Month: October 2012

Sandy and Disaster Preparedness

Disaster recovery is an important, though not explicitly mandatory, component of compliance program. The Securities and Exchange Commission alludes to this in the release for the compliance rule. It’s also a key part of personal plan. I’m learning that first hand.

My family is spending its third day without power. Fun and exciting at first, it has become troublesome. A shower by candlelight is much less romantic when doing so to get ready for work. Fortunately, it’s warm in Boston so the lack of heat is not a problem.

There are many worse off than me and we escaped unscathed, other than the little wire connecting our house to the world. My hearts go out to those battling much worse damage.

Adoption and the FCPA

The latest Opinion Procedure Release from the Department of Justice comes from a group of non-profit adoption agencies. Based on the stories I’ve heard from friends who have adopted from overseas, I’m not surprised that adoption agencies are concerned about the Foreign Corrupt Practices Act. Opinion Release No. 12-02 is focused on an event hosted by the agencies and not the actual adoption practices. This is the second opinion release focused on adoption agencies.

Nineteen adoption agencies want to host 18 officials involved in the adoption process. The event sounds like a typical business/entertainment gathering:

  • Business class airfare on international portions and coach airfare for domestic portions of flights;
  •  Two or three nights hotel stay at a business-class hotel;
  • Meals; and
  • Transportation.

To minimize the concerns of concerns of corruption, the agencies put a few protections in place:

  1. Entertainment events will be of nominal value
  2. The agencies will not pick the attendees, but leave it up to the government agency.
  3. Souvenirs will have a business logo and be of nominal value.
  4. No stipend or spending money.

This sounds familiar because the Department of Justice dealt with very similar issues last year in Release 11-01. This year’s request sounds like there will be a bit more entertainment involved, but nothing extravagant.

The fact pattern does reflect anything new. I think it’s how most businesses would treat the situation. I suppose that’s helpful. But it also reflects a paranoia about the FCPA. It’s not a violation for merely giving something of value to a foreign official, there needs to be corrupt intent for a violation of the bribery sections of the FCPA. Obviously, a company should be anxious when a government official is involved and there should be heightened scrutiny. There was nothing about this release that has not been covered in other releases.

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Compliance Bricks and Mortar for October 26

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

Enforcement Actions Against Advisors Nearly Doubled: NASAA by Melanie Waddell in AdvisorOne

Enforcement actions taken against investment advisory firms by state securities regulators nearly doubled to 399 in 2011—accounting for 15% of all enforcement actions handled by state securities regulators, according to the North American Securities Administrators Association’s (NASAA) annual enforcement report.

The Flaws of Whistleblower Hotlines and Rewards by Matt Kelly in Compliance Week

So the real headache of the SEC’s whistleblower program isn’t that it will threaten “your industry” and put you out of a job; it’s that SEC whistleblower rewards threaten your focus and distract you from doing your job as you think best. Compliance officers have plenty of risks and misconduct to manage already, and the SEC’s whistleblower program pours accelerant onto that already flammable situation. I recall one compliance executive at a real estate firm who received a complaint about possible misconduct in China. “Within 36 hours, I was on the ground in Beijing and stayed there for a week,” that person told me. “It was a wild goose chase, as far as we could tell. Nothing there.”

The Mummy and Using Challenges to Improve Compliance Cultures by Tom Fox

So the compliance angle here? It’s the difference between two companies in their responses to compliance challenges. Exhibit A is Goldman Sachs and their continuing PR nightmare named Greg Smith. Smith exploded onto the ethics scene with his very public resignation from Goldman Sachs and Op-Ed piece in the New York Times (NYT) in March. The NYT piece castigated Goldman Sachs both internally for their drive towards the all mighty dollar (horror) and their external relationships with their clients, for basically the same reason (horror, horror). This week Smith has made the rounds of several shows including a prominent feature on 60 Minutes to plug his recently released book entitled, “Why I Left Goldman Sachs.”

The SEC’s New Focus on Performance Reporting: What Private Fund Managers Need to Know

During this complimentary webcast, hosts Justin Guthrie and Coley McKinstry will give an industry update, discuss specific case studies where ACA has recently assisted private fund managers, and how managers can reduce their risk when presenting performance.

• Industry Update:

o Presence Examinations
o Investor Led Transparency Push
o Implications of SEC Aberrational Performance Inquiry
o Form PF Performance Reporting Requirements
o Implications of SEC Registration

• Case Studies on Performance Reporting:

o Recordkeeping Requirements
o Hypothetical Track-records
o Investor vs. Fund Level Performance
o Side Pockets
o Model vs. Actual Fees
o Private Equity and Real Estate Considerations
• Overview of a Performance Audit

After their presentation, Justin and Coley will take questions and comments from attendees. To register, click here.

The Long Road Back: Business Roundtable and the Future of SEC Rulemaking by Jill E. Fisch, Institute for Law and Economics, University of Pennsylvania Law School

The Securities and Exchange Commission has suffered a number of recent setbacks in areas ranging from enforcement policy to rulemaking. The DC Circuit’s 2011 Business Roundtable decision is one of the most serious, particularly in light of the heavy rulemaking obligations imposed on the SEC by Dodd-Frank and the JOBS Act. The effectiveness of the SEC in future rulemaking and the ability of its rules to survive legal challenge are currently under scrutiny.

This article critically evaluates the Business Roundtable decision in the context of the applicable statutory and structural constraints on SEC rulemaking. Toward that end, the essay questions the extent to which deficiencies in the SEC’s rulemaking process can accurately be ascribed to inadequate economic analysis, arguing instead that existing constraints impede the SEC’s formulation of regulatory policy, and that this failure was at the heart of Rule 14a-11.

Bad rules make bad law, and Rule 14a-11 was a bad rule. This essay argues that the flaws in SEC rule-making are quite different, however, than those identified by the DC Circuit. Moreover, in the case of Rule 14a-11, Congress played a critical role by explicitly authorizing the SEC to adopt a proxy access rule. By substituting its own policy judgment for that of Congress, the DC Circuit threatens not just the ability of administrative agencies to formulate regulatory policy, but the ability of Congress to direct agency policymaking.

Unauthorized Board Meeting

For its latest mission, Improve Everywhere staged an unauthorized boardroom meeting in the office chair department of a Staples. The chairs in this particular office supply store were already arranged in a boardroom configuration, making it easy for us to hold a surprise meeting. Actor Will Hines gave a presentation to the board, using a whiteboard and an easel he had bought from the store just minutes prior. Minutes into the meeting, the board was asked to leave by a confused store manager.

Filing Private Fund Private Placement Memoranda with FINRA

Starting on December 3, 2012, FINRA members must file a copy of any private placement memorandum, term sheet or other offering document the firm used within 15 calendar days of the date of the sale. Placement agents for private funds will likely be FINRA members and subject to this rule.

FINRA Rule 5123 is part of FINRA’s approach to increase oversight and investor protection in private placements. FINRA established standards on disclosure, use of proceeds and a filing requirement for private placements issued by a member firm or a control entity in Rule 5122. FINRA also has previously provided guidance on the scope of a firm’s responsibility to conduct a reasonable investigation of private placement issuers in Regulatory Notice 10-22.

However, the rule has some big exemptions. The following private placements are exempt from the requirements of this Rule:

(1) offerings sold by the member or person associated with the member solely
to any one or more of the following:

(A) institutional accounts, as defined in Rule 4512(c);
(B) qualified purchasers, as defined in Section 2(a)(51)(A) of the Investment Company Act;
(C) qualified institutional buyers, as defined in Securities Act Rule 144A;
(D) investment companies, as defined in Section 3 of the Investment Company Act;
(E) an entity composed exclusively of qualified institutional buyers, as defined in Securities Act Rule 144A;
(F) banks, as defined in Section 3(a)(2) of the Securities Act;
(G) employees and affiliates, as defined in Rule 5121, of the issuer;
(H) knowledgeable employees as defined in Investment Company Act Rule 3c-5;
(I) eligible contract participants, as defined in Section 3(a)(65) of the Exchange Act; and
(J) accredited investors described in Securities Act Rule 501(a)(1), (2), (3) or (7).

