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G-20 for the New UN Security Council

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By Omer Er

In the aftermath of World War II, governments around the world signed onto the United Nations Charter, which codified the major principles of international relations: maintaining international peace and security, protecting human rights, delivering humanitarian aid, and supporting sustainable development.

These bedrock principles were originally stated in 1945. Seventy-eight years later, leaders from around the globe and their top diplomats have gathered in New York once again for the annual meeting of the UN General Assembly. Given the state of our world, there were continued calls for reform in the UN organization at the meetings, particularly with regard to the UN Security Council, which is dominated by five nations—China, France, Russia, the United Kingdom and the United States— all with veto powers.

No doubt about it, the cries for a reform of the Security Council have become much louder of late, especially in the wake of Russia’s invasion of Ukraine. Invasion aside, this is not a new debate for the international community.

The world has changed significantly since 1945. Back then, the global population was around 2.3 billion and there were only 51 founding members of the UN. Today, our planet is home to nearly 8 billion people and the UN has over 190 member states. Beyond those numbers, there has been a major shift in the economic centers of gravity across the globe—so much so that it is no longer possible to maintain worldwide peace and prosperity under Security Council as currently configured.

The U.S. has been seeking an increase in the permanent and non-permanent members of the Security Council for some time. Brazil, Germany, India and Japan, known as the G4 governments, are also advocating for equal permanent memberships, and another group—dubbed Uniting for Consensus and including Argentina, Canada, Colombia, Costa Rica, Italy, Malta, Mexico, Pakistan, Republic of Korea, San Marino, Spain and Türkiye—are calling for an increase to the number of elected members of the Security Council as well. So too is the African Union, which wants additional permanent and elected seats on the Security Council for the African nations.

Of note, Security Council reform has been on the table ever since 1992, when a working group was put in place to review reform methods. Three decades later, the needle has yet to move, which is reflective of the size of the challenge.

Truth be told, the glaring lack of action in terms of reform is not surprising. The interests of many sovereigns are far from aligned. And even for those nations that are united in their call for change, a consensus as to methods of reform is hard to come by. Conflict regarding the addition of more permanent and elected seats, issues around dilution, whether to preserve or eliminate certain veto powers, and the criteria for new membership (economics, population, military might) remain.

By virtue of the current impasse, world leaders must seize upon a more practical solution to the problems associated with Security Council reform. As otherwise stated, a healthy international legal order is needed to ensure a peaceful global order.

The fastest path to reform could be forged by establishing a secretariat for the G-20 and involving its members in the issues before the Security Council. Indeed, this approach could gradually evolve into the delegation of duties from the Security Council to the G-20, which would make for a more fair and secure platform to achieve the goals of the UN Charter given the representation of the world populations and economies on the G-20.

In the wake of the annual meeting of the UN General Assembly, the time is now to harness the G-20 as a practical tool to achieve the UN Charters stated objectives, above all else, peace and security.

This blog post is not offered, and should not be relied on, as legal advice. You should consult an attorney for advice in specific situations.

Regulation of Investment Advisers Under the Final New Private Funds Rules Adopted by the SEC

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By Elliot Weiss

Investment advisers play a pivotal role in providing investor guidance and managing assets; a particularly important role given the complexity of the financial markets. Depending upon circumstances, investment advisers may interact with investors either directly or indirectly through a number of complex entity forms, all the while regulated by the Securities and Exchange Commission (SEC), which has established a comprehensive framework to regulate investment advisers under the Investment Advisers Act of 1940 and investment companies and funds under the Investment Company Act of 1940.

More recently, the SEC has adopted new private fund rules—this under the Investment Advisers Act—aiming to enhance transparency and investor protection of private fund advisers. Those rules are examined here. But first, some context.

What Are Private Funds?

Private funds are typically not available to the general public and cater to a more limited number of accredited investors. These are pooled investment vehicles excluded from the definition of investment company under sections 3(c)(1) and 3(c)(7) of the Investment Company Act. Examples include hedge funds, private equity funds, and venture capital funds.

Historically, many private funds were exempt from registering with the SEC due to the applicable "private adviser exemption" under the Investment Advisers Act allowing certain advisers with fewer than 15 clients to avoid registration. However, this exemption was supplanted by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which set forth new exemptions for advisers. Now, only those advising exclusively to venture capital funds or solely to private funds with less than $150 million in assets under management in the U.S. are exempt from registration requirements.

The net effect of the Dodd-Frank Act: many previously unregistered advisers to private funds must register with the SEC or the states.

Private Fund Regulation

In recent years, the SEC recognized the need to enhance oversight of private funds and address potential systemic risks arising from their operations. This led to the adoption of rules contemplating all of the following:

1. Form PF: Form PF (Private Fund) mandates registered investment advisers to private funds to provide detailed information about their funds' assets, strategies, leverage, and

counterparty exposures—data that enhances the SEC's ability to monitor systemic risks and potential market vulnerabilities stemming from private funds. SEC-registered investment advisers with at least $150 million in private funds under management use Form PF to report, on a non-public basis, information about the private funds that they manage, including fund type (hedge fund or private equity), size, and liquidity.

2. Liquidity Risk Management Program: SEC Rule 22e-4 requires open-end funds, including mutual funds and some ETFs, to implement a comprehensive liquidity risk management program. This ensures that funds maintain a sufficient level of liquidity to meet investor redemptions during times of market stress.

3. Reporting Modernization: Also in place are reporting requirements for regulated investment companies and ETFs to provide investors with more accurate and timely information about fund holdings, risk exposures, and performance, all in an effort to promote greater transparency and enable investors to make informed decisions.

New Private Funds Rules

The need to bolster investor protection beyond that provided for in the aforementioned rules led the SEC—last month—to approve final rules and amendments to the Investment Advisers Act. These new rules, which further enhance protections afforded investors in private funds managed by private fund advisers, impact not just SEC-registered investment advisers, but also exempt reporting advisers, state-registered investment advisers, and other unregistered investment advisers.

A. Restrictions on Conflicted Activities

The new private funds rules impose restrictions on certain conflicted activities that investment advisers may engage in, particularly concerning fees, expenses, and clawbacks. Conflicts of interest can undermine investors' trust and compromise the integrity of the investment management process. The SEC's regulations aim to mitigate these conflicts and promote greater alignment between investment advisers and their clients.

1. Fees and Expenses. Investment advisers are now subject to new restrictions on charging or allocating certain fees and expenses to the funds they manage. Restricted activities include (i) charging or allocating fees and expenses associated with any regulatory, compliance or examination fees or expenses of the adviser or its affiliates; (ii) charging or allocating fees associated with an investigation of the adviser or its affiliates by any governmental or regulatory authority; (iii) charging or allocating fees and expenses related to an investigation of the adviser or its affiliates that results or has resulted in a court or governmental authority imposing a sanction for a violation of the Investment Advisers Act or the rules promulgated thereunder; and (iv) charging or allocating fees and expenses related to a portfolio investment on a non-pro rata basis when more than one private fund or other client advised by the adviser or its related persons have invested in

the same portfolio company. Some of these restricted activities may be authorized with informed consent and/or subsequent or advanced disclosure while other are prohibited outright. The goal here is to prevent advisers from allocating excessive or unjustified fees to funds, ensuring that investor returns are not unduly diminished by such practices.

2. Borrowing or receiving an extension of credit from a private fund client. Investment advisers are now subject to new restrictions on borrowing money, securities or other private fund assets, or receiving loans, or extensions of credit, from private fund clients. When seeking to borrow from a private fund client, investment advisers are required to obtain informed consent and accompany such consent with explicit disclosure of the material terms of the borrowing to the client.

3. Reduction of Clawbacks. The new rules also restrict an adviser from reducing the amount of any performance, compensation clawback (e.g., clawback of carried interest, performance allocations, etc.) by actual, potential or hypothetical taxes applicable to the adviser, its affiliates or their respective owners or interest holders. The restrictions here can be waived in the event the adviser subsequently discloses to investors the aggregate amount of the clawback both before and after the clawback reduction.

For conflicted activities to be waived, the adviser must provide appropriate disclosures and, under certain circumstances, informed consent, which must be obtained from at least a majority of investors unrelated to the adviser.

B. Prohibitions on Preferential Treatment and Increased Transparency

The new rules introduce prohibitions on providing certain investors with privileges or advantages that are not extended to other investors (a practice frequently seen in the use of side letters, side arrangements and more favorable liquidity terms provided in a fund's governing documents with respect to preferred investors). These prohibitions relate to:

1. Redemptions. Investment advisers are now prohibited from granting preferential treatment to specific investors concerning redemptions; specifically, advisers cannot provide an investor in a private fund or in a similar pool of assets the ability to redeem an interest on terms that the adviser reasonably expects to have a material, negative effect on other investors.

2. Information. Similar to redemptions, the new rules prohibit preferential treatment in terms of information dissemination regarding portfolio holdings or exposures of a private fund, or of a similar pool of assets, to any investor if the adviser reasonably expects that providing the information would have a material, negative effect on other investors in that private fund or in a similar pool of assets. Investment advisers must ensure that all investors have access to the same information, preventing information asymmetries that could be exploited by certain investors to gain unfair advantages.

C. Enhanced Transparency and Accountability

For SEC-registered investment advisers to private funds, the new rules further require them to furnish detailed quarterly statements to investors. The statements encompass a comprehensive array of critical information such as performance, fees and expenses, and adviser and adviser-related compensation.

In addition, SEC-registered private fund advisers are now subject to enhanced annual audit mandates that require them to conduct more comprehensive and rigorous annual audits of their private funds. Among other things, they must obtain an annual financial statement audit of the covered private funds they advise.

Finally, the new private funds rules include requirements related to adviser-led secondary transactions (e.g., any transaction initiated by an adviser or its affiliate that offers fund investors the option between selling all or a portion of their interests in a private fund and converting or exchanging them for new interests in another vehicle advised by the adviser or any of its related persons). SEC-registered investment advisers engaging in these transactions must obtain fairness or valuation opinions for adviser-led secondary transactions and written summaries of any material business relationships between advisers or their affiliates and the independent opinion providers within a specified time frame.

