Category: Compliance Programs

SEC’s National Exam Program Overview

The SEC’s Office of Compliance Inspections and Examinations (“OCIE”) mission is to protect investors through its nationwide examination and inspection program. Examiners in Washington DC and in the SEC’s 11 regional offices conduct examinations of the nation’s registered entities. Besides investment advisers, OCIE also examines broker-dealers, transfer agents, investment companies, the national securities exchanges, clearing agencies, the nationally recognized statistical rating organizations, SROs (Financial Industry Regulatory Authority and the Municipal Securities Rulemaking Board), and the Public Company Accounting Oversight Board. That’s a lot of ground to cover.

OCIE recently released its National Exam Program Overview (.pdf). The first 23 pages ramble on about the statutory and regulatory framework. The good stuff starts on page 24 with a description of the inspection and examination process.

  1. Overview
  2. Scope
  3. Scheduling Fieldwork
  4. Entrance Interviews
  5. Document Requests
  6. Questions
  7. Exit Interviews/Exit Conference Calls
  8. Results

The staff may identify compliance deficiencies or internal control weaknesses. If this is the case, the staff generally will provide the registrant with a deficiency letter identifying the problems, asking the registrant to take remedial steps, and requesting that the registrant provide a written response. Examinations often conclude with a deficiency letter.

It’s a good roadmap to help prepare your firm for when the SEC inevitably comes knocking on your door.

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Are you a Supervisor?

As a compliance officer, how far do you need to go in dealing with a problem employee? The Urban case was trying to address this question, but got twisted up in procedural machinations. In dropping the case, the two SEC commissioners didn’t explain when a compliance officer or in-house counsel at a broker-dealer or investment adviser becomes a supervisor liable for an employee’s actions.

The case began with suspicious trading at Ferris, Baker Watts, Inc. by Stephen Glantz, a top-performing broker. In 2007, the U.S. attorney in Cleveland accused Glantz and an accomplice of scheming to artificially increase the stock price of Innotrac Corp., a company that provides e-commerce fulfillment services. Glantz pleaded guilty in September 2007 to one count of stock fraud and one count of making a false statement. He was sentenced to 33 months in prison.

The SEC moved up the chain and began investigating Theodore W. Urban, Ferris, Baker Watts, Inc.’s, General Counsel, Executive Vice President, and a voting member of the Board of Directors, the Executive Committee of the Board, and the Credit Committee. The SEC’s claim was that Urban was a supervisor of Glantz and that he failed to properly supervise him.

Urban had a hearing before the SEC’s chief administrative law judge in March 2010. The judge decided that that although Urban was, under the law, the broker’s supervisor, he “performed his responsibilities in a cautious, objective, thorough and reasonable manner.” As a result, “Urban did not fail to supervise.”

Apparently, the SEC was not happy with losing that case, so the Enforcement Division petitioned the commission for a review of the decision. On Jan. 26, the SEC dismissed the case, leaving compliance officers and in-house counsel with no guidance on when you are a supervisor.

SEC Chairman Mary Schapiro, Elisse Walter and Daniel Gallagher recused themselves for unexplained reason. The remaining two, Parades and Aguilar, couldn’t agree.

Commissioner Gallagher to address the topic in his speech at The SEC Speaks in 2012:

Once again, I want to stress that firms and investors are best served when legal and compliance personnel feel confident in stepping forward and engaging on real issues. An overbroad interpretation of “supervision” risks tacitly deputizing as a supervisor, with concomitant liability, anyone who becomes actively involved in assisting management in dealing with problems. Deterring such active involvement will erode investor confidence in firms, to the detriment of all.

Looking at the Enforcement Division’s view of a supervisor:

Gutfreund 51 S.E.C. 93 (1992): the person was not a line supervisor and others shared supervisory responsibility; still, he was a supervisor because he had the requisite degree of responsibility, ability, or authority to affect the person’s conduct when senior management informed him of the misconduct to obtain his advice and guidance and to involve him as part of management’s collective response to the problem.

Kirk Montgomery, 55 S.E.C. 485, 500 (2001): a chief compliance officer is a supervisor because it was sufficient if the person plays a significant, even if shared, role in the firm’s supervisory structure and that his authority was subject to countermand at a higher level.

Urban was required to take concerns about Glantz’s conduct to the Ferris Board or Executive Committee, and, if they did not act, he was required to resign and report the matter to regulatory authorities.

That is a very harsh standard for compliance officer or general counsel when dealing with an employee that he or she does not directly supervise. The final decision by the SEC leaves it murky as to whether that position by the Enforcement Division is the position of the Commissioners.

If you can’t get a compliance problem fixed what should you do?

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Valuations, Private Equity, and the SEC

The SEC has been poking around valuations for a while. First it was from the chaos of the 2008 financial crisis. The sudden illiquidity and drop in prices left many scratching their heads about the proper valuations for their assets.

That was the main charge against the Bear Stearns hedge fund managers. The Justice Department and the SEC brought parallel criminal and civil charges against former Bear Stearns executives Ralph Cioffi and Matthew Tannin in 2008. They were accused of lying to investors about the health of their hedge funds. The problem was that they were holding mostly complex securities backed by subprime mortgages that were hard to value.

Valuations are always difficult with private equity funds because by definition most of the assets are private securities, with little or no market to determine price. The difficulty is offset by the result of the valuation. That is, there is very little. It’s rare that a private equity fund limited partner/investor can redeem its interest. Private equity limited partners commit their capital long term to the fund since the fund makes long term investments that take many years to realize.

A private equity fund investor can be happy that the fund is performing well or be disappointed that the the fund is under-performing based on valuations. Either way, they are largely stuck as investor. But that’s okay because the investors true returns come when the investment is realized, not when there is a valuation.

There is some opportunity for malfeasance. Marketing would be the weak spot. A private equity fund manager might be inclined to overstate valuations on unrealized investments to make their track record look better when raising money for a new fund.

Federal regulators and the Massachusetts attorney general are investigating whether a private equity fund that was part of Oppenheimer Holdings Inc. overstated the value of one of its holdings. The result would be to make it look like the fund was performing better than it actually was.

According to the Wall Street Journal, the fund manager place a value of $9.3 million on an investment. Some other trading on that investment indicated a value of only $2 million, and an intermediary placed the value at $6 million. According to the Boston Globe, the result was to set the interim performance of the fund at 38 percent instead of a loss of 6.3 percent. I assume that the investigators are claiming that the fund manager used those inflated valuations to lure investors.

Valuations have clearly been a target for securities regulators for several years. The SEC sweep letter sent to several private equity firms was just a continuation of this investigative objective.

Part of the business model of private equity is that they are able to better value companies and re-structure them for success. That means that valuations of their underlying assets are going to vary from those of other firms and appraisers.

The key is documenting your approach and then documenting that you followed that approach.

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Image is Measuring by Jonathan Khoo

Technical Problems

Sometimes things just go wrong. No matter how hard you try (or don’t) you need to expect the unexpected. Software and systems inevitable break and go down. And when a system goes down, it will inevitably go down at the least convenient time.

The key is testing, redundancy, and back-up. You can’t prepare for all of the potential problems. But you can prepare for some.

My latest technical problem happened right here. Something went wrong with the code that runs this website. Technical support offered some mumbo jumbo on what I could do. I only know just enough html and css to get myself in trouble. I tried a few things, but they each failed to work. I was in way over my head.

I could have spent hours and hours poring through the error logs and files. Or I could have hired someone who knew what they were doing to help out. I don’t have the time or money to do that.

That left me with one choice. Nuke it and start over. Fortunately, I have a system that runs regular back ups. And it worked.

The website’s design is still a mess. The problem appears to have resided somewhere in the old design. That can be fixed eventually. The key is that the data is still intact.

Lesson Learned. Prepare, back-up, and test. I think there is even an SEC rule on the topic.

I end with a recent cartoon from Saturday Morning Breakfast Cereal on the stock market, blame, and reward.

Dodd-Frankenstein

You would expect that a publication with a libertarian tilt like The Economist would not look favorably at the Dodd-Frank Wall Street Reform and Consumer Protection Act. They call it Too big not to fail. Being The Economist, the article argues with the facts on its side.

  • Dodd-Frank: 848 pages
  • Federal Reserve Act of 1913: 32 pages
  • Glass-Steagall act: 37 pages
  • Sarbanes Oxley: 66 pages

“The scope and structure of Dodd-Frank are fundamentally different to those of its precursor laws, notes Jonathan Macey of Yale Law School: “Laws classically provide people with rules. Dodd-Frank is not directed at people. It is an outline directed at bureaucrats and it instructs them to make still more regulations and to create more bureaucracies.”

It’s not a matter of more regulation. The focus should be on better regulation. Much of Dodd-Frank is just tacked on because it had the momentum to become law. I’m pretty sure extractive minerals had nothing to do with the financial crisis. But Section 1502 of Dodd-Frank requires public companies to make extensive disclosures on the use of conflict minerals in their supply chain.

There are some good things. An unregulated derivatives market was a bad thing. Although, I’m not sure they are getting the regulations right in the new regulated derivatives market.

The test will be the next financial crisis. I assume one will come. Inevitably there will be an oversupply of capital in some area of investment and investors will run in to trouble. Companies will be in trouble, consumer will be in trouble, and investors will be in trouble. Will Dodd-Frank succeed in reducing that likelihood and reducing the impact? Only time will tell.

Compliance, the Middle-Finger Malfunction, and the Reluctant Touchdown

It’s sad day in Boston. We’ve become accustomed to winning and the Super Bowl drought continues for at least another year. There were two compliance-related stories that came out of Super Bowl XLVI.

The first was singer M.I.A.’s obscene gesture and expletive during the halftime show. After Janet Jackson’s nipple-gate incident eight years ago, you would think the network would keep a finger close to the censor button during halftime. Perhaps they were too closely following Madonna and forgot about the other performers.

Madonna hasn’t been controversial for two decades. Others on the half-time show stage have been known to do and say things that would violate network standards.

The second compliance-related incident was the reluctant touchdown by Ahmad Bradshaw as time was winding down in the fourth quarter. Was his job to score touchdown? or to help his team win? usually, those goals are aligned.

By scoring that touchdown, he gave his team the lead, but also gave Tom Brady more time to mount a comeback. (A comeback that failed. ) If Bradshaw had managed to sit down on the 1 yard line, the Giants would be able to burn more time off the clock and just have to make a relatively easy field goal.

The Patriots had a similar problem. Rarely is a defense called up to let the opposing team score.

Even firms where conflicts of interest are well managed need to realize that sometimes the alignment of interests breaks down. Sometimes, doing the right thing for the organization is different from what you are used to doing.

Is a Mitt Romney Candidacy Good for Private Equity?

Mitt Romney puts his business background at the front of his campaign message. As the current front-runner for the Republican nomination, his background is going under increased scrutiny. Since his business background is in private equity, the industry should stop and wonder whether all of this publicity will be good or bad for private equity.

Hopefully people will not be as confused by private equity as they are with whether “Mitt” is short for Mittens. In listening to hearings on private equity and venture capital, many congressmen seem to think that private equity is only about leveraging healthy companies with lots of debt, firing lots of the employees, then quickly ripping them apart, and selling the pieces. If successful. Otherwise, they fire most of the employees and merely plunge their portfolio companies them into bankruptcy.

There is the obvious problem in how you define success. The Wall Street Journal looked at the Bain portfolio and found that 22% of its portfolio companies either filed for bankruptcy or shut down. The story failed to add any context about whether that is better or worse than average. Lots of companies run into trouble. There were over 13,000 Chapter 11 bankruptcy filings in fiscal year 2010. Add in some percentage of the 1.5 million chapter 7 bankruptcies that were businesses, not individuals.

Certainly, Bain Capital made money for its investors. The Wall Street Journal found that Bain produced about $2.5 billion in gains for its investors who had put in $1.1 billion in capital.

Even in the Walk Street Journal story, there is a disagreement about the right measuring stick and which failures should be attributed to Bain. In some cases, the failure came after a partial Bain exit.

Of course, the statistics can’t cover what would have happened to the business if Bain failed to step in or private equity failed to take an interest. They may have failed anyway.

I suspect the answer to whether private equity is good or bad will be twisted around Mitt Romney. His supporters will laud his business success and his detractors will attack his job cuts and business failures. (I lived with Mitt Romney as governor and don’t have a position on candidacy. He was mostly limited by the state legislature in what he could do, a similar position that Congress limits Presidential action. )

In the end, private equity will likely come out of the election cycle bruised and battered.

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US Private Equity Fund Compliance Companion

If you are looking for a good guide to help your private equity compliance program, PEI Media’s US Private Equity Fund Compliance Guide is a good place to start. There have been a few changes since its publication in 2010. PEI Media has just published the US Private Equity Fund Compliance Companion to provide an update on the new and amended regulations, hoping to deliver some timely information before the March 30, 2012 registration deadline.

Charles Lerner of Fiduciary Compliance Associates was the lead editor and asked me to contribute a chapter. (That means I can offer you a discount of 20%. use the code: COMP_20)

Other contributors include:

  • Daniel Bender
  • Erik A. Bergman
  • Timothy M. Clark
  • Winston Chan
  • Peter Cogan
  • Doug Cornelius
  • Karl Ehsam
  • Kimberly Everitt
  • Daniel Faigus
  • Craig Friedman
  • Thomas S. Harman
  • David Harpest
  • Ebonie D. Hazle
  • Jeanette Lewis
  • Matthew Maulbeck
  • Leslie Meredith
  • Edward D. Nelson
  • John J. O’Brien
  • James T. Parkinson
  • Scott Pomfret
  • Michael Quilatan
  • Jay Regan
  • John Schneider
  • Justin J. Shigemi
  • Kate Simpson
  • Mark Trousdale
  • Joel A. Wattenbarger

PEI’s description.

 Featuring expert advice from over 30 compliance and legal professionals, this guide for chief compliance officers (CCOs) provides practical guidance on the legal and operational issues that registered investment advisers are required to comply with, and what the CCO role entails with useful checklists and practical tips.

The companion also features an exclusive roundtable discussion among a chief compliance officer, a head of investor relations and three attorneys. In this candid and informative session, these compliance experts discuss reporting net as well as gross performance results, limitation on general or public solicitations of investors, fundraising in new markets, limited partner due diligence and social media policy – it’s a discussion that will reveal the realities of the brave new world for registered investment advisers.

You can see the table of contents and read two chapters in the US PE Compliance Companion. (.pdf)

Compliance Bits and Pieces for December 23

Here are some recent compliance-related stories that caught my attention.

The Saga of MF Global – Don’t Shoot the Messenger, Fire the Chief Compliance Officer by Tom Fox

Both the DOJ minimum best practices and the amendment to the US Sentencing Guidelines, giving the CCO direct access to a company’s Board of Directors, would seem to provide the profile that would mandate that a Board wants to know the reason why a CCO (or Chief Risk Officer) would suddenly resign, particularly after he “repeated clashed” with a CEO over compliance issues. The universal corporate blanket “resigned to pursue other opportunities” is a white-wash that a Board should look beyond, if indeed that reason was given to the MF Board. The bottom line is that when a CCO leaves, particularly if it was due to a clash with the CEO, the Board had better take a close look into the reasons as it may be that the CEO wants to take risks which could put the company at grave risk.

The SEC Issues Disclosure Guidance on RELPs and REITs by Vanessa Schoenthaler in 100 F Street

The Securities and Exchange Commission’s Office of Investor Education and Advocacy published an Investor Bulletin on real estate investment trusts (REITs) and, at the same time, the Division of Corporation Finance issued informal disclosure guidance detailing the comments it most frequently raises when reviewing sales materials submitted by real estate limited partnerships (RELP) and REITs pursuant to Securities Act Industry Guide 5.

Legal bloggers are eligible for free passes to attend the LegalTech conference in New York, Jan. 30 to Feb. 1, 2012. This is a full-access pass, covering all programs and the exhibit hall. There is also a Blogger’s Breakfast on Tuesday, Jan. 31, at 9 a.m. in the Petit Triannon room at the New York Hilton. To reserve your free pass, send an email to Carl Seering at [email protected]. Be sure to include your name, company or firm, address, email and phone number.

 

The Cost of Regulating Fund Managers and Investment Advisers

A group of organizations with Investment Adviser stakeholders engaged the Boston Consulting Group to conduct an economic analysis of IA oversight scenarios (.pdf) in the Securities and Exchange Commission’s study released in January 2011. The analysis came down solidly in favor of increased funding of the SEC as the solution for increased oversight of investment advisers.

BCG looked at the three options in the SEC’s 914 study: (1) enhancing the SEC’s ability to oversee advisers (2) allowing FINRA to oversee RIAs and (3) creating a new IA-only SRO. The first option was examined in two segments: (a) giving the SEC enough examiners to do the job and (b) full resources. The costs represented what it would take for each option to examine every registered investment adviser firm at least once every four years.

Estimates from BCG study of costs for 3 top choices for examining RIAs

Topic Enhanced SEC FINRA New IA SRO
Annual cost per RIA $11,300-$27,300* $51,700 $57,400
Set-up costs $6m-$8m (Increasing OCIE) $200m-$255m $255m-$310m
Set-up time 6-12 months 12-18 months 18-24 months
Mandate costs from fees $100m-$270m $460m-$510m $515m-$565m
SEC Oversight of SRO $0 $90m-$100m $95m-$105m
Total annual costs $100m-$270m $550m-$610m $610m-$670m

The study provides some interesting insight as to staffing. The average examiner productivity is assumed to be 3.0 examinations per examiner per year, based on the five year SEC average of 3.0 IA examinations per examiner per year.31 In order to achieve an average examination frequency of once every four years, with examiner productivity of 3.0 examinations per examiner per year, 787 examiners are required.

The parties who requested the study are the Investment Adviser Association, Certified Financial Planner Board of Standards, the Financial Planning Association, the National Association of Personal Financial Advisors and TD Ameritrade Institutional in commissioning the study.Given that the vast majority of investment adviser firms do not want FINRA as their regulator/examiner it should come as no surprise as to the results of the study.

I expected to see the additional costs of SEC oversight of an SRO. It’s a bit unfair that the SEC costs are only for examination and not enforcement. The SRO figures include that additional cost.

It should also come as no surprise that FINRA disputed the findings. Rumor has it that they are pushing hard to become the SRO for investment advisers.

In any event, it will take legislation from Congress to implement any of these scenarios. The typical Congressman’s knee-jerk reaction to this seems to be “Madoff.” That does not bode well for increased resources for the SEC.

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