Tag: lex nova law

audience asking questions by raising hands

The Series LLC And Crowdfunding Vehicle: A Legal Explanation And A Funding Portal WSP

On By crowdfundattnyIn Crowdfunding Portals, Crowdfunding Vehicles, Series LLC2 Comments

Lots of people have asked for a legal explanation in response to my previous post about crowdfunding vehicles and the series LLC. Plus, many funding portals will want a Written Supervisory Procedure (WSP) addressing the issue.

Here’s the legal reason why a “series” of a limited liability company can’t serve as a crowdfunding vehicle.

Rule 3a-9(b)(1) (17 CFR §270.3a-9(b)(2)) defines “crowdfunding vehicle” as follows:

Crowdfunding vehicle means an issuer formed by or on behalf of a crowdfunding issuer for the purpose of conducting an offering under section 4(a)(6) of the Securities Act as a co-issuer with the crowdfunding issuer, which offering is controlled by the crowdfunding issuer.

You see the reference to the crowdfunding vehicle as an “issuer” and a “co-issuer.”

Now here’s a C&DI (Compliance & Disclosure Interpretation) issued by the SEC in 2009:

Question 104.01

Question: When a statutory trust registers the offer and sale of beneficial units in multiple series, or a limited partnership registers the offer and sale of limited partnership interests in multiple series, on a single registration statement, should each series be treated as a separate registrant?

Answer: No. Even though a series of beneficial units or limited partnership interests may represent interests in a separate or discrete set of assets – and not in the statutory trust or limited partnership as a whole – unless the series is a separate legal entity, it cannot be a co-registrant for Securities Act or Exchange Act purposes.

Note the conclusion:  “. . . .unless the series is a separate legal entity, it cannot be a co-registrant for Securities Act or Exchange Act purposes.”

A “series” of a limited liability company is not a separate legal entity. Under section 218 of the Delaware Limited Liability Company Act and corresponding provisions of the LLC laws of other states, if you keep accurate records then the assets of one series aren’t subject to the liabilities of another series. That makes a series like a separate entity, at least in one respect, but it doesn’t make the series a separate legal entity. A motorcycle is like a car in some respects but it’s not a car.

That’s the beginning and end of the story:  a crowdfunding vehicle must be an “issuer”; a series of a limited liability company can’t be an “issuer” because it’s not a separate legal entity; therefore a series of a limited liability company can’t be a crowdfunding vehicle.

Maybe someone will challenge the application of the C&DI in court. Until that happens the result is pretty clear.

A couple more things.

First, this same C&DI is the basis of many successful offerings under Regulation A. Suppose, for example, that you’d like to use Regulation A to raise money for real estate projects (or racehorses, or vintage cars, or anything else), but you don’t want to spend the time and money to conduct a Regulation A offering for each project. This same C&DI allows sponsors to treat the “parent” limited liability company as the only “issuer” in the Regulation A offering even while allowing investors to choose which project they’d like to invest in and segregating the projects in separate “series” for liability purposes. If each series were a separate issuer that wouldn’t work.

Second, suppose a funding portal creates a new series for each offering and has conducted 25 offerings (that is, 25 series for 25 crowdfunding vehicles), each with a different type of security (one for each offering). Because we know that only the “parent” can be an issuer:

  • They’ve violated Rule 3a-9(a)(3) because the parent has issued more than one class of securities; and
  • They’ve violated Rule 3a-9(a)(6) because there is no one-to-one correspondence between the securities of the parent and the securities of the crowdfunding issuer.

To quote Simon & Garfunkel, any way you look at this you lose.

If you’re a funding portal, you’ll probably be asked by FINRA to add a WSP dealing with crowdfunding vehicles. Here’s an example.

Questions? Let me know. 

Caution: Don't Use Series LLC As A Crowdfunding Vehicle

FINRA: Don’t Use Series LLC As A Crowdfunding Vehicle

On By crowdfundattnyIn Crowdfunding, FINRA, Series LLC2 Comments

At least one high-volume Crowdfunding portal once used a “series LLC” for each crowdfunding vehicle and used a crowdfunding vehicle for almost every offering. Maybe that portal and others still do.

In a post that has yet to be picked up by the Associated Press, this blog once explained why that was a bad idea from a legal liability point of view. Now FINRA has chimed in.

The Series LLC

Some states, notably Delaware, allow a single limited liability company to be divided into “series,” the way an auditorium could be physically divided into cubicles. If operated correctly, Delaware provides that the creditors of one series can’t get at the assets of another series. So if one series of the LLC operates an asbestos plant and is hit with a giant lawsuit, the plaintiffs can’t get at the assets of the real estate owned by a different series of the same LLC.

Why Not to Use a Series LLC

I argued that it would be foolish to use a series LLC as a crowdfunding vehicle because:

  1. The series LLC concept has never been tested in a bankruptcy court, so we’re still not 100% sure the walls between cubicles will hold up.
  2. Some states, like Arizona, don’t even recognize the series LLC concept. So if an Arizona resident invests in a series LLC that goes bad, she can theoretically get to the assets owned by every other series of the same LLC. When you have a high-volume portal using a new series over and over, that could be a nightmare.
  3. Using a series LLC rather than a brand new LLC saves less than $200.

FINRA Chimes In

According to a recent statement by FINRA, a series LLC would not satisfy 17 CFR §270.3a-9(a)(6), which requires a crowdfunding vehicle to “Maintain a one-to-one relationship between the number, denomination, type and rights of crowdfunding issuer securities it owns and the number, denomination, type and rights of its securities outstanding.”

FINRA is saying, in effect, that while one series of an LLC might be protected from the liabilities of a different series under Delaware law, the series is not itself an “issuer.” The “issuer” is the LLC itself, i.e., the “parent” limited liability company formed by the portal. Because the securities of that parent do not reflect a one-to-one correspondence with the securities of any particular company raising money on the platform, it doesn’t qualify as a crowdfunding vehicle – it’s a plain vanilla investment company. And investments companies aren’t allowed to use Reg CF (they’re also subject to a bunch of other rules).

For what it’s worth, FINRA’s position about who can be an “issuer” is consistent with SEC practice.

The Upshot

If FINRA is right, it probably means that every offering that used a series LLC as a crowdfunding vehicle was illegal. 

Some possible ramifications:

  • Any investor who lost money can sue the issuer and the funding portal, and possibly their principals.
  • Every issuer can sue the funding portal.
  • Funding portals might be sanctioned by FINRA.

In short, a bonanza for plaintiffs’ lawyers and a black eye for the Crowdfunding industry.

Questions? Let me know. 

chess board raising capital

Improving Legal Documents In Crowdfunding: Give Yourself The Right To Raise More Money

On By crowdfundattnyIn Crowdfunding, Crowdfunding LawsLeave a comment

Interest rates have gone up, real estate valuations have gone down, banks have disappeared, and investors have become more cautious. Many real estate sponsors, faced with looming loan repayments, wonder how they’re going to raise more equity.

They might be surprised when they check the Operating Agreement. Too often, Operating Agreements prohibit the sponsor from raising more equity without the consent of a majority of the LPs or even a single large investor. And getting that consent might not be easy or even possible, for several reasons:

  • Existing investors might not agree that new money is needed.
  • Existing investors might be unrealistic about market conditions, thinking the new equity can have the same terms as the existing equity.
  • Existing investors hate being diluted.
  • Existing investors might prefer to contribute the new money themselves on terms the sponsor believes are exorbitant.
  • A large investor might be angling to buy the property for itself at a fire sale price.

When times are good and the Operating Agreement is signed those possibilities seem far-fetched. Then you get to an April 2023.

Knowing that an April 2023 is always on the horizon, sponsors should negotiate hard at the outset for the right to raise more equity. They won’t always get it because people who write very large checks usually get what they want (that’s why we call it “capitalism”). But in my experience, too many sponsors give away the right too easily or don’t even think about it.

If the sponsor has the right to raise more equity, how do we protect the original investors? What’s to stop the sponsor from raising equity from her own family or friends on terms very favorable to them and very unfavorable to existing investors, even if the equity isn’t needed? 

The answer is “preemptive rights.” If the sponsor wants to raise more equity, she must offer the new equity to existing investors first. Only if they don’t buy it may she offer it to anyone else.

Preemptive rights aren’t perfect. The main flaw is that Investor Jordan, who had money to invest when the deal was launched, has fallen on harder times and doesn’t have money to participate in the new round. Or Mr. Jordan does have the money to participate but is no longer accredited and therefore can’t participate. 

Even with the flaws, preemptive rights generally allow for the equitable resolution of a difficult situation, much better than the alternatives most of the time.

You can see my form here. Let me know if you think it can be improved.

NOTE:  Sponsors might also consider “capital call” provisions, i.e., provisions allowing them to demand more money from investors if needed. In my opinion, however, they typically do more harm than good, driving away investors at the outset while not providing enough cash when it’s needed. And in practical terms, a large investor who would balk at allowing the sponsor to raise more equity certainly won’t agree to an unlimited capital call.

Questions? Let me know. 

Don't Use Lead Investors and Proxies in Crowdfunding Vehicles

Don’t Use Lead Investors And Proxies In Crowdfunding Vehicles

On By crowdfundattnyIn Crowdfunding, Crowdfunding Vehicles2 Comments

Some high-volume portals use a crowdfunding vehicle for every offering, and in each crowdfunding vehicle have a “lead investor” with a proxy to vote on behalf of everyone else. This is a very bad idea.

Lead investors are a transplant from the Silicon Valley ecosystem. Having proven herself through  successful investments, Jasmine attracts a following of other investors. Where she leads they follow, and founders therefore try to get her on board first, often with a promise of compensation in the form of a carried interest.

A lead investor makes sense in the close-knit Silicon Valley ecosystem, where everyone knows and follows everyone else. But like other Silicon Valley concepts, lead investors don’t transplant well to Reg CF – like transplanting an orange tree from Florida to Buffalo.

For one thing, Reg CF today is about raising money from lots of people who don’t know one another and very likely are making their first investment in a private company. Nobody is “leading” anyone else.

But even more important, giving anyone, lead investor or otherwise, the right to vote on behalf of all Reg CF investors (a proxy) might violate the law. 

A crowdfunding vehicle isn’t just any old SPV. It’s a very special kind of entity, created and by governed by 17 CFR § 270.3a-9. Among other things, a crowdfunding vehicle must:

Seek instructions from the holders of its securities with regard to:

  • The voting of the crowdfunding issuer securities it holds and votes the crowdfunding issuer securities only in accordance with such instructions; and
  • Participating in tender or exchange offers or similar transactions conducted by the crowdfunding issuer and participates in such transactions only in accordance with such instructions.

So let’s think of two scenarios.

In one scenario, the crowdfunding vehicle holds 100 shares of the underlying issuer. There are 100 investors in the crowdfunding vehicle, each owning one of its shares. A question comes up calling for a vote. Seventy investors vote Yes and 30 vote No. The crowdfunding vehicle votes 70 of its shares Yes and 30 No.

Same facts in the second scenario except the issuer has appointed Jasmine as the lead investor of the crowdfunding vehicle, with a proxy to vote for all the investors. The vote comes up, Jasmine doesn’t consult with the investors and votes all 100 shares No.

The first scenario clearly complies with Rule 3a-9. Does the second?

To appreciate the stakes, suppose the deal goes south and an unhappy investor sues the issuer and its founder, Jared. The investor claims that because the crowdfunding vehicle didn’t “seek instructions from the holders of its securities,” it wasn’t a valid crowdfunding vehicle, but an ordinary investment company, ineligible to use Reg CF. If that’s true, Jared is personally liable to return all funds to investors.

Jared argues that because Jasmine held a proxy from investors, asking Jasmine was the same as seeking instructions from investors. He argues that even without a crowdfunding vehicle – if everyone had invested directly – Jasmine could have held a proxy from the other Reg CF investors and nobody would have blinked an eye.

When the SEC issues a C&DI or a no-action letter approving that structure, terrific. Until then I’d recommend caution.

Questions? Let me know. 

