Doug Cornelius on compliance for private equity real estate
No, it’s not.
“March 1st and March 2nd, NBC Studios will be in Norman B. Leventhal Park to film large crowd scenes for the pilot of their television series “Odyssey”. While filming will only be on the weekends, certain production work will take place during the week. Any set design or props in the Park are part of the “Odyssey” set.”
Apparently, the “crowd scenes” must be an Occupy Boston or Occupy Wall Street scene for the story.
These are some of the compliance-related stories that recently caught my attention.
Are You a “Rat Trader?” by Bruce Carton in Compliance Week
Today I stumbled up on the following headline from the Chinese publication, Global Times: “Rat trader faces 5-10 years for insider dealing.” Rat trader?? It turns out that in China, at least, “rat trading” is the phrase used to describe what we would call “front-running” in the U.S.
Commitment to Compliance: the Compliance Committee by Tom Fox
One of the commitments I believe can enhance a compliance program is the creation of a compliance committee. As far back as in the 2005 Monsanto Corporation Deferred Prosecution Agreement (DPA) the compliance committee concept appears to have found favor with the Department of Justice (DOJ). In Appendix B to the DPA, Monsanto agreed to, among other things, “the establishment and maintenance of a committee to supervise the review of (I) the retention of any agent, consultant, or other representative for purposes of business development or lobbying in a foreign jurisdiction”, or a Compliance Committee. Later, this concept was used in the settlement of Halliburton’s shareholder action around its Foreign Corrupt Practices Act (FPCA) enforcement action.
SEC’s Newest Enforcement Weapon: Powerful Software in Money News
Officials expect Palantir’s platform to help the SEC find evidence of illegal activity more quickly and easily by linking trading records and personal contact information from paid databases with tips, complaints and referrals the agency has received, said the sources, who were not authorized to speak publicly about the matter.
A human-readable explorer for SEC filings in Flowing Data
Maris Jensen just made SEC filings readable by humans. The motivation:
But in the twenty years since, despite hundreds of millions invested in rounds of contracted EDGAR modernization efforts and interactive data false starts, the SEC’s EDGAR has remained almost untouched. In 2014, the SEC is quite literally doing less with SEC filings than their predecessors had planned for 1984. Data tagging is the red-headed stepchild of the Commission — out of hundreds of forms, only about a dozen are filed as structured data — and the first program to automate the selection of SEC filings for review, the Division of Economic and Risk Analysis (DERA)’s ‘Robocop’, has been ‘aspirational’ for years. The academics in the division responsible for the SEC’s interactive data initiatives write papers about information asymmetry, using EDGAR data they repurchase in usable form for millions each year, but do nothing to fix it. Companies are chastised for insufficient and inefficient disclosure, while the SEC fails to help retail investors navigate corporate disclosures at all.
How Grocery Bags Manipulate Your Mind by Carmen Nobel in HBS’ Working Knowledge
People who bring personal shopping bags to the grocery store to help the environment are more likely to buy organic items—but also to treat themselves to ice cream and cookies, according to new research by Uma R. Karmarkar and Bryan Bollinger. What’s the Quinoa-Häagen-Dazs connection?
Above is a photograph of outdoor curling in Central Park in New York City. I love this picture, so I thought I would share it. More 1890s curling photos.
Emory University accounting professor Shivaram Rajgopal points an accusatory finger at Securities and Exchange Commission employees and proclaims a pattern of selling stocks of companies subject to enforcement actions. His study finds “significant abnormal returns of (i) about 4% per year for all securities in general; and (ii) about 8.5% in U.S. common stocks in particular. The abnormal returns stem not from the buys but from the sale of stock ahead of a decline in stock prices.”
Rajgopal throws the big rock:
Most of these returns stem from the timely sale of these stocks, suggesting that a regulator’s employees are most likely to know about sanctions against companies before the market as a whole.
The study is based on reported securities trades by 3,500 SEC employees during late 2009, and for all of 2010 and 2011. However, the data is severely constrained. Rajgopal merely had a list of transactions and no ability to compute the profits or losses. There is also no data on holdings. The study only looks at what was bought and sold. Rajgopal constructs a synthetic hedge model in an attempt to model the trading.
I’m going to assume his analysis is correct and that SEC employees were more likely to sell in companies that become subject to SEC enforcement actions. Rajgopal claims this is illegal trading before public announcements. I think it’s just SEC employees over-emphasizing SEC actions as a reason to sell the stock.
One fault in Rajgopal’s accusation is how limited the news about an enforcement action may be. The SEC is a huge organization. But even if the news of an enforcement action is leaky, only a small percentage of the 3,500 employees would have that information and be able to make the illegal trade. That small number would not be as statistically significant as Rajgopal finds in his study.
The only meaningful part of the report is its focus in Table 3 of 87 trades of the 7,200 employee trades studied. Those 87 trades are in Bank of America, General Electric, Citi, Johnson & Johnson, JP Morgan, and General Electric in the period prior to the announcement of enforcement actions.
The trades highlight the need for preclearance. An organization may have material non-public information. But the information is only seen by a subset of employees. Clearly, you can track document and email traffic to prove that someone knew that information. That’s what the SEC does in its insider trading investigations. The tough part is defending from an accusation of having the knowledge.
It’s hard to prove that you didn’t know something.
The SEC is stuck with an accusation and little way of proving that those 87 trades were not made on material non-public information. Clearly, the information existed within the SEC. Perhaps the SEC can find a smoking gun that proves that some of those 87 were made by employees who knew about the enforcement action. I would guess that majority were made without that knowledge and no way to prove that they lacked the knowledge.
The SEC should have a pre-clearance requirement or a planned sell window so that the SEC and its employees can avoid the taint of accusations like Rajgopal’s accusation. That’s why public companies have 10b-5 plans and registered investment advisers have pre-clearance requirements.
References:
In the presence exam initiative, the Securities and Exchange Commission identified conflicts of interest as a high risk area. Included in that high risk area is the allocation of fees and expenses. The SEC just brought charges against a private equity fund manager for the improper allocation of fees and expenses.
The SEC charged Scott A. Brittenham and his company, Clean Energy Capital LLC, with paying more than $3 million of the firm’s expenses from its funds. Brittenham did not consent to the order, so I can only rely on the SEC’s view of the facts.
The SEC order states that the $3 million in expenses was primarily employee compensation and office expenses for Clean Energy Capital. That includes executive bonuses, health benefits, retirement benefits and rent. The SEC goes for the kitchen sink when it also mentions “group photos, legal fees for estate planning maintenance costs on CEC’s offices, CEC checks and letterheads, office and mobile telephone, bottled water, office lunches, car washes and insurance, holiday cards, CEC’s registration expenses, and business cards, and charges relating to transporting Brittenham’s daughter to and from school.”
Theoretically, a fund manager could charge these expenses to the fund if properly disclosed. (I doubt investors would line up to invest in such a fund.) But the Clean Energy Capital funds did not disclose these expenses. The limited partnership agreements described the expenses to be borne by the funds as “reasonable” partnership expenses “related to the acquisition or disposition of securities.”
The SEC charges that CEC treated all of its funds equally when it came to the expense reimbursement. However, that means that CEC did not make an effort to allocate the actual expense to the fund that benefited.
On top of the alleged improper allocation, CEC was making loans to the funds because they had insufficient cash reserves to pay their expenses. The SEC claims the interest rate on these internal loans ranged from 11.86% to 17.38%. That’s a high rate in this low interest rate environment.
The SEC order goes on to describe other alleged compliance failures, including violation of the custody rule, lying about the GP investment amount, and failure to disclose previous disciplinary actions.
References:
Frank Hixon Jr. is trying to evade insider trading charges by denying he knew his father. His father is not a malevolent cyborg. His name is even easier to decipher than Darth Vader; It’s Frank Hixon Sr.
Hixon is challenging the charges so I have only the government’s version of the facts. Perhaps he has some better explanations or perhaps the SEC and DOJ do not have the evidence to back up their charges.
Hixon was investment banker focusing on the mining, metals and materials industries. According to the SEC complaint, there was suspicious trading around a few of the deals he worked on, including his own company’s earnings announcements. FINRA inquired and his firm circulated a list of suspicious traders. Frank Hixon Sr. of Duluth, Georgia and Destiny Robinson of Austin, Texas were on the list.
According to the SEC, Hixon denied realizing that those two people on a list of suspected transactions were his father and the mother of his child.
His father had lived in the same home for two decades. In 2006, the area incorporated as Johns Creek. Hixon claimed that “Hixon” was a common name in the South and that his father lived in Johns Creek, not Duluth. Duluth and Johns Creek share a zip code.
As for Ms. Robinson, Hixon claimed he only knew her as Nicole, not Destiny. The SEC complaint de-bunks this lame defense because it has text messages that makes it clear he knew her by both names. The FBI also found checks he had written to her using “Destiny” name. The SEC alleges that Hixon was using the insider trading profits to pay child support to Ms. Robinson. The trading logs tie many of the suspicious trades back to the IP address of Hixon’s firm.
Hixon was fired by his firm. The Department of Justice must have thought that Hixon’s lies were egregious because the U.S. Attorney has also brought criminal charges. The DOJ brought seven charges of securities fraud and a false statement charge.
References:
One of the challenges with having a government pension plan investor is the potential disclosure obligations under the states’ sunshine laws. A similar problem exists with Securities and Exchange Commission. The SEC is subject to the Freedom of Information Act and exam information is potentially subject to some level of disclosure.
But the state level equivalents of FOIA are worded a bit differently. You also have the situation where the state’s pension fund is an investor. So the performance of an investment is somewhat relevant to the public, since public tax dollars are at work.
A recent ruling came out of California. That case involves the efforts by a news publication to obtain individual private fund information for investments made by the Regents of the University of California. Reuters made the request under the California Public Records Act, Gov. Code, § 6250 et seq. The Regents refused to provide the information. Reuters sued.
The Superior Court ruled in favor of Reuters and found that the Regents were required to use “objectively reasonable efforts” to obtain individual fund information for the Regents’ current investments even though the Regents had not prepared, owned, used, or retained this fund information.
The First District Court of Appeal reversed in Regents of the University of California v Superior Court, (Cal. App. 1st Dist. Dec. 19, 2013). The Court held that
unless a writing is related “to the conduct of the public’s business” and is “prepared, owned, used, or retained by” a public entity, it is not a public record under the Public Records Act, and its disclosure would not be governed by the Act.
Clearly, the private fund information is related to the public’s business because tax dollars are being invested.
The decision made in Coalition of University Employees v. The Regents of the University of California (Super. Ct. Alameda County, 2003, No. RG03-089302) (the CUE Case) made it clear that private fund reporting on investments by the Regents is subject to California’s Public Records Act. That case involved a request for the internal rate of return for 94 separate private fund investments.
As a result, some of the fund managers stopped reporting to the Regents.
Subsequently, the Public Records Act was amended and California Government Code Section 6254.26 carves out specific pieces of information about private funds. Although the fund documents, meeting materials and financial statements are not part of the public record, fund return information is still within the bounds of disclosure.
Some of the Regents’ fund managers provided minimal information because they did not want it disclosed to the public. In the discussion, the Court makes it clear that it is not ruling on whether it is proper for private fund managers to withhold the information or whether the Regents should continue to do business with private fund managers who withhold information because of the sunshine law.
References:
These are some of the compliance-related stories that recently caught my attention.
SEC claims drunk lawyer had insider tipple By Kara Scannell in FT.com
The SEC sued Tibor Klein, a New York investment adviser, in September for allegedly buying securities of King Pharmaceuticals after learning from one of his clients that the drug company was in talks to be acquired by Pfizer. Mr Klein’s client and friend, Robert Schulman, a patent attorney at Washington law firm Hunton & Williams, allegedly became intoxicated after drinking several glasses of wine over dinner and “blurted out to Klein, ‘It would be nice to be King for a day,’” according to the SEC complaint filed in a Florida court.
Chasing Compliance: JPMorgan has paid out billions in penalties. Did it fix the problems? by Sue Reisinger in Corporate Counsel
A spokesman said bank officials would not comment for this story. But under pressure from regulators, the bank hired more than 3,000 employees last year to enhance its risk and compliance efforts. It also hired a new compliance chief and removed the compliance function from the purview of general counsel Stephen Cutler. In statements to shareholders and employees, chairman and chief executive Jamie Dimon expressed humiliation over bank mistakes. He said the bank spent over $1 billion in 2013 on reforms, and he vowed, “Our control agenda is now priority No. 1.”
Turning Blind Eye to Tippers No Protection From Charges by Patricia Hurtado in Bloomberg
U.S. prosecutors may bring charges for ignoring the source of illegal information used for trading, an appeals court ruled in its second decision in as many days widening the scope and penalties for insider cases
The Uneasy Connection Between Securities Disclosure and Job Creation by Ian K. Peck in the CLS Blue Sky Blog
The Jumpstart Our Business Startups Act (the “JOBS Act” or “the Act”) was signed into law in the spring of 2012, amidst the ongoing fallout from the 2008 financial crisis as well as a hotly-contested presidential election. Having received uncharacteristic bi-partisan support, the JOBS Act’s explicit goal is “To increase American job creation and economic growth by improving access to the public capital markets for emerging growth companies”. In order to accomplish this goal, the Act seeks to reduce the perceived regulatory burden that U.S. securities laws place on companies, mostly firms in the early stages of existence. This lessened burden focuses primarily on the amount and timing of required disclosure firms owe investors and potential investors.
Mark Cuban Visits D.C. to Speak About SEC Case, Enforcement Policy by Bruce Carton in Compliance Week
Cuban repeated a criticism that he also made from the courthouse steps in October following his victory at trial: that the securities laws, including the insider trading laws, are ineffective because the public often has no idea what is legal and what is illegal. How can a “Broken Windows” strategy work for the SEC, has asked, if people don’t even know what a broken window is in the securities law context?
Take Two Video: “The SEC’s Disclaimer” by Broc Romanek in The Corporate Counsel.net
Did you know that the disclaimer that SEC Staffers give when they speak is actually required by law? [Broc] recently learned that on my own even though I gave that disclaimer many times when I spoke in my capacity as a Staffer. Here is a 1-minute video about the disclaimer’s origins – [Broc] tried to inject some humor at the end:
Image of Brick work, Belconnen, Canberra is by Rebecca Dominguez
CC BY NC SA
With the flood of new registered investment advisers after the enactment of Dodd-Frank, the Securities and Exchange Commission launched the presence exam program. The goal was to get to a big chunk of the newly registered fund managers. What got left out was the big chunk of investment advisers who had never been examined. That is about to change.
The SEC announced a new initiative directed at never-before examined registered investment advisers. It looks a lot like the presence exams.
The letter highlights five high-risk areas that are likely to be the focus of the exam:
The presence exam initiative was planned to have a two year life and that life is just about expired. The SEC’s exam priorities for 2014 identified the never-before examined as a priority area for the SEC this year. So it’s no surprise that this new initiative is being rolled out.
The only surprising thing is that it lacks a snappy title like “presence exam.” The “Never-Before Examined Initiative” lacks pizazz.
Letters were sent out this week. So if you fit into that category of advisers who registered before 2011 and have not had an SEC exam, look in the mail for your letter.
What can you do if you get one of the letters? Prepare for the exam. Grab one of the sample SEC request letters and give yourself a week to pull the information together.
References:
As a fund manager one of the best ways to be prepared for a visit from the Securities and Exchange Commission is to practice. You should grab a recent document request from a SEC examination. Then give yourself one week to pull all the requested information together in a coherent package.
I put together a collection of SEC Document Requests. Hopefully you might find this collection useful.
By doing a practice run, you will have a collection of documents ready to go if the SEC suddenly arrives. You may also find some weak spots in your internal records.
It gives you a chance to make sure that you know who in the firm is responsible for maintaining the information and that they will keep it update.
Of course, the document request letters vary greatly from the books and records requirements in SEC Rule 204-2. I expect we may see some changes in that rule after the SEC has run through its presence exam program and digested the record-keeping of private funds.
So far, I have seven nine 10 request letter examples plus links to 3 more on IA Watch, but I’m looking for more. If you have an document request example and are willing to share it, you can send it to [email protected]. I will always delete any information about the firm and I will only publish any additional information about the letter that you consent to.
References:
Photo of Stack of Papers is by Jenni From the Block
CC BY
A new no-action letter from the SEC’s Division of Investment Management should allow more employees of a fund manager to invest in their firm’s private funds under the Investment Company Act. Even better for the compliance department, compliance staff could fit the expanded definition of a “knowledgeable employee.”
When operating under the Section 3(c)(7) exemption from the Investment Company Act, the issue becomes how a private investment fund can provide an equity ownership to key employees. Its unlikely that your key employees will have the $5 million in investments needed to qualify as an investor. (Each investor in a 3(c)(7) private investment fund must be Qualified Purchaser.) When operating under the Section 3(c)(1) exemption, you need to worry about employee taken up one of those valuable 100 spots.
The SEC established Rule 3C-5 to allow “knowledgeable employees” to invest in their company’s private fund without having to be a qualified purchaser. The rule also exempts these knowledgeable employees from the 100 investor limit under the Section 3(c)(1) exemption from the Investment Company Act.
Rule 3C-5 creates two categories of “knowledgeable employees”. The first category of “knowledgeable employees” is the management of the covered company, which covers these positions:
Executive Officer is defined in Rule 3C-5 as:
The second group of knowledgeable employees are those who participate in the investment activities. Those employees need to meet these requirements:
It’s a typically fuzzy definition. I expect most fund managers have people that clearly fit in the definition, some that are clearly outside the definition, and some that are in a gray area. It depends on how you define “principal business unit”, “policy-making function”, and “participates in the investment activities”. There was a 1999 American Bar Association SEC No Action Letter that provided some guidance. This no-action letter goes even further.
Your IT head is likely to be happy with the guidance on “principal business unit”:
“While the ultimate determination of whether any business unit, division, or function should be deemed principal is a factual determination that must be made on a case-by-case basis, we believe that an investment manager could determine that its IT and investor relations departments are principal business units, divisions, or functions under the circumstances described above and, accordingly, the individual in charge of each such department could be a knowledgeable employee.”
In particular, the guidance points out that unit need not be part of the investment activities to be considered principal.
The letter opens a bit wider the definition of “policy-making function”:
“Further, we agree that the rule does not require that the policy-making function be concentrated in one individual and that employees serving as active members of a group or committee that develop and adopt an investment manager’s policies, such as the valuation committee, could be executive officers under the rule. We do not believe that individuals who merely observe committee proceedings or merely provide information or analysis to the decision-makers of a committee or group would be engaged in making policy and, therefore, such individuals generally would not be executive officers under the rule.
On the “participate in investment activities” term, the SEC says each of these could fit in the definition, depending on the facts and circumstances:
The SEC steps away from creating a bright line and leaves it up to the private fund to address the particular facts and circumstances for each employee. But you will need to write down why you treated an employee as a “knowledgeable employee.”
“[I]nvestment managers should maintain in their books and records a written record of employees the investment manager has permitted to invest in a Covered Fund as knowledgeable employees and should be able to explain the basis in the rule pursuant to which the employee qualifies as a knowledgeable employee.”
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