Month: May 2015

The SEC Exam: What We’ve Learned from Recent Exams

These are my notes, live from the forum. (Please pardon the rougher nature.)
Private fund Compliance forum

Speakers:
Jason Brown, Partner, Ropes & Gray
James Gaven, Senior Counsel and Chief Compliance Officer ,Welsh, Carson, Anderson & Stowe
Byron Pavano, COO & Fund Counsel, Audax Group
Abrielle Rosenthal, Managing Director, Chief Compliance Officer, TowerBrook Capital Partners LP

The new registrant presence exam initiative is over. What’s next?

The exams are much more focused than when the presence exam started. Requests across regional offices are looking more similar. SEC personnel are getting more knowledgeable. Enforcement actions are coming.

Work hard to get documents in by the deadline or before the deadline to the SEC examiners. Speed makes you look good.

Don’t underestimate the importance of the process. Make sure you know who is going to do what. Decide who to notify. Plan on how to leverage outside counsel and consultants to help with the process.

Focus on how to use attorney-client privilege for disclosure. It does change the tenor of the exam process.

How to stay ready for an exam.

Mock audits. Maybe it’s better to have a deeper dive on specific issues than a full audit.

Grab an example of a request list and make sure you can get all of the documents.

Have a day one pack ready at all times, with an introductory presentation.

The SEC will be focused on fees and expenses. Make sure you have that information put together. Examiners are focused on the allocation of expenses between the funds and the management company. Keep an eye on broken deal expenses. Focus on employee/consultant/operating partner expenses. The SEC will be looking at a general ledger and deep-diving.

Are examiners giving credit to ADV and LPAC disclosures? It seems to be a mixed bag. You definitely can’t amend the LPA through the ADV. It won’t save you if there is an actual issue. Don’t say “may” if you are actually doing the act and always doing it.

Accelerated monitoring fees are continuing to be a hot button. It’s moving from a deficiency to an enforcement action.

You need to be accurate and full-some in your responses. You also need to make sure you understand the question. The SEC questions tend be one-side fits all. You don’t need to answer more than what is asked.

Consultant versus employee and charging to the portfolio companies. If the person is exclusive, then the SEC is going to take the default position that the person is an employee, regardless of how the firm treats the person.

Valuation is continuing to be a focus are for the SEC when examining private funds, private equity and real estate in particular. The SEC will want to see what caused changes in valuation. The focus is on good process. The SEC has hired evaluation experts. The examiners are challenging underlying assumptions. Of course, examiners are looking for documentation.

Allocation of opportunities has been a point of focus. Examiners are looking for allocations among funds and allocations among co-investors. The key is to disclose what you are going to do and to make sure you follow that disclosure. It’s okay to cherry-pick as long as that what was disclosed.

In at one exam, there was  side letter in which the investor expressed an interest in co-investment opportunities. The examiners determined that that provision required the manager notify when there was a co-investment even if that opportunity was not offered to that investor.

The Custody Rule is still a tough fit for private equity firms. They are looking for thoughtful consideration of the rule.

Compliance Today: What’s Impacting the Compliance Community

These are my notes, live from the forum. (Please pardon the rougher nature.)
Private fund Compliance forum

Moderator:
Rob Kotecki, Reporter, Private Funds Management

Speakers :
Roman A. Bejger, Esq., General Counsel & Chief Compliance Officer, Providence Equity
Danielle Ryea, Senior Manager, EY
David Smolen, General Counsel & Chief Compliance Officer, GI Partners

The Blackrock enforcement action was levied against the firm and the CCO for a conflict of interest issue with an investment and one of its portfolio managers. The portfolio manager had disclosed the conflict to the CCO. The charge was that the CCO failure to report a “material compliance matter” to the board of directors. The CCO was personally liable and had to pay a fine of $60,000.

On the other hand, a CCO can be a whistleblower and get the financial windfall of the bounty. (Assuming the company fails to fix the problem.

If the firm retaliates, the SEC can pass along part of the award for the retaliation.

How does an internal procedure for reporting problems compete with large whistleblower payments?

Life of a whistleblower is difficult. Few see the big financial reward and if they do, it takes a long time to get to the point of an award being granted. It’s more like winning the lottery, with long odds.

