Month: August 2016

The SEC Wants To Know If You Have An Outsourced CCO

Continuing this week on the changes to the Form ADV is a revision to Item 1.J that lists the chief compliance officer.

Folder with the label Compliance

The new Form ADV will require a registered investment adviser to disclose whether the firm’s CCO is compensated or employed by someone other than the adviser. That is, the SEC wants to know if the CCO is outsourced.

The SEC has previously noted that it has observed a wide spectrum of quality and effectiveness with outsourced CCOs. Clearly, having an outsourced CCO will be a risk factor when deciding to examine a firm.

I think that is true in part, but depends on the outsourcing itself.

I believe the SEC is looking for trends and will be able to see which firms do a good job of acting as an outsourced CCO and which do a bad job. If the SEC sees a trend that a particular outsourcing firm is doing a bad job, it will certainly take a closer look at the advisers that used that outsourcing firm.

The disclosure will work to identify both the good outsourcing firms and the bad outsourcing firms in the eyes of the SEC.

There is one small flaw in the disclosure. That is the instance in which the outsourced CCO is not employed by a firm, but is self-employed. The new question asks for the name of the “person” (corporations are people too) and the IRS EIN that employs or compensates the outsourced CCO. The self-employed outsourced CCO would not disclose the other firms that have hired him or her. And the person would definitely not want the SSN to be used as the EIN.

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Separately Managed Accounts

The biggest change to the Form ADV is reporting on separately managed accounts. The Securities and Exchange Commission is looking for data and insight into advisers’ operations. I think the benefit to consumers is a side benefit.

Cash in the grass.

I have to admit that I was confused as I was browsing through the new changes to Form ADV. I mistook “separately managed accounts” for “separate accounts.” That left me particularly confused when the section started with the scope of the changes:

we consider advisory accounts other than those that are pooled investment vehicles (i.e., registered investment companies, business development companies and pooled investment vehicles that are not registered (including, but not limited to, private funds)) to be separately managed accounts.

Later on in the release, the SEC specifically chooses not to define “separately managed accounts.” That only exacerbated my initial confusion. Many advisers and fund managers are familiar with separate accounts, a species of investing vehicle used by insurance companies

Then the light came on and realized that the SEC had created a completely new term that compliance professionals for registered investment advisers will need to learn and understand. There are “separate accounts” and “separately managed accounts.”  To add to the confusion, a separate account could be a separately managed account. But maybe that was just me.

With Dodd-Frank giving the SEC more oversight over private funds, it realized that it was collected vast amounts of information about private funds, but much less about the bread and butter separately managed accounts. But rather than collect that information in the private manner for Form PF, the SEC is mandating additional disclosure in the public Form ADV filing.

Registered investment advisers will have to report the approximate percentage of their separately managed account assets invested in twelve asset categories:

  1. exchange-traded equity securities;
  2. non-exchange traded equity securities;
  3. U.S. government bonds;
  4. U.S. state and local bonds;
  5. sovereign bonds;
  6. corporate bonds – investment grade;
  7. corporate bonds – non-investment grade;
  8. derivatives;
  9. securities issued by registered investment companies and business development companies;
  10. securities issued by other pooled investment vehicles;
  11. cash and cash equivalents; and
  12. other

Don’t look for definitions of these terms in Form ADV. The SEC is leaving it up to advisers to determine how to categorize assets, so long as the methodology is consistently applied. If an adviser has more than $10 billion in RAUM, the information will have to be reported twice a year, instead of just an annual filing.

If an adviser has more than $500 million in RAUM, the adviser will have to disclose the use of borrowing attributable to those assets. If the adviser has more than $10 billion in RAUM, the adviser will also have to report on the use of derivatives in those accounts.

As with private funds, advisers will need to report information on the use of custodians. The new Item 5.K.(3) requires investment advisers to identify any custodian that accounts for at least 10 percent of total RAUM attributable to its separately management accounts, the custodian’s office location and the amount of RAUM held at the custodian.

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The SEC Wants To Know About Your Social Media

The Securities Exchange Commission published an update to Form ADV last week. I’m going to devote this week’s stories to some of the new requirements. Today, I’m looking at reporting of social media.

SOCIAL MEDIA DATABASE

Item 1.I of Part 1A of Form ADV currently requires registered investment advisers to list their websites. The SEC is casting a wider net.

Instead of just websites, the SEC is requiring the listing of accounts on social media platforms such as Twitter, Facebook and LinkedIn. We will be required to include the address of the registered adviser’s social media pages. (see page 34 of the release)

There were comments to the proposed release about the scope of this listing requirement. It’s limited to accounts on social media platforms where the adviser controls the content. You are not required to disclose information on employee social media accounts. It’s also limited to publicly available social media platforms.

Twitter, Instagram, and Facebook all fall clearly into this requirement.

LinkedIn is little fuzzy. A company can update the company page on LinkedIn. But many firms just have the default company page on LinkedIn. A firm can control the content, to some extent, but may not have exercised any control. That being said, those pages that have not been edited don’t provide much information. It would be unlikely to be of interest to the SEC. But if you are publishing information, then clearly the SEC is going to take a look at when it comes to exam time.

I do have a question about dormant accounts. I know many firms signed up for an account to control a particular account name, without intending to actually publish information. I remember back in the early days of Twitter, Lexis Nexis ignored the platform. Some yahoos grabbed the handle and started publishing strange stuff on the @LexisNexis twitter account. Lexis would eventually get it back because it was its trade name. I think you would need to list these unused accounts.

A hitch will be updating this social media information. If you add a new account or create an account on a new platform you will need to file an update to Form ADV, just as you would if you created a new website.

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Compliance Bricks and Mortar for August 26

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

bricks and mortar

Private Fund Advisers Must Pay Close Attention to Nuances under Pay-to-Play Restrictions in Light of Upcoming Elections Nationwide

As the elections approach nationwide, advisers to private investment funds with current or prospective state or local government entity investors should be mindful of political activities by their personnel which could raise concerns under existing pay-to-play regulations. Given the magnitude of governmental plan investors in private funds, in addition to a potential loss of revenue, even the disclosure of a pay-to-play inquiry could result in significant reputational implications with current and prospective private fund investors. [More…]

Compliance Alert: Enforcement hammer falls on real estate by Kim Nemirow and Amanda Raad in the FCPA Blog

Regulators charged with enforcing anti-corruption, anti-money laundering, and economic sanctions laws and regulations have turned new attention to the real estate industry, and investigations and enforcement efforts span the globe.

Over recent years, U.S. and UK authorities have investigated real estate investors and their employees for allegedly making payments to government officials in order to construct and sell properties, as well as the conduct of management companies and the use of third parties to pay bribes, launder money, or evade economic sanctions. [More…]

Introduction to Blockchain Interview on Its impact on Practice and Firms by Ron Friedmann in Prism Legal

It is novel ledger technology that allows for the immutable recordation, transfer, settlement and audit of any currency or asset that can be “tokenized” – all in a decentralized environment that does not require the participants to trust each other. The innovation is in the decentralization, which tips our traditional thinking upside down because there is no longer a need for one party to be in charge or grant or deny access to a system. Blockchain technology is built on open protocols and often open source software. Blockchain technology also is new platform technology that is enabling an entirely new batch of “smart” transactions in capital markets, insurance, trade finance, supply chain management and smart cities. [More…]

The SEC and Whistleblowers: A Spotlight on Severance Agreements by John F. Savarese, Jeannemarie O’Brien, Wayne M. Carlin, and David B. Anders in NYU Law’s Program on Corporate Compliance and Enforcement

In the space of one week, the SEC brought two enforcement actions that reiterate its focus on protecting the rights of whistleblowers.  In each case, companies attempted to remove the financial incentives for departing employees to submit whistleblower reports to the SEC.  The result instead was a pair of administrative orders (on a neither admit nor deny basis) finding that each company violated SEC Rule 21F-17, which prohibits any person from taking any action to impede a whistleblower from communicating with the SEC about possible securities law violations.  In the Matter of BlueLinx Holdings Inc. (August 10, 2016); In the Matter of Health Net, Inc. (August 16, 2016).  [More…]

The Things You Learn at Strip Clubs… by Matt Kelly in Radical Compliance

According to an article in the New Orleans Times-Picayune, the Louisiana Department of Alcohol and Tobacco Control wants to launch a voluntary program with bar owners in the French Quarter to reduce a variety of violations, from liquor law abuses to human trafficking. Part of that program would be annual training for bar employees so they can avoid infractions in the first place—and yes, part of it would send mystery shoppers into the strip clubs to see what’s really happening inside. [More…]

The SEC Wants You to Know that It Intends to Protect Whistleblowers’ Rights by Kevin LaCroix in the D&O Diary

The SEC has long made it clear that it intends to protect whistleblowers and to suppress activities it believes will have the effect of discouraging whistleblower activity. The agency recently launched enforcement actions against companies that had incorporated various waivers in employee severance agreements that discouraged employees from reporting possible securities law violations to the SEC. The agency’s actions shows that the agency is prepared to actively target corporate actions the agency believe may suppress the whistleblowing process. [More…]

When Is Fraud Just A Breach Of Contract?

If you are going to originate some shady mortgages, maybe you shouldn’t nickname the program the “hustle.” If you package up the mortgages and sell them as good mortgages, it would seem you are committing fraud. But maybe not.

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It may come as no surprise that the company running the “hustle” was Countrywide. According to Countrywide, the High Speed Swim Lane or HSSL (or hustle) was an automated program created to improve loan quality by limiting the number of people who processed loans. According to the government, the Hustle program was meant to churn out home loans, rewarding employees for speed rather than quality and removing financial penalties that employees could incur for making bad loans. In the end Countrywide made $165 million from the program while Fannie Mae and Freddie Mac had net losses of $131 million.

Countrywide had a contract with Fannie Mae and Freddie Mac to sell Acceptable Mortgages. As you might expect, the Hustle mortgages did not all meet the Acceptable Mortgage standard, so it was delivering some sub-standard mortgages under the contract.

The government claims fraud and Countrywide claims that it was merely a breach of contract.

A jury ruled in favor or the government and the judge ordered $1.27 billion in penalties. The Second Circuit overturned that decision and the judgment. It was was merely a breach of contract.

The Second Circuit phrased the question like this:

“B’s Fraud theory is that A knowingly and intentionally provided substandard widgets in violation of the contractual promise—a promise A made at the time of contract execution about the quality of widgets at the time of future delivery. Is A’s willful but silent noncompliance a fraud—a knowingly false statement, made with intent to defraud—or is it simply an intentional breach of contract?”

The law does not permit a fraud claim merely on a contractual breach. Fraud turns on the parties intention when the contractual obligations and representations were made. The party claiming fraud need to prove that the other party had fraudulent intent at the time the party entered into the contract.

So to prove fraud, the government would need to prove that Countrywide did not intent to perform its obligations when it entered into the contract.

[T]he Government has never argued—much less proved at trial—that the contractual representations at issue were executed with contemporaneous intent never to perform, and the trial record contains no evidence that the three Key Individuals—or anyone else—had such fraudulent intent in the contract negotiation or execution. Instead, the Government’s proof shows only post-contractual intentional breach of the representations. Accordingly, the jury had no legally sufficient basis on which to conclude that the misrepresentations alleged were made with contemporaneous fraudulent intent

This is a fairly arcane area. The court agrees with this arcane assessment. I think the decision also hinges on the way the contract was structured. The contract did not call for a restatement of the representations when each mortgage was delivered. Many contracts are structured with the restatement of representations to avoid this arcane treatment.

It does not mean that Countrywide is off the hook. It’s still liable for damages from the contractual breach. It does mean that Countrywide did not commit fraud under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 and is not liable for the ensuing civil penalties.

The big loser in this was Ed O’Donnell. He was the whistleblower in this case. He is doing okay. He had already been awarded $58 million as a result of the $16.65 billion that Countrywide paid for the contractual breaches and mortgage securities fraud. I assume he would have been eligible to get a chunk of the $1.27 billion fine in this case.

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U.S. Pacific Fleet 120706-N-VF350-021
CC BY NC

SEC Brings Another Private Equity Fund Fee Case

Apollo has been variously recognized as a god of sun, truth, healing, and poetry, and more in classical Greek and Roman mythology. It’s namesake private equity firm has settled charges with the Securities and Exchange Commission that it was less than truthful in disclosing fees charged to investors.

Giuseppe_Collignon_-_Prometheus_Steals_Fire_from_Apollo's_Sun_Chariot,_1814

The main thrust of the Apollo case was over monitoring fees. Apollo, like many private equity firms, charged a monitoring fee to its portfolio companies. The SEC has previously announced its distaste for these fees, especially when the fees relate to periods after the sale of the portfolio company.

Apollo disclosed in its fund documents that it charge monitoring fees. The SEC felt that Apollo did not adequately disclose that sometimes these fees would be accelerated upon the sale of a company and therefore earn a fee for period where there was no company to monitor.

I believe this practice has largely stopped in the private equity world or the disclosure is now more robust regarding this standard industry practice.

Regardless, it was a big chunk of change. The order lists $37 million of disgorgement.

In addition to its distaste of monitoring fees, the SEC did not like a loan from the funds to the management company. It’s not clear from the order what was going on with the loan, but it looked like a vehicle to defer taxes on carried interest. The fatal flaw for the SEC was that the accrued interest on the loan was allocated to the fund’s GP which was not fully disclosed in the financial statements.

Lastly, one of Apollo’s senior partners charged personal items to the funds in violation of the Apollo’s policies. This conduct was repeated. Apollo ended up firing the partner and making him (or her) repay the expenses. Apollo self-reported this to the SEC.

But still the SEC decided to include that expense infraction in this order.

Private fund compliance professionals have been focusing on fees and expenses. To me the monitoring fee is a leftover from a few years ago when the SEC announced its distaste for the practice. It’s not clear to me what impact the loan had on the fund investors.

Clearly, the fund investors were made whole by the malfeasance of the senior partner. Apollo did everything right in that context, including self-reporting. I’m not sure why the latter item had to be part of a big, public enforcement action.

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Weekend Reading: Rise of the Warrior Cop

It only takes a few minutes of watching the national news before you will see a crime story with police dressed in battle gear.  In Rise of the Warrior Cop, Radley Balko traces the history of US law enforcement to see how we got to this.

Mr. Balko thinks the founding fathers, distrustful of a standing army, would be appalled by today’s approach to law enforcement. Of course, the United States has changed dramatically over the last 240 years. The City of Boston had 15,000 residents then and has grown to over 650,000 today. The colonial era approach to policing of constables and private justice would not work today.

Mr. Balko takes the position that the current approach of militarization of the police also does not work.

Mr. Balko keys the rise of militarization to one event: the Texas Bell Tower Sniper. Local police did not have the weapons or techniques to end that mass shooting.

The next advancement was the work of Daryl Gates in Los Angeles. swat tvHe pushed for the creation of the first SWAT team. I remember that television show. But they were far from the battle-clad soldiers of today’s SWAT.

Next up was Nixon’s “war on crime” that pushed federal money to local police. That transformed into the “war on drugs” and the latest iteration, the “war on terror”. Each of those came with federal money for local police to buy weapons. Surplus military gear was made available to local police. Who would not want to have a tank for their police force.

All that money lead to this: Battle-clad, heavily armed police.

swat

Mr. Balko proposition is that when they have these tools, they use them. Even if other police techniques would have been more effective. Rise of the Warrior Cop is full of stories of botched police raids using excessive force to invade people’s homes for non-violent offenses.

He further presents the theory that acting more like the military than civil protectors, police forces develop an “us versus them” mentality. It’s clear in the war who the enemy is. It’s not clear on the streets.

Many will dismiss Rise of the Warrior Cop as anti-police, libertarian propaganda. There is no doubt that Mr. Balko brings his viewpoint to the story and his Cato Institute philosophy.

This book was published in 2013 and predates the current Black Lives Matter and Blue Lives Matter debates that are happening today. The book takes a harsh look at the development of policing that got us to this point. It’s not just the militarization of the police, but the erosion of Constitutional rights that I find troubling.

Compliance Bricks and Mortar for August 19

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

bricks

Anti-Corruption Laws and Other International Risks – What it Means for the Real Estate Industry and How to Protect against Risks by Ropes & Gray

The real estate industry is commonly viewed to be higher risk in light of the numerous government touch points, the heavy reliance on third parties such as joint venture partners or property managers, particularly in emerging or higher risk markets, and the frequency with which bad actors seek to launder ill-gotten gains through the purchase of property. However, as described in more detail below, these risks can effectively be managed by investors with robust compliance controls, including pre-transaction due diligence and post-investment compliance monitoring.[More…]

How Much Is A Whistleblower Waiver Really Worth? by Keith Paul Bishop in California Corporate & Securities Law

Unless someone successfully challenges the SEC’s enforcement position, it is likely that companies will eliminate waivers from their severance agreements. One might hypothesize that companies will reduce severance compensation as a result. But how much is a waiver worth to a former employee? Through fiscal 2015, the SEC paid out $54 million since its whistleblower rules went into effect in August 2011. While that is a sizable sum, only 22 tippers received payment. [More…]

Due Diligence Questions Chief Compliance Officers Should Ask In A Job Interview by Maurice Gilbert in the FCPA Compliance & Ethics Blog

What follows is an aggregate of questions candidates have recently asked management and Boards when being considered for a CCO role with a new employer. The list is unedited and unfiltered – their words to your ears.

Print and save this list. And so that we can all help one another, I hope you will respond below with questions of your own.

[More…]

No D&O Insurance Coverage for Costs of Responding to Informal SEC Investigation by Kevin LaCroix in the D&O Diary

Among the most frequently recurring D&O insurance coverage issues is the question of the carrier’s obligation to pay for costs incurred in connection with an informal SEC investigation. Indeed over the years, numerous policy revisions have been adopted in various forms by various carriers to address certain aspects of this issue. Yet the issues continue to arise, as shown most recently in District of Colorado Judge Robert E. Blackburn’s August 4, 2016 opinion (here), in which he held that the D&O policy at issue did not provide coverage for the insured company’s expenses incurred in responding to an informal SEC investigation. The opinion raises a number of issues, as discussed below. [More…]

No More Coffee for You by Adam Turteltaub in the SCCE’s Compliance and Ethics Blog

There’s a lesson to be learned here, other than that we all should avoid running for elected office.  It’s that proposed rules, whether they are legislation in a state house or policy in an organization, are never as clear as they appear on paper, and that once they meet the public eye, all kinds of questions are likely to be asked.  Worse, all kinds of assumptions are going to be made. [More…]

So Many Wrongs…

I tripped across an enforcement case that was so full of wrong things that I had to re-read it. In one sense, I saw a clever way to exploit an investment feature. On the other hand, the whole investment felt morally wrong, was deceptive and violated at least one important rule under the Investment Advisers Act.

grim reaper

Given my station in life, I had not come across bonds with a “survivor option.” It’s a feature that allows an investor’s heirs to redeem the bonds at par value upon the investor’s death. It’s an attractive investment feature for older investors who are concerned that rising interest rates will hurt the value of their bond holdings. The survivor option allows a bond to be redeemed at face value. If the bond has decreased in value because of higher interest rates, the investor’s principal is protected at death.

If you are clever, terminally ill, and want to leave cash to your heir, there is a way to exploit this feature.

Step one: find some bonds with a survivor option that are trading at a discount.
Step two: buy those bonds.
Step three: die quickly.
Step four: have your heir redeem the bonds at face value, turning the purchase discount into a gain.

If you are morally challenged and have a terminally ill family member, perhaps you could convince them to make this investment for your benefit.

If you are morally challenged and want to make some money, you could seek out terminally people, befriend them, open a joint account and invest together in the bonds.

If you are Donald Lethen, as least according to the Securities and Exchange Commission, you could raise capital to do this and break a bunch of security laws in the process.

According to the SEC Order, Mr Lethen created an investment fund managed by his Eden Arc Capital Management firm to invest in these bonds with survivor options.  He  used contacts as nursing homes and hospices to find patients with less than six months to live. He gave them a fee and then opened joint accounts with the patients to invest in the bonds with survivor options that were trading at a discount.

The SEC alleges that Mr. Lethen was merely a nominee for the investment fund that had funded the purchase of the bond. The fund could not be joint account owner and receive the survivor benefits. Mr. Lethen himself was the joint owner of the account funded with the investment fund’s money to buy the bonds.

Let me know if you see the Investment Advisers Act rule violation.

Let’s look at the other issues while you think about it.

Mr. Lethen does not seem to be misleading the patients. They get paid for their involvement in the scheme.

He may be misleading the bond issuers. That would depend on the wording of the survivor option. Mr. Lethen was the named joint account holder. It’s not clear if he was making untrue statements to exercise the survivor option.

Back to the Advisers Act issue. Do you see the problem?

The Custody Rule.

Mr. Lethen is putting the fund money into a joint account controlled by Mr. Lethen. The account was not in the fund’s name or controlled by the fund’s general partner/investment manager. Mr. Lathen failed to custody the fund assets in accounts in the fund’s name or in an account that contained only fund assets controlled by the fund manager.

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The Grim Reaper On a cottage in Netton Street. Copyright Maigheach-gheal and licensed for reuse under this Creative Commons Licence

 

A Pair Of Pharma Insider Trading Cases

Pharmaceutical company stock is known to be volatile depending on success or failure of drug trials. As pharma companies become successful they become targets for larger pharma companies looking to supplement their lines. The Securities and Exchange Commission filed two actions recently for suspect trading in pharma companies.

Paxil by JustinLing CC BY

The first case is a bread and butter insider trading case where the SEC alleges that two brokers found a source inside a pharma company that was feeding them material non public information. In the second case, the SEC charged a doctor involved in a drug trial with trading on the non-public results of the trial.

In that first case, the SEC alleges that Paul T. Rampoldi was the ringleader of an the insider trading ring at his brokerage firm. They had an insider at Ardea Biosciences. The Ardea insider tipped one of the brokers with material non-public information in at least two instances. Once was ahead of the company’s announcement of an agreement to license a cancer drug and the second was in advance of its acquisition by AstraZeneca PLC. The SEC charged the other two brokers and the Ardea employee last year. To avoid detection by his brokerage firm, they traded in an account at a different firm.

As Sharon B. Binger, Director of the SEC’s Philadelphia Regional Office, said: “As a stockbroker, Rampoldi should have known better than to allegedly trade on tips about significant corporate events before they were announced.”

In the second case, Dr. Edward Kosinski was working on the clinical trials for Regado Biosciences. He started with a small holding in the company. Small enough to be below its compliance reporting level. I assume that Dr. Kosinski must have thought highly of the drug being test because he dramatically increased his holdings in the company.

The things took a turn for the worse. The company announced problems with the trial. Dr. Kosinski did what most people would do on hearing bad news: he sold his stock. The problem was that he had signed a confidential nondisclosure agreement that, according to the SEC’s allegation, prohibited from trading on the stock based on the trial. In selling the stock, Dr. Kosinki realized a small gain and avoided a huge loss. The stock tanked when the problems were announced to the public.

When further details were announced to the trial group, Dr. Kosinski did a worse thing. He shorted the stock, buying put contracts that would make him more money if the stock dipped even further. It did and he did.

Perhaps with selling his stock, Dr. Kosinski could have argued that he didn’t know better. But doing the second trade in options adds a level of scienter. That’s probably why the DOJ brought criminal charges on top of the SEC’s civil case.

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Image is by JustinLing