Month: November 2011

Failure to Adequately Oversee Service Providers

Citing what it called “wholly inadequate” oversight of a faraway subadviser, the Securities and Exchange Commission fined and ordered repayment of advisory fees by Morgan Stanley Investment Management. According to the settlement, Morgan Stanley will repay its client, the Malaysia Fund, $1.8 million for fees it paid from 1996-2007 for “research, intelligence, and advice” that  AMMB Consultant Sendirian Berhad of Malaysia, was to provide as subadviser.

AMMB served as a sub-adviser to the Fund from inception until it was terminated at the end of 2007. The Research and Advisory Agreement specified that AMMB would register with the SEC as an investment adviser under the Investment Advisers Act and furnish Morgan Stanley “such investment advice, research and assistance, as [Morgan Stanley] shall from time to time reasonably request.” AMMB did not exercise investment discretion or authority over any of the assets in the Fund. Morgan Stanley took responsibility for monitoring AMMB’s performance of services. The Fund would pay AMMB an escalating fee based on the fund’s assets. During the relevant time period, the Fund paid AMMB advisory fees totaling $1,845,000. As the fund administrator, Morgan Stanley facilitated the Fund’s payment of AMMB’s advisory fees.

Section 15(c) of the Investment Company Act requires an investment adviser of a registered investment company to furnish such information as may reasonably be necessary for such company’s directors to evaluate the terms of any contract whereby a person undertakes regularly to serve or act as investment adviser of the company.

It was an OCIE exam in 2008 that first questioned the arrangement between AMMB and Morgan Stanley. AMMB did not provide any of the services it and Morgan Stanley represented to the Fund’s Board. Instead, AMMB provided two monthly reports that Morgan Stanley neither requested nor used in its management of the Fund. The first was a two-page list of the market capitalization of the Kuala Lumpur Composite Index. The second was a two-page comparison of the monthly performance of the Fund against other Malaysian equity trusts. For twelve years, the fund’s Board relied on Morgan Stanley’s representations and submissions of information regarding AMMB’s services when it unanimously approved the continuation of AMMB’s advisory contracts. The SEC stated that even though Morgan Stanley took responsibility for monitoring AMMB’s services, its oversight and involvement with AMMB during the relevant time period were wholly inadequate.

The settlement calls on the RIA to devise written procedures, reimburse the fund and pay a fine of $1.5 million.

If you are charging a fund for services provided by a third, then there is an obligation to make sure the third party is providing those services.  The SEC stated a violation of Section 206(2) of the Investment Advisers Act that prohibits an investment adviser from engaging “in any transaction, practice or course of business which operates as a fraud or deceit upon any client or prospective client”. It also imposes on investment advisers a fiduciary duty to act in “utmost good faith,” to fully and fairly disclose all material facts, and to use reasonable care to avoid misleading clients. SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 191, 194 (1963). Morgan Stanley willfully violated Section 206(2) of the Investment Advisers Act by representing and providing information to the Fund’s Board that AMMB was providing advisory services for the benefit of the Fund, which it was not.

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Three Compliance Failures

One for the money, two for the show, three because uh – uh, comes before four, and here we go!

 – Tigger

On Monday, the Securities and Exchange Commission announced not one, not two, but three actions against investment advisers for failing to put in place compliance procedures designed to prevent securities law violations. The firms charged with compliance failures in separate cases are Utah-based OMNI Investment Advisors Inc., Minneapolis-based Feltl & Company Inc., and Troy, Mich.-based Asset Advisors LLC. The SEC also charged OMNI’s owner Gary R. Beynon, who served as the firm’s chief compliance officer.

Under Rule 206(4)-7 of the Investment Advisers Act (the “Compliance Rule”) registered investment advisers are required to adopt and implement written policies and procedures that are reasonably designed to prevent, detect, and correct securities law violations. The Compliance Rule requires annual review of the policies and procedures for their adequacy and the effectiveness of their implementation. It also requires the designation of a chief compliance officer, responsible for administering the policies and procedures.

In the case of Asset Advisors, the SEC had previously warned the firm about compliance deficiencies. In 2007, the SEC examined Asset Advisors and issued a deficiency letter. The firm waited until November 2009 to update the compliance manual to incorporated the SEC comments. That happened to coincide with an announcement that the SEC was coming for another examination. The failings:

  • The firm did not collect from its staff written acknowledgements that the staff received the code of ethics.
  • The firm did not collect any quarterly transaction reports from any of its access persons.
  • The firm did not pre-clear any of its access person’s transactions in initial public offerings or limited offerings.
  • The firm failed to at least annually review its written policies and procedures and the effectiveness of their implementation.

Asset Advisors received the nuclear punishment. The SEC required the firm to close operations and transfer its advisory accounts to another SEC-registered investment adviser with a compliance program.

Feltl & Company was a dually-registered broker-dealer and investment adviser. The SEC charged the firm with failing to adopt and implement comprehensive written compliance policies and procedures. This failure resulted in Feltl engaging in hundreds of principal transactions with its advisory clients’ accounts without making the proper disclosures and obtaining consent in violation of Section 206(3) of the Advisers Act. It also resulted in Feltl charging undisclosed fees to its clients participating in Feltl’s wrap fee program by charging both wrap fees and commissions in violation of Section 206(2) of the Advisers Act. The SEC laid the blame for Feltl’s compliance breakdown on its failure to invest necessary resources in the firm’s advisory business as it changed and grew in relation to its brokerage business.

OMNI’s was penalized for a complete failure to adopt and implement a compliance program between September 2008 and August 2011. In 2007, the SEC examined OMNI and issued a deficiency letter noting several issues, including OMNI’s failure to conduct an adequate annual review of its compliance program. In November 2010, the Commission began another examination of OMNI. When the exam began, the Commission was provided with a Compliance Manual dated November 3, 2010, which was one day after OMNI responded to the examiners’ request to initiate an examination. OMNI was unable to provide the Commission with any compliance manual adopted and implemented prior to November 3, 2010. Additionally, OMNI was unable to provide any policies and procedures that would have been in effect prior to November 3, 2010. The November 3, 2010 Compliance Manual appeared to be an off-the-shelf compliance manual that included language from both broker-dealer and investment adviser regulations, and was not specifically tailored to OMNI’s business.

OMNI was owned by Gary Beynon who also served in the role of CCO after the previous CCO left in 2008. The big problem with OMNI was that Beynon left for a three-year religious mission to Brazil in 2008, leaving OMNI’s advisory representatives completely unsupervised. He wanted to keep the firm in business while he was away so he could return to the firm when his religious mission ended.

The SEC expects more when you are responsible for other people’s money.

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Compliance Officer Banned in the United Kingdom

As a compliance officer, I often find that many lessons come from enforcement actions. Those actions imposed on compliance officers are especially instructive. The latest to catch my attention comes from the United Kingdom.

The Financial Services Authority levied a £14,000 fine and banned a compliance officer from performing any significant influence function in regulated financial services. The circumstances arose from an employee’s attempt to conceal losses after the collapse of Lehman Brothers in 2008.

Dr Sandradee Joseph was Compliance Officer at Dynamic Decisions Capital Management (DDCM), a hedge fund management company based in London. One of DDCM’s funds suffered catastrophic losses during the fall of 2008, losing 85% of its assets under management. A fund employee, rather than report the losses, decided to enter into a complicated bond transaction to create false profits. Essentially, the employee was buying bond units at a steep discount, but reporting a much greater value when calculating the fund’s NAV. The fund had lost $255 million, but the employee booked a $268 million gain on the bond transaction. A bond that the fund had only paid $5 million.

Three problems arose that the FSA thinks were instances of the compliance officer not doing her job.

The first was that the fund’s prime broker terminated its agreement with the fund because of the bond transaction. Any trade that causes the prime broker to leave should be a big red flag.

The second was an unhappy investor. The investor had put $48 million into the fund. The bond happened to violate some of its investment restrictions: maturity greater than 12 months, issued by an unlisted entity, no option to convert equity, and greater than 3% of the fund’s NAV. Violations of an investor’s investment guidelines should be a big red flag for a compliance officer.

The third problem was another unhappy investor. The bond transaction also violated this investor’s permitted investments limitation. A second big red flag that the compliance officer failed to remedy. This investor dug a bit deeper and felt that the bond may have been fraudulent.

The compliance officer tried a few defenses that sound weak to me. They sounded weak to the FSA as well.

  • The compliance officer’s role was a reporting function and it was up to individual employee to ensure compliance.
  • The compliance officer was not the fund’s lawyer and she could take a back seat on legal matters.
  • The compliance officer felt enough advisers were looking at the issue.
  • The compliance officer did not understand the bond and was relying on external lawyers to review it. (However, she never instructed a  law firm to to carry out due diligence on the bond.)
  • The compliance officer believed the bond was legitimate. (Even though she disclosed that she didn’t understand it.)

The FSA lays out the lesson learned: “In her role, if [the compliance officer] became aware of concerns that the firm was not complying with its regulatory obligations, she should have taken steps to ensure that these concerns were investigated, to verify if the concerns appeared to be legitimate, and if so to take appropriate action.”

