Monday, October 15, 2012

Investing in Hedge Funds is a Risky Business

As of April 2012, the estimated size of the global hedge fund industry was $2.13 trillion. Investing in hedge funds is not open to everyone. Only accredited investors can do so. The threshold is often raised to allow only “qualified purchasers” to invest, - these individuals are not only accredited investors, but also have at least $5 million in investments in addition to the money they are investing in the hedge fund. However, even these wealthy individuals suffer from fraudulent activities that may, and do occasionally, occur inside the hedge funds.

Just recently, on October 3rd, the Securities and Exchange Commission charged two hedge fund managers and their firms with lying to investors about how they were handling investor money. In one case, the SEC alleged that the San Francisco-based fund manager and his firm stole more than half a million dollars from a retired schoolteacher who was investing her retirement savings. According to the SEC complaint, the fund manager told the teacher that the money would be invested in the stock market using the long / short equity investment strategy, but instead used it to pay unauthorized personal and business expenses, including home mortgage, office rent and staff salaries. In addition to the SEC action, the U.S. Attorney’s Office announced criminal charges against the fund manager.

In the other case, the SEC charged the Chicago-based fund managers and their firm with fraudulently taking out at least $147,000 in excessive fees and capital withdrawals from a hedge fund they managed. Investors in the fund were not aware that the manager removed various performance hurdles when calculating the management fees. Also, the managers made unauthorized capital withdrawals from the fund.

Since the beginning of 2010, the SEC has filed more than 100 cases against hedge fund managers for lying to the investors about investment strategy or performance, hiding conflict of interests, misusing investor funds and charging excessive fees. It seems that investing into hedge funds is risky not only because of the risk of investing money in the stock market or derivatives, but also because of the possibility that fund managers may defraud the fund investors.

To protect investors and help them evaluate the risks, the SEC issued an investor bulletin on October 3, 2012. In it, the SEC advises investors to really understand the funds’ investment strategy and the use of leverage, derivatives and other investment techniques. Also, investors should identify and evaluate the managers’ conflicts of interests and conduct independent research of the managers’ backgrounds. The bulletin is a helpful and practical summary of what the investors should look for when considering a hedge fund investment. Although it will not prevent the fraudulent activities that apparently go on in some of the funds, it will at least help keep some investors away making these risky investments.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.

Friday, October 12, 2012

COPPA Enforcements are on the Rise

This blog post is “directed to” all website owners and operators whose websites may be “directed to” (the actual term used in COPPA) children under the age of 13 or who actually know that kids access their site.

COPPA is the Children’s Online Privacy Protection Act of 1998. Its purpose is to safeguard personally identifiable information of children under the age of 13. COPPA applies to operators of commercial websites or online services “directed to” children that collect, use, and/or disclose personal information from children, and to operators of commercial websites or online services that have actual knowledge that they collect, use, and/or disclose personal information from children. In particular, COPPA requires these operators to: (1) post a privacy policy on their website; (2) provide notice to parents about the site’s information collection practices and, with some exceptions, get verifiable parental consent before collecting personal information from children; (3) give parents the choice to consent to the collection and use of a child’s personal information; (4) not condition a child’s participation in an activity on the disclosure of more personal information than is reasonably necessary for the activity; and (5) maintain the confidentiality, security and integrity of the personal information collected from children.

COPPA is currently being amended. September 24, 2012 was the deadline to submit public comments to the FTC.

In the meantime, the FTC has promised to step up its enforcement of COPPA. Just recently, on October 2nd, 2012, the FTC settled with Artist Arena LLC, an operator of fan websites for Justin Bieber, Selena Gomez, Rihanna and Demi Loyato, for $1 million. The FTC charged the defendant with the violation of COPPA because it allegedly collected children’s personal information without their parents’ consent. The websites asked the users (often kids under the age of 13) to register on the websites, create online profiles, post messages and sign up for newsletters. According to COPPA, the websites should have notified the children’s parents, disclosed what information was being collected and for what purposes, and obtained verifiable parental consent before collecting any such information.

It is always best to learn from the mistakes of others rather than your own.  So, it is best for the websites that are likely to be visited by children to (i) have a privacy policy that discloses the information collection practices of the website and (ii) obtain verifiable parental consent before such websites collect any information from children under the age of 13.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.

Friday, October 5, 2012

Don't Forget to Comply With Securities Laws When Raising Capital, Even if Just for a Film Project

On September 20, 2012, the California Department of Corporations filed a complaint in the Los Angeles Superior Court that alleged that a number of companies did not qualify the offer and sale of limited liability company interests, bridge loans, promissory notes and convertible debentures in at least 215 transactions worth more than $23 million. Further, the Department of Corporations claimed that the information that the investors were given contained numerous misstatements and omissions. The money raised was used for financing of entertainment projects, including motion pictures.

Although this law suit is taking place in California, the allegations lead to believe that there may be a number of federal securities law violations that are typically investigated by the Securities and Exchange Commission (SEC).

The federal Securities Act of 1933 (the “Securities Act”) requires all companies to register offerings of their securities with the SEC unless an offering complies with one of the exemptions. These exemptions from registration are typically found in Regulation D. Each state has its own securities laws (referred to as “blue sky” laws). So, when raising capital, companies need to comply with both the federal and the state securities laws.

First, let’s take a look at the definition of a “security” in the Securities Act. Apart from the obvious stocks, “security” includes many debt instruments and even certain contracts. Courts have determined, for example, that an investment contract can be a security, if a person invests his or her money in a common enterprise with an expectation of profit derived solely from the efforts of others. There is no requirement to issue formal certificates to such investors. According to this rule, membership interests in an LLC can be “securities” if the investors have passively invested their money in the LLC with an expectation of a financial return on their investment.

Similarly, a promissory note can also be a security. The question of whether a promissory note is a security turns on whether the note looks like a security and whether the selling of the note looks like a securities offering. Factors to consider include the number and sophistication of the investors/lenders, whether the note is collateralized, whether the investors/lenders are also owners of the business they are lending money to, etc. It is likely that if a company is raising money for its general operations, and the investors are investing with an expectation of return, the promissory note will be deemed to be a security. Same analysis applies to other forms of investments.

When a company is offering and selling its securities to the investors, it generally distributes a disclosure document in which it describes the offering terms, its own business, management, market, competition, financial condition, and other factors, including the risks, that can influence the investors’ decision-making. According to the federal Rule 10b-5 under the Securities Exchange Act, companies cannot intentionally include material misstatements and omissions in such disclosure documents, and they have to update all stale information to make the statements be true.

Although compliance with the federal and state securities laws may be onerous, but it is not optional. Timely compliance with the applicable securities laws and regulations is much cheaper than paying hefty fines imposed as a result of the securities law violations.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.