Compliance Bricks and Mortar for June 28

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

Performance Fantasies Lead to SEC Enforcement Action by Jay B. Gould in Pillsbury’s Investment Fund Law Blog

For fund managers and investment advisers, there are a number of takeaways from the D’Amato case. First, when back tested or hypothetical “performance” is used in marketing materials, full and accurate disclosure must be made to investors and potential investors. The methodology used must be sound and records must be kept. Similarly, with respect to actual performance, calculations must be accurate and verifiable and must be presented in a context that does not make otherwise accurate information misleading in any material way. Fund managers, in particular, should not dismiss the D’Amato case because it occurred in the context of mutual funds and more “retail” type investors. The SEC and state regulators are willing to go back and look at past marketing presentations for inflated or inaccurate claims, all of which are required to kept as part of an adviser’s books and records.

Some Thoughts on What Makes a Good CCO by Tom Fox

There are several prominent commentators who frequently discuss the role a Chief Compliance Officer (CCO). One such commentator is Donna Boehme, who regularly writes articles, speaks about, and even tweets on this subject. But what type of mindset does a CCO need to be successful? What are some of the skills? I thought about those questions when I read three very different articles on unrelated topics recently.

Paul Weiss discusses ISDA’s March 2013 Dodd-Frank Protocol by Manuel Frey in The CLS Blue Sky Blog

Since the effectiveness of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”), the Commodity Futures Trading Commission (the “CFTC”) has finalized many of the rules that implement the detailed regulatory regime outlined by the Dodd-Frank Act. A number of these rules require market participants to update their swap trading documentation to comply with this new regulatory regime. This client alert outlines coverage and adherence mechanisms of the ISDA March 2013 Dodd-Frank Protocol (the “March Protocol”), the newest installment of ISDA’s well-tested mechanism aimed at facilitating the multilateral and standardized amendment of swap trading documentation.

Why Do Family Firms Thrive? by Chris MacDonald in the Business Ethics Blog

The family in question may have not just a strong position in terms of the stock it holds; they may also bear the name that’s emblazoned on the company letterhead. And the company’s origins and evolution may be intimately bound up with the family’s own history. This adds up to considerable influence. Is that influence a good or a bad thing? In principle, at least, there’s a worry that the family’s influence might not always work in the interests of other shareholders. And this worry is exacerbated by the fact that family-controlled companies often don’t stick to widely-acknowledged best practices in terms of corporate governance.

Crisis Chronicles: 300 Years of Financial Crises (1620–1920) by James Narron and David Skeie in Liberty Street Economics

The Kipper und Wipperzeit is the common name for the economic crisis caused by the rapid debasement of subsidiary, or small-denomination, coin by Holy Roman Empire states in their efforts to finance the Thirty Years’ War (1618–48). In a 1991 article, Charles Kindleberger—author of the earlier work Manias, Panics and Crashes and originally a Fed economist—offered a fascinating account of the causes and consequences of the 1619–23 crisis. Kipper refers to coin clipping and Wipperzeit refers to a see-saw (an allusion to the counterbalance scales used to weigh species coin). Despite the clever name, two forms of debasement actually fueled the crisis.

 

Brick Wall by Aaron Smith

DOMA, the SEC, and the Accredited Investor

us supreme court and compliance

The US Supreme Court ruled on same sex marriages and removed the broad federal definition of marriage that applies to over a thousand laws and regulations. Decision in US v. Windsor (.pdf) One of those regulations is from the Securities and Exchange Commission and affects fundraising for private funds and other private placements.

One of the standards for private placements of securities is that an investor generally needs to meet the definition of “accredited investor.” For an individual that means a (1) net worth, excluding the primary residence, of $1 million, or (2) annual income in excess of $200,000 in each of the two most recent years or joint income with a spouse in excess of $300,000.

Section 3 of the Defense of Marriage Act mandated that the word “spouse” refer only to a person of the opposite sex who is a husband or a wife.” 1 U.S.C. § 7 (1997)

Less than 10 years ago, the Massachusetts Supreme Judicial Court went through a laundry list of legal rights that couples enjoy once they are married. In the landmark Goodridge decision, that court decided that “spouse” should not be limited to a man and a woman. It affects a broad spectrum of rights granted by the government to people who are married.

The US Supreme Court decided that Section 3 of the Defense of Marriage Act is unconstitutional. Therefore, the accredited investor definition’s use of the word “spouse” is no longer restricted by DOMA to a person of the opposite sex who is a husband or a wife.

In the states that allow same-sex marriage, an issuer should now be able to allow a same-sex married couple to combine their income to meet the standard. I don’t think the SEC needs to take any action for this to happen.

In states that allow civil unions, the answer is a bit murkier and depends on the rights granted under state law. The civil union law would need to deem the two participants to be “spouses.” That is exactly what Illinois did in its civil union law:

“Party to a civil union” means a person who has established a civil union pursuant to this Act. “Party to a civil union” means, and shall be included in, any definition or use of the terms “spouse”, “family”, “immediate family”, “dependent”, “next of kin”, and other terms that denote the spousal relationship, as those terms are used throughout the law. SB1716

What is even murkier is a married couple who move to a state that does not recognize same sex marriage. Are they still “spouses” if not recognized by their state of residence? Justice Scalia raises this issue in his dissent.

Whether you agreed with DOMA or not, it made a very bright line test for “spouse”. That line is now more complicated for determining if a potential investor is an “accredited investor.”

This may become even more complicated when the SEC finally issues the regulation that lifts the ban on general solicitation and advertising. The new regulation will require a firm to take reasonable steps to determine that an investor is accredited if it wants to engage in general advertisement or solicitation. It will be interesting to see if the SEC includes something on this issue.

Given the SEC’s huge rulemaking backlog, I doubt they will make a separate statement on same-sex marriages under securities law. The SEC could tuck something into the advertising rule since it is already in the works. Perhaps the SEC was waiting for the Windsor case to be decided.

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Image of the US Supreme Court by OZinOH

LRN’s 2013 Ethics & Compliance Leadership Survey Report

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LRN’s has published its 2013 Ethics & Compliance Leadership Survey Report. This sixth annual Ethics & Compliance Leadership Survey Report provides guidance and specific recommendations on critical risks and challenges. The report is based on a survey of more than 180 ethics and compliance leaders from across industries and geographies.

This year’s report has a new metric: the Program Effectiveness Index (PEI). The US Sentencing Guidelines, the UK Bribery Act, regulators, and law enforcement all talk about having an effective compliance program. LRN looks at three major roles to address the Program Effectiveness Index:

  1. a network of corporate controls
  2. facilitator of business operations in regulated contexts
  3. promotion of ethical conduct and culture

At first I was startled to see the Program Effectiveness Index measured on a scale from 0-1. I forgot about decimal points for a moment. In its survey, LRN reports an average PEI score of  0.71, with the scores distributed across a typical bell curve. The highest score was a 0.98 and the lowest was a 0.23.

The report highlights five attributes that distinguish the most effective ethics and compliance programs from the least:

  1. Celebration of acts of ethical leadership
  2. Adapting program to changing business needs
  3. Focus on employees as a key element of risk assessment
  4. Access to and support of senior management
  5. Management’s use of risk data in decision-making

The survey respondents consisted of 11% financial services and 10% insurance, with the rest covering a broad spectrum of industries. The report does not dovetail neatly with the needs of a private fund manager.  Of course it is always useful to see what others are doing with their programs, not just your peers.

Small Business Capital Access and Job Preservation Act

Capitol Hill

Congress, or at least the the House Financial Services Committee, is proposing some relief for private equity funds. The Committee approved the Small Business Capital Access and Job Preservation Act, along with three other pieces of legislation.