That list is likely going to mean that private fund offering will not be subject to the rule as long as they exclude non-accredited investors from the offering. Or at least exclude the placement agent from soliciting non-accredited investors. Given the likely lifting of the ban on general solicitation for private funds that exclude non-accredited investors this rule is likely to further limit the access of non-accredited investors to private funds.

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Compliance Bits and Pieces for October 19

These are some of the compliance-related stories that recently caught my attention:

Frankenstein, Lance Armstrong and FCPA/Bribery Act Compliance by Tom Fox

So how does Frankenstein relate to compliance and ethics? Exhibit A for today is my fellow Texan Lance Armstrong. Yesterday, in the FCPA Blog I wrote about Armstrong and ethical values in the context of engaging in conduct which is so unethical, that you would be embarrassed to tell your children about it. Today I want to focus on some other aspects of Armstrong. Should he be analogized to Dr. Frankenstein, the Monster, or perhaps both?

Schapiro SEC Reign Nears End With Rescue Mission Not Done by Joshua Gallu and Robert Schmidt in Bloomberg

It’s not surprising that Schapiro’s frustrations boiled over that August evening. She has told friends that the late nights and almost constant policy battles have left her exhausted and eager to depart after the November election. Admirers and critics agree Schapiro rescued the agency from the threat of extinction when she was appointed by President Barack Obama four years ago. Still, she hasn’t fulfilled her mission — to overcome the SEC’s image as a failed watchdog by punishing those who steered the financial system toward disaster and by proving regulators can head off future breakdowns.

SEC Examinations of Investment Advisers – Highlights of IAA 2012 Boston Compliance Workshop in Compliance Avenue

At an Investment Adviser Association (IAA) 2012 Compliance Workshop in Boston yesterday, IAA legal staff, law firm attorneys and Securities Exchange Commission (SEC) staff, including a regional representative from the SEC’s Office of Compliance Inspections and Examinations, discussed current developments in SEC exams, including current inspection priorities and issues for advisers to consider. As noted by each speaker from the SEC, their statements are their own views and not necessarily those of the SEC.

This post provides highlights of the discussions about 2012 SEC examinations, the new SEC “presence” examinations for newly-registered investment advisers and the anticipated focus of SEC investment adviser examinations in 2013.

Caution Advised for Newly Registered Advisers a client alert from Pepper Hamilton LLP

In addition, the SEC examination staff has indicated that meeting with the firm’s “leadership” during an examination is likely to be of special importance. The SEC examination staff views effective risk governance as including the following three essential lines of defense, which are in turn supported by senior management and the board of directors or the principal owners of the firm:

(1) The business is the first line of defense responsible for taking, managing and supervising risk effectively and in accordance with laws, regulations and the risk appetite set by the board and senior management of the whole organization.

(2) Key support functions, such as compliance and ethics or risk management, are the second line of defense. They need to have adequate resources, independence, standing and authority to implement effective programs and objectively monitor and escalate risk issues.

(3) Internal audit is the third line of defense and is responsible for providing independent verification and assurance that controls are in place and operating effectively.

FDIC Insurance End May Spark Money-Market Turbulence, Pimco Says by Liz Capo McCormick in Bloomberg

A potential flood of cash into the U.S. money markets if unlimited Federal Deposit Insurance Corp. coverage is allowed to lapse in December is creating investor concern and may lower short-term interest rates, according Pacific Investment Management Co. An emergency 2008 government provision providing unlimited insurance on certain bank accounts during the U.S. financial crisis to help prevent sudden withdrawals will expire at the end of the year unless Congress extends it. There is about $1.4 trillion sitting in banks’ non-interest-bearing transactions accounts holding more than $250,000, the previous insurance ceiling, which would become uninsured in January if Congress doesn’t act, FDIC data show.

Aberrational Performance Inquiry of Nabs Another Private Fund Manager

The SEC has once again claimed that its Aberrational Performance Inquiry has identified another miscreant. Once again, I’m skeptical that the SEC is actually using “proprietary risk analytics” to identify hedge funds with suspicious returns.

The SEC alleges that Yorkville Advisors overstated the value of the assets in its funds to improve marketability and increase fees. According to the SEC complaint, the failure was two-pronged: one of misstatements and a second failure to follow the funds’ own policies and procedures on valuation. Yorkville denies the charges. Yorkville claims to have maintained “robust control procedures” to ensure that assets were valued properly, including having two former SEC enforcement lawyers as members of Yorkville’s valuation committee.

