Doug Cornelius

No More Accelerated Monitoring Fees

In the proposed Private Fund Reform Rules, the Securities and Exchange Commission had contemplated a ban on charging a portfolio investment for monitoring, servicing, consulting, or other fees in respect of any services the investment adviser does not, or does not reasonably expect to, provide to the portfolio investment. This was an attack on a practice of some private equity firms to enter into a long term agreement with a portfolio company to enter into long term contracts, then have unexpired terms paid at exit.

That ban was dropped as an explicit rule from the reforms package. Instead the SEC made it an implicit rule.

The SEC stated on page 250:

“We believe that charging a client fees for unperformed services (including indirectly by charging fees to a portfolio investment held by the fund) where the adviser does not, or does not reasonably expect to, provide such services is inconsistent with an adviser’s fiduciary duty.”

The SEC also points out that it has brought actions in the past under Section 206(2) against private fund managers for improperly charging monitoring, servicing, consulting, or other fees, which may accelerate upon the occurrence of certain events, to a portfolio investment.

It did so again this week with charges against American Infrastructure Funds because it accelerated a portfolio company monitoring fee without timely disclosure to clients or investors. The SEC’s order also finds that American Infrastructure Funds violated its duty of care by failing to consider whether the fee acceleration was in its clients’ best interest.

I’m not sure why the SEC pulled back and didn’t make the accelerated fee ban explicit. The whole purpose of the series of 206(4) rules is to allow the SEC to “define, and prescribe means reasonably designed to prevent, such acts, practices, and courses of business as are fraudulent, deceptive, or manipulative.” Instead, the SEC is relying on regulation by enforcement under the fiduciary standard.

Sources:

Another SEC Whistleblower Action

For the second week in a row, the Securities and Exchange Commission brought a “pre-taliation” charge against a company for bad provisions in its employee separation agreements. This time it was the real estate company CBRE that had a bad provision.

In response to a Congressional mandate in Dodd-Frank, the SEC adopted Rule 21F-17 in August 2011, which provides:

(a) No person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement . . . with respect to such communications.

Back in 2016 the Securities and Exchange Commission filed a series of cases against companies that restricted departing employees from contacting government authorities. Some of the language the SEC found illegal was broad non-disparagement clauses that forbid former employees from engaging “in any communication that disparages, denigrates, maligns or impugns” the company. Companies responded by adding carve-outs that explicitly stated that employees could contact government regulators to reporting possible wrongdoing.

CBRE had an appropriate carve-out:

Nothing in this Agreement shall be construed to prohibit Employee from filing a charge with or participating in any investigation or proceeding conducted by the Equal Employment Opportunity Commission, National Labor Relations Board, the Securities and Exchange Commission, the Department of Justice, or a comparable federal, state or local agency.

What the SEC did not like is a representation earlier in the form separation agreement:

Employee represents and acknowledges [t]hat Employee has not filed any complaint or charges against CBRE, or any of its respective subsidiaries, affiliates, divisions, predecessors, successors, officers, directors, shareholders, employees, representatives or agents (hereinafter collectively “Agents”), with any state or federal court or local, state or federal agency, based on the events occurring prior to the date on which this Agreement is executed by Employee.

The SEC’s view was that the carve-out was prospective in application and did not fix the representation.

Last week’s whistleblower pre-taliation case against Monolith was clearly problematic. Allowing a complaint, but disallowing any financial rewards is clearly too cute and deters a whistleblower.

The CBRE language is not so obviously problematic. Some would argue that its fair to ask an employee if they’ve filed a complaint in the exit process.

If the form had a left a blank for an employee to fill in any exceptions to the representation, would that make the form okay? Probably not, based on this case. I think the case is trying to say that even asking if the employee has filed a complaint would be a deterrent and would violate Rule 21F-17.

Will these two be the last of the whistleblower cases form the SEC? The SEC’s fiscal year is fast approaching so we should expect a flurry of cases conclusions over the next week and a half..

Sources:

What We’ve Learned About Marketing Hypothetical Performance

When the Securities and Exchange Commission enacted the Investment Adviser Marketing Rule at the end of 2020, it threw out decades of cobbled together opinions, no action letters, and informal guidance. In the 18 months it took to reach the compliance date, the SEC offered little in the way of additional guidance. The SEC made it very clear that it would be taking a closer look at investment advisers’ marketing practices shortly after the compliance date a year. There have been signs that the examiners have been doing just that.

Enforcement has begun. The SEC announced action against nine firms for improper use of hypothetical performance.

(8) Hypothetical performance means performance results that were not actually achieved by any portfolio of the investment adviser.
(i) Hypothetical performance includes, but is not limited to:
(A) Performance derived from model portfolios;
(B) Performance that is backtested by the application of a strategy to data from prior time periods when the strategy was not actually used during those time periods…

Each of the nine firms published hypothetical performance on its website. Under 206(4)-1(d)6, an investment adviser can’t use hypothetical performance in an advertisement unless the firm:

(i) Adopts and implements policies and procedures reasonably designed to ensure that the hypothetical performance is relevant to the likely financial situation and investment objectives of the intended audience of the advertisement;

(ii) Provides sufficient information to enable the intended audience to understand the criteria used and assumptions made in calculating such hypothetical performance; and

(iii) Provides (or, if the intended audience is an investor in a private fund, provides, or offers to provide promptly) sufficient information to enable the intended audience to understand the risks and limitations of using such hypothetical performance in making investment decisions; ….

In the adopting release for the Marketing Rule at page 220, the SEC points out that hypothetical performance should not be used in mass advertising:

We believe that advisers generally would not be able to include hypothetical performance in advertisements directed to a mass audience or intended for general circulation. In that case, because the advertisement would be available to mass audiences, an adviser generally could not form any expectations about their financial situation or investment objectives.

There is no higher form of general circulation than using a public webpage to broadcast hypothetical performance. There is also the additional challenge of meeting the record-keeping requirements of the Marketing Rule for a website. To of the firms failed to have tools in place to archive their websites.

The lesson learned from these nine cases is don’t put hypothetical performance on your firm’s website.

Sources:

The One with the Stoner Cats

With the onset of the crypto winter, the Securities and Exchange Commission is continuing to bring cases against crypto companies. The latest is against a funding model for animated series: Stoner Cats. The producers wanted to try finding a crypto method to fund the production.

It started off as Kickstarter mixed with Non-Fungible Tokens. The tokens were digital pictures of the animated characters on the production. I think that’s okay and the tokens would not likely to be securities. You initially buy the NFT from producer to be able to watch the series. That’s like buying a movie ticket. That funds the production of the series.

Then the producers added in a royalty feature. When the NFT is traded from the initial buyer to secondary user, the producers take a 2.5% fee that gets passed to the actors and producers. I still that’s okay and doesn’t move the tokens into the treatment as a security.

Under the Howey test, it’s clearly a pooled investment and it’s success is clearly due to the efforts of the production team. The question is there an expectation of profits required by the third prong of the Howey test?

The cash flow from re-sale fee goes to the producers, not the token holders. So, the expectation of profits does not flow directly from the success of the production.

The SEC focused on the potential increase in value of the tokens.

“[I]t led investors to expect profits from their entrepreneurial and managerial efforts, because a successful web series could cause the resale value of the Stoner Cats NFTs to rise in the secondary market.” …

“Investors were also told that “the more successful the show, the more successful your NFT” will be.”

There are plenty of securities offerings that investors look to an increase in value and not to a payment of dividends. Those equity offerings still offer investors a residual claim on the business, even if they don’t get cash flow.

The SEC seems to hang it’s charges on the marketing efforts of the producers that the NFTs could increase in value if there is demand for the series. But of course that is part of the pitch to token holders and the whole NFT eco-system. Buy these tokens and they will increase in value. NFTs occupy this space between commodities and securities.

There is probably an interesting legal analysis and this could be an interesting court case. However, the producers settled with the SEC, agreed to return funds and destroy the NFTs.

Sources:

A New Regulatory Action to Help Potential Whistleblowers

In response to a Congressional mandate in Dodd-Frank, the SEC adopted Rule 21F-17 in August 2011, which provides:

(a) No person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement . . . with respect to such communications.

Monolith Resources included that language in its separation agreements:

“nothing in this agreement is intended to limit in any way your right or ability to file a charge or claim with any federal, state, or local agency,”

But Monolith took away the financial aspect of a whistleblower by adding:

“You retain the right to participate in any such action, but not the right to recover money damages or other individual legal or equitable relief awarded by any such governmental agency.”

Monolith’s former employees could file a whistleblower complaint, but not get any cash. An interesting approach, but one that is clearly designed to impede whistleblower actions.

Monolith got hit with a $225,000 fine. There was no indication that any employee was impeded from communicating with the SEC and Monolith never enforced that provision.

Maybe there has been some prior action by the SEC on this type of pretaliation and I just missed it. Let me know.

Sources:

New Division of Examinations Risk Alert

The Securities and Exchange Commission tries to be transparent about the areas of examination. The Division of Examinations publishes its exam priorities each year. Of course, in practice it may vary from region to region and examiner by examiner. A new risk alert focuses on what an registered investment adviser should expect from an exam.

As it has stated many times over the years, the Division once again states in the Risk Alert that it takes a “risk-based approach” to selecting exam targets. The Division also adds in that a firm could be picked because of the interest in a particular compliance risk area (a sweep exam?), or a tip, complaint, or referral (a for-cause exam).

The Division does list 11 factors for selecting an adviser for examination:

prior examination observations and conduct, such as when the staff has observed what it believes to be repetitive deficient practices during more than one review of a firm, significant fee- and expense-related issues, and significant compliance program concerns;
supervisory concerns, such as disciplinary history of associated individuals or affiliates;
tips, complaints, or referrals involving the firm;
business activities of the firm or its personnel that may create conflicts of interest, such as outside business activities and the conflicts associated with advisers dually registered as, or affiliated with, brokers;
the length of time since the firm’s registration or last examination, such as advisers newly registered with the SEC;
material changes in a firm’s leadership or other personnel;
indications that the adviser might be vulnerable to financial or market stresses;
reporting by news and media that may involve or impact the firm;
data provided by certain third-party data services;
the disclosure history of the firm; and
whether the firm has access to client and investor assets and/or presents certain gatekeeper or service provider compliance risks.

I think the key for most firms is number 5: How long has been since you’ve had an exam. If it’s been at least six years, the clock is ticking. If it’s been seven years, have a stack of documents ready.

To help you with that stack of documents, the Risk Alert includes an attachment with the staff’s typical initial request for documents and information.

I think it’s great that the SEC published this information. I do find it strange to be labeled as a “Risk Alert.” Those are usually to highlight areas where the Division is seeing problems in examinations. I find it hard to believe that registered investment advisers are being surprised that examiners are knocking on their doors or surprised at the scope of information. It can be a lot. In my recent exam I produced over 800 documents.

Sources:

The One with the Failure to Disclose Fees

The private fund industry is plagued with bad actors who don’t disclose fees and affiliate relationships. That has directly lead to the new reporting rule issued by the SEC for private fund advisers. The latest firm to get caught is the Prime Group, based in Saratoga Springs, New York. Prime’s business is investing in self-storage properties.

Prime is not registered with the Securities and Exchange Commission as an investment adviser. The new private fund reforms will only be partially applicable. Prime has at least two investment funds according to the SEC order. I assume they fall outside the definition of a “Private Fund” because Prime is relying on the c(5) exemption or claiming that the fund doesn’t invest in securities.

Prime also has an affiliate real estate brokerage firm owned by Prime’s CEO. Prime had employees and independent contractors that sourced acquisitions. When a fund bought one of these sourced acquisitions, it paid a brokerage fee to the affiliate. This arrangement is, of course, very usual and legal. According to the SEC Order, the majority of Fund II’s transactions paid a brokerage fee to the affiliate.

What Prime did wrong was sell interests in the fund without disclosing the payment of brokerage fees to the affiliate. There was some disclosure, but not enough. From the Fund II Limited Partnership Agreement:

“The General Partner may, from time to time, engage any person to render services to the Fund on such terms and for such compensation as the General Partner may determine, including attorneys, investment consultants, brokers, independent auditors and printers. Person so engaged may be Affiliates of the General Partner or employees of Related Persons.”

The SEC stated that “from time to time” failed to reflect that most of the transactions involved payment of the brokerage fee. This sounds a bit like the SEC’s attack on the use of “may” in disclosures.

The PPM for Fund II disclosed other affiliate fees, a 1% acquisition fee charged on all transactions and 5% property management fee paid to an affiliate, but failed to disclose the brokerage fee. It obviously would have been better practice to disclose the fee. It is common to pay a brokerage fee on transactions, although it usually paid by the seller, not the buyer. In my opinion if this is all the disclosures, it is potentially misleading.

The SEC dug further into Prime’s own DDQ and specific DDQs from some investors:

“Do you use the service of a broker to source deals?”
“Prime has not and does not use a broker; all sourcing is done internally.

“[Disclose]any fees, including consulting fees, paid to any affiliated group or person.”
“NA.”

Any other fees?
“Individual deal team members, unaffiliated with Prime Group Holdings or the fund manager, receive a brokerage fee of 1% to 3% of net purchase price.”

Unfortunately, Prime took a perfectly usual and legal fee and got itself in trouble by not disclosing it.

The twist, at least for a compliance geek, is that the SEC charge was not under the Investment Advisers Act. It was under Section 17(a)(2) of the Securities Act.

(a) It shall be unlawful for any person in the offer or sale of any securities … directly or indirectly—

(2) to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading.”

Since Prime was not registered as an investment adviser and the fund was not a private fund, there is a strong argument that there was no investment advice about securities and therefore the activity falls outside the scope of the anti-fraud provisions of the Investment Advisers Act. But the interests in Prime’s funds are securities, so the Securities Act does apply to the sale of those interests. So the SEC relied on the anti-fraud provisions of the Securities Act.

Sources:

Abusing Hypothetical Performance Under the New Marketing Rule

“These charges mark the first violation of the SEC’s amended marketing rule” according to the SEC press release.

Really, when use marketing collateral that your strategy has a 2700% return, you are going to catch the attention of the regulators. Titan Global Capital Management USA LLC, a New York-based FinTech investment adviser, used this hypothetical performance in its advertisements. Plus this was for a crypto strategy, so it’s even more suspect. I assume this lead the Securities and Exchange Commission to take a closer look at Titan Global and find a host of other problems.

The SEC Order provides great insight into what the SEC thinks about compliance with the Marketing Rule as a registered investment adviser. There has been a great deal of mumbling in the compliance world about the lack of guidance from the SEC on how to comply with the general provisions. The SEC annulled decades of guidance on how to be complaint with advertising. The one substantive FAQ about net performance for a single investment in a fund didn’t come out until four months after the compliance deadline.

So how did Titan Global achieve this 2700% return? They took their strategy and ran it for three weeks against price changes, with no actual money invested. During those three weeks, the strategy yielded a 21% return. Titan Global extrapolated that being able to achieve that return for a whole year and came up with a 2700% annualized return.

Titan Global is registered with the SEC as an investment adviser and put a marketing policy in place in June 2021 to comply with the Marketing Rule. There is no question about jurisdiction or applicability of the rule.

A list of the errors cited by the SEC:

Titan Global failed to adopt and implement any policies or procedures reasonably designed to ensure that the hypothetical performance metrics included in its advertisements complied with the Marketing Rule.
The hypothetical performance results were materially misleading. (Advisers Act section 2026(2)
Titan Global failed to present material criteria used and assumptions made in calculating its hypothetical performance projection, including sufficient information to appreciate the significant risks and limitations associated with this hypothetical performance projection.
Titan Global’s target audience was retail investors which requires heightened disclosure.
Titan Global did not disclose in the advertisements that the 2,700 percent annualized return was based on a purely hypothetical account in which no actual trading had occurred.
Titan Global failed to disclose that the annualized return had been extrapolated from a period of only three weeks.
Titan Global failed to disclose Titan’s views as to the likelihood that this three week performance could continue for an entire year.
Titan Global did not disclose whether the hypothetical projection was net of fees and expenses.
Titan Global did provided information about the assumptions it used to calculate the hypothetical annualized return, and risks, as clearly and prominently as the highlighted 2,700 percent annualized return.
The disclosures failed to disclose the significant risks associated with the strategy.

The SEC sums this all up by saying Titan Global’s “advertisement did not present the hypothetical projected performance in a fair and balanced way, or in a way that was not materially misleading.”

I don’t think there is much argument with that summary. This is not a marginal case. I think this advertising would have been found to be misleading under the old Advertising Rule. This part of the SEC Order just uses some of the new language in the Marketing Rule to frame the violation.

Sources:

Kirschner Update: Leveraged Loans are Not Securities

The Second Circuit put the leveraged loan market at ease and ruled that those notes are not securities. The Court had asked the Securities and Exchange Commission to offer its opinion on whether they were securities and the SEC declined to do so.

The Second Circuit followed the four factors of the Reeves “family resemblance” test.

1) “[T]he motivations that would prompt a reasonable seller and buyer to enter into” the transaction;
2) “[T]he plan of distribution of the instrument”;
3) “[T]he reasonable expectations of the investing public”; and
4) “[W]hether some factor such as the existence of another regulatory scheme significantly reduces the risk of the instrument, thereby rendering application of the Securities Acts unnecessary.”

The court found that the company and the note purchasers had different motivations. The company was entering into a commercial transaction. The note purchasers may have been motivated for investment.

Even though there ended up being lots of note purchasers, the distribution was controlled and not made available to the general public.

The court found that the note purchasers should have expected the notes to be treated as loans and not investments in the company.

Finally, the court found that there was some regulatory guidance and the loans were secured by a perfected interest in the company’s assets.

The court found that the notes had a family resemblance to loans issued by banks for commercial purposes. Therefore they are not securities.

The result of the decision is that the note purchasers can’t bring fraud claims under the state securities laws, which would have given them an additional remedy. In end, it was a lot of worrying, with no change in the law. It does stand as a reminder to focus on structuring loan transactions and documents to make sure you hit the points of the Reeves test.

Sources:

The Private Fund Rule Is Coming

The Securities and Exchange Commission has set the agenda for its August 23 meeting.

ITEM 2: Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews

OFFICE: Division of Investment Management

STAFF: William A. Birdthistle, Sarah G. ten Siethoff, Melissa Harke, Marc Mehrespand, Tom Strumpf, Robert Holowka, Shane Cox, Neema Nassiri

The Commission will consider whether to adopt rules and amendments under the Investment Advisers Act of 1940 (“Advisers Act”) for private fund advisers and whether to adopt amendments to the compliance rule under the Advisers Act.

It would be really unusual for the rule to not be adopted if its on the agenda. The question is “what will be in the final rule?”

The proposed rule in second quarter of 2022 had proposals that could be very problematic:

Limitations on indemnification for private fund advisers
Limitations on clawbacks for taxes
Limitations on different treatment for different investors
Standards for fee and expense disclosure
Not allowing existing contractual arrangement to continue if they differ from the rule requirements

The proposed rule was a kitchen sink of items with no unifying theme, other than to try to make private funds more like mutual funds without the liquidity. The rule could have a profound impact on the private fund industry.

Sources: