Month: July 2011

Anti-Money Laundering Obligations For Private Funds

The Financial Crimes Enforcement Network, Treasury’s financial intelligence unit has been trying to impose anti-money laundering obligations on private funds for years. On September 26, 2002, FinCEN issued a notice of proposed rulemaking, proposing to require unregistered investment companies to establish and implement anti-money laundering programs. (Anti-Money Laundering Programs for Unregistered Investment Companies, 67 FR 60617 (Sep. 26, 2002))

In that notice of proposed rulemaking, FinCEN proposed to define the term “unregistered investment company” as (1) an issuer that, but for certain exclusions, would be an investment company as that term is defined in the Investment Company Act of 1940, (2) a commodity pool, and (3) a company that invests primarily in real estate and/or interests in real estate. FinCEN proposed requiring these companies to file a notice so that FinCEN could readily identify such companies and require them to establish and implement anti-money laundering programs.

I think most real estate fund managers and other private fund managers keep an eye on the parties to see if there is a reason to be wary and to see if they on the Specially Designated Nationals and Blocked Persons List. But I had some concern that FinCEN could extend the “know your customer” rules deep into transactions, imposing lots of administrative overhead for little benefit.

In November of 2008, FinCEN filed a notice of Withdrawal of the Notice of Proposed Rulemaking for Anti-Money Laundering Programs for Unregistered Investment Companies . In that notice, FinCEN stated that they were not abandoning the possibility of pursing the rulemaking. Given the six year span since the notice, they feel it has gone stale. If (or when) they decide to proceed with an anti-money laundering program requirement for unregistered investment companies, they will publish a new notice.

The “when” seems to be coming closer.

Senator Levin introduced the Stop Tax Haven Abuse Act. Section 203 of that bill would require the Department of Treasury to require

unregistered investment companies, including hedge funds or private equity funds, to establish anti-money laundering programs and submit suspicious activity reports under subsections (g) and (h) of section 5318 of title 31, United States Code.

The bill defines an “unregistered investment company” as one that would be an investment company but is exempt under 3(c)(1) or 3(c)(7).

Hedge funds may be an attractive source for money-laundering (I’m not sure), but private equity can’t be very enticing. Cash is called as investments are made over the course of the investment period and then slowly returned as investments are realized. I don’t generally think of terrorists and drug lords as patient capital sources.

Nonetheless, most private equity fund managers I’ve talked to investigate the background of their investors. It’s a long term relationship on both sides and managers don’t want to have the headache of having a bad investor. The repercussions of having a blocked-person would be tremendous, both from the legal fallout as well as the damage to the sponsor’s reputation. Most lenders require the fund to warrant that there are no blocked persons in their funds.

The Levin bill would technically leave out real estate fund companies, assuming they are taking advantage of the 3(c)(5) exemption. I sense more regulatory overhead approaching.

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Compliance Bits and Pieces for July 15

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

A snapshot of this year’s disclosure avalanche by Theo Francis in Footnoted

But the biggest filings are also getting bigger: While the top 20 filings in the first half of 2010 totaled 52,514 pages, the top 20 so far this year add up to 56,571 pages, an increase of just under 8%. And the most prolific filers are sending the SEC more documents: 16,412 of them from the top 20 companies, up 9% from the first half of 2010, when the figure was 15,028 filings. With that kind of growth, among other factors, you can imagine why Mary Schapiro wants a budget increase.

Corporate hospitality – The SFO’s five factors in the Bribery Act .com

In response to these continuing uncertainties the SFO have told us that they will be looking at five factors when considering corporate hospitality in the context of the Bribery Act.

“Social Checks” Come of Age: What Does It Mean for Employers? by Philip Gordon in Littler’s Workplace Privacy Counsel

Last month, the Federal Trade Commission (FTC) published a letter closing its investigation into whether an “Internet and social media background screening service used by employers in pre-employment background screening” complied with the Fair Credit Reporting Act (FCRA). At first blush, the letter appears to be a non-event. The FTC did not impose a penalty but also admonished that its “action is not to be construed as a determination that a violation may not have occurred.” While not much can be drawn from this equivocal result, the FTC’s letter does contain the following important conclusion: the “social check” service in question, known as Social Intelligence, “is a consumer reporting agency because it assembles or evaluates consumer report information that is furnished to third parties that use such information as a factor in establishing a consumer’s eligibility for employment.” Put into plain English, employers that rely on a social check service, like Social Intelligence, to search social media for information about job candidates must comply with the FCRA.

Image of file cabinets is by redjar

Chief Compliance Officer and General Counsel Supervisory Responsibility and Liability Brian L. Rubin, Partner

ACA Compliance sponsored this webinar on Thursday. Brian L. Rubin, Partner, Sutherland Asbill & Brennan LLP was the presenter. These are my notes.

Section 203(e) of the Advisers Act:

If an investment adviser fails to reasonably supervise an employee or any other person subject to the adviser’s supervision, and that person violates the federal securities laws, then the SEC may take action against such investment adviser

In the Matter of Pegasus Investment Management, LLC, Peter Bortel, and Douglas Saksa (.pdf) (June 15, 2011) Pegasus VP Peter Bortel, under the supervision of President and CCO Douglas Saksa, allegedly did not disclose the arrangement to their fund investors and retained retained broker rebates for Pegasus, rather than passing it along to the investors. The SEC stated that Saksa failed to reasonably supervise Bortel within the meaning of Section 203(e)(6)

Direct Liability

CCO has direct liability for:

–Aiding and abetting, and causing firm violations such as:

•Responding to regulatory inquiries
•Responding to deficiency letters
•Adopt/implement policies and procedures
•Failing to file

– Permitting unregistered individuals to act

As an example the they cited In the Matter of the Buckingham Research Group, Inc., Buckingham Capital Management, Inc., and Lloyd R. Karp (.pdf) (November 17, 2010). The CCO allegedly represented in deficiency letter response that certain corrective action would occur (new policies/monitoring). The SEC claimed CCO was liable because he was responsible for establishing and administering the policies at issue and he “was aware of the compliance weaknesses and failures and either failed to act or failed to correct them”

Are you a supervisor?

Some factors are whether you have the ability to hire, fire, discipline, affect compensation. You would have the requisite degree of “responsibility, ability or authority” to “affect” the conduct of the employee whose behavior is at issue.

You can still be held liable as the SEC if you are overruled by superiors. (Scary!!)

In the Matter of Theodore W. Urban (.pdf), Adm. Proc. File No. 3-13655, Initial Decision (Sept. 8, 2010) Urban was General Counsel and headed Compliance, HR and Int. Audit. Urban had no authority to hire or fire employees outside of these departments, but he served on the board of directors and the firm’s credit and risk committee as a full voting member. SEC alleged that Urban was bad rep’s supervisor because of the role he played in monitoring bad rep’s actions. SEC also alleged that Urban failed to follow up on numerous red flags and took inadequate action regarding other red flags. As General Counsel, his opinions on legal/compliance matters were “viewed as authoritative and his recommendations were generally followed” by all business units.

The Administrative Law Judge found that Urban was a bad rep’s supervisor, but he had not failed to supervise because he performed his supervisory responsibilities “in a cautious, objective, thorough and reasonable manner”. The decision has been appealed to the SEC. So this ruling may change.

Combination/Separation of Legal and Compliance Functions

Some advantages to combining the roles:

  • Federal Sentencing Guidelines call for adoption of a compliance program overseen by senior personnel
  • Compliance is represented at senior management level
  • GC is actively involved in strategic business decisions, offering exposure to potential compliance issues
  • May be better positioned to push the firm toward appropriate actions/conclusions
  • Direct or tangential experience with regulations
  • “Noisy Withdrawal” trigger
  • Reduced headcount
  • GC is generally consulted on key compliance matters by senior management

Why separate the roles?

  • Respects the differing goals of legal versus compliance (legal protects the firm; compliance prevents and detects violations
  • Allows firms to acquire necessary skill set in each area
  • Avoids misplaced privilege claims
  • Creates necessary bandwidth to execute each role fully
  • Allows each person to serve appropriate stakeholders
  • Avoids conflicts at the board level/recusals
  • Compliance gets same standing as legal in organization charts

Reporting

How about the CCO Reporting to GC?

  • Centralizes legal and compliance in a single functional area. There is overlap.
  • Matters identified can be more quickly resolved due to combination of functions
  • GC may be in a good position to muster resources or provide a platform
  • Gives clout to the compliance function. To the extent legal has clout.

How about an Independent CCO

  • Highest degree of independence
  • Decisions to report matters up to senior management or to regulators not subject to approval by GC
  • CCO does not have to go outside reporting structure to raise matters to senior management
  • GC does not need to create time to supervise the CCO
  • Consistent with ICA 38a-1 and FINRA Rule 3130

As a case study, they used the Wunderlich case.

Avoiding Supervisory Responsibility

  • Document with written supervisory policies and procedures
  • Identify the direct supervisors of all employees
  • Specifically state that compliance personnel are limited to offering advice and recommendations and do not have the responsibility, ability or authority to affect the conduct of employees outside of their departments
  • Where misconduct is addressed, document which business-line supervisor is handling the issue and how
  • Make it clear that the role on committees and boards is only advisory in nature

Compliance and Google+

google-plus

Over the past few weeks, Google+ has exploded as a new social web platform. We had friends on Facebook and followers on Twitter. Now there are Circles on Google+.

What does this mean from a compliance perspective?

Not much for right now. Google+ does not seem to present any new issues that we haven’t already seen in social media. My general impression is that it’s a hybrid of Twitter and Facebook. This is both in terms of privacy and the way communications flow.

I expect there will be a few hiccups with the privacy settings as we have already seen with Facebook. The use of “circles” allows you limit who can see your communications. But since anyone in that circle can then share it with people in their circle, any message can easily become public. If you want to keep you message a bit more private, there is a button that can check to prevent sharing.

To the extent you have a social media or communications policy you should make sure it takes into account Google+. To the extent you need to archive and preserve messages, you will need to take Google+ into account. Hopefully Smarsh and the other vendors will get access to the API so they can find a way to preserve the messages.

If you block access to social networking sites, Google+ is a little trickier to deal with. It looks like it operates as a subdomain on Google.com. I don’t think too many c0mpanies want to block access to Google.com. Your blocking software will need to make sure it only limits the plus.google.com subdomain. And it’s https:, not http:.

Will Google+ live long enough to be a concern for compliance? Maybe. I have a hard time believing people will use Facebook, Twitter and Google+. I suspect that Google+ will need to take users away from Facebook and Twitter to be successful.

I don’t suspect it will cause many people to abandon Facebook. Google+ is slicker, but Facebook has the bigger user base. As Andrew McAfee once told me, the new tool can’t just be a little better, it has to be many times better for people to switch.  I don’t find Google+ to be that much better than Facebook. Most importantly for me, Facebook has the largest collection of close friends and family. (My “Family” circle on Google+ is empty, my “Friends” only has a few handfuls of people, and my “compliance” circle has a single person.)

Twitter is the most likely victim of Google+. It removes the 140 character shackle and threads conversations together. Twitter still has better integration with other platforms. On the other hand, there is the possibility that Google+ could tie together many of Google’s other platforms.

It will be hard to kill Twitter. All of the news coverage about placing the valuation of Twitter in the billions of dollars are tied to Twitter’s latest round of raising money from investors. I would guess that the company is sitting on a big pile cash that will take a long time to burn through, leaving them plenty of cash to improve the product and find ways to generate revenue.

Google+ will cause more compliance headaches. For now, it doesn’t appear to create any new headaches.

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SEC Made It Harder to Earn Performance Fees

As a general rule, investment adviser cannot charge performance fees. Section 205(a)(1) of the Investment Advisers Act of 1940 generally prohibits an investment adviser from entering into, extending, renewing, or performing any investment advisory contract that provides for compensation to the adviser based on a share of capital gains on, or capital appreciation of, the funds of a client. That means no performance fees.

Unless the SEC makes an exception, which it has done so for people that don’t need the protections of that prohibition. Historically, that has meant the person has a “big pile of cash”. The big pile of cash standard had been if the client has at least $750,000 under the management of an investment adviser or the adviser reasonably believes the client has a net worth of more than $1,500,000.

Back in May the SEC has proposed raising those limits to $1 million under management or a minimum net worth of $2 million. The SEC was required to adjust the standard under Section 418 of Dodd-Frank. The adjustment was keyed to inflation. The SEC decided to exclude the value of person’s home, just as they did with the accredited investor standard, in calculating net worth.

As for private  funds, Rule 205-3(b) requires a look -through from the fund to the investors in the fund if it is relying on the 3(c)(1) exemption under the Investment Company Act. 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.

The new standard will go into effect on September 19, 2011.

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Image: http://www.rgbstock.com/image/misbgGc/Money+series+2
licensed for reuse

How Close Should You Come to Crossing the Line?

It’s clearly wrong to break the law. How close should you come to the limit of what is legal and what is illegal? Let’s hear from a federal prosecutor:

[I]f you are single-mindedly focused on walking the line, you are bound to end up afoul of regulators, and God forbid, criminal prosecutors. Even more dangerous perhaps, you are sending a message to every other person at the firm that line-walking is a good idea. That can work for a while, but people will invariably miscalculate and bad things will invariably follow.

– Preet Bharara, United States Attorney for the Second Circuit

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Image is Linda Crossing the Line by Ville Miettinen

Another FCPA Opinion Procedure Release on Corporate Hospitality

The Department of Justice released the latest Opinion Procedure Release on the Foreign Corrupt Practices Act. The releases are great tool to help you figure out if a proposed corporate action could lead to an enforcement action. Anyone with an interest in the FCPA looks to the existing body of opinion releases as a way to help understand the DOJ’s interpretation of the law and what corporate actions are acceptable, which are risky and which are forbidden.

This opinion request came from an adoption agency. So maybe there is an interesting twist to their corporate behavior that could offer an interesting new perspective on the FCPA.

Unfortunately FCPA Opinion Procedure Release 11-01 (.pdf) covers no new ground. In fact the fact pattern is nearly identical to those presented in the FCPA Opinion Procedure Release 2007-01 and 2007-02.

At best the release once again lays out best practices for corporate hospitality:

  • Let the government agency pick who will come.
  • No spouses or family members on the trip
  • Pay costs directly to providers
  • No cash to the government officials
  • Souvenirs should be of nominal value and/or have the corporate logo
  • Don’t fund side trips or leisure activities
  • Focus the function on educating the visiting officials about the operations and services of your company

These best practices were in the old opinion releases. Howard Sklar scratched his head over why the requestor went through the trouble and expense of getting this opinion release.  I share the same thoughts. The fact pattern was not a close call. Anyone who could spell FCPA should have been able to find the releases. The DOJ has all of the FCPA Opinion Procedure Releases published on their FCPA website.

Maybe it was the nature of the requestor: and international adoption agency. I would guess that the government officials are from either Russia or China, two countries with an international reputation for bribery and corruption.

From what I’ve heard from some friends, there are often numerous shakedowns and cash requests made on the adoptive parents during the international adoption process.  Obviously, the parents are in an emotionally fragile state when heading overseas to adopt. They are likely in a country that is unfamiliar to them, lost in a fog of foreign languages. Could some of those “gifts” be bribes and could some of the recipients be foreign officials? Sure.

There have been big headlines about FCPA enforcement actions in the US and the coming rise of enforcement under the UK Bribery Act. The adoption agency should be concerned that its activities could be in violation of these laws.

International adoption agencies also have a larger moral question to consider. To the extent they are making payment or encouraging the adoptive parents to make payments, their activities start to look more like baby buying. If the activity is more wholesale, you end up looking like a baby farmer. I think more people are concerned with that moral question, than the legal question of bribery.

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Compliance Bits and Pieces for July 8

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

Lessons of the Financial Crisis: The Dangers of Short-Termism by Sheila C. Bair, Chairman of the Federal Deposit Insurance Corporation, in the Harvard Law School Forum on Corporate Governance and Financial Regulation

[I]n my opinion, the overarching lesson of the crisis is the pervasive short-term thinking that helped to bring it about. Short-termism is a serious and growing problem in both business and government. I would like to devote my remarks to explaining what I mean by this, and discussing how I think it plays into the policy challenges arising from the crisis.

SEC works to get rid of “The Lease to Nowhere” by Sonya Hubbard in Footnoted

The temperature may have officially reached the high 80s yesterday afternoon in Washington, D.C., but we bet it was significantly hotter in room 2167 of the Rayburn House Office Building. That’s where the SEC’s Chairman, Mary Schapiro, and its Inspector General, H. David Kotz, were in the hot seat to answer questions for the Congressional Sub-Committee on Economic Development, Public Buildings, and Emergency Management (which falls under the auspices of the Committee on Transportation and Infrastructure) about the $556 million, 10-year lease that the SEC signed last summer for 900,000 square feet of space in D.C.’s Constitution Center.

How Is Law School Like the NFL Draft? Jonathan Tjarks in Policymic

Admittance into a top-14 law school, like a scholarship from a top-10 college football program, is the culmination of a lifetime of striving. Of the over 100,000 high school seniors who play football, fewer than 3,000 sign Division I letters of intent. Similarly, the top 25% in Harvard Law’s 2009 class had an average GPA of 3.95 and a LSAT score of 175, which puts them in the 99th percentile of the over 100,000 test takers each year.

Can a Libyan Rebel Be a Foreign Governmental Official under the FCPA? by Tom Fox in FCPA Compliance and Ethics Blog

So I began to wonder, can a person be a Foreign Governmental Official when the persons they are assisting, the Libyan rebels, are not recognized as the national government of a country. Even if a government is under economic sanctions by almost every country in the world that does not necessarily mean that it is not the government of that country.

Yes, the SEC Wants Real Estate Fund Managers to Register

After six months baking in the oven, the new Form ADV is ready. (To be more precise, the new Part 1 is ready. Part 2 has been sitting on the table for almost a year.) Form ADV still calls for real estate fund managers to register as investment advisers

Earlier I had pointed out how a real estate fund manager could be considered an investment adviser and have to register with the SEC under the Investment Advisers Act. In the Proposed Changes to Form ADV the SEC included “real estate fund”. They also changed the way you calculate assets under management, taking in the value of the fund assets, not just securities held by the fund.

While waiting for Form ADV to finish baking, I wondered if there might be some clarification or changes to pull real estate funds out of the registration requirement. It didn’t happen.

As you can see from the image above, “real estate fund” is still one of the choices when it comes to designating the type of fund. That gives it equal status with hedge fund, venture capital fund, and private equity fund. The definition of real estate fund is unchanged in the instructions for Part 1A of Form ADV:

“Real estate fund” means any private fund that is not a hedge fund, that does not provide investors with redemption rights in the ordinary course, and that invests primarily in real estate and real estate related assets.

Maybe there is room under the definition of “private fund”? In the Glossary it’s defined as “An issuer that would be an investment company as defined in section 3 of the Investment Company Act of 1940 but for section 3(c)(1) or 3(c)(7) of that Act.” That does leave open the position that the fund could be exempt under section 3(c)(5). That’s a murkier exemption than the one provided by 3(c)(1) or 3(c)(7).

The other confusion over how to value the assets under management is gone. The old version of Form ADV had a 50% test for assets under management. If less than 50% of the value was not securities, then you didn’t have a securities portfolio and the value was zero.

The new way of calculating assets under management for a private fund from the Instructions for Part 1A:

For purposes of this definition, treat all of the assets of a private fund as a securities portfolio, regardless of the nature of such assets. For accounts of private funds, moreover, include in the securities portfolio any uncalled commitment pursuant to which a person is obligated to acquire an interest in, or make a capital contribution to, the private fund.

It still gets back to being a “private fund” and relying on a 3(c)(1) or 3(c)(7), instead of a 3(c)(5) definition. One thing to realize is that the definition of “private fund” actually comes from Section 402 of Dodd-Frank, not from the wishes of the SEC. The intent of the SEC is clear, even if there may be some wiggle room.

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Real Estate Fund Managers and the CFTC

Many real estate fund managers, used to the lack of regulatory oversight, are wrestling with the implications of Dodd-Frank. One of the biggest sources of hand-wringing is whether to register as an investment adviser given the removal of the 15 clients exemption from the Investment Advisers Act. Another agency is potentially making regulatory changes leading to a registration requirement.

The Commodity Futures Trading Commission has proposed removing some exemptions from the requirement to register as Commodity Pool Operator or a Commodity Trading Advisor. I have never paid much attention to these requirement. That is because interest rate swaps and foreign exchange hedges generally fell outside the definition of a commodity.

However, Section 712(d)(1) of the Dodd-Frank Act empowers the CFTC and SEC to define swaps and could re-classifies “swaps” as “commodities”. That brings these formerly unregulated contracts under the regulatory regimes of the CFTC and the SEC. Under the comprehensive framework for regulating swaps and security-based swaps established in Title VII of Dodd-Frank, the CFTC is given regulatory authority over swaps and the SEC is given regulatory authority over security-based swaps. They can fight over mixed swaps.

The concern I have is that a real estate fund is likely to have “swaps” in place to reduce interest rate risk. If they are operating overseas, they may have hedges in place to reduce foreign exchange risk. Since those are likely to fall under the new definition of swap, and there is no end-user exemption, the real estate fund and its manager could now also fall under the regulatory regime of  the CFTC.

CFTC Rule 4.13(a)(3) currently exempts a fund from registration as a Commodity Pool Operator if:

  • the fund’s interests are exempt from registration under the Securities Act of 1933 (’33 Act);
  • the investors in the fund are only Qualified Eligible Persons, accredited investors or knowledgeable employees;
  • the pool’s aggregate initial margin and premiums attributable to futures and options on futures do not exceed 5 percent of the liquidation value of the pool’s portfolio;
  • the fund is not marketed at a vehicle for trading in commodity futures or commodity options markets.

Rule 4.13(a)(4) currently exempts you from registration as a Commodity Pool Operator if the interests in the fund are exempt from registration under the ‘33 Act and the operator reasonably believes all participants are Qualified Eligible Persons or accredited investors.

The CFTC  is proposing to eliminate these exemptions because it is concerned that they are big loopholes from exemption. I think an unintended consequence could be dragging real estate funds and real estate operators into the regulatory framework.

I have to admit that I’ve just started reading the swap rules and the CFTC framework so I don’t understand how it all fits together. Frankly, the provision in Dodd-Frank and the proposed rules are a mess and full of inconsistencies, making this situation even harder to figure out and likely creating some unintended consequences.

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