A number of questions have arisen around the implementation of California’s new law requiring placement agents to register as lobbyists pursuant to the California Political Reform Act. In particular, the application of the law to investment advisers and their personnel has been subject to some ambiguity.
Investment advisers and their personnel are potentially subject to registering as lobbyists because the law defines placement agents broadly. As investment advisers grapple with the application of the law, it is helpful to note some recent guidance provided by the Fair Political Practices Commission (FPPC), the agency that enforces the California Political Reform Act.
In a letter to Peter C. Williams, dated April 20, 2011 (the “April 20 Letter”), the FPPC stated that the law does not apply retroactively to contracts that an investment adviser had with a California state pension plan before the law took effect on January 1, 2011. However, to the extent that the investment adviser makes updates to the contract or enters into new or additional contracts, the law applies.
In the April 20 Letter and in a letter to Mayer Brown LLP dated April 7, 2011 (the “April 7 Letter”), the FPPC addresses issues related to the implementation of the following two exemptions:
Competitive Bidding Process Exemption
In the April 7 Letter, the FPPC provided guidance on the second prong of the Competitive Bidding Process Exemption. With respect to the second prong, the FPPC addressed questions that had arisen as to whether the exemption is effective before the competitive bidding process begins, during the process, or upon selection. The FPPC made it clear that the second prong applies to the entire process of obtaining a contract, from the time the California state pension plan issues a request for proposal (RFP) until the contract is awarded, and made it clear that the second prong only applies to RFPs.
The FPPC’s position means the following are outside of the scope of the second prong of the Competitive Bidding Process Exemption and, therefore, the exemption would not be available:
Furthermore, the FPPC made it clear that the Competitive Bidding Process Exemption is not a systematic exemption. So, even though an investment adviser has been awarded a contract through an RFP process and qualified for the exemption, efforts outside of an RFP process to obtain contracts for other types of services from the same California state pension plan would fall outside of the exemption. On the other hand, the adviser may engage in efforts to obtain an extension of an existing contract.
Portfolio Manager Exemption and Other Exclusions
In the April 7 Letter, the FPPC provided guidance on the Portfolio Manager Exemption. Under this exemption, a question has arisen as to whether employees of an investment adviser other than portfolio managers who have a limited role in soliciting contracts, such as the CFO, would qualify for the exemption. The FPPC stated in the letter that it could not answer this question without knowing more about the duties of such employees (adhering to a strict interpretation of the exemption), but then provided a possible exclusion for such employees outside of the Portfolio Manager Exemption.
Specifically, the FPPC turned to the regulation defining lobbyists and determined by analogy that if a knowledgeable employee of an investment adviser, such as the CFO, occasionally attends meetings with a California state pension plan to provide information about the investment adviser, and attends any such meetings with a registered placement agent, then such employee does not need to register as a lobbyist.
In the April 20 Letter, the FPPC provides another possible exclusion outside of the Portfolio Manager Exemption. The exclusion arises in the context of employees of an investment adviser who make trades “under the direction” of a California state pension plan. Presumably, these employees did not qualify for the Portfolio Manager Exemption (although this is not expressly addressed in the letter). So, the FPPC looks by analogy to guidance it has provided under lobbyists regulations concluding that consultants whose duties extend only to providing advice to a state pension plan are not required to register as lobbyists because they are analogous to employees of the state pension plan.
The FPPC then states that by analogy this guidance applies to consulting work that an investment adviser provides to a California state pension plan, meaning that under the “limited circumstances of performing trades” for a state pension plan “under its direction,” the employees performing those trades would not need to register as lobbyists.
On May 25, 2011, the SEC adopted final rules implementing the whistleblower program Congress prescribed in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). In light of this development, investment advisers and investment companies should take steps to protect themselves from potential whistleblower lawsuits by ensuring that they have systems in place to efficiently facilitate internal reporting and that they thoroughly investigate all internal complaints. It is critical to think creatively about the most effective ways to communicate to employees the importance of internal reporting to ensure that any problems are addressed promptly before they become larger problems.
Action Items for Investment Advisers and Investment Companies
Investment advisers and investment companies should take the following actions to minimize exposure and encourage internal dialogue under the new rules. Review and update compliance policies and procedures to ensure that they:
If you learn your company has no exposure or a rogue whistleblower is off track, request a proactive meeting with the government to inform the SEC that there are two sides to the allegations.
If you learn of a complaint, ask the SEC for an opportunity to formally respond before making a decision whether to accept the whistleblower’s referral.
Brief Summary of Rules
Section 922 of Dodd-Frank added new Section 21F to the Securities Exchange Act of 1934 entitled, “Securities Whistleblower Incentives and Protection.” Section 21F directs the SEC to pay awards to whistleblowers who voluntarily provide the SEC with original information about a violation of the securities laws that leads to the successful enforcement of an action brought by the SEC or a related action and that results in monetary sanctions exceeding $1 million. A brief summary of the key provisions of Section 21F and the new rules follows.
Persons Eligible to Receive an Award
The rules allow persons to report either actual or potential violations of the law.
Amount of Award
Included in Dodd-Frank was the requirement that the SEC implement a rule to ban persons, subject to certain sanctions and disciplinary proceedings, who have been convicted of a felony or misdemeanor related to the purchase or sale of a security, from being able to utilize the securities registration exemption under Rule 506 of Regulation D under the Securities Act of 1933. That particular rule, which can be used for any amount of securities offering, is, by far, the most widely used exemption by issuers under Regulation D.
The SEC’s proposed rule, now out for public comment until July 14, 2011, if implemented as proposed, would apply the bad-actor events that occurred prior to the enactment of the provision under Dodd-Frank. This application of the proposed rule to pre-existing convictions and sanctions is likely to cause the most opposition to the proposed rule. The opposition would argue, and properly so, that if Congress wanted pre-existing convictions and sanctions to serve as a disallowance of the use of the exemption, they could have stated so in the law. Indeed, two of the SEC’s commissioners, Kathleen Casey and Troy Paredes, stated that the retroactive approach included in the proposed rule was the primary reason they could not support the proposed rule. The vote by the Commission was 3-2 in favor of going forward with the rule as proposed.
The disqualifying events that are applied to the issuer of the securities, its directors, officers, managing members, 10 percent or more beneficial owners, and promoters include: criminal convictions; court injunctions and restraining orders; final orders of state securities, insurance, banking, or credit union regulators; certain SEC disciplinary orders; and SEC stop orders to suspend exemptions. The SEC, in its proposed rule, asks for public comment whether final orders issued by the SEC or the CFTC also should be included as a disqualifying event.
The SEC also asks for comment whether these disqualifying events should be applied to other securities registration exemptions under Rule 504 of Regulation D, and Regulation A and Regulation E. Congress did not address those exemptions in its Dodd-Frank provision regarding the disqualification of bad actors from the use of the securities registration exemption under Rule 506 of Regulation D.
The proposed rule would provide an exception to the disqualification if the issuer relying upon the exemption could show that it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed.
The proposed bad-actor disqualification rule by the SEC should be of interest to investment advisers who manage or sponsor private funds that rely primarily upon Rule 506 under Regulation D for an exemption from securities registration. When the proposed rule becomes final, such advisers will need to ensure that there are no bad actors connected with the issuer so not to disqualify the utilization of the exemption. In addition, advisers to a fund of funds will need to include in its due diligence whether such funds have any bad actors involved that could risk the loss of the exemption.
The SEC charged a New-York-based investment adviser, Lloyd V. Barriger, with fraudulently conducting a private placement offering of two New York real estate funds he managed.
According to the SEC’s complaint as filed in federal court on May 13, 2011, Mr. Barriger misled investors who invested in his Gaffken & Barriger Fund about the risks of such investment while the actual performance of the Fund indicated that such an investment included substantial risk of losing the entire investment. In addition, Mr. Barriger defrauded investors in Campus Capital Corp. by not telling them that their investments in Campus Capital would be used to basically prop up the ailing Gaffken & Barriger Fund. Mr. Barriger, according to the SEC complaint, used new investor funds to pay off investors who requested redemptions and/or preferred return distribution payments promised by Mr. Barriger. The SEC claims that Mr. Barriger used the funds from investors in Campus Capital to inject nearly $2.5 million into the Gaffken & Barriger Fund without informing such investors about that fund’s financial distress. Between the two funds, Mr. Barriger raised approximately $32 million from investors during the period of 1998 to 2008.
The SEC’s complaint alleges that Mr. Barriger violated Sections 206(1) and (2) of the Investment Advisers Act of 1940 (i.e., “anti-fraud” provisions) and anti-fraud provisions under the Securities Act of 1933 and the Securities Exchange Act of 1934.
The SEC is seeking a permanent injunction enjoining Mr. Barriger from further violations of the anti-fraud provisions under the federal securities laws, civil penalties, and disgorgement of ill-gotten gains.
The SEC issued an administrative order on May 19, 2011 under Section 203(f) of the Investment Advisers Act of 1940 against Jonathan Hollander, a former analyst of a registered investment adviser (In the Matter of Jonathan Hollander, File No. 3-14398, SEC IAA Release No. 3208).
The SEC’s administrative action follows the settlement of a civil action against Mr. Hollander (SEC v. Jonathan Hollander, Civil Act No. 11-CV-2885, U.S. Dist. Ct. S.D.N.Y.), which resulted in the imposition of a permanent injunction against Mr. Hollander from future violations of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, ordering him to pay disgorgement and a civil penalty. The SEC’s complaint alleged that Mr. Hollander, among other things, used material non-public information to trade in securities and tipped others who traded on such information.
The administrative order issued against Mr. Hollander serves to bar him from association with any broker, dealer, investment adviser, municipal securities dealer, or transfer agent, with the right to reapply for association after three years. Any reapplication for association will have to be accompanied by the satisfaction of any or all of the following: (a) any disgorgement ordered against Mr. Hollander or the SEC’s waiver of such payment, fully or partially; (b) any arbitration award related to the conduct that served as the basis of the SEC’s order; (c) any self-regulatory organization arbitration award to a customer; and (d) any restitution order by a self-regulating organization, whether or not related to the conduct that served as the basis for the SEC’s order.
Terry D. Nelson
Peter D. Fetzer