Private Equity and the Custody Rule

With the impending removal of the 15 Client Rule exemption from registration with the SEC, I was scratching my head trying to figure how to make the SEC’s new custody rule work for private equity.

The SEC recently updated its guidance on custody rule compliance truing to add clarity for advisers to pooled investment vehicles.

Here is one:

Question II.3

Q: If an adviser manages client assets that are not funds or securities, does the amended custody rule require the adviser to maintain these assets with a qualified custodian?

A: No. Rule 206(4)-2 applies only to clients’ funds and securities. (Posted 2003.)

Actually that does not help. A private equity fund will hold interests in private companies. Those interests may be stock, LLC interests or partnership interests.  Just because the company is private, those interests may still be securities.

For real estate private equity, the deeds to the underlying property would fall outside the custody rule. The intermediate entities, REITs and joint ventures may not fall outside the custody rule.

§ 275.206(4)-2(b)(2) has an exemption for certain privately offered securities, if the securities are:

(A) Acquired from the issuer in a transaction or chain of transactions not involving any public offering;
(B) Uncertificated, and ownership thereof is recorded only on the books of the issuer or its transfer agent in the name of the client;
and
(C) Transferable only with prior consent of the issuer or holders of the outstanding securities of the issuer.

This exemption is available only if the fund is audited, and the audited financial statements are distributed, as described in paragraph (b)(4) of this section.

The “uncertificated” requirement can be a problem. It is common practice for lenders relying on private company interests to require they be certificated to get better priority under the UCC.

The limits on transfer are a problem because as the holder of the interests, you want the flexibility to transfer interests.

The financial statements requirement is another extra burden, although may not be a problem for many funds. This requires:

  • annual audit
  • in accordance with GAAP
  • within 120 days of the end of the fiscal year
  • independent accountant registered and subject to inspection by PCAOB

(I’m not sure how quickly the SEC can change this rule if the Supreme Court rules PCAOB unconstitutional.)

In looking towards Capitol Hill, the Senate’s would exempt private equity firms from having to comply with the custody rule since they would not have to register. The House’s would not exempt private equity firms from registration and they would be subject to the custody rule.

One interesting aspect of the bills is that fund advisers that are currently registered because they have more than 15 clients/funds may no longer have to be registered if they fall under the venture capital fund advisers exemption or private equity fund advisers exemption. (Assuming those exemptions survive in the final bill.)

Sources:

Image of Old West Bank – It’s a beautiful bank is by oddsock

Ernst & Young’s 11th Global Fraud Survey

Driving ethical growth – new markets, new challenges, the title of  Ernst & Young’s 11th Global Fraud Survey, shows fraud is up; audit and legal are stretched to deal with these challenges; compliance is patchy; and Boards need more and better information to manage the risks.

They interviewed more than 1,400 chief financial officers, and heads of legal, compliance and internal audit in 36 countries to get their views on how companies are managing the risks associated with fraud, bribery and corruption.

The survey was conducted in 2009 and 2010 on behalf of Ernst & Young’s Fraud Investigation & Dispute Services practice.

Consistent with the experience of past recessions, companies have been struggling with an upsurge in fraud and corruption. Almost one in six of our respondents have experienced a significant fraud in the past two years.

Compliance is New

Compliance is still a developing area outside of the highly regulated industries, such as life sciences and financial services.

About half of the compliance professionals surveyed have been in a compliance role for less than five years.

As a relative newcomer, the compliance function faces the extra hurdle of demonstrating its value. Of course, you need to demonstrate value if you want to get more resources. This was the greatest challenge identified by compliance professionals in their survey.

The competition for resources also reduces compliance’s ability to gather the current management information required to do its job, making it harder still to demonstrate value to the rest of the business.

Board Concerns

Seventy-six percent of respondents feel their boards are increasingly concerned about their personal liability from fraud, bribery and corruption. The survey indicates that the Board’s level of concern with fraud has risen with the overall rise in fraud and corruption risks in the current economic climate. All the survey participants think that board members are taking their own personal exposure seriously.

Private Fund Manager Registration Status

Shearman & Sterling put together a great client publication on private fund manager registration requirements being considered by Congress: Private Fund Manager Registration as U.S. Financial Reform Legislation Approaches the Finish Line.

Among the many provisions to be reconciled in the 1,600+ pages of each bill are those that would require private fund managers to register as investment advisers with the U.S. Securities and Exchange Commission. The registration provisions would strike the existing registration exemption on which many fund managers now rely, that being the so-called “private adviser” or “fourteen or fewer clients” exemption. The result is that many fund managers that are currently exempt from SEC investment adviser registration will be forced to register in due course. With that background, this alert highlights differences between the Senate and House treatment of these registration requirements.

Compliance Bits and Pieces for June 4

Here are some recent stories that I found interesting:

The Auditors And Financial Regulatory Reform: That Dog Don’t Hunt by Francine McKenna in re: The Auditors

The firms are broken and their basic product is worthless. The auditors were completely impotent to warn investors of over-leverage and risky business models, to prevent erroneous and potentially fraudulent financial reporting and to mitigate the impact on everyone of these errors, misstatements, obfuscations and subterfuge by executives of the failed, bailed out and nationalized financial institutions.

Why Links Belong in text by Felix Salmon in Reuters

A blog entry with links at the bottom has aspirations to being self-contained, like say a newspaper column: the links are optional extras. I never have such aspirations and anybody looking to make full use of the power of the internet is doing themselves a huge disservice if they start thinking that way. In these days of tabbed browsing, there’s a difference between clicking and clicking away: most of us, I’m sure, control-click many times per day while reading something interesting, letting tabs accumulate in the background as we find interesting citations we want to read later.

Whistleblowers, Cooperators Making Their Way to the SEC’s Door by Kara Scannell in WSJ.com‘s Law Blog

While speaking at a recent Practicing Law Institute seminar, Reisner said the SEC has signed 10 cooperation agreements so far with other potential deals in the pipeline. The insiders are helping investigators in probes involving insider trading, financial and accounting fraud, stock offering frauds, and public company disclosures, he said. Reisner said the vast majority of cooperators came in the door after the probes were already underway. “One was a situation where someone walked in the door,” he said.

Dan Ariely asks, What is the right amount to pay bankers? in TED blog

To look at the question of how bonuses affect performance, Uri Gneezy, George Loewenstein, Nina Mazar, and I conducted a few experiments. In one, we gave participants an array of tasks that demanded attention, memory, concentration, and creativity. We asked them, for instance, to fit pieces of a metal puzzle into a plastic frame, to play a memory game that required reproducing a string of numbers, to throw tennis balls at a target, and a few other such tasks. We promised payments of different amounts (either low, medium, or very high bonuses) if they performed any of these tasks exceptionally well. About a third of the subjects were told they’d be given a small bonus (relative to their normal wages), another third were promised a medium-sized bonus, and the last group could earn a very high bonus.

Four-Year Sentence In Haiti Case in The FCPA Blog

A former employee of Haiti’s state-owned national telecommunications company was sentenced yesterday to 48 months in prison for being part of a bribery and money-laundering scheme. Robert Antoine, 62, of Miami and Haiti, pleaded guilty in March this year to conspiracy to commit money laundering. He was also ordered by the federal judge in Miami to pay $1,852,209 in restitution and to forfeit $1,580,771, and serve three years of supervised release following his prison term.

What’s Your KM? by Mary Abraham in Above and Beyond KM

Substitute compliance for KM:
Critics says that the inability of knowledge management proponents to settle on a universally accepted definition of KM is a sign of failure. Others say that the lack of definition and resulting ambiguity present marvelous opportunities. If you are like me (i.e., firmly settled in the second camp), then it is doubly important not to let the discipline’s perceived lack of definition translate into a personal lack of definition. Knowledge managers who lack definition make administrators very nervous. And that is not career enhancing. So the real challenge for knowledge managers is to define themselves and their work, and then help the administrators understand and accept that definition.

Side-by-Side Comparison Chart of Financial Reform Bills

The Wall Street Reform and Consumer Protection Act of 2009, passed by the House on December 11, 2009 is over 1300 pages long. The Restoring American Financial Stability Act of 2010, passed by the Senate on May 20, 2010, is over 1600 pages long.

You have lots of reading to figure out the differences between the two bills.

Davis Polk put together a great side-by-side chart that compares key issues in the Senate and House Bills. At a 160 pages, the chart provides a much more detailed analysis than any other I have seen published.

Check out The Checklist Manifesto

As a former transactional attorney, I was trained to use checklists. The transactions were too complicated to keep track of everything in my head. I also needed to communicate with the rest of the transaction team. In The Checklist Manifesto, Atul Gawande approaches checklists from the perspective of a surgeon.

I had put off reading this book because I’m already a fan of checklists. I didn’t need to be sold on their effectiveness. But I was still floored by the effectiveness Gawande reported in his studies.

In using a checklist for placing a central line, the ten-day infection rate was reduced from 11% to zero. He cites many other examples and studies that show that checklists can improve the performance of highly-trained workers.

“In a complex environment, experts are up against two main difficulties. The first is the fallibility of human memory and attention, especially when it comes to mundane, routine matters that are easily overlooked under the strain of more pressing events…. A further difficulty, just as insidious, is that people can lull themselves into skipping steps even when they remember them. In complex processes, after all, certain steps don’t always matter.”

I was particularly happy to see Gawande cite the correct story about Van Halen’s use of M&M’s as a compliance checklist tool. (See my prior post: Compliance Van Halen and Brown M&M’s.)

If you haven’t already read The Checklist Manifesto you should add it to your reading list.

Other’s thoughts on The Checklist Manifesto:

Portugal and Ethics Hotlines

Under guidelines published by the Portuguese Data Protection Authority on the 1st October 2009, a whistleblower cannot make a report anonymously. I have to admit that I can’t read Portuguese, so reading Deliberação Nº 765 /2009 does not help me much in interpreting the limitations. (Google translate helps.)

Most EU member states allow anonymous reporting as a last resort. Portugal went a step further and outlawed anonymous reporting completely.

The Portugal guidelines also limit hotline use to reports of corruption, banking and financial crime and internal accounting controls. It’s not allowed for breaches of general codes of conduct. To go a step further, whistleblowers may only report against individuals in managerial positions.

If you are a public company with operations in Portugal and required to have whistleblower hotline under Sarbanes-Oxley, you need to look at these limitations. They seem to be in direct conflict.

Thanks to Bill Piwonka of EthicsPoint for letting me know about this. EthicsPoint supplies my company’s hotline.

Sources:

SEC’s Mickey Mouse Sting Operation

Maybe this would have worked last year. But traders are probably a little nervous when it comes to buying inside information since the Galleon insider trading case. Hedge funds are now well aware that the SEC and FBI are willing to use a broader range of investigation techniques including wire taps and undercover agents.

That’s probably exactly what they were thinking when they got this mysterious email in March 2010:

“Hi, I have access to Disney’s (DIS) quarterly earnings report before its release on 05/03/10 [sic]. I am willing to share this information for a fee that we can determine later. I am sorry but I can’t disclose my identity for confidentiality reasons but we can correspond by email if you would like to discuss it. My email is [email protected]. I count on your discretion as you can count on mine. Thank you and I look forward to talking to you.”

According to the criminal complaint, at least 33 investment firms received the email. It’s not clear which firms alerted the SEC or the FBI.

The FBI sent in “Al Tyson”, a hedge fund trader to discuss the purchase of the inside information. Al was was an undercover FBI agent. The FBI also used undercover agents “Kurt” and “Bill Evers” in separate discussions. There was even a confidential informant for the FBI: “Oscar.”

Bonnie Hoxie worked for Disney as an executive assistant and thought she could get pre-release earnings information. Her boyfriend, Yonni Sebbag sent the emails.

Bonnie and Yonni must not have heard of the Galleon insider trading case. I’m sure the investment firms they contacted have heard of Galleon and I’m sure are extra cautious of insider trading cases. Especially anonymous emails offering to sell inside information.

I guess they smelled a rat instead of a mouse.

Sources:

Compliance Bits and Pieces – Compliance Week Edition

If you stuck around for my blog posts on Compliance Week 2010, I figured I would end the week with other attendee’s coverage:

Lanny Breuer at Compliance Week by Tom Fox on FCPA Compliance and Ethics Blog

He stated that tools which had been previously used to combat organized crime would now be employed in the fight against white collar crime, including both wiretaps and sting operations as were used against the gun manufacturing industry in the operations which culminated in the arrests of 22 individuals in Las Vegas in January of this year. He also discussed that many foreign governments had entered into collaboration agreements to facilitate cross-border investigations and enforcement actions.

Barney Less Than Frank About Auditor Reform by Francine McKenna in Going Concern

To the question about fears of going after the accounting firms, Rep. Frank rambled on about McCarthyism, the Inquisition and not spending time looking back – that’s what courts and prosecutors are for. I suspect the industry’s lobbyists and their campaign contributions have whispered in his ear. Employees of KPMG, PwC and Deloitte are among his top 25 contributors in 2009-2010 period. In the 2008 election year, all of the Big 4 made it to Rep. Frank’s top 20 contributors list.

SEC Commissioner Aguilar Says Still a Long Way to Go by Jaclyn Jaeger in Compliance Week‘s The Filing Cabinet

The SEC’s current way of doing things is not tough enough, SEC Commissioner Louis Aguilar told an audience of compliance and risk officers during Compliance Week’s annual conference in Washington D.C. this week. While problems in the market are “seamlessly connected, regulatory oversight is piecemeal,” he said.

JetBlue on Why CEO/Chair Split Works for Them by Melissa Klein Aguilar in Compliance Week‘s The Filing Cabinet

JetBlue Airways not only split the posts, but its board chairman, Joel Peterson, hails from outside of the airline industry—an approach he notes that not many companies have taken.

Observers Share Tips, Views On Navigating Social Media by Melissa Klein Aguilar in Compliance Week‘s The Filing Cabinet

Companies wrestling with how to navigate the rapidly changing social media landscape got some advice from executives whose companies have already taken the plunge. During a panel discussion at Compliance Week’s annual conference in Washington D.C., executives from Best Buy, Johnson & Johnson and The Travelers Companies shared their own experiences and tips for using social media tools such as Twitter and Facebook and crafting a corporate social media policy.

Grindler Touts Importance of Compliance, But Doubts Linger by Chris Matthews in Main Justice

“I want to emphasize… that having an effective compliance program will be taken under consideration when you have to talk to the government about a criminal violation,” Grindler said at the annual Compliance Week conference in Washington, D.C.

Fraud Chief: Effective Compliance Programs Can Prevent Monitors by Christopher M. Matthews in Main Justice

Criminal Fraud Section Chief Denis McInerney said Monday that an effective compliance program can prevent companies facing deferred and non-prosecution agreements from having to install an expensive compliance monitor. “If you have already established an excellent compliance program, then it will be less likely that we’ll install a compliance monitor, which can come at some cost to the company,” McInerney said.

Breuer: FCPA Facilitating Payments Worth Discussing by Christopher M. Matthews in Main Justice

Assistant Attorney General Lanny Breuer indicated Wednesday that the Justice Department was open to revisiting its exemption for “facilitating payments” under the Foreign Corrupt Practices Act. “That’s worth discussing,” Breuer, head of the DOJ’s Criminal Division, said during his remarks at the annual Compliance Week conference in Washington, D.C. “Facilitation payments — obviously this area is dynamic — so I don’t rule that out. I’m not currently aware of any real movement to make that change here. I think as other countries laws evolve and mature… I suspect over time, we too will be modifying our law.”

Creating a GRC Strategy Roadmap by Jaclyn Jaeger in Compliance Week‘s The Filing Cabinet

To build a successful enterprise governance, risk, and compliance program, companies need a solid roadmap that aligns people, processes, and information.David Walter, RSA director for Archer eGRC Solutions, discussed ways in which companies can achieve that, during a recent seminar at Compliance Week’s annual conference in Washington, D.C., this week.

Live Blogging from Compliance Week 2010 by Gordon Burnes for Open pages

Shelley Parratt of the SEC’s Corporation Finance Division gave the afternoon keynote on Day 2 of Compliance Week 2010. She spoke about the Commission’s program of enhanced disclosure.

Live Blogging from Compliance Week 2010 by Gordon Burnes for Open pages

US Rep and House Financial Services Committee Chair Barney Frank gave the opening keynote at Compliance Week 2010, day 2. As usual, he was witty and insightful. His remarks covered the conceptual underpinnings of financial services regulatory reform. He then took questions from the group.

Derivatives Spinoff Proposal ‘Goes Too Far,’ Says Frank Wall Street Journal

A key House Democrat signaled Tuesday that a controversial derivatives provision in the Senate’s financial-regulation bill could be stripped out during negotiations when the two chambers hammer out compromise legislation that could be signed into law by July 4.

Barney Frank Speaks Frankly About Financial Reform by Jaclyn Jaeger in Compliance Week‘s The Filing Cabinet

Now that the healthcare reform bill has been passed, legislators can begin to focus on another equally important issue: financial reform. “It’s very important for the financial industry that we get some stability,” Barney Frank, chair of the House Financial Services Committee, told an audience of compliance, risk, and audit executives during Compliance Week’s annual conference in Washington D.C. this week. It’s important to move quickly, he said, adding that the bill is very close to passage.

SEC Commissioner Aguilar Says Still a Long Way to Go by Jaclyn Jaeger in Compliance Week‘s The Filing Cabinet

The Securities and Exchange Commission still has a long way to go in its quest to understand the causes of the financial crisis and from deterring those who commit wrongdoing.

SEC Commish: Agency Needs to Get Tough on Miscreants Kara Scannel’s coverage from the Wall Street Journal’s Law Blog

If Securities and Exchange Commissioner Luis Aguilar has his way, corporate miscreants will face stronger sanctions.

Maximizing Privacy Effectiveness by Jaclyn Jaeger in Compliance Week‘s The Filing Cabinet

From internal investigations to data privacy issues to regulatory compliance, the overlap of privacy, security and compliance functions within an organization is inevitable. But where should privacy be housed in the organization to ensure effectiveness, and how should it interact with compliance, legal, and IT? These were only some of the questions answered during a panel at Compliance Week’s annual conference in Washington, D.C., this week

Update:

Parting Thoughts on Compliance Week 2010 by Compliance Week‘s Editor-in-Chief Matt Kelly

Well, the Compliance Week 2010 conference is now done and fading into history. The event was excellent, and credit belongs to all the attendees, speakers and helpers who altogether made our 2010 conference the largest and most successful we’ve ever had. Anyone who didn’t make it to Washington this year can see what you missed on our home page, but let me also share a few wrap-up thoughts here.