The Family Office Exemption under the Investment Advisers Act

The Dodd-Frank Wall Street Reform and Consumer Protection Act wiped out the exemption enjoyed by most private funds. I’m still waiting to see how the SEC will define a “venture capital fund manager.” In the meantime, the SEC has published its proposed rule defining a “family office” and its exemption from registration under the Investment Advisers Act.

Historically, family offices have not been required to register with the SEC under the Advisers Act because of the same exemption used by private funds. The Dodd-Frank Act removed that “small adviser” exemption under section 203(b)(3) to enable the SEC to regulate hedge fund and other private fund advisers, but includes a new provision requiring the SEC to define family offices in order to exempt them from regulation under the Advisers Act.

“Family offices” are established by wealthy families to manage their wealth and provide other services to family members. That leaves the fabulously wealthy time to go yachting and leaves others to manage their securities portfolios, plan for taxes, worry about accounting services, and to directing charitable giving. The issue is the the family office management of securities.

In the past, the SEC has issued dozens of exemptive orders for family offices who requested them, removing them from the registration and supervision of the SEC. The proposed rule 202(a)(11)(G)-1 would largely codify the exemptive orders. Most of the conditions of the proposed rule are designed to restrict the structure and operation of a family office relying on the exemption to activities unlikely to involve commercial advisory activities, while still allowing family office activities involving charities, tax planning, and pooled investing.

(b) Family office. A family office is a company (including its directors, partners, trustees, and employees acting within the scope of their position or employment) that:

(1) Has no clients other than family clients; provided that if a person that is not a family client becomes a client of the family office as a result of the death of a family member or key employee or other involuntary transfer from a family member or key employee, that person shall be deemed to be a family client for purposes of this section 275.202(a)(11)(G)-1 for four months following the transfer of assets resulting from the involuntary event;

(2) Is wholly owned and controlled (directly or indirectly) by family members; and

(3) Does not hold itself out to the public as an investment adviser.

The key is how the SEC defines a family member:

(d) (3) Family member means:

(i) the founders, their lineal descendants (including by adoption and stepchildren), and such lineal descendants’ spouses or spousal equivalents;

(ii) the parents of the founders; and

(iii) the siblings of the founders and such siblings’ spouses or spousal equivalents and their lineal descendants (including by adoption and stepchildren) and such lineal descendants’ spouses or spousal equivalents.

I guess that some family offices will be cutting off some distant relations to get under this definition. For “less-beloved” family members, the family office management can use SEC regulation as an excuse to kick them out.  Of course, they can still seek and exemptive order from the SEC if they don’t fit under this definition.

The comments should involve a whole new area for the SEC: family law.

As I expected, this exemption is of no value to private funds look for a safe harbor from SEC registration.

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Rosand Enterprises and Real Estate Fraud

I find looking at fraud cases instructive, seeing common themes, failures and techniques. Since my company is in real estate, real estate fraud catches my eye. Recently the SEC brought a case against Rosand Enterprises and one of its principals, Robert A. Anderson.

The Securities and Exchange Commission came in late. The Illinois Secretary of State had already filed an order against Rosand Enterprises, Rossetti and Anderson.

In the Illinois order, they alleged that the enterprise had solicited investors to loan them $2.735 million, with repayment at 15% per month for a six-month note or 20% for a twelve-month note.

The SEC found a broader network of $12 million solicited from 77 investors. (I wonder why the SEC did not include Mr. Rossetti their complaint.) The US Attorney also got involved and announce criminal charges.

Let’s look at some of the red flags.

Extremely high returns should be a big warning. Rosand was offering returns of 15% or 20% per month on loan payments. If the business is that profitable, why bother getting outside collateral. They are doubling their money every six months.

The money was guaranteed. Risk equates to reward. If money is in a safe investment, you should only get a small return. If there is a high rate of return then the investment is going to be risky. Any promised returns above 10% per year should immediately be suspect.

They were offering the notes to non-accredited investors. If you make less than $200,000 per year or have a net worth of less than $1 million you are non an accredited investor. That means you are not generally able to purchase unregistered securities like the notes offered by Rosand.

One aspect of real estate is that ownership is part of the public record. Anyone can walk into the registry of deeds and see who owns a piece of property and who they bought it from. In most places, you can also see the price paid.  If Rosand was buying and rehabilitating houses, a potential investor could easily look up the information in the land records.

The Cook County Registry of Deeds is online. I ran a quick grantor/grantee search on “rosand.” No surprise, Rosand Enterprises has not bought or sold any real estate in the past 15 years.

Like most Ponzi schemes, eventually you will run out ways to get new money in the door to cover the money going out. Rosand stopped making payment in June 2008. Two years later, the State of Illinois and the SEC stepped in to protect investors.

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The Corruption of Scott Rothstein

In Miles Away… Worlds Apart, Alan Sakowitz tells the story of the biggest financial fraud in South Florida history, from his unique perspective of a whistleblower. Throughout the book Sakowitz compares his close-knit neighborhood to the Scott Rothstein’s greed.

Sakowitz takes us through the narrative of the events leading to the arrest of Scott Rothstein. He was contacted through a broker to invest in structured settlements offered by Rothstein. The investment was to but a stream of payments from an employment dispute and deliver a lump sum payment to Rothstein’s client.

Conversion of structured settlements is completely legitimate, but usually subject to regulation and judicial oversight. A victim may prefer a big lump sum instead of installment payments made over time. Certainly, the capital source in the middle is going to want some reward for exchanging cash today for future payments.

Rothstein was offering a huge reward for investors willing to be the capital source. In one example he was offering a $900,000 settlement, payable over three months for an investment of $660,000. Why would any plaintiff be willing to take $660,000 today when they could have the entire $900,000 at the end of 90 days?

For an investor, that is an incredible return. Even more incredible given the assurances from Rothstein that payments are guaranteed. Sakowitz found the returns and Rothstein’s showmanship to be intoxicating, but was suspicious. The intoxication was enough for Sakowitz to have three meetings with Rothstein.

When asked about volume, Rothstein said he was settling 3,000 cases per year, all without actually filing a lawsuit. The smallest of his payouts was $500,000. When asked to speak to the attorneys handling the cases, Rothstein claimed he was personally handling all of the cases.

The biggest red flag for me was Rothstein acting as a seller of the settlements and the attorney for plaintiffs at the same time. There is a terrible conflict between trying to get the best financial deal for his clients at the same time he is trying to offer an enticing return for “investors.” A real attorney would have advised his clients to get a better deal in structuring a settlement.

With all the red flags, it’s easy to see why someone would think that the investment was a fraud and not get involved. It’s a bigger step to call the authorities and make the assertion. Even being 90% sure that it was fraud, that leaves a 10% chance that you’re wrongly accusing an innocent man, damaging both of your reputations.

Why did Sakowitz call the FBI? He tells interleaves stories from his close-knit community telling stories of charity and self-sacrifice for the benefit of others. He writes about his parents as role models and wanting to set a fine example for others.

Rothstein’s walls were plastered with hundreds of awards and plaques from charitable causes, plus photos of Scott with the governor of Florida, the Broward County Sheriff, the Fort Lauderdale chief of police, other politicians, famous athletes and entertainers. Given Rothstein’s connection to the political establishment, the predicament becomes who do you call to tell you found the fraud. The Fort Lauderdale Police Department would be a bad a choice. It turns out that when Rothstein fled the country, he had a police escort to his plane from a lieutenant in the FLPD. After eliminating all of the other government organizations appearing on Rothstein’s wall of shake-n-smile, he turned to the FBI. I found it interesting to hear how Sakowitz felt a sense a relief after making the call.

I was drawn to the story for a few reasons. Sakowitz runs Pointe Development Company, a real estate company. Like me, he is an attorney by training, working in the real estate industry. As a compliance professional, I am fascinated by the mechanics of fraud and Ponzi schemes. Sakowitz was kind enough to send me a copy of the book to review.

Although the book provided great information and perspective on the Rothstein fraud, I was hoping for more. Sakowitz provides plenty of information about his own background to show why he turned in Rothstein. He does not provide equivalent information to show how Rothstein went bad.

Most people do not wake up one morning and decide to perpetrate a fraud on his clients, friends, business partners and anyone who walks through his office door. Clearly greed was a factor. He must have seen an opportunity to sell a settlement for his own benefit. It’s not clear that Rothstein felt the pressure to be a mover and a shaker or what the pressure was that made him initially step over the line. Clearly his extravagant lifestyle created the pressure to keep the scheme going. We certainly could guess at the rationalization Rothstein used to justify his crimes. Perhaps he thought he was supporting the political system, endowing charities and creating jobs.

I would have liked to read more about Sakowitz’s thought process in deciding to report Rothstein to the authorities. Walking away is easy when you suspect a fraud. You merely risk passing on an investment. Reporting a fraud does put you at risk. If you’re wrong, you risk the personal and professional repercussions.  If you accuse a person like Rothstein, who showed off a gun strapped to his ankle, you risk physical harm.

In the end, Rothstein was an evil man, blatantly stealing money. Sakowitz was a good man, who saw through the greed, and took the extra step to try and stop the evil man. That alone is makes a compelling story.

Enjoy Columbus Day

Replicas of the Pinta, Santa Maria, Nina, lying in the North River, New York. The caravels which crossed from Spain to be present at the World's Fair at Chicago.

I’m enjoying Columbus Day. School is closed and the office is closed.

The Chicago World’s Fair in 1893 celebrated the 400th anniversary of Christopher Columbus’s arrival in the New World in 1492.

The Nina, the Pinta, and the Santa Maria Come to the World’s Columbian Exposition

During the fair, replicas of the Nina, the Pinta, and the Santa Maria were moored in the south lagoon of Jackson Park.

William Curtis, an official with the U.S. State Department in Spain, had proposed the idea of building replicas of Columbus’s caravels. A commission was established in Spain to build the ships and sail them to Chicago, site of the World Columbian Exposition marking the 400th anniversary of Columbus’ voyage.

Building the Santa Maria went smoothly, but the construction on the Nina and the Pinta which Americans in Spain were building, went more slowly. Instead of building new ships, the builders used the hulls of two rotting ships for the replicas of the Nina and Pinta.

The Santa Maria was finished and sea worthy by July 1892, but officials ruled that the Nina and the Pinta were not sea worthy. The Santa Maria sailed for Puerto Rico under its own steam, while two United States Navy ships towed the Nina and Pinta from Spain. All three of the replica ships were towed through the St. Lawrence River and the Great Lakes to Chicago.

After the fair, the three ships were turned over to the City of Chicago. Tourists still came to see and tour them, but the city of Chicago didn’t maintain them. The city of Chicago decided to use them in the ceremonies for the opening of the Panama Canal, sailing them from Chicago to the new Panama Canal.

The three ships ran into rough seas on Lake Michigan. The Nina and the Pinta managed to reach the shores of Lake Erie, where they had to be beached and eventually towed back to Chicago. The Santa Maria struggled on to Boston.

The idea then became to show of the ship at ports along the East Coast. But the crowds did not come.

The Pinta sank at its moorings and in 1919. The Nina caught fire and sank. In 1920, the Santa Maria was rebuilt and drew tourists until 1951, when it, too, burned.

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Compliance Bits and Pieces for October 8

Here are some interesting compliance related stories that I’ve run into recently:

Birthday Parties Not Enough to Support Inference of Discrimination; Shifting Reasons for Termination Get Case to Jury Though by Dan Schwartz in the Connecticut Employment Law Blog

First, beware the birthday parties. They may be good morale boosters but some people may find them distasteful. In any event, keep the age-related jokes to a minimum.

Explaining the AIG Exit by Felix Salmon in Reuters

There’s now an end in sight to a huge and enormously complex corporate restructuring, of an entity — AIG — which was too big to fail, too big to manage, and which had an enormous black hole at its heart known as AIG Financial Products. Today, AIG is set to emerge as a viable entity roughly half its former size, small enough to fail, with the black hole gone. That’s not only a substantial achievement; it’s also a good proof of concept when it comes to the FDIC’s new resolution authority.

This Week in Social Media & Employment Law: Facebook Privacy Settings, Stored Communications Act, Social Media Policies by Daniel Schwartz in the Connecticut Media and Employment Law Blog

As social media continues to dominate the world — or at least conversations about employment law — there are a few notable posts that are worth delving into this week that explore the topic further.

Image is courtesy of Cake Wrecks

Save Your Company, Save Yourself

What happens when you have a business disaster on your resume? Maybe listing an Enron or WorldCom would not be so bad. Those companies are big enough that you may not be tainted by the corporate fraud. Unless you ended up in handcuffs.

As the company gets smaller, you’re more likely to get caught in the stink of corporate fraud. That gets even worse when you share the last name on the door.

The Wall Street Journal highlighted the lack of future job prospects with former Madoff employees: Not Exactly a Résumé Highlight: Madoff Work

The story focuses on the Madoff sons, Mark and Andrew, who are labeled as being “untouchable in any firm that deals with the public.” I am not surprised that they are unemployable. Would you hire a Madoff?

But the scar of the fraud falls farther down the corporate ladder. Eleanor Squillari, Bernard Madoff’s former assistant, has moved on to cosmetology. She knows she’ll “never get a job in finance.”

The trading business, which was not implicated in the Madoff fraud and was purchased by Surge Trading, Inc., has the challenge of convincing clients to do business with former Madoff employees.

I suppose the upside is that company schwag could turn into collector’s items.

Real Estate, China and the FCPA

China is hotbed for violations of the Foreign Corrupt Practices Act. The real estate industry is not immune from the dangers. In February of 2009 Morgan Stanley’s real estate group reported an employee based in China in an overseas real estate subsidiary that appeared to have violated the Foreign Corrupt Practices Act.

My company has significant business relationships with CB Richard Ellis so it saddens me that they are the latest to report a problem under the FCPA.

As a result of an internal investigation that began in the first quarter of 2010, the Company determined that some of its employees in certain of its offices in China made payments in violation of Company policy to local governmental officials, including payments for non-business entertainment and in the form of gifts. The payments the Company discovered are minor in amount and the Company believes relate to only a few discrete transactions involving immaterial revenues. Nonetheless, the Company believes that the payments may have been in violation of the U.S. Foreign Corrupt Practices Act or other applicable laws. Consequently, the Company voluntarily disclosed these events to the U.S. Department of Justice (the “DOJ”) and the Securities and Exchange Commission (the “SEC”) on February 27, 2010 and has continued to cooperate with both the DOJ and the SEC in connection with this investigation. The Company engaged outside counsel to investigate these events and has implemented thorough remedial measures.

In addition, in the third quarter of 2010, the Company began another internal investigation, with the assistance of outside counsel, involving the use of a third party agent in connection with a purchase in 2008 of an investment property in China for one of the funds the Company manages through its Global Investment Management business. This investigation is ongoing and at this point the Company is unable to predict the duration, scope or results thereof. In light of the Company’s cooperation with the DOJ and the SEC as described above, the Company voluntarily notified both agencies of this separate internal investigation and will report back to them when the Company has more information.

The real estate industry should be just as concerned about bribery of foreign officials as any other industry. Perhaps even more so. Real estate is inherently local and you undoubtedly need to deal with government officials to get building permits, occupancy permits, zoning approvals and a myriad of other interactions.

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Revoking a Subscription Agreement

Private equity funds investors sign a subscription agreement, promising to deliver cash when the fund makes a capital call. In a recent Delaware case, investors sought to revoke their subscription agreements and recover their capital contribution. They were investors in a Lehman Brothers sponsored investment fund.

In 2007 the three plaintiffs became limited partners in Lehman Brothers Merchant Banking Partners IV L.P. After Lehman declared bankruptcy, the the Fund’s management team bought out Lehman, took over the Fund’s general partner and investment advisor, and changed the Fund’s name to Trilantic Capital Partners IV, L.P.

Among the other investors in the fund was Lehman Brothers itself. The company had made a $250 million capital commitment. The fund itself was not part of the Lehman bankruptcy estate, but the general partner’s interest, the investment advisor and the $250 capital commitment were involved.

The plaintiffs told the fund they would not make any capital calls after they heard of the Lehman bankruptcy. That was probably a sensible position to take initially.

But the fund emerged from the Lehman bankruptcy proceedings. The existing fund management team would stay in place. A third party capital source funded their purchase of Lehman’s general partner interest and investment adviser. The investor also agreed to assume the unfunded and uncommitted portion of the Lehman’s capital commitment. The management team offered all the limited partners a chance to reduce their capital commitments. Ultimately, the fund reduced in size from $3.3 billion to $2.6 billion.

These three plaintiffs sought a rescission based on three counts: supervening frustration, mutual mistake and violations of the Texas Securities Act.

Supervening frustration

“The doctrine of supervening frustration can be invoked ‘[w]here, after a contract is made, a party’s principal purpose is substantially frustrated without his fault by the occurrence of an event the non-occurrence of which was a basic assumption on which the contract was made.’ … The doctrine does not apply if the supervening events were “reasonably foreseeable, and could (and should) have been anticipated by the parties” at the time of contracting.”

The limited partnership agreement contemplated that Lehman might transfer its general partnership interest and the fund would continue to operate. The LP Agreement also contemplated the potential bankruptcy of Lehman.

This claim did not even come close to working.

Mutual mistake

“Under this doctrine, a party can rescind an agreement if (i) both parties were mistaken as to a basic assumption underlying the agreement; (ii) the mistake materially affects the agreed-upon exchange of performances; and (iii) the party adversely affected did not assume the risk of the mistake.”

The plaintiffs claimed they were mistaken about Lehman’s financial condition and the continued presence of Lehman was one of their basic assumptions. The LP agreement contemplated the removal of Lehman. The private placement memorandum made not representations about Lehman’s financial health. The subscription agreement stated that the investors were not relying on any other representations.

This claim did not even come close to working.

Texas Securities Act

“This statute prohibits the soliciting of an investment ‘by means of an untrue statement of a material fact or an omission to state a material fact necessary in order to make the statements made, in the light of the circumstances in which they are made, not misleading.’”

The plaintiffs claimed that Lehman failed to disclose its financial instability. Given this instability, its unlikely Lehman could continue its sponsorship of the fund.

But the false statements were in Lehman’s public filings, not the fund documents. They failed to show that the subscription agreement, the limited partnership agreement or the PPM contained any representation about Lehman’s financial health. They merely pointed to general statements in the PPM about how the fund would benefit in the future from its affiliation with Lehman.

The plaintiffs also failed to allege that the fund knew its representations about Lehman were “false when made.” It failed the scienter requirement under the Texas Securities Act.

It’s tough for a fund to get in a fight with its investors. Here, it was the investors who filed suit. it was probably sensible to resist making capital calls when Lehman filed bankruptcy. Once the fund survived and was spun out with the existing management team, the investors should have re-thought their position.

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Embarrassment from the American Bar Association

As the head of compliance, I frequently call on a team of lawyers for advice on how to interpret the law and move that interpretation into implementation. As a consumer of legal services, I have an interest in innovation and improvements in the delivery of those services. As an former practicing lawyer, I understand the challenges.

The American Bar Association ran a  Legal Rebels contest on the theme of “What innovation will be most valuable to you in your future practice as a solo practitioner?”

I don’t deal with solo practitioners very often for legal advice, even though they represent a big portion of legal practice. Having left a big law for compliance, I’m now more like a solo practitioner (without having to look for clients.)

I was interested to hear what innovations the ABA found interesting. The crop of runners-up was a mixed bag. With some interesting thoughts and some mere statements that technology alone will be innovative.

I was hoping the winner would offer something new and interesting about improving the delivery of legal services, legal skills or the delivery of client service.

The winner thinks a fancy answer machine will be the most valuable innovation: Solo Dreams of Full-Functioning Digital Messaging Assistant.

Kevin O’Keefe and Scott Greenfield already expressed their dismay. I think this one of the worst things to come out of American Bar Association. I don’t see how this would help the lawyer. I don’t see how this helps you be a better lawyer or deliver better client service.

For the most part, lawyers are dealing with their clients at a critical time in their lives: divorce, imprisonment, merger, bankruptcy, internal investigation, etc. A personalized greeting from a robot on the phone is not going to make me think any better of the lawyer.

For me, simple questions can be answered by email. More complicated issues and more problematic issues require a real person. Do you feel better about a service provider because you can handle transactions through voicemail?

Parts of the lawyers day can be handled by technology, but personal interaction between the lawyer and the client cannot.

Maybe the ABA should just stick with selling skateboards.

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Compliance Bits and Pieces for October 1

Here are some recent compliance-related stories that I found interesting:

The face of the financial crisis by Larry Ribstein in the Creative Destroyer

We need somebody we can send off to jail. Jail apparently provides the moral clarity necessary to wrap up a financial crisis. Bernie Madoff’s just an old-fashioned fraud from another era. The Justice Department has sent almost 3,000 people to jail for financial fraud between October, 2009 and June 2010, but no faces.

House Passes Impotent Debarment Bill by Mike Koehler in FCPA Professor

On September 15th, the House, by a unanimous 409-0 vote, passed H.R. 5366 (“Overseas Contractor Reform Act”) (see here). The Act generally provides that a corporation “found to be in violation of the [FCPA’s anti-bribery provisions] shall be proposed for debarment from any contract or grant awarded by the Federal Government within 30 days after a final judgment of such a violation.” The Act’s key trigger term for debarment – “found to be in violation” of the FCPA’s anti-bribery provisions – is a trigger that is not reached in nearly every FCPA enforcement action because of the façade of FCPA enforcement. Thus, the Act represents impotent legislation.

Small Change – Why the revolution will not be tweeted by Malcolm Gladwell in the New Yorker

Innovators tend to be solipsists. They often want to cram every stray fact and experience into their new model. As the historian Robert Darnton has written, “The marvels of communication technology in the present have produced a false consciousness about the past—even a sense that communication has no history, or had nothing of importance to consider before the days of television and the Internet.” But there is something else at work here, in the outsized enthusiasm for social media. Fifty years after one of the most extraordinary episodes of social upheaval in American history, we seem to have forgotten what activism is.

After Dodd-Frank, SEC Getting At Least One FCPA Tip A Day in WSJ.com’s Corruption Currents

The Securities and Exchange Commission has been receiving at least one tip a day about potential foreign bribery violations since a whistleblower bounty program became law in July, according to a person familiar with the matter.

A Tale of Two Strategies for SOX Compliance by Matt Kelly in Compliance Week‘s the Big Picture

Only that elite group can manage the responsibility of working with public investors—people so far removed from the corporation itself, that they have no choice but to trust in the accuracy of financial statements. SOX is one measure this country uses to determine which corporations belong in that group, and which don’t. Alloy Steel and Facebook both said today that they don’t, and they deserve praise for it. This is how the system is supposed to work.

Image of Bits & Pieces is By Thunderchild7.