SEC Rules and Regulations

SEC Announces Final Rule Mandating Electronic Filing and Simplification of Form D

In a release issued on February 6, 2008 (the "Release"), the SEC adopted final rules that mandate the electronic filing and alter the information requirements of Form D.  Issuers can voluntarily begin filing Form D electronically on September 15, 2008 and will be required to file electronically beginning on March 16, 2009.  An issuer must still file Form D with the SEC within 15 days of the issuer's first sale of securities offered pursuant to Regulation D of the Securities Act of 1933 (the "Securities Act").

The Release noted that electronically filed Form D data will be made available to the public via the SEC's website in an interactive format that can be easily read, searched and downloaded.  The mechanics of the SEC's online filing system have not been finalized; however, the SEC expects the system to be in place by September 15, 2008.  Form D filings will be part of the SEC's EDGAR system and will resemble the online filing system currently used for Forms 3 and 5 filed pursuant to Section 16(a) of the Securities Exchange Act of 1934.

The new Form D does not incorporate the SEC's proposed changes to Regulation D and the accredited investor standard that were the subjects of Releases No. 33-8828 (August 3, 2007) (as discussed in greater detail in the September 2007 Investment Management Regulatory Update) and 33-8766 (December 27, 2006) (as discussed in greater detail in the January 2007 Investment Management Regulatory Update), respectively.  The new Form D also differs from the form provided in the proposing release, Release No. 33-8814, (the "Proposing Release") (as discussed in greater detail in the July 2007 Investment Management Regulatory Update), because the Form D in the Proposing Release reflected the changes to Regulation D and the accredited investor standard contemplated by Releases No. 33-8828 and 33-8766.  The SEC is still in the process of considering changes to Regulation D and the accredited investor standard, and it may update Form D in the future to reflect the adoption of any such changes.

According to the Release, the SEC and the North American Securities Administrators Association are working on a proposal that would allow for "one-stop" electronic filing of Form D for federal and state regulators.  Currently, "one-stop" electronic filing of Form D is not available.  However, the SEC envisions a system whereby a filer could, in one online transaction, file its Form D with the SEC and designate states to receive its Form D simultaneously.  According to the SEC, implementing "one-stop" filing of Form Ds would significantly reduce the filing costs of small businesses and others filing Form D information.

The SEC has revised the information requirements for Form D in an attempt to ease the burden on those completing the form while still collecting the data the SEC deems relevant for fulfilling its duty to oversee the private placement market.  The SEC also uses the data it collects from Form D to enhance its rulemaking efforts generally, and the SEC noted that numerous other market participants, such as investors and self-regulatory organizations, utilize Form D data.  The information requirements of Form D have been structured around responses to 16 Items of information.  A brief description of the 16 Items follows:

  • Item 1.  As in the current Form D, the new Form D will require issuers to provide basic identifying information about themselves, such as the issuer's name, date of formation and jurisdiction of organization.  Item 1 of Form D will accommodate multiple issuers for multiple-issuer offerings.
  • Item 2.  Like the current Form D, the new Form D will require issuers to provide their address and contact information.  Item 2 of Form D will allow for, but not require, listing the contact information for all issuers of a multiple-issuer offering.
  • Item 3.  Due to privacy concerns, issuers will no longer have to identify as related persons those persons who own 10% or more of a class of the issuer's equity securities.  Previously, Form D required such persons to be identified as related persons notwithstanding their potential lack of actual decision-making authority with respect to the issuer.  The SEC stated in the Release that it expects that the persons identified in response to Item 3 would be the issuer's "principal policymakers."  Therefore, issuers typically will have to identify as related persons such individuals as executive officers and directors.
  • Item 4.  Issuers will be required to select a standardized industry group from a pre-supplied drop-down list and no longer will be able to provide their own description.  Among the industry group options will be "Pooled Investment Fund."  Upon selecting "Pooled Investment Fund" as its industry group, such an issuer will be prompted to provide various additional sub-categories of data, including whether the issuer is registered as an investment company pursuant to the Investment Company Act of 1940 (the "Investment Company Act").
  • Item 5.  Generally, Item 5 will prompt issuers to report revenue range information; however, issuers will be able to choose to "Decline to Disclose" revenue information.  The SEC stated that the "Decline to Disclose" option "might be used if a private company considered its revenue range to be confidential information."  Funds that seek asset appreciation, such as venture capital and private equity funds, will also be able to choose "Not Applicable."  Issuers that have identified themselves as hedge funds (or other pooled investment vehicles aside from venture capital and private equity funds) will have the option, though they will not be required, to provide aggregate net asset value information.
  • Item 6.  An issuer will have to specify the Regulation D exemption on which it is relying for its private placement.  If the issuer is relying on an exemption pursuant to Rule 504, it will be required to specify the paragraph or sub-paragraph of Rule 504 that applies to its offering.  If the issuer claims an exemption from the Investment Company Act pursuant to Section 3(c) of the same, it will be required to denote the specific paragraph on which it is relying for its exemption.
  • Item 7.  Issuers will be required to indicate whether they are filing a new Form D or an amendment to a previously filed Form D.  New filings will have to indicate the date of the first sale of securities or that the securities have yet to be sold. The instructions to Form D will provide guidance with respect to when the date of the first sale of securities is deemed to occur.  The new instructions also will clarify when an amendment must be filed to correct a previously filed Form D.  A previously filed Form D will be required to be amended to correct any material mistake or error as well as to reflect certain other changes in information pertinent to the offering and/or the issuer; however, no amendment will need to be filed to denote changes after an offering has terminated.  Changes that the SEC considers material and that would necessitate an amendment include, but are not limited to, a greater than 10% increase in the total offering amount and a greater than 10% increase in the amount of sales commissions, finders' fees or proceeds used to pay related persons since the Form D was originally filed.  At the time an amendment is filed, all other information on the Form D must be up-to-date.  Finally, if the offering is continuing, Form D must be amended annually on or before the first anniversary of the filing of the previous Form D.
  • Item 8.  Form D filings must indicate the duration of the offering and must note in particular whether the duration will exceed one year.
  • Item 9.  Issuers must state with specificity the type of securities being offered.
  • Item 10.  Issuers must state whether the offering that is the subject of the Form D filing is being made pursuant to a tender offer, merger, or other "business combination" transaction.
  • Item 11.  Issuers must specify the minimum investment amount applicable to the offering for outside investors.
  • Item 12.  Issuers must state the amount of sales compensation paid to any person in connection with the offering.  Issuers must also note the CRD number of all such persons registered with FINRA.
  • Item 13.  The amount of total sales and total offering amount must be provided by the issuer.
  • Item 14.  The issuer must report whether it intends to offer its securities to non-accredited investors, and, if applicable, the issuer must report the number of any non-accredited investors who have already invested in the offering.
  • Items 15 and 16.  Item 15 will require the issuer to report the total amount of sales fees and finders' fees it paid in connection with the offering, and Item 16 will require the issuer to supply information regarding the amount of the gross proceeds of the offering that will be used to pay "related persons."  Previously, issuers were required to describe what they intended to do with the proceeds raised in the offering.  The SEC stated in the Release that it typically received vague answers in response to the question, which yielded little information "of regulatory interest."  The SEC believes that the information now sought in Items 15 and 16 is specific enough to be useful for regulators without overburdening filers.

The signature block of Form D will also be updated.  The two signature blocks of the old Form D will be replaced by one signature block in the new Form D.  The new signature block will, among other things, confirm that the issuer signing the Form D has read the Form D and knows it to be true and, unlike the current Form D, consents to service of process via the Secretary of the SEC or the designated officer of the state in which the issuer has its principal place of business and any state where the Form D is filed.

The Release also states that because Form D will now be publicly available, Rule 502(c) will be amended to include a safe harbor from Regulation D's prohibitions on "general solicitation" and "general advertising" for issuers providing the information requested in Form D, so long as the information provided in the Form D is put forth in a "good faith and reasonable effort" to comply with form's requirements.  Additionally, issuers will be able to use "free writing" to clarify their responses to Items 3, 10, 13, 15 and 16 of Form D.  Such "free writing" will be permissible so long as it is "consistent with the safe harbor," according to the Release.

In connection with the revision of Form D and mandating its electronic filing, the SEC will also make conforming changes to Rules 100, 101, 104, 201 and 202 of Regulation S-T and Rules 502 and 503 of Regulation D.

SEC Votes to Propose Form ADV Rule Amendments

In a release dated February 13, 2008, the SEC announced its unanimous vote to propose amendments to Part 2 of Form ADV that would require investment advisers to prepare and deliver to existing and potential clients a narrative brochure written in plain English, and to file the brochure electronically. The brochure would then be publicly accessible through the SEC-sponsored Investment Adviser Public Disclosure website.

In remarks at the Commission Open Meeting on February 13, SEC Chairman Christopher Cox explained that the goal of the proposal was to better equip clients to make informed decisions about choosing an investment adviser. According to Chairman Cox, part of the rationale for the proposed amendment is that "current disclosure requirements are outdated, often do not result in useful information for clients and do not reflect substantial changes in the marketplace that have occurred in recent years."

Currently, Part 2 of Form ADV allows investment advisers to use a "check-the-box, fill-in-the-blank" format to inform clients about the investment adviser's business practices, fee arrangements, conflicts of interest and disciplinary history, among other things. Chairman Cox used the examples of conflicts of interest and soft-dollar arrangements to explain how the proposed amendments would improve the quality and usefulness of Form ADV disclosure. He explained that while the current "check-the-box" format allows an adviser simply to indicate the existence of facts that could give rise to a potential conflict, the proposed amendments would require the adviser to elaborate on how those facts present the adviser with a conflict. Similarly, while an adviser currently need only indicate the existence of soft-dollar arrangements, the proposed amendments would require the adviser to describe the products and services obtained through these arrangements, as well as whether the adviser pays more for research under these arrangements than it would without the use of soft dollars.

The proposed rule amendments contain many of the same changes proposed by the SEC in April 2000. That proposal required, among other things, electronic filing of Form ADV, narrative disclosure in plain English, as well as the delivery to clients of "brochure supplements" containing certain information about an adviser's supervised persons. The SEC deferred adoption of these rule changes due in part to concerns expressed by industry groups that the requirements of the proposal were unduly burdensome. Please see the May 2000 Regulatory Update for a detailed discussion of the 2000 proposal.

The SEC has not yet posted the full details of the proposed rule and form changes. We will follow any new developments and will discuss the full proposal in a future update.

Industry Update

Director of SEC's Office of Compliance Inspections and Examinations Discusses Frequently Asked Questions

In a January 17, 2008 speech at the SIFMA Compliance and Legal Division January General Luncheon Meeting, Lori Richards, Director of the SEC's Office of Compliance Inspections and Examinations, discussed "frequently asked questions about SEC examinations."

Likelihood of examination. Richards' division is frequently asked about the likelihood of a particular registered firm being examined. Richards acknowledged that the vast number of firms under the jurisdiction of the SEC leads to a small chance that any particular firm will be examined. However, Richards noted that the SEC tends to pursue "firms and issues that have the greatest potential to pose harm to investors." Therefore, for example, larger firms, where compliance lapses will affect a greater number of investors, have a higher chance of being examined. Firms that have historically shown lapses in compliance are likely to be reexamined, according to Richards. Additionally, firms that engage in inherently risky activities are more likely to receive an examination. On the other hand, firms that have shown "strong compliance controls" are less likely to be examined, said Richards.

Current areas of interest for the Office of Compliance Inspections and Examinations. Richards stated that the most frequent question her division receives relates to its current compliance priorities. Currently, Richards and her division are focused on several priorities, including, but not limited to, addressing the dually registered broker-dealer and adviser issues raised by the recently completed RAND study (as discussed in more detail in the January 2008 Investment Management Regulatory Update), valuation controls, insider trading controls and compliance with regulations governing the marketing of financial products to senior citizens.

With respect to the RAND study, Richards noted that her division has embarked on a "pilot" program that "will include examinations of a number of dually registered broker-dealers and investment advisers at the same time, with a view towards a common examination module." The goal of the program, according to Richards, is to make the examination process more efficient for regulated firms while at the same time providing the examination team with the "whole picture" of a firm's multiple lines of business.

Valuation remains a concern for examiners, and Richards noted that her office plans on giving close scrutiny to whether firms have in place procedures to ensure that securities, including illiquid securities, are valued at prices "that could be obtained in a current sale."

