Sunday, February 27, 2005
The Dark Side of 3rd Party Marketing
Hedge Funds Can Be Headache
For Broker, as CIBC Case Shows
By SUSANNE CRAIG
Staff Reporter of THE WALL STREET JOURNAL
February 22, 2005; Page C1
On Wall Street, hawking hedge funds has become hugely profitable. But a recent arbitration award against Canadian Imperial Bank of Commerce shows the downside for brokerage firms that market these lightly regulated investment vehicles.
A three-person arbitration panel this month ordered the bank's brokerage arm, CIBC World Markets, to pay almost $3.6 million to 11 wealthy investors who lost $5.5 million investing in a New York-based hedge fund marketed by the firm. One of the investors was former professional baseball player Bobby Bonilla.
The case is a cautionary tale for both brokers who are pushing hedge funds more aggressively and for investors who are putting more of their savings into them. Hedge funds are private investment partnerships that traditionally have catered to the wealthy and big institutions, but they increasingly are available to smaller investors. The funds sometimes make high-stakes bets on stocks, currencies and other investments, often using borrowed money to boost returns.
U.S. hedge funds today manage about $1 trillion in assets, up from around $400 billion just four years ago.
In the CIBC case, the aggrieved investors claim that the bank's brokerage conducted almost no "due diligence," or research, on the fund that it sold its client, part of a hedge-fund family known as Red Coat, and failed to disclose that some of Red Coat's other funds were losers. Then, after they learned that the fund was tanking, they weren't allowed to cash out -- even though a CIBC employee involved in the brokerage's marketing efforts for Red Coat was allowed to pull his money, documents in the arbitration show.
"This case sends a message that firms can be held accountable if they market a virtually unregulated product to their customers without performing proper due diligence and then fail to monitor once it has been sold," says Philip Aidikoff, the investors' lawyer.
CIBC declined to comment. During the arbitration process, it said it did extensive background research on Red Coat and argued that the investors were well aware of the risky nature of the investment, having signed agreements stating Red Coat was "designed for sophisticated persons who are able to bear the risk of substantial loss."
Most people who put money in hedge funds have few legal options if they feel they were wronged when investments go sour, other than going through the costly process of suing. Brokerage clients, however, agree ahead of time to settle any disputes through arbitration, usually overseen by the National Association of Securities Dealers. That restricts their access to the courts, but provides a lower-cost alternative.
The CIBC case is one of the first big ones involving a hedge fund to snake its way through the arbitration process, so it could be a harbinger. Unlike judges in court cases, arbitration panels don't formally create precedents that subsequent panels must follow because each case is decided independently on its merits. But arbitrators sometimes look to other decisions for guidance.
Because most of their investors are very wealthy and sophisticated, regulators have approached hedge funds with a laissez-faire, buyer-beware attitude. But U.S. federal regulators have moved to increase scrutiny of the vehicles as they have become more available to the middle class.
That trend has been driven in part by the desire of Wall Street firms like CIBC World Markets to get into the lucrative game, selling their own hedge funds, creating investment vehicles based on multiple hedge funds (so-called funds of funds) and marketing independently run hedge funds in exchange for a share of the fees that investors pay.
Traditionally, hedge funds have required an initial investment of at least $1 million. But some clients who invested in Red Coat through CIBC World Markets put down as little as $75,000, suggesting that some might not have been as wealthy as typical hedge-fund investors. Red Coat charged investors a 1% management fee, plus 20% of any profits the fund earned. CIBC World Markets got one-fourth of both fees for clients it steered toward Red Coat -- or one-quarter of a penny for every dollar invested plus 5% of any fund profits, the brokerage firm said during the arbitration process. CIBC shared those proceeds with its brokers.
Red Coat also steered stock-trading business -- and the commissions it paid for such services -- to the CIBC brokerage. That provided an added incentive for CIBC brokers to steer investment clients to Red Coat, Mr. Aidikoff says. In September 2000, the executive who ran the CIBC World Markets office in Los Angeles told the CIBC executive in charge of deciding which hedge funds to market to CIBC clients that Red Coat had promised to double the amount of stock-trading commissions it would pay the brokerage to $3 million in 2002.
"This is a very sharp group of individuals that are worthy of our consideration and hopefully your department's approval," CIBC's Los Angeles-based Richard Wisely said in the letter to Howard Singer, the chief of the brokerage's Alternative Investments Group. Mr. Wisely no longer works for CIBC and didn't respond to requests for comment.
Mr. Aidikoff says most of his clients were persuaded to invest in Red Coat by CIBC in early 2001 -- without being told that Red Coat's other funds weren't doing very well. In a letter to Red Coat investors the previous November, the former mutual-fund executive who ran the hedge fund, Ken Londoner, said 2000 performance for one of his other funds was "very disappointing." Mr. Aidikoff says CIBC would have known about this letter if had done proper due diligence on Red Coat.
CIBC told the aggrieved investors that Red Coat was a good way to invest in a broad range of companies, Mr. Aidikoff said in the arbitration proceeding, adding that the clients also were told the fund wouldn't invest more than 5% of its assets in any one stock and would automatically sell any stock that dropped in value by 15%.
In September 2001, the hedge fund's performance took a turn for the worse, and CIBC canceled its sales agreement with the hedge fund a month later. But CIBC's clients were locked into the fund because they had signed documents agreeing to keep their money in the fund for a year unless the fund gave them permission to withdraw earlier. All 11 of the aggrieved investors tried to cut their losses by liquidating their investments, but Mr. Londoner refused to let them, Mr. Aidikoff says.
One of that fund's investors, however, was allowed to liquidate: Mr. Wisely, the man who used to run CIBC World Markets' Los Angeles office and who told CIBC's alternative investment chief, Mr. Singer, that Red Coat's managers were "worthy." Mr. Wisely had told Red Coat's Mr. Londoner in an August 2001 letter that he needed the money so he could help out a brother who was going through a divorce.
Later, in a letter to another CIBC executive, Mr. Singer called Mr. Wisely's move a "preferential" liquidation that constituted "a significant ethical breach." Mr. Singer couldn't be reached for comment.
By the end of 2001, Mr. Aidikoff said during the arbitration process, the fund's assets had fallen in value by 71%, and investors learned that most of Red Coat's assets -- including some borrowed funds -- were invested in the poorly performing stock of one health-care company: e-MedSoft.com, which is now known as Med Diversified and has been in bankruptcy proceedings since late 2002.
Write to Susanne Craig at susanne.craig@wsj.com1
URL for this article:
http://online.wsj.com/article/0,,SB110902566097860225,00.html
For Broker, as CIBC Case Shows
By SUSANNE CRAIG
Staff Reporter of THE WALL STREET JOURNAL
February 22, 2005; Page C1
On Wall Street, hawking hedge funds has become hugely profitable. But a recent arbitration award against Canadian Imperial Bank of Commerce shows the downside for brokerage firms that market these lightly regulated investment vehicles.
A three-person arbitration panel this month ordered the bank's brokerage arm, CIBC World Markets, to pay almost $3.6 million to 11 wealthy investors who lost $5.5 million investing in a New York-based hedge fund marketed by the firm. One of the investors was former professional baseball player Bobby Bonilla.
The case is a cautionary tale for both brokers who are pushing hedge funds more aggressively and for investors who are putting more of their savings into them. Hedge funds are private investment partnerships that traditionally have catered to the wealthy and big institutions, but they increasingly are available to smaller investors. The funds sometimes make high-stakes bets on stocks, currencies and other investments, often using borrowed money to boost returns.
U.S. hedge funds today manage about $1 trillion in assets, up from around $400 billion just four years ago.
In the CIBC case, the aggrieved investors claim that the bank's brokerage conducted almost no "due diligence," or research, on the fund that it sold its client, part of a hedge-fund family known as Red Coat, and failed to disclose that some of Red Coat's other funds were losers. Then, after they learned that the fund was tanking, they weren't allowed to cash out -- even though a CIBC employee involved in the brokerage's marketing efforts for Red Coat was allowed to pull his money, documents in the arbitration show.
"This case sends a message that firms can be held accountable if they market a virtually unregulated product to their customers without performing proper due diligence and then fail to monitor once it has been sold," says Philip Aidikoff, the investors' lawyer.
CIBC declined to comment. During the arbitration process, it said it did extensive background research on Red Coat and argued that the investors were well aware of the risky nature of the investment, having signed agreements stating Red Coat was "designed for sophisticated persons who are able to bear the risk of substantial loss."
Most people who put money in hedge funds have few legal options if they feel they were wronged when investments go sour, other than going through the costly process of suing. Brokerage clients, however, agree ahead of time to settle any disputes through arbitration, usually overseen by the National Association of Securities Dealers. That restricts their access to the courts, but provides a lower-cost alternative.
The CIBC case is one of the first big ones involving a hedge fund to snake its way through the arbitration process, so it could be a harbinger. Unlike judges in court cases, arbitration panels don't formally create precedents that subsequent panels must follow because each case is decided independently on its merits. But arbitrators sometimes look to other decisions for guidance.
Because most of their investors are very wealthy and sophisticated, regulators have approached hedge funds with a laissez-faire, buyer-beware attitude. But U.S. federal regulators have moved to increase scrutiny of the vehicles as they have become more available to the middle class.
That trend has been driven in part by the desire of Wall Street firms like CIBC World Markets to get into the lucrative game, selling their own hedge funds, creating investment vehicles based on multiple hedge funds (so-called funds of funds) and marketing independently run hedge funds in exchange for a share of the fees that investors pay.
Traditionally, hedge funds have required an initial investment of at least $1 million. But some clients who invested in Red Coat through CIBC World Markets put down as little as $75,000, suggesting that some might not have been as wealthy as typical hedge-fund investors. Red Coat charged investors a 1% management fee, plus 20% of any profits the fund earned. CIBC World Markets got one-fourth of both fees for clients it steered toward Red Coat -- or one-quarter of a penny for every dollar invested plus 5% of any fund profits, the brokerage firm said during the arbitration process. CIBC shared those proceeds with its brokers.
Red Coat also steered stock-trading business -- and the commissions it paid for such services -- to the CIBC brokerage. That provided an added incentive for CIBC brokers to steer investment clients to Red Coat, Mr. Aidikoff says. In September 2000, the executive who ran the CIBC World Markets office in Los Angeles told the CIBC executive in charge of deciding which hedge funds to market to CIBC clients that Red Coat had promised to double the amount of stock-trading commissions it would pay the brokerage to $3 million in 2002.
"This is a very sharp group of individuals that are worthy of our consideration and hopefully your department's approval," CIBC's Los Angeles-based Richard Wisely said in the letter to Howard Singer, the chief of the brokerage's Alternative Investments Group. Mr. Wisely no longer works for CIBC and didn't respond to requests for comment.
Mr. Aidikoff says most of his clients were persuaded to invest in Red Coat by CIBC in early 2001 -- without being told that Red Coat's other funds weren't doing very well. In a letter to Red Coat investors the previous November, the former mutual-fund executive who ran the hedge fund, Ken Londoner, said 2000 performance for one of his other funds was "very disappointing." Mr. Aidikoff says CIBC would have known about this letter if had done proper due diligence on Red Coat.
CIBC told the aggrieved investors that Red Coat was a good way to invest in a broad range of companies, Mr. Aidikoff said in the arbitration proceeding, adding that the clients also were told the fund wouldn't invest more than 5% of its assets in any one stock and would automatically sell any stock that dropped in value by 15%.
In September 2001, the hedge fund's performance took a turn for the worse, and CIBC canceled its sales agreement with the hedge fund a month later. But CIBC's clients were locked into the fund because they had signed documents agreeing to keep their money in the fund for a year unless the fund gave them permission to withdraw earlier. All 11 of the aggrieved investors tried to cut their losses by liquidating their investments, but Mr. Londoner refused to let them, Mr. Aidikoff says.
One of that fund's investors, however, was allowed to liquidate: Mr. Wisely, the man who used to run CIBC World Markets' Los Angeles office and who told CIBC's alternative investment chief, Mr. Singer, that Red Coat's managers were "worthy." Mr. Wisely had told Red Coat's Mr. Londoner in an August 2001 letter that he needed the money so he could help out a brother who was going through a divorce.
Later, in a letter to another CIBC executive, Mr. Singer called Mr. Wisely's move a "preferential" liquidation that constituted "a significant ethical breach." Mr. Singer couldn't be reached for comment.
By the end of 2001, Mr. Aidikoff said during the arbitration process, the fund's assets had fallen in value by 71%, and investors learned that most of Red Coat's assets -- including some borrowed funds -- were invested in the poorly performing stock of one health-care company: e-MedSoft.com, which is now known as Med Diversified and has been in bankruptcy proceedings since late 2002.
Write to Susanne Craig at susanne.craig@wsj.com1
URL for this article:
http://online.wsj.com/article/0,,SB110902566097860225,00.html
Wednesday, February 09, 2005
Loopholes to SEC HF RIA Reg (II 2/9/05)
February 9, 2005
Lawyers Spot Loopholes To Hedge Fund Registration
Hedge funds torn with the unappetizing choice of registering with the Securities and Exchange Commission by February 2006 or talking their clients into a two-year lockup are casting around for other loopholes. While it's unlikely most hedge funds will go to such lengths, Section 3 of the Investment Company Act of 1940 contains 12 exemptions besides the lock-up period that could offer an escape hatch. Some lawyers are also looking at the way the 40 Act defines "investment company" to see if this, too, can offer a way out.
One alternative is Section 3-c3, which exempts banks and insurance company pooled funds from SEC regulation. There are some lawyers who wonder why any hedge fund firm could not just adopt the guise of an insurance company in one of several states that regulate insurance very lightly. Robert Rosenblum, partner in Kirkpatrick & Lockhart, thinks that view is simplistic. But he does believe a large financial conglomerate, which already happens to own a bank or insurance company, could set up a common trust fund to function as a hedge fund.
The 1940 Act definition of what is an "investment company" subject to registration also raises possibilities. The SEC takes the position that futures are not securities so a hedge fund trading solely in futures would not be covered by either 40 Act registration or the new IAA rule. It would even be possible to put some portion of the portfolio into the spot market, since a company may trade in securities up to 40% of assets without being a registered investment company. Hedge funds concentrating on mortgages or taking title to real estate could use another exemption, Section 3-c5.
Lawyers Spot Loopholes To Hedge Fund Registration
Hedge funds torn with the unappetizing choice of registering with the Securities and Exchange Commission by February 2006 or talking their clients into a two-year lockup are casting around for other loopholes. While it's unlikely most hedge funds will go to such lengths, Section 3 of the Investment Company Act of 1940 contains 12 exemptions besides the lock-up period that could offer an escape hatch. Some lawyers are also looking at the way the 40 Act defines "investment company" to see if this, too, can offer a way out.
One alternative is Section 3-c3, which exempts banks and insurance company pooled funds from SEC regulation. There are some lawyers who wonder why any hedge fund firm could not just adopt the guise of an insurance company in one of several states that regulate insurance very lightly. Robert Rosenblum, partner in Kirkpatrick & Lockhart, thinks that view is simplistic. But he does believe a large financial conglomerate, which already happens to own a bank or insurance company, could set up a common trust fund to function as a hedge fund.
The 1940 Act definition of what is an "investment company" subject to registration also raises possibilities. The SEC takes the position that futures are not securities so a hedge fund trading solely in futures would not be covered by either 40 Act registration or the new IAA rule. It would even be possible to put some portion of the portfolio into the spot market, since a company may trade in securities up to 40% of assets without being a registered investment company. Hedge funds concentrating on mortgages or taking title to real estate could use another exemption, Section 3-c5.
Monday, February 07, 2005
Latest on SEC PIPEs Probe
Short-selling probe snags three hedge fund managers
Fri Feb 4, 2005 07:37 PM ET
By Michael Flaherty
NEW YORK, Feb 4 (Reuters) - U.S. and Canadian regulators have charged three hedge fund managers with insider stock trading violations as part of a broad investigation launched last spring into a string of alleged short-selling abuses.
CompuDyne Corp. (CDCY.O: Quote, Profile, Research) said this week it recently learned that former investor Hilary Shane faces NASD charges of violating securities laws in a financing deal the security company did in October 2001.
Shane, a former hedge fund manager at First New York Securities, LLC, made $1.1 million from inside information of the deal, according to an NASD complaint filed in late December.
Michael Finkelstein and Elizabeth Leonard, of Toronto-based Stonestreet LP, face similar charges by the Investment Dealers Association, a Canadian regulatory agency.
The charges come less than a year after the U.S. Securities and Exchange Commission and the NASD pursued allegations of hedge funds profiting from inside knowledge of private investments in public equity, a transaction known on Wall Street as a PIPE.
PIPEs help cash-strapped companies raise money quickly by selling discount-priced shares to a group of investors. The stock of a company conducting a PIPE usually falls in the short-term because the transaction floods the market with additional shares.
Regulators are investigating whether individuals who helped finance a PIPE profited from selling short the company's shares before the deal closed, knowing its stock was about to fall.
Shane, who left First New York in 2002, is accused of doing exactly that.
Short sellers borrow shares of a company and then sell them in anticipation of a decline. They profit when the stock falls since they can buy back the shares at a lower price and pocket the difference.
In September 2001, a representative at investment bank Friedman, Billings, Ramsey Group Inc. (FBR.N: Quote, Profile, Research) contacted Shane about doing a PIPE with CompuDyne, according to the NASD complaint.
The complaint says Shane made false representations about her investment intent, obtained the right to acquire 475,000 shares of CompuDyne and then engaged in unlawful insider trading by selling the company's stock short while in possession of material, nonpublic information.
First New York has not been charged in relation to the case. Shane could not be reached for comment.
The complaint does not list charges against FBR, but FBR said on Nov. 9, 2004 that the SEC and the NASD were investigating the bank's role as a placement agent for an unspecified PIPE transaction in 2001. An FBR spokesman declined to comment further.
Finkelstein and Leonard face similar charges stemming from a PIPE involving Novatel Wireless Inc. (NVTL.O: Quote, Profile, Research) in 2001 and another with Trikon Technologies Inc. (TRKN.O: Quote, Profile, Research) a year later.
Stonestreet LP's Web site lists Finkelstein and Leonard as officers of the investment firm. The IDA complaint says that Stonestreet maintains a non-client account at Canaccord Capital Corp.'s Toronto office that operates as a hedge fund, which Finkelstein and Leonard co-manage.
The fund would hedge against its anticipated investment in a PIPE by "shorting the issuer's underlying stock," according to the complaint that was filed on Jan. 7.
Reached by telephone at Stonestreet, Finkelstein said he would not comment. Leonard could not be reached.
Last week drugmaker Nuvelo Inc. (NUVO.O: Quote, Profile, Research) said the SEC had contacted it about a private transaction the company did in 2002.
"We're concerned about instances in which hedge funds executed profitable short sales in an issuer's underlying equity after learning about a pending PIPE transaction," said SEC spokesman John Heine. "Our review is continuing."
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Fri Feb 4, 2005 07:37 PM ET
By Michael Flaherty
NEW YORK, Feb 4 (Reuters) - U.S. and Canadian regulators have charged three hedge fund managers with insider stock trading violations as part of a broad investigation launched last spring into a string of alleged short-selling abuses.
CompuDyne Corp. (CDCY.O: Quote, Profile, Research) said this week it recently learned that former investor Hilary Shane faces NASD charges of violating securities laws in a financing deal the security company did in October 2001.
Shane, a former hedge fund manager at First New York Securities, LLC, made $1.1 million from inside information of the deal, according to an NASD complaint filed in late December.
Michael Finkelstein and Elizabeth Leonard, of Toronto-based Stonestreet LP, face similar charges by the Investment Dealers Association, a Canadian regulatory agency.
The charges come less than a year after the U.S. Securities and Exchange Commission and the NASD pursued allegations of hedge funds profiting from inside knowledge of private investments in public equity, a transaction known on Wall Street as a PIPE.
PIPEs help cash-strapped companies raise money quickly by selling discount-priced shares to a group of investors. The stock of a company conducting a PIPE usually falls in the short-term because the transaction floods the market with additional shares.
Regulators are investigating whether individuals who helped finance a PIPE profited from selling short the company's shares before the deal closed, knowing its stock was about to fall.
Shane, who left First New York in 2002, is accused of doing exactly that.
Short sellers borrow shares of a company and then sell them in anticipation of a decline. They profit when the stock falls since they can buy back the shares at a lower price and pocket the difference.
In September 2001, a representative at investment bank Friedman, Billings, Ramsey Group Inc. (FBR.N: Quote, Profile, Research) contacted Shane about doing a PIPE with CompuDyne, according to the NASD complaint.
The complaint says Shane made false representations about her investment intent, obtained the right to acquire 475,000 shares of CompuDyne and then engaged in unlawful insider trading by selling the company's stock short while in possession of material, nonpublic information.
First New York has not been charged in relation to the case. Shane could not be reached for comment.
The complaint does not list charges against FBR, but FBR said on Nov. 9, 2004 that the SEC and the NASD were investigating the bank's role as a placement agent for an unspecified PIPE transaction in 2001. An FBR spokesman declined to comment further.
Finkelstein and Leonard face similar charges stemming from a PIPE involving Novatel Wireless Inc. (NVTL.O: Quote, Profile, Research) in 2001 and another with Trikon Technologies Inc. (TRKN.O: Quote, Profile, Research) a year later.
Stonestreet LP's Web site lists Finkelstein and Leonard as officers of the investment firm. The IDA complaint says that Stonestreet maintains a non-client account at Canaccord Capital Corp.'s Toronto office that operates as a hedge fund, which Finkelstein and Leonard co-manage.
The fund would hedge against its anticipated investment in a PIPE by "shorting the issuer's underlying stock," according to the complaint that was filed on Jan. 7.
Reached by telephone at Stonestreet, Finkelstein said he would not comment. Leonard could not be reached.
Last week drugmaker Nuvelo Inc. (NUVO.O: Quote, Profile, Research) said the SEC had contacted it about a private transaction the company did in 2002.
"We're concerned about instances in which hedge funds executed profitable short sales in an issuer's underlying equity after learning about a pending PIPE transaction," said SEC spokesman John Heine. "Our review is continuing."
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New RIA Rules - Some Effective 2/10/05 (Opalesque 2/7/05)
Bryan Cave alerts some hedge fund rules will be effective Feb. 10th While the new rules only require registration by February 1, 2006, certain provisions of the new rules will be effective on February 10, 2005. First, the Advisers Act prohibits registered hedge fund managers from charging a performance fee unless the client is a "Qualified Client" (as defined in Rule 205-3 under the Advisers Act). The New Rules contain a grandfathering provision that allows hedge fund managers registering under the New Rules to continue charging performance fees to existing clients that are not "Qualified Clients". However, the grandfathering provision only applies to existing investors as of February 10, 2005. As a result, currently unregistered hedge fund managers that will be required to register under the New Rules may only charge a performance fee to a client admitted to a fund or otherwise investing with the hedge fund manager after February 10, 2005, if the client is a "Qualified Client".
Second, a registered investment adviser must keep and maintain certain books and records supporting its performance history in order to advertise such performance history. As with the performance fee rule, the New Rules contain a grandfathering provision that allows hedge fund managers required to register under the New Rules to continue advertising on the basis of their (or their hedge funds') performance despite not having kept adequate books and records. However, an unregistered hedge fund manager that will be required to register under the New Rules may only rely on this grandfathering provision if it keeps and maintains appropriate records relating to performance beginning February 10, 2005.
Second, a registered investment adviser must keep and maintain certain books and records supporting its performance history in order to advertise such performance history. As with the performance fee rule, the New Rules contain a grandfathering provision that allows hedge fund managers required to register under the New Rules to continue advertising on the basis of their (or their hedge funds') performance despite not having kept adequate books and records. However, an unregistered hedge fund manager that will be required to register under the New Rules may only rely on this grandfathering provision if it keeps and maintains appropriate records relating to performance beginning February 10, 2005.
Thursday, February 03, 2005
NASD BD Registration Still Needed
Finders Keepers
The SEC is hearing new demands to make it easier for small companies to raise capital.
Ronald Fink, CFO Magazine
February 01, 2005
It's no secret that small businesses have an especially hard time raising capital. But risk-averse banks and investors don't deserve all, or perhaps even most, of the blame, according to some observers. The real culprit, they charge, is federal regulation — in particular, a 70-year-old rule that bars companies from hiring unregistered intermediaries, or "finders," to help them raise money.
The rule, part of the Securities Exchange Act of 1934, was obviously designed to keep middlemen from engaging in securities fraud and other unsavory financial activities (see "Under the Radar," at the end of this article). But critics believe the rule has outlived its usefulness. One is Bill Evers, a retired attorney in San Francisco who is trying to start a chain of weight-management clinics but is unsure where to turn for financing. Evers complains that traditional sources for start-ups, such as venture capitalists, are now more interested in providing second- or even third-round financing, or in refinancing better-established but struggling companies.
Meanwhile, says Evers, small, federally registered broker-dealers that might once have provided capital have either gone under or merged into larger investment banks that don't consider start-ups worth their time. "The system starves start-ups," he insists. While Evers says legitimate but unregistered finders are common, he complains that the rules make them publicity-shy. As a result, he says, "small-business guys can't find the finders."
Support for Evers's views comes from the CEO Council, a group representing some 200 senior executives of public companies whose stocks trade in the over-the-counter market and 150 broker-dealers that back their deals and execute their transactions. In recommendations recently delivered to the Securities and Exchange Commission, the council noted that "a major difficulty facing small business is obtaining equity capital," and that the current regulatory environment, including registration rules for broker-dealers, "unfairly restricts capital formation for small businesses."
Such groups have sought relief from the SEC for years, most recently at a forum on small-business capital formation that the commission held last September. But so far, their demands have fallen on deaf ears. Brian Bussey, assistant chief counsel for the SEC's division of market regulation, told the forum that "the possibility of lesser regulation...is a massive undertaking," and indicated that the commission has yet to receive hard evidence of how companies are being hurt by its broker-dealer registration rules.
A License to Deal
Now, however, the SEC is facing new pressure to reconsider its stance. A task force of the American Bar Association (ABA) has been studying the issue since 2002, and is expected to offer its recommendations to the SEC around the time of the ABA's spring meeting next month. Although details weren't available as this article went to press, experts familiar with the task force's deliberations expect it to recommend that the SEC ease its registration requirements under certain circumstances.
"It is time to seek out a way to permit the capable, honest financial intermediaries who are not presently registered to find a means to attain compliance," stated Hugh Makens, a former securities commissioner for the state of Michigan and a partner in law firm Warner Norcross & Judd LLP in Grand Rapids, in a report he presented at the SEC forum.
Under federal securities law, anyone can become a broker-dealer of securities by obtaining a license from the National Association of Securities Dealers (NASD) and registering with the SEC and state authorities. But because of rising costs and competition, the industry is now dominated by large investment banks.
At the minimum, Makens contends, the commission should ease the registration requirements for finders that limit their services to asset sales. "A significant number of M&A transactions [use] unregistered finders who receive transaction-based compensation," he noted in his report. Yet Makens says many of the deals are legitimate and that more would take place if finders didn't have to obtain a Series 7 license, as NASD and the SEC require, for purposes of promoting stocks. "These finders act more like business brokers" than dealers in securities, he observes.
Makens contends the test involved is essentially irrelevant to M&A transactions. Not to mention time-consuming and costly: the Series 7 exam lasts six hours and typically requires months of preparation. Also, an examinee must be sponsored by a member firm of the NASD.
Take Money, Run
But as Bussey makes clear, the SEC is unconvinced that its registration rules are overly onerous and thus hinder capital formation. Of course, the SEC's priority is to protect investors from fraud, but while it's also required by law to consider the interests of companies, the latter, too, are often victimized by unregistered brokers.
The SEC isn't alone in its defense of registering broker-dealers. In line with the 1934 act, state laws generally prohibit finders that aren't registered with the SEC from accepting payment for transactions. "It's not that difficult to find a broker-dealer willing to raise capital for small business," insists Joe Borg, director of the Alabama Securities Commission and chairman of the enforcement section of the North American Securities Administrators Association. "A lot of issuers don't want to go to the trouble of finding a licensed finder," he adds.
But he warns that they're taking a big risk in not doing so, since deals arranged by such finders can run afoul of regulators, sending companies in need of capital back to square one. Nonetheless, says Borg, "a lot of issuers want to get the money in a hurry, and worry about the problem later."
Also, lawyers who specialize in this area report that companies often pay unregistered brokers big upfront fees only to see the brokers abscond. Steven Hecht, a partner in the Roseland, New Jersey, law firm of Lowenstein Sandler PC, says he is litigating a number of cases on behalf of small companies seeking to recover at least some of the money they've lost in this fashion. Hecht declines to identify any of these clients by name, but explains that in one case, a finder who claimed to be helping his client actually used his position to drive down the price of the company's stock in hopes of taking over control. "Unfortunately," says the attorney, "you get what you pay for."
Despite the SEC critics' arguments, Hecht and other attorneys believe that the regulators should not bow to pressure for easier registration requirements. He notes that broker-dealer registration "goes hand in hand with corporate governance" and that the SEC cannot relent on such issues in light of the widespread fraud revealed in the wake of the failure of Enron and other companies. "They're still trying to reinstill confidence in the public markets," says Hecht.
The Singing Rolodex
What's more, the SEC has already made exceptions to registration possible through a number of "no-action" letters. The most widely cited letter involved the singer Paul Anka, whom the SEC allowed in 1991 to receive payment in return for introducing the general partner of the Ottawa Senators hockey team to several acquaintances who became limited partners in the franchise. Essentially, the SEC ruled that Anka's payment complied with the 1934 act so long as he confined his involvement to the introduction and didn't make a practice of such activities. "He was able to sell his Rolodex once," explains Bruce MacKenzie, a partner in the Minneapolis office of Dorsey & Whitney LLP.
Makens contends that the exception the SEC made for Anka is far too narrow to address the needs of small businesses. But recent actions by the SEC suggest that it's trying to narrow its scope even further. In 2000, the commission withdrew a no-action letter that it had issued to Dominion Resources 15 years earlier allowing the utility to arrange a wide array of securities transactions without registering as a broker-dealer. (That makes it more onerous for CFOs to cut out the middleman by issuing securities themselves.)
Also, as a result of Sarbanes-Oxley, the SEC has amended its auditor-independence rules to include a specific prohibition against certified public accounting firms acting as promoters or underwriters of an audit client's securities, whether or not the CPA firm was registered as a broker-dealer.
In light of all this, MacKenzie predicts that lobbying efforts to get the SEC to loosen its registration rules will amount to "an uphill battle." And even if the SEC or lawmakers were inclined to change course, either would most likely run into stiff resistance from a lobby more influential than the CEO Council — the NASD polices broker-dealers for the SEC. As a government-sanctioned monopoly, observers say, the NASD would surely oppose any move to ease registration requirements, since that would invite smaller, less-well-capitalized brokers into the business, threatening its members' market share and profit margins. "Why would the NASD welcome the competition?" wonders attorney Hecht.
For that reason, Bill Evers says that the federal regulatory regime needs fundamental reform to benefit start-ups. "We need a small-business alternative to the NASD," he insists.
But he isn't counting on one in time to help get his weight-management clinics off the ground.
Ronald Fink is a deputy editor of CFO.
--------------------------------------------------------------------------------
Under the Radar
Just how many unregistered finders try to fly under the regulatory radar is anyone's guess. But the Securities and Exchange Commission can cite plenty of fraud cases in support of its current regulatory requirements for broker-dealers. One recent case involved Vector Medical Technologies Inc., a biotech company based in Boca Raton, Florida. The commission sued several of Vector's stock promoters in late 2001 on charges of defrauding 450 investors — primarily individual physicians from around the country — of roughly $16 million in 1999 and 2000. The SEC claimed that Michael H. Salit, Vector's chairman and CEO, along with other individuals, sold the investors stock in the company based on false claims that their capital would help Vector market a "breakthrough" transdermal patch it had developed that was capable of delivering insulin and similar drugs.
Since neither Salit nor any of the other individuals named in the complaint were registered broker-dealers, the SEC argued that they acted as illegal finders when they pocketed hefty commissions from the money they raised instead of using it as promised. A federal district court in Florida agreed in October 2004, barring Salit from ever again serving as an officer or director of a publicly held company, and all of the defendants from participating in penny-stock offerings.
The SEC may see the Vector case as one more reason not to loosen its registration rules. But representatives of small business contend the commission should draw the opposite conclusion. These critics argue that a looser regime would help the SEC oversee activity that is now widespread but unregulated. The current rules, they say, have the unintended effect of discouraging scrupulous brokers from registering, leaving more of the field to those inclined toward fraud.
Meanwhile, the potential abuse of investors by unregistered finders is by no means limited to the promotion or sale of securities. Consider the case of Frank E. Walsh Jr., former lead director and compensation-committee chairman of Tyco International Inc. Walsh received a $20 million finder's fee for recommending that Tyco acquire financial-services firm CIT Group, and for arranging an initial meeting between the companies' CEOs. Within a year of buying CIT for $9.2 billion in June 2001, however, a series of corporate-governance scandals rocked Tyco, forcing it to unload CIT for less than half of the purchase price.
In this case, however, the SEC went after the payment to Walsh not because he wasn't registered as a broker-dealer, but because the fee wasn't publicly disclosed, and the SEC considered it a material event. Walsh settled with the SEC in December 2002 by agreeing to disgorge the $20 million and never again serve as an officer or director of a publicly held company. —R.F.
The SEC is hearing new demands to make it easier for small companies to raise capital.
Ronald Fink, CFO Magazine
February 01, 2005
It's no secret that small businesses have an especially hard time raising capital. But risk-averse banks and investors don't deserve all, or perhaps even most, of the blame, according to some observers. The real culprit, they charge, is federal regulation — in particular, a 70-year-old rule that bars companies from hiring unregistered intermediaries, or "finders," to help them raise money.
The rule, part of the Securities Exchange Act of 1934, was obviously designed to keep middlemen from engaging in securities fraud and other unsavory financial activities (see "Under the Radar," at the end of this article). But critics believe the rule has outlived its usefulness. One is Bill Evers, a retired attorney in San Francisco who is trying to start a chain of weight-management clinics but is unsure where to turn for financing. Evers complains that traditional sources for start-ups, such as venture capitalists, are now more interested in providing second- or even third-round financing, or in refinancing better-established but struggling companies.
Meanwhile, says Evers, small, federally registered broker-dealers that might once have provided capital have either gone under or merged into larger investment banks that don't consider start-ups worth their time. "The system starves start-ups," he insists. While Evers says legitimate but unregistered finders are common, he complains that the rules make them publicity-shy. As a result, he says, "small-business guys can't find the finders."
Support for Evers's views comes from the CEO Council, a group representing some 200 senior executives of public companies whose stocks trade in the over-the-counter market and 150 broker-dealers that back their deals and execute their transactions. In recommendations recently delivered to the Securities and Exchange Commission, the council noted that "a major difficulty facing small business is obtaining equity capital," and that the current regulatory environment, including registration rules for broker-dealers, "unfairly restricts capital formation for small businesses."
Such groups have sought relief from the SEC for years, most recently at a forum on small-business capital formation that the commission held last September. But so far, their demands have fallen on deaf ears. Brian Bussey, assistant chief counsel for the SEC's division of market regulation, told the forum that "the possibility of lesser regulation...is a massive undertaking," and indicated that the commission has yet to receive hard evidence of how companies are being hurt by its broker-dealer registration rules.
A License to Deal
Now, however, the SEC is facing new pressure to reconsider its stance. A task force of the American Bar Association (ABA) has been studying the issue since 2002, and is expected to offer its recommendations to the SEC around the time of the ABA's spring meeting next month. Although details weren't available as this article went to press, experts familiar with the task force's deliberations expect it to recommend that the SEC ease its registration requirements under certain circumstances.
"It is time to seek out a way to permit the capable, honest financial intermediaries who are not presently registered to find a means to attain compliance," stated Hugh Makens, a former securities commissioner for the state of Michigan and a partner in law firm Warner Norcross & Judd LLP in Grand Rapids, in a report he presented at the SEC forum.
Under federal securities law, anyone can become a broker-dealer of securities by obtaining a license from the National Association of Securities Dealers (NASD) and registering with the SEC and state authorities. But because of rising costs and competition, the industry is now dominated by large investment banks.
At the minimum, Makens contends, the commission should ease the registration requirements for finders that limit their services to asset sales. "A significant number of M&A transactions [use] unregistered finders who receive transaction-based compensation," he noted in his report. Yet Makens says many of the deals are legitimate and that more would take place if finders didn't have to obtain a Series 7 license, as NASD and the SEC require, for purposes of promoting stocks. "These finders act more like business brokers" than dealers in securities, he observes.
Makens contends the test involved is essentially irrelevant to M&A transactions. Not to mention time-consuming and costly: the Series 7 exam lasts six hours and typically requires months of preparation. Also, an examinee must be sponsored by a member firm of the NASD.
Take Money, Run
But as Bussey makes clear, the SEC is unconvinced that its registration rules are overly onerous and thus hinder capital formation. Of course, the SEC's priority is to protect investors from fraud, but while it's also required by law to consider the interests of companies, the latter, too, are often victimized by unregistered brokers.
The SEC isn't alone in its defense of registering broker-dealers. In line with the 1934 act, state laws generally prohibit finders that aren't registered with the SEC from accepting payment for transactions. "It's not that difficult to find a broker-dealer willing to raise capital for small business," insists Joe Borg, director of the Alabama Securities Commission and chairman of the enforcement section of the North American Securities Administrators Association. "A lot of issuers don't want to go to the trouble of finding a licensed finder," he adds.
But he warns that they're taking a big risk in not doing so, since deals arranged by such finders can run afoul of regulators, sending companies in need of capital back to square one. Nonetheless, says Borg, "a lot of issuers want to get the money in a hurry, and worry about the problem later."
Also, lawyers who specialize in this area report that companies often pay unregistered brokers big upfront fees only to see the brokers abscond. Steven Hecht, a partner in the Roseland, New Jersey, law firm of Lowenstein Sandler PC, says he is litigating a number of cases on behalf of small companies seeking to recover at least some of the money they've lost in this fashion. Hecht declines to identify any of these clients by name, but explains that in one case, a finder who claimed to be helping his client actually used his position to drive down the price of the company's stock in hopes of taking over control. "Unfortunately," says the attorney, "you get what you pay for."
Despite the SEC critics' arguments, Hecht and other attorneys believe that the regulators should not bow to pressure for easier registration requirements. He notes that broker-dealer registration "goes hand in hand with corporate governance" and that the SEC cannot relent on such issues in light of the widespread fraud revealed in the wake of the failure of Enron and other companies. "They're still trying to reinstill confidence in the public markets," says Hecht.
The Singing Rolodex
What's more, the SEC has already made exceptions to registration possible through a number of "no-action" letters. The most widely cited letter involved the singer Paul Anka, whom the SEC allowed in 1991 to receive payment in return for introducing the general partner of the Ottawa Senators hockey team to several acquaintances who became limited partners in the franchise. Essentially, the SEC ruled that Anka's payment complied with the 1934 act so long as he confined his involvement to the introduction and didn't make a practice of such activities. "He was able to sell his Rolodex once," explains Bruce MacKenzie, a partner in the Minneapolis office of Dorsey & Whitney LLP.
Makens contends that the exception the SEC made for Anka is far too narrow to address the needs of small businesses. But recent actions by the SEC suggest that it's trying to narrow its scope even further. In 2000, the commission withdrew a no-action letter that it had issued to Dominion Resources 15 years earlier allowing the utility to arrange a wide array of securities transactions without registering as a broker-dealer. (That makes it more onerous for CFOs to cut out the middleman by issuing securities themselves.)
Also, as a result of Sarbanes-Oxley, the SEC has amended its auditor-independence rules to include a specific prohibition against certified public accounting firms acting as promoters or underwriters of an audit client's securities, whether or not the CPA firm was registered as a broker-dealer.
In light of all this, MacKenzie predicts that lobbying efforts to get the SEC to loosen its registration rules will amount to "an uphill battle." And even if the SEC or lawmakers were inclined to change course, either would most likely run into stiff resistance from a lobby more influential than the CEO Council — the NASD polices broker-dealers for the SEC. As a government-sanctioned monopoly, observers say, the NASD would surely oppose any move to ease registration requirements, since that would invite smaller, less-well-capitalized brokers into the business, threatening its members' market share and profit margins. "Why would the NASD welcome the competition?" wonders attorney Hecht.
For that reason, Bill Evers says that the federal regulatory regime needs fundamental reform to benefit start-ups. "We need a small-business alternative to the NASD," he insists.
But he isn't counting on one in time to help get his weight-management clinics off the ground.
Ronald Fink is a deputy editor of CFO.
--------------------------------------------------------------------------------
Under the Radar
Just how many unregistered finders try to fly under the regulatory radar is anyone's guess. But the Securities and Exchange Commission can cite plenty of fraud cases in support of its current regulatory requirements for broker-dealers. One recent case involved Vector Medical Technologies Inc., a biotech company based in Boca Raton, Florida. The commission sued several of Vector's stock promoters in late 2001 on charges of defrauding 450 investors — primarily individual physicians from around the country — of roughly $16 million in 1999 and 2000. The SEC claimed that Michael H. Salit, Vector's chairman and CEO, along with other individuals, sold the investors stock in the company based on false claims that their capital would help Vector market a "breakthrough" transdermal patch it had developed that was capable of delivering insulin and similar drugs.
Since neither Salit nor any of the other individuals named in the complaint were registered broker-dealers, the SEC argued that they acted as illegal finders when they pocketed hefty commissions from the money they raised instead of using it as promised. A federal district court in Florida agreed in October 2004, barring Salit from ever again serving as an officer or director of a publicly held company, and all of the defendants from participating in penny-stock offerings.
The SEC may see the Vector case as one more reason not to loosen its registration rules. But representatives of small business contend the commission should draw the opposite conclusion. These critics argue that a looser regime would help the SEC oversee activity that is now widespread but unregulated. The current rules, they say, have the unintended effect of discouraging scrupulous brokers from registering, leaving more of the field to those inclined toward fraud.
Meanwhile, the potential abuse of investors by unregistered finders is by no means limited to the promotion or sale of securities. Consider the case of Frank E. Walsh Jr., former lead director and compensation-committee chairman of Tyco International Inc. Walsh received a $20 million finder's fee for recommending that Tyco acquire financial-services firm CIT Group, and for arranging an initial meeting between the companies' CEOs. Within a year of buying CIT for $9.2 billion in June 2001, however, a series of corporate-governance scandals rocked Tyco, forcing it to unload CIT for less than half of the purchase price.
In this case, however, the SEC went after the payment to Walsh not because he wasn't registered as a broker-dealer, but because the fee wasn't publicly disclosed, and the SEC considered it a material event. Walsh settled with the SEC in December 2002 by agreeing to disgorge the $20 million and never again serve as an officer or director of a publicly held company. —R.F.
