Looking Ahead – Five Compliance Predictions for 2016

With my 2015 almost gone, I was thinking about what to expect in 2016 in the private fund and real estate fund compliance area. My crystal ball is not very reliable. If it was fully operational, I would have bought Apple stock in 2002 before the iPod came out.

Hand drawing New Year concept with white chalk on blackboard. Going ahead to year 2016 and leaving the year 2015 behind.

Real Estate Fund Enforcement Actions

There was a focused review of real estate fund advisors that wrapped up about a year ago. Given how enforcement actions work through the SEC, I expect the enforcement actions from the bad apples will come out in 2016. One area he noted was problematic was when a fund manager claimed to providing services at market rate, but had no evidence that the rate used was actually market rate. I had the chance to ask a member of the private funds unit if we could expect these actions. The response was a strict “no comment.”

Succession Planning

Several speeches coming from the SEC have pointed to certain operational risks becoming part of the compliance mandate. The SEC staff is developing recommendations to help advisers assess and plan for the impact on investors when an investment adviser is no longer able to serve its clients. For most fund managers, investors already cast a wary eye on firms that don’t have succession plans in place. The SEC is going to stick its thumb into this tricky area. This will be an area that compliance will loath as they have to talk to their firms’ principals about death and disability.

Fees and Expenses

This area is a continuing area of focus for private fund exams. I expect more enforcement actions will come out in 2016. I’m sure there will be new types and approaches that will require firms to react to the SEC’s interpretation of what is fair.

Anti-Money Laundering

If you are opposed to anti-money laundering requirements then you will get labeled as pro-terrorism. FinCEN will come out with new regulations imposing anti-money laundering requirements on investment advisors and fund managers.

Employees, Consultants and Expenses

I suspect we will see more cases brought by the SEC against firms that are dedicating employees to portfolio companies and charging those expenses to investors instead of the management company.

 

Another Potential Reason for Companies Not to Go Public

Cybersecurity is a real threat and needs to be taken seriously. But is it a Board of Directors level issue for all public companies? I don’t think so. But apparently Senators Jack Reed and Susan Collins think that is. That would mean another headache for public companies.

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Of course there may be some companies that need cybersecurity as a priority for a seat in the boardroom. Does a pharma company trying to create a new drug need to devote a precious board seat to a cybersecurity expert?

The legislation imposes an obligation on the Securities and Exchange Commission to implement this concept.

It also requires the SEC to work with the National Institute of Standards and Technology to define what constitutes expertise or experience in cybersecurity. That of course is whole other issue. There are lots of people out there claiming to be cybersecurity experts. The best are likely trying to hack into your system right now.

I’m sure cybersecurity experts are frothing at the concept of getting board seats. Unfortunately, it will take away a seat from someone who might bring better expertise to the company.

Like the conflict minerals legislation, it’s another rule that brings little protection to investors but imposes large costs and difficulties on public companies.

As you might expect, the SEC has it’s own cybersecurity issues. I wonder if one of the SEC Commissioners will be required to have cybersecurity expertise.

Sources:

Brian Klug: Anonymous Hacker
CC BY SA

This Year’s Most Popular Posts

top 20

As 2015 comes to an end, I looked back at some website wonkiness and saw a report for the top stories this year based on the number of views. Maybe you missed some of these.

Qualified Purchasers under the Investment Company Act

What is a Security? Is Real Estate a Security?

Private Equity Real Estate Top 50 – 2014 Edition of Who Is Registered

Private Fund Exemptions under the Investment Company Act

Private Equity Real Estate Top 50 – 2015 Edition of Who is Registered

SEC Exam Document Request Examples

Real Estate Funds and the Investment Company Act

Is a Note a Security?

Social Media Policies Database

Yes, the SEC Wants Real Estate Fund Managers to Register

Hypothetical Backtested Performance

The NFL Teaches Us the Difference Between Ethics and Compliance

Is a Fund Manager an Investment Adviser?

Corporate Compliance Scam Continues. . .

Corporate Compliance Fraud in Georgia, Florida and Massachusetts

Is a General Partnership Interest a Security?

Kleptocracy Asset Recovery Initiative

The Knowledgeable Employee Exemption for Private Funds

Ethics and the Sales Relationship in World-Class Bull

Ethical Integrity Leadership – Setting the Tone From The Top

Shkreli Gets His Holiday Gift… Handcuffs

One of the most hated men in American business was grabbed by the FBI and put in handcuff. The Securities and Exchange Commission slapped a “me too” suit on him as well. Martin Shkreli did the perp walk last week for running a ponzi scheme.

shkreli

Shkreli became the face of what is wrong with the American health industry when he jacked the price of treating a life-threatening parasitic infection from $13.50 a tablet to $750.

With his engorged wallet he spent $2 million to purchase the sole copy of Wu Tang Clan’s latest album. To prove that it was just an expensive trinket, he claimed to have not listened to it.

That all just makes him gross, but not a criminal.

But it turns out that he got there through running a ponzi scheme. He pulled off the rare ability to exit from a ponzi scheme.

The vast majority of ponzi schemes collapse under the weight of promised payouts exceeding the inflow from new investors. The original investment scheme fails and the sponsor is scrambling to find anything that might work to score the redemptive returns. Given that the supply of capital is significantly smaller, the returns need to be astronomical.

Skreli had lost all of his investors’ money. He had just settled a FINRA Arbitration over naked short-selling that took the last few dollars out of his hedge fund accounts.

He started MSMB Capital, a hedge fund company, in his 20s and drew attention for urging the Food and Drug Administration not to approve certain drugs made by companies whose stock he was shorting. The strategy did not work.

Nonetheless he send a message out to investors that he had doubled their money.

Mr. Shkreli started Retrophin, which also acquired old neglected drugs and sharply raised their prices. The company was wildly successful and went public.

As a public company, Retrophin can’t pay off Mr. Shkreli’s disgruntled hedge fund investors. But fiduciary obligations were apparently not important to him and he caused the company to write the checks.

Retrophin’s board fired Mr. Shkreli a year ago. Last month, it filed a complaint in Federal District Court in Manhattan, accusing him of using Retrophin as his personal piggy bank to pay back disgruntled investors in MSMB Capital.

The DOJ and SEC piled on and brought their own suits.

Sources:

SEC Takes a Look at the “accredited investor” definition

The Securities and Exchange Commission left a new Report on the Review of the Definition of “Accredited Investor” as an early Christmas present under your compliance tree. [Feel free to replace Christmas with New Years or the year end celebration of your choice.] We will need to keep an eye on what happens with this report.

 

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The accredited investor definition falls right into battle zone of the SEC where it needs to balance capital formation on one side and investor protection on the other. I expect there will a Festivus feats of strength contest to see who wins the battle over the definition.

Section 413(b)(2)(A) of Dodd-Frank requires the SEC to study the accredited investor definition every four years.  This is the first study. It’s not a SEC inspired review, but one mandated by Congress.

SEC Chair Mary Jo White encourages “investors, companies and other market participants to provide comments as public input will be very valuable as the Commission considers the definition.” The report considers alternative approaches to defining “accredited investor,” provides staff recommendations for potential updates and modifications to the existing definition and analyzes the impact potential approaches may have on the pool of accredited investors.

Few people think that the current income and net worth tests for an accredited investor have much to do with the ability to judge the risks of a private investment. Of course, it also does not mean that non-accredited investors can judge a publicly listed security either.

But the current tests do offer a bright-line than makes it easy toe evaluate a potential investor’s eligibility to participate in the offering.

“Clarity and certainty in the accredited investor definition foster greater confidence in unregistered markets and ultimately could reduce the cost of capital, thereby promoting increased capital formation, particularly for small businesses.”

Given that Regulation D offerings still raise more money than registered offerings, you have to wonder if Congress and the SEC have made it more palatable to stay private.

As for private placements being more risky than registered investments, I will disagree. They may be more or less risky on whether the investment will produce a return. The risk is not in the return. The risk is one of liquidity. A private placement by Exxon may not be any more risky than the public stock. The risk is that there is no market to resell the security. If you suddenly need the cash back from the investment you may have no ability to get it until a liquidation event.

Here are the two groups of recommendations from the Report:

The Commission should revise the financial thresholds requirements for natural persons to qualify as accredited investors and the list-based approach for entities to qualify as accredited investors. The Commission could consider the following approaches to address concerns with how the current definition identifies accredited investor natural persons and entities:

  • Leave the current income and net worth thresholds in place, subject to investment limitations.
  • Create new, additional inflation-adjusted income and net worth thresholds that are not subject to investment limitations.
  • Index all financial thresholds for inflation on a going-forward basis.
  • Permit spousal equivalents to pool their finances for purposes of qualifying as accredited investors.
  • Revise the definition as it applies to entities by replacing the $5 million assets test with a $5 million investments test and including all entities rather than specifically enumerated types of entities.
  • Grandfather issuers’ existing investors that are accredited investors under the current definition with respect to future offerings of their securities.

The Commission should revise the accredited investor definition to allow individuals to qualify as accredited investors based on other measures of sophistication. The Commission could consider the following approaches to identify individuals who could qualify as accredited investors based on criteria other than income and net worth:

  • Permit individuals with a minimum amount of investments to qualify as accredited investors.
  • Permit individuals with certain professional credentials to qualify as accredited investors.
  • Permit individuals with experience investing in exempt offerings to qualify as accredited investors.
  • Permit knowledgeable employees of private funds to qualify as accredited investors for investments in their employer’s funds.
  • Permit individuals who pass an accredited investor examination to qualify as accredited investors.

Personally, I think some increase in the income and asset tests are okay if it also includes an ability for an investor to prove financial sophistication to gain access to private offerings.

Sources:

Wrapped Gifts Under Tree is by Jimmie
CC BY

The Compliance of the Winter Solstice

The winter solstice marks the longest night and shortest day of the year with the latest dawn and the sun at its lowest point in the sky. Its the shortest day of the year. But that is not entirely true and we see a problem of scope, bias, and definition.

solsitice

The solstice happens at the same instant for all of us, everywhere on Earth. This year the solstice occurs on Tuesday December 22nd at 04:49 GMT (Universal time).

The first problem with my opening paragraph is bias. It’s not winter for everyone. In the Southern Hemisphere its summer. Explorers in the Antarctic are enjoying long, long hours of sunlight.

The second problem is using a singular time to define something else. The December Solstice marks a single point in time. The longest day or night may fall on either side of the event time.

It’s not true that it’s the earliest sunset and latest sunrise of the year. Earth’s orbit is not round so sunsets have already begun to be later in the North Hemisphere.

What does this have to do with compliance?

Are you describing things accurately in your program? Sometimes you need to rethink the description to make things work and meet your obligations.

It also means that the we are coming out to of the darkness. Hopefully you will have some time to celebrate the end of the year and the longer daytime hours. At least if you are North of the Equator.

Compliance Bricks and Mortar for December 18

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

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Star Wars Week Part I – How do You Evaluate a Risk Assessment? by Tom Fox in the FCPA Compliance Report

Today I begin a series of Star Wars themed blog posts to celebrate the upcoming release of the next entry in the Star Wars franchise, Episode VII – The Force Awakens. Please note that I will only use the first three movies, now known as Episodes IV-VI, for the themes this week. So if you are a millennial and the prequels are your Star Wars sorry but you can write about them as the first three are my Star Wars movies.

Star Wars Week Part II – The Empire Strikes Back – Levels of Due Diligence

Star Wars Week, Part III – VI – Return of the Jedi-Moderating Training

Star Wars Week Part IV – Disruption Innovation in Compliance

 


Five Predictions for 2016 in Private Funds Management

SEC wrist-slaps real estate GPs: After completing a ‘sweep’, or coordinated inspection review, the US Securities and Exchange Commission (SEC) needs about two years to evaluate its findings before bringing enforcement action. With private equity firms, a sweep was finished in 2012 that led to more than a dozen enforcement cases in 2015 and more expected next year. A similar sweep of real estate advisors began a year or so after the private equity exams started, so if the timeline stays true, 2016 will be when real estate enforcement cases begin coming through. Already senior SEC officials have sounded the alarm on real estate GPs charging fees for certain ancillary services like property management without proper disclosure. [More…]


Section 12(g)(1)(A) – How The SEC Is Putting Words In Congress’ Mouth by Keith Paul Bishop

That, however, is not what Section 12(g)(1)(A) literally states.  Congress was quite specific.  The shareholder trigger is either 2,000 persons or 500 persons who are not accredited investors.  There is no “or more” in the statute.  Read literally, an issuer would have to have a class of equity security (other than an exempted security) held of record by either exactly 2,000 persons or 500 non-accredited persons.

Surely, Congress did not intend such an odd rule.  It must have meant, as the SEC states, 2,000 or more or 500 or more. [More…]


Regulation Crowdfunding: The Long Wait Is Over, But Is Equity Crowdfunding D.O.A.? by by Sam Effron and Kristin Gerb in Mintz Levin’s Securities Matters

What we think will make Reg. CRWD offerings particularly burdensome and expensive, however, will be the compliance requirements for issuers and intermediaries. The SEC has created new “Form C”, which issuers utilizing Reg. CRWD will be required to file for all filings related to a Reg. CRWD, including an initial offering statement (and updates thereto) and ongoing annual reports. The initial Form C will need to be filed at least 21 days before any offering commences, and the disclosure requirements for a Reg. CRWD offering are extensive. [More…]


CFTC Brings First Insider Trading Case by Bruce Carton in Compliance Week

Until last week, the CFTC had never been brought an insider trading case for commodities trading. Indeed, the only example of insider commodities trading that most lawyers (or anyone else) could probably point to would be the ill-fated effort of the Duke brothers in the Eddie Murphy movie Trading Places.[More…]