Month: May 2012

Is a Note a Security?

In the post-Dodd-Frank world of securities regulation, the definition of a security remains important when looking at funding options and regulatory regimes. Kickstarter works from the securities law perspective because it’s not selling securities. It’s helping project mangers sell products or receive contributions, with no expectation of an a profits interest in the underlying project. Equity crowdfunding platforms will need to wait for new SEC regulations to be enacted before they go live.

I’ve spent most of my time looking at securities from the perspective of equity because that it where I spend my working time. Of course, debt instruments can also be securities. Section 3(a)(10) of the Securities Exchange Act of 1934 explicitly includes “notes” in the definition of a security, but does not include loans. Recently, the influential Delaware Chancery Court took a look at some promissory notes and found that some were securities and some were loans. ( Francis Pileggi highlighted this case in his Delaware Commercial & Commercial Litigation Blog.)

The case involves several promissory notes, each with different terms and attributes, issued by ION. A shareholder of ION, Fletcher International, Ltd., claimed that the issuance of the notes was a violation of the terms of the contractual rights that governed the terms of ION’s preferred stock that required ION to obtain Fletcher’s approval before issuing any securities. Fletcher claims that the promissory notes were “securities”.

The Delaware court sets the standard of review using the the four-factor formula set forth by the United States Supreme Court in Reves v. Ernst & Young (.pdf). That decision limits the Howey four part analysis of securities to “investment contracts”, Instead, it creates a new framework to determining if a note is a “note” under section 3(a)(10), and therefore a security. This is the Family Resemblance test.

This test came from another decision that gave a list of notes that are not securities:

  1. the note delivered in consumer financing,
  2. the note secured by a mortgage on a home,
  3. the short term note secured by a lien on a small business or some of its assets,
  4. the note evidencing a ‘character’ loan to a bank customer,
  5. short-term notes secured by an assignment of accounts receivable, or
  6. a note which simply formalizes an open-account debt incurred in the ordinary course of business (particularly if, as in the case of the customer of a broker, it is collateralized [… and]
  7. notes evidencing loans by commercial banks for current operations.

The Reves decision states that this list needed more guidance. The Court starts from the position that “all notes are presumptively securities”.  Then you need to need analyze whether the note fits into one of those exceptions through a four part test.

First, we examine the transaction to assess the motivations that would prompt a reasonable seller and buyer to enter into it. If the seller’s purpose is to raise money for the general use of a business enterprise or to finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate, the instrument is likely to be a “security.” If the note is exchanged to facilitate the purchase and sale of a minor asset or consumer good, to correct for the seller’s cash-flow difficulties, or to advance some other commercial or consumer purpose, on the other hand, the note is less sensibly described as a “security.” .

Second, we examine the “plan of distribution” of the instrument, to determine whether it is an instrument in which there is “common trading  for speculation or investment”.

Third, we examine the reasonable expectations of the investing public: The Court will consider instruments to be “securities” on the basis of such public expectations, even where an economic analysis of the circumstances of the particular transaction might suggest that the instruments are not “securities” as used in that transaction. […]

Finally, we examine whether some factor such as the existence of another regulatory scheme significantly reduces the risk of the instrument, thereby rendering application of the Securities Acts unnecessary.

You need to look at an instrument to see if it bears a “family resemblance” to one of the enumerated instruments. Under this test, the presumption can be rebutted if the note bears a strong resemblance to one of the enumerated types of notes.

I scratch my head with a bit of confusion with the Reves test. The Delaware Court shares that confusion:  “Multi-factor tests can sometimes make the mind glaze over, and obscure their own fundamental purposes. Some of the less-than-logically-compelling case law under Reves illustrates that danger.” (In my mind there is even more confusion in the mix given the trading activity of residential mortgages. They were readily traded around during the overabundant years of the real estate boom.)

