The SEC Still Hates the Word “May”

Disclosure of conflicts is a cornerstone is a cornerstone of the regulation of investment adviser. 3D/L Capital Management clearly came up short.

3D/L entered into an arrangement with an ETF manager that would provide a revenue share to 3D/L they labeled an “onboarding fee.” The SEC complaint points out that the onboarding fee creates a conflict, by incentivizing 3D/L to allocate client money to those ETF funds. 3D/L failed to disclose the onboarding fee for two years.

Then 3D/L revised its Form ADV Part 2. The SEC was not happy with the wording of the disclosure.

The ETF Manager had paid an “onboarding fee to make ETFs available for inclusion in 3D/L’s composite portfolios.” While this disclosure exposed the existence of the fee, it further stated that “[t]his [p]rogram may create a potential conflict of interest.”

(My emphasis)

The SEC stated that this was inadequate because there was an actual conflict of interest.

The SEC seemed happier when 3D/L revised its Form ADV to “onboarding fee . . . results in a conflict of interest.”

Lawyers love the word “may”. (speaking as one) The SEC does not like the word “may.”

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Reviewing the Accredited Investor Definition


The Securities and Exchange Commission issued a Staff Review of the “Accredited Investor” Definition at the end of 2023. The Dodd-Frank Wall Street Reform and Consumer Protection Act directs the SEC to review the accredited investor definition every four years.  The Staff previously reviewed the definition in 2015 and in 2019 (as part of the Concept Release on Harmonization of Securities Offering Exemptions).

There were several changes in 2020 to the definition of “accredited investor” as a result of the 2019 report. The SEC allowed those meeting the “knowledgeable employee” standard to meet the “qualified purchaser” standard would also be deemed an “accredited investor.” The SEC added a qualification-based standard, initially allowed holders in good standing of the Series 7, Series 65, and Series 82 licenses as accredited investors. And lastly, the SEC added the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors. There were a few other tweaks to the definition.

But the financial thresholds remained unchanged. I think that is likely to change this year. On the Fall 2023 RegFlex Agenda the SEC listed Regulation D and Form D Improvements (3235-AN04) letting us know that the SEC is thinking about “amendments to Regulation D, including updates to the accredited investor definition, and Form D to improve protections for investors.”

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SEC Begrudgingly Approves Bitcoin ETP

We all saw this train coming down the tracks. Even the hacker who took over the SEC’s Twitter account announcing the approval, merely jumped the gun. The Securities and Exchange Commission, by a 3-2 vote, authorized a dozen spot Bitcoin exchange traded products.

Gary Gensler’s SEC has been trying stem the tide and prevent crypto from becoming more legitimate by denying any form of SEC authorization. Last year’s loss in the Grayscale’s court case was the break that could not be plugged. In the original Grayscale Order, the SEC determined that the proposal had not established that the CME bitcoin futures market was a market of significant size related to spot bitcoin, or that the “other means” asserted were sufficient to satisfy the statutory standard. The U.S. Court of Appeals for the D.C. Circuit held that the SEC failed to adequately explain its reasoning. The court vacated the Grayscale Order and remanded the matter to the SEC. “Because we don’t like it” is not a sufficient reason.

That didn’t stop Chair Gensler from slapping crypto.

“While we approved the listing and trading of certain spot bitcoin ETP shares today, we did not approve or endorse bitcoin. Investors should remain cautious about the myriad risks associated with bitcoin and products whose value is tied to crypto.”

He points out that “the vast majority of crypto assets are investment contracts and thus subject to the federal securities laws.”

Commissioner Peirce countered:

“[O]ur actions here have muddied people’s understanding of what the SEC’s role is. Congress did not authorize us to tell people whether a particular investment is right for them, but we have abused administrative procedures to withhold investments that we do not like from the public.”

The SEC has allowed crypto to take step towards more credibility, liquidity and lower costs.

Personally, I don’t see ordinary people using crypto. They just trade it. I appreciate the blockchain infrastructure and potential innovation to move money cheaply. Criminals love it. It’s an easy way to move money around anonymously.

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Corporate Transparency Act Deadline Extended

It’s coming down to crunch time on the Corporate Transparency Act. Passed as part of the National Defense Authorization Act for 202, it requires companies to submit a report of their beneficial ownership and control to the U.S. Department of the Treasury’s Financial Crimes and Enforcement Center. For new companies, this information has to be submitted at the time of formation. Existing companies will have to submit this information during 2024.

Originally, at the time of formation meant within 30 days. FinCEN just announced that it will be extended for 90 days during 2024.

I understand why FinCEN is looking for reporting on entities formed in the US. As numbered Swiss bank accounts and offshore Cayman Island trusts are falling into line with prudential KYC-ALM laws, it’s the United States that makes it really easy to create a company and not disclose ownership or control.

I don’t think FinCEN is ready to make it easy to disclose the information required by the Corporate Transparency Act. I’ve heard there are concerns about whether the new database can handle the crush of information. I’ve worked with a few vendors trying to help with solutions for filing but haven’t had the ability to access a prototype of the FinCEN database.

It’s great that the initial deadline has been extended from 30 days to 90 days. Good luck to those brave souls who are going to be the first to file after January 1, 2024.

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The One With the Gambling Edge

Buying and selling securities is often equated with gambling. (The differences are that you can hold your securities and keep winning without making any bets.) Gamblers and investors are always looking for an edge to increase their odds of success. When it comes to investing, that edge can be the misuse of insider information.

The headline of SEC Charges Former Employee of Online Gambling Company with Insider Trading jumped out at me. Finally, the intersection of gambling and investing in an enforcement case.

It turns out to be a fairly standard insider trading case. David Roda worked at Penn Interactive Ventures, a subsidiary of Penn National Gaming, as a programmer for its online sportsbook application. He heard from a co-worker that Penn was working on an acquisition. Mr. Roda got himself added to the acquisition team and found out about the target.

According to the SEC complaint, Mr. Roda quickly acquired some call options on the target. Penn sent a message warning employees not violate the insider trading policy. That apparently spooked Mr. Roda so he sold those options. Or maybe it didn’t spook him, because he then bought more options on the target.

As you might expect, the trades looked suspicious. They were short duration options that were “out of the money.” Since the options were just above the current trading price with little time left for the price to rise, they were cheap. It would be very aggressive to buy these, unless you had a gambler’s edge. Or insider knowledge.

According to the SEC complaint, Mr. Roda’s $21,000 purchase of those options netted him over $580,000 in profits in less than two weeks. I’m sure that triggered warning lights for compliance at whatever firm he had used for the trading.

Obviously, this is just the government’s side of the case. The Department of Justice has stepped in with criminal charges as well. Mr. Roda may or may not be guilty.

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Dam, That’s Securities Fraud

The collapse of the Bumadinho Dam in Brazil in 2019 was a disaster. The structure was holding back iron ore waste before it collapsed, sending million of tons of toxic waste into the village of Córrego do Feijão. It killed 270 people. The dam was controlled by the Brazilian mining company: Vale S.A.

Clearly a massive disaster, but was it securities fraud?

The US Securities and Exchange Commission seems to think so. And the SEC is positioning the case an ESG disclosure violation.

The complaint accuses Vale of deliberately manipulating multiple dam safety audits; obtaining
numerous fraudulent stability declarations; and regularly and intentionally misleading local
governments, communities, and investors about the dam’s integrity. The SEC points to Vale’s public Sustainability Reports and other public filings that assured investors that Vale adhered to the “strictest international practices” in evaluating dam safety and that 100 percent of its dams were certified to be in stable condition.

“By allegedly manipulating those disclosures, Vale compounded the social and environmental harm caused by the Brumadinho dam’s tragic collapse and undermined investors’ ability to evaluate the risks posed by Vale’s securities.”

How is a Brazilian mining company subject to the jurisdiction of the SEC? Vale has American Depositary Shares and some debt notes registered with the SEC. That clearly moves it into SEC jurisdiction.

Why brings a securities fraud case? The complaint goes into great deal about the allegedly fraudulent acts that Vale took around the regulation and evaluation of the dam. The SEC takes the position that making public statements, especially at an investor presentation, that were false and misleading about the dam safety was misleading to investors.

The primary motivation is that the SEC’s new Climate and ESG Task Force in the Division of Enforcement is on duty.

The SEC launched the Climate and ESG Task Force within the Division of Enforcement to develop initiatives to proactively identify ESG-related misconduct consistent with increased investor reliance on climate and ESG-related disclosure and investment.

Vale said its ESG was not too bad, at least not for a mining company. But in reality its ESG was very bad, even bad for a mining company. The SEC says that is securities fraud.

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Fund Fee Calculation Error

Calculating fund fees during the commitment period is usually easy for most private equity funds. Take the committed capital and multiply it by the applicable fee percentage. After the commitment period, the calculation often gets more complicated. Most funds have some reduction to actual capital deployed with deductions for write-downs and partial realizations.

Global Infrastructure Management got the calculation wrong for its funds. Part of the problem was an inconsistency between the funds’ PPMs and the funds’ partnership agreement in how to treat partial realizations. The PPMs stated the post-commitment management fee would be based on the capital contributions relating to the retained portion of investments. The partnership agreements said the fee would be calculated based on each limited partner’s capital contribution that was used to acquire an investment, and thus a partial disposition of the investment would not reduce management fees.

Global followed the partnership agreement and didn’t reduce the fee for partial dispositions. Unfortunately, Global employees appeared to have also told some investors that it would reduce and others that it wouldn’t.

It seems clear that the SEC view is that inconsistency works against the fund manager. The SEC made Global rebate fees back to investors based on the partial realization language in the PPMs. Fund managers need to prove that they are entitled to the fees and are may be cut short by inconsistent language.

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The SEC Has Observed Your Private Funds and the SEC Is Not Happy

On January 27, the SEC’s Division of Examinations published a Risk Alert on the EXAMS staff Observations from Examinations of Private Fund Advisers. The Risk Alert is labeled as a follow up to the 2020 Observations from Examinations of Investment Advisers Managing Private Funds and the 2017 The Five Most Frequent Compliance Topics.

The EXAMS staff breaks their problematic observations into four broad categories:

  1. failure to act consistently with disclosures;
  2. use of misleading disclosures regarding performance and marketing;
  3. due diligence failures relating to investments or service providers; and
  4. use of potentially misleading “hedge clauses

Disclosures

The staff found fund managers not getting consent from their LPACs when required by the fund documents. That seems like a poor choice by those fund managers.

Fund managers were not getting the management fee calculations right during the post-commitment period. Sure, commitment period is easy, just the percentage against the commitment. Post-commitment you typically have to deal with equity invested calculations, impairments and partial sales.

Some funds were diverting from their designated strategy. I see this issue pop up during long term funds. The world ends up in a different place than when the fund originated. You still need to stay within the guard rails.

Marketing Performance

Fund managers like to think they are a unique flower and benchmarks don’t apply to them and their performance needs to be shown in a special way. (That is true.) The problem is stepping over the line and showing it in a misleading way. The Risk Alert points out failures in calculations by using the wrong dates, cherry picking, omitting information on leverage, and not including fees. This is a continuing problem with private funds. It’s been raised by the SEC many times and the SEC is raising the issue again. I don’t think the new Marketing Rule went into enough detail on what the SEC wants.

Due Diligence

“A reasonable belief that investment advice is in the best interest of a client also requires that an adviser conduct a reasonable investigation into the investment that is sufficient to ensure that the adviser is not basing its advice on materially inaccurate or incomplete information.”

Hedge Clauses

The EXAMS staff observed private fund advisers that had included hedge clauses in fund documents that waive or limit the Advisers Act fiduciary duty except for certain exceptions, such as a non-appealable judicial finding of gross negligence, willful misconduct, or fraud. That could violate Section 206(1) and section 206(2) of the Advisers Act. You can’t contract away your fiduciary obligations.

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The SEC Continues its Attack on the Word “May”

I’ve been critical before of the Securities and Exchange Commission’s Attack on May. Personally, I’ve always viewed “may” as a permissive position when it comes to disclosure. The SEC thinks its completely inadequate.

The SEC view is that if an investment adviser always takes the fee or usually take the fee, “may” is inadequate. How often is “usually” when it comes to “may”? Sixty percent of the time is bad, according to a recent SEC complaint against TCFG Wealth Management and the firm’s CEO/President/COO.

According to the complaint, TCFG imposed a fee markup on rates charged by the firm’s clearing broker. Those fees, and the markup, would be passed on to the TCFG clients when the firm made trades on their behalf. The individual advisers at the firm could chose not to pass the markup through to their clients. In which case the markup was still imposed. The individual investment adviser employee would pay the markup instead of the client.

According to the complaint, 60% of the transactions passed through the fee markup to the firm clients. That was 10,000 transactions and $300,000 in revenue to the firm.

The TCFG form ADV Firm Brochures stated that TCFG “may” receive portions of the fees charged to accounts of TCFG
clients. It further stated that these additional fees TCFG received were “charged” by Clearing Broker, not TCFG, and were for things like wire fees, postage fees, clearing fees and ticket charges, which TCFG said it used to help pay for administrative support for its various entities.

Obviously, the second half was false when disclosing what the fee was used for. The SEC took issue with the statement that the clearing broker charged the fees, when it was TCFG that charged the fee. Plenty of messiness in this arrangement to draw the wrath of the SEC. We haven’t heard the TCFG side of the story.

It’s clear that the SEC has drawn a line in the sand over “may” when disclosing fees. If your firm charges the fee more than half the time, “may” is not the right word to use.

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“May” Can Be a Failure to Disclose

I’ve complained about the Securities and Exchange Commission focusing on the use of the word “may” in disclosures. I’ve typically expected “may” to offer some optionality for the adviser. The SEC has found it inadequate in several instances. We can agree to disagree.

I just came across a case in which I agree that the use of “may” was clearly inadequate in the disclosure.

Diastole Wealth set up a private fund to help its clients pool investments so that they can indirectly invest in things they would not otherwise be able to invest in individually, like private funds. Diastole is run by Elizabeth Eden. Her son had worked at Diastole. He also owned a piece of the firm.

The son left to set up software companies to make tools to help small investment advisers. Several of Diastole’s client invested in the software companies. A potential problem? Yes. Although Diastole and Eden were aware of these investments they did not select or recommend these investments to the clients and did not receive advisory fees related to these investments. No problem.

The problem comes in 2017 when Eden had the Diastole fund invest in the software companies. To me that seems like a conflict that would need to disclosed. Diastole eventually realized this as well and send a “Disclosure and Conflicts of Interest Waiver” to the fund investors. The Disclosure stated that the firm “may” recommend investments in the son’s software companies. In this case, the investments had already occurred. That’s a problem.

I agree in this case that “may” is misused. If you agree with me that “may” provides optionality, this is not a case of optionality. The investments has already occurred. The Disclosure should have been clear that the investments had already happened. If Diastole wanted to have the option to make future investments, then “may” would be appropriate. It does not work at all when the conflict has already happened.

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