Category: Compliance Programs

Real Estate Fund CCO Forum

NEW YORK

We are starting a new forum for real estate fund compliance managers in New York. The first meeting is noon on July 24 near Chelsea Market.

BOSTON

The Boston group of real estate fund compliance professionals will meet again in September after taking the summer off.

ABOUT

The groups meet to discuss the issues that are particular to real estate funds post Dodd-Frank. We have moved past the register or non register discussions. (At least most of us have.) Here are some of the topics for the agenda:

  • Who are your access persons (entire company, a smaller subset, just the managing directors/executives)?
  • Are you getting brokerage statements or just having employees attest to the securities that they do have by providing a brokerage statement or listing the required security information on a separate sheet of paper?
  • Do you use any technology to assist in the compliance duties (certificate database, security software, email archiving, social media tracking etc.)?
  • Are you using a third party consultant?  If so, what are they doing for you?
  • Who is doing your required annual training?
  • How are you keeping up with current compliance news relating to real estate?

The meetings operate under the Chatham House Rule. So that discussion can be open without concern that any position would be attributed to you personally or your firm.

If you are interested in joining either (or both) of the group you can reach me at [email protected]. I can send you more detailed information.

This is Not Compliance

UPDATE (9/10/2019):

The CEO/CCO in question contacted me and told me her side of the story with regards to the SEC. According to her, an investor sued based on the SEC case and the charges were largely dismissed. As I point out and have now highlighted, I relied on the order to illustrate what the SEC does not like and what you should not do. At her request, I’ve edited the post and removed her name. 

Sometimes you see a careless disregard for the rules governing private funds and investment advisers. Last week, the CEO/CCO of Calhoun Asset Management, settled fraud charges with the Securities and Exchange Commission. Her problems are probably common for start-up managers.

Calhoun and the CEO/CCO entered into an Order Making Findings (.pdf) with the SEC, but neither admitted nor denied the facts. I’ll assume the statements in the Order are true for educational purposes.

Assets Under Management

In 2006, the CEO/CCO started two hedge funds: Triumph Multi-Series Fund (later renamed Calhoun Multi-Series Fund LP) and Calhoun Market Neutral Fund. CEO/CCO attracted capital to the Funds by aggressively marketing herself as an experienced hedge fund manager, despite having no experience in portfolio management.

In filling out a due diligence questionnaire for a potential investors, CEO/CCO state that the firm grew from $27 million in assets under management in 1999 to $200 million. However, the firm never had more than $3 million in assets under management.

I understand the desire of fund managers to puff up the AUM number. After all, that dollar amount often stands for measure of success. However, the calculation of AUM needs to be documented and defensible. Lies can easily be detected and puffery will raise red flags.

Performance

The fund marketing materials refer to a 10-year track record with 11+% average annual returns. The CEO/CCO failed to maintain the documentation supporting this track record. CEO/CCO only maintained records dating back to 2007. In a PowerPoint presentation, CEO/CCO included a full-page chart of monthly and annual performance returns from 1999 through 2009. The legend at the bottom of the page states that “[t]hese returns represent our flagship fund, Calhoun Fund SPC, Ltd.” Calhoun Fund SPC, Ltd. However, the fund did not commence operations until January 1, 2007.

The SEC rules are very clear that any statements in marketing materials about performance must be well documented. Calhoun’s overstatement should be easily detected with a little due diligence by a prospective investor.

Due Diligence

Calhoun promoted its due diligence capabilities in its marketing materials. This included regular monitoring, performance reviews, and on-site visits. “We take every precaution necessary to complete thorough due diligence and research on every manager we recommend” (emphasis in original).

The truth was that Calhoun’s actual due diligence was virtually nonexistent. CEO/CCO did not even perform the due diligence herself. Instead, she outsourced the due diligence to a third party, and that third party did little actual diligence.

Form ADV

Of course, lying to the SEC will really get you. On the Forms ADV she filed with the SEC, CEO/CCO repeatedly misrepresented  assets under management.

