides that a public company may not enter into non-cleared swaps unless an “appropriate committee of the issuer’s board or governing body has reviewed and approved its decision to enter into swaps that are subject to such exemptions” and other aspects of the end-user exemption? A similar requirement for “approval by an appropriate committee” is included for security-based swaps under the SEC’s jurisdiction.
  • Are we able to continue to effect bilateral, uncleared swap transactions in the same manner as we have historically done? What alternatives are there to hedge risk?
  • How will our relationship with our banks change as a result of these evolving regulatory requirements?
  • To what extent are our transactions in swaps subject to CFTC or SEC jurisdiction and oversight? How does that change over time as new regulations and rules are imposed and the regulatory regime evolves?
  • How do these rules impact our inter-affiliate transactions?
  • What type of derivatives risk management infrastructure and compliance monitoring protocol should we have in place?

5. Conclusion

In light of the Dodd-Frank Act and various rulemakings of the CFTC and SEC since its passage, the derivatives markets are undergoing an unprecedented regulatory and structural evolution that will present public company end-users of derivatives with both compliance and disclosure challenges, as well as new opportunities. Public companies should continually assess their use of derivatives and the potential implications under the Dodd-Frank Act as this regulatory regime continues to evolve.

1 Among the excepted categories are options on securities subject to the Securities Act of 1933 and the Securities Exchange Act of 1934, contracts for the sale of commodities for future delivery and certain physically settled forward contracts.

© 2012 Schiff Hardin LLP