You CAN’T contractually prevent employees from being whistleblowers or talking to regulators. See the KBR case: SEC Action for Stifling Whistleblowers in Confidentiality Agreements.

Take a look at the Shelton case. The administrative order required the firm to split the general counsel and chief compliance officer roles:

“For a period of five (5) years from the entry of this Order, [Shelton Financial Group] shall employ a Chief Compliance Officer whose sole responsibility will be serving in that position.”

The burden of compliance is only continuing to grow.

Are the SEC rules getting in the way of private equity compliance? The SEC rules mandates you to pre-clear trades and monitor employee trading, but the big issue is monitoring fees and expenses charged to portfolio companies. (UPDATE: Pre-clearance is not required by SEC rules.)

How have things changed since Bowden’s sunshine speech? Some have changed the Form ADV. Some have increased testing. Some have changed their policies. The LPA can’t be changed, so fees and expenses need to be in compliance with the agreement.

Cybersecurity- How does a compliance officer get his or her hands around this without a technology background? It is a tough gap to bridge. The SEC at least wants you to be thoughtful. (At least we think so.)

Private Fund Compliance Forum 2015

I’m spending a few days in New York attending PEI’s Private Fund Compliance Forum. Last year, the SEC’s Drew Bowden dropped his illegal expenses bombshell. I wonder what his acting replacement, Marc Wyatt, will do as follow up later today.

Private fund Compliance forum

I plan to live-blog my notes during the conference. We’ll see how the power and internet access function in the conference’s rooms.

Speakers confirmed for 2015 include:
Doug Cornelius Anthony S. Dell April E. Evans David A. Smolen Marc Wyatt
View speaking list

SEC’s Home Court or Federal District Court?

Dodd-Frank gave the Securities and Exchange Commission broader powers to bring its enforcement actions in its own administrative court, instead of federal district court. Dodd-Frank changed that with its Section 929P. The SEC may now impose a civil penalty in an administrative proceeding against any person or company.

SEC Seal 2

The SEC recently released its “Division of Enforcement Approach to Forum Selection in Contested Actions” (.pdf) in what I think was an attempt to create greater transparency in the decision-making process.

There is no rigid formula dictating the choice of forum. The Division considers a number of factors when evaluating the choice of forum and its recommendation depends on the specific facts and circumstances of the case. Not all factors will apply in every case and, in any particular case, some factors may deserve more weight than others, or more weight than they might in another case. Indeed, in some circumstances, a single factor may be sufficiently important to lead to a decision to recommend a particular forum.

At just over three pages, you couldn’t expect much and it met that low bar.

At least one SEC Commissioner thought the SEC should have written guidelines. I assume that was part of the reason for releasing these guidelines.

The guidelines start off solid with the acknowledgment that certain claims and relief require a particular forum. If the SEC is looking for a temporary restraining order or asset freeze, it needs the powers of federal district court and has to bring the case in that forum. For registered entities or individuals, the SEC needs its administrative courts to impose a bar or suspension.

Then the guidelines wander into the messy and ill-defined areas of the efficient use of the SEC resources.

Towards the end, I found one section troubling.

If a contested matter is likely to raise unsettled and complex legal issues under the federal securities laws, or interpretation of the Commission’s rules, consideration should be given to whether … obtaining a Commission decision on such issues, subject to appellate review in the federal courts, may facilitate development of the law.

I don’t like the idea of the SEC developing law in its home court. Based on this statement, the SEC may be deciding to use its administrative courts as an incubator to create novel cases and areas of enforcement.

SEC developed the law of insider trading. There is no act of Congress that makes it specifically illegal. The SEC deemed it a fraud and developed the legal theory. The federal district court has recently handed the SEC a big set-back with the Newman insider trading case.

In federal district court, the judge will decide the law and the jury will determine if there is a violation. Obviously, a jury will be less sophisticated than an SEC administrative law judge in understanding the facts and the implications. The concept is to add a reasonable person standard to the process.

The guidelines seem to give the SEC the ability to take the ball back into its own court if it does not like what the federal district courts are doing. Of course that is subject to appellate review, after appealing to the Commission. That may cause the defendant in the SEC’s cross-hairs to spend more time and money appealling the decision.

Sources:

Is a “Man Camp” a Security?

There was a land rush in North Dakota because of the stuff in the ground. Fracking for shale oil turned towns around the Bakken oil field into boom towns. It takes people to run those rigs, so the local population swelled in size, resulting in a shortage of housing. Some of the housing was minimally designed “man-camps” designed to meet the basic housing needs of a worker. An enterprising developer came up with an idea to finance construction by selling fractional interests in the real estate. The Securities and Exchange Commission just filed a securities fraud case against the developer.

Can a man camp be a security?

man camp

According to the SEC’s complaint North Dakota Developments marketed “units” to investors”. But since the units were managed collectively, the SEC took the position that the units are actually securities. An investor could purchase a unit for $50,000 to $90,000, rent space at the NDD project and let NDD manage the unit.

So far that sounds like a real estate investment, not a securities investment. Ignoring the alleged fraud for now, the SEC only has jurisdiction over securities fraud and needs to show that this investment involved a security.

The securities laws define “security” to include an “investment contract.”  The Supreme Court, in 1946, defined an investment contract as “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” SEC v. W.J. Howey Co., 328 U.S. 293(1946). The requirement that profits be expected “solely” from the efforts of the promoter has been given a liberal reading and has largely dropped the term “solely” from the investment contract test.

According to the complaint, NDD charged a high land rent for the unit. But NDD was willing to waive the land rent if the investor let NDD manage the unit. The SEC alleges that every investor had NDD manage the unit. The SEC described the land rent as punitive. Under the management agreement, investors could chose a guaranteed rate or a variable rate based on actual income received in a pooling program.

Typically, if the real estate investor is giving a choice to manage the unit separately, the developer can escape the transaction being designated as an “investment contract.” In this case the investor is given a choice, but the separately managed choice pays a large financial penalty. The SEC is going to argue that the choice is there in name only.

My view is that NDD took clever steps to avoid the treatment of the investments as securities. It may be enough to avoid the SEC’s case.

That does not mean there was or was not fraud involved in the investment scheme. The SEC’s complaint alleges some bad actions. It’s now up to NDD to defend itself from the SEC.

Sources:

Weekend Reading: In The Kingdom of Ice

It’s amazing to me that we have gone from having unexplored areas on Earth to sending a spaceship to Pluto in less than 150 years. Hampton Sides’ In The Kingdom of Ice tells the story of terrible journey to find the North Pole. (If you’re interested in Pluto, New Horizons is approaching the dwarf planet at 36,373 mph and scheduled to flyby on July 14, 2015.)

James Gordon Bennett was the eccentric and extremely wealthy owner of The New York Herald. He had recently funded Stanley’s trip to Africa to find Dr. Livingstone as way to sell papers. Now he was looking to create the next sensation. He set his sights on an expedition to reach the North Pole.

At the time, the North Pole was still unknown and unexplored. The foremost cartographer in the world, a German named August Petermann, believed that warm currents sustained open water at the top of the world. The theory was that the warm Japan current flowed through the Bering Strait toward the pole and created an area of warmer, ice-free water around the pole. If a ship could just break through the ice ring, it could reach the pole. Peterman even forecast that there was a landmass at the pole.

uss jeanette

George Washington De Long led a team of 32 men deep into those uncharted Arctic waters based on those theories. On July 8, 1879, the USS Jeannette set sail from San Francisco to cheering crowds in the grip of “Arctic Fever.”

Of course, we now know that Petermann was wrong. The Jeannette and her crew suffered the consequences.

The book starts as a tale of risk and facing the unknown. Unfortunately, the captain has faith in the one theory and does not accept the unknown as a risk. He hedged his risk. He had the ship prepared to be trapped in the ice and provisioned to survive being trapped for an extended period of time.

The risk was fueled by a bubble. The world had Arctic fever. Several explorers had attempted to reach the pole. Some of the fever was fueled by the media. Mr. Bennett funded the voyage because he wanted to sell newspapers.

Compliance Bricks and Mortar for May 8

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

bricks

Cyber Insurance: A Pragmatic Approach to a Growing Necessity by John Reed Stark and David R. Fontaine in Cybersecurity Docket

To manage this burgeoning yet still nascent threat, just like other routine day-to-day risk and hazards, companies have started to include cybersecurity concerns when considering enterprise risk management and insurance risk transfer mechanisms – such as cyber insurance. There is little doubt that cyber insurance will soon become yet another basic element of a company’s overall insurance coverage program, just like general comprehensive liability, professional liability and officers and directors coverage.

39 Reasons Why Your Employee Handbook May Violate the Law by Eric B. Meyer in the Business of HR

The National Labor Relations Board issued a report this week from General Counsel Richard Griffin, Jr. replete with examples of how your employee handbook is overly broad and violates the National Labor Relations Act.

The purpose of the report is to educate employers, with recent case developments, on what can and cannot be included in an employee handbook.

What can’t be included is anything that could chill your employees from discussing the terms and conditions of employment with one another. That’s because the Act give employees, union or not, the right to do that.

The Consequences of Baltimore and Body Cameras by Matt Kelly in Compliance Week

Some day in the future—hopefully after I am long dead—everyone will have body cameras implanted directly into their persons. Everyone will have an indisputable record of everything they do, all the time.

To Fire or Not to Fire for Employee’s Social Media Posts by Travis Crabtree in eMedia Law Insider

I guess we should advise anyone that wants to talk trash about their employer to follow whatever crazy thing they want to say with “Vote YES for the UNION!!!!!!” It may prevent you from getting fired — unless you are the official voice of the organization and you use a gun emoji.

Reps and Warranties Insurance: Why it is Increasingly Common by Kevin LaCroix in The D&O Diary

 Reps and Warranties insurance has been available for several years now, but there is no doubt that more recently there has been an increase in the product uptake. Indeed, according to an April 29, 2015 article from George Wang of the Haynes and Boone law firm (here), reps and warranties insurance “has gained popularity as a tool to decrease transaction liability exposure in M&A transactions” and more recently there has been a “dramatic increase” in the use of reps and warranties insurance products.

Private Equity Real Estate Top 50 – 2015 Edition of Who is Registered

Private Equity Real Estate has released its ranking of the top 50 real estate private equity fund managers. As I have done in the past, I parsed the list to see which managers are registered with the Securities and Exchange Commission as investment advisers. (Disclosure: my company is on the list.)

PERE top 50 2015

— Name of institution — SEC Registered?
1 — The Blackstone Group Registered
2 Starwood Capital Group — Registered
3 Lone Star Funds (Hudson Advisors) — Registered
4 Global Logistic Properties —   Overseas
5 Brookfield Asset Management — Registered
6 Tishman Speyer — Registered
7 Colony Capital — Registered
8 The Carlyle Group — Registered
9 Fortress Investment Group — Registered
10 Oaktree Capital Management — Registered
11 Ares Management  — Registered
12 Rockpoint Group — Registered
13 KSL Capital Partners Registered
14 LaSalle Investment Management Registered
15 Westbrook Partners
16 CBRE Group Registered
17 Invesco Real Estate Registered
18 Greystar Real Estate Partners Registered
19 GreenOak Real Estate Registered
20 Northwood Investors Registered
21 Beacon Capital Partners Registered
22 TA Realty Registered
23 Angelo Gordon Registered
24 Hines Registered
25 Cerberus Capital Management Registered
26 GTIS Partners Registered
27 Och-Ziff Capital Management Registered
28 Harrison Street Real Estate Capital Registered
29 Shorenstein Properties
30 CIM Group
31 Walton Street Capital Registered
32 Almanac Realty Investors Registered
33 DRA Advisors LLC Registered
34 Kayne Anderson Capital Advisors Registered
35 Rialto Capital Management Registered
36 AEW Global Registered
37 USAA Real Estate Company (Square Mile) Registered (Registered)
38 The JBG Companies
39 GI Partners Registered
40 Mapletree Investments  Overseas
41 Kildare Partners Registered
42 ECE Real Estate Partners  Overseas
43 Fir Tree Partners Registered
44 PAG/ Secured Capital  Exempt Reporting
45 Merlone Geier Partners
46 Paramount Group Registered
47 Tricon Capital Group Inc. Registered
48 DivcoWest Registered
49 Carmel Partners Registered
50 Gaw Capital Partners Exempt Reporting

 

On this year’s list, 40 of the top 50 are registered with the SEC as investment advisers. Of those not registered, five are overseas, likely outside the scope of SEC registration requirements. Two of those overseas firms filed as exempt reporting advisers. That leaves five firms that are not registered 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 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 50 measures capital raised for direct real estate investment through commingled vehicles, together with co-investment capital, over the past five years. This edition measures from January 1, 2010 to March 2015 for direct investment through closed-end commingled real estate funds. It excludes core and core-plus funds.

Sources:

UPDATED to delete a reference to a firm that is not registered.

Want to Buy a Boston Skyscraper?

The old fraud was someone selling you the Empire State Building. A new company wants you to buy State Street Financial Center in downtown Boston. But it’s not a fraud; just a focused real estate investment.

state street financial

Commercial real estate involves big chunks of capital. Some of those investments will meet underwriting, some will be home runs, and some will be duds. There are very few investors who have the capital to invest in a diversified portfolio of real estate to even out the highs and lows. That was the lure of REITs. An investor could access to a diversified pool of real estate assets.

ETRE Financial is trying to go the opposite way and float a public offering of an interest in a single real estate asset. The firm would own half of a joint venture that owns the Boston skyscraper. You, the investor, would hold an interest in that one building.

This is ETRE’s second attempt at this structure. The first attempt was for 1201 Connecticut Avenue NW, Washington D.C.

State Street Financial Center is a 36-story office tower that has a million square feet of primarily office space and a five-level parking garage. The Property was developed in 2003 through a collaboration among the Gale Company, State Teachers Retirement System of Ohio and a Morgan Stanley real estate fund. The Property was named “Boston Building of the Year” by the Building Owners and Managers Association International, or BOMA, in 2003.

It’s a great real estate asset. But the value is tied to one lease. The building is rented to a single tenant: a subsidiary of State Street Financial. That lease expires in 2023, subject to two ten-year renewals.

You also have to deal with the mortgage financing that matures in 2017.

To me, it seems like the investment is very focused. You would want to make sure you like the credit of State Street, that you like the Boston office market, that you understand what could happen with the mortgage re-financing, and that you understand the effects of the lease extension and expiration. Again, this is the opposite of an investment in a diversified REIT or private real estate fund.

I think it’s an intriguing investment choice. Possibly, it could be an intriguing way for real estate funds to exit from investments.

Typically, I don’t think a single lease negotiation or extension wold be material non-public information. Changes to this lease would definitely be material non-public information and subject to insider trading abuse.

By the way, you can own a chunk of the Empire State Building, as part of the diversified REIT, Empire State Realty Trust.

Sources:

UPDATE: A prior version of this story indicated that this was the third attempt at this structure. The first filing was merely a template using an unnamed building in Manhattan.

Can A Fund Pay for the Manager’s Office Expenses?

adoption money

This is not a question that you can answer without any background. Theoretically, a fund can directly pay a fund’s office expenses. It’s just that most investors do not expect to pay for a manager’s office expenses. Investors expect the management fee they pay to cover those expenses, with the rest as profit for the manager.

The key is what the fund documentation says. Generally you will see something like this is the partnership agreement:

The Partnership bears all of the expenses incurred by it or by others on its behalf or for its benefit, including ordinary operational and administrative expenses, expenses incurred in connection with the continuing offering of the Interests, expenses incurred in direct or indirect investment activities, financing and transaction costs, interest expenses on funds borrowed on its behalf, and extraordinary expenses, if any.

This provision came from the partnership agreement for Alpha Titans. That firm got in trouble with the Securities and Exchange Commission for using fund assets to pay more than $450,000 in office rent, employee salaries and benefits, and similar expenses. Alpha Titans was in violation of its fund documents.

In addition to the LP Agreement, the Form ADV should have also disclosed that the investors would be paying these operating expenses.

Finally, Alpha Titans financial statements failed to meet GAAP standards since the statements omitted the disclosure of these operating expenses. They should have disclosed the expenses and related party transactions. The funds were relying on the financial statement delivery option for funds under the Custody Rule. Since the financial statements failed to meet GAAP standards, they were inadequate for Custody Rule compliance, and therefore Alpha Titans failed to comply with the Custody Rule.

That is 1,2,3 punch from the SEC for expense allocation failures.

Sources: