Month: April 2011

Patriots’ Day and Compliance

Patriots’ Day is a Massachusetts holiday honoring the anniversary of the Battles of Lexington and Concord, the first battles of the Revolutionary War. Since Maine was once part of Massachusetts, it is also a holiday in Maine. Although they switch the possessive to Patriot’s Day.

That means Paul Revere and William Dawes mount their horses to re-create the warning: “The British are coming!” That means battle re-enactments in Lexington. That means the Boston Marathon passes through. That means a Red Sox home game.

That means a holiday for me from thinking too much about compliance.

Sources:

Image of the Minuteman Statue in Lexington Massachusetts is by Daderot
CC BY-SA 3.0

Free Will and Compliance

“Human Irony” from Saturday Morning Breakfast Cereal

Heisenberg Uncertainty: Published by Werner Heisenberg in 1927, the principle implies that it is impossible to determine simultaneously both the position and the momentum of an electron or any other particle with any great degree of accuracy or certainty.

Intent and the Advertising Rule for Investment Advisers

In it’s prohibition against fraud, deceit and manipulation, Section 206 of the Investment Advisers Act is strict. There is no requirement of intent. You can argue that you didn’t mean to mean to commit fraud. That may affect whether you get referred to enforcement instead of merely getting hit with a deficiency letter or an injunction.

Under common law there us generally some requirement of intent. That is not so true under securities laws.

In SEC v. Capital Gains Research, Inc. 375 U.S. 180 (1963) (.pdf 16 pages), the Supreme Court allowed an injunction without a finding of intent to commit fraud.

The foregoing analysis of the judicial treatment of common-law fraud reinforces our conclusion that Congress, in empowering the courts to enjoin any practice which operates “as a fraud or deceit” upon a client, did not intend to require proof of intent to injure and actual injury to the client. Congress intended the Investment Advisers Act of 1940 to be construed like other securities legislation “enacted for the purpose of avoiding frauds,” not technically and restrictively, but flexibly to effectuate its remedial purposes.

The limitations in Rule 206(4)-1 on investment adviser advertising approach the communication from the view of a client or prospective client, not the adviser. The limitations are designed to prevent an adviser from doing things that could be perceived as fraudulent even if the adviser is acting with good intent.

The use of testimonials and ratings are an example of this. More on that subject later.

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Is it an Advertisement?

Section 206 of the Investment Advisers Act prohibits fraud, deception or manipulation, regardless of whether the fund manager is registered. Once registered, Rule 206(4)-1 imposes additional restrictions on advertising that the SEC has determined would be fraudulent deceptive or manipulative.

So what is an advertisement for purposes of the rule 206(4)-1:

“[A]ny notice, circular, letter or other written communication addressed to more than one person, or any notice or other announcement in any publication or by radio or television, which offers (1) any analysis, report, or publication concerning securities, or which is to be used in making any determination as to when to buy or sell any security, or which security to buy or sell, or (2) any graph, chart, formula, or other device to be used in making any determination as to when to buy or sell any security, or which security to buy or sell, or (3) any other investment advisory service with regard to securities.”

That is a very broad definition.

The first thing I notice is that it must be in written. So oral communications do not fall within the definition. A speaking engagement would not be an advertisement for purposes of this rule. However, the Powerpoint presentation would be, especially if it’s handed out or otherwise made available.

The second is that it must be a “communication addressed to more than one person.” So one-on-one communications should fall outside the limitations of this rule.

A reply for a request for information is generally not an advertisement. In the 1984 SEC Letter to the Investment Counsel Association of America, Inc. they pointed out that an unsolicited request by a client, prospective client or consultant for specific information is not an advertisement.

Thus, for example, if a consultant specifically requests an investment adviser to provide it with written information about the adviser’s past specific recommendations, the adviser’s mere communication of that information in writing to the consultant would not, by itself, be an “advertisement” within the meaning of the rule and would not be prohibited by rule 206(4)-1(a)(2) under the Act, so long as the adviser did not directly or indirectly solicit the consultant to make the request. We also would reach the same conclusion if the adviser provided the same information to (a) one consultant that was requesting the information on behalf of several clients or (b) several consultants, so long as the adviser was providing the information in response to a specific, unsolicited request for information about the adviser’s past specific recommendations.

In that same letter, the SEC pointed out that a communication to existing investors is generally not an advertisement. “In general, written communications by advisers to their existing clients about the performance of the securities in their accounts are not offers of investment advisory services but are part of the adviser’s advisory services. ”

Keep in mind that even if the communications falls outside the definition of “advertisement” and the limitations of Rule 206(4)-1, it is still subject to the anti-fraud provision of Section 206.

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Image is A & P (Great Atlantic & Pacific Tea Co.), 246 Third Avenue, Manhattan.. Abbott, Berenice — Photographer. March 16, 1936 made available to the public by the New York Public Library

Marketing Limitations on Private Funds

As a private fund manager registering as an investment adviser, you get new limitations on how you market and sell interests in your funds.

It all starts with Section 206 of the Investment Advisers Act:

It shall be unlawful for any investment adviser, by use of the mails or any means or instrumentality of interstate commerce, directly or indirectly–

1. to employ any device, scheme, or artifice to defraud any client or prospective client;
2. to engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client;
…
4. to engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative. The Commission shall, for the purposes of this paragraph (4) by rules and regulations define, and prescribe means reasonably designed to prevent, such acts, practices, and courses of business as are fraudulent, deceptive, or manipulative.

In case you didn’t notice, that provision is applicable to all investment advisers, not just registered investment advisers. Since this law was enacted in 1940, it has always been illegal for a private fund manager to engage in fraud, deception or manipulation.

Once you register with the SEC as an investment adviser, the new marketing rules that come into place are in Rule 206(4)-1. That rule lays out five things than an investment adviser can not do with an advertisement:

1.  Refer, directly or indirectly, to any testimonial of any kind concerning the investment adviser or concerning any advice, analysis, report or other service rendered by such investment
adviser; or

2.  Refer, directly or indirectly, to past specific recommendations of such investment adviser which were or would have been profitable to any person: Provided, however, That this shall not prohibit an advertisement which sets out or offers to furnish a list of all recommendations made by such investment adviser within the immediately preceding period of not less than one year if such advertisement, and such list if it is furnished separately: (i) State the name of each such security recommended, the date and nature of each such recommendation (e.g., whether to buy, sell or hold), the market price at that time, the price at which the recommendation was to be acted upon, and the market price of each such security as of the most recent practicable date, and (ii) contain the following cautionary legend on the first page thereof in print or type as large as the largest print or type used in the body or text thereof: “it should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list”; or

3.  Represent, directly or indirectly, that any graph, chart, formula or other device being offered can in and of itself be used to determine which securities to buy or sell, or when to buy or sell them; or which represents directly or indirectly, that any graph, chart, formula or other device being offered will assist any person in making his own decisions as to which securities to buy, sell, or when to buy or sell them, without prominently disclosing in such advertisement the limitations thereof and the difficulties with respect to its use; or

4.  Contain any statement to the effect that any report, analysis, or other service will be furnished free or without charge, unless such report, analysis or other service actually is or will be furnished entirely free and without any condition or obligation, directly or indirectly; or

5. Contain any untrue statement of a material fact, or which is otherwise false or misleading.

More about some of these later.
Image is Apples and Oranges by Jeremy / http://creativecommons.org/licenses/by-nc-sa/2.0/

Possible Extension to Registration for Private Fund Managers

Dodd-Frank put enormous pressure on the Securities and Exchange Commission to create dozens of new rules. Tile IV of the law, the Private Fund Investment Advisers Registration Act of 2010, shifts thousands of mid-sized investment advisers from federal to state registration. It also repeals the private adviser exemption, causing most private fund managers to register with the SEC.

Section 419 of Dodd-Frank pegs the transition period at one year. That means there is July 21, 2011 registration deadline. The SEC may be bending on that deadline for the registration of private fund advisers.

In an April 8, 2011 letter to the president of the North American Securities Administrators Association, the SEC indicated it may try to push back that July 21 deadline to the first quarter of 2012.

The letter states that the SEC intends to have the necessary rulemaking done by July 21. Of course, that means the subjects of the rules need to get in line. Since there is only three months until that deadline, the clock is ticking very loudly.

The SEC also needs to get the computer systems in place. Once the rules and forms are finished, they need to update the Investment Adviser Registration Depository System. Back in November, the SEC proposed big changes to the Part 1 of Form ADV to address these new registration and reporting requirements. The final form has not been released. I thought the release may have been because they were re-programming IARD to deal with the new form, allowing them to release the final Form ADV and the registration at the same time. According to this letter, that is not the case. The SEC does not expect IARD to be re-programmed until the end of 2011.

Obviously, this letter merely indicates that at least one person inside the SEC thinks the deadline could be extended. That is a long way from actually extending the deadline. I still have a question about whether the SEC can extend the deadline without some sort of legislative action.

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Compliance Bits and Pieces – UK Bribery Act Edition

With the recent release of the Guidance under the UK Bribery Act, I decided to pull together some other stories:

Howard Sklar decided to start from the back of the guidance and give his thoughts on the case studies:

From Securities Docket, Avoiding Prosecution Under the UK Bribery Act-Playing Offense and Defense, including Vivian Robinson, Q.C. discussing the position of the UK’s Serious fraud office.

Bribery Act in force from July 1: Ken Clarke’s statement in full from Bribery Act .com

“Today I have announced that the Bribery Act will enter into force on July 1st, replacing and bringing together the current bribery laws which date back to 1889.  I am also publishing guidance to businesses about how they can reduce their exposure to bribery and understand the Act.  This guidance is available on the Ministry of Justice’s website here http://www.justice.gov.uk/guidance/bribery.htm

UK Bribery Act guidelines: has the lobbying worked? By Helen Parry, senior regulatory intelligence expert, Complinet

Seemingly unnerved at the anti- Bribery Act lobby’s dire predictions of British corporations losing out to competitors hailing from jurisdictions with a more relaxed approach to such matters, the Ministry of Justice appears to have taken heed. This is clearly demonstrated by the reassuring, empathetic and positively emollient tone employed in the revised version of the guidance for companies issued last week, particularly when sensitive issues such as facilitation payments and corporate hospitality are being addressed. This change of heart can be clearly discerned by comparing the original and revised versions of the case study on facilitation payments featured in the guidance documents.

UK Bribery Act guidance fails to clarify compliance issues by Mark Sands on Risk.net

New guidance from the Ministry of Justice and the Serious Fraud Office (SFO) on the UK’s Bribery Act does not clear up issues of prosecutorial discretion, according to first responses to the papers.

The papers are designed to clarify both the way in which the new bribery laws will be enforced and the appropriate procedures that firms can put in place to make sure they are not liable. However, sources have responded by saying that, while the guidance does help in some areas, it also muddies the waters.

“I think the issue is that this new guidance doesn’t have force of law, so it’s up to the SFO and the courts to decide to prosecute,” says one source at a UK consultancy. They say although Kenneth Clark, in his role as the UK’s secretary of state for the Ministry of Justice, is required to provide guidance to firms, it is not absolute. “You could actually do everything it says and still be prosecuted. Because it’s not prescriptive guidance, it won’t give you the silver bullet,” they say.

Don’t get hysterical – taking an extra biscuit won’t get you arrested under the Bribery Act by Andrew Clark in the Guardian

Rather like the All Blacks performing the haka, a full-scale tantrum by Britain’s business elite can be majestic in its fury. So it was difficult to ignore the histrionic reaction afforded to Jack Straw’s Bribery Act, which got royal assent in the dying days of the Labour government.

The act, intended to update a patchwork of anti-corruption legislation dating back to 1906, clamps down on backhanders, sweeteners and brown envelopes lubricating the progress of transactions and is largely aimed at British companies operating overseas.

Good Act, Deplorable Guidance from Transparency International

Corruption matters to the UK Government. Taking a strong anti-corruption stance should allow the UK to speak with authority at times when it matters, such as in Afghanistan and in the Arab Spring. The new Government is a year old, and has yet to set out its anti-corruption strategy. Judged by its deplorable approach to the Bribery Act, it has made a very poor start.

Life After Guidance: No Change by Michael Volkov in the FCPA Blog

What now? Companies need to review existing anti-corruption programs and make sure U.K. compliance is covered. Because one fact has always been certain: No one wants to become known as the first defendant in a prosecution under the Bribery Act.

‘Questionable Guidance’ From Justice Secretary by Bill Waite in the FCPA Blog

The recent friction between the SFO and Lord Justice Thomas and Mr Justice Bean suggest to me at least that the judiciary will remain staunchly independent in this area and reject guidance where they consider that it conflicts with the statute.

Report on SEC Referrals to Enforcement

For a registered investment adviser, it’s okay to have the SEC’s Office of Compliance Inspections and Examinations visit you. It’s a big problem if the enforcement division visit. OCIE will issue a deficiency letter asking you to fix any deficiencies it finds. If your noncompliance is serious or the examiners think investor funds are at risk, OCIE can refer the case to the enforcement division.

We get to see how well this referral process works as part of a recent Inspector General Report: OCIE Regional Offices’ Referrals to Enforcement (.pdf)

This report was triggered by the fallout from the Stanford case. “The OIG found that the SEC’s Fort Worth regional office had been aware since 1997 that Robert Allen Stanford was likely operating a Ponzi scheme. The investigation also discovered that after a series of OCIE examinations of Stanford Group Company (Stanford’s registered investment advisor) in which each examination concluded that the likelihood of a Ponzi scheme or similar fraud existed, the SEC’s Fort Worth Enforcement unit did not take significant action to investigate or stop such expected fraud until late 2005.” The allegation against the Fort Worth enforcement office is that they were being judged on the number of cases they won. They wanted to stay away from Stanford because is would consume lots of resources and had an uncertain outcome. The OIG claims there was perception that they only wanted “quick-hot” or “slam-dunk”cases.

The OIG report’s objective was to determine “whether and to what extent OCIE examiners were frustrated in matters other than Stanford where Enforcement did not pursue cases identified by examiners in the SEC regional offices.”

One highlight was that the OCIE staff identified thethe SEC’s Asset Management Unit as having significantly assisted with the acceptance rate of referrals.

They also highlight the the different missions and focuses of OCIE and Enforcement: “OCIE focuses its efforts on assessing whether SEC registrants are in compliance with securities laws, while Enforcement’s mission is to protect investors and the markets by investigating potential violations of securities laws and litigating the SEC’s enforcement actions.”

The SEC’s Asset Management Unit

Yesterday, Bruce Carton of Securities Docket hosted a webinar: The SEC’s Asset Management Unit and Strategies for Avoiding Trouble in 2011 and Beyond. He managed to get Bruce Karpati, the co-head of the SEC’s Asset Management unit, to participate. Also joining the presentation were John Reed Stark, Managing Director of Stroz Friedberg and former Chief, SEC Office of Internet Enforcement; and Bradley J. Bondi, a litigation partner at Cadwalader, Wickersham & Taft LLP and former counsel to SEC Commissioners Troy Paredes and Paul Atkins for enforcement matters.

The SEC’s Asset Management Unit focuses on investment advisers and investment companies. If you run a private fund, this unit is keeping an eye on you.

You can see replay of the presentation yourself, but here are the things that caught my attention:

Private fund registration under Dodd-Frank is very important to his unit. They work closely with OCIE. They are looking forward to the new data that will come from fund registration and Form PF.

They are especially concerned about the level of transparency, even for private funds, and the information given even to institutional investors.

Weak and fraudulent valuation processes are high on his list of concerns. In particular, he is concerned about private funds with an incentive to overvalue assets. He mentioned the Palisades funds use of side pockets that lead to an enforcement action. He also mentioned the

Another highlight was “investment drift.” Make sure that your investment activity is not wandering from the areas that you told your investors you were going.

Of course, insider trading and expert networks are taking up a fair amount of his unit’s time and energy.

He raised the “suspicious performance investigation” where the SEC is looking at funds that have consistently outperformed market. The leading example is the Madoff scandal. Madoff’s outlying performance should have been a red flag for investors. The SEC wants to spot these kind of problems.

He is looking at adviser background misrepresentation. It sounds like they are ready to bring fraud charges for misstating educational background and experience.

Stark praised the unit. As a lawyer who would be on the opposite side of the table he would prefer someone with specialized knowledge of the investment management industry than a generalist enforcement lawyer.

Stark focused on the In the Matter of AXA Rosenberg Group LLC, et al.(Feb.2011) involving a flaw in the computer model for a quantitative fund. The model’s algorithm had a flaw that resulted in under-performance. This is tough one for compliance because the compliance geeks are rarely in the room with the math geeks.

Bondi laid out a series of compliance policies and issues that new investment adviser registrants should be concerned about.  He spent a great deal of time focusing on privacy and security breaches. (Maybe too much for the focus of this presentation.)

Sources:

participants in April 5 Webcast, Karpati, Stark and Bondi

Pay for Performance from Future Fund Flows

Michael Weisbach Professor and Ralph W. Kurtz Chair in Finance at The Ohio State University, and his colleagues, Ji-Woong Chung, Berk A. Sensoy and Léa H. Stern, are looking a the effect of the pay for performance at private equity funds. One hand, there is the current income from management fees and a percentage of the profit earned by the fund. On the other hand, there is the potential future income from future funds.

A fund sponsor’s lifetime income can be as dependent on the ability to raise capital in the future as it is for the income on capital currently under management. A fund sponsor’s “total pay for performance equals the sum of pay for performance features of the explicit compensation contract and the implicit, market-based pay for performance caused by the relation between today’s performance and future fundraising.”

Weisbach takes a closer look at the magnitude of pay for performance for private equity fund managers.

  • For every extra percentage point of returns (or every extra dollar) earned for the current fund’s investors, how much, in expectation, does the lifetime revenue to the fund’s general partners change?
  • How strong is this implicit pay for performance sensitivity relative to the much-discussed explicit one?
  • Theoretically, how should implicit pay for performance vary across different types of partnerships and over time within a partnership? Do these predicted patterns appear true in the data?
  • More generally, how do today’s returns affect the ability of partnerships to raise capital subsequently? How important is future fundraising to the total (explicit plus implicit) pay-performance relation facing private equity general partners, and for what types of partnerships and at what point in a partnership’s lifecycle is it most important?

The results are not particularly surprising:

For all types of funds, both the probability of raising a follow-on fund and the size of the follow-on conditional on raising one are significantly positively related to the performance of the current fund. The magnitude of these relations varies with the scalability of the investments. Buyout funds, which are the most scalable, have the strongest relation, while venture capital funds, which are the least scalable, have the weakest relation.

We also find that these relations are stronger for funds that are earlier in a partnership’s sequence of funds, that is, younger partnerships have stronger relations between future fundraising and current fund returns than older partnerships. This suggests that fund flows in the private equity industry reflect learning about ability over time, and that the strength of the market-based, implicit pay for performance facing a private equity partnership depends on the extent of its prior track record.

The paper does have some interesting data on private equity funds and their operations:

  • The mean (median) preceding fund size is $497.9 ($210.0) million for all funds taken together,
    • $866.4 ($380.0) million for buyout funds,
    • $217.7 ($125.0) million for venture capital funds, and
    • $501.0 ($314.9) million for real estate funds.
  • The mean (median) preceding fund performance is 15.1% (10.6%) for all funds taken together,
    • 16.5% (14.3%) for buyout funds,
    • 14.1% (5.8%) for venture capital funds, and
    • 14.6% (14.1%) for real estate funds.
  • The mean (median) follow-on fund size, conditional on raising one, is $792.2 ($314.0) million for all funds taken together,
    • $1,465.3 ($632.6) million for buyout funds,
    • $283.9 ($181.0) million for venture capital funds, and
    • $694.2 ($425.0) million for real estate funds.
  • The time between successive fundraisings averages 3.3 years for the entire sample,
    • 3.8 years for buyout funds,
    • 3.3 years for venture capital funds, and
    • 2.4 years for real estate funds.

In the end, they conclude that the implicit component of pay for future performance from future funds is on the same order of magnitude as the explicit component of compensation in the carried interest of the current fund. That sounds like a fund manager’s interests are well aligned with the long term interest of the investors in its funds. That’s something that public companies continue to struggle with.

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