More Private Fund Advisers Register than SEC Expected

From the great sources at IA Watch:

The numbers may not be final, but they’re close. Some 1,400 private fund advisers registered with the SEC by the first week of April, sources tell IA Watch. Owing for some stragglers, these appear to be what Dodd-Frank wrought by way of new advisers. They join some 2,600 private fund advisers that had elected to register long before the congressional mandate.

By last week, an additional 1,968 so-called exempt-reporting advisers had filed (IA Watch, June 27, 2011). These private fund advisers will have to update their subset of Form ADV questions annually. The agency expects more ERAs to file this month, bringing the total to about 2,000 by May.

The additional reporting growing out of Dodd-Frank and the financial crisis means the agency now has data on about 38,000 private funds, including feeder funds, the source states.

There are now more than 12,600 RIAs, although the agency expects about 2,600 of these to shimmy over to state registration by July (IA Watch, Dec. 12, 2011).

Compliance Bits and Pieces for April 13

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

The Skyscraper Index from Barclays Capital (via Barry Ritholz’s The Big Picture)

Our Skyscraper Index continues to show an unhealthy correlation between construction of the next world’s tallest building and an impending financial crisis:New York 1930; Chicago 1974; Kuala Lumpar 1997 and Dubai 2010.

Yet often the world’s tallest buildings are simply the edifice of a broader skyscraper building boom, reflecting a widespread misallocation of capital and an impending economic correction.

Investors should therefore pay particular attention to China – today’s biggestbubble builder with 53% of all the world’s skyscrapers under construction – andIndia – which with just two completed skyscrapers, now has 14 skyscrapers under construction

Why Matzo Makers Love Regulation by Adma Davidson in NPR’s Planet Money

Alain Bankier, co-president of Manischewitz, said that the capital investment in the company’s state-of-the-art matzo machinery poses a huge barrier to entry for potential competitors. So rather than being bad for business, all those kosher rules mean Manischwitz won’t have much competition.

Taxes and Cheating by Dan Ariely

To see how witnessing and act of dishonesty would affect participants, we had one student—a confederate named David—stand up after only a minute and claim he’d solved all 20 matrices. The experimenter merely responded that in that case he could take his earnings and go. So how did the participants respond to this display when asked to self-report the number of matrices they solved? By cheating a whole lot: they claimed an average of 15 correct answers, more than twice the average score when cheating was not allowed.

Weighing SEC’s Crackdown on Fraud by Jean Eaglesham in the Wall Street Journal

More than 100 people and firms have now been charged with fraud tied to the financial crisis by the Securities and Exchange Commission, but that hasn’t quelled criticism that the agency hasn’t cracked down hard enough.The SEC passed that milestone Friday when the regulator filed civil-fraud charges against two former Texas bank executives accused of using a loan-modification scheme to make bad real-estate loans look good.

Why The Law Is So Perverse

In Why the Law Is So Perverse, Leo Katz, Frank Carano Professor of Law at the University of Pennsylvania Law School, examines features of the legal system which seem to not make sense on some level.

I admit that I offered to read and review the book based on the title. I’m not sure that Professor Katz makes the case that the law is perverse. He does show the complexity and the complexity in human decision-making in the legal system.

The better title would be the Impact of Multi-criterial Decision Making in Legal Analysis. I suppose that title is not quite as catchy.

That title is more closely aligned with the style of writing and content. For me, the book was like stepping back into law school and analyzing choices and consequences of actions in the context of legal decision making. That means there are some interesting puzzles and thought exercises. It also means that it’s a bit disconnected from the real world.

Two disclosures. First, the publisher supplied me with a free copy of the book. Second, some of the statements in the book left me bitter with the way Professor Katz characterized the legal profession. The most notable was:

The exploitation of loopholes is in fact the lawyer’ daily bread, which makes it all the stranger that both lawyers and non‐lawyers profess such outrage about it. Actually, the point should probably be put the other way around: What is strange is that, given the contempt in which loophole exploitation is held, it is nevertheless central to legal practice. What can a profession say for itself whose main preoccupation consists of this kind of activity?

I don’t know any lawyers who get excited looking for loopholes, or who would even call their daily practice exploiting loopholes. On the criminal side, it’s all about the evidence and culpability. On the business side it’s about trying to figure out what the government will allow and not allow. The law is complex and the decision-making is difficult, but that doesn’t make it perverse and doesn’t make the lawyer’s job one of merely searching for loopholes.

In a whimsical example of a loophole, Professor Katz uses children cutting in line. According to playground law, line-cutting requires the consent of the party who will be immediately behind the cutter. So you can let someone cut into the line in front of you, but no backsies. The loophole is to allow the cut in front, then let the consenting party cut in front of you. A-Ha! A tremendous loophole. Professor Katz even parades a cartoon involving a playground lawyer to illustrate the point.

Where Professor Katz sees a loophole, I see a flawed law. It should either be cutting allowed or no cutting allowed. By allowing only one type of cutting, the law creates a distortion in behavior.

The law can be changed and flawed laws should be changed.

The central thesis is that the transitive law of math that we learned in elementary school (A>B and B>C, so A>C) only works with a single criteria and can fail once there are multiple factors in the decision-making: multi-criterial decision-making.

Besides loopholes, Professor Katz focuses on a few other “perversities.” One involves the law’s refusal to allow people to consent to certain things – prohibiting people from selling a kidney to a willing buyer or allowing criminals to choose torture instead of a long prison sentence. Legal decisions are essentially made in an either/or fashion—guilty or not guilty—but does not allow in-between verdicts. Legal systems don’t punish certain kinds of highly immoral conduct while prosecuting other far less pernicious behaviors.

Professor Katz contends, sometimes persuasively and at other times less so, that these thorny issues arise from their multicriterial’ character. If you miss law school, Why the Law Is So Perverse will take you back through some of the best and some worst features of law school.

If you’re interested, you can read an excerpt from Why the Law Is So Perverse (.pdf)

SEC Seeks Public Comment Prior to Jobs Act Rulemaking

In an unusual move, the SEC has opened up for comments on the proposed rules under the recently-signed Jumpstart Our Business Startups Act, before it has proposed the rules.

The SEC is generally required by law to establish a public comment period at the time it proposes rules or rule amendments. However, similar to the Commission’s action with the Dodd-Frank Act, the public will have an opportunity to voice its views before rules or amendments are proposed under the JOBS Act. The public also will be able to see what others are saying to the agency about these issues.

To facilitate public comment, the SEC is providing a series of links on its website organized by titles of the JOBS Act. Those links are replicated below.

See also: Jumpstart Our Business Startups Act updates from the SEC

Will Private Funds Be Excluded?

Title II of the Jumpstart Our Business Startups Act directs the SEC to lift the ban on general solicitation and advertising under Rule 506 of Regulation D. That rule creates a safe harbor that deems the covered transactions to not involve any public offering within the meaning of section 4(2) of the Securities Act.

However, private funds also have to deal with the restriction in the Investment Company Act that also limits public offerings. Under the exclusions in 3(c)1 and 3(c)7 the fund must be an issuer “which is not making and does not presently propose to make a public offering of its securities”. Historically, the SEC has interpreted the meaning of “public offering” to be the same between the two acts. So not being a public offering under Rule 506 meant the offering was not public under the Investment Company Act.

For real estate fund managers relying on the 3(c)5 exclusion, there is no ban on a public offering in that exclusion.

The JOBS Act requires the SEC to revise its rule, so we don’t know exactly how the changes to Rule 506 will work. It’s possible that the SEC will limit the changes to the Securities Act and not open general advertising to funds under 3(c)1 and 3(c)7 who are required to be private.

However, Section 201(b) of the JOBS Act contains this:

(b) CONSISTENCY IN INTERPRETATION.—Section 4 of the Securities Act of 1933 (15 U.S.C. 77d) is amended—

(1) by striking ‘‘The provisions of section 5’’ and inserting

‘‘(a) The provisions of section 5’’; and

(2) by adding at the end the following:

‘‘(b) Offers and sales exempt under section 230.506 of title 17, Code of Federal Regulations (as revised pursuant to section 201 of the Jumpstart Our Business Startups Act) shall not be deemed public offerings under the Federal securities laws as a result of general advertising or general solicitation.’’.

(My emphasis)

I assume the Investment Company Act is part of the “Federal securities laws.” I suppose you could argue that the Investment Advisers Act and the Investment Company Act operate separately from the Securities Act and the Exchange Act. That would be a tough argument for the SEC to make. The SEC could explicitly not include 3(c)1 and 3(c)7 under the changes to Rule 506.

That would seem unlikely. Take a look at the SEC’s own website “Researching the Federal Securities Laws Through the SEC Website” where it lists the Investment Company Act and Investment Advisers Act as part of the federal securities laws.

More likely would be the SEC issuing a rule with no mention of 3(c)1 and 3(c)7 or the Investment Company Act. That might leave practitioners a bit nervous about the gap.

Sources:

Smells Like Insider Trading

Apparently Blue Horseshoe loved Zhongpin Inc., a China-based pork processor whose shares trade in the U.S. The SEC jumped on the accounts of six Chinese citizens and a British Virgin Islands entity. (Apparently the Chinese prefer to use British Virgin Islands entities. It’s the second largest investor in China after Hong Kong.) The facts stink of insider trading, but I would wager the SEC will lose this one.

According to the SEC’s complaint, the seven defendants bought substantial quantities of common stock and call options in Zhongpin between March 14 and March 26. Zhongpin’s stock price jumped 21.8% on March 27 when the company publicly announced a management buyout.

The SEC alleges that the purchases were inconsistent with the defendants’ financial situations and prior investment behavior.  In particular:

  • The defendants’ trades made up a significant portion of the trading in Zhongpin between March 14 and March 26, over 41% of the common stock trading in this period.
  • Only one of the defendants had traded in Zhongpin before March 14.
  • The purchases of Zhongpin securities equaled or exceeded their stated annual income.
  • Yang identified himself to his broker as an accountant in
  • Each of the defendants placed at least some of their trades from computer networks and hardware that other defendants also used to place trades.

“The defendants in this action – all with seemingly limited resources – suddenly and inexplicably purchased more than $20 million in Zhongpin securities just before an important public announcement,” said Merri Jo Gillette, Director of the SEC’s Chicago Regional Office. “The SEC’s swift action to secure a judicial freeze order prevented millions of dollars from moving offshore.”

At least temporarily.

What’s missing from the insider trading complaint is the insider. The charge is for trading while they were in possession of material, non-public information. The SEC needs to find that information and its source. That’s going to be very hard when the defendants all live out of the country.

We saw this recently in the SEC case against Luis Martin Caro Sanchez for trading in shares of Potash. The SEC failed to find the insider. No inside information, no insider trading.

The one hope for the SEC is that one of the defendants was employed at Baron Capital, Inc., a registered investment adviser. If Siming Yang was foolish enough to document the inside information in one of the Baron systems, the SEC may be able to find some evidence.  Yang’s position was terminated at Baron on March 30. I assume for violating the firm’s policy on personal security trading.

Perhaps the SEC is hoping the defendants will merely default. Some might. But Yang made over $7.6 million on the trades. I assume he will invest some cash in getting a lawyer and fighting the charge, leaving it up to the SEC to find the source of the inside information.  Unfortunately, the SEC will also be up against a language issue, given that the communication was likely in Chinese.

The SEC needs to try and hope the smoking gun is lying around. The trades stink of the insider trading. Perhaps the SEC can find a bigger case of insider trading in the company’s shares. You also have to wonder where Yang got $20 million to make the trades.

I have my doubts that the SEC can win this case. But you can’t win if you don’t play. The SEC can’t win if it just lets the cash go overseas.

As with the Sanchez case, Interactive Brokers held the accounts for three of the seven defendants.  It sounds like its compliance group is spotting suspicious trades, holding the cash before it goes overseas, and alerting the SEC.

