Month: February 2013

What Happens If You Violate the Ban on General Advertising and Solicitation?

compliance and advertising

I’m not planning to run late night ads for a latest security offering. But what could the Securities and Exchange Commission do about it? Keith Bishop asks: Can the SEC really create illegal actions by its own failures to comply with the law?

Last year’s JOBS Act contained an explicit mandate with an explicit time frame.

 Not later than 90 days after the date of the enactment of this Act, the Securities and Exchange Commission shall revise its rules issued in section 230.506 of title 17, Code of Federal Regulations, to provide that the prohibition against general solicitation or general advertising contained in section 230.502(c) of such title shall not apply to offers and sales of securities made pursuant to section 230.506, provided that all purchasers of the securities are accredited investors.

However, 90 days was never a feasible deadline to draft a rule, make it available for comment, respond to the comments, and publish a final rule. Congress could have made the change a statutory one, leaving the SEC rule explicitly out-of-date. But instead they mandated a regulatory change.

The first question is what would the SEC do to a violator? The SEC has published a JOBS Act page full of Frequently Asked Questions. Under Title III for crowdfunding the SEC published a statement warning would be entrepreneurs that securities crowdfunding is not legal until the regulations are finalized. The FAQ for Title II turns to the Broker-Dealer exemption for advertising. I don’t take the lack of a warning to mean that the SEC won’t prosecute. But given limited resources, you would have to wonder why the SEC would bother.

Assuming the SEC did prosecute, what would the courts do? …

I think I’ve gone on long enough. At this point, your offering is tied up in expensive legal roadblocks and your burning through cash to pay your lawyers. Whatever advantage you thought you might gain from advertising is gone.

Some brave soul may step up and be willing to test the advertising waters out of principle. But it would be a test rooted in sensible economic analysis.

Compliance Bricks and Mortar – Blizzard Edition

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I’m bunkered down waiting for a blizzard to unleash its wrath on Boston. While my snowblower is waiting for the flakes to fall from the sky, these are the compliance-related stories I’m reading.

‘Without Wheels’: Sometimes Circumstantial Evidence Can Be Quite Powerful by Bruce Carton in Compliance Week

The SEC alleged that Vance learned about the merger when he was asked to help Clear One’s CEO resolve an e-mail issue and saw confidential merger documents, and tipped Wellington. The agency also alleged some extraordinary steps that Vance and Wellington took so that they could have the funds to purchase Clear One shares the very next day:

  • Wellington allegedly obtained a $25,000 loan from an “online peer lending site.”
  • Vance allegedly borrowed $5,285 from his 401(k) retirement account, but also “sold personal computer equipment, and sold his truck to finance his purchases of Clear One shares.”

SEC Charges Husband With Insider Trading Using Wife’s Information by Thomas O. Gordon in SEC Actions

The action centers on the acquisition of National Semiconductor Corporation by Texas Instruments, announced after the close of the market on April 4, 2011. Defendant James Balchan, an IT specialist, is married to a partner in a law firm. One of her partners, called Partner A in the complaint, was a close friend of the general counsel of National Semiconductor. In honor of his friend the general counsel, the Partner A organized a “wine and dine” weekend. Mr. Balchan and his wife were invited.

Carried Interest Explained in Latest PEGCC Whiteboard Video

Judge: “Carried interest is commonly misunderstood in public discourse. Our newest whiteboard video demystifies the topic and answers questions about what carried interest really is, how it works and why it’s appropriately taxed at the capital gains rate.”

Annual Compliance Obligations — What You Need to Know in Pillsbury’s Investment Fund Law Blog

As the new year is upon us, there are some important annual compliance obligations Investment Advisers either registered with the Securities and Exchange Commission (the “SEC”) or with a particular state (“Investment Adviser”) should be aware of.

Two Hedge Fund Managers Charged in Alleged $311 Million Fraud Case by Debbie Cai in WSJ.com’s Corruption Currents

Two hedge fund managers were indicted for alleging defrauding institutional investors and causing total losses of more than $311 million, the U.S. Department of Justice said. …

The charges state between March 2005 and December 2008, Kiener led Bear Stearns entities to believe, under his management, Bear Stearns investment funds would be diversified and independently managed. However, Kiener allegedly funneled Bear Stearns money from K1 through the Oceanus Funds and back to K1, giving the false impression the funds were growing in size and were viable investments.

Have You Disclosed Your Derivatives Positions?

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The Securities and Exchange Commission filed charges against a fund manager and its subadviser for their extensive use of derivatives. From April 2007 through October 2008, the Fiduciary/Claymore Dynamic Equity Fund engaged in derivative strategies to supplement the Fund’s primary investment strategy. But the Fund failed to include adequate disclosure about the risks to the Fund arising from the Fund’s use of derivatives, either in its annual report or in an amended Fund registration statement.

The Fund’s primary investment strategy was to invest in equities and write call options on a substantial portion of those equities. This covered call strategy trades upside potential in the equities held in the portfolio for current income from option premiums received.

Things changed in April 2007 when the Fund supplemented its income and returns by writing out-of-money S&P 500 put options. The Fund collected a premium from the purchaser of the option, and in exchange agreed to compensate the purchaser for any declines in the S&P 500 beyond the strike price of the option. Between April 2007 and August 2008, the Fund collected $9.6 million in premiums from written put options. For the six months ending May 31, 2008, written put options  added approximately 2.1% to the Fund’s return.

Then the financial markets collapsed in October 2008. The Fund lost  $45,396,878, or 45% of the Fund’s NAV in its undisclosed derivates strategy.

The Fund was a registered investment company so some of the violations stem from the failure to make proper disclosures under the Investment Company Act. The SEC also found violations under the anti-fraud provisions of the Investment Advisers Act, Section 206(4) and Rule 206(4)-8. Those provisions prohibit the making of any untrue statement of a material fact or the omission of a material fact necessary to make statements made not misleading, or to otherwise engage in any act, practice, or course of business that is fraudulent, deceptive, or manipulative with respect to any investor or prospective investor in a pooled investment vehicle.

If derivatives are substantial part of a fund’s portfolio, it sounds like the SEC expects you to disclose that fact to investors.

Sources:

S & P and the SEC

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The Securities and Exchange Commission took the bold step of filing charges against Standard and Poor’s, one of the three giant rating agencies. Personally, I think the role of rating agencies in the run up to the 2008 financial crisis has been under-appreciated. Without the the top AAA rating they bestowed on securitized mortgage bonds, the flow of cash into those toxic instruments would have stopped much earlier and decreased the size of the bubble.

The SEC complaint claims that S&P continued to give subprime mortgage securities high ratings as the the securities looked increasingly fragile and financial crisis began to bubble to the surface. In the first half of 2007, S&P rated a large number of large mortgage-backed securities, bestowing top grades on the investments. It then quickly downgraded the securities, which defaulted in months.As a result, federally insured banks incurred losses. That gives the SEC jurisdiction.

As with any government investigation, the SEC found emails saying stupid things. In one case there is a March, 2007 satire in an email based on the Talking Heads song “Burning Down the House”:

“Watch out
Housing market went softer
Cooling down
Strong market is now much weaker
Subprime is boi-ling o-ver.
Bringing down the house.”

The SEC claims that S&P knew that the performance of non-prime residential mortgage backed-securities was bad and getting worse. The firm expected deals to rush in before those packaging the mortgages were stuck with them on their books.  The SEC takes individual instances of ratings failures by S&P and ties them to losses sustained by the banks that bought them.

Another e-mail from an analyst in response to a question about how his new job was going reads:

“Job’s going great. Aside from the fact that the M.B.S. world is crashing, investors and the media hate us and we’re all running around to save face … no complaints.”

But then went on to state the central part of the case:

“The fact is, there was a lot of internal pressure in S&P to downgrade lots of deals earlier on before this thing started blowing up. But the leadership was concerned of p*ssing off too many clients and jumping the gun ahead of Fitch and Moody’s.”

….

This might shake out a completely different way of doing biz in the industry. I mean come on, we pay you to rate our deals, and the better the rating the more money we make?!?! Whats [sic] up with that? How are you possibly supposed to be impartial????

There is an unforgiving conflict in the way mortgage bonds were rated. The issuer pays for the ratings work. So there is an incentive by the ratings agency to met the issuer’s expectations, keep them happy, and retain their business.

Finally, in July, 2007, S&P downgrades 612 classes of RMBS, totaling $12 billion in securities. Of course it was too late for the securities that S&P had favorably rated just days and weeks earlier. It is the ratings issued between March and July of 2007 that the SEC is focused on this complaint. The SEC claims that S&P could see the walls crumbling, but held back saying anything to appease the pipeline of deals in the works.

My big unanswered question is whether the SEC is going to make a similar case against Moody’s and Fitch.

Sources:

Revisiting the SEC’s Stance on When Real Estate is a Security

Compliance and real estate

After last week’s charges against Cay Clubs, I remembered that I wanted look at an old SEC Release on the applicability of the federal securities laws to condominiums and real estate development. Back in 1973 The Securities and Exchange Commission issued a release describing situations where a real estate offering could become a securities offering. At least according to the SEC.

SEC Release 33-5347 (pdf) discusses situations when the sale of condominium units, or other units in a real estate development, coupled with an agreement to perform rental or other services for the purchaser would become the offering of a security in the form of an investment contract or a participation in a profit sharing arrangement within the meaning of the Securities Act of 1933 and the Securities Exchange Act of 1934.

The offering of real estate units in connection with any the following will cause the offering to be viewed as an offering of securities in the form of investment contracts:

  1. The condominiums, with any rental arrangement or other similar service, are offered and sold with emphasis on the economic benefits to the purchaser to be derived from the managerial efforts of the promoter, or a third party designated or arranged for by the promoter, from rental of the units.
  2. The offering of participation in a rental pool arrangement; or
  3. The offering of a rental or similar arrangement whereby the purchaser must hold his unit available for rental for any part of the year, must use an exclusive rental agent or is otherwise materially restricted in his occupancy or rental of his unit.

In all of the above situations, investor protection requires the application of the federal securities laws.

Sources:

Image is Western shot of Edgehill Condominiums in Edgewater NJ by Tguless. http://commons.wikimedia.org/wiki/File:Edgehill_Condominium.JPG

Compliance Bricks and Mortar for February 1

bricks 13

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

SEC Charges Former Jefferies Executive with Defrauding Investors in Mortgage-Backed Securities by Mark Astarita in the Securities Law Blog

According to the SEC’s complaint filed in federal court in Connecticut, the former executive arranged trades for customers as part of his job as a managing director on the MBS desk at Jefferies. The SEC alleges that the former executive would buy a MBS from one customer and sell it to another customer, but on many occasions he lied about the price at which his firm had bought the MBS so he could re-sell it to the other customer at a higher price and keep more money for the firm. On other occasions, he misled purchasers by creating a fictional seller to purport that he was arranging a MBS trade between customers when in reality he was just selling MBS out of his firm’s inventory at a higher price. Because MBS are generally illiquid and difficult to price, it is particularly important for brokers to provide honest and accurate information.

Floyd Landis’ Whistleblower Lawsuit Against Lance Armstrong and Others

I’m sure you have heard about the whistleblower lawsuit initiated by Lance Armstrong’s former teammate, Floyd Landis, but if not, where have you been? In this suit Landis has targeted several others that were part of the U.S. Postal Service team for being a part of or knowing of teammates using banned substances for performance enhancement.

What’s in a Name? Speculation, Hedging, They Are Not the Same Thing by Ernest E. Badway in Securities Compliance Sentinel

Recently, in a settled SEC enforcement action, a mutual fund manager allegedly used an option strategy, but the SEC believed it was more speculative than hedging.  See http://www.sec.gov/litigation/admin/2012/33-9377.pdf.

Raising a Deaf Puppy in GeekDad

When we moved into our new house last year, we wanted to expand our family. It was time to get a dog. I grew up with a dog in my family and wanted my kids to have the same experience. I expected that would mean random items around the house would get destroyed by the playful puppy. What I didn’t expect was having to learn sign language.

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