The essence of the Reves analysis is to determine whether the note in question is more like an investment or, more like a commercial loan or consumer loan transaction. “If the note in question looks more like a corporate bond, debenture, or other instrument the value of which rises and falls with the success of the issuer’s business, has a term of several years, and is easily traded, then that presumption will not be rebutted, because the note will not bear a strong resemblance to any of the notes listed in Reves for the basic reason that such a note is easily characterized as an investment, and thus a
security.”

Going back to the Delaware case, the court found one of the notes to be a security. The determination seems to pivot mostly on the length of the loan: four years. Another factor was that the note had a securities legend with references to a security. So it looked like a paper security/bond instead of a promissory note.

In the end, this case does little to help me clarify my thoughts about typical private equity and real estate fund note holdings. I suppose if the note has securities legends, that will tip it more towards the category of securities than a typical vanilla promissory note.

One follow-up from the Reves analysis of a note. In SEC v. Edwards, 540 U.S. 389 (2004), the Supreme Court held that a note that falls outside the family resemblance test as a “note” could still qualify as an “investment contract” under the Howey test.

Sources:

Image of the Sears, Roebuck bond is by SpreeTom

http://www.delawarelitigation.com/author/francispileggi/

Skin in the Game

Limited partners prefer that a private fund manager have an equity stake in the fund.  In the past, the general partner had to put in equity to make sure the fund qualified as a partnership under tax law. The change in the tax law categorization by the check-the box regulations removed the multipart test to determine if an entity should receive partnership or corporate tax treatment. That effectively ending the tax driven decision that the general partner have a significant ownership interest in the partnership.

A secondary benefit from the general partner’s equity stake was that the fund manager’s economic interest was better aligned with the limited partners’ interests. If the fund took a loss, the general partner also experienced the loss.

A recent SEC case focused on a fund manager’s false claim of having “skin in the game.” Quantek Asset Management represented to prospective investors that its principals had invested their own money in the private funds. Quantek, Bullick Capital, Javier Guerra, and Ralph Patino each settled the charges, but without admitting or denying the findings. I’m treating the findings as true for educational purposes, hoping to find some lessons from this SEC enforcement.

The Alternative Investment Management Association’s standard Illustrative Questionnaire for Due Diligence Review of Hedge Fund Managers asked two questions about “skin in the game”:

  1. What is the total amount invested by the principals/management in the fund and other investment vehicles managed pari passu with the fund?
  2. Has the management reduced its personal investment?

In December 2006, Quantek answered question with $13 million. In later questionnaires that amount was reduced to $10 million, then in June 2007 it went down to $10 million, and in December 2007 fell to $7 million. In each instance the answer to question 2 was “no”.

The SEC says that the correct answer to question 1 was always zero. The principals had not invested any capital in the funds. In their defense, Quantek claims a misunderstanding that they thought some unrelated investments should have been credited as being made pari passu with the funds.  Quantek finally got the amount right in June 2009 when it finally answered no to question 1.  By this point, Quantek had obtained almost $1 billion in assets under management.

In addition to the due diligence questionnaires, Quantek also entered into side letters that limited the ability of the principals to reduce their fund ownership by more than 20%. Such a provision does not make any sense if the principals do not have any fund ownership.

In addition, the SEC found two other areas of failure. Quantek misled investors about certain related-party loans made by the fund to affiliates of Guerra and Bulltick. Second, Quantek  repeatedly failed to follow the robust investment approval process it had described to investors in the fund. Quantek concealed this deficiency by providing investors with backdated and misleading investment approval memoranda signed by Guerra and other Quantek principals.

Quantek and Guerra agreed jointly to pay more than $2.2 million in disgorgement and pre-judgment interest, and to pay financial penalties of $375,000 and $150,000 respectively. Bulltick agreed to pay a penalty of $300,000, and Patino agreed to a penalty of $50,000.Guerra consented to a five-year securities industry bar. Patino consented to a securities industry bar of one year.

Sources:

Image of the Petronas Towers is by Magnus Manske

What SEC Registration Means for Hedge Fund Advisers

Earlier this month Norm Champ, Deputy Director, Office of Compliance Inspections and Examinations at the SEC, addressed the New York City Bar and gave a preview of what the SEC has in mind for private fund advisers. I thought this tied nicely with the speech given by Norm’s boss, Carlo V. di Florio, at PEI’s Private Fund Compliance Forum.

First, some statistics:

  • As of early April, there were approximately 4,000 investment advisers that manage one or more private funds registered with the Commission
  • 34% (more than 1,350) registered since the effective date of the Dodd-Frank Act.
  • This represents a 52% increase in registered private fund advisers
  • 32% of all advisers currently registered with the Commission report that they advise at least one private fund.
  • Of the registered private fund advisers, approximately 7% (284) are domiciled in a foreign country; most of these (136) are in the United Kingdom.
  • Registered private fund advisers report on Form ADV that they advise approximately 30,000 private funds with total assets of $8 trillion, which is 16% of total assets managed by all registered advisers.
  • Based on available information, 48 of the 50 largest hedge fund advisers in the world are now registered with the Commission.
  • Fourteen of these largest hedge fund advisers are new registrants.

It sounds like fund advisers should expect a visit from the SEC this fall.

“Our strategy for these new registrants will include (i) an initial phase of industry outreach and education like today (sharing our expectations and perceptions of the highest risk areas), (ii) followed by a coordinated series of examinations of a significant percentage of the new registrants that will focus on the highest risk areas of their business and help us to risk rate the new registrants, and (iii) culminating in the publication of a series of “after action” reports, reporting to the industry on the broad issues, risks, and themes identified during the course of the examinations.”

This is exactly what Mr. DiFlorio described as the upcoming SEC strategy. Given the current staffing, it would seem that the SEC visit would need to be brief in order to reach a substantial portion of the 1,350 new registrants in a short period of time.

Champ ends with Ten Suggested Takeaways for Registered Advisers to Hedge Funds

  1. Review your control and compliance policies and procedures annually.
  2. Assess and prepare for Form PF requirements.
  3. Identify risks.
  4. Enhance your expertise.
  5. Verify client assets.
  6. Get rid of any silos, identify conflicts.
  7. Provide clear, complete, and accurate disclosure in performance and advertising.
  8. Verify portfolio management compliance.
  9. Address your complaints.
  10. Check your IT security.

We know the SEC is coming and what they are looking for. It’s time for newly installed CCOs to put the work in to make the SEC happy when they appear on your doorstep.

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Complexity

Does your policy look something like this sign? This is a real sign that was posted near schools on Bogie Lake Road in White Lake, Michigan.

The speed limit is normally 45 on that street, except during these half hour periods on school days when the speed limit drops down to 25, except the first period which is only 26 minutes. The end result is that drivers need to almost stop in order to read the sign. Presumably, they also need to make sure their watch is precise because they can travel at 45 mph at 6:48 am, but need to slow down to at 6:49 am. They need a copy of the school calendar to determine if it’s a school day, and not merely a work day.

The sign became complex because of cost, the underlying regulations, and the surrounding environment. The complexity is there for a good reason. There are three schools on that stretch of road, a high school, a middle school, and an elementary school. As you might expect, each school has different pick up and drop off times, resulting in different times that drivers need to be aware of the extra traffic and danger of children in the area.

The size and style of the sign is strictly regulated, so the sign maker has limited flexibility.

Because of cost, the sign designer puts the burden on the driver. Another choice would have been a “school speed limit only when lights are flashing” sign. But that costs significantly more than the this sign. That shifts the burden to the municipality to pay the additional cost to put up an automated sign. By the way the cost is significant: $50,000.

The complicating factor is that three schools are clustered together. That is unusual and clearly the rules for signs were not designed to deal with that type of complexity.

I assume by the strict rules for school speed zones, they only apply during the drop-off and pick-up time for each school. That leaves a gap in the times. The hours could have been from 6:49 am to 9:07 am and 2:03 pm to 4:29 pm. Presumably, the sign maker thought that choice was unduly strict.

The sign is complex because the underlying rules are complex. (I’m sure you can think of your own policies that are complex because the underlying law is complex.)

Perhaps one of the goals of compliance should be to craft simpler policies out of the complex maelstrom of applicable laws. That will ultimately limit employees from taking actions that would be permitted by the underlying law. The trade off is a policy that’s simpler to understand. After all, if you can’t understand the policy or easily figure out if it applies to you, then compliance with the policy is only a matter of luck.

Thankfully, the sign was removed and replaced by a simpler sign.


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You Scratch My Back, I’ll Scratch Yours

Back scratcher

The Securities and Exchange Commission charged Robert W. Kwok, who was Yahoo’s senior director of business management, and Reema D. Shah who was a former mutual fund manager at a subsidiary of Ameriprise, with insider trading on confidential information about a material business combination partnership between Yahoo and Microsoft Corporation. The SEC alleges that Kwok breached his duty to the company when he told Shah in July 2009 that a deal between Yahoo and Microsoft would be announced soon. The SEC further alleges that a year earlier, the roles were reversed. Shah tipped Kwok with material nonpublic information about an impending acquisition announcement between two other companies. This seems to be a classic case of executives trading inside information for personal gain.

Kwok and Shah pled guilty and acknowledged the facts in the complaint. Not the typical “neither confirm nor deny” settlement of the SEC’s charges. Financial penalties and disgorgement will be determined by the court at a later date. Under the settlements, Shah will be permanently barred from the securities industry and Kwok will be permanently barred from serving as an officer or director of a public company.

In July 2009, Kwok tipped Shah that an internet search engine partnership agreement between Yahoo and Microsoft would be announced soon. Shah was a portfolio manager for multiple mutual funds and hedge funds at RiverSource. Based on the inside information she received from Kwok, Shah caused the funds to purchase approximately 700,000 shares of Yahoo. Two weeks later, she sold the shares for a profit of almost $400,000.

Previously, in April 2008, Shah tipped Kwok material, nonpublic information she had received concerning an upcoming acquisition of Mold flow Corp. by Autodesk, Inc. Based on that inside information, Kwok purchased 1,500 shares of Mold flow in a personal account. After the acquisition was publicly announced on May 1,2008, Kwok sold those shares, realizing profits of $4,754.

It looks Kwok got the better end of the deal financially. Although she ran the benefit through her funds, instead of through a personal account. At least she respected her firm’s policy on personal trading.

Sources:

Image of Man scratching back with a Backscratcher by Archos

The Danger of Overstating Assets Under Management

Form ADV requires a registered investment adviser to state the firm’s assets under management. The new form changed the calculation and the term to “regulated assets under management”. At the same time, the threshold between state and federal registration has been increased from $25 million to $100 million.

I thought it would be useful to look back to 1997 when the regulation of investment advisers was first split at the $25 million level. Warwick Capital Management wanted to stay registered with the SEC and was accused of inflating its assets under management to maintain SEC registration. The main charge was a violation of Section 203A of the Investment Advisers Act. But the firm was also found to have violated section 207 by making an untrue statement of material fact in an SEC filing. Fraudulent intent is not required under Section 207. Even more, violations of Sections 206(1) and 206(2), by falsely representing Warwick’s assets under management and 2003 total performance returns to database services that published the misrepresentations to subscribers in the securities industry. Section 206 prohibits actions would operate as a fraud or deceit on a client.

In 1996 Warwick’s Form ADV listed $5 million of assets under management on a discretionary basis. In 1997 when the registration threshold increased, Warwick inflated assets under management to $26.55 million. That kept the firm under SEC registration and examination, instead of state-level.

Warwick also used inflated numbers in database services that acted as referral sources for Warwick. The amounts differed from those used in Form ADV and even differed from service to service.

Of course, you probably realize the importance of keeping the records that prove performance. Warwick did also. But they were destroyed in a fire, or a smoking chimney, or a flood. When asked by the SEC to make the records available, the firm used those series of excuses. The Administrative judge took the position that records never existed.

It probably comes as no surprise that in addition to inflating assets under management, Warwick inflated performance returns.

Sources:

Inflating the Balloon by Terry Feuerborn

Compliance Bits and Pieces for May 18

These are some compliance-related stories that recently caught my attention.

Compliance officers face multiple options for credentials

Certification and continuing education courses abound for compliance professionals, as the demand for their expertise grows and as they seek new jobs and higher wages. Membership groups and educational programs abound to help professionals increase their skills and understanding of the specific regulations in their industries — or to increase their proficiency at spotting risk and ethics lapses in general — while networking with like-minded peers.

Signed Laws & Rules Around the Corner by William Carleton

One way to remind ourselves how much is at stake in JOBS Act rulemaking – even though the JOBS Act itself has already passed – is to remember what happened to the net worth standard under the accredited investor definition of Regulation D, following the passage of Dodd-Frank.

Top 10 Reasons to Avoid Crowdfunding by Andrew Ledbetter in The Venture Alley

In today’s age of social media success stories, there is something superficially interesting about crowdfunding as a high-level idea. There has certainly been no shortage of attention to crowdfunding in the press and from business people. But in looking at the new JOBS Act exemption for crowdfunding, I see lots of reasons why many companies will avoid it. While this list could be expanded – and will need to be revised as the SEC adopts rules to implement the new exemption – to get things started I offer up these ten reasons: …

Walls of Silence Explained by Howard Sklar

What do you think the reaction of the CCO would be? My first thought about the CCO’s reaction is that it would be, “are you out of your f%&$#ng mind?!” But perhaps that’s not a cultural fit with the company. He might also say, “that’s an interesting perspective.” Which, in one company I know, is the code for “are you out of your f%&$#ng mind?!” One of the first things you have to learn when you go in-house is the company’s (or your boss’) code phrase for “that’s the most boneheaded idea I’ve ever heard!”

At the SEC, Investigations About Investigators Who Investigate Other Investigators by Bruce Carton in Compliance Week

David Kotz, the former SEC Inspector General, departed the agency in January 2012 to rejoin the private sector, and it seemed as if this surge of “investigations of investigations” had ended. It turns out that it has not and, if anything, it seems to be headed for levels of “investigations of investigations” that we have not before reached.

Compliance Balloon by Ront

The Richer Sex: The New Majority of Female Breadwinners

Almost 40% of US working wives now outearn their husbands. Washington Post reporter Liza Mundy argues that “the Big Flip” in gender roles “is just around the corner” in her new book: The Richer Sex. Soon “women, not men, will become the top earners in households” and that will transform the dynamics of male-female relationships.

Mundy sprinkles interviews with women and men throughout the book to highlight her positions and theories.  She sees the emergence of a country (and world) where both sexes are “freer to make purely romantic choices” based on individual preference rather than constrained by long-held stereotypes about who should be the primary breadwinner. For large parts of the US economy, you don’t need physical strength and stamina to put food on the table and a roof over your head.

Mundy speculates that women are better adapting to the knowledge-driven economy of the United States. Middle skill jobs are disappearing. Men lost 75% of the 7 million jobs that disappeared during the Great Recession. Industrial jobs are being outsourced. That means making the educational leap to higher tier jobs. Women receive 57% of bachelor degrees and account for 60% of graduate school enrollment.

Mundy concludes that the bread-winning woman is dramatically changing the face of marriage and quality of marriage. They prefer a marriage of equals, or at least a man with strong career ambition and intellect. That means women would choose being single to being in a bad marriage. With their earning potential, they don’t need a husband for financial support.

Mundy relates the story of a high-powered executive in a lackluster marriage, with a husband that was resentful of his wife’s career. (He didn’t have one.) They fought over getting a dog. He thought the dog would absorb too much of her time and affection. She ended up getting the dog and he got mad. Then she had a brainstorm. Get rid of him and keep the dog. “The dog is very supportive of her achievements.”

This growth of female breadwinners is not just a US phenomenon. It’s happening in South Korea, Japan, Singapore, France, Chile, Ireland, Belgium, Canada, the Philippines, and Norway. As the world economy is starting to rely more on brainpower than musclepower, women are the winning participants in the economy. There is still great inequality. But it’s changing. This book looks ahead to where that may lead as women overtake men as the breadwinners.

I first heard of this book while listening to an interview of Liz Mundy on a podcast of C-SPAN’s Book TV. (Yes, I’m that much of a geek.) The interview was great and prompted me to run down to the library and borrow a copy. I suggest you do the same.

How Wall Street Killed Financial Reform

I’m sure you heard in the news that JP Morgan lost $2 billion in a trades using complex derivatives tied to corporate bond defaults. But didn’t we fix this two years ago when Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act? It seems like JP Morgan’s mistakes should be the first test of Dodd-Frank. The law fails. It’s just lucky that JP Morgan’s trade was stopped before it destroyed the bank.

By coincidence, Matt Taibbi wrote a piece in Rolling Stone about the failings of Dodd-Frank: How Wall Street Killed Financial Reform. I generally find Mr. Taibbi’s take on finance to be a bit over the top, with more hyperbole in a world that lacks the subtle shades of compromise. This article is no different. But he also gets lots of the right points. Dodd-Frank will not result in financial reform.

Taibbi makes five key points.

1. Strangle it in the Womb

Financial reform started off with some great ideas. But they were watered down as the law progressed through the legislative process. For example, Mr. Volker’s simple concept of banning proprietary trading got twisted and poked, allowing broad exemptions. The Consumer Financial Protection Bureau went from being an independent watchdog to an office under the budgetary constraints of the Federal Reserve System.

2. Litigation

The federal regulators will need to contend with courtroom challenges to their regulations, with industry arguing that they go beyond the scope of the legislation or failed to adequately run a cost-benefit analysis of the regulation.

3. If You Can’t Win, Stall

Many sections of the law are experiencing “unforeseen delays.” Taibbi blames Wall Street lobbyists. I blame the law itself. Dodd-Frank deferred much of the implementation to the regulators, meaning they would need to craft new complex regulations and definitions of key terms that are mere sketched out in the law itself. This overloaded the ability of the regulators to produce new regulations. They are tasked with a ten-fold increase in the rule-making agenda. That means the regulators need more staff and the time to get them up to speed. But Congress largely failed to provide the financial support.

4. Bully the Regulators

When Congress is frustrated with a regulator, they just cut funding. Rather than increase the SEC’s budget to allow for the resources to create and implement the new regulations, Republican congressmen tried to cut the Commission’s budget.

5. Pass a Gazillion Loopholes

Congress is moving bills forward to further undercut Dodd-Frank. We saw that with the Rapid passage of the Jumpstart Our Business Startups Act. (I would argue that it undercuts Sarbanes-Oxley, not Dodd-Frank.) As the balance of power in Congress shifts, parts of financial reform become less viable. I think the true test will come a year from now, after the Presidential election. A Romney win and some Republican congressional wins will likely lead to a rapid erosion of Dodd-Frank.

The one point that Taibbi only alludes to is that Congress does not understand the financial markets or the securities laws. I watched some of the Congressional testimony on the JOBS Act. Only a handful of the member of Congress had any idea what was really in the law. Dodd-Frank is even worse. It was a massive law. I would place a wager that no more than 10 members of Congress actually read the whole law before voting on it. Even fewer understood the implications.

 

Social Media and the Financial Risk

This is not meant to be a scare tactic. It’s just pointing out that web publishing tools have made it very easy to be a publisher. That’s great from an information perspective because it’s so much easier to find relevant information.

The problem is that the ease of publishing and finding information has nothing to do with it’s quality, veracity, or appropriateness. What your business publishes, what your employees publish, and what your business’s critics publish all affect your business and can affect its bottom line. (Positively or negatively.)

Infographic sources: