Month: June 2015

Allocation of Broken Deal Expenses

The Securities and Exchange Commission charged Kohlberg Kravis Roberts & Co. (KKR) with misallocating more than $17 million in “broken deal” expenses to its private equity funds. The SEC found this to be a breach of KKR’s fiduciary duty.

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An SEC investigation found that from 2006 to 2011, KKR incurred $338 million in broken deal or diligence expenses.  Even though KKR’s co-investors, including KKR executives, participated in the firm’s successful transactions efforts, KKR largely did not allocate any portion of these broken deal expenses to them. According to the SEC Order, there was a partial allocation to certain co-investors in 2011.

The main KKR fund invested $30.2 billion in successful transaction, while co-investors put in $3.9 billion and KKR executives put in $750 million.

In June 2011, KKR began examining its allocation strategy and recognized a problem. That resulted in that first allocation in 2011. In January 2012, KKR implemented its new allocation policy and began charging less in broken deal expenses to the fund and some to co-investors and executives.

Then in 2013 OCIE knocked on KKR’s door and conducted an exam. During the exam, KKR refunded $3.26 million to the fund for mis-allocation from 2009 to 2011.  The SEC wanted more and claimed that there was another $17.4 million in broken deal expenses that were improperly allocated to the fund based on the 2012 allocation policy.

The period in question goes back to 2006. That pre-dates KKR’s 2008 registration and most private equity fund’s Dodd-Frank registration in 2008. The SEC’s claim is under 206(4) of the Adviser Act which applies regardless of whether the fund manager is registered.

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SEC Loosens the Standards in Trade Monitoring

One of the more difficult aspects of a private equity fund when it registers as an investment adviser is dealing with the Rule 204A-1 requirement of monitoring employee trading. The SEC recently issued guidance on the applicability to managed accounts when there is no direct or indirect influence or control.

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The Guidance focuses on the code of ethics rule: Advisers Act rule 204A-1. The rule requires supervised persons to report their personal securities holdings and transactions. Subsection (b)(3)(i) offers an exception to the personal trading review requirement provided the supervised person has “no direct or indirect influence or control.”

Typically, CCOs have taken a hard line on this and the SEC has as well. For example, the hard line standard had typically been a blind trust, where the access person has no influence or control, and may not even know the holdings in the accounts. Some CCOs have take a more liberal approach. Clearly, the SEC has seem some CCOs incorrectly determine that some access persons’ trusts and third-party discretionary accounts qualify for the exception when they don’t.

Under the Guidance, the SEC is demanding more diligence.

Having “a third-party manager with discretionary authorities isn’t enough to qualify for the exception.” That does not eliminate actual or possible influence on what securities the third-party manager sells or purchases. The Guidance recommends CCOs probe deeper with managed accounts.

The Guidance states that obtaining a general certification alone is insufficient to determine if the access person exercised direct or indirect influence or control. The Guidance recommends that the CCO issues some probing questions:

“Did you suggest that the trustee or third-party discretionary manager make any particular purchases or sales of securities for account X during time period Y?”

“Did you direct the trustee or third-party discretionary manager to make any particular purchases or sales of securities for account X during time period Y?”

“Did you consult with the trustee or third-party discretionary manager as to the particular allocation of investments to be made in account X during time period Y?”

The Guidance may offer some relief for CCOs that took the hard line on the definition of managed accounts. On the other hand, it may he a tougher standard for those CCOs who took a more liberal view. In either case, there is clear guidance.

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Can a Real Estate Fund Manager Be a Venture Capital Fund Manager?

The Dodd-Frank Wall Street Reform and Consumer Protection Act split the world of fund managers into a few groups. One group that was able to grab a limited exemption from the Investment Advisers Act registration was venture capital fund managers. What does it take to be a venture capital fund manager? And could a real estate fund manager take advantage of it? I ask because I came across a real estate crowdfunding platform that took this choice.

Venture Capital - Inscription on Red Road Sign on Sky Background.