Sources:

Which 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 were registered with the Securities and Exchange Commission. Given that we just passed the March 30, 2012 registration deadline, I thought I would update the list. (Disclosure: my company is on the list.)

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

 

If you do the math, now 28 of the top 30 are now registered with the SEC as Investment Advisers.

There are good arguments to be made on both sides of the registration debate for real estate funds. The core requirement under the Investment Advisers Act is that the manager is giving investment advice about securities. Most of these real estate fund managers are truly focused on real estate and not securities. However, the discussion between what is and is not a real estate security may be fun for the first week of your securities law class in law school. It’s not a fun discussion when trying to comply with regulatory requirements.

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:

The Death of Martindale Connected

When Lexis backed a social networking platform for lawyers, I paid attention. I didn’t think a platform for lawyers would be interesting, but if it connected to some of Lexis’s massive collection of legal content it could at least be informative. That never came to the Martindale Connected platform. The platform has remained boring and uninformative.

One part of Connected’s approach was to create an authenticated community. So that the person is who they say they are. At first, that limited membership to practicing lawyers. That meant law firm marketers were excluded. Eventually, Martindale changed its mind and opened the doors to a broader membership. The additional membership did very little to energize the platform.

Now the spammers have arrived. I found this sitting in my inbox from Martindale Connected:

Dear new friend,
How are you hope fine my dear my name is Benita you can call me isatu I really like your profile in this site I would to get to know you, i want us to be friends well i will be waiting for your reply to my email ([email protected]) not in the site i will tell you more about my self and will attached my picture in my next mail thanks wait your reply
Benita  or you can call me Isatu.
[email protected] )

I checked my Martindale inbox and found a half dozen of spam messages like this that must have had their notifications trapped in my corporate spam filter.

I’m skeptical that Benita is a student (Judge) in Florida.

Or that Mrs Lisa Lechuga wants to give me $2,400,000 “for the good work of humanity, and also to help the motherless and less privilege and also for the assistance of the widows”.

Or that Lillian Mokan was “moved and become interested in you, I will like you to send me an email to my address ([email protected]) so that i can give you my pictures for you to know whom i am.”

I guess Martindale’s standards for validating users has either failed or they have dramatically lowered their standards. It’s one thing to be boring, it’s another to be annoying.

I was replicating my posts in Connected, but now I have decided to stop.  No reason to pile more dirt in the graveyard.

Related:

Compliance Bits and Pieces for April 6

Earl Scruggs: Banjo, Bluegrass and the Fight against Corruption and Bribery by Tom Fox

So what is the lesson of Earl Scruggs for the compliance practitioner? It is this, even if you develop a completely new style that makes you one of the foremost experts in an area, you can still evolve. Further, the style you use may have significant effects on other styles, even in the fight against bribery and corruption.

General Solicitations, Rule 506, and the Missed Opportunity by J Robert Brown Jr. in the Race to the Bottom

Second, the risk of liability associated with the use of the exemption is significantly greater than many other exemptions. The ability to use a general solicitation is determined not at the time of the solicitation but at the time the purchases are made. To the extent a company engages in a general solicitation but sells to unaccredited investors, the exemption under 506 will be unavailable. Because the fallback, Section 4(2) does not permit a general solicitation, the inapplicability of the exemption will result in a violation of Section 5.

SEC Enforcement to Focus on Private Equity Insider Trading and Conflicts of Interest by Howard Sobel in The Harvard Law School Forum on Corporate Governance and Financial Regulation

The Enforcement Division’s increasing attention to private equity corresponds with the implementation of new rules under the Dodd-Frank Act that will significantly increase the number of private equity firms subject to SEC regulation as “investment advisers.” The Asset Management Unit, one of a number of specialized enforcement units formed by the Division of Enforcement in 2010 to focus on “priority areas,” is staffed with 65 professionals, including private equity experts.

The Impact of the JOBS Act on D&O Liability by Kevin LaCroix in the D&O Diary

These and many other changes introduced in the Act could require the D&O insurance industry to make changes in its underwriting and perhaps in policy forms to accommodate these changes. As was the case with the Sarbanes-Oxley Act and the Dodd-Frank Act, the D&O insurance industry may face a long period where it must try to assess the impact of changes introduced by this broad, new legislation. Though many of the Act’s provisions seem likely to reduce the potential scope of liability for many companies (particularly the EGCs), the Act could also introduce other changes that might result in increased potential  liability for other companies (particularly those resorting to crowdfunding financing).

Advisory Contracts – Transition for Newly Registered Advisers

The SEC’s Division of Investment Management supplemented its Investment Management Staff Issues of Interest posting on the SEC website to include no-action relief for a newly registering adviser under Section 205(a)(2) and (3). Those include requirements that (1) an investment advisory contract not be assigned without consent and (2) that if the advisor is a partnership, the advisor will notify the client of any change in the membership of such partnership within a reasonable time after such change

The SEC has previously sought to minimize the disruption to the contracts of newly registering advisers when such contracts were permissible at the time they were entered into. For example, the SEC allowed performance fees for newly registered funds in Investment Advisers Act Release No. 2333 (Dec. 2, 2004)  More recently, the SEC permitted performance fees to formerly qualified clients after the SEC increased the threshold to be so qualified in  Investment Advisers Act Release No. 3372 (Feb. 15, 2011.

The advisor will need to meet three standards:

 (i) the advisory contract was entered into or last amended prior to the submission of the adviser’s application for registration;

(ii) any future amendment of the advisory contract will include the provisions required under Sections 205(a)(2) and (3);

(iii) the adviser undertakes to operate and perform under the advisory contract as if it contained the provisions specified in sections 205(a)(2) and (3)

 

Here is the text of the SEC language:

Advisory Contracts – Transition for Newly Registered and Registering Advisers

Sections 205(a)(2) and (3) of the Advisers Act generally prohibit registered advisers, and advisers required to be registered, from entering into, extending, renewing, or performing under an advisory contract that fails to include the provisions specified by those sections. In general, this means that an advisory contract must provide that (i) the contract may not be assigned by a registered adviser without the consent of the client and (ii) the registered adviser, if a partnership, will notify its clients of any change in membership within a reasonable time after such change.

As a result of the Dodd-Frank Act changes to the Advisers Act, previously exempt advisers are now required to register with the Commission. Nevertheless, newly registering advisers may be operating under existing advisory contracts that were entered into when such advisers were neither registered nor required to be registered with the Commission. As a result, these advisory contracts may fail to include the specified provisions of sections 205(a)(2) and (3). Advisers may need to seek the consent of their clients to amend the advisory contracts to include these provisions. Obtaining the consent of clients in a timely fashion to amend all existing advisory contracts, however, may be impracticable for some advisers.

The Commission has previously sought to minimize the disruption to the contracts of newly registering advisers when such contracts were permissible at the time they were entered into. See e.g., Investment Advisers Act Release No. 2333 (Dec. 2, 2004) (the Commission adopted rules to grandfather pre-existing contractual arrangements providing for performance-based compensation that were entered into when the adviser was exempt from registration) and Investment Advisers Act Release No. 3372 (Feb. 15, 2011) (the Commission adopted rules to grandfather pre- existing performance fee contractual arrangements that satisfied the requirements of the rule at the time that the contract was entered into ).

Accordingly, the staff would not recommend enforcement action to the Commission under sections 205(a)(2) and (3) of the Advisers Act if an adviser that has applied for registration but was not registered, nor required to be registered, when it entered into its advisory contracts, did not amend an advisory contract to include the provisions required by sections 205(a)(2) and (3), provided that: (i) the adviser undertakes to operate and perform under the advisory contract as if it contained the provisions specified in sections 205(a)(2) and (3), (ii) the adviser discloses such undertaking to the client and, in the case of a private fund client, each investor (or independent representative of the investors) in such client, (iii) the advisory contract was entered into or last amended prior to the submission of the adviser’s application for registration; and (iv) any future amendment of the advisory contract would include the statutory provisions set forth in sections 205(a)(2) and (3). [March 30, 2012]