Over the past two decades, the SEC has tried to make it easier for early-stage companies to raise capital, and for main street investors to access those opportunities, by expanding registration exemptions. Regulation Crowdfunding (Reg CF), introduced in 2012, allows companies to raise up to $5 million from non-accredited investors, subject to per investor limitations, through registered online platforms. Regulation A (Reg A), overhauled in 2015, enables companies to raise up to $75 million from non-accredited investors upon filing and SEC qualification of a detailed disclosure document.

While nearly all of our firm’s deals are traditional private placements using Rule 506(b) of Regulation D or Section 4(a)(2) of the Securities Act of 1933, there are other exemption options. Many of our entrepreneurial clients are intellectually curious and have read about alternatives, while also inclined to explore disruption and leverage technology, so clients ask us from time to time whether an offering under Reg A or Reg CF would be a better option. We have generally been skeptical at the prospect, but thanks to the SEC’s latest reports on Reg A and Reg CF offerings, we can quantifiably assess some of our concerns.

Let’s dive into the data.

Regulation A: Rarely used, rarely successful

The SEC’s report on Regulation A covers offerings from June 19, 2015 (the date when the 2015 Reg A amendments went into effect) through December 31, 2024. During that time 1,618 total offerings were filed, which requires a publicly available disclosure, but only 1,426 were qualified by the SEC. This means nearly 15% of the filings did not complete the SEC review process, with most unqualified offerings subsequently abandoned despite being publicly announced. Of the offerings that were qualified, only 817 offerings reported raising money, meaning slightly over 50% of all attempted Regulation A offerings raised nothing, despite the cost of preparing and filing a detailed disclosure document with the SEC.

Even for companies that successfully raised money, the bad news continues. The average qualified offering sought just under $20 million but raised only $11.5 million. The median qualified offering aimed for $10 million and raised just $2.3 million. Given this difficulty in raising intended amounts, it is unsurprising that previous SEC analysis found Reg A issuers underperform post-offering relative to Reg D issuers. The skewed distribution of proceeds and offering amounts is primarily driven by larger deals in the financial sector, an industry that accounted for 46% of aggregate financing sought but 64% of reported proceeds.

Notably, 80% of all attempted offerings were in Reg A’s “Tier 2.” This is not surprising—Tier 2 offerings preempt state blue sky laws, allowing nationwide marketing and solicitation over the internet without the need to clear the offering with securities regulators in each state under “merit” review standards (which considers the substantive terms of a transaction). But the disclosure burden for Tier 2 is substantially higher than under Tier 1, further squeezing companies that took this long and expensive route to Securities Act compliance—especially for those who failed to complete the SEC review process, failed to raise funds, or raised less than they sought.

Standing back, in the aggregate companies raised $9.4 billion through Reg A offerings over nearly a decade, for an average of less than $1 billion per year. To put that number into context, in just the year 2019, companies raised $1.5 trillion through just Rule 506(b) (not Section 4(a)(2), Rule 504, Rule 506(c) or other private structures).

Regulation crowdfunding: More popular, still problematic

The SEC’s Regulation Crowdfunding report covers offerings between May 16, 2016 (the effective date of Reg CF) and December 31, 2024. In that time, 9,482 offerings were attempted, 8,492 were not withdrawn, and 3,869 reported receiving proceeds.

While more than seven times as many Reg CF offerings raised money than did Reg A offerings, the failure rate was even higher—approximately 60% of all attempted Reg CF offerings raised nothing. And despite no SEC qualification requirement, 990 offerings were voluntarily withdrawn, notwithstanding the companies having already spent money on a Form C filing, facing the reputational risk of canceling an announced deal, and the withdrawal raising integration considerations that may complicate future offerings.

In line with the lower investment limit, offerings under Reg CF raised substantially less than those under Reg A. The average offering sought just over $1 million and raised $346,000. The median offering sought $800,000 and raised only $113,000. In total, companies raised $1.3 billion in proceeds through Reg CF offerings over nearly a decade, averaging $150 million per year. Going back to our 2019 Reg D comparison, $150 million is just 0.01% of the amount raised under Rule 506(b). Worse still, $1.3 billion represents only 15% of the $8.4 billion Reg CF issuers intended to raise.

The policy disconnect

Expanding access to capital is a laudable policy goal, and some companies in specific situations have used Regulations A and Crowdfunding to raise money. But while providing permission to sell tends to increase the supply of offerings, it may not necessarily induce investor demand.

The data could be cynically read to suggest that these registration exemptions have meaningfully expanded neither non-accredited investor access to high-quality private offerings, nor company access to capital. These policy goals seem potentially better accomplished through simplified exemptions: the complexity of Reg A and Reg CF require meaningful outlays, yet the usage and results seem disappointing.

Takeaway for startups: Stick with what works

For aspiring venture-backed startups, Regulation A and Regulation Crowdfunding remain niche tools with limited upside in most cases. We for years have been concerned that Reg A and Reg CF are complicated, expensive ways to raise small amounts of capital – and now a decade of data helps to quantify that concern:

• A majority of attempted issuers raise no funds
  • 50.5% of attempted Reg A filers raised no funds
  • 59.2% of attempted Reg CF filers raised no funds
• The minority who raise funds only raise a fraction of what they seek
  • 23% of funds sought is the most common Reg A experience
  • 14% of funds sought is the most common Reg CF experience

These numbers are certainly skewed by companies that are not financeable, or that intentionally report high amounts sought but do not really need them (such as those using securities offerings primarily for customer acquisition/retention purposes).  The effect of this is difficult to quantify, but perhaps the bigger question is whether other companies wish to be associated with exemption pathways cluttered by such companies and marred by high failure rates and disappointing proceeds. 

Interestingly, the median Reg A issuer is a two-year-old company with one employee and $0 revenue, while the median Reg CF issuer is a two-year-old company with three employees and less than $10,000 in revenue.  While it is possible such companies could have spent their first two years and limited employee bases to build out technological, regulatory or other moats for their business, this is somewhat uncommon profile for a growth business.

Of course, not every Reg A or Reg CF issuer fits this mold, and venture capital firms do not find success by relying on snap judgments to assess startups. But in a world where first impressions and heuristics matter, aspiring VC-backed startups should think carefully before choosing these paths.

Withholding Obligations Under Section 1446(f)

Under US tax law, when a limited partner sells its interest in a venture capital fund and realizes a gain on such sale, a portion of such gain is treated as being effectively connected income with a US trade or business (“ECI”) if the venture capital fund would have recognized ECI on a deemed sale of its assets for their fair market value.  For example, if (i) a limited partner sold its interest in a venture capital fund for a $100 gain and (ii) a deemed sale of the venture capital fund’s assets for their fair market value would have resulted in a gain of which 10% constituted ECI, then 10%, or $10, of the limited partner’s $100 gain on the sale of its interest would be treated as ECI.  If the limited partner is a US limited partner, the ECI question is not really relevant, as a US limited partner will be required to report and pay tax on its gain in the US regardless.  However, if the limited partner is a non-US limited partner, the ECI question is important, as a non-US limited partner would generally not be required to report and pay tax on its gain in the US if no portion of such gain was treated as ECI.

When the transferor of a venture capital fund interest is a non-US limited partner, then subject to certain exceptions as described below, Section 1446(f) effectively enlists the transferee of that interest as a collection agent for the IRS and requires the transferee to withhold 10% of the amount realized by the transferor on the transfer of its interest.  Should the transferee fail to withhold when required, then the venture capital fund itself has a secondary obligation to withhold the required amount out of future distributions that are attributable to the transferred interest. 

In addition, the transferee is required to certify to the venture capital fund the manner in which the withholding obligations under Section 1446(f) have been satisfied.  Such certification must be provided within 10 days of the transfer in question.

Exceptions to 1446(f) Withholding Obligations

Fortunately, there are multiple exceptions potentially available under Section 1446(f) that would allow a transferee to avoid having to withhold proceeds in connection with the transfer of an interest in a venture capital fund by a non-US limited partner.  Potential exceptions include the following:

Certifications by the Transferring Non-US Limited Partner

• The transferring non-US limited partner certifies that the transfer of its interest in the venture capital fund would not result in any realized gain.

• The transferring non-US limited partner certifies that:

• It was a partner in the venture capital fund for the entirety of the three tax years immediately preceding the transfer;

• Its share of ECI from the venture capital fund for each of those prior three years was (i) less than $1 million and (ii) less than 10% of such non-US limited partner’s share of gross income from the venture capital fund; and

• Its share of any ECI in each of those three prior years was timely reported on a US income tax return and all amounts due have been timely paid.

Certifications by the Venture Capital Fund

• The venture capital fund certifies that it was not engaged in a trade or business within the United States at any time during its current tax year through the date of the transfer.

• The venture capital fund certifies that a deemed sale of its assets for fair market value would either (1) not result in ECI in an amount that exceeds 10% of the venture capital fund’s gain from the deemed sale or (2) not result in the transferring non-US limited partner’s share of any ECI that would result from such deemed sale being 10% or more of such partner’s share of the venture capital fund’s gross income from such deemed sale.

Potential Difficulties in Meeting Available Exceptions

Despite the fact that multiple potential exceptions are available under Section 1446(f), depending on the circumstances, it may be difficult to qualify for an exception.  For example:

• If a transferring non-US limited partner has not held its interest in the venture capital fund for three entire taxable years, then the exception whereby it could simply certify that its share of ECI from the venture capital fund has been less than $1 million or 10% of its gross income from venture capital fund would not be available.

• The transferee may need to rely on the cooperation of the transferring non-US limited partner or the venture capital fund itself in order to obtain the certifications required to alleviate the transferee’s withholding obligation.

• If a venture capital fund’s secondary withholding obligations are triggered (i.e., in the event the transferee fails to withhold when required), the fund would need to know the amount realized by the transferring non-US limited partner on the transfer of its interest in order to determine the amount the fund must withhold from future distributions to the transferee (which is information the venture fund is often not privy to). 

Takeaways

The task of processing transfers of limited partner interests in venture capital funds has been made more difficult as a result of the new withholding requirements under Section 1446(f).  From the venture capital fund’s perspective, it will need to make sure that it receives information from the transferee regarding the manner in which the withholding obligations under Section 1446(f) have been satisfied, because if it does not, the venture capital fund may have to withhold from future distributions to the transferee.  In addition, venture capital funds should be prepared to start receive requests from transferring parties asking them to provide certifications about whether, and if so, to what extent, their activities have or would result in the generation of ECI.  Historically venture capital funds have been generally reluctant to venture (no pun intended) down the path of providing certifications of this nature, but this is likely something that venture capital funds will need to revisit in light of the new withholding obligations under Section 1446(f) if they want to be supportive of non-US limited partners. 

For questions or more information on this topic or any other topic relating to venture capital funds, please contact any of the members of the DLA Piper Pacific Northwest Venture Fund Practice:

Mel Wheaton (mel.wheaton@dlapiper.com)
Chris Thorson (chris.thorson@dlapiper.com)
Lindsey Haythorn (lindsey.haythorn@dlapiper.com)
Luke Postma (luke.postma@dlapiper.com)

On May 13, 2024, the Securities and Exchange Commission (SEC) and the US Department of the Treasury’s Financial Crimes Enforcement Network (FinCEN) jointly proposed a new rule that would impose requirements on SEC-registered investment advisers (RIAs) and exempt reporting advisers (ERAs) to establish, record, and maintain customer identification programs (CIPs) under the US Bank Secrecy Act (BSA) and related regulations. 

The SEC and FinCEN designed the proposal to target illicit actors, illicit funds, and illicit financial activity involving customers of investment advisers by increasing the anti-money laundering and countering the financing of terrorism (AML/CFT) requirements for the investment adviser sector. 

Background

In its press release, Treasury highlighted that the May 2024 proposed rulemaking (Proposed Rule) complements the separate February 2024 FinCEN proposal to designate RIAs and ERAs as “financial institutions” under the BSA and subject them to AML/CFT program requirements and suspicious activity report (SAR) filing obligations, covered in our February 2024 client alert. FinCEN and the SEC explain that the aim of these two complementary proposals is “to prevent illicit finance activity in the investment adviser sector and further safeguard the U.S. financial system.” 

The February 2024 FinCEN proposed rule – released in conjunction with the AML/CFT Program and the Treasury’s Investment Advisor Risk Assessment (Treasury Risk Assessment) and which drew more than 50 comments from industry and others – notably expands the definition of financial institutions to include “investment advisers.” If the February rule is adopted, FinCEN and the SEC would be required to jointly promulgate rules that establish minimum standards for verifying the identities of customers when they open an account with these covered investment advisers. Accordingly, the Proposed Rule is designed to “align the requirements for investment advisers with existing rules for other financial institutions, such as broker-dealers, mutual funds, credit unions, banks, and others, to adopt and implement CIPs.” Thus, investment advisers will be subject to the same or similar requirements regarding CIPs as other financial institutions. 

According to SEC Chair Gary Gensler in his statement supporting the Proposed Rule, “[s]uch harmonization would help reduce the risk of terrorists and other criminals accessing U.S. financial markets by using investment advisers to launder money, finance terrorism, or move funds for other illicit purposes.” Similarly, and consistent with the Treasury Risk Assessment findings, FinCEN Director Andrea Gacki stated that the Proposed Rule is designed to help “investment advisers better identify and prevent illicit actors from misusing their services” for money laundering and terrorist financing because “[c]riminal, corrupt, and illicit actors have exploited the investment adviser sector to access the U.S. financial system and launder funds.”

If adopted in its current form, the Proposed Rule would require RIAs and ERAs to implement, and customers (after being given adequate notice) to comply with, reasonable procedures for establishing a customer identification program, including: 

• Verifying the identity of any person seeking to open an account with the investment adviser (which would not generally include investors in private funds managed by the adviser) to the extent reasonable and practicable
  
• Maintaining records of the information used to verify the person’s identity, including name, address, and other identifying information, and 
  
• Consulting lists of known or suspected terrorists or terrorist organizations provided to the financial institution by any government agency to determine whether a person seeking to open an account appears on any such list.

The Proposed Rule also explains that these procedures “must enable the investment adviser to form a reasonable belief that it knows the identity of each customer.” The reasonableness of such procedures depends on “the investment adviser’s assessment of relevant risks.” Further, the Proposed Rule specifies the customer information and records required to be collected and maintained, the acceptable methods of verification, and the situations in which additional verification is needed. Importantly, the Proposed Rule also provides that, under certain circumstances, investment advisers may rely on another registered financial institution, including an affiliate, when reasonable, and/or continue to use third-party vendors for compliance functions. 

Key Takeaways

• The Proposed Rule, along with the February 2024 proposed rule, addresses the perceived gap in the current AML framework highlighted in the Treasury Risk Assessment and comports with this administration’s continued, whole-of-government focus on strengthening AML/CFT enforcement. 
  
• In light of the time invested on the Proposed Rule, FinCEN appears poised to adopt the February 2024 rule at least in some form. And, if the February 2024 proposed rule passes with little modification, RIAs and ERAs will be required to create and implement risk-based AML programs not later than 12 months from the passage of the final rule. This is especially relevant to RIAs and ERAs that do not have broker-dealer or already-BSA-regulated financial institution parents or affiliates with existing AML programs.
  
• As we advised in February, investment advisers should consider whether they will be subject to the Proposed Rule if it passes in its current, or close to current, form, and what steps they may need to take to ensure they have adequate policies and controls to fulfill the SEC and FinCEN’s expectations for CIPs. This will involve RIAs and ERAs implementing reasonable procedures to identify and verify the identities of their customers and notifying customers that the adviser is requesting information to verify their identities.
  
• Importantly, for private fund managers, the Proposed Rule’s definition of “customers” does not expressly include investors in private funds managed by the adviser. The Proposed Rule only requires investment advisers to collect and verify the identity of customers that directly open and hold accounts with the adviser. Where the adviser has a private fund as a customer, however, the investment adviser would be required to collect information about the private fund and, in some cases, those with authority or control over such private fund, which would implicate sub-advisory arrangements. While the Proposed Rule may cover individuals with authority or control over the private fund (such as members of a general partner to a fund), the adviser would need to collect information from investors in a private fund in certain cases where an investor could be deemed to have authority or control over the private fund and only when the adviser cannot verify the true identity of a non-individual investor.
  
• The government appears to acknowledge – and a number of the public comments assert – that a one-size-fits-all approach to developing AML programs and CIPs is not required and, in any event, may not effectively combat money laundering and terrorist financing. First, the SEC and FinCEN recognize that some investment advisers already are required to have practices consistent with the requirements of the Proposed Rule to obtain and verify customer identity information, ie, (a) if they are an affiliate, operating subsidiary, or otherwise a dual registrant of a bank or broker-dealer which has an AML program including CIP; (b) for compliance with global sanctions and screening for names on the Office of Foreign Assets Control specially designated nationals list; and/or (c) because of counterparty/third-party contractual requirements. Second, the February 2024 proposed rule would allow smaller advisers to adopt simpler policies and procedures, consistent with their organizational structures and a risk-based approach to compliance.

For more information as to how the Proposed Rule and the earlier February 2024 proposed rule may impact your business or how to assess your AML framework for compliance, please contact any of the authors or any of the members of the DLA Piper Pacific Northwest Venture Fund Practice:

Mel Wheaton (mel.wheaton@dlapiper.com)
Chris Thorson (chris.thorson@dlapiper.com)
Lindsey Haythorn (lindsey.haythorn@dlapiper.com)
Luke Postma (luke.postma@dlapiper.com)

A three-judge panel of the US Court of Appeals for the Fifth Circuit unanimously vacated the US Securities and Exchange Commission (SEC)’s private fund adviser rules and amendments (Private Fund Rules),[1] stating that “no part of it can stand.”[2]

In August 2023, the SEC adopted the Private Fund Rules, which included five new rules: the Private Fund Audit Rule, the Quarterly Statements Rule, the Restricted Activities Rule, the Adviser-Led Secondaries Rule, and the Preferential Treatment Rule. These rules would have imposed significant compliance and regulatory requirements on private fund advisers. Also included were two rule amendments addressing annual compliance documentation and retentions of books and records.

The petitioners[3] asked the court to treat the Private Fund Rules as a single “rule,” and vacate them all together. The court agreed, holding that the SEC exceeded its statutory rulemaking authority in adopting the Private Fund Rules.[4]

What does this mean for compliance?

Private fund advisers, including those registered and exempt from registration, are no longer required to comply with the technical requirements of the private fund adviser rules as of the respective compliance dates. In addition to the five new rules, this includes the amendment to the Compliance Rule[5] that required registered investment advisers to document the annual review of their compliance policies and procedures in writing.

While technical compliance with the Private Fund Rules is no longer required, advisers and their dealings with private fund clients continue to be subject to the Investment Advisers Act of 1940, as amended. Advisers should remain aware that the SEC and its staff have interpreted certain activities highlighted in the Private Fund Rules as potentially prohibited under the Advisers Act, and an adviser’s fiduciary duty. SEC examination and enforcement staff likely will continue to focus on concerns sought to be addressed by the Private Fund Rules.

Going forward

The SEC now has the option to seek a rehearing en banc in the court, although such a step seems unlikely, or appeal the decision to the Supreme Court. The SEC has not made any public statements following the decision about whether they intend to take further action in the courts.

In the meantime, this ruling sets precedent for future efforts to regulate the private fund industry. There are a number of proposed rules and amendments on the SEC’s regulatory agenda that rely on similar statutory authority and may be impacted by this ruling.

If you have any questions about the Fifth Circuit’s decision, please contact the authors or any of the members of the DLA Piper Pacific Northwest Venture Fund Practice:

Mel Wheaton (mel.wheaton@dlapiper.com)
Chris Thorson (chris.thorson@dlapiper.com)
Lindsey Haythorn (lindsey.haythorn@dlapiper.com)
Luke Postma (luke.postma@dlapiper.com)

.


^{[1] See Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, Release No. IA-6368 (Aug. 23, 2023) (the Adopting Release) available at https://www.sec.gov/files/rules/final/2023/ia-6383.pdf.
[2] National Association of Private Fund Managers v. Securities and Exchange Commission, No. 23-60471, (5th Cir.) (June 5, 2024).
[3] Petitioners included National Association of Private Fund Managers, Alternative Investment Management
Association, Ltd., American Investment Council, Loan Syndications and Trading Association, Managed Funds Association, and the National Venture Capital Association.
[4] The court stated that the SEC exceeded its statutory authority under both Section 211(h) (“We therefore hold that section 211(h) applies to ‘retail customers’…) and Section 206(4) (“The Commission cannot rely on section 206(4) for the authority to adopt the [Private Fund Rules].”)
[5] Advisers Act Rule 206(4)-7.}

Non-Public Offering

In order to be exempt from registration under both the Section 3(c)(1) exemption and the Section 3(c)(7) exemption, a venture capital fund must not plan to or make a public offering of its securities. To satisfy this requirement, venture capital funds typically offer and sell interests to investors in accordance with the safe harbor under Rule 506(b) of Regulation D of the Securities Act of 1933. To qualify for such safe-harbor, a venture capital fund must: (i) issue interests to no more than 35 non-accredited purchasers of securities (see below), (ii) not offer or sell securities by any form of a general solicitation or general advertisement (see below), (iii) exercise reasonable care to assure that the purchasers of the securities are not underwriters and that the purchasers are not acquiring the securities for the purpose of resale; and (iv) file certain forms with the SEC at certain times, including notices on Form D.

Although the safe harbor permits a venture capital fund to issue interests to up to 35 non-accredited investors, most venture capital funds avoid taking any non-accredited investors because of the regulatory risk and additional disclosure requirements that would accompany taking in such investors. Thus, Venture capital funds generally offer and sell interests only to accredited investors. Additionally, despite the fact that the safe harbor under Rule 506(b) does not allow the offer and sale of securities by any form of general solicitation, general solicitation is permitted under Regulation Crowdfunding and Rule 506(c) of Regulation D. Venture capital funds, however, typically do not rely on these potential exemptions because of the additional verification requirements (e.g., Rule 506(c) requires a venture capital fund to take reasonable steps to verify that investors are accredited investors, whereas investors in a Rule 506(b) offering typically are able to just self-certify their accredited investor status via completion of an investor questionnaire) and capital raising limits that come along with such exemptions (e.g., Regulation Crowdfunding only permits a venture capital fund to raise up to $5,000,000 in a 12 month period).

If a venture capital fund establishes that it is not making a public offering of its securities, it must also satisfy at least one of the following requirements in order to be exempt from registration under Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act: (i) have fewer than 100 beneficial owners (a “3(c)(1) Fund”) or (ii) sell its securities only to qualified purchasers (a “3(c)(7) Fund”).

3(c)(1) Funds

To satisfy the 3(c)(1) exemption under the Investment Company Act and thus be a 3(c)(1) Fund, a venture capital fund must have fewer than 100 beneficial owners. The method for counting beneficial owners of a venture capital fund can be complex and requires an examination of certain look-through rules. For purposes of counting beneficial owners, certain look-through rules apply with respect to investors in the venture capital fund that are (i) “formed for the purpose” of investing in such venture capital fund and/or (ii) themselves registered investment companies or 3(c)(1) Funds or 3(c)(7) Funds exempt from registration and that own more than 10% of the voting securities of such venture capital fund. An investor will generally be treated as “formed for the purpose” of investing in a venture capital fund if (a) the investor (which is an entity and not a natural person) invests more than 40% of its committed capital in such venture capital fund or (b) the investor’s stockholders, partners, members or other beneficial owners have individual discretion as to their participation or non-participation in such investor’s investment in such venture capital fund. The reason for these look-through rules is to prevent venture capital funds and their investors from circumventing the 100 beneficial owner limitation (e.g., by aggregating a number of investors who would otherwise invest directly in a particular venture capital fund into an entity that is formed just for the purpose of investing in such venture capital fund). Venture capital fund managers should pay special attention to these look-through rules to avoid not having more than 100 beneficial owners.

3(c)(7) Funds

To satisfy the 3(c)(7) exemption under the Investment Company Act and thus be a 3(c)(7) Fund, a venture capital fund must sell its securities only to qualified purchasers. Qualified purchasers include: (i) any natural person who owns at least $5 million in investments (as defined by the SEC, but investments generally include cash, stock, bonds and other investment securities), (ii) an entity that is owned by two or more natural, related persons and which was not formed for the purpose of investing in the venture capital fund and which owns at least $5 million in investments and, (iii) a trust not formed for the specific purpose of investing in the venture capital fund, so long as the trustee and each settlor or other person contributing assets to the trust is a qualified purchaser, (iv) an entity which was not formed for the purpose of investing in the venture capital fund and which owns and invests on a discretionary basis at least $25 million in investments, and (v) any entity owned exclusively by qualified purchasers. Unlike a 3(c)(1) Fund, a 3(c)(7) Fund is not subject to a 100 beneficial owner limit.

Parallel Fund Structure

To maximize its potential investor base, venture capital funds may structure themselves as a parallel 3(c)(1) Fund and a parallel 3(c)(7) Fund which are set up to invest side-by-side in portfolio companies pro-rata based on their respective capital commitments. Section 3(c)(7) of the Investment Company Act allows a parallel 3(c)(1) Fund and a parallel 3(c)(7) Fund to co-invest without the risk of integration.

Knowledgeable Employees

A “knowledgeable employee” is defined under the Investment Company Act as (i) an executive officer, director, trustee, general partner, advisory board member, or person serving in a similar capacity of a venture capital fund, the general partner of such fund or the management company of such fund, and (ii) an employee of the management company of a venture capital fund (other than an employee performing solely clerical, secretarial or administrative functions) who, in connection with his or her regular functions or duties, participates in the investment activities managed by such management company or any of its affiliates and has been performing such functions or duties for or on behalf of such fund, the general partner of such fund or the management company of such fund, or substantially similar functions or duties on behalf of another company, for at least the past twelve (12) months. Investors who are “knowledgeable employees” (a) fall withing the definition of, and are thus, accredited investors, (b) do not count towards the 100 beneficial owner limit for purposes of the Section 3(c)(1) exemption, and (c) are permitted to invest in a 3(c)(7) Fund, whether or not they are otherwise qualified purchasers, without jeopardizing a venture capital fund’s Section 3(c)(7) exemption.

Takeaway

Avoiding registration under the Investment Company Act is of critical importance for any venture capital fund. Thus, it is vital to structure a venture capital fund as either a 3(c)(1) Fund or 3(c)(7) Fund. Failure to do so could result in a venture capital fund inadvertently becoming an investment company and hence being subject to substantial regulation by the SEC which, from a practical perspective, would likely make the operation of such fund untenable.  

For questions or more information on this topic or any other topic relating to venture capital funds, please contact any of the members of the DLA Piper Pacific Northwest Venture Fund Practice:

Mel Wheaton (mel.wheaton@dlapiper.com)
Chris Thorson (chris.thorson@dlapiper.com)
Lindsey Haythorn (lindsey.haythorn@dlapiper.com)
Luke Postma (luke.postma@dlapiper.com)

A letter agreement between a portfolio company and an investing venture capital fund which provides the venture capital fund with certain “management rights” that allow it to substantially participate in, or substantially influence the conduct of, the management of the portfolio company.

Why are they important?

A management rights letter is critical for any venture capital fund that is seeking to rely upon the venture capital operating company (“VCOC”) exemption in order to avoid its assets from being subject to the Employee Retirement Income Security Act of 1974 (“ERISA”) and the onerous requirements that would be imposed thereunder (which would include managers of the venture capital fund becoming personal fiduciaries under ERISA with respect to any private pension plans that invest in the venture capital fund and becoming subject to a set of strict prohibited transaction rules and conflict of interest and self-dealing issues as a result of the venture capital fund manager’s receipt of performance fees in the form of its carried interest).

As background, private pension plans constitute a meaningful percentage of the investors in venture capital funds.  The assets of such pension plans are subject to ERISA.  When a venture capital fund takes in investors who are themselves subject to ERISA, the venture capital fund will want to avoid the assets of the venture capital fund from also becoming subject to ERISA.  There are two exemptions that a venture capital fund can seek to rely upon in order to avoid such an outcome:

1. The Not Significant Participation Exemption (i.e., the 25% Test)

• If less than 25% of each class of equity interests of the venture capital fund (and a venture capital fund typically only has one class of equity interest) is held by investors who are subject to ERISA, then the assets of the fund will not be subject to ERISA.

• In determining whether the 25% threshold has been surpassed, investments by public (i.e., governmental) pension plans and non-US pension plans are not counted towards the threshold.

2. The VCOC Exemption

• If the venture capital fund qualifies as a VCOC, then the assets of the venture capital fund will not be subject to ERISA.

• In order to qualify as a VCOC:
  • at least 50% of the venture capital fund’s assets must be invested in operating companies in which the venture capital fund has direct contractual management rights (which is where the management rights letter comes into play); and
  • the venture capital fund must exercise such management rights with respect to at least one operating company that it holds an investment in.

• The 50% requirement must be met on the date the venture capital fund makes its first investment.

• The securing of a management rights letter by a venture capital fund is critical in that it is the means through which the venture capital fund has direct contractual management rights in its underlying portfolio companies.

What should they contain?

A management rights letter should secure as many of the following rights as possible for the investing venture capital fund:

• The right to appoint one or more directors to the board of the portfolio company;

• The right to regularly informally consult with and advise the management team of the portfolio company;

• The right to receive quarterly and annual financial statements of the portfolio company, including the annual auditor’s report;

• The right to examine the books and records of the portfolio company;

• The right to receive copies of all documents, reports, financial data and other information that the venture capital fund may reasonably request; and

• The right to appoint a person to serve as  corporate officer of the portfolio company.

Potential Traps.

• Rights that a venture capital fund secures and shares with other investors do not count as management rights for purposes of meeting the VCOC exemption (i.e., the rights must be individual to the venture capital fund).  Thus, parallel funds or related co-investment funds should each obtain separate management rights letters.

• Portfolio company investments which are made by a venture capital fund indirectly through a special purpose vehicle which is not wholly owned by such venture capital fund can be an issue in situations where the special purpose vehicle only holds a minority position in the underlying portfolio company.  In that scenario, the special purpose vehicle will not be treated as an operating company for purposes of the VCOC exemption due to the fact that such special purpose vehicle is not primarily engaged, directly or through a majority owned subsidiary, in the production or sale of a product or service other than the investment of capital.

• If a venture capital fund seeking to rely on the VCOC exemption makes an investment which does not qualify as an investment in an operating company prior to making its first investment in an operating company, then such venture capital fund can never qualify as a VCOC.

Takeaway.

A management rights letter is a key aspect for venture capital funds when investing in portfolio companies, as it enables venture capital funds to raise capital without subjecting the activities of the venture capital fund to the various restrictions imposed under ERISA.  Requests for management rights letters are fairly common in today’s market and do not impose significant burdens on the portfolio companies from whom such letters are sought.

For questions or more information on this topic or any other topic relating to venture capital funds, please contact any of the members of the DLA Piper Pacific Northwest Venture Fund Practice:

Mel Wheaton (mel.wheaton@us.dlapiper.com)

Chris Thorson (chris.thorson@us.dlapiper.com)

Lindsey Haythorn (linsdey.haythorn@us.dlapiper.com)

Luke Postma (luke.postma@us.dlapiper.com)

As we head into 2024, employers can expect more risk related to the use of restrictive covenants at both the federal and state level. From the Federal Trade Commission’s (FTC) anticipated final rule and National Labor Relations Board (NLRB) unfair labor practice charges to new state laws and court decisions, employers are monitoring the landscape, preparing to meet compliance deadlines, and reassessing their approach to noncompete agreements. Below we discuss the latest developments and what to watch for in the new year.

Federal agencies are expected to remain active

In January 2023, the FTC proposed a rule that would ban virtually all non-competes in employment agreements, with limited exceptions for noncompete clauses between franchisees and franchisors and certain noncompete clauses relating to the sale of a business. A vote on the final rule is expected by April 2024, with legal challenges likely to follow – the Chamber of Commerce has stated that it will sue the FTC if the rule goes forward.

Even if a final rule is immediately challenged and/or enjoined, employers should consider the FTC’s (and the Department of Justice Antitrust Division’s) hostile posture toward agreements that can restrict labor market competition. Recent enforcement has shown that both agencies will closely scrutinize restraints on workers, consistent with the Biden Administration’s commitment to enforcement of antitrust laws in labor markets. While the DOJ’s efforts to obtain a criminal conviction for alleged “no-poach” agreements and wage-fixing between competitors have been largely unsuccessful – most recently, it voluntarily dismissed its only pending criminal no-poach case in November – protecting employees from anticompetitive agreements remains an enforcement priority. In a December 2023 speech, the Division’s principal deputy committed that the agency’s courtroom setbacks would not dissuade it from future prosecutions of no-poach and wage-fixing agreements and teased forthcoming matters that might rely on evidence obtained via wiretap or other covert means. DOJ also has shown a willingness to bring civil enforcement actions involving labor practices, and both the FTC and Antitrust Division committed to consider the impacts of mergers on workers in their revised Merger Guidelines, which were published in December 2023.

At the federal level, the Biden Administration’s “whole of government” approach to antitrust enforcement also promised to involve agencies beyond the FTC and Antitrust Division.

The NLRB is one such agency, and it is likely to follow the lead of its General Counsel (GC) and move to restrict the use of noncompete agreements. On May 30, 2023, NLRB GC Jennifer Abruzzo issued a memorandum asserting that certain noncompete provisions in employment-related agreements violate the National Labor Relations Act (NLRA). While GC memoranda are not binding and do not represent the views of the Board or federal appellate courts, several complaints have adopted the GC’s theory.

Last year the Regional Director of NLRB Region 9 filed a consolidated complaint accusing an operator of spas and medical clinics of violating the National Labor Relations Act (NLRA) by allegedly seeking to enforce its noncompete, non-solicitation and confidentiality agreement. The complaint alleged that the noncompete provision prevented former employees from practicing “aesthetic medicine” within 20 miles of any company location for 24 months following their termination and further obligated them to repay training costs in the event of a violation of the noncompete period. The respondent moved to partially dismiss portions of the consolidated complaint related to noncompete provisions on the grounds that noncompete agreements do not implicate the NLRA and are enforceable under state law. In December, a three-member panel of the Board denied the motion.

An earlier enforcement action in June reported by Bloomberg Law resulted in a private settlement.

Employers can expect more litigation related to noncompetes, as well as challenges to regulatory authority, moving forward.

California enacts two new laws that further restrict employers’ use and enforcement of noncompetes

On January 1, 2024, two new laws took effect in California which could significantly increase the risk of lawsuits related to noncompetes.

Assembly Bill (AB) 1076 makes it unlawful for an employer to include a “noncompete clause” in an employment contract, or to require an employee to enter into a noncompetition agreement, with very limited exceptions.

Of particular note, the new law requires employers to send individualized written notices to all current and former employees (employed after January 1, 2022) whose agreements include an unlawful noncompete clause or who were required to enter into a noncompete agreement that the noncompete clause or agreement is void. Notice is to be provided both by email and regular mail.  A violation of these provisions constitutes an act of unfair competition that could result in civil penalties for unfair competition of up to $2,500 per violation under California’s Unfair Competition Law.

AB 1076 further codifies existing case law to specify that the statutory provision voiding noncompete contracts is to be broadly construed to void the application of any noncompete agreement in an employment context, or any noncompete clause in an employment contract, no matter how narrowly tailored, that does not satisfy specified exceptions. It also provides that the existing state law restricting noncompetition agreements is not limited to contracts where the person being restrained is a party to the contracts, which raises the question of whether employee nonsolicitation clauses or agreements are also void and subject to the individualized written notice requirement.

Senate Bill (SB) 699, which also took effect on January 1, 2024, prohibits employers from entering into or attempting to enforce post-employment noncompete agreements, regardless of where and when the contracts were signed. The bill specifically provides that California’s noncompete restrictions trump other states’ laws when an employee seeks employment in California, even if the employee had signed the noncompete while living outside of California and working for a non-California employer.

Significantly, SB 699 also creates a private right of action, authorizing employees, former employees, and prospective employees to seek injunctive relief and / or actual damages, and entitles a prevailing employee to recover reasonable attorneys’ fees and costs.  

Given new legal remedies and penalties, California employers are encouraged to take steps now to ensure compliance.

More states are moving to restrict noncompetes

In addition to California, several other states enacted new laws in 2023 that broadly limited the use of noncompetes (eg, Minnesota), raised the salary threshold for noncompetes (eg, Maryland) and restricted the use of noncompete agreements for certain employees such as physicians, mental health professionals and other health care practitioners. This trend is expected to continue in 2024.

New York employers are watching for new legislation following the defeat of Senate Bill S3100A, a bill that would have banned all noncompetes in the employer-employee context and created a private right of action. On December 22, 2023, New York Governor Kathy Hochul vetoed the bill after she and legislative leaders were unable to reach a compromise. Governor Hochul had expressed support for the bill subject to “chapter amendments” exempting highly compensated employees (those earning $250,000 or more annually).

New York employers may still see new limits. The Governor has stated that she remains committed to enacting noncompete legislation protecting “middle-class and low-wage earners,” and Senator Sean Ryan, who sponsored SB S3100A, has indicated that noncompete legislation will be reintroduced this year.

Bills restricting the use of noncompete provisions are also pending in other states, including Iowa, Maine, Michigan, New Jersey, and Oklahoma.

Further, employers are encouraged to monitor changes to salary thresholds, which can increase annually, including based on changes to the state’s minimum wage or federal poverty level. For example, Maryland’s amended law prohibits noncompete clauses for employees who earn less than or equal to 150 percent of the state minimum wage ($15.00/hour effective January 1, 2024). Colorado’s threshold increased to $123,750 effective January 1, 2024. In Washington, starting on January 1, 2024, only workers who earn more than $120,559.99 per year for employees or $301,399.98 per year for independent contractors can be held to non-competition agreements.

Judicial scrutiny of noncompetes is expected to continue

Courts may be increasingly unwilling to correct facially overbroad noncompete provisions. For example, in several decisions last year, the Delaware Chancery Court declined to blue-pencil or otherwise modify an overbroad covenant (even when the agreement expressly authorized the court to do so), noting that the practice can create a “no-lose” incentive.

In one case, the court ruled that a 30-month noncompete in a sale of a business agreement was unenforceable where the definition of “business” encompassed all of the purchaser’s business lines and geographic areas rather than just the one in which the seller worked. According to the court, the purchaser’s legitimate economic interest could support restraining the seller’s employment only in the goodwill and competitive space of the purchased asset and the market it serves, and not that of the purchaser’s subsidiaries.

In November, in Sunder Energy, LLC v. Jackson, the Delaware Chancery Court again declined to modify various restrictive covenants in a limited liability company agreement, finding them facially unreasonable (interlocutory appeal to the Delaware Supreme Court pending). According to the court, “when a restrictive covenant is unreasonable, the court should strike the provision in its entirety.”

With respect to the noncompete provision, the court held that it was “astonishingly broad” insofar as it: covered the entire door-to-door sales industry, without regard to whether the company marketed or sold similar products; applied not only to Jackson but also to his “Affiliates,” broadly defined to include his spouse, parents, siblings, and descendants (natural and adopted); covered any state in which the company reasonably anticipated conducting business (46 states); and lasted indefinitely because it applied for the period during which Jackson owned incentive units and for a two-year period thereafter and transfer restrictions prohibited Jackson from divesting himself of the units to “start the clock.”

Next steps

The direction of travel is clear – noncompetes are being scrutinized more closely than ever before. Employers are encouraged to review their current noncompete agreements and ensure they are fit for purpose and narrowly tailored to protect their legitimate business interests.

If you have questions about developments related to restrictive covenants and the best approach for your business, please contact any of the authors or your DLA Piper relationship attorney. For more information about key considerations for global employers see our handbook, Noncompetes around the world: Top issues and strategies for global employers.

In the wake of the appointment of the Federal Deposit Insurance Corporation (FDIC) as receiver for Silicon Valley Bank (SVB) and Signature Bank (SB) on March 10 and March 12, respectively, investors may be considering whether there will be opportunities to acquire failed bank assets. This alert provides a high-level overview of the process for acquiring assets from the FDIC as receiver.

Overview

An FDIC insured bank fails when the chartering regulator closes the bank and appoints the FDIC as receiver. Upon its appointment, the FDIC as receiver succeeds by operation of law to all of the assets and liabilities of the bank, ensuring that depositors have access to their insured deposits. To address potential systemic risk arising from the failures of SVB and SB, federal authorities determined that the SVB and SB receiverships would each be handled “in a manner that fully protects all depositors.” The Deposit Insurance Fund (DIF) overseen by the FDIC absorbs the costs of covered deposits. The DIF is funded mainly through quarterly assessments on all insured banks.

By statute, the FDIC is required to resolve failed banks using the method that results in the “least-cost resolution” for the DIF. This means the FDIC’s options must be considered based on whether one approach might cost more to the DIF than other options.  In its role as receiver, the FDIC may:

• Negotiate a “whole bank” purchase and assumption (P&A) transaction, in which a financially healthy institution acquires all of a failed bank’s assets in return for agreeing to assume its deposit liabilities. This is the FDIC’s preferred approach because it assures the immediate availability of all deposits, even uninsured, without unnecessary costs to the DIF. Customers of the failed bank, both depositors and borrowers, become customers of the acquiring bank without action on their part.
• Liquidate an institution, meaning that the FDIC issues checks for all insured deposits, dissolves the bank, and sells off the bank’s assets in an attempt to recoup its losses. This is not a preferred approach but can occur when a bank is closed precipitously and the FDIC does not have time, or cannot generate interest, for a P&A transaction.
• Execute an insured deposit transfer, in which the FDIC as receiver transfers a failed bank’s insured deposits to another institution for a fee. This is similar to a liquidation in that the FDIC makes no effort to preserve the failed bank as an ongoing business. Asset sales would also be expected in this type of transaction.

To ensure a fair and equitable process, the FDIC conducts a structured bid process whenever it seeks a third-party transaction. The FDIC as receiver must demonstrate that the transaction it approves and enters into is the least costly transaction among the alternatives, taking into account the cost to pay off the deposits and liquidate the assets from the receivership.

Loan sales

Through a Loan Sale Agreement (which is drafted by the FDIC with limited room for negotiation), the FDIC may sell loans of failed banks in single loan sales or in pools, depending on the size of specific loans and commonality of terms and structures of the failed bank’s loan portfolio. When pooling loans, the FDIC seeks to aggregate assets that share specific criteria such as loan size, performance status, type, collateral, and location, typically through sealed bid sales.

Bidders might inform the FDIC of their preference for pools that meet certain parameters, such as performing commercial real estate secured loans in a specific region, and the FDIC may or may not attempt to offer pools that satisfy those requests. Even if pools are formed that generally comport with a bidder’s requested parameters, any sale by the FDIC as receiver will occur through an open bidding process involving all qualified and interested bidders.

The FDIC makes no representations or warranties in connection with any failed bank loans it sells, thus bidder diligence is critical to determining an appropriate bid amount. The only remedies or recourse provided to the buyer are those set forth in the Loan Sale Agreement. Generally, all risk associated with the loans are passed to the buyer. Once a sale is awarded, it is usually closed within 20 business days.

The FDIC conducts loan sales with the support of the following loan sale advisors:

First Financial Network (FFN)
www.ffncorp.com
405-748-4100

Mission Capital Advisors
www.missioncap.com
212-925-6692

Newmark Knight Frank
www.ngkf.com
212-372-2000

The Debt Exchange (DebtX)
debtx.com
617-531-3400

Those that may be interested in participating in a loan sale are encouraged to contact each of the loan sale advisors and request to have an account established on the applicable website. Although the FDIC provides a sample copy of the Purchaser Eligibility Certification, each loan sale advisor has its own requirements for granting access to its website and may have different certification forms. Those interested in purchasing loans should review and complete the sample Certification and access each loan sale advisor’s website to collect and complete the requisite forms to open an account.