As firms engage in new lines of business, Richards said that she expects them to maintain up-to-date internal controls on insider trading. She characterized insider trading by industry professionals as particularly detrimental to investor confidence in the market.

Finally, Richards noted that she and her office will monitor marketing practices aimed specifically at senior citizens to ensure that firms are following all applicable regulations with respect to such activities. Of particular concern to Richards and her office are the "free lunch" sales seminars offered to senior investors by many firms.

Documents typically requested during an examination. Each examination is unique, stated Richards, making standardized document requests impossible to produce, but Richards also stated that her division is attempting to make the process more "transparent" in response to numerous questions regarding the documents that a firm might be expected to produce if examined. Richards noted that firms under examination should expect that examiners might request "a significant number of documents."

Examination outcomes. Richards is frequently asked about what possible outcomes a firm faces from an examination. She noted that most firms receive a non-public deficiency letter. Such letters describe the deficiencies noted by the examiners and request a response by the firm. Should more serious problems be uncovered during the process, the examiner may refer the matter to enforcement staff. Matters are typically referred to enforcement because the examination has uncovered fraud, investor harm, systematic rule violations, poor supervision or failure to alert the examiners to internally known compliance issues, among other considerations.

Ensuring a smooth examination. Many compliance officers have asked Richards about how to ensure a smooth examination, and Richards suggested that communication, honesty and preparation are the keys to a smooth examination. She recommended that those in charge of compliance view examinations as "a normal part of your business as a responsible regulated firm." Compliance officers should ensure that written procedures and policies are up-to-date and adequate given their business model and risks. Richards emphasized that proactive responses to examinations, including keeping a running dialogue with the examiner, helps to ensure a smooth examination. Finally, Richards stated that those facing an examination should be "scrupulously honest" with the examiners.

Litigation

Bayou Fund CFO Sentenced to 20 Years

On January 29, 2008, Daniel E. Marino, the former chief operating officer and chief financial officer of the Bayou group of hedge funds, was sentenced to 20 years in prison for defrauding investors of more than $450 million. Marino's incarceration is to be followed by three years of supervised release. In addition, the court ordered Marino to forfeit cash, property and interests in partnerships and to pay $300 million in restitution to the defrauded investors. A final order of restitution will be issued by April 30, 2008.

Marino had pleaded guilty to conspiracy, investment adviser fraud, mail fraud and wire fraud. Although Marino's co-conspirators, Samuel Israel III (Bayou's chief executive officer) and James G. Marquez, who ran the first Bayou fund together with Israel, have both also pleaded guilty to conspiracy and fraud charges brought against them, Judge Colleen McMahon, in imposing Marino's sentence, called Marino "the linchpin of the fraud." Israel is awaiting sentencing. Marquez was sentenced on January 22, 2008 to 51 months' imprisonment, which is close to the maximum of five years that could have been imposed. Marquez's imprisonment is to be followed by two years of supervised release; he has been ordered to pay over $6 million in restitution and to forfeit all property traceable to the fraud.

According to the civil complaint filed by the United States Attorney with the US District Court for the Southern District of New York in September 2005, in the period from 1998 to 2005, Marino, Israel and Marquez fraudulently misrepresented the performance of the Bayou funds, disseminating to Bayou investors newsletters and reports that contained inflated profits and rates of return. They also sent to investors falsified financial statements, claiming the statements had been audited and certified by an independent accounting firm when in fact the firm was a sham set up by Marino as part of the co-conspirators' scheme to deceive investors. At the time, Marino was a certified public accountant.

The Bayou funds collapsed in August 2005, after Marino and Israel attempted to recoup mounting losses by investing the funds' capital in various private placements. Lewis Malouf, a managing director of Bayou, with the assistance of Karl Johnson, was to invest approximately $100 million of what remained of the Bayou funds in bank instruments that would supposedly yield $1.7 billion over ten years. Through a series of international bank transfers carried out by Bayou, the capital to be invested in these private placements ended up in a Wachovia bank account for which Johnson was the sole signer. As part of a separate investigation of a so-called "prime bank instrument" fraud on financial institutions, the Arizona Attorney General's Office seized the approximately $100,010,673 in the account in May 2005. The following month, Bayou sued to quash the seizure and reclaim the funds, but the pleadings were struck by the Arizona Superior Court in September, after the US Attorney's Office in New York sued to freeze the funds. Shortly thereafter, Israel and Marino entered guilty pleas to charges of conspiracy and fraud.