In Conclusion

The new private funds rules— set to go effective 60 days after publication in the Federal Register—mark a significant step towards enhancing investor protection, transparency, and fairness within the private funds sector. Likewise, they represent a substantial expansion of the SEC’s regulation of private fund advisers that are sure to have a significant impact on future SEC examination and enforcement activities. That being said, it is expected that private fund advisers will have 12 to 18 months (depending on the rule) following the date of publication in the Federal Register to become compliant with the new private rules.

This blog post is not offered, and should not be relied on, as legal advice. You should consult an attorney for advice in specific situations.

The Implications of Marijuana Reclassification Part 3: The Real Estate Space

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By Mehdi Sinaki

The recent recommendation by the U.S. Department of Health and Human Services to reclassify marijuana as a Schedule III controlled substance has sent ripples across multiple sectors, the real estate space included. The prospect of marijuana’s reclassification from its current Schedule I status could dramatically alter the legal landscape in which real estate professionals and investors operate. Here, the potential implications of this proposed change are addressed.

Zoning and Land Use Regulations

Presently, the Schedule I status of marijuana imposes strict limitations on where dispensaries, cultivation centers, and manufacturing facilities can be located. These federal restrictions often dovetail with state and local zoning rules, creating a highly complex matrix of laws that operators must navigate. Reclassification to Schedule III could potentially simplify zoning regulations, allowing investors greater flexibility when selecting locations for cannabis-related businesses.

Real Estate Financing

Currently, securing financial backing for a cannabis-related real estate deal can be an arduous process. Most major financial institutions are reluctant to engage in transactions involving Schedule I substances due to the inherent legal risks. However, moving marijuana to Schedule III could make banks and institutional investors more amenable to offering financing for cannabis-related real estate transactions. This would likely spur a wave of new developments and transactions in the sector.

Lease Agreements and Contract Law

Landlords and tenants in the cannabis industry often face unique challenges in contractual relationships due to the current federal classification of marijuana. Lease agreements often incorporate specific clauses that address the legal uncertainties surrounding cannabis-related businesses. Reclassification could result in a normalization of these relationships, allowing for more standard lease agreements and thereby reducing legal costs and complexities for both parties.

Federal Asset Forfeiture Risks

Under existing laws, properties involved in the production, storage, or sale of Schedule I substances are subject to federal asset forfeiture. This creates a significant risk for property owners and investors. A downgrade in marijuana’s classification would likely reduce these risks, making real estate investment in the sector a more secure proposition.

Public Sentiment and Market Demand

The reclassification of marijuana would send a strong signal to the market that the federal government recognizes the substance’s medical potential and lower abuse risk. This could further destigmatize marijuana use and increase market demand, driving up property values in zones earmarked for cannabis-related activities.

Lingering Challenges

While reclassification of marijuana from Schedule I to Schedule III would address several existing obstacles, it would not eliminate them entirely. For instance, the conflict between federal and state laws would still exist. For their part, real estate stakeholders would still need to be vigilant about local ordinances that may place restrictions on cannabis-related businesses.

Without question, reclassification of marijuana would constitute a watershed moment in both the cannabis and real estate industries. Nonetheless, while it would resolve certain existing challenges, reclassification would not completely alleviate the legal complexities inherent when these two sectors intersect. Therefore, it is essential for real estate professionals to remain well-informed and consult legal expertise to navigate the evolving landscape successfully.

This blog post is not offered, and should not be relied on, as legal advice. You should consult an attorney for advice in specific situations.

The Implications of Marijuana Reclassification Part 2: The Healthcare Sector 

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By Mehdi Sinaki

The Implications of Marijuana's Potential Reclassification for the Healthcare 

As word spreads about the U.S. Department of Health and Human Services' recent recommendation to reclassify marijuana from a Schedule I to a Schedule III controlled substance, healthcare providers, insurers, and pharmaceutical companies are justifiably keen to understand the full scope of this proposed change. This article provides an overview of just how reclassification would reverberate throughout the healthcare industry. 

Expanded Research Capabilities 

Currently, marijuana’s Schedule I status severely curtails medical research by imposing rigorous regulatory hurdles, including stringent DEA approval requirements and a limited supply of research-grade cannabis. A reclassification to Schedule III would relax these constraints, permitting an acceleration in clinical trials and research. This could yield new cannabis-based medical treatments and significantly expand our understanding of marijuana's therapeutic effects. Moreover, partnerships between academic research institutions and the private sector could flourish, advancing more rapid and diverse studies. 

Prescribing Regulations 

Moving marijuana to Schedule III would affect prescribing practices. Unlike Schedule I substances, Schedule III drugs can be prescribed by a healthcare provider, but with certain restrictions. Providers would need to familiarize themselves with these new rules and possibly undergo specific training to prescribe cannabis-based products legally, even opening up new specialized health insurance products. 

Insurance Coverage 

The Schedule I status of marijuana has long been a sticking point in the insurance industry, making it virtually impossible for patients to get coverage for medical cannabis treatments. A change in federal classification would likely lead to a re-evaluation of insurance policies concerning marijuana. While immediate universal coverage is improbable, incremental changes could result in more comprehensive insurance options for patients seeking cannabis-based therapies. 

Drug Scheduling and Pharmacy Distribution 

Currently, marijuana products are generally distributed through specialized dispensaries. A shift to Schedule III would open the possibility for mainstream pharmacies to dispense cannabis-based medications, under strict regulations. Pharmacies and healthcare facilities would need to adhere to new guidelines for the storage, prescription, and sale of these products, a change that would require legal oversight and compliance procedures. Furthermore, pharmaceutical companies may compete for patents and FDA approval of specific cannabis-based drugs, changing the competitive landscape. 

Risk Management and Liability 

Healthcare providers prescribing or administering cannabis-based treatments would find themselves navigating a new landscape of potential risks and liabilities. Medical malpractice insurance policies may need to be updated to include cannabis-related treatments, and informed consent procedures would need to be revised to incorporate the specific risks and benefits associated with such therapies. 

Regulatory Compliance 

Should the proposed reclassification materialize, healthcare institutions would need to update their compliance programs to incorporate new federal and state regulations concerning the use and prescription of cannabis-based products. Failure to adhere to these evolving guidelines could result in legal penalties, including fines and potential revocation of medical licenses. Telemedicine protocols for prescribing cannabis could also come into play, requiring an update to existing telehealth regulations. 

Ethical Considerations 

Beyond the legal implications, healthcare providers would face ethical questions, particularly regarding the prescription of cannabis for certain patient demographics like minors or pregnant women. This would necessitate revising ethical guidelines and potentially require consultations with ethics committees to navigate complex scenarios. The potential for increased recreational use also raises public health concerns, especially among adolescents. 

The possible reclassification of marijuana could serve as a transformative catalyst in the healthcare sector, presenting new opportunities, challenges, and legal complexities. Given the seismic shifts that would result should cannabis be classified as a Schedule III substance, which could happen as early as 2024, it is imperative for stakeholders in the healthcare industry to seek informed legal counsel to prepare for the challenges and opportunities that lie ahead and navigate the intricacies of this evolving landscape effectively. 

This blog post is not offered, and should not be relied on, as legal advice. You should consult an attorney for advice in specific situations. 

Yet Another Court Win for Crypto, but SEC’s Gensler Fights Back 

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By Sam Licker and Liza Kirillova

Following a federal court’s ruling that Ripple Labs did not violate federal law by selling its XRP token on public exchanges, the U.S. Security and Exchange Commission took another hit with respect to its aversion to cryptocurrency. In late August, a three-judge panel of the D.C. Court of Appeals ruled that the SEC was wrong to deny Grayscale Investment’s (Grayscale) proposal to convert its Bitcoin Trust (OTC:GBTC) into a spot Bitcoin ETF, which would follow Bitcoin’s underlying market value and provide investors with exposure to the digital currency without actually needing to buy it.  

By way of background, an ETF—or exchange-traded fund—is a “bundle” of securities that investors can buy or sell on a stock exchange. The securities underlying the ETF can be stocks, bonds, commodities, or other assets. While ETFs fluctuate just like the rest of the market, they are poised to allow investors to diversify their portfolios and allow everyday investors access to certain stocks that they may otherwise be priced out of or unable to purchase. Notably, the SEC has denied all spot EFT applications in the past, claiming that applicants have not successfully proven that they can protect investors from market manipulation.   

 The legal battle involving Grayscale commenced when the investment company sued the SEC for allegedly arbitrarily blocking Grayscale’s proposal for conversion. Ultimately, the appellate court determined that the SEC had, in fact, acted too hastily in denying Grayscale’s proposal and ordered that the Commission “reevaluate” its decision. In the opinion filed by Judge Neomi Rao, the three-judge panel held that the “Commission’s unexplained discounting of the obvious financial and mathematical relationship between the spot and futures markets falls short of the standard for reasoned [sic] decisionmaking.” In other words, the SEC failed to adequately explain why it previously approved the listing of Bitcoin futures ETFs, but not Grayscale’s proposed Bitcoin ETF. For its part, Grayscale’s legal counsel commented that if there was a reason “offered in attempting to differentiate” the two arrangements “[they] are confident that it would have surfaced by now.” The ruling lead to an immediate surge in Bitcoin prices and gave many domestic investors hope that we may yet see a spot Bitcoin ETF in the U.S.  

The impact of the ruling by the Court of Appeals goes far beyond Grayscale and Bitcoin. Indeed, the decision has rippled throughout the entire crypto industry, leading stocks for crypto exchanges, such as Coinbase, and crypto mining companies, like Marathon Digital, to soar. The outcome on appeal has also provided some reassurance to other asset managers seeking to win approval for their products (read: BlackRock’s proposal to create its own spot Bitcoin ETF, which it filed in June).  

 Of note, excitement in the wake of the determination in the Grayscale case may be premature. The ruling does not serve to approve the ETF; instead, it only orders the SEC to reevaluate its denial. As a matter of procedure, the SEC has 45 days from the August 29 ruling to appeal, after which the case will be sent to the entire D.C. appeals court or, potentially,  to the Supreme Court. In the meantime, the SEC has postponed its decisions on six pending applications for spot Bitcoin EFTs.  

The SEC and Chairman Gary Gensler still have an arsenal of options to delay or deny Grayscale’s proposal. If the SEC appeals, the process could take months or years to work its way back through the legal system, and even if the Commission acquiesces to the ruling, it may demand Grayscale to file an entirely new application, which could take up to another year to process. The SEC may also cite concerns over market manipulation that could result from a spot ETF, as the SEC’s position appears to remain that the crypto market as a whole is not a normal functioning market. That being said, a spot ETF could help bring stability to the marketplace, providing consumers with the peace of mind that comes with regulatory oversight, accessibility, investor protection, and institutional adoption for crypto.  

As the story unfolds, we will be keeping an eye on this ruling, the SEC’s response, and future crypto news.  

This blog post is not offered, and should not be relied on, as legal advice. You should consult an attorney for advice in specific situations. 

The Implications of Marijuana Reclassification Part 1: The Corporate Sector

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By Mehdi Sinaki

The U.S. Department of Health and Human Services’ recent call to the Drug Enforcement Agency for the reclassification of marijuana to a Schedule III substance under the Controlled Substances Act has roused considerable attention across industries. For those in the burgeoning cannabis space, it represents a potential paradigm shift, though the potential move is not without its drawbacks. This analysis aims to dissect the prospective changes that reclassification could engender for marijuana-related businesses.

Corporate Governance and Compliance

The reclassification of marijuana to a Schedule III drug would necessitate an extensive review of existing compliance protocols for cannabis-related businesses. Regulatory frameworks would be expected to evolve, affecting licensing, distribution, and marketing strategies. Companies would be well-advised to anticipate such changes and adapt their compliance mechanisms accordingly. Moreover, the acknowledgment of marijuana's medicinal benefits could open up avenues for more FDA-approved medical applications and pharmaceutical collaborations.

The Stock Market and Investment

Investors have already reacted positively to the news of the possible reclassification of marijuana, as evidenced by a spike in cannabis-related stocks. Reclassification could also pave the way for these cannabis companies to be listed on major stock exchanges, providing an infusion of investment capital that could catalyze further growth. Additionally, reclassification could open up the U.S. market for foreign cannabis companies, leading to a more globalized marketplace.

Taxation Ramifications

Currently, marijuana is classified as a Schedule I substance, rendering it subject to severe federal restrictions and penalties. Critically for corporate interests, Section 280E of the Internal Revenue Code prohibits businesses dealing with Schedule I substances from claiming standard tax deductions or credits. As a result, cannabis enterprises have been shouldering taxes on their total revenue without the ability to offset taxable income through standard business deductions. A transition to Schedule III would not only relieve this tax burden but also enable interstate commerce, adding a new dimension of business expansion opportunities.

Remaining Challenges and Criticisms

It is crucial to note, however, that mere reclassification of marijuana to a Schedule III substance would fall short of resolving some broader legal challenges, most notably the conflicts between state and federal law. While a Schedule III status would signify federal acquiescence to some extent, it would not end the disconnect between federal illegality and state legalization efforts. Nor would it necessarily mitigate ongoing social justice issues related to marijuana criminalization.

The prospective reclassification currently under the microscope is undoubtedly a watershed moment in federal drug policy and offers several benefits for marijuana-related enterprises. That being said, it is not an end-all solution and cannabis-related companies should remain agile, attentive to forthcoming regulatory changes, and prepared to navigate a landscape that remains fraught with legal intricacies and social implications. With the possibility of reclassification as early as 2024, ahead of the Presidential elections, companies should be prepared for rapid policy shifts and should adjust their corporate strategies accordingly.

No doubt about it, as we move closer to a potential reclassification, perhaps as early as 2024, proactive legal strategy will be paramount for corporate success in this complex and evolving sector.

This blog post is not offered, and should not be relied on, as legal advice. You should consult an attorney for advice in specific situations.

Understanding Regulation D of the Securities Act: A Summary Guide for Company Management

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By Elliot Weiss

In the realm of corporate finance, Regulation D of the Securities Act of 1933, as amended, plays a pivotal role in enabling companies to raise capital through private placements of securities. This regulation provides issuers of securities with safe harbor exemptions from registration requirements under the Securities Act that would otherwise apply to public offerings. As otherwise stated, Regulation D lets companies doing specific types of private placements raise capital without needing to register the securities with the U.S. Securities and Exchange Commission. That being said, for company management, a comprehensive understanding of Regulation D is essential to navigate the complexities of fundraising while staying compliant with securities laws. Here, some of the most significant rules and implications of Regulation D are summarized.

Regulation D: A Brief Overview

Section 5 of the Securities Act requires all offers and sales of securities to be registered with the SEC unless there is an available registration exemption. Failure to comply with these requirements grants the purchaser a right to sue to rescind the purchase or seek damages against the issuer.

The two most common exemptions provided for in the Securities Act are Section 4(a)(2) and Regulation D. Regulation D is a set of rules and safe harbor exemptions that allow companies to raise capital through sales of securities without the need for a full-scale registration process with the SEC. Of note, any type of security can be offered to investors through a private placement under Regulation D including promissory notes, SAFE notes or equity interests (e.g.  common stock, preferred stock or membership interest in a limited liability company, etc.).

