Month: April 2012

Mortgage Fraud Rises in 2011

The Financial Crimes Enforcement Network released its full year 2011 update (.pdf) of mortgage loan fraud reported suspicious activity reports. It  reveals a 31% increase in submission.It also shows some of the trends that lead to the 2008 financial crisis.

Financial institutions submitted 92,028 MLF SARs in 2011, compared to 70,472 submitted in 2010. Financial institutions submitted 17,050 MLF SARs in the 2011 fourth quarter, a 9 percent decrease in filings over the same period in 2010 when financial institutions filed 18,759 MLF SARs. While too soon to call a trend, the fourth quarter of 2011 was the first time since the fourth quarter of 2010 when filings of MLF SARs had fallen from the previous year.

Since 2001, the number of mortgage loan fraud SARs has grown each year.

The report pins the sharp increase in 2011 on mortgage repurchase demands. Those demands prompted a review of mortgage loan origination files where filers discovered fraud. In 2011 a majority of the SAR filings related to fraud that was more than 4 years old. So this is the fraud leading up to the bubble now being detected.

Simply redo the chart by focusing on the year of the fraudulent activity instead of the date of filing.

You can see the rise in fraud tracking the heights of the real estate bubble in 2005 through 2008.

Going back to the 2011 reports:

  • 21% involved occupancy fraud, when borrowers claim a property is their primary residence instead of a second home or investment property
  • 18% involved income fraud, either overstating income to qualify for a larger mortgage or understating to qualify for hardship concessions.
  • 12% involved employment fraud

The up and coming frauds are related to the repercussions of the housing bubble.

Short sales are a source of fraud. SAR filers noted red flags in short sale contracts, such as language indicating that the property could be resold promptly, or “common flip verbiage” in the sales contract, or discovered that the “buyer’s
agent” was not a licensed realtor.

Several SAR filers described borrowers who “stripped” or removed valuable items from their foreclosed homes before vacating the premises. In one SAR, borrowers removed $33,000 worth of fixtures from the home, including major appliances and fixtures.

Sources:

Real Estate Executive Guilty of FCPA Violations

Back in February, 2009, Morgan Stanley self-reported FCPA violations in the firm’s China real estate investment operations. Garth Peterson, the ex-Morgan Stanley Real Estate Investing managing director has pleaded guilty for his role in evading he firm’s internal controls for the purposes of personal gain.

Peterson agreed to a settlement of the SEC’s charges in which he will be permanently barred from the securities industry, pay more than $250,000 in disgorgement, and relinquish his ill-gotten real estate (currently valued at approximately $3.4 million). The U.S. Department of Justice has filed a related criminal case against Peterson.

“Peterson crossed the line not once, but twice. He secretly bribed a government official to illegally win business for his employer and enriched himself in violation of his fiduciary duty to Morgan Stanley’s clients.”
– Robert Khuzami, Director of the SEC’s Division of Enforcement

Both the DOJ and the SEC acknowledged Morgan Stanley’s internal controls and compliance procedures. Morgan Stanley regularly updated the policies to reflect regulatory developments and specific risks to the firm. Mr. Peterson received FCPA training seven times and was reminded to comply on 35 occasions. In one instance the firm specifically told him that certain employees of  China-based counterparty, Yongye, were government officials for FCPA purposes. Periodically Morgan Stanley required Mr. Peterson to certify compliance.

What saved Morgan Stanley from prosecution? The DOJ  concluded that Morgan Stanley’s internal policies and procedures “provided reasonable assurances that its employees were not bribing government officials.” Once the firm discovered the problem, it took decisive action, shutting down the office and disciplining Mr. Peterson. The firm self-reported and  cooperated with the government investigation.

Peterson worked for Morgan Stanley in Hong Kong and Shanghai from mid-2002 to December 2008. The firm fired him when they found out he conspired to dodge Morgan Stanley’s controls  to transfer an interest in a property interest from the firm to himself and a Chinese official.

His scam was to sell the property interest to Shanghai Yongye Enterprise Group, a China state-controlled company, at a discount. However, Peterson intervened and the interest was sold to a shell company controlled by Peterson, the Chinese official and a Canadian lawyer. During their ownership, they accepted distributions from the asset and realized appreciated.

According to allegations from the SEC, Peterson also arranged to pay himself and the official at least $1.8 million in finders fees which they represented to Morgan Stanley as fees required to be paid to third parties. In exchange for offers and payments from Peterson, the official is alleged to have helped Peterson and Morgan Stanley obtain business from which they personally benefited.

The DOJ’s assistant attorney General Breuern said in its statement: “Mr. Peterson admitted today that he actively sought to evade Morgan Stanley’s internal controls in an effort to enrich himself and a Chinese government official. As a managing director for Morgan Stanley, he had an obligation to adhere to the company’s internal controls; instead, he lied and cheated his way to personal profit. Because of his corrupt conduct, he now faces the prospect of prison time.” Following his sentencing, scheduled on July 17, Peterson could be imprisoned for a maximum of five years in prison and a maximum fine of $250,000 or twice his gross gain from the offense.

Morgan Stanley itself condemned Peterson’s actions as an “intentional circumvention” of its controls and a “deliberate and egregious violation of our values and policies.” The bank said: “Morgan Stanley is pleased that this matter is resolved. We cooperated fully with the government and we are very satisfied with this outcome.”

Sources:

Bill Backs SRO for RIAs

Financial Services Committee Chairman Spencer Bachus and Rep. Carolyn McCarthy, a member of the Committee, introduced legislation that would create a Self Regulatory Organization for retail investment advisers. The legislation would amend the Investment Advisers Act of 1940 to provide for the creation of National Investment Adviser Associations (NIAAs), registered with and overseen by the SEC. Investment advisers that conduct business with retail customers would have to become members of a registered NIAA.

The bill exempt private fund managers from having to belong to a NIAA. It looks like it uses the current definition of “private fund” as a company exempt under Section 3(c)(1) or 3(c)(7) of the Investment Company Act. For real estate fund managers still wondering if the SEC cares about you, the bill also include those funds relying on the exemption under Section 3(c)(5)(C) of the Investment Company Act for real estate funds to be exempt from the NIAA requirement.

For investment advisers that have a combination of retail and fund management, the bill sets the the threshold at 90% fund management for the exemption.

The question for investment advisers is what organization will try to be a (the?) NIAA. FINRA is an obvious candidate and one that will upset many.

As for fund managers, presumably they would remain subject to SEC oversight and examination instead of NIAA oversight.

Sources:

Hypothetical Backtested Performance

Yesterday’s post on faking returns made me think about the use of theoretical models and the ability of an investment adviser or fund manager to use hypothetical performance instead of actual performance. The real use of performance figures is in advertising, so the SEC’s rules on advertising are the key focus. (I don’t see how hypothetical performance works on reports to investors, unless you’re Bernie Madoff.)

Backtesting involves the use of theoretical performance developed by applying a particular investment strategy to historical financial data. You’re more likely to see it for a quantitative or formula-based strategy than anything else. The backtested results show investment decisions that theoretically would have been made had the given strategy been employed during the particular past period of time. However, backtesting does not involve actual market risk or client money.

The SEC rules do not explicitly address model performance. You would have to look at IA Rule 206(4)-1 (a)(5) which prohibits any advertisement that “contains any untrue statement of a material fact, or which is otherwise false or misleading.” Backtesting is going to start from a position as being highly suspect since it’s not based on actual events.

The adviser will need to disclose that there are inherent limitations on the data derived from the retroactive application of a model developed with the benefit of hindsight. The adviser needs to disclose the reasons why actual results may differ. See In re Market Timing Systems, Inc. et al., SEC Release No. IA-2047

One of the problems with backtesting is whether the securities and trades that would be used going forward were available in past. This is a particular problem when using synthetic products or derivatives. Of course, the advertised performance must reflect the deduction of advisory fees, brokerage or other commissions, and any other expenses that a client would have paid.

The most obvious need in using a theoretical model is that adviser needs to disclose that the performance was derived from the retroactive application of a model developed with the benefit of hindsight and not with real money at stake. See In re Schield Management Company et al., SEC Release No. IA-1872

The SEC has indicated that labeling backtested returns as “hypothetical”, “pro-forma”, or that “actual results were available upon request” in and of itself, is insufficient to satisfy the disclosure requirement. (see In re Schield Management Company et al., SEC Release No. IA-1872  and In re LBS Capital Management, Inc., SEC Release No. IA-1644) It  fails “to convey fully the inherent limitations of the data derived from the retroactive application of a model developed with the benefit of hindsight.” The disclosures need to be robust enough to dispel the misleading suggestion that the advertised performance represented actual trading.

There are no set rules, so you need to look toward enforcement actions to see what actions the SEC found to be egregious.

In re Patricia Owen-Michel, SEC Release No. IA-1584 (Sept. 27, 1996)

In the enforcement case against Patricia Owen-Michael, the SEC sanctioned the president of an investment adviser for allegedly circulating misleading advertisements that used a computer-based statistical model to select stocks and mutual funds and to generate trading signals. The adviser’s advertisements included charts and graphs depicting hypothetical performance of an investment model applied retroactively. The SEC alleged that the various charts and graphs depicting hypothetical performance of the model failed to disclose:

  • That the adviser only began offering the given service after the performance period depicted by the advertisement;
  • That the advertised performance results do not represent the results of actual trading but were achieved by means of the retroactive application of a model designed with the benefit of hindsight;
  • All material economic and market factors that might have had an impact on the adviser’s decision making when using the model to manage actual client accounts;

In re Schield Management Company et al., SEC Release No. IA-1872 (May 31, 2000)

In the 2000 case against Schield Management, the SEC alleged that the firm distributed materially false and misleading advertisements because it combined the pre-implementation data with performance data from periods following Schield’s implementation of the relevant trading strategies. One chart showed that the Schield’s model consistently outperformed the S&P 500 index without disclosing that Schield’s actual implementation of the strategy actually underperformed the S&P 500 index. The advertisements also failed to disclose that it applied materially different trading rules in calculating the performance of the strategy before and after the actual implementation of the strategy.

According to the SEC, Schield published advertisements that materially overstated their performance because they failed to deduct the full management fee and other fees earned by the firm from the performance results. On a cumulative basis, this had the effect of overstating the performance of the strategy by more than thirteen percent. The firm also included performance numbers that were calculated erroneously.

In re LBS Capital Management, Inc., SEC Release No. IA-1644 (July 18, 1997)

In the case against LBS Capital Management, Inc., the SEC sanctioned an investment adviser who had developed a mutual fund timing and selection service by using historical financial data, but failed to “disclose with sufficeint prominence or detail that the advertised results … did not represent the results of actual trading using client assets”.

The advertisement disclosed in a footnote that the performance results were “pro-forma,” that “model” performance was “no guarantee of future results,” that the timing service “ went live” in January 1994, and that “actual results” were “available upon request.”

The SEC found that the footnote disclosure was inadequate under the  facts and circumstances.  Citing In the Matter of Jesse Rosenbaum (IA Release No. 913, May 17, 1984), the SEC pounded on the table and stated that a misleading statement in an advertisement cannot be “cured by the disclaimers buried in the [smaller print] text [of the advertisement].”

The SEC also noted that the advertisement was distributed to the adviser’s existing and prospective retail clients “without regard for their investment sophistication or acumen.” Using the facts and circumstances test, the SEC used the standard of an unskilled and unsophisticated investor.

In re Market Timing Systems, Inc. et al., SEC Release No. IA-2047 (Aug. 28, 2002)

In the case against Market Timing Systems, the SEC alleged that Market Timing Systems, Inc. promoted returns for its model of over 70% for a 13 year time period. However, the advertisements did not disclose that the performance results were hypothetical and were generated by the retroactive application of the mode. The advertisements with 13 years of performance were distributed in 1999 and Market Timing did not begin business until 1998.

One point in this case clarifies the problem with using hypothetical models. The actual performance of client accounts during its first quarter of operations was materially less than the model’s hypothetical results for the same period.

Sources:

 

Faking Your Returns

Some Securities and Exchange Commission enforcement actions catch my attention in looking for lessons on what not to do. The SEC recently charged a Boston-based father-son duo of fund managers and their firms with securities fraud for misleading investors about their investment strategy and past performance. This case caught my attention because it came out of Boston and the father is a professor at MIT. The respondents have consented to the SEC’s administrative order, but neither admit nor deny the findings in the order. For the discussion below, I’m assuming the findings are true so we can learn some lessons on what fund managers should not do.

Gabriel Bitran founded GMB Capital Management LLC in 2005 for the stated purpose of managing hedge funds using quantitative models he developed based on his academic optimal pricing research. Gabriel and his son Marco Bitran solicited potential investors with three selling points that ultimately ended up not being true:

(1) very successful performance track records purportedly based on actual trades using real money from 1998 to the inception of the hedge funds;
(2) the firm’s use of Gabriel’s proprietary optimal pricing model to trade ETFs; and
(3) Gabriel’s pedigree and his involvement as the founder and portfolio manager of the hedge funds.

They managed to raising over $500 million for eight funds and various managed accounts. But in the process made misrepresentations to investors and made at least two disastrous investment decision.

First, they told potential investors that the pre-inception performance track records since 1998 were based on actual trades using real money. That was not true. Their track record was based on back-tested hypothetical simulations. It was a great performance, showing an average annual return of over twenty percent without a single calendar year of investment losses since 1998.

Second, they solicited investors to two funds by promising that GMB would use Gabriel’s optimal pricing models to trade liquid securities such as ETF.  But those funds were actually invested almost entirely in other hedge funds and funds of funds.

Third, in May 2008, Gabriel and Marco divided GMB’s business. Marco started advising the hedge funds under a new entity, GMB Capital Partners LLC, and Gabriel managed the other clients through GMB Management. Although Gabriel had no involvement in the GMB Partners’ hedge funds, GMB Partners and they continued to tell potential investors that they were managed by Gabriel.

When the SEC’s Boston Regional Office examined GMB Management and they provided a document that supposedly was a contemporaneous record of Gabriel’s trades since 1998. They provided this document in response to the exam staff’s request for books and records that supported GMB Management’s claims in its marketing material of a successful track record since 1998. In fact, the document was not true or accurate and was created solely for the purpose of responding to the staff’s books and records request.

Using hypothetical backtested performance is not inherently false and misleading, but it is highly suspect. It’s all too easy to continually tweak the formulas as market conditions evolve in the present day to meet your needs.

It turns out that one of GMB’s funds has a significant interest in funds that had invested in the Petters Group Worldwide and Bernard L. Madoff Investment Securities LLC.

The Bitrans released this statement:

“The Bitrans invested the vast majority of their (and their family’s) net worth in the GMB funds, alongside other investors, and had great confidence in GMB’s quantitative models. To be sure, 2008 was a difficult year for the markets and for the investment industry as a whole. That aside, the majority of GMB’s funds and managed accounts either made money for investors, or significantly outperformed the S&P 500 over their operating lifetime. This strong relative performance was delivered during one of the most challenging market environments of the last several decades. The Bitrans are pleased to have reached a settlement with the SEC, on these issues which date back several years, and to put this matter behind them.”

Gabriel Bitran’s optimal pricing model is the basis for airline prices and their constant fluctuations. Bitran’s models estimate optimal pricing by assessing the factors that create demand and make supply available in the marketplace. The parallel in the financial markets is willingness to pay. Bitran’s models focuses on the value market participants place on securities at different points in time. Based on this data, they theoretically can anticipate capital flows into various markets and instruments.

This is another one of the cases that makes me scratch my head and wonder how a smart, reasonable person could make such mistakes. Clearly, the full background and key facts are missing from the news stories and SEC order. Some could be simple footfaults or a failure to under stand regulatory requirements. A few of the statements indicate more overt action that seems wrong. Given that the Bitrans are likely subject to other claims, it’s unlikely we will ever learn what lead them down the dark corridors of fraud and deceit.

Sources:

Compliance Bits and Pieces for April 20

These are a few of the compliance-related stories that recently caught my attention.

How Many Errors Can You Make In 9,000 Words, More Or Less? By Keith Paul Bishop California Corporate and Securities Law Blog

The Jumpstart Our Business Startups Act (JOBS Act) is a very modest 9,000+ words. In comparison, the Dodd-Frank Act is a hefty 360,000+ words. Thus, I find the number of technical errors in the JOBS Act to be surprising. One such error is likely to cause some consternation.

Did Facebook’s Zuckerberg just have a Van Gorkom moment? by Professor Bainbridge

In other words, a board is not excused from exercising its fiduciary duties just because there is a controlling shareholder. To the contrary, judges will be especially skeptical of transactions railroaded through the decision-making process by “an imperial CEO or controlling shareholder with a supine or passive board.”

In other words, if I had been his legal counsel, I would have advised Zuckerberg to be a lot more respectful of his board and the legal niceties.

Condo Rental Programs Are Not Investment Contracts by Ernest E. Badway in Fox Rothschild’s Securities Compliance Sentinel

The court believed that the purchases of these condos with rental options did not rise to the level of an investment contract requiring adherence to the securities laws. In particular, the court considered if the transaction qualified as an investment contract, analyzing if there was an investment of money, common enterprise, and the reasonable expectation of profits to be derived from the efforts of others, among others things. The court focused on the uncertainties of both vertical and horizontal commonality required under the common enterprise element test. In determining that there was a lack of horizontal commonality, the court found that the plaintiffs were not sold securities. The court also noted that there was no requirement to participate in the rental program as well.

SEC Promises Better Rulemaking Efforts in Compliance Week

Speaking at a hearing of the House Government Oversight Committee (which the committee had tartly titled, “SEC’s Aversion to Cost-Benefit Analysis”), SEC Chairman Mary Schapiro admitted that her office has heard an earful of criticism lately, including a stinging federal appeals court decision in 2011 that invalidated a rule for shareholder access to the proxy statement that specific cited poor cost-benefit analysis as part of its reasoning.

The FCPA Database Has A New Name

The Power of Habit and Compliance

One of the keys to success in life is instilling good habits. We are creatures of habit. We may like to think that our daily actions result from deliberation and willpower. But mostly they are the products of our unconscious habits. These habits make our lives more efficient. (Try to remember how many steps it took you to get from your front door into your office chair.) Charles Duhigg, an investigative reporter for the New York Times, presents an exploration of this subject in his latest book: The Power of Habit.

Habits are about organic efficiency. They do not distinguish between what is good for you and what is bad for you.  I suppose one of the goals of a good compliance program is to instill good habits in your company and to shut down bad habits. But how?

Duhigg has loaded the book with information on how habit patterns work in the brain and suggestions on how to change them. The scientific study of habits is extensive. Biologists have investigated the habit formation aspect of the brain, but it’s the marketers who have pushed the envelope. They realize that creating habits means products moving off the shelf.

Take the background story on the crafting of Febreeze, the odor eliminating spray. Procter & Gamble came up with a powerful product. One test subject was a park ranger who regularly had to wrangle wayward skunks. Her clothes, her car, and her home all stunk of skunk. Febreeze changed her life. Less odoriferous customers loved the product, but ended up rarely using it.

Then the marketing scientists focused on the habits of cleaning. Febreeze was scent-free. A person would spray it, but the application wouldn’t produce a sensory trigger to create a habit from using it. They added a fresh scent and advertised it for use as the final step in cleaning. “No one craves scentlessness. On the other hand, lots of people crave a nice smell after they’ve spent thirty minutes cleaning.” The addition of scent turned Febreeze from a smart product into a billion dollar product.

The Power of Habit is divided into three parts. The first focuses on individuals and how habits shape lives. Duhigg includes stories on how habits can be broken, reset, and persist. You can be trapped by a predictable cycle: you feel tired in the afternoon, you head out to Dunkin’ Donuts, and then you get the reward of feeling much better. Marketers reinforce these routines by fiddling with the Pavlovian rewards.

Not all habit are good habits. You probably feel trapped by your bad habits. Duhigg argues that you can also escape from the trap of the routines that trigger bad habits. Alcoholics Anonymous has proved so successful in part because it replaces one routine (drinking to feel better) with another (going to meetings and talking about your addiction to feel better). You re-wire your mind to appreciate and seek out the new reward.

The second part looks at the habits of organizations. Duhigg argues that managers can change entire firms by changing habits. A handful of these are “keystone habits” that can change the entire culture of a firm. Duhigg uses Paul O’Neill as a poster child. O’Neill transformed Alcoa by focusing on safety. Worker appreciated not getting injured (or killed) and mangers appreciated the more productive workers. This focus on safety turned out to be a keystone habit that transformed the workplace, increasing a focus on principles and increasing communications across the firm. At first the communication was about safety issues, but that evolved into a more open dialogue.

The book’s third part looks at the habits of societies. Duhigg argues that some of the greatest social reformations have in part been produced by rewiring social habits. He links the pressure of weak ties and social norms with habit.

That all sounds interesting, but can reading The Power of Habit help your compliance program? Yes. I’m rethinking some of my approaches (and own personal behaviors). The appendix is focused on techniques to help focus on habits and how to change habits. Finding keystone habits could help improve your organization.

If you’re interested in more of the research, the book’s notes go on for 50 pages citing hundreds of primary sources and research papers.

The book is full of interesting ideas and based on an impressive collection of research. But it does a great job of balancing intellectual seriousness with practical advice. Even better, it’s written in a lively style, making it easy to read and digest. (The book was on my to read list before the publisher sent me a review copy.)

Are You Systemically Important?

RMS Titanic

The first step in figuring out if a financial company is too big to fail, is to figure what it means to be “big”.  Section 113 of the Dodd-Frank Wall Street Reform and Consumer Protection Act authorizes the Financial Stability Oversight Council to determine that a nonbank financial company will be subject to supervision by the Board of Governors of the Federal Reserve System and prudential standards. It’s up to the FSOC to determine whether material financial distress at the nonbank financial company, or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the nonbank financial company, could pose a threat to the financial stability of the United States.

The FSOC has come up with a three stage process. First, based on quantitative criteria, the FSOC narrows the universe of nonbank financial companies by de facto defining “big”.

The Too Big to Fail thresholds are—

  • $50 billion in total consolidated assets;
  • $30 billion in gross notional credit default swaps outstanding for which a nonbank financial company is the reference entity;
  • $3.5 billion of derivative liabilities;
  • $20 billion in total debt outstanding;
  • 15 to 1 leverage ratio of total consolidated assets (excluding separate accounts) to total equity; and
  • 10 percent short-term debt ratio of total debt outstanding with a maturity of less than 12 months to total consolidated assets (excluding separate accounts).

In the second stage of the process, the FSOC will conduct a comprehensive analysis, using the six-category analytic framework, of the potential for the nonbank financial companies identified in Stage 1 to pose a threat to U.S. financial stability. In general, this analysis will be based on a broad range of quantitative and qualitative information available to the  FSOC through existing public and regulatory sources, including industry- and company-specific metrics beyond those analyzed in Stage 1, and any information voluntarily submitted by the company.

Based on the analysis conducted during Stage 2, the FSOC intends to identify the nonbank financial companies that the Council believes merit further review in the third stage. The FSOC will send a notice of consideration to each nonbank financial company that will be reviewed in Stage 3, and will give those nonbank financial companies an opportunity to submit materials within a time period specified by the FSOC .

The  FSOC will determine whether to subject a nonbank financial company to supervision by the Fed and the prudential standards based on the results of the analyses conducted during the three-stage review process.

Looking at those thresholds from the perspective of the private equity industry, it’s the $20 billion in debt threshold that most concerns me.

I’m looking for guidance on whether it should be aggregated across funds and from the portfolio companies. It would seem that debt in a portfolio company should not be consolidated to the fund if it’s not recourse to the fund. Similarly, debt in separate funds should not be consolidated since the debt will not be recourse from one fund to another.

Of course the FSOC could take the opposite view and consolidate all of the debt under a fund manager together for purposes of clearing the Stage 1 hurdle and then work on the “too big to fail” analysis in Stage 2.

Sources:

How Popular is Regulation D Fund Raising?

 

With the passage of the Jumpstart Our Business Startups Act, it makes sense to look at the regulations around capital formation and see how they affect the ability of companies to raise capital and how they chose to do so. Of course larger economic effects may outsize the influence of the choices.

The SEC’s Division of Risk, Strategy and Financial Innovation published a report on capital raising using Regulation D. (.pdf) The Division looked at Form D filings from January 2009 to March 2011.

The most startling aspect of the report is that the SEC has only been collecting Reg D filings in a machine-readable form since March, 2009. There are decades worth of data sitting in paper format. The other flaw is that the Reg D filings do not require a filing as to the final dollar amount of securities sold through the offering. Although the SEC has very exact information about publicly available securities, it only has estimates of private offerings.

Some key findings:

  • In 2010, Reg D offerings surpassed debt offerings as the dominant offering method in terms of aggregate amount of capital raised in the U.S.: $905 billion.
  • The average Reg D offering is $30 million, but the median Reg D offering is modest in size: approximately $1 million.
  • Public issuances fell by 11% from 2009 to 2010 while private issuances increased by 31% over the same period.

I also found it interesting to compare this report’s findings with a recent article published in the Business Lawyer: The Wreck of Regulation D: The Unintended (and Bad) Outcomes for the SEC’s Crown Jewel Exemptions by Rutheford B. Campbell, Jr. The two studies cover different time frames and the SEC excludes some types of filings, but there are some startling differences.

The SEC found that 55% of the offerings were under Rule 506. Campbell found that 94% of the offerings were under Rule 506. The biggest problem is that Rule 504 and Rule 505 offerings are subject to state blue-sky laws. Campbell’s argument is that the failure to preempt state regulation pushes more issuers into the tougher requirements of Rule 506, even though the fundraising totals are small enough to fit under Rule 504 or Rule 505. That still with the ban on general solicitation and advertising under Rule 506.

Both found that very few non-accredited investors purchased securities through the Reg D offerings. The SEC found that 90% of the offering had no non-accredited investors, with average amount of 0.1 non-accredited investors and a median of 0. Campbell merely used a sample, but similarly found that the vast majority of offering were limited to accredited investors.

The SEC study emphasizes that Reg D offerings are the opposite of crowdfunding. The median number of investors in an offering is 4, with almost 90% of the offerings involving 30 or fewer investors and 99% of offerings having fewer than 155 investors.

What’s clear is that capital raised in private offering under Regulation D rivals the capital raised in public offering.

It does leave you questioning why Congress felt the need to remove the ban on general solicitation and advertising on private offering to accredited investors under the JOBS Act. It looks like private offerings are raising lots of capital.

It seems clear to me that the private capital market is poorly understood by the Securities and Exchange Commission and poorly understood by Congress. There needs to be better data and better studies.

Sources:

Compliance and Patriots’ Day

And the shot heard ’round the world
Was the start of the Revolution.
The Minute Men were ready, on the move.
Take your powder, and take your gun.
Report to General Washington.

– Schoolhouse Rock!

Patriots’ Day honors the anniversary of the Battles of Lexington and Concord, the first battles of the Revolutionary War. That means Paul Revere and William Dawes mount their horses to re-create the warning: “The British are coming!” That means battle re-enactments in Lexington. That means the Boston Marathon passes through. That means a Red Sox home game.

What does this have to do with compliance or business ethics? Nothing.

Patriots’ Day is a Massachusetts holiday. Since Maine was once part of Massachusetts, it is also a holiday in Maine. Although they switch the possessive to Patriot’s Day.

So I’m out of the office.

Sources: