A New Regulatory Action to Help Potential Whistleblowers

In response to a Congressional mandate in Dodd-Frank, the SEC adopted Rule 21F-17 in August 2011, which provides:

(a) No person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement . . . with respect to such communications.

Back in 2016 the Securities and Exchange Commission filed a series of cases against companies that restricted departing employees from contacting government authorities. Some of the language the SEC found illegal was broad non-disparagement clauses that forbid former employees from engaging “in any communication that disparages, denigrates, maligns or impugns” the company. Companies responded by adding carve-outs that explicitly stated that employees could contact government regulators to reporting possible wrongdoing.

Monolith Resources included that language in its separation agreements:

“nothing in this agreement is intended to limit in any way your right or ability to file a charge or claim with any federal, state, or local agency,”

But Monolith took away the financial aspect of a whistleblower by adding:

“You retain the right to participate in any such action, but not the right to recover money damages or other individual legal or equitable relief awarded by any such governmental agency.”

Monolith’s former employees could file a whistleblower complaint, but not get any cash. An interesting approach, but one that is clearly designed to impede whistleblower actions.

Monolith got hit with a $225,000 fine. There was no indication that any employee was impeded from communicating with the SEC and Monolith never enforced that provision.

Maybe there has been some prior action by the SEC on this type of pretaliation and I just missed it. Let me know.

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Private Funds and the Economic Growth, Regulatory Relief, and Consumer Protection Act

Last week, the Economic Growth, Regulatory Relief, and Consumer Protection Act became law,  providing some revisions to Dodd-Frank and some new regulatory wrinkles. Some of those revisions apply to private funds.

Section 203 exempts Banks and Bank Holding Companies with (1) $10 billion or less in total consolidated assets and (2) total trading assets and trading liabilities of 5% or less of total consolidated assets from the Volcker Rule.

Section 204 allows hedge funds and private equity funds to share the name with a banking entity acting as its investment adviser provided that the investment adviser is not an insured depositary institution and the name does not contain the word “bank.” Interestingly, that new exemption would seem to apply to real estate funds or venture capital funds.

Section 504 Revises the exemption in 3(c)(1) of the Investment Company Act. it adds a new exemption for “qualifying venture capital funds” to have up to 250 investors instead of the 100 investors limit for other types of funds. A “qualifying venture capital funds” is a venture capital fund that has not more than $10 million in aggregate capital contributions and uncalled committed capital.

I suppose this allows venture capital fund managers to create a pool with a larger number of less wealthy investors that are making smaller commitments. Otherwise, to exceed 100 investors, a fund manager would have to use the 3(c)(7) exemption that requires investors to be Qualified Purchasers. This was a Senate amendment sponsored by Senator Heitkamp as the “Supporting America’s Innovators Act.”

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Congress Disapproving The SEC Rule That Congress Made The SEC Make

Dodd-Frank made the Securities and Exchange Commission create a rule on the disclosure of payments by resource extraction issuers. The SEC finally got the rule out this fall. Now Congress is threatening to abolish the rule.

Section 1504 of the Dodd-Frank Act directed the Securities and Exchange Commission to

“issue final rules that require each resource extraction issuer to include in an annual report . . . information relating to any payment made by the resource extraction issuer, a subsidiary of the resource extraction issuer, or an entity under the control of the resource extraction issuer to a foreign government or the Federal Government for the purpose of the commercial development of oil, natural gas, or minerals..”

SEC finished the rule and finally adopted the Rules for Resource Extraction Issuers Under Dodd-Frank Act in September.

The strategy is not to pass a law removing section 1504. That would require getting the supermajority in the Senate to overcome the filibuster obstacle. That is hard and unlikely.

The plan is to use the Congressional Review Act to repeal the rule. That Act was part of Newt Gingrich’s Contract with America.

Under the law, Congress can stop a regulation passed within the last 60 legislative days. That counting is a bit fuzzy, but seems to stretch all the way back to the middle of June 2016.

I have little doubt that the rule will be rolled back. My question is whether this repeal counts towards the two repealed rules it takes to get a new one enacted under the Executive Order.

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Dodd-Frankly, My Dear, I Don’t Give..

Perhaps one day there’ll be another famous movie line: “Dodd-Frankly, my dear, I don’t give…” But probably not. Its not clear if Dodd-Frank has been a success or a failure.

GoneWiththeWind1

It certainly has been a change.

From the regulated side, I think the failure or success depends on which part of Dodd-Frank affects you. New regulations make winners and losers. Most research shows that it makes it harder for new firms to enter the regulated space.

From 2009 to 2013 only 7 new banks were formed, fewer than 2 per year. From 1990 to 2008, over 2,000 new banks were formed, more than 100 per year. Its easy to blame that on Dodd-Frank, but the economy has been weak and interest rates low.

Certainly, big banks are not any smaller and few believe that too big to fail is gone. It brief glance at bank credit ratings, you can see a boost in the ratings for an implied government bail-out.

It also depends on how you rate size: amount of deposits, amount of assets, amount of lending activity.

We have seen the reach of the non-bank too big to fail labeled and then removed. The firms may be important, but not systemically important.

One of the clear winners is the compliance profession. Dodd-Frank clearly requires more compliance efforts and people to take on those efforts.

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Yet Another Rule to Discourage Companies From Going Public

sec-seal

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

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

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

(b) ADDITIONAL DISCLOSURE REQUIREMENTS.—

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

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

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

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

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

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

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

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Action in Congress

act of congress

Robert Kaiser was granted rare access to the action behind the scenes of the creation of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Act of Congress is an enjoyable study of the enactment of that law, used as tool to explore how Congress works, and largely how it it doesn’t work.

Kaiser was already an associate editor and senior correspondent with the Washington Post and had just finished a book on lobbying and money in Washington. He proposed to Congressman Frank that Kaiser become the historian of the congressional response to the Great Crash of 2008. Frank was planning a big legislative changes to the financial services industry and the new president shared this goal. Senator Chris Dodd and Representative Barney Frank let Kaiser talk on the record with staff.

Act of Congress lives by the famous remark “Laws are like sausages, it is better not to see them being made.” The book’s goal is to be both entertaining and educational as it sneaks behind the curtain to watch the sausage production.

“Of the 535 members of the House and Senate, those who have a sophisticated understanding of the financial markets and their regulation could probably fit on the twenty-five man roster of a Major League Baseball team.”

Kaiser lets the stupidity of some Congress make it to the pages. He lets their public statements stand for themselves, although he tosses the phrase “intellectual lightweight” at a few. I sense he had a lot of personal perspective some of the congressmen that did not make it to the pages.

I found the book to be well-written and interesting. I suspect the interesting part may be governed more by my interest in the Dodd-Frank Act. It’s an enormous piece of legislation with profound impact on the financial services industry. In places it is poorly written and in others it’s full of exemptive holes. This books will enlighten you to some of the compromises that were made to get the law enacted.

I suspect those who have that interest may be limited. If you have made it this far, perhaps you share that interest. In which case you should add Act of Congress to your reading list.

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Dodd-Frank a year on: Where is the compliance industry now?

PEI PFC Forum 2013

These are my notes from the Private Fund Compliance Forum 2013. They are live notes, so excuse the typos.

David Smolen, Chief Compliance Officer, Silver Lake
Brynn Peltz, Partner, Goodwin Procter LLP
Roman A. Bejger, Counsel and Chief Compliance Officer, Providence Equity Partners, LLC
Michael Barnes, Senior Manager, Financial Services, Ernst & Young LLP

Fund managers fell into four categories: 1. those who accepted, 2. those who are still kicking and screaming, and 3. Those who are fighting and trying to find ways to escape, and 4. Those who registered and restructured to escape registration.

The panel felt that it’s inevitable that carried interest will be taxed differently. Of curse it’s felt inevitable for a few years and nothing has been implemented. In perspective, the change in tax of carried interest is estimated to be between $1.3 billion and $1.6 billion per year.

As a result of the Volcker Rule, we are seeing more business development companies coming on line to address bank’s trading activity. Whenever the rule comes out it may have broad impact on funding and capital commitments for private funds.

There is an uncertainty about marketing rules with the changes mandated by the JOBS Act.

There is increased focus on fees as part of examinations. The SEC is trying to re-label fees, other than advisory fees, as compensation that could require broker-dealer registration. Brynn has seen this in several deficiency letters over the last few months. The SEC is asking examinees to explain why they do not have to register as a broker-dealer. Acquisition fees, disposition fees and other transaction based fees could trigger the question of broker-dealer registration. A marketing department is suspect if the employee compensation is tied to successful placement of interests in a fund.

The SEC does not seem to be using the term “presence exam” when initiating an exam. The panelists seem to think that the SEC is still robustly conducting regular exams and presence exams are not being conducted as widely as expected.

What additional responsibilities have you taken on post-registration?

  • Lobbyist registration
  • International blue sky law analysis
  • Review of secondary transfers
  • Form PF
  • Internal marketing of compliance
  • Tracking regulatory changes
  • EU’s AIFMD
  • FCPA

Is there personal liability for CCOs?

We are looking for more guidance in this area. Keep the CCO from having supervisory liability. If the CCO hands out discipline, then the CCO could be considered a supervisor and be held liable for the bad act. However, the cases imposing supervisory liability on CCO generally are at the extreme, involving fraud or other egregious acts.

Presence exams generally last a few days. Union examiners leave right at 5. Non-union may stay longer. Generally it’s 2 to 3 people, with a junior person, a mid-level manager, and a senior person who usually does not stay all day. Sometimes there will be a group of trainees. Sometimes enforcement will also come, but it may be just a learning experience and not an indication of wrongdoing. Ask for an exit interview. If it’s refused then the exam may not be over.

 

First the SEC, Now the CFTC

The Dodd-Frank Wall Street Reform and Consumer Protection Act is getting ready to land its second regulatory punch to private equity funds. The first was the registration requirement with the Securities and Exchange Commission. The second is the upcoming registration requirement with the Commodities Futures Trading Commission.

Two recent developments pull fund managers into the CFTC’s world. The first is the inclusion of interest rate and foreign exchange swap transactions into the regulatory oversight of the CFTC. That’s part of the Dodd-Frank regulation of derivatives. The second is the repeal of a popular exemption from registration. That exemption was available for funds that were limited to investors that were accredited investors and qualified eligible persons. That exemption will cease to be available after December 31, 2012.

Title VII (the “Derivatives Act”) of Dodd-Frank creates a new framework for regulating derivatives. Securities derivatives get SEC oversight, but non-securities derivatives get CFTC oversight.

Under the Commodity Exchange Act, as amended by the Derivatives Act, swaps are now considered “commodity interests” and need to be considered when determining whether an entity is a “commodity pool” and whether the operator or adviser to the entity is a Commodity Pool Operator or Commodity Trading Advisor.

  • A “Commodity Pool” is “any investment trust, syndicate, or similar form of enterprise operated for the purpose of trading in commodity interests, including any… commodity for future delivery, security futures product, or swap. . .””
  • A “Commodity Pool Operator” (a “CPO”) is any person “engaged in a business that is of the nature of a commodity pool…and who, in connection therewith, solicits, accepts or receives from others, funds, securities or property. . .for the purpose of trading in commodity interests, including any… commodity for future delivery, security futures product or swap. . .”
  • A “Commodity Trading Advisor” (a “CTA”) is any person “who, for compensation or profit, engages in the business of advising others. . . as to the value of or advisability of trading in… any contract of sale of a commodity for future delivery, security futures product, or swap . . .””

I don’t think most private equity funds would consider themselves to be “trading” in commodity interests. However, the CFTC release indicates that entering into a single commodity interest transaction would be sufficient to cause a fund to be a Commodity Pool. So, a fund that enters into a single interest rate hedge could be treated as a Commodity Pool and the adviser of the fund would have to register as a CPO or CTA, or establish an available exemption.

I would guess that the CFTC will have a few thousand new registrants by the end of the year. Fortunately, there is another exemption that should allow many funds to avoid the full regulatory oversight of the CFTC. More on that later.

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Whistleblower Only Has to Believe There is Something Wrong

Whistleblower rights are growing stronger. The recent award of a reward in excess of $100 million to a whistleblower will certainly attract those looking for financial reward. Dodd-Frank not only increased the chances of getting a reward, it also provided broader rights to employees and the courts are starting to rule strongly in favor of employees. A recent ruling highlights the new legal world of whistleblowers.

An employee wrote a letter to the Securities and Exchange Commission and reported that the company had failed to submit its 2009 amendment to the pension plan to its board of directors for approval and had failed to file its amendment with the SEC. The employee, Richard Kramer, was a human resources officer and member of the pension plan committee. Kramer had also told the company that there needed to be three member of the committee, not just the two in place at that time.

Kramer argues that as a result of his complaints, the company disciplined him, reduced his responsibilities, and eventually fired him.

The Dodd-Frank Act provides this protection against whistleblower retaliation:

No employer may discharge, demote, suspend, threaten, harass, directly or indirectly, or in any other manner discriminate against, a whistleblower in the terms and conditions of employment because of any lawful act done by the whistleblower —

(i) in providing information to the Commission in accordance with this section;
(ii) in initiating, testifying in, or assisting in any investigation or judicial or administrative action of the Commission based upon or related to such information; or
(iii) in making disclosures that are required or protected under the Sarbanes-Oxley Act of 2002, the Securities Exchange Act of 1934, including section 10A(m) of such Act, and any other law, rule, or regulation subject to the jurisdiction of the Commission.

A “whistleblower” is defined as “any individual who provides, or 2 or more individuals acting jointly who provide, information relating to a violation of the securities laws to the Commission, in a manner established, by rule or regulation, by the Commission.” 15 U.S.C. § 78u-6(a)(6)

The company first argues that Kramer is not a whsitleblower because he did not us the SEC’s new method of reporting on Form TCR. Mailing a regular letter is insufficient. The court did not believe that it is unambiguously clear that the Dodd-Frank Act’s whistleblower retaliation provision is limited to those individuals who have provided information relating to a securities violation to the SEC, and have done so in a manner established by the SEC. In the court’s view, the company’s interpretation would dramatically narrow the available protections available to potential whistleblowers. I suspect that the use of Form TCR will be required for whistleblower payouts, but not required for retaliation claims.

The company that argued that it had filed the form with the SEC on the date of the 2009 amendment to the plan. There was no securities law violation.

The court noted that in order to qualify for whistleblower protection the employee need only demonstrate that he reasonably believed there had been a violation. There need not be an actual violation of securities laws. The court found that the employee may have reasonably believed the company to be committing violations of SEC rules or regulations.

The ruling was just on the motion to dismiss and amend claims, so it is not over. It does appear to be the first Dodd-Frank whistleblower claim to survive a motion to dismiss in federal court.  I expect it will not be the last.

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Financial Illiteracy Found in Study of Financial Literacy

“Understanding the needs of investors is critical to carrying out the Commission’s investor protection mission,” said SEC Chairman Mary L. Schapiro. Section 917 of Dodd-Frank required the SEC to study the existing level of financial literacy among retail investors. The study was recently released and paints an ugly picture.

Here’s a key quote:

These studies have consistently found that American investors do not understand the most basic financial concepts, such as the time value of money, compound interest and inflation. Investors also lack essential knowledge about more sophisticated concepts, such as the meaning of stocks and bonds; the role of interest rates in the pricing of securities; the function of the stock market; and the value of portfolio diversification…

Perhaps a few decades ago this was less of a problem when big unions were at their most powerful position and big businesses were offering pensions to retirees. With the rapid decline in pensions in favor of 401(k)s and other defined contribution plans, more and more people are responsible for their own investment decisions. It seems they do not have the skills or literacy to do so.

What to do? Neal Lipschutz suggests:

Here’s a modest suggestion: make passing a course in the basics of personal finance a requirement for a high school diploma. You can teach about credit cards, checking accounts, mutual funds and the like. You might even throw in how to vet an investment adviser.

I expect this problem will soon get worse. Private funds will soon be able to start advertising. That means investors that meet the minimal standard of accredited investor will be barraged with opportunities to invest in the once secretive world of hedge funds. That advertising will be limited by the false, misleading or deceptive standard of investment advisers, not by the more strict standards for mutual funds under the Investment Company Act.

I suspect, as does Felix Salmon, that it will not be the excellent funds that advertise. It will be the those that want the flash of the media spotlight.

Private funds will not be held to a uniformity standard allowing potential investors to better compare fund to fund. They’ve gotten accustomed to the relative uniformity with the highly regulated mutual fund products.

It was very obvious that the SEC was not happy with the JOBS Act and is washing its hands of the problems by doing exactly what Congress demanded, and nothing more. At some point there will be a backlash and some additional legislation to deal with the problems that will inevitable arise. Good firms, doing the right thing will likely be subject to further oppressive regulation because of the unrestrained actions of a few bad actors.

Being an accredited investor just means that you have money, not that you understand how to invest your money. I suspect many more will start making bad investments as they hear the siren song of hedge funds.

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