Month: December 2014

Backtesting Performance Failure

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One area of performance advertising that the Securities and Exchange Commission has given great scrutiny, but not banned, is using backtested performance. Since, backtesting only shows theoretical past trades, it does not involve market risk. That means it’s inherently suspect. You can just keep fine-tuning the model to maximize results, with no ability to carry that forward to maximize returns going forward.

The SEC delivered a Christmas enforcement present to F-Squared Investments and its co-founder Howard Present for failures with back-tested performance.

There were two failures. One was that F-Squared failed to disclose that the past performance advertised was based on back-tested performance and not actual trading. Second, the past performance was incorrectly calculated. In reading the settlement documents for the case it looks like the problem originated with the data sources for the F-Squared AlphaSector index. It relied on a third-party data provider to generate the trading models.

F-Squared advertised that $100,000 invested on April 1, 2001 would have been worth $235,000 on August 24, 2008.

There were two problems with that statement. F-Squared was not in existence until 2006 and did not use this trading model until 2008. F-Squared failed to disclose that the performance was based on backtested performance.

The second problem was that the calculation was incorrect. In compiling the past performance the data provider was off by a week on each trade. That actual performance would only have been $138,000 if the past performance was calculated correctly. (Merely taking the broad bet by investing in S&P 500 ETFs would have resulted in $128,000.)

According to the complaint, Mr. Present tried to get better back up for the past performance methodology. That arose again during a 2012 mock audit. When he sought the information again, he discovered that the data model was created by a 20 year old former intern who would have only been 14 in 2001. It was at that time that Mr. Present discovered the dating problem with the past performance.

The SEC has not come out and said the backtested performance is not allowed by investment advisers and fund managers. It has addressed the issue in at least four other enforcement cases. In the F-Squared case, the SEC did not say that the backtesting was by itself was fraudulent, deceptive or manipulative. It was the incorrect calculations and disclosure failure that was fraudulent, deceptive or manipulative.

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Weekend Reading: Boys in the Boat

TheBoysintheBoat

Do you hate Hitler?
Do you like sports?

Then Boys in the Boat is a book to add to your “To Read” list.

In the middle of the Great Depression, Joe Rantz is a farmboy from the Pacific Northwest who was literally abandoned as a child and rarely had two pennies to rub together. He scrapes together the money to attend the University of Washington during the Great Depression. At school he joins a pack of strong, young men looking to make it onto the crew team.

It’s not going to be a surprise, but Joe makes the team. That’s just the first step. His crew needs to beat their rivals at Berkeley, then travel East to battle the rowing elites of the east coast. If his crew comes in first, then it’s off to Berlin to battle the Nazi’s crew for Olympic glory.

This is a tremendously enjoyable story, full heart, soul, and determination.

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Happy Holidays From Compliance Building

 

2014 Holiday 2

I hope you have a happy and joyous holiday season. Whether it be Christmas, Hanukkah, Kwanza, Festivus, Feast of Winter Veil, Saturnalia, or New Year’s Eve, I hope you get to spend some extra time with friends and family.

I will be trying to spend some extra time with my friends and family so there will likely be no published stories until January.

Doug

Train Fares, Integrity, and Financial Services

Stonegate_Railway_Station

On Monday Britain’s financial regulator banned a senior financial services professional from the industry for life. His transgression was the failure to pay his train fare. BlackRock director Jonathan Paul Burrows was caught by inspectors at Cannon Street station last year.

Mr Burrows has admitted that, on a number of occasions, he deliberately and knowingly failed to purchase a valid ticket to cover his entire journey whilst traveling on he Southeastern train service between Stonegate Railway Station, East Sussex, and Cannon Street Station, London.

Based on Mr Burrows’ admission, the Authority considers that Mr Burrows is not fit and proper to conduct any function in relation to any regulated activity carried on by any authorised or exempt persons … because he lacks honesty and integrity.

That means his has failed to meet the FCA’s Fit and Proper Test for Approved Persons.

The fare he failed to pay was £21.50. That’s an expensive train ticket. Mr. Burrows avoided paying the fare by boarding the London-bound train at Stonegate, a rural station with no turnstiles. Without the turnstiles, there is no control to make sure passengers have a ticket.

