Some Relief for a Fund Manager Under the Political Contributions Rule

Politician: Holding Out a Stack of Money

SEC Rule 206(4)-5 for investment advisers and fund managers limits the ability of a firm’s employees to make political contributions. It’s a nasty rule. Violation of the rule does not require any bad intent. The breadth of affected political candidates is long, diverse, and hard to discover.

Anthony Yoseloff worked at Davidson Kempner Capital Management which ran a private investment fund. Three of the investors in the fund were Ohio public pension plans. Under the SEC Rule, Yoseloff would be limited in making political contributions to politicians who could directly or indirectly influence the decision to invest in the private investment fund.

Yoseloff gave a $2500 donation to the federal senate campaign of Joshua Mandel. Yoseloff though federal elections were exempt from the political contributions limit. He was wrong. Mandel was the Ohio Treasurer and had the power to appoint trustees to the Ohio pension plans. Yoseloff had violated the rule and the firm was at risk of losing two years worth of management fees from Ohio pension plans.

The firm applied for exemption from the SEC, hoping the innocent mistake would not cost them thousands of dollars. (tens of thousands? hundreds of thousands?)

The rule does provide for exemptive relief. This case may be the first such relief.

Here’s what the SEC said mattered in the ruling granting the relief:

  • The Ohio pension plans established the investment relationship on a arms’ length basis prior to the date of the contribution
  • Only one investment was made after the contribution
  • The firm had pay-to-play policies and procedures compliant with the rule’s requirements and implemented compliance testing
  • After discovering the contribution, the firm requested it’s return from the candidate
  • The firm set up an escrow account to hold the fees.
  • The contribution was consistent with Mr. Yoseloff’s past contributions.
  • Mr. Yoseloff mistakenly thought the contribution policy was not applicable to federal candidates.

Thankfully, the SEC is showing some relief from this oppressive rule that distorts political campaigns. Mr. Yoseloff could have given the $2500 to Sherrod Brown, the other candidate in the election, and there would have been no problem. In the 2012 republican presidential primaries, of the 10 candidates only Rick Perry was limited by the SEC rule.

On the other hand, there was a long history of pay-to-play in the municipal finance industry that was snuffed out by the MSRB rules. (This SEC rule was based on those.) We have several instances of politicians and investment advisers/fund managers doing bad things to steer investments. I understand the need.

Clearly the firm is trying to run tests on political contributions. It found the contribution because the federal database allows you to search by “employer name.” The Ohio state database does not. If the contribution was made to the treasurer’s state campaign, the firm may never have discovered it. Most of the state election finance databases that I’ve reviewed do not allow you to search by employer. This effectively limits the ability to monitor contributions. Yet another problem with the rule.

References:

Compliance Bricks and Mortar for November 20

bricks freedon trail

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

JP Morgan’s Twitter Mistake by Emily Greenhouse in the New Yorker

This is Twitter’s very purpose: to allow any individual to share the same space with, for instance, a hugely powerful bank. With this space comes attention and authority. Unlike at JPMorgan’s Park Avenue headquarters, there are no security guards keeping undesirable elements out of Twitter. If JPMorgan executives expected that #AskJPM would attract only future job applicants—the kind who would don snappy new suits and genuflect nervously—they must have been stunned at the reckoning.

Missouri recognizes same-sex marriage exclusively for tax purposes by Darla Mercado in Investment News

As far as Missouri’s reasoning for the decision, the impression among tax experts seemed to be that recognizing same-sex marriages for income tax purposes is a way to avoid an administrative mess. “For states that have their own filing status tied to the federal status [as is the case with Missouri], it would begin to create a logistical nightmare” if they did not recognize same-sex marriages for income tax purposes, said John McGowan, senior vice president, national practice leader for the LGBT and non-traditional family practice at Northern Trust Corp.

Crowdsourcing a Title III Crowdfunding Cost Model by kiranlingam in SeedInvest

A successful $99,999 crowdfunding raise with no audited financials will result in negative cash flow to the company of about $38,000.