Rules 504 and 506 of Regulation D set forth different qualification requirements and restrictions with respect to an offer and sale by an issuer. As a safe harbor mechanism, Regulation D is non-exclusive, which means where it does not provide an exemption, Section 4(a)(2) still may. Pursuant to both Regulation D and Section 4(a)(2), securities sold under pursuant to these exemptions are considered restricted securities and cannot be resold without registration with the SEC or qualification under another exemption.

Types of Offerings under Regulation D

Regulation D provides three main types of exemptions for private placements:

(i) Rule 504. The exemption under Rule 504 allows companies to offer and sell up to $10 million of securities to any type of investor within a 12-month period. Rule 504 is often used by smaller companies and may be subject to state securities laws, which can vary significantly.

(ii) Rule 506. According to the SEC, the exemption under Rule 506 is by far the most widely used under Regulation D, accounting for an estimated 90 to 95% of all Regulation D offerings and the overwhelming majority of capital raised in transactions thereunder. Rule 506 offers two distinct options:

  • Rule 506(b): This rule allows an issuer to raise an unlimited amount of capital from up to 35 non-accredited investors and an unlimited number of accredited investors. Pursuant to Rule 506(b), issuers must provide specific disclosure documents to non-accredited investors and must have a pre-existing relationship with them. General solicitation is prohibited under Rule 506(b) offerings.
  • Rule 506(c): Rule 506(c) permits companies to broadly solicit and advertise their offerings to the public, but all investors must be accredited. This option does not have a specific limit on the amount of capital that can be raised. Rule 506(c) is especially helpful for rolling and other private investment funds since it allows management to engage in general solicitation. The SEC has confirmed that privately offered pooled investment vehicles relying on the qualified purchaser (Section 3(c)(7)) or 100-holder (Section 3(c)(1)) exclusions under the Investment Company Act of 1940 may engage in general solicitation under Rule 506(c).

Integration

Taking advantage of any registration exemptions through a Regulation D offering requires that all sales of securities of the same class or for the same purpose within the six months preceding and following a reported Reg offering must be integrated. Essentially, these types of offerings will all be considered a single offering, and as such, any limits on the sale price or number of purchasers is cumulative; however, any offers and sales will not be integrated if, based on the particular facts and circumstances, the issuer can establish that each offering either complies with the registration requirements of the Securities Act or that an exemption from registration is available for the particular offering (including four specific safe harbors for non-integration). The concept of integration seeks to prevent issuers from improperly evading registration with the SEC by artificially dividing a single offering into multiple offerings.

Accredited Investors

Accredited investors play a central role in many Regulation D offerings. These investors are deemed to have the financial sophistication and capacity to assess the risks associated with private placements. Examples of accredited investors include individuals with high income, institutions with substantial assets, holders of certain professional certifications, and certain knowledgeable employees of the subject company. In recent years, the SEC has modernized the definition of "accredited investor” by including new groups given accredited investor status.

Company management must take steps to confirm that an investor qualifies as an accredited investor in each offering. These steps differ depending on the type of Regulation D offering being conducted. Under Rule 506(b), all accredited investors participating in a 506(b) private placement offering may self-verify that they qualify as an accredited investor, generally, by completing an accredited investor questionnaire issued by company management.

Issuers wishing to solicit or advertise under 506(c) must also take reasonable steps to verify the accredited investor status of purchasers. Rule 506(c) sets out a principles-based method for accredited investor verification, requiring an objective determination by the issuer as to whether the steps taken in verification were “reasonable” in context of the particular facts and circumstances of each purchaser and transaction. Note that the verification standard is heightened under Rule 506(c). The non-exhaustive list for accredited investor verification from Rule 506(c) includes:

  • Reviewing IRS documentation (e.g., tax returns) that state income levels and obtaining a written representation that the investor has a reasonable expectation of reaching the same income level necessary to qualify as an accredited investor during the current year;
  • Reviewing bank statements, brokerage statements, and other similar reports to determine net worth; and
  • Obtaining written confirmation of the investor’s accredited investor status from one of the following persons: a registered broker-dealer, an investment adviser registered with the SEC, a licensed attorney, or a CPA.

Disclosure Requirements

Even though Regulation D offerings are exempt from full SEC registration, issuers are still required to provide accurate disclosure of material information to non-accredited investors (there are no specific disclosure requirements for offerings sold only to accredited investors). If an offering is sold to any non-accredited investors, Rule 502(b) requires disclosure similar to that which would be required for a public offering. For example, if an offering is sold to any non-accredited investors under Rule 506(b), Rule 502(b) disclosure requirements are required to match Regulation A’s disclosure mandates (e.g., the disclosure of unaudited financial statements, as long as the offering amount is no more than $20 million, and in the case of Rule 506(b) offerings over $20 million, disclosures in Article 8 of Regulation S-X instead of the disclosures required in a registration statement).

Compliance and Investor Protection

While Regulation D provides valuable exemptions, companies must remain vigilant about compliance with stipulated rules. Missteps can lead to serious legal consequences and damage to a company's reputation. Investors are still afforded a certain level of protection, and any fraudulent or misleading practices can result in legal action.

