Month: March 2015

SEC Brings a Valuation Case Against an Investment Adviser

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Lynn Tilton and her firm, Patriarch Partners, are known for their high-risk, high-return investments in distressed companies. The Securities and Exchange Commission brought a case against her and the firm claiming that they were using improper valuations, failing to mark down assets when the investment became more distressed.

At this point we only have the SEC’s charges. According to a quote in the Wall Street Journal: “I’m choosing to fight,” Ms. Tilton said. “My reputation is very important to me and my companies. When my integrity or my intent are questioned, I fight back and let truth prevail.”

She will have to fight the SEC on its home turf. The SEC chose to bring the case as an action in its administrative court,s instead of federal district court. According to the Wall Street Journal the SEC brought the case through its in-house court in part to try to move the case quickly, since one of the funds at issue has a maturity date in November 2015.

Debt tends to be trickier to value than equity. There is the judgment call about how likely you are to have the debt repaid. This is even trickier with Patriarch where the debt is being used to fund the company’s turnaround being managed by Tilton and her companies. She would have the direct power or influence to determine when debt was repaid.

Patriarch’s valuation policy calls for current loans to be valued at the principal amount of the outstanding loan. A defaulted loan is supposed to be written down under the policy. The SEC viewed a default under the documents to be when the debtor fails to make an interest payment. According to the SEC, Tilton determined a loan in default when she will no longer provide financial and management support to the company.

In addition, the funds were supposed to have GAAP-compliant financial statements. Under GAAP, a loan is impaired, and must be measured for impairment when, based on all available information, it is probable that the creditor will be unable to collect all amounts due for interest and principal based on the contract with the debtor.

The difference in characterizing a default resulted in more than $200 million in fees earned on the higher valuations. It sounds like many of the problems could have been fixed with a stronger compliance program. Disclosure would have solved many of the issues in the SEC Order.

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A New Exception to the Custody Rule

custody and private funds

The Custody Rule can be difficult for private equity and real estate fund managers to navigate. When I see some regulatory relief or clarification I hope for the best. 16th Amendment Advisors received relief for one of its funds based its particular circumstance Could that relief may be useful for other fund managers?

That’s not likely to be true. The fund’s sole investor are the firm’s principals. The Securities and Exchange Commission agreed in a new “no-action” letter that the firm does not have to comply with independent verification and account statement delivery provisions of clauses (a)(2), (a)(3) and (a)(4) of the Custody Rule in connection with that fund.

While the adviser does have custody of the assets in that fund, requiring a surprise exam or an annual independent audit would seem to be an unnecessary expense given that the people who control the adviser are the only investors in the fund.

The conditions the SEC recognized in giving the relief were:

  1. All investors have easy access to information (either statutory, contractual or some combination of the two) concerning the management of adviser, the Funds and each of the Fund’s general partners;
  2. All investors are listed as “control persons” in Schedule A to Form ADV because of their status as 16th Amendment’s officers or directors with executive responsibility (or having a similar status or function;
  3. All investors have a material ownership in the fund; and
  4. Investors, their spouses, children, and investment vehicles established for the individual or joint benefit of them are the only investors in the fund.

This relief is useful for feeder funds for ownership by the principals in the fund. It may be too narrow for a broader employee ownership vehicle.

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Weekend Reading: Argo

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In 1979, Iranian militants stormed the American embassy in Tehran and captured dozens of American, holding them hostage for 444 days. Six Americans escaped and hid in the home of the Canadian ambassador. A top-level CIA officer named Antonio Mendez devised an ingenious yet incredibly risky plan to rescue them before they were detected. You can read more in Argo: How the CIA and Hollywood Pulled Off the Most Audacious Rescue in History.

The first chapter is great look at the history of the United States’ involvement in Iran. It’s riddled with U.S. mistakes, largely because the singular focus was keeping Iran out of the hands of the Soviets. As a result, the U.S. propped up malicious dictators. That lead to rise of the ayatollahs and the 1979 uprising to overthrow the bad government. The hatred towards the US was because of the bad actions of the U.S.

While the embassy was being stormed, a handful of embassy workers escaped out a side door and fled to the Canadian embassy to hide. The hostages in the embassy were trapped, but the escapees had a chance to get out of Iran. If they could only come up with a plan.

It was CIA operative Antonio Mendez who comes up with the plan. His area of specialty is documentation. They’ll need good, fake paperwork to get out of Iran and avoid the clutches of the Revolutionary Guard.

The rescue attempt is the best part of the book. It’s what inspired Argo, the movie. I loved the movie. The book came out after the movie. It’s written by Tony Mendez, the CIA operative who an the rescue. The role is played by Ben Affleck in the movie.

Unfortunately, the book is more autobiographical, using the Iranian escape as scaffold to tell more spy stories. In the end I think Mendez is a better operative than he is a storyteller. I would recommend skipping the book and watching the movie instead.

I should also point out that I don’t write for Wired’s GeekDad anymore because of the book and movie. The story came in to the public eye as an article in Wired: How the CIA Used a Fake Sci-Fi Flick to Rescue Americans From Tehran. The publisher of Wired was apparently unhappy with its cash from the book and the movie. As a result, it wanted additional rights to the content in case it developed into something more. The GeekDad writers didn’t like that grab and left Wired.

Compliance Bricks and Mortar for March 27

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March Madness! SEC Loses an AP for First Time Since FY 2013 by Bruce Carton in Compliance Week

In FY 2014, however, the SEC maintained 100% perfection in its administrative proceedings. The agency reportedly prevailed in every single one of its more than 200 APs in FY 2014, including 14 consecutive victories in cases that went to a litigated hearing before an SEC Administrative Law Judge. That will not be the case in FY 2015, however, as the SEC actually lost a case this week that had made it all the way to a litigated hearing before Administrative Law Judge Jason S. Patil.

Regulating Lawyer Blogging by Cathy Gellis in Digital Age Defense

A few months ago an advisory committee for the California State Bar promulgated an interim ethics opinion addressing when lawyers’ blogs should be subject to applicable bar rules governing lawyer advertising.

The impetus behind having bar rules addressing lawyer advertising is generally a reasonable one. The nature of the lawyer-client relationship, the relative imbalance in their respective expertise, and the stress inherent with the sort of situation that would require a lawyer’s assistance makes it important to ensure that lawyers are not misleading or overly aggressive in their solicitation of business. The applicable bar rule regarding lawyer advertising in California is also not especially onerous (although the same may not necessarily be said about similar rules in other jurisdictions).

Why is the SEC still so low-tech? by Hudson Hollister in CNBC

Like many U.S. regulators, the SEC hasn’t kept pace with technological evolution. As a result, the firms it’s charged with overseeing are getting away with shady practices, investors are being denied easy access to key information, and, our economy is being put at risk.

SCCE/HCCA Reaches 15,000 members by Roy Snell

This milestone and growth of membership has a big impact on our effort to help the profession speak for itself. We have a lot of people trying to speak for compliance professionals, define the role and define the function of a compliance program. It’s not always helpful. Every year it gets easier and hitting 15,000 members helps.

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Failure to Disclose Loans Among Affiliated Funds

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Once you hear the words “inter-fund loans”, a compliance professional is going to sit up straight and be concerned. Anything “inter-fund” is an inherent conflict. That one fund is loaning another fund money is an indicator that something has gone wrong.

Stilwell Value managed several private funds. According to the SEC order, the Stilwell funds made at least eight loans to other funds. The loans were relatively short – days to six months. At the time they were made, the loans were not documented and the terms were not memorialized.

The big problem is that the loan terms were not necessarily at market prices, so one fund was profiting from the other fund. If the rate was below market, the borrower was gaining at the expense of the lending fund. The firm should have documented the process to confirm the loans were at market rates. Of course that is assuming the fund documents permit the affiliate loan and, if so, that the conflict is disclosed.

According to the SEC order, Stilwell was taking a big position in a public company. Stilwell is known as an activist investor. It was trying to take the position to influence the company. Some funds needed liquidity, but only had the public company stock. Rather then sell some stock for liquidity, Stilwell made the inter-fund loans.

One thing to note is that the settlement order includes no findings that fund investors were harmed. Stilwell agreed to disgorge to investors of the lending funds more than $239,000 representing management fees charged to the lending funds with respect to the loans, plus pre-judgment interest.

If the name Stilwell sounds familiar, it’s because he was fighting back against the SEC for bringing the action in an administrative court instead of federal district court. In a related development, Stilwell dismissed its suit against the SEC claiming that the SEC administrative proceeding before an administrative law judge was unconstitutional.

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Compliance Bricks and Mortar for March 20

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It’s finally Spring. Someday, all of this snow in Boston will melt. Someday.

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

The Fraudster Next Door by Scott Greenfield in Simple Justice

Whether an epidemic of white collar crime exists in Utah isn’t clear.  There isn’t much of an epidemic of any type of crime these days, but that only serves to lower the bar on what’s needed for hyperbole. Regardless, it has nothing whatsoever to do with the need for a registry.  Are white collar criminals (which covers a vague but broad panoply of offenses) so prone to recidivism that we must watch them, know where they are every minute of the day, keep them away from our children portfolio?

Doctor “No” Versus Doctor Practical by Michael Volkov in Corruption, Crime & Compliance

The attitude of “No” can have disastrous consequences on a compliance program. If company executives and managers view the compliance function as an obstacle to promoting business opportunities, executives and managers will not call or visit the compliance staff.

Court Strikes on Insider Trading, and Congress Lobs Back by Peter Henning in NYTimes.com’s DealBook

The legislative proposals go much further than just overturning the approach to tipping liability adopted by the appeals court in the Newman case. They jettison much of the law of insider trading that has developed over the last 35 years, since the Supreme Court first dealt with the issue in Chiarella v. United States. That approach focuses on breaching a duty of trust and confidence to the source of the information.

But the legislation would create confusion about how much trading would potentially violate the law. The Senate bill creates a gray area about what types of information would be subject to the prohibition. It allows trading on information derived from “publicly available sources” but does not define them.

Ethics Resource Center and Ethics & Compliance Officer Association Join Forces

The  ERC  is  America’s  oldest  nonprofit  advancing  high  ethical  standards  and  practices  in  public  and  private institutions,  and  the  ECOA  is  a member‐driven  association  for practitioners responsible  for  their  organization’s ethics and  compliance  and  programs. The  combination  of ERC  research  and benchmarking  and  ECOA’s  professional membership  organization  is  unique  in the  industry.

We’re asking the wrong question about police shootings by Radley Balko in the Washington Post

We shouldn’t be asking if the police actions were legal or within department policy; we should be asking if they were necessary. Or if you’d like to use a word with a bit more urgency behind it, we should ask if they’re acceptable.

Bells and Wall is by Lucyna Andrzejewska

Drew Bowden Thinks Private Equity is a Great Business

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“I tell my son, I have a teenaged son, I tell him, ‘Cole, you want to be in private equity. That’s where to go, that’s a great business, that’s a really good business. That’ll be good for you.'” – Andrew Bowden

Mr. Bowden, Director of the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations, was speaking at Emerging Regulatory Issues in Private Equity, Venture Capital, & Capital Formation in Silicon Valley, hosted by Stanford Law School.

His quote was in the context of the financial services industry complaining about too much regulation. His comment led some to question the SEC’s coziness with the industry.

I still remember Bowden’s speech delivered at the 2014 PEI Private Fund Compliance Forum. He figuratively threw a grenade in the room by saying his team found violations of law or material weaknesses in over 50% of the exams of private equity firms when it came to fees and expenses.

I don’t see his speech as industry capture. I see it as telling private equity to quit complaining and get your house in order. Private equity is good for investors and good for managers. Don’t screw up.

It’s the job of compliance to keep the good thing going and not let the firm screw up.

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Image of Andrew Bowden is by the Securities and Exchange Commission (on Flickr!?!)

What Does the Regulatory Scheme for Financial Services Look Like?

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Click for the full PDF file

SEC Commissioner Daniel M. Gallagher drew this picture of the new rules applicable to U.S. financial services holding companies since Dodd-Frank.

“The stakes here are considerable: regulatory burdens divert capital away from the real economy—this acts as a barrier to entry for new market participants and further entrenches those institutions that are increasingly ‘too big to fail.'”

 

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Referral Fee Disclosure and Conflicts

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The Securities and Exchange Commission brought another enforcement case involving an investment adviser and private funds. PageOne is a registered investment adviser that recommended three private investment funds to its clients. The SEC found serious conflicts the were not disclosed or materially misrepresented.

PageOne disclosed that is was paid a “referral fee” by the private funds. What PageOne failed to disclosed was

  • one of the private funds’ managers was in the process of acquiring at least a 49% interest in PageOne
  • PageOne had pledged to raise millions from its clients for the private funds, and
  • The fund manager was paying for the acquisition in installments tied to Page’s ability to direct the client money into the private funds.

The SEC characterized the “referral fee” as installment payments on the acquisition. I’m not sure that is a meaningful distinction, cash is cash, but it certainly seems to have annoyed the SEC.

The bigger failure is that the Form ADV disclosed the “referral fee” as being between 7% and 0.75% when it was as much as 15%. It also labeled the funds as managed by unaffiliated investment advisers. Clearly, that is not true when the fund manager has the right to buy the adviser.

PageOne’s clients invested between $13 million and $15 million in the private funds based on his recommendation and earned over $2.7 million in acquisition payments. The problem bubbled to surface because PageOne was required to raise $20 million for the acquisition to close. It turns out the “referral fees” were loan advances. When the acquisition did not close, PageOne’s owner was personally liable for repayment.

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