The lesson from the complaint is to follow your own policies and procedures when it comes to valuation and don’t hide information from your auditors.

According to the SEC press release, this is the seventh case arising from the “SEC’s Aberrational Performance Inquiry, an initiative by the Enforcement Division’s Asset Management Unit that uses proprietary risk analytics to identify hedge funds with suspicious returns.” I have seen four other cases, but I’m not sure I can identify the other two cases.

Robert Khuzami, the Director of the Division of Enforcement for the SEC revealed an investigative initiative concerning hedge funds during Congressional testimony in March, 2011.  The Aberrational Performance Inquiry program is now focusing on hedge funds that outperform “market indexes by 3% and [are] doing it on a steady basis.”  Khuzami referred to such performance as “aberrational,” and stated that Enforcement is “canvassing all hedge funds” for such “aberrational performance.

Yorkville disclosed that the SEC started looking at it in August, 2009. That’s almost two years before the Aberrational Performance Inquiry program was announced and only six months after Khuzami joined the SEC. That timing leaves me skeptical that the Aberrational Performance Inquiry program discovered the issues with Yorkville. In addition, Yorkville made investments in equities and debt so there is not a good index to benchmark the funds’ performance to determine if it is “aberrational.”

I have no doubt that the SEC is looking closer at the performance of private funds to see if the performance numbers make sense given the markets and a fund’s investment strategy. That is a direct result of the aberrations in Madoff’s performance.  And I have no doubt that there is group in the SEC looking at performance and worked on the Yorkville case.

And I have no doubt that the SEC is taking a closer at private equity funds and hedge funds. At a minimum, the SEC has a window into these fund now that fund managers have registered with the SEC.

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A CFTC Exemption for Private Equity Funds

The CFTC is going to dramatically expand its realm through the one-two punch of gaining regulatory control over non-securities derivatives and the removal of a widely used exemption. (With the release of REITs from the definition of “commodity pool” perhaps the CFTC is loosening its grip.) Fortunately, there is another exemption that most private equity funds will be able to utilize. But it requires some math.

CFTC Regulation 4.13(a)(3) contains a “De Minimis Exemption.” To take advantage of the exemption a fund must satisfy these requirements:

  1.  The Funds is exempt from registration under the Securities Act of 1933 and offered without marketing to the public in the U.S.
  2.  The CPO has a reasonable belief that investors are “accredited investors”, “knowledgeable employees” or “qualified eligible persons”.
  3. The fund discloses to each prospective investor in the Commodity Pool that the CPO is exempt from registration under the De Minimis Exemption and therefore, unlike a registered CPO, is not required to deliver a disclosure document or a certified annual report to investors.
  4. File an initial notice of claim with the National Futures Association, and renew on an annual basis.
  5. One of two trading tests must be met:
  • 5% cost: the aggregate initial margin, premiums, and required minimum security deposit for retail forex transactions required to establish commodity interest positions (including securities futures positions), determined at the time the most recent position was established, will not exceed 5 percent of the liquidation value of the pool’s portfolio, after taking into account unrealized profits and unrealized losses on any such positions it has entered into; or
  • 100% value: the aggregate net notional value of such positions, determined at the time the most recent position was established, does not exceed 100 percent of the liquidation value of the pool’s portfolio, after taking into account unrealized profits and unrealized losses on any such positions it has entered into.

What’s not clear to me is how portfolio companies and subsidiaries fit into the tests. I assume you would treat a wholly-owned subsidiary as you would treat fund -level activity. At some point the fund’s ownership in an entity should remove it from being part of the fund level calculation. I just have not dived deep enough into the CFTC world to figure out where that threshold is.

For private equity funds and real estate funds, the 100% test may be close depending on the type of leverage used and the risk mitigation used. However, the 5% cost should be easy. Interest rate swaps and foreign exchange hedge are usually very cheap, less than 5% of the nominal value of the hedge.

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REITs and the CFTC

Dodd-Frank’s Title VII is likely to sweep a bunch of private equity fund operators under the CFTC’s registration requirement. The CFTC stated that a single interest rate swap or foreign exchange hedge could drag the fund manager into the definition of “Commodity Pool Operator” (7 USC §1a(10) and have to register with the CFTC. The National Association of Real Estate Investment Trusts was also concerned the equity REITs that use interest rate hedges could be considered a commodity pool.

The CFTC released an interpretative letter releasing REITs from the grasps of the CFTC. The CFTC agrees with the NAREIT position that REITs are operating companies and are therefore not commodity pools.

But will this interpretative letter help real estate private equity funds? Most real estate private equity funds have a REIT somewhere in their structure, so the letter offers some benefit.

The CFTC notes that equity REITs are, in part, operating companies because they engage in substantial management and operational function. (Check for real estate funds.)

Equity REITs use derivatives is limited to supporting its primary focus on real estate ownership and operation. (Check for real estate funds.)

The CFTC list three criteria for this relief:

  • The REIT primarily derives its income from the ownership and management of real estate and uses derivatives for the limited purpose of “mitigat[ing] their exposure to changes in interest rates or fluctuations in currency”;
  • The REIT is operated so as to comply with all of the requirements of a REIT election under the Internal Revenue Code, including 26 U.S.C. §856(c)(2) (the 75 percent test) and 26 U.S.C. §856(c)(3) (the 95 percent test); and
  • The REIT has identified itself as an equity REIT in Item G of its last U.S. income tax return on Form 1120-REIT and continues to qualify as such, or, if the REIT has not yet filed its first tax filing with the Internal Revenue Service, the REIT has stated its intention to do so to its participants and effectuates its stated intention.

I’m not yet sure if this gets a real estate fund all the way out of CFTC registration. I think there will be more to come.

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First the SEC, Now the CFTC

The Dodd-Frank Wall Street Reform and Consumer Protection Act is getting ready to land its second regulatory punch to private equity funds. The first was the registration requirement with the Securities and Exchange Commission. The second is the upcoming registration requirement with the Commodities Futures Trading Commission.

Two recent developments pull fund managers into the CFTC’s world. The first is the inclusion of interest rate and foreign exchange swap transactions into the regulatory oversight of the CFTC. That’s part of the Dodd-Frank regulation of derivatives. The second is the repeal of a popular exemption from registration. That exemption was available for funds that were limited to investors that were accredited investors and qualified eligible persons. That exemption will cease to be available after December 31, 2012.

Title VII (the “Derivatives Act”) of Dodd-Frank creates a new framework for regulating derivatives. Securities derivatives get SEC oversight, but non-securities derivatives get CFTC oversight.

Under the Commodity Exchange Act, as amended by the Derivatives Act, swaps are now considered “commodity interests” and need to be considered when determining whether an entity is a “commodity pool” and whether the operator or adviser to the entity is a Commodity Pool Operator or Commodity Trading Advisor.

  • A “Commodity Pool” is “any investment trust, syndicate, or similar form of enterprise operated for the purpose of trading in commodity interests, including any… commodity for future delivery, security futures product, or swap. . .””
  • A “Commodity Pool Operator” (a “CPO”) is any person “engaged in a business that is of the nature of a commodity pool…and who, in connection therewith, solicits, accepts or receives from others, funds, securities or property. . .for the purpose of trading in commodity interests, including any… commodity for future delivery, security futures product or swap. . .”
  • A “Commodity Trading Advisor” (a “CTA”) is any person “who, for compensation or profit, engages in the business of advising others. . . as to the value of or advisability of trading in… any contract of sale of a commodity for future delivery, security futures product, or swap . . .””

I don’t think most private equity funds would consider themselves to be “trading” in commodity interests. However, the CFTC release indicates that entering into a single commodity interest transaction would be sufficient to cause a fund to be a Commodity Pool. So, a fund that enters into a single interest rate hedge could be treated as a Commodity Pool and the adviser of the fund would have to register as a CPO or CTA, or establish an available exemption.

I would guess that the CFTC will have a few thousand new registrants by the end of the year. Fortunately, there is another exemption that should allow many funds to avoid the full regulatory oversight of the CFTC. More on that later.

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