CEO/CCO first registered Calhoun as an investment adviser on August 31, 2007. On Calhoun’s Form ADV, CEO/CCO stated that Calhoun had $30 million in assets under management. In reality Calhoun had less than $6 million under management. On February 18, 2009, CEO/CCO filed an amendment to the ADV showing $79.8 million in assets under management. In reality, Calhoun had approximately $7 million under management.

Lessons?

Lying is bad. Unlike a fisherman’s tale about the one that got away, fund managers are expected to document their tales in detail.

CEO/CCO has to pay a $50,000 fine and is barred from the securities industry for five years.

Sources:

The US Private Real Estate Fund Compliance Guide

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 requires US advisers to private funds with at least $150 million in assets under management to register with the Securities and Exchange Commission as investment adviser. Venture capital fund managers are explicitly exempted from many aspects of registration. Real estate funds are not explicitly exempt from registration. For private real estate advisers, the key question whether to register depends on if the funds contain a sufficient amount of securities.

PEI Media’s brand new publication, The US Private Real Estate Fund Compliance Guide, is a detailed source of practical and insightful advice on SEC registration and compliance for private real estate fund managers who are registering for the first time, newly registered investment advisers, or experienced advisers who are seeking guidance on the latest regulatory reforms and changes.

Lead-edited by Charles Lerner of Fiduciary Compliance Associates, this publication addresses in detail key compliance areas including the registration process, marketing, custody, anti-corruption, setting up a compliance program, managing conflicts of interest, books and records, valuation and pricing, and advisory boards.

View the full table of contents and an extract (.pdf)

Update:

If you’re interested in the book, I have an offer for 20% off the list price. Email me at [email protected] and I can send you the code.

 

Compliance Bits and Pieces for June 1

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

The Symbolism of the Bull and the Bear by Amy Farber, New York Fed Research Library

The term “bear” dates back to 1709, when it was used as shorthand for the bearskin jobber occupation. The title “bearskin jobber” originates from a proverb highlighting the practice of selling bearskins before catching the bear. In a more modern sense, a bear is someone who expects prices to fall, thus selling stocks in hopes of a future compensation.

Reasonable Efforts May Be A Promisor’s Best Efforts by Keith Paul Bishop in California Corporate & Securities Law

Does a “best efforts” clause require a party to subordinate its interests to the other party or undertake extraordinary efforts to fulfill its obligations? Does a “best efforts” clause establish a fiduciary relationship between the parties? Is a “best efforts” requirement the same as good faith? … [T]he Court of Appeal rejected the plaintiff’s contention; holding that when a contract does not define “best efforts”, the promisor “must use the diligence of a reasonable person under comparable circumstances”.

Drachma! by David R. Kotok in Barry Ritholz’s The Big Picture

Since reintroduction in 1832, all modern Grecian drachma forms have ended badly.  The single exception WAS the exchange of the drachma for the euro in 2001. That chapter of Greek history is being re-written now.

After NLRB’s Memo, Drafting Employment Policies Got Trickier by Daniel Schwartz in Connecticut Employment Law Blog

I’ve had a little more time to digest the latest memo from the NLRB opining on what is and what isn’t appropriate for employers to have in their policies. And I’ve come to a very serious conclusion:

It’s an utter mess.

Occupy the regulatory system! by Suzy Khimm in the Washington Post

Many of the Occupy wonks once worked on Wall Street, and some of them still do. They’re former derivatives traders, risk analysts, compliance officers and hedge fund quants. They hail from Morgan Stanley, Deutsche Bank, Bear Stearns, D.E. Shaw, Merrill Lynch and JPMorgan Chase — and at least one is a former Securities and Exchange Commission regulator. They’re more likely to use a flowchart than protest signs to fight big banks. But they identify with the movement’s animating belief that America’s financial heavyweights wield too much power, and that its political leaders are too eager to do their bidding.

A Guidebook For What It Means To Know Your Customer by Joshua Horn in Fox Rothschild’s Securities Compliance Sentinel

On July 9, FINRA Rules 2090 and 2111 go into effect.  In Rule 2090, FINRA has defined what a member firm/registered representative must do to know their customers.  In addition, Rule 2111 defines suitability when it comes to investment recommendations.  For what this means for you as a practical matter, I have written the attached guidebook.  http://www.foxrothschild.com/uploadedFiles/attorneys/eBook_aGuideToAnswerThatAgeOldQuestion.pdf

In Hindsight, 37.5 Million Dollars Isn’t Cool. You Know What’s Cool? A Billion Dollars by Bruce Carton in Compliance Week’s Enforcement Action

Yes, Sean Parker’s character (played by Justin Timberlake) uttered that memorable line in The Social Network, but you know who else might be saying that soon? Irving Picard, the court-appointed trustee in the Madoff case who is tasked with recovering funds for the victims of Madoff’s Ponzi scheme.
Image of the Bull and Bear at the Frankfurt Stock Exchange is by Thomas Richter

What SEC Registration Means for Hedge Fund Advisers

Earlier this month Norm Champ, Deputy Director, Office of Compliance Inspections and Examinations at the SEC, addressed the New York City Bar and gave a preview of what the SEC has in mind for private fund advisers. I thought this tied nicely with the speech given by Norm’s boss, Carlo V. di Florio, at PEI’s Private Fund Compliance Forum.

First, some statistics:

  • As of early April, there were approximately 4,000 investment advisers that manage one or more private funds registered with the Commission
  • 34% (more than 1,350) registered since the effective date of the Dodd-Frank Act.
  • This represents a 52% increase in registered private fund advisers
  • 32% of all advisers currently registered with the Commission report that they advise at least one private fund.
  • Of the registered private fund advisers, approximately 7% (284) are domiciled in a foreign country; most of these (136) are in the United Kingdom.
  • Registered private fund advisers report on Form ADV that they advise approximately 30,000 private funds with total assets of $8 trillion, which is 16% of total assets managed by all registered advisers.
  • Based on available information, 48 of the 50 largest hedge fund advisers in the world are now registered with the Commission.
  • Fourteen of these largest hedge fund advisers are new registrants.

It sounds like fund advisers should expect a visit from the SEC this fall.

“Our strategy for these new registrants will include (i) an initial phase of industry outreach and education like today (sharing our expectations and perceptions of the highest risk areas), (ii) followed by a coordinated series of examinations of a significant percentage of the new registrants that will focus on the highest risk areas of their business and help us to risk rate the new registrants, and (iii) culminating in the publication of a series of “after action” reports, reporting to the industry on the broad issues, risks, and themes identified during the course of the examinations.”

This is exactly what Mr. DiFlorio described as the upcoming SEC strategy. Given the current staffing, it would seem that the SEC visit would need to be brief in order to reach a substantial portion of the 1,350 new registrants in a short period of time.

Champ ends with Ten Suggested Takeaways for Registered Advisers to Hedge Funds

  1. Review your control and compliance policies and procedures annually.
  2. Assess and prepare for Form PF requirements.
  3. Identify risks.
  4. Enhance your expertise.
  5. Verify client assets.
  6. Get rid of any silos, identify conflicts.
  7. Provide clear, complete, and accurate disclosure in performance and advertising.
  8. Verify portfolio management compliance.
  9. Address your complaints.
  10. Check your IT security.

We know the SEC is coming and what they are looking for. It’s time for newly installed CCOs to put the work in to make the SEC happy when they appear on your doorstep.

Sources:

Complexity

Does your policy look something like this sign? This is a real sign that was posted near schools on Bogie Lake Road in White Lake, Michigan.

The speed limit is normally 45 on that street, except during these half hour periods on school days when the speed limit drops down to 25, except the first period which is only 26 minutes. The end result is that drivers need to almost stop in order to read the sign. Presumably, they also need to make sure their watch is precise because they can travel at 45 mph at 6:48 am, but need to slow down to at 6:49 am. They need a copy of the school calendar to determine if it’s a school day, and not merely a work day.

The sign became complex because of cost, the underlying regulations, and the surrounding environment. The complexity is there for a good reason. There are three schools on that stretch of road, a high school, a middle school, and an elementary school. As you might expect, each school has different pick up and drop off times, resulting in different times that drivers need to be aware of the extra traffic and danger of children in the area.

The size and style of the sign is strictly regulated, so the sign maker has limited flexibility.

Because of cost, the sign designer puts the burden on the driver. Another choice would have been a “school speed limit only when lights are flashing” sign. But that costs significantly more than the this sign. That shifts the burden to the municipality to pay the additional cost to put up an automated sign. By the way the cost is significant: $50,000.

The complicating factor is that three schools are clustered together. That is unusual and clearly the rules for signs were not designed to deal with that type of complexity.

I assume by the strict rules for school speed zones, they only apply during the drop-off and pick-up time for each school. That leaves a gap in the times. The hours could have been from 6:49 am to 9:07 am and 2:03 pm to 4:29 pm. Presumably, the sign maker thought that choice was unduly strict.

The sign is complex because the underlying rules are complex. (I’m sure you can think of your own policies that are complex because the underlying law is complex.)

Perhaps one of the goals of compliance should be to craft simpler policies out of the complex maelstrom of applicable laws. That will ultimately limit employees from taking actions that would be permitted by the underlying law. The trade off is a policy that’s simpler to understand. After all, if you can’t understand the policy or easily figure out if it applies to you, then compliance with the policy is only a matter of luck.

Thankfully, the sign was removed and replaced by a simpler sign.


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Compliance Bits and Pieces for April 6

Earl Scruggs: Banjo, Bluegrass and the Fight against Corruption and Bribery by Tom Fox

So what is the lesson of Earl Scruggs for the compliance practitioner? It is this, even if you develop a completely new style that makes you one of the foremost experts in an area, you can still evolve. Further, the style you use may have significant effects on other styles, even in the fight against bribery and corruption.

General Solicitations, Rule 506, and the Missed Opportunity by J Robert Brown Jr. in the Race to the Bottom

Second, the risk of liability associated with the use of the exemption is significantly greater than many other exemptions. The ability to use a general solicitation is determined not at the time of the solicitation but at the time the purchases are made. To the extent a company engages in a general solicitation but sells to unaccredited investors, the exemption under 506 will be unavailable. Because the fallback, Section 4(2) does not permit a general solicitation, the inapplicability of the exemption will result in a violation of Section 5.

SEC Enforcement to Focus on Private Equity Insider Trading and Conflicts of Interest by Howard Sobel in The Harvard Law School Forum on Corporate Governance and Financial Regulation

The Enforcement Division’s increasing attention to private equity corresponds with the implementation of new rules under the Dodd-Frank Act that will significantly increase the number of private equity firms subject to SEC regulation as “investment advisers.” The Asset Management Unit, one of a number of specialized enforcement units formed by the Division of Enforcement in 2010 to focus on “priority areas,” is staffed with 65 professionals, including private equity experts.

The Impact of the JOBS Act on D&O Liability by Kevin LaCroix in the D&O Diary

These and many other changes introduced in the Act could require the D&O insurance industry to make changes in its underwriting and perhaps in policy forms to accommodate these changes. As was the case with the Sarbanes-Oxley Act and the Dodd-Frank Act, the D&O insurance industry may face a long period where it must try to assess the impact of changes introduced by this broad, new legislation. Though many of the Act’s provisions seem likely to reduce the potential scope of liability for many companies (particularly the EGCs), the Act could also introduce other changes that might result in increased potential  liability for other companies (particularly those resorting to crowdfunding financing).

Accredited Investors and the JOBS Act

The Jumpstart Our Business Startups Act repeals the SEC’s ban on general solicitation and advertising under Rule 506. That is the exemption from registration used by most private fund managers. Is this a good thing?

I didn’t like the ban, mostly because it was so broad. The SEC gave little guidance as to what was advertising in support of the company and what was advertisement in support of the sales of securities. I would have welcomed better guidance. Now it looks like private fund managers will be free to have late-night television ads, email campaigns, twitter accounts, and Facebook fan pages.

Section 201(a) gives the SEC 90 days to

“revise its rules issued in section 230.506 of title 17, Code of Federal Regulations, to provide that the prohibition against general solicitation or general advertising contained in section 230.502(c) of such title shall not apply to offers and sales of securities made pursuant to section 230.506, provided that all purchasers of the securities are accredited investors.”

At first, I thought the last proviso was extraneous. Rule 506 allows unlimited fundraising as long, but it’s limited to accredited investors. But that’s not right. Rule 506 allows up to 35 investors that are not accredited, as long as they are “sophisticated” – have sufficient “knowledge and experience in financial and business matters” to make them “capable of evaluating the merits and risks of the prospective investment”.

If a manager is going to advertise that it is fundraising, then it needs to ban those previously allowed 35, even if they are sophisticated. Money rules. You need $ 1 million, excluding your primary residence, or $200,000 in income, $300,000 income with your spouse. It doesn’t matter if you are sophisticated. Even though the Crowdfunding section of the JOBS Act is supposed to allow a broader range of capital sources, this part of the law cuts off access to non-accredited investors.

That means fund managers may have to cutoff  “friends and family” investors from the fund, unless they are accredited investors.

The jumper cables are Heavy-Duty Auto Jumper Cables – 20-Ft Length – Heavy 4-Gauge Copper Wire by Tooluxe

Hot Topics for SEC Exams

As part of the SEC’s new National Exam Program Overview, OCIE highlights six areas of focus for Investment Advisers:

“[T]he Program has identified specific strategic areas on which to focus when examining firms…. In FY2012, focus areas include the following priorities, among others:

Complex Entities. Staff will examine for the risks and practices associated with the SEC’s rapidly growing complex registrant population. Review areas may include:

(i) Newly registered, private fund advisers that may be unfamiliar with the Federal securities laws.

(ii) Complex relationships in the private equity space.

(iii)Model risk of quantitative investment decision, order routing, and trade execution models utilized by various industry participants.

Sales Practice of New or Risky Products. The staff will review for the sale or recommendation of inappropriate investments by advisers. Among the areas of concern:

(i) The retailization of complex investments and smaller, niche-type products (e.g., structured products, reverse convertibles bonds, alternative mutual funds, leveraged ETFs).

(ii) Aggressive marketing of retirement/senior products and investments marketed as being “safe.”

(iii)Portfolio management activities that may increase the risk of investor loss or harm.

(iv) Lack of due diligence performed on underlying investment vehicles/managers and any undisclosed conflicts and/or fee arrangements.

(v) Valuation practices and any conflicts that exist in the pricing process.

Fund Governance. The NEP will evaluate practices or oversight weaknesses that may increase the risk of shareholder loss or harm, such as:

(i) Mutual funds investing in a manner that is inconsistent with fund disclosures or engaging in activities that may pose higher risk.

(ii) Directors failing to satisfy fiduciary duties.

(iii) Systemic compliance breaches and processing issues that may have a significant impact on fund investors.

Compliance, Supervision, and Risk Management. The NEP will assess the appropriateness of compliance programs and risk management processes relative to business operations to identify potential weaknesses that raise investor protection concerns, such as:

(i) Effects of cost-cutting, mergers and acquisitions, and aggressive business strategies to make up for losses and revenue cuts.

(ii) Lack of oversight of outside business activities and weak compliance of remote locations, branch offices, and independent contractor representatives.

(iii)Dual and affiliated registrants transitioning broker-dealer customers into advisory clients.

(iv) Ineffective compliance and risk management with respect to complex investments and/or investment strategies.

Fraudulent Activities/Safety of Assets. The NEP continues its initiative to identify fraudulent, abusive, and manipulative activities surrounding the safety of client assets. Areas of focus include:

(i) Custody arrangements that increase the potential for misappropriation of assets.

(ii) Ponzi schemes or ponzi-like schemes.

(iii)Manipulative activity, such as front-running and insider trading.

(iv) Cyber security risks associated with malicious hacking and fraudulent schemes.

 Performance and Advertising. The NEP will assess performance characteristics and marketing practices that have been associated with an increased risk of misrepresentations and investor harm. For example:

(i) Aberrational performance that may be indicative of abusive valuation.

(ii) The use of solicitors to attract new clients, particularly when non-cash compensation is used by advisers.