As a compliance officer, I initially found the punishment to be on the harsh side especially since it seems to single out the compliance officer. Then I dug a little deeper and saw that criminal investigations were started by the SFO and the investors filed suit against DDCM.

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Compliance Bits and Pieces for November 18

These are some recent compliance related stories that caught my attention:

Where the Bribes Are by the James Mintz Group

The Foreign Corrupt Practices Act, passed in 1977, has led to more than 200 cases covering activity in about 80 countries. On this map, the darker red that a country appears, the larger the total penalties assessed for FCPA violations in that country. Roll over a country to see the FCPA cases there (the bigger the box, the larger the penalty in that case). Click on each box for case details. Click on the sector list (lower left) for a breakdown by industry.

EEOC Advisory Opinion on Employer Use of Arrest & Conviction Records During Hiring Process in Littler’s  Privacy and Data Protection Practice Group

The Equal Employment Opportunity Commission’s Office of Legal Counsel released an advisory opinion on employer use of arrest and conviction records during the hiring process. The non-binding letter provides some insight into the Commission’s current enforcement position and suggests the Commission: (1) will continue to differentiate between arrest and conviction records; (2) may not be prepared to adopt a presumption of disparate impact in this context; and (3) will in the event of a finding of disparate impact, closely scrutinize the employer’s policy with regard to both how long convictions are disqualifying and whether the underlying criminal conduct is related to the job duties for the position in question.

Louis XIV, the Old Pretender and Splitting the GC/CCO Roles by Tom Fox

Hence the War of the Spanish Succession and all may not be as it appears at first blush. This is because a GC often prefers to keep issues in-house and “not take on the responsibility of reporting to an enforcement agency.” Recognizing that such a decision is not made lightly or without thorough discussions, if the GC is also the CCO, “In difficult situations, a CCO’s perspective about a controversial transaction or event would obviously go unnoticed, if that person was also serving as the GC who happened to agree with executive management.” Hutchins concludes by noting, even the attorney who balances the two roles “will face the challenges of conflicts and the consequences of the silent compliance voice when defaulting to the professional responsibility obligations of the legal profession.”

12 Tips on How to Build a Comprehensive Anti-Corruption Compliance Program by William M. Sullivan, Jr. and G. Derek Andreson of Pillsbury

Legal Issues Surrounding Social Media Background Checks by Michelle Sherman in TOm Fox’s FCPA Complinace and Ethics Blog

Boomerang – Michael Lewis Looks at the New Third World

Michael Lewis packages his stories on the effects of the global financial crisis in Iceland, Greece, Ireland, Germany, and California into one book: Boomerang. If you had ready the stories when they were published in Vanity Fair, then you’ve ready the book. If you missed some (or all) of those stories then this book is great viewpoint on how five countries got themselves into trouble with excessive debt.

I had already read the first four articles when they appeared in Vanity Fair, but I had not yet gotten to the article on California. In fairness, Boomerang was a given to me as a gift so I did not come out of pocket to put it on my bookshelf. I enjoyed revisiting the four stories and the new California story.

They each seemed to work better in the collection than standing on their own. Since each story is relatively short, they lack the depth and understanding I’m used to getting in one of Michael Lewis’ books. Collectively, there is bit more depth as you can see how the five different countries got into trouble in different ways by becoming over-leveraged.

It’s a Michael Lewis book, so that means it’s easy to read and smart. He has a gift for taking complicated subjects and using individuals to highlight how his theories work in the real world.

My gripe is not with the book, but with Vanity Fair who sponsored Lewis in writing the five stories, each of which has appeared in the magazine. I purchased a subscription to Vanity Fair just because of these Lewis articles. I thought I was choosing to upgrade the freemium model.  I was willing to pay more for the superior experience of reading the article in the magazine instead of online. However, the publisher would put them on the website (for free) before the magazine ended up in my mailbox. One premium of getting access to the content first, was actually the opposite. I was getting the content later than if I had chosen not to pay for it. It’s not like the magazine is ad-free.

So why I would I renew my subscription?

Salute a Veteran


U.S. President Woodrow Wilson first proclaimed an Armistice Day for November 11, 1919.

“To us in America, the reflections of Armistice Day will be filled with solemn pride in the heroism of those who died in the country’s service and with gratitude for the victory, both because of the thing from which it has freed us and because of the opportunity it has given America to show her sympathy with peace and justice in the councils of the nations…”

The United States Congress passed a resolution seven years later on June 4, 1926, requesting the President issue another proclamation to observe November 11 with appropriate ceremonies. An Act approved May 13, 1938, made the 11th of November in each year a legal holiday:

“a day to be dedicated to the cause of world peace and to be thereafter celebrated and known as ‘Armistice Day’.”

Congress amended this act on November 8, 1954, replacing “Armistice” with Veterans, and it has been known as Veterans Day since.

My thoughts go out to Marine Corps Sergeant Jason Cohen, currently serving his last few weeks in active service.

Massachusetts Revises Proposed Private Fund Adviser Exemption

From my discussions, many real estate fund managers are still not sure if they are subject to registration under the Investment Advisers Act. The definition of “private fund” can exclude many real estate funds depending on the structure of their investments. I think the result is that you end up under the federal level of registration and in the state level of regulation. Many states are still trying to get their regulations to mesh better with the changes coming from Dodd-Frank.

One of those is my home state of Massachusetts. Back in April the Massachusetts Securities Division proposed changes to 950 CMR 12. 00 et. seq. that would alter the definition of institutional buyer found at 950 CMR 12.205(1)(a)(6) and proposed an exemption for certain “private fund” advisers. A public hearing was held on June 23, 2011. In light of the comments and the SEC’s changes in the regulatory framework since the original proposal, the Securities Division has amended the proposed regulations and is now seeking additional comment.

A public hearing is scheduled for December 6. That’s going to be a tight time frame for advisors that are trying navigate through the new regulatory framework and face a mid-February filing deadline.

Currently, Massachusetts has an exemption from registration for advisers who only clients are “institutional buyers.”

An investing entity whose only investors are accredited investors as defined in Rule 501(a) under the Securities Act of 1933 (17 CFR 230.501(a)) each of whom has invested a minimum of $50,000.

For a private fund manager, this was a great exemption since their investors would need to be accredited investors. As long they kept capital commitments at a minimum of $50, 000 they could usually take advantage of this exemption.

The proposed regulations would phase out the use of the institutional buyer exemption for new funds. The regulations would also create an exemption for private fund advisers that is better aligned with the federal exemptions.

The regulations probably will not help real estate fund advisers who are looking at state-level exemptions to avoid registration.

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Form ADV, Valuations, and Timing for New Registrations

With hundreds (thousands?) of private fund managers set to register with the Securities and Exchange Commission next quarter, the new form ADV is on the IARD system and ready for you to start uploading information.

I noticed the first problem.

Question 5 asks you to “determine your regulatory assets under management based on the current market value of the assets as determined within 90 days prior to the date of filing this Form ADV.” I expect most private fund managers to wait until the filing deadline in the middle of February. That means third quarter valuations, presumably accurate as of September 30, will be older than 90 days. For private equity firms with very illiquid assets like interests in real estate and private companies, they are unlikely to have valuations as of December 31 finalized by the middle of February. Even if they do have final valuations, they probably have not yet disclosed the final valuations to the investors in their funds.

With a normal end of March annual filing deadline for Form ADV, this is less likely to be a problem. But initial registrants need to file 45 days ahead of that deadline to meet the SEC’s 45 approval period.

Perhaps I’m missing something, but I’m wondering if anyone else has thought about this issue and how they are handling it. One option is to use the third quarter valuations and be worried about getting a negative SEC response. Another is to get valuations finalized and disclosed earlier than usual.

I’d appreciate any of your thoughts on this. You can leave a comment or send an email to [email protected]

SEC Says it is Bringing Charges Against Wall Street

You’ve probably heard the charges made by politicians and activists that the Securities and Exchange Commission is ineffective and not bringing charges against those who caused the 2008 financial crisis.

“YOU’RE WRONG!” says the SEC.

The SEC has begun publishing “Enforcement Actions Addressing Misconduct That Led to or Arose From the Financial Crisis.”

Key Statistics (through Oct. 19, 2011)

Number of Entities and Individuals Charged 81
Number of CEOs, CFOs, and Other Senior Corporate Officers Charged 39
Number of Individuals Who Have Received Officer and Director bars, Industry Bars, or Commission Suspensions 24
Penalties Ordered > $1.2 billion
Disgorgement and Prejudgment Interest Ordered > $393 million
Additional Monetary Relief Obtained for Harmed Investors $355 million*
Total Penalties, Disgorgement, and Other Monetary Relief $1.97 billion

* In settlements with Evergreen, J.P. Morgan, State Street, and TD Ameritrade

In the prism of the enormous losses of  the 2008 financial crisis this may not seem by much. I think most people, though rightly upset, will have a hard time finding criminal conduct among those activities subject to the jurisdiction of the SEC. Sure, the proliferation of CDOs in 2007 can be seen as suspect. But criminal?

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