September 2014 – Compliance Building

When Fundraising Becomes More Lucrative Than Running the Business

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Erick Mathe had a vision of creating a media empire. Well, maybe not an empire, more of a small keep. His plan was to broadcast over Low Power Television Service. Those are locally-oriented television broadcasts in small communities. Mr. Mathe had a line up of streaming music and infomercials. He just needed capital to get the business going.

It won’t surprise you that Mathe has been charged with fraud. There is an SEC complaint in Florida and a criminal indictment in Pennsylvania. Mathe has not responded to the charges so I have to rely on the government’s view of the facts. It looks like Mathe saw that raising the capital and taking a commission was more lucrative than running the television business.

Vision Broadcast Network had four stations lined up for delivery of its content and said that it had licenses for 70 more. It’s “Ask the Specialist” subsidiary was lined up to provide medical educational resources. That subsidiary was particularly useful because it put Mathe in contact with wealthy doctors who were potential investors.

What caught my eye was a registration filing that Vision Broadcast Network made in 2009 with the Securities and Exchange Commission. It looks like it had the good intention at that time to be a legitimate business.

In the filing, there is a Code of Ethics as an exhibit.

“Act in good faith, responsibly, with due care, competence and diligence, without misrepresenting material facts or allowing one’s independent judgment to be subordinated. “

Mathe met Ashif Jiwa who persuaded him that he could help raise additional investment funds because he operated a hedge fund and acted as a financial adviser to the Prince of Dubai. Mathe paid Jiwa a commission on capital raised. At some point Mathe decided that he should also pay himself a commission for capital raised.

Perhaps that was the turning point. Mathe became more focused on raising capital than operating his business. According to the SEC complaint Mathe was misleading investors about revenue, capital commitments, and the success of the business.

He was ignoring his own code of ethics.

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Why I think the Accredited Investor Standard Should Not Change

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The SEC Investor Advisory Committee is scheduled to vote on a reform plan from a subcommittee at its Oct. 9 meeting. That plan calls for the SEC to rethink the income and net-worth minimums used to define an “accredited investor.”

Much of the concern about private placements is about risk. They seem to be universally labeled as the most risky of investments. The accredited investor definition is categorized as the class of individuals who do not need the ’33 Act protections in order to be able to make an informed investment decision and protect their own interests. They get to pass the red velvet rope and buy securities through a private placement

It’s not that the ’33 Act protections remove risk. There are plenty of people who have lost money in the stock markets. Prices can fluctuate wildly, fraud exists, the markets get manipulated and we are all being fleeced by high-speed traders.

It’s too easy to label private placements as risky. They cover a broad swath of investments with different levels of risk. Public companies may raise capital through a private placement because its quicker, easier and less expensive than through a public offering. Hedge funds are sold through private placements, but they can be anywhere on the risk spectrum. Of course there are start-ups and crowdfunded firms that are the most risky of investments. This would be true if the capital were raised through a public offering or a private offering.

The risk is incredibly varied for private placements. So labeling them as risky investments is an incorrect categorization.

In my view, it’s not the risk of loss that is the main problem with private placements.

It’s the loss of liquidity.

Whether the investment ends up being a bad one or a wildly successful one, the investor will have limited ability to access that gain or loss and limited ability to time the realization of that gain or loss.

With an investment in the public markets, the investor can sell at any time. With a private placement, the investor may have no ability to sell.

The net worth prong of the accredited investor definition is key because it shows that the individual has other resources and is not reliant on the private placement. Excluding the primary residence was a good change for the definition. Someone who is house rich and cash poor is less likely to be able to deal with the liquidity problem.

Excluding retirement accounts is exactly the wrong thing to do with the net worth requirement. That money is already relatively illiquid. An investor can access it, but is subject to penalty. Retirement money is long term money that will not be subject to liquidity demands and can be invested over the long term.

The current income test is a useful measure of liquidity demands of an investor. A higher income indicates that the investor is more likely to be able to absorb the loss in liquidity from a private placement.

I’m all for expanding the definition to more individuals who can prove their financial sophistication. One recommendation from the sub-committee is to have a test for financial sophistication. That’s a great idea to expand the base, but I’m skeptical that there would be many people lining up to take the test.

Another recommendation is that private placement investments be limited to a portion of income or net worth. That is better aligned with the liquidity risk. However, it would impossible to verify and incredibly intrusive to implement.

That comes back to the compliance aspect. The more complicated the method for determining whether an investor is an accredited investor that harder it is for a company to use private placements or to open them to individuals. Removing the primary residence from the net worth definition was a good idea to address the liquidity risk, but it makes the confirmation more difficult.

The failure to ensure that all investors in a private placement are accredited investors can lead to very bad results. Complicating the definition will lead to a reduction in the usefulness of this fundraising regime.

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Weekend Reading: Predator

Predator covers the story of the birth of the Predator drone and its effect on military and covert operations. Richard Whittle manages to weave through the military and aeronautic bureaucracy of the Predator as it is destined to become the most successful military unmanned aircraft.

I was surprised to see the level of detail about the development of the aircraft. I would think that much of the information would be secret. Or that those involved would be quiet about its history. Whittle clearly was able to uncover a tremendous amount of detail. The story is rich, enjoyable to read, and compelling.

The Predator drone was ugly, slow and unreliable. The key to its success was its ability to stay in the air for an extended period of time. Manned craft are limited by human endurance. The Predator can have flight crews swapped while in flight.

Everything else was good old-fashion ingenuity to expand the use and conquer the problems with the plane’s technical limitations. One key was the ability to transmit video not only to the pilots, but to other military leaders. That level and length of surveillance was compelling for military leaders.

According to the author, the turning point for the Predator happened during the Bosnian War. Those were the first flights in combat, but limited to surveillance.

It was the war in Afghanistan that pushed the Predator into more action. That turning point was the idea of mounting a hellfire missile on the aircraft. The Predator could not only watch the enemy, but could take action.

The book is focused on the history of the Predator, not the legal and ethical implications of the Predator. Part of that history is the legal analysis of mounting a missile on the aircraft and who can authorize taking a shot. There was some concern that the Predator with a missile could be classified as a cruise missile and be subject to weapon treaties with Russia.

The book’s historical narrative ends in 2002. That leaves most of the ethical implications to the book’s epilogue. Is it ethical to fight a war by remote control, with uniformed Air Force pilots blowing up targets on the other side of the world from their safe, air-conditioned work stations? Are the attacks assassinations or merely defensive strikes in the War on Terror?

The ethical implications are felt by the pilots. They are not whisking over target at supersonic speeds delivering their payloads with little time to see the damage. A Predator pilot has the continuing transmission to watch as the aircraft lumbers along above the target looking at survivors and victims.

The publisher provided me with a free review copy of the book.

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Compliance Bricks and Mortar for September 26

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

Fixing a Company’s Ethics and Compliance Culture by Michael Volkov in Corruption, Crime & Compliance

A company’s ability to enact meaningful change depends on the innate desire of its leadership to execute real change. It is too easy to say that such change depends on the CEO. Instead, a change in culture requires the dedication of two important players – the CEO and the board of directors.

SEC Finds Deficiencies at Hedge Funds by Andrew Ackerman and Rob Copeland in the Wall Street Journal

Mr. Bowden, who spoke at an investment advisory conference sponsored by industry newsletter IA Watch, said regulators have discovered some funds engaging in what he called “flip-flopping,” boosting valuations by changing the way they measure holdings several times a year. In some instances, the funds chose the measurement with the highest value or intentionally classified certain assets in a way that gave the fund manager more flexibility to inflate the price of the fund’s holdings.

SEC Awards Largest Ever Whistleblower Bounty, $30 Million by Joe Mont in Compliance Week

“Our client exposed extraordinarily deceitful and opportunistic practices that were deeply entrenched and well hidden,” Erika Kelton, an attorney with the law firm Phillips & Cohen and legal counsel to the whistleblower says. “Federal regulators never would have known about this fraud otherwise, and the scheme to cheat investors likely would have continued indefinitely.”

First Enforcement Action for Private Equity Fund Expense Allocation

The Securities and Exchange Commission has been making lots of noise about how its unhappy with how private equity firms are allocating expenses to portfolio companies. And it has finally hit its first target. The SEC charged a a private equity fund manager with breaching its fiduciary duty to a pair of private equity funds by sharing expenses between a company in one fund’s portfolio and a company in the other fund’s portfolio in a manner that improperly benefited one fund over the other.

Lincolnshire’s Fund I bought Peripheral Computer Support, Inc. in 1997. PCS primarily serviced and repaired computer hard disk drives. In 2001, PCS thought an acquisition of Computer Technology Solutions Corp. would be a great strategic acquisition. CTS serviced and repaired laptop computers and handheld devices.

But by 2001 Fund I’s commitment period had expired. So Lincolnshire had Fund II acquire CTS. Lincolnshire integrated PCS and CTS together and sold them together in 2013 to a single buyer.

Commingling investments across different funds is tricky. You need to be concerned about different expectations for investors in the different funds with different investment horizons for the exit. Operationally, you need to be careful how fees and expenses are allocated to treat each fund fairly.

Lincolnshire did set an unwritten policy where it tried to treat each fairly. Generally, shared expenses were allocated based each company’s revenue. So, PCS, the smaller company, paid 18% of the shared expenses. However, PCS and CTS had no written agreements about how to share expenses or the company’s rights and obligations toward each other.

Even though the revenue-basis sharing was the general practice, there were variations. Lincolnshire failed to document why some shared expenses were allocated differently.

Lincolnshire was in a tricky situation and mishandled it.

The SEC based its enforcement action on a violation of Section 206(2) as a “transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client.” The SEC is quick to point out that a violation of 206(2) can be based on a finding of simple negligence. The SEC does not need to prove scienter.

The SEC made no charges that Lincolnshire benefited from the misallocation. The SEC makes no charges that either Fund I or Fund II was harmed by the misallocation. Although, presumably, Lincolnshire did benefit and one fund did end paying more than its fair share of expenses.

The SEC merely charges that Lincolnshire was negligent in not having a written policy on the allocation of expenses and not following that policy.

Without any charges that it intended to defraud its investors, Lincolnshire has to pay $2.3 million to the SEC.

Private equity fund managers should take this as a warning to properly document investments combined across more than one fund and to take extra steps to ensure that they are treating each fund fairly.

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The NFL Teaches Us the Difference Between Ethics and Compliance

The National Football League is by far the most popular sport in the US. NFL Commissioner Roger Goodell talks about what he calls “protecting the shield.”

He originally handed down a two-game suspension to Ray Rice for a punch to the head of Mr. Rice’s fiance that left her lying unconscious on the floor of an elevator.

That decision was complaint with the NFL rules, which did not carry a specific penalty for domestic violence.

That two game suspension was shorter that the season long penalty handed down to Josh Gordon for his use of marijuana.

That decision was compliant with the NFL rules. Marijuana happens to be legal in two NFL cities and is subject to regulated use in many of the other NFL cities.

The Minnesota Vikings suspended Adrian Peterson for one game after being indicted for child abuse. The team reinstated him to allow the judicial process to proceed.

That decision was compliant with NFL rules.

Those are just three examples where the NFL was being complaint with the law and its own rules. Those are three examples where the NFL came to the wrong outcome.

Ray Rice has now been suspended indefinitely, Josh Gordon’s punishment has been reduced and Adrian Peterson is suspended.

It leaves you wondering what the NFL Commissioner means by “protecting the shield.”

During this tenure as commissioner, he negotiated very lucrative television contracts for the NFL owners. He negotiated a collective bargaining agreement that is very favorable to the NFL owners. He has made a great deal of money for his 32 bosses, the NFL owners.

The NFL has continued to grow in popularity. Gregg Easterbrook in his Tuesday Morning Quarterback column has been noting for five years: “There is no law of nature that says the NFL must remain popular.”

Now there is a perception that Goodell engaged in a cover-up to control the narrative of the Ray Rice story. The initial suspension for domestic violence was dramatically shorter than the punishment for use of a largely legal drug. Peterson was only suspended after a key sponsor cried foul and pulled its support of the Vikings.

“Protecting the shield” is not about making money for the owners in the short term. It’s about protecting the integrity of the game and the league. It’s about ensuring the long-term popularity of the game and the league. It’s the difference between acting ethically and being compliant.

Compliance Bricks and Mortar for September 19

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

The NFL’s True Problem: Misplaced Priorities Trumping Ethics & Compliance by Matt Kelly in Compliance Week

Contrary to what you might believe lately, the National Football League does have an ethics & compliance program. What’s more, the program actually looks pretty good.

Except, of course, for that small bit about deciding to have high standards in the first place.

Is Funny Really the Right Tone for your Compliance Program? by Joel A. Rogers in Communicating Compliance

For the past few years the debate has raged: Is it OK to use humor to communicate compliance? What sparked this dialogue was a series of very funny compliance videos produced by one of the world’s premiere comedy brands. These guys know humor and many of those videos have been genuinely funny.

To Be Clear, SEC Reviewers Want Filings in Plain English, Period by Theo Francis in the Wall Street Journal

Meet the stock market’s punctuation police. Corporate securities filings are plagued by some of the world’s most impenetrable prose, but it isn’t for lack of effort. Every year, SEC lawyers and accountants review several thousand of the more than half-million documents that companies file with the agency. And while they are primarily on the prowl for accounting inconsistencies and breaches of securities regulations, they also chase down typos, sentence fragments, jargon, puffery and sloppy punctuation.

Compliance, groundskeepers, and chalk lines by Jason B. Meyer in LeadGood

So as I raked, I wondered: is there a parallel between the Compliance Officer and the Groundskeeper?

I mean, compliance is in large part about winning while staying inside the lines. But for an organization, who paints those lines?

Controls on Fee Deductions and Disbursements

Company Theft

A recent action by the Securities and Exchange Commission caught my attention. The SEC charged a hedge fund manager with taking excess management fees. For a more exciting headline, the SEC press release says the excess fees were to “make lavish purchases.”

Sean C. Cooper improperly withdrew more than $320,000 from a hedge fund he managed for San Francisco-based investment advisory firm West End Capital Management LLC. West End disclosed to clients that a 1.5% management fee is applicable and taken from their capital account balance. But Cooper took more than the permitted 1.5%.

It’s no surprise that Cooper was charged. He was stealing money from his investors. (I don’t care what he spent it on.) Cooper owned West End with two other partners. The other two had little involvement in the day-to-day operations of the hedge fund.

West End was also charged because the firm failed to have controls in place to prevent Cooper from making improper withdrawals. The fund documents provided quarterly management fee payments. Cooper made eleven fee withdrawals in 2010. Cooper continued this behavior through 2011 and only stopped in April 2012 because of a SEC examination.

In June 2012, the Fund’s independent auditors determined that West End’s lack of monitoring and approval of Cooper’s withdrawals in excess of the amounts permitted by the Fund’s governing documents was a significant deficiency in internal controls. I think the auditors were a bit late in coming to that determination.

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CFTC Allows General Solicitation for Private Funds

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In early 2013, the Commodity Futures Trading Commission decided to grab for more regulatory oversight and revoked some long-standing exemptions. The CFTC also got handed the regulatory oversight of non-securities derivatives. As a result, private funds with interest rate hedges had to figure out if they had to register with the CFTC as a commodity pool operator. One of the limitations with registration was a ban on advertising.

As required by the Jumpstart Our Business Startups Act in July 2013 the Securities and Exchange Commission amended Rule 506 to permit “general solicitation” and “general advertising” for private placements as long as certain other conditions are met.

Private funds could advertise under the SEC rules, but could not under the CFTC rules.

Last week, the Commodity Futures Trading Commission issued an exemptive letter that would allow private funds treated as commodity pools to use the JOBS Act general solicitation provisions.

Private fund sponsors who relied on a CPO registration exemption under CFTC Regulation 4.13(a)(3) or exemptive relief from certain registered CPO obligations under CFTC Regulation 4.7(b) were prohibited from engaging in general advertising or general solicitation under Rule 506(c). CFTC Regulation 4.13(a)(3) requires that interests in an applicable pool must be “offered and sold without marketing to the public in the United States”. I heard some arguments that the limitation only prevented advertsing as a commodity pool. Few felt comfortable with that position.

Exemptive Letter No. 14-116 provides exemptive relief from certain provisions in Regulations 4.7(b) and 4.13(a)(3) and permits CPOs relying on these Regulations to engage in general advertising and general solicitation under Rule 506(c). For some reason the CFTC decided to not make the exemption self-executing.

You need to make a filing. In order to rely on the exemptive relief in Letter 14-116, you must make a written claim for the exemption by filing with the CFTC.

This is good news for funds that want to use 506(c) or at least avoid the public marketing footfault in fundraising. The only question is why did it take the CFTC over a year to fix its mistake.

Sources:

Exemptive Letter No. 14-116 (.pdf) Exemptive Relief from Provisions in Regulations 4.7 (b) and 4.13 (a)(3) Consistent with JOBS Act Amendments to Regulation D and Rule 144

Weekend Reading: House of Debt

In House of Debt, Atif Mian, an economist at Princeton University, and Amir Sufi, a finance professor at the University of Chicago, make the case that household debt was the 2008 recession’s main culprit. This is a nuanced view that differs slightly from the view that it was the 2007 home price decline.

Mian and Sufi point out that the poorest homeowners suffered the most from the crash in home prices. They relied the most on home equity for net worth. Richer homeowners had other non-real estate assets that were less directly affected by the decline in home prices.

You can compare the dramatically different effects on the economy between the 2003 crash in internet stocks and the 2007 crash in home prices. The 2003 crash mostly hurt those with enough wealth to be invested in the stock market. The housing price decline hid a broader section of the population. By losing their net worth, the poorest homeowners lost their spending power, which lead to a drop in sales, which lead to a loss in production, which lead to a dramatic increase in unemployment. The 2003 crash was followed by a very shallow and brief recession, with little job loss.

The mortgage default rate from the 2008 recession was unprecedented. Since 1979 the mortgage default rate had never been above 6.5%. In 2009 the rate spiked above 10%. Loans were originated that went into default a few months later. The models for the securitized loans failed to address the widespread defaults.

There is no denying that some consumers were manipulated by lenders into taking out a lot of terrible home loans. There was a lot fraud and looking the other way on all sides of the mortgage loan closing table. But there was money to be made. Lenders flooded low-credit quality neighborhoods with credit despite the lack of indications that these loans could be repaid by the borrower.

The authors’ solution is a “shared-responsibility mortgage.” The lender takes some risk additional risk on the decline in value of the home and also gets a slice of the appreciation in value of the home. The monthly mortgage payment and amortization schedule gets reduced proportionally if housing prices fall. If prices increase, the lender gets a share of the appreciation. I think it’s an interesting idea, but not one that would work practically.

Regardless, the book is interesting look back at 2008 using empirical data.