Category: SEC News

Private Fund Theft Through Diligence Payments

camelot and compliance

The Securities and Exchange Commission charged Lawrence E. Penn III and his firm Camelot Acquisitions Secondary Opportunities Management, a private equity manager, with stealing $9 million from investors in their private equity fund. He is accused of siphoning off $9.3 million through sham due diligence payments.

The SEC claims that Penn used a shell company to funnel due diligence expense payments from the private equity funds. That money was then transferred to Penn and Camelot. Penn and Camelot are merely charged so we can only see the issue through the SEC’s eyes. Since it was a private equity fund, the story caught my eye.

Camelot’s audit firm could not obtain satisfactory evidence that certain due diligence payments were legitimate. The fund only paid millions in due diligence expenses to a firm called Ssecurion. But no other firm for due diligence.That;s strange for a firm to be using a single diligence provider given the many areas of diligence required for private equity investments.

Another red flag should have been the cost. I think $9 million is a big expense item for a fund with about $175 million AUM.

The audit firm kept poking and Camelot produced generic looking materials that could be found on the internet. None were branded or had any indication that they came from Ssecurion. The audit firm was worried and didn’t have any credible evidence that the costs were legitimate.

The audit firm reported the matter to the Securities and Exchange Commission.  The SEC’s Office of Compliance and Inspections and Examinations initiated a for-cause exam. Camelot failed to produce requested books and records and Penn failed to show up for several meetings. As a result, OCIE could not complete the examination and handed the case over to enforcement.

Camelot’s Form ADV Part 2 states Deloitte and Touche terminated the audit relationship during the summer of 2013. Deloitte disowns prior financial statements and did not prepare a report for 2012.

It sounds like a great job by Deloitte reporting the problem. Except it took the firm a few years and a few audits to uncover the problem. Alleged problem. Penn and Camelot have not responded to the charges.

References:

Gustave Doré’s illustration of Lord Alfred Tennyson’s “Idylls of the King”, 1868

NEAT and MIDAS: The SEC’s New Tools

univac

“This is not your father’s SEC – or your mother’s or even your older brother or sister’s.”

Securities and Exchange Commission Chair Mary Jo White is proud of two new technology tools the Commission is rolling out. She spoke about the new tools at the 41st Annual Securities Regulation Institute.

The first is NEAT, the National Exam Analytics Tool. This new tool is designed to analyze trading data, looking for potential insider trading by comparing trades against significant corporate events. That will be fun. But then the SEC needs to find the connection between the suspicious activity and now connection with an obligation to hold material non-public information confidential. That’s the hard part.

NEAT will also be able to find signs of front running, improper allocations, and other misdeeds by investment advisers. Chair White told the tale of running NEAT against an adviser’s 17 million transactions. Sounds scary. Mostly because of the headache it will be trying to match a trade blotter against the format required by NEAT to input the data.

MIDAS, the Market Information Data Analytics System, collects one billion records of trading data, time-stamped to the microsecond, every day. MIDAS is focused on market stability. It should help the SEC monitor and understand mini-flash crashes, reconstruct market events, and to develop a better understanding of long-term trends.

Both of these tools will create a tremendous amount of data. But that’s just the first step. It’s about understanding the data and finding the signal through the noise.

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SEC’s First Deferred Prosecution Agreement With an Individual

SEC Enforcement Logo

The Securities and Exchange Administration announced that it entered into its first deferred prosecution agreement with an individual. What’s remarkable is that this is first time the SEC has done so.

Back in early 2010, the SEC announced that it had launched a new enforcement cooperation initiative. The SEC did a big (for the SEC) marketing campaign to announce initiative. The SEC even went so far as to allow me and a few other bloggers to chat with then SEC Enforcement Director Robert Khuzami. The SEC set out how it will evaluate whether, how much, and in what manner to credit cooperation, to serve as an incentive to report violations and cooperate fully and promptly in enforcement cases.

It’s been almost three years and the SEC has finally found a bad guy willing to cooperate. Scott Herckis served as administrator for Connecticut-based Heppelwhite Fund LP. The fund was run by Berton M. Hochfeld. The SEC filed an emergency enforcement action against Hochfeld in November 2012 for misappropriating more than $1.5 million from the fund and overstating its performance to investors. The SEC’s action halted the fraud.

Herckis started as the Heppelwhite fund administrator in 2010. Hochfeld asked for transfers from the fund’s account to Hochfeld’s account. Eventually those transfers ended up getting very large and Herckis realized the fund’s NAV was overstated. He resigned and contacted the SEC.

“We’re committed to rewarding proactive cooperation that helps us protect investors, however the most useful cooperators often aren’t innocent bystanders,” said Scott W. Friestad, an associate director in the SEC’s Division of Enforcement. “To balance these competing considerations, the DPA holds Herckis accountable for his misconduct but gives him significant credit for reporting the fraud and providing full cooperation without any assurances of leniency.”

Herckis cannot serve as a fund administrator or otherwise provide any services to any hedge fund for a period of five years, and he also cannot associate with any broker, dealer, investment adviser, or registered investment company.  The Deferred Prosecution Agreement requires Herckis to disgorge approximately $50,000 in fees he received for serving as the fund administrator.

I suppose that’s not a bad result for Herckis. It’s hard to assess his culpability in the fraud. Herckis looks more like a whistleblower. However, it appears that he continued to cooperate with Hochfeld’s fraud long after he realized it was wrong. The fraud would not have happened without Herckis allowing the transfers.

It’s good to see that the SEC is using its shiny new tools. The SEC announced its first Deferred Prosecution Agreement against a company back in May 2011.

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SEC Brings its First Charges Against a Municipal Issuer

town toyota center

Nine Washington cities and counties in the Wenatchee Valley region thought it would be a good idea to join forces to build a regional events center and ice hockey arena. They formed the Greater Wenatchee Regional Events Center Public Facilities District and authorized the District to issue bonds to fund the construction of the Town Toyota Center. In 2011 the District defaulted on $41.77 million in bonds anticipation notes.

According to the SEC order, the problem began at the start when the developer/operator, the district, and its consultants had trouble arranging financing. That was in part because earlier projections raised questions about the Center’s economic viability. Unexpected building costs led to overruns and a redesign to a smaller facility. Even though the developer was experiencing weak ticket sales and seeing other troubling signs about future revenue, it revised its projections upward.

The District issued Bond Anticipation Notes to raise capital in the fall of 2008 to purchase the Center from the developer. Those notes are short term and issued in anticipation of a future issuance of long term bonds to pay them off in three years at maturity. The District had to use those notes because the bond market was shut down by the financial crisis of 2008.

In 2011, the Center’s revenues were worse than its pessimistic obligations and was operating at a significant loss. That means the Center did not have the cash flow to support the issuance of long term bonds and was unable to pay the notes at maturity in 2011.

The big problem was a disclosure in the offering document for the notes that the financial projections and assumptions had not been reviewed by a third party. In fact, they had been reviewed and the independent consultant raised concerns.

“This municipal issuer is paying an appropriate price for withholding negative information from its primary offering document and giving investors a false picture of the future performance of the project.” – Andrew Ceresney, co-director of the SEC’s Division of Enforcement

Whether it’s a municipal issuer or a private fund, full and honest disclosure is important so an investor has all the material facts to make his or her investment decision. “The SEC is happy to go against sloppy, negligent conduct if need be.”

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When the Numbers Don’t Add Up

compliance and a calculator

Sometimes when you look at an investment opportunity, you run through the math and see that things don’t add up. That means it might be a fraud. Take a look at the offering of Bio Profit Series V, LLC detailed in an enforcement action by the Securities and Exchange Commission.

Assuming the SEC’s complaint is true, the fund was selling 10-year notes paying 6% per year with a bonus payment of 45% of the outstanding principal at maturity. That is not an outrageous return by itself. On top of that, the managing member receives a business operations and management fee of 7.5% of the proceeds from the note sale. (See item 15 on the Form D for the offering.)

The fund is supposed to be in the business of buying and making residential loans secured by first or second deeds of trust in California. How can the fund offer that kind of return when interest rates are below 6%?

The SEC lawyers laid out the math in the complaint. Bio Profit Series V would have to generate an average annual return of 12.2% per year to pay the annual return and bonus payment. It was the fourth fund raised by Yin Nan Wang and his Velocity Investment Group, all of which had promised returns that did not add up. (Apparently, Wang skipped over Series IV.)

According to the SEC complaint, Wang was using new investor money to pay old investors. He admitted to the ponzi scheme when talking to a company that originated loans for one of the Bio Profit funds.

Although the underlying investments may be in loans that constitute real estate, the interest in the funds are securities. That gives the Securities and Exchange Commission jurisdiction. It appears that all, or at least a large portion of the investors are from overseas. That may complicate matters.

What’s missing in the story of how the SEC found out about the alleged scam. It does not appear that any investors are complaining of lost money. Perhaps it was the person who was told it was a ponzi scheme. Perhaps that person used the SEC’s relatively new Tip, Complaints and Referrals Portal to alert them to the fraud?

Yet Another Rule to Discourage Companies From Going Public

sec-seal

There has always been a tension between regulating the capital markets to protect the public and making capital formation more efficient. While I was focusing on Tuesday’s meeting SEC Advisory Committee on Small and Emerging Companies discussing changes to private placements, the SEC passed another rule that smacks public companies. Now public companies need to start worrying about the ratio of the CEO’s compensation to the median compensation of all employees.

I think it’s a silly rule that will do nothing except fire up shareholder activists and further discourage companies from going public.

At least this rule is not the fault of the Securities and Exchange Commission. Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act mandated this rule. Blame Congress, not the SEC.

(b) ADDITIONAL DISCLOSURE REQUIREMENTS.—

(1) IN GENERAL.—The Commission shall amend section 229.402 of title 17, Code of Federal Regulations, to require each issuer to disclose in any filing of the issuer described in section 229.10(a) of title 17, Code of Federal Regulations (or any successor thereto)—

(A) the median of the annual total compensation of all employees of the issuer, except the chief executive officer (or any equivalent position) of the issuer;

(B) the annual total compensation of the chief executive officer (or any equivalent position) of the issuer; and

(C) the ratio of the amount described in subparagraph (A) to the amount described in subparagraph (B).

There is an exception for Emerging Growth Companies from the rule. Yet another benefit to grabbing this status under the JOBS Act.

The SEC did not mandate any particular methodology for the calculation. This rule will be a big challenge for bigger companies and multi-national companies.

I also wonder if there will be a math problem with companies using “average” instead of “median.” Surely, at least one company will put someone in charge of the calculation that does not know the difference.

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Ignoring Changes to Regulation D

compliance and ignore this sign
While many embraced lifting the ban on general solicitation and advertising, most despised the additional mess that the SEC added in. Fortunately, you can probably ignore much of that mess. At least for a few months.

We knew that the SEC was going to require that firms selling public private-placements were going to have to take some reasonable steps to confirm that the purchasers were actually accredited investors. Congress wrote that into the JOBS Act. (Although I suspect they would have written it differently if they knew the end result.)

Based on the July 10 SEC meeting, 506(c) and 506(d) go into effect on September 23. The dreaded changes to Form D and Rule 156 do not. Those are only proposed rules.

SEC Chairman Mary Jo White made this obvious in a recent letter response to Congressman McHenry.

It’s clear that funds can use the public private-placement regime under Rule 506(c) on September 23, 2013. The current rules on filing the Form D are in place. There will be no requirement to file the advertisements with the SEC. There will be no required legends on the advertisements.

For now.

The changes to Form D and the advertising legends are merely in a proposed rule. The SEC may abandon its concerns and not issue a final rule. (unlikely) The SEC may make significant changes to the rule. (possibly)

Chairman White makes it clear that there will need to be some transitional guidance for offerings that commence before the effective date of the final rule. So you can ignore the proposals.

But the proposed rule is clearly a signal that the SEC wants to do something more for private placements. I would guess that some form of the rule will be adopted before the end of the year. The mutual fund industry will be furious that their product advertisements are weighed down with disclaimers, while cowboy hedge funds are all over the place and grabbing bigger fees.

There are signs ahead. But we can ignore them for now.

References:

Ignore This Sign, 2004
Marietta, Georgia, USA
Hacking the City, by Brad Downey

SEC Compliance Outreach Program

sec-seal

In May attended the SEC Compliance Outreach program hosted by the Securities and Exchange Commission’s Boston office. That was supposed to be the first in a new series from the SEC. The SEC just announced a few other program dates and locations. I highly recommend attending.

From the SEC:

The SEC’s Office of Compliance Inspections and Examinations (OCIE), Division of Investment Management, and Division of Enforcement’s Asset Management Unit (AMU) are jointly sponsoring the regional seminars for investment companies and investment advisers. The seminars highlight areas of focus for compliance professionals. They provide an opportunity for the SEC staff to identify common issues found in related examinations or investigations and discuss industry practices, including how compliance professionals have addressed such matters.

The Compliance Outreach Program was created to promote open communication on mutual fund, investment adviser, and broker-dealer compliance issues. The program, formerly known as the CCOutreach Program, was redesigned in 2011 to include all senior officers, not just CCOs, underscoring the importance of compliance throughout a firm’s business operations.

The series of regional seminars kicked off in Boston on May 16 with panel discussions on the priorities for the SEC’s National Examination Program, current topics in money management regulation, and OCIE’s process for assessing risks and selecting firms for examination.

The remaining seminars:

• Chicago – August 28: This seminar will present an overview of the examination process, including how registrants are selected for examination and the most commonly identified deficiencies. There also will be three discussion panels on traded and non-traded real estate investment trusts, on investment companies with special emphasis on alternative investment funds and money market funds, and on current enforcement actions in the investment management industry. Lastly, there will be a breakout session focusing on custody and compliance for small advisers. Register for this event.

• New York – September 13: This seminar will be most relevant to newly registered investment advisers, to dual registrants and to investment advisers affiliated broker-dealers. The topics most relevant to newly registered advisers will include the SEC’s examination process, priorities, risk surveillance, and examination selection process. In addition, the staff will discuss Form PF and other filing requirements and recent industry and regulatory developments. The topics most applicable to dual registrants or advisers with affiliated broker-dealers will address the staff’s coordinated examination process, common examination findings, and controls that some firms use to address conflicts of interest. Register for this event.

• Atlanta – September 25: This seminar will discuss the importance of enterprise risk management and effective compliance and will identify key issues noted during examinations, including conflicts of interests and issues associated with fees, such as undisclosed remuneration, miscalculation, and layering. Additional discussion topics include the changing demographics of SEC-registered investment advisers and key examination program initiatives to address such changes. Register for this event.

• San Francisco – November 6: This seminar will feature an overview of the SEC’s examination processes and procedures and a discussion of OCIE and AMU priorities. Emphasis also will be placed on valuation issues, including best practices for valuing assets by private and registered investment funds. Register for this event.

If registrations exceed capacity at an event location, investment company and investment adviser CCOs will be given priority based on the order in which their registration requests were received. Information regarding these seminars was also provided in SEC Press Release 2013-127 (see http://www.sec.gov/news/press/2013/2013-127.htm). For more information, contact: [email protected].

What’s Next For Private Funds Now that the SEC has Lifted the Ban on General Solicitation

SEC Seal 2

On Wednesday, the Securities and Exchange Commission adopted a new rule that will allow private funds to advertise. (Perhaps “private fund” is not the right label anymore.) Of course it’s not as simple as merely removing the word “not” and allowing public advertising of private placements.

The new rule creates a new option. It creates a public private placement. A fund manager or company can publicly advertise the offering so long as all purchasers of the securities are accredited investors and the issuer takes reasonable steps to verify that such purchasers are accredited investors

The existing option is still viable that operates under the regulatory regime as it existed before 10:00 am yesterday. I suppose it’s a private private placement.

One concern I had was how a public private placement under the new Rule 506(c) would affect a private fund under its Section 3(c)1 or 3(c)7 exemption under the Investment Company Act. Private funds are precluded from relying on either of these two exemptions if they make a public offering of their securities. The SEC explicitly addressed this concern.

As we stated in the Proposing Release and reaffirm here, the effect of Section 201(b) is to permit private funds to engage in general solicitation in compliance with new Rule 506(c) without losing either of the exclusions under the Investment Company Act.(page 48 of Release 33-9415)

Another concern was whether the SEC was eliminating the “reasonable belief” standard that an investor is accredited under the new Rule 506(c) offerings. The SEC specifically addressed this concern.

We note that the definition of accredited investor remains unchanged with the enactment of the JOBS Act and includes persons that come within any of the listed categories of accredited investors, as well as persons that the issuer reasonably believes come within any such category.

My last concern was what it meant to take “reasonable steps to verify” that investors are accredited. The SEC stuck with its principles-based approach, but did provide four non-exlusive methods for verifying accredited investor status for individuals.

The principles-based approach requires you to take an “objective determination … in the context of the particular facts and circumstances.” That’s a bit messy. I was hoping the SEC would explicitly state that a minimum investment of $1 million would be enough. If the investor has $1 million, then the investor has $1 million of net worth and meets the accredited investor threshold. The SEC states that the minimum investment is a highly relevant factor.

The SEC expresses some concern that the cash investment could be financed by the issuer or a third party. Those are legitimate concerns given the potential for fraud by shady operators who would hide behind such a bright line test. But it does cause me a headache.

Clearly there will need to be some additional recordkeeping when it comes to a public offering of a private placement.

The SEC also passed a rule banning “bad actors” from having a substantial role in a private placement, regardless of whether it is public or private. I’ll take a closer look at that one later.

Lastly, the SEC is proposing changes to the Form D required to filed with a private placement. There are many changes in that rule. More than I expected.

  • the filing of a Form D no later than 15 calendar days in advance of the first use of general solicitation in a Rule 506(c) offering;
  • the filing of a closing Form D amendment within 30 calendar days after the termination of a Rule 506 offering; and
  • additional information on Form D about the offering

In addition, the rule is proposing a new disclosure on advertising materials in public private placements. The new rule 509 will require all issuers to include: (i) legends in any written general solicitation materials used in a Rule 506(c) offering; and (ii) additional disclosures for private funds if such materials include performance data.

The SEC is also proposing amendments to Rule 156 under the Securities Act that would extend the guidance contained in the rule to the sales literature of private funds.

There is a lot to digest. Looks like my weekend will be spent reading SEC releases and rules.

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