Month: April 2011

Employment Opportunity – Senior Compliance Role

I occasionally get calls from people looking to hire compliance personnel. Here is the latest:

  • Private Equity firm looking to expand its compliance team
  • Senior compliance role reporting to the CCO
  • Company is a prominent PE firm based in TX with a large office in San Francisco
  • Knowledge of Investment Advisers Act essential
  • Experience reviewing marketing material and interacting with investor relations and fund raising required
  • Firm has a small compliance team so it is expected that this person will be willing to take on a variety of responsibilities
  • JD not required
  • Relocation available

If you are interested, you can drop me a note on the Compliance Building hotline: [email protected].

Compliance Bits and Pieces for April 29

Here are some recent compliance-related stories that caught my eye:

SFO GC resigns: SFO future cast into further doubt in The Bribery Act .com

We’re delighted to congratulate Vivian Robinson QC on his reported move today from the SFO to join a US law firm, Richmond Virginia headquartered McGuire Woods, in the near future. We’ve enjoyed working together with Vivian over recent months and look forward to doing so during the remainder of his time at the SFO.

Vivian’s move places in the spotlight once again the current uncertainty surrounding the future of the SFO.

Examining Bernie Madoff, ‘The Wizard Of Lies’ on NPR’s Fresh Air

The first journalist to interview Bernie Madoff after the money manager was sentenced to 150 years in prison says she was struck that Madoff hadn’t fundamentally changed.

Even behind bars, says New York Times financial writer Diana Henriques, Madoff was a “fluent liar.”

“The magic of his personality is how easy it is to believe him — almost how much you want to believe him,” she tells Fresh Air’s Terry Gross. “For example, he assured me in that first interview — and in emails subsequently that we exchanged — that he wasn’t going to talk to other writers. … Of course, it wasn’t true, he was talking to others. It was all a lie.”

Whistleblower Rules May Not Be Ready Until Summer by Joe Palazzolo in WSJ.com’s Corruption Currents

After missing an April deadline, the Securities and Exchange Commission said it now expects to finalize rules for its whistleblower program by July, reports Dow Jones’ Jessica Holzer. Congress had given the SEC until April 21 to write rules for the program, which was created in the Dodd-Frank law nine months ago. The commission plans to adopt rules sometime between now and the end of July, according to a revised schedule on the agency’s website.

Risk Disclosures and Form ADV Part 2 for Fund Managers

If you’re a fund manager getting ready to register because you’ve been Dodd-Frank’ed, then you are likely in the middle of drafting Part 2 of Form ADV, the brochure. One item that caused my to pause was the risk factor requirements in Item 8.

8.B:  For each significant investment strategy or method of analysis you use, explain the material risks involved. If the method of analysis or strategy involves significant or unusual risks, discuss these risks in detail. If your primary strategy involves frequent trading of securities, explain how frequent trading can affect investment performance, particularly through increased brokerage and other transaction costs and taxes.

Fund sponsors spend a great deal of time, money, and energy drafting risk factors for their fund’s private placement offering memorandum.

Do you need to duplicate those risk factors in response to 8B or can you ignore them?

The SEC staff answered that question about Part 2 of Form ADV.

Question II. 4

Q: Item 8.B of Part 2A requires an adviser to explain the material risks for each significant investment strategy or method of analysis the adviser uses. Does Item 8.B require an adviser that uses pooled investment vehicles as a significant investment strategy or method of analysis to duplicate the risk disclosures contained in a prospectus or other offering document for the pooled investment vehicle?

A: An adviser may satisfy the requirement of Item 8.B by providing a brief explanation of the material risks for each strategy and referring clients to the prospectus, offering memoranda, or other documents that a client participating in the pool will or has received that set out a more detailed discussion of risks. (Posted March 18, 2011)

Sources:

The Case for Executive Assistants

Why would you pay managers big salaries and then ask them to make their own hotel reservations?

Since it’s Administrative Professionals Day, a story in this month’s Harvard Business Review caught my eye: The Case for Executive Assistants. (Now looking at the Administrative Professionals’ website, I see it has grown from being mere a day to become an entire week.)

Technologies like e-mail, voice mail, mobile devices, and online calendars have allowed managers at all levels to operate with a greater degree of self-sufficiency. At the same time, companies have faced enormous pressure to cut costs, reduce head count, and flatten organizational structures. As a result, the numbers of assistants at lower corporate levels have dwindled in most corporations. That’s unfortunate, because effective assistants can make enormous contributions to productivity at all levels of the organization.

The author does some simple math to justify the cost of administrative assistants.

Consider a senior executive whose total compensation package is $1 million annually, who works with an assistant who earns $80,000. For the organization to break even, the assistant must make the executive 8% more productive than he or she would be working solo—for instance, the assistant needs to save the executive roughly five hours in a 60-hour workweek.

Of course, lots of the burden for getting that productivity boost lies with the executive/manager. You need to delegate wisely.

It’s a great, short article and timely. Unlike most content from the Harvard Business review, this article is available for free. (At least for today.)

Turning Your PowerPoint into an Advertisement

Once a fund manager is registered, Rule 206(4)-1 imposes additional restrictions on advertising that the SEC has determined would be fraudulent deceptive or manipulative. That means public presentations could be considered an advertisement.

First I want to look back at the definition of an “advertisement” for purposes of the rule. An advertisement for purposes of the rule 206(4)-1 is:

“[A]ny notice, circular, letter or other written communication addressed to more than one person, or any notice or other announcement in any publication or by radio or television, which offers (1) any analysis, report, or publication concerning securities, or which is to be used in making any determination as to when to buy or sell any security, or which security to buy or sell, or (2) any graph, chart, formula, or other device to be used in making any determination as to when to buy or sell any security, or which security to buy or sell, or (3) any other investment advisory service with regard to securities.”

In meeting with potential investors, invariably, someone will pull out a Powerpoint presentation to discuss the fund manager, their past performance, and future business plan. In looking at the definition of advertisement, a purely oral presentation would not be an advertisement. One the projector lights up, the presentation starts moving into the realm of an advertisement.

The final straw is leaving a copy of the presentation behind. Now the presentation is clearly a “written communication.”

And don’t forget about the requirements of Regulation D regarding advertising and disclosure requirements for privately-offered securities.

Fees and Performance Results for Advisers and Fund Managers

Section 206 of the Investment Advisers Act prohibits fraud, deception or manipulation, regardless of whether the fund manager is registered. Once registered, Rule 206(4)-1 imposes additional restrictions on advertising that the SEC has determined would be fraudulent, deceptive or manipulative.

The first item on the list of fraudulent, deceptive or manipulative practices is testimonials, which I wrote about earlier. The second item in the advertising rule is a prohibition on using past performance in an advertisement, subject to some limitations. I also wrote about that last week.

One of the controversial standards when using performance results is that they must be shown net of fees.

In a 1986 No Action Letter to Clover Management the SEC said it was their view that “Rule 206(4)-1(a)(5) prohibits an advertisement that: … (2) Includes model or actual results that do not reflect the deduction of advisory fees, brokerage or other commissions, and any other expenses that a client would have paid or actually paid; ”

Can you just include a description of your fees? No.

[B]ecause advertisements typically present adviser performance results over a number of
years, narrative disclosure of the existence and range of advisory fees, in our view, would
not be an adequate substitute for deducting advisory fees because of the compounding
effect on performance figures that occurs if advisory fees are not deducted. In our view it is
inappropriate to require a reader to calculate the compounding effect of the undeducted
expenses on the advertised performance figures. Investment Company Institute No Action Letter (1987)

But you can include gross returns, as long as they are side-by-side with net of fees results. See Association of Investment Management and Research (1996). Both the net and gross performance figures need to be presented in an equally prominent manner. The “advertisement” must contain sufficient disclosure to ensure that the performance figures are not misleading. For example, when showing a performance figure gross of fees there should be a disclaimer that the figures do not reflect the payment of investment advisory fees and other expenses.

Sources:

Compliance Bits and Pieces – Good Friday Edition

The stock markets are closed, but most banks are open. I’m taking the day off from work, but wanted to highlight a few compliance-related stories that caught my eye.

Justice is served, but more so after lunch: how food-breaks sway the decisions of judges by Ed Yong in Discover’s Not Exactly Rocket Science

There’s an old trope that says justice is “what the judge ate for breakfast”. It was coined by Jerome Frank, himself a judge, and it’s a powerful symbol of the legal realism movement. This school of thought holds that the law, being a human concoction, is subject to the same foibles, biases and imperfections that affect everything humans do. We’d love to believe that a judge’s rulings are solely based on rational decisions and written laws. In reality, they can be influenced by irrelevant things like their moods and, as Frank suggested, their breakfasts.

Chief Compliance Officers: The Evolving Picture by Michael Volkov in White Collar Defense & Compliance

In the next five years, the position of CCO will take on a new and more dynamic role in every company. With the rise of enforcement, it is inevitable that the importance of the CCO will increase in every organization. CCOs are likely to rise in organizations to a level equal to General Counsels and Chief Financial Officers.

How Do I Know If My Company Is Compliant If I Don’t Know Every Applicable Law and Regulation? by Ted Polakowski in Corporate Compliance Insights

This is one of the hardest questions to answer since you just don’t know what you don’t know. … This is because within any country, there exist – in addition to the governmental body that creates law – many regulatory agencies that are chartered with putting the rules of operation into play. Just trying to find out who those agencies are and where they list their regulations can be a daunting task in itself.

The housing boom and bust, part 2 by Russ Roberts in Cafe Hayek

Once the price of housing started rising dramatically, it became profitable to bet on the rise continuing. So a lot of people, smart and stupid, tried to ride that meteor as it shot upward. And that’s where the shadow banking system and the low interest rates come in. The shadow bankers pumped trillions into that market via all those innovative new assets (CDO’s, CDO squared etc). They use borrowed money because they could. The lenders lent the money because the government had signaled that lenders would get made whole even when the bets their loans financed were worthless.

Richard Ford on the Meaning of Work in the Wall Street Journal’s Speakeasy

Work, after all — to me, anyway — signifies something hard. And while writing novels can be (I love this word) challenging (it can also be tedious in the extreme; take forever to finish; demoralize me into granite and make me want to quit and find another line of work), it’s not ever what I’d call hard. A hard job, okay, would have to be strenuous and pressurized (writing’s almost never that way). It would have to be obdurate, never offering me a chance to let up (I can quit writing any time I want to and come back tomorrow, or never). And it would have to be skimpy on personal-spiritual rewards (I’m always trying to do what Chekhov did…change the way some reader sees the world; so big rewards are always out there). In my view, being a first-year law student at Harvard would not be hard; but being a non-partnered associate at Skadden, Arps would be. Learning to play “The Flight of the Bumble Bee” on a Sousaphone would not be hard; but working on the dashboard assembly team for the Ford-150 would most certainly be. You see what I mean. Hard is staring into one of those mind-corroding x-ray machines at LaGuardia. Or taking tolls on the Jersey Turnpike.

Performance Results in Fund Brochures

Section 206 of the Investment Advisers Act prohibits fraud, deception or manipulation, regardless of whether the fund manager is registered. Once registered, Rule 206(4)-1 imposes additional restrictions on advertising that the SEC has determined would be fraudulent, deceptive or manipulative.

The first item on the list of fraudulent, deceptive or manipulative practices is testimonials, which I wrote about earlier.

The second item in the advertising rule is prohibition on using past performance in an advertisement, subject to some qualification:

206(4)-1(a)(2): Which refers, directly or indirectly, to past specific recommendations of such investment adviser which were or would have been profitable to any person:

Provided, however, That this shall not prohibit an advertisement which sets out or offers to furnish a list of all recommendations made by such investment adviser within the immediately preceding period of not less than one year if such advertisement, and such list if it is furnished separately:

(i) State the name of each such security recommended, the date and nature of each such recommendation (e.g., whether to buy, sell or hold), the market price at that time, the price at which the recommendation was to be acted upon, and the market price of each such security as of the most recent practicable date, and

(ii) contain the following cautionary legend on the first page thereof in print or type as large as the largest print or type used in the body or text thereof: “it should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list”

Of course, all advertising is still subject to the prohibition on advertising that is otherwise false or misleading in Rule 206(4)-1(a)(5).The SEC has adopted a facts-and-circumstances test to determine whether the use of performance results is false or misleading.

[W]e believe the use of model or actual results in an advertisement would be false or misleading under Rule 206(4)-1(a)(5) if it implies, or a reader would infer from it, something about the adviser’s competence or about future investment results that would not be true had the advertisement included all material facts. Any adviser using such an advertisement must ensure that the advertisement discloses all material facts concerning the model or actual results so as to avoid these unwarranted implications or inferences. Because of the factual nature of the determination, the staff, as a matter of policy, does not review any specific advertisements. Clover Capital Management, Inc. 1986 No Action Letter

A facts-and-circumstances test is not one that helps a compliance officer sleep at night. That means judgment calls and disagreements with management on what can be included and how it can be included.

There are many SEC no action letters out setting some lines in the sand. A 1986 No Action Letter to Clover Management lays out a series practices that are bad for disclosing model and actual results:

(1) Fails to disclose the effect of material market or economic conditions on the results portrayed (e.g., an advertisement stating that the accounts of the adviser’s clients appreciated in the value 25% without disclosing that the market generally appreciated 40% during the same period);

(2) Includes model or actual results that do not reflect the deduction of advisory fees, brokerage or other commissions, and any other expenses that a client would have paid or actually paid;

(3) Fails to disclose whether and to what extent the results portrayed reflect the reinvestment of dividends and other earnings;

(4) Suggests or makes claims about the potential for profit without also disclosing the possibility of loss;

(5) Compares model or actual results to an index without disclosing all material facts relevant to the comparison (e.g. an advertisement that compares model results to an index without disclosing that the volatility of the index is materially different from that of the model portfolio);

(6) Fails to disclose any material conditions, objectives, or investment strategies used to obtain the results portrayed (e.g., the model portfolio contains equity stocks that are managed with a view towards capital appreciation);

(7) Fails to disclose prominently the limitations inherent in model results, particularly the fact that such results do not represent actual trading and that they may not reflect the impact that material economic and market factors might have had on the adviser’s decision-making if the adviser were actually managing clients’ money;

(8) Fails to disclose, if applicable, that the conditions, objectives, or investment strategies of the model portfolio changed materially during the time period portrayed in the advertisement and, if so, the effect of any such change on the results portrayed;

(9) Fails to disclose, if applicable, that any of the securities contained in, or the investment strategies followed with respect to, the model portfolio do not relate, or only partially relate, to the type of advisory services currently offered by the adviser (e.g., the model includes some types of securities that the adviser no longer recommends for its clients);

(10) Fails to disclose, if applicable, that the adviser’s clients had investment results materially different from the results portrayed in the model;

(11) [for actual results] Fails to disclose prominently, if applicable, that the results portrayed relate only to a select group of the adviser’s clients, the basis on which the selection was made, and the effect of this practice on the results portrayed, if material.

The other important thing to keep in mind when deciding to use performance results is that you must keep all of the accounts, books, internal working papers and other records necessary to demonstrate the calculation of the performance results. SEC Rule 204-2(a)(16)

Sources:

Ratings and Fund Managers

Investment advisers, and therefore fund managers once they register as investment advisers, are limited in how they advertise. Section 206 of the Investment Advisers Act already prohibits fraud, deception or manipulation, regardless of whether the fund manager is registered. Once registered, Rule 206(4)-1 imposes additional restrictions on advertising that the SEC has determined would be fraudulent deceptive or manipulative.

The first item on the list of restrictions is testimonials. This prohibition reflects the concern that the experience of one customer is not necessarily typical of the experience for all customers.

To some extent this also covers third party ratings since they are relying on the testimonials of clients. If you have a good rating you may want to include that rating as part of your fundraising materials. That means you are indirectly including a testimonial in your advertising and are staring squarely at the prohibitions in the advertising rule.

However, the SEC has recognized that the distribution of unbiased third-party ratings may not be fraudulent. In a 1982 No Action Letter to New York Investors Group, Inc., the SEC allowed the investment adviser to include an article from a financial publication that “lauds the Company/ and or the Company president’s success in picking stocks that do well under both favorable and unfavorable market conditions.”

The SEC ruled that “an article by an unbiased-third party concerning an investment adviser’s performance, however, is not a testimonial unless it includes a statement of a customer’s experience or endorsement. ” While clarifying that the article is not a testimonial, it is still an advertisement.

The more detailed discussion about the use of ratings is in a 1998 No Action Letter to DALBAR, Inc. The company conducted a survey to measure the effectiveness of investment advisers and their representatives.  Based on the survey, DALBAR would assign a numerical ranking. Since the investment adviser was paying for the survey, presumably they would want to publish a good result to attract more clients. That means the ratings would be part of an advertisement.

The SEC said that the DALBAR rating is a testimonial because the rating carries an implicit statement of clients’ experiences. The DALBAR rating is testimonial, made indirectly.

