Month: March 2012

Are you a Supervisor?

As a compliance officer, how far do you need to go in dealing with a problem employee? The Urban case was trying to address this question, but got twisted up in procedural machinations. In dropping the case, the two SEC commissioners didn’t explain when a compliance officer or in-house counsel at a broker-dealer or investment adviser becomes a supervisor liable for an employee’s actions.

The case began with suspicious trading at Ferris, Baker Watts, Inc. by Stephen Glantz, a top-performing broker. In 2007, the U.S. attorney in Cleveland accused Glantz and an accomplice of scheming to artificially increase the stock price of Innotrac Corp., a company that provides e-commerce fulfillment services. Glantz pleaded guilty in September 2007 to one count of stock fraud and one count of making a false statement. He was sentenced to 33 months in prison.

The SEC moved up the chain and began investigating Theodore W. Urban, Ferris, Baker Watts, Inc.’s, General Counsel, Executive Vice President, and a voting member of the Board of Directors, the Executive Committee of the Board, and the Credit Committee. The SEC’s claim was that Urban was a supervisor of Glantz and that he failed to properly supervise him.

Urban had a hearing before the SEC’s chief administrative law judge in March 2010. The judge decided that that although Urban was, under the law, the broker’s supervisor, he “performed his responsibilities in a cautious, objective, thorough and reasonable manner.” As a result, “Urban did not fail to supervise.”

Apparently, the SEC was not happy with losing that case, so the Enforcement Division petitioned the commission for a review of the decision. On Jan. 26, the SEC dismissed the case, leaving compliance officers and in-house counsel with no guidance on when you are a supervisor.

SEC Chairman Mary Schapiro, Elisse Walter and Daniel Gallagher recused themselves for unexplained reason. The remaining two, Parades and Aguilar, couldn’t agree.

Commissioner Gallagher to address the topic in his speech at The SEC Speaks in 2012:

Once again, I want to stress that firms and investors are best served when legal and compliance personnel feel confident in stepping forward and engaging on real issues. An overbroad interpretation of “supervision” risks tacitly deputizing as a supervisor, with concomitant liability, anyone who becomes actively involved in assisting management in dealing with problems. Deterring such active involvement will erode investor confidence in firms, to the detriment of all.

Looking at the Enforcement Division’s view of a supervisor:

Gutfreund 51 S.E.C. 93 (1992): the person was not a line supervisor and others shared supervisory responsibility; still, he was a supervisor because he had the requisite degree of responsibility, ability, or authority to affect the person’s conduct when senior management informed him of the misconduct to obtain his advice and guidance and to involve him as part of management’s collective response to the problem.

Kirk Montgomery, 55 S.E.C. 485, 500 (2001): a chief compliance officer is a supervisor because it was sufficient if the person plays a significant, even if shared, role in the firm’s supervisory structure and that his authority was subject to countermand at a higher level.

Urban was required to take concerns about Glantz’s conduct to the Ferris Board or Executive Committee, and, if they did not act, he was required to resign and report the matter to regulatory authorities.

That is a very harsh standard for compliance officer or general counsel when dealing with an employee that he or she does not directly supervise. The final decision by the SEC leaves it murky as to whether that position by the Enforcement Division is the position of the Commissioners.

If you can’t get a compliance problem fixed what should you do?

Sources:

How Do State Regulators Really Feel About the JOBS Act?

The House of Representatives recently voted to pass The Jumpstart Our Business Startups (JOBS) Act (H.R. 3606), a collection of several bills focused on barriers to capital formation. I’m focused on the bill because of mostly because of the Access to Capital for Job Creators section that would override the ban on general solicitation and advertising under Regulation D.

I welcome some sensible changes to Regulation D because I find the ban a bit vague as part of the fundraising process. Private fund managers could use guidance from the SEC on what is allowed and what is prohibited by the ban.

On the other hand, knowing the general ban exists makes it easy to dismiss scams and spam spinning tales of possible investment opportunities. That unsolicited message is either a straight-up scam or a naive entrepreneur who thinks they can operate without competent advice. Either way you can easily dismiss the opportunity.

Another provision of the JOBS Act that I found interesting is the Private Company Flexibility and Growth Act. The main purpose is to raise the thresholds under Section 12(g)(1)(A) of the Exchange Act. Currently under that provision, private companies with more than 500 shareholders and a big stream of revenue effectively have to become public companies. That shareholder limit forced Google into going public and most recently is forcing Facebook to go public.

The centerpiece of the JOBS Act is the new crowdfunding platform. Currently, platforms like Kickstarter are prohibited from offering equity. Project sponsors have to ask for donations, offer schwag, or pre-sell products. All of which seems to work very well.

Commentators like William Carleton think the concept of crowdfunding will be great for entrepreneurs. The Wall Street Journal has a point-counterpoint this morning on crowdfunding:

Like most stuff coming out of Congress, even if the concept is good I think Congress is likely to screw up the drafting of the law.

That is my view of the JOBS Act. Most of the concepts are good, but the execution is poor. I think Congress is missing the balance between investor protection and access to capital. That opinion is shared by the North American Securities Administrators Association. Here is a snippet from an editorial by Jack E. Herstein, president of NASAA:

The most jobs this cleverly named bill may create are jobs for fraudsters, like the Nigerian scammers, penny-stock pitchers and Ponzi schemers already lurking behind the Internet to cloak their schemes.

The Senate is mulling over their version of these bills where it seems to have bi-partisan support. President Obama has also thrown his support to some of the concepts in the JOBS Act. It seem likely that something will pass. According to Talking Points Memo it looks like Senate Majority Leader Harry Reid is willing to trade support for the JOBS Act for approval of some judicial nominees.

Sources:

Compliance Bits and Pieces for March 16

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

Availability of Staff Analysis of Market Data Related to Credit Default Swap Transactions from the Securities and Exchange Commission

The staff of the Securities and Exchange Commission today has made available publicly an analysis of market data related to credit default swap transactions. … The SEC staff believes that the analysis of market data has the potential to be informative for evaluating certain final rules under Title VII, including rules that further define “major security-based swap participant” and “security-based swap dealer,” and rules implementing the statutory de minimis exception to the latter definition. Analyses of this type particularly may supplement other information considered in connection with those final rules, and the SEC staff is making this analysis available to allow the public to consider this supplemental information.

SEC Chair Schapiro Urges Senate to Include Additional Investor Protections in House-Passed JOBS Act in Jim Hamilton’s World of Securities Regulation

In a letter to Senate Banking Committee Chair Tim Johnson (D-SD)and Ranking Member Richard Shelby (R-AL), Sec Chair Mary Schapiro said that the Jumpstart Our Business Startups (JOBS) Act, HR 3606, passed by the House would weaken investor protections by, for example, exempting emerging growth companies from the internal control auditor attestation provisions of Section 404(b) of Sarbanes-Oxley. … In the letter, she also noted that SEC rulemaking mandated by HR 3606 is simply not achievable within the indicated time limits. For example, the rulemaking implementing the crowdfunding provisions must be completed 180 days. Chairman Schapiro suggested that a deadline of 18 months would be more appropriate for regulations of this magnitude.

Behind the Standards: Clarifying SAS 70’s Confusing Departure by Dan Zitting in Corporate Compliance Insights

The demise of SAS 70 audits raises questions, confusion and a dose of drama. To gain clarity on the auditing standard’s replacement and its alternatives, it helps for service providers and their customers to understand what went on behind the scenes that caused in this change.

World’s Most Ethical Companies – 2012 Edition

The Ethisphere Institute announced its sixth annual selection of the World’s Most Ethical Companies. One hundred forty-five organizations made the list in 2012 from more than three dozen industries, including 43 headquartered outside the United States.

Twenty-three companies that have been honored each of the six years the WME has been awarded, including Aflac, American Express, Fluor, General Electric, Milliken & Company, Patagonia, Rabobank. and Starbucks.

In the past, I’ve analyzed the list and found that investing in the companies on the list was a good choice. Last year, I looked at the 2007 list and projected forward and found that an investment in those companies would have out-performed the S&P 500 and Dow Jones Industrials.

Last year, Ethisphere highlighted the fact that this list of companies outperformed the S&P 500. That’s missing this year.  I went back to the 2007 list to see what happened .

I still see an outperformance: 13.12% versus -3.48% for the S&P and 3.02% for the Dow Jones Industrials.

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

That seems to show that being ethical is generally good for a company’s shareholders.

Real Estate Funds and Form PF

In addition to filing Form ADV with the SEC when they register with the Securities and Exchange Commission, private fund managers will also need to start filing Form PF. I received a helpful reminder about this last week form SEC’s IARD system. (I’ll need to get used to messages with the subject line: “Firm 158137: An Important Message from the SECURITIES AND EXCHANGE COMMISSION”.)

SEC-registered investment advisers that manage one or more private funds and, collectively with an adviser’s related persons, had at least $150 million in private fund assets under management will be required to file Form PF in the future (beginning either after June 2012 or December 2012 depending upon each adviser’s specific situation). Please see Form PF and its general instructions for additional information … and the SEC’s recently adopted rule …. Please note that advisers report private funds in Item 7.B on Form ADV as well. Form PF will be filed in the future either through an online form or through an XML submission process.

The amount of information required by Form PF is tiered, depending on the type of fund. Hedge funds have the biggest burden.

Where do real estate funds fit into the reporting requirements?

In the glossary, a Real estate fund is

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.

That sounds right, but I still need to look at the definition of Hedge fund:

Any private fund (other than a securitized asset fund):
(a) with respect to which one or more investment advisers (or related persons of investment advisers) may be paid a performance fee or allocation calculated by taking into account unrealized gains (other than a fee or allocation the calculation of which may take into account unrealized gains solely for the purpose of reducing such fee or allocation to reflect net unrealized losses);
(b) that may borrow an amount in excess of one-half of its net asset value (including any committed capital) or may have gross notional exposure in excess of twice its net asset value (including any committed capital); or
(c) that may sell securities or other assets short or enter into similar transactions (other than for the purpose of hedging currency exposure or managing duration).

That definition talks about getting performance fees on unrealized gains. That would be unusual for a real estate fund or private equity fund.

The form also has more detailed requirements for large private equity advisers. For purposes of Form PF, “private equity fund”is

any private fund that is not a hedge fund, liquidity fund, real estate fund, securitized asset fund or venture capital fund and does not provide investors with redemption rights in the ordinary course.

So a real estate fund is not a private equity fund and not subject to the additional reporting requirements.

The last category that has enhanced reporting is liquidity fund advisers:

Any private fund that seeks to generate income by investing in a portfolio of short term obligations in order to maintain a stable net asset value per unit or minimize principal volatility for investors.

That leaves real estate funds reporting the information in Section 1a and Section 1b. That’s still a great deal of information.

Being a member of the “all other advisers” category, the filing is due with 120 days after the end of the fiscal year. Assuming calendar year is my fiscal year, the first filing is due by April 30, 2013.

Sources:

Compliance Bits and Pieces for March 9

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

SEC commissioner, deputy director in public flap over private funds by Mark Schoeff Jr. in Investment News

Just as a new regulation requiring private-investment funds to register with Securities and Exchange Commission is about to go into effect, an agency official said that the regulator should consider lifting the mandate on some managers because they cater to sophisticated investors.

“I would not anticipate broad exemptive relief at this point,” Mr. Plaze said. “If there are any changes in the area, it will be done in Congress.”

“Accredited Investor” Net Worth Standard: A Small Entity Compliance Guide from the SEC

The accredited investor standards are used in determining the availability of certain exemptions from Securities Act registration for nonpublic and limited offerings, including most offerings under Regulation D. The accredited investor concept identifies investors who are eligible to participate in those offerings of unregistered and illiquid securities. In order to rely on investor status as an “accredited investor,” issuers must know or have a reasonable basis to believe that the investor falls within one of eight categories. The individual net worth standard is one such category.

How FATF Recommendations on Anti-Money Laundering Inform Your Compliance Program by Tom Fox

The Financial Action Task Force (FATF) is an inter-governmental body established in 1989 by the Ministers of its Member jurisdictions. Its mandate is to set standards and to promote effective implementation of legal, regulatory and operational measures for combating money laundering, terrorist financing and the financing of proliferation, and other related threats to the integrity of the international financial system. In collaboration with other international stakeholders, it also works to identify national-level vulnerabilities with the aim of protecting the international financial system from misuse.

2012 Annual Compliance Obligations: What You Need To Know by: Ildiko Duckor and Peter Chess in Pillsbury’s Investment Fund Law Blog

In light of the current regulatory environment, now more than ever, it is critical for you to comply with all of the legal requirements and best practices applicable to Investment Advisers. The beginning of the year is a good time to review, consider and, if applicable, satisfy these requirements and best practices.

Scalping as a Fraud


Today, it’s fairly well establish that an investment adviser should not be buying positions on their own behalf shortly before recommending that position to its clients. Fifty years ago, there was some question as whether the Securities and Exchange Commission could take steps to prevent this or require disclosure.

The test case came against Capital Gains Research Bureau. The firm produced a monthly newsletter recommending securities. In 1960 the firm purchased securities before recommending them in its report for long-term investment. On each occasion, there was an increase in the market price and the volume of trading of the recommended security within a few days after the distribution of the Report. Immediately thereafter, the firm sold its position at a profit.

The SEC sought an injunction to stop that practice unless the firm disclosed that it may be trading in the securities mentioned in the report. The firm challenged the injunction by saying the SEC has to show an intent to injure clients or an actual loss of money. The trial court and the appellate court agreed with the firm. The SEC continued the fight and the case ended up in the hands of the Supreme Court.

The justices of the high court came to the rescue of the SEC.

The high standards of business morality exacted by our laws regulating
the securities industry do not permit an investment adviser to trade on the market effect of his own recommendations without fully and fairly revealing his personal interests in these recommendations to his clients.

Experience has shown that disclosure in such situations, while not onerous to the adviser, is needed to preserve the climate of fair dealing which is so essential to maintain public confidence in the securities industry and to preserve the economic health of the country.

And so, the SEC gained the ability to expand the types of activity that could be considered fraudulent, deceptive, or  manipulative. And to do so without having to show an intent to injure clients or an actual loss of money.

Sources:

Image is The scalping of Josiah P. Wilbarger

This image is in the public domain in the United States. This applies to U.S. works where the copyright has expired, often because its first publication occurred prior to January 1, 1923.

Battling Back Against Spammers

The SEC posted a warning on Bogus E-Mail Purporting to be from SEC Office of the Whistleblower. The SEC’s Office of the Whistleblower is real; the e-mail is a hoax.

Earlier this week I received an angry email complaining about spam sent by me. That left me a bit confused because I don’t send out spam. It turns out a scumbag was sending around a fake message from the SEC’s Whistleblower Office:

Dear customer, Securities and Exchange Commission Whistleblower office has received complaint about alleged misconduct at your company, including Material misstatement or omission in a company’s public filings or financial statements, or a failure to file Municipal securities transactions or public pension plans, involving such financial products as private equity funds.

Failure to provide a response to this complaint within 21 day timeframe will result in Securities and Exchange Commission investigation against your company. You can have access to the complaint details in U.S. Securities and Exchange Commission Tips, Complaints, and Referrals portal under the following link …

It turns out the email was using a hotlink to a copy of the SEC logo I store on this website. So the email displays the SEC logo by pulling the image from Compliance Building.

My first action was to delete the image file. I don’t want to help the spammers. This left a little red “x” in the email indicating a missing image.

Then I noticed that the email was running rampant. My site stats tools did not pickup hotlinked image files. My webhost pointed me to the visitors log. That showed thousands of instances of that image file being accessed every hour.

I decided to change course and fight back. Since I know just enough html to get myself in trouble, I decided to change the image, but keep the same image file name and file path. I inserted the simple image you see at the top of this story.  Email recipients of the spam will see that image instead of the SEC logo. Hopefully that will make email much less effective.

In case you couldn’t follow, the spam email originally looked like this:

By changing the image file on my site, the spam email now looks like this:

I’m just sorry that I didn’t see the usage sooner. I also contacted the site that supposedly hosted the complaint details. They removed the offending file, hopefully putting an end to the mischief. The spam email seems to still be in wide circulation since I see that image file getting accessed so often.

Private Fund Advisers and State Registration

As a result of the shifting boundaries between state and federal regulation of investment advisers, NASAA created a model rule for Registration Exemption for Investment Advisers to Private Funds. The rule tracks the general parameters of the new federal rules for investment adviser registration for private fund advisers.

Massachusetts became the latest state to adopt its own regulations with such an exemption. A new private fund adviser exemption was adopted by the Massachusetts Securities Division, along with amendments to the “qualified institutional buyer” definition and IA custody requirements.

While the amendments took effect February 3, 2012, they will be not be enforced until August 3, 2012. You’ve got six months to get in compliance. The rules apply to adviser firms doing business in the Commonwealth, which generally means having a place of business in Massachusetts.

The new Massachusetts exemption is available to advisers to private funds that take money only from “qualified clients.” That definition carries over from Rule 205-3. Under that updated SEC rule,  “qualified clients” must have at least $1 million of assets under management with the adviser, up from $750,000, or a net worth of at least $2 million, up from $1 million.

Private funds using the Section 3(c)(7) exemption under the Investment Company should already meet this standards. Managers to section 3(c)1 funds will need to increase their threshold for investors from accredited investors to qualified clients.

The Massachusetts regulation tries to complement the SEC changes affecting private fund advisers under Dodd-Frank. So private fund advisers with between $25M-$150M in AUM, would have to file the exempt-reporting adviser sections of Form ADV. Those with more than $150M in AUM would have to notice file in the state as well as register with the SEC. Those private fund advisers with under $25M in AUM would also complete the exempt reporting sections of the form for Massachusetts.

States are still trying to catch up to the Dodd-Frank requirements:

They are well behind, leaving some uncertainty for managers of smaller private funds about their registration requirements.

Sources:

Are You a CPO?

The first question is what is a CPO and why should I care? The Commodities and Futures Trading Commission decided to tighten the exemptions from registration potentially pulling some hedge funds and private equity funds that previously ignored the CFTC. Davis Polk held a webinar on this topic. Some private fund managers may get the CPO label and have to deal with the CFTC regulatory regime.

CPO is the CFTC acronym for “Commodity Pool Operator”, which refers to any person engaged in the business of soliciting investors for an investment trust operated for the purpose of trading in commodity interests.

  • Commodity interests include futures (including agricultural, metal and financial futures), commodity options and, upon the issuance of final rules under Dodd-Frank, swaps.
  • Swaps include a wide variety of transactions, including interest rate swaps, many types of currency swaps, energy and metal swaps, agricultural swaps, commodity swaps, swaps on broad-based indices, and swaps on government securities.

The CFTC has long expressed the view that transacting in any amount of futures contracts (either directly or indirectly) would cause a fund sponsor to be deemed a commodity pool operator. There is no de minimis exception in the definition. So the CFTC position results in the conclusion that fund sponsors who have interest rate swaps or foreign exchange swaps will likely be deemed to be commodity pool operators and will need to evaluate whether an exemption is available. Even a funds of funds may also be deemed to be commodity pools depending on the investment activities of underlying funds.

There used to be a broad exemption. CFTC Rule 4.13(a)(4) provides a blanket exemption from CPO registration for sophisticated investor funds (i.e., those offered to Qualified Purchasers). The CFTC has decided to rescind this exemption.

A private fund sponsor will be required to register unless each of its funds satisfies the de minimis trading limitations under the terms of Rule 4.13(a)(3). Under these requirements, either:

  • Initial margin and premiums for commodity interest transactions must be less than 5% of the liquidation value of the fund; or
  • Aggregate net notional value of commodity interest transactions must be less than 100% of the liquidation value of the fund.

In addition to those de minimis trading requirement, Rule 4.13(a)(3) is available so long as:

  • the fund is offered privately to certain types of investors; and
  • the fund is not marketed as a vehicle for trading in the commodity futures or commodity options markets.

Investors in a Rule 4.13(a)(3) vehicle may include, among others:

  • any accredited investors under Reg D; and
  • knowledgeable employees as defined under Rule 3c-5 under the 1940 Act and certain other employees.

Most private equity and real estate private equity fund should be able to meet these hurdles and can focus on the 5% margin test and the 100% net notional exposure test.

5% margin test: The aggregate initial margin and premiums for commodity interest transactions (and minimum security deposits for retail forex transactions) must be less than 5% of liquidation value of the fund (including unrealized profits and losses to date).

100% net notional exposure test: The aggregate net notional value of commodity interest positions must not exceed 100% of the liquidation value of the fund.

  • Notional value is defined by asset class.
  • Futures contracts are valued by multiplying the number of contracts by the size of the contract.
  • Futures options are based on the strike price per unit and adjusted by the option’s delta.
  • Futures contracts with the same underlying commodity may be netted across markets.
  • Notional value of swaps cleared by the same DCO may be netted, “where appropriate”.

The 5% margin test or 100% net notional exposure tests are required to be met at each time that a commodity position is established.

The CFTC has requested comments during the 60-day period beginning on Friday, February 11, 2011.  If the proposed rule is adopted, the CFTC will issue a final rule that will specify when hedge fund and other private fund managers relying on CFTC Rules 4.13(a)(3) and 4.13(a)(4) will need to revise or cease their commodity interest trading or register as CPOs (and, if applicable, CTAs) and become members of the NFA.

The text of the proposed rule can be found here: http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2011-2437a.pdf