Month: June 2014

New Guidance on the Custody Rule for SPVs and Escrows

walt-disney-company-stock certificate

The Securities and Exchange Commission’s Division of Investment Management recently released updated guidance on the Custody Rule. Private funds, especially private equity funds, have been wrestling with the SEC’s Custody Rule. The rule clearly comes from the perspective of regulating retail investment advisers and hedge funds. It fails to deali n a useful manner with investments in assets that are not publicly traded. The SEC has been retreating from its latest version of the rule and trying to clarify its overly broad requirements.

The latest guidance (IM Guidance Update 2014-07) tries to add some clarity around the special purpose vehicles for investments and post-closing escrow accounts.

Last summer, the SEC tried to provide some clarity under the Custody Rule for private stock certificates, which was supposed to provide additional relief from the SEC’s overly narrow definition of “privately offered securities.” That guidance made it easier for private equity funds to comply with the Custody Rule without having to wastefully warehouse documents with banks to meet the strict boundaries of the rule.

But there is still lots of uncertainty around the Custody Rule. Compliance with custody is important. It’s a key control for consumers to make sure that their investment adviser is not stealing their money or investing it contrary to their requirements. Last year, the SEC announced that 1/3 of firms examined had custody rule problems.

For a private funds the question will arise as to who is the client for purposes of the Custody Rule when it comes to special purpose vehicles for investments. The new guidance answers questions using four scenarios where SPVs may be involved as fund subsidiaries.

The guidance provides that its okay to not treat the SPV as a separate client, but merely as an asset of the fund, as long as the fund or funds controlled by the same adviser are the owners of the SPV. The SEC states that an SPV owned by the fund and third parties would fall outside this. I’m a bit confused because I never thought an entity with multiple unrelated owners would be considered an SPV.

The guidance also tackles post-closing escrow accounts. The concern is that the escrow account would hold cash owed to the fund, as well as other sellers not related to the fund. The problem is that the Custody Rule requires the client’s assets to be in an account in the client’s name and contain only the client’s funds or securities. A mixed post-closing escrow would violate the rule.

In the Guidance, the SEC retreats from commingling requirement so long as:

  • the fund is audited
  • the commingled escrow is in connection with sale or merger of a portfolio company
  • the escrow is maintained by a qualified custodian

The Guidance fixes some problems and creates some more. The rule clearly states that commingling is never allowed. The guidance now says that commingling is allowed in certain circumstances. Good luck reading the published regulations.

The SEC has just laid down the law on how post-closing escrows are handled in private equity transactions. I can hear the screams now that the Guidance does not match up with how the deals are structured or how the escrow is designed. Of course for real estate fund managers, they are left scratching their heads trying to figure out how to make this exception work for them.

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Weekend Reading: Fierce Patriot

fierce patriot and compliance

General Sherman is known for burning Atlanta. That is as much I knew about him. Having been raised in Boston, my schooling in American History emphasized the Revolutionary War. But my friend and author Megan Kate Nelson has piqued my interest in the Civil War.

Why did I read about Sherman? The publisher offered me a copy of the book. Even better than a free book, is a good free book. And Fierce Patriot is very good book.

Robert O’Connell does not plug through Sherman’s life in a purely chronological way. He breaks the biography into three parts. The first is Sherman’s career. Starting with his West Point education, then moving from soldier into banker, then back to soldier. The second part covers his influence on military strategy and the role of changing technology on the battlefield. The last part focuses on his personal life. My gripe with the book is that the second and third parts are less successfully executed than the first part.

The author’s main thesis is that Sherman was a nationalist. He believed in the UNITED States and would not put up with the South’s secession. Even though he burned a path across the South in his march to the sea, he made his army recognize that the enemy was fellow countrymen. There was plenty of pillaging to feed his army. The march was designed to be painful and to deliver psychological blows to the South. But there was not supposed be raping and murdering of southern citizens. The goal was to once again make them citizens of the United States.