But the SEC turns around and and blesses the DALBAR rating, granting the sought after “we would not recommend enforcement action.” The SEC lists these factors:

  • DALBAR rating does not emphasize the favorable client responses or ignore the unfavorable responses.
  • The rating represents all or a statistically significant sample of an adviser’s clients.
  • The client questionnaire has not been prepared to produce any pre-determined results.
  • The client questionnaire makes it easy for a client to give negative or positive responses.
  • DALBAR does not perform any subjective analysis of the survey results, but merely assigns numerical ratings after averaging client responses.
  • DALBAR is not affiliated with any advisers.
  • DALBAR charges a uniform fee, paid in advance.
  • Survey results clearly identify the percentage of survey participants who received each designation and the total number of survey participants.

While the SEC blesses the DALBAR rating system, they took the opportunity to point out that an adviser’s use of the rating in their advertisement materials could still be a violation of Section 206(4) and Rule 206(4)-1(a)(5). The SEC provided some guidance that advisers should consider when using a DALBAR or similar rating:

1. Whether the advertisement discloses the criteria on which the rating was based;

2. Whether an adviser or IAR advertises any favorable rating without disclosing any facts that the adviser or IAR knows would call into question the validity of the rating or the appropriateness of advertising the rating (e.g., the adviser or IAR knows that it has been the subject of numerous client complaints relating to the rating category or in areas not included in the survey);

3. Whether an adviser or IAR advertises any favorable rating without also disclosing any unfavorable rating of the adviser or IAR (or the adviser that employs the IAR);

4. Whether the advertisement states or implies that an adviser or IAR was the top-rated adviser or IAR in a category when it was not rated first in that category;

5. Whether, in disclosing an adviser’s or IAR’s rating or designation , the advertisement clearly and prominently discloses the category for which the rating was calculated or designation determined, the number of advisers or IARs surveyed in that category, and the percentage of advisers or IARs that received that rating or designation;

6. Whether the advertisement discloses that the rating may not be representative of any one client’s experience because the rating reflects an average of all, or a sample of all, of the experiences of the adviser’s or IAR’s clients;

7. Whether the advertisement discloses that the rating is not indicative of the adviser’s or IAR’s future performance; and

8. Whether the advertisement discloses prominently who created and conducted the survey, and that advisers and IARs paid a fee to participate in the survey.

If you are using third-party ratings as part of your fundraising materials, DALBAR presents you with a laundry list of things you can and cannot do with those ratings.
Sources:

Client Lists and Private Fund Managers

Section 206 of the Investment Advisers Act prohibits fraud, deception or manipulation, regardless of whether the fund manager is registered. Once registered, Rule 206(4)-1 imposes additional restrictions on advertising that the SEC has determined would be fraudulent deceptive or manipulative.

The first item on the list of restrictions is testimonials. This prohibition reflects the concern that the experience of one customer is not necessarily typical of the experience for all customers.

Merely including a list of client names is not a testimonial, but could still be considered fraudulent. You can see that in the example of Reservoir Capital Management. Reservoir provided prospective clients a client list, which Reservoir described as “representative,” that consisted of the names of eight institutional investors. In the SEC’s view this created the impression that a substantial portion of Reservoir’s client base was institutional clients. The truth was that no more than fifteen percent of Reservoir’s assets under management were assets of institutional clients.

A list of all clients would unlikely to be considered a testimonial in violation of the rule. Once you start producing a partial list, the SEC gets considered that the inclusion or exclusion of clients on the list could be fraudulent or manipulative.

The SEC offered some additional guidance on including a partial list of clients in a 1993 No Action Letter to Denver Investment Adviser Associates. They came up with three conditions that need to be satisfied:

1. You can’t use performance based criteria in determining which clients to include in the list

2. The client list has a disclaimer similar to this: “It is not known whether the listed clients approve or disapprove of the adviser or the advisory services provided.

3. The client list includes a statement disclosing the objective criteria used to determine which clients to include in the list.

For a fund manager, the funds are the clients. However, I could easily see how this limitation could be taken the next step to investors in the funds.

Also keep in mind that the fact that a particular customer or consumer is a client could be considers nonpublic personal information, making it subject to Regulation S-P. Several states prohibit an investment adviser from disclosing a client’s identity
without consent.

Sources: