T I M E LY I N S I G H T S F R O M T H E R E I S A
FALL 2013 VOLUME 7 , ISSUE 4
The Uncharted Waters of General Solicitation PAGE 4
Know Your Arbitration Claim: Understand Claimants’ Strategies Ahead of TimePAGE 9
The Small Broker/ Dealer Is Not Dead…YetPAGE 11
REISA Editorial Board
Co-Chair DeVonna MurrinIndependent Financial Group
Co-Chair Alex SimsMoody National Companies
Linda DewlaneyPreferred Partnership Services
Eric PerkinsPerkins Law PLLC
Brandon RaatikkaFactRight, LLC
Table of Contents
Copyright © 2013By REISA, formerly the Tenant-In-Common Association.All rights reserved. Readers may copy sections of this publication for personal use. However, it is a violation of U.S. copyright laws to copy substantial portions of the publication for any reason without permission. The Copyright Act of 1976 provides for damages for illegal copying. If you wish to copy and distribute sections of this publication, contact Jennifer Fitzgerald at [email protected].
1 President’s Letter
3 Executive Director’s Letter
4 The Unchartered Waters of General Solicitation
7 Real Estate Sponsors Should Know About the New Rule 506(c)
9 Know Your Arbitration Claim: Understand Claimants’ Strategies Ahead of Time
11 The Small Broker/Dealer Is Not Dead…Yet
12 Why Should You Attend REISA’s Annual Conference & Trade Show?
Contact Information
You can find all PDFs of FYI issues on the REISA members-only web site, www.reisa.org.
FYI is published by REISA. Views expressed in the articles are not necessarily endorsed by the REISA.
REISA10401 N Meridian St., Suite 202Indianapolis, IN 46290
Direct: 317-663-4180Toll Free: 866-353-8422Fax: 317-815-0871E-mail: [email protected]
John HarrisonExecutive Director317.663.4172
Tanisha BibbsEducation & Meetings Coordinator317.663.4174
Jennifer FitzgeraldDirector of Marketing317.663.4175
Tony GregoDirector of Business Development317.663.4173
FYI FALL 2013 1
President’s Letter
Looking back at the first ten months of 2013, simply making sense of what was going on in the public markets has been challenging enough. This sense of uncertainty is fairly warranted: I straddle both public and private markets, and
these markets have been at odds with each other. Each market, however, also continues to afford unique opportunities for discerning investors to profit.
Yield-demanding investors of late have not been overly particular about their investment vehicles so long as they brought that elusive ‘high yield at low risk.’ As capital flowed in, the very yield that investors clamored for sank to historic lows. This, in turn, caused investor psychology to shift again, and yields rose as risk-off risk-on sentiment reasserted itself in the second half of the year.
A recurring theme in the turbulence of the year we have witnessed has been, at least in my own mind, the role played by the Federal Reserve in exacerbating market volatility – with markets reacting to, what I think we can safely describe has been extreme skittishness. As tough as times like ours are, we are reminded of one of the fundamental rules of investing: no one has a crystal ball.
This suggests that prudent investors should not be obsessed with trying to guess what the next hot investment trend might be. History would suggest that in doing so, they risk undermining their strategic, long-term investment strategy.
As stewards of investor confidence, we would do better with a balance of traditional assets and the appropriate allocation to alternative investments. When carefully chosen, and within the context of a broader portfolio, alternatives can play a pivotal role in meeting one’s financial goals.
This approach serves as the backdrop for what I believe is a much larger realization within the investor and financial advisor community: alternatives constitute both a skill class and an asset class. Their complementary functions of generating absolute returns over the long-run and of providing portfolio diversification, thereby achieving rates of risk-adjusted return above those accrued from investing in passive traditional asset classes are considerable causes for this increased recognition.
Financial advisors, justifiably skeptical of alternatives in the past, now acknowledge the enormous value alternatives add when developing and implementing quantitative, model-driven approaches to asset allocation, borrowing from practices formerly reserved for the institutional investing world. Alternative investment vehicles and their sponsors proliferate in tandem, perpetuating the allocation of client capital to the best managers, as well as allowing for opportunistic exposure to thematic ideas. This, in so many words, is good for our industry.
That said, our industry has much further to go. Only if it continues to reinvent and revitalize itself will alternative investments consistently meet, or exceed advisor and client needs.
The world is changing. With it, we must also change.
Active Management in Alternative Investments
Investors familiar with exposure to passive risk factors are increasingly seeing passive investing as largely undifferentiated and commoditized. Smarter investors and their advisors within the alternative investment space have begun to focus on active risk as a means of improving investment returns.
Active risk refers to the risk and return generated by the unique decisions of an investment manager or product sponsor, such as security selection and market timing decisions. Active risk is a powerful addition to portfolios for at least three reasons:
Michael Weil American Realty Capital
2 FYI FALL 2013
(i) Diversification: since active risk relates to the unique decisions of a manager, it is generally uncorrelated with passive risk. Therefore, it serves as a diversifier in portfolios.
(ii) Larger Opportunity Set: because passive risk comes from exposure to passive asset classes, investors have a fairly limited number of passive risk sources from which to choose. By contrast, each active manager provides a unique source of active risk.
(iii) Higher Risk Adjusted Returns: some active managers perform far better than passive asset classes.
Developments in the active alternative space have not happened overnight. During the last decade, capital market innovations have provided investors access to a plethora of index returns (betas) at very low cost, through futures, swaps, exchange–traded funds etc. While seemingly simple and commonly accepted now, these products have had their share of growing pains. Now evolved, alternatives allow investors to construct accretive portfolios in a flexible and efficient manner.
Investors no longer need to rely on (what were) active managers, and pay for performance-based fees to gain exposure to traditional asset classes within equity and fixed income. Instead, they can obtain asset class returns (beta) through passive investments, and focus on identifying only those managers who generate attractive skill-based returns (alpha).
Outperformance is the New Mantra
While investors have long sought skilled, active managers who generate excess returns, the recent emphasis on identifying and engaging those sponsors who generate skills-based returns (alpha) is perhaps unprecedented. This interest has been fueled in large part by positive developments in the alternative industry. Perhaps more important is the recalibration of durable income and fixed income return expectations, which has led investors to turn their attention to searching for investments or asset classes that help meet expectations for high return. Additionally, the long-term secular trend of falling costs for passive investing in equity and fixed income (beta) means that investment managers
ought be evaluated exclusively on those managers’ value-added performance — as costs for beta return have declined, investors should no longer need to pay investment managers for anything other than legitimate expenses and for the value they create. This principle is embodied by the skills-based alpha.
The New Era
Figuring out how to identify and appropriately structure and compensate skills-based alpha within a portfolio defines this new era of alternative investing.
The foundation for any great portfolio resides in strategic asset allocation, in tactical allocation and, within alternatives, in identifying and allocating capital to skilled managers who have the potential to consistently outperform their peers.
Although investors intuitively recognize the value of alpha, they lack the tools required to build portfolios that include active managers. Traditional asset allocation models designed for a different era are ill-equipped to meet this need.
I, however, remain excited about the future. I see the early evolution of rigorous, integrated, and perhaps most importantly, practical frameworks for active investing which represent a departure from the alternatives of the last decade. Exciting new tools and methods are being developed, such as those for a multi-variable stochastic alternative asset model, a radical improvement when analyzing and interpreting databases of historical performance metrics, better approaches for performance analysis, time series and cross sectional peer group comparison, arriving at alpha attribution and customized performance analysis.
Optimism about the Future
I am confident that these developments, as well as so much more happening in the retail alternative space, are building blocks for a brighter future. I expect that they will eventually bring virtually every financial advisor and their client an integrated alternative investment framework that brings advice and product expression together — a framework that, above all, anticipates, meets and possibly exceeds investor needs.
I believe that we as an industry are just getting started. New ideas are compelling and have huge potential. New financial instruments and products, and more nuanced ways of asset allocation and portfolio construction will make the case for alternatives more feasible and accessible at low cost.
“I believe that we as an industry are just getting started. New ideas are compelling and have huge potential. New financial instruments and products,
and more nuanced ways of asset allocation and portfolio construction will make the case for alternatives more feasible and accessible at low cost.”
FYI FALL 2013 3
Executive Director’s Letter
Recently, at a recent REISA Board dinner, I related the story of how my father, who at one point in his career was a financial advisor and worked from a home office, would put on his dress shoes, starched shirt, suit trousers and tie to go
downstairs to his basement office. I asked my dad why he did this when he didn’t have to.
“First, you have to know a little bit about the history of the necktie,” he said. I was a teenager at the time, so I instinctively rolled my eyes and pretended not to listen (but the conversation still resonates).
“It had its origin in the bandages military officers wore draped around their necks to use to help their wounded troops. To me that’s a symbol of servant leadership—something good to remind myself of everyday,” my father told me.
He told me this during the 1970s, when fashions were in an uproar—folks wearing such notables as leisure suits and Nehru jackets, and not wearing such notables as underwear. The clothes in the window at Brooks Brothers, however, stayed the course. It seems that the clothes of our financiers never went casual.
A few years later I became a military officer in fact, and the etiquette training to us in those days: officers tied only the Windsor knot, and always wore Class As (military coat and tie) in airports and other public places. Nowadays, soldiers of all ranks shuffle through the airports in dusty fatigues. I do still see marines in their dress uniforms on planes. They look proud, but of course, there are only a few of them.
“Secondly,” my father told me, “if I’m dressed for business, then I’m less likely to get involved in some distraction-- some fix-it errand or unrelated project. Getting the newspaper in the rain would even be a risk in my starched shirt. Nope I’m stuck here at the desk alright unless I go out to make a call on a client—and then I’m already dressed and ready.”
In my first full-time job after the military, I was a YMCA Program Director. When not teaching or coaching actual programs, we were required to be in coat and tie, ostensibly for appearance’s sake. But we staff knew it was really to keep us from shooting hoop, sneaking in some pick-up racquetball, or at the very least doing a few pull-ups or something instead of being at our desks. Not a bad management strategy for productivity although I did lose some time to changing clothes several times a day.
Our mothers always told us there’s nothing wrong with looking nice, and fair enough if those wearing business casual look nice and are wearing “smart casual” (and what does that compare with exactly: stupid casual?). There’s nothing wrong with looking nice by wearing a coat and tie either—for some of us it seems easier and eliminates guess work.
Comfort I can understand; a casual attitude toward our careers, I can’t. Both the volunteers and staff at REISA take the job of connecting you with your industry colleagues (be they suppliers or customers) to learn the latest developments in our alternative investment space very seriously, and we hope very professionally. Hundreds of volunteer and staff hours and thousands of sponsor dollars go into making the REISA annual event unparalleled in our field. Presentations and panels are reviewed and continually revised up to the last minute to keep you in the know.
If you only have one chance to meet face-to-face during the year with your colleagues in the industry, the REISA Annual Conference is it. We strive to make this the one-stop annual check-in for you to renew your knowledge and networks. You, as a professional, are expected to be there. And as servant leaders to the industry, REISA dedicates itself to making sure it’s the professional experience you expect and need—no guess work involved.
John HarrisonExecutive Director, REISA
FYI FALL 2013 3
4 FYI FALL 2013
The JOBS Act Mandate
The Jumpstart Our Business Startups Act (the “JOBS Act”) directed the Securities and Exchange Commission (the “SEC”) to enact an amendment to Regulation D
of the Securities Act of 1933 (“Regulation D”) which would permit general solicitation advertising in offerings made under Rule 506 of Regulation D. On July 23, 2013, the SEC issued Release No. 33-9415 which set forth new Rule 506(c) of Regulation D permitting general solicitation for private offerings if certain requirements are met. Rule 506(c) becomes effective on September 23, 2013. In addition, the JOBS Act mandated a change to the Securities Act of 1933, as amended (the “Securities Act”) which provided an exemption from registration as a broker or a dealer under the Securities and Exchange Act of 1934, as amended (the “Exchange Act”) for persons that maintained a platform for solicitation of investors in a Rule 506 offering (the “JOBS Act Exemption”). While many had hoped that these changes would allow issuers to make private offerings in an unfettered manner, upon closer examination there are still pitfalls of which issuers (and in particular their principals and employees) and broker-dealers must be aware.
The Requirements of Rule 506(c)Rule 506 provides a safe harbor from registration of securities issued pursuant to Section 4(a)(2) of the Securities Act. New Rule 506(c) expands this safe harbor to permit issuers to engage in general solicitation when offering and selling securities in a private offering, provided that:
1. All purchasers are accredited investors (or investors that the issuer reasonably believes are accredited at the time of the sale);
2. the issuer takes reasonable steps to verify the accredited investor status of each purchaser; and
3. the issuer complies with other applicable provisions of Regulation D.
Purchasers Must Be AccreditedAlthough the general solicitation will be permitted to be sent to persons who are not accredited, the securities may only be purchased by persons who are accredited investors or investors that the issuer reasonably believes are accredited at the time of the sale.
Reasonable Steps to Verify Accredited Investor StatusNew Rule 506(c) requires the issuer to take reasonable steps to verify that the purchasers of the securities are accredited
investors. Offerings conducted under Rule 506 typically have relied on a “check the box” subscription agreement where the investor indicates that they are (or are not) accredited. This method of accreditation confirmation is not likely to satisfy the requirements of Rule 506(c). Rule 506(c) provides several non-exclusive methods which would satisfy the issuer’s reasonable requirement to verify including (i) reviewing two years of tax returns and obtaining a certificate from the purchaser that such purchaser has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor in the current year, (ii) reviewing bank, brokerage or other statements with respect to assets, and a consumer report from at least one of the nationwide consumer reporting agencies dated within 3 months with respect to liabilities, and obtaining a certificate from the purchaser that all liabilities necessary to make a determination of net worth have been disclosed or (iii) obtaining written confirmation from a registered broker-dealer, registered investment advisor, licensed attorney or certified public accountant that such person has taken reasonable steps to verify the purchaser’s accredited investor status.
Investors in Rule 506(c) offerings will be required to provide significantly more information to the issuer. Some investors may feel uncomfortable with providing this information or may question why it is necessary. However, the information being provided is similar to what the investors have traditionally provided to their broker-dealers.
Regulation D Compliance RequirementsNew Rule 506(c) requires that the issuers comply with the other requirements of Regulation D. In a separate release, the SEC has proposed that issuers that want to conduct an offering pursuant to Rule 506(c) must also file an Advance Form D at least 15 days prior to the offering being made. The Advance Form D would include basic information about the offering. Issuers would still be required to amend the Form D within 15 days after the first sale of the securities to provide all required information.
In addition, the SEC has adopted new rules with respect to the disqualification of persons from all Rule 506 offerings. The so-called “bad actor” disqualification provisions will eliminate the ability of persons (including officers, directors, principals and owners of more than 20% of an issuer or sponsor) to conduct a Rule 506 offering, including those who are subject to certain orders of federal or state agencies or have been found liable for things such as fraud. The disqualification provisions require that the trigger event occur after the effective date of the new provisions. Events that occurred prior to such date which would have been a disqualification event if they occurred after the effective date have become mandatory disclosure events for the issuer.
The Uncharted Waters of General SolicitationBy Darryl Steinhause and Amy Giannamore, DLA Piper
FYI FALL 2013 5
Definition of a Broker and Safe Harbor Under the Exchange ActSection 3(a)(4) of the Exchange Act defines a “broker” as any person engaged in the business of effecting transactions in securities for the account of others. Section 15(a)(1) of the Exchange Act requires brokers and dealers to register as a broker or dealer. The definition of “broker” has customarily been interpreted by the SEC as not requiring the issuer itself to register as a broker because the issuer is not effecting a transaction for the account of others. However, the officers, directors and employees of an issuer do not benefit from the same interpretation. Rule 3a4-1 is a “safe harbor” for persons associated with an issuer (i.e., the officers, directors and employees of the issuer) which allows them to not register under Section 15(a)(1) of the Exchange Act as a broker. Rule 3a4-1 requires that an associated person will only fall within the “safe harbor” if several criteria are met.
In order to qualify under Rule 3a4-1, the associated person (i) cannot be subject to a statutory disqualification, (ii) is not compensated in connection with his or her participation by the payment of commissions or other remuneration either directly or indirectly on transactions in securities and (iii) is not at the time of his or her participation an associated person of a broker or dealer. In addition to complying with all of (i) through (iii) above, the person must also comply with one of the following:
General Solicitation and General AdvertisingRule 506(c) will allow issuers to use all means of general solicitation and general advertising to conduct Rule 506 offerings. This would include internet, print media, television, radio and other forms of advertising. The SEC has indicated that it will be focused on ensuring that the materials used for any general solicitation are not fraudulent in nature. In a separate release, the SEC has proposed that all general solicitation materials be filed with the SEC no later than the first day of use.
Broker-Dealer ImplicationsUnder the current Rule 506, which prohibits general solicitation, issuers generally rely on broker-dealers to bring clients to the issuer for the purchase of the issuer’s securities. Rule 506(c) gives the issuers the ability to conduct offerings directly with the public instead of working through a selling group of broker-dealers. However, lifting the ban on general solicitation may not be the magic bullet that issuers may have been hoping for. If the officers, directors and employees of an issuer are engaged in the marketing and sale of securities to the public, the associated persons of the issuer must comply with the broker-dealer requirements set forth in the Exchange Act or find an exemption.
6 FYI FALL 2013
(1) the security must be sold through a registered broker-dealer (or other specified person), (2) the associated person (a) primarily performs, or is intended to perform at the end of the offering, substantial duties for or on behalf of the issuer other than the sale of securities for the issuer, (b) is not, and has not for the prior 12 months, been an associated person of a broker-dealer and (c) does not participate in more than one offering every 12 months, or (3) the associated person (x) only prepares or delivers written communications through the mail or means that does not include oral solicitation, (y) only responds to inquiries initiated by potential investors which are limited to the contents of the offering material or (z) only performs administrative work with respect to the transaction. Associated persons that work with a sponsor that conducts only one offering every 12 months or more may be able to take advantage of Rule 3a4-1 because such persons may be able to meet the requirement set forth in (2) above. The requirements of Rule 3a4-1 will not be easy to meet for persons associated with a sponsor that conducts multiple offerings, unless the transaction is completed through a broker-dealer. In the release proposing Rule 3a4-1, the SEC stated that the safe harbor was not intended to be available to promoters of real estate syndications and other so-called “tax sheltered investments” that are regularly engaged in actively marketing securities. As a general matter, both examples raise traditional broker-dealer regulation concerns. Even if satisfied, Rule 3a4-1 only provides a “safe harbor” for federal purposes. Certain states have their own requirements regarding registration as a broker-dealer.
In comments to the American Bar Association, David Blass, the Chief Counsel of the SEC discussed a recent case involving the payment of transaction-based fees to a consultant who was not a registered broker or dealer. The fees were paid for actively soliciting investors for private fund investments. The SEC found that the arrangement violated the registration requirements of the Exchange Act. Mr. Blass noted the following items are important in determining whether a person is required to register as a broker-dealer:
• One should consider the duties and responsibilities of personnel performing solicitation and marketing efforts. Mr. Blass indicated a dedicated sales force of employees working within in a “marketing” department may strongly indicate that such persons are in the business of effecting transactions, regardless of how the personnel are compensated.
• One should consider whether employees who solicit investors have other responsibilities and whether the primary responsibility of the employee is to solicit investors.
• One should consider how employees who solicit investors are compensated. If the employee receives bonuses or other types of compensation that is linked to successful investments it could be considered transaction-based compensation.
• One should consider whether it charges a transaction fee in connection with the sale of the security.
JOBS Act ExemptionThe JOBS Act also required the adoption of the JOBS Act
Exemption. The JOBS Act Exemption provides that no person is subject to registration pursuant to Section 15(a)(1) of the Exchange Act solely because: (A) that person maintains a platform or mechanism that permits the offer, sale, purchase or negotiation of or with respect to securities, or permits general solicitations, general advertisements or similar or related activities by issuers of such securities, whether online, in person or through any other means; (B) that person or any person associated with that person co-invests in such securities or (C) that person or any person associated with that person provides ancillary services (generally due diligence services) with respect to such securities. On its face, it appears that this provision may eliminate the problem of registration as a broker or dealer for associated persons. However, the JOBS Act Exemption has important limitations, the most significant of which is that the person and each person associated with that person must not receive any compensation in connection with the purchase or sale of such securities. The SEC has indicated that the compensation limitation is to be interpreted broadly. This compensation prohibition is not limited to traditional transaction-based compensation (i.e. commissions) but includes any direct or indirect economic benefit to the person or any of its associated persons. This includes salaries paid to employees in marketing or investor relation departments or carried interests or promotes held by the issuer in a fund. The SEC indicated that it believed that the JOBS Act Exemption will have limited practical applicability and it is unlikely that a person outside the venture capital area would be able to rely on the exemption from broker-dealer registration. The JOBS Act Exemption only provides an exemption from the registration requirements but not does not exempt a person from being considered a broker or dealer who would be subject to certain provisions of the Exchange Act (i.e. anti-fraud provisions, etc.).
Recent No Action Letters Related to Broker-Dealer StatusRecently, the SEC issued two no action letters that addressed the use of internet solicitation of potential investors in the venture capital context. The facts of the no action letters were similar. The no action letter applicant (the “Applicant”) was a company that maintained a website that solicited investors to determine investor interest in funding certain venture capital opportunities that had been identified by the Applicant. If sufficient investor interest was generated, the Applicant would form a fund that would make an investment in the target company (the “Private Fund”). The issuance of securities in the Private Fund would be made in reliance on Rule 506 of Regulation D. The Applicant became the advisor to the Private Fund and was registered as an investment advisor under the Investment Advisers Act of 1940. The Applicant did not receive any compensation at the time that the investment was made (other than for reimbursement of actual expenses)
Continued on page 8
FYI FALL 2013 7
General Solicitation and Advertising Allowed
1General solicitation and advertising had been strictly prohibited since the advent of Regulation D in 1982. The new Rule 506(c) recently adopted by the SEC
(and scheduled to go into effect on September 23, 2013) permits sponsors to publicly advertise and solicit investors, so long as certain requirements are met (discussed below). To view the full text of the new rule, visit: http://www.sec.gov/rules/final/2013/33-9415.pdf. This new freedom means that private equity funds, hedge funds, real estate sponsors, and other promoters of alternative investment programs may now promote their Reg. D, Rule 506 (accredited investor-only) offerings through online ads, TV commercials, newspapers advertisements, cold calling, seminars and other educational programs. Query whether widespread advertising campaigns will be cost-effective given the relatively small population of accredited investors in the U.S., but this new freedom of expression will surely facilitate capital-raising efforts in the small business community.
Who is an Accredited Investor?
2 The extraordinary benefit of general solicitation and advertising under Rule 506(c) is limited to offerings that are open only to accredited investors. For
various reasons, many sponsors have been limiting their Regulation D private offerings to accredited investors for years, but now they have even more incentive to do so.
Rule 501(a) defines eight different categories of accredited investor. For individuals, an investor with a net worth (excluding value of a principal residence) in excess of $1 million or annual income in excess of $200,000 ($300,000 jointly with spouse) will be considered an accredited investor. For some frequently asked questions about accredited investors, check out the “Articles” page of www.ericperkinslaw.com for an article discussing commonly asked questions about accredited investor categories, interpretations, and related issues.
The Burden of Establishing Accredited Investor Status
3 Sponsors promoting Reg. D private, accredited-only offerings are accustomed to bearing the burden of having a reasonable basis for believing that the
investors accepted into their programs are accredited, so to some extent there is nothing new about having to establish the accredited status of an investor. However, the burden is arguably higher (at least in perception if not reality) under the new Rule 506(c) for sponsors to demonstrate. The SEC has established a principles-based verification standard for sponsors to follow. Relevant
factors include (i) the nature of the investor and applicable category of accredited investor; (ii) the amount and type of information the sponsor has about the investor; and (iii) the nature of the offering in question. In short, sponsors must be prepared to conduct additional due diligence, request additional documentation from prospective investors, and/or rely on third-party certifications (e.g., financial advisors, accountants, attorneys, etc.).
“Bad Boy” Disqualifiers Extended to Rule 506
4 Rule 506 will not be available to sponsors who are tainted with certain “disqualifying events” such as: (i) felony or misdemeanor convictions within the last
decade (five years for the issuing entity) in connection with the purchase or sale of a security, involving making a false filing with the SEC, or arising out of actions as an intermediary, advisor, or solicitor; (ii) any court order, within the last five years, which, at the time of the sale of securities in a Rule 506 offering, restrains or enjoins a person from engaging in practices in connection with the offer or sale of a security, making false filings with the SEC, or acting as an intermediary, advisor, or solicitor; and, among others, (iii) SEC disciplinary or cease-and-desist orders related to the offer and sale of a security. In other words, Rule 506 should be viewed as a useful capital-raising tool for those sufficiently committed to compliance and conducting business in a professional manner.
Don’t Forget About Broker-Dealer Registration and Compliance Issues
5 Sponsors should not forget that federal and state securities law also regulates who can legally offer and sell securities. Section 15 of the Securities
Exchange Act of 1934 provides, in relevant part, that no person can make use of the mails or interstate commerce to purchase or sell any security unless such person is registered as a broker-dealer. While sponsors can take advantage of federal and state exemptions from the broker-dealer registration requirements under certain circumstances, these compliance issues must be carefully analyzed based on specific facts and circumstances. Many sponsors will continue to find it useful and appropriate to sell their programs through affiliated or independent broker-dealer firms.
There is quite a bit more to the new Rule 506(c) to understand before embarking on a Rule 506(c) offering, and note that Rule 506(c) does not officially go into effect until September 23, 2013, following a 60-day public comment period, so resist the temptation to jump the gun and devote the necessary time and energy to fully understand and properly implement the new rules.
Five Things Real Estate Sponsors ShouldKnow About the New Rule 506(c)
By Eric C. Perkins, Esq.
8 FYI FALL 2013
some investors may want to maintain relationships with their registered broker-dealer. As a result, some investors will still be obtained through traditional broker-dealer relationships. However, many investors may not want to incur the additional cost of engaging a broker-dealer. In that case, issuers would be able to use general solicitation and general advertising to attract investors, but the investor would be directed to purchase the investment through a broker-dealer. Assuming that the sales activities occur through the broker-dealer, the issuer and its associated persons would have an exemption from the broker-dealer registration requirements. In this type of arrangement, the registered broker-dealer will still need to comply with the requirements imposed by the Financial Industry Regulatory Authority (“FINRA”), including all of the “know your client” rules and suitability requirements. Because the broker-dealer will not have a pre-existing relationship with the client, it may be more difficult for the broker-dealer to comply with the FINRA requirements. FINRA rule changes may be required in order for broker-dealers to operate under the new general solicitation provision.
ConclusionLifting the prohibition against general solicitation may provide issuers with direct access to investors that is not currently available. However, the issuers, and the persons associated with the issuer, must be mindful of the Exchange Act and state requirements related to registration as a broker-dealer. Most sponsors that do more than one offering per year will still need to utilize broker-dealers. However, the roles of the registered broker-dealer and the structure of the transaction are likely to change.
but received a carried interest in the Private Fund. The SEC noted that because the Applicant received the carried interest in the Private Fund, the JOBS Act Exemption was not available. Even though the JOBS Act Exemption was not available to the Applicant, the SEC found that the Applicant was not required to register as a broker or dealer. The SEC took particular note that neither the Applicant nor any of its associated persons were receiving any transaction-based compensation, the Applicant was a registered investment advisor and the Applicant would have no right to withdraw any deposited funds from the custody accounts established to hold investor money. Thus, the SEC took the position that the Applicant was not a broker or dealer as defined by the Exchange Act.
What Does it All Mean?Issuers, and in particular the persons associated with issuers, must ensure that they do not have to register as a broker or dealer for purposes of the Exchange Act. As discussed above, the traditional exemption provided in Rule 3a4-1 may be difficult for many issuers (and their associated persons) to meet. The JOBS Act Exemption appears to be extremely limited in application because of the prohibition on compensation and the broad interpretation given to that prohibition by the SEC. As a result, it is not practical for issuers and their associated persons to rely on the JOBS Act Exemption. Further, the recent no action letters appear to provide a limited structure under which to sell investments.
It is likely that the real estate syndication industry will adjust so that there will be two alternative structures. First,
Continued from page 6
Spring SymposiumMarch 16-18, 2014
Sheraton San Diego Hotel & Marina
SaveDatethe
reisa.org
FYI FALL 2013 9
Know Your Arbitration Claim: Understand Claimants’ Strategies Ahead of Time By Barbara Halper and Vicki Lubben, FactRight, LLC
Financial Industry Regulatory Authority (“FINRA”) arbitrations, specifically focused upon private placements, have become part of doing business
for broker-dealers. Integral to the arbitration claims against broker-dealers has been failure of the broker-dealer to supervise activities related to sales. According to claimants’ attorneys, the failure to supervise directly resulted in the failure to follow rules and regulations related to due diligence and suitability and that as a result of that failure, the broker-dealer caused claimants to lose money because they were sold unsuitable investments. In this article, we will look at what claims are typically alleged, what those claims are based upon, and risk management strategies to mitigate future claims.
The ClaimsClaimants’ attorneys communicate with each other and share their strategies. They also create templates for claims that they use repeatedly and adapt for different products. The template generally includes the following:
INADEQUACY OF THE BROKER-DEALER’S WRITTEN SUPERVISORY PROCEDURES (WSPs):
• The WSPs for internal and external staff and contractors were inadequate, not maintained, and not followed
• There was no system for on-site or off-site supervisory review of representations, recommendations, and actions by the broker-dealer’s registered representatives.
• There was no system to track client investment history, including any prior high-risk, long term illiquid investments
• There was no system for monitoring for excessive concentration
BECAUSE OF INADEQUATE WSPs:
• Supervisory personnel, including the Compliance Department, could not exercise effective supervision
• Supervisory personnel could not determine whether or not a specific recommendation would result in an over-concentration of a high risk investment in view of the customer’s liquid net worth, financial situation, investment objectives and needs
• Registered representatives, off-site persons, employees or contractors who engage in securities-related activities on a full or part time basis are left to supervise themselves with no unannounced records inspections and compliance audits to insure that their methods
of business and day-to-day operations comply with applicable rules
How would you respond to these allegations today?
Claimants’ Legal ArgumentsCourt decisions under federal and state securities laws and regulations have made it clear that broker-dealers have a duty to supervise their employees’ and registered representatives’ sales activities, under the principal-agent and respondeat superior doctrines. The duty of a broker-dealer to supervise the sales activities of its registered representatives is also one of the most basic and important duties of members under FINRA rules. The claim that negligence or failure to supervise a registered representative resulted in harm to a customer has been the basis for broker-dealer liability under numerous lawsuits and arbitrations.
Failure to meet any of the following or other supervisory obligations under FINRA rules may contribute to a negligent supervision or failure to supervise claim against the member or a supervising principal in an arbitration or lawsuit:
• NASD Rule 3010 (a) requires that each member establish and maintain a system to supervise the activities of each registered representative, registered principal, and other associated person that is reasonably designed to achieve compliance with applicable securities laws and regulations, and NASD/FINRA Rules. The system must include the establishment and maintenance of written procedures as required by Rule 3010(b) (Written Procedures), and internal inspections and reviews as required by 3010(c) (Internal Inspections).
• Under FINRA Rule 3130 Annual Certification of Compliance and Supervisory Processes, a member is required to designate and identify a chief compliance officer and have its chief executive officer (or equivalent officer(s)) certify annually that it has in place processes to establish, maintain, review, test and modify written compliance policies and WSPs reasonably designed to achieve compliance with applicable FINRA rules, federal securities laws and regulations, as well as other certifications.
• FINRA Rule 2090 (Know Your Customer) requires that every member undertake reasonable due diligence related to the opening and maintenance of every client account, to know (and retain) essential facts concerning every customer, including those that are required to effectively service the customer’s account, understand the authority of each person acting on behalf of the customer, and comply with applicable laws and rules.
10 FYI FALL 2013
• FINRA Rule 2111(a) (Suitability) requires that every member or associated person have a reasonable basis to believe that a recommended securities transaction is suitable for the customer, based on reasonable diligence to ascertain the customer’s investment profile. To comply with Rule 2111(a), a member must establish and enforce supervisory and compliance processes reasonably designed to ensure the investments recommended and sold are suitable for at least some investors, and registered representatives must attempt to gather all of the information required for a complete investment profile, and document the suitability of their investment recommendations
• FINRA Notice 11-02 reiterates that a member’s Know Your Customer and Suitability obligations under FINRA rules are fundamental to ensuring investor protection and promoting fair dealing with customers and ethical sales practices.
• Other FINRA Rules establish member obligations to supervise a variety of types of securities sales transactions with customers, and include rules governing special products. The special products rules include FINRA Rule 2310 (Direct Participation Programs), which sets forth suitability, due diligence, and customer account statement obligations that members must meet and ensure registered representatives comply with when recommending and selling direct participation programs.
On top of this, FINRA has issued several Notices to Members expressing the view that members have a heightened obligation to supervise recommendations and sales of complex products. The SEC has also focused its examinations on sales and supervision of sales of complex investments. FINRA Notice 12-03 provides characteristics which may make a product “complex,” which is defined as a product with multiple features that affect returns differently under various scenarios. In such contexts, Notice 12-03 identifies areas for heightened procedures that may be appropriate, including:
• Approval of the sale of complex products (based on a reasonable basis suitability determination)
• Post approval review
• Training of registered representatives to ensure they understand the features and risks of complex products before they recommend them
• Consideration of an investor’s financial sophistication by imposing prior-approval requirements for certain types of transactions, and taking steps such as imposing specific prohibitions or conditions such as concentration limitations or limitations on the types of investors to whom the product may be sold
• Discussions with customer concerning the features of the product, how it is expected to perform under different market conditions, the risks and benefits, the costs of
the product, and possible scenarios in which the product could perform poorly
• Consideration of whether less complex or costly products could achieve the customer’s objectives
Through notices such as 12-03 and broker-dealer examination program priorities, FINRA and the SEC are attempting to establish and enforce a heightened supervisory obligation for members with regard to complex products.
The previous discussion is not exhaustive, but it will give you a snapshot of the various bases on which claimants’ attorneys focus their claims.
Risk ManagementWhat can you do about the risk of supervision-related claims? Avoid the prospect of successful claims by proactively focusing on risk management. What exactly is risk management? It is identifying, analyzing, and prioritizing risks in order to develop plans for mitigation, monitoring, and control of them. No matter how long you have been in business or how you may have avoided claims in the past, take a fresh look at what you are doing today.
• Conduct an internal review of your WSPs now, not just when they are scheduled to be reviewed in the future
• Consider an audit of your WSPs by an outside firm and take their recommendations seriously
• Review your WSPs to make sure discretion is written in where you need it, especially for concentration
• Review the qualifications of your key personnel involved in the development, maintenance, and implementation of those procedures
• Make sure your chief compliance officer has the qualifications and authority to adequately perform that role, and that he or she has the support of the organization
• Make sure your personnel know the WSPs and follow them. Take corrective action if they do not follow them.
Pay specific attention areas that claimants’ counsel love to focus on:
• Review all of your registered representatives to determine if there are any that should be under heightened supervision and act upon that determination
• Make sure the unannounced audits of off-site offices are conducted, documented and findings acted upon
• Follow your WSPs
• Keep timely and organized documentation of the enforcement of your WSPs
THE BOTTOM LINE IS:
Know what you are required to do for it to be done the right way, make sure that you have qualified people trained to do it, check twice that they are in fact doing it, and document that you have done it.
FYI FALL 2013 11
Despite the slowing trend of b/d closings, Alsup still doesn’t have much hope for the small broker/dealer. He expects the industry to continue to consolidate and for small firms to be gobbled up by others to survive.
“You’ve got to get bigger,” he said. “Unless you’re in a real narrow niche where you’re managing hundreds of millions, with a sidebar RIA, you’ve got to add personnel. You need compliance people; you need back-office people. It takes manpower; it takes money to do this.”
Reprinted with permission from the July 1, 2013, online edition of WealthManagment, www.wealthmanagement.com
The Small Broker/Dealer Is Not Dead…YetBy Diana Britton, Managing Editor, REP., WealthManagement.com
For the last several years, industry experts (and WealthManagement.com) have talked about the small independent broker/dealer as if it were an endangered
species. Sure, many small b/ds—bogged down by increasing regulation, compliance costs, litigation and competition—have closed their doors. But new data from Fishbowl Strategies suggests there may be a turnaround in the cards.
In May, 15 broker/dealers went out of business, compared to 25 that closed up in May 2012 and 18 that shut down in May 2011, according to David Alsup, founder of Fishbowl Strategies, which tracks changes in firm registrations at FINRA. Meanwhile, 11 firms opened up in May, compared to six new firms in May of last year.
Alsup attributes the decline in b/d closings to the rise in the equity markets this year. An increase in trading activity has given a much-needed lift to b/ds’ margins. “You have a market up, very strong, so there’s a little more profitability.”
Another good sign is that the gap between the number of firms opening and closing is narrowing, Alsup said. The three-year average has dropped to 11.4 new formations and 24.8 closures per month. And while the 12-month ratio is still a net loss (155 firms), that loss has declined year over year. (See chart, below.)
But the trend continues that people aren’t opening up as many new b/ds as they used to, and Alsup expects that number to continue to waver around 11 each month until the end of the year.
“The overhead from the standpoint of overregulation is so difficult to get a new firm admitted to FINRA,” Alsup said. “It’s much more difficult than it used to be.”
“Tax Considerations in ‘Debt-for-Equity’
Partnership Deb Restructuring, Part 1:
Creditor’s Perspective,” prepared by REISA’s Capital Markets Subcommittee, can now be found on REISA’s website at www.reisa.org/whitepapers.
REISA Releases Second in White Paper Series
This paper provides an overview of the various U.S. federal income tax rules that must be taken into consideration by a
creditor in connection with a “debt-for-equity” partnership debt restructuring. These rules include the various statutory and regulatory provisions, as well as certain judicial doctrines and relevant case law.
Survival of the FittestThe number of new broker/dealers has been slowing over the last couple years, but so has the number of firms shutting their doors. 350
300
250
200
150
100
50
02010 2011 2012 2013
177
325
148
173
317
144127
173
300
114
269
155
■ 12-Month Total of New Firms
■ 12-Month Total Shuttered
■ 12-Month Net Loss
Source: David Alsup, Fishbowl Strategies
12 FYI FALL 2013
By Jennifer Fitzgerald, Director of Marketing, REISA
Why Should You Attend REISA’s Annual Conference & Trade Show?
REISA is dedicated to providing industry-leading events for those who sponsor, analyze, market, distribute or sell alternative investments. With quality attendance
and exceptional educational programs, REISA’s Annual Conference is set apart from other industry events!
Marketing & Technology• Social Media• Email Communication• Public Relations Efforts
For REPS• Marketing & Practice Management• Alternative Diversification Strategies
For BROKER-DEALERS• Preparing for DPP Audits• Ongoing Due Diligence—The Purpose, Practice and
Being Persistent• Driving Change Without Rocking the Boat• For Retail Broker-Dealers ONLY: Broker-Dealer Advisory
Council Meeting
Col. Oliver North
Opening Keynote Speaker
“Investing in Your Future”
Oliver North is a combat decorated U.S. Marine, a #1 best-selling author, the founder of a small business, an inventor with three U.S. patents, a syndicated columnist, and the host of “War Stories” on Fox News Channel.
Former NBA Player Grant Hill, Closing Keynote Speaker <with picture>
“A Champion’s Approach to Business and Sports”
The Grant Hill story is one of faith, guts, family, friends, commitment and the incredible will to play basketball. On the court, he amplifies the talents of his teammates, and he’s a winner
as part of two elusive NCAA Championships. He is unselfish, possessing a strong work ethic, and shows creativity with the basketball. He is a confident leader who rises to the occasion in close ball games. Off the court, Grant is humble and a true believer in community investment.
Both speakers will be available afterward for photo opportunities!
For more conference and registration information, go to reisaconference.org.
Join us at Caesars Palace in Las Vegas October 6-8 for REISA’s Annual Conference & Trade Show. Our Conference Planning Committee has worked tirelessly to ensure that this year’s agenda is the best yet.
EDUCATIONAL HIGHLIGHTS INCLUDE:
Real Estate Boot Camp• The Resurgence of the 1031 TIC/DST Market• Understanding Cap Rates and Rates of Return• Tactical Analysis of Fees and Expenses
Alternative Investments Product Overview• Standards, Risks, Sales Strategies
Legislative and Regulatory Sessions• The Current Regulatory Environment Affecting Alternative
Investments• Regulatory Audits and Inspections• Hot Topics Involving Non-Traded Products• Developments in Arbitration• FINRA/SEC Updates
New General Solicitation Impact—Ramifications of New Advertising Rates
DPP• Best Practices• 1031 Exchanges• Working Out TICs and DSTs
REITs• CIO Panel• What is the Future of Capital Raising for Both NTRs and
BDCs?
BDCs• Evaluation & Metrics• Investing Throughout a Market Cycle• Credit Market Overview
REISAAnnual
CONFERENCEand TRADE SHOW
2013
October 6-8,2013
Caesars PalaceLas Vegas, Nevada
reisaconference.org
REISA—the leading Alternative Investments Association
providing education, networking and advocacy for members
Why Go?• Network with an expected 1,000 leading industry
professionals, including 500 registered reps, financial advisers and broker-dealers/RIAs
• Participate in a variety of educational tracks, breakout sessions and roundtable discussions
• Gain exclusive knowledge on sponsors and new products emerging in the industry
• Products include REITs, BDCs, 1031s, Private Placements, Oil & Gas, Equipment Leasing, Debt and more
• Earn your continuing education credits, including CFPs, CLEs and CEUs, and DPP credits
• Get the latest on how regulatory changes will affect your business
Register today!Broker-Dealers/RIAsSign up today to receive complimentary registration and up to two hotel room nights for two principals, owners or officers per company (limit 2). Register early to guarantee hotel availability.Registered Reps/IARsNew this year! Registered Representatives/IARs are eligible for one complimentary night at Caesars Palace. Availability is limited – register early.Sponsors/AffiliatesExhibit space and special sponsorship opportunities are still available! Contact Tony Grego, [email protected] or 317-663-4173, for more information.
Caesars Palace October 6-8, 2013 Las Vegas, Nevada
Two Meridian Plaza10401 North Meridian StreetSuite 202Indianapolis, IN 46290
