Compliance Bricks and Mortar for May 29

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

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Whistleblowers Find SEC Rewards Slow and Scarce by Jean Eaglesham and Rachel Louise Ensign in the Wall Street Journal

An SEC spokeswoman declined to say how much money has been collected for any of the 658 enforcement actions the agency’s website lists as being potentially eligible for awards. She also declined to say how many, if any, of the pending award claims relate to cases in which no bounty is available, even if the claim is approved. [More…]


Law School Moral Hazard and Flawed Public Policy by Steven J. Harper in the CLS Blue Sky Blog

Law schools have become poster children for market dysfunction. As the Great Recession decimated the demand for new lawyers, a functioning market would have led most schools to reduce enrollments. Instead, the overall number of admitted students increased to more than 60,000 in 2010 – up ten percent from 2008. Three years later, the result was the largest-ever graduating class of JDs: 46,776 in 2013. Nine months after law school, only about half of them had found full-time long-term (“FTLT”) JD-required jobs.[More…]


SEC Broadens Constitutional Inquiry into Its Own Administrative Judges in Timbervest Case in Securities Diary

On May 27, 2015, the SEC agreed to expand its own consideration of constitutionality challenges to its administrative law adjudicative process.  It issued an order asking for further briefing on whether the appointment of its administrative law judges conforms to the Constitution’s Appointments Clause.  The order, which was issued in the administrative proceeding In the Matter of Timbervest LLC et al., File No. 3-15519, is laid out below. [More…]


How FIFA’s Structure Lends Itself To Corruption by in FiveThirtyEight

FIFA has 209 member-nations, and each one’s soccer association is equally powerful in the sport’s governing body. Every member, from China (population: 1.36 billion) to tiny Montserrat (population: 5,215), gets one vote in the FIFA Congress. That means each one gets to cast a vote in the FIFA presidential election scheduled for this Friday in Zurich. And each one — from Brazil (five men’s World Cup wins, one of the world’s best women’s teams) to, well, let’s stick to Montserrat (men’s team never ranked higher than No. 165, women’s team unranked) — will get equal say in choosing hosts of future World Cups. [More…]


Bricked is by Henk Sijgers
CC BY NC


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What is a “Voting Equity Security” under the Bad Actor Rule?

When the Securities and Exchange Commission adopted Rule 506(d), it did not define “voting equity securities.” That left many fund managers having to take an aggressive approach on compliance with the “bad actor rule.” The SEC has provided some additional clarity.

Vote

I have to admit that I did not pay much attention to the recent rule release for Regulation A. I’m skeptical that it’s a particularly useful fundraising tool for funds. Also, Regulation recently came under siege from state securities regulators.

It turns out that the SEC buried some clarification about Rule 506(d) in the release for the updated Regulation A. If you don’t want to read all 450+ pages of the rule release, just turn to page 203 for the discussion of the change.

The SEC has reconsidered its initial interpretation as it applies to the bad actor rule in 506(d) and created a bright-line test. (As a compliance professional, I like bright-line tests.)

Previously the SEC consider securities as voting equity securities if:

“securityholders have or share the ability, either currently or on a contingent basis, to control or significantly influence the management and policies of the issuer through the exercise of a voting right.”

I think most people looked at this and said if you have or could possibly have 20% of anything in the company, you fall within the bad actor rule. The SEC decided this interpretation was too broad and wanted a definition that would “facilitate compliance.”

The new definition:

In this regard, we believe that such a term should include only those voting equity securities which, by their terms, currently entitle the holder to vote for the election of directors. In other words, we believe the term should be read to denote securities having a right to vote that are presently exercisable. Additionally, while the ability to control or significantly influence the management or policies of the issuer may be derived in part from the power to vote for the election of directors, in order to dispel any uncertainty as to the scope of our interpretation, we believe the term “voting equity securities” should be interpreted based on the present right to vote for the election of directors, irrespective of the existence of control or significant influence.

That is a great change, making the definition more narrow. A great change that is limited to investment vehicles formed as corporations.

Of course, the SEC flubbed and used the term “directors” in this definition. That leaves fund compliance professionals scratching their heads as to how this interpretation applies to a private fund, which is typically organized as a limited partnership.

I think you have to ignore it. You can argue that a right of limited partners to remove the general partner without fault is the equivalent to the right to elect a director of a corporation. I’m just not sure you win that argument. It certainly make the bright line test much more blurry.

Sources:

Vote by Theresa Thompson
CC BY

Compliance and Co-Investment Allocation

Icon of Money in the Hand on Rusty Warning Sign.

Co-investment is an area that many institutional investors look for when investing with a fund manager. It’s generally a good deal for them because the investment is overseen by the fund manager without having to pay the fund management fee. Depending on the program, it may be a lesser fee or no fee. And of course they still have to pay the expenses charged by the fund manager to the portfolio company. The fund manager gets more capital to invest and can reduce the exposure of the fund to a particular investment. The fund manager is likely earning less of a fee for doing the same amount of work.

It does not seem like an area that is ripe with the conflicts and issues that grab the attention of the Securities and Exchange Commission. However, Marc Wyatt, the Acting Director, Office of Compliance Inspections and Examinations, chose to spend a few minutes raising the issue during his speech at the recent Private Fund Compliance Forum.

Another area where we have been dedicating resources is co-investment allocation. We’ve spoken before about our observation that co-investment allocation was becoming a key part of an investor’s thesis in allocating to a particular private equity fund, and over the past year, co-investments have become even more important to the industry.

If the SEC is dedicating some of its limited resources in this area, we should take notice.

While most of our co-investment observations have been around policies and procedures, we have detected several instances where investors in a fund were not aware that another investor negotiated priority co-investment rights. … Therefore, allocating co-investment opportunities in a manner that is contrary to what you have promised your investors can be a material conflict and can result in violations of federal securities laws and regulations.

From that quote it seems the SEC exam team has encountered situations where a fund manager was misleading investors about co-investment rights. Clearly, you can’t promise an investor something and then do the opposite.

Ironically, many in the industry have responded to our focus by disclosing less about co-investment allocation rather than more under the theory that if an adviser does not promise their investors anything, that adviser cannot be held to account.

Many fund managers do keep their co-investment allocations under wraps, doling them out in a manner that works best for the deal. There are many factors that go into partnering up with investor through a co-investment. The co-investor needs to be able make capital available and make decisions as quickly as the fund manager. Otherwise strategic decisions are jeopardized. The need for a co-investment may vary over the course of the fund life. Deals maybe smaller and not be good opportunities for co-investments.

I believe that the best way to avoid this risk is to have a robust and detailed co-investment allocation policy which is shared with all investors. … I am suggesting that all investors deserve to know where they stand in the co-investment priority stack.

I’m not sure I know what to make of that. Most investors do not have co-investment rights and have no expectation of co-investment opportunities. Some negotiate for contractual rights to co-investments. Others merely ask to be place in a pool of availability with no specific promises of opportunities.

Ultimately, it’s a contractual right negotiated between the fund manager and the investor. Clearly, the fund manager needs to live up to its contractual obligations with its investors. Failing to do so is an area appropriate for SEC intervention.

Sources:

Compliance Bricks and Mortar for May 21

It’s a day early because of the long weekend. If you’re looking to read some other compliance-related stories this weekend, these are some that recently caught my attention.

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Former SEC Chairman Cox Weighs in on Administrative Proceedings by Bruce Carton in Compliance Week

On Wednesday, former SEC Chairman Christopher Cox offered his own interesting perspective on the SEC’s use of administrative proceedings. In his remarks at Securities Enforcement Forum West 2015 entitled, “The Growing Use of SEC Administrative Proceedings: An Historical Perspective from Congress and the Agency,” Chairman Cox pointed out that APs have now developed to the point that they often take the place of trials — despite bearing little resemblance to civil courts and their accustomed rules of civil procedure. This has occurred, Chairman Cox stated, through a combination of federal agencies using their rulemaking powers to maximum effect while Congress has remained largely absent from the discussion. […more]


The Importance of Effective Policy Writing for Compliance by Muhammad Talib Uz Zaman in Corporate Complaince Trends

Why it is imperative to have a clearly-written policy? Policy engagement starts with (effective) policy writing, which is the foundation for an effective code of conduct. A policy basically defines the general business guidelines by which the organization operates. Policy, as laid out in a clearly written code of conduct, establishes the compliance and ethics practices on an enterprise-wide level, which can be further distilled into procedures that define ongoing process of work. […more]


Ceresney Reviews SEC’s Successes with National Litigation Program by Jacquelyn Lumb in Jim Hamilton’s World of Securities Regulation

The SEC typically does not litigate cases where it has obtained the strongest evidence of wrongdoing, according to Ceresney. Those cases typically are brought by the criminal authorities or they settle on terms that are favorable to the Commission, he explained. Litigated cases tend to be those where the evidence is less clear, the law is unsettled, or the defendants are willing to spare no expense to clear their names, he advised. […more]


Compliance Wars: SEC and FINRA Disciplinary Actions Against Chief Compliance Officers and In-House Counsel in a Galaxy Not Too Far Away (.pdf) by Brian L. Rubin and Irene A. Firippis for Sutherland

Unfortunately, Chief Compliance Officers (CCOs) and in-house counsel for broker-dealers (BDs) or investment advisers (IAs) cannot call on this team of heroes or the sage Jedi Master Obi-Wan Kenobi when serving their roles. CCOs and in-house counsel are tasked with the challenge of advising their colleagues and helping to ensure that their firms comply with securities laws and regulations, without having the authority (or light sabers) to enforce their decisions or advice. The U.S. Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) might not watch over the galaxy, but both agencies carefully monitor and scrutinize the conduct of CCOs and in-house counsel. […more]


The Anti-Corruption Enforcement Problem by Kevin LaCroix in the D&O Diary

While the enforcement of anti-corruption laws is to be applauded, at the same time, questions are being asked about whether in at least some cases things might have come too far, as the enforcement process has become astronomically expense and time-consuming.

A May 9, 2015 Economist article entitled “Corporate Bribery: The Anti-Bribery Business” (here), as well as a leader article in the same issue (here), refers to what the magazine describes as “a mounting body of evidence that the war on commercial bribery is being waged with excessive vigor, forcing companies to be overcautious in policing themselves,” noting that “some under investigation are starting to fight back.” […more]


Credit Suisse dropped SEC waiver request amid opposition by Sarah N. Lynch in Reuters

The bank had applied for the waiver following its agreement last year to pay $2.5 billion to resolve criminal charges that it helped wealthy Americans evade U.S taxes. The criminal charges automatically triggered a federal law that deprives the bank for three years of the privilege of being known in the market as a “well-known seasoned issuer,” or WKSI. The designation lets public companies bypass SEC approval and raise capital “off the shelf” – a process that is speedier and more convenient. Failing to obtain the waiver will make it more costly and burdensome for Credit Suisse to sell shares and debt to the public. […more]


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Vertical Integration of Fund Manager and Related Party Expenses

Marc Wyatt had been on the job for 16 days as the Acting Director Office of Compliance Inspections and Examinations when he took his first shots at private fund managers. He took a shot directly at real estate fund managers and indirectly at other types of fund managers with vertical integration.

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The Speech

While we found that sometimes these ancillary services are indeed not disclosed, a more frequent observation was that investors have allowed the manager to charge these additional fees based on the understanding that the fees would be at or below a market rate. Unfortunately, we rarely saw that the vertically integrated manager was able to substantiate claims that such fees are “at market or lower.”

In-House Counsel

I particularly noted that Mr. Wyatt included charges for a fund’s in-house attorneys as part of vertical integration. It’s tucked into the real estate advisers portion of the speech, but I’ve seen fund managers in many industries charge in-house lawyers’ time to funds and portfolio companies.

There is nothing inherently wrong with charging this expense, provided it is disclosed to investors. If it’s not disclosed, the explanation is that the services are being provided at less expense than if the fund manager engaged outside counsel.

Mr. Wyatt raises the concern that fund managers are not documenting the cost savings. If a fund manager is claiming that the expense is “at market or lower” the manager needs to be able to prove it.

For in-house counsel, that may be as easy as documenting the costs when using outside counsel and comparing rates.

Property Management, Construction Management and Leasing Agents

The specific concern in Mr. Wyatt’s speech was for real estate fund managers that have their own property management, construction or leasing divisions. Again, there is nothing inherently wrong with this integration and charging the expenses as long as it is disclosed to investors.

If the fund manager is claiming that it is charging these expenses “at market or lower”, the fund manager needs to prove this statement is true. The SEC exam team will be looking for good benchmarks to substantiate the claims. Anecdotal evidence will not suffice.

Sources:

Boston Skyline is by Dennis Forgione
CC BY SA

Brady, Footballs, and Tone at the Top

Handsome rich man from New England forced to take four-week vacation with supermodel wife.

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As a football fan, New England Patriots fan and a compliance professional, I can’t let the Wells Report and the punishment levied by the NFL pass without comment.

There was a violation of the league rules and there should be punishment.

A low level employee, Jim McNally, admitted to working on the footballs. A high-level manager, Tom Brady, had previously expressed his dissatisfaction with the condition of the balls. Brady has said he likes his footballs inflated to the lowest permissible levels because they are easier to grip, throw, and catch.

It is easy to conclude that McNally wanted to please Mr. Brady and worked hard to do so. Hard enough that he was even willing to step over the line and work the balls after they inspected by the NFL referee.

There is no clear evidence that Brady told McNally to deflate the balls, but clearly McNally was working to please Brady. The “tone at the top” was to fix the balls and win at all costs.

The NFL levied punishment that affects the team at all levels. Brady loses a quarter of his pay for the year with a four game suspension. Coach Belichick loses a first-round draft pick next year and a fourth-round choice the year after. Robert Kraft, the owner has to write a check for the $1 million fine. The franchise as whole loses their most important player for a a fourth of the season and dramatically reduces their chances to repeat as the Super Bowl winner.

You can argue over the appropriate punishment.

Ray Rice was initially suspended for two games for assaulting his girlfriend, now wife. That punishment was only increased after the clear and convincing evidence in the videotape was made public.

A previous ball tampering violation in the 2014 season went with out punishment. During the frigid December game between the Vikings and the Panthers, sideline attendants were videotaped using heaters to warm up the footballs. That is a clear violation of NFL rules. The penalty was a verbal warning.

You can also argue that the football condition standards are outdated. Before 2006, the home team prepared all the footballs used by both sides. The football condition rule would keep the preparation within a range of acceptable norms. Each quarterback has their own preference for the condition of the balls. Mr. Brady and Peyton Manning helped change the rule so that each team could prepare balls to the their liking, with the rules parameters of course.

The Patriots scored 17 points with one interception in the first half with the under-inflated footballs. The team scored 28 points and had no interceptions in the second half with the properly inflated footballs. It’s hard to see how the small change in the footballs’ pressure affected the outcome of the game.

But it does affect the integrity of the game. For the Patriots, that came from the tone at the top. “Win at all costs.” Mr. Brady pressured the lower level employee to fix the balls.

The Wells Report did not find a smoking gun. There was no written message to condition the balls outside the rules parameters.

From the compliance perspective, there was no message to obey the rules. For most organizations with a compliance program you would expect the employee to have signed a certification that they understood the rules.

Perhaps the outcome would have been different if the investigation had turned up the certification that Mr. McNally understood the ball rules and protocol for handling them.  You would have another one from Mr. Brady that he also understood the parameters. Maybe the incident would never had occurred in the first place.

In the end, Patriots-haters will call them cheaters. Patriots fans will scream over the injustice and over-punishment.

I see it as a call for the teams to start implementing compliance programs.

Sources:

Compliance Bricks and Mortar for May 15

These are some of the compliance-related stories that recently caught my attention. You need to build a wall, brick by brick.

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Cyberattacks Represent Top Risk, SEC Chief Says by Andrew Ackerman in the Wall Street Journal

“One of my major concerns about this area is nearly everybody gets how high-level the risk and priority of this is,” she said at a conference sponsored by a mutual-fund group. “But who’s really got the ticket overall to make sure that it’s all sort of coming together in an optimal way? That’s something we’re still working on I think in the government.”


Compliance alert: OFAC issues report on blocked terrorist assets by Richard L. Cassin in the FCPA Blog

Last week OFAC — the Office of Foreign Assets Control — issued its 23rd report to congress detailing blocked assets in the U.S. belonging to terrorist organizations and state sponsors of terrorism. The blocked assets in total are worth about $2.3 billion. Most belong to Iran.


SEC’s Daniel Gallagher resigning as commissioner in Investment News

The White House will now need to replace him as well as Luis Aguilar, the Democratic commissioner whose term expires next month. The departures herald a transformation at the agency, which has struggled to write dozens of new regulations arising from the 2010 Dodd-Frank Act.


What To Expect From The SEC In The Year Ahead

These are my notes, live from the forum. (Please pardon the rougher nature.)
Private fund Compliance forum

Speaker:
Marc Wyatt , Deputy Director -Office of Compliance Inspections and Examination, US Securities and Exchange Commission

(Of course, his comments are his own and don’t represent the viewpoints of the Commission or the rest of the staff.) This also only his 16th day in this position.

The “presence exam initiative” was a response to the flood of new registrants coming from Dodd-Frank. The SEC wants to push the results back to the firms.

Capital formation is important. The private equity industry has grown 25% and capital raised has increased by 40% over the last few years. The size of funds currently being marketed is down 14%.

He interprets that the SEC’s oversight is not impeding capital formation.

OCIE’s private fund unit wants to conduct targeted risk-based exams to ensure compliance. The unit spreads the results throughout OCIE to keep examiners aware of risks and what to look for. The unit is also running training sessions for the large population of examiners.

Based on last year’s speech by Bowden, investors are focused on fees.

Disclosures on Form ADV does not work if the disclosure is not made until after the investor comes into the fund.  Get consent if you imposing a new fee or expense.

The SEC is happy to seeing a split between the general counsel and chief compliance officer role.

There is still room for improvement.

By far the most common deficiencies noted by our examiners in private equity relate to expenses and expense allocation. Many managers still seem to take the position that if investors have not yet discovered and objected to their expense allocation methodology, then it must be legitimate and consistent with their fiduciary duty.

Co-investment allocation is an area of concern. All investors must understand where they stand.

In addition to the SEC’s focus on traditional private equity, the National Examination Program began utilizing our Private Funds Unit to systematically look at private equity real estate advisers. There was an observation that real estate managers, especially those executing opportunistic and value-add strategies, tended to be much more vertically integrated than traditional private equity managers.

They found that some ancillary services are not disclosed. More often they found that the manager would charge these additional fees based on the understanding that the fees would be at or below a market rate. Unfortunately, the SEC fund that the manager was not able to substantiate claims that such fees are “at market or lower.” The SEC saw that the managers collects no data to justify their fees at all. Other times, the data is collected informally through calls to other industry participants and is not documented.

I hope that private equity real estate managers who have promised to provide their investors with “rates at or below market rate” review their benchmarking practices to ensure they can support their claims.

We can expect additional enforcement recommendations involving undisclosed and misallocated fees and expenses as well as conflicts of interest.

The speech was published during the session.  Here it is: Private Equity: A Look Back and a Glimpse Ahead.

Post-speech questions and comments:

OCIE wants to be risk-based, data-driven, and transparent. They don’t want to be a “gotcha” regulator.

How do you get the examiners out of the office faster? Give them accurate and consistent responses quickly. Don’t cross-talk. Make sure you understand the question and understand the definition/terminology. If you data-dump that will slow down the process. If you give the examiners 700 documents, they will have 700 documents to read and that takes time.

Exempt reporting registrants? The SEC will show up if there is a TCR or a sweep.

He looks at CCOs as colleagues to help spread compliance. CCO liability situations came from egregious behavior (Blackstone aside.)

Ensuring Compliance in Your Marketing and Advertising Procedures

These are my notes, live from the forum. (Please pardon the rougher nature.)

Private fund Compliance forum

Speaker:
Julia D. Corelli, Partner, Pepper Hamilton
Ross A. Oliver, Senior Counsel & Chief Compliance Officer, Crestview Partners
Gwen Reinke, Chief Compliance Officer, Vista Equity Partners

You need to think of marketing as a broader area than advertising.

Deal press releases and portfolio company press releases may describe the firm. Make sure it meets the standards. Your website is marketing.

How do you monitor compliance with your policy? Set up the Google search. Look at employee LinkedIn accounts.

You should on-board new employees to make sure they understand the dos and don’ts, followed by annual training.

Are private funds using general solicitation under 506(c)? The proposed rules have raised many unknowns about the downside to using it. Many are skeptical through true general advertising would be a good way to reach potential investors. Some funds are using to avoid the common foot-faults. (like speaking at a conference.)

The SEC has increased its review of marketing materials as part of its examinations. One focus it the inclusion of GP or other non-fee paying LPs in the performance data.

Prospective investors want to see case studies. The regulatory concern is that it could be considered cherry-picking. Best practice is to include a list of all investments with performance results.

When it comes to net returns there was a split in the audience poll. Half calculated as if everyone paid the highest fee, and the other half exclude non-fee or reduced fee investors in the calculation. Regardless of the choice, you need to disclose.

When it comes to books and records, remember you need to keep the performance backup materials for at least five years after last used.

Cybersecurity and Risk Management

These are my notes, live from the forum. (Please pardon the rougher nature of this report.)

Private fund Compliance forum

Speakers:
Terry E. Everett, CFO & COO, Rockland Capital
Garth Nichols, Senior Manager- Financial Services, EY
Christopher Anderson, CCO & General Counsel, KPS Capital Partners LP

First step is to figure out what you want to protect. For private equity and real estate funds the information may be all over the place. It’s not not just a client account database.

It’s not just about digital access, but also physical access. Figure out if people can get into your offices and if they do get in, what can can they get easy access to. Walk around and see if people have passwords stuck to their monitors.

Assess where risks may be coming from. Protect the higher risks.

Look to third parties that you share sensitive information with. Look at their program to make sure it’s up to your standard and not a vulnerability.

Your employees are likely your weakest link. Phishing and spearphishing are common attacks. Accidents happen: employees lose laptops and phones that may offer access to your systems.

You should be able to show that you have been thoughtful, have a plan a place to review, and a plan in place to deal with a breach.