What eBAY Tells Us About Secondary Markets For Private Companies

On By crowdfundattnyIn Blockchain Technology, Private Companies, Private Securities1 Comment

The securities of private companies are illiquid, meaning they’re hard to sell.

Since 2017 I’d guess a billion dollars and a million person-hours have been spent by those who believe blockchain technology will create liquidity for private securities. Joining that chorus, a recent post on LinkedIn first noted that trillions of dollars are locked up in private securities, then claimed that blockchain technology (specifically, the technology created by the company posting) could unlock all that value.

This is all wrong, in my always-humble opinion. All that money and all those person-hours are more or less wasted.

My crystal ball is no clearer than anyone else’s. But when I try to believe that blockchain will create active secondary markets I run up against two facts:

  • Fact #1: Secondary markets for private securities have been perfectly legal in this country for a long time, yet there are very few of them.
  • Fact #2: The New York Stock Exchange and other exchanges around the world were vibrant even when they were using little slips of paper.

Those two things tell me that it’s not the technology that creates an active secondary market and hence that blockchain won’t change much.

An active secondary market is created when there are lots of buyers and lots of sellers, especially buyers. When millions of people wanted to buy Polaroid in the 1960s they didn’t care whether Polaroid used pieces of paper or stone tablets. Conversely, put the stock of a pink sheet company on a blockchain and you won’t increase the volume.

As described more fully here, there are a bunch of reasons why there aren’t lots of potential buyers for a typical private company:

  • It probably has a very limited business, possibly only one product or even one asset.
  • It probably has limited access to capital.
  • It probably lacks professional management.
  • Investors probably have limited voting rights.
  • There are probably no independent directors.
  • Its business probably depends on one or two people who could die or start acting like Elon Musk.
  • Insiders can probably do what they want, including paying themselves unlimited compensation.
  • No stock exchange is imposing rules to protect investors.

All that seems obvious now and was obvious in 2017. But now I’m thinking of another company with lessons about secondary markets: eBay.

If there’s anything even less liquid than stock in a private company, it’s a used refrigerator, a bracelet you inherited from your grandmother, the clock you haven’t used for 15 years.

All those things and thousands more were once completely illiquid and therefore worth nothing. eBay changed that, almost miraculously adding dollars to everyone’s personal balance sheet. Just as every ATS operating today seeks to create an active market for securities, eBay created a market for refrigerators, bracelets, and clocks. Quite amazing when you think about it.

eBay didn’t create the market by turning refrigerators, bracelets, and clocks into NFTs. To the contrary, when you sell something on eBay you have to ship it, physically, using the lowest of low technology. eBay created the secondary market simply by connecting buyers and sellers using Web2. Just like another company that has created a pretty active market, Amazon.

If any ATS operating today had a thousandth of the registered users eBay has, its founders and investors would be even rubbing their hands with glee.

As a Crowdfunding advocate, I wonder what the world would look like if all those dollars and person-hours had been spent improving the experience of initial investors rather than pursuing secondary markets and blockchain, things dreams are made of. As the shine comes off blockchain maybe we’ll find out.

Questions? Let me know. 

Title III Crowdfunding

When Should A Crowdfunding SAFE Or Convertible Note Convert?

On By crowdfundattnyIn Convertible Note, SAFELeave a comment

Convertible notes and SAFEs often make sense for startups because they don’t require anyone to know the value of the company. Instead, the company and early investors can piggyback on a later investment when the value of the company might be easier to determine and the size of the investment justifies figuring it out.

Which raises the question, when should the convertible note or SAFE convert?

In the Silicon Valley ecosystem that’s an easy question. Per the Y Combinator forms, a convertible note or SAFE converts at the next sale of preferred stock, which necessarily involves a valuation of the company.

That works in the Silicon Valley ecosystem because (i) in the Silicon Valley ecosystem investors always get preferred stock, and (ii) the Silicon Valley ecosystem is largely an old boy network where founders and investors know and trust one another.

As I’ve said before, the Crowdfunding ecosystem is different. There are at least two reasons why the Y Combinator form doesn’t work here:

  • For a company that raises money with a SAFE in a Rule 506(c) or Reg CF offering, the next step might be selling common stock (not preferred stock) in a Regulation A offering. The SAFE has to convert.
  • Say I’ve raised $250K in a SAFE and think my company is worth $5M. If I’m clever, or from Houston*, I might arrange to sell $10,000 of stock to a friend at a $10M valuation, causing the SAFEs to convert at half their actual value. All my investors are strangers so I don’t care.

Which brings us back to the original question, what’s the right trigger for conversion?

Half the answer is that it should convert whether the company sells common stock or preferred stock. 

Now suppose that I’ve raised $250K in a SAFE round. The conversion shouldn’t happen when I raise $10,000 because that doesn’t achieve what we’re trying to achieve, a round big enough that we can rely on the value negotiated between the investors and the founder. What about $100,000? What about $1M?

In my opinion, the conversion shouldn’t be triggered by a dollar amount, which could vary from company to company. Instead, it should be triggered based on the amount of stock sold relative to the amount outstanding. So, for example:

“Next Equity Financing” means the next sale (or series of related sales) by the Company of its Equity Securities following the date of issuance of this SAFE where (i) the Equity Securities are sold for a fixed price (although the price might vary from purchaser to purchaser), and (ii) the aggregate Equity Securities issued represent at least ten percent (10%) of the Company’s total Equity Securities based on the Fully Diluted Capitalization at the time of issuance.

You might think 10% is too high or too low, but something in that vicinity.

Finally, the conversion should be automatic. Republic sells a SAFE where the company decides whether to convert, no matter how much money is raised. In my opinion that’s awful, one of the things like artificially low minimums that makes the Reg CF ecosystem look bad. You buy a SAFE and the company raises $5M in a priced round. The company becomes profitable and starts paying dividends. You get nothing. You lie awake staring at your SAFE in the moonlight.

*Go Phils!

Questions? Let me know.

The Crowdfunding Bad Actor Rules Don’t Apply To Investors

On By crowdfundattnyIn 100 Investor Rule, Accredited Investor, Investor, Investor Disclosures, Reg CF, Regulation A, Rule 506, Title III, Title III CrowdfundingLeave a comment

I often see Subscription Agreements asking the investor to promise she’s not a “bad actor.” This is unnecessary. The term “bad actor” comes from three sets of nearly indistinguishable rules:

  • 17 CFR §230.506(d), which applies to Rule 506 offerings;
  • 17 CFR §230.262, which applies to Regulation A offerings; and
  • 17 CFR §227.503, which applies to Reg CF offerings.

In each case, the regulation provides that the issuer can’t use the exemption in question (Rule 506, Regulation A, or Reg CF) if the issuer or certain people affiliated with the issuer have violated certain laws.

Before going further, I note that these aren’t just any laws – they are laws about financial wrongdoing, mostly in the area of securities. Kidnappers are welcome to use Rule 506, for example, while ax murderers may find Regulation A especially useful even while still in prison.

Anyway.

Reg CF’s Rule 503 lists everyone whose bad acts we care about:

  • The issuer;
  • Any predecessor of the issuer;
  • Any affiliated issuer;
  • Any director, officer, general partner or managing member of the issuer;
  • Any beneficial owner of 20 percent or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power;
  • Any promoter connected with the issuer in any capacity at the time of filing, any offer after filing, or such sale;
  • Any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with such sale of securities; and
  • Any general partner, director, officer or managing member of any such solicitor.

Nowhere on that list do you see “investor.” The closest we come is “Any beneficial owner of 20 percent or more of the issuer’s outstanding voting equity securities,” but even there the calculation is based on voting power. In a Crowdfunding offering you wouldn’t give an investor 20% of the voting power, for reasons having nothing to do with the bad actor rules. 

So it just doesn’t matter. This is one more thing we can pull out of Subscription Agreements. 

I know some people will say “But we want to know anyway.” To me this is unconvincing. If you don’t ask about kidnapping you don’t need to ask about securities violations.

Questions? Let me know.

Crowdfunding web portal

Updated Crowdfunding Cheat Sheet

On By crowdfundattnyIn Crowdfunding, Crowdfunding Cheat Sheet, Regulation CF, Regulation S, Rule 506(c), Title II, Title II Crowdfunding, Title III, Title III Crowdfunding, Title IV of the JOBS Act3 Comments

I first posted this Crowdfunding Cheat Sheet in January of 2014. Since then the rules have continued to change and improve. So here’s the current version, up to date with all the new rules and also expanded to answer questions my clients ask. For example, I’ve added a column for Regulation S because many clients want to raise money from overseas while simultaneously raising money here in the U.S.

I hope this helps, especially those new to the world of Crowdfunding.

CLICK HERE TO VIEW THE UPDATED CROWDFUNDING CHEAT SHEET

Questions? Let me know.

Three Ways To Improve Reg CF

On By crowdfundattnyIn Reg CF, Title III Crowdfunding11 Comments

Reg CF is off and running, on its way to becoming the way most American companies raise capital. Still, there are three things that would improve the Reg CF market significantly.

Revise Financial Statement Requirements

Financial disclosures are at the heart of American securities laws, I understand. The best way to understand an established company is often to pore over its audited financial statements, footnotes and all.

But that’s just not true of most small companies, whether the micro-brewery on the corner or a new social media platform. For these companies, reviewed or audited statements yield almost no worthwhile information to prospective investors. Yet the cost of the statements and the time needed to create them are significant impediments in Reg CF.

In my opinion, the following financial disclosures would be more than adequate:

  • Copies of the issuer’s tax returns for the last two years;
  • Interim financial statements (profit and loss and balance sheet) from Quickbooks or other financial software, through the last day of the month before the offering is launched;
  • A separate statement of the issuers’ assets and liabilities in Form C;
  • An attestation from the Chief Executive Officer;
  • A statement in Form C describing where and how the issuer expects to derive revenue during the next 12 months (e.g., subscription fees, advertisements, rents, etc.);
  • Reviewed financial statements for offerings in excess of $1,235,000; and
  • No requirement for audited statements.

Conversely, I believe annual audited financial statements should be required after a successful raise.

Address Artificially Low Target Amounts

Artificially low target amounts are the worst thing about Reg CF, by a long shot.

In the common approach, a company that needs $750,000 to execute its business plan sets a target amount of $25,000.

The artificially low target works for both the platform and the company. If the company raises, say $38,000, then the platform receives a small commission and advertises a “successful” offering, while the company can at least defray its costs.

But investors have thrown their money away.

Artificially low target amounts are terrible for investors and terrible for the industry, in a vicious cycle. Nobody wants to throw money away, and with so many Reg CF offerings using artificially low target amounts many serious investors will simply stay away from the industry.

Speaking of the Vietnam war, John Kerry asked “Who wants to be the last man to die for a lie?” Here, the question is “Who wants to be the first to invest in a company that needs a lot more?”

The fix is pretty simple. Issuers should be required to disclose what significant business goal can be accomplished if the offering yields only the minimum offering amount or, if no significant business goal can be achieved, should be required to say so.

In the meantime, it’s pretty shocking that while many offerings use an artificially low target amount, very few disclose the enormous additional risk to early investors. That’s a lot of lawsuits waiting to happen.

More Automation for Issuers

Speaking of lawsuits waiting to happen. . .

Most platforms do a pretty good job automating the process with investors. With issuers not so much.

Instead, platforms interact with issuers through people. Theoretically the role of these people is simply to guide the issuer through a semi-automated process. In practice, however, they end up as all-purpose advisors, giving issuers advice about everything from the type of security the issuer should offer to the issuer’s corporate structure to whether an SPV should be used.

As nice and well-meaning as these people may be, they aren’t qualified to give all that advice. Too often they end up giving advice that is either incomplete or wrong, doing a disservice to issuers and creating an enormous potential liability for the platform.

It’s unrealistic to think the platform will staff a team of investment bankers and securities lawyers giving individual advice to each issuer. Instead, in my opinion, the solution is to do a much better job automating the issuer side of the platform. That’s easier said than done, I realize. I hope and expect that the software providers active in Reg CF can provide some industry-wide solutions.

Questions? Let me know.

SEC Proposes New Restrictions For Private Fund Advisers

On By crowdfundattnyIn Private Fund Advisors, SEC2 Comments

The SEC recently proposed new rules for private fund advisers. If you raise and/or manage money from other people, you should probably pay attention.

A private fund adviser is an investment adviser who provides advice to private funds. A “private fund” is any issuer that would be treated as an “investment company” if not for the exemptions under section 3(c)(1) (no more than 100 investors) or section 3(c)(7) (all qualified purchasers) of the Investment Company Act.

  • EXAMPLE:  Nikki Chilandra forms an LLC of which she is the sole manager, raises money from her private network of investors (no more than 100), and uses the money to buy a limited partnership interest in one real estate deal. The LLC is a private fund, and Nikki is likely a private fund adviser.
  • EXAMPLE:  Jerry Cooperman forms an LLC of which he is the sole manager, raises money from his private network of investors (without limit), and uses the money to buy a duplex, which is rented to tenants. The LLC is not a private fund because it owns real estate, not securities. Hence, Jerry is not a private fund adviser.

In general, investment advisers are required to register either with the SEC or with the state(s) where they do business. But an advisor who provides advice only to private funds and manages assets of less than $150 million is exempt from registration with the SEC, and many states have similar exemptions. In fact, the SEC has expanded the definition of “private funds” for these purposes to include an issuer that qualifies for any exclusion under the Investment Company Act, not just the exemptions under sections 3(c)(1) and 3(c)(7).

An advisor who qualifies for the private fund exemption, like Nikki, is often referred to as an “exempt reporting adviser.” That’s because while she doesn’t have to register as an investment adviser, she does have to file reports with the SEC (an abbreviated Form ADV) and probably with the state where the fund is located also.

All of that is just to say that investment advisers who provide advice to private funds fall into two categories:  those who are required to register with the SEC and those who are not registered but still have to file reports. The SEC proposals affect both.

The following proposals would affect only advisers registered with the SEC:

  • Advisers would be required to provide investors with quarterly statements with information about the fund’s performance, fees, and expenses. Advisers would be required to obtain an annual audit for each fund and cause the auditor to notify the SEC upon certain events.
  • Advisers would be required to obtain fairness opinions in so-called adviser-led secondary transactions.

The following proposal would affect all advisers, including Nikki:

  • An adviser couldn’t charge for services not provided. For example, if an asset were sold, the adviser couldn’t charge for the advisory fees that would have been due over the next two years.
  • An adviser couldn’t charge the fund for expenses incurred in a regulatory examination of the adviser.
  • An advisor couldn’t reduce her clawback by the amount of any taxes.
  • An adviser couldn’t limit her liability for a breach of fiduciary duty, willful misfeasance, bad faith, recklessness, or even negligence.
  • An adviser couldn’t allocate fees among funds on a non-pro rata basis.
  • An adviser couldn’t borrow money from the fund.
  • An adviser couldn’t give preferential rights to redemption or preferential information rights to some investors if it would have a material negative effect on other investors.
  • An adviser couldn’t give other preferential rights to some investors without full disclosure to all investors.

I’ll just mention two of those items that come up frequently.

First, general partners typically seek to protect themselves from lawsuits brought by investors. Delaware and other states allow the general partner to disclaim all traditional fiduciary duties and adopt a “business judgment” standard in their place. If the SEC’s proposals are adopted, general partners acting as private fund advisers will no longer be allowed to protect themselves in this way and will be liable for a breach of fiduciary obligations as well as simple negligence.

NOTE:  Sponsors like Nikki wear more than one hat. They provide investment advice but perform other duties as well, like deciding whether to admit new LPs and on what terms. The SEC’s proposals would require Nikki to remain liable for negligence when she’s wearing her investment adviser hat but not when she’s wearing her other hats. The LLC Agreement could and should make that distinction.

Second, general partners typically enter into “side letters,” giving some limited partners a better economic deal than others – either a lower promote or a higher preferred return. These arrangements will still be allowed if the SEC’s proposals are adopted, but only if the terms are disclosed to everyone, which is not typically done today.

Questions? Let me know.