United States: SEC/SRO Update

Wall Street Lawyer (Vol. 17, 5)

The Green Light to Social Media Use for Regulation FD Purposes Looks More Like Yellow; SEC Issues Additional FAQs Regarding Form PF; SEC Provides Guidance on the Custody Rule; Broker–Dealer FAQs under the JOBS Act

The Green Light to Social Media Use for Regulation FD Purposes Looks More Like Yellow

On April 2, the U.S. Securities and Exchange Commission (SEC) issued a report of investigation¹ related to Netflix and social media issues. The report (i) brings closure to the Division of Enforcement investigation of whether Netflix, Inc. and its CEO, Reed Hastings, violated Regulation FD and Section 13(a) of the Securities Exchange Act of 1934 (Exchange Act) (see previous items in "SEC/SRO Updates" in the March 2013, February 2013 and January 2012 issues of Wall Street Lawyer about Netflix and Mr. Hastings each receiving a "Wells Notice" from the SEC Staff in connection with Mr. Hastings' July 2012 announcement on his Facebook page that Netflix's monthly viewing exceeded 1 billion hours); and (ii) provides guidance on the use of social media for Regulation FD purposes.

The report brings good news that the SEC determined not to pursue an enforcement action against Netflix and Mr. Hastings (a different determination was likely to have a chilling effect on corporate communications via social media channels). And even more significantly, the SEC uses this report as a forum to extend the principles set forth in its 2008 Guidance on the Use of Company Web Sites (2008 Guidance)² to announcements made through social media channels (e.g., Facebook and Twitter) for Regulation FD compliance purposes.

The cornerstone of Regulation FD is the concept that material nonpublic information should be disseminated in a manner "reasonably designed to provide broad, nonexclusionary distribution of the information to the public." When the SEC issued its 2008 Guidance, it officially acknowledged that a company's website could serve as a broad, nonexclusionary method of distribution of the information to the public under Regulation FD, provided such website was a recognized channel of distribution. The SEC now expects issuers "to examine rigorously the factors indicating whether a particular [social media] channel is a 'recognized channel of distribution' for communicating with their investors."

The SEC's report emphasizes the importance of providing notice to "the market about which forms of communication a company intends to use for the dissemination of material, non-public information, including the social media channels that may be used and the types of information that may be disclosed through these channels." The SEC suggests that "disclosures on corporate websites identifying the specific social media channels a company intends to use for the dissemination of material non-public information would give investors and the markets the opportunity to take the steps necessary to be in a position to receive important disclosures e.g., subscribing, joining, registering, or reviewing that particular chan nel." Netflix chose to file a Form 8-K on April 10, encouraging investors and the media to review the information posted on the social media channels listed in its Form 8-K, including Mr. Hastings' Facebook page.

However, in addition to the notice to investors, applying the 2008 Guidance, there are other factors that are important in the determination of whether a company's website, and now social media channels, can be viewed as "recognized" channels of distribution of information. For example, companies should evaluate "the extent to which information posted... is regularly picked up by the market and readily available media, and reported in, such media... and the size and market following of the company involved." This report provides the logical and expected clarification that the 2008 Guidance applies to social media communications. But what has really changed for public companies and their Regulation FD compliance?

Although the SEC encourages companies "to seek out new forms of communication to better connect with shareholders," the SEC guidance leaves a company to perform a difficult facts-and circumstances analysis of  whether the company's website or Facebook page is a recognized channel of distribution of information to the investing public even if the company provides the required notice to investors. In the absence of a clear definition of what constitutes such "recognized channel," companies may not be utilizing the full potential of the SEC's 2008 Guidance and its 2013 extension to social media channels.

SEC Issues Additional FAQs Regarding Form PF

In March, the SEC issued additional FAQs³ related to Form PF. SEC-registered investment advisers which advise one or more private funds and have at least $150 million in regulatory assets under management attributable to private funds are required to file Form PF with the SEC. The breadth of the disclosure requirements and the frequency of filings on Form PF vary based on the types of private funds advised and the adviser's assets under management. The purpose of Form PF is to allow the SEC and the U.S. Commodity Futures Trading Commission (CFTC) to collect risk exposure information. Information reported on Form PF is not publicly filed and remains confidential.

The new FAQs address very specific questions regarding how to respond to questions contained in Form PF. Accordingly, these FAQs should be reviewed prior to completing and submitting their client's next (or initial) Form PF. Some of the matters discussed in the new FAQs include:

• Treatment of short positions, derivatives, repurchase agreements, total return swaps and other financial instruments: if the private fund has a balance sheet, the fund may rely on gross assets reflected on the balance sheet to calculate regulatory assets under management and gross asset value. Therefore, the fund does not need to assess the value of these financial instruments in a manner different than applicable accounting standards. If a filer reported private funds in a masterfeeder arrangement on an aggregated basis on its Form ADV, then the filer must report the master-feeder arrangement on an aggregated basis on Form PF.
• If a filer elects to aggregate a master-feeder arrangement for reporting purposes in accordance with Instruction 6, the filer should treat the aggregated funds as if they were all one private fund. Therefore, the filer should collapse the master-feeder structure and aggregate all investors in the master-feeder arrangement (but should not count the feeder funds themselves as investors) when responding to questions 15, 16 and 50 about investors of the master-feeder arrangement.
• When reporting aggregate value of all derivatives positions of a reporting fund in questions 13(b) and 44, the filer should report the absolute value of all outstanding derivatives positions, and should not report a negative number. A filer should include derivatives exposure when measuring exposures to each sub-asset class under the "ABS/structured products" asset class.
• A fund's exposure to interest rate derivatives should be reported in terms of 10-year bond equivalents for purposes of Questions 26 and 30.
• The breakdown of a fund's investments in portfolio companies by North American Industry Classification System (NAICS) codes should be based on the percentage of the total gross value of the fund's investments in portfolio companies attributable to specific NAICS codes.
  
  
• The FAQs also provided guidance on how to calculate the trade volume percentage of derivatives trades for purposes of Questions 24(b) and 24(c) and how to calculate and report net asset value and percentages thereof.

SEC Provides Guidance on the Custody Rule

In March, the SEC issued a Risk Alert⁴ and an Investor Bulletin⁵ related to compliance with its custody rules for investment advisers. The Risk Alert was issued following recent examinations of investment advisers which revealed various deficiencies related to compliance with the SEC's custody rules.

Custody by an investment adviser means holding client funds or securities, directly or indirectly, or having the authority to obtain possession of them. For example, an investment adviser has custody of its clients' assets when an investment adviser has the power to withdraw funds or securities from its client's accounts, including fees. SEC-registered investment advisers who have custody of client assets must, subject to certain exceptions, (i) use qualified custodians to hold client assets; (ii) provide notice to their clients in writing of the qualified custodian's name, address, and the manner in which the client's funds or securities are maintained; (iii) have a reasonable basis to believe that the qualified custodian that maintains its clients' funds and securities sends account statements at least quarterly to the adviser's clients directly; (iv) must enter into a written agreement with an independent public accountant to examine client funds and securities on a surprise basis every year to verify such funds and securities; and (v) comply with certain additional rules when the adviser uses a related qualified custodian.

The deficiencies identified in recent exams of investment advisers included:

• failure of advisers to recognize that they had custody;
• failure of advisers to comply with the custody rule's surprise examination requirements;
• failure of advisers to comply with the custody rule's qualified custodian requirement; and
• failure of advisers to comply with the audited fund exception to the surprise audit requirement for pooled investment vehicles.

As a result of recent examinations, the SEC staff has required advisers with custodial deficiencies to take various actions, including remedial measures, such as drafting, amending or enhancing their written compliance procedures, policies, or processes; changing their business practices; or devoting more resources or attention to the area of custody. In addition, in certain cases, the staff has made referrals to the SEC's Division of Enforcement. Investment advisers should pay particular attention to their custodial policies, procedures and actual business practices in light of this recently issued Risk Alert.

Broker–Dealer FAQs under the JOBS Act

On February 5, the Division of Trading and Markets of the SEC issued FAQs⁶ providing guidance on the exemption from broker-dealer registration contained in Title II of the Jump Start Our Business Startups Act (JOBS Act). Title II of the JOBS Act offers a limited exemption from broker dealer registration for intermediaries facilitating Rule 506 offerings under Regulation D of the Securities Act of 1933 (the Title II broker-dealer exemption). It should be noted that although the Title II broker-dealer exemption is technically currently in effect, it has limited utility until the SEC adopts amendments to its rules relating to Rule 506 offerings. The FAQs clarify various matters related to the Title II broker-dealer exemption, including:

• The Title II broker-dealer exemption is only available when securities are offered and sold pursuant to Rule 506 of Regulation D.
• Social media internet websites can qualify as a platform or mechanism under the Title II broker-dealer exemption.
• The Title II broker-dealer exemption is not available if a person or its associated persons receives "compensation" in connection with the purchase or sale of such security. The staff interprets the term "compensation" broadly, to include any direct or indirect economic benefit to the person or any of its associated persons. At the same time, the staff recognizes that Congress expressly permitted co-nvestment in the securities offered on the platform or mechanism. Therefore, the staff does not believe that profits associated with these investments would be impermissible compensation.
• Venture capital funds and their advisers can rely on the Title II broker-dealer exemption.
• An associated person of an issuer can maintain a platform or mechanism for sale of the issuer's securities in reliance on the Title II broker-dealer exemption.
• Any salary paid to a person to promote, offer, and sell shares of a complex of privately offered funds (e.g., in an internal marketing department) is compensation to that person in connection with the purchase or sale of securities. As a result, that person would not be able to rely on the Title II broker-dealer exemption.
• Persons relying on the Title II broker-dealer exemption may still be required to register as a broker-dealer due to their other activities.In addition, the Title II broker-dealer exemption only provides an exemption from registration as a broker-dealer and compliance with requirements applicable only to registered broker-dealers, some portions of the federal securities laws apply to brokers or dealers regardless of registration.

The Title II broker-dealer exemption does not provide an exemption from state registration requirements.

Footnotes

<sup>1. See SEC Release N o. 69279 "Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: Netflix, Inc., and Reed Hastings" (April 2, 2013); available at http://www.sec.gov/litigation/investreport/34-69279.pdf .
2. See SEC 17 CFR Parts 241 and 271 (Release Nos. 34-58288, IC-28351; File N o. S 7-23-08); "Commission Guidance on the U se of Company Websites"; available at http://www.sec.gov/rules/interp/2008/34-58288.pdf .
3. See SEC's Form PF "Frequently Asked Questions"; available at http://www.sec.gov/divisions/investment/pfrd/pfrdfaqshtml .
4. National Exam Program, Risk Alert; "Significant Deficiencies Involving Adviser Custody and Safety of Client Assets"; Volume III, Issue 1; March 4, 2013; available at http://www.sec.gov/about/offices/ocie/custody-risk-alert.pdf .
5. See SEC's "Investor Bulletin: Custody of Your Investment Assets"; available at http://wwwsec.gov/investor/alerts/bulletincustody.htm .
6. See SEC Division of Trading and Markets' "Frequently Asked Questions About the Exemption from Broker-Dealer Registration in Title II of the JOBS Act" February 5, 2013; available at http://www.sec.gov/divisions/marketreg/exemption-broker-dealer-registration-jobs-act-faq.htm .</sup>

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