Supervision and Recordkeeping Violations by Registered Futures Commission Merchant Lead to Over $77 Million CFTC Settlement

The US Commodity Futures Trading Commission (the "CFTC"), recently announced a suit against, and settlement with, MF Global Inc. ("MFG") and Thomas Gilmartin stemming from their alleged violations of the supervision and recordkeeping provisions of Section 4g of the Commodity Exchange Act and CFTC Regulations 1.35(a-1)(1) and 166.3.

MFG, a registered Futures Commission Merchant, employed Gilmartin, who served as the account executive at MFG for the account of the Philadelphia Alternative Asset Fund Ltd. (the "Fund"), an offshore hedge fund dedicated to trading commodity futures and options managed by Paul M. Eustace, the president of the Philadelphia Alternative Asset Management Company LLC ("PAAMCo").

According to the CFTC, the failure of Gilmartin and MFG to implement and adhere to adequate supervisory and recordkeeping policies and practices aided Eustace's fraudulent concealment of massive losses in the Fund. In particular, the CFTC noted that Gilmartin and MFG failed to investigate a sub-account opened at MFG by Eustace for the Offshore Fund although they knew that the sub-account consistently lost money while the main account for the Fund posted gains. Gilmartin and MFG were also cited by the CFTC for failing to disclose in applicable regulatory filings Gilmartin's ownership interest in PAAMCo. Additionally, the CFTC noted that Gilmartin and MFG failed to follow MFG's own internal procedures regarding cross-trades between the Fund's accounts, which allowed Eustace to move loss-generating positions into the sub-account. Gilmartin, contrary to MFG policies, allowed Eustace to control access to all information regarding the sub-account, and Eustace used this control to mislead the Fund's administrator, who then provided inaccurate NAV calculations to the Fund's investors. According to the CFTC, Gilmartin also failed to investigate the apparent back-dating of certain trades by Eustace, and MFG's internal controls were inadequate to identify such practices.

Pursuant to their settlement with the CFTC, Gilmartin and MFG were fined $250,000 and $2 million, respectively, and both must contribute a combined $75 million towards the receivership estate of the Fund, of which $6 million represents legal costs incurred by the estate in litigating claims against Gilmartin and MFG.

Commenting on the matter, Greg Mocek, the CFTC's Director of Enforcement, stated, "MFG and Mr. Gilmartin have recognized that the Commission and the Courts consider failures of supervision and recordkeeping to be serious offenses that will have dramatic consequences."

SEC Settles Action Against Former UBS Broker for Aiding and Abetting Hedge Fund Fraud

On January 14, 2008, the SEC settled charges against a former UBS broker, Justin M. Paperny, relating to allegations that he aided and abetted the fraudulent offering of interests in a hedge fund, GLT Venture Fund, L.P. (the "Fund").

According to the complaint, the Fund purported to use a "zero cost collar strategy" to generate returns of approximately 27% per year; however, the Fund never employed such a strategy and lost most of the $14.1 million that it had raised from 42 investors over the course of its existence.

The complaint alleges that Paperny, the Fund's broker, knew that the manager of the Fund, Keith G. Gilabert, paid returns to existing investors through new contributions, had large trading losses, never employed the "zero cost collar strategy" and otherwise was misappropriating client funds, but he nevertheless facilitated the subscriptions of new investors to the Fund and collected hundreds of thousands of dollars of commissions on thousands of trades by the Fund. It further alleges that Paperny falsely represented to a prospective investor in the Fund (who ultimately committed over $4 million to the Fund) that he could procure access to "hot" IPO shares for the Fund's benefit and falsely represented to a retiring money manager (who ultimately gave Gilabert his multi-million dollar book of business) and his clients the condition of the Fund and claimed that UBS had "vetted Gilabert as a fund manager."

Paperny settled charges brought against him by the SEC by consenting to a judgment that enjoined him from future violations of the securities laws, required him to disgorge ill-gotten gains and assessed a civil fine against him.