Persons with accounts on the respective advisors’ systems will receive emails notifying them of an FDIC loan sale when they are made available to the market. Bidders are required to provide an initial deposit (the amount of which is determined by the bid instructions in a given sale) by wire transfer to be able to bid on a specific loan sale. Any other requirements will be defined in the bid instructions.

Other asset purchases

The FDIC also may sell certain debt; equity; mortgage-related, municipal, and other securities; mortgage servicing portfolios; mortgage servicing platforms and related assets; loan origination platforms and related assets; shared national credits (interests in syndicated loans); credit card receivables; and interests in structured transactions (i.e., joint ventures, limited liability companies and other newly-formed entities) involving loans, notes, other evidences of indebtedness and collateral property. The FDIC, as receiver for failed institutions, is required by law to maximize recovery on these assets.

The FDIC uses a variety of strategies to manage and sells assets of a failed institution, including structured joint venture transactions (Structured Transactions). As the term is used by the FDIC, Structured Transactions are joint ventures or partnerships between the FDIC, as receiver, and private sector entities, which are designed to facilitate the placement back to the private sector of selected assets from failed banks. Structured transactions allow the FDIC to retain an interest in the assets, while transferring day-to-day management responsibility to private sector managers who acquire a financial interest in the assets and share in the costs and risks associated with ownership.

The FDIC initiates a Structured Transaction by forming an investment vehicle (typically an LLC) into which it contributes assets from one or more failed institutions in return for the equity interest in the LLC. The winning bidder purchases a portion, typically ranging from 20 to 40 percent, of the equity in the LLC. The future expenses and income will be shared based on the percentage ownership to the purchaser and the FDIC. These types of transactions can be offered and sold on a leveraged, unleveraged, or whole loan “all cash” basis. You can find examples of historic FDIC sale transactions coming out of receivership here.

Those interested in bidding on FDIC sales of these assets will be required to meet certain criteria and are encouraged to initiate the pre-qualification process as soon as possible to avoid delays in access to information on transactions that intentionally move quickly. The first steps for prospective bidders seeking to become pre-qualified are to complete, execute and deliver to the FDIC the following:

• Pre-Qualification Request
• Purchaser Eligibility Certification, and
• Contact Information Form.

The forms can be delivered electronically to prospectivepurchaser@fdic.gov or in hard copy to: FDIC – DRR/Asset Marketing Section, 3501 Fairfax Drive, Office 3701 – 8048, Arlington, VA 22226-3500.

In order to preserve status as a pre-qualified bidder for certain securities sales, the Pre-Qualification Request and Purchaser Eligibility Certification must be newly executed and delivered to the FDIC every six months.

Pre-qualification does not necessarily allow a prospective bidder to participate in all asset sales, and the FDIC reserves the right to require any prospective bidder to meet additional or different qualification criteria for any particular asset sale at the time of that sale and complete and submit transaction specific qualification requests and materials as well as confidentiality agreements, financial, and other information.

For certain sales of other financial assets (including partnerships and other structured transactions of loans), even if a bidder has been pre-qualified and qualified to receive transaction specific information, the bidder will also be required to provide information regarding financial, managerial, and legal matters by completing the Bidder Qualification Application in accordance with the instructions contained in the Application Guidance and Instructions. 

DLA Piper has significant experience advising on acquiring assets from the FDIC.  If you would like to discuss or have any questions regarding the topics discussed in this alert or related matters, please contact any of the authors or your relationship attorneys.

The failures of Silicon Valley Bank and Signature Bank sent many companies into credit and liquidity crises. With the most pressing short-term impacts now stabilized, corporate boards and management should consider steps to be better prepared in the future.

What happened

On March 10, 2023, Silicon Valley Bank (SVB) was closed by the California Department of Financial Protection and Innovation, which appointed the Federal Deposit Insurance Corporation (FDIC) as receiver. Two days later, New York regulators stepped in to close Signature Bank under the same structure. On March 12, 2023, the Federal Reserve, FDIC and Treasury Department jointly announced an emergency program to backstop all deposits at both SVB and Signature Bank.

As the FDIC looks for a purchaser of the SVB and Signature assets, it has established the Silicon Valley Bridge Bank and Signature Bridge Bank and transferred all insured and uninsured deposits to these new “bridge banks.” On March 14, 2023, the FDIC announced that all customers of the predecessor banks would automatically become customers of the new bridge banks, which will hold “normal banking hours and activities.”

Moving forward

Companies seeking to evaluate their risk, rights and obligations and to stabilize their banking and financial positions should consider the following steps, whether or not they were a customer of the predecessor banks:

• Revisit your company’s investment policies – The company should review any existing investment policies on the company’s liquid assets and update such policies to include diversity of account requirements and other measures intended to secure the financial condition of the company against sudden shifts in market conditions. Investment policies should reflect that certain kinds of accounts and cash equivalents are protected from the credit risk of the deposit bank.
• Review any cash management services – The company should carefully review all sweep allocations, customer deposit instructions and auto-debit arrangements as they may need to be adjusted, turned off or replaced based on service availability and stability with deposit banks.
• Review your loan documents – If the company has loans with financial institutions, review the affirmative covenants to determine if there are limitations on the company’s ability to set up bank accounts and investment accounts at other financial institutions or hold cash in other bank accounts. Loan agreements generally survive bank takeovers and borrowers are expected to continue to comply with their terms. There may be exceptions to rules which place limitations on the company’s ability to put in place its investment policies. Recent events may also provide an opportunity to renegotiate with banking partners the scope of any covenants that would impact the company’s investment policy.
• Review your commercial contracts – For companies holding letters of credit as a beneficiary, review the terms of the applicable contracts that require letters of credit to determine any rights to demand replacement letters of credit from other financial institutions or cash collateral.
• Consider alternative liquidity structures – Many companies rushed to put in place bridge loan facilities or equity raises to stem a potential liquidity crisis. Companies should discuss and have contingency plans in place for addressing similar issues in the future.
• Consider establishing, or adjusting allocations to, deposit accounts under insured cash sweep programs – Your deposit bank may offer insured cash sweep (ICS) programs that sweep excess cash into secure investments that are not subject to credit risk of the deposit bank.

Importantly, properly document all decision-making regarding cash management and investment to support the record of action by the company. As part of their corporate oversight, the board of directors of the company (or the audit committee, if established) should work with company management to complete the matters contemplated above and document their attention to these matters in corporate minutes.

On Friday, March 10, 2023, Silicon Valley Bank (SVB) was closed by its chartering regulator, the California Department of Financial Protection and Innovation, and the Federal Deposit Insurance Corporation (FDIC) was appointed as receiver which is typical for a bank receivership. The FDIC formed Deposit Insurance National Bank of Santa Clara (DINB) (chartered by the Office of the Comptroller of the Currency) and immediately transferred to DINB all insured deposits of SVB. No loans or other products were transferred to DINB nor were uninsured deposits.

Unlike most banks, SVB’s deposit base was heavily weighted toward fund and technology companies and less reliant on retail or consumer deposits. This created a significant portion of uninsured deposits for depositors with more than $250,000 on deposit at SVB at the time of its failure. In fact, reports suggest that roughly 88 percent to 93 percent of SVB’s $173 billion in total deposits was uninsured. While FDIC’s $250,000 deposit insurance coverage applies per depositor, per insured bank, for each account ownership category, major institutional depositors of SVB were anxiously assessing their exposure and recovery options as uninsured depositors, and the timing for access to their funds.

Following a process used in the IndyMac failure in 2008, the FDIC announced a plan to make payments of an advance dividend of uninsured deposits within the week, but the exact timing for availability and amount of funds distributed with the advance were unknown. The potential for “haircuts” on recovery of uninsured deposits existed.

Then, on Sunday, March 12, 2022, Signature Bank (SB) was closed by its chartering regulator, the New York State Department of Financial Services, and the FDIC was appointed as receiver. The deposit base of SB was similarly weighted heavily toward large depositors. It was reported that SB had approximately $89 billion in total deposits with 90 percent above the FDIC’s deposit limits.

At the same time the announcement was made about SB’s failure, a joint statement issued by the Department of Justice, the Federal Reserve, and the FDIC confirmed that both the SVB resolution and the SB resolution would be handled “in a manner that fully protects all depositors. Depositors will have access to all of their money.” However, shareholders and certain unsecured debtholders will not be protected, and any losses to the Deposit Insurance Fund to support uninsured depositors will be recovered by a special assessment on banks, as required by law.

The FDIC then formed “bridge banks” for both failed depository institutions – Silicon Valley Bank, NA for SVB, and Signature Bridge Bank, NA for SB. A bridge bank is an institution formed by federal banking regulators to operate an insolvent bank until a buyer of the whole bank or specific bank assets can be found and the sale or sales can be consummated. All assets and liabilities of SVB and SB were transferred to their respective bridge banks. While bridge banks make efforts to retain employees from the failed banks to manage the bridge bank operations (e.g., paying 150 percent of prior salaries for a period of time), the board and management of the failed banks are removed and replaced with people selected by the FDIC.

With the formation of Silicon Valley Bank, NA, the insured deposits of SVB previously transferred to DINB two days prior were then transferred to Silicon Valley Bank, NA. All customers (depositor and creditor) of the failed banks became customers of the respective bridge banks without any action on their part.

While the urgency of the weekend has settled somewhat as it relates to depositors of SVB and SB, the events raise many questions and are causing banks and their customers to re-assess their operations and relationships. Some are (or should be) asking whether their deposits are insured and to what amount/extent. Others are preparing for participation in assets sales from the receiverships of SVB and SB, if particular operations or assets fit within their business strategies.

Insured deposit status

Insured deposit products include:

• Checking accounts
• Savings accounts
• Money market deposit accounts
• Certificates of deposit (CD) and
• Prepaid cards (assuming certain FDIC requirements are met).

Depositors do not need to apply for FDIC insurance; coverage is automatic whenever a deposit account is opened at an FDIC-insured bank or financial institution.

As noted above, the FDIC insurance limit is $250,000 per accountholder per ownership category, not per account. Examples of FDIC ownership categories include single accounts (checking accounts, savings accounts, and money market deposit accounts); joint accounts; certain retirement accounts and employee benefit plan accounts; trust accounts; and business accounts. A subsidiary entity or portfolio company is a separate depositor with its own deposit insurance limit, notwithstanding common ownership. However, divisions or offices that are not separate legal entities are aggregated for deposit calculation purposes, even if operating under a trade name or “DBA.”

Priority of status of uninsured deposits and other claims

Payments made to various stakeholders in a standard failed bank are made as follows:

1. Insured deposits to depositors, with the FDIC subrogated for repayment of such amount from the receivership with other uninsured deposits (see item 3.b., below).
2. Federal Home Loan banks as secured creditor, which is granted priority treatment among secured creditors.
3. Other secured claims which are paid out by the receivership from the assets securing them to the extent of such assets. (Any unsecured portion becomes a general unsecured claim against the receivership.)
4. Unsecured claims (in the following order):
   • Administrative expenses of the receiver
   • Deposit liability claims, generally consisting of the uninsured portion of any deposit account and including FDIC as subrogee of insured deposits
   • Other general or senior liabilities of the bank
   • Subordinated obligations
   • Shareholders.

With the announcement on Sunday, the FDIC effectively “promoted” uninsured depositors from group 4(b) in the waterfall above, to group 1.

Deposits versus other financial products

Various deposit account sweep products offered by depository institutions have terms that differ dramatically from product to product. Relevant FDIC rules (12 CFR 360.8(d)) try to keep up with the products, but not all products fit nicely into a “bucket.” Depending on the specific financial product involved, some funds from those accounts might not be deposits (for example, amounts exceeding a “target” balance in the customer’s deposit account may have been held by the bank as an agent for its customers in securities issued by funds).

If funds are swept to a third-party to acquire government bonds or securities or to a money market mutual fund, for example, those assets are likely investment assets which belong to the customer of bank and should not be considered deposits or part of the bank’s receivership estate. The governing agreement will include language making this clear, including specifically the warnings that the funds:

• Are not insured by the FDIC or any other federal government agency
• Are not deposits of or guaranteed by a bank and
• May lose value.

Such a disclosure is referred to as the “not, not, may” disclosure. While the timing and process for accessing funds in such investment accounts is unclear at this point, the full amount of such funds should ultimately be made available to the customer.

Accountholders should ultimately recover those amounts, but there could be some delay as the funds issuing these securities and other financial institutions confirm accountholder ownership interests in these securities or funds and receive instructions from either the FDIC as receiver or elsewhere as to the appropriate disposition of these amounts.

By contrast, a sweep product that places depositor funds into a money market account at the bank to earn interest are likely still deposits and the “not, not, may” disclosure is not likely provided in the associated account documentation. It is essentially a sweep from one deposit account to another. Funds swept in these products above the FDIC limits are likely still uninsured deposits.

When swept funds are held by the bank as agent in an omnibus account (external to the bank), the customer should look to see exactly how the bank discloses its rights at failure. FDIC rules (see, 12 CFR 360.8(e)) require the bank to disclose, for example, the customer holds those assets as a secured creditor of the bank, putting the customer much higher in the waterfall of payees if the bank fails, or as an unsecured creditor.

Finally, sweeps must be completed on the ledger of the bank at the time of receivership (referred to in the FDIC rules as the “Applicable Cutoff Time”). This factor is why many “overnight sweeps” are structured such that the funds are swept from a deposit account right before the close of business and returned to the deposit account right after the opening of business the next day. However, the SVB failure occurred during the business day (which is unusual), making it unclear how overnight sweep products would be handled by the FDIC. Presumably, sweep products structured to return funds to the bank at the opening of a business day would not provide any benefit to depositors if the bank were closed during operating hours.

It will be critical to (i) review and understand the terms of the specific sweep products that depositors enter into; (ii) to retain records of any selected allocation made by the depositor and any defined “target balance” that must be retained in the associated depository accounts; and (iii) be certain the depositor has readily available complete agreements, with all schedules and appendices, and is not in a position of seeking copies from the failed bank.

Purchasing assets from the receiverships

As receiver, the FDIC will sell assets or both SVB and SB or will sell the whole bridge bank to eligible parties. If the FDIC negotiates a “whole bank” sale, which is typically the FDIC’s preference, there won’t be an opportunity to buy specific assets. However, if they consider asset sales the FDIC accepts bids from eligible bidders that result in the “least cost resolution of the bank,” meaning they make every effort to get the best aggregate price for the failed bank’s assets. Some details about the process are published on the FDIC’s Institution and Asset Sales page. There is also information about qualifying for the process.

Purchasing assets form the FDIC can be a complicated process and strict timelines are often set by the FDIC, but making interest known and obtaining access to related data rooms with content about the assets being sold is a crucial first step.

There will certainly be addition questions over the next few days and weeks.