The Securities and Exchange Commission (SEC) has postponed issuing rules which would allow issuers of private securities to immediately begin to solicit the general public. Instead the SEC will issue a proposed rule and solicit comment from the public.
While this rule change is mandated under the JOBS (Jumpstart Our Business Startups) Act, I am not sure this is in the best interest of Joe Public. There are reasons certain rules exist. Allowing private issuers to solicit the general public while not having checks and balances in place is a recipe for more scandals.
Again, I look to my family, this time my mother, with her $5,000 to invest. And, I envision someone asking her to invest in a start-up company selling the best widget in the world. Not having all the details about the investment and my mother wanting to make some quick money, a shrewd investment adviser might be able to take that $5,000 from her. Under the current rules, this can’t happen because my mom is not an accredited investor. If she was, maybe I wouldn’t have had to work all these years.
The following are some of the rules:
- Currently, companies can use Rule 506 exemption to raise an unlimited amount of money. But it must stay within the Section 4(2) exemption by satisfying the following standards:
- The company cannot use general solicitation or advertising to market the securities;
- The company may sell its securities to an unlimited number of “accredited investors” and up to 35 other purchases. Unlike Rule 505, all non-accredited investors, either alone or with a purchaser representative, must be sophisticated—that is, they must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment;
- Companies must decide what information to give to accredited investors, so long as it does not violate the antifraud prohibitions of the federal securities laws. But companies must give non-accredited investors disclosure documents that are generally the same as those used in registered offerings. If a company provides information to accredited investors, it must make this information available to non-accredited investors as well;
- The company must be available to answer questions by prospective purchasers;
- Financial statement requirements are the same as for Rule 505; and
- Purchasers receive “restricted” securities, meaning that the securities cannot be sold for at least a year without registering them.
On Monday, August 20, 2012, the PCAOB released its first report on the progress of its interim inspection program for auditors of brokers and dealers (BDs). The result was a whopping 10 for 10 deficiency rate. Not bad if you are batting for the Yankees. Not good if you want to minimize another Bernie Madoff scheme.
If you remember, a couple of years back the PCAOB required all BDs to be audited by Certified Public Accounting firms that were registered with the PCAOB. This was to ensure that only the most “reputable” firms would perform these audits. One problem with this course of action was that the PCAOB was not going to inspect these firms’ audits of the BDs. Thus, CPA firms could register with the PCAOB and not fear having them perform an inspection of these audits.
After a couple of years the PCAOB wised up and decided to pilot a program to inspect 100 firms who audit these BDs. This program would not publicize the names of any firms it inspected, just the results.
During the period from October 2011 to February 2012, the PCAOB inspected 10 audit firms covering 23 audits of BDs registered with the Securities and Exchange Commission (SEC) and identified deficiencies in ALL of the audits inspected. Yes, I said ALL – that’s 100%.
The areas of the deficiencies observed were:
- Audit procedures related to the computations of customer reserve and net capital requirements
- Audits of financial statements such as related party transactions, revenue recognition, fair value measurements, evaluation of control deficiencies, consideration of risks of material misstatements due to fraud
- Auditor independence
The PCAOB expects to review approximately 100 audit firms covering portions of more than 170 audits of BDs through 2013. They will use this testing to assess the compliance of registered firms and their associated persons conducting audits of brokers-dealers with the Sarbanes-Oxley Act, PCAOB and SEC rules, and professional standards. They will also use it to gage the eventual scope and elements of a permanent inspection program.
Let’s hope the next 90 are a little better.
I have been asked recently… What is carried interest and what’s all the hoopla about?
First, what is carried interest? In the financial service industry, carried interest refers to the share of profits that the manager of a private equity or hedge funds receives. Typically this performance fee or carried interest is 20% of a fund’s profits. The tax treatment of this carried interest has been debated for years and took a front seat when presidential candidate Mitt Romney released his personal income tax return. His return showed that most of his income came from carried interest and was taxed at the favorable long term tax rate of 15%.
Now, let’s take a step back and understand how private equity and hedge funds operate. A fund manager, usually a partnership, will raise funds from private investors while putting in very little of its own money. The manager will get paid a management fee which is typically 2% of net assets in the fund. It will also receive a 20% performance fee. This performance fee or carried interest is based on the profits of the fund. Thus, a fund that has $100 million under management and earns $10 million in profits in year one, will pay the manager a management fee of $2 million (2% of the $100 million) which is taxed at ordinary income tax rates. The manager will also receive carried interest of $2 million (20% of $10 million in profits). The carried interest, depending on who you believe, is taxed at the favorable long term capital gains rate of 15%.
I say “depending on who you believe” because this isn’t exactly the truth. Private equity and hedge funds earn different types of income: interest income, dividend income, short term capital gains and long term capital gains. The 20% carried interest that is earned by the manager keeps the same attributes as it was earned by the fund. That is, in our example above, if the $10 million in profits was all from interest income, then the carried interest would be taxed to the manager as interest income which is taxed at ordinary tax rates and NOT the favorable long term capital gains rates.
Well, that was easy, but unfortunately not the end of this mystery. Carried interest that represents long term capital gains means the fund generated income by investing in businesses for more than one year and then sold that business for a profit. The debate right now is whether the manager should receive that capital gain treatment, when for the most part the money used to generate that capital gain belongs to the limited partners who put up the bulk of the money. And you know what Frank and to the Point says about that? Read the blog Double Taxation by my partner Anthony Nitti. After all, he is the tax guy around here and has no problem speaking his mind on these touchy topics.
There are many things happening so quickly and I am finding it hard to keep on top of all the changes. My job is to be proactive, get an understanding of the regulatory rule changes and meet with my clients to plan a proper course of action. Here are a couple of things we are tracking:
The new Health Care and Education Reconciliation Act of 2010 will go into effect in 2013. This will subject some individuals to a 3.8% Medicare contribution tax on unearned income. What is unearned income? Unearned income is income such as dividends, interest and capital gains. And what do investors in hedge funds receive? You guessed it – interest, dividends and capital gains.
There has been some discussion/disagreement as to whether a hedge fund constitutes a trade or business and if it does, then the income is not considered unearned. There are code sections that require material participation in the trade or business for these types of income to not be considered passive or unearned income.
This will be an interesting year as our tax planning strategy with our clients may include trying to accelerate income into 2012 rather than pushing off to 2013. This should be a fun consultation in December, “Mr. X we want you to pay more taxes now because you will really be saving taxes later.” Ok, get my bullet proof vest ready.
The Financial Accounting Standards Board (FASB) has been actively exploring the definition of an investment company. This is important because there are proposals regarding when and what companies should be consolidating their financial statements. This could have a huge impact on the hedge fund industry, not just to the funds but to the management and advisors to these funds, as they may need to consolidate the funds they work with or BE consolidated by the funds.
The FASB is working in conjunction with the International Accountings Standards Board (IASB) to collaborate on a set of rules the entire planet can abide by. This is necessary if the US ever switches from GAAP (Generally Accepted Accounting Principles) to IFRS (International Financial Reporting Standards).
On a side note, I feel bad for all of the CPA candidates sitting for the CPA exam. The new exams include questions on IFRS, yet not many companies here in the US have made the switch.
Anyway, here at WS+B, we are monitoring these legislative issues and will be notifying you and all of our clients as to what is the best course of action in the months ahead. So, keep reading…
A few weeks back I blogged about an article my partner Matt Pribila wrote concerning the push for more regulations over Registered Investment Advisors (RIAs). The issue, at the time, seemed to be whether the SEC (Securities and Exchange Commission), FINRA (Financial Investment Regulator Association) or an SRO (self regulating organization) should be granted the authority to perform annual examinations of RIAs.
The House Financial Services Committee Chair, Spencer Bachus (R-Ala.), introduced a bill which would maintain the SECs control over the examination process. There was an additional bill brought to the House that would allow the SEC to charge user fees for exams, which was backed by advisers.
Hours after introducing his bill, Mr. Bachus put his bill on hold stating to InvestmentNews, “Everyone agrees there is a serious problem, unfortunately, there is no consensus on how to fix it. No bill, including the bipartisan bill I offered, will move forward in the committee unless and until there is a consensus.”
Now, I am the first one to admit that making knee-jerk decisions isn’t always in the best interest of anyone, but when faced with the serious problems surrounding the financial community, something needs to be done to restore investor confidence.
With only a few congressional sessions left in 2012, it doesn’t look like anything will change this year.