Under Rule 203(l)-1, a venture capital fund is any private fund that:

(1) Represents to investors and potential investors that it pursues a venture capital strategy;

(2) Immediately after the acquisition of any asset, other than qualifying investments or short-term holdings, holds no more than 20 percent of the amount of the fund‘s aggregate capital contributions and uncalled committed capital in assets (other than short-term holdings) that are not qualifying investments, valued at cost or fair value, consistently applied by the fund;

(3) Does not borrow…… in excess of 15 percent of the private fund‘s aggregate capital contributions and uncalled committed capital, and any such borrowing, indebtedness, guarantee or leverage is for a non-renewable term of no longer than 120 calendar day….;

(4) Only issues securities the terms of which do not provide a holder with any right, except in extraordinary circumstances, to withdraw, redeem or require the repurchase of such securities but may entitle holders to receive distributions made to all holders pro rata; and

(5) Is not registered under section 8 of the Investment Company Act of 1940 (15 U.S.C. 80a-8), and has not elected to be treated as a business development company pursuant to section 54 of that Act (15 U.S.C. 80a-53).

I gave up on this treatment because the debt limitation in (3) makes it hard to use a subscription secured credit facility. But if you’re not using a credit facility, the other provisions seem achievable for private equity funds or other funds investing in private securities, including real estate.

The big limitation would be that the fund “pursues a venture capital strategy.”

So I poked around looking for a definition of “venture capital” or “venture capital strategy” in the SEC’s rule release.

The rule and its release never bother to define “venture capital” or “venture capital strategy.” The rule merely states that the fund manager has to represent that it pursues a venture capital strategy. I found no color on what is and what is not “venture capital” or “venture capital strategy.”

I poked around on the National Venture Capital Association website. I thought the big trade association would have an easy to find definition. I was wrong. I could not find a meaningful definition of “venture capital.”

At the end of 2013, the SEC issued a guidance update on the exemption for advisers to venture capital funds. This guidance helped with some of the legal structures and the terms “qualifying investments” in part (2) of the definition. It does not discuss “venture capital strategy.”

I looked at some of the real estate crowdfunding platform’s documents and found these provisions:

In addition, the Subscriber understands that the Manager is not registered as an investment adviser under the Investment Advisers Act of 1940, as amended. The Manager is expected to be treated as an investment adviser exempt from federal or state registration under the venture capital strategy being pursued by the Company….

The Company is pursuing a venture capital strategy through investments in operating companies that manage and develop real estate.

I think it’s a bold approach to call itself a venture capital fund manager. But it kind of works. It may not make sense from a common sense perspective or a common expectation of what “venture capital strategy” is. But it’s a term that is not well defined in common practice. The SEC did not even try to define it.

The big problem is the consequences. The release for Rule 203(l)-1 says that you can’t merely state that you are pursuing a venture capital strategy; You have to actually pursue that strategy. (Again, without defining it.)

In the rule release, the SEC also states that it is a violation of the anti-fraud provisions if you merely state that you are pursuing a venture capital strategy when you are not actually engaged in that strategy.

A real estate fund with an opportunity investing style or value-add investing style could argue that it is a “venture capital strategy.” Those fund types are looking to invest in companies and get them to grow. Of course, each investment is likely a single-asset real estate company.

I would not sleep well at night, worrying that the SEC was going to challenge that regulatory choice.

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Compliance Bricks and Mortar for June 19

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

bricks and mortar

Ethisphere Announces the 2015 Attorneys Who Matter

 Honorees represent all areas of practice including federal agencies, in-house counsel, top ethics and compliance officers of major companies, and outside counsel. Each one raises the bar for ethical behavior and boasts a commendable track record of public service, legal community engagement, and academic involvement. [More…]

Never Tick Off a Redbird by Tom Fox in the FCPA Compliance and Ethics Blog

As to the Cardinals, what on earth could the Astros have that they could possibly want? Take the Astros record over the past five years; it’s the worst in baseball. You want a piece of that? How about secret information on the leadership savoir fare of the Astros owner ‘Mr. I am smarter than everyone in the room because I made a $100mm in business’ Jim Crane. Why be one of the best-run sports franchises, when you can mimic the Astros? First you can tell everyone how stupid they are because they do not understand how it is in your interest to try and lose; next why you should cut off over 70% of your fan base from even watching games on television so they will not see your joke of a team play and, finally, how to sue the prior owner who sold you the team for mis-representing the quality of the assets.

Why the SEC can’t easily solve Appointments Clause problem with ALJs by Alison Frankel for Reuters

It seems as though there ought to be an easy way for the Securities and Exchange Commission to stomp out claims that its in-house judges are unconstitutionally appointed through a bureaucratic process, a defense theory that has spread as fast among SEC defendants as viral cute-animal memes on the Internet. But the SEC has so far avoided even addressing the potential consequences of that quick fix – perhaps because the solution isn’t so simple after all. If the SEC changed the way it appoints in-house judges, the fix could call into question the outcome of scores of past and present SEC enforcement actions as well as cases at other regulatory agencies.

 

wall street

You Can Finally Spend That Extra $12,000 On A WALL ST Vanity Plate by Alexander C. Kaufman in The Huffington Post

The seller bought the plates when they first became available in 1976, and he slapped them on his brand-new Chrysler Cordoba, according to Bloomberg Business. At the time, the Saratoga Springs resident, whose name hasn’t been reported, was working at the brokerage firm E.F. Hutton.

Now, the plates are attached to his 2002 Mercedes-Benz S-Class sedan. And, yeah, you get the car if you buy the plates, per Bloomberg.

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Compliance Building is a free resource I publish for me, and share with you, to help the compliance profession. It will still be free, but I’m asking for money.

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I’m riding the 2015 Pan-Mass Challenge to raise money for the Dana-Farber Cancer Institute.
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2. My Dad. He just fought a battle with cancer. And won, thanks to help from the Dan-Farber Cancer Institute. It’s a battle that my aunt and uncle, his brother and sister, did not win.

3.  Action Dave. My friend was diagnosed with metastatic oropharyngeal cancer in November of 2013. The Dana-Farber Cancer Institute helped him beat back the disease. I’ll be riding by his side during the PMC.

4.  Jack Ramsden. In 2005 I rode the Pan-Mass Challenge with Team Kinetic Karma. The Team’s Pedal Partner was Jack. In March 2004, a then seven-month-old Jack was diagnosed with Stage IV Neuroblastoma, a rare and aggressive childhood cancer. This young boy valiantly endured treatments that have been known to kill grown men. With piercing blue eyes and a contagious smile, he defied the expectations of his doctors. But in the end, he could not overcome the disease. He passed away in December 2008.

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6. 100%. The Pan-Mass Challenge donates 100% of every rider-raised dollar to Dana-Farber Cancer Institute through its Jimmy Fund. (I pay an extra fee to pay for the ride expenses.) The PMC raises more money for charity than any other single event in the country.

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Doug

The SEC Goes After the Gate Keeper

When a fraud is uncovered, the Securities and Exchange Commission no only wants to get the fraudsters, it also wants to get those who should have stopped the fraud. The SEC just brought an action against an IRA Custodian for ignoring red flags for its accounts that invested in Ponzi schemes.

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The underlying fraud was conducted by Ephren Taylor with his City Capital Corporation investment fraud, and Randy Poulson with his Equity Capital Investments fraud. Taylor was convicted and was sentenced to 235 months in prison. Poulson has been indicted but is still fighting his case.

Equity Trust is a leading provider of self-directed IRAs. The firm pushes the laudable goal of seeking diversity outside of the stock market. It’s successful, with over 30,000 clients and approximately $12 billion of assets in custody.

According to the SEC complaint, the problem is that the firm’s salespeople have goals of opening accounts. That lead at least one unnamed salesperson to enter into a cozy relationship with Taylor and City Capital. Equity Trust’s accounts were a source of new capital for its Ponzi scheme and City Capital was a source of new accounts for Equity Trust.

The relationship was too cozy for the custodian from the view of the SEC. The salesperson was pushing its client accounts at Taylor and City Capital.

For example, in an email dated January 14, 2009, Salesperson A wrote to Taylor that he learned that the broker of an Equity Trust customer recommended to the customer that she not invest in Taylor Notes. Salesperson A then told the customer, “‘how can you comment on something you know nothing about….how can this broker comment on real estate when he has never done it.’” The customer responded, “‘great point’ let’s do it.” Salesperson A concluded his email to Taylor stating: “I am on it…I will close it.” The customer then invested more than $500,000 in Taylor Notes.

The salesperson trained City Capital on the use of self-directed IRAs. The firm even hosted a webpage for potential investors. The City Capital notes came in poorly documented and started having repayment issues. The firm began escalating holds and added City Capital to the “do not process” list. The firm continued to process existing accounts and collect fees. But did not inform the account holders of the problems with City Capital.

A similar story occurred with the Poulson’s investment fraud. Accounts were open and investments made, but the documentation was poor or missing. During one review, 25 out of 25 accounts were missing proper documentation. But Equity Trust continued to process to new accounts. It was only a year later that the firm put a stop on new investments.

The description above comes from the SEC charges which Equity Trust is contesting. The SEC also re-issued an investor alert on self-directed IRAs and the risk of fraud.

In my reading of the complaint, Equity Trust is charged with not acting quickly enough to stop investments in these two fraudulent schemes. At least one of the salespeople went too far and encouraged investment in the Ponzi scheme.

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Château de Crécy-la-Chapelle: Gate is by Baishiya 白石崖
CC BY SA

Whistleblower Retaliation

A year ago, the Securities and Exchange Commission charged Paradigm Capital Management with engaging in prohibited transactions and then retaliating against the head trader who reported the trading activity to the SEC. It was the first time the SEC filed a case under its new authority to bring anti-retaliation enforcement actions. Now it has handed part of the penalty to the whistleblower.

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The underlying problem, according to the SEC’s order, was that the firm’s principal conducted transactions between Paradigm and a broker-dealer that she also owned while trading on behalf of a hedge fund client. Principal transactions pose conflicts between the interests of the adviser and the client. Under an SEC rule advisers are required to disclose that they are participating on both sides of the trade and must obtain the client’s consent.

It’s tricky to effectuate consent for a hedge fund. Most hedge funds are privately-owned so there is no board of directors to act on behalf of the fund. The head trader and the SEC thought that the hedge fund’s conflict process was ineffective. Paradigm made the mistake of mistreating the head trader, turning the actions into retaliation against the whistleblower. Paradigm settled the case for $2 million.

In turn, the SEC granted the whistleblower the maximum award of 30% of the settlement.

The whistleblower first submitted the case to the SEC in March 2012 and disclosed that he or she had done so to Paradigm in July 2012, suffering a month of mistreatment before resigning. It took two years before the SEC settled the case with Paradigm and another year for the whistleblower to receive the award.

That’s a long time for the wheels of justice to turn for the whistleblower.

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Compliance Bricks and Mortar for June 12

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

fort jackson brick wall

Jamie Dimon Says He’s Unsure If Elizabeth Warren Understands Global Banking System by Kim Chipman for Bloomberg

[W]hen asked about his biggest worries, Dimon expressed concern that the U.S. may eventually be hurt by ideological decisions being made in Washington. [More…]

Legal Ethics for Compliance Lawyers By Jeffrey Kaplan From Compliance & Ethics Professional, a publication for SCCE members

I do not think that there is any great tension between the two. Of course, a company’s lawyers have to abide by somewhat different rules with respect to reporting suspected violations than do employees generally, because the lawyer’s knowledge of possible wrongdoing may be subject to the attorney-client privilege. But this is as it should be, since jeopardizing the privilege would make it less likely that a company would seek legal advice on C&E matters, thereby weakening C&E programs.[More…]

Warning: Keeping Compliance Simple by Michael Volkov in Corruption, Crime & Compliance

CCOs have to avoid something that comes with influence and authority – making compliance programs too complex. Why do I worry about this?

Compliance depends on simplicity and accessibility. It does not depend on self-actualizing theories and designs of wordy compliance concepts. Take one example – (and I apologize to advocates of this) the so-called “three-lines of defense” (“TLOD”) or other compliance program acronyms and theories.[More…]

How biased are you about bribery (or anything else)? Watch the first video. Then read the post and find out. by Etai Biran in thebriberyact.com

Being aware of our biased behavior during the information selection stage has significant implications on the rest of the decision making process. Selecting the right information to form a decision will have great impact on the decision’s outcome. Using the wrong information to evaluate a situation will have a “domino effect” on the rest of the decision making process and will eventually lead to bad judgment and bad decisions. If the information selection process is biased it may well be that the final decision turns out to be a bad one because it was based on wrongful information all along.[more…]

pmc-badgeIf you enjoy reading Compliance Building, please consider making a donation to my Pan-Mass Challenge bike ride. 100% of your donation goes to support cancer research.

Click here to make a $50 donation.

 

Fort Jackson; Brick Wall is by Jodi Green
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Cyber Insurance: A Pragmatic Approach to a Growing Necessity

Cybersecurity has become an increasing focus of financial regulators. Insurance companies are stepping up to help deal with the risk of cyber attacks.  Bruce Carton’s CyberSecurity Docket hosted a great webinar on cyber insurance. These are some of the highlights.

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John Reed Stark is President of John Reed Stark Consulting LLC, a data breach incident response and digital compliance firm. 

David R. Fontaine is Executive Vice President, Chief Legal & Administrative Officer and Corporate Secretary of Altegrity, a privately held company that among other entities owns Kroll’s data breach response services. 

The industry has accumulated the actuarial data needed to underwrite the damages and likelihood of a cyberattack. But the market is still very new and evolving. There is no standard policy language.

One focus is what will be covered by the insurance. There are three areas of losses:

  1. liability (lawsuits from customers for the breach)
  2. breach response cost (notifying customers of the breach)
  3. government fines/penalties.

You also need to focus on what triggers the coverage: a lost laptop, internet intrusion, data sourced from the company.

The coverage will be based on some detailed reps and warranties. You need to make sure they are right and you understand them.

Here is an incident response workflow:

  1. Preserve. Assmble the team, unhook the infected machines
  2. Digital Forensic Analysis: figure out what happened to the machine
  3. Logging analysis: figure out how the machine was accessed
  4. Malware reverse engineering.
  5. Surveillance
  6. Remediation efforts
  7. Exfiltration analysis. Figure out what was taken.
  8. State regulatory analysis. There are 47 different regulatory schemes.
  9. Federal regulatory analysis. Everyone thinks they have jurisdiction.
  10. PCI Compliance, if credit card data was involved
  11. Law enforcement liaison.
  12. Customer notifications

It’s clear that every company is at risk for a cyber attack. If bad guys want to attack, you can’t stop them. Insurance may be able address some of the risk and damages.

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The SEC Suffers a Setback In Its Use of In-House Judges

Prior to the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Securities and Exchange Commission’s authority to impose penalties in a case brought as an administrative proceeding was restricted to regulated entities. Dodd-Frank changed that with its Section 929P. The SEC may now impose a civil penalty in an administrative proceeding against any person or company. That means the SEC could use its in-house courts for insider trading cases. The SEC suffered its first major setback in that strategy.

SEC Seal 2

The SEC charged Charles L. Hill with the illegal use of material non-public information in the purchase of Radiant stock. The SEC alleged that Hill was tipped off by Radiant’s COO that the company was about to be acquired by NCR Corporation. Hill bought over 100,000 shares of Radiant and turned a profit of $744,000 in a month.

Hill is a real estate developer and is not a registered with SEC. The SEC chose to use an administrative proceeding instead of federal district court to bring the charges.

Hill fought back.

Hill filed for Temporary Restraining Order against the SEC, seeking to declare the administrative proceeding unconstitutional and to stop the SEC proceedings.

The judge found that the administrative proceeding does not provide meaningful judicial review. The SEC tried to deal with this challenge in the proceeding, but even the administrative judge admitted that the constitutional challenge was outside the SEC’s expertise.

The judge did not agree with Mr. Hill’s non-delegation claim. The SEC was free to chose the forum because Congress properly delegated that choice.

The judge also did not agree with Mr. Hill’s claim that the administrative proceeding wrongfully took away his Seventh Amendment right to a jury trial. Past interpretations of the Seventh Amendment have carved out the position that the jury is not the exclusive fact-finding mechanism for civil cases.

Mr. Hill did succeed in arguing that the administrative proceeding was a violation of the Appointments Clause of Article II of the Constitution.

Under that Clause, the President has principal officers who he or she selects, and are then confirmed by the Senate. There are inferior officers who may be appointed by the President, the heads of departments or the judiciary. The judge agreed that the SEC’s administrative judges are inferior officers.

As inferior officers, the administrative judges must be appointed by the five commissioners of the SEC. The SEC hired the judge in Mr. Hill’s case through its office of in-house judges.

The ruling is a setback for the SEC, but it seems it could be easily fixed. The SEC commissioners could directly make the appointments. That would likely cure the Appointment Clause violation.

The judge did not get to the two levels of tenure argument that might violate the Removals Clause of Article II. That issue is still out there and may be another roadblock to the SEC’s use of administrative judges for contested insider trading cases.

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