His nationalist beliefs stayed with him after the war. He was a key player in the building of the transcontinental railroad, literally binding California to the rest of the country.

Sherman’s personal life was a mess. His father died young, leaving a flock of children and no money for his widow to support them. Sherman was adopted by the wealthy and politically connected Ewing family. Certainly, the Ewing family played key roles is setting him up for future success. Sherman ended up marrying his foster sister.

All of this is mixed together in wonderfully written style by O’Connell.

Sherman’s march to sea happened 150 years ago in 1864. If you’re looking for a way to learn more about the battles and the man that lead the march, Fierce Patriot is a book you should add to your “To Read” shelf.

Compliance Bricks and Mortar for June 27

soccer brick compliance

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

A Committee of Fund Manager Personnel May Not Be Able to Provide the Requisite Consent on Behalf of the Fund for a Principal Transaction by Steve Ganis in Securities Litigation & Compliance Matters

So what constitutes sufficient consent for a principal transaction or an agency cross trade that does not meet the blanket consent exemption? Generally speaking, fund managers may, depending on the circumstances, rely upon a committee of underlying investors or independent third-parties to consent to principal transactions.

What’s the best way to document that training has taken place? by Kortney Nordrum in SCCE’s Compliance & Ethics Blog

It’s a common compliance requirement to train your employees – on safety procedures, regulations, products they are selling, and so forth.  And very often the regulator requires you not just to train but to document your training or confirm understanding.  What is the best way to document that training has taken place?

There are 3 obvious routes:

  • Have the instructor take attendance
  • Get employees ‘ signatures confirming they have understood training
  • Administer a test after the training, so that employees can demonstrate their understanding

Halliburton: U.S. Supreme Court Declines to Overturn Basic, Allows Defendants to Rebut Presumption of Reliance by Kevin LaCroix in The D&O Diary

While the Court’s decision will not alter the securities litigation landscape as much as might have been the case if it had overturned Basic, the Court’s holding that defendants may at the class certification stage seek to rebut the presumption of reliance based on the absence of price impact could have a significant effect on securities litigation. In many cases, plaintiffs may be unable to obtain class certification where in the past they might have been able to have a class certified. In any event, the class certification phase likely will become more costly as the parties dispute the issues surrounding the impact of the alleged misrepresentation on the share price.

Court fight bares SEC insider-trading probe by Kevin McCoy in USA TODAY

SEC investigators are probing whether anyone on Capitol Hill improperly leaked information about the federal Centers for Medicare & Medicaid Services’ final decision on 2014 rates the federal government would pay insurers that offer private Medicare plans.

Formally issued at 4:15 p.m. on April 1, 2013, the rates increased by 3.5%. The surprise decision scrapped the 2.3% rate decline in a preliminary government plan that drew bipartisan congressional opposition.

Approximately 15 minutes before the 4 p.m. market close that day, trading volume and stock prices of some health insurers likely to benefit from the increase “rose precipitously,” SEC attorney Amanda Straub wrote in Manhattan federal court papers filed on Friday.

PEGCC Releases New State and Congressional District Rankings for Private Equity Investment

Private equity firms invested more than $443 billion in U.S.-based companies last year, a 27 percent increase over the previous year, according to the Private Equity Growth Capital Council’s fourth annual investment report, “Private Equity: Top States and Districts.” The analysis, which ranks the top 20 states and congressional districts by investment value and number of investments, found that Texas received the most investment in 2013, topping California, Pennsylvania, New York and Florida.

Private equity firms invested more than $443 billion in U.S.-based companies last year, a 27 percent increase over the previous year, according to the Private Equity Growth Capital Council’s fourth annual investment report, “Private Equity: Top States and Districts.” The analysis, which ranks the top 20 states and congressional districts by investment value and number of investments, found that Texas received the most investment in 2013, topping California, Pennsylvania, New York and Florida.

Visit the PEGCC’s Interactive Map to see data, including pension fund investment, for all 50 states and rankings.

– See more at: http://www.pegcc.org/newsroom/in-the-news/pegcc-releases-new-state-and-congressional-district-rankings-for-private-equity-investment-see-more-at-httpwww-pegcc-orgnewsroompress-releasespegcc-releases-new-state-and-congressional-distri/#sthash.DzUFhnQy.dpuf

Private equity firms invested more than $443 billion in U.S.-based companies last year, a 27 percent increase over the previous year, according to the Private Equity Growth Capital Council’s fourth annual investment report, “Private Equity: Top States and Districts.” The analysis, which ranks the top 20 states and congressional districts by investment value and number of investments, found that Texas received the most investment in 2013, topping California, Pennsylvania, New York and Florida.

Visit the PEGCC’s Interactive Map to see data, including pension fund investment, for all 50 states and rankings.

– See more at: http://www.pegcc.org/newsroom/in-the-news/pegcc-releases-new-state-and-congressional-district-rankings-for-private-equity-investment-see-more-at-httpwww-pegcc-orgnewsroompress-releasespegcc-releases-new-state-and-congressional-distri/#sthash.DzUFhnQy.dpuf

Private equity firms invested more than $443 billion in U.S.-based companies last year, a 27 percent increase over the previous year, according to the Private Equity Growth Capital Council’s fourth annual investment report, “Private Equity: Top States and Districts.” The analysis, which ranks the top 20 states and congressional districts by investment value and number of investments, found that Texas received the most investment in 2013, topping California, Pennsylvania, New York and Florida.

Visit the PEGCC’s Interactive Map to see data, including pension fund investment, for all 50 states and rankings.

– See more at: http://www.pegcc.org/newsroom/in-the-news/pegcc-releases-new-state-and-congressional-district-rankings-for-private-equity-investment-see-more-at-httpwww-pegcc-orgnewsroompress-releasespegcc-releases-new-state-and-congressional-distri/#sthash.DzUFhnQy.dpuf

Massachusetts Stops Real Estate Scam

Flag-map_of_Massachusetts.svg

Secretary of State William Galvin claims Cabot Investment Properties LLC and its principals, Carlton P. Cabot and Timothy J. Kroll, stole more than $5 million from Massachusetts residents. Cabot was offering tenant-in-common interests to investors. But I remember from law school that a tenant-in-common interest is real estate. So why are the defendants charged with securities fraud?

Tenant-in-common arrangements are common for real estate. (More often you see joint tenancy, where the other party gets the whole when the other dies.) The tenant-in-common arrangement is more often used in commercial properties as part of a 1031 exchange. It’s a way to park cash from the sale of another asset to defer the payment of taxes.

A TIC Interest is a co-ownership structure that allows multiple investors to share undivided fractional ownership in a property such as an office building or shopping center. The owners share equally in the management and other property decisions. If it was organized as a partnership or fund, the investment would not be considered real estate and therefore not subject to the tax deferral of 1031.

The challenge is getting collective decision-making and management from a group of unrelated investors to manage the commercial property. That means the group will have to layer some management rights onto the tenant-in-common relationship. That means the investor may be relying the efforts of others for success of the project.  This is not a novel issue. Tenant-in-common sponsors have been wrestling with their treatment as securities. The twist is that the investment can be considered real estate for tax purposes and a security for regulatory purposes. The structuring of a TIC is more focused on meeting the IRS rules for treatment as real estate than the SEC’s view of what is a security.

It looks Cabot treated the TIC interests as securities because the Administrative Complaint mentions the offering documents which include a private placement memorandum. You’re not likely to have the document for a real estate investment. In searching through EDGAR its easy to find many of the Form D filings for Cabot’s TIC offerings.

I don’t have access to the documents, but one item in the list of an investor’s real estate documents is a master lease and a property management agreement. Those will likely leave management of the property firmly in the hands of the sponsor.

From there, the charges run through pilfering money and commingling money among the investments. In reading the complaint it’s hard to tell what was poor management or poor disclosure or poor communications with investors or fraud. The investments failed and investors lost money. According to the complaint and other lawsuits, a substantial sum was diverted outside the investment TIC structure to Cabot.

This seems to be a clear case of real estate being turned into a security.

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SEC Charges Private Equity Firm With Pay-to-Play Violations

compliance politics and money

The SEC has brought its first case under the pay-to-play rule for registered investment advisers. It’s just as horrible as I thought it would be.

The Securities and Exchange Commission enacted Rule 206(4)-5 to address pay-to-play abuses involving campaign contributions made by registered investment advisers and their key employees. The concern was contributions to government officials who are in a position to influence the selection of advisers to manage government client assets, including public pension assets. The SEC perceived that there is a culture of making contributions in exchange for investment.

TL Ventures sponsored private equity funds. The Pennsylvania State Employees’ Retirement System is an investor in two funds. The City of Philadelphia Board of Pensions and Retirement is an investor in one fund. The commitments were made in 1999 and 2000. As a limited partner in the fund, neither government pension fund had the right to withdraw its contribution or to make a bigger contribution.

In 2011, a covered associate of TL Ventures made a $2500 campaign contribution to the Mayor of Philadelphia. The Mayor appoints three of the nine members of the City of Philadelphia Board of Pensions and Retirement. Therefore the Mayor has indirect influence over the investment decisions and contributions are subject to Rule 206(4)-5.

In 2011, a covered associate of TL Ventures made a $2000 contribution to the Governor of Pennsylvania. The Governor appoints six of the eleven members of the board of the Pennsylvania State Employees’ Retirement System. Therefore the Governor has indirect influence over the investment decisions and contributions are subject to Rule 206(4)-5.

In this case, the dollar amounts are not huge. In the current race for Governor, Ed Rendell and Bob Casey have together spent $31.5 million. The violation in this case was $2500. I assume the Covered Associate lived in Pennsylvania. Therefore the cap under Rule 206(4)-5 was $350.

The contributions were made more than 10 years after the investment decision was made. There is no statement of malice or bad intent by TL Ventures. But Rule 206(4)-5 does not require a showing of quid pro quo or actual intent to influence an elected official or candidate. You make a contribution; you violate the rule.

The SEC action also includes a charge of failing to register with the SEC. TL Ventures tried to structure its business to avoid registration. TL Ventures managed venture capital funds and therefore was able to be an exempt reporting adviser. Its affiliate, Penn Mezzanine, had less than $150 million under management and therefore would be subject to state registration, not SEC registration. The SEC has stated that it will treat two or more affiliated advisers that are separate legal entities but are operationally integrated as a single adviser. The SEC found that the operations of the two were integrated. Therefore, the firm should have registered with the SEC.

The firm ended up paying a disgorgement of $256,697. I assume that translates to the two years worth of fees that TL Ventures collected from the government pension funds.

The amounts are relatively small. The firm was not currently soliciting the government pension funds for business. There is no finding of malice or egregious behavior.

Good luck going to sleep tonight.

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Comply With What?

Yes I'm Compliant Badge Rules Regulations Compliance

The starting point for any compliance program is to determine what you are trying to comply with. Every company has some legal requirements or contractual requirements that govern how it operates its business. Every company will place different emphasis on which of those requirements it will put under its compliance program. Every company will operate its compliance program differently.

Within the private fund industry, the most significant law will be the Investment Advisers Act. The anti-fraud provisions apply, whether the fund manager is registered or not. If the fund manager is registered, then there is another set of requirements. Since those requirements are largely principles based, it’s up to each fund manager to craft its compliance program based on the firm’s operations.

For private funds, the fund documents will be the most significant contractual requirement. The combination of the private placement memorandum and limited partnership agreement will govern fund operations. Each fund manager has crafted those documents with different provisions, so the compliance provisions will change from manager to manager.

If the private fund has overseas investors or operations, then the Foreign Corrupt Practice Act will come into the compliance program. Not because it’s the most important, but because it has been grabbing the headlines.

Overseas operations or investors will also bring the Foreign Account Tax Compliance Act into play. That means jumping through hoops with the Internal Revenue Service for overseas accounts and overseas investors.

The list will go on and on and on as you look at more and more laws.

And the end of the day, you want to be able to say you are compliant. But it still leaves the question: compliant with what?

Whistleblower Mistakes by a Private Fund

whistle blower

Paradigm Capital Management encountered a whistleblower and handled it poorly. The hedge fund had been conducting principal trades in violation of  Section 206(3) of the Investment Advisers Act. Paradigm’s head trader reported the violations to the Securities and Exchange Commission.

It’s tricky to deal with a hedge fund making principal trades with an affiliated broker-dealer. The principal trade requires consent of the client under SEC Rule 206(3)-2. With a hedge fund, it’s not the investors who are the client. It’s the fund that is the client.

That makes it tricky to structure the consent. Most hedge funds are privately-owned so there is no board of directors to act on behalf of the fund. That was true with Paradigm where Candace King Weir owned 73% of the advisory firm and 73% of the broker-dealer.

Paradigm tried to do the right thing and established a conflicts committee. It consisted of the CCO and CFO of Paradigm. The problem was that the CFO reported to Weir, so the CFO’s presence did not alleviate the conflict.

Paradigm was ordered to pay a penalty of $1.7 million as an “approximation of certain administrative fees the Fund paid in connection with the principal transactions….” The order does not go into detail about the investors in the fund were hurt by the principal trades.

The order spends its most time discussing the whistleblower aspects of the case.

It was Paradigm’s head trader who made a whistleblower submission to the SEC in March 2012. That’s about seven months after the new whistleblower rule went into effect, making the trader eligible for up to 30% of the penalty.

The head trader continued doing his job until the middle of July. At that point he told the firm that he reported a possible securities law violation to the SEC.

The next day Paradigm pulled him off the trading desk and relieved him of his day-to-day responsibilities. The firm sent him off-site to prepare a report on all the facts that supported his claims. Eventually, he ended up working at home.

Paradigm was looking for a “gotcha” moment to fire the whistleblower. That came when he sent a confidential document to Paradigm’s CCO. The firm accused the whistleblower of removing confidential documents in violation of firm policy and the confidentiality agreement he signed when he joined the firm. He eventually resigned because of the adverse treatment.

Paradigm had a compliance failure. Principal trades are bad for investment advisers and tricky for hedge funds.  But I would guess that it was the firm’s treatment of the whistleblower that resulted in such a harsh penalty.

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Don’t Lie About Being GIPS Compliant

GIPS logo

The Global Investment Performance Standards (GIPS) attempts to be a set of standardized, industry-wide principles that guide investment firms on how to calculate and present their investment results to prospective clients. An SEC-registered investment adviser touting that it is GIPS Compliant in advertising, moves GIPS from an accounting concern to a regulatory concern.

ZPR Investment Management made that mistake. The firm and its principal were hammered with penalties for the violations. Zavanelli is barred from the industry and must pay a $660,000 fine for its advertising that falsely claimed GIPS compliance.

It’s a big penalty for an advertising failure.

It was interesting to see that Zavanelli used some international operations and tried, unsuccessfully, to keep those separate from the US operations. The reason, according to an email found during the SEC investigation was to keep the communication away from the “prying eyes of the SEC Monster.” In the decision, the Administrative Law Judge details the combative nature of Mr. Zavanelli during the hearing. That lead the ALJ to the finding that he acted willfully and with scienter.

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Compliance Bricks and Mortar for June 13

Brick and Timber

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

Thinking About the Applicability of SOX Whistleblower Protection to Private Company Employees by Kevin LaCroix in the D&O Diary

Since their 2002 enactment, the whistleblower protections in Section 806 of the Sarbanes-Oxley Act have been presumed to apply only to employees of publicly traded companies. After all, the provisions are entitled “Protection for Employees of Publicly Traded Companies Who Provide Evidence of Fraud.” However, in its March 4, 2014 holding in Lawson v. FMR, LLC (here), the U.S. Supreme Court held that Section 806 protects whistleblowing activity by employees of a private contractor of a public company.

Confronting the Two Faces of Corporate Fraud by Miriam H. Baer in CLS Blue Sky BLog

From this typology, one can see why corporate fraud so often mixes planned and impulsive conduct and why the corporate compliance department is likely to have its hands full: With the exception of the employees in category (a), everyone within the corporation has the potential to contribute to or perpetrate a fraud.

How should a compliance department respond to these prototypes? The latter half of the Article concludes that much of the compliance officer’s work falls within two categories: corporate policing and corporate architecture. The policing approach is the most familiar one: It reduces corporate crime by empowering internal corporate policemen to identify and punish actual and would-be transgressors. The latter approach is different in feel and effect: It encourages corporate personnel to seek out and mitigate problematic situations by adopting different decision-making structures and systems, thereby reducing the opportunity and temptation for fraud. The policing approach is more judgmental and punitive, while the architectural approach is more regulatory and intrusive.

Behold the Burrito Bond by Josie Coz in WSJ.com’s MoneyBeat

London high street fast food outlet Chilango, favored by City types with elastic waistbands, is offering an 8% coupon on a four-year corporate bond that gives some buyers a free burrito* every week for the lifetime of the debt. All you have to do is cough up £10,000 pounds ($16,800) and trust that it is as good at servicing its debt as it is at serving bankers their lunch.
….
It is unclear whether the free burritos come with guacamole. It is also unclear whether anyone genuinely can eat that many burritos.

Bricks and Timber is by Patrick Dalton
CC BY NC ND

Bad Actors on Form ADV and Under Rule 506(d)

venn diagram and compliance

The Securities and Exchange Commission has layered two tests for bad actors on to private fund managers. On Form ADV, the fund manager will need to disclose bad actor events. Then the second test comes under the new Rule 506(d) that also requires disclosure for bad actors in private placements and a bar for recent bad actors. From a compliance perspective, the question comes down to how do you deal with certifications.

Unfortunately, the employees for Form ADV disclosure are potentially different than the employees than the 506(d) disclosure and bans. For 506(d) its limited to “officers participating in the offering.”

Participation in an offering would have to be more than transitory or incidental involvement, and could include activities such as participation or involvement in due diligence activities, involvement in the preparation of disclosure documents, and communication with the issuer, prospective investors or other offering participants.

I’m not sure that helps much for fund managers. It does mean that you can exclude administrative assistants.

For Form ADV, the disclosure pertains to

Your advisory affiliates are: (1) all of your current employees (other than employees performing only clerical, administrative, support or similar functions); (2) all of your officers, partners, or directors (or any person performing similar functions); and (3) all persons directly or indirectly controlling you or controlled by you.

The Form ADV disclosure is potentially for a broader group of employees. Your organization may have employees who are not clerical, but are also not officers participating in the offering.

I think it’s probably just easier to require every employee to fill out the questionnaires. Then you can get into the weeds of the analysis if there is a disclosure event.

That leads to the next item which is the questionnaires. The main concept between the two are the same. If your employees have been involved in financial crimes, you need to disclose that information. However, the time frames, laws covered, and conviction status vary between each regulatory requirement.

I tried to sit down and create a unified questionnaire that would address disclosures for both Form ADV and Rule 506(d). In ended up being a huge pain in the neck and I gave up. I have two separate questionnaires that I require all employees to deliver.  Let me know if you have come up with a unified questionnaire.

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