Category: SEC News

What Will the SEC Do About Advertising and Solicitation?

UPDATE: The SEC will wait a week. A new meeting has been scheduled for August 29.

At today’s meeting the Securities and Exchange Commission is set to consider a rule on lifting its longstanding ban on general solicitation and advertising for privately-issued securities.

Item 3: The Commission will consider rules to eliminate the prohibition against general solicitation and general advertising in securities offerings conducted pursuant to Rule 506 of Regulation D under the Securities Act and Rule 144A under the Securities Act, as mandated by Section 201(a) of the Jumpstart Our Business Startups Act

Personally, I would welcome better information about what the SEC considers a general solicitation or general advertisement in connection with the private placement of securities. I don’t think lifting the ban is necessarily a good idea. The appearance of an ad for a private security has been a prominent red flag for an offering. Either it’s a fraud or the company is ignoring the advice of its legal counsel.

The bigger concern is what the SEC will do about verifying that the potential investor meets the accredited investor standard. Currently, most fund manager use a certification filled out by the investor. In addition to meeting the accredited investor standard, the questionnaire will typically include many other items of disclosure.

This process has worked well for decades. Hopefully the SEC won’t mess it up.

If you are wondering what changes the SEC could make, McGuire Woods put together an excellent Preview of New SEC Provisions Permitting Advertised Private Placements. The report tries to summarize the numerous comments submitted to the SEC.

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Wait a Bit Longer for Removing the Ban on General Solicitation and Advertising

On June 28 Securities and Exchange Commission Chairman Mary L. Schapiro testified that the SEC will not make the deadline for lifting the ban on general solicitation and advertising and the reasonable process for verification of accredited investors. Title II of the JOBS ACT gave the SEC 90 days to craft the regulation.

“As I stated to Congress prior to the passage of the Act, time limits imposed by the JOBS Act are not achievable. Here, the 90 day deadline does not provide a realistic timeframe for the drafting of the new rule, the preparation of an accompanying economic analysis, the proper review by the Commission, and an opportunity for public input.”

Since there has not even been a proposed rule available for comment, there was no doubt the SEC was going to miss the deadline.

The regulation will likely be a key change for private fund managers.

I don’t expect private funds to engage in bulk email or late night television commercials. I would expect more advertising in trade publications and more engagement with the media.

For me the bigger concern is what the SEC is going say about the “reasonable steps to verify that purchaser of the securities are accredited investors…” that the SEC has been empowered in include in this new regulation. The SEC has been empowered to implement requirements for years. It has just chosen not do any thing. The JOBS Act has given the SEC a little nudge to act.

Perhaps the SEC will not act.

The current method of self-certification for accredited investors seems to work for now. Imposing some requirement to gather financial information would dramatically increase the amount of sensitive personal information being transmitted and stored. That will mean firms will need to beef up their data security and deal with this new source of personal information. Inevitably, there will be a breach and investors identity’s will be stolen.

The current process of self-certification of investors seems to work well. Of course, I could see how the failure to review a potential investor could lead to fraud. It would seem to hurt the investor, committing to an investment he or she could not afford. perhaps it would be a red flag to regulators that the adviser is not conducting the diligence to conclude that an investor is accredited, and is therefore preying on unsophisticated investors.

However, for private funds the minimum investment amount is usually equal to or in excess of the standard for being an accredited investor. If the fund requires a minimum investment of $1 million, then the investor presumably has the $1 million net worth required by the accredited investor standard. Hopefully, the rule will contemplate that situation and not overly burden private funds.

 

 

Faking Your Returns

Some Securities and Exchange Commission enforcement actions catch my attention in looking for lessons on what not to do. The SEC recently charged a Boston-based father-son duo of fund managers and their firms with securities fraud for misleading investors about their investment strategy and past performance. This case caught my attention because it came out of Boston and the father is a professor at MIT. The respondents have consented to the SEC’s administrative order, but neither admit nor deny the findings in the order. For the discussion below, I’m assuming the findings are true so we can learn some lessons on what fund managers should not do.

Gabriel Bitran founded GMB Capital Management LLC in 2005 for the stated purpose of managing hedge funds using quantitative models he developed based on his academic optimal pricing research. Gabriel and his son Marco Bitran solicited potential investors with three selling points that ultimately ended up not being true:

(1) very successful performance track records purportedly based on actual trades using real money from 1998 to the inception of the hedge funds;
(2) the firm’s use of Gabriel’s proprietary optimal pricing model to trade ETFs; and
(3) Gabriel’s pedigree and his involvement as the founder and portfolio manager of the hedge funds.

They managed to raising over $500 million for eight funds and various managed accounts. But in the process made misrepresentations to investors and made at least two disastrous investment decision.

First, they told potential investors that the pre-inception performance track records since 1998 were based on actual trades using real money. That was not true. Their track record was based on back-tested hypothetical simulations. It was a great performance, showing an average annual return of over twenty percent without a single calendar year of investment losses since 1998.

Second, they solicited investors to two funds by promising that GMB would use Gabriel’s optimal pricing models to trade liquid securities such as ETF.  But those funds were actually invested almost entirely in other hedge funds and funds of funds.

Third, in May 2008, Gabriel and Marco divided GMB’s business. Marco started advising the hedge funds under a new entity, GMB Capital Partners LLC, and Gabriel managed the other clients through GMB Management. Although Gabriel had no involvement in the GMB Partners’ hedge funds, GMB Partners and they continued to tell potential investors that they were managed by Gabriel.

When the SEC’s Boston Regional Office examined GMB Management and they provided a document that supposedly was a contemporaneous record of Gabriel’s trades since 1998. They provided this document in response to the exam staff’s request for books and records that supported GMB Management’s claims in its marketing material of a successful track record since 1998. In fact, the document was not true or accurate and was created solely for the purpose of responding to the staff’s books and records request.

Using hypothetical backtested performance is not inherently false and misleading, but it is highly suspect. It’s all too easy to continually tweak the formulas as market conditions evolve in the present day to meet your needs.

It turns out that one of GMB’s funds has a significant interest in funds that had invested in the Petters Group Worldwide and Bernard L. Madoff Investment Securities LLC.

The Bitrans released this statement:

“The Bitrans invested the vast majority of their (and their family’s) net worth in the GMB funds, alongside other investors, and had great confidence in GMB’s quantitative models. To be sure, 2008 was a difficult year for the markets and for the investment industry as a whole. That aside, the majority of GMB’s funds and managed accounts either made money for investors, or significantly outperformed the S&P 500 over their operating lifetime. This strong relative performance was delivered during one of the most challenging market environments of the last several decades. The Bitrans are pleased to have reached a settlement with the SEC, on these issues which date back several years, and to put this matter behind them.”

Gabriel Bitran’s optimal pricing model is the basis for airline prices and their constant fluctuations. Bitran’s models estimate optimal pricing by assessing the factors that create demand and make supply available in the marketplace. The parallel in the financial markets is willingness to pay. Bitran’s models focuses on the value market participants place on securities at different points in time. Based on this data, they theoretically can anticipate capital flows into various markets and instruments.

This is another one of the cases that makes me scratch my head and wonder how a smart, reasonable person could make such mistakes. Clearly, the full background and key facts are missing from the news stories and SEC order. Some could be simple footfaults or a failure to under stand regulatory requirements. A few of the statements indicate more overt action that seems wrong. Given that the Bitrans are likely subject to other claims, it’s unlikely we will ever learn what lead them down the dark corridors of fraud and deceit.

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SEC Seeks Public Comment Prior to Jobs Act Rulemaking

In an unusual move, the SEC has opened up for comments on the proposed rules under the recently-signed Jumpstart Our Business Startups Act, before it has proposed the rules.

The SEC is generally required by law to establish a public comment period at the time it proposes rules or rule amendments. However, similar to the Commission’s action with the Dodd-Frank Act, the public will have an opportunity to voice its views before rules or amendments are proposed under the JOBS Act. The public also will be able to see what others are saying to the agency about these issues.

To facilitate public comment, the SEC is providing a series of links on its website organized by titles of the JOBS Act. Those links are replicated below.

See also: Jumpstart Our Business Startups Act updates from the SEC

SEC Sweep Letter for Private Equity Funds

The San Francisco Office of the SEC has an informal inquiry into the valuations of private equity funds. IA Watch has received a copy of the sweep letter from the Division of Enforcement directed to a private equity fund manager.

Some highlights in the request:

  • All formation and offering documents for the fund, including private placement memoranda, limited partnership agreements, and operating agreements
  • List of investors and capital commitments
  • List of all investments, realized amount, and gross IRR
  • All communications with investors regarding fund performance
  • Support for valuations of the fund assets for the most recent fiscal year

It seems to be a fairly short list for an SEC document request. But any SEC document request is intimidating.

The request shouldn’t be construed as indication that there has been a violation of the federal securities law. It’s indication that the SEC is continuing to look for funds and managers that manipulated valuations.

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What the SEC Wants Next Year

It is time once again for the Securities and Exchange Commission to sing for its supper. Even though it’s an independent agency, supposedly insulating it from political pressure, it still needs to go back to Congress each year to get funding. The budget request for FY 2013 totals $1.566 billion, an increase of $245 million (19 percent) over the agency’s FY 2012 appropriation.

The SEC included several performance goals that caught my attention.

  • Percentage of firms receiving deficiency letters that take corrective action in response to all exam findings. The SEC has a goal of 93%. I still find that number shockingly low. If the regulator says you’re doing something wrong, I would expect that number to be closer to 100%.
  • Percentage of attendees at the Compliance Outreach program that rated the program as “Useful” or “Extremely Useful” in their compliance efforts. For FY 2011 the target was 80% and the actual was 86%. Apparently positive responses in SEC program evaluations could increase SEC funding.
  • Percentage of investment advisers, investment companies, and broker-dealers examined during the year. For FY 2011 the plan was to examine 11%, but the SEC only achieved 8%. The FY 2012 is 9% and the 2013 estimate is 11%.  There is a separate goal for high risk advisers, but measures have not been in place for a few years.
  • Percentage of exams that identify deficiencies, and the percentage that result in a “significant finding” This one leaves me nervous as a goal. It’s hard to parse the indicator because it covers all SEC examination, not just investment advisers. The Actual number for FY 2011 was 82% with 42% having a significant finding.  I hate to see enforcement target and deficiency targets.
  • Average Cost of Capital.  Here is a metric I would like to learn more about. The SEC states that FY 2010 was 10.99% and FY 2011 was 10.67%. Frankly, I have no idea what those percentage mean.
  • Survey on whether SEC rules and regulations are clearly understandable.  This a great goal. Unfortunately, the measure has no data, no data source and no goal.

From the SEC examination side, the Office of Compliance Inspections and Examinations is looking to add an additional 65 positions to the exam staff to “address the disparity between the number of exam staff and the growing number and complexity of registered firms; and more effectively risk target, monitor, and examine market participants.”

The Division of Investment Management is requesting 40 additional positions, largely to focus on the “major milestone” when private fund advisers begin to file systemic risk information with the SEC on Form PF in late FY 2012.

Now it’s up to Congress to decide how mush to put in the SEC’s kitty. Anyone willing to bet that the SEC gets most of what it asks for? No, I didn’t think so.

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Rudy – Securities Fraud

Who cares how much effort I put in, if it doesn’t produce any results.

In a sad turn of event, Daniel “Rudy” Ruettinger was charged by the SEC with securities fraud. Ruettiger and 10 of the scheme’s other participants have agreed to settle the SEC’s charges without admitting or denying the allegations. (I guess they can still do that if you’re not in front of Judge Rakoff.)

I guess he thought his effort was better spent pumping up the stock of the penny-stock company that ran his sport drink company. I guess I have to cross Rudy off the list of inspirational sports movies to show my kids.

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Three Compliance Failures

One for the money, two for the show, three because uh – uh, comes before four, and here we go!

 – Tigger

On Monday, the Securities and Exchange Commission announced not one, not two, but three actions against investment advisers for failing to put in place compliance procedures designed to prevent securities law violations. The firms charged with compliance failures in separate cases are Utah-based OMNI Investment Advisors Inc., Minneapolis-based Feltl & Company Inc., and Troy, Mich.-based Asset Advisors LLC. The SEC also charged OMNI’s owner Gary R. Beynon, who served as the firm’s chief compliance officer.

Under Rule 206(4)-7 of the Investment Advisers Act (the “Compliance Rule”) registered investment advisers are required to adopt and implement written policies and procedures that are reasonably designed to prevent, detect, and correct securities law violations. The Compliance Rule requires annual review of the policies and procedures for their adequacy and the effectiveness of their implementation. It also requires the designation of a chief compliance officer, responsible for administering the policies and procedures.

In the case of Asset Advisors, the SEC had previously warned the firm about compliance deficiencies. In 2007, the SEC examined Asset Advisors and issued a deficiency letter. The firm waited until November 2009 to update the compliance manual to incorporated the SEC comments. That happened to coincide with an announcement that the SEC was coming for another examination. The failings:

  • The firm did not collect from its staff written acknowledgements that the staff received the code of ethics.
  • The firm did not collect any quarterly transaction reports from any of its access persons.
  • The firm did not pre-clear any of its access person’s transactions in initial public offerings or limited offerings.
  • The firm failed to at least annually review its written policies and procedures and the effectiveness of their implementation.

Asset Advisors received the nuclear punishment. The SEC required the firm to close operations and transfer its advisory accounts to another SEC-registered investment adviser with a compliance program.

Feltl & Company was a dually-registered broker-dealer and investment adviser. The SEC charged the firm with failing to adopt and implement comprehensive written compliance policies and procedures. This failure resulted in Feltl engaging in hundreds of principal transactions with its advisory clients’ accounts without making the proper disclosures and obtaining consent in violation of Section 206(3) of the Advisers Act. It also resulted in Feltl charging undisclosed fees to its clients participating in Feltl’s wrap fee program by charging both wrap fees and commissions in violation of Section 206(2) of the Advisers Act. The SEC laid the blame for Feltl’s compliance breakdown on its failure to invest necessary resources in the firm’s advisory business as it changed and grew in relation to its brokerage business.

OMNI’s was penalized for a complete failure to adopt and implement a compliance program between September 2008 and August 2011. In 2007, the SEC examined OMNI and issued a deficiency letter noting several issues, including OMNI’s failure to conduct an adequate annual review of its compliance program. In November 2010, the Commission began another examination of OMNI. When the exam began, the Commission was provided with a Compliance Manual dated November 3, 2010, which was one day after OMNI responded to the examiners’ request to initiate an examination. OMNI was unable to provide the Commission with any compliance manual adopted and implemented prior to November 3, 2010. Additionally, OMNI was unable to provide any policies and procedures that would have been in effect prior to November 3, 2010. The November 3, 2010 Compliance Manual appeared to be an off-the-shelf compliance manual that included language from both broker-dealer and investment adviser regulations, and was not specifically tailored to OMNI’s business.

OMNI was owned by Gary Beynon who also served in the role of CCO after the previous CCO left in 2008. The big problem with OMNI was that Beynon left for a three-year religious mission to Brazil in 2008, leaving OMNI’s advisory representatives completely unsupervised. He wanted to keep the firm in business while he was away so he could return to the firm when his religious mission ended.

The SEC expects more when you are responsible for other people’s money.

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SEC Says it is Bringing Charges Against Wall Street

You’ve probably heard the charges made by politicians and activists that the Securities and Exchange Commission is ineffective and not bringing charges against those who caused the 2008 financial crisis.

“YOU’RE WRONG!” says the SEC.

The SEC has begun publishing “Enforcement Actions Addressing Misconduct That Led to or Arose From the Financial Crisis.”

Key Statistics (through Oct. 19, 2011)

Number of Entities and Individuals Charged 81
Number of CEOs, CFOs, and Other Senior Corporate Officers Charged 39
Number of Individuals Who Have Received Officer and Director bars, Industry Bars, or Commission Suspensions 24
Penalties Ordered > $1.2 billion
Disgorgement and Prejudgment Interest Ordered > $393 million
Additional Monetary Relief Obtained for Harmed Investors $355 million*
Total Penalties, Disgorgement, and Other Monetary Relief $1.97 billion

* In settlements with Evergreen, J.P. Morgan, State Street, and TD Ameritrade

In the prism of the enormous losses of  the 2008 financial crisis this may not seem by much. I think most people, though rightly upset, will have a hard time finding criminal conduct among those activities subject to the jurisdiction of the SEC. Sure, the proliferation of CDOs in 2007 can be seen as suspect. But criminal?

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The SEC and Rating Agencies

The SEC examined all 10 firms registered Nationally Recognized Statistical Rating Organization (.pdf 23 pages) and found all 10 had “apparent failures”. The SEC has requested remediation plans from each of the agencies within 30 days and is continuing its investigation.

The issues found included “apparent failures in some instances to follow ratings methodologies and procedures, to make timely and accurate disclosures, to establish effective internal control structures for the rating process and to adequately manage conflicts of interest.”

Personally, I think the rating agencies have not gotten enough of the blame for their roles in the events leading up to the 2008 financial crisis. Without the golden top rating they issued to the toxic mortgage-backed securities,  I think the popping of the housing bubble would not have been so vicious.

In 2006, the Credit Rating Agency Reform Act granted the authority to establish a registration and oversight program for credit rating agencies to the SEC and gave them oversight over those credit rating agencies that register with the Commission as Nationally Recognized Statistical Rating Organizations (“NRSROs”). However, it expressly prohibits the SEC from regulating the substance of credit ratings or the procedures and methodologies by which an NRSRO determines credit ratings.

The Dodd-Frank Wall Street Reform and Consumer Protection Act enhanced the regulation and oversight by imposing new reporting, disclosure, and examination requirements. The new law also requires the SEC to conduct an examination of each NRSRO at least annually.  The 2011 Summary Report of t Commission’s Staff Examinations of Each Nationally Recognized Statistical Rating Organization (.pdf 23 pages) is the first to look at the ten under the new framework.

  1. A.M. Best Company, Inc.
  2. DBRS Inc.
  3. Egan-Jones Rating Company
  4. Fitch, Inc.
  5. Japan Credit Rating Agency, Ltd.
  6. Kroll Bond Rating Agency
  7. Moody’s Investors Service, Inc.
  8. Morningstar Credit Ratings, LLC
  9. Rating and Investment Information, Inc.
  10. Standard & Poor’s Ratings Services

The SEC did not determine that any finding discussed in this Report constitutes a “material regulatory deficiency”. That would have meant a referral to the Division of Enforcement and gotten more lawyers involved. The SEC does not single out by name any credit-rating agency for questionable actions in the report, but it does describe specific problems it found.

It will be interesting to see what happens next year. As most compliance people know, the failure to fix a problem pointed out by the SEC is likely to lead to trouble the next time they show up.

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Nationally Recognized Statistical Rating Organization (.pdf 23 pages)