SEC Releases Fiscal 2013 Whistleblower Report by Kevin LaCroix in the D&O Diary

In 2012, the first full fiscal year in which the program was in place, the agency received 3,001 whistleblower tips. The number of whistleblower reports increased in fiscal 2013 to 3,228, an increase of about 7.5%, bringing the total number of whistleblower reports since the program’s inception to 6,573.

High Performance with High Integrity

high performance with high integrity

What is the proper role of business?

Ben W. Heineman Jr. served as the senior vice president and general counsel of GE for 15 years so he has some sense of the role of business. During that period GE was one of the most respected and valuable companies in the world.

Mr. Heineman has an answer the question and it’s the name of his book. High Performance  with High Integrity.

High performance means

  • Strong sustained economic growth
  • That is based on superior products and services, and
  • That provides durable benefits both to the shareholders and to other stakeholders.

High integrity means

  • A tenacious adherence on the part of the corporation to the spirit and the letter of the formal rules, financial and legal
  • Voluntary adoption of global ethical standards that bind the company ans its employees to act in its enlightened self-interest
  • Employee commitment to the core values of honesty, candor, fairness, reliability, and trustworthiness – values which infuse the creation and delivery of products and services and which guide internal and external relationships

The book covers a broad swath of business ethics and compliance issues in a concise 177 pages. Half-sized pages. The book can fit in a coat pocket.

It’s a book that only a compliance geek could love. The larger pool of business readers will find insights and may enjoy the admiration of Mr. Heineman’s tenure at GE.

JOBS Act 2.0

Im-just-a-bill -schoolhouse rocks

It was an unusual show of bipartisan support when the original JOBS Act was passed in the Spring of 2012. Congress is following in the footsteps of movie studios and looking to produce a sequel. Financial Services Committee Chairman Jeb Hensarling has promoted a group of bills that he thinks will comprise the JOBS Act 2.0.

Here is the pitch:

H.R. 1800 Small Business Credit Availability Act will increase the ability of Business Development Companies to lend to small businesses and help ensure the flow of capital to Main Street.

H.R. 2274 the Small Business Mergers, Acquisitions, Sales, and Brokerage Simplification Act will streamline and simplify regulations so that small business owners can sell their small businesses when they retire, rather than perhaps be forced to close them up.

H.R. 3448 The Small Cap Liquidity Reform Act will make small companies more attractive to investors and, in turn, produce higher rates of capital formation and jobs.

Here is what the legislation actually does.

The Small Business Credit Availability Act amends the Investment Company Act of 1940 to allow a business development company to own interests in the business of a registered investment adviser or an adviser to an investment company. It also reduces from 200% to 150% the asset coverage requirements applicable to BDCs and allows a BDC to issue stock. BDCs have been become the hot topic for financing. I have to admit my ignorance about the benefits of using a BDC. Clearly, this bill is trying to clear a bunch of the obstacles to the use of this type of financing. I did notice that the SEC recently issued a no action letter allowing a BDC, Main Street Corporation, to own an investment adviser.

The Small Business Mergers, Acquisitions, Sales, and Brokerage Simplification Act creates a new regulatory framework for “Mergers & Acquisition Brokers” who are in the business of effecting the transfer of ownership of an eligible privately held company. That is a complication in the sale of a small company. If it’s structured as an asset sale, the broker does not need SEC registration. But if transaction is structured as the sale of securities, the broker does need to be registered.

The Small Cap Liquidity Reform Act will provide a pilot program allowing certain emerging growth companies to increase the tick size of their stocks. That’s been a quest for Wall Street ever since decimalization was introduced. It’s killed the profit margin for market makers. That it’s tied to emerging growth companies is just an added bonus. That status allows the company to file privately with the SEC while working on the IPO. It will make this designation more attractive for the deal runners who stand to make a better profit by acting as a market maker on the stock.

Like most movie sequels, this legislative sequel is not as good as the first. Clearly, Congressmen Hersarling recognizes the importance of good marketing to get a bill passed that changes the financial services regulatory regimes. These are three very specific bills that are unlikely to catch the attention of the rest of Congress.

The original JOBS Act flew through Congress with enticing tidbits that would make IPOs easier and enable crowdfunding (sort of). I can’t see JOBS Act 2.0 getting the same kind of interest, even with the positive spin given the bills.

Is Your Fund Name Misleading?

You_Can_Call_Me_Al

Last week, the SEC’s Division of Investment Management released a guidance update that focuses on funds that use a name that “suggests safety or protection from loss.” The IM Guidance Update is a shot across the bow, warning a fund to considering changing its name if it exposes investors to “market, credit, or other risks.”

Every investment fund has exposures to “market, credit or other risks”, so the Guidance presumably applies to every fund. That means your fund name should not suggest “safety or protection from loss.”

The Guidance points to two bad words: “protected” and “guaranteed.”

The Guidance states that the agency has recently asked some managers to change the names of their funds.

We have made these requests because we believe that, in practice, investors sometimes focus on a fund’s name to determine the fund’s investments and risks, either because the name sometimes appears without the clarifying prospectus disclosures (e.g. , in advertisements) or because of the prominence of a fund’s name or for other reasons.

Funds that managed volatility by investing a portion of the fund’s assets in cash, short-term fixed income instruments, short positions on exchange-traded futures, or other investments had included the term “protected” in their name. The SEC was rightly concerned that “protected” only meant partly protected. Similarly, some funds had entered into shortfall guarantees to protect a fund’s downside. That protection may not have covered a 100% of the loss. Of course the protection is only as good as the credit of the company providing the coverage.

References:

You Got Questions About 506(c) – The SEC Has Answers

sec-seal

The new Rule 506(c) is a big substantive change on how private placements can be run. That leaves many, including me, with a lot of questions. The Securities and Exchange Commission just posted a series of new questions and answers on the new rule. Most of the answers are expected confirmations, but there are a few surprises.

Question 260.05 If you switch a pre-rule offering to new Rule 506(c) offering, do you need to file an amendment to From D. YES.

Question 260.06 If you take reasonable steps to verify that all investors are accredited, but after the sale you find out that an investor did not meet the standard. The SEC says that’s okay as long you took reasonable steps and had a reasonable belief.

Here was a surprise.

Question 260.07 All of your investors are accredited investors, but you didn’t take reasonable steps to verify that they were accredited. The SEC says that you failed the exemption. “The verification requirement in Rule 506(c) is separate from and independent of the requirement that sales be limited to accredited investors.”

The other item for fund managers to take a look at is Question 260.10 regarding existing investors. The SEC makes it clear that the exemption for existing investors in the non-exclusive list of verification methods only apples to the same issuer. So you can’t rely on this exemption when raising a new fund.

Another small surprise is that the SEC will allow you to retreat from a 506(c) offering back to a 506(b) offering. Question 260.11 makes it clear that as long as you did not engage in general solicitation you can amend the Form D to change the exemption. And vice-versa. Question 260.12 explicitly allows an offering to switch from 506(b) to 506(c). Many people I talked to thought you could make switch, but it’s good to hear it explicitly form the SEC.

Compliance Bricks and Mortar for November 15

bricks 1

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

We chat with Harvey Pitt about CCO independence, prestige in The FCPA Blog

The FCPA Blog wanted to explore the idea of the dual-hatted compliance officer — the one who occupies both the general counsel and chief compliance officer roles in a company. We talked with the former SEC Chairman and now Kalorama Partners CEO, Harvey Pitt. The conversation turned into a thoughtful exchange about what it means to be an independent and effective CCO in any industry today. Executive editor Julie DiMauro asked the questions for the FCPA Blog.

Update: When will payroll employment exceed the pre-recession peak? in Calculated Risk

Right now it appears payrolls will exceed the pre-recession peak in mid-2014.

Currently there are about 1.5 million fewer payroll jobs than before the recession started, and at the recent pace of job growth it will take about 8 months to reach the previous peak.

Of course this doesn’t include population growth and new entrants into the workforce (the workforce has continued to grow).

“Demo Days” and General Solicitation by Joe Wallin in Startup Law Blog

I’ve been writing an article on general solicitation, a long one, and doing a lot of research. As part of that, I found the attached SEC No-Action letter that I wanted to share with everyone, because it directly hits on the question of whether “demo days” constitute general solicitation.

Just Who Is A Promoter And Why You May Want To Know by Keith Paul Bishop in California Corporate & Securities Law

The SEC’s adoption of its so-called “bad actor” rules makes knowing the meaning of “promoter” important for issuers relying on Rule 506 under the Securities Act.  Under these amendments, the disqualification provisions apply to a long list of covered persons.   Buried in this list is “any promoter connected with the issuer in any capacity at the time of such sale.”  The adopting release provides this additional color: …

The Texans Are 2-7: What is Missing from Your Compliance Program? by Tom Fox in FCPA Compliance and Ethics Blog

I thought about Reed and the Texans when I read a post from the noted site JDSupra entitled, “What’s the One Thing Missing From Your Corporate Compliance Program?” They put that question to various compliance attorneys writing on JD Supra, asking each to commit to just one essential element that, in their experience, they regularly see missing from corporate programs; IE., programs that are required to address myriad regulatory issues to do with privacy and data security, insider trading, bribery and corruption, and other such matters across numerous jurisdictions. I found the replies quite interesting and perhaps some insights which the Texans can use.

Classic KM quote by Jack Vinson in Knowledge Jolt with Jack

“He who receives ideas from me, receives instruction himself without lessening mine; as he who lights his taper at mine receives light without darkening me”
-Thomas Jefferson

SEC’s First Deferred Prosecution Agreement With an Individual

SEC Enforcement Logo

The Securities and Exchange Administration announced that it entered into its first deferred prosecution agreement with an individual. What’s remarkable is that this is first time the SEC has done so.

Back in early 2010, the SEC announced that it had launched a new enforcement cooperation initiative. The SEC did a big (for the SEC) marketing campaign to announce initiative. The SEC even went so far as to allow me and a few other bloggers to chat with then SEC Enforcement Director Robert Khuzami. The SEC set out how it will evaluate whether, how much, and in what manner to credit cooperation, to serve as an incentive to report violations and cooperate fully and promptly in enforcement cases.

It’s been almost three years and the SEC has finally found a bad guy willing to cooperate. Scott Herckis served as administrator for Connecticut-based Heppelwhite Fund LP. The fund was run by Berton M. Hochfeld. The SEC filed an emergency enforcement action against Hochfeld in November 2012 for misappropriating more than $1.5 million from the fund and overstating its performance to investors. The SEC’s action halted the fraud.

Herckis started as the Heppelwhite fund administrator in 2010. Hochfeld asked for transfers from the fund’s account to Hochfeld’s account. Eventually those transfers ended up getting very large and Herckis realized the fund’s NAV was overstated. He resigned and contacted the SEC.

“We’re committed to rewarding proactive cooperation that helps us protect investors, however the most useful cooperators often aren’t innocent bystanders,” said Scott W. Friestad, an associate director in the SEC’s Division of Enforcement. “To balance these competing considerations, the DPA holds Herckis accountable for his misconduct but gives him significant credit for reporting the fraud and providing full cooperation without any assurances of leniency.”

Herckis cannot serve as a fund administrator or otherwise provide any services to any hedge fund for a period of five years, and he also cannot associate with any broker, dealer, investment adviser, or registered investment company.  The Deferred Prosecution Agreement requires Herckis to disgorge approximately $50,000 in fees he received for serving as the fund administrator.

I suppose that’s not a bad result for Herckis. It’s hard to assess his culpability in the fraud. Herckis looks more like a whistleblower. However, it appears that he continued to cooperate with Hochfeld’s fraud long after he realized it was wrong. The fraud would not have happened without Herckis allowing the transfers.

It’s good to see that the SEC is using its shiny new tools. The SEC announced its first Deferred Prosecution Agreement against a company back in May 2011.

References: