Should You Invest in the World’s Most Ethical Companies 2011 Edition

The Ethisphere Institute announced its fifth annual selection of the World’s Most Ethical Companies, highlighting 110 organizations that lead the way in promoting ethical business standards. Of the 110 companies honored this year, 74were on the 2010 list. (If you need help with the math, 36 are new to the list in 2011 and 26 companies dropped off from the 2010 list.)

As they did with the 2010 list, Ethisphere is emphasizing the better financial performance by the companies on this year’s list.

“The World’s Most Ethical Companies, if indexed, would have significantly outperformed the S&P 500 by delivering a nearly 27 percent return to shareholders since 2007, compared to the S&P’s negative 8.5 percent shareholder return during the same period, proving there is a strong correlation between a company’s ethics program and its performance,” said Alex Brigham, Executive Director of the Ethisphere Institute.

Personally, I think its bit misguided to judge the past performance of companies on the 2011 list by looking backwards, especially for the new companies included in the list. As we hear for all investments, past performance is no measure of future performance. A good investor would want a tool to help decide whether to invest in a company, not whether they should have invested 5 years ago.

Is inclusion on the list of Most Ethical Companies an indicator of future performance?

Last year, I looked at Ethisphere’s 2007 World’s Most Ethical Companies and tracked their performance forward to determine whether you should invest in ethical companies. The answer was “yes.” That first class, as a whole, did outperform the broader markets.

I decided to update my study and see if it still held true. The answer is still “yes.”  Those public companies on the 2007 list significantly outperformed the broader markets. If you bought one share of each, you would have realized a 3.96% return. That compares to a -12.36% loss on the S&P index and a -9.1% loss on the Dow Jones Industrials.

You can see my calculations in this spreadsheet (in Google Docs):
https://spreadsheets.google.com/ccc?key=0AuuCq02eKVqldDhydERtRmVsdVo2X0NfOUdXbkZTcmc&hl=en

They are not all winners. About half outperformed and half underperformed. But as a whole, you came out ahead. Salesforce is the bigger gainer on the list with a 126% gain. Nokia is pulling up the rear with a 70% loss.

The weak spot in my analysis is that it leaves out the effect of dividends on the returns. In looking through the Ethisphere list, they seem to be a broad mix of companies so I assumed the dividends of these companies would be similar to the dividends from the companies in that broader indexes.

My conclusion is that the companies on the 2007 list of the most ethical companies were a good investment. I may just put some money on some of those new 26 companies on the 2011 list.

The Small Business Capital Access and Job Preservation Act

With the House of Representatives’ change in political control, the Republicans are taking some steps to cut back on Dodd-Frank. Earlier this week the House Committee on Financial Services distributed a press release about five potential bills that would revise the financial service legislation:

  • The Asset-Backed Market Stabilization Act
  • The Small Company Capital Formation Act
  • The Small Business Capital Access and Job Preservation Act
  • The Business Risk Mitigation and Price Stabilization Act
  • The Burdensome Data Collection Relief Act

Besides the sensationalist graphics, the Small Business Capital Access and Job Preservation Act caught my attention because it is targeted at private equity fund managers:

The Financial Services Committee has received testimony regarding the role private equity firms play in preserving existing jobs and creating new ones by providing capital to struggling and growing companies.  The Dodd-Frank Act requires most advisers to private investment funds to register with the SEC, including advisers to private equity funds. The Small Business Capital Access and Job Preservation Act exempts advisers to private equity funds from the registration requirements. The draft legislation will be sponsored by Representative Robert Hurt.

It sounds like a nice bill. But I’m skeptical that it could enacted before the July 21 deadline for private equity fund managers to register under Dodd-Frank (assuming it could pass at all).

The Committee is holding testimony on Wednesday, March 16 at 2 p.m. in room 2128 Rayburn. Scheduled to appear are:

  • Kenneth A. Bertsch, President and CEO, Society of Corporate Secretaries & Governance Professionals
  • Tom Deutsch, Executive Director, American Securitization Forum
  • Pam Hendrickson, Chief Operating Officer, The Riverside Company
  • David Weild, Senior Advisor, Grant Thornton, LLP
  • Luke Zubrod, Director, Chatham Financial

The text of the proposed legislation is just in the form of discussion drafts and I  have not been able to find copies. I’m sure much will hinge on the definition of “private equity fund managers” just as Dodd-Frank created a new category of venture capital fund managers.

Sources:

More on the Proposed Limitations on Compensation for Fund Managers

There is a new joint federal rule in the works for all financial institutions. This will lump together banks, credit unions, broker-dealers and investment advisers. If you have more than $1 billion in assets under management, you need to pay attention to this rule.

Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act requires federal regulators to

“prescribe regulations or guidelines to require each covered financial institution to disclose to the appropriate Federal regulator the structures of all incentive-based compensation arrangements offered by such covered financial institutions sufficient to determine whether the compensation structure:

(A) provides an executive officer, employee, director, or principal shareholder of the bank holding company with covered financial institution with excessive compensation, fees, or benefits; or

(B) could lead to material financial loss to the covered financial institution.”

The proposed rule is tied to the proposed method of calculation for the investment advisers and private fund managers released in November 2010. Unfortunately, the Form ADV in that proposed rule has not yet been finalized, so we don’t know exactly how that assets under management will be calculated. Assuming there are not big changes to the new Form ADV, if your fund assets plus uncalled capital commitments are in excess of $1 billion, then you are a “covered financial institution.

If you are a “covered financial institution” then you must submit a new report to the SEC. In that report you will need to describe the structure of your incentive-based compensation arrangements and whether they provide for excessive compensation or could lead to to material financial loss. This report must include the following:

  1. A clear narrative description of the components of the covered financial institution’s incentive-based compensation arrangements applicable to covered persons and specifying the types of covered persons to which they apply;
  2. A succinct description of the covered financial institution’s policies and procedures governing its incentive-based compensation arrangements for covered persons
  3. If the covered financial institution has total consolidated assets of $50 billion or more, an additional succinct description of incentive-based compensation policies and procedures specific to the covered financial institution’s:
    (i) Executive officers; and
    (ii) Other covered persons who the board of directors, or a committee thereof, of the covered financial institution has identified and determined under §248.205(b)(3)(ii) of subpart C of this part individually have the ability to expose the covered financial institution to possible losses that are substantial in relation to the covered financial institution’s size, capital, or overall risk tolerance;
  4. Any material changes to the covered financial institution’s incentive-based compensation arrangements and policies and procedures made since the covered financial institution’s last report submitted under paragraph (a) of this section; and
  5. The specific reasons why the covered financial institution believes the structure of its incentive-based compensation plan does not encourage inappropriate risks by the covered financial institution by providing covered persons with:
    (i) Excessive compensation; or
    (ii) Incentive-based compensation that could lead to a material financial loss to the covered financial institution.

“Covered person” means any executive officer, employee, director, or principal shareholder of a covered financial institution.  (So, everyone.)

According to the SEC’s Office of Risk, Strategy and Financial Innovation there are about 132 broker-dealers with assets of $1billion or more and 18 with assets in excess of $50 billions. Since investment advisers do not currently report their assets so the SEC lacks hard numbers. They estimated that about 70 investment advisers meet the $1 billion asset threshold and only about 10 would be large enough to get hit by the proposed bonus retention rules. (see page 70 of the proposed draft (.pdf).)

I assume that the investment adviser counts do not take into account the thousands of hedge fund, private equity fund and real estate fund managers who will be registering with the SEC in the next few months.

The rule will not require a report on the actual compensation. But it does try to limit incentive-based compensation that is “unreasonable or disproportionate to the services performed.”

For private equity funds, this should just be a paperwork issue and not a substantive issue. Since private equity funds pay most of their performance based on the final realization of assets in the fund, there are generally few short-term incentives. Private equity fund managers get their incentive pay when their investors get paid.

Nevertheless, this rule will be a headache for registered private fund managers.

The rule has not yet been officially published by the SEC. They are waiting for the other federal regulators to formally approve the draft.

Sources:

The Buck Stops Here – Harry S. Truman Presidential Museum and Library – Independence, Missouri / Marshall Astor / http://creativecommons.org/licenses/by-sa/2.0/

SEC’s Pay-to-Play Rule Is Effective Today

Dilbert.com

If you have (or want to have) government investors in your private fund then you need to be in compliance with Rule 206(4)-5 starting today.

Summary (from the SEC):

The Securities and Exchange Commission is adopting a new rule under the Investment Advisers Act of 1940 that prohibits an investment adviser from providing advisory services for compensation to a government client for two years after the adviser or certain of its executives or employees make a contribution to certain elected officials or candidates. The new rule also prohibits an adviser from providing or agreeing to provide, directly or indirectly, payment to any third party for a solicitation of advisory business from any government entity on behalf of such adviser, unless such third parties are registered broker-dealers or registered investment advisers, in each case themselves subject to pay to play restrictions. Additionally, the new rule prevents an adviser from soliciting from others, or coordinating, contributions to certain elected officials or candidates or payments to political parties where the adviser is providing or seeking government business. The Commission also is adopting rule amendments that require a registered adviser to maintain certain records of the political contributions made by the adviser or certain of its executives or employees. The new rule and rule amendments address “pay to play” practices by investment advisers.

Limitations on Political Contributions

It is now unlawful for an investment adviser to provide “investment advisory services for compensation to a government entity within two years after a contribution to an official of the government entity is made by the investment adviser or any covered associate of the investment adviser.”

The rule defines an official as candidate for an elective office that can

  1. directly or indirectly influence the hiring of an investment adviser, or
  2. has the authority to appoint a person who can directly or indirectly influence the hiring of an investment adviser.

Unfortunately, investment advisers are left on their own to figure out if any political position is one that falls into the prohibited bucket.

De Minimis Exception

There are two de minimis exceptions. For an official they are entitled to vote for, a covered associate can contribute up to $350 per election. That exception is lowered to $150 if they are not entitled to vote for the official.

Record-Keeping

The new rule also imposes new record-keeping requirements. A private fund will need to keep track of

  1. its covered associates
  2. all government entities that are investors
  3. all contributions made to an “official of a government entity”
  4. all contributions made to a political party
  5. all contributions made to a political action committee

You don’t need to keep records if you have no government clients.

Covered Associates

The limitation on contributions only applies to “covered associates.” they key will be identifying who in the organization falls into this category. Who is a Covered Associate?

  1. Any general partner, managing member or executive officer, or other individual with a similar status or function;
  2. Any employee who solicits a government entity for the investment adviser and any person who supervises, directly or indirectly, such employee; and
  3. Any political action committee controlled by the investment adviser or by any person described in 1 or 2.

Good luck.

Sources:

Compliance Bits and Pieces for March 11

These are some compliance-related stories that recently caught my eye.

Inside The Mind of An Inside Trader by Francine McKenna in re: The Auditors

No Big 4 audit firms or their partners have been named in the insider trading scandal surrounding the now-defunct hedge fund Galleon Management. But the SEC has accused one of the most prominent businessmen ever implicated in such crimes, Rajat Gupta, a former McKinsey & Company Global Managing Director.

SEC `Capacity Gap’ Risks Oversight Lapses as Regulator’s Targets Multiply by Robert Schmidt and Jesse Hamilton in Bloomberg

The U.S. Securities and Exchange Commission is about 400 employees short of what it needs to manage its current workload, according to a consultant’s four- month internal review mandated by the Dodd-Frank Act. The preliminary findings by Boston Consulting Group Inc. reinforce arguments by SEC officials that the agency is underfunded and understaffed as it takes on oversight of derivatives, credit-rating firms and municipal bonds, according to a draft copy of the report obtained by Bloomberg News.

Is it Really Illegal to Require an Applicant or Employee to Disclose her Password to a “Friends-Only” Facebook Page? in Littler’s Workplace Privacy Counsel

Recently, the American Civil Liberties Union of Maryland tried to publicly embarrass the Maryland Department of Public Safety and Correctional Services (the “Maryland Corrections Department”) into suspending its practice of asking job applicants to disclose their Facebook password so that the Department could check whether the applicant’s wall or stored e-mail revealed any connection to criminal activity. According to a letter dated January 25, 2011 (pdf), sent by the ACLU to the Maryland Corrections Department, this practice “is illegal under the federal Stored Communications Act (SCA), 18 U.S.C. §§2701-11 and its state analog, Md. Courts & Jud. Proc. Art., §10-4A-01, et seq.” The ACLU’s contention is inaccurate.

Buying a Private Fund Manager: An Overview of Legal Issues by Nathan J. Greene, Kwang-Duk (Kasey) Choi of Shearman & Sterling

An unprecedented degree of uncertainty has characterized the asset management business environment over 2009 and 2010—a period that saw extreme market volatility, threatened changes to key tax structures, a rapidly shifting regulatory environment, and rising expectations from institutional investors. One collateral result is a dramatic fall-off in asset management industry mergers-and-acquisitions (M&A) deal activity relative to 2006 and 2007. But the same forces of change that put dealmakers on the sidelines carry the seeds for a rebound in activity. Moreover, the Volcker Rule and other significant regulatory changes under the Dodd- Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act)—the import of which are just becoming clear—will themselves prompt new M&A activity.

FASB Sounds Retreat on New Accounting Standards for Leases by John W. Hanley, Jr. in Davis Wright Tremaine LLP’s Corporate Finance Law Blog

It now appears that the FASB may be ready to reverse course, and perhaps even to adhere to its current rules, which draw a bright line between capital and operating leases. We believe that those who have been preparing for the new rules may want to hold tight until the FASB’s direction becomes more certain. In a nutshell, the new rules would discard the fundamental distinction in today’s generally accepted accounting principles (GAAP) between an operating lease and a capital lease. The premise of the new rules is that all leases—no matter the duration or economic terms—should give rise to an asset, and a liability, on the balance sheet of both the lessor and the lessee. These new accounting standards would create real challenges for lessees, since a lessee is required to value the future liability created by a lease using a complex “expected outcome analysis.”

Massachusetts Brings Charges Against a Hedge Fund

You need to worry about more than just the Securities and Exchange Commission when it comes to private fund fraud. State securities regulators generally have the ability to bring fraud charges. Case in point is the Massachusetts’ Secretary of the Commonwealth bringing charges against Risk Reward Capital Management, RRC Management, the RRC Bio Fund and James A. Silverman.

William F. Galvin’s office moved against the parties because the fund allegedly used the “expert network” firm, Guidepoint Global LLC, to gain inappropriate information about clinical trials for biotech drugs.

“The first year returns for the Fund were poor, losing 16.9% of its value. In early 2008 Silverman began to pay $80,000.00 a year from the Fund’s assets to retain the services of Guidepoint Global LLC, (“Guidepoint”) a so-called “expert network” firm, in an effort to make the hedge fund more profitable. With access to Guidepoint, the Fund began a dramatic resurgence, generating returns of over 55% in 2009 and 52% in 2010. These returns were generated, at least in part, upon Silverman’s receipt of material non-public information he received through Guidepoint consultations.”

The complaint focuses on two public companies for which Silverman received non-public information through Guidepoint consultants: Ariad Pharmaceuticals, Inc. and Questcor Pharmaceuticals Inc.

The complaint lays out in detail how the government sees an “expert network” in operation and how it breaks the law.

The Secretary of the Commonwealth is looking not just at the misuse of the information, but also administrative violations of the Massachusetts’ Uniform Securities Act

The Division’s books and records review of Risk Reward also uncovered a widespread pattern of non-compliance with the Act and the Regulations. The Division uncovered violations of minimum financial requirements, document retention requirements, and a myriad of dishonest and unethical business practices, including improper assessment of performance-based fees. The Division observed a disorderly office appearance during the on-site Examination. In addition to leaving client documents including sensitive financial information laying about on tables, chairs, sofas and floors, the Division discovered that the office doors did not lock, leaving client data vulnerable.

This action was brought pursuant to the enforcement authority under M.G.L. c. 110A §§204 and 407A. You may have notice that the operative agency is the Secretary of the Commonwealth, not the Secretary of State. Massachusetts is a commonwealth, not a state. Not that there is a difference.

Sources:

Lords of Finance

The financial crisis of 2008 was not the first. In reading Lords of Finance you see some of the obvious parallels from the 1920s.

Liaquat Ahamed focuses his story on Montagu Norman of the Bank of England, Benjamin Strong of the New York Federal Reserve, Hjalmar Schact of the Reichsbank and Emile Moreau of the Banque de France.

One focus of the 1920 s financial crisis was the stock market crash. Rampant speculation caused a bubble, even though it was initially rooted in economic reality. This was the “new economy” era of automobiles and radios. The old railroad based economy was being surpassed by trucking. Stock prices were rising, but so were the profits of the companies listed on the stock exchange. But then stock prices began rising out of proportion to the rise in corporate earnings.

There was clearly a speculative bubble. Investors were clamoring to find the next Google General Motors. Amateur investors were pouring in and borrowing to make their investments. The Federal Reserve did nothing and then when it decided to act it found it was unable to find a way to curb the speculation. When the Fed pulled back on the ability of banks to lend for stock speculation, non-banks stepped in to provide capital.

There was a thought that “the Fed could pierce the bubble with a surgical incision that would bring it back to earth without harming the economy. It was a completely absurd idea. Monetary policy does not work like a scalpel but more like a sledgehammer.”

As far back as the beginning of the Federal Reserve system there was the question of whether the Fed should intervene in an asset bubble.

The 1920s financial crisis was caused more than just stock speculation, just as the 2008 crisis was caused by more than just residential real estate speculation. It was fueled by debt. The world economy was trying to recover from the economic effects of World War I. Germany began the 1920 owing $12 billion ($2.4 trillion in 2011 values) in reparations to France in Britain, France owed the US and Britain $7 billion ($1.4 trillion in 2011 values)  in war time debts and Britain owed the US $4 billion ($800 billion in 2011 values).

The book goes further back  and focuses on the gold standard as one of the core underlying economic problems that helped cause the Great Depression. Up until this point there was an “almost theological belief in gold as the foundation for money.” Gold was the international currency. Each country’s currency was pegged to the value of gold. The ability to convert paper money into gold instilled confidence in the currency.

By coincidence, the discovery of gold through the late nineteenth century kept pace with economic growth. Then came World War I. The largest economic powers in the world met in the battlefield. Pound Sterling and Franc versus the Mark. The United States and the Dollar came in eventually. After spending the first few years sitting on the sidelines and supplying the Allies, the United States had accumulated an enormous trough of reserves.

One of the problems with the gold standard is that it gives people the option to cash in that paper money for actual gold. That obviously creates some faith in the currency. But it has opposite effect in times of crisis. people will lose faith in the paper money and redeem it for gold. That drains the system of gold, causing a tightening of credit. To counter, the banking system will need to raise interest rates to encourage people to keep money in the bank instead of gold in their mattress. Raising interest rates during a financial crisis will make things worse. You want to be able to reduce interest rates to encourage the flow of capital.

The other contributing factor was the failure of banks. This was before the days of the FDIC and insured deposits. So if you thought your bank was going under, you pulled your money out. This lead to bank runs and banks hoarding cash instead of investing the cash in loans that would grow the economy.

In the end, each economy began its recovery after it suspended the gold standard.  Is some ways the gold standard is just about digging up gold and re-burying it. The huge treasure of US gold was sitting underground, literally underneath Wall Street. France’s gold reserves were underwater; its vaults sat beneath a subterranean aquifer.

As George Santayana wrote: “Those who cannot remember the past are condemned to repeat it.” Ben Bernanke was a scholar of the Great Depression. He saw what the four Lords of Finance did, leading them to the subtitle of the book: The Bankers who Broke the World. It’s worth your time to read the book.

The SEC Continues to Investigate Side Pockets and Valuations

The SEC brought another case against a private investment fund for misuse of side pockets. Lawrence R. Goldfarb of Baystar Capital Management agreed to pay a hefty fine to settle claims brought by the Securities and Exchange Commission for misuse of his investment fund’s assets.

When used properly, a side pocket is a mechanism that a hedge fund uses to separate illiquid investments from the liquid investments. If a fund investor redeems their investment in a hedge fund with a side pocket, the investor cannot redeem the pro-rata portion of their investment allocated to the side pocket. That portion of the redemption is delayed until the asset is liquidated or is released from the side pocket. It’s a way to protect all of the investors when the fund has a big chunk of illiquid assets. A wave of redemptions would force the sale of liquid assets, leaving those who did not redeem with the illiquid assets.

The typical abuse is to hide under-performing assets from limited partner scrutiny. The manager still collects the management fee on the over-valued assets. Without recognizing the loss, partners are less likely to redeem their capital.

The SEC complaint alleges that Goldfarb acted even more egregiously than disguising valuations. He stole profits from the fund.

The complaint states that Goldfarb’s fund invested in a real estate partnership. Since that investment was likely a very illiquid asset it would typically end up in a side pocket. Shortly after the investment was made the real estate partnership started making cash distributions. Goldfarb has these distributions sent to him instead of the investment fund. He ended up transferring the whole interest to himself, using the side pocket to hide the asset and the distributions.

At first I thought this might be an interesting action to highlight Rule 206(4)-8. From the complaint, is sounds more like a case of blatant theft from the fund. This enforcement actions shows that the SEC is focusing on private funds, valuations, side pockets and affiliate transactions.

Without admitting or denying the SEC’s allegations, Goldfarb and Baystar Capital Management consented to permanent injunctions against violations of certain provisions of the federal securities laws and to pay disgorgement of $12,112,416 and prejudgment interest of $1,967,371, which will be distributed to the fund’s investors. Goldfarb also agreed to pay a $130,000 penalty, be barred from associating with any investment adviser or broker (with the right to reapply in five years), and be barred from participating in any offering of penny stock.

Sources:

Custody and Private Funds

Last year, the Securities and Exchange Commission put a new rule in place restricting an investment adviser’s ability to have custody of its clients’ assets. Given that many private fund managers are going to have to register as investment advisers they need to figure out how to comply with this rule.

The rule is the anti-Madoff rule. The SEC wants client assets separate from the manager’s control and for the manager to safeguards in place to prevent a manager from sending out false statements to investors. This includes having a third party custodian and having the custodian send statements directly to investors and subjecting the accounts to a surprise inspection by an auditor.

Safekeeping required

Rule 206(4)-2(a) If you are an investment adviser registered or required to be registered under section 203 of the Act, it is a fraudulent, deceptive, or manipulative act, practice or course of business within the meaning of section 206(4) of the Act for you to have custody of client funds or securities unless:

(1) A qualified custodian maintains those funds and securities:

(i) In a separate account for each client under that client’s name; or

(ii) In accounts that contain only your clients’ funds and securities, under your name as agent or trustee for the clients.

If your fund has securities, then you need a “qualified custodian” holding those securities. There is an exception for “privately offered securities” that will make life much easier for private equity funds and real estate funds.

Use of a Qualified Custodian

So who can you use as a “qualified custodian“?

(d)(6) Qualified custodian means:

(i) A bank as defined in section 202(a)(2) of the Advisers Act or a savings association as defined in section 3(b)(1) of the Federal Deposit Insurance Act (12 U.S.C. 1813(b)(1)) that has deposits insured by the Federal Deposit Insurance Corporation under the Federal Deposit Insurance Act (12 U.S.C. 1811);

(ii) A broker-dealer registered under section 15(b)(1) of the Securities Exchange Act of 1934, holding the client assets in customer accounts;

(iii) A futures commission merchant registered under section 4f(a) of the Commodity Exchange Act (7 U.S.C. 6f(a)), holding the client assets in customer accounts, but only with respect to clients’ funds and security futures, or other securities incidental to transactions in contracts for the purchase or sale of a commodity for future delivery and options thereon; and

(iv) A foreign financial institution that customarily holds financial assets for its customers, provided that the foreign financial institution keeps the advisory clients’ assets in customer accounts segregated from its proprietary assets.

Surprise audits and custodian statements

In addition to the requirement in (a)(1) that a qualified custodian hold the securities, there are addition requirements in (a)(2), (a)(3) and (a)(4) that you notify the client about the custodian, require separate statements be sent to the client and that the account be subject to surprise audits.

When investment funds are the clients these requirements make less sense, so (a)(5) requires funds to send the account statements to their limited partners.

There is an exception for pooled investment vehicles:

(b)(4) Limited Partnerships subject to annual audit. You are not required to comply with paragraphs (a)(2) and (a)(3) of this section and you shall be deemed to have complied with paragraph (a)(4) of this section with respect to the account of a limited partnership (or limited liability company, or another type of pooled investment vehicle) that is subject to audit (as defined in rule 1-02(d) of Regulation S-X (17 CFR 210.1-02(d))):

(i) At least annually and distributes its audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners (or members or other beneficial owners) within 120 days of the end of its fiscal year;

(ii) By an independent public accountant that is registered with, and subject to regular inspection as of the commencement of the professional engagement period, and as of each calendar year-end, by, the Public Company Accounting Oversight Board in accordance with its rules; and

(iii) Upon liquidation and distributes its audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners (or members or other beneficial owners) promptly after the completion of such audit.

If your auditor is not subject to inspection by PCAOB, you would have to switch auditing firms for your private fund to use this exception. You need to make sure your auditing firm has the horsepower to get the audited down in time for you to get financial statements out in within 120 days of fiscal year end.

Certain privately offered securities

There is a exception for having to deliver “privately offered securities” to the qualified custodian. Certain privately offered 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.

Notes and Interests in Subsidiaries and Portfolio Companies

For real estate private equity, the problem will be notes. They may be considered securities. Notes won’t meet the definition of uncertificated and they are most likely transferable.

For entities and portfolio companies, the key will be to make sure the subsidiaries under the funds are not certificated and there is requirement for consent in order to transfer. I think fund managers are going to have to back and inventory their subsidiary entity documents.

Of course you may be able to make an argument that the interest in the subsidiary is not a security. If it’s wholly-owned you can make a strong argument that the ownership is not a security since you are not relying solely on the efforts of others. But if the subsidiary is corporation you may be stuck treating it as a security. It’s generally hard to argue that shares in a corporation are not a security.

In the SEC Q&A about the custody rule:

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.

So you don’t need to deliver all of the fund assets to the custodian. Just those that are securities and cash. Presumably, fund managers are already keeping their funds’ cash in a bank account and not in a mattress. They just need to make sure that the cash accounts are in the fund names.

At first, I thought the limited partnership exception would allow private fund managers to completely avoid the burden of this rule. That was too broad. Now I think fund managers are stuck with hiring a qualified custodian if they register with the SEC. I would guess there will lots of private fund managers looking for custodians before they register.

Sources:

ARMOR * PLATE / ptufts / http://creativecommons.org/licenses/by-nc-sa/2.0/

Compliance Bits and Pieces for March 4

Here are some recent compliance-related stories that caught my attention. But not enough attention to anything with them other post a snippet of the story.

Board Member of Goldman Sachs and Procter & Gamble Charged in Insider Trading Scheme

The Securities and Exchange Commission today announced insider trading charges against a Westport, Conn.-based business consultant who has served on the boards of directors at Goldman Sachs and Procter & Gamble for illegally tipping Galleon Management founder and hedge fund manager Raj Rajaratnam with inside information about the quarterly earnings at both firms as well as an impending $5 billion investment by Berkshire Hathaway in Goldman.

Executive Compensation, a Divided Commission, and the Consequences of Dissent (Part 2) by J. Robert Brown Jr. in The Race to the Bottom

[T]he dissent is liberating. The staff know that, by voting against the proposal, the two commissioners will likewise vote against the final rule when it is proposed, assuming the substantive requirements remain in place. That means that the rule can be written without worrying about the views of the dissenting commissioners.

Ponzi Operater Rides Phony Pedigree to Profits in Investor’s Watchdog

Sometimes, as alleged in this case, the claimed credentials are phony. Vigilant investors investigate to find that out. Sometimes, though, the scamster actually graduated from an Ivy League school. What do Marc Dreier, Kirk Wright, and Alicia Eimicke have in common? Two things. All of them ran investment frauds, and all of them graduated from Harvard. I don’t mean to pick on Harvard. There are plenty of Yale and Princeton grads who’ve also run Ponzi schemes. The point is that, while a degree from an impressive university might say something about a person’s intelligence and work ethic, it says nothing about his or her character, per se. And character is what a vigilant investor is looking for.

Chancery Declines to Dissolve LP and Declines to Appoint Receiver of Failing Investment Fund by Francis G.X. Pileggi in Delaware Corporate and Commercial Litigation Blog
The limited partner of a limited partnership sought to force a dissolution of the LP that had invested most of its assets in an investment fund based in the Cayman Islands.

What are the differences in the FCPA and Bribery Act? by Tom Fox

With the recent information coming out, largely from reports by the UK Telegraph, we thought it might a propitious time to review the differences in the Bribery Act and the Foreign Corrupt Practices Act (FCPA) so that US companies might begin to plan to acclimate their FCPA based compliance program to one which includes concepts found in the Bribery Act, if such action is appropriate.