Securities Compliance Sentinel - Analysis of Cutting Edge Securities Industry Issues

The SEC recently completed the Dodd-Frank mandated study on financial literacy for retail investors and it revealed, not shockingly, an absence of basic financial literacy.  The study also found that it was important for retail customers to have a better appreciation of the costs associated with their investments, as well as conflicts of interest related to transactions. 

All those years of hearing customers testify of not knowing the difference between a stock and a bond may not have been a lie.  Without basic financial literacy, how can you know your customer to make investment recommendations with a reasonable basis and satisfy the applicable rules.

These issues should not come as a surprise to you because they are fundamental things that both your clients must know and you need to certain that they know. The absence of financial literacy will lead to two bad results.  First, you do not know your customer as required.  Second, if you do not know your customer, you could not have had a reasonable basis for making your investment recommendations.  As such, you will have liability exposure if sued by this client.

So what do you do.  For one, make sure that you do what you can to make your clients financially literate.  Once you have level of comfort that your client possesses some basic understanding of investing, you are then able to make suitable investment recommendations.  Take your time with this analysis; it may be the best way to protect yourself from customer complaints.

As a result of conclusions from a recent study by Woodbine Associates, Senator Charles Schumer wrote to SEC Chairman Schapiro requesting that the SEC take action to ensure that brokerages disclose rebates and incentive payments they receive from national exchanges and other trading venues that they receive for routing securities transactions to those entities.  According to Schumer, the current disclosures do not go far enough to ensure customers are fully informed; he wants the SEC to take action.  Moreover, Schumer raised the spectre of conflicts of interest if routing decisions are based upon the economics for the brokerage.

The study found that most brokers are routing their trading orders to exchanges not based upon "best execution", but rather on pricing incentives.  In other words, decisions are being made to route trades based upon the remuneration that the brokerage will receive from the exchange.  This system, the study says, has a direct impact on investment returns.  To combat this system, Schumer has called for more robust disclosures to ensure transparency for customers.

Although there are currently rules requiring the disclosure of information at the customer's request, Schumer's letter seeks to have the SEC put more of the onus on the brokerage to provide this information without a request.  If the SEC revisits this issue, the focus will surely be on transparency in the market.  Customer's should know that they are obtaining best execution at the best price, not possibly best execution but the brokerage received an economic incentive.  It seems to me that with more transparency, there will be better competition and a more disciplined trading system based more on best execution than something else.

In its never ending quest to find suitable ways to address capital formation issues in the United States, the SEC’s Division of Corporation Finance is looking to see if foreign jurisdictions handle some of these issues better and if it could be applied in the United States. 

For example, the SEC is looking to see if other jurisdictions handle solicitations and advertising of private offerings differently.  Coupled with this item, Corporation Finance is also reviewing the regulation of private issuers as well.  In particular, Corporation Finance is looking at private placements and general solicitation bans in light of the new age of social media, and 24 hour news coverage.  One consideration is if the current regulatory scheme of a registered offering regime is relevant when one considers the way information is received in this type of market and the attempts to encourage investors through these communications.

The SEC is intrigued at the way foreign private issuers handle these matters overseas and if its current system should remain in place.  Historically, foreign private issuers in the United States ahd been the traditional large cap companies.  However, this model is changing, and it is unclear if the SEC’s current regulatory framework has adapted.

Finally, the SEC should be applauded for its efforts in realizing not all regulation needs to be addressed from an American standpoint, but that certain goals could be achieved by following an overseas model.

According to an internal SEC guidance report, the SEC is taking to heart the criticism that it does not employ enough of an economic analysis in its rule-making process.  The guidance directed the SEC to take a cost-benefit approach to all rule-making, regardless if the rules are discretionary or mandated by Congress.

This guidance report is in direct response to an earlier report that sharply criticized the SEC for not conducting the cost-benefit analysis for rules mandated by Dodd-Frank.  As part of its response, Chairman Schapiro has noted that the SEC has hired 20 economists and is asking Congress form the funding to hire an additional 20 economists.

Although the SEC should be praised for taking criticism to heart, it also reflects a bit of self-preservation.  If the SEC did not take this action, then it faced the risk of legislation that would require the cost-benefit analysis in rule-making.  Some in Congress still want to press for such a statutory mandate.  That way, there would be no room for confusion as to what is expected from the SEC. 

Regardless of why the SEC is employing a cost-benefit analysis in its rule-making, it should only be seen as a positive development.  In the absence of such an analysis, we could be faced with, for example, a uniform fiduciary duty for anyone providing investment advice regardless of its costs.  Such a result would be problematic to say the least.

The SEC and CFTC launched a working group to discuss and identify money laundering vulnerabilities. 

These issues have lingered for awhile.  Both agencies believe that there is an opportunity to clarify their positions relating to money laundering and if their programs could potentially uncover such events.  This group will also include representatives from the Treasury Department, the Financial Crimes Enforcement Network, as well as a variety of self regulatory organizations and agencies.

This announcement demonstrates that the SEC and CFTC are very much interested in the effects of money laundering in their respective markets.  Time will tell if this will impact examinations and enforcement actions, but the SEC and CFTC will, likely, concentrate on some of these issues in their future programs. 

The Cayman Islands will amend a 2011 law to clarify that master funds will now have to register if they have even one Cayman regulated feeder fund.  This registration will have to take place with the Cayman Islands Monetary Authority. 

Previously, the Neutral Funds Law that was effective in December 2011, stated that, if there was only one feeder fund, no registration was required.  However, the Cayman Islands Government and its Monetary Authority determined that registration would be required.  As such, the legislation was to have been reviewed in March 2012, and likely approved shortly thereafter.

Much has happened in nearly one since since the Dodd-Frank Act became effective, and much more remains.  According to the recent thoughts of one commentator, Kyle Colona of Compliance EX, Dodd-Frank may be doomed to fail as it faces it first year of existence.

Colona noted five factors working against the full implementation of the law: (1) the CFTC and SEC are far behind schedule; (2) the regulatory authority under the Act is shared by too many entities; (3) recent comments from the Federal Reserve Bank suggest that the Volcker Rule may not become law because of its impossibility to implement; (4) the financial services industry has unleashed a full-scale effort to defeat the full implementation of the Act; and (5) certain banks are trying to influence the public that implementation of the Volcker Rule would be bad.

I think that there is now a sixth factor that may work against the full implementation of the Dodd-Frank Act; namely, a presidential election this fall.  With the politicalclimate becoming more and more focused on the election, it is only natural that there would be less attention devoted to a law that the financial services industry is committed to pealing back or doing away with altogether.  If the President loses the election, there are some who believe that Dodd-Frank may be in trouble.  Even if the President prevails, it is unlikely that there will be full implementation because attention will surely be focused elsewhere.

Although it is unlikely that there may ever be full implementation of the Act, we need to still anticipate that many provisions of the Act will come to pass.  For example, at some point, the SEC will finally commit to the adoption of the uniform fiduciary duty rule and there will be a decision on who will serve as the SRO for investment advisors.  Dodd-Frank is not dead; it just may limp along for the next year.

Like many others, my interest in the JOBS Act really started with crowdfunding.  This is probably because securities law is an imposing tangle of archaic acts, byzantine regulations and repetitive rules.  (Securities lawyers commonly say things like “…Rule 506 under Regulation D, promulgated pursuant to Section 4(2) of the ’33 Act…” and expect you to understand/stay awake).  Crowdfunding, however, is the hip, internet-based, exciting new thing!  It’s like that Kickstarter thing your cousin, the “performance artist”, keeps posting about on Facebook!  Everyone is talking about crowdfunding, so it MUST be awesome, right?  Well, not so fast: a lot of media coverage and law blogs doesn't mean a law will live up to the hype (I admit my own guilt).   So, what impact will Crowdfunding really have once the SEC passes all its rules? 

I’m leaning towards not much.  First, they have 270 days to enact the rules, but as this guy explains quite well, you really shouldn’t bother writing that down in your calendar: the SEC will be late. More to the point, some think this will be the panacea to our economies ailments, while others expect it to pretty much license fraud.  Obama called this a “game changer” and I agree, but - to make a football analogy - this is more like a “two-point conversion” game changer than a “forward pass” game changer.  Most start ups will eschew crowdfunding for more traditional fund raising methods.

First, we need to ask: what kind of issuer will use crowdfunding?  Not the guys who are looking to ramp up an already humming business, they already have venture capitalist to turn to.  And remember that the JOBS Act also amended Reg A (allows a company to sell up to $50 Million in securities with minimal disclosures and no restrictions on advertising) and Sec. 12(g) of the ’34 Act (now companies can have up to 2000 investors without being forced to go public, and employees don’t count towards the limit).  One the SEC makes rules on these changes, a company can offer up to $50 Million in stock, advertising however it likes, using a Regulation A circular, provided that it keeps non-accredited investors under 500 and total number of investors under 2000.  $50 Million divided by 2000 investors is a mere $25,000 per investor – not an extravagant amount by any means, and this might deepen the venture capital markets.  For many more established or promising start ups, this will present a much more appealing opportunity.  The “start up” that already has a product and some employees probably won’t resort to crowdfunding.

Crowdfunding is limited to $1,000,000 dollars, gleaned from any number of investors.  Issuers (and the funding portals) are prohibited from advertising the offering, beyond director investors to the website (it will be interesting to see whether Facebook and Twitter links will be considered advertising or mere directing).  And if the issuer wants to raise over $500,000, it will need to release audited financial statements.  That means dropping a few grand on a CPA, on top of the whatever fees the funding portal will charge (and issuers would be remiss to do any of this without an attorney).  The transaction costs will be high.  If the issuer wants to raise somewhere between $100,000 and $500,000, then the financial statements need only be “reviewed”, which is slightly less pricey.  On top of those requirements (and the basics like names of officers and addresses), issuers will need to describe the purpose of the fundraising, a description of the ownership and capital structure of the issuer and file annual reports with the SEC, including financial statements.  And, do note, the SEC is empowered to make “any other requirements…for the protection of investors and in the public interest.”  That means that the SEC could make any of these requirements more onerous and costly.  Again, given that Mary Schapiro and Luis Aguilar have pooh-poohed the concept generally, expect the SEC to add some regulatory meat to the statutory bones.

Normally, a start up gets going using the founder’s own funds, and the money he can beg, borrow or steal from his friends and family, and sometimes they find an “angel investor” – some wealthy person willing to give them a shot in the form of a few thousand dollars.  Crowdfunding will be popular among the start ups that can’t find this kind of “seed money”.  Younger entrepreneurs, whose friends are all also broke, are more likely to turn to crowdfunding.  In addition, crowdfunding will be huge for entrepreneurs living outside of seed-money friendly areas.  It will also help individuals with really solid ideas of how to return 20% on the dollar, which isn’t the sort of return that excites many angel investors (think pizza shop in a small town without so much as a Dominos).  And, to be frank, it will help the socially awkward types who can’t sell their vision face-to-face. 

Crowdfunding isn’t the democratization of equity investment; it’s the democratization of angel investment.  Most of us will still be unable to invest in the next Facebook or Google, because they’ll skip crowdfunding altogether.  I suspect most crowdfunding offerings will end up being for less than $100,000 (meaning the issuer only needs to provide self-certified financial statements and last year’s tax return, plus the other rules).  It will be for just enough to make a prototype or launch a beta version.  In other words, just enough to attract a venture capitalist.

For investors, crowdfunding means a lot of chances to lose some money.  Some will get to support the next must-have app for your phone, but more will probably invest in a bar or restaurant (an industry famous for failures), or with tech-geeks without a lick of business acumen.  I’m okay with this, to be honest.  Some will invest for philosophical reasons (support only small/local businesses), others will gamble (better here than a casino), but I think most will do it almost for fun (another venue for those who “dabble” or “play” in the stock market).  And there are limits on how much someone can lose.  The Act uses “income or net worth” in setting limits, which will allow some retirees with over $100,000 saved to potentially risk the greater of 10% or $20,000.  Potential for fraud is restricted by investment limits, the fact that issuers need to use a broker or a funding portal*, and that said fraudsters need to give the SEC their name, address, etc. (generally not a good criminal plan, giving the Feds your personal info).  More importantly, the Act requires brokers/funding portals to ask and receive answers from the investors, making sure they understand the risks.  I’m pretty sure that no other group of investors have to pass a quiz before they can invest.  That’s a lot of work for something that should be understood as allowing the Average Joe to invest $100 in a company a few times a year.

Crowdfunding will be good for the little guy start up.  Investors who decide to go into crowdfunding should do so understanding the risks, and should model themselves after angel investors, who often invest in a dozen companies in the hopes that one strikes it big. 

Crowdfunding will be fun and exciting, don’t get me wrong, and I intend to invest this way myself.  For some, it really will be a game changer, but only if the game is already really, really close. 

* This is really an aside: Funding portals and brokers acting as crowdfunding intermediaries will need to register with the SEC and register with an applicable self-regulatory organization.  There are already a few nascent organizations coming together to create a funding portal SRO.  Thus, these guys will face the type of serious and undoubtedly complex regulations not unlike those that broker-dealers already face.  In addition, if a funding portal wants to skip registration as a broker-dealer, it will need to be a member of a national securities association, which means a battery of tests and not-insignificant fees.  Most importantly, they will be exposed to all sorts of liabilities, which will make prudent portals wary of shady start-ups.  The net effect will mean that a crowdfunding boiler room will have a similiar likelihood of getting caught as any other, only for a lot less potential payout.

This post is a continuance of a series reviewing the JOBS Act.  For more on the registration requirement threshold shift from 500 to 2000 investors, click here.  For Jim's initial analysis of Crowdfunding, click here.  Check back later for a flushed-out analysis of Title I of the Jobs Act, which creates the "Emerging Growth Company" classification.   

Today’s the day! President Obama signed the JOBS Act in a Rose Garden signing ceremony today.  Most of the Act requires the SEC to weigh in, so there won’t be much immediate impact.  That said, effective today, “Emerging Growth Companies” - most companies with under $1 billion in annual revenues that have been public for less than 5 years - will be excluded from some of the SOX auditing requirements and Dodd-Frank corporate governance requirements that their older and bigger brethren are burdened by.  By one professor’s calculations, 94% of companies (excluding banks, savings and loans, and IPOs involving units) that went public between 1980 and 2011 had under $1 billion dollars in annual revenue.  I don’t know the exact legal threshold for “seismic regulatory landscape shift”, but I think something impacting 9 out of 10 IPOs probably does it.

That said, I promised to write about Titles II and IV of the JOBS Act today, and I’m a man who stands by his word. 

Title IV of the Act, Small Company Capital Formation, amends the curiosity that is Regulation A.  Unless you are Professor of securities law (my condolences if you are), you probably never heard of Reg A.  That’s because it was such a small exemption from the registration requirements under the Securities Act of ’33 that no one used it.  It was so unimportant that it doesn’t even have a Wikipedia page, making it less important than an individual episode of the Simpsons.  Regulation A is a safe harbor that lets small issuers avoid most registration requirements.  Before, the company was limited to raising $5 million in a year, so most companies relied on the limitless Rule 506 under Regulation D instead, even though Reg D came with a handful more restrictions on who you could sell securities to.  (Note that Reg D has its own wiki page.  Also note that its smaller than the Simpsons episode wiki.  I’ve already asserted that a topic’s importance can be gauged by it’s Wikipedia page so… QED: the Simpsons are more important than securities law?)  But now the limit is $50 million, which makes Reg A relevant for the first time.  But you start can’t handing out fliers about your $50 million dollar issuance under Reg A just yet, because the Act amends Section 3(b)(2) of the Securities Act of ’33, which states, “The [Securities and Exchange] Commission shall by rule or regulation….”  That means that you need to wait until the SEC gets around to revamping Regulation A. Sure, it seems as easy as just adding an extra zero to the current Reg A, but Congress didn’t give the SEC a deadline (not that they really matter: almost 70% of the Dodd-Frank deadlines were not met), so this could take a while.

A quick aside on the SEC’s take on the JOBS Act: they kind of seem to hate it.  Commission Aguilar and Chairwoman Shapiro both lambasted the Act when Congress was debating it.  Now that its law, they have been tasked with passing the necessary rules and regulations to enact the law.  First off, the SEC has been swamped with enacting Dodd-Frank, so the odds of them getting to the JOBS Act sometime soon are somewhat worse than the odds of the Pirates winning the pennant this year.  We are a long way off on seeing   Secondly, once they do make some rules, you can expect the SEC to only relent as much as the statute forces them. 

Title II of the Act will eliminate the prohibition on general solicitation on Rule 506 offerings under the Securities Act.  Before, companies using the Reg D exemption to do a private offering couldn’t use public advertising to sell their securities, or else they might be deemed a public offering.  Now they can, provided that they only sell shares to “accredited investors”.  The Act also amends Rule 144A under the Securities Act in a similar way, just replace “sell” with “resell” and “accredited investors” with “qualified institutional buyers.”   This provision is more of a stimulus package for the Wall Street Journal than anything else, coming out of the hides of some Wall Street law firms, who used to have plenty of work making sure that their clients weren’t engaged in “general solicitation.”  Now, an issuer relying on Rule 506 of Reg D can go shout it on the mountaintop that they are looking for one-percenters to buy their securities.  Congress gave the SEC a 90 day deadline to enact this change.  Title II should make it easier for companies using Rule 506 to stay in compliance, and "easier... to stay in compliance" means "cheaper, because of less lawyers fees."

Like I said yesterday, the JOBS Act isn't about jobs.  And it isn't about increasing the number of IPOs.  These two provisions, which make it easier for companies to raise money privately, makes that obvious.  Along with the changes to 12(g) of the Exchange Act, it'll be easier for small companies to stay private longer.  Notably, a bigger Reg A and easier-to-use Rule 506 means that angel investors will have an easier time cashing out of start ups.  

I joked a few weeks back about how no one could oppose something called the JOBS Act, but apparently I really was onto something.  The JOBS Act will reduce the fund-raising costs for many small- and mid-cap businesses.  That's not a bad thing, but its disheartening that it had to come under the guise of an IPO and employment booster.

Gail Collins weighed in on the JOBS Act today in a column glibly titled “The Senate Overachieves”.  Normally, I love her work – everything she does is glib, and I honestly feel there is a glib shortage in America – but this time I believe her winking nonchalance has descended into full-on flippancy.  Worse than that, I’m pretty disappointed that she couldn’t work into the column that Mitt Romney once drove to Canada with the dog strapped to the roof.  But I digress.

Securities regulation is a serious matter (and kind of my job).  That doesn’t mean we can’t have fun discussing it, but great zingers can only go so far.  Dismissing reforms because they let smaller businesses avoid excessively expensive auditing requirements makes sense, even if this means reducing (by a small amount) Sarbannes-Oxley’s reach.  Just because Sarbannes-Oxley and Dodd-Frank were passed to correct egregious regulatory gaps doesn’t mean that they cannot still overreach.  If anything, it makes just such overreaching more likely.

Crowdfunding does present a larger potential for hucksters to shill worthless stock.   But that is still fraud, and still illegal, regardless of the medium used to do it. 

For what it’s worth, I think a lot of securities regulation are misguided attempts to treat symptoms of the problems rather than the problems themselves.  So long as there are massive incentives to innovate new products and skirt regulatory requirements, firms will do so, and will pay their lawyers handsomely to make it happen within the confines of the law.

Rather, I believe that approaches towards fixing the fundamental flaws in the market must be addressed.  No recession or crisis will be caused by minimized auditing of mid-cap companies, or small start-ups raising a few hundred thousand over the internet.  As I noted in my last post, regulations that incentivize companies to stay small in order to avoid disproportionately larger regulatory burdens are counterproductive.

Instead, we need to work to realign the incentives of market participants with the incentives of the economy in general.  The Economist mentioned the interim Kay review last week, “it is easy to forget what the main economic functions of the equity markets are supposed to be.”  I agree with John Kay, the review’s author: the markets should promote long-term growth, not short-term profits.  And, for what it’s worth, Warren Buffet, Judge Richard Posner and Nassim Taleb, among others, also agree (oh my, am I clumsy! Just dropping those names all over the place!).

So, Gail’s barbed wit hit the wrong target this time, not unlike how some regulations aimed to prevent awful abuses end up frustrating legitimate businesses from growing.  The JOBS Act has its flaws too: the "emerging growth companies" that get to avoid some of the registration requirements of the '33 Act are defined to include companies with $1 Billion in revenue.  If you make $1 Billion, you aren't emerging anymore.  You've emerged.  But these call for sensible amendments, not lambasting the entire bill. 

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