The bill would exempt private equity fund managers from the registration and reporting requirements of the Investment Adviser Act. The big hurdle in the bill for the exemption is that the fund has not borrowed a principal amount in excess of twice its invested capital commitments.

That’s a terrible standard. In the early days of a fund, it may draw down on its subscription line of credit for fees and expenses before it invests its first dollar in a transaction. That means the fund will have borrowed more than twice its “invested” capital. Many private equity funds would not be able to pass this test. Dropping the word “invested” would make the exemption useful.

The other big hurdle missing in the bill is the definition of private equity. The bill leaves it up to the Securities and Exchange Commission to define a private equity fund for purposes of the bill. The bill gives the SEC 6 months to craft the definition.

The bill is notable, but I suspect it has little chance of becoming law.


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Compliance Bricks and Mortar for June 21

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

SEC Buys Itself a Headache by David Smyth in Cady Bar the Door

If you’re reading this, you’re surely aware of the several-years-old-now fight between the SEC and some federal judges regarding the SEC’s policy of settling cases while allowing defendants to neither admit nor deny the claims against them.  Very briefly, the SEC contends that its policy allows it to settle cases against companies that would otherwise take on vast liability in follow-on private litigation if it were forced to admit bad conduct that hurt shareholders.  Otherwise, the SEC says, the litigation burden would be almost overwhelming.

Recent FCPA Enforcement Actions Show Increased Scrutiny on Financial Services Sector (.pdf) by Ruti Smithline and Jarod G. Taylor of Morrison & Foerster

Last week, the U.S. Department of Justice (DOJ) announced the indictment of a managing partner of U.S. broker-dealer Direct Access Partners (DAP) for violations of the Foreign Corrupt Practices Act (FCPA), the Travel Act, and money laundering statutes. This indictment follows on the heels of last month’s indictment of two other DAP employees for the same alleged conduct, as well as the foreign official who received the bribes at issue.

The investigation into DAP was prompted by information discovered during a routine, periodic examination by the U.S. Securities and Exchange Commission’s (SEC’s) New York office broker-dealer examination staff. The discovery of the alleged conduct without the involvement of any whistleblower, self-reporting, or regulator tasked directly with FCPA enforcement should serve as a wake-up call for the need for anticorruption compliance by regulated companies.

Justice Department Fought to Conceal NSA’s Role in Terror Case From Defense Lawyers by Keven Poulsen in Wired.com’s Threat Level

When a senior FBI official told Congress the role the NSA’s secret surveillance apparatus played in a San Diego terror financing case today, nobody was more surprised to hear it than the defense attorney who fought a long and futile court battle to get exactly the same information while defending the case in court.

If You Pay More, Do You Actually Get More? by Keith Paul Bishop in California Corporate & Securities Law

The typical private fund is organized as a limited partnership or limited liability company that is managed by a general partner or manager.  The fund manager is usually compensated in three ways – an annual management fee (often 2%), a carried interest (often 20%), and an investment in the fund (often 1%).  In a recently presented paper, Professors David T. Robinson and Berk A. Sensoy tackled the question of whether private fund managers actually earn their keep.

Given the limited rights of limited partners and members and asymmetrical access to information, one might expect that these professors would conclude that fund managers who charge more, actually under perform.  Based on an analysis of 837 buyout and venture capital private equity funds from 1984-2010 to, the two scholars reach the opposite conclusion:

 

Curvy bricks by Orange Steeler
CC BY

Trouble on Top of Trouble

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MayfieldGentry Realty Advisors mastered the one-two by disclosing to a client that the firm stole their funds on the evening before they were brought up on charges for a pay-to-play violation.

In May, 2012, the Securities and Exchange Commission charged former Detroit mayor Kwame M. Kilpatrick, former city treasurer Jeffrey W. Beasley, and MayfieldGentry in a secret exchange of gifts to peddle influence over the city funds’ investment process. The SEC alleges that Kilpatrick and Beasley, who were trustees to the pension funds, received $125,000 worth of private jet travel and other perks paid for by MayfieldGentry. That would currently be a violation of SEC Rule 206(4)-5.

As long as the firm was going down, MayfieldGentry decided to also disclose that the firm had stolen $3.1 million. The SEC brought new charges against the firm for that theft.

In reading the complaint, assuming the facts are true, it looks like MayfieldGentry was as best sloppy and lazy. The firm had an agreement to buy two shopping centers for $7.4 million and obtained a bank loan for $4.3 million of the price. That left the firm needing $3.1 million of equity, but only had $200,000 of cash. The easy answer was to have its client, the Police and Fire Retirement System of the City of Detroit, fund the equity.

The problem is that MayfieldGentry didn’t bother to get approval from the pension fund. Even worse, it purchased the property in a subsidiary wholly-owned by MayfieldGentry. The firm didn’t transfer ownership of the subsidiary to the pension fund.

Apparently, the plan was to have another investor purchase the property and transfer the cash back to the pension fund’s account. Bad timing trapped the firm. The acquisition happened in March 2008. Then the financial markets imploded and the value of the shopping centers collapsed.

Since the case involved real estate, perhaps the SEC lacks jurisdiction? No, MayfieldGentry was registered with the SEC as an investment adviser.

Maybe the case was an instance of an adviser making a mistake, then failing to remedy the problem. Would the pension fund have agreed to investment? We don’t know. I assume the answer was “no”, otherwise the firm would have transferred the properties to the pension fund.

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Same Sex Marriage and Accredited Investors

Compliance, the SEC and the Supreme Court

The US Supreme Court is likely to come out shortly with its ruling on same sex marriages. The ruling may have an impact on fundraising for private funds and other private placements.

One of the standards for private placements of securities is that the investors generally need to meet the definition of “accredited investors.” For individuals that means a (1) net worth, excluding the primary residence, of $1 million, or (2) annual income in excess of $200,000 in each of the two most recent years or joint income with a spouse in excess of $300,000.

That word “spouse” is the one being addressed by the Supreme Court.  Section 3 of the Defense of Marriage Act (DOMA) states that in determining the meaning of “any ruling, regulation, or interpretation of the various administrative bureaus and agencies of the United States,…the word ‘spouse’ refers only to a person of the opposite sex who is a husband or a wife.” (1 U.S.C. § 7 (1997)

William Carleton picked up on the wrinkle in Rule 506 that same-sex marriages were not treated equally for purposes of the accredited investor standard.

Here in my home state of Massachusetts, “spouse” is not limited to a man and a woman. In the landmark Goodridge decision that made same-sex marriage legal, the Massachusetts Supreme Judicial Court went through a laundry list of legal rights that couples enjoy once they are married. Those were rights not available not available to same-sex couples.

You can add the accredited investor standard to that big pile of legal rights.

The accredited investor concept was included in Regulation D “based on the presumption that accredited investors can fend for themselves without the protections afforded by registration.” I’m not sure how gender plays a role in determining the financial ability of a couple. But currently it does.

What happens if the Supreme Court strikes down the DOMA restriction? I assume the SEC will not do anything and let the term “spouse” sit in the definition. They have enough political landmines to deal with, I don’t see the SEC jumping out with a rulemaking embrace of same-sex marriage when it still has not yet removed the ban on general advertising or issued rules on crowdfunding.

That will leave it up to the issuers, the fund managers, the start-up companies, and their lawyers to wrestle with the definition of “spouse.” I expect a few intrepid offerings will get an extra investor or two. I expect many conservative issuers will wait for more guidance from the SEC.

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Regulation of Investment Advisers

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The Securities and Exchange Commission recently published a compendium describing the regulation of investment advisers: Regulation of Investment Advisers. It’s not light reading, but the 59-pages provide a helpful overview of investment adviser regulation.

It comes from the Staff of the Investment Adviser Regulation Office in the Division of Investment Management. So it carries a bit different take than the Office of Compliance and Inspections, whose examiners will show up your doorstep. OCIE focuses a bit more on the nuts and bolts, while this compendium is more like the architectural drawings for compliance.

One interesting aspect of the compendium is the document file: rplaze-042012.pdf

I assume that it means it was one of the last actions of long-time SEC staffer Robert Plaze. Mr. Plaze retired as the Deputy Director of the Division of Investment Management at the end of August, 2012. It looks like he did not quite hang up his white hat and worked on this compendium. I’m glad he did.

Compliance Bricks and Mortar for June 14

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

Investor Alert—Don’t Trade on Pump-And-Dump Stock Emails

FINRA and the SEC’s Office of Investor Education and Advocacy are issuing this Investor Alert to warn investors to be on the lookout for email spam promoting “pump-and-dump” stock scams.

SEC Compliance Program Annual Reviews: A Guide for Newly Registered Advisers by Nathan J. Greene, Jesse P. Kanach of Shearman & Sterling

Many newly registered investment advisers will need to complete their first annual compliance review this year. This article describes SEC requirements regarding annual reviews of compliance programs and, in particular, covers who should conduct the review, planning and documenting the review, reporting review findings and responding to problematic conduct identified by the review.

SEC’s Cohen Predicts Major Whistleblower Awards Soon in Corporate Crime Reporter

In its three years of existence, the Securities and Exchange Commission’s (SEC) whistleblower program has produced only one $50,000 payout. But within the next couple of months, it will produce “incredibly impactful cases” with “some extremely significant whistleblower awards.” That’s the take of Stephen Cohen, Associate Director of the SEC’s Division of Enforcement.

If DOMA is overturned, will the discrimination in the accredited investor definition go away? by William Carleton

To address the problem of the insidious discrimination in the accredited investor definition, either the term “spouse” will need to be removed, or a constructive definition arrived at.

I’m not sure which solution is better.

I am sure, however, that there will be broad consensus in the angel investing community that the sexual orientation discrimination in the SEC rule is repugnant.

To learn more about this issue, go to http:\\startupequality.com.

The Leaky Merger and Insider Trading

chattem

On December 21, 2009, Sanofi-Aventis, a French pharmaceutical company, announced a tender offer for Chattem, a Tennessee-based distributor of over-the-counter pharmaceutical products, at the price of $93.50 per share. Shares of Chattem closed 32.60% higher than the prior trading day’s close of $69.98 and volume increased more than 3,000% to 10.3 million shares. This may be one of the leakiest M&A transactions. So far the SEC has brought 8 insider trading cases that came from this transaction. The latest case is against Andrew W. Jacobs and his brother Leslie J. Jacobs II.

Andrew met with his brother-in-law who was the vice-president of marketing for Chattem. The brother-in-law leaked the news that Chattem was going to be acquired in the near future. He was apparently looking for career advice since the transaction was likely to affect his employment. Andrew had been through a similar experience when his company was acquired by a European company.

Even though the brother-in-law required Andrew to keep the conversation confidential, the SEC alleges that Andrew leaked the information to Leslie. He saw the opportunity and purchased 2,000 shares of Chattem and made a tidy profit of almost $50,000.

That’s not going to cover his legal bills.

The SEC charged Leslie with insider trading and Andrew for tipping the material non-public information. The brother to brother connection is a lot easier to prove than the Facebook friends sources of inside information the SEC used in the Badin Rungruangnavarat insider trading case.

Chattem was a leaky company when it came to information about the transaction.

Most of the insider trading cases are sourced to one conversation. A Chattem board member told his accountant, Thomas D. Melvin about the transaction. Melvin tipped a bunch of friends who traded on Chattem stock. Melvin, his friends, neighbors and brokers have all been charged with insider trading.

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