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Succession Plans for Financial Advisers

September 7, 2023 By Rick Randel Leave a Comment

If you’re a business owner, you’ve probably received umpteen email blasts telling you that you should have a business continuity and/or succession plan. Most businesses are not legally required to have a plan. But some are, including many financial advisers. This post lays out which financial advisers are required to have a business continuity and/or succession plan, and what those plans are supposed to include.

But first, let’s clarify the difference between continuity plans and succession plans. Although the words tend to be used interchangeably, business continuity (sometimes called contingency) plans primarily address business disruptions such as natural disasters, power outages, cyberattacks, and things of that nature.

Succession plans are addressed more toward changes at the individual level, such as death, disability and retirement. These are sometimes referred to as ownership transition plans, or what I referred to in a previous post as a “hit by a bus plan”.

Broker-Dealers

Because broker-dealers are associated with firms that have custody of the clients’ funds and don’t have the fiduciary duties of investment advisers, FINRA is more concerned with continuity plans (business disruptions) than succession plans. FINRA Rule 4370 specifically requires broker-dealers to have a “Business Continuity Plan”. The elements of the plan must at a minimum address:

(1) data back-up and recovery (hard copy and electronic);

(2) all mission critical systems;

(3) financial and operational assessments;

(4) alternate communications between customers and the member;

(5) alternate communications between the member and its employees;

(6) alternate physical location of employees;

(7) critical business constituent, bank, and counter-party impact;

(8) regulatory reporting;

(9) communications with regulators; and

(10) how the member will assure customers’ prompt access to their funds and securities in the event that the member determines that it is unable to continue its business.

The full text of FINRA Rule 4370 is available here. Fortunately, FINRA even goes so far as to provide you with a sample continuity plan template, which you can download here. Of course their sample is highly generic and needs and needs to be customized to match your business.

As far as succession planning (death, disability, retirement), FINRA doesn’t affirmatively require a plan. However, FINRA Notice 22-23 encourages the use of succession plans to address these possible events. It doesn’t contain a template, but there’s a good bullet point list of things to consider.

Investment Advisers

Unlike FINRA and broker-dealers, the SEC does not specifically require SEC registered RIAs to adopt business continuity plans. However, the SEC has stated its opinion that business continuity and transition plans are mandated by RIAs’ fiduciary duties and existing requirements to adopt “written policies and procedures” to prevent violations of those duties. But because such plans are not specifically required in any SEC rule, the SEC has proposed new Rule 206‑4(4) that would affirmatively require SEC-registered adviser firms to adopt business continuity and transition (e.g. succession) plans. Although the new rule has not been formally adopted, it would be best practice for RIAs to adopt such plans now, to fulfill their fiduciary obligations to their clients and make sure they are in compliance with proposed Rule 206-4(4) when it goes into effect.

New Rule 206(4)(4) is proposed in SEC Release IA-4439, which is available here. In addition to requiring a business continuity plan to safeguard against business disruptions similar to FINRA Rule 4370, the SEC goes a step further and requires the plan to include policies and procedures concerning “business transition in the event the investment adviser is unable to continue providing investment advisory services to clients” (i.e. a succession plan).

The SEC defines a business continuity and transition plan to mean “policies and procedures reasonably designed to address operational and other risks related to a significant disruption in the investment adviser’s operations, including policies and procedures concerning: (i) business continuity after a significant business disruption; and (ii) business transition in the event the investment adviser is unable to continue providing investment advisory services to clients. The release makes it clear that business transition includes events such as death, disability and retirement.

According to the SEC, business continuity and transition plans must address the following issues:

(1) maintenance of critical operations and systems, and the protection, backup, and recovery of data, including client records;

(2) pre-arranged alternate physical location(s) of the adviser’s office(s) and/or employees;

(3) communications with clients, employees, service providers, and regulators;

(4) identification and assessment of third-party services critical to the operation of the adviser; and

(5) plan of transition that accounts for the possible winding down of the investment adviser’s business or the transition of the investment adviser’s business to others in the event the investment adviser is unable to continue providing investment advisory services, that includes the following:

(a) policies and procedures intended to safeguard, transfer, and/or distribute client assets during transition;

(b) policies and procedures facilitating the prompt generation of any client-specific information necessary to transition each client account;

(c) information regarding the corporate governance structure of the adviser;

(d) identification of any material financial resources available to the adviser; and

(e) an assessment of the applicable law and contractual obligations governing the adviser and its clients, including pooled investment vehicles, implicated by the adviser’s transition.

Unfortunately, the SEC doesn’t provide a template like FINRA does, but the FINRA template can be a good starting point for RIAs, at least to address the business continuity components required by the SEC (potential business disruptions). You will have to develop the transition/succession part of it yourself. FINRA Notice 22-23 (mentioned above) and the NASAA model rule (see next paragraph) lay out some excellent guidance for fleshing out such plans, and a good attorney can help as well.

Although state-registered IAs won’t be subject to the new SEC rule when it goes final, you should be aware that the North American Securities Administrator Association has recommended that state securities law agencies require state-registered IAs to “establish, maintain, and enforce written policies and procedures relating to a business continuity and succession plan” (this appears in the NASAA Model Rule for Investment Adviser Written Policies and Procedures adopted in 2020). Although the State of California has not officially required state-registered IAs to adopt such plans, IAs are required to attest in their applications that they have such a plan in place. Even if you are SEC registered, the NASAA Model Rule contains excellent information to guide you in developing your plan to comply with the SEC’s requirements.

Feel free to contact me if you have any questions or would like my assistance in developing a customized plan for your firm.

This post is not intended and should not be relied upon as legal or tax advice pertaining to any specific matter. You are encouraged to seek competent legal and tax counsel before proceeding with any transaction involving any of the matters discussed above.

Demystifying Ownership Percentages

June 14, 2023 By Rick Randel

Rick Randel Authorized Shares Verses Issued and Outstanding Shares

Here’s a riddle for you: XYZ Corporation’s Articles of Incorporation authorize it to issue up to 1,000,000 shares. Founder 1 owns 100,000 shares and Founder 2 owns 100,000 shares. No one else owns any shares. What percent of the company does each founder own? Many people would say 10% each. They would be wrong. Each founder owns 50% of the company.

This is a commonly misunderstood issue that confuses many business people. The confusion stems from not understanding the difference between the authorized number of shares and the number issued and outstanding.

The authorized number of shares (often referred to as authorized capital) is the number of shares the corporation is permitted to issue under its Articles of Incorporation. In the above example, the authorized capital is 1,000,000 shares.

The issued and outstanding shares is the number of shares that have actually been issued and are held by current shareholders. A shareholder’s ownership percentage is based on their percentage of the issued and outstanding shares. So in the above example, Founder 1 and Founder 2 each own 50% of the company:

Founder 1	100,000
Founder 2	100,000
Total outstanding:	200,000

The 800,000 shares that XYZ Corporation has not issued are called “authorized but unissued shares”. If the corporation eventually issues all 800,000 of those shares to employees or investors, then Founder 1 and Founder 2 will own only 10% each at that time. But that hasn’t happened yet. Ownership percentage is based on the number currently issued and outstanding.

Sometimes we want to know what percentage a person will own based on future issuance of shares. This is especially true when there is a stock option or other equity incentive plan. This determines the percentage a person owns “on a fully-diluted basis.” Let’s say XYZ Corporation has a stock option plan calling for the issuance of an additional 100,000 shares. To calculate the percentage Founder 1 and Founder 2 each own on a fully-diluted basis, you would treat all the options as if they had been granted and exercised. Therefore Founder 1 and Founder 2 each own one third of the company on a fully-diluted basis:

Founder 1	100,000
Founder 2	100,000
Option Plan	100,000
Total fully-dilluted:	300,000

Investors use fully-diluted basis when deciding how much to pay for a certain percentage of the company. Let’s say Angel 1 thinks the company is worth $4,000,000, and she is willing to invest $1,000,000. That means the “post-money” valuation (the company’s value after she invests) is $5,000,000. Her $1,000,000 investment would equal 20% of the post-money valuation. Therefore she should own 20% of the company after she invests. Founder 1 and Founder 2 offer to issue her 50,000 shares (20% of the new total of 250,000):

Founder 1	100,000
Founder 2	100,000
Angel 1	50,000
Total outstanding:	250,000

Angel 1 would say no. She’s aware of the option plan because she did her due diligence. So she knows that once the corporation issues the 100,000 shares under the option plan, there will then be 350,000 shares outstanding. Her 50,000 would only represent 14.3% of that number. She wants to be sure that the number of shares she is issued represents 20% of the number that will be issued and outstanding after the options are granted (i.e. on a fully-diluted basis). She insists on receiving 75,000 shares, so that even if the company issues all 100,000 shares under the option plan, she will still own 20% of the Company on a fully-diluted basis (75,000 divided by 375,000 shares):

Founder 1	100,000
Founder 2	100,000
Option Plan	100,000
Angel 1	75,000
Total:	375,000

Angel 1 understands the company could issue an additional 625,000 shares in the future, which would dilute her (reduce her percentage). But that’s something investors anticipate and tolerate. They only make their fully-diluted calculations based on quantifiable future issuances such as stock options.

I hope this clears up any confusion you may have regarding the difference between authorized shares and issued and outstanding shares. Feel free to contact me if you have any questions.
Thanks,

Rick

Capital Raising Trends

January 23, 2023 By Rick Randel

Rick Randel Raising Capital Business and Succession Planning

Every year the SEC has a “town hall” meeting to discuss trends in capital raising for start-up and small cap businesses. This year’s meeting takes place on January 24 at 10:00 AM pacific time.

The virtual meeting will cover:

what has been happening with capital raising across the country, including a spotlight on how and where capital is being raised and the unique challenges faced by underrepresented businesses,
the SEC’s work in supporting small businesses and their investors, and
the recommendations the SEC shared with Congress in its 2022 annual report.

If you are interested in attending the meeting, click here. Thanks,

Rick

This article is not intended and should not be relied upon as legal or tax advice pertaining to any specific matter. You are encouraged to seek competent legal and tax counsel before proceeding with any transaction involving any of the matters discussed above.

New Company Ownership Reporting Requirement

October 21, 2022 By Rick Randel

Rick Randel New Company Ownership Reporting

Companies have always been required to report information regarding their officers and directors. They have never had to report information about their owners.

Until now. (Well, soon.)

Last month the U.S. Treasury’s Financial Crimes Enforcement Network (FinCEN) issued the final version of its rules requiring small privately held businesses to report information about their owners under the Corporate Transparency Act of 2021. According to FinCen, the rule is “designed to protect U.S. national security and strengthen the integrity and transparency of the U.S. financial system, [by helping] to stop criminal actors, including oligarchs, kleptocrats, drug traffickers, human traffickers, and those who would use anonymous shell companies to hide their illicit proceeds.”

Almost all small, privately held businesses in corporate, LLC, or limited partnership form will be required to report the names of their stockholders, members or partners (it’s the business that files the report, not the individuals). There are many exemptions, including companies in highly regulated industries, publicly traded companies, and companies that have all three of the following: (1) twenty or more employees, (2) over $5,000,000 in annual revenue, and (3) an operating presence at a physical office within the U.S. As FinCen states in the press release adopting the rule: “The rule will require most corporations, limited liability companies, and other entities created in or registered to do business in the United States to report information about their beneficial owners”.

Not all owners must be reported. Only individuals who own 25% or more of the company or exercise “substantial control” over the company must be reported. Not surprisingly, there are complicated rules to determine percentage ownership, including indirect ownership or “look through” rules. The term “substantial control” has a broad definition and includes being a director or senior officer, having the power to elect or appoint senior officers or a majority of the board of directors, or otherwise having substantial influence over important decisions within the company.

The report must name the above individuals and include their date of birth, address, and an identifying number from a driver’s license, passport or similar document as well as a copy of that document. FinCen is still working on the system (presumably online) by which the ownership reports will be filed.

Companies currently in existence or formed any time through December 31, 2023 have until January 1, 2025 to file their first report. Companies formed on January 1, 2024 or after have 30 days after formation to file their report. All companies must file an updated report within 30 days after any change to, or discovering any inaccuracy in, the information previously reported.

There are penalties of up to $10,000 per occurrence or up to two years in jail for willful failure to comply with the reporting requirement.

The good news is that the information won’t be publicly available. In most cases, it will only be available to FinCen itself and certain law enforcement agencies that will be required to keep it confidential. However, the reporting obligation alone will be a significant administrative burden on small, privately held companies. Owners of small businesses should mark their calendars for mid-2024 to start preparing to file their required report no later than December 31, 2024.

For more information about the ownership reporting requirements, click here for a link to FinCen’s fact sheet on the new rule.

Feel free to contact me if you have any questions. Thanks,

Rick

Don’t Skip the Term Sheet!

May 17, 2022 By Rick Randel

Remember your high school English teacher telling you to write an outline first before writing the whole paper? But sometimes you didn’t follow their advice, and when you got halfway through, you realized it was a mess and you had to throw away what you’d written and start all over? (Or turn in a piece of junk and get a bad grade.)

The same thing is true of deals. You need a roadmap of the deal before you start documenting it. You need to make sure both parties and their tax advisors are all on the same page before you spend money on legal fees having your attorney draft the documents. It’s better to learn that the parties can’t reach agreement on principal terms while negotiating the term sheet than to find that out after blowing tens of thousands of dollars drafting full-blown legal documents or conducting due diligence.

Usually this roadmap is called a “term sheet”. A term sheet sets forth the principal terms or the major “deal points” of the transaction. Things like purchase price, payment terms, and other major components of the deal. In the M&A (mergers and acquisitions) context it is usually referred to as an LOI (Letter of Intent) and sets forth the parties’ agreement on structure (asset purchase, stock purchase or merger), payment terms, indemnification, etc. In other contexts it is referred to as an MOU (Memoranda of Understanding).

You don’t always need a formal LOI or MOU. In smaller transactions we sometimes just exchange bullet points by email. In either case, the point is for all parties to get on the same page on the principal terms before drafting lengthy and expensive legal documents.

Sometimes clients are worried that the term sheet is just an extra document that will add to the cost of the transaction, but in most cases the term sheet saves them money. Recently I was assisting a client on a significant financing/joint venture transaction. I asked the client if there was an LOI or term sheet and she said no. I asked what the terms were and she kind of summarized her understanding of the terms over the phone and through a series of emails. Before the two sides had reached agreement on principal terms, counsel to the other side sent us a draft of the full agreement with all the bells and whistles. I recommended to my client that we hammer out a term sheet first, or even just agree by email on a bullet point list of the principal terms.

But she didn’t want to do that, so we basically used the other side’s draft of the full-on agreement as the term sheet. Not only did our redline of the agreement push back on the major terms, we had to insert our changes to all the finer points including some tax and accounting concepts. Several drafts and at least $10,000 in legal fees later, the parties realized they couldn’t come to terms on some of the major deal points. The deal cratered and the two sides walked away. If we had used a term sheet, they would’ve realized this much earlier in the process, and each side would’ve saved dozens of hours in time and energy and thousands of dollars in legal fees.

So the next time you’re wondering if a term sheet is worth the time and cost, think about the above scenario and decide to use a term sheet!

Feel free to contact me if you have any comments. Thanks,

Rick