Month: May 2017

The Positives and Negatives of A Subscription Credit Line

I came across two competing narratives on the use of subcription credit facilities for private equity funds: (1) Howard Marks of Oaktree Capital published a memo on subscription lines of credit for closed-end funds and (2) Eileen Appelbaum’s Private Equity’s Latest Con.

Unlike hedge funds, private equity funds call capital from limited partners over time as investments are made, up to the amount of their commitment. Subscription credit facilities allow a funds to use the commitments as collateral for a line of credit.

Subscription credit facilities are substantially different than margin borrowing used by hedge funds. They do not leverage the limited partner’s capital.  It acts a temporary substitute for capital, to repaid with a later call for capital from a the limited partners. A $10 million fund can’t invest more $10 million in total, but it may delay calling that capital.

To summarize Mr. Mark’s view of the positives:

  • Less frequent capital calls
  • Quicker ability to deploy capital from a loan draw
  • The use of borrowed money can reduce or even eliminate the deleterious impact on early returns of the so-called “J-curve.”

To summarize Mr. Mark’s view of the negatives:

  • Higher expenses for the fund to pay for interest and borrowing expenses
  • Lowering the hurdle can increase the GP’s probability of collecting incentive fees and cause the payment of incentive fees to the GP to begin sooner
  • Some LPs may actually want to have their capital called and earn their preferred return.
  • Complicates the selling of LP interest in a secondary transfer
  • Disclosure of LP financial information to the lender
  • Possibility of LP default

Ms. Applebaum takes the reduction of the J Curve as a negative and calls it a “sleight of hand.” The J curve is a particular quirk of private equity as it generally requires putting more capital into an investment resulting in a negative return before that new capital starts generating an appreciation for the investment.

Ms. Applebaum and Mr. Marks both agree with the negative distortion of the IRR calculation caused by delaying the capital contributions. Mr. Marks points out that the expenses affect a fund’s overall return and the total amount of IRR. Therefore it also has a effect on the fund manager’s IRR.

Mr. Marks then takes it to the next level by pointing out that IRR is not the single metric that determines a fund’s performance. Investors should also judge a fund by the amount of the capital deployed and the total amount of cash returned to investors.

Some things that funds have done to address the negatives:

  • Limit the length a time an investment can be on the line of credit before calling capital
  • Eliminating deal-by-deal incentive payments, so that overall fund performance, including the costs of the line, are taken into account
  • Reporting overall fund performance along side deal-by-deal performance

Subscription credit facilities provide fund managers with funding flexibility and liquidity, allowing quicker execution. As with any tool, you need to manage the risks.

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Compliance Bricks and Mortar – Memorial Day Edition

As we pause this weekend to remember those who have fallen while serving the armed forces, these are some of the compliance-related stories that caught my attention recently.

No Movie Could Capture the Crazy Details of Bernie Madoff’s Story by GORDON MEHLER AND LARRY H. KRANTZ in The Atlantic

Bernie Madoff is back, nearly a decade after his arrest for the largest known financial fraud in history. An HBO movie, The Wizard of Lies, starring Robert De Niro, premieres on Saturday, and Madoff, an earlier ABC miniseries starring Richard Dreyfuss, have catapulted the preeminent Ponzi schemer into the limelight again, even as lawsuits to recover his investors’ losses continue to grind on in the courts. [More…]

More Details on COSO ERM Framework by Matt Kelly

COSO is streamlining the framework’s principles, not gutting them. The draft ERM framework published last summer had five primary components, supported by 23 underlying principles. Public feedback on the draft said some of the 23 principles seemed overlapping or redundant, so could COSO consolidate them? That’s how the final framework came to 20 principles. [More…]

The Supreme Court Meets Lehman Brothers by Frank Partnoy in the CLS Blue Sky Blog

The U.S. Supreme Court will soon decide an unusual, yet important, case brought by investors in bonds issued by Lehman Brothers, the infamous investment bank that collapsed in September 2008. The case, CalPERS v. ANZ Securities, Inc., is not about whether those investors were defrauded: It is widely known that Lehman concealed its exposure to subprime mortgage loans and complex derivatives, just as it used accounting gimmicks to hide risks. The investigation after Lehman’s bankruptcy showed incontrovertibly that its investors had been wronged.

Nor is the case about whether those investors could properly recover in class action litigation alleging that Lehman and others violated the federal securities laws. Various lawsuits filed by Lehman bond investors were consolidated in federal court in New York and then settled in 2011, three years after Lehman’s bankruptcy filing. That settlement has not been challenged. But the date of that settlement – and the three-year time period – are important. [More…]

Appeals Court Questions Impact of SEC Forum Challenge in Bloomberg

If the D.C. Circuit rules in favor of the SEC, it probably won’t resolve the issue, as the circuit split would be “destined for decision by the Supreme Court, which has shown in the recent days a willingness to limit the reach of the SEC,” R. Daniel O’Connor of Ropes & Gray, Boston told Bloomberg BNA. [More…]

Former SEC Officials Say Don’t Bank on Big Regulatory Disruption by B. Colby Hamilton

Be happy about the prospect of regulatory upheaval in Washington, D.C. Don’t worry.

That was the sentiment shared by former U.S. Securities and Exchange Commission chairwoman Mary Jo White and JPMorgan Chase & Co. vice chairman Stephen Cutler—himself the former head of enforcement at the SEC—at a legal summit Wednesday.  [More…]

If you enjoy Compliance Building, please join many of my other readers and support my Pan-Mass Challenge ride to fight cancer next week. (Thank you to those who have already donated.) I’m pedaling from the New York border to Provincetown on August 5-6. 100% of your donation goes to the fight against cancer. You can read more and donate here: http://profile.pmc.org/DC0176

The One With the Fake Fitbit Steps and Fake News

The quest of any insider trader is to get a stock bet in place before a big announcement is made. Robert W. Murray thought he could just make his own announcement and sell out of his trade. The target was Fitbit.

This case caught my attention because of the yelling about “fake news” and Fitbit. I became a fan of the Fitbit products a few years ago when I wanted to lose some weight. I managed to drop 25 pounds using my Fitbit (and watching what I ate and exercising more).

Mr. Murray had no inside information, so he decided he could make some money by manufacturing his own announcement. He did some research and thought he could put a fake filing on EDGAR, the SEC filing system. According to the SEC complaint, Mr. Murray figured out how to do a fake filing by research at least two prior EDGAR manipulation cases:  the 2015 Nedko Nedev Case and the 2016 Nauman Aly case.

Mr. Murray bought some out-of-the-money call option cheap the filed a fake tender offer for Fitbit, Inc. on EDGAR. It worked. The stock price spiked by 10% on news of the tender offer. The stock came back down after Fitbit made an announcement that it had received no communications about a tender offer.

Mr. Murray had a great ROI on his call options of 351%. He did not have much money at risk. He only spent $887 on the options and realized a gain of $3,118.

Mr. Murray was able to disguise his IP address for his filing. However, he used his real email as a backup recovery email for the EDGAR account. He booked a hotel reservation using that account. There was a recovery email for the the first recovery email that tied back to Mr. Murray’s employer.

Assuming the facts in the complaints turn out to be true, Mr. Murray spent a lot of time and energy to create the fake steps and fake news for a $3200 profit. Looks like he is going to use all of that up in legal fees, and then a lot more to try to keep himself out of jail.

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The One With The Floundering Hedge Fund

I’m a local homer, so fraud cases in Massachusetts catch my attention, especially when they involve private funds. The case of the floundering hedge fund, MC2 Capital, founded by Yasuna Murakami, is the usual example of greed and failure to acknowledge one’s mistakes.

Mr. Murakami had big dreams and in the glory days of 2007 thought he could graduate from business school and start a hedge fund. According to the order from the Massachusetts Secretary of State, he had no professional experience trading securities.

He convinced a business school classmate who had been working at Bear Stearns in 2007 to join with him to form MC2 Capital. They were able to raise $3.6 million. The fund was supposed to focus primarily on small to medium cap US stocks with an emphasis on value-oriented investments. However, in reality it had no strategy and had significant holdings in extractive industries and used margin loans for its trading.

It should come as no surprise that inexperienced managers with no strategy lost a great deal of money for the fund investors. By August 2011, the fund had only $33,577.51 in net equity. MC2 lied to investors and covered up the losses. Investors got fake K-1s and account statements.

The trading losses did not deter them. They started a second fund, and then a third fund for Canadian investments.

For the Canadian investments, MC2 managed to eventually link up in 2011 with a successful Canadian asset management firm and fund manager who agreed to run the investments for 70% of the fund fees. That firm cancelled the arrangement in 2015. To make up for the loss, MC2 made up a fake firm as the replacement asset manager.

By the end of 2016, the combined worth of all three funds was less than $10,000. Yet, MC2 told one if its investors that its investment was worth over $4.5 million, with a year to date gain of 18.7%.

It should come as no surprise that some of the investor money was not just lost in trading, but ended up directly in Mr. Murakami’s pocket.

As you might expect, MC2 was using new investor money to pay redemption requests. MC2 turned into a Ponziu scheme.

The Massachusetts fraud case did not pull in the other MC2 partner, Avi Chait. The SEC action does and implicates Mr. Chait in the wrongdoing. It may be that Mr. Chait was not aware of Mr. Murakami’s wrongdoing. The SEC complaint has this quote from Mr. Chait to Mr. Murakami, “I am trying to sell a fund that I know nothing about at all.” It all became too much for him in 2016 and Mr. Chait redeemed his interest and his relatives’s interest, pocketing the fake returns.

The SEC swooped in May, after Massachusetts has already brought its action in January and fund investors had brought their suit in November.

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Compliance Bricks and Mortar for May 19

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

Cybersecurity: Ransomware Alert from SEC’s OCIE

Starting on May 12, 2017, a widespread ransomware attack, known as WannaCry, WCry, or Wanna Decryptor, rapidly affected numerous organizations across over one hundred countries. Initial reports indicate that the hacker or hacking group behind the attack is gaining access to enterprise servers either through Microsoft Remote Desktop Protocol (RDP) compromise or the exploitation of a critical Windows Server Message Block version 1 vulnerability. Some networks have also been affected through phishing emails and malicious websites. [More…]

Personal Liability for Compliance Officer in MoneyGram Settlement: Powerful Motivator or Chilling Deterrent? by Erin Schrantz, Anouck Giovanola, and Justin Spiegel

On May 4, 2017, the U.S. Attorney’s Office for the Southern District of New York (“SDNY”) and the Financial Crimes Enforcement Network (“FinCEN”) announced the settlement of civil claims brought under the Bank Secrecy Act (“BSA”) against the former Chief Compliance Officer of MoneyGram International, Inc. (“MoneyGram”), Thomas Haider, stemming from MoneyGram’s failure to implement and maintain an effective anti-money laundering (“AML”) program or to timely file suspicious activity reports (“SARs”).[1]  The settlement represented the resolution of the first-ever suit filed by the federal government against an individual compliance officer in the finance industry,[2] and is likely to add fuel to increasing anxiety regarding the Department of Justice’s (“DOJ”) willingness to hold corporate executives liable for compliance failings.[More…]

McConnell Is Pessimistic Congress Will Overhaul Dodd-Frank by Elizabeth Dexheimer in Bloomberg

Senate Majority Leader Mitch McConnell said he’s pessimistic Congress will overhaul the Dodd-Frank Act because he doubts Republicans can secure enough Democratic votes to make major changes to the sweeping legislation that tightened oversight of banks after the financial crisis.

“I’d love to do something about Dodd-Frank, particularly with regard to community banks but that would require Democratic involvement,” Kentucky’s McConnell told Bloomberg News in an interview Tuesday. “I’m not optimistic.” [More…]

Household Borrowing in Historical Perspective by Andrew Haughwout, Donghoon Lee, Joelle Scally, and Wilbert van der Klaauw in Liberty Street Economics

Today, the New York Fed’s Center for Microeconomic Data released its Quarterly Report on Household Debt and Credit for the first quarter of 2017. The report shows a rise in household debt balances in the quarter of $149 billion, the eleventh consecutive quarterly increase since the long period of deleveraging following the Great Recession. As of March 31, 2017, household debt balances stood at $12.73 trillion, surpassing the previous 2008 peak and hitting a level 14 percent above the trough seen in the second quarter of 2013. With this report’s release, we’re adding two new charts which show both early and severe delinquency trends by loan product type. The report and the analyses presented here are based on the New York Fed’s Consumer Credit Panel (CCP), which is sourced from Equifax credit report data. [More…]

The Case for Federal Preemption of State Blue Sky Laws by Rutheford B. Campbell, Jr.in The CLS Blue Sky Blog

The pernicious effect of state registration rules is easily and vividly demonstrated. For example, a business that announces its offering by posting the offering information on its website or advertising its offer in a widely distributed publication would likely be subject to the separate and individual registration requirements of each of the 50 states. In each state, therefore, the issuer would be required either to file a registration statement with the state or qualify for one of the state’s exemptions from its registration requirements. [More…]

If you enjoy Compliance Building, please join many of my other readers and support my Pan-Mass Challenge ride to fight cancer next week. (Thank you to those who have already donated.) I’m pedaling from the New York border to Provincetown on August 5-6. 100% of your donation goes to the fight against cancer. You can read more and donate here: http://profile.pmc.org/DC0176

The SEC Reaching Back Far In The Past With Its Powers of Disgorgement

We have become used to the Securities and Exchange Commission extracting disgorgement of ill-gotten gains from those violating the securities laws. However, the enabling laws do not explicitly grant the SEC the right to disgorgement. We seem to accept that power, but how far back can the SEC go to grab cash from defendants?

In the SEC’s case against Charles Kokesh, the SEC wants to go back ten years. Between 1995 and 2006, Kokesh pilfered $34.9 million from the business-development companies for which his firm was acting as investment adviser. Some of that ill-gotten cash was overcharging to pay expenses of the investment advisory firm, but some went into his pocket and that of his stable of polo ponies. The SEC brought charges in 2009. The court ordered disgorgement of all of the pilfered funds.

Mr. Kokesh argues that 28 U.S.C. §2462 limits the disgorgement to five years by stating that “an action, suit or proceeding for the enforcement of any civil fine, penalty, or forfeiture, pecuniary or otherwise, shall not be entertained unless commenced within five years from the date when the claim first accrued”.

If the five-year limit is imposed, Mr. Korkesh’s penalty would be reduced to $5 million.

The briefs and arguments are a delight for legal scholars. The parties are battling over legal history and dictionary definitions to determine what Congress meant in 1839 when it passed that five year limit and used the word “forfeiture.”

The arguments are compounded by the creation of the SEC’s power of disgorgement, not by Congressional action, but by case law. The SEC only legitimized disgorgement in 1970 in the case of  SEC v. Texas Gulf Sulphur Co., 312 F. Supp. 77 (S.D.N.Y. 1970).

The Kokesh case was argued in front of the Supreme Court last month, so we should be looking ahead to decision shortly that may have a profound impact on SEC enforcement actions.

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I’m Once Again Asking You For Your Hard-Earned Money

Compliance Building is a free resource I publish for me, and share with you, to help the compliance profession.

Now I need some of your hard-earned money. I should point out that the money is not for me; It’s for charity. Help me fight cancer, by raising money for the Dana Farber Cancer Institute.

I’m riding the Pan Mass Challenge in 2017 and hope you will consider supporting me this year. [Click here to make a donation]

Your money will go to help kids like Maya. She is my PMC team’s pedal partner this year. 

In January, Maya turned five years old. A month later, doctors found a large mass on one of her kidneys. Maya has Clear Cell Sarcoma, a very rare renal cancer. Maya went through surgery to remove the mass and has completed six days of radiation.  The next step is seven months of chemotherapy to beat her cancer. Maya’s mom reported that Maya is taking her treatments in stride as only a five year old who loves unicorns can. They are seeing to positive results!

I ride the Pan-Mass Challenge because I believe the money it raises makes a difference in the fight against cancer. It’s making a difference for Maya.

If you’ve read this far, you are either a very dedicated reader of Compliance Building or have also been touched by cancer. Unfortunately, most people have been touched by this terrible disease.

Last year, I lost my best friend to cancer. Jeff was diagnosed with cancer just before Thanksgiving 2015. This terrible disease killed him just two months later. Jeff and I grew up with Dave. After Dave’s mom died of cancer, Dave formed Team Kinetic Karma and I first rode my first Pan-Mass Challenge.

I came back to ride again when Dave was diagnosed with cancer. He fought back and won. The Dana-Farber Cancer Institute helped him beat back the disease.

Then my dad was diagnosed with cancer. He fought back and won. The Dana-Farber Cancer Institute helped him beat back the disease. But his sister, brother, and mother (my aunt, uncle and Nana) did not win and lost their battles with cancer.

We are hoping that Maya will win her battle. Your donations will help.

100% of your donation to my PMC ride will go the Dana-Farber Cancer Institute. The Pan- Mass Challenge is the biggest source of income for Dana-Farber.

Compliance Building readers have been very generous. So many of you have donated in the past and helped me to achieve my fundraising goal. (Many you have already donated this year and I apologize for this additional request.)

If everyone who reads Compliance Building donated a few dollars I would exceed my fundraising goals. If you think Compliance Building worth $1 a week. Then, please contribute $50…(Or More)

The Pan Mass Challenge ride is 192 miles over two days from Sturbridge to Provincetown. If I hit my fundraising goal, I will add another 100 miles on a third day of riding from the New York border over the Berkshires to Sturbridge.

Donations can be made by clicking on any of the links below, or sending a check to my mailing address:

Doug Cornelius
15 Lockwood Rd
West Newton MA 02465

Click here to make $25 donation

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The One With The Pilfering Lawyer and The Document Management System

The SEC and the DOJ broght charges against Walter C. Little and his neighbor Andrew M. Berke for illegal insider trading. This particular case caught my attention because Mr. Little was a law firm partner and he found the information by searching through his law firm’s document management system.

According to the complaints, Mr. Little obtained material, nonpublic, confidential information about seven issuers and 11 corporate announcements through his access rights on law firm’s internal computer network. However, Mr. Little did not work for those clients or on those transactions.

Mr. Little and Mr. Berke have not settle the claims. Mr. Little is going to have an uphill battle because the law firm disclosed the data about Mr. Little accessing the confidential documents.

In one case, the law firm was serving as legal counsel to Pentair on a possible merger with ERICO Global in a transaction that the firm called Project Lionel.

The damning timeline:

  1. On August 4, The document management system shows Mr. Little accessing documents titled “Pentair – Commitment Letter” and “Lionel Goldman Sachs Engagement Letter”.
  2. On August 5, Mr. Little and Mr. Berke exchange text messages and phone calls.
  3. On August 6, Mr. Berke starts buying call option on Pentair stock.
  4. On August 11, Mr. Litte accessing a document entitle “Project Lionel – Form 8-K(Execution of Merger Agreement)”
  5. On August 11 and over the next few days, Mr. Little buys Pentair call options.
  6. On August 17, Pentair issues a press statement announcing the merger.

A partner at a big law firm knows that accessing merger information about firm clients is wrong and trading on that information is illegal. The trading would be flagged as suspicious by the brokerage firm and sent the information to FINRA. If there was enough suspicious activity around the merger, FINRA would send a query to the law firms involved. The law firm would see the partner’s name and turn over all of the relevant information.

The only question I have is how well did Mr. Little disguise his trading. Since the trading happened over the course of a year with several different clients, I assume he did a good job of hiding the trading. I would guess that it was the last deal with Hanger, Inc. that caught the regulators attention. Once in their sights, the regulators were able to trace back to Mr. Little’s trading on other law firm clients.

Mr. Berke seems to have a more defensible position. The prosecutors will need to prove the information was passed to him and that the trading was not just a coincidence. Then, it’s into the post-Newman world of whether he needed to know the information was supposed to be confidential or whether the relationship between the two needed some level of significance.

Then there is the law firm leaving documents unprotected. This is common. It’s tough to balance the sharing needs of a sprawling team against the information security impositions in the document management system.

At a minimum it’s an embarrassment to the law firm. I would assume the law firm has changed its document security settings, defaulting to limited rights, instead of defaulting to a public setting. I’m sure there is plenty of complaining because it makes it hard to work collaboratively when document security gets in the way.

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We Have Seen The Enemy And It Is US

There was a massive cyberattack over the weekend that has afflicted 200,000 computers in more than 150 countries. The malware locks users out of their computers and threatens to destroy data if a ransom is not paid. It turns out that the the malicious software used in the cyberattack was originally been developed by the National Security Agency. It was then stolen by a hacking group known as the Shadow Brokers and converted into the ransom malware, WannaCrypt.

There was concern that there might be a second wave spread this morning as people return to work. So far that is not the case.

It turns out that WannaCrypt was especially effective in China. Probably because there is a lot more pirated versions of the Microsoft software on Chinese computers. Microsoft released a patch in March.

The scary news is that the US government is stockpiling malware. As pointed out in Countdown to Zero Day there is no US or international norms on the use of computer malware as weapons. We have the US government funding weaponized computer malware that can be released into the wild causing wanton destruction. We like to think that malware is being used to protect the US, but this is an example of the dangers of creating this malware.

Like any weapon, we should be concerned that it can’t fall into the wrong hands. In the case of WannaCrypt, it was stolen and put to evil use.

Thankfully a benevolent hacker found the weakness in WannaCrypt. There was a kill switch. If not, it could have done much more damage.

The malware attack was a good example of the need to keep software up to date.

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The Jay Clayton Era at the SEC Has Begun

Jay Clayton was sworn in last week as the new Chairman of the Securities and Exchange Commission. That makes him the first permanent head of a financial regulator during the Trump administration.

Yesterday, Chairman Clayton gave his first public speech by making the opening remarks at the SEC Advisory Committee on Small and Emerging Companies.

Facilitating capital formation is one of the central tenets of the SEC’s mission and it is a focus that this committee and I share. One of my priorities is for the Commission to focus on facilitating capital-raising opportunities for all companies, including, and importantly, small- and medium-sized businesses. Doing so will not only help those companies, but it also will provide expanded opportunities for investors, help our economy grow, facilitate innovation, and further job creation.

Nothing dramatic. We expected Chairman Clayton to have more of a focus on capital formation than enforcement actions. He comes from a capital formation background. Former Chair White came from a prosecutorial background.

It’s not too early to look to the rest of the Commission. There are still two vacancies. The candidates put worth by President Obama are back working at their old jobs. I think there is little expectation that they will end up in those vacant seats.

Commissioner Stein’s term expires next month. That will give President Trump three seats to fill.

The law is that no more three commissioners may belong to the same political party (Section 4 of the Exchange Act). Chairman Clayton and Commissioner Piwowar are both Republicans. Would it surprise anyone if President Trump nominated another Republican to fill the vacant seat of Commissioner Stein and leave the other two seats vacant?

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