Month: May 2014

Compliance Bricks and Mortar for May 30

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

Cybersecurity Crackdown in ThinkAdvisor

Think that your firm is too small or that your cyberdefenses are too strong to worry about digital attacks on your firm’s—and your clients’—data? The SEC and FINRA don’t think so. A reading of the regulators’ official announcements and the insights of those who know how they operate suggest that advisors run the risk not only of compromised data but of major fines as the regulators gear up to make examples of firms for cybersecurity shortcomings.

Lawyers as SEC Enforcement Targets, What a Fund Manager Needs to Know by Jay B. Gould in Pillsbury’s Investment Fund Law Blog

In a move that should place securities lawyers and their clients on notice, Commissioner Kara Stein of the Securities and Exchange Commission (“SEC”) recently indicated that lawyers may become targets of SEC enforcement actions when a registrant has been poorly advised by its attorney and the result of that advice ends up harming investors or violating regulatory standards.  The SEC has the ability to sanction, fine and bar attorneys and accountants from practicing before the SEC pursuant to SEC Rules of Practice 102(e).  As a practical matter, a bar pursuant to Rule102(e) precludes an attorney or an accountant from representing a regulated entity, such as an investment adviser or broker dealer, in any further dealings with the SEC or otherwise.

SEC judge bans money manager for misleading Morningstar, investors by Trevor Hunnicutt in InvestmentNews

The administrative law judge found that Max E. Zavanelli — a portfolio manager who has compared his success at investing to the legendary Fidelity Investments manager Peter Lynch — misrepresented and omitted important data in newspaper advertisements, its own newsletters and reports for Morningstar.

Godzilla versus Collateralized Debt Obligations by Erik Gerding in the Conglomerate

gozilla v toxie

Private Equity at Work

private equity at work

Eileen Appelbaum and Rosemary Batt tried to take an academic look at private equity firms and published their results in Private Equity at Work: When Wall Street Manages Main Street. The authors paint the world in black and white. They present the book as a question of whether private equity firms are (1) financial innovators that save failing businesses or (2) financial predators that bankrupt otherwise healthy companies and destroy jobs?

You can guess the answer from the first two paragraphs. The authors spend eight lines on the successful Aidells Sausage Company investment and 19 lines on the disastrous Mervyn’s Department Store investment.

The authors largely treat private equity firms as parasites and propose far-reaching and ill-thought out ideas to curb them. They reach their conclusions from a misunderstanding of private equity, poor comparisons, and a lack of data.

The authors chose to use the corporate-raiding barbarians of the 1980s leveraged buyouts as the origin of private equity instead of Bain Capital’s genesis of management consulting.

The authors routinely use public companies as a benchmark. They fail to note that public companies are merely a small fraction of the operating companies in the United States. It’s hard to get data on private companies, of course, because they are private.

In my mind comparing the bankruptcy rate of private equity-owned companies to the rate of public companies is not a true comparison of failure. I accept the premise that public companies typically carry less debt as a percentage of their capital structure. But I don’t accept the premise that the public company standard is true for non-public companies, whether they are operator owned or private equity-owned.

The authors get trapped in the idea that private equity is all about taking public companies private using high levels of debt. The LBO sector is only one part of the private equity world.

I was particularly annoyed at the authors for their failure to correctly describe the regulatory framework and background for private equity firms. Private equity firms were not subjected to SEC regulation by Dodd-Frank. The SEC always had the power to enforce the anti-fraud provisions of the various securities laws. Dodd-Frank removed a commonly-used exemption from registration as investment advisers. That old exemption was based the number of clients (i.e. funds) the firm managed, not size.

When it comes to performance, the authors have some good data, but much of it is admittedly flawed data on performance. Those flaws don’t keep them from reaching their conclusions. They note that a large chunk of private equity firms do not beat the S&P 500 or similar public company benchmark. They state that many investors would have been better off investing in an ETF. They fail to note that the same is true for mutual funds. The majority of which fail to exceed their respective benchmarks.

The authors also label private equity as focused on short-term shareholder value. They seem to forget that public companies are even more focused on short-term issues. A public company’s value is determined with every trade and the value swings up and down with the stock ticker wrapping around the tote board.

Eventually, the authors sprinkle in some positive stories of private equity. But the book is largely a hatchet job on private equity.

Eileen Appelbaum is Senior Economist at the Center for Economic and Policy Research. Rosemary Batt is the Alice Hanson Cook Professor of Women and Work at the ILR School, Cornell University.

A publicist sent me a copy to review. There were many times while reading the book that I wished he had saved the postage.

Fees, Expenses and the S.E.C.

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Andrew Bowden threw a grenade at the private fund industry three weeks ago when he spoke at PEI’s Private Fund Compliance Forum. He said that the SEC found violations of law or material weaknesses in over 50% of the exams they had conducted of private equity funds when it came to fees and expenses.

Mr. Bowden pointed to two particular types of fees and expenses: monitoring fees and operating partners. Although both of these are customary in private equity deal and disclosed in PPMs and financial statements, the SEC does not like them. He lumped them together with fraudulent expenses in the Camelot case.

Two recent news stories are carrying on Bowden’s view of private equity.

Last week, the Wall Street Journal ran a story on how KKR failed to credit certain fees back to investors because the unit was not an affiliate:  KKR Error Raises Question: What Cash Should Go to Investors? KKR is required to share with investors in its largest buyout fund 80% of any “consulting fees” collected by any KKR “affiliate.” The unit in question was owned by KKR’s management and not considered an affiliate. The article specifically tied back to Mr. Bowden’s speech.

On Sunday, Gretchen Morgenson penned an article in the New York Times about monitoring fees: The Deal’s Done. But Not the Fees. The article highlighted $30 million in monitoring fees paid to Goldman Sachs, Kohlberg Kravis Roberts and TPG Capital for their oversight of Biomet. The unpaid fees under the 10-year monitoring contract became due on the sale to Zimmer Holdings. This article also specifically mentions Mr. Bowden’s speech.

In my view, it’s not that the fees are illegal or “fraudulent, manipulative or deceptive” under Section 206. It’s a matter of disclosure to investors and internal procedure. Investors deserve a right to know the fees they are paying, either directly through the fees by the fund, or indirectly by the fees paid by the portfolio company to the fund manager. Perhaps in some fund documents the fees can be laid out in more detail. Fund managers should have internal procedures for how fees are implemented and checked to make sure they comply with the fund documents.

Personally, I think Mr. Bowden is lumping a lot of customary fees and expenses into his 50% bucket. I’m offended that he is including the case of fraud, like the Camelot case, in with instances of fees that the SEC merely does not like.

References:

Weekend Reading: The Sea & Civilization

sea and civilization

Lincoln Paine wants to change your view of the world. He wants you to focus on the blue parts of the map that cover over 70% of the world’s surface. In his book, The Sea and Civilization, he makes that case that mankind’s technological and social adaptation to the water has been a driving force in human history, whether it was to wage war, or for migration or commerce.

Perhaps Jared Diamond’s great book Guns, Germs and Steel should have been Guns, Germs, Steel and Boats. Paine makes the case by telling the tales of recorded history through the lens of the seas.

At times he succeeds. At other times, the book comes across as a rote recital of history. There were several places in the book where I wanted more insight. Paine is incredibly thorough, hitting most of the major events affected by sea travel. I wish there was more depth instead of breadth.

Compliance Bricks and Mortar for May 23

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

SEC Enforcement Director: What Empowered Compliance Looks Like by Jaclyn Jaeger in Compliance Week

“Companies that have done well in avoiding significant regulatory issues typically have prioritized legal and compliance issues and developed a strong culture of compliance across their business lines,” said Ceresney. “I’ve found you can predict a lot about the likelihood of an enforcement action by asking a few simple questions about the role of the company’s legal and compliance requirements:

  • Are legal and compliance personnel included in critical meetings?
  • Are their views sought and followed?
  • Do legal and compliance officers report to the CEO, and have significant visibility to the board?
  • Are legal and compliance departments viewed as important partners in the business, and not simply as support functions, or a cost center?

SEC officials seek clarity on compliance officers’ liability by Sarah N. Lynch

At separate conferences, Securities and Exchange Commission members Kara Stein and Daniel Gallagher called for the agency to provide more clarity, noting many officers fear they will become the subject of an enforcement action.

Financial Literacy by Alex Tabarrok in Marginal Revolution

Only about a third of Americans answer all three questions correctly (and that figure is inflated somewhat due to guessing). The Germans and Swiss do significantly better (~50% all 3 correct) on very similar questions but many other countries do much worse. In New Zealand only 24% answer all 3 questions correctly and in Russia it’s less than 5%.

Second Circuit Reverses SEC Market Timing Verdict by Thomas O. Gorman in SEC Actions

The Second Circuit reversed a jury verdict in favor of the SEC in a market timing case, concluding that there was no evidence to support it. Specifically, the Court found that the “SEC ultimately succumbs to its strategic choice at trial to pursue a theory of scienter or nothing. Its entire jury presentation was premised on the idea that [Defendant] O’Meally violated Section 17(a) through intentional conduct. The SEC’s summation relied solely on intent and recklessness; theories rejected by the jury. And as to negligence, the SEC never introduced testimony or any other evidence on the appropriate standard of care against which a jury could measure O’Meally’s conduct.” This was “fatal” to its case. SEC v. O’Meally, No.. 13-213 (2nd Cir. Decided May 19, 2014).

What Kills You and Your Investments by Barry Ritholtz in Bloomberg View

You don’t understand risk.

I don’t mean you, in your professional capacity. I mean you, the human being whose brain is desperately trying to keep you alive. An endless procession of mortal threats are trying to end your particular genomic variation, forcing your brain to respond first and think later.
…

Let’s look at some of the world’s top predators as an example of risk in the modern world.

…

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Image is from GatesNotes: The Deadliest Animal in the World

What is an “Instrumentality” under the FCPA?

compliance and bribery

If your are trying to figure out whether a company is a private company or an “instrumentality” of a foreign government under the Foreign Corrupt Practices Act you are already in trouble. To reach that point in the FCPA analysis you’ve already paid a bribe, or are thinking of paying a bribe. (If you’re just thinking about it; Don’t do it.) Otherwise you’ll end up in the position of Joel Esquenazi and Carlos Rodriguez.

The two owned a Florida telecommunications company that was doing business with Telecommunications D’Haiti, S.A.M. (“Teleco”), a company closely linked to the Haitian government. They were paying bribes to officials of Teleco. They were hiding these payments, so they were also involved in money-laundering. The bribery scheme was uncovered by the Internal Revenue Service. Esquenazi and Rodriguez were convicted of FCPA violations and money-laundering.

They appealed their convictions arguing that Teleco was not an “instrumentality” of a foreign government under the FCPA. Instrumentality is not defined in the FCPA and this is the first appellate decision to tackle the definition.

The Court started with the premise that “an instrumentality must perform a government function at the government’s behest…. What the defendants and the government disagree about, however, is what functions count as the government’s business.”

Esquenazi and Rodriguez had a losing hand. The Court looked to the “grease payment” exception under the FCPA. That allow facilitation payments of a “routine government action.” That provision goes on to list phone service as a type of routine government action. At this point, it’s clear they are losing the case.

The Court did not stop there, but decided to use its stature as the first case deciding this issue to provide a list of factors to help future courts decide if the government controls an entity:

  • the foreign government’s formal designation of that entity;
  • whether the government has a majority interest in the entity;
  • the government’s ability to hire and fire the entity’s principals;
  • the extent to which the entity’s profits, if any, go directly into the governmental fisc,
  • the extent to which the government funds the entity if it fails to break even; and
  • the length of time these indicia have existed.

Again, I don’t think any company should be looking at these factors to decide whether or not to pay a bribe. If you pay it, your attorneys are going to be looking at this list to see if they can keep you from going to jail.  Esquenazi and  Rodriguez were sentenced to lengthy jail terms: Esquenazi receiving 15 years and Rodriguez receiving 7 years.

References:

Private Equity Real Estate Top 50 – 2014 Edition of Who Is Registered

PERE 50 long

Private Equity Real Estate has released its ranking of the top 50 real estate private equity fund managers. As I have done in the past, I parsed the list to see which managers are registered with the Securities and Exchange Commission as investment advisers. (Disclosure: my company is on the list.)

Rank Name of institution SEC Registered?
1 The Blackstone Group Registered
2 Lone Star Funds (Hudson Advisors) Registered
3 Starwood Capital Group Registered
4 Colony Capital Registered
5 Brookfield Asset Management Registered
6 Tishman Speyer Registered
7 Angelo Gordon Registered
8 Westbrook Partners Registered
9 Oaktree Capital Management Registered
10 Global Logistic Properties  Overseas
11 Walton Street Capital Registered
12 GI Partners Registered
13 Orion Capital Managers Registered (overseas)
14 The Carlyle Group Registered
15 Fortress Investment Group Registered
16 TA Associates Realty Registered
17 CapitaLand  Overseas
18 Cerberus Capital Management Registered
19 LaSalle Investment Management Registered
20 Beacon Capital Partners Registered
21 Hines Registered
22 Northwood Investors Registered
23 Rockpoint Group Registered
24 Prudential Real Estate Investors Registered
25 GTIS Partners Registered
26 Ares Management (formerly AREA Property) Registered
27 KSL Capital Partners Registered
28 Secured Capital (Exempt Reporting)
29 Rialto Capital Management Registered
30 DRA Advisors LLC Registered
31 Merlone Geier Partners
32 Paramount Group Registered
33 CBRE Group Registered
34 Perella Weinberg Partners Registered
35 Hemisferio Sul Investimentos Overseas
36 Alpha Investment Partners Exempt Reporting
37 Gaw Capital Partners Exempt Reporting
38 Harrison Street Real Estate Capital Registered
39 Kayne Anderson Capital Advisors Registered
40 Phoenix Property Investors Registered
41 Kildare Partners Registered
42 DivcoWest Registered
43 Patron Capital Exempt Reporting
44 Mapletree Investments Overseas
45 GreenOak Real Estate (TFG) Registered
46 Heitman Registered
47 GE Capital Real Estate
48 The JBG Companies
49 Related Companies Registered
50 Tristan Capital Partners Overseas

 

Last year, PERE expanded the list from 30 to 50.  On this year’s list, 38 of the top 50 are registered with the SEC as investment advisers. Of those not registered, 9 are overseas, some of which filed as exempt reporting advisers and the rest are likely to be outside the scope of SEC registration requirements. That leaves 3 firms that are not registered or overseas.

There are good arguments to be made on both sides of the registration debate for real estate funds. The core requirement under the Investment Advisers Act is that the manager is giving investment advice about “securities.” Most of these real estate fund managers are truly focused on real estate and not securities. However, the discussion between what is and is not a security may be fun for the first week of your securities law class in law school. It’s not a fun discussion when trying to comply with regulatory requirements.

The PERE 50 measures capital raised for direct real estate investment through commingled vehicles, together with co-investment capital, over the past five years. This edition measures from January 1, 2009 to March 2014 for direct investment through closed-end commingled real estate funds. It excludes core and core-plus funds.

Sources:

 

Update on the Cay Clubs

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The Securities and Exchange Commission brought charges against several executives of Cay Clubs Resorts and Marinas for defrauding investors. The case originally caught my eye because it involved real estate and would likely play a role in my continuing quest to figure out what’s a security. The SEC’s complaint stated that the defendants “offered investors the opportunity to purchase undervalued condominium units and obtain an immediate 15 percent return through a two-year leaseback agreement with Cay Clubs.” Cay Clubs was not named as defendant in the action against its CEO Fred Davis Clark Jr.; Clark’s wife, Cristal Coleman; sales director Barry Graham; investor-relations director Ricky Lynn Stokes; and CFO David Schwarz.

In its first stumbling block, the Securities and Exchange Commission failed to include a copy of the purchase agreement for the sale of the investments. The judge ruled in July 2013 that without that document the court could not apply the Howey test to see if the investment was an “investment contract.”

Apparently, the Securities and Exchange Commission fixed that mistake, but ran into a bigger stumbling block: time.

The SEC filed its charges over a year ago in January 2013. However, it appears that the investment sales had stopped in 2007. Several of the individuals had left Cay Clubs in October 2007. That’s more than five years and beyond the statute of limitations. Under 28 U.S.C. §2462 the SEC must bring an action for enforcement of any civil fine or forfeiture within five years from the date the claim first accrued.

Finding that the Securities and Exchange Commission “failed to meet its serious duty to timely bring” an enforcement action, the federal judge in Miami closed the case. He dismissed the action with prejudice, noting that “the SEC waited” despite an exhaustive seven-year investigation.

“In essence, the SEC’s argument in this case is that because the words ‘declaratory relief,’ ‘injunction,’ and ‘disgorgement’ do not appear in §2462, no statute of limitations applies.”

Judge King disagreed and cited the U.S. Supreme Court’s decision last year in Gabelli v. SEC.

We are not going to reach the substance of the case and the point of my original interest: were they selling “real estate” or were they selling “investment contracts.”

Resources:

The SEC Says Be Wary of Bitcoin

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Bitcoin has been the Dutch Tulips of investment for a few years. So of course that means the fraudsters have latched on. The Securities and Exchange Commission has piled on and issued an Investor Alert: Bitcoin and Other Virtual Currency-Related Investments.

This is the second investor alert from the SEC on Bitcoin. The first was part of an enforcement action against an alleged Ponzi scheme.

It’s not that Bitcoin is inherently illegal. It actually has an interesting approach on funds transfers. Transfers are free of transaction costs. That’s in sharp contrast to the swipe fees charged by Visa, Mastercard, and the other credit card companies.

One of the current problems with bitcoin is that the value has fluctuating wildly. That’s not what you want in a currency. You want to know that a gallon of gas costs about $4 today and will be about $4 next month. You don’t want the uncertainty that it could be $2 of $8 next month. That turns bitcoin from a currency into an investment.

The IRS recently issued guidance that it will treat Bitcoin and other virtual currencies as property for federal tax purposes. As a result, general tax principles that apply to property transactions apply to transactions using bitcoin.

Bitcoin fraud schemes look like other fraud schemes. The fraudsters use the lure of high returns in a lightly regulated asset. The growth chart of value in Bitcoin is an irresistible lure. Don’t forget to look for the red flags like “guaranteed returns” and “no risk” opportunities. If it sounds too good to be true, it probably is not true.

References:

Compliance Bricks and Mortar for May 9

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

Image of Brick production in Songea, Tanzania is by Egbert

SEC Says Dodd-Frank’s Statute of Limitations Doesn’t Apply to It by Ernest Badway in Securities Compliance Sentinel

According to the SEC, the Dodd-Frank Act does not require the SEC to bring an enforcement action within 180 days of issuing a Wells Notice. See http://www.sec.gov/litigation/opinions/2014/ia-3829.pdf.

Although the Dodd-Frank Act amended the Securities and Exchange Act of 1934 Section 4E(a)(1) to require the SEC to bring the action within 180 days, the SEC said it was not applicable since Congress never said what the consequences if it failed to do so. The SEC claims to be relying upon precedent from other admiminstrative agencies.

Money Laundering 101 by Kortney Nordrum in SCCE’s Compliance and Ethics Blog

AML (Anti-Money Laundering) and BSA (Bank Secrecy Act) laws are absolutely my favorite regulations. No other regulation can provide the feeling of accomplishment when money-laundering violations are found and reported. The same goes for anti-terrorist funding reports. You feel you made a difference that is valued by law enforcement and government. However, no matter what your business line is, money laundering can influence your bottom line. That said, here is a brief overview on how and what should happen when detecting and deterring money-laundering.

Hitting the Ground Running – Your First 100 Days as a New CCO by Tom Fox

In the March-April issue of the Red Flag Group’s Compliance Insider magazine, the issue of what you can do to help yourself to succeed in a new role was explored in an article entitled “The First 90 Days in Compliance”. The article uses the book The First 90 Days by author Michael Watkins as a starting point to provide “systematic methods you can employ to both lessen the likelihood of failure and reach the break-even point faster.”

CFPB Seeks to Overhaul Rules for Bank Privacy Notices by Joe Mont in Compliance Week

The Consumer Financial Protection Bureau has proposed a rule that would streamline the requirements for privacy notices issued by financial institutions, allowing them to be posted online instead of the current practice of delivering them individually to customers.