January 2015 – Page 2 – Compliance Building

Private Equity Funds and Broker-Dealer Registration

Broker concept.

There was a lots of hand-wringing after a speech by David Blass indicated that the SEC was focusing on transaction based fees that private equity funds were earning on securities transactions. Since then, there has been rumblings during presence exams, but no official enforcement action or ruling from the SEC.

One group of fees at issue was compensation paid to the fundraising team. If your sales team was paid a commission on fund commitments, it raised an issue of broker/dealer registration for the employee. The second group was the fund or fund manager receiving fees for arranging debt or equity for a portfolio company. This raised broker/dealer issues for the fund manager.

Gretchen Morgenson wrote a story in the New York Times that was focused on the hiring of an independent adviser to monitor a private equity fund’s practices. That oversight was triggered by an SEC exam in April 2013, according to the story.

Although the monitoring aspect is interesting, I also found the trigger events to be more interesting. The firm was “reaping fees from investment-banking-type transactions without fulfilling the regulatory requirement of being registered as a broker-dealer.” This seems to be evidence that the SEC is (or was) looking at this issue during private fund exams.

But, the story also notes that the firm was failing to share those fees with the funds as apparently required by the fund documents. So that leaves it unclear if the SEC was continuing to focus on broker/dealer registration or was merely noting a violation of fee calculations. (Not that violating fee calculations is okay.)

Sources:

Entering the Secret Garden of Private Equity by Gretchen Morgensen in the New York Times
Private Equity Miscreant Freeman Spogli Illustrates Investor and SEC Cowardice by Yves Smith in naked capitalism
Are Your Private Fund Employees Licensed?

Cheating In Ethics Class

Dartmouth_logo

Is this the worst ethics teacher?

64 Dartmouth Students Charged With Cheating In Ethics Class

According to the story, attendance in religion professor Randall Balmer’s “Sports, Ethics and Religion” was measured using handheld devices known as “clickers.” In late October, some students passed their clickers to fellow classmates. Those classmates then used the clickers to answer questions which made it appear as though they were present in class.

The ethics course was originally intended to help student-athletes. In its second year, the class grew to more than 280 students. Attendance and cheating became a problem.

Balmer discovered the problem when he noticed a discrepancy in the number of student responses to in-class questions using handheld clickers and the number of students in the classroom on Oct. 30, 2014. Balmer presented both a hard copy version and a clicker version of certain questions, and noted that 43 students did not respond to the paper version of the questions but did respond using clickers.

Obviously the students are at fault for breaking the school’s honor code. Clearly, professor Balmer did not make an impression on his students’ ethics during the first few classes. They felt they could cheat and still get a good grade.

Sources:

64 Dartmouth Students Charged With Cheating In Ethics Class
Dartmouth: 64 Students Cheated by Rob Wolfe in Valley News
Sixty-four students charged with honor code violations by Parker Richards in The Dartmouth

Working at Home this Weekend?

I home your home computer works better than this one and that you don;t have to use Fortran, no matter easy it may be to use.

Perhaps this is a good example of why past performance is not an indication of future results. I think this gentlemen from 1954 would be very surprised at what a computer looked like in 2004.

Compliance Bricks and Mortar for January 9

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

Majority of RIAs should move under state regulation: Study by Mark Schoeff Jr. in InvestmentNews

Shifting oversight of more registered investment advisers from the Securities and Exchange Commission to states would increase exam coverage at less cost than establishing third-party reviewers, a new report asserts. A study by the compliance firm RIA in a Box calls for advisers with less than $500 million in assets under management to transition to state regulation, a move that would involve about 7,250 of the approximately 11,400 investment advisers currently registered with the SEC.

D&O Insurance: No Coverage for Enforcement Action Because Claim First Made When SEC Subpoena Served Before Policy Inception by Kevin LaCroix in The D&O Diary

A recurring D&O insurance coverage issue involves the question of whether or not a subpoena constitutes a claim, as I have noted on prior posts (for example, here). When this issue comes up, the dispute is usually over whether or not there is coverage under the policy for the costs of responding to the subpoena and ensuing costs. But there are other implications if a subpoena is a claim, as was demonstrated in a January 6, 2015 decision (here) by District of Massachusetts Judge Rya Zobel.

SEC Use of Administrative Proceedings Challenged Again by Thomas O. Gorman in SEC Actions

Bebo v SEC, Case No. 15-cv-00003 (E.D. Wis. Filed Jan. 2, 2015) is another suit challenging the decision to bring an action as an administrative proceeding rather than in Federal District Court. The underlying administrative proceeding named as Respondents Laurie Bebo and John Buono, respectively, the CEO and CFO of Assisted Living Concepts, Inc. In the Matter of Laurie Bebo and John Buono, Adm. Proc. File No. 3-16293 (December 3, 2014). The firm is a publicly-traded assisting living and senior residence firm based in Wisconsin. The Order, which alleges violations of Exchange Act Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)B) and 13(b)-5, centers on claimed false disclosures in the SEC filings of the company. Those filings represented Assisted Living was in full compliance with a lease for certain properties when in fact the Respondents had falsified certain occupancy data to deceive the lessee into believing that the company was in compliance, according to the Order.

The Bebo complaint alleges due process and equal protection violations, a violation of the right to a jury trial and presents a separation of powers issue.

SEC Fights ‘Pre-taliation’ Against Dodd-Frank Whistleblowers by Bruce Carton in Compliance Week

According to whistleblower lawyer Erika Kelton, companies that fear Dodd-Frank whistleblower programs are aggressively trying to squash potential tips to the SEC through a practice the agency has dubbed “pre-taliation.”

Kelton, a partner at law firm Phillips & Cohen LLP who recently helped one of her clients obtain the largest SEC whistleblower reward ever ($30 million), says that companies are attempting to intimidate employees from coming forward as whistleblowers in the first place by requiring employees to enter into confidentiality agreements, separation agreements and other employment agreements that may prevent or deter employees from doing so…

Image of bricks is by Peter Alfred Hess

Getting Ready for Your SEC Exam – Introductory Presentation

presentation

The phone rings and the caller ID pops up with US Securities and Exch… You swallow hard. They are coming. What now?

One thing a private fund manager can do to smoothly take the SEC through an exam is to have an introductory presentation when they walk in the door.

The SEC examiners will have read your firm’s Form ADV and looked at your firm’s website. They may also have run a quick web search for any stories. That three things are unlikely to give them much insight into the operations of your firm. The better they understand your firm, the less likely they are to be concerned. (Assuming you are not actually lying, cheating or stealing.)

The goal of the presentation should be to provide an understanding of the firm, that your firm is treating its investors well, that your firm understands the regulatory requirements, and that your firm is serious about compliance.

These are some things I have in my opening presentation:

History of the firm
Ownership of the firm
Overview of each fund: closing date, investment period, size
Investment strategy for each fund
Types of investors (look at Form PF filing)
Case study for an investment: why we bought it, what we plan to do with it, how to make money from it
Key personnel
Overview of compliance program
Fees and revenue paid to the firm and how calculated
Custody and how you comply with the custody rule
Valuation policy and procedures
Marketing
Conflicts in the firm and how they are managed
Address key regulatory compliance requirements
- Code of ethics
- Political contributions
- Disaster recovery/business continuity
- Placement agents
- Anti-money laundering

The presentation is not a pitch to investors, so it’s not time to sell the firm or use a pitchbook. (You likely could take some elements from the pitchbook for this opening presentation.) You want to sell compliance.

I recommend putting together the opening presentation now and updating it every quarter. Once that call comes from the SEC you are going to be crunched for time. It’s much easier to update the presentation than create a new one.

More on the SEC and Funds’ REIT Subsidiaries

reit stock certificate

I discovered some additional information about the SEC’s position on the application of the Custody Rule to the REIT subsidiaries of private real estate funds. A few months ago, a real estate fund was undergoing an SEC exam and the examiners focused on custody. The examiners used the June 2014 Guidance on SPVs to take the position that the fund must issue audited financial statements to the accommodation shareholders in the REIT subsidiaries.

I discovered that the SEC office involved in the exam was the Philadelphia office. So real estate funds in Delaware, Maryland, Pennsylvania, Virginia, West Virginia, and the District of Columbia should be especially focused on this issue.

Second, I discovered that the firm disagreed with the SEC’s position (obviously) and fought the deficiency through several rounds. Ultimately, the firm apparently decided to cede to the SEC’s position. I assume the firm decided the cost of obeying was less than the cost of fighting. Too bad.

The IM Guidance Update 2014-07 was a poorly put together document from the SEC. The key problem with the Guidance is Scenario 4 when a fund invests in another investment vehicle. Unlike the three previous scenarios in the Guidance, this clearly is not an SPV. The investment vehicle could be another fund, a joint venture or co-investment. The Guidance reaches the conclusion that the fund manager should get audited financial statements for the investment vehicle to comply with the custody rule because it is a separate advisory client.

Many people (and apparently SEC examiners) skip over footnote 10 that states that the SEC assumes that the SPVs in the four scenarios are investment advisory clients. But in many situations, that investment vehicle may not be an investment advisory client. The assumption in footnote 10 drives you directly to the conclusion in the Guidance

The Guidance also makes the mistake of stating that compliance with the Custody Rule can only be be achieved through providing audited financial statements. A fund manager can use the standard Custody Rule method of having information sent directly to investors by a third-party custodian and a surprise exam.

I don’t have the details on how that firm used REITs in its structure. The deficiency jumps right into the position that the REITs are advisory clients. But it also makes an overly broad statement:

“[T]his guidance indicates that Registrant must distribute the audited financial statements of all pass-through entities or special purpose vehicles that are controlled by Registrant or a related person and have outside investors to each such entity’s beneficial owners.”

That is not what the Custody Rule requires and it is not what the Guidance on the Custody Rule requires.

I would be interested to hear what other real estate fund managers are doing with their REIT subsidiaries for the Custody Rule. You can email me directly at my office or at [email protected].

Sources:

Weekend Reading: Book de Tour

Do you like cycling?
Do you like watercolors?

Then Book de Tour is the perfect book for you. For the past few years, Greig Leach has been painting watercolors of key events from the Tour de France. This year he decided to compile all of the artwork with a narrative description into a single book.

I’m a big fan of his artwork and have a handful of his pieces. In the book, I have the original of Vincenzo Nibali’s win on Stage 13 on the top of Chamrousse. (See page 128).
Victorious - The Art of Cycling

The book is great addition to your library if you like cycling.