June 2016 – Page 2 – Compliance Building

Fraud, But Is It Securities Fraud?

Although the Securities and Exchange Commission gets blamed for not bringing enough fraud claims, it’s jurisdiction is limited to securities fraud. When I see a real estate case filed by the SEC I pay attention. The case against Richard W. Davis, Jr. brought the “What is a Security?” questions out.

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The SEC alleges that Richard W. Davis Jr. breached his fiduciary duty and had conflicts of interest using investor money to enter into transactions with entities he beneficially owned or controlled. The SEC further alleges that Davis made false or misleading statements to investors before and after they made their investments, failed to inform investors of their losses, commingled funds and took more management fees than was allowed.

Davis sold interests in two funds and he marketed them as investing in “hard assets” like real estate and mineral rights. I will assume those interests are securities. Mr. Davis would have needed to comply with the private placement requirements. According to the complaint, he did not do so.

The complaint labels the funds as “pooled investment vehicles” within the meaning of Rule 206(4)-8(b) of the Advisers Act, 17 C.F.R. § 275.206(4)- 8(b):

(b) Definition. For purposes of this section “pooled investment vehicle” means any investment company as defined in section 3(a) of the Investment Company Act of 1940 (15 U.S.C. 80a-3(a)) or any company that would be an investment company under section 3(a) of that Act but for the exclusion provided from that definition by either section 3(c)(1) or section 3(c)(7) of that Act (15 U.S.C. 80a-3(c)(1) or (7))

To be an “investment company”, the pooled fund would need to invest in securities. A pooled fund that invests mostly and directly in real estate would fall outside the definition of an investment company.

The complaint is short on the details other than the bad acts alleged by the SEC. The issue is not contested since Mr. Davis agreed to settlement.

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Mountains National Bison Range Montana
By Jaix Chaix
CC BY SA

Compliance Bricks and Mortar for June 3

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

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How the Feds Pulled Off the Biggest Insider-Trading Investigation in U.S. History by Patricia Hurtado & Michael Keller in Bloomberg

For more than seven years, the U.S. government has relentlessly prosecuted Wall Street traders who used inside information to rake in hundreds of millions of dollars in profits.

Federal prosecutors in New York have racked up 91 convictions and collected almost $2 billion in fines. In the latest action on May 19, the government looked beyond Wall Street, accusing a legendary Las Vegas gambler of profiting from insider tips.

Here’s a by-the-numbers look at what happens when the Feds get serious about insider trading. [More…]

The Most Powerful Man in Banking by Ryan Tracy and Emily Glazer in the Wall Street Journal

The most important person in the banking business isn’t a banker.

To most Wall Street executives, that title goes to Federal Reserve governor Daniel Tarullo, a brusque, white-haired former law professor who has come to personify Washington’s postcrisis influence over how banks do business.

Mr. Tarullo heads the Fed’s Committee on Bank Supervision. On paper—and in practice for most of the previous decades—the post isn’t a hugely powerful one. But the 63-year-old took office at the Fed in 2009 at a moment of broad public support for a more aggressive tack and has pressed that advantage ever since. [More…]

The Wall Street Golden Boy Who Allegedly Fleeced His Friends and Family by William D. Cohan in Vanity Fair

Groomed at Groton, Princeton, and Harvard Law, financial expert Andrew Caspersen had the trust of everyone around him. So why, as prosecutors allege, would he start a fraudulent investment that targeted his Wall Street buddies and even his own mother? William D. Cohan delves into the case and the two tragedies—the death of Caspersen’s fiancé on 9/11 and his father’s suicide—that could provide an answer. [More…]

Want to Work in Compliance – Learn How to Read a Balance Sheet by Tom Fox in the FCPA Compliance & Ethics Report

One of the most interesting tag lines I heard at Compliance Week 2016 was the following, if you want to work in my compliance department; you need to learn how to read a balance sheet. I thought that single line encapsulated the change in the compliance function over the past few years more than any other. Why, because it speaks to the change of compliance from being centered in the legal department, run by lawyers as a rules based program, to fully understanding that compliance is a business process that needs to centered in its own discipline. For if you cannot read a balance sheet you cannot bring a positive value to a business unit. [More…]

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Doug with Team Kinetic Karma, stopping at the Scituate Lighthouse, on our Memorial Day Weekend Training Ride

Private Equity Fund Managers and Broker Dealer Registration

The Securities and Exchange Commission has been poking around fees earned by private equity firms and found many to its distaste. One item the SEC has highlighted in the past was fees for acting as a broker dealer. I’ve been waiting to see if the SEC’s distaste would be enough to bring an enforcement action. The SEC has brought that case.

Blackstreet Capital Management paid itself transaction based compensation in connection with acquisition and disposition of portfolio companies. The fund documents permitted this fee.

Blackstreet purchased and sold securities on behalf of its private equity fund and earned a transaction based fee for those services. Those services included soliciting deals, identifying buyers or sellers, negotiating and structuring transactions, arranging financing, and executing the transactions. Those transactions would have largely been securities that Blackstreet was buying and selling for its private equity fund.

The problem is that those services look a lot like the services of a broker dealer. By collecting transaction based compensation, it seems to fall right into the definition of broker dealer.

“The rules are clear: before a firm provides brokerage services and receives compensation in return, it must be properly registered within the regulatory framework that protects investors and informs our markets,” said Andrew J. Ceresney, Director of the SEC Enforcement Division. “Blackstreet clearly acted as a broker without fulfilling its registration obligations.”

The charge is not for improperly charging fund investors. The fee was disclosed in the fund documents and presumably Blackstreet was charging an appropriate fee. The SEC charge is merely because Blackstreet was not registered as a broker dealer.

There are other issues disclosed in the order, so its not clear if the SEC would bring an enforcement action solely because of this issue. It is clear that the SEC is sending a signal.

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Delaying Losses To Earn Current Fees

Fee structure is a guiding force for how fund managers operate and a keystone for compliance professionals. A compliance professional needs to focus on ways that a fee structure could cause the fund manager to act to the detriment of fund investors. The Securities and Exchange Commission just charged a fund manager for using distorted timing to generate more fees.

Cash in the grass.

According the SEC complaint, Hope Advisors and its principal owner, Karen Bruton, distorted the trading patterns of its hedge fund it managed to maximize fees to the detriment of fund investors. Hope Advisors and Ms. Bruton are challenging the charges so I’m looking at the complaint as an example of problematic behavior and not that they actually did these things.

Hope was entitled to an incentive fee of 20% of any realized gains during the previous month. But first the fund needed to make up for any realized losses. Unrealized gains and unrealized losses were not used in calculating the incentive fee.

The PPM for the fund discloses that the incentive fee may be paid even though the fund is experiencing unrealized losses.

According to the SEC, Hope was causing the fund to realize gains currently by deferring current unrealized losses through options. The fund would sell call options in the current month, earning a fee, and buy an equivalent set of options that expired in the next month. The SEC claims that there was no economic substance to the trades because there was little chance to make or lose money regardless of the market’s direction.

The fund would keep kicking the unrealized losses into the next month, while still taking fees. The fund had an NAV of $136 million, with unrealized losses of $57 million.

According to the statements in the complaint, it seems that Hope was acting to the detriment of fund investors. However, this behavior and risk is disclosed in the PPM.

Is disclosure enough for this circumstance?

I think trades that have no economic benefit (or risk) to the fund investors but are done merely to increase a fund managers compensation are suspect. Compliance professionals should look closely to see if the trade is merely done to benefit the fund manager.

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