Month: August 2013

The Dog Days of Summer and Compliance

Dog Days of Summer and Compliance

The phrase “dog days” refers to the sultry days of summer, the months of July and August in the Norther Hemisphere. The Romans referred to the dog days as diēs caniculārēs. The Dog Days were the days when the star Sirius rose just before or at the same time as sunrise. They considered Sirius to be the “Dog Star” because it is the brightest star in the constellation Canis Major (Large Dog).

Like many things Roman, the term “Dog Days” was adopted from its earlier use by the Greeks. It may even be traced back to the ancient Egyptian astronomer-priests who noted that Sirius rose with the Sun just prior to the annual flooding of the Nile.

The lazy days of summer can be great days to sit back and relax with a cold glass of iced teas to cool you down. With fewer people in the office, you may have some free time to catch up on lagging projects. or you may have some free time to spend out of the office.

For me it’s a bit of both. But currently, I’m looking forward to some vacation days coming up. That means things will likely be quiet on Compliance Building until September.

How Good Is Your Business Continuity Plan?

compliance and hurricane sandy

The Securities and Exchange Commission wants it to be better.

In the aftermath of Hurricane Sandy, the Securities and Exchange Commission joined the Commodity Futures Trading Commission and the Financial Industry Regulatory Authority in issuing a joint staff advisory on business continuity and disaster recovery planning.

The advisory follows a review by the regulators after Hurricane Sandy closed U.S. equity and options markets for two days in October 2012. Many firms had a hard time dealing with such a widespread area of severe impact.

When considering alternative locations (i.e., back-up data centers, back-up sites for operations, remote locations, etc.) firms should consider the implications of a region wide disruption. Firms are encouraged to consider geographic diversity when determining the physical location of alternative sites. An alternative site, particularly a system back-up location, in close proximity to the primary site may not sufficiently protect the firm from the effects of a region wide event. Firms should consider whether their primary site and alternative sites rely on the same critical utility services, such as electricity, transportation and telecommunications.

That is a somewhat achievable goal for big firms, but not one for smaller firms.

The alert ignores that reality of the physical location of people, their homes, and their families. It would be great to have a fully redundant backup site located a thousand miles away from the main location. But you’re not going to be able to quickly get people there in the event of such a widespread event.

Not only are businesses affected by a disaster, but so are homes. Many (most?) employees are not going to abandon their families, stuck with limited access to power, food, and other needs.

Of course, firms need a solid business continuity and disaster recovery plan. It should be tested and evaluated regularly. A firm needs to plan for small disruptions and big disruptions. Small disruptions are more likely and need to be well addressed.

It’s much harder to have a bullet-proof plan for an event like Sandy that disrupts power to huge parts of the urban center, knocks out power to a huge swath of residential areas, floods office buildings, floods thousands of homes, disrupts transportation, and does so over hundreds of miles.

References:

Compliance Bricks and Mortar for August 16

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

SEC Charges Two J.P. Morgan Traders With Fraudulently Overvaluing Investments to Conceal Losses

The SEC alleges that Javier Martin-Artajo and Julien Grout were required to mark the portfolio’s investments at fair value in accordance with U.S. generally accepted accounting principles and JPMorgan’s internal accounting policy. But when the portfolio began experiencing mounting losses in early 2012, Martin-Artajo and Grout schemed to deliberately mismark hundreds of positions by maximizing their value instead of marking them at the mid-market prices that would reveal the losses. Their mismarking scheme caused JPMorgan’s reported first quarter income before income tax expense to be overstated by $660 million.


BREAKING: Serious Fraud Office lays its first Bribery Act charges.

“Four men connected to Sustainable AgroEnergy plc have today been charged with offences of conspiracy to commit fraud by false representation and conspiracy to furnish false information, contrary to section 1 of the Criminal Law Act 1977, in connection with the investigation by the Serious Fraud Office into the promotion and selling of “bio fuel” investment products to UK investors.

SEC’s Andrew Ceresney to Join Historic ‘Directors’ Panel’ at Securities Enforcement Forum 2013

Don’t miss the historic “Directors’ Panel” that will be one of the highlights of Securities Enforcement Forum 2013, which will be held on Wednesday, October 9 at the Mayflower Hotel in Washington, D.C. For perhaps the first time, five current and former SEC Enforcement Directors will come together on a panel to discuss today’s most important securities enforcement issues from their own unique perspectives.

Please register here!

Bad Things Come In Threes for CCOs

Whatever the origin of this folkloric belief, all I can say is that over the past couple of weeks, Chief Compliance Officers (CCOs) have taken it on the chin three times and, once again, the job of the CCO just got quite a bit harder and more challenging.

What AngelList is doing about the proposed SEC rules to overhaul startup financing

AngelList has set up a webpage to educate everyone on the SEC’s proposed rules that would impose pre-filing, information filing and mandatory legend requirements on Rule 506(c) offerings.

THE SEC’S PROPOSED REG D RULES: WHY WE CARE

The proposed rules, if they go into effect as the SEC has proposed them, will change many practices that have grown up and evolved over the last several years that are beneficial to the early stage company ecosystem.

Action Against a Crowdfunding Platform

somoLend

SoMoLend – which stands for Social Mobile Local Lending – is a crowdfunding platform that allows small businesses to borrow money from a network of lender. The State of Ohio claims that SoMoLend failed to meet the regulatory hurdles currently in place for crowdfunding. It’s also claiming that SoMoLend acting fraudulently when seeking its own investment capital.

There are many entrepreneurs and wantapreneurs trying to jump on the crowdfunding bandwagon. For those willing to take the time to understand the securities laws, there are ways to enter the field. For some, the upcoming gate opening on general solicitation and advertising will allow them to jump on board. Others are looking to the Securities and Exchange Commission to issue rules on crowdfunding under the JOBS Act.

Just by looking at that web of requirements, the regulatory landscape for crowdfunding is complicated and currently in flux. That likely means that fraudsters are circling for easy targets and well intentioned businesses can easily make a mistake.

The State of Ohio says that SoMoLend made a mistake when working for lending sources and crossed the line when soliciting its own investors.

The Ohio action is not against the crowfunding aspect, it’s against the way SoMoLend raised its own capital and its business model. Ohio has an exemption from registration for securities offerings that comply with the SEC’s Regulation D. Until September 23, 2013 that means the securities can’t be offered through general solicitation and advertising. Ohio is claiming that SoMoLend violated that ban and therefore does not qualify for the exemption from registration under Ohio law.

On top of that violation, Ohio is also claiming fraud for SoMoLend using financial projections in investor pitches that depicted a more profitable company. The company projected millions in revenue and profits. Those projections lacked any meaningful disclosure about the assumptions that went into the projections and lacked cautionary risk factors for investors.

In a March 2013 article, SoMoLend claimed:

Since the beta site launched in May 2012, SoMoLend has facilitated some 100 small-business loans totaling nearly $3.5 million. Loans range from $500 to $1 million, with interest rates ranging from 3 to 22 percent and terms spanning six weeks to five years, depending on a business’s needs and creditworthiness. SoMoLend also charges a 4 percent transaction fee on funds borrowed.

Ohio claims the true amount of lending activity was 13 loans to 9 businesses for $94,000. According to the Ohio filing, the company has brought in only $3404 in revenue.

On top of that, SoMoLend met with the Ohio regulators who pointed out that the firm would need to be registered as broker-dealer if it was going to collect transaction-based fee for selling notes through the platform. That 4% transaction fee is effectively a commission on the sales of securities. You can compare that to Funder’s Club that took a different approach to crowdfunding by taking a promote on the back-end. Funder’s Club even obtained a No Action letter from the SEC validating its business model.

Finally, the state gets to the crowdfunding piece and alleges that some, or all, of the promissory notes offered through SoMoLend were not registered or exempt from registration. Ohio seems a bit sympathetic to the note issuers when it says SoMoLend “exposed approximately 200 small business issuer to potential liability”.

I decided to take a look at the platform. To start, I saw this warning:

If you are an accredited investor, we require you attest to your status prior to viewing borrowers on the platform.

I still have not gotten any more for verification and am still blocked from seeing any investment opportunities. I assume the business has come to grinding halt, even though the hearing on the order is not until October. SoMoLend’s CEO, Candace Klein recently resigned because of the regulatory action.

According to a story on Cincinnati.com:

Klein is a passionate entrepreneur who was honest about the company’s finances with investors and board members, but consistently lacked discipline and precision when discussing and presenting the company’s actual performance.

A combination of those missteps and the state’s apparent concerns about crowdfunding, lead to trouble.

References:

 

Failing to Turn Real Estate Into a Security

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Fee simple ownership of the “bricks and mortar” of real estate is not a security. “The offer of real estate as such, without any collateral arrangements with the seller or others, does not involve the offer of a security.” As you move further away from that model, you move closer and closer to the ownership a security than the ownership of real estate. The line between the two is not a bright line.

A transaction that looks nothing like a sale of stock and involving such diverse items as citrus groves and vacation homes may qualify as a sale of a security under federal law.

There has been a recent ruling in case battling over that line. In Salameh v. Tarsadia Hotels, the purchasers of real estate are suing the developer of the Hard Rock Hotel in San Diego. The project was a condominium- hotel ownership structure to help provide capital.  The purchase/investment turned out to be a bad one, so the purchasers sued the developer.

Their claim was that a series of documents, including the Purchase Contract, the Unit Maintenance and Operations Agreement, and the Rental Management Agreement turned the ownership of the hotel/condo interest into a “security” and not the mere ownership of real estate. Since the securities were not registered, they could seek rescission. In this case, the ownership and control issues were not just split into separate documents, some of the documents were entered into at significantly different times.

The purchasers lost the case and appealed. They just lost the appeal.

The Ninth Circuit Court of Appeals affirmed the ruling from the district court.  The Court distinguished these facts from Hocking v. Dubois, 885 F.2d 1449 (9th Cir. 1989)  in which it had found that there was a general issue of material fact whether the sale of a condominium along with a rent-pooling arrangement constituted a security.

In Hocking, the the purchaser would not have made the real estate investment but for the availability of the rental pool arrangement. The sale of the real estate was coupled together with the management and income sharing that made the real estate investment look more like a security.

In contrast, the Salameh plaintiffs failed to allege facts showing that the real estate was coupled together with the management and income sharing as a package. The hotel developer pointed out in its pleading that the rental management agreements were executed eight to fifteen months later.

The ruling is another loss for the SEC in this edge between real estate and securities. The SEC had filed an amicus brief that relied on its 1973 Guidelines as to the Applicability of the Federal Securities Laws to Offers and Sales of Condominiums or Units in a Real Estate Development (Securities Act Release No. 33-5347 (Jan. 4, 1973) as the standard.

References:

Ignoring Changes to Regulation D

compliance and ignore this sign
While many embraced lifting the ban on general solicitation and advertising, most despised the additional mess that the SEC added in. Fortunately, you can probably ignore much of that mess. At least for a few months.

We knew that the SEC was going to require that firms selling public private-placements were going to have to take some reasonable steps to confirm that the purchasers were actually accredited investors. Congress wrote that into the JOBS Act. (Although I suspect they would have written it differently if they knew the end result.)

Based on the July 10 SEC meeting, 506(c) and 506(d) go into effect on September 23. The dreaded changes to Form D and Rule 156 do not. Those are only proposed rules.

SEC Chairman Mary Jo White made this obvious in a recent letter response to Congressman McHenry.

It’s clear that funds can use the public private-placement regime under Rule 506(c) on September 23, 2013. The current rules on filing the Form D are in place. There will be no requirement to file the advertisements with the SEC. There will be no required legends on the advertisements.

For now.

The changes to Form D and the advertising legends are merely in a proposed rule. The SEC may abandon its concerns and not issue a final rule. (unlikely) The SEC may make significant changes to the rule. (possibly)

Chairman White makes it clear that there will need to be some transitional guidance for offerings that commence before the effective date of the final rule. So you can ignore the proposals.

But the proposed rule is clearly a signal that the SEC wants to do something more for private placements. I would guess that some form of the rule will be adopted before the end of the year. The mutual fund industry will be furious that their product advertisements are weighed down with disclaimers, while cowboy hedge funds are all over the place and grabbing bigger fees.

There are signs ahead. But we can ignore them for now.

References:

Ignore This Sign, 2004
Marietta, Georgia, USA
Hacking the City, by Brad Downey

Compliance and Breaking Bad

compliance and breaking badI was up last night hooked into latest episode of Breaking Bad. Besides it being a great show, it highlights a focus of compliance. How do you prevent your employees from going bad?

For those of you who haven’t seen the show, Walter White, a mild-mannered high school chemistry teacher helps ends meet by making drugs. As the story progresses and Walter makes a series of bad choices, he transforms into the murderous drug lord Heisenberg.

Perhaps the evil has always been inside Walter. Perhaps it was a mid-life crisis gone horrible wrong. Perhaps it was pure greed.

Walter’s first choice was clearly across the line when he met with his former student to cook his first batch of crystal meth. As he escapes each increasingly threat to his life and his livelihood he moves progressively further from Walter to Heisenberg. The success of each bad act leads to more bad acts.

One goal of company’s compliance program is discourage an employee from going bad. And to the extent an employee goes bad, to promptly catch them to prevent further bad acts.

Compliance Bricks and Mortar for August 9

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

JOBS Act Update: Can the Genie go back in the Bottle? by Jay B. Gould in Investment Fund Law Blog

But what happens if a fund manager is initially enamored of the new rules and decides to advertise generally, but later changes his mind? Can a fund manager go back to the old “pre-existing, substantial relationship” days, and how do you do that once the fund has been “generally offered” to the public?

SEC’s Proposed Regulation D Rules Generates Wide Ranging Concern by Alexander J. Davie in Strictly Business

In my last post, I discussed new proposed Regulation D rules which impose new obligations upon issuers of securities in private placements. In that post, I expressed some concern that these new rules could be quite burdensome, especially the rule disqualifying issuers from using Rule 506 on future securities offerings for failing to file Form D in a timely fashion. Others involved with startup capital formation have also expressed similar concerns. In this post, I’ll compile the comments I’ve seen thus far.

You Can’t Tweet That by Joe Wallin in Startup Law Blog

One of the aspects of the proposed rules that hasn’t drawn a lot of attention in the blogs and press is the new legend requirement. What is a legend? A legend is a specifically required disclosure; frequently in all caps or bold, or called out in some other manner from other text in a document so that it is less likely to be missed.

When Is A ‘Whistleblower’ Not Really A ‘Whistleblower’? by Catherine Foti

Since the promulgation of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd Frank”), five federal district courts have held that employees who report suspected wrongdoing to upper management, but not to the U.S. Securities and Exchange Commission (“SEC”), are “whistleblowers” for purposes of the Act, entitled to the protection of Dodd Frank’s anti-retaliation provisions.  Going against the tide, in a recent ruling in Asadi v. G.E. Energy (USA), L.L.C., the Fifth Circuit Court of Appeals – the first Circuit Court to address this issue – has held exactly the opposite, ruling that an employee who reported a potential Foreign Corrupt Practices Act violation to his employer, G.E. Energy (USA), L.L.C., was not a “whistleblower” because he did not “provide information relating to a violation of the securities laws to the SEC.”

Colbert’s take on the SEC against the Fabulous Fab

The Colbert Report
Get More: Colbert Report Full Episodes,Video Archive

Is Bitcoin a Security?

bitcoin

You may have noticed that I focus on SEC actions against real estate companies. At the core of that interest is a look at whether the Securities and Exchange Commission has jurisdiction. The SEC is limited to securities. Commodities get covered by the CFTC and real estate gets covered by …..

Bruce Carton pointed to another item in the news that also addresses the realm of what is and is not a security: Bitcoin.

The SEC brought charges against Trendon T. Shavers, who is the founder and operator of Bitcoin Savings and Trust (BTCST). The SEC alleged that he was running a Ponzi scheme based on a “virtual currency” arbitrage on Bitcoin. Shavers apparently used the handle Pirateat40.

Beginning in November of 2011, Shavers began advertising that he was in the business of
“selling Bitcoin to a group of local people” and offered investors up to 1% interest daily “until
either you withdraw the funds or my local dealings dry up and I can no longer be profitable” Shavers obtained at least 700,467 Bitcoin in principal investments from BTCST investors, or $4,592,806 in U.S. dollars, based on the daily average price of Bitcoin.

Shavers argued that the BTCST investments are not securities because Bitcoin is not money, and is “not part of anything regulated by the United States. Shavers also contends that his transactions were all Bitcoin transactions and that no money ever exchanged hands.

The SEC argued that the BTCST investments are both investment contracts and notes, and therefore are securities. The SEC said that Shaver returned about 500,000 Bitcoins to investors, but made off with another 200,000

Bad news for Shavers. A decision in the case this week ruled that BTCST investments meet the definition of investment contract, and as such, are securities. The court concluded that it had subject matter jurisdiction to hear the SEC’s case.

15 U.S.C. § 77b of the U.S. Code defines “security” as “any note, stock, treasury stock, security future, security-based swap, bond…[or] investment contract…”  Under the Howey line of cases, an investment contract is any contract, transaction, or scheme involving (1) an investment of money, (2) in a common enterprise, (3) with the expectation that profits will be derived from the efforts of the promoter or a third party.

Investment of money

Bitcoin can be used to purchase stuff. The only limitation (and its a big one) is that it is limited to places that accept it as currency. Bitcoin can also be exchanged for conventional currencies, such as the U.S. dollar. It was that recent spike in the exchange rate between Bitcoin and the US dollar that attracted so much attention.

Common enterprise

A common enterprise requires interdependence between the investors and the promotor, for example where the investors colelctively rely on the promotor’s expertise. The investors were giving Shaver their bitcoins and he was supposed to trade them and get more value back them.

Expectation of profits from efforts of others

In this case, the investors were not taking an active role in the investment. They were relying on Shavers.

The court’s finding that it has subject matter jurisdiction means that the SEC’s case against Shaver can  move forward. The SEC still has not proven fraud and will likely face another round of arguments on jurisdiction.  The SEC still has to prove fraud.

The interest rate Shavers gave to investors was a staggering 7% per week for large investments. That smells like a Ponzi scheme. Personally, I don’t think I’d hand any money, bitcoin or US dollars, to someone named “Pirate.”

References:

Use of Data Collected from Form PF

compliance and form pf

Many private funds struggled with getting Form PF filed. Many in fund compliance were dubious that the Securities and Exchange Commission would be able to do anything meaningful with the massive amount of data pushed through the form. Regardless, Section 404 of Dodd-Frank required the SEC to gather the data so the Financial Stability Oversight Council could assess systemic risk.

Section 404 also required an annual report on how the SEC has used the data collected in Form PF. The first report came out a short time ago.

In total, there are big numbers:

Types of Private Funds Advised by all Filers

  • 6,683 Hedge Funds ($4.061 trillion cumulative RAUM)
  • 5,928 Private Equity Funds ($1.603 trillion cumulative RAUM)
  • 2,922 Other Private Fund Type ($698 billion cumulative RAUM)
  • 1,121 Real Estate Funds ($299 billion cumulative RAUM)
  • 966 Securitized Asset Funds ($338 billion cumulative RAUM)
  • 329 Venture Capital Funds ($23billion cumulative RAUM)
  • 66 Liquidity Funds ($258 billion cumulative RAUM)

For a total of $7.280 trillion in Private Fund Regulatory Assets Under Management Reported by all Filers

The report goes on to imply that the SEC is still figuring out what to do with the data after it passes on the information to FSOC.

The mysterious Division of Economic and Risk Analysis is plugging some of the information into its black box of analytic tools.

More importantly for fund managers, the Office of Compliance Inspections and Examinations is using the information for pre-examination and research. Once selected for an exam, a fund manager should assume that the examiners have a copy of Form PF. OCIE is also working with a system to use Form PF to identify red flags that could trigger exams.

References: