Month: April 2014

Form PF Filing Day

Form PF

If you run a private fund, today is deadline for the annual Form PF filing with the Securities and Exchange Commission. Depending on the type of fund, you have different reporting requirements. The SEC gets bogged down with poor definitions trying to distinguish among the types of funds.

In the glossary to Form PF, a Real estate fund is

Any private fund that is not a hedge fund, that does not provide investors with redemption rights in the ordinary course and that invests primarily in real estate and real estate related assets.

That sounds right, but I still need to look at the definition of Hedge fund:

Any private fund (other than a securitized asset fund):

(a) with respect to which one or more investment advisers (or related persons of investment advisers) may be paid a performance fee or allocation calculated by taking into account unrealized gains (other than a fee or allocation the calculation of which may take into account unrealized gains solely for the purpose of reducing such fee or allocation to reflect net unrealized losses);

(b) that may borrow an amount in excess of one-half of its net asset value (including any committed capital) or may have gross notional exposure in excess of twice its net asset value (including any committed capital); or

(c) that may sell securities or other assets short or enter into similar transactions (other than for the purpose of hedging currency exposure or managing duration).

That definition talks about getting performance fees on unrealized gains. That would be unusual for a real estate fund or private equity fund. The borrowing standard in part (b) may cause some people to pause on the definition and get entwined in a rabbithole of definition.

The form also has more detailed requirements for large private equity advisers. For purposes of Form PF, “private equity fund” is

any private fund that is not a hedge fund, liquidity fund, real estate fund, securitized asset fund or venture capital fund and does not provide investors with redemption rights in the ordinary course.

So a real estate fund is not a private equity fund and not subject to the additional reporting requirements.

Being a member of the “all other advisers” category, the filing is due with 120 days after the end of the fiscal year. Assuming calendar year is my fiscal year, the first filing is due by April 30, 2013.

Sources:

Cybersecurity and Private Funds

hacker

The Securities and Exchange Commission has off-an-on expressed concerns about cybersecurity for broker-dealers and registered investment advisers. Now it’s officially concerned. The SEC’s Office of Compliance Inspections and Examinations has announced a new cybersecurity initiative. The Risk Alert follows the announcement of a technology element in OCIE’s 2014 examination priorities and the SEC’s March 26, 2014 Cybersecurity Roundtable.

As part of the initiative, OCIE will conduct cybersecurity examinations of registered investment advisers. These examinations will be conducted as a ”sweep exam” to assess cybersecurity risks. The Risk Alert states the sweep will be of more than 50 registered broker-dealer and registered investment advisers.

In anticipation of the sweep exams, the SEC included a sample request list for the Identification of Risks/Cybersecurity Governance.

I would anticipate that the sweep exam will be targeted at the big BDs and retail investment adviser shops and not be focused on private fund managers. However, I plan to sit down and go through the sample letter to make sure I can answer all of the questions.

References:

Hacker is by Dani Latore
CC BY SA

Cleaning Up An Oil Spill Is Insider Trading

oil platform and compliance

Keith A. Seilhan was 20-year employee of BP and a senior responder during the 2010 Deepwater Horizon oil spill. Seilhan directed BP’s oil skimming operations and its efforts to contain the expansion of the oil spill. What he saw scared him so he sold his entire portfolio of BP stock.

The Securities and Exchange Commission charged him with insider trading. The SEC’s view was that he had confidential information about the magnitude of the disaster. BP was telling the public that the spill was only 5,000 barrels of oil per day. Seilhan obtained information that the magnitude of the oil spill and BP’s potential liability and financial exposure, was likely to be greater than had been publicly disclosed. The truth was more than ten times that publicly reported amount.

This case reminded of the railroad case where workers in the railroad yard noticed unusual activity around the railyard and came to the conclusion that the railroad was up for sale. They made a stock bet on their conclusion and won. But the SEC charged them with insider trading, but lost the case.

In the oil case, Seilhan knew the company was lying about the scope of the spill. The information was not publicly available because BP was purposefully deceiving the public and regulators.

You could argue that the information is more like the counting of cars in a retailers parking lot to see how business in doing. Anyone could jump in a plane and see the scope of the oil spill. The news organizations were doing just that. I assume it would take a trained eye to notice that the spill was being misjudged by an order of magnitude.

Regardless of my thoughts about the case, Mr. Seilhan felt it was better to settle the charges than fight the SEC. A month after the trade he received a reminder memo from BP legal to not trade on the stock based on an employee’s possession of price sensitive information. That prohibition was in BP’s code of conduct. Seilhan replied to legal and wanted to discuss his trade, but never followed up or disclosed.

Seilhan agreed to return $105,409 of allegedly ill-gotten gains, plus $13,300 of prejudgment interest, and pay a civil penalty of $105,409.

References:

Image is Thunder Horse Semisub by Andyminicooper
CC BY SA

Happy Patriots’ Day

patriots day compliance

The Redcoats are coming!
The Redcoats are coming!

Patriots’ Day is a Massachusetts state holiday commemorating the opening battles of the American Revolutionary War in Lexington and Concord in April, 1775.  The more modern day event is the running of the Boston Marathon, starting in Hopkinton and ending 26.2 miles later in Copley Square.

Last year’s marathon was horribly marred by two homicidal psychopaths. This marathon is being taken back this year.

In the morning there is a battle reenactment on the Lexington Green of the early-morning engagement between the town’s militia and the British regulars. If you remember back to U.S. history class, that battle was the shot heard round the world.

There is also a re-enactment of the rides of Paul Revere and William Dawes from Boston out to Lexington. (You don’t know about Hawes because Longfellow didn’t write a poem about him.) That ride started out with the “one if by land, two if by sea” signal to Charlestown in case Revere and Dawes were captured.

What does this have to do with compliance or business ethics? Nothing. It’s a holiday here in Massachusetts so I am out of the office.

Compliance Bricks and Mortar for April 18

bricks curvy

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

Quantity does not equal quality: Expanding ‘disclosure events’ on BrokerCheck a bad idea: Brokerage industry is only one in which professionals as deemed guilty until proven innocent by S. Lawrence Polk in Investment News

Under the current version of Form U4, brokers and their firms are required to disclose any written customer complaint, no matter how frivolous, as long as it somehow relates to a sales practice issue, even if the broker is not named in the complaint. The broker that is the subject of the complaint has it reported on his or her CRD and can remove the disclosure only by going through an expensive and time consuming expungement action, in which the broker bears the burden of proving the complaint is false.

In other words, the broker is deemed guilty until he or she proves his or her innocence. No other profession has a reporting system where the mere filing of a complaint, even if it is later withdrawn, remains part of the public record for years afterward.

Massachusetts Regulators Allege TelexFREE Is $1 Billion Ponzi Scheme by Jordan D. Maglich in Ponzitracker

Massachusetts securities regulators have initiated civil proceedings accusing a Massachusetts and Nevada company of operating a massive pyramid andPonzi scheme targeting Brazilian-Americans that, through the promises of guaranteed annual returns exceeding 200%, raised more than $90 million from Massachusetts residents alone and nearly $1 billion worldwide.  TelexFREE, Inc., a Massachusetts corporation, and TelexFREE, LLC, a Nevada limited liability company (collectively, “TelexFREE”), were accused of violations of the Massachusetts Uniform Securities Act by engaging in the fraudulent offering and sale of unregistered securities.  The Massachusetts Enforcement Section of the Massachusetts Securities Division is seeking, in relevant part, a permanent cease-and-desist order, an accounting, restitution to victims, and disgorgement of profits and ill-gotten gains.

Was the Conflict Minerals Ruling a “Win” for SEC Rulemaking? by Dave Lynn in CorporateCounsel.net

With this outcome, the rule writers at the SEC are no doubt breathing a sigh of relief, as they still have a relatively full plate of Dodd-Frank Act and JOBS Act mandated rulemakings that continue to percolate. After a string of high profile losses in this Court and the U.S. District Court for the District of Columbia, this outcome is probably the best that the SEC and the Staff could have hoped for and may serve to pave the way for moving forward with the rest of the rulemaking agenda.

The High Cost of Procrastination by Dan Ariely

This is what procrastination is all about. When we think about our life in general we see the benefits of getting our work done on time, saving for retirement, eating better and other good habits. Yet when we face the decision about right now, we get tempted and too often follow our immediate desires and not what it is good for us in the long-term.

Best Practices Under the FCPA and Bribery Act

FCPA Compliance

Tom Fox is prolific writer on the Foreign Corrupt Practices Act. He publishes the excellent FCPA Compliance and Ethics Blog. One of the downsides to a blog is that it’s a running commentary and not a narrative guide. Blogs are great for sharing ideas among practitioners. But a blog does not come together as a nuts and bolts tool.

Tom took action and organized some of his best posts into Best Practices Under the FCPA and Bribery Act. Now you can pull a comprehensive collection off your shelf to help you create and manage a world class compliance program for bribery and corruption.

The book is a “best of” collection, but organized topically, making it a great resource for the FCPA practitioner.

I was not an unbiased reader of the book. I’ve spoken with Tom many times and spent some time with him at the Compliance Week conference in 2010. Tom kindly mentioned me in the acknowledgements and sent me a copy of the book.

My only demerit on the book is that there is little new material that did not appear on his blog.

The SEC Expresses Its Displeasure on Fund Fees

money penny

A few days ago, Bloomberg published a story that the Securities and Exchange Commission has examined about 400 private equity firms and found that more than half charged “unjustified fees and expenses without notifying investors”. The SEC followed through with that story and recently charged Total Wealth Management with improperly disclosing fee revenue.

Total Wealth sponsored a series of private funds that invested in other funds. Total Wealth had revenue sharing arrangements in place with several of the funds in which it invested, paying Total Wealth a fee when it placed client investments in those funds. Total Wealth would split the revenue sharing income among the firm’s principals.

Revenue sharing is not illegal  and not necessarily misleading, deceptive, or fraudulent. The key is disclosure. If properly disclosed, the SEC would have little basis for bringing charges.

According to the SEC order, the funds’ offering memoranda failed to adequately disclose the revenue sharing arrangement. One of document stated”

“Some Private Funds may pay the General Partner or its affiliates a referral fee or a portion of the management fee paid by the Private fund to its general partner or investment adviser, including a portion of any incentive allocation” (emphasis added).

The revenue sharing arrangement was not disclosed in the “other fees and expenses” summary portion of the offering document.

The SEC argues that Total Wealth should have disclosed that it was already receiving the fee income and not merely that it “may” receive the income.

Stopping at this point, the SEC charges leave me unsettled. The argument over the definitive nature of the fees seems to be over-reaching to me. I think many fund disclosures use “may” when describing other revenue sources.

The other aspect of fee arrangements is the distortion in behavior. Disclosure of the fees alone may be enough, but not if the fee distorts behavior so the fund manager might not be acting in the best interest of its investors.

Here is where the SEC’s case is stronger. About 92% of Total Wealth’s fund assets were invested in entities that had revenue sharing arrangements. Total Wealth’s behavior was apparently distorted because it was more likely to invest in funds with a revenue sharing arrangement. Some of these arrangements also had lock-ups that prevented investors from withdrawing money.

The SEC also accused Total Wealth of deliberately burying the revenue sharing arrangement. The revenue was shared through two entities and labeled the fees as consulting fees, even though the entities did not do any consulting work. Total Wealth fired an experienced compliance consultant who drafted a Form ADV Part 2 that very clearly disclosed the revenue sharing arrangement. The next consultant was much less experienced and used the “may” language instead.  The SEC also accused Total Wealth of hiring an inexperienced accountant who inadequately investigated the revenue sharing.

Total Wealth has not agreed to the charges, so we only have the government’s side of the story. The SEC also threw in charges of failing to comply with the Custody Rule and Total Wealth’s failure to meet its own diligence standard.

I’m troubled by the SEC’s position in this case over the use of “may.” (Of course, there are other issues in the case.) If this truly is the SEC’s position, then I understand why the SEC thinks 50% of private fund managers have problematic fees. And if it this truly is the SEC’s position then there will be lots of fund managers going back through and revising their documents.

References:

Real Estate Investing and Crowdfunding

crowdfunding real estate

Real estate investing is capital-intensive. It should be a natural area for crowdfunding. The big concern is fees and conflicts.

With a tech startup, you are investing in an idea and the people with the idea. It may grow exponentially or blow up, leaving little behind. Part of the investment is paying the people to run the business. With real estate, the cost of managing the investment may be an additional expense beyond the investment. The people managing the investment may be connected with the people selling the investment. That can work well, or be a conflict.

The Wall Street Journal highlighted crowdfunding opportunities in real estate: Real-Estate Crowdfunding Finds Its Footing. The Securities and Exchange Commission has not enacted crowdfunding regulations yet, so the investments will have to be limited at accredited investors, or otherwise exempt from securities registration. Of course, if the investor has enough rights, it’s possible that the investment might not be a security.

The stories highlights three real estate crowdfunding platforms:

  • RealtyMogul
  • Fundrise
  • Prodigy Network

So I decided to take a closer look.

Realty Mogul

After logging in, the site asks for self-reporting of income and net worth to determine if the user is an accredited investor. The final step is a click wrap agreement that:

“By checking this box, you represent that you have such knowledge and experience in financial and business matters that you are capable of evaluating the merits and risks of this investment, and you are able to bear the economic risk of this investment including the risk of complete loss.”

Then the site imposes a 21 day delay. I presume that this is set up to distance the site registration from a general solicitation. By coming back 21 days later, I assume the firm is trying say that there is now a relationship.

Even with the delay, you can browse available investments. There were 5 available when I viewed the site, ranging from $510,000 to $760,000 of equity sought. Each sets up a Realty Mogul subsidiary to invest alongside a property operator/co-investor. The site discloses the operator’s compensation and Realty Mogul’s compensation.  The available assets all had a $10,000 minimum investment.

Fundrise

This site also has you self-certify as an accredited investor. I was surprised to see the no option as “No – most people choose this option”. I chose this first, then went back to switch it to accredited investor.

Apparently, Fundrise has seen the SEC rule on general advertising and requires verification that you are accredited. The site requires a verification letter from a broker-dealer, registered investment adviser, attorney, or CPA before granting you status as an accredited investor.

The platform has regulation A offerings available for non-accredited investors, but limited by state. The documentation is substantial. The offering document for one investment was over 100 pages.

Fundrise is less transparent about fees than Realty Mogul. The Reg A investment allowed an investment as little as $100. The private placements required a minimum of $5000.

Fundrise has a social network aspect, allowing you to see the investors in an investment and to join investment network within the platform.

Prodigy Network

Offered little detail behind its introductory pages.

Summary

Here is the big problem with real estate crowdfunding. To purchase or sell real estate, you need to act and convince the other side that you can close. If you are buying a property and sourcing the capital with crowdfunding, there is the possibility that you won’t raise the money and not be able to close. Presumably you would have to include the successful crowdfunding as a closing condition, or have a backup source of more expensive capital to cover the failed crowdfunding. As a seller, why would you accept an offer contingent on crowdfunding?

The alternative is that the real estate is already warehoused with a party and is looking to lay off some of the equity or fund capital improvements.  Then you are looking to crowdfunding as a cheaper source of capital or a quicker source of capital. I have a hard time believing that crowdfunding is cheaper or faster than other sources of capital. And if other sources of capital are not interested in the investment, perhaps that is an indication.

However, I applaud the efforts of these sites and think they offer an interesting opportunity to make an alternative investment.  I had only a short opportunity to see what these platforms have to offer and how they go about offering their investments. There is lots more to see and learn.

References:

Compliance Bricks and Mortar for April 11

ponzi bricks and mortar

Charles Ponzi’s former home up for sale by Erin Ailworth

For the first time, the butter-colored stucco house with the slate roof and second-story balustrades, is going on the broader real estate market, available to anyone willing to take a run at the $3.3 million asking price. All previous sales have been private.

One of the biggest selling points, of course, is Ponzi’s one-time ownership — although he occupied the property for only about six weeks in 1920 before he was arrested on charges of mail fraud. The home has only changed hands three times since Ponzi bought the house from the previous owner, paying him initially with one of his company’s worthless securities.

Introducing Cybersecurity Docket!

Cybersecurity Docket, the “Global Cybersecurity and Incident Response Report,” seeks to be the most comprehensive and timely source of news and commentary on the exploding fields of cybersecurity, data breach and incident response. Continuously updated throughout the day, Cybersecurity Docket delivers important news and developments as they occur – not days or weeks later. Lawyers, executives, compliance officers, consultants, regulators and other professionals throughout the cybersecurity industry rely on Cybersecurity Docket as their “one-stop” way to quickly and easily stay informed.

Answering the questions high-frequency trading raises by Brian Schreiner in Investment News

There has been a media firestorm over high-frequency trading since Michael Lewis appeared on “60 Minutes” on March 30 to discuss his new book Flash Boys. But HFT is nothing new. It has been around since at least 1999 when stock exchanges became fully electronic. HFT is a complex and nuanced issue, which requires more than a cursory overview to gain an informed opinion.

Trust Hero: Brad Katsuyama, on CBS 60 Minutes by Charles H. Green in Trust Matters

Of course, it is anything but crazy. As Michael Lewis says, “When someone walks in the door who is actually trustworthy, he has enormous power. And this is about trying to restore trust to the financial markets.”

Exactly. As anyone who’s been reading this blog for years knows, trust sells. Trust scales. Trust creates value. Trust is an enormous competitive advantage.

Do Compliance Professionals Have to Be Lawyers? by Michael Volkov in Corruption, Crime & Compliance

As compliance professionals enjoy the rise of their profession, lawyers are sensing a decline in importance.  I am hearing from compliance professionals a new and disturbing trend – companies are requiring compliance professionals to be trained attorneys.

 

Pay to Play and the Supreme Court

Supreme Court

The US Supreme Court struck down some campaign finance limitations in McCutcheon v. Federal Election Commission. My first question was whether this court ruling would impact the Securities and Exchange Commission’s Rule 206(4)-5. The answer is “no.”

Mr. McCutcheon wanted to contribute $1776 dollars to a long list of political candidates. Each individual contribution is less than the $2600 federal limit. But the sheer number of candidates and political groups he targeted would violate the aggregate limits.

It was this aggregate limit that the Supreme Court struck down. The case did not strike down the individual limit.

The First Amendment protects political campaign contributions as a type of free speech. Therefore, any restrictions on political contributions must promote a compelling state interest and undertake the least restrictive means to further the state interest.

The Supreme Court has found that the government can regulate campaign contributions that target “quid pro quo” corruption or its appearance. Individual campaign contributions can be limited to prevent the dollars for political favors problem. That is a compelling state interest.

SEC Rule 206(4)-5 is specifically targeted at the corruption or appearance of corruption problem. The SEC can point to specific instances of government investments being tied to political contributions. It’s unlikely that the SEC’s pay-to-play rule will be overturned anytime soon.

References:

Image of the Supreme Court is by Matt H. Wade