But it was not just the one time. He was alleged to have failed to pay for his ticket on almost 2,000 occasions. He settled with the transit authority for £42,550.

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Stonegate Railway Station photograph is by Simon Carey
cc by sa

Real Estate Crowdfunding

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Real estate investing has a long history of crowdfunding. Prior to the 1986 changes to the tax code, there was a large syndication business for getting investors into real estate. Although the investment was usually more for the tax breaks involved instead of income and capital appreciation.

With the surge of product crowdfunding through sites like Kickstarter, the regulatory changes for equity crowdfunding from the SEC, and state-level implementation of crowdfunding, investors and sponsors are once again looking to crowdfunding for real estate. Currently, it’s largely limited to accredited investors due to SEC limits or limited to state specific projects and investors.

Goodwin Procter put together a publication full of real estate crowdfunding articles: A Guide to Real Estate Crowdfunding Today.

The guide hits one major theme: crowdfunding is new and there are few success stories. No one site has been very successful at pulling investors and meaningful projects together.

Real estate investing is capital-intensive. It should be a natural area for crowdfunding. The big concern is fees. The crowdfunding platforms I’ve looked at are expensive. It’s expensive for the sponsor and its expensive for the investor.

The other concern is execution. To purchase or sell real estate, you need to decide quickly on the best deals 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. 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 real estate seller, why would you accept an offer contingent on crowdfunding?

The alternative is that the crowdfunded real estate is already warehoused with the sponsor and is looking to lay off some of the equity or fund capital improvements. The sponsor is looking to crowdfunding as a cheaper source of capital or a quicker source of capital. So far, crowdfunding does not seem 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 of the investment’s quality.

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Compliance Bricks and Mortar for December 12

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

Mark Cuban vs. The SEC in WealthManagement.com

The only way to reform what ails the Securities and Exchange Commission is to “burn it down and start again,” says Mark Cuban, billionaire entrepreneur, host of the television show “Shark Tank,” and the owner of the Dallas Mavericks.

Corruption Allegations Lead to Securities Lawsuits by Kevin LaCroix in The D&O Diary

I was on a panel at a law firm event last week during which I was asked to make some predictions for 2015. Among other things, I said that I thought we would see an increase of securities class action lawsuit filings following in the wake of regulatory investigations, especially bribery investigations. I also said that many of these lawsuits next year will involve bribery investigations being led by governments other than that of the United States. Well, we not yet into the new year, but there has already been a flurry of activity consistent with my predictions.

Forum Selection For SEC Cases – District Court or Administrative Proceeding? by Thomas O. Gorman in SEC Actions

Under this approach the seven insider trading cases filed as administrative proceedings since September would not represent a new trend or a move toward bringing these actions as administrative proceedings rather than the traditional civil injunctive action. At the same time the filing of so many insider trading cases as administrative proceedings in a brief period does represent a significant departure from prior practice. That is particularly notable for an agency which frequently looks for consistency. No doubt, the Director is correct that selecting the administrative forum quickly ends the matter – there is no district court to seek the assistance of or to ask questions and delay the entry of the settlement.

SEC Chief Is Not Pleased Over Insider Trading Decision by Michelle Celarier in the NY Post

Securities and Exchange Commission chief Mary Jo White is none too pleased about Wednesday’s landmark federal appeals court ruling that overturned two insider trading convictions. “My initial sense is that it is an overly narrow view of the insider trading law, and that is a concern,” she said at a conference in New York on Thursday.

Brick Pattern is by AGF81 at DeviantArt

SEC Demanding Audited Financial Statements for Funds’ REIT Subsidiaries

reit stock certificate

The Custody Rule is a well intentioned beast of regulation designed to prevent investment advisers from stealing money from their clients. The Rule works well for retail investment advisers and most hedge funds. It starts falling apart for private equity funds and real estate funds. The Securities and Exchange Commission tried providing some additional guidance in June with its IM Guidance Update 2014-07. Unfortunately, I think the guidance only made it more confusing for funds trying to comply with the rule and the examiners trying to do their jobs in the field.

The problem with the Guidance was Scenario 4 when a fund invests in another investment vehicle. Unlike the three previous scenarios in the Guidance, this clearly is not an SPV. The investmentvehicle could be another fund, a joint venture or co-investment. The Guidance reaches the conclusion that the fund manager should get audited financial statements for the investment vehicle to comply withe custody rule because it is a separate advisory client.

Many people skip over footnote 10 that states that the SEC assumes that the SPVs in the four scenarios are investment advisory clients. But in many situations, that investment vehicle may not be an investment advisory client. The assumption in footnote 10 drives you directly to the conclusion.

The Guidance also makes the mistake of stating that compliance with the Custody Rule can only be be achieved through providing audited financial statements. A fund manager can use the standard Custody Rule method of having information sent directly to investors by a third-party custodian.

Getting back to the headline, one question for real estate funds has been what to do with REIT subsidiaries in the fund structure. This was also an issue pre-Dodd-Frank in deciding whether to include them as clients in determining whether you had reached the old 15-client threshold.

The subsidiary REITs could fit into the bucket of scenario 4. The fund is an investor in the subsidiary REIT and there are third party owners in the REIT. One of the requirement of REIT status is that you must have at least 100 shareholders. Since it’s a subsidiary, the fund manager is focused on its interest and typically uses accommodation shareholders to fill in the other 99 slots. I remember in my early years of practice that REITs would round up lawyers, accountants, family and friends to fill in the empty slots. Now, third party vendors will fill up those slots.

Those 100 accommodation shareholders get a preferred return paid to them, but have no interest in the ultimate economics of the REIT subsidiary. The accommodation shareholders collect their annual payment but have no concerns about investment performance. The current market rate is about 12% on their $1000 investment. They get their $120 a year and then the $1000 back at the end of the fund life.

In speaking with a group of real estate fund CCOs we discussed what their approach is for subsidiary REITs under the Custody Rule. We were startled to learn that the SEC had recently issued a deficiency letter to another real estate fund manager during an SEC exam for failing to issue audited financial statements for the REIT subsidiaries. From a redacted copy of the deficiency letter:

“This guidance [IM Guidance Update 2014-07] does not contemplate whether a client pays fees to the investment adviser, because entities are not required to pay advisory fees in order to be considered investment advisory clients. Accordingly, this guidance indicates that Registrant must distribute the audited financial statements of all pass-through entities or special purpose vehicles that are controlled by Registrant or a related person and have outside investors to each such entity’s beneficial owners.”

I think this is a shocking overreach by those SEC examiners. They seem to skip right over Footnote 10 and its assumption for purposes of the guidance that the investment vehicle, in this case the subsidiary REITs, are advisory clients.

I would be interested to hear what other real estate fund managers are doing with their REIT subsidiaries for the Custody Rule. You can email me directly at my office or at [email protected].

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Miscounting Residents as Securities Fraud

courtyard

A recent SEC enforcement action caught my attention because it involved defrauding a landlord and miscounting residents. That left me scratching my head over why the Securities and Exchange Commission was involved with a senior living residence.

The SEC Enforcement Division alleges that then-CEO Laurie Bebo and then-CFO John Buono made false disclosures and manipulated internal books and records when it appeared likely that their company, Assisted Living Concepts Inc., would default on financial covenants in a lease agreement. Under the leases for the facilities, ALC was required to maintain occupancy levels as well as debt service coverage levels.

Like lots of fraud, it started off with a small bad act. Bebo and Buono wanted to include ALC employees who stayed overnight at the facilities as occupants. Then it got worse and they started counting employees who never stayed at the facility, family members, friends and people they interviewed for job openings. At the end of the fourth quarter 2011, the SEC alleges that between 45 and 103 reported occupants were non-residents.

The fraud was all directed at the landlord to avoid a default. ALC had publicly traded stock so the landlord fraud turned into public company accounting fraud.

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Compliance Bricks and Mortar for December 5

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

Sherlock Holmes and Innovation in the Compliance Function, Part I – A Study In Scarlet by Tom Fox in the FCPA Compliance and Ethics Blog

First I am back with an homage to Sherlock Holmes, for it was in the magazine Beeton’s Christmas Annual that the characters Sherlock Holmes and Watson were introduced to the world in 1887, in the short story A Study in Scarlet. The second theme will be innovation in the compliance department. I will take some recent concepts explored in the December issue of the Harvard Business Review (HBR) and apply them to innovation and development of your compliance function. I hope that you will both enjoy my dual themed week and find it helpful.

