Category: SEC News

SEC Warns About Exemptive Order Compliance

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The SEC’ Division of Investment Management issued new guidance to reminds firms to comply with conditions and representations in exemptive orders. The guidance suggests that firms “adopt and implement policies and procedures reasonably designed to ensure ongoing compliance with each representation and condition in any such order.”

The  guidance was triggered by June 2011 report from the SEC’s Office of Inspector General which noted noncompliance with exemptive order requirements and no-action letters. Besides this guidance, the Office of Compliance Inspections and Examinations’ 2013 examination priorities listed compliance with exemptive orders as an examination priority.

The SEC may allow a firm to engage in transactions that would otherwise be prohibited by securities laws by means of an exemptive orders. In order to receive this exemptive relief, a firm will make certain representations in its application and may agree to comply with certain conditions.

Based on its review of a sample of OCIE examination reports, the OIG determined in its 2011 report that many firms failed to comply with the representations and conditions of SEC exemptive orders and no-action letters they have received.
The OIG report found that the SEC divisions that issue relief do not have a process for confirming whether firms subsequently comply.

It’s a simple problem found in many organizations. One part of the SEC issues the exemptive relief and another conducts the inspections. The one conducting the inspections is probably not aware of the exemptive order or the need to comply with the provisions. It sounds like that is starting to change.

The OIG report made five recommendations intended to enhance the SEC’s oversight of exemptive order compliance.

(1) The Divisions of Investment Management, Trading and Markets, and Corporation Finance should develop processes for coordinating with OCIE regarding reviewing for compliance with conditions and representations in exemptive orders and no-action letters issued to regulated entities on a risk basis;

(2) The Divisions of Investment Management, Trading and Markets, and Corporation Finance, in coordination with the Office of Information Technology and OCIE, should develop and implement processes to consolidate, track, and analyze information regarding exemptive orders and no-action letters;

(3) The Divisions of Investment Management and Trading and Markets should, in their plans for implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act requirement that they establish their own examination staffs, develop procedures to coordinate their examinations with OCIE and include provisions to review for compliance with conditions and representations in exemptive orders and no-action letters on a risk basis;

(4) The Divisions of Investment Management and Trading and Markets should include compliance with the conditions and representations in significant exemptive orders and/or no-action letters issued to regulated entities as risk considerations in connection with their monitoring efforts; and

(5) OCIE should include compliance with conditions and representation in significant exemptive orders and no-action letters issued to regulated entities as risk considerations in connection with its compliance efforts.

Although the 2011 OIG report also include no-action letter, this 2013 guidance only mentions exemptive orders.

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SEC’s Compliance Outreach Program

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I was able to attend the Boston stop on the SEC’s Compliance Outreach Program.

Michael Garrity, the Associate Director of the Boston Examination Program kicked off the program, by highlighting some examination statistics. There are 1200 registered adviser in the Boston region. But there are only 50 examiners. Last year, they had 80 exams. They are clearly taking a risk-based approach to examinations because the resources are so limited. They are getting increased data and are working on finding the signal through all the noise.

The first panel focused on examination priorities and risks.

The selection process is one involving qualitative and quantitative review. The SEC uses the Form ADV information, third-party data providers, and media stories, among other sources to select firms for examination.  These are some of the red flags that may make an exam more likely:

  • Firms in the media
  • Firms with new product lines / closed product lines
  • Management changeover
  • New fee arrangements
  • Decentralized firms or odd structures
  • Use of riskier service providers

In a post-Madoff world, the SEC takes Tips, Complaints, and Referrals as the top indicators for examination. The biggest red flag is when someone takes the time to the tell the SEC that a firm is doing something wrong.

The SEC is trying to be transparent in examination priorities. The 2013 SEC Examination Priorities clearly lay out what the SEC is most likely to focus upon. The exam staff expects to update the exam priorities each year.

The panel made it clear that the Form ADV is used in selecting firms for examination. However, they seemed to indicate that the exam staff has not quite figured out how to deal with all of the information in Form PF.  Examiners will use the information in Form PF as part of the examination. But its seems that the data is not yet an integral part of the selection criteria.

Valuation was the number one topic for examination when it comes to funds. It affects performance marketing and fee generation. The examiners are not going to second-guess assumptions, but do want to see a robust process. Although an examiner will not second-guess assumption, an examiner may look at other market data to see if it distinctly contradicts the assumptions used.

In particular, an examiner will note if valuations are “being tweaked when new funds are raised”. The panel referred to the Oppenheimer case where there was distinct change in the valuation process with no justification or disclosure. The panel also referenced the Morgan Keegan case where there was distinct hanky-panky during the valuation process.

The examiners want to see if the written polices and procedures are effective. They want to make sure that marketing pressure does not affect valuations. The exam staff is looking for ad hoc changes.

Social media is hot topic for examination. The panel pointed to last year’s risk alert on investment adviser use of social media. The use of social media is clearly subject to the anti-fraud rule. Most of it will also be subject to the advertising rule. The exam will focus on social media if the adviser uses social media to target clients and potential clients, not for personal or non-business use.

Safety and security of client assets is another hot topic for examinations.  Based on the recent risk alert, the SEC is not happy with compliance under the custody rule. Many advisers fail to understand that they have custody.

A new issue is the application of the identity theft rules under the FRCA. Dodd-Frank made the Red Flags Rule applicable to the SEC. Regulation SID will have a November compliance deadline.

The second panel was on the current topics in money management regulation.

The first line of discussion was who would show up at an examination. In the Boston office, it is now common to have a member of enforcement take part in an examination. However, this is for educational purposes, not because of the likelihood to bring an action. With the massive inflow of hedge funds, private equity funds, and real estate funds, the SEC is trying to develop expertise in these types of advisers. The Boston office also has staff intern in different divisions. So an examination person will work for six months in enforcement and an enforcement person will work for six months on exams.

The number one reason for an enforcement action is failing to fix problems that you say you will fix. The SEC is now routinely making follow-up returns to see if a firm has made the changes mandated in the deficiency letter.

The panel downplayed the enforcement actions against compliance staff. The cases against compliance officers are for egregious failures.

Expenses bubbled up as a hot topic. Examiners will look closely at expenses billed to investors.  The examiners want to know that these expenses are clearly disclosed to investors. For funds that means the PPM and Partnership Agreement. The examiners said they want to see written expense policies and to see them tested.

The SEC examiner strongly suggested that registrants prepare a risk matrix.  One advisor thought this was providing a blueprint for the SEC to conduct their audit. They want to see a catalog of risks, status, rating and worst case impact for the risk.

The panel listed a few things that make an enforcement action more likely:

  • Fraud
  • Misappropration of funds
  • Intent
  • Investor harm
  • Recidivism
  • Failure to respond to exam staff
  • Providing false information to staff

The panel raised the current hot topic of Broker-dealer registration for internal marketing personnel at private fund managers.  The panel noted the David Blass speech on private funds and broker-dealer registration.

The third panel focused on the examination process.

There are four types of exams:

  1. Risk priority exam
  2. Cause exam
  3. Sweep exam
  4. Presence exams for new registrants.

The presence exam program started 10/12 and is expected to end in the  fall of 2014. The SEC plans on compiling findings from these exams and releasing that compilation or risk alert to all registered advisors. The presence exams are short – less than a week.  The focus is on the five areas in the October welcome letter: Marketing, Conflict of interest, Safety of client asset,  Portfolio Management, and Valuation.

They also mentioned a fifth type of exam: corrective action review. This a follow-up after an “exam summary letter” (nee’ deficiency letter) and focuses on whether the firm fixed the deficiencies they said they would in the letter.

It is the SEC’s policy to not disclose the type of exam during the examination process.

As for the process, it usually starts with a phone call to let you know they are coming.  The notice could be from none to two weeks. Typically it will be one week’s notice. Can you postpone the field date? Almost never. (One participant told me that the SEC came on the date of his annual investor meeting and would not move the date.)

The examiners will interview senior staff. The CCO can be present for all interviews.

The panel paid a lot of attention on annual reviews. After all, it is required by the SEC rules. They expect the following to be addressed in the annual review:

  • Review and document compliance issues for the year
  • Review change in business activities
  • Note Regulatory changes
  • Changes in key personnel

It’s okay to outsource the annual review.

Identify risks and either (1) change the policies and procedures, (2) test, and/or (3) mitigate.

Use the annual review as an opportunity to highlight your resources and all of the good things you have done over the past year.

At the end of the exam you will get a letter to know its over. The letter will be either a summary letter or a no further action letter.

 

As you can tell from my notes, this was a great program for compliance officers.

The First Enforcement Action Under the JOBS Act

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I believe the Securities and Exchange Commission has taken its first enforcement action under the JOBS Act. The SEC announced fraud charges against a Spokane Valley, Wash., company and its owner for misleading investors with claims to raise billions of investment capital under the Jumpstart Our Business Startups (JOBS) Act and invest it exclusively in American businesses.

Every critic has some concerns about investor protections in a post-JOBS Act securities world. There has been a whirlwind of entrepreneurs and wanta-preneuers who want to take advantage of the crowdfunding rules and the removal of the ban on general solicitation for private offerings.

“The JOBS Act is intended to help small businesses raise capital, not to legalize fraud or give unscrupulous entrepreneurs a right to make false claims to fleece investors.”
– Michael S. Dicke, Associate Director in the SEC’s San Francisco Regional Office.

According to the SEC complaint, Daniel Peterson sold his USA Real Estate Fund 1 securities, raising more than $400,000 based on false and misleading statements.  According to the business plan, the fund could invest in real estate, mortgage notes and technology companies. I consider all of these to be high risk investments. But the website touts that investors won’t lose their money.

Q: How do you assure the investor that they will not lose their investment?
A: Our protection works much the same as flood insurance or earthquake or tornado insurance. We buy Financial Instruments comprised of US Government treasuries, Top Rated US and World Insurance and Reinsurance Companies (GIC and Annuity) contracts. The fund reserves the right to invest up to 5% of its assets in other Debt securities, such as but not limited to, high yield securities, foreign bonds, and money market instruments, when to do so would be considered within the strategy of the fund and in the best interest of its investors. These are the financial instruments that will provide the money to insure against loss.

I’m not quite sure how to reconcile that answer with the investment strategy.

According to the SEC complaint, the firm claimed it would offer additional securities and raise more investment capital, made possible by the Jumpstart Our Business Startups Act. Again, its not clear to me how passage of the JOBS Act would create value for the fund investors. I suppose that’s one of the reasons the SEC is making a claim against the fund for false and misleading statements.

It is clear that this is not a case of legitimate fundraising trying to take advantage of the JOBS Act before the JOBS Act regulations are put in place. If you, like me, were looking for a juicy and sordid tale instead of mere fraud you will be disappointed with the headline.

Equity crowdfunding portals are not yet legal because the regulations have not been enacted. General solicitation for Rule 506 private placements is not yet legal, because the regulations have not been enacted. Of course there are legal ways to use exemptions in these situations, but they are all pre-JOBS Act.

Anyone currently touting ways to get rich using the JOBS Act should be viewed as suspect. They are merely speculating on what the SEC may do and how entrepreneurs would take advantage of the potential new regimes.

You need to draw the distinction between entrepreneurs and wanta-preneuers.

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New SEC Rule to Protect Investors from Identity Theft

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The Securities and Exchange Commission adopted new rules requiring investment advisers, broker-dealers, mutual funds, and certain other entities regulated by the agency to adopt programs to detect red flags and prevent identity theft.

In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act amended the Fair Credit reporting Act to add the SEC to the list of federal agencies that must adopt and enforce identity theft red flags rules. In February 2012, the SEC proposed for public notice and comment identity theft red flags rules and guidelines and card issuer rules. Yesterday, the SEC issued the final rule.

Originally, it looked like investment advisers (and therefore private fund managers) might escape the rule. However, the final rule explicitly includes registered investment advisers as being subject to the rule.

Investment advisers who have the ability to direct transfers or payments from accounts belonging to individuals to third parties upon the individuals’ instructions, or who act as agents on behalf of the individuals, are susceptible to the same types of risks of fraud as other financial institutions, and individuals who hold transaction accounts with these investment advisers bear the same types of risks of identity theft and loss of assets as consumers holding accounts with other financial institutions. If such an adviser does not have a program in place to verify investors’ identities and detect identity theft red flags, another individual may deceive the adviser by posing as an investor.

The SEC concluded that the red flag program of a qualified custodian that maintains custody of an investor’s assets would not adequately protect individuals holding transaction accounts with an adviser. The adviser could give an order to withdraw assets, but at the direction of an impostor. However, an adviser that has authority to withdraw money from an investor’s account solely to deduct its own advisory fees would not hold a transaction account, because the adviser would not be making the payments to third parties.

Does this apply to private funds?

Private fund managers may directly or indirectly hold transaction accounts. According to the SEC rule, if an individual invests money in a private fund, and the adviser to the fund has the authority to direct the individual’s investment proceeds (such as distributions) to third parties, then that adviser would indirectly hold a transaction account. The SEC concludes that a private fund adviser would hold a transaction account if it has the authority to direct an investor’s redemption proceeds to other persons upon instructions received from the investor.

I’m not sure that I agree with the SEC conclusion. However, I do agree that funds need to make sure that distributions are not re-directed improperly. Private fund managers will have to put some effort into this.

This rule is going to take some time to figure out how it applies in the context of fund operations. The subscription agreement and partnership agreement for a fund may not explicitly address if an investor can direct distributions to a third party account. I think that would be an unusual restriction.

The SEC-mandated program under rule should include policies and procedures designed to:

  • Identify relevant types of identity theft red flags.
  • Detect the occurrence of those red flags.
  • Respond appropriately to the detected red flags.
  • Periodically update the identity theft program.

The rules require entities to provide such things as staff training and oversight of service providers. The rules include guidelines and examples of red flags to help firms administer their programs.

The final rules will become effective 30 days after publication in the Federal Register. The compliance date for the final rules will be six months after their effective date.

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The SEC and Social Media

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Netflix chief executive Reed Hastings got into trouble on July 3, 2012 when he used his personal Facebook page to announce that Netflix had more than one billion hours of online viewing in June. That trouble came from an SEC rule implemented in August of 2000: Regulation FD. That rule was implemented to stop the egregious practice of some companies delivering company news to select recipients ahead of a general announcement. Those select recipients would be able to make money from getting the news ahead of time and trading on the upcoming stock movement.

The SEC issued its report on the investigation of Mr. Hastings and determined not to pursue an enforcement action against him. The SEC publicly released its Report of Investigation to help provide some guidance on the use of social media for public company disclosure.

Personally, I thought Mr. Hastings made a bad decision in using his personal Facebook page to make a company announcement. The information had already been released, but in more technical releases. His personal Facebook page did have 200,000 friends who could see the news, but it was still gated and not available to the general public in a broad and non-exclusionary manner. It was a poor choice, but not one that should subject him or the company to an enforcement action.

Regulation FD is written to be platform neutral. You can release “important” company information as long as it available to everyone at the same time. It applies equally to press releases, company websites, Twitter, Facebook, or the big rock in front of your headquarters.

The key for correct distribution is to let people know where the news will be distributed. You could argue that Steve Jobs’ annual display of the latest gadget from Apple is a distribution channel that everyone knows about. A company could carve company announcements into the stone in front of its headquarters if it so chose.

Mr. Hastings foot-fault was that Netflix had not previously used his personal page as a platform for releasing company news. In early December 2012, Hastings stated for the public record that

“we [Netflix] don’t currently use Facebook and other social media to get material information to investors; we usually get that information out in our extensive investor letters, press releases and SEC filings.”

Hastings errant Facebook post was probably not “important” enough and the Facebook page was probably just public enough that the SEC thought it could not win an enforcement action. I’m sure Hastings and Facebook paid quite a bit in legal fees to address the repercussions of that errant post.

It’s not big news that the SEC has embraced social media. The SEC merely reminded companies that they need to go through the Regulation FD analysis when using social media platforms. The SEC embraced social media a long time ago.

I think Facebook is terrible primary platform for important corporate disclosures. It lacks the workflow and content management tools that any corporate communication professional would want to have. The same is even more so with Twitter. It’s hard to do much with 140 characters, except direct the reader to another website.

To de-emphasize the importance of the SEC guidance, it’s not even released as SEC guidance, a risk alert, or other typical SEC regulatory rulings. It merely restates what Regulation FD says and drops in the word Facebook. Too many social media specialists will merely read the headline.

Even Facebook does not use Facebook for company announcements. This announcement will not change that. Maybe Facebook will see the potential for including content management and compliance tools that will allow companies to embrace Facebook and be in compliance with securities laws.

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Challenging the SEC on the New Five Year Limit

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illustration by Steve Brodner in D Magazine

 

It didn’t take long for defendants to take advantage of the Gabelli decision. That Supreme Court decision enforced the strict five year statute of limitations on enforcement actions by the Securities and Exchange Commission. The SEC is not entitled to the “discovery rule” which would have allowed the SEC’s five-year time bar to start running until the SEC discovered the fraud.

In 2010, the SEC brought an enforcement case against Samuel E. Wyly and his brother, Charles J. Wyly, Jr., claiming the brothers had engaged in a 13-year fraudulent scheme to trade tens of millions of securities of public companies while they were members of the boards of directors of those companies, without disclosing their ownership and their trading of those securities. One fraudulent claim by the SEC involved the Wylys making a massive and bullish transaction in Sterling Software in October 1999 based upon the material and non-public information that they, the Chairman and Vice-chairman of Sterling Software, had jointly decided to sell the company.

A little math would place the statute of limitations on an enforcement of that case after five years at October 2004. It sounds like the SEC was six years too late in bringing that claim.

In a court filing yesterday the Wylys’ attorney swung at the SEC with the Gabelli hammer.

“Summary judgment should be granted for Defendants on nearly all the SEC’s claims for penalties because they are barred by applicable statutes of limitation and the SEC cannot establish that equitable tolling is warranted.”

Unfortunately for Mark Cuban, the SEC managed to file its case against him in four years, so he will not be able to swing the Gabelli hammer.

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The SEC Is Not Happy with Custody Compliance

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The Securities and Exchange Commission issued a Risk Alert on compliance with its custody rule for investment advisers. Beyond the warning to investment advisers, it also issued an Investor Bulletin to protect advisory clients from theft or misuse of their funds and securities.

After a review of recent examination, the SEC’s Office of Compliance Inspections and Examinations found significant deficiencies in custody-related issues in about one-third of the firms examined that had serious deficiencies.

  • Failure to recognize that they have custody, such as situations where the adviser serves as trustee, is authorized to write or sign checks for clients, or is authorized to make withdrawals from a client’s account as part of bill-paying services
  • Failure to meet the custody rule’s surprise examination requirements
  • Failure to satisfy the custody rule’s qualified custodian requirements, for instance, by commingling client, proprietary, and employee assets in a single account, or by lacking a reasonable basis to believe that a qualified custodian is sending quarterly account statements to the client.
  • For fund managers, failures to (1) meet requirements to engage an independent accountant and (2) demonstrate that financial statements were distributed to all fund investors.

In the Risk Alert, the SEC is shares some of the custody deficiencies observed in order to assist investment advisers in complying with the custody rule.

Private Equity Enforcement Concerns

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Bruce Karpati, chief of the SEC’s Enforcement Division’s Asset Management Unit laid out a clear picture of the SEC’s expectations and concerns about private equity in a recent speech. He was speaking at Private Equity International’s annual CFOs and COOs Forum. The speech was centered around five main questions.

Q1:  How has the creation of the Asset Management Unit impacted the Commission’s activities in the private equity space?

Q2: The Commission hasn’t traditionally brought many private equity enforcement actions. Do you expect that to change?

Q3: What are some of the Unit’s concerns about practices in the private equity industry?

Q4: You’ve spoke before about AMU’s Risk Analytic Initiatives. What are they and are there any currently under way in the private equity industry?

Q5: What can a private equity COO or CFO do to reduce the risk of inquiry by the Division of Enforcement?

It seems clear that the SEC is focused on two area: valuations and fees.

Private equity investments are inherently illiquid and therefore requires the fund manager to make judgment calls about pricing. Poor judgment can lead to poor valuations. Fraudulent judgment can lead to fraudulent valuations.

Fees and revenue generation are always a focus of the SEC for investment advisers and funds, whether private or public mutual funds. Private equity merely has some additional ways of generating revenue. It seems clear from Karpati’s speech that that SEC has been looking closely at those revenue streams.

  • The shifting of expenses from the management company to the funds including utilizing the funds’ buying power to get better deals from vendors — such as law and accounting firms — for the management company at the expense of the fund.
  • Charging additional fees especially to the portfolio companies where the allowable fees may be poorly defined by the partnership agreement.
  • Broken deal expenses rolled into future transactions that may be ultimately paid by other clients.
  • Improper shifting of organizational expenses, where co-mingled vehicles foot the bill for preferred clients.

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The SEC Launches a Private Equity Initiative

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Bruce Karpati, Chief of the SEC Enforcement Division’s Asset Management Unit, disclosed the launch of a Private Equity Initiative in a speech on Tuesday. While speaking to the Regulatory Compliance Association, Karpati spoke about the Enforcement Division’s and in particular the Asset Management Unit’s priorities in the hedge fund space.

The Private Equity Initiative is coordination between RiskFin, the Division of Investment Management, and OCIE to identify private equity fund advisers that are at higher risk for certain specific fraudulent behavior. Karpati mentioned two behaviors that cause concern.

With Zombie Funds, managers delay the liquidation of the fund because the management fee is their only source of revenue. The SEC had mentioned back in June that it was hunting down zombie funds.

The second area is valuations. The SEC is rightly focused on valuations when it comes to private equity. The assets are inherently hard to value. Even the best valuation process will lead to an internal judgment on the value the fund. Karpati claims that the SEC uses “certain data sources” as part of the SEC’s risk analytic initiative to identify those private equity fund advisers that may be improperly failing to liquidate assets, or have been misrepresenting the value of their holdings to investors.

Karpati finished the speech by ask fund managers to be nice to examiners:

Finally, I think all investment advisers need to be alert and prepared for exam inquiries.  It is important to be cooperative with exam staff while an examination takes place.  It is also important to implement any necessary corrective steps if the SEC identifies violations or possible violations.  Taking these steps will help the examination process to proceed more efficiently and reduce the likelihood of more formal inquiries by Enforcement or AMU staff.

I didn’t find anything new in the speech. That’s a good thing. The SEC has made it clear what they are looking for in their welcome to the SEC letter, enforcement actions, and speeches for many month now.  I give them credit that it sounds like the SEC better understands the risk and compliance problems for private fund advisors in a way they did not understand 12 months ago.

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Recent SEC Document Request for Private Equity

It appears the Securities and Exchange Commission has started its initial examination program for newly registered investment advisers, including private equity fund managers. This is a recent document request list sent by Boston’s regional office:
August Boston document request (.pdf).

The request list is shorter than the typical request letter. This seems to be in line with the earlier announcement that the SEC intended to make brief visits to lots of newly registered advisers.

Let me know if you have been visited by the SEC under this new program.