Navigating State Securities Laws

Companies engaging in Regulation D offerings must also consider state securities laws, often referred to as "Blue Sky Laws." These laws vary by state and may impose additional filing requirements and regulations that could impact the offering.

Seeking Legal Counsel

Given the complexity of Regulation D and its potential legal ramifications, it is highly advisable for companies looking to avail themselves of Regulations D’s safe harbors to seek the expertise of legal professionals with experience in private financings and securities law. An attorney can help guide company management through the compliance process, draft necessary documents, and ensure that the company's interests are protected.

Without questions, Regulation D presents a valuable framework for companies seeking to raise capital through private placements. By understanding Regulation D and similar exemptions, investor qualifications, disclosure requirements, and compliance obligations, company management can navigate the intricacies of fundraising while adhering to securities laws.

This blog post is not offered, and should not be relied on, as legal advice. You should consult an attorney for advice in specific situations.

When It Comes to AI, No Human Authorship Means No Copyright Protection

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For a work to be protected under the U.S. Copyright Act of 1976 (the Act), it must be an original work of authorship fixed in a tangible medium of expression. With that background, United States District Judge Beryl A. Howell recently ruled that art created solely by Artificial Intelligence (AI)—in that case, a program called “Creativity Machine”—is not subject to copyright protection. This is believed to be the first of its kind ruling.

In Thaler v. Perlmutter, the plaintiff and owner of the Creativity Machine applied for a copyright registration, seeking to protect a piece of art titled “A Recent Entrance to Paradise.” The plaintiff’s application stated that the artwork was “created autonomously by machine” and that his copyright claim was premised on his ownership of the Creativity Machine.

The Copyright Office denied Thaler’s application because the piece at issue “lack[ed] the human authorship necessary to support a copyright claim.” The Copyright Office further noted that copyright law only extends to works created by human beings. Judge Howell agreed.

It is the lack of human authorship that was central to Judge Howell’s decision. In ruling on summary judgment, she reiterated that courts have “uniformly declined to recognize copyright in works created absent any human involvement.” This decision tracks the March 2023 guidance issued by the U.S. Copyright Office concerning works containing material generated by AI, as well as the famous “monkey selfie” case where, a photograph taken by a monkey was denied copyright protection because of its lack of human authorship.

Questions Remain Concerning Copyright Protection of AI-Generated Works

Judge Howell’s decision, which is likely to be appealed by Thaler, concerns works created solely by machines. That determination does not definitively apply to all AI-generated creations. Specifically, Judge Howell stated, “Undoubtedly, we are approaching new frontiers in copyright as artists put AI in their toolbox to be used in the generation of new visual and other artistic works.” That being said, Judge Howell acknowledged that generative AI will “prompt challenging questions” regarding (1) the level of human input necessary to qualify for copyright protection and (2) the way in which originality of AI-generated works born of systems trained on existing copyrighted works will be assessed.

Takeaways

While the Thaler case was an easy one for Judge Howell to decide, these types of cases will certainly become much more challenging when registration is sought for AI-generated material that was created with significant human involvement. Of course, how much human involvement is necessary to move the needle from registrable to non-registerable remains to be seen.

This blog post is not offered, and should not be relied on, as legal advice. You should consult an attorney for advice in specific situations. 

An Apparent Blow to the SEC’s Regulatory Authority Over Crypto Exchanges 

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By Samuel Licker

A federal district judge in New York has handed down a long-awaited ruling to determine whether sales by Ripple Labs Inc. of its cryptocurrency, XRP, was considered a security. 

In SEC v. Ripple Labs Inc., Judge Analisa Torres, presiding in U.S. District Court for the Southern District of New York, decided that the  token is a security when sold to institutional investors but not the general public. In so ruling, Judge Torres accepted the SEC’s argument to use the so-called Howey Test to decide whether XRP should be classified as a security and, therefore, fall within the SEC’s regulatory ambit. By way of background, the Howey Test requires four elements to be satisfied for a transaction to trigger SEC regulation: (1) an investment of money, (2) in a common enterprise, (3) with the expectation of profits, (4) to be derived solely from the efforts of others. 

Judge Torres’s ruling—that sales of XRP to sophisticated investors satisfied the Howey Test, yet sales to the general public through crypto exchanges failed the test because there was no evidence presented that these investors knew that Ripple was the seller and they were not investing in Ripple’s future efforts, but rather buying for any number of reasons, such as general cryptocurrency market dynamics—is certainly a blow to the SEC’s regulatory authority.  

The SEC has indicated it will appeal the ruling as it relates to programmatic buyers. In the meantime, pursuant to the ruling, it appears that XRP, and other tokens like it, are not securities under the Howey Test, though sales of cryptocurrencies could still be considered sales of securities if there are subjective expectations between buyers and sellers. For instance, in the case before Judge Torres, institutional buyers entered into lock-up agreements or agreed to resale restrictions, which led to her conclusion that the expectation was not that the tokens in these circumstances would be used as a currency.  

Back in May, M&R reported on Bittrex, a global cryptocurrency exchange, having been charged by the SEC with, among other things, failing to register as a national securities exchange. In the wake of the ruling in the Ripple Labs case, the SEC’s argument in Bittrex is called into question. If tokens sold on an exchange fail the Howey Test and are not considered securities, then the exchange itself likely cannot be considered a securities exchange. While the Bittrex case is pending in the Washington Western District Court, litigators defending Bittrex are optimistic that the determination in Ripple will bolster Bittrex’s position that the crypto assets the company sold should not be considered unregistered securities.   

With both sides gearing up for a long fight, other jurisdictions or the Second Circuit Court of Appeals might flip the switch on the SEC’s ability to regulate cryptocurrencies sold on consumer exchanges, especially as other companies are on the hotseat, including Binance, TerraForm Labs, Gemini Trust Company, and Coinbase. The corporate and securities pros at M&R are keeping their heads on a swivel as more rulings and analysis emerge in the crypto markets. We will be sure to report back. 

This blog post is not offered, and should not be relied on, as legal advice. You should consult an attorney for advice in specific situations.   

New SEC Cybersecurity Disclosure Rules Are on the Horizon 

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Megan Penick and Jia Song


By Megan Penick and Jia Song

Last week, new cybersecurity rules were adopted by the Securities and Exchange Commission that directly impact public companies, including foreign private issuers (FPIs), requiring them to make certain disclosures about cybersecurity incidents, risk management, strategy and governance. Taken together, the SEC’s new rules markedly expand upon the federal agency’s current cybersecurity disclosure mandates.

Disclosure on Current Report

The final rule requires public companies to disclose material cybersecurity incidents within four business days on a Current Report on Form 8-K under a new Item 1.05 (Form 6-K for FPIs). Pursuant to Item 1.05, public companies must disclose any cybersecurity incidents they experience that are determined to be material and describe their (1) nature, scope and timing and (2) the expected impact or reasonably likely impact of the incidents upon the companies, their financial condition and results of operations.

A disclosure under Item 1.05 of Form 8-K will need to be filed within four business days after a company has determined an incident to be material in nature. As reporting on cybersecurity breaches can be difficult—because the severity or extent of a breach may not be clear until after significant internal investigation—the SEC has also adopted a rule that requires companies to amend their original Item 1.05 disclosures when and as additional information material to a given breach (or breaches, if there is more than one that is deemed related) is discovered. The SEC has indicated that in order to make cybersecurity incident disclosures clear and easy to find by investors, it was preferred that a Form 8-K disclosing the breach be amended for further disclosures, as opposed to companies simply reporting additional findings in their periodic reports on Forms 10-Q or 10-K.

Disclosure on Annual Report

In addition, the final rule compels public companies to disclose material information regarding their cybersecurity risk management, strategies and governance on their annual reports on Form 10-K (Form 20-F for FPIs)—this by adding a new Item 1C to Part I of the Form 10-K. Item 1C requires registrants to furnish the information required by Item 106 of Regulation S-K (Item 106). Item 106(b) requires registrants to describe their processes, if any, for assessing, identifying and managing material risks from cybersecurity threats, as well as the material effects or reasonably likely material effects of risks from cybersecurity threats and previous cybersecurity incidents. Board of directors’ oversight of risks from cybersecurity threats and managements’ role and expertise in assessing and managing material risks from cybersecurity threats are also mandated pursuant to Item 106(c).

Effective Timeline

The final rule will become effective 30 days after publication in the Federal Register. The Form 10-K and Form 20-F disclosures will be due beginning with annual reports for fiscal years ending on or after December 15, 2023, while the due date for the Form 8-K and Form 6-K disclosures will be the later of 90 days after the date of publication in the Federal Register or December 18, 2023. For their part, smaller reporting companies will have an additional 180 days before they must begin providing the Form 8-K disclosure. With respect to compliance with the structured data requirements, all registrants must tag disclosures required under the final rules in Inline XBRL beginning one year after initial compliance with the related disclosure requirement.

Practical Guidance

Historically, many companies have been slow to disclose hacking or other cybersecurity incidents, fearing that disclosure could expose them to further risks and hamper their ability to assess and secure their data and systems. As a result, many of these incidents have not been reported until long after they occurred. However, as more and more companies have been affected by cyber criminals and data breaches in recent years, a need for prompt and effective disclosure has been seen by many as increasingly necessary. This is particularly the case because many companies rely on third parties to handle data storage and data management, and customers and investors need to be able to assess their own risk and exposure as a result of such incidents. The SEC’s new disclosure mandate is designed to do just that.

To decide whether an event qualifies as a material incident requiring  SEC reporting is a practical issue. Companies should consult with their securities counsel to determine whether an incident is material in nature and, accordingly, whether it will need to be disclosed in a Current Report on Form 8-K. Further, companies, along with their legal counsel and financial advisors, need to value the size, nature and /or reputation or financial harms such incidents may cause, as well as other factors to determine materiality.

Of course, the public securities and cybersecurity pros at Michelman & Robinson, LLP are available to provide more detail and answer any questions you may have about the SEC’s new cybersecurity rules.

This blog post is not offered, and should not be relied on, as legal advice. You should consult an attorney for advice in specific situations.