Month: November 2015

Red-Hot SEC Enforcement Priorities

coping with regulatory change

I’m attending a conference sponsored by IA Watch: Coping with Regulatory Change. These are my brief notes.

William McLucas, Mark Schonfeld and Frank ______ spoke on what is happening on the enforcement side of the Securities and Exchange Commission.

The Madoff fraud and the 2008 financial crisis are still driving forces for SEC enforcement. The SEC still feels the sting of the inquiries coming out of those two events.

The panel thought that the SEC is not willing to let cases go because of the fear that there is a missed, bigger problem. The panel also thought the SEC has taken a disproportionate blame for the 2008 financial crisis. “Why hasn’t the SEC put any bank executives in jail for crashing the economy?” Of course, because the SEC can’t bring criminal actions. The Enforcement Division is much more focused on investment management. The division works closer with OCIE in exams and uses exams for enforcement investigations.

The panel thinks what were considered minor deficiencies in the past are now blowing up into bigger enforcement actions. There is little incentive to close cases. More of the enforcement division attorneys have come from the Department of Justice. They are less afraid to go to court. The government use the threat of action to extract settlements. The SEC has much more access to data for bringing actions. The courts have given the SEC much more deference to its own interpretation of its own rules. The SEC has a broader ability to create law.

Investigation has a cost to the business beyond the direct costs of legal fees and fines. Investors are skittish. They have lots of options. Institutional investors have their own fiduciary responsibilities to their constituents. Enforcement does not always take this into account. They key is to avoid attracting enforcement during an SEC exam.

The SEC did have one of its swords taken away. The Newman decision will make it harder to bring insider trading cases. The government will need to prove the benefits in the tipping relationship. The personal benefit standard from the Dirks case has been heightened. To go after the remote tippee, the government needs to prove a benefit to the tipper, and that the remote tippee knew of the benefit. The SEC thinks is can still prove cases because its civil standard is merely “preponderance of the evidence” as opposed to the “beyond a reasonable doubt” standard in a criminal action. In end, Newman will not reduce the number of insider trading cases, but there may be more civil cases and fewer criminal cases.

CCO liability is generally only when there is a wholesale failure by the COO, at least according to the SEC staff. However, “wholesale failure” is in the eye of the beholder. The panel disagrees that the SEC is only bringing the most egregious examples. The panel thinks the SEC is dis-incentivizing CCOs from getting involved is bad situations. Obviously, a CCO stealing and trading on inside information is fair game. The panel does not think the SEC should be naming CCOs except for those situations. The SEC has gone too far. CCOs do need to worry.

Coping With Regulatory Change – Office of Investor Advocate

coping with regulatory change

I’m attending a conference sponsored by IA Watch: Coping with Regulatory Change. These are my brief notes.

Rick Fleming, Director of the Office of Investor Advocate at the Securities and Exchange Commission, started with a keynote. His office and position was created by Dodd-Frank. He currently has a staff of ten people. (One of the inherent conflicts at the Securities and Exchange Commission is between investor protection and capital formation.) He created the position of Ombudsman for complaints against the SEC itself. Most of the staff is focused on policy issues, including those of the SROs. He hired an economist to focus on the benefits to investors, not just the cost to the industry, for the cost-benefit analysis of proposed regulatory actions.

He reports to Congress twice a year. The statutory mandate prevents the Commissioners from imposing their views on that report.

If the Office is not happy with an action, it can make a formal recommendation and the SEC must respond according to the statute.

Top Priorities for this year:

  • High frequency trading
  • More effective disclosures to investors
  • Variable annuity disclosures
  • Accounting and auditing issues
  • Millennial investors – how are they different?
  • Fiduciary Duty

He thinks there needs to be more exams of investment advisory firms. He recommended an additional fee to pay for more frequent exams. (He came from a state regulator.) However, he is not a fan of SROs and the FINRA model of self-exam. Review of investment advisers is a legitimate government action. He prefers more funding for SEC exams. He does advocate for third party verification of assets. His current idea is the use of consultants for review.

He thinks the SEC will come out with a Fiduciary Duty rule at some point this year, applying a higher duty to brokers who advertise themselves as something other than a broker. His biggest concern is that Dodd-Frank limits the duty when a proprietary product is being sold. That is where he has seen the most problems.

Compliance Bricks and Mortar for November 13

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

Bricks by iwanna

Compliance Officers Think Regulators Are Targeting Them By Samuel Rubenfeld in the Wall Street Journal’s Risk & Compliance Journal

Thomson Reuters, for its Personal Liability Report, found that 93% of compliance professionals expect their personal liability to increase over the next year, with 64% of them expecting a “significant” increase. Half of the respondents believe senior managers don’t really know what’s going on in their businesses. And yet, nearly two-thirds of the 2,000 risk and compliance professionals surveyed by Thomson Reuters also expect the regulatory focus on holding senior managers accountable to extend internationally. [More…]

Volcker’s Covered Fund Rules: When Banking Law Borrows from a Securities Law Statute by Erik F. Gerding in the CLS Blue Sky Blog

In a recent short article just published in The Capital Markets Law Journal (an earlier ssrn draft is available here), I examine this decision by Congress and federal regulators. In crafting the statutory provision and the final rule respectively, Congress and federal regulators chose to apply the covered funds rule to bank investments in entities that would otherwise be investment companies but for the exemptions in Sections 3(c)(1) and 3(c)(7) of the Investment Company Act. This importation from the Investment Company Act – in what I call a trans-statutory cross reference – has profound consequences. [More…]

U.S. Justice Dept Borrows From Academics for Policy Shift by Stephen Dockery in the Wall Street Journal’s Risk & Compliance Journal

The U.S. Justice Department is considering a new policy that gives companies a clearer idea of what to expect when self-reporting foreign corruption violations to the government, a move strikingly similar to a corporate-minded approach to criminal liability advocated by law professor Jennifer Arlen at New York University. [More…]

Still think fantasy sports isn’t gambling? Don’t bet on it by Phil Mushnick in the New York Post

They’re sold as get-rich-quick, no-downside methods to win thousands, tens of thousands, millions, the come-ons geared toward mostly young, impressionable (vulnerable) men stoked by the promise of winning more treasure than they can stuff in a 1996 Civic. [More…]

Marc Wyatt Named Director of the Office of Compliance Inspections and Examinations

Mr. Wyatt previously was OCIE’s Deputy Director and has been the office’s Acting Director since April 2015, following the departure of former director Andrew Bowden.

Mr. Wyatt joined the SEC in December 2012 as a senior specialized examiner focused on examinations of advisers to hedge funds and private equity funds. He was named Deputy Director in October 2014 and in that position he led OCIE’s Technology Controls Program and served as a member of the office’s Operating and Executive Committees. He also was the national co-coordinator of OCIE’s Private Fund Specialized Working Group and participated in the creation of its Private Fund Examination Unit, whose attorneys, accountants, and examiners specialize in examinations of advisers to private funds.

The SEC Frowns Upon Outsourced CCOs

Apparently, the Securities and Exchange Commission was running a sweep of firms with outsourced CCOs. The Office of Compliance Inspections and Examinations “stopped by” 20 registered firms that outsourced their CCOs to third parties. The SEC published a new risk alert to let us know what they found.

tight security

Surprisingly, the SEC did not paint a big sad face on the use of outsourced CCOs. They were found to be “generally effective.”

In reading the outsourced CCOs risk alert, it sounds like the issues that the SEC are concerned about are the same issues that the SEC is concerned about with in-house CCOs.

  • Are there enough resources? The SEC was concerned that outsourced CCOs were spread too thin across multiple clients. The SEC is as focused on the resources in-house.
  • Empowerment. The SEC was concerned that outsourced CCOs had enough power to enforce the policies and procedures.
  • Risks. Does the CCO understand the risks at the firm? This issue is perhaps accentuated by outsourcing, but there are plenty of instances of in-house CCOs being isolated from business operations.

Clearly, the risk alert does not advocate using out-sourced CCOs. It does provide a plan for using that structure.

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Don’t Charge Your Examination and Investigation Expenses to Your Funds

Most private fund documents allow the manager to charge the funds for expenses incurred in the operation of the funds. Most investors expect and most managers charge the funds for some of the legal expenses and consulting expenses. The Securities and Exchange Commission though Cherokee went too far in charging the funds for expenses related to registration with the SEC.

money

Like many private fund managers, Cherokee spent a great deal of time, money and energy in 2011 in preparing to register with the SEC as an investment adviser. According to the SEC order, Cherokee charged $171,000 of those expenses to the funds it managed. The expenses were for a third-party consultant and outside counsel, as well as registration fees.

Cherokee was subject to an exam in 2013 and incurred $239,362 of expenses that it charged back to the funds. In 2014, Cherokee got notice of an impending enforcement action and charged $45,000 to the funds for legal services incurred during the investigation.

The SEC takes the position in the enforcement action that the disclosure would need to specifically state that funds would be charged for a portion of the adviser’s own legal and compliance expenses. Cherokee’s partnership provided that the funds would be charged for expenses that in the good faith judgment of the general partner arose out of the operation and activities of the funds. That was not good enough for the SEC.
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Twitter for Stock Manipulation

Twitter is stream of random thoughts, news, insightful commentary, boring stories, humor, sadness, food pictures, hate, love, and cat pictures. The internet as a whole. At least a few traders have used Twitter as stock pricing indicator. Theoretically, that means stories could be planted that would move the stock price of a company. One trader tried to do so under false pretenses and is now subject to civil charges by the Securities and Exchange Commission and criminal charges by the Department of Justice.

twitterlogo

James Alan Craig set up a few Twitter accounts. One was modeled after Muddy Waters Research, the influential equity research company. Another was modeled after Citron Research, another influential securities research firm. In each case he stole the firm’s logo to use on the Twitter accounts.

On Jan. 29, 2013, Craig used a Twitter account to send a series of tweets that falsely said Audience, Inc. was under investigation. Audience’s share price plunged and trading was halted before the fraud was revealed and the company’s stock price recovered. On Jan. 30, 2013, Craig used another Twitter account to send tweets that falsely said Sarepta Therapeutics, Inc. was under investigation. Sarepta’s share price dropped 16 percent before recovering when the fraud was exposed.

false tweets

Craig used his girlfriend’s brokerage account to buy the companies’ shares at depressed prices, hoping to sell them later after they rebounded. He was a terrible trader and missed the low prices. He bought $13,000 worth of stock in the companies, but made less than $100 of profit.

However, there was substantial short term damage to the targeted companies. The stock drop erases $1.6 million of shareholder value for at least a short time. There was enough of an impact that the NASDAQ halted trading in one of the companies.

It’s hard to believe that an unverified Twitter account that is poorly used could dupe the market into thinking that the claims were true. But I may be underestimating how much traders are using Twitter algorithms in their trading strategy. Craig’s accounts had very few followers and brief histories. Most people would discount the quiet tweeting from such an account. The algorithms did not.

For a few tweets and $100 of profit Craig faces a maximum prison sentence of 25 years, a fine of $250,000, penalties and restitution. Of course that is only if the US authorities can get their hands on him. His whereabouts are unknown.

If the case ever makes it to trial, it would be an interesting legal examination of the intersection of social media an securities fraud.

I don’t think I could be convicted of securities fraud for standing on a street corner and telling everyone that passes that Company X is a fraud and subject to upcoming charges. I didn’t think the same would be true if I did the same thing on Twitter. But maybe I’m wrong.

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Compliance Bricks and Mortar for November 6

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

Decay: Aged brick & mortar in Puerto Rico by Rusty Long

Definition of Materiality Depends Who You Ask by Emily Chasan in the Wall Street Journal

As CFO Journal reported on Tuesday, at least half a dozen standard setters, including the accounting rule makers, Securities and Exchange Commission and stock exchanges, have some guidelines on what information must be told to investors and when.  Companies want to take a fresh look at “what disclosures are effective and necessary, and what might be obsolete,” said Tom Quaadman, vice president of the U.S. Chamber of Commerce’s Center for Capital Markets Competitiveness.

Companies are increasingly worried that so many different interpretations of materiality are part of the problem, he said.

Here are some of the definitions of materiality from five different regulators: [More…]

Compliance officers are executives and subject matter experts by Michael Scher in The FCPA BLog

Under Compliance 2.0, compliance officers aren’t in-house lawyers. They are not auditors, or human resource people, or project managers, or part of general risk management.

They are the leadership for, and subject matter experts on, all of the elements that make up the company’s compliance program. [More…]

Morrison & Foerster reports SEC Settles Charges that Investment Adviser Failed to Adequately Disclose Changes in Investment Strategy by Kelley A. Howes in the CLS Blue Sky Blog

According to the SEC, the fund originally invested in distressed debt, but in 2008, it began investing a significant portion of the fund’s assets in credit default swaps (CDS). Prior to 2008, the market value of the CDS portfolio never exceeded 2.6% of the fund’s net assets. The SEC found that by the end of the first quarter of 2009, however, the fund’s CDS portfolio grew to 25% of net assets. [More…]

J.P. Morgan Adviser Admits Stealing $22 Million From Clients by Anna Prior in the Wall Street Journal

According to federal prosecutors, Mr. Oppenheim defrauded multiple clients over a seven-year period. He claimed to have invested their money in low-risk municipal bonds and sent doctored account statements purportedly showing profits earned on those investments. However, he was using the clients’ money for his own personal benefit—including to pay for a home loan, bills and, according to his lawyer, gambling—and to pay back other investors. [More…]

Do You Speak Fluent Private Equity? Take the Quiz!

The private equity industry, like every other major industry, has plenty of jargon and industry-specific terminology. How well do you know the jargon and terminology of private equity?

Privcap Academy presents a fun challenge – take this quiz to test your command you have of the language of private equity.
[Take the Quiz!]

Another Private Equity Fee Case from the SEC

When the Securities and Exchange Commission announced last year that it was not happy with the fees private equity funds were charging and how they were disclosed (or not disclosed) to investors, we expected enforcement cases to follow. They are here. The latest is against Fenway Partners for failing to disclose conflicts of interest to a fund client and investors when fund and portfolio company assets were used for payments to former firm employees and an affiliated entity.

fenway

According to the SEC order, Fenway had management service agreements with the portfolio companies which were partially offset against the fund management fee charged to investors.

In 2011, Fenway cancelled those agreements and entered into similar agreements with a new consultant firm largely owned and operated by the principals of Fenway. Fenway did not offset these consulting fees against the fund management fee.

The SEC found several faults with the change. The SEC found the disclosure to the fund’s advisory board to be lacking in detail. The SEC also challenged the fund’s financial statements for failing to be GAAP compliant and disclose the payments to affiliates, the new Fenway consultant firm.

I assume Fenway was taking the position that the new consultant firm did not meet the definition of “affiliate” under the fund documents and could be carved out separately. Clearly, the SEC does not like this approach. KKR was challenged on taking this position last year by the SEC.

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Net of Fees Performance Figures

Last year, the U.S. Securities and Exchange Commission looked at how many private equity firms calculate net of fees internal rates of return for their funds. The focus was on whether the performance figures disclosed if general partner investments are included in or excluded from that calculation.

SEC Seal 2

General partners in a private equity fund typically do not pay management or incentive fees. So if the general partner’s capital is included in the net of fees IRR calculation, the net IRR returns would be higher than if that capital was excluded.

I think this distortion will be largely limited to situations where general partner capital is a large percentage of fund assets. One aspect is that calculation of fees in private funds is not tightly regulated as it is for mutual funds. Different strategies will require managers to sho performance in different ways.

Private equity funds have a particularly difficult time with net IRR calculations for funds that are not fully realized. The fees keep tolling as the fund continues through its life-cycle and underlying investments are realized. A fund manager cannot show the net of fees return for a particular realized investment because the standard management fee is not tied to the investment itself, but instead to the life of the private equity fund.

The concern is always that net IRR returns for such funds should not mislead prospective investors. That means inserting adequate disclosure regarding the net IRR calculation methodology.

The SEC has stated that performance should be what a typical investor will experience. A private equity fund manager should construct and show its performance as a typical investor would have its investment perform.
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