Monthly Archives: April 2009

Hedge Fund Regulation Hearing May 7

Congress Looks to Regulate Hedge Funds

According to an article by Reuters, the U.S. House Financial Services Committee will be holding a hearing on hedge fund regulation.  The meeting is expected to be held on May 7.   The HouseFinancial Services Committee website has not yet announced the hearing.   We will keep up to date on this issue and will publish any updates below.

Related hedge fund law stories include:

Over 100 Hedge Fund Managers Apply For PPIP

The Treasury announced today that they received over 100 applications from fund managers who want to participate in the Public Private Investment Program (PPIP).  There have been a number of questions regarding the structure of investment vehicles under the PPIP.  In addition to the Treasury release from earlier today, I have included below some additional information on the PPIP that might be useful to hedge fund managers who are thinking of participating in this program in the future.

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Treasury Announces Receipt of Applications to Become Fund Managers under Public Private Investment Program

Washington, DC — The Treasury Department today announced the receipt of more than 100 unique applications from potential fund managers interested in participating in the Legacy Securities portion of the Public Private Investment Program (PPIP).  A variety of institutions applied, including traditional fixed income, real estate, and alternative asset managers.

Successful applicants must demonstrate a capacity to raise private capital and manage funds in a manner consistent with Treasury’s goal of protecting taxpayers.   Treasury will also evaluate the applicant’s depth of experience investing in eligible assets. Finally, the applicant must be headquartered in the United States.

Treasury expects to inform applicants of their preliminary qualification around May 15, 2009. Once a fund receives preliminary qualification, it can begin raising the expected minimum of $500 million in private capital that will serve as the investment that, pending further approval, will be matched with taxpayer funds.  As we have stated previously, Treasury anticipates opening the program to smaller fund managers in the future, which may result in a lower minimum private capital raising requirement.

Since announcing the program details on March 23, Treasury has encouraged small, veteran, minority and women owned private asset managers to partner with other private asset managers. On April 6, Treasury extended the deadline for fund manager applications to provide more time to facilitate these types of partnerships. We are pleased to see a number of creative partnership proposals among the applications we are currently evaluating.

Today’s announcement is the latest milestone in making operational the PPIP for legacy loans and securities, a key part of the Administration’s efforts to repair balance sheets throughout our financial system and ensure that credit is available to the households and businesses, large and small, that will help drive us toward recovery.

For further information on the PPIP, please visit:

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Public-Private Investment Program

Updated: April 6, 2009

To address the challenge of legacy assets, Treasury – in conjunction with the Federal Deposit Insurance Corporation and the Federal Reserve – has announced the Public-Private Investment Program as part of its efforts to repair balance sheets throughout our financial system and ensure that credit is available to the households and businesses, large and small, that will help drive us toward recovery.

Three Basic Principles: Using $75 to $100 billion in TARP capital and capital from private investors, the Public-Private Investment Program will generate $500 billion in purchasing power to buy legacy assets – with the potential to expand to $1 trillion over time. The Public-Private Investment Program will be designed around three basic principles:

  • Maximizing the Impact of Each Taxpayer Dollar: First, by using government financing in partnership with the FDIC and Federal Reserve and co-investment with private sector investors, substantial purchasing power will be created, making the most of taxpayer resources.
  • Shared Risk and Profits With Private Sector Participants: Second, the Public-Private Investment Program ensures that private sector participants invest alongside the taxpayer, with the private sector investors standing t o lose their entire investment in a downside scenario and the taxpayer sharing in profitable returns.
  • Private Sector Price Discovery: Third, to reduce the likelihood that the government will overpay for these assets, private sector investors competing with one another will establish the price of the loans and securities purchased under the program.

The Merits of This Approach: This approach is superior to the alternatives of either hoping for banks to gradually work these assets off their books or of the government purchasing the assets directly. Simply hoping for banks to work legacy assets off over time risks prolonging a financial crisis, as in the case of the Japanese experience. But if the government acts alone in directly purchasing legacy assets, taxpayers will take on all the risk of such purchases – along with the additional risk that taxpayers will overpay if government employees are setting the price for those assets.

Two Components for Two Types of Assets: The Public-Private Investment Program has two parts, addressing both the legacy loans and legacy securities clogging the balance sheets of financial firms:

  • Legacy Loans: The overhang of troubled legacy loans stuck on bank balance sheets has made it difficult for banks to access private markets for new capital and limited their ability to lend.
  • Legacy Securities: Secondary markets have become highly illiquid, and are trading at prices below where they would be in normally functioning markets. These securities are held by banks as well as insurance companies, pension funds, mutual funds, and funds held in individual retirement accounts.

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PPIP Whitepaper

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Legacy Securities Termsheet

Fund Structure

Treasury and a vehicle controlled by the applicable Fund Manager through which private investors will invest in a Fund (each, a “Private Vehicle”) will be the sole investors in a Fund. Additional detail with respect to Fund Structure can be found under “Fund Structure Detail” below.

Pre-Qualification of Fund Managers

Private asset managers wishing to participate in this program should submit the application found at http://www.financialstability.gov/ to Treasury as part of the selection process. Fund Managers will be pre-qualified based upon criteria that are anticipated to include:

  • Demonstrated capacity to raise at least $500 million of private capital.
  • Demonstrated experience investing in Eligible Assets, including through performance track records.A minimum of $10 billion (market value) of Eligible Assets under management.
  • Demonstrated operational capacity to manage the Funds in a manner consistent with Treasury’s stated Investment Objective while also protecting taxpayers.
  • Headquarters in the United States.

Other criteria are identified in the application. Treasury will consider suggestions from Fund Managers to raise equity capital from retail investors.

3 year lock up period

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Q&A on the Program

Legacy Securities FAQs

How are Legacy TALF and the Legacy Securities PPIP related?

Legacy TALF and the Legacy Securities PPIP are separate programs. Legacy TALF will be a Federal Reserve lending program with its own set of terms, conditions and eligibility requirements. Legacy TALF will be made widely available to investors (who meet Federal Reserve eligibility standards) regardless of whether or not they participate in the Legacy Securities PPIP. Pre-qualified Fund Managers in the Legacy Securities PPIP may choose to utilize leverage pursuant to the Legacy TALF program, when it becomes operational and subject to its terms and conditions. For the avoidance of doubt, a qualified investor utilizing Legacy TALF will do so on the same terms and conditions as a Legacy Securities PPIP investor utilizing Legacy TALF.

Will Treasury require pre-qualified Fund Managers to raise a minimum level of private capital?

Yes. In the initial group, pre-qualified Fund Managers will be expected to raise at least $500 million of private capital. However, as discussed above, Treasury currently anticipates opening the program to smaller Fund Managers in the future which may result in a lower minimum private capital raising requirement.

Will Treasury provide a public list of all pre-qualified Fund Managers?

Yes. Treasury expects to provide a public list including only the pre-qualified Fund Managers.

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Please contact us if you have a question on this issue or if you would like to start a hedge fund.  If you would like more information, please see our articles on starting a hedge fund.

Interpretive Release on Regulation D

There are occasionally times when questions arise as to the meaning of certain undefined terms within statutes or regulations.  Practitioners have a variety of different resources which can help shed light onto these undefined terms or at least provide background information or context.  Below is the SEC’s Interpretive Release on the Regulation D rules.  Please note that some of the items in this release may be superceeded by other SEC pronouncements or other lawmaking activities.

Other related hedge fund law articles include:

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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 231
[Release No. 6455]
Interpretive Release On Regulation D
AGENCY: Securities and Exchange Commission.
ACTION: Publication of Staff Interpretations.

SUMMARY: The Commission has authorized the issuance of this release setting forth the views of its Division of Corporation Finance on various interpretive questions regarding the rules contained in Regulation D under the Securities Act of 1933. These views are being published to answer frequently raised questions with respect to the regulation.

FOR FURTHER INFORMATION CONTACT: David B. H. Martin, Jr., Office of Chief Counsel, Division of Corporation Finance, Securities and Exchange Commission, Washington, D.C. 20549, (202) 272-2573.

SUPPLEMENTARY INFORMATION: In Release No. 33-6389 (March 8, 1982) (47 FR 11251), the Commission adopted Regulation D (17 CFR 230.501-.506) which provides three exemptions from the registration requirements of the Securities Act of 1933 (the “Securities Act” or the “Act”) (15 U.S.C. 77a-77bbbb (1976 & Supp. IV 1980), as amended by the Bus Regulatory Reform Act of 1982, Pub. L. No. 97-261 §19(d), 96 Stat. 1121 (1982)).1 Regulation D became effective on April 15, 1982.

In the course of administering the regulation, the staff of the Division of Corporation Finance has answered numerous oral and written requests for interpretation of the new provisions. This release is intended to assist those persons who wish to make offerings in reliance on the exemptions in Regulation D by presenting the staff’s views on frequently raised questions. As indicated in Preliminary Note 3 to the regulation, Regulation D is intended to be a basic element in a uniform system of federal-state exemptions. As such, aspects of Regulation D have been incorporated in many state statutes and regulations. The interpretations set forth in this release relate only to the federal provisions.

Regulation D is composed of six rules, Rules 501-506. The first three rules set forth general terms and conditions that apply in whole or in part to the exemptions. The questions arising under Rules 50.1-503 fall into four general categories: definitions, disclosure requirements, operational conditions, and notice of sale requirements. The exemptions of Regulation D are set forth in Rules 504-506. Questions concerning those rules usually raise issues pertaining to more than one exemption. This release, an outline of which follows, is organized so as to reflect this pattern of inquiries.

I. Definitions — Rule 501

A. Accredited Investor — Rule 501(a) (Questions 1 – 30)

1. General

2. Certain Institutional Investors — Rules 501(a)(1) – (3)

3. Insiders — Rule 501(a)(4)

4. $150,000 Purchasers — Rule 501(a)(5)

a. $150,000 Purchase

b. 20 Percent of Net Worth Limitation

5. Natural Persons — Rules 501(a)(6) – (7)

6. Entities Owned By Accredited Investors — Rule 501(a)(8)

7. Trusts as Accredited Investors

B. Aggregate Offering Price — Rule 501(c) (Questions 31 – 36)

C. Executive Officer — Rule 501(f) (Question 37)

D. Purchaser Representative — Rule 501(h) (Questions 38 – 39)

II. Disclosure Requirements — Rule 502(b)

A. When Required (Questions 40 – 41)

B. What Required (Questions 42 – 51)

1. Non-reporting Issuers — Rule 502(b)(2)(i)

2. Reporting Issuers — Rule 502(b)(2)(ii)

C. General (Question 52)

III. Operational Conditions

A. Integration — Rule 502(a) (Question 53)

B. Calculation of Number of Purchasers — Rule 501(e) (Questions 54 – 59)

C. Manner of Offering — Rule 502(c) (Question 60)

D. Limitations on Resale — Rule 502(d) (Question 61)

IV. Exemptions

A. Rule 504 (Questions 62 – 65)

B. Rule 505 (Question 66)

C. Questions Relating to Rules 504 and 505 (Questions 67 – 71)

D. Rule 506 (Questions 72 – 73)

E. Questions Relating to Rules 504-506 (Questions 74 – 80)

V. Notice of Sale — Form D (Questions 81 – 92)

SEC DOCKET(1973-Current)
SEC-RELEASE Interpretive Release on Regulation D Release No. 33-6455

27 SEC-DOCKET 347-01

March 3, 1983

I. Definitions–Rule 501

A. Accredited Investor–Rule 501(a)

Defined in Rule 501(a), the term “accredited investor” is significant to the operation of Regulation D. 2 Under Rule 501(e), for instance, accredited investors are not included in computing the number of purchasers in offerings conducted in reliance on Rules 505 and 506. Also, if accredited investors are the only purchasers in offerings under Rules 505 and 506, Regulation D does not require delivery of specific disclosure as a condition of the exemptions. Finally, in an offering under Rule 506, the issuer’s obligation to ensure the sophistication of purchasers applies to investors that are not accredited. See Rule 506(b)(2)(ii).

The definition sets forth eight categories of investor that may be accredited. The following questions and answers cover certain issues under various of those categories. Given the frequency of questions regarding the application of the definition to trusts, however, there is a separate section addressing that area.

1. General

The definition of “accredited investor” includes any person who comes within or “who the issuer reasonably believes” comes within one of the enumerated categories “at the time of the sale of the securities to that person.” What constitutes “reasonable” belief will depend on the facts of each particular case. For this reason, the staff generally will not be in a position to express views or otherwise endorse any one method for ascertaining whether an investor is accredited.

(1) Question: A director of a corporate issuer purchases securities offered under Rule 505. Two weeks after the purchase, and prior to completion of the offering, the director resigns due to a sudden illness. Is the former director an accredited investor?

Answer: Yes. The preliminary language to Rule 501(a) provides that an investor is accredited if he falls into one of the enumerated categories “at the time of the sale of securities to that person.” One such category includes directors of the issuer. See Rule 501(a)(4). The investor in this case had that status at the time of the sale to him. 3

2. Certain Institutional Investors–Rules 501(a)(1)-(3)

(2) Question: A national bank purchases $100,000 of securities from a Regulation D issuer and distributes the securities equally among ten trust accounts for which it acts as trustee. Is the bank an accredited investor?

Answer: Yes. Rule 501(a)(1) accredits a bank acting in a fiduciary capacity. 4

(3) Question: An ERISA employee benefit plan will purchase $200,000 of the securities being offered. The plan has less than $5,000,000 in total assets and its investment decisions are made by a plan trustee who is not a bank, insurance company, or registered investment adviser. Does the plan qualify as an accredited investor?

Answer: Not under Rule 501(a)(1), Rule 501(a)(1) accredits an ERISA plan that has a plan fiduciary which is a bank, insurance company, or registered investment adviser or that has total assets in excess of $5,000,000. The plan, however, may be an accredited investor under Rule 501(a)(5), which accredits certain persons who purchase at least $150,000 of the securities being offered.

(4) Question: A state run, not-for-profit hospital has total assets in excess of $5,000,000. Because it is a state agency, the hospital is exempt from federal income taxation. Rule 501(a)(3) accredits any organization described in section 501(c)(3) of the Internal Revenue Code that has total assets in excess of $5,000,000. Is the hospital accredited under Rule 501(a)(3)?

Answer: Yes. This category does not require that the investor have received a ruling on tax status under section 501(c)(3) of the Internal Revenue Code. Rather, Rule 501(a)(3) accredits an investor that falls within the substantive description in that section. 5

(5) Question: A not-for-profit, tax exempt hospital with total assets of $3,000,000 is purchasing $100,000 of securities in a Regulation D offering. The hospital controls a subsidiary with total assets of $3,000,000. Under generally accepted accounting principles, the hospital may combine its financial statements with that of its subsidiary. Is the hospital accredited?

Answer: Yes, under Rule 501(a)(3). Where the financial statements of the subsidiary may be combined with those of the investor, the assets of the subsidiary may be added to those of the investor in computing total assets for purposes of Rule 501(a)(3). 6

3. Insiders–Rule 501(a)(4)

(6) Question: The executive officer of a parent of the corporate general partner of the issuer is investing in the Regulation D offering. Is that individual an accredited investor?

Answer: Rule 501(a)(4) accredits only the directors and executive officers of the general partner itself. Unless the executive officer of the parent can be deemed an executive officer of the Subsidiary, 7 that individual is not an accredited investor.

4. $150,000 Purchasers–Rule 501(a)(5)

This provision accredits any person 8 who satisfies two separate tests. To be accredited under Rule 501(a)(5), an investor must purchase at least $150,000 of the securities being offered, by one or a combination of four specific methods: cash, marketable securities, an unconditional obligation to pay cash or marketable securities over not more than five years, and cancellation of indebtedness. The rule also requires that “the total purchase price” may not exceed 20 percent of the purchaser’s net worth. The two tests under Rule 501(a)(5) must be considered separately. Thus, for instance, in computing the “total purchase price” for the 20 percent of net worth limitation, the investor may have to include amounts that could not be included towards the $150,000 purchase test.

a. $150,000 Purchase

(7) Question: Two issuers, a general partner and its limited partnership, are selling their securities simultaneously as units consisting of common stock and limited partnership interests. The issues are part of a plan of financing made for the same general purpose. If an investor purchases $150,000 of these units, would it satisfy the $150,000 purchase element of Rule 501(a)(5)?

Answer: Yes. The issuers are affiliated and the simultaneous sale of their separate securities as units for a single plan of financing would be deemed one integrated offering. Rule 501(a)(5) applies to a purchase “of the securities being offered.” The rule thus applies not to the securities of a particular issuer, but to the securities of a particular offering. 9

(8) Question: An investor will purchase securities in cash installments. Each installment payment will include amounts due on the principal as well as interest. If the total of all payments is $150,000, will the investor have purchased “at least $150,000 of the securities being offered” for purposes of Rule 501(a)(5)?

Answer: No. Under Rule 501(a)(5), any amount constituting interest due on the unpaid purchase price is not payment for the “securities being offered.”

(9) Question: The installment payments for interest in a limited partnership that will develop commercial real estate will be conditioned upon completion of certain phases of the project. Will the obligation to make those payments be deemed “an unconditional obligation to pay” for purposes of Rule 501(a)(5)?

Answer: Yes, as long as the only conditions relate to completion of successive stages of the development project.

(10) Question: An investor will purchase securities in a Regulation D offering by delivering $75,000 in cash and a letter of credit for $75,000. Will such a purchase satisfy the $150,000 element of Rule 501(a)(5)?

Answer: No. Because there is no assurance that the letter of credit will ever be drawn against, the staff does not deem it to be an unconditional obligation to pay.

(11) Question: In connection with the sale of limited partnership interests in an oil and gas drilling program, an investor in a Regulation D offering commits to pay subsequent assessments that are mandatory, non-contingent, and for which the investor will be personally liable. Will the commitment to pay the assessments constitute an “unconditional obligation to pay” under Rule 501(a)(5)?

Answer: Yes. The assessments are essentially installment payments for which the investor makes the investment decision at the time the limited partnership interest originally is purchased. 10

(12) Question: If the assessments in Question 11 are voluntary, contingent and non-recourse, can they be included in determining whether or not the investor has purchased $150,000 of the securities being offered?

Answer: No. voluntary assessments of this nature are not deemed to constitute an unconditional obligation to pay. 11

(13) Question: A purchaser of interests in a limited partnership makes a partial down payment and commits unconditionally to pay the balance over five years. Formation of the partnership is conditioned upon the sale of a specified number of interests. Under Rule 501(a)(5), when must the five year period for installment payments being to run?

Answer: Rule 501(a)(5) provides that the unconditional obligation is to be discharged “within five years of the sale of the securities to the purchaser.” For ease in the administration of an offering that is conditioned on a certain minimum level of sales, the staff believes it is reasonable to compute the length of installment obligations from the same date for the investors involved in reaching that minimum. Therefore, without any bearing on when the sale of the security actually occurs, the five-year time period of the investor’s obligation may be measured from the date such minimum level of sales has been reached. 12

b. 20 Percent of Net Worth Limitation

(14) Question: Where an investor makes installment payments composed of principal and interest, must the interest payments be included in computing the “total purchase price” for purposes of meeting the 20 percent of net worth limitation?

Answer: No. The interest is not part of the total purchase price but rather is an expense associated with financing the total purchase price.

(15) Question: A corporate investor will purchase $200,000 of the securities being offered for cash. Additionally, the investor will deliver an irrevocable letter of credit for $50,000 which the issuer will use as collateral in connection with a line of credit it will establish with a lending institution. Must the issuer include the $50,000 letter of credit when determining whether or not the purchaser’s total purchase price exceeds 20 percent of its net worth under Rule 501(a)(5)?

Answer: Yes. Since the investor has committed to pay the $50,000 at the election of the issuer, that amount must be included with other forms of consideration in order to measure what percentage of the investor’s net worth has been committed in the investment. 13

(16) Question: As part of the purchase of an interest in a sale and lease-back program, the purchaser will deliver “non-recourse” debt where the source of payment for the debt is limited exclusively to the income generated by the security being purchased or the assets of the entity in which the security is being purchased. Must the non-recourse debt be included in the total purchase price for purposes of the 20 percent of net worth limitation under Rule 501(a)(5)?

Answer: No. Because the investor has no personal liability for the non-recourse debt, and because no part of the investor’s assets at the time of purchase is available as a source of payment for the debt, the debt should not be included as part of the purchase price. 14

(17) Question: Where the purchaser is a natural person, Rule 501(a)(5) provides that the total purchase price may be measured against the purchaser’s net worth combined with that of a spouse. Would property held solely by one spouse be available for calculating the net worth of the other spouse who is making the $150,000 investment?

Answer: Yes.

(18) Question: An investment general partnership is purchasing securities in a Regulation D offering. The partnership was not formed for the specific purpose of acquiring the securities being offered. May the issuer consider the aggregate net worth of the general partners in calculating the net worth of the partnership?

Answer: Yes. An investment general partnership is functionally a vehicle in which profits and losses are passed through to general partners and in which the net worths of the general partners are exposed to the risk of partnership investments. 15

(19) Question: A totally held subsidiary 16 makes a cash investment of $200,000 in a Regulation D offering. May that subsidiary use the consolidated net worth of its parent in determining whether or not its total purchase price exceeds 20 percent of its net worth?

Answer: Yes. 17

5. Natural Persons–Rules 501(a)(6)-(7)

Rules 501(a)(6) and (7) apply only to natural persons. Paragraph (6) accredits any natural person with a net worth at the time of purchase in excess of $1,000,000. If the investor is married, the rule permits the use of joint net worth of the couple. Paragraph (7) accredits any natural person whose income has exceeded $200,000 in each of the two most recent years and is reasonably expected to exceed $200,000 in the year of the investment.

(20) Question: A corporation with a net worth of $2,000,000 purchases securities in a Regulation D offering. Is the corporation an accredited investor under Rule 501(a)(6)?

Answer: No. Rule 501(a)(6) is limited to “natural” persons.

(21) Question: In calculating net worth for purposes of Rule 501(a)(6), may the investor include the estimated fair market value of his principal residence as an asset?

Answer: Yes. Rule 501(a)(6) does not exclude any of the purchaser’s assets from the net worth needed to qualify as an accredited investor.

(22) Question: May a purchaser take into account income of a spouse in determining possible accreditation under Rule 501(a)(7)?

Answer: No. Rule 501(a)(7) requires “individual income” over $200,000 in order to qualify as an accredited investor.

(23) Question: May a purchaser include unrealized capital appreciation in calculating income for purposes of Rule 501(a)(7)?

Answer: Generally, no.

6. Entities Owned By Accredited Investors–Rule 501(a)(8)

Any entity in which each equity owner is an accredited investor under any of the qualifying categories, except that of the $150,000 purchaser, is accredited under Rule 501(a)(8).

(24) Question: All but one of the shareholders of a corporation are accredited investors by virtue of net worth or income. The unaccredited shareholder is a director who bought one share of stock in order to comply with a requirement that all directors be shareholders of the corporation. Is the corporation an accredited investor under Rule 501(a)(8)?

Answer: No. Rule 501(a)(8) requires “all of the equity owners” to be accredited investors. The director is an equity owner and is not accredited. Note that the director cannot be accredited under Rule 501(a)(4). That provision extends accreditation to a director of the issuer, not of the investor.

(25) Question: Who are the equity owners of a limited partnership?

Answer: The limited partners.

7. Trusts as Accredited Investors

(26) Question: May a trust qualify as an accredited investor under Rule 501(a)(1)?

Answer: Only indirectly. Although a trust standing alone cannot be accredited under Rule 501(a)(1), if a bank is its trustee and makes the investment on behalf of the trust, the trust will in effect be accredited by virtue of the provision in Rule 501(a)(1) that accredits a bank acting in a fiduciary capacity.

(27) Question: May a trust qualify as an accredited investor under Rule 501(a)(5)?

Answer: Yes. The Division interprets “person” in Rule 501(a)(5) to include any trust. 18

(28) Question: In qualifying a trust as an accredited investor under Rule 501(a)(5), whose net worth should be considered in determining whether the total purchase price meets the 20 percent of net worth limitation test?

Answer: The net worth of the trust.

(29) Question: A trustee of a trust has a net worth of $1,500,000. Is the trustee’s purchase of securities for the trust that of an accredited investor under Rule 501(a)(6)?

Answer: No. Except where a bank is a trustee, the trust is deemed the purchaser, not the trustee. The trust is not a “natural” person.

(30) Question: May a trust be accredited under Rule 501(a)(8) if all of its beneficiaries are accredited investors?

Answer: Generally, no. Rule 501(a)(8) accredits any entity if all of its “equity owners” are accredited investors. The staff does not interpret this provision to apply to the beneficiaries of a conventional trust. The result may be different, however, in the case of certain non-conventional trusts where, as a result of powers retained by the grantors, a trust as a legal entity would be deemed not to exist. 19 Thus, where the grantors of a revocable trust are accredited investors under Rule 501(a)(6) (i.e. net worth exceeds $1,000,000) and the trust may be amended or revoked at any time by the grantors, the trust is accredited because the grantors will be deemed the equity owners of the trust’s assets. 20 Similarly, where the purchase of Regulation D securities is made by an Individual Retirement Account and the participant is an accredited investor, the account would be accredited under Rule 501(a)(8).

B. Aggregate Offering Price–Rule 501(c)

The “aggregate offering price,” defined in Rule 501(c), is the sum of all proceeds received by the issuer for issuance of its securities. The term is important to the operation of Rules 504 and 505, both of which impose a limitation on the aggregate offering price as a specific condition to the availability of the exemption. 21

(31) Question: The sole general partner of a real estate limited partnership contributes property to the program. Must that property be valued and included in the overall proceeds of the offering as part of the aggregate offering price?

Answer: No, assuming the property is contributed in exchange for a general partnership interest.

(32) Question: An owner of a mining or oil and gas property is selling interests in the property to investors for cash. The owner will retain a royalty interest in the property. Must any subsequent royalty payments be included in the aggregate offering price of the property interests?

Answer: No. Royalty payments to the seller of the property are treated as operating expenses, rather than capitalized costs for the property. As such, the royalty payments are not part of the consideration received by the issuer for issuance of the securities.

(33) Question: Where the investors pay for their securities in installments and these payments include an interest component, must the issuer include interest payments in the “aggregate offering price?”

Answer: No. The interest payments are not deemed to be consideration for the issuance of the securities. 22

(34) Question: An offering of interests in an oil and gas limited partnership provides for additional voluntary assessments. These assessments, undetermined at the time of the offering, may be called at the general partner’s discretion for developmental drilling activities. Must the assessments be included in the aggregate offering price, and if so, in what amount?

Answer: Because it is, unclear that the assessments will ever be called, and because if they are called, it is unclear at what level, the issuer is not required to include the assessments in the aggregate offering price. In fact, the assessments will be consideration received for the issuance of additional securities in the limited partnership. This issuance will need to be considered along with the original issuance for possible integration, or, if not integrated, must find its own exemption from registration.

(35) Question: In purchasing interests in an oil and gas partnership, investors agree to pay mandatory assessments. The assessments, essentially installment payments, are non-contingent and investors will be personally liable for their payment. Must the issuer include the assessments in the aggregate offering price?

Answer: Yes. 23

(36) Question: As part of their purchase of securities, investors deliver irrevocable letters of credit. Must the letters of credit be included in the aggregate offering price?

Answer: If these letters of credit were drawn against, the amounts involved would be considered part of the aggregate offering price. For this reason, in planning the transaction, the issuer should consider the full amount of the letters of credit in calculating the aggregate offering price.

C. Executive Officer–Rule 501(f)

The definition of executive officer in Rule 501(f) is the same as that in Rule 405 of Regulation C (17 CFR 230.405).

(37) Question: The executive officer of the parent of the Regulation D issuer performs a policy making function for its subsidiary. May that individual be deemed an “executive officer” of the subsidiary?

Answer: Yes.

D. Purchaser Representative–Rule 501(h)

A purchaser representative is any person who satisfies, or who the issuer reasonably believes satisfies, four conditions enumerated in Rule 501(h). Beyond the obligations imposed by that rule, any person acting as a purchaser representative must consider whether or not he is required to register as a broker-dealer under section 15 of the Securities Exchange Act of 1934 (the “Exchange Act”) (15 U.S.C. 78a-78kk (1976 & Supp. IV 1980)) or as an investment adviser under section 203 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-1-80b-21 (1976 & Supp. IV 1980)). 24

(38) Question: May the officer of a corporate general partner of the issuer qualify as a purchaser representative under Rule 501(h)?

Answer: Rule 501(h) provides that “an affiliate, director, officer or other employee of the issuer” may not be a purchaser representative unless the purchaser has one of three enumerated relationships with the representative. The staff is of the view that an officer or director of a corporate general partner comes within the scope of “affiliate, director, officer or other employee of the issuer.”

(39) Question: May the issuer in a Regulation D offering pay the fees of the purchaser representative?

Answer: Yes. Nothing in Regulation D prohibits the payment by the issuer of the purchaser representative’s fees. Rule 501(h)(4), however, requires disclosure of this fact. 25

II. Disclosure Requirements–Rule 502(b)

A. When Required

Rule 502(b)(1) sets forth the circumstances when disclosure of the kind specified in the regulation must be delivered to investors. The regulation requires the delivery of certain information “during the course of the offering and prior to sale” if the offering is conducted in reliance on Rule 505 or 506 and if there are unaccredited investors. If the offering is conducted in compliance with Rule 504 or if securities are sold only to accredited investors, Regulation D does not specify the information that must be disclosed to investors. 26

(40) Question: An issuer furnishes potential investors a short form offering memorandum in anticipation of actual selling activities and the delivery of an expanded disclosure document. Does Regulation D permit the delivery of disclosure in two installments?

Answer: So long as all the information is delivered prior to sale, the use of a fair and adequate summary followed by a complete disclosure document is not prohibited under Regulation D. Disclosure in such a manner, however, should not obscure material information.

(41) Question: An issuer commences an offering in reliance on Rule 505 in which the issuer intends to make sales only to accredited investors. The issuer delivers those investors an abbreviated disclosure document. Before the completion of the offering, the issuer changes its intentions and proposes to make sales to non-accredited investors. Would the requirement that the issuer deliver the specified information to all purchasers prior to sale if any sales are made to non-accredited investors preclude application of Rule 505 to the earlier sales to the accredited investors?

Answer: No. If the issuer delivers a complete disclosure document to the accredited investors and agrees to return their funds promptly unless they should elect to remain in the program, the issuer would not be precluded from relying on Rule 505.

B. What Required

Regulation D divides disclosure into two categories: that to be furnished by non-reporting companies and that required for reporting companies. In either case, the specified disclosure is required to the extent material to an understanding of the issuer, its business and the securities being offered.

1. Non-Reporting Issuers–Rule 502(b)(2)(i)

If the issuer is not subject to the reporting requirements of section 13 or 15(d) of the Exchange Act, 27 it must furnish the specified information “to the extent material to an understanding of the issuer, its business and the securities being offered.” For offerings up to $5,000,000, the issuer should furnish the “same kind of information” as would be contained in Part I of Form S-18, 28 except that only the most recent year’s financial statements need be certified. For offerings over $5,000,000, the issuer should furnish “the same kind of information” as would be required in Part I of an available registration statement. 29

(42) Question: When an issuer is required to deliver specific disclosure, must that disclosure be in written form?

Answer: Yes.

(43) Question: Form S-18 requires the issuer’s audited balance sheet as of the end of its most recently completed fiscal year or within 135 days if the issuer has been in existence for a shorter time. With a limited partnership that has been formed with minimal capitalization immediately prior to a Regulation D offering, must the Regulation D disclosure document contain an audited balance sheet for the issuer?

Answer: In analyzing this or any other disclosure question under Regulation D, the issuer starts with the general rule that it is obligated to furnish the specified information “to the extent material to an understanding of the issuer, its business, and the securities being offered.” Thus, in this particular case, if an audited balance sheet is not material to the investor’s understanding, then the issuer may elect to present an alternative to its audited balance sheet.

(44) Question: Is Securities Act Industry Guide 5 30 applicable in a $4,000,000 Regulation D offering of interests in a real estate limited partnership?

Answer: Rule 502(b)(2)(i)(A) requires the issuer to provide the same kind of information as that required in Part I of Form S-18. 31 Form S-18 directs the issuer’s attention to the Industry Guides, noting that such guides “represent Division practices with respect to the disclosure to be provided by the affected industries in registration statements.” In preparing its Regulation D offering material, therefore, an issuer of interests in a real estate limited partnership should consider Guide 5 in determining the disclosure that will be material to the investor’s understanding of the issuer, its business and the securities being offered.

(45) Question: In a $4,000,000 Regulation D offering of interests in an oil and gas limited partnership, what are the issuer’s disclosure obligations with respect to financial statements of the general partner?

Answer: Item 21(h) of Form S-18 provides that the issuer should furnish the audited balance sheet as of the end of the most recent fiscal year of any corporation or partnership that is a general partner of the issuer. For any general partner that is a natural person, in lieu of an audited balance sheet, the issuer may furnish a statement of that individual’s net worth in the text of the disclosure document, where assets and liabilities are estimated at fair market value with provisions for estimated income taxes on unrealized gains. 32

(46) Question: The issuer in a $3,000,000 Regulation D offering is a limited partnership that will acquire certain real estate operations with the offering proceeds. What is the appropriate consideration for disclosure of the operating history of these operations?

Answer: Item 21(g) of Form S-18, which provides special guidance for such disclosure, calls for the audited income statements of the operations, with certain exclusions, for the two most recent fiscal years. If the issuer can meet certain conditions, however, the instruction reduces that requirement to only one year of audited income statements. 33

Under Regulation D, Rule 502(b)(2)(i)(A) provides that only the financial statements for the issuer’s most recent fiscal year must be certified in an offering not in excess of $5,000,000. The staff is of the view that this provision applies to all financial statements in the disclosure document.

Thus, in the Regulation D offering described, the following considerations apply. If the issuer can meet the conditions in Item 21(g) of Form S-18, it may present one year of audited income statements on the operations to be acquired. If the issuer cannot meet the conditions in Form S-18, then it should present two years of income statements, only one of which must be audited.

(47) Question: If the issuer in Question 46 cannot obtain the financial statements on the operations to be acquired without unreasonable effort or expense, what further considerations are applicable under Regulation D?

Answer: Rule 502(b)(2)(i)(A) provides that “if the issuer is a limited partnership and cannot obtain the required financial statements without unreasonable effort or expense, it may furnish financial statements that have been prepared on the basis of federal income tax requirements and examined and reported on in accordance with generally accepted auditing standards by an independent public or certified accountant.” The staff interprets this provision to apply to all financial statements that the issuer presents in the offering document. Thus, the issuer described above may present tax basis operating statements on the operations to be acquired. 34

(48) Question: Has the Commission defined or will the staff issue interpretations on the term “unreasonable effort or expense?”

Answer: No. The meaning of “unreasonable effort or expense” depends on the particular facts and circumstances attending each case. Only the issuer will know the facts and circumstances and be able to evaluate them with respect to the requirements of the rule.

(49) Question: The issuer in a Regulation D offering of $7,000,000 is a corporation. That corporation is acquiring a business. The issuer is unable to obtain the financial statements for that business without unreasonable effort or expense. 35 What are the relevant considerations under Regulation D?

Answer: Rule 502(b)(2)(i)(B) provides that if the issuer is not a limited partnership and “cannot obtain audited financial statements without unreasonable effort or expense, then only the issuer’s balance sheet, which shall be dated within 120 days of the start of the offering, must be audited.” The staff has interpreted this provision in the context of Rule 3-05 of Regulation S-X to apply to the financial statements of the business being acquired. Thus, if the business being acquired is other than a limited partnership, and if the issuer cannot obtain audited financial statements of that business without unreasonable effort or expense, then the issuer may provide the relevant financial statements for the business being acquired on an unaudited basis so long as it also provides an audited balance sheet for that business dated within 120 days of the start of the offering, or, if appropriate, as of the date of acquisition of the business. 36

2. Reporting Issuers–Rule 502(b)(2)(ii)

If the issuer is subject to the reporting requirements of section 13 or 15(d) of the Exchange Act, Regulation D sets forth two alternatives for disclosure: the issuer may deliver certain recent Exchange Act reports (the annual report, the definitive proxy statement, and, if requested, the Form 10-K (17 CFR 249.310)) or it may provide a document containing the same information as in the Form 10-K or Form 10 (17 CFR 249.210) under the Exchange Act or in a registration statement under the Securities Act. In either case the rule also calls for the delivery of certain supplemental information.

(50) Question: Rule 502(b)(2)(ii)(B) refers to the information contained “in a registration statement on Form S-1.” Does this requirement envision delivery of Parts I and II of the Form S-1?

Answer: No. Rule 502(b)(2)(ii)(B) should be construed to mean Part I of Form S-1.

(51) Question: A reporting company with a fiscal year ending on December 31 is making a Regulation D offering in February. It does not have an annual report to shareholders, an associated definitive proxy statement, or a Form 10-K for its most recently completed fiscal year. The issuer’s last registration statement was filed more than two years ago. What is the appropriate disclosure under Regulation D?

Answer: The issuer may base its disclosure on the most recently completed fiscal year for which an annual report to shareholders or Form 10-K was timely distributed or filed. The issuer should supplement the information in the report used with the information contained in any reports or documents required to be filed under sections 13(a), 14(a), 14(c) and 15(d) of the Exchange Act since the distribution or filing of that report and with a brief description of the securities being offered, the use of the proceeds from the offering, and any material changes in the issuer’s affairs that are not disclosed in the documents furnished.

See Rule 502(b)(2)(ii)(C).

C. General

Rule 502(b)(2) also contains four general provisions applicable to all classes of issuer in all offerings where specified disclosure is required. These provisions govern exhibits, disclosure of additional information to non-accredited investors, the opportunity for further investor inquiries, and disclosure of certain additional information in business combinations.

(52) Question: In a Rule 505 or 506 offering of interests in a limited partnership where certain purchasers are not accredited investors, must the issuer obtain an opinion of counsel regarding the legality of the securities being issued or an opinion regarding the tax consequences of an investment in the offering?

Answer: Rule 502(b)(2)(iii) provides that the issuer is not required to furnish the exhibits that would accompany the form of registration or report governing the issuer’s disclosure document if the issuer identifies the contents of those exhibits and makes them available to purchasers upon written request prior to purchase. 37 Any form of registration to which the issuer refers in preparing its disclosure document under Regulation D requires that the issuer furnish the exhibits required by Item 601 of Regulation S-K. Item 601 requires that the issuer furnish, among other exhibits, an opinion of counsel as to the legality of the securities being issued. Thus, under Rule 502(b)(2)(iii), the issuer should identify the contents of this opinion of counsel and make it available to purchasers upon written request. Item 601 also sets forth certain requirements for an opinion as to tax matters. Such an opinion is required to support any representations in a prospectus as to material tax consequences. Thus, assuming the Regulation D issuer will make representations in the disclosure document as to material tax consequences of investing in a limited partnership, the issuer should identify the contents of and make available upon request an opinion supporting that discussion. 38

III. Operational Conditions

A. Integration–Rule 502(a)

Rule 502(a) achieves two purposes. First, it explicitly incorporates the doctrine of integration into Regulation D. Second, it establishes an exception to the operation of that doctrine.

Integration operates to identify the scope of a particular offering by considering the relationship between multiple transactions. It is premised on the concept that the Securities Act addresses discrete offerings and on the recognition that not every offering is in fact a discrete transaction. The integration doctrine prevents an issuer from circumventing the registration requirements of the Securities Act by claiming a separate exemption for each part of a series of transactions that comprises a single offering. Because the determination of whether transactions should be integrated into one offering is so dependent on particular facts and circumstances, the staff does not issue interpretations in this area. 39 The Note to Rule 502(a), however, does set forth a number of factors that should be considered in making an integration determination.

Rule 502(a) also sets forth an exception to the integration doctrine. It provides that a Regulation D offering will not be integrated with offers or sales that occur more than six months before or after the Regulation D offering. This six month safe harbor rule only applies, however, where there have been no offers or sales (except under an employee benefit plan) of securities similar to those in the Regulation D offering within the applicable six months. 40

(53) Question: An issuer conducts offering (A) under Rule 504 of Regulation D that concludes in January. Seven months later the issuer commences offering (B) under Rule 506. During that seven month period the issuer’s only offers or sales of securities are under an employee benefit plan (C). Must the issuer integrate (A) and (B)?

Answer: No. Rule 502(a) specifically provides that (A) and (B) will not be integrated. 41

B. Calculation of the Number of Purchasers–Rule 501(e)

Rule 501(e) governs the calculation of the number of purchasers in offerings that rely either on Rule 505 or 506. Both of these rules limit the number of non-accredited investors to 35. Rule 501(e) has two parts. The first excludes certain purchasers from the calculation. The second establishes basic principles for counting of corporations, partnerships, or other entities.

(54) Question: One purchaser in a Rule 506 offering is an accredited investor. Another is a first cousin of that investor sharing the same principal residence. Each purchaser is making his own investment decision. How must the issuer count these purchasers for purposes of meeting the 35 purchaser limitation?

Answer: The issuer is not required to count either investor. The accredited investor may be excluded under Rule 501(e)(1)(iv), and the first cousin may then be excluded under Rule 501(e)(1)(i). 42

(55) Question: An accredited investor in a Rule 506 offering will have the securities she acquires placed in her name and that of her spouse. The spouse will not make an investment decision with respect to the acquisition. How many purchasers will be involved?

Answer: The accredited investor may be excluded from the count under Rule 501(e)(1)(iv) and the spouse may be excluded under Rule 501(e)(1)(i). The issuer may also take the position, however, that the spouse should not be deemed a purchaser at all because he did not make any investment decision, and because the placement of the securities in joint name may simply be a tax or estate planning technique.

(56) Question: An offering is conducted in the United States under Rule 505. At the same time certain sales are made overseas. Must the foreign investors be included in calculating the number of purchasers?

Answer: Offers and sales of securities to foreign persons made outside the United States in such a way that the securities come to rest abroad generally do not need to be registered under the Act. This basis for non-registration is separate from Regulation D and offers and sales relying on this interpretation are not required to be integrated with a coincident domestic offering. 43 Thus, assuming the sales in this question rely on this interpretation, foreign investors would not be counted.

(57) Question: An investor in a Rule 506 offering is a general partnership that was not organized for the specific purpose of acquiring the securities offered. The partnership has ten partners, five of whom do not qualify as accredited investors. The partnership will make an investment of $100,000. How is the partnership counted and must the issuer make any findings as to the sophistication of the individual partners?

Answer: Rule 501(e)(2) provides that the partnership shall be counted as one purchaser. The issuer is not obligated to consider the sophistication of each individual partner.

(58) Question: If the partnership in Question 57 purchases $200,000 of the securities being offered and if that amount does not exceed 20 percent of the partnership’s net worth, how should the partnership be counted?

Answer: Rule 501(e)(2), which provides that the partnership shall be counted as one purchaser, operates in tandem with Rule 501(e)(1). Thus, because the partnership is an accredited investor (in this case under Rule 501(a)(5)), the partnership may be excluded from the count under Rule 501(e)(2)(iv).

(59) Question: An investor in a Rule 506 offering is an investment partnership that is not accredited under Rule 501(a)(8). Although the partnership was organized two years earlier and has made investments in a number of offerings, not all the partners have participated in each investment. With each proposed investment by the partnership, individual partners have received a copy of the disclosure document and have made a decision whether or not to participate. How do the provisions of Regulation D apply to the partnership as an investor?

Answer: The partnership may not be treated as a single purchaser. Rule 501(e)(2) provides that if the partnership is organized for the specific purpose of acquiring the securities offered, then each beneficial owner of equity interests should be counted as a separate purchaser. Because the individual partners elect whether or not to participate in each investment, the partnership is deemed to be reorganized for the specific purpose of acquiring the securities in each investment. 44 Thus, the issuer must look through the partnership to the partners participating in the investment. The issuer must satisfy the conditions of Rule 506 as to each partner.

C. Manner of Offering–Rule 502(c)

Rule 502(c) prohibits the issuer or any person acting on the issuer’s behalf from offering or selling securities by any form of general solicitation or general advertising. The analysis of facts under Rule 502(c) can be divided into two separate inquiries. First, is the communication in question a general solicitation or general advertisement? Second, if it is, is it being used by the issuer or by someone on the issuer’s behalf to offer or sell the securities? If either question can be answered in the negative, then the issuer will not be in violation of Rule 502(c). Questions under Rule 502(c) typically present issues of fact and circumstance that the staff is not in a position to resolve. In several instances, however, the staff has been able to address questions under the rule.

In analyzing what constitutes a general solicitation, the staff considered a solicitation by the general partner of a limited partnership to limited partners in other active programs sponsored by the same general partner. In determining that this did not constituted a general solicitation the Division underscored the existence and substance of the pre-existing business relationship between the general partner and those being solicited. The general partner represented that it believed each of the solicitees had such knowledge and experience in financial and business matters that he or she was capable of evaluating the merits and risks of the prospective investment. See letter re Woodtrails-Seattle, Ltd. dated July 8, 1982.

In analyzing whether or not an issuer was using a general advertisement to offer or sell securities, the staff declined to express an opinion on a proposed tombstone advertisement that would announce the completion of an offering. See letter re Alma Securities Corporation dated July 2, 1982. Because the requesting letter did not describe the proposed use of the tombstone announcement and because the announcement of the completion of one offering could be an indirect solicitation for a new offering, the staff did not express a view. In a letter re Tax Investment Information Corporation dated January 7, 1983, the staff considered whether the publication of a circular analyzing private placement offerings, where the publisher was independent from the issuers and the offerings being analyzed, would violate Rule 502(c). Although Regulation D does not directly prohibit such a third party publication, the staff refused to agree that such a publication would be permitted under Regulation D because of its susceptibility to use by participants in an offering. Finally, in the letter re Aspen Grove dated November 8, 1982 the staff expressed the view that the proposed distribution of a promotional brochure to the members of the “Thoroughbred Owners and Breeders Association” and at an annual sale for horse owners and the proposed use of a magazine advertisement for an offering of interests in a limited partnership would not comply with Rule 502(c).

(60) Question: If a solicitation were limited to accredited investors, would it be deemed in compliance with Rule 502(c)?

Answer: The mere fact that a solicitation is directed only to accredited investors will not mean that the solicitation is in compliance with Rule 502(c). Rule 502(c) relates to the nature of the offering not the nature of the offerees.

D. Limitations on Resale–Rule 502(d)

Rule 502(d) makes it clear that Regulation D securities have limitations on transferability and requires that the issuer take certain precautions to restrict the transferability of the securities.

(61) Question: An investor in a Regulation D offering wishes to resell his securities within a year after the offering. The issuer has agreed to register the securities for resale. Will the proposed resale under the registration statement violate Rule 502(d)?

Answer: No. The function of Rule 502(d) is to restrict the unregistered resale of securities. Where the resale will be registered, however, such restrictions are unnecessary.

IV. Exemptions

A. Rule 504

Rule 504 is an exemption under section 3(b) of the Securities Act available to non-reporting and non-investment 45 companies for offerings not in excess of $500,000.

(62) Question: A foreign issuer proposes to use Rule 504. The issuer is not subject to section 15(d) and its securities are exempt from registration under Rule 12g3-2 (17 CFR 240.12g3-2). May this issuer use Rule 504?

Answer: Yes.

(63) Question: An issuer proposes to make an offering under Rule 504 in two states. The offering will be registered in one state and the issuer will deliver a disclosure document pursuant to the state’s requirements. The offering will be made pursuant to an exemption from registration in the second state. Must the offering satisfy the limitations on the manner of offering and on resale in paragraphs (c) and (d) of Rule 502?

Answer: Yes. An offering under Rule 504 is exempted from the manner of sale and resale limitations only if it is registered in each state in which it is conducted and only if a disclosure document is required by state law.

(64) Question: The state in which the offering will take place provides for “qualification” of any offer or sale of securities. The state statute also provides that the securities commissioner may condition qualification of an offering on the delivery of a disclosure document prior to sale. Would the issuer be making its offering in a state that “provides for registration of the securities and requires the delivery of a disclosure document before sale” if its offering were qualified in this state on the condition that it deliver a disclosure document before sale to each investor?

Answer: Yes. 46

(65) Question: If an issuer is registering securities at the state level, are there any specific requirements as to resales outside of that state if the issuer is attempting to come within the provision in Rule 504 that waives the limitations on the manner of offering and on resale in Rules 502(c) and (d)?

Answer: No. 47 The issuer, however, must intend to use Rule 504 to make bona fide sales in that state and not to evade the policy of Rule 504 by using sales in one state as a conduit for sales into another state. See Preliminary Note 6 to Regulation D.

B. Rule 505

Rule 505 provides an exemption under section 3(b) of the Securities Act for non-investment companies for offerings not in excess of $5,000,000.

(66) Question: An issuer is a broker that was censured pursuant to a Commission order. Does the censure bar the issuer from using Rule 505?

Answer: No. Rule 505 is not available to any issuer who falls within the disqualifications for the use of Regulation A (17 CFR 230.251-.264). See Rule 505(b)(2)(iii). One such disqualification occurs when the issuer is subject to a Commission order under section 15(b) of the Exchange Act. A censure has no continuing force and thus the issuer is not subject to an order of the Commission.

C. Questions Relating to Rules 504 and 505

Both Rules 504(b)(2)(i) and 505(b)(2)(i) require that the offering not exceed a specified aggregate offering price. The allowed aggregate offering price, however, is reduced by the aggregate offering price for all securities sold within the last twelve months in reliance on section 3(b) or in violation of section 5(a) of the Securities Act.

(67) Question: An issuer preparing to conduct an offering of equity securities under Rule 505 raised $2,000,000 from the sale of debt instruments under Rule 505 eight months earlier. How much may the issuer raise in the proposed equity offering?

Answer: $3,000,000. A specific condition to the availability of Rule 505 for the proposed offering is that its aggregate offering price not exceed $5,000,000 less the proceeds for all securities sold under section 3(b) within the last 12 months.

(68) Question: An issuer is planning a Rule 505 offering. Ten months earlier the issuer conducted a Rule 506 offering. Must the issuer consider the previous Rule 506 offering when calculating the allowable aggregate offering price for the proposed Rule 505 offering?

Answer: No. The Commission issued Rule 506 under section 4(2), and Rule 505(b)(2)(i) requires that the aggregate offering price be reduced by previous sales under section 3(b). 48

(69) Question: Seven months before a proposed Rule 504 offering the issuer conducted a rescission offer under Rule 504. The rescission offer was for securities that were sold in violation of section 5 more than 12 months before the proposed Rule 504 offering. Must the aggregate offering price for the proposed Rule 504 offering be reduced either by the amount of the rescission offer or the earlier offering in violation of section 5?

Answer: No. The offering in violation of section 5 took place more than 12 months earlier and thus is not required to be included when satisfying the limitation in Rule 504(b)(2)(i). The staff is of the view that the rescission offer relates back to the earlier offering and therefore should not be included as an adjustment to the aggregate offering price for the proposed Rule 504 offering.

(70) Question: Rules 504 and 505 contain examples as to the calculation of the allowed aggregate offering price for a particular offering. Do these examples contemplate integration of the offerings described?

Answer: No. The examples have been provided to demonstrate the operation of the limitation on the aggregate offering price in the absence of any integration questions.

(71) Question: Note 2 to Rule 504 is not restated in Rule 505. Does the principle of the note apply to Rule 505?

Answer: Yes. Note 2 to Rule 504 sets forth a general principle to the operation of the rule on limiting the aggregate offering price which is the same for both Rules 504 and 505. It provides that if, as a result of one offering, an issuer exceeds the allowed aggregate offering price in a subsequent unintegrated offering, the exemption for the first offering will not be affected.

D. Rule 506

(72) Question: May an issuer of securities with a projected aggregate offering price of $3,000,000 rely on Rule 506?

Answer: Yes. The availability of Rule 506 is not dependent on the dollar size of an offering.

(73) Question: Rule 506 requires that the issuer shall reasonably believe that each purchaser who is not an accredited investor either alone or with a purchaser representative has such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment. Former Rule 146 required the issuer to make a similar determination with respect to each offeree. Rule 506 is not an exclusive basis for satisfying the requirements of the private offering exemption in section 4(2). See Preliminary Note 3 to Regulation D. What is the Commission’s view of the relevance of the nature of the offerees in an offering that relies exclusively on section 4(2) as its basis for exemption from registration?

Answer: Clearly, in an offering relying exclusively on section 4(2) for an exemption from registration, all offerees who purchase must possess the requisite level of sophistication. The sophistication of each of those to whom the securities are offered who do not purchase is not a fact that in and of itself should determine mechanically the availability of the exemption; the number and the nature of the offerees, however, are relevant in determining whether an issuer has engaged in a general solicitation or general advertising that would preclude reliance on the exemption in section 4(2).

E. Questions Relating to Rules 504-506

(74) Question: If an issuer relies on one exemption, but later realizes that exemption may not have been made available, may it rely on another exemption after the fact?

Answer: Yes, assuming the offering met the conditions of the new exemption. No one exemption is exclusive of another.

(75) Question: May foreign issuers use Regulation D?

Answer: Yes. Recent amendments to Regulation D have clarified the disclosure requirements for foreign issuers. 49

(76) Question: Is Regulation D available to an underwriter for the sale of securities acquired in a firm commitment offering?

Answer: No. As Preliminary Note 4 indicates, Regulation D is available only to the issuer of the securities and not to any affiliate of that issuer or to any other person for resales of the issuer’s securities. See also Rule 502(d) which limits the resale of Regulation D securities.

(77) Question: Regulation T (12 CFR 220.1-.8) of the Federal Reserve Board imposes certain restrictions on brokers and dealers for the use of credit in the purchase of securities. Regulation T provides an exemption from those provisions for the arrangement of credit in a sale of securities that is exempt from the registration requirements of the Securities Act under section 4(2). See 12 CFR 220.7(g). What is the applicability of this provision to offerings conducted under Regulation D?

Answer: Regulation T is interpreted by the Federal Reserve Board which has expressed the view that the exemption from Regulation T in 12 CFR 220.7(a) is available for offerings conducted in reliance on Rules 505 and 506, 50 but not for those under 504. 51

(78) Question: A corporation proposes to implement an employee stock option plan for key employees. Can the issuer rely on Regulation D for an exemption from registration for the issuance of securities under the plan?

Answer: The corporation may use Regulation D for the sale of its securities under the plan to the extent that such offering complies with Regulation D. In a typical plan, the grant of the options will not be deemed a sale of a security for purposes of the Securities Act. The issuer, therefore, will be seeking an exemption for the issuance of the stock underlying the options. The offering of this stock generally will commence when the options become exercisable and will continue until the options are exercised or otherwise terminated. Where the key employees involved are directors or executive officers, such individuals will be accredited investors under Rule 501(a)(4) if they purchase securities through the exercise of their options. Other key employees may be accredited as a result of net worth or income under Rules 501(a)(6) or (a)(7).

(79) Question: In an “all or none” or minimum-maximum Regulation D offering of interests in a limited partnership, the general partner proposes, if necessary, to purchase enough interests for the issuer to sell a specified level of interests by the specified expiration date of the offering. What disclosure and other considerations are relevant?

Answer: The staff is of the view that pursuant to Rule 10b-9 under the Exchange Act, the issuer must disclose the possibility that the general partner may make purchases of the limited partnership interests in order to meet the specified minimum. In addition, the issuer should disclose the maximum amount of the possible purchases. Finally, these purchases must be for investment and not resale. Questions regarding these views should be directed to the Division of Market Regulation, Office of Trading Practices, (202) 272-2874.

(80) Question: An issuer will conduct a Regulation D offering on an “all or none” basis within a specified time. What considerations are there for the issuer if it wishes to extend the offering beyond the specified time in order to sell the specified amount of securities? Answer: The staff is of the view that an offering may be extended beyond the specified time without resulting in a violation of Rule 10b-9 under the Exchange Act or, in the case of an offering in which a broker-dealer is a participant, Rule 15c2-4 under the Exchange Act, under the following conditions:

a. Prior to the specified expiration date, a reconfirmation offer must be made to all subscribers that discloses the extension of the offering and any other material information necessary to update previously provided disclosure.

b. The reconfirmation offer must be structured so that the subscriber affirmatively elects to continue his investment and so that those subscribers who take no affirmative action will have their funds returned to them.

c. The reconfirmation offer must be made far enough in advance of the specified expiration date so that any subscriber who does not elect to continue his investment will have his funds returned to him promptly after the specified expiration date.

Questions regarding these views should be directed to the Division of Market Regulation, Office of Trading Practices, (202) 272-2874.

V. Notice of Sale–Form D

Rule 503 requires the issuer to file a notice of sale on Form D. The notice must be filed not later than 15 days after the first sale, every six months thereafter, and no later than 30 days after the last sale. 52

(81) Question: Where can an issuer obtain copies of Form D and where must the form be filed?

Answer: Form D is available through the Public Reference Branch of the Commission’s main office, 450 5th Street, N.W., Washington, D.C. 20549, (202)272-7460, or any of its regional or branch offices. The form should be filed at the Commission’s main office. There is no filing fee.

(82) Question: In a minimum-maximum offering where subscription funds are held in escrow pending receipt of minimum subscriptions, when is the first Form D required to be filed?

Answer: In the context of Rule 503, the first sale takes place upon receipt of the first subscription agreement and the deposit of the first funds into escrow. The issuer, therefore, should file its first Form D not later than 15 days after the receipt of the first subscription agreement.

(83) Question: An issuer conducting a minimum-maximum offering has received subscriptions for the minimum number of interests needed to form the limited partnership. Subsequent to closing and formation of the partnership, the issuer continues to offer interests. After two months in which no sales take place, the issuer decides to terminate the offering. Because more than 30 days have elapsed since the last sale, how can the issuer comply with Rule 503 in the filing of its final Form D?

Answer: The staff is of the view that a final Form D may be filed not later than 30 days after the last sale or after the termination of the offering, whichever occurs later.

(84) Question: In an employee stock option plan, when would the first and last Form D be filed?

Answer: The first Form D should be filed not later than 15 days after the exercise of the first option. The final Form D would be due not later than 30 days after the exercise or expiration of the last outstanding option, whichever occurs later.

(85) Question: An issuer commences a Regulation D offering and files an original Form D not later than 15 days after the first sale. Subsequently, because no further sales are made, the issuer returns the money to the one investor and terminates the offering. How should the issuer reflect the unsuccessful offering on its Form D?

Answer: The issuer should file a final Form D indicating zero sales, investors, and proceeds.

(86) Question: If the issuer is a limited partnership, who would be considered the chief executive officer for purposes of Form D questions?

Answer: The chief executive officer of a limited partnership is that individual who fulfills the function of chief executive officer. That individual may be the chief executive officer of a corporate general partner.

(87) Question: What is a Standard Industrial Classification (C”) and where is it obtained?

Answer: The SIC is a code associated with a particular economic activity. The SIC system, developed by the Bureau of the Census under the auspices of the Office of Management and Budget, is used in classification of establishments by the type of activities in which they are engaged. An issuer’s SIC can be found in the Standard Industrial Classification Manual, a publication of the U.S. Government that may be obtained from the Superintendent of Documents and is generally available in public and university libraries.

(88) Question: Question 8 of Part A asks for the issuer’s CUSIP number. What is a CUSIP number?

Answer: CUSIP 53 is the trademark for a system that identifies specific security issuers and their classes of securities. Under the CUSIP plan, a CUSIP number is permanently assigned to each class and will identify that class and no other Generally, a CUSIP number will be assigned only to a class for which there is a secondary trading market. The operation of the CUSIP numbering system is controlled by the CUSIP Board of Trustees which awarded a contract to Standard & Poor’s Corporation to function as the CUSIP Service Bureau, the operational arm of the system. Issuers relying on Regulation D that do not have a class of securities with a secondary trading market and thus do not have a CUSIP number should answer Question 8 in the negative.

(89) Question: Part B of Form D requests statistical information about the issuer. In an offering of interests in a limited partnership to be formed, how should this part be answered?

Answer: The answers to Part B should be with respect to the partnership to be formed and will be zero or “not applicable.” This will reflect the statistical profile of a start-up issuer.

(90) Question: Question 2 to Part C requests certain information as to the number of accredited and non-accredited investors in a Rule 505 or 506 offering. Must an issuer make a finding as to accredited investors even if the issuer is not relying on the accredited investor concept in its offering?

Answer: No. Where an issuer under Rule 505 or 506 is not relying on the accredited investor concept for all or certain investors, it should treat those investors as non-accredited for purposes of this question.

(91) Question: Questions 5 and 6 to Part C request certain information regarding the offering expenses and the use of proceeds. May the issuer attach a separate schedule listing expenses and use of proceeds in lieu of completing these questions?

Answer: No. The Form D has been formulated for keypunching and entry of the information into an automatic data storage system. Failure to complete the questions on the form in the space provided frustrates the objectives of the form.

(92) Question: May the Form D be signed by the issuer’s attorney?

Answer: Form D may be signed on behalf of the issuer by anyone who is duly authorized.

FOOTNOTES:

n1 Prior releases leading to the adoption of Regulation D included Release No. 33-6274 (December 23, 1980) (46 FR 2631) in which the Commission considered and requested comments on various exemptions under the Securities Act and Release No. 33-6339 (August 7, 1981) (46 FR 41791) in which the Commission published proposed Regulation D for comment.

n2 The term also is essential to the operation of section 4(6) of the Securities Act which exempts certain transactions involving sales solely to accredited investors. The definition of accredited investor for section 4(6) is found at section 2(15) of the Securities Act and Rule 215 (17 CFR 230.321). Rule 501(a) combines and repeats those provisions. As a result, interpretations regarding the definition of “accredited investor” in Regulation D also apply to the definition of that term under section 4(6).

n3 Preliminary Note 6 to Regulation D would support a different analysis if it could be shown that the director’s appointment or resignation was “part of a plan or scheme to evade the registration provisions of the Act.”

n4 Rule 501(a)(1) refers to “any bank as defined in section 3(a)(2) of the Act.” Section 3(a)(2) provides that the term “bank” includes “any national bank.” Section 3(a)(2) also provides that where a common or collective trust fund is involved, the term “bank” has the same meaning as in the Investment Company Act of 1940 (the “Investment Company Act”) (15 U.S.C. 80a-1-80a-65 (1976 & Supp. IV 1980)). Section 2(a)(5) of the Investment Company Act defines “bank.”

n5 See letter re Voluntary Hospitals of America, Inc. dated November 30, 1982.

n6 See letter re Voluntary Hospitals of America, Inc. dated September 10, 1982.

n7 See Question 37.

n8 Section 2(2) of the Securities Act includes corporations and partnerships within the definition of “person.”

n9 See letter re Intuit Telecom Inc. dated March 24, 1982.

n10 See letter to Kim R. Clark, Esq. dated November 8, 1982.

n11 See letter to Kim R. Clark, Esq. dated November 8, 1982.

n12 See letter re Winthrop Financial Co., Inc. dated May 25, 1982.

n13 Note that this $50,000 is not deemed to be “an unconditional obligation to pay” and cannot be included in calculating whether or not the investor meets the $150,000 purchase test of Rule 501(a)(5). See Question 10.

n14 See letter to Lola M. Hale, Esq. dated July 1, 1982.

n15 See letter re Smith Barney, Harris Upham & Co. dated July 14, 1982.

n16 See 17 CFR 230.405 for the definition of “totally held subsidiary.”

n17 See letter re Federated Financial Corporation dated May 13, 1982.

n18 Section 2(2) of the Securities Act includes “a trust” within the definition of “person” but limits that inclusion to “a trust where the interest or interests of the beneficiary or beneficiaries are evidenced by a security.” The Division does not view that limitation as being necessary in the context of a trust as a purchaser of securities under Rule 501(a)(5).

n19 The result would also be different in the case of a business trust, a real estate investment trust, or other similar entities.

n20 See letter re Rule 501(a)(8) of Regulation D dated July 16, 1982.

n21 The basis for a limitation on the aggregate offering price derives from section 3(b) of the Securities Act. Section 3(b) accords authority to the Commission to adopt rules exempting any class of securities as long as no issue of securities is exempted “where the aggregate amount at which such issue is offered to the public exceeds $5,000,000.” See also section 4(6) which exempts a transaction involving offers and sales solely to one or more accredited investors “if the aggregate offering price of an issue” does not exceed the amount allowed under section 3(b).

n22 This presumes that the payments are in fact for interest. See Preliminary Note 6 to Regulation D.

n23 See letter to Kim R. Clark, Esq. dated November 8, 1982.

n24 See letters to Winstead, McGuire, Sechrest & Trimble dated February 21 and 25, 1975 and re Kenisa Oil Company dated April 6, 1982. Questions regarding registration as a broker-dealer should be directed to the Office of Chief Counsel, Division of Market Regulation, (202) 272-2844. Questions regarding registration as an investment adviser should be directed to the Office of Chief Counsel, Division of Investment Management, (202) 272-2030.

n25 Note 3 to Rule 501(h) points out that disclosure of a material relationship between the purchaser representative and the issuer will not relieve the purchaser representative of the obligation to act in the interest of the purchaser.

n26 As noted in Preliminary Note 1, Regulation D transactions are exempt from the registration requirements of the Securities Act, not the antifraud provisions. Thus, nothing in Regulation D states that an issuer need not give disclosure to an investor. Rather, the regulation provides that in certain instances the exemptions from registration will not be conditioned on a particular content, format or method of disclosure.

n27 An issuer is subject to section 13 reporting obligations if it has a class of securities registered under section 12 of the Exchange Act. An issuer is subject to section 15(d) reporting obligations if it has had a Securities Act registration statement go effective, or if in any year after the year of effectiveness, it has at least 300 holders of the class of securities to which the registration statement applied. In the latter instance, however, even if the issuer has 300 or more shareholders, it may not be subject to section 15(d) reporting obligations if it has had less than 500 shareholders and less than $3,000,000 in assets during the last three years. See Rule 15d-6 (17 CFR 240.15d-6) under the Exchange Act.

n28 See 17 CFR 239.28. Form S-18 is an abbreviated registration form for certain offerings not exceeding $5,000,000. The form is not available to issuers that report under the Exchange Act.

n29 Rules 502(b)(2)(i)(C) and 502(b)(2)(ii)(D) contain special provisions for foreign issuers recently adopted by the Commission. See Release No. 33-6437 (November 19, 1982) (47 FR 54764).

n30 The Commission adopted 53 Securities Act Guides in 1968 (Release No. 33-4936 (December 9, 1968) (33 FR 18617)) and 10 additional ones subsequently. The Guides served as an expression of the policies and practices of the Division of Corporation Finance. Most of those Guides have been incorporated into Regulation C (17 CFR 230.400-.494) and Regulation S-K (17 CFR 229.10-.802) (see Release No. 33-6383 (March 3, 1982) (47 FR 11380)) and thus were rescinded (see Release No. 33-6384 (March 3, 1982) (47 FR 11476)). Five of the Guides applicable to specific industries were not rescinded, however, and were redesignated. Guide 5, which was Guide 60, applies to the preparation of registration statement relating to interests in real estate limited partnerships. Guide 5 was revised in Release No. 33-6405 (June 3, 1982) (47 FR 25140).

n31 Form S-18 has been amended recently to permit its use by limited partnerships. Release No. 33-6406 (June 4, 1982) (47 FR 25126).

n32 The same general rule would be applicable to an offering in excess of $5,000,000. See Release No. SAB-40, Topic 6.D.3.d. (January 23, 1981).

n33 The parallel to this instruction under other forms of registration is Rule 3-14 of Regulation S-X (17 CFR 210.3-14). Rule 3-14 requires income statements for the three most recent fiscal years, unless the issuer meets certain conditions, in which case the issuer need present only one year of audited income statements.

n34 See letter re Winthrop Financial Co., Inc. dated May 25, 1982. In response to inquiries regarding the appropriateness of tax basis financial statements, issuers should refer to Statement on Auditing Standards No. 14, Special Reports, American Institute of Certified Public Accountants, December 1976.

n35 The issuer should refer to Rule 3-05 of Regulation S-X (17 CFR 210.3-05) for the disclosure guidelines on businesses to be acquired. If the offering were for less than $5,000,000 and the issuer were thus referring to Form S-18, Item 21(d) of that form provides a parallel rule on businesses to be acquired.

n36 See letter re Walnut Valley Special Cable TV Fund dated May 13, 1982.

n37 This provision is similar to that found in former Rule 146 at paragraph (e)(1)(ii)(c).

n38 See letters to Hecker & Phillips dated December 22, 1982 and Hopper, Kanouff, Smith and Peryam dated September 10, 1982.

n39 See Release No. 33-6253 (October 28, 1980) (45 FR 72644); letters re Security Bancorp, Inc. dated January 21, 1980 and Kearney Plaza Company dated March 8, 1979.

n40 The Note to Rule 502(a) also points out that certain foreign offerings are not integrated with domestic exempt offerings.

n41 Rule 502(a), however, does not provide a safe harbor to the possible integration of offering (C) with either offering (A) or (B). In resolving that question, the issuer should consider the factors listed in the Note to Rule 502(a).

n42 The Note to Rule 501(e) provides that the issuer must satisfy all other conditions of Regulation D with respect to purchasers that have been excluded from the count. Thus, for instance, the issuer would have to ensure the sophistication of the first cousin under Rule 506(b)(2)(ii).

n43 See Release No. 33-4708 (July 9, 1964) (29 FR 828), Preliminary Note 7 to Regulation D and Note to Rule 502(a).

n44 See letter re Madison Partners Ltd. 1982-1 dated January 18, 1982. See also letter re Kenai Oil & Gas, Inc. dated April 27, 1979.

n45 The Division is of the view that the provision in Rules 504 and 505 that bars an investment company from using the exemptions should be construed to mean an investment company as that term is defined in section 3 of the Investment Company Act.

n46 See letter to Geraldine D. Green dated November 22, 1982.

n47 See letter re Freeport Resources, Inc. dated December 9, 1982.

n48 Note that under Rule 502(a) these offerings may not have to be integrated because they are separated by six months.

n49 See Release No. 33-6437 (November 19, 1982) (47 FR 54764).

n50 Letters from Laura Homer Securities Credit Officer, Board of Governors of the Federal Reserve System to Ardith Eymann, Esq., Chief Counsel, Division of Market Regulation, Securities and Exchange Commission (April 10, 1982) and to Mrs. Mary E. T. Beach, Associate Director, Securities and Exchange Commission (January 8, 1982).

n51 Letter from Laura Homer, Securities Credit Officer, Board of Governors of the Federal Reserve System to Alan G. Rosenberg, Esq. (May 20, 1982).

n52 A Form D is also required to be filed in connection with an offering conducted pursuant to section 4(6). See 17 CFR 239.500.

n53 The acronym “CUSIP” derives from the title of the American Banker’s Association committee that developed the CUSIP system–Committee on Uniform Security Identification Procedures.

SEC Chairman Discusses Potential New IA Custody Rules

Hedge Fund Advisors May be Impacted

Yesterday SEC Chairman Mary Schapiro discussed many new SEC initiatives in a speech given to the Society of American Business Editors and Writers.  One of the new initiatives involves those advisors who have “custody” of client assets.  With respect to such advisors, Shapiro said:

I anticipate that this proposal will include a consideration of “surprise” examinations by a certified public accountant, and a requirement that investment advisers undergo third-party compliance audits.

The tone of the speech was that of a new gunslinger who has come into town to clean up – in addition to the new custody provisions, she discussed regulatory reform and giving SEC examiners more room to initiate investigations.  Many of the ideas expressed in the speech may be worrisome to investment advisors and investors because the initiatives are likely to add significantly to the operating costs of hedge fund managers who are registered as investment advisors.  Additionally, registered managers may face increase inquiries into their business by nosy SEC examiners which will not go over well within the industry.

Below I have reprinted what I thought were important or interesting parts of the speech; the full text can be found here.

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Speech by SEC Chairman:
Address to the Society of American Business Editors and Writers

by

Chairman Mary L. Schapiro
U.S. Securities and Exchange Commission
SABEW Annual Conference 2009
Denver, Colorado
April 27, 2009

Policies/Rules:

Enforcement has been the most visible program at the SEC in recent history. But the financial crisis teaches us that there are policy and regulatory gaps that the SEC must also address.

Again, if investors are to have confidence in the ratings assigned to securities, that corporate boards are working on behalf of stockholders, that investment advisers are not running Ponzi schemes, that money market funds won’t break the buck, then the SEC needs to be pushing forward a real agenda of reform.

Let me just highlight a few of these:

Custody:

In response to major investment scams — such as Madoff — and a rash of Ponzi schemes, we will be considering two proposals as part of a package of initiatives designed to better assure the safekeeping of investor assets.

In short order, the Commission will consider a proposal to strengthen the controls applicable to investment advisers with custody of client funds and securities. I anticipate that this proposal will include a consideration of “surprise” examinations by a certified public accountant, and a requirement that investment advisers undergo third-party compliance audits.

Also, as part of this package, I have asked the staff to draft a Commission requirement that a senior officer from broker-dealers and investment advisers with custody certify that controls are in place to protect investor assets.

***

Reforming the Landscape:

As a result, there is significant debate about regulatory reform — not about whether it should happen, but about what form it will take. You might say the train has left the station, but no one quite knows for sure where it will come to stop.

Whatever form it takes, I support the view that there is a need for system-wide consideration of risks to the financial system and to create mechanisms to reduce and avert such systemic risks.

But, at the same time, I believe that any reform must not — and cannot — compromise the quality of our capital markets or the protection of investors.

If we cannot show investors that we are looking out for their interests as much as the interests of the financial institutions — then we will have little success in restoring confidence.

Investors need to see that we are going after those who engage in wrongdoing. They need to see that we are forcing companies to be truthful and transparent in their reporting. They need to see that we are limiting risk in areas where substantial risk is not what they’re buying. And, they need to see that we’re rooting out fraud.

In short, they need an agency that’s there for them — and primarily them. They need an independent agency that exists not just to protect Wall Street, but to protect Main Street.

By offering that to investors, we can help to restore confidence.

****

In addition, I have streamlined our enforcement procedures by no longer requiring full Commission approval to launch an investigation. And, I’ve eliminated the need for full Commission approval before negotiating a settlement with a corporate defendant.

Before these directives, enforcement attorneys will tell you that they worried about red lights at every turn — now they see green.

Additionally, I brought on a consulting firm to assess and revamp the way we handle the nearly 1 million tips and complaints we get each year. Because we do not have unlimited resources we cannot pursue every lead — we get about 2,000 every day. But we can do a better job ensuring that each tip lands on the right desk and that the person reviewing it has the necessary skills.

Further, we are looking at improving our training programs and hiring new skill sets — from financial analysis to experts in complex trading strategies. It’s all an effort to keep pace with the fraudsters and the ever-changing financial concoctions of the day.

For me, the progress cannot be fast enough.

When I review the pipeline of cases I see how much we are confronting.

  • We have approximately 150 active hedge fund investigations, some of which include possible Ponzi schemes, misappropriations, and performance smoothing.
  • We have about two dozen active municipal securities investigations possibly involving offering frauds; arbitrage-driven fraud; public corruption; and price transparency.
  • And, we have more than 50 current investigations involving Credit Default Swaps, Collateralized Debt Obligations and other derivatives-related investments.

… and that’s just a small slice.

Please contact us if you have a question on this issue or if you would like to start a hedge fund.  If you would like more information, please see our articles on starting a hedge fund.  Other related hedge fund law articles include:

SEC to Examine Short Sales

Last year we discussed the SEC’s ban on short sales and the implementation of the new Form-SH.  Next week the SEC will be considering modifications to the short sales rules.  The press release is below and we will continue to bring updated information on this issue.

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SEC to Hold Roundtable on May 5 to Examine Short Sale Price Test and Circuit Breaker Restrictions

FOR IMMEDIATE RELEASE
2009-88

Washington, D.C., April 24, 2009 — The Securities and Exchange Commission will hold a roundtable on May 5 beginning at 10 a.m. ET to further discuss whether short sale price test restrictions or short sale circuit breakers should be adopted.

The Commission voted unanimously on April 8 to propose two approaches to restrictions on short selling. If adopted, the price test approach would apply on a permanent market-wide basis, and the circuit breaker approach would apply to a particular security during severe market declines in the price of that security.

“This roundtable will help ensure that any policy decisions going forward in the area of short selling regulation are the product of a highly deliberate review process,” said SEC Chairman Mary L. Schapiro.
Roundtable participants will include leaders from self-regulatory organizations, trading venues, the financial services industry, investment firms, and the academic community. The final agenda and list of panelists will be announced at a later date.

The roundtable will be held in the auditorium at the SEC’s headquarters at 100 F Street, N.E., in Washington, D.C. The roundtable will be open to the public with seating on a first-come, first-served basis. The roundtable also will be webcast on the SEC Web site.

For additional information about the roundtable, contact the SEC’s Division of Trading and Markets at (202) 551-5720.

* * *

Preliminary Agenda for Short Sale Restrictions Roundtable

May 5, 2009
U.S. Securities and Exchange Commission
100 F St., N.E.
Washington, D.C. 20549

Format: Chairman and Commissioners will question several panelists
(with a staff member facilitator).
________________________________________
Welcome from the Chairman
10:00 a.m. – 10:10 a.m.
________________________________________
Panel 1
10:10 a.m. – 11:20 a.m.
Market Changes and Investor Confidence; Are short sale price tests or short sale circuit breakers necessary or effective?
________________________________________
Break
11:20 a.m. – 11:30 a.m.
________________________________________
Panel 2
11:30 a.m. – 12:45 p.m.
Bid versus Tick versus Circuit Breakers; Discussion of short sale price tests and views on short sale circuit breakers.
________________________________________
Lunch
12: 45 p.m. – 1:45 p.m.
________________________________________
Panel 3
1:45 p.m. – 3:00 p.m.
Lessons and Insights from Empirical Data; Short sale price tests and short sale circuit breakers by the numbers.
________________________________________
Closing Remarks
3:00 p.m. – 3:15 p.m.

Hedge Fund Due Diligence Firm Drops Ball, Receives Fine

In what represents an unbelievable screw-up, professed hedge fund due diligence firm Hennessee Group was charged by the SEC with not performing the due diligence it supposedly provided to hedge fund investors who used their services.  According to the SEC Administrative Order, Henessee did not perform certain key elements of the due diligence process which they advertised to potential clients.  Because of the lack of due diligence, Henessee recommended investing into the fraudulent Bayou hedge fund.

A few of the more interesting parts of the release include the following:

From February 2003 through August 2005, approximately forty clients of Hennessee Group invested a total of over $56 million in the Bayou funds after receiving Hennessee Group’s recommendations. Most of those monies were lost and dissipated by Bayou’s principals, who defrauded their investors by fabricating Bayou’s performance in client account statements, periodic newsletters, and year-end financial statements that included a phony audit opinion fabricated by one of Bayou’s principals.

****

Hennessee Group and Gradante, in their capacities as investment advisers, owed fiduciary duties to their clients to perform the services that they represented they would provide and to disclose all material departures from the representations that they made to their clients. Despite their representations about their services, with regard to the Bayou Funds and the funds’ management, Hennessee Group and Gradante did not perform two of the five elements of the due diligence evaluation that they had represented to their clients they would undertake. In addition, Hennessee Group and Gradante failed to adequately respond to information that they received that suggested that the identity of Bayou’s outside auditor was in doubt and that there existed a potential conflict of interest between one of Bayou’s principals and its purported outside auditor.

****

With regard to Bayou, Hennessee Group, at Gradante’s direction, failed to perform two elements of the due diligence evaluation that Hennessee Group had told its clients and prospective clients that it would do: (1) a portfolio/trading analysis; and (2) a verification of Bayou’s relationship with its purported independent auditor. By not conducting the entire due diligence evaluation that it had advertised, and by failing to disclose to clients that its evaluation of Bayou deviated from its prior representations, Hennessee Group and Gradante rendered the prior representations about the due diligence process materially misleading and breached their fiduciary duties to Hennessee Group’s clients.

****

In the fall of 2002, Bayou refused to provide Hennessee Group with the prime brokerage reports that Hennessee Group had requested. However, instead of insisting that Bayou provide the reports as a condition of potentially being recommended, Hennessee Group proceeded to the next phases of due diligence. Gradante decided that a portfolio/trading analysis was irrelevant for a day-trading fund like Bayou, which stated in marketing materials that it held securities positions for brief periods of time and converted positions to cash prior to each day’s market closing.

As a result, Hennessee Group did not obtain or evaluate any quantitative information about Bayou’s portfolio characteristics, investment and trading strategies, or risk management discipline. Instead of confirming Bayou’s results and processes through an analysis of Bayou’s historical trading data to determine whether the fund was, in fact, executing its purported “high-velocity” day-trading strategy and utilizing appropriate risk management techniques, Gradante and Hennessee Group relied entirely on Bayou’s uncorroborated representations and purported rates of return that Bayou had provided during its initial information-gathering phases.

Hennessee Group never told the clients to whom it recommended Bayou that it had not conducted a portfolio/trading analysis on the funds. By failing to disclose this information in connection with its recommendation of Bayou, Hennessee Group left those clients with the misleading impression that it had conducted a portfolio, trading, and risk management evaluation of Bayou and that Bayou had satisfied Hennessee Group’s purported standards. In so doing, Hennessee Group and Gradante breached their fiduciary duties to Hennessee Group’s clients.

I have written a number of posts about proper hedge fund due diligence and am always surprised how haphazardly investments are made into some hedge funds.  Over the past six to eight months I have also been surprised that so many sophisticated and savvy investors would be duped by frauds like Madoff… but I guess if those gatekeepers who are paid to help investors research managers are asleep at the wheel we can’t really expect much more from investors.

Please contact us if you have a question on this issue or if you would like to start a hedge fund.  If you would like more information, please see our articles on starting a hedge fund.  Other related hedge fund law articles include:

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SEC Charges Investment Adviser That Recommended Bayou Hedge Funds to Clients

FOR IMMEDIATE RELEASE
2009-86

Washington, D.C., April 22, 2009 — The Securities and Exchange Commission today charged New York-based investment adviser Hennessee Group LLC and its principal Charles J. Gradante with securities law violations for failing to perform their advertised review and analysis before recommending that their clients invest in the Bayou hedge funds that were later discovered to be a fraud.

In a settled administrative proceeding, the Commission issued an order finding that Hennessee Group and Gradante did not perform key elements of the due diligence that they had represented they would conduct prior to recommending investments in the Bayou hedge funds. The SEC also finds that they failed to conduct a reasonable investigation into red flags concerning Bayou. Hennessee Group and Gradante routinely represented to clients and prospective clients that they would not recommend investments in hedge funds that did not satisfy all phases of their due diligence evaluation.

“Forewarned is forearmed — investment advisers must make good on their promises or face the consequences of vigorous SEC enforcement action,” said Robert Khuzami, Director of the SEC’s Division of Enforcement.

“As the Commission found, these investment advisers failed to honor the representations they made to their clients and did not disclose these material departures from their advertised services,” said Antonia Chion, Associate Director of the SEC’s Division of Enforcement. “The advice that clients receive from hedge fund consultants is especially critical when the hedge funds are neither regulated nor transparent.”

According to the Commission’s order, approximately 40 clients invested millions of dollars in the Bayou hedge funds from February 2003 through August 2005 after the Hennessee Group recommended those investments. Most of the money was lost through trading or dissipated by Bayou’s principals, who defrauded their investors by fabricating Bayou’s performance in client account statements and year-end financial statements. The SEC charged the managers of the Bayou hedge funds with fraud in 2005.

The Commission’s order finds that Hennessee Group and Gradante failed to conduct the portfolio and trading analysis that it had advertised to clients. Instead of analyzing Bayou’s results and processes through a review of Bayou’s historical trading methods to determine whether the fund was, in fact, successfully executing its purported day-trading strategy, Hennessee Group and Gradante decided not to perform any analysis after Bayou refused to produce its trading data. They relied entirely on Bayou’s uncorroborated representations about its strategy and its purported rates of return.

The Commission’s order also finds that despite conflicting reports from Bayou about the identity of their independent auditor, Hennessee Group and Gradante failed to verify Bayou’s relationship with its auditor. In fact, the accounting firm that purportedly conducted Bayou’s annual audit was a non-existent entity fabricated by one of Bayou’s principals, who was identified in publicly available state accountancy board records as the registered agent for the bogus accounting firm.

According to the Commission’s order, Hennessee Group and Gradante also failed to respond to red flags concerning Bayou that came to their attention while they were monitoring Bayou on behalf of their clients. In particular, they failed to inquire or investigate when Bayou provided contradictory responses regarding the identity of its auditor or to adequately inquire about a rumor that one of Bayou’s principals was affiliated with Bayou’s purported outside auditing firm.

The Commission’s order finds that Hennessee Group and Gradante violated Section 206(2) of the Advisers Act. The order requires Hennessee Group and Gradante to pay $814,644.12 in disgorgement and penalties, and to cease and desist from committing or causing further violations. The parties also are required to adopt policies to ensure adequate disclosures in the future and to provide copies of the Commission’s Order to all current and prospective clients for a period of two years.

Hennessee Group and Gradante consented to the entry of the Commission’s order without admitting or denying the findings.
# # #
For more information, contact:
Antonia Chion
Associate Director, SEC’s Division of Enforcement
(202) 551-4842
Yuri B. Zelinsky
Assistant Director, SEC’s Division of Enforcement
(202) 551-4769

Series 30 Exam Information

Overview of Series 30 Exam

The Series 30 exam is a National Futures Association sponsored exam which is required for those persons who are branch office managers of a NFA member firm (see our post on CPO and CTA Branch Office Information).  Generally if a NFA Member firm (such as a CPO or CTA) has a branch office (any place of business other than the main office), the firm will need to make sure that a branch office manager is employed at each such branch office.

Exam Specifics

  • Branch Manager Examination.
  • 50 True/False and Multiple Choice questions.
  • One hour long.
  • $70.
  • 70% correct answers required to pass

Signing up for the Exam

The Series 30, like all of the other exams sponsored by the NFA, is administered by FINRA.  Accordingly, an applicant will need to first register to take the exam by completing a FINRA Form U-10.  After the U-10 has been completed, submitted and processed, the applicant will be “in the FINRA system” and will be able to sign up for an exam time at either a Prometric or Pearson testing facility.  Applicants can determine available times and locations by visiting these websites.  The test is generally given a number of times a day, six days a week.

Series 30 Exam Topics

BRANCH MANAGER EXAM—FUTURES

SERIES 30

The following is a general listing of the major subject areas covered by the examination and does not represent an exhaustive list of the actual test questions.

A. General

  • Books and records, preparation and retention
  • Order tickets, preparation and retention
  • Written option procedures
  • Handling of customer deposits
  • NFA Compliance Rule 2-9, supervision of employees
  • Business Continuity and Disaster Recovery Plan
  • Registration requirements—who needs to be registered, sponsor verifi cation, NFA Bylaw 1101, AP termination notices, temporary licenses
  • NFA disciplinary process
  • Reportable positions
  • NFA Arbitration Rules
  • On-site audits of branch offices
  • Bona fide hedging transactions
  • Trading on foreign exchanges

B. CPO/CTA General

  • Registration requirements
  • Books and records to be maintained
  • Reports to customers
  • Bunched orders

C. CPO/CTA Disclosure Documents

  • Management and incentive fees
  • Performance records
  • How long a CPO or CTA can use a disclosure document
  • Conflicts of interest
  • Pool units purchased by principals
  • Business backgrounds of principals
  • Amendments to disclosure documents
  • Disclosure of disciplinary actions
  • NFA review of document before each use

D. NFA Know Your Customer Rule

  • Client information required
  • Responsibility to obtain additional client information
  • Risk disclosures

E. Disclosure by CPOs and CTAs Required for Costs Associated with Futures Transactions

  • Disclosure of upfront fees and expenses
  • Effect of upfront fees and organizational expenses on net performance

F. Disclosure by FCMs and IBs Required for Costs Associated with Futures Transactions

  • Explanation of fees and charges to customers

G. IB General

  • Accepting funds from customers
  • Guarantee agreements
  • Responsibilities of guarantor FCM
  • Minimum net capital requirements
  • Time stamping of order tickets
  • Books and records to be maintained

H. General Account Handling and Exchange Regulations

  • Risk Disclosure Statement
  • Margin requirements
  • Stop loss orders
  • Preparing orders
  • Proprietary accounts
  • Positions limits and reporting requirements
  • Trade confirmations

I. Discretionary Account Regulation

  • Requirements relating to discretionary accounts
  • Supervision and review of discretionary accounts

J. Promotional Material (Compliance Rule 2-29)

  • Definition of promotional material
  • Standardized sales presentations
  • Use of a third-party consulting or advertising firm
  • Reprints of articles from industry publications
  • Recordkeeping of promotional material
  • Past performance
  • Hypothetical trading results
  • Written procedures for promotional material
  • Supervisory review of promotional material

K. Anti-Money Laundering Requirements

  • Developing policies, procedures and internal controls
  • Customer identification program and recordkeeping
  • Detection and reporting of suspicious activity
  • Training staff to monitor trading activity
  • Recordkeeping
  • Designation of individual or individuals (“compliance officer”) to be responsible for overseeing the program
  • Employee training program Independent audit function

Other NFA Information

The NFA also has this to say about the Series 30 exam:

Branch Manager Examination – Futures (Series 30)

NFA must receive evidence that individuals applying to be a branch office manager have passed the Series 30. However, NFA will not require evidence that they have passed the Series 30 if, since the date they last ceased acting as a branch office manager, there has not been a period of two consecutive years during which they have not been registered as an AP. Additionally, individuals whose sponsor is a registered broker-dealer may, in lieu of the Series 30, provide proof that they are qualified to act as a branch office manager or designated supervisor under the rules of FINRA.

Please contact us if you have a question on this issue or if you would like to start a hedge fund, CPO or CTA.  If you would like more information, please see our articles on starting a hedge fund.  Other related hedge fund law articles include:

NFA Branch Office Designation

CPO and CTA Information on Branch Offices

Many commodity pool operators and commodity trading advisors are large enough that they have more than one central office.  Even small CPOs and CTAs may have more than one central office.  In these situations the CPO or CTA is deemed to have both a main office as well as one or more branch offices.  A branch office will need to have a branch office manager who has taken the Series 30 exam.

What is a “branch office” for CFTC / NFA Purposes?

The term “branch office” is not really defined in any meaningful way in the Commodities Exchange Act but the CFTC Regulation 166.4 specifically discusses branch offices.  The NFA too has promulgated rules on branch offices (see below) and has also published an Interpretive Release on Branch Offices (see below).  The Interpretive Release gives the best definition of what exactly a branch office is:

Any location, other than the main business address at which an FCM, IB, CPO or CTA employs persons engaged in activities requiring registration as an AP, is a branch office. This is true even if there is only one person at the location.

Series 30 Exam for Branch Office Managers

Each branch office must have an Associated Person who is licensed as a branch office manager.  According to the NFA Interpretive Release:

Each location must have a branch office manager, and that person’s status as a branch office manager should be listed in the Registration Categories section of the person’s Form 8-R even if previously listed as a principal in the Registration Categories section of the person’s Form 8-R. Each branch office must have a different manager.

Each branch office manager must pass a proficiency exam called the Series 30 exam unless the branch office manager is sponsored by a registered broker-dealer and is qualified to act as a branch office manager under the rules of either the New York Stock Exchange or the Financial Industry Regulatory Authority.  The NFA has provided the following overview of the Series 30 exam requirement:

NFA must receive evidence that individuals applying to be a branch office manager have passed the Series 30. However, NFA will not require evidence that they have passed the Series 30 if, since the date they last ceased acting as a branch office manager, there has not been a period of two consecutive years during which they have not been registered as an AP. Additionally, individuals whose sponsor is a registered broker-dealer may, in lieu of the Series 30, provide proof that they are qualified to act as a branch office manager or designated supervisor under the rules of FINRA.

The Series 30 exam is called the Branch Manager Exam – Futures.  The exam is 50 questions long (multiple choice and true/false) and applicants must answer at least 70% correct in order to pass.  It is broken up into eleven main parts and the applicants will have 1 hour to complete the exam.  For more information, please see our detailed discussion about the Series 30 exam.

Other Branch Office Issues

The CPO or CTA, as well as the branch office manager, must be aware of a couple very important issues with regard to the branch office:

1.    Branch office cannot be a separate corporation.
2.    Branch office APs must be paid directly by the Member firm.

Hypothetical Example

A typical question we receive involves whether certain activity (even activity out of a home office) rises to the level of a branch office.  Generally the answer is going to be, if you have to ask then it will probably be considered a branch office.  Please note that the NFA has taken a very hard stance on this issue – I have had conversations with NFA examiners when they specifically questioned me regarding the activities of a firm.  Additionally, the following bold text is part of the NFA Interpretive Release:

IF YOUR FIRM CURRENTLY HAS PERSONS OPERATING OUT OF LOCATIONS OTHER THAN ITS MAIN BUSINESS ADDRESS, THOSE LOCATIONS MUST IMMEDIATELY BE REPORTED TO NFA BY FILING AN UPDATE ELECTRONICALLY TO THE FIRM’S FORM 7-R AND BY ADDING BRANCH OFFICE MANAGER STATUS ON EACH BRANCH OFFICE MANAGER’S FORM 8-R.

Application to Forex Managers

Managers who trade in the off-exchange spot forex markets may be subject to reqistration requirements in the near future.  If this is the case then it is likely that those firms which register and become NFA Members will need to adhere to the branch office rules as well.  This means that a forex branch office manager would likely need to have Series 3, Series 30 and Series 34 exam licenses.

Conclusion

CPO and CTA managers should be very aware of this potential issue.  If there are questions regarding a branch office, the manager should immediately speak with an attorney.

Various laws and rules which are applicable are provided below.  Please contact us if you have a question on this issue or if you would like to start a hedge fund, CPO or CTA.  If you would like more information, please see our articles on starting a hedge fund.  Other related hedge fund law articles include:

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Below are some various primary sources on branch offices.

CFTC Regulation § 166.4

Branch offices.

Each branch office of each Commission registrant must use the name of the firm of which it is a branch for all purposes, and must hold itself out to the public under such name. The act, omission or failure of any person acting for the branch office, within the scope of his employment or office, shall be deemed the act, omission or failure of the Commission registrant as well as of such person.

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[¶ 9002] REGISTRATION REQUIREMENTS; BRANCH OFFICES
(Staff, September 6, 1985; revised July 1, 2000 and December 9, 2005)

INTERPRETIVE NOTICE

Form 7-R, Branch Offices

Any location, other than the main business address at which an FCM, IB, CPO or CTA employs persons engaged in activities requiring registration as an AP, is a branch office. This is true even if there is only one person at the location. If the firm has one or more branch offices, NFA’s registration records on the firm must include the names of all persons who are branch office managers. Each location must have a branch office manager, and that person’s status as a branch office manager should be listed in the Registration Categories section of the person’s Form 8-R even if previously listed as a principal in the Registration Categories section of the person’s Form 8-R. Each branch office must have a different manager.

The address must also be given for each branch office. A P.O. Box is not sufficient. Anyone with a status as branch office manager must also be currently registered as an AP or have applied for such registration. Whenever a new branch office is established it must be reported, with all the required information, to NFA by filing an update electronically to the firm’s Form 7-R. The closing of an existing branch office should also be reported by filing an update electronically to the firm’s Form 7-R.

IF YOUR FIRM CURRENTLY HAS PERSONS OPERATING OUT OF LOCATIONS OTHER THAN ITS MAIN BUSINESS ADDRESS, THOSE LOCATIONS MUST IMMEDIATELY BE REPORTED TO NFA BY FILING AN UPDATE ELECTRONICALLY TO THE FIRM’S FORM 7-R AND BY ADDING BRANCH OFFICE MANAGER STATUS ON EACH BRANCH OFFICE MANAGER’S FORM 8-R.

NFA may take disciplinary action against any Member which fails to properly list all of its offices.

An important point to recognize is that a branch office may not itself be a separate corporation or partnership. CFTC Regulation 166.4 requires each branch office to use the name of the firm of which it is a branch for all purposes and to hold itself out to the public under such name. Also, in CFTC Interpretive Letter No. 84-10 (May 29, 1984) it was concluded that a branch office could not maintain a separate identity from the Member. One obvious conclusion to be drawn from this information is that each AP in a branch office must be paid directly by the Member. Payment through any intermediary would lead to the assumption that the intermediary would be required to register as an IB.

The requirement that a branch office hold itself out to the public under the name of the Member is intended to ensure that customers are always aware of the Member with which they are doing business. It is necessary that any branch office AP, even one operating out of a residence or an unrelated place of business, make sure that customers understand who they are doing business with.

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[¶ 5053] RULE 2-7. BRANCH OFFICE MANAGERS AND DESIGNATED SECURITY FUTURES PRINCIPALS.

[Adopted effective September 30, 1992. Effective date of amendments: January 28, 1994; August 21, 2001; December 9, 2005; and December 17, 2007.]

(a) No Member shall allow an Associate to be a branch office manager unless:

(1) The Associate has taken and passed the “Branch Manager Exam-Futures”: Provided, however, that any Associate who subsequently ceases acting as a branch manager will not be required to retake and pass the examination in order to resume acting as a branch manager unless after acting as a branch manager the Associate was not registered in any capacity for a period of more than two years; or

(2) The Associate is sponsored by a registered broker-dealer and is qualified to act as a branch office manager under the rules of either the New York Stock Exchange or the Financial Industry Regulatory Authority.

(b) Each Member registered as a broker-dealer under Section 15(b)(11) of the Exchange Act must have at least one designated security futures principal. No such Member shall designate a person as a security futures principal unless:

(1) The person is a partner, officer, director, branch office manager or supervisory employee of the Member;

(2) The person is a Member or an Associate of the Member as defined in Bylaw 301(b); and

(3) The person has taken and passed the “Branch Manager Exam-Futures.”

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[¶ 9019] COMPLIANCE RULE 2-9: SUPERVISION OF BRANCH OFFICES AND GUARANTEED IBS

(Board of Directors, October 6, 1992; revised July 24, 2000)

INTERPRETIVE NOTICE

NFA Compliance Rule 2-9 places a continuing responsibility on every Member to diligently supervise its employees and agents in all aspects of their futures activities. Rule 2-9 applies not only to the supervision of branch office operations, but also imposes a direct duty on guarantor FCMs to supervise the activities of their guaranteed IBs. NFA Compliance Rule 2-23 provides that a guarantor FCM may be held jointly and severally subject to discipline by NFA for violations of NFA rules committed by the FCM’s guaranteed IBs. In practice, NFA’s Business Conduct Committee has charged FCMs under Rule 2-23 only where it appears that the guarantor failed to diligently supervise its guaranteed IBs.

NFA recognizes that, given the differences in the size of and complexity of the operations of NFA Members, there must be some degree of flexibility in determining what constitutes “diligent supervision” for each firm. It is NFA’s policy to leave the exact form of supervision to the Member, thereby providing the Member with flexibility to design procedures that are tailored to the Member’s own situation. Nevertheless, NFA’s Board of Directors believes that it is appropriate to provide Members with specific minimum standards for a supervisory program for branch offices and guaranteed IBs (“remote locations”) and therefore issues the following Interpretive Notice.

Though Members may tailor their supervisory procedures to meet their particular needs, any adequate program for supervision must include procedures for performing day-to-day monitoring and surveillance activities, conducting on-site visits of remote locations and conducting ongoing training for firm personnel. The firm’s policies and procedures, including those for the supervision of branch offices and guaranteed IBs, should be in written form. Firm personnel and guaranteed IB personnel should be provided a copy of the appropriate policies and procedures relating to their duties, and be aware of the firm’s requirements. A copy of all policies and procedures should be on file with the branch office or guaranteed IB. All supervisory personnel should be knowledgeable of the firm’s requirements for supervision.

I. Day-to-Day Monitoring

On a regular basis a Member should perform a number of supervisory procedures in order to monitor the business being conducted in its remote locations. The extent of the supervision depends on a number of factors, including the volume of trading, the experience of the personnel, the nature of the customers, the trading strategies followed by the office or certain APs, the number of customer complaints and the length of time that the office has conducted business with the firm. Repeated problems in any particular area should heighten the level of scrutiny and follow-up by the main office or guarantor.

The procedures to review the day-to-day activities of an office should include the following areas.
Hiring. An adequate program for supervision must include thorough screening procedures for prospective employees to ensure they are qualified and to determine the extent of supervision the person would require if hired. The appropriate documentation to support any “yes” answers on the Form 8-R should be obtained and reviewed for potential disqualifying information. Derogatory information, which the applicant may have submitted in connection with any past regulations, should be obtained from NFA.1 Prior employers should be contacted to confirm the person’s previous work experience.

In connection with the review of the person’s prior work experience, a prospective employer should check for any futures-related disciplinary proceedings against the person’s prior employer.2 This information should be used by the prospective employer to determine the extent of supervision a particular applicant would require after he or she is hired.

Due Diligence Check of Guaranteed IBs. Guarantor FCMs must do a due diligence inquiry before entering into a guarantee agreement. The due diligence review must include a check to ensure that the IB is properly registered. The FCM’s due diligence review should also include inquiries concerning the disciplinary history of the IB and the disciplinary and employment history of the IB’s principals and APs. This type of information could be helpful to a prospective guarantor in determining the types of difficulties, if any, experienced by an IB, its principals and APs in the past and the extent of supervision which may be required of that IB under a guarantee agreement. For example, if the APs at a certain IB have received their futures training and experience at a firm or firms that have been subject to serious disciplinary actions by NFA or the CFTC, that IB may well require more supervision. Both registration and disciplinary information is readily available from NFA.3

Registration. Records of commissions payable to or generated by the branch office or guaranteed IB should be broken down by sales person and should be frequently reviewed to ensure that no commissions are being paid to unregistered individuals.

Customer Information. NFA Compliance Rules require each Member to adopt and enforce procedures regarding customer information and risk disclosure. The procedures for opening new accounts should require that the appropriate account documentation, including an acknowledgment of receipt of the required risk disclosure statement, be forwarded to the main office or guarantor.4 The documentation should be reviewed to ensure that the appropriate supervisory personnel approved the account. The information obtained from a customer should be reviewed to determine whether additional risk disclosure should have been provided to the customer. For any customer who should have received additional risk disclosure, the main office or guarantor should ensure that additional disclosure has been given and that such disclosure has been documented. It may also be necessary to contact the customer to verify that the disclosure was provided and that the customer understood its meaning. Notwithstanding these procedures, a firm may wish to require that all new account information and documentation be forwarded to the main office or guarantor for approval before trading commences in the account.

Account Activity. The trading activity in customer and AP personal accounts should be reviewed and analyzed on a regular basis in order to highlight those accounts which may require further scrutiny. There are a number of calculations and comparisons which can be performed to flag accounts for follow-up or further monitoring. For example, significant losses, commission charges or number of trades should be reviewed for inappropriate trading strategies. The reason for error and correction entries to trading accounts should be investigated, especially if there appears to be a pattern of errors or corrections made by an office. Commission-to-equity ratios should be calculated for discretionary accounts to detect possible excessive trading. In order to identify improper trade allocations for discretionary accounts or front running, the trading results in an AP’s personal account should be compared to the trading gains and losses in his or her customer accounts. Profitable customer accounts for a given AP should be reviewed for possible preferential treatment.

Appropriate supervisory personnel at the remote location should be notified of questionable account activity. Measures should be taken to follow up, such as reviewing order tickets and trade blotters, discussing the activity with the broker or contacting the customer.

Discretionary Accounts. NFA Compliance Rule 2-8 contains detailed requirements concerning the supervision and review of discretionary accounts. The written customer authorization and customer acknowledgment for third-party account controllers should be forwarded to the main office or guarantor. 5 Confirmation of the registration history of APs of FCMs and IBs exercising discretion should be made to ensure that they have been properly registered for the requisite two-year minimum.

Promotional Material. NFA Members are required by rule to adopt and enforce procedures regarding communications with the public. All promotional material should be submitted by the branch office or guaranteed IB to the home office or guarantor for review and approval prior to its first use. Review and approval of the material should be documented by the appropriate supervisory personnel.

Customer Complaints. An adequate system for handling customer complaints should require that a written record of all complaints be maintained, and that complaints which meet certain criteria be sent to the main office or guarantor. Notification of the main office of customer complaints may be based on factors including the seriousness of the allegations of wrong-doing, the monetary amount involved, and which APs or principals are subjects of the complaints. If the remote location is responsible for resolving customer complaints, the home office or guarantor should also be notified of the outcome of resolved complaints. Notwithstanding these criteria, a firm may wish to consider having all customer complaints received by a remote location submitted to the main office.

The main office or guarantor should review the complaints for possible rule violations. It should also compare the allegations in the complaint for similarity to other complaints received against the same individuals or office. Such a review may detect a pattern of sales practice or other abuses.
The status of unresolved complaints should be periodically reviewed to ensure that the branch office or guaranteed IB has promptly responded to complainants.

II. On-Site Visits

In addition to day-to-day supervisory procedures, adequate supervision of the personnel who do work in the main office must also include periodic on-site inspections. As a general matter, NFA would expect these on-site inspections of guaranteed IBs or branch offices to be performed annually.

Members should develop written procedures for the on-site review process including detailed steps to be followed during the visit. This will help ensure that the review process is performed in a consistent manner and will not vary due to the involvement of different personnel in the review process. A Member’s supervisory procedures should also address the number of visits to be made to a branch office or guaranteed IB. The frequency and nature of the visits, as well as whether the visit will be announced or unannounced, will depend on a number of factors including: the amount of business generated; the number of customer complaints received; the previous training and experience of the branch office personnel; and the frequency and nature of problems or concerns that arise as the result of day-to-day monitoring and surveillance of the office’s activities. The personnel who make the visits should be qualified to perform examinations and knowledgeable of the industry and the nature of the firm’s business. Such personnel should be able to perform their work with an independent, objective perspective.

The length of time between visits to the remote location coupled with the size and scope of its operation also plays a role in determining the procedures for on-site review of records and account documentation.6 In reviewing a smaller operation, it is feasible to conduct a comprehensive review of the remote location’s records and documents over the entire time period between visits, while reviewing a larger scale operation may require the selection of a sample of records and documents for given time intervals. The selection of samples should be accomplished on a random basis, for example, selecting every third account for review for randomly selected time periods.

Promptly after the completion of an on-site visit, a written report should be prepared and its findings discussed with the branch office and regional managers or guaranteed IB’s principals and supervisory personnel. Follow-up procedures should also be performed to ensure that any deficiencies revealed during an on-site visit are promptly corrected. The written procedures for the on-site examination should include steps to review the following areas:

Customer Order Procedures. An on-site visit to a remote location should include a review of procedures for handling and recording customer orders. The individuals responsible for accepting customer orders should be identified and a sample of a order tickets should be selected for review. NFA recommends that order tickets be prenumbered and that the on-site review test to ensure that all order tickets within the chosen samples are accounted for. The order ticket review should also confirm that all order tickets are properly time stamped and that all information required by CFTC Regulation 1.35 is included. If option orders are placed by the branch office or guaranteed IB, those order tickets should be reviewed to ensure that they contain the additional information required by CFTC Regulation 1.35.

Discretionary Accounts. If a branch office or guaranteed IB handles discretionary accounts, the supervisory visit should confirm that the branch office or guaranteed IB identifies discretionary orders as such and that the firm’s procedures regarding the supervision of discretionary trading activity are followed. In the event a branch office or guaranteed IB enters block orders, those orders should be reviewed to confirm that customer orders are not included with proprietary orders and that nondiscretionary customer orders are not included with discretionary customer orders. Split fills should be reviewed to ensure that they have been allocated according to established procedures.

Sales Practices. The on-site visit should include a review of sales solicitation practices as well as any promotional material utilized. A suggested starting point for review of the sales solicitation practices of a branch office or guaranteed IB is to identify the persons involved in sales solicitation and to confirm that they are properly registered. The individuals conducting the on-site review should also monitor sales solicitations while at the branch office or guaranteed IB. Interviews with selected customers should be conducted concerning the solicitation process and the handling of the customer’s account. The individuals at the branch office or guaranteed IB responsible for supervising sales solicitations should be identified, and the method by which sales solicitations are supervised should be reviewed for adequacy.

The branch office or guaranteed IB’s promotional material, including sales solicitation scripts, must be approved by appropriate supervisory personnel. Therefore, an on-site visit should be designed to ensure that the branch or guaranteed IB is not using any promotional material that has not received prior approval. If the main office or guarantor has not approved the promotional material, it should be reviewed during the on-site visit.

Customer Complaints. The on-site review should include steps to confirm that all complaints requiring notification have been reported to the main office.

Handling of Customer Funds. In order to assure that customer funds are being properly handled by a branch office, the on-site review should determine whether the branch office accepts funds from customers and, if so, whether appropriate bank accounts, including segregated accounts for customer funds, have been established by authorized personnel. In addition, for guaranteed IBs, the on-site review should confirm that if funds are accepted from customers, they are received in the name of the FCM. The branch office or guaranteed IB should make copies of any customer checks that they deposit into a qualifying or branch bank account. The check copies should be reviewed during the visit to ensure that the branch office or guaranteed IB only accepts checks made payable to the FCM. In addition, third-party checks should be scrutinized to ensure that no customers are acting as unregistered FCMs or CPOs. If the guaranteed IB receives customer funds in the FCM’s name, the review should confirm that the proper authorization to do so exists, that appropriate bank accounts are maintained and that proper procedures for forwarding the funds have been established and are followed. For both branch offices and guaranteed IBs, the flow of customer funds in a sample of accounts should be reviewed to determine that all funds have been timely transmitted and properly credited.

Proprietary Trading. To the extent feasible, there should be a separation of duties between persons handling customer orders and firm employees or principals trading for the firm’s proprietary accounts or their own accounts to prevent misuse of non-public information or the occurrence of other trading abuses.

III. Ongoing Training

A Member’s supervisory responsibilities include the obligation to ensure that its employees are properly trained to perform their duties. Procedures must be in place to ensure that employees receive adequate training to abide by industry rules and regulations and to properly handle customer accounts and that APs have completed the ethics training required by CFTC Regulation 3.34. Employees must be educated on developments and changes in the markets, futures products, rules and regulations, technology, and firm policies and procedures. The formality of a training program will depend on the size of the firm and the nature of its business. The individuals responsible for providing the training must be qualified to do so.
Certain APs may require training for soliciting and handling customer accounts. If an AP has previously worked at firms closed through an enforcement action for sales fraud and has therefore received his or her training from such firms, that AP may need specialized training in proper sales practices.

This Notice is intended to specify minimum supervisory standards for branch offices and guaranteed IBs. A failure to adhere to the requirements specified in this Notice will be deemed a violation of NFA Compliance Rule 2-9.
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1 The detailed explanation of any “yes” answers on an 8-R is treated as nonpublic information; however, it is available to prospective employers under NFA Registration Rule 701(c). See Interpretive Notice at ¶9010.

2 Information concerning futures-related disciplinary proceedings can be obtained by checking the BASIC system on NFA’s web site at www.nfa.futures.org, sending a request to NFA through the “contact” feature of the web site, or calling NFA’s Information Center at (800) 621-3570. See Interpretive Notice at ¶9010.

3Registration Information is also available by checking the BASIC system on NFA’s web site at www.nfa.futures.org, sending a request to NFA through the “contact” feature of the web site, or calling NFA’s Information Center at (800) 621-3570. See Interpretive Notice at ¶9007.

4 NFA Rules require that a guaranteed IB maintain a record of the information obtained from a customer and a copy of the risk disclosure acknowledgment. A branch office may wish to keep copies of this information for its files.

5 NFA Rules require that a guaranteed IB maintain a record of the written customer authorization and customer acknowledgments for third-party account controllers. A branch office may wish to keep copies of this information for its files.

6 If a visit is prompted by awareness of a particular problem at a remote location or if a problem is discovered during a routine visit, the Member must ensure that the scope of the review is adequate to thoroughly examine the problem area.

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[¶ 9007] COMPLIANCE WITH NFA BYLAW 1101
(Staff, March 19, 1987; revised July 1, 2000)

INTERPRETIVE NOTICE

6. Members should ensure that their branch offices are not separately incorporated entities. The CFTC Division of Trading and Markets has issued an interpretive letter stating that branch offices which are separately incorporated entities are required to be registered as introducing brokers;

Revising the Hedge Fund Compensation Structure

Syndicated Post on Hedge Fund Fees

I have recently come across a very good blog called Ten Seconds Into the Future by Bryan Goh of First Avenue Partners, a hedge fund seeder.  Bryan’s posts are very insightful and I recommend all managers take a look at his writings.  The post below discusses some possible ways which hedge fund fees may be designed in the future – this is an especially good topic as I am often asked for suggestions on alternative fee structures.

Please feel free to comment below or contact me if you have any questions or would like more information on starting a hedge fund.

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Hedge Fund Fees. Suggestions for the Future

I have argued before that hedge fund fees were poorly designed, and in that article had suggested a possible design for performance fees. Here I provide more detail into what I think is a practical solution which addresses some but not all of the problems with current fee structures.

Management fees:

This is the simpler issue to deal with. First of all, one has to question what is the purpose of management fees. In traditional long only mutual funds, management fees are the compensation for the manager for managing the fund. With the rise of absolute return funds, and their performance fees, management fees were no longer intended to be the primary compensation for managing of assets. The industry generally represents that management fees are compensation for overheads and the costs of running the asset management business.

If this is in fact the case, then the current flat percentage of assets management fee does not do as represented. The costs and overheads of running an asset management business are not linear in the size of assets under management. There are economies of scale. By charging a flat percentage of assets under management, these economies of scale accrue to the investment manager and not to the investor.

If management fees are indeed intended to cover overheads and costs, then a sliding scale is closer to the intended purpose. One can envisage management fees being charged as follows: 2% of assets as long as assets under management in the fund are under a certain amount, 1.5% when assets rise to a certain level, and 1% whenever assets are over a certain amount. This is just an example of course and there are other ways management fees can be designed to reflect the represented purpose.

A further finessing of management fees which is useful is to waive management fees for side pocketed investments. This encourages the manager to think carefully about side pocketing any assets. Certainly investors would not appreciate management fees being charged on assets that have been ‘gated’ or suspended.

Performance Fees:

Hedge funds fees typically include a profit share by the manager. This can range from 15% to 30% but for the vast majority of funds is 20% of profits. Pre-2005 there were a significant minority of funds which had a hurdle rate (strictly positive). That is, performance fees were only applied once the fund’s returns were higher than some positive return. In the later years, this practice had mostly disappeared as demand outstripped supply and hedge fund managers were able to increase their prices. Almost all hedge funds still operate a ‘High Watermark’ by which is meant that the investor pays fees only if the fund’s NAV is above the previous high. Should the fund’s value fall, performance fees are not collected until the previous high NAV is exceeded again.

This all sounds fair except that there are timing issues. Fees are accrued and at some point crystallized. This usually happens annually. A situation can arise therefore where performance fees are paid out at the end of the year or quarter, the NAV falls thereafter. Even if there is a recovery but the high watermark is not re-attained, fees paid out are not reclaimed.

A simple solution is as follows:

  • Fees are accrued semi-annually.
  • 50% of the performance fee is paid out semi-annually.
  • 50% of the performance fee is retained in Escrow (not to be invested in the fund.)
  • Each retained performance fee vests and is paid out 30 months later (for example, the delay can be made equal to the lock up for example).
  • All retained fees in Escrow are subject to negative performance fees = 20% of loss from the NAV of last performance fee calculation period.
  • When redemptions are paid in full, fees held back are released to the manager.

This design has the following features:

  • The investor pays performance fees on the net performance for their holding period, unless the performance is negative over the entire holding period. Unfortunately the manager cannot be expected to pay a negative performance fee over the entire holding period if the performance turned out to be negative over the holding period.
  • The manager is incentivized to make money over the long term instead of making money only in a given year.
  • The manager has 50% of their performance fee at risk on a rolling basis. On a cumulative basis, the manager may have a whole year’s performance fee at risk.
  • It has the same kind of incentive as a private equity clawback fee structure.
  • The above fee structure can be adjusted for the length of the holdback. The longer the holdback, the more performance fee is at risk.
  • A manager who is confident in generating returns over the length of their lock up should not object to such a fee schedule.
  • It incentivizes a manager to force redeem investors if they do not expect to be able to make money.

The Future:

Customers are the ultimate regulator of an industry, so it is investors who ultimately regulate the hedge fund industry. As long as investors are small and numerous, there may not be the aggregation of bargaining power to negotiate with fund managers. The huge concentration of assets under control in the fund of funds industry afforded funds of funds the opportunity to negotiate, not harshly but fairly with hedge fund managers. Not just on fees but on liquidity terms, transparency and controls. This was an opportunity that was missed. The battering taken by funds of funds in 2008 has greatly impaired their powers. We can only hope that investors find some way of communicating their needs to fund managers. And we can only hope that fund managers are enlightened enough to see that investors are not deliberately antagonistic, although it may seem so today.

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Other related hedge fund law blog articles:

Hedge Funds Care LA Event

3rd Annual Los Angeles Benefit

4/30/2009 – Los Angeles

The Hedge Funds Care Los Angeles Committee cordially invites you to their 3rd Annual Benefit.

Thursday, April 30, 2009

5:00 PM

W Los Angeles
930 Hilgard Avenue
Los Angeles, CA 90024

For more information, please contact Dan Butchko at [email protected] or 212-991-9600 ext. 336.

The Invitation:

You’re Invited!

The Hedge Funds Care Lose Angeles Committee
cordially invites you to their 3rd Annual Benefit…

Good Times in Trying Times
Thursday, April 30th, 2009
The Backyard at The W Hotel, Westwood
930 Hilgard Avenue | Los Angeles 90024
5:00pm – 8:00pm
Business Attire

Join us to help support Los Angeles’ children in need.  Times are challending for many, especially for those who rely on agencies that prevent and treat child abuse.  Please open your hearts and enjoy an evening of reaching out to your peers while reaching out to the children.

Non-hoseted Valet Parking Available Onsite

* Appetizers
* Cocktails
* Silent Auction
* Raffle
* And Much More!

Los Angeles Committee 2009

Michael Smith,
Co-Chair

Michelle White,
Co-Chair

Brett Alpert
Cresta Archuletta
Erin Brodie
Conrad Gorospe
Kathleen Kenney
Mary Beth Salter
Yaela Shamburg
Steve Smith
Mason Snyder
Kristine Stromeyer
Rita Swann
Mark Trousdale