Be Careful When You Are 100% Correct by Roy Snell in SCCE’s Compliance & Ethics Blog

People are often careful when they are not sure how to fix a particular problem. They do their research and bring everyone along. Everything is covered and everything is explained, when you are in doubt. However, when we are 100% correct we let our guard down. At least I do. I get indignant and ask questions like “why do I have to explain this all over again?”

2015 SEC Trial Scorecard Update: Agency is Undefeated After Two Trials by Bruce Carton in Compliance Week

To date in FY 2014 (which began on October 1, 2014), the SEC has had two trials in federal court reach a verdict. The first verdict was in the SEC’s case against iShopNoMarkup.com, Inc. in the U.S. District Court for the Eastern District of New York. In that case, the SEC charged that in 1999-2000, among other things, iShop conducted a fraudulent and unregistered securities offering.

Compliance Yesterday, Today, and Tomorrow by Matt Kelly in Compliance Week

Part of the challenge, of course, comes from the huge advances in technology that have allowed businesses to do more things, and to do them more efficiently—because once you can do something more efficiently, it’s only a matter of time before “the market” compels you to do something  more efficiently. Hence the quest to develop new products, to reach new customers, to launch new mergers, to enter new markets—more than we could ever dream of 50 years ago. All of those things bring new risks, and new ways to manage them.

Largest Derivative Lawsuit Settlements by Kevin LaCroix in the D&O Diary

My purposes in posting this list are two-fold: first, in response to several requests, to share the information I have; and two, to encourage others who may have different or additional information to share the information so that I can update or supplement the list as appropriate. Here is my list of the eight largest derivative lawsuit settlements of which I am aware:

Get the SEC Out of the PR Business by Russell G. Ryan in the Wall Street Journal (opinion section)

Given the SEC’s peculiar quasi-judicial role in these cases, you might think the agency would refrain from gratuitously stoking prehearing publicity against the accused. Think again. The SEC now routinely issues press releases when it files charges in administrative cases it will eventually decide. This practice calls into question the agency’s ability to decide those cases fairly and impartially.

Failure to Register with the SEC as an Investment Adviser

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One of the questions that come up with private funds and Dodd-Frank was what would happen if you failed to register with the SEC? HSBC Holdings Plc found out for us. HSBC  will pay $12.5 million to settle claims that its Swiss private-banking unit solicited U.S. investors without being registered.

The Securities and Exchange Commission charged HSBC’s Swiss-based private banking arm with violating federal securities laws by failing to register with the SEC before providing cross-border brokerage and investment advisory services to U.S. clients. HSBC agreed to admit its wrongdoing and paid the fine to settle the SEC’s charges.

It looks like HSBC tried to put boundaries between its Swiss bankers and US clients to stay outside the reach of US law. But its relationship managers were unwilling to comply and went around the compliance policies.

According to the SEC’s order, HSBC began providing cross-border advisory and brokerage services in the U.S. more than 10 years ago and had as many as 368 U.S. client accounts. HSBC created a dedicated North American desk to consolidate U.S. client accounts and service them in a compliant manner.  However, Swiss relationship managers were reluctant to transfer clients to the North American desk.

Personnel traveled to the U.S. on at least 40 occasions to solicit clients, provide investment advice, and induce securities transactions.  Those Swiss relationship managers were not registered to provide such services nor were they affiliated with a registered investment adviser or broker-dealer.  The relationship managers also communicated directly with clients in the U.S. through overseas mail and e-mails.

In 2010, HSBC Private Bank decided to exit the U.S. cross-border business, and nearly all of its U.S. client accounts were closed or transferred by the end of 2011.

In this case, HSBC was trying to avoid US registration and failed to control its personnel. So it’s not the same as a fund manager claiming it was not required to register.

As for punishment, the HSBC fine consists of a disgorgement of fees earned, plus interest and penalty of about 50% of the fees.

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