Month: May 2017

Comey and Compliance

The firing of FBI Director has set off a firestorm. Obviously, there is a great deal of partisan tilt to the action. I wanted to focus on the lesson we can see from a compliance perspective. It is an example of the need for independence of compliance and investigations.

President Trump fired someone who was investigating him or his circle of supporters for violations. The Attorney General recused himself from probe into Russia and President Trump because he was potentially involved. But the Attorney General recommended firing the person leading the probe into Russia and President Trump.

Perhaps, Director Comey was issuing subpoenas and continuing an investigation that would have been adverse to President Trump. That would be a problem, a cover-up.

Perhaps, President Trump legitimately thought Director Comey was unfit for his job. It would not be the first time a President has fired the FBI Director. President (Bill) Clinton fired  FBI Director William Sessions for serious ethical lapses.

The problem is that it looks like a cover-up. Without independence, the motives for firing or disciplining an employee for investigating his boss is always going to look suspicious. If it looks like a cover-up, many people are going to assume there is a cover-up.

It’s better to structure a compliance program so that it has some independence operationally. For a firm with a board of directors, the compliance program should have a way to report to the board of directors. Compliance officers should have alternative reporting structures in case they have to investigate a boss.

For an private fund adviser, there should be mechanisms for the CCO to report to a compliance committee instead of a single individual.

What you want to avoid is having to investigate your boss. That is an irreconcilable conflict. People are always going to question the end result. People are especially going to question why the investigator was fired in the middle of an investigation.

 

Real Estate Fund Information from the SEC

The Securities and Exchange Commission has been acquiring troves of data about private funds through the Form PF filing requirement. Some, including myself, have been skeptical that the SEC will figure out what to do with the data as a tool to protect investors. But, the SEC has been able to compile statistics and published a suite of new data and analyses of private fund statistics and trends. The SEC released the third quarter private fund statistics.

The number of real estate funds reporting on Form PF has increased.
The number of real estate funds reporting on Form PF has increased.

period 2014Q4 2015Q1 2015Q2 2015Q3 2015Q4 2016Q1 2016Q2 2016Q3
Funds 1,802 1,800 1,801 1,806 2,056 2,093 2,091 2,108
Advisers 262 263 264 265 288 290 288 290
Net NAV ($billions) 280 280 281 319 323 323 323 323

The rise from 1802 to 2108 in advisers is a big increase. There is only a small rise of 52 from the end of 2015 to the end of the third quarter in 2016. It’s the larger multi-platform Form PF filers who file quarterly.

Pure real estate fund advisers are only filing quarterly. Given that, I didn’t expect to see much change intra-year, and that held true.

There is a wealth of information in the SEC’s report. I’m still looking for some trends.
Sources:

Weekend Reading: Bourbon Empire

I went on Spring vacation to Kentucky with Mrs. Doug and the compliance nuggets. There was a lot of bourbon and horses. For vacation reading, I dug into my ever-growing tower of books to read and brought along Bourbon Empire by Reid Mitenbuler to read. It seemed appropriate.

Reid Mitenbuler portrays bourbon as a balance of Jefferson and Hamilton’s ideas, still being argued today in politics. On one side is the small agrarian culture championed by Jefferson, in opposition to the capitalist growth of Hamilton. Bourbon is Jefferson on the outside, with Hamilton on the inside.

In Kentucky, bourbon finds that its color. History collides with myth, filling in the recorded gaps with burnt oak.

I found the origins of “proof” to be a fascinating relic of taxation. Ever since President Washington imposed the whiskey tax, distillers have tried to work around taxes for profit. Tax collectors would measure the strength of the whiskey by mixing it with gunpowder and setting it on fire. If the flame sputtered, the alcohol content was low and if it flared up it, there was too much alcohol. A steady flame proved that the alcohol content was proper. This proof came at about 50% alcohol. So if the whiskey was 100% proved, it was was about 50% alcohol.

There was little government oversight of what could be put in the bourbon bottle or put on the label. The biggest first step of regulation was the 1897 Bottled-in-Bond Act that required the whiskey be made a single distillery by a one distiller, aged for at least four years, unadulterated and bottled at exactly 100 proof. The bottle’s label had to identify the distillery where the whiskey was distilled and bottled. If it met those standards, the whiskey would have the right to bear the green stamp of approval featuring the image of John G. Carlisle, a Kentucky congressman.

Whiskey, like all alcohol, was scrubbed out of existence by Prohibition. Okay, so that is clearly an overstatement. It went from local farmers and big distillers, to the underground criminal element. One interesting loophole of prohibition was an exception for medicinal whiskey. (Medicine has come a long way in the last few decades.) If you are going to dispense medicine, you need pharmacies. Walgreens grew from 20 stores in Chicago to over 525 stores during the era of prohibition. Mr. Mitenburger points to The Great Gatsby in which Daisy describes the mysterious bootlegging Mr. Gatsby as having “owned some drugstores, a lot of drugstores.”

Bourbon and Kentucky are linked. My tourguide at the Woodford Reserve distillery point to Kentucky limestone, with its removal of iron from the water, as the key to Kentucky bourbon. Whatever may be the truth or the myth or marketing, 95% of the world’s bourbon is made in Kentucky.

With the fall of Prohibition, government regulation of alcohol increased. That was especially true in labeling and identification of what was inside the bottle. To earn the “straight” identification, the whiskey needs to be aged in brand-new charred oak barrels for at least two years.

It was the rise of Maker’s Mark in the 1980s that turned bourbon towards its “craft” status, embracing quality over mass-production in its marketing. It was the embracing of the Kentucky mystery and Jeffersonian small-batch aesthetics that define most bourbon today. Behind the scenes, a handful of distilleries make the vast majority of bourbon and pour different variations into long line of product labels.

I enjoy a good bourbon and I enjoyed Bourbon Empire.

Compliance Bricks and Mortar for May 5

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

House Panel Approves Plan to Undo Parts of Dodd-Frank Financial Law by Rachel Witkowski

The House Financial Services Committee launched a Republican-supported rollback of Obama-era financial regulations, voting 34-26 along party lines Thursday for a plan to undo significant parts of the 2010 Dodd-Frank law.

The committee vote sent the Financial Choice Act to the full House, where it likely will be approved in the coming weeks. [More…]

SEC Staff Reports On “Real Estate Funds”, But What Exactly Are They? by Keith Paul Bishop

The SEC gathers the data from Form PFs.  You are required to file a Form PF if, among other things, you manage a “private fund”.  The Form PF does require disclosures from “real estate funds” and it defines these as “any private fund that is not a hedge fund, that does not provide investors with redemption rights in the ordinary course and that invests primarily in real estate and real estate related assets.”  A “private fund” is defined as “Any issuer that would be an investment company as defined in section 3 of the Investment Company Act of 1940 but for section 3(c)(1) or 3(c)(7) of that Act.”  Notably missing from the definition of “private fund” is a fund that relies on the exclusion in section 3(c)(5) of the ICA but not either section 3(c)(1) or 3(c)(7).   [More…]

SEC Probes Solar Companies Over Disclosure of Customer Cancellations by Kirsten Grind

The Securities and Exchange Commission is examining whether San Francisco-based Sunrun Inc. RUN -0.63% and Elon Musk’s San Mateo, Calif.-based SolarCity Corp. have adequately disclosed how many customers have canceled contracts after signing up for a home solar-energy system, the person said. Investors use that cancellation metric as one way to gauge the companies’ health. Companies typically give customers a few days after signing a contract, or even up until the time of installation, to back out of a deal. [More…]

Trump Pick for SEC Chairman Assembling Top Agency Staff by Dave Michaels

Mr. Clayton has considered at least two well-known defense attorneys for enforcement director, typically the SEC’s highest-profile staff position. The lawyers include Steven Peikin, a former prosecutor who works with Mr. Clayton at Sullivan & Cromwell LLP. Mr. Peikin represented Goldman Sachs Group Inc. in its dealings with prosecutors and SEC lawyers over claims a former member of its board, Rajat Gupta, had leaked inside information to a hedge-fund manager. . . .Another candidate for the top enforcement job is Matthew Martens, a partner at Wilmer Cutler Pickering Hale and Dorr LLP, who was the SEC’s top trial attorney from 2010 to 2013. [More…]

In S.E.C.’s Streamlined Court, Penalty Exerts a Lasting Grip by Gretchen Morgensen

A money manager settled his case with the S.E.C. thinking he could go back to work in a year. Nearly five years later, he is still waiting.

Mr. Wanger, who now calls himself the $2,200 Man on a website he has created, said his experience with the S.E.C.’s in-house court system did not feel like he was in America. “I’ve spent the last seven years fighting for the right to defend myself in a real court in front of a real judge,” he said. “Constitutional rights have no meaning unless you’re willing to extend them to people you don’t necessarily like. [More..]

 

A Classic Example of a General Solicitation Failure

The SEC opinion in KCD Financial Inc. (SEC Opinion 34-80340, March 29, 2017) affirms a fine and disciplinary action against KCD for selling securities in a private placement when no exemption from registration was available under Rule 506. The KCD opinion makes clear that you can’t fix the general solicitation failure by then only selling only to people had a prior relationship with issuer.

The action is against KCD, a broker-dealer, for selling the unregistered securities of Westmount Realty Finance’s WRF Distressed Residential Fund 2011. The offering’s PPM stated that the securities were being made in reliance on an exemption from the registration requirements of the Securities Act and that interests in the Fund were being offered only to persons who were accredited investors as set forth in Regulation D. In 2011, that meant no general solicitation or advertising.

Westmount screwed up and issued a press release that ended up being published in two local newspapers. Westmount screwed up even further by linking to those newspaper articles from Westmount’s website.

As long ago as 1964, [the SEC] has held that the statutory definition of “offer to sell” included “any communication which is designed to procure orders for a security,” and that even a communication that did not on its face refer to a particular offering could nonetheless constitute an offer as long as it was “designed to awaken an interest” in the security. [Gearhart & Otis, Inc., Exchange Act Release No. 7329, 1964 SEC LEXIS 513, at *59 (June 2, 1964), aff’d on other grounds, 348 F.2d 798 (D.C. Cir. 1965)]

The articles reported that “Dallas-based Westmount Realty Finance LLC announced Tuesday that it launched a $10 million real estate fund to acquire bank-owned residential properties and nonperforming, discounted residential loans.” (Yes, the article is still visible online.) That seems to clearly be general solicitation.

The argument from KCD was that it did not generally solicit any of the actual investors in the WRF Fund. When prospective new investors called, KCD asked if they had seen the article. If yes, they were not allowed to invest.

This argument was rejected. Once you engage in a general solicitation in violation of Rule 502(c), the Rule 506 exemption is not available for any subsequent sales of the securities regardless of limiting the sales only to investors who did not see the general solicitation. SEC guidance in 1983 pointed out that soliciting people with a pre-existing relationship and had reasonably believed that the recipients had the knowledge and experience in financial and business matters that he or she was capable of evaluating the merits and risks of the prospective investment is not general solicitation. “The mere fact that a solicitation is directed only to accredited investors will not mean that the solicitation is in compliance with Rule 502(c). Rule 502(c) relates to the nature of the offering not the nature of the offerees.”

Some of this has gone away since the SEC changed the general solicitation rules. Most firms do not want to check the box that says they engaged in general solicitation, fearing it will create greater SEC scrutiny.

Sources:

Headline Risk

On Thursday, The Wall Street Journal published an article on conflicts between the top executives of some private equity firms and their personal investments: “Fund Kings Open Family Offices.”

The article focused on two aspects of the executives’ wealth management: (1) distractions from activities outside the funds and (2) conflicting investments with the funds.

On the distraction issue, the article provided conflicting views from investors. One view is that executives should have all of their own money in the firms’ funds. The other view is the more pragmatic approach that diversification makes sense as long as the outside investments are not a distraction. Primarily, the concern is that the fund is the primary beneficiary of investment ideas and the executives’ time.

The second issue comes from those “distractions.” Personal investments may intersect with the fund investments. The article identifies instances where there was an overlap and a potential conflict. The article mentions the use of “family offices” by some fund executives. Some of these family offices also invest in private equity and other opportunities that may be opportunities that also interest the fund.

I think the article is a compilation of “headline risk.” There are no wrongdoings outlined in the article. There is just the appearance of conflicts.

The private equity firms require the investments of executives to be run through compliance and a conflicts review process. I have little doubt that big private equity firms that Blackstone, Apollo and TPG would have thoughtful review processes to make sure that the potential conflicts are resolved in a way that protects the funds.

The conflict review process is internal and the transaction is private so there is little disclosure made available to the public or to reporters that may be interested. That leaves the firms open to this type of headline risk.

The more high profile the outside investments, the greater media scrutiny they attract and the greater the headline risk.

One of the Fortress Investment Group executives bought a professional sports team, one of the most high profile investments you can make.