Month: December 2012

Private Placement of Fund Interests and Rule 5123 Filings

Under the new FINRA rule 5123, FINRA member firms that sell securities in certain private placements to submit a notice filing with FINRA.  That means your placement will likely have to file a fund’s private placement memorandum with FINRA. FINRA recently released FAQs and a user guide related to Rule 5123 filings. The notice filing must include a copy of any private placement memorandum, term sheet or other offering document, including any materially amended versions thereof, used in connection with such sale.

Submissions must be made within 15 calendar days of the first sale.

The FAQs answer practical questions regarding filing requirements, such as:

  • how members file a notice with FINRA
  • when does the 15-day period commence for filing with FINRA
  • What exemptions are there to form Rule 5123

Exemptions

1. Are private placements sold to institutional accounts exempt from the filing requirements of Rule 5123?

Private placements sold solely to institutional accounts (as defined in Rule 4512(c)) are exempt from the filing requirements of the rule (see Rule 5123(b)(1)(A)).

2. Are private placements sold to accredited investors exempt from the filing requirements of Rule 5123?

No, unless the sales are solely to entities that satisfy the definition of accredited investor under Rule 501(b)(1), (2), (3), or (7). Sales to accredited investors that are natural persons are not exempt from the filing requirements of the rule (see Rule 5123(b)(1)(J)).

If your fund uses a placement agent and is marketing to high-net worth individuals, it looks like the marketing materials will end up being filed with FINRA.

Mortgage REITs Get Relief from the CFTC

The CFTC continues the journey out of the hole it dug itself. In February the CFTC stated that one swap contract would be enough to trigger the registration requirement. This runs with the CFTC long standing narrow interpretation of the commodity pool definition. The CFTC retreated from this position with respect to REITs in October. The CFTC has also retreated from this position for Mortgage REITs.

Mortgage REITs are a bit trickier because the underlying assets are real estate loans instead of real estate. There is likely to be more financial engineering with derivatives to mange the risks in the portfolio.

The CFTC lays out four tests for relief:

  1. No more than 5% of assets are for initial margin and premiums
  2. Net income from derivatives is less than 5% of income
  3. Interests in the mortgage REIT are not marketed as a commodity pool
  4. The company has made or will make the IRS filing as a mortgage REIT

Unlike the REIT relief, the mortgage REIT relief is not self-executing. The Mortgage REIT needs to send an email no-action relief claim.

In footnote 19, in bold type, the CFTC continues to backpedal:

The Division notes that we remain open to discussions with mREITs to consider the facts and circumstances of their mREIT structures with a view to determining whether or not they might not be properly considered a commodity pool.

The CFTC also release an interpretative letter offering no action relief for securitization vehicles. Word is that there may be a few more letters providing relief in the works.

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New Document Request List for Presence Exams

We’ve had the first siting of the new document request letter for the new presence exams. IA Watch has obtained a copy of the letter issued from the Atlanta Regional Office.

This letter sets the exam period to start on March 30, 2012. That addresses some concerns that the SEC would look at period prior to a firm’s registration as an investment adviser.

It’s clear from the request list that the examiners will be looking closely at fees. Among the items is a “schedule of fees earned by the Adviser from each portfolio company and whether they were credited back to clients. It goes on to ask for all compensation received by the adviser, besides management and performance fees. Further, it asks for the total expenses reimbursed by each portfolio company.

Notably missing from the letter are items related to marketing, custody, portfolio management, and valuation. You may remember that the SEC’s Presence Exams are set to concentrate on five areas:

  • marketing
  • portfolio management
  • conflicts of interest
  • safety of client assets
  • valuation

It looks like this Atlanta RO letter is focused on conflicts of interest.  I’m going to guess that this document request is just one of several versions, with each version concentrating on different area.

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Compliance Bricks and Mortar for December 7

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

High-Speed Trades Hurt Investors, a Study Says by Nathaniel Popper and Christopher Leonard in the New York Times

A top government economist has concluded that the high-speed trading firms that have come to dominate the nation’s financial markets are taking significant profits from traditional investors.

The chief economist at the Commodity Futures Trading Commission, Andrei Kirilenko, reports in a coming study that high-frequency traders make an average profit of as much as $5.05 each time they go up against small traders buying and selling one of the most widely used financial contracts.

The Encyclopedia of Ethical Failure… by Dan Ariely

Wondering whether you can ask someone to give you a PhD in exchange for a kickback? Curious whether you can get away with stuffing ballot boxes? Allow me to introduce you to the Encyclopedia of Ethical Failure. Every couple years the Department of Defense publishes the Encyclopedia (Word doc), which is likely the most sarcastic government document out there. Interestingly, golf and taxes seem to turn up a lot.

An introduction to behavioral ethics

A quarter of a century ago, as a young criminal defense lawyer, I began to be struck by how different the causes of many white collar crimes were from the then (and still) traditional view. The latter saw (sees) white collar crimes as based largely on rational calculations by profoundly bad individuals – what was then the Ivan Boesky model and now is best associated with Bernie Madoff. Although there are certainly offenses of this sort, many of the crimes of which I became aware seemed based more on environmental factors than on the indelibly bad characters of those involved. While the field did not exist at the time, this turned out to be my introduction to what was to become “behavioral ethics.”

Phone Calls Can Get You Caught Insider Trading

The insider trading prosecution of Raj Rajaratnam was centered around phone calls. Prosecutors were able to get a recording of those calls. Can you get a conviction merely by tying phone calls to trades, without knowing the content of the calls? The Securities and Exchange Commission is hoping that old-fashioned phone call logs will be enough.

In bringing an insider trading case against John Femenia and group of his friends, the SEC merely lays out a series of trades made after Femenia called his friends. Pursuant to the complaint, Femenia was the source of information based on his position in the Investment Bank Group of Wells Fargo Securities.  Femenia and his friends have not had a chance to publicly respond to the charges, so I just looking at what the SEC is saying and why the SEC thinks there is enough evidence for insider trading charges.

Femenia Tips Wens Who Trades on the Inside Information.
96. Prior to May 27, 2010, Wens had no history of trading in ATC.
97. On May 27,2010 at approximately 12:04 a.m., Femenia called Wens. The call lasted approximately 32 minutes.
99. On May 27,2010 at approximately 9:31a.m., Wens made his first purchase of ATC in a TD Ameritrade brokerage account.
100. Between May 27,2010 and June 29,2010, Wens bought thousands ofATC shares. During this time  period, Wens exchanged frequent telephone calls with Femenia, including calls often on the same day or the days before the trading in A TC securities.

Wells Fargo provided financing to GENCO to help in its acquisition of ATC. The complaint goes on and on linking phone calls to the times the group made trades.

The complaint charges Femenia with knowledge of the underlying capital transaction, but does not link it to specific pieces of information or internal emails. Similarly, the SEC does not have recordings of the phone calls. (At least Femenia and his group were smarter than these guys who communicated about insider trading on internal IM that gets archived.)

Will it be enough?

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Image of a 1896 Telephone is from Wikimedia

Airport Use as Illegal Inside Information

I’m a bit confused by the big story in Bloomberg about David Slaine, a key informant for the recent crackdown on insider trading. It starts off with Slaine trying to claim that a money manager was illegally using airplane flight information into Teterboro Airport to profit on stocks. The claim was that his tipsters would let him know when bankers came in and out of the airport, presumably to talk to one of the numerous pharmaceutical companies in the area.

Let’s start off with whether the information is even non-public information. Perhaps the FBI has not heard of the internet. The FAA aircraft registration database is available online. You can easily search for a company’s planes. There are databases and services like FlightAware.com that will track flights based on the plane’s tail number.

There has been some privacy added back to the databases. You may be surprised that privacy push and concerns came from sport teams. Avid fans had been tracking owners’ plane flights to see who they are trying to sign as free agents or coaches.

If you lost the fight over whether the information was non-public, you also need to pass a materiality standard. You have no way to predict how the travel activity will relate to stock activity. If you mix up the target with acquirer you may get a drop in stock price. The Slaine story talks about bankers. Those bankers could just easily be coming to offer bankruptcy financing as they could be to trigger an event that would increase the stock price.

Lastly, you need to prove some obligation to keep the information confidential. I don’t see how that obligation exists for airport personnel.

The information sounds a lot like the old story of fund managers who would count cars in a retailer’s parking lot as a way to estimate sales. Lots of cars would likely mean better sales numbers.

This leads back to the tricky part of expert network firms. At one extreme, fund managers were explicitly paying for and extracting confidential, material, non-public information from company insiders. The complaint against Martoma is an example of the illegal kind. On the other extreme is a fund manager merely trying to get a better understanding of the industry, the issues, the opportunities, and the companies involved in an area. This is perfectly legal. From this side, the fund manager may be able to find some external factors of correlation that could lead to movements in a company’s stock price. The retail parking lot is an example.

But airport use? That does not seem to offer much insight. I guess the FBI was desperate to get any sort of insight into insider trading, even if it was not insider trading.

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CFTC Relief for Funds of Funds

The CFTC has given funds of funds six more months to determine whether they needs to register as a commodity pool operator. Dodd-Frank has made interest rate and some foreign exchange derivatives “commodities” and made them subject to oversight by the CFTC. There is a December 31, 2012 deadline approaching. However, the CFTC rescinded guidance to help funds of funds determine how and when to look through their investments to determine if the fund of fund is a commodity pool.

However, the Managed Fund Association and Investment Adviser Association are concerned that their members do not yet have enough access to the underlying information from their investment funds to make the determination. And the CFTC has not issued new guidance to replace the guidance they rescinded.

This relief is not self operative. There are detailed instructions in the no-action letter stating what steps the fund manager needs to take.

I still have a problem that the is applies to a commodity pool operator, that is contingent on there actually being a commodity pool. The CFTC has not helped with that definition which still relies on the fund being organized for the purpose of trading in commodities.

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How to Get Caught Insider Trading

Thomas C. Conradt and David J. Weishaus were brokers at Euro Pacific Capital when they came across a golden source of information. IBM was getting ready to purchase SPSS, Inc. for $50 per share. Now the SEC is charging them with illegally trading on that inside information.

Both are challenging the complaint, so we will need to assume the SEC’s complaint is accurate. It has some bad evidence for the two defendants, like these messages:

Weishaus: we should get [RR3] to buy a f***load
Conradt: jesus don’t tell anyone else
Weishaus: like, [RR3] buy 100000 shares
Conradt: we gotta keep this in the family
Weishaus: dude, no way
i don’t want to go to jail
f*** that
Conradt: jesus christ
Weishaus: martha stewart spent 5 months in the slammer
Conradt: does [a friend] know?
Weishaus: and they tried to f*** the mavericks owner

Unfortunately, the two seemed to have forgotten or not realized that their firm captures email and IM communication. They do so for exactly this purpose.

Conradt purchased a bunch of SPSS stock. He had never traded in the stock before. He must have been short on cash because he only ended up with $2500 of gain.

Weishaus leveraged his bet and purchase call options as well as stock. He ended up with $127,000 in gains. At one point, 99% of his account was in SPSS securities.

The key to the inside information with Conradt’s roommate, an unnamed “Source” who is an Australian citizen. The Source had a friend who worked for the law firm on the IBM side of the merger, the unnamed “Associate.” According to reports, Cravath, Swaine & Moore represented IBM in the acquisition.

The Associate told the Source about the transaction and the merger price. The Source bought some SPSS securities and told Conradt. Conradt told Weishaus. They told three other brokers who are unnamed in this complaint. I expect we will hear more about them in the future.

All the trading activity in SPSS prior to the merger caught the attention of the Securities and Exchange Commission, who contacted Euro Pacific. Of course trading on inside information is a violation of the firm’s policy. When the Source found out about the SEC investigation he apparently exercised his Australian citizenship and returned home instead of facing the SEC inquiry.

The SEC challenge will be push the duty not to trade on Conradt and Weishaus. It seems clear that the Associate had a duty and the knew enough about the source of the information to impute a duty on the Source to not trade. According to the complaint, the Source clearly knew that the information was held in confidence by the Associate and had a duty to keep it confidential.

But did Conradt and Weishaus know of the illicit source? From the IM traffic it seems that they thought is was illegal. That may be enough to convince a jury.

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