M&A Broker vs. Broker-Dealer

SEC issues M&A Advisor interpretations.

Securities and Exchange Commission
SEC issues M&A Advisor interpretations.

I have written in the past about the challenges of people looking to facilitate deals without a broker-dealer license. Short answer: You probably can’t get paid.

However, there is an entire industry of business brokers and M&A advisors that seem to get close to the line. In January 2014, the SEC outlined when an M&A advisor could assist in the sale of a privately held company without registering as a broker-dealer. Its been hanging out there for a while, but I figured this was a good enough time to write about it.

First, it defined “M&A Broker” as “a person engaged in the business of effecting securities transactions solely in connection with the transfer of ownership and control of a privately-held company (as defined below) through the purchase, sale, exchange, issuance, repurchase, or redemption of, or a business combination involving, securities or assets of the company, to a buyer that will actively operate the company or the business conducted with the assets of the company.”

In addition, a “privately-held company” is not an SEC filing company

The SEC provided a list of several conditions:

  • The M&A Broker will not have the ability to bind a party to an M&A Transaction.
  • An M&A Broker will not directly, or indirectly through any of its affiliates, provide financing for an M&A Transaction.
  • The M&A Broker may not have custody, control, or possession of or otherwise handle funds or securities issued or exchanged in connection with an M&A Transaction or other securities transaction for the account of others.
  • No M&A Transaction will involve a public offering.
  • Any offering or sale of securities will be conducted in compliance with an applicable exemption from registration under the Securities Act of 1933.
  • No party to any M&A Transaction may be a shell company, other than a business combination related shell company.
  • To the extent an M&A Broker represents both buyers and sellers, it will provide clear written disclosure as to the parties it represents and obtain written consent from both parties to the joint representation.
  • An M&A Broker will facilitate an M&A Transaction with a group of buyers only if the group is formed without the assistance ofthe M&A Broker.
  • The buyer, or group of buyers, in any M&A Transaction will, upon completion of the M&A Transaction, control and actively operate the company or the business conducted with the assets of the business.
  • Any securities received by the buyer or M&A Broker in an M&A Transaction will be restricted securities within the meaning of Rule 144(a)(3) under the Securities Act.

There are more details in the SEC’s letter, which we may cover in another post. It will be interesting over time to see if the SEC focuses on one or more elements of the interpretation.

SEC Due Diligence Alert Released For Investment Advisers

SEC due diligence alert regarding processes for selecting alternative investments is released.



Link: SEC Risk Alert – Investment Advisor Due Diligence Processes for Selecting Alternative Investment and their Respective Managers

The SEC has been reviewing due diligence processes for investment advisers for alternative investments and is getting concerned. After all, assets under management, or “AUM” in industry talk, reached $6.5 trillion for alternative investments. The SEC issued an alert reminding advisers to perform due dilience to determine whether the investment:

  • Meets the clients’ investment needs; and
  • Is consistent with disclosed investment strategies.

According to the SEC, “alternative investments” include hedge funds, private equity, venture capital, real estate and funds of private funds.

The SEC conducted examinations of registered advisers and noted the following trends in alternative investment due diligence to identify risk indicators:

  1. Advisers are seekeing more information directly from alternative investment managers
  2. Advisers are using third parties to supplement their analyses and verify data
  3. Advisers are performing additional quantitative analysis of performance returns and risk measures
  4. Advisers are expanding their due diligence processes and focus areas

The SEC then used the alert to remind advisers about their obligations to adopt and review their compliance programs and codes of ethics.

 

SEC Logo
SEC Office of Compliance Inspections and Examinations issues risk alert for due diligence processes by investment advisers

 

 

 

 

 

 

 

SEC Files Fraud Charges Against Wing Chau, One of the CDO Managers Profiled in Michael Lewis’ “The Big Short”

This won’t be good for the Wing chau defamation suit against Michael Lewis.

Some readers may be familiar with “The Big Short: Inside the Doomsday Machine,” Michael Lewis’ chronicle of the run up to the financial meltdown.  I strongly recommend it.  It is a great read.
The Big Short
Michael Lewis, The Big Short. Short review: A good read.

In the book, there was a discussion of Wing Chau, who helped create and, in theory, manage some disastrous CDOs.  He was not portrayed like the brilliant hedge fund managers who cashed in on the crash of real estate-backed securities.  He was portrayed like a fool.  For this, he sued Lewis for defamation.

I’m not sure if that case is ongoing or not, but the SEC has weighed in.  Verdict:  fraud charges against Chau for misleading investors in a CDO and for breach of fiduciary duties.

The SEC’s claims that Chau and his firm, Harding Advisory LLC, compromised their independent judgment as collateral manager to a CDO in favor of a hedge fund firm.  The hedge fund, the awesomely named Magnetar Capital LLC, had invested in the equity of the CDO.  Merrill Lynch structured and marketed the CDO.  Harding was collateral manager for the CDO.

Specifically, the SEC claims that Harding agreed to let the hedge fund help select the subprime mortgage-backed assets underlying the CDO.  This was not disclosed to investors.

The SEC claims that the influence of the hedge fund led Harding to select assets that its own credit analysts disfavored.  In the tradition of criminal geniuses everywhere, in accepting the bonds, Chau wrote in an e-mail to the head of CDO syndication at Merrill Lynch:

“I never forget my true friends.”

The SEC claims that Chau understood that Magnetar was interested in investing as the equity buyer in CDO transactions, and that Magnetar’s strategy included “hedging” its equity positions in CDOs by betting against the debt issued by the CDOs.  Because Magnetar stood to profit if the CDOs failed to perform, Magnetar’s interests were not necessarily aligned with investors in the CDO debt, which depended solely on the CDO performing well.

SEC Rolls Out Market Structure Website

It is actually a part of their sec.gov website, but it is a new part.

MIDAS Website here.
SEC Press Release here.

The SEC released its new MIDAS site to “promote better understanding of our equity markets and equity market structure through the use of data and analytics.”  This is a fancy way of saying that you can make charts of market info that you usually don’t see in traditional stock tickers rolling across your t.v. screen.

I am still combing through it to see what it does and how it can be useful.  It seems to provide some very detailed information relating to trading activity.  We are not talking about mere buy-sell-bid-ask information for stocks, but information that generates pretty charts purporting to show how the market functions.

It seems aimed at understanding (or providing the premise for going after) the high frequency trading (HFT) crowd and flash crashes.

The SEC believes it will help it to monitor and understand mini-flash crashes, reconstruct market events, and develop a better understanding of long-term trends.  To this end, MIDAS collects:

  • posted orders and quotes on national exchanges;
  • modifications/cancellations of those orders;
  • trade executions against those orders; and
  • off-exchange trade executions.

The SEC’s new website will be making available broadly:

  • ratios related to the number and volume of orders that are canceled instead of traded;
  • percentage of on-exchange trades and volume that are not disseminated on the public tape (odd-lot trades);
  • percentage of on-exchange trades and volume that are the result of hidden orders; and
  • quarterly distributions analyzing the lifetime of quotes ranging from one millionth of a second to one day.

The website can be used to:

  • compare and contrast data series according to the type of security, market capitalization, volatility, price, and turnover; and
  • explore detailed quote-life distributions, and download data series and quote-life distributions.

It is not immediately clear to me how this will be used as a policy-making tool, but you can expect charts generated from MIDAS to be displayed in some very exciting Congressional hearings.

Do Section 10(b) and Rule 10b-5 Apply Outside of the U.S.?

Spoiler Alert: No, and this applies to civil and criminal matters, according to the Second Circuit.

Link:  U.S. v. Vilar 

Amid a selection of evidentiary and litigation-y claims, the recent 2nd Circuit case of U.S. v. Vilar did have some interesting nuggets for securities professionals.  Looking at an open issue following the U.S. Supreme Court case of Morrison v. National Australia Bank Ltd., the court looked at whether criminal liability under the Securities Exchange Act of 1934 extended to conduct outside the U.S.

Morrison was a civil case that limited Exchange Act Section 10(b) and Rule 10b-5 to domestic transactions in securities.

Background

The defendants were investment managers and advisers managing up to $9 billion before the tech bubble burst.  They offered select clients the opportunity to invest in securities that paid a high, fixed rate of interest, which were backed primarily by high quality, short-term deposits.  However a portion was invested in publicly traded emerging growth stocks.  See where this is going?

The bubble burst and the defendants were not able to meet the interest payments.  They created another investment vehicle and sold it to an investor, using the proceeds to settle a portion of the previous securities and for various personal expenses.  This investor complained to the SEC after demands to return her funds were met with questionable responses.

The defendants were convicted on a variety of securities, mail and wire fraud counts.

The Argument

Relying on Morrison, he defendants argued that their convictions should be reversed since their conduct was extraterritorial, or outside the U.S.

The court agreed and quoted Morrison for the proposition that when a statute gives no clear indication of an extraterritorial application, it has none.  Although Section 10(b) clearly forbids a variety of fraud, its purpose is to prohibit crimes against private individuals or their property, which is the sort of statutory provision for which the presumption against extraterritoriality applies (responding to the government’s examples of cases broadly applying statutes extraterritorially where the victims were government actors).  A statute either applies exterritorially or it does not, and once it is determined that  a statute does not apply extraterritorially, the only relevant question is whether the conduct occurred in the territory of a foreign sovereign.  In such a case, the court’s test is:

A securities transaction is domestic when the parties incur irrevocable liability to carry out the transaction within the United States or when title is passed within the United States.  More specifically, a domestic transaction has occurred when the purchaser has incurred irrevocable liability within the United States to take and pay for a security, or the seller has incurred irrevocable liability within the United States to deliver a security.

The Upshot

The conviction stands.  The conduct at issue was conducted in the United States, with ties to New York and Puerto Rico, which counts for the court’s purposes.

The defendants claimed that they structured the transaction carefully to avoid U.S. jurisdiction.  However, the court declined to “rescue fraudsters when they complain that their perfect scheme to avoid getting caught has failed.”

The Takeaway

The court summarized its conclusion on the relevant (to us) point as follows:

  • Section 10(b) and Rule 10b-5 do not apply to extraterritorial conduct, regardless of whether liability is sought criminally or civilly.
  • A defendant may be convicted of securities fraud under Section 10(b) and Rule 10b-5 only if he has engaged in fraud in connection with:
    1. a securities listed on a U.S. exchange; or
    2. a security purchased or sold in the United States.

SEC Issues Alert and Addresses Weaknesses of Investment Advisor Plans in Disruptions Caused By Weather

Following Hurricane Sandy, the SEC contacted investment advisors in the Northeast to try to understand how they were impacted by the storm.*  The SEC just released its findings, which it believes will help improve responses and reduce recovery time after “significant large scale events.”

Among the weaknesses noted by the SEC in certain advisors’ “business continuity plans,” or BCPs, were:

  • Some BCPs that did not adequately address and anticipate widespread events, such as adequate plans addressing situations where key personnel were unable to work from home or other remote locations.
  • Some advisers did not have geographically diverse office locations, and many smaller advisers had fewer geographically dispersed staff.
  • Some advisers did not evaluate the BCPs of their service providers.
  • Some advisers did not engage service providers to ensure that back-up servers functioned properly and relied solely on self-maintenance.
  • Some advisers did not adequately plan how to contact and deploy employees during a crisis, and inconsistently maintained communications with clients and employees.
  • Some advisers inadequately tested their BCPs relative to their advisory businesses.
  • Some advisers opted not to conduct certain critical tests because vendors provided disincentives or charged for testing.

The alert did not distinguish between large and small advisors or how appropriate BCP provisions addressing these weaknesses would be for smaller firms.  Geographic diversity is the most obvious example in that case.

______
*Investment advisors are required to implement these types of BCPs under the SEC’s interpretation of Rule 206(4)-7.

 

SEC Pounces on Bitcoin Ponzi Scheme – In Securities Fraud, Everything Old Is New Again

Movie critics would call the scheme cliched and hackneyed.
Link:  SEC Charges Texas Man With Running Bitcoin-Denominated Ponzi Scheme

This week, the SEC charged McKinney, Texas-based Trendon T. Shavers with defrauding investors in a Ponzi scheme involving Bitcoin.  He may have raised more than $4.5 million in the scheme, but due to the Bitcoin-denominated transactions and vague SEC release, it is hard to tell.  The SEC also says that in more recent dollars, the 700,000 Bitcoin raised exceeds $60 million, which screams “We Want Headlines!!!!” to me.

Shavers’ vehicle was called Bitcoin Savings and Trust and he used the names “Pirate” and “pirateat40” to sell his dirty wares.  Despite the scary name, Shavers is probably just a Jimmy Buffet fan.

Jimmy Buffet, A Pirate Looks At Forty

The SEC claims Shavers claimed that investors would have no risk and huge profits over the Internet.  It appears that Shavers took in Bitcoin investments and then sent them out in withdrawals and interest payments while losing money in his investments and siphoning off funds for himself.  This is classic Ponzi scheme.  Nothing new or notable other than the Bitcoin angle, which isn’t that interesting considering other schemes that are far more imaginative.

 

Insider Trading – How Much Of A Factor Must The Material Non-Public Information Play In The Investment Decision?

Spoiler alert: Not much.

Link: United States v. Raj Rajaratnam

Raj Rajaratnam, former billionaire hedge fund manager, appealed his notorious insider trading conviction.  If you recall, he was the founder of the Galleon Group hedge funds who received insider information from contacts at McKinsey, Intel, Goldman Sachs and other hedge funds.

Among the issues raised at trial was whether the fraud counts should be vacated because the court told the jury that it could convict Rajaratnam if the “material non-public information given to the defendant was a factor, however, small, in the defendant’s decision to purchase or sell stock.  He claimed that this allowed to jury to convict without a causal connection between the inside information and the trade.

The court noted that under the misappropriation theory of insider trading, a person commits fraud “in connection with” a securities transaction in violation of Rule 10b-5 when he misappropriates confidential information for securities trading purposes in breach of a duty owed to the source of the information.  The Supreme Court in the O’Hagan case enshrined/created this theory to “protect the integrity of the securities markets against abuses by ‘outsiders’ to a corporation” who have access to confidential information that will affect the corporation’s security price but otherwise owe no duty to the corporation’s shareholders.

The court in this case endorsed the “knowing possession” standard* that is consistent with the cardinal rule of insider trading:

If you have a fiduciary or other duty to the company and hold material non-public information, disclose or abstain.

On this basis, the appeals court said that the district court’s instruction was more favorable to Rajaratnam than the legal standard.  Rather than merely be in possession of the information, the jury had to find that he used it in some manner to find him guilty of insider trading.  As a result, the jury instruction satisfied the “knowing possession” standard.

*The knowing possession standard became the law in the 2nd Circuit in United States v. Teicher and United States v. Royer.