Greater Boston Real Estate CCO Forum

Are you running a real estate fund and wondering what do about registering with the Securities and Exchange Commission? Are you near Boston?

If your answers are yes and yes, join a group of CCOs who are getting together on an informal basis to discuss the issues. Our next meeting is Thursday, March 3 at noon in downtown Boston.

Send a message to me at [email protected] and I will give you more information.

Parking and Compliance

Do you pull into a parking space or back in? Does it matter? Do you need a rule?

The other day I pulled into a parking lot and saw one of these “head in parking only” signs. It bothered me. Why does it matter whether I parked with my headlights in or my taillights in?

Of course you need some order to a parking lot for it to function. You paint lines to designate where people can park and where they can’t park. If you are charging a fee, you need some way to collect the fee and enforce its payment. Maybe you paint some lines for traffic flow and to show people the way to the exit.

If the lot requires a window sticker to prove you are authorized to park in the lot, then it may make sense to require cars be in a certain direction. The enforcement personnel can then just patrol the lot, looking at the same place on each space to make sure the vehicle is authorized. You could also argue that it’s a bit lazy. Enforcement can look around the vehicle. After all, vehicles are all shapes and sizes. A window sticker on the back window of a station wagon is in a very different place than a pickup truck.

Why does it matter whether I back into the space or back out of the space? You have to take the time to back up either way.

I admit that I usually back into parking spaces. That is why the sign bothered me. I have my reasons for backing in. I have terrible lines of sight to the back of my truck and it’s very long. (Yes, I drive a pick up truck.) So parking takes more effort. I prefer to look into the space to make sure there are no obstacles, especially people, in the way, then swing around to back in. Yes, it takes longer getting in, but it would take just as long getting out. Backing out means I have to look for passing people and cars on the way out with poor vision. I think it’s safer to back in, instead of pulling in.

I’m pretty sure there are some lessons in here for a compliance professional.

  • Are there reasons for your rule?
  • Can you be flexible?
  • Are you making people do things just because it’s easier for you?
  • Does your rule reduces risks?

I’m sure there are more.

Sources:

You’re Parking Wrong: Why it’s almost always better to back into a space than pull into it head-on by Tom Vanderbilt in Slate

A Question of Parking by Tom Vanderbilt in his How We Drive the companion blog to his New York Times bestselling book, Traffic: Why We Drive the Way We Do (and What It Says About Us)

Complying with Regulations and Ethics

If you are running a compliance program you spend a lot of time reading regulations and trying to figure out how they apply to your company. Some are very clear and make it easy to understand what you need to do. Unfortunately, many are not.

Are there corruption and ethical issues tied to your interpretation?

In my experience, the laws and regulations are often not so clear that you can draw a bright line around what is legal and what is illegal. In those instances where the rules are very clear, you end up having to implement some internal routines that seem obtuse. More often, you decide whether your approach to complying with the law is conservative or aggressive. Usually, that posture on your company’s approach is a matter of corporate culture.

A recent Harvard Business School Working paper by Malcolm Salter caught my eye: Lawful but Corrupt: Gaming and the Problem of Institutional Corruption in the Private Sector.

In the business world, gaming society’s “rules of the game” refers to subverting the intent
of socially mandated or legislated rules for private gain without resorting to blatantly illegal
acts.

He breaks “gaming” into two forms:

The Rule-Making Game involves influencing the writing of society’s rules by legislative or regulatory bodies, so that loopholes, exclusions, and ambiguous language provide future opportunities to “work around” or circumvent the rules’ intent for private gain. The Rule-Making Game is an influence game.

The Rule-Following Game involves the actual exploitation of these gaming opportunities. This game involves following the letter of the law but not necessarily its intent or spirit, as well as violating grey areas of the law in ways that are not easily understood or recognized as violations. The Rule-Following Game is thus a compliance game.

I end up disagreeing with Salter on many of his points.

On the Rule-Making side, I think there are really two distinct paths: the statutory and the regulatory. Certainly the statutory side is full of gamesmanship in setting the legislative framework. Political influence can be corrosive. There are few who think that political lobbying is a good thing. Most of the American population thinks poorly of Congress, often rating Congressman below car salesman in their perception of ethical standards.

I’ve written about the problems of pay-to-play many times. On the other hand, a company should not have to sit on its hands when faced with adverse laws being proposed in the legislature.

Look at one example in the recent Dodd-Frank Act. Section 403 of Dodd-Frank eliminated the Private Adviser Exemption used by many private fund companies to be exempt from registration as an investment adviser. But section Section 407 of Dodd-Frank created a new exemption for venture capital fund advisers. On one hand you could follow Salter’s argument and use this an example of “gaming.” On the other hand, you could argue that venture capital funds are inherently different from other types of private funds, don’t pose the same risks, and don’t need as much oversight. Clearly, the venture capital industry lobbied for this exemption. I expect your view on whether this was “gaming” depends on your view of venture capital.

The other half of rule-making is the regulatory bodies. You will get a spread of quality and respectability, but they are generally not subject to the same level of gamesmanship as elected officials. Sure, some agencies are subject to excessive influence by the industry they regulate. More often than not, the regulatory bodies are dedicated professionals who are looking to do the right thing for the long term success of the industry while protecting the interests of the consumer, the investor and the economy.

When it comes to following the rules, a company’s approach can be indicative of underlying issues.

Like violations of fairness norms and conflicts of interests, the Rule-Following (or
compliance) Game is often fueled by self-serving interpretations of appropriate conduct.
Many business people and their lawyers and accountants view testing the outer limits of the
law as a natural and acceptable feature of U.S. capitalism—as “American as apple pie.”
Herein lies the particular insidiousness of gaming—and the major difference between it and
clearly illegal conduct.

As I said earlier, rules are often not so clear. I agree with Salter when he points out that “inconsistent management style by institutional leaders—coupled with perverse incentives, breakdowns in internal controls, ineffective board oversight, and an absence of transparency—can quickly neutralize published codes, grease the wheels of ethical drift, and encourage gaming of society’s rules of the game.”

Of course the core goal of compliance programs is to prevent that kind of drift. You want to prevent your company from spending too much time close to the line of legal conduct. Spending that much time may make it too easy to stick a toe over into the land of illegality and be seduced by the ways of easy profit (fake profit) and magical gains (fake gains).

UPDATE: For another take at rule-making, NPR’s Planet Money published a story a yesterday on this topic: Writing the Rules.

Sources:

Private Fund Compliance Forum

Thousands of private equity firms are scrambling to meet the July deadline to register with the SEC. New disclosure rules are being proposed for private equity managers with more than $1bn in assets. PEI Media is producing its second annual PEI Private Fund Compliance Forum 2011 to help prepare you prepare for the new wave of regulations.

I will be speaking on a panel on the new rules governing fundraising. Here is the rest of the agenda:

Day One: Wednesday, May 3, 2011

8:50 – 9:00
PEI welcome & Chairman’s introduction

9:00 – 10:00
Expert panel:  Brave new world – Impact of SEC registration on finance and operations
– Creating a culture of compliance
– Getting buy-in from the GPs and other key stakeholders
– What does it mean to take on the role of a Chief Compliance Officer?
– Defining the function for your organization
– Budgeting for staff, outside consultants, technology
– Who do you appoint to be the CCO – CFO, GC or COO?

10:00 – 10:30
Keynote Speaker
Carlo V. di Florio, Director, United States Securities and Exchange Commission, Office of Compliance Inspections and Examinations

10:30 – 10:50
Networking break

10:50 – 12:00
Panel: The new form ADV 2 part 2
– Most important required elements for the brochure
– Addressing the  most challenges aspects i.e. confidential information and fees
– Handling updates and brochure supplements
– Effective delivery

12:00 – 1:00
Panel: CCO Clinic
What does it take to be an effective chief compliance officer?

1:00 – 2:15
Luncheon

2:15 – 3:15 – Workshop Session I

Workshop A: For new SEC registrants
– What to expect during the first year as a RIA
– ADV I and II forms
– Formalizing the code of ethics
– Custody rule compliance

Workshop B: For multi-strategy PE firms and  hedge fund affiliates
– Whether or not to have information barriers
– What  types of controls need to be put in place
– How do you prevent the misuse of information
– Conflicts of interest
– Flows of information

3:15 – 3:30
Refreshments

3:30 – 4:30 – Workshop Session II

Workshop C: Stepping up your internal compliance program
– Creating a firm compliance manual and training your staff
– Administering the terms of the limited partnership agreement
– Building a risk matrix and conducting an annual review
– Identifying risks; conflicts and fees

Workshop D: International Tax issues
– Recent tax changes and new regulatory frameworks in China, Australia, South Korea, India
– FATCA
– How do these changes impact returns?
– Modifying fund structures for tax efficiency

4:30- 5:30
Panel: What to do when the SEC knocks on your door?
– SEC hot buttons in an audit
– Disclosure issues
– Top 10 deficiencies for private funds

5:30 – 7:00
Cocktail Reception

Day Two: Thursday May 4, 2011

8:50 – 9:00
Chairman’s welcome

9:00 – 9:50
Panel: Update from Washington
– Hedge Fund Transparency Act
– Regulation of venture capital firms
– New initiatives on the horizon

9:50 – 10:35
Panel: The new due diligence regime – meeting requirements from LPs and regulators
– Presentation and documentation of track record
– Monitoring of trading activities
– Increased scrutiny around valuation
– Importance of integrity of reporting
– Compensation of operating partners

10:35 – 10:55
Coffee break

10:55 – 11:45
Panel: New rules governing fundraising
– Presentation materials and being compliant
– State procurement lobbying laws and their effect on raising money from public pensions
– Monitoring your employees’ political contributions•   Presentation materials and being compliant
– Coordination of global offering to US and non-US investors
– Monitoring your employees’ political contributions – prohibit vs. preclear?

11:45 – 12:40
Panel:  Effective and appropriate marketing materials
– Consider your audience – presentation to existing LPs, prospective LPs and portfolio companies
– Making sure that presentations are reviewed by compliance
– Interpreting rules governing marketing and advertising
– Web sites and other marketing materials
– Guidelines regarding talking to the press

12:40-1:15
Panel: Regulatory issues beyond Dodd Frank
– FCPA and UK Bribery Act compliance

1:15 – 2:15
Closing Luncheon

Do Hedge Funds Create Criminals?

Lynn Stout takes the recent charges against arrest of Raj Rajaratnam, founder of the Galleon Group, and the recent raids on expert networks as an indictment of the entire hedge fund industry. She makes the mistake of using a few bad apples to state the whole industry is corrupt. The vast majority of hedge funds operate completely in compliance with the law and ethical obligations. You would not say the entire energy industry is corrupt because of the failures of Enron.

The expert networks Stout mentions are not your classic cases of insider trading. The involved parties were trying to get information about how a company is doing. By getting access to orders for computer chips you can make some estimates about how many computers a company is producing. Depending on the type of information, some should have been protected and some is just business intelligence.

After all, there is nothing wrong with looking at satellite photos of a shopping center to see how many cars are in the parking lot. Compare the photos from year to year and you may have a good indication of whether sales are up or down.

There is plenty of evidence demonstrating that bad environments contribute to bad behavior. That is backbone for compliance. Create an environment where there is more pressure to follow the rules than to break the rules.

Stout lays out three social signals that have been repeatedly shown in formal experiments to suppress pro-social behavior:

Signal 1: Authority Doesn’t Care About Ethics.
Signal 2: Other Traders Aren’t Acting Ethically.
Signal 3: Unethical Behavior Isn’t Harmful.

Signal 1 is the classic call for a tone from the top. Signal 2 is the classic call for corporate culture. Signal 3 is the classic call for regulatory (and criminal) enforcement.

No. Hedge funds do not create criminals. Unethical work environments create criminals. It’s a problem not just at hedge funds, but every industry.

Lynn Stout is the Paul Hastings Professor of Corporate and Securities Law at the UCLA School of Law and the author of Cultivating Conscience: How Good Laws Make Good People.

Sources:

The Role of Compliance in Criminal Cases

handcuffs

Plan Now or Pay Later.

Compliance failures are expensive. Failures result in big fines, expensive investigative costs and expensive legal fees. Plus you end up diverting valuable management resources from managing the business to managing the damage. Executives would much rather be sitting in the boardroom than in a deposition. Compliance has become a key consideration for under the federal sentencing guidelines for companies convicted of violating federal law.

Charlotte Simon of University of Houston Law Center, Ryan D. McConnell of Haynes and Boone LLP and Jay Martin of Baker Hughes, Inc. put together a paper on the role of compliance in criminal cases: Plan Now or Pay Later: The Role of Compliance in Criminal Cases

The DOJ’s focus on compliance has forced both U.S. and foreign companies that access U.S. capital markets to reevaluate their approaches toward compliance. Companies have begun to reassess, formalize, and improve what have historically been only informal or general codes of conduct. Faced with the reality that compliance is both a key federal charging consideration and a determinative factor in sentencing, companies today must ensure that their compliance programs contain carefully crafted policies and procedures tailored to minimize the risk of civil and criminal liability.

The article provides an excellent analysis and background on the role of compliance in federal criminal prosecutions.

However, they miss the point of having a compliance program. It’s to avoid ending up with criminal liability. If the case ends up with that the Department of Justice, that means the regulators found the conduct so egregious that civil liability was insufficient given the severity of the activity. Of course it also means that the activity was bad enough to catch the eyes of a regulator for action.

The authors use a chart showing that only three companies of 1349 charged from 1996 to 2009 received a culpability score reduction for having an effective compliance program. If they had an effective compliance program, they would not have ended up in the federal sentencing guidelines to begin with.

A compliance program should not be in place to reduce the sentence, it should be in place to prevent problems from occurring.

Repeal of Dodd-Frank?

Most compliance professionals have trepidation about parts of the Dodd-Frank Wall Street Reform and Consumer Protection Act. I would bet that most of the Representatives and Senators who voted for it (and against it) did not read the whole law and do not understand the changes being made.

But should it be repealed in it’s entirety?

Since the Republicans have taken over the House of Representatives there is growing backlash against the law. Take a look at the new Republican-authored House Committee on Financial Services website. Here are the headline topics:

  • Collateral Damage – the real impact of the Democrat’s bailout bid
  • Financial Regulatory Reform
  • Fannie and Freddie Reform
  • What’s NOT in the Dod-Frank?
  • What’s Really in Dodd-Frank?

Along with the changes to the website comes a H.R. 87: To repeal the Dodd-Frank Wall Street Reform and Consumer Protection Act from Representative Bachman:

“I’m pleased to offer a full repeal of the job-killing Dodd-Frank financial regulatory bill. Dodd-Frank grossly expanded the federal government beyond its jurisdictional boundaries. It gave Washington bureaucrats the power to interpret and enforce the legislation with little oversight.

“Dodd-Frank also failed to address the taxpayer-funded liabilities of Fannie Mae and Freddie Mac. Real financial regulatory reform must deal with these lenders who were a leading cause of our economic recession.”

Speaking personally, I don’t like Dodd-Frank. But repealing it would be worse. I think needs the SEC needs more funding and a longer time frame to promulgate the new regulations. The SEC normal produces just a handful of new rules each year. Dodd-Frank tasks them with dozens that need to be in place in the next few months.

As for Fannie Fae and Freddie Mac being the cause of the crisis, I think Representative Bachman should take the time to read All the Devils Are Here by Bethany McLean and Joe Nocera. (I’m halfway through it.) Fannie and Freddie played a role, but lots of things went wrong to get us into the trouble of 2008.

Putting companies into a limbo of whether they need to change or not is bad. I may not like the law, but uncertainty is worse.

On the other hand, I think the repeal is unlikely. It’s merely a political football to throw around.

Sources:

Compliance and Foreclosures in Massachusetts

Why is the foreclosure machinery of our nation’s largest banks grinding to a halt? Failure to follow the legal rules. In other words: Compliance Failure.

The latest comes from my home state of Massachusetts. The state’s highest court rulet that two foreclosures were invalid because they were not properly assigned to the foreclosing party.

The theory of simply trading mortgage notes ran into the reality of real estate law. The foreclosure process and laws are different in every state. There are 23 states that require approval of a court to get a foreclosure order. These have been labeled the “judicial states.” The remaining states do not require court action. In non-judicial states, banks aren’t required to submit anything to the court until they are sued by a homeowner seeking to stop a foreclosure.

These homeowners sued because the assignments to the foreclosing lender were missing at the time of foreclosure. The financial institutions finally sorted out the mess and executed the assignments after the foreclosure sale.

We agree with the judge that the plaintiffs, who were not the original mortgagees, failed to make the required showing that they were the holders of the mortgages at the time of foreclosure. As a result, they did not demonstrate that the foreclosure sales were valid to convey title to the subject properties, and their requests for a declaration of clear title were properly denied.

The decision does not seem to extinguish the mortgage debt, it merely invalidates the foreclosure process. There is some doctrine that the mortgage follows the note. That seems to be brushed aside when it comes to the foreclosure process.

I don’t think it’s the lenders who are the ultimately the losers in this case. Now that the assignments are in order, they can go back and re-start the foreclosure process. For sure they are losing money. But it’s not the nuclear effect of having to walk with empty hands.

The group with the problem are the people who bought foreclosed property from lenders. If an assignment is missing, the foreclosure is improper and the lender never obtained good title to the property. That means there was no transfer to the purchaser. If that person did not purchase an owner’s policy of title insurance, they are in trouble. At best, they will have trouble refinancing the home and selling at home. At worst, the original property owner is going to come back for the property.

Sources:

Image: Sign Of The Times – Foreclosure by Jeff Turner

Hedge Fund Hotels and Compliance

The Massachusetts Secretary of the Commonwealth has been investigating hedge fund hotels. Start-up hedge fund managers receive reduced-rent office space in return for send their trading business to the landlord.

UBS AG has agreed to pay $100,000 to settle charges that it failed to disclose the relationship. Galvin charged there was a conflict that harmed investors who did not know the hedge funds were receiving beneficial treatment in return for sending the bulk of their business to UBS.

To me it seems more like a disclosure problem with the hedge funds, receiving reduced rent in exchange for the sending business to UBS. The Massachusetts regulator found fault with UBS for failing to enforce a requirement that its hedge fund hotel clients disclose the arrangements to their investors.

That’s a tough one to swallow from a compliance perspective.

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Email, Warrants and Corporate Email

Inside the company, you can take away your employees expectations of privacy when it comes to email. It has been unclear whether the same is true when it comes to the government inspecting your email. Surprisingly, there has been little law on whether your email would be subject to same protections as your phone calls from government snooping. Does the government need a warrant to obtain the contents of your email from your internet service provider?

The latest case to address the issue is U.S. v. Warshak out of the Sixth Circuit Court of Appeals which held:

If we accept that an email is analogous to a letter or a phone call, it is manifest that agents of the government cannot compel a commercial ISP to turn over the contents of an email without triggering the Fourth Amendment. An ISP is the intermediary that makes email communication possible. Emails must pass through an ISP’s servers to reach their intended recipient. Thus, the ISP is the functional equivalent of a post office or a telephone company. As we have discussed above, the police may not storm the post office and intercept a letter, and they are likewise forbidden from using the phone system to make a clandestine recording of a telephone call—unless they get a warrant, that is.


The case is based on charges against the manufacturer of Enzyte with its Smilin’ Bob commercials. The company got into mess of mail and wire fraud because of their sales practices and banks closing down their accounts.

The government seized 27,000 emails from the company’s internet service provider under the the Stored Communication Act (18 U.S.C. §§ 2701 et seq.), a statute that allows the government to obtain certain electronic communications without procuring a warrant. As you might expect, the company objected to this government action.

Once you become a registered investment advisers, you are going to be subject to inspection by the Securities and Exchange Commission. The SEC will likely not need a warrant for any records or communication required to be kept under the Investment Advisers Act. You can’t have an expectation of privacy for stuff you are required to submit to SEC examination.

As an employer, you own the hardware and the network and you can decide how your employees use them. If you clearly state that your employees have no expectation of privacy for email on the company’s network then you are free to dig into their email traffic as part of an internal investigation.

The Warshak case is important for criminal law, but has no effect on corporate email policies.

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