Month: May 2011

Is the SEC Going to Reform Advertising Rules?

Advertising and corporate communications is a rough area for compliance when used in capital formation. The rules are restrictive, not always intuitive, often vague, and in direct opposition to the revenue-hungry side of the company.

Last week, the House Committee on Oversight and Government Reform heard testimony on “how securities regulations have harmed public and private capital formation in the United States.”

“Economists now estimate that the market for underwritten initial public offerings in the U.S. have plummeted from an annual average of 530 during the 1990s to about 126 since 2001. Meanwhile, the number of companies listed on the major American exchanges peaked in 1997 at more than 7,000. Today, there are approximately 4,000. Furthermore, private capital formation in the U.S. is increasingly difficult, as demonstrated by Facebook’s recent decision to issue its high-profile private offering to foreign investors but not Americans.”

Since I’m in the private equity sector, I care more about the limitations placed on private capital formation. SEC Chairman re-stated the justification for the ban on general advertising under Regulation D.

“The ban was designed to ensure that those who would benefit from the safeguards of registration are not solicited in connection with a private offering.”

“I recognize that some continue to identify the general solicitation ban as a significant impediment to capital raising for small businesses. I also understand that some believe that the ban may be unnecessary because those who do not purchase the offered security would not be harmed by the solicitation that occurs. At the same time, the general solicitation ban is supported by others on the grounds that it helps prevent securities fraud by making it more difficult for fraudsters to attract investors or unscrupulous issuers to condition the market. We need to balance these considerations as we move forward in analyzing this issue.”

Barry Silbert, CEO of Second Market phrased it nicely:

It should not matter that non-accredited individuals know that unregistered securities are available for sale. No one prohibits car manufacturers from advertising, even though children under the legal driving age are viewing the advertisements. The general solicitations prohibition unnecessarily limits the pool of potential investors, thereby restricting companies’ ability to raise capital to fuel growth.

Chairman Shapiro said the SEC staff is looking at the offering rules and whether the general solicitation ban should be revisited. Given all of the rule-making from Dodd-Frank, it’s hard to imagine that the SEC will find the bandwidth to revisit the rule in the near future.

Sources:

Image is Reaching for Blue Skies by Kelvin Tan
CC BY 2.0

Compliance Bits and Pieces for May 13

These are some compliance related stories that recently caught my attention.

Are Girl Scout Cookies Evil? by Chris MacDonald in the Business Ethics Blog

Well, apparently nothing is safe from criticism. Girl Guide cookies, as it turns out, are under attack for being made with palm oil, a tropical oil the production of which has been blamed for deforestation and for endangering the habitat of orangutans. Girl Scout cookies, in their current form, are apparently evil.

Division of Investment Management Requests Extensions of Deadlines for Mid-Sized Advisers and Private Fund Advisers in Compliance Avenue

IA Watch is reporting that the Division of Investment Management has formally requested that the Securities and Exchange Commission (SEC) move to next year the deadlines for mid-sized advisers (certain advisers with between $25 million and $100 million in assets under management) to switch to state registration and for private fund advisers with more than $150 million in assets under management to register with the SEC.  IA Watch states: “The formal request moves this closer to becoming reality, should the Commission act on it.”

Federal Court Rules that Private Invocation of Dodd-Frank Anti-Retaliation Whistleblower Section Requires Providing Information to SEC in Jim Hamilton’s World of Securities Regulation

In a case of first impression, a federal court ruled that the anti-retaliation whistleblower protection provisions of the Dodd-Frank Act require a prospective whistleblower to show that he either provided the information to the SEC, or that his disclosures fell specific categories listed in the whistleblower provisions. Further, even if the prospective whistleblower did not provide the information directly to the SEC, he could still be covered by Section 922 of Dodd-Frank if he gave information to outside counsel hired by the company’s independent directors to investigate the allegation and who he alleges reported it to the SEC. (Egan v. TradingScreen, Inc. et al., (SD NY), 10 Civ 8202 (LBS), May 4, 2011).

Treasury Clarifies FBAR Regulations for Private Investment Funds in the Harvard Law School Forum on Corporate Governance and Financial Regulation

On March 28, 2011, the Final Regulations, issued by the Financial Crimes Enforcement Network of the U.S. Department of the Treasury (“Treasury”) relating to the filing of Reports of Foreign Bank and Financial Accounts (“FBAR”) became effective. Notably, the Final Regulations do not require ownership interests in, or signing or other authority over, private investment funds, such as hedge funds and private equity funds, to be reported on FBARs, although Treasury will continue to study the issue. The Final Regulations apply to FBARs required to be filed by June 30, 2011 with respect to foreign financial accounts maintained in the calendar year 2010, and for all subsequent years.

The SEC Remains Behind the Times on Social Media by Bruce Carton in Securities Docket

The Securities and Exchange Commission continues to dip its toe into the social media waters, but it’s doing so in such a cautious, disjointed way that it undermines the usefulness of powerful online communication tools.

Raj is Guilty. Nobody Is Surprised.

If you read about the evidence, you can’t really be surprised that Raj Rajaratnam was found guilty of insider trading. That he was found guilty on all counts was mildly interesting, but not much.

We may get some interesting new legal developments in insider trading law from the appellate decisions. But probably not. The case seems solid. It does not pose the more interesting legal analysis seen in the charges brought in some of the expert network case.

The most interesting aspect of Raj’s case is the government’s use of wiretaps and surveillance. The typical insider trading case relies on some extremely timely trades and a clear opportunity to have acquired knowledge about a significant corporate action. With Raj, his own voice betrayed him. The government was willing to spend considerable considerable effort to gather evidence.

Was it a legal victory? How do you measure success from a legal perspective?:

“We started out with 37 stocks, we’re down to 14,” defense attorney John Dowd said today after his client was found guilty on 9 counts of insider trading and 5 counts of conspiracy. “The score is 23 to 14 for the defense. We’ll see you in the Second Circuit.”

Sources:

The SEC Is Making it Harder for Investment Advisers to Earn Performance Fees

The Securities and Exchange Commission is proposing to raise the dollar thresholds for someone to be considered a “qualified client.”

The definition of a qualified client is set out in Rule 205-3. This is an exemption to the Section 205(a)(1) general prohibition on performance fees.  Section 205(e) grants the SEC the power to create an exemption from the limitation “on the basis of such factors as financial sophistication, net worth, knowledge of and experience in financial matters, amount of assets under management, relationship with a registered investment adviser,” and other factors. The SEC created an exemption in Rule 205-3 for “qualified clients.”

Section 418 of the requires the SEC to adjust the standard for a Qualified Client for the effects of inflation within one year and then every five years.

Back in August I predicted the standard would be raised to a minimum investment of $1 million and the minimum net worth would rise to $2 million. I was proven wrong about my prediction of a rise in the accredited investor standard.

The SEC is proposing that the standard increase to a minimum investment of $1 million and the minimum net worth would rise to $2 million. As to net worth, they are excluding the value of a person’s primary residence.

The SEC is using the same primary residence calculation they used in the “new” accredited investor standard. So, if you owe more on your mortgage than the value of your house, then you need to treat the overage as a negative asset. Once again, owning a house can only be a negative for the SEC standards.

While I used the CPI-I standard as the benchmark for inflation, the SEC chose to use the Personal Consumption Expenditures Chain-Type Price Index (“PCE Index”), published by the Department of Commerce

One of the comments the SEC is seeking in the proposed rule is whether the PCE index is the appropriate measure of inflation.

As for private  funds, Rule 205-3(b) requires a look -through from the fund to the investors in the fund. Each “equity owner … will be considered a client for purposes of the” limitation.  If the fund is relying on the 3(c)(7) exemption from the Investment Company Act then the fund’s investors should be “qualified purchasers”  and you won’t need to look much further. If the fund is using the 3(c)(1) exemption, then it will need to take a closer look at its investors to make sure that each is a qualified client.

Sources:

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The House Financial Services Committee Wants to be Your Friend

Congressman Bachus must have let one of his grandkids near the computer. The House Committee on Financial Services, of which Congressman Bachus is the chairman, has jumped into the world of social media. They have a Twitter feed, a YouTube Channel, a Facebook page and a blog: The Bottom Line.

Even though the SEC has not yet come out with its final whistleblower rule, the committee has set up its own whistle blower form. They have a comment box so you can send comments about legislation.

As for the blog,

“We will bring to your attention what we think is important and interesting. We will post what we’re reading and what we’re thinking. We will post short reaction pieces and longer thought pieces. We will blog about ideas and policies that we support and that we don’t support. We will try to entertain. Most importantly, we will try to engage our readers.”

It’s a nice, although extremely partisan, attempt to provide more information. I’m all for open government and an open discussion of the issues. Maybe using these communication channel will help bring more openness. Maybe they will just bring more grandstanding and partisan bickering.

One of the features on the committee’s website is Collateral Damage: the real impact of the Democrat’s bailout bill.  I get the sense that the website is more about political propaganda than open government.

Sources:

Are Real Estate Fund Managers Registered with the SEC?

Last year, I looked a the top 30 real estate private equity fund managers to see which are already registered with the SEC. The 2011 version of the PERE 30 just came out, so I decided to look at the list again.   (Disclosure: my company is on the list.)

It was mostly re-shuffling, but three new names were added to the list. One is registered as an investment adviser and the other two are not. Of the three that fell off the list, two were registered.

1 The Blackstone Group Yes
2 Morgan Stanley Real Estate Investing Yes
3 Tishman Speyer
4 Colony Capital Yes
5 Goldman Sachs Real Estate Principal Investment Area Yes
6 Beacon Capital Partners
7 LaSalle Investment Management Yes
8 The Carlyle Group Yes
9 Prudential Real Estate Investors Yes
10 Lone Star Funds Yes (Hudson Advisers)
11 Westbrook Partners
12 AREA Property Partners
13 MGPA
14 KK daVinci Advisors
15 CB Richard Ellis Investors Yes
16 Shorenstein Properties
17 Rockpoint Group
18 Lubert-Adler Real Estate Yes
19 Citi Property Investors Yes
20 Walton Street Capital Yes
21 Starwood Capital Group Yes
22 Bank of America Merrill Lynch Global Principal Investments Yes
23 (new) TA Associates Realty Yes
24 (new) GI Partners
25 Lehman Brothers Real Estate Private Equity Yes
26 (new) KSL Capital
27 Aetos Capital Yes
28 Angelo, Gordon & Co Yes
29 Hines
30 Grove International Partners
x -off the list Heitman Yes
x-off the list Rockwood Capital
x-off the list RREEF Alternative Investments Yes

 

If you do the math, now 18 of the top 30 are already registered with the SEC as Investment Advisers. I expect to see several more in the “yes” column before the registration deadline under Dodd-Frank. The question is whether that deadline will be July 21, 2011 or sometime in the first quarter of 2012.

The PERE 30 measures capital raised for direct real estate investment through commingled vehicles, together with co-investment capital, over the past five years.

Sources:

Compliance Bits and Pieces for May 6

Here are some compliance-related stories that recently caught my eye:

Investing in an ethical corporate culture by Aarti Maharaj in Corporate Secretary

Companies are starting to distinguish between non-financial and financial risks in order to continue improving their overall governance and business structures. But non-financial risks, such as ethics, still don’t get the attention they deserve from industry experts. And this could have real – and financial – implications for your company.

Buffet, Sokol and Reporting to the SEC by Tom Fox

We certainly applaud the fact that Buffet timely notified the SEC. However, to publicly praise someone for conduct which may have violated securities law and led to that employee’s resignation and expect such praise to send a signal of reproach still leaves us, as it did initially with Andrew Ross Sorkin, “scratching my head about his reaction.”

Avon Probe Expands To Countries Beyond China by Joe Palazzolo in WSJ.com’s Corruption Currents

Avon Products Inc.’s probe into possible bribery of foreign officials has found evidence of improper payments to government officials in several countries beyond the probe’s original focus of China, The Wall Street Journal reported. The probe has uncovered millions of dollars of questionable payments to officials in Brazil, Mexico, Argentina, India and Japan that may have violated the Foreign Corrupt Practices Act, the Journal reported, citing a person familiar with the matter. The payments date back as far as 2004.

Russia Criminalizes Foreign Bribery by Joe Palazzolo in WSJ.com’s Corruption Currents

Russian President Dmitry Medvedev, who has made tamping down on corruption his signature issue, signed a bill on Wednesday outlawing foreign bribery and allowing prosecutors to seek large fines instead of prison sentences for graft. The law pushed Russia closer to accession to the Organization for Economic Cooperation’s anti-bribery convention, a key anti-corruption benchmark and a prerequisite for full membership to the OECD, which Russia has sought since 2009.

On a lighter note, Causation, Correlation and Your Dog from Doghouse Diaries
Correlation

Near Misses, Catastrophes, and Compliance

The theme of the April edition of the Harvard Business Review is “Failure.” As scary as that term is in the world of compliance, “catastrophe” is even scarier. That means that the failure resulted is real, significant damage.

But you can learn from failures. You can especially learn from others’ failures.

In How to Avoid Catastrophe, Catherine H. Tinsley, Robin L. Dillon, and Peter M. Madsen look at “unremarked small failures that permeate day-to-day business but cause no immediate harm.” Their research has revealed a pattern: “Multiple near misses preceded (and foreshadowed) every disaster and business crisis we studied, and most of the misses were ignored or misread.” (Sorry, you need a subscription to read the entire HBR article.)

They come up with seven strategies that can help an organization recognize near misses and root out the error behind them. These seem very applicable to compliance programs.

  1. Heed high pressure. The greater the pressure to meet performance goals, the greater likelihood that managers will discount near miss signals.
  2. Learn from deviations. Don’t just recalibrate operations, focus on the significance of the change.
  3. Uncover root causes. Don’t just correct the symptoms.
  4. Demand accountability. Require managers to justify their assessments of near misses.
  5. Consider worst-case scenarios. people tend to not think of the possible negative consequence of a near miss. Walk through a situation where the near-miss does not miss.
  6. Evaluate projects at every stage. Take a look at your successful projects, not just your failures.
  7. Reward owning up. Don’t punish errors, but reward those who uncover near misses.

The authors:

Failure and Compliance

The theme of the April edition of the Harvard Business Review is “Failure.” That’s a scary term in the world of compliance. Generally, that means you’ve got government regulators or enforcement personnel sitting in your offices. And they are not happy. Failure and compliance can mean disciplinary action, fines, or jail time.

But you can learn from failures. You can especially learn from others’ failures.

Ethical Breakdowns by Max H. Bazerman and Ann E. Tenbrunsel takes an insightful look at ethical breakdowns and comes up with five barriers to an ethical organization. (Sorry, you need a subscription to read the entire HBR article.)

  • Ill-conceived goals
  • Motivated blindness
  • Indirect blindness
  • Slippery slope
  • Overhauling outcomes

An ill-conceived goal is the classic failure seen in sales targets, revenue projections, and stock price targets. If you give mechanics a sales goal of $147 hour they can very easily lapse into fixing things that were not broken rather than being more efficient. Sears encountered this problem in the 1990s.

The authors lump a few things into the motivated blindness category, but most notably included are conflicts of interest. They use the failure of rating agencies during the financial collapse as one example. Since the rating agencies are paid by the issuer instead of the buyer of securities, they have a misalignment of motivation. They end up serving the one who pays them, leading to lax ratings and competition for business. That means they may have rated something higher than they should have. (That’s a big understatement.)

Indirect blindness is when third parties are involved. What caught my eye was an experiment examining perceptions of an increase in the cost of a pharmaceutical drug. In the first scenario, the drug company raises the price from $3 to $9. In the second scenario, the drug company sells the rights to a smaller company who then increases the price to $15. The first scenario was judged more harshly, even though it resulted in a lesser price.

We’ve all been concerned about the slippery slope. Little lapses lead to a culture of lapses, eventually leading a big failure. The authors present some interesting research showing how this works and that it is a real problem. From a compliance perspective, they focus on auditors and how good accountants can do bad audits.

The final category is the one I found the most intriguing: overvaluing outcomes. The author’s research showed an inclination to judge actions based on outcomes rather than the behavior. One example is a research failure.

In the scenario A, a researcher pulls four subjects back into the results after they were removed for technicalities. However, the researcher thinks their data is appropriate. When adding them back in, the results shift and allows the drug to go to market. Unfortunately, the drug ends up killing six people and is pulled from the shelves.

In scenario B, a researcher makes up four more data points for how he believes subjects are likely to behave. The drug goes to market, becomes profitable and effective.

The participants in the author’s experiment judged the researcher in scenario A much more critically than the researcher in scenario B. The problem is that the person B had the bigger ethical lapse and worse behavior. It’s just that the outcome, largely by luck, was worse in A than B.

They extrapolate the findings to the situation where a manager is overlooking ethical behaviors when outcomes are good and unconsciously helping to undermine the ethical culture of an organization.

The Monstrous Size of Dodd-Frank

“What is 20 times taller than the Statue of Liberty, 15 times longer than “Moby Dick” and would take the average reader more than a month to read, even if you hunkered down with it for 40 hours a week?”

If you’ve been Dodd-Frank’ed, you know the answer.

The last round of financial overhaul was the Sarbanes-Oxley Act that came out of the Enron scandal. SOx weighs in at 66 pages. Dodd-Frank eats that for breakfast; It’s in heavyweight class at 849 pages.

That is just the legislation. Dodd-Frank put a big burden on financial regulators to work out the details to implement their vision (as myopic as it may be at times).

“In addition to the 30 rule-making procedures that already have missed the deadline set by Congress, 145 are supposed to be completed by year end…. Officials at the SEC, on the hook for more Dodd-Frank-related regulations than any other U.S. agency, have finished six rules, proposed 28 additional rules, missed deadlines on 11—and still have 50 to go, on which they have yet to issue any proposals.”

So far the regulatory “process has produced more than three million words in the Federal Register—or more than 3,500 11-inch-high pages.” And almost 2/3 of the rules required by Dodd-Frank have not even been proposed.

Congressman Barney Frank thinks missing the deadlines is no a big deal. “There is no penalty for not meeting the deadline,” Mr. Frank said during a webinar sponsored by the National LGBT Bar Association. “There’s no gun at their heads. Nobody gets fired.”

Sources: