Category: Compliance Programs

United States Senators Elizabeth Warren (D-Mass.), Tammy Baldwin (D-Wisc.), and Sherrod Brown (D-Ohio), Ranking Member of the Senate Banking Committee, along with Representatives Mark Pocan (D-Wisc.), and Pramila Jayapal (D-Wash.) unveiled the Stop Wall Street Looting Act last week. I don’t think there is any chance it will become law. But it will create talking points and speeches as we continue on what will be an endless election campaign.

I took a few minutes to traipse through the bill to see if anything caught my eye.

Most of the provisions attack “private funds” and the bill uses the same definition of a “private fund” that was added to the Investment Advisers Act by Dodd-Frank:

a company or partnership that (i) would be considered an investment company under Section 3 of the Investment Company Act of 1940 but for the application of paragraph (1) or (7) of subsection (c) of such section 3; …(iii) is not a venture capital fund, as defined in 17 C.F.R. section 275.203(l)-1…

Title I imposes a piercing of the liability shields of private funds by making them jointly and severally liable for all liabilities of portfolio companies, including debt, government fines, WARN Act violations, ERISA withdrawal liability and unfunded pensions.

That doesn’t just stop “looting”; that ends the private fund business. If you can’t isolate liabilities, it makes investing nearly impossible. With the fund manager responsible for the debts of the portfolio companies, the manager will have trouble obtaining third-party capital for the portfolio companies. That capital would have to underwrite not only the target, but also the fund manager and all of its other portfolio companies.

The isolation of corporate liability has been the core of capitalism for a few centuries allowing tremendous growth in technology, manufacturing. It allows you to make riskier bets knowing that only your invested capital is at risk.

The bill relies on that murky definition of “private fund.” I would fear that conglomerate operating companies could get pulled into the definition.

Assuming the private fund business found a way to continue after Title I, Title II stops certain activities labeled as “looting.”

The portfolio company can’t make a capital distribution to the private fund during the first two years after a change in control. Another section bans monitoring fees by imposing a 100% tax on monitoring fees.

Section 204 attacks excessive debt by reducing the ability to deduct interest if the debt to equity ratio for a portfolio company exceeds 1.

Title III imposes greater worker protection and limits executive compensation during bankruptcy, gives greater rights under the WARN Act, and gives priority to gift cards in bankruptcy.

Title IV tries to close the “carried interest loophole.” Of course, it’s not a loophole; it’s a feature of partnership taxation for all types of partnerships and the disparate treatment of ordinary income and capital gains.

In the case of an “investment services partnership interest”, any net capital gain is treated as ordinary income and net capital losses are treated as ordinary losses. The definition of “investment services partnership interest” is broad enough to capture any type of partnership, not just private equity funds, but also real estate funds, hedge funds and venture capital funds. It’s probably broad enough to beyond that as well.

Title V creates a whole new disclosure regime for private funds. Here are some of the disclosure highlights:

• names of each limited partner in the fund
• debt held by the fund
• Gross performance
• Performance net of fees
• Income statement
• balance sheet
• cash flow statements
• Total amount of debt of each portfolio company
• Disclosure of all fees paid to the fund manager

All of that information would be publicly available.

It’s obvious that the bill’s proponent are lumping all private funds into the category of highly leveraged buyout firms. There is a broad spectrum of funds with different investing styles, different levels, different uses of debt and different fee structures. In my view, this bill would kill the entire private fund industry.

Sources:

• Press Release
• Full Text of Bill
• Section-by-Section Summary

The Securities and Exchange Commission published its Reg Flex Agenda for the Spring of 2019. This gives us some insight to what regulatory changes are in the works. Three items caught my eye as likely to apply to private funds.

Harmonization of Exempt Offerings. Chairman Clayton had previously noted that the regulations around exempt offerings is a mess.

The Division is considering recommending that the Commission seek public comment on ways to harmonize and streamline the Commission’s rules for exempt offerings in order to enhance their clarity and ease of use.

Amendments to the Custody Rules for Investment Companies and Investment Advisers . The Custody Rule is full of footfaults. Most CCOs I’ve talked to have run into problems trying to figure out how the Rule applies to some particular circumstance. The abstract does not provide much insight into what aspect of the Rule is being discussed.

The Division is considering recommending that the Commission propose amendments to rules concerning custody under the Investment Company Act of 1940 and the Investment Advisers Act of 1940.

Amendments to the Marketing Rules Under the Advisers Act. Changes to the marketing regulations have been mentioned by the Commissioners several times. The regulations are well out of date from the age of digital communication. Plus, there is well of practice and unofficial law buried in No-action letters. It sounds like there is a lot of support to formalize that unofficial through a formal rulemaking.

The Division is considering recommending that the Commission propose amendments to rules 206(4)-1 and 206(4)-3 under the Investment Advisers Act of 1940 regarding marketing communications and practices by investment advisers.

These are merely items the Commission are working on or thinking about for regulatory action. It will take a consensus of the Commissioners to agree to start the rulemaking and agree to language. That may not happen. But at least they are thinking about them.

It is generally bad to have one client trade with another client. Rule 206(3)-2 imposes some very specific requirements and leaves you with a final twist:

This rule shall not be construed as relieving in any way the investment adviser or another person relying on this rule from acting in the best interests of the advisory client, including fulfilling the duty with respect to the best price and execution for the particular transaction for the advisory client ….

The problem is especially enhanced when cross-trade involves illiquid, hard-to-value assets, like complex securities or real estate. Mortgage loans fall into that category. As the investment matures, you find out if the underwritten price was good or bad. One side is likely to make out better than the other.

Talimco added to the problem by acting in bad faith during the cross-trade.

According to the Securities and Exchange Commission charges against Talimco LLC and its former chief operating officer, Grant Gardner Rogers, they manipulated the auction of a commercial real estate mortgage asset on behalf of one client for the benefit of another in a cross-trade. 

Talimco was the collateral manager for a collateralized debt obligation client on one hand and a commercial real estate investment fund on the other hand.  The CDO had a defaulted mortgage loan participation that it was trying to sell.

As an investment adviser, Talimco owed a general fiduciary duty to the CDO. In addition, the CDO governing documents required Talimco to dispose of the assets in a competitive auction with at least three bids.

The real estate fund wanted the investment at a certain price, so Rogers rigged the auction. Rogers convinced two unwilling bidders to participate in the auction by giving assurances that the bidders would not win the auction.  As a result of this manipulation, Talimco’s real estate fund client was the highest bidder and acquired the asset.

To prove the problem with cross-trade, the real estate fund ended up selling the interest for a substantial profit and the CDO ended up underwater.  It was going to be a good enough investment that Rogers committed an additional $1 million to the fund during the acquisition. That may have been coincidence, but it looks bad.

Not as bad as the written messages about the rigged auction disclosed in the SEC order: 

I get it, for you guys and other people that we’ve talked to it’s like, you know it’s not that attractive. It’s small, it’s a non-controlling participation. But, you know, in order to, for us to purchase this, we need like, we need a bid from three different market makers …. And look, I won’t hit you on this, but I need a bid for it.

“By rigging the auction, Talimco and Rogers failed to fulfill their fiduciary duty to their client,” said Daniel Michael, Chief of the SEC Enforcement Division’s Complex Financial Instruments Unit.  “Investment adviser firms are expected to have controls in place to detect and disclose conflicts of interest.  This action evidences the vigilance of the SEC’s exam and enforcement staff in identifying investments advisers that exploit client relationships and harm investors.”

Notably, the case started with an examination by the Private Funds Unit, who handed the investigation over to the Complex Financial Instruments Unit and the New York Regional Office. 

Sources:

• SEC Charges Registered Investment Adviser and Former Chief Operating Officer With Defrauding Client
• SEC Order – Talimco
• SEC Order – Rogers
• SEC Scrutinizes Sale of Mortgage Interests Among Affiliated Funds by Ropes & Gray

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

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Listing Gaps, Merger Waves, and the Privatization of U.S. Equity Finance by Gabriele Lattanzio, William L. Megginson and Ali Sanati in The CLS Blue Sky Blog

The number of U.S. listed companies declined by almost half between 1996 and 2012, from 8,090 to 4,102, and had risen only slightly, to 4,336, by year-end 2017. However, the real market valuation of these listed companies tripled over the same period, from $10.2 trillion in 1996 to $32.1 trillion in 2017[1], implying that the average market valuation of a U.S. listed firm has increased six-fold over the past two decades. In other words, the U.S. public stock market has become populated exclusively by behemoths. Over the same period, the U.S. has experienced historically high levels of merger and acquisitions (M&A) activity and private investments of equity. We show that a new model of equity finance has emerged in the United States over the past quarter-century, which differs significantly from both late-20^th century norms and the equity model observed in other advanced economies.

http://clsbluesky.law.columbia.edu/2019/03/11/listing-gaps-merger-waves-and-the-privatization-of-u-s-equity-finance/

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What is ‘Compliance Training,’ Anyway? A Simple Explanation of What it is—and isn’t. by Ricardo Pellafone in SCCE’s The Compliance & Ethics Blog

In one sentence, compliance training is (1) a tool (2) that you use to drive behavior (3) of willing people (4) by helping them make decisions.

http://complianceandethics.org/what-is-compliance-training-anyway-a-simple-explanation-of-what-it-is-and-isnt/

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Fidelity’s new cryptocurrency company is up and running despite a bear market for digital coins by Kate Rooney in CNBC

Fidelity Digital Assets, a new company created by the investing giant last year, has quietly rolled out its cryptocurrency custody and trade execution operations. In the past few months it has been up and running with institutional investors like hedge funds and family offices, according to its top executive.

https://www.cnbc.com/2019/03/08/fidelitys-new-cryptocurrency-company-is-up-and-running-despite-a-bear-market-for-digital-coins.html

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The Economic Growth, Regulatory Relief, and Consumer Protection Act, enacted on May 24, 2018, amended the Bank Holding Company Act by modifying the definition of “banking entity” to exclude certain small banks from the Volcker Rule’s restrictions and permitting a banking entity to share a name with a hedge fund or private equity fund that it organizes and offers under certain circumstances.

The Volcker Rule had provided that a banking entity, including an investment adviser, that organized and offered a hedge fund or private equity fund, could not share the same name or a variation of the same name with the fund. Section 204 of the Economic Growth, Regulatory Relief, and Consumer Protection Act amended the Volcker Rule to permit a hedge fund or private equity fund organized and offered by a banking entity to share the same name or a variation of the same name as a banking entity that is an investment adviser to the hedge fund or private equity fund, if:

• the investment adviser is not an insured depository institution, a company that controls an insured depository institution, or a company that is treated as a bank holding company
• the investment adviser does not share the same name or a variation of the same name with any such entities; and
• the name does not contain the word “bank.”

The SEC, CFTC, FDIC, Federal Reserve and the Treasury submitted a joint proposed regulation that does just what the law did in allowing the name-sharing. The agencies managed to publish the regulation just before the government shutdown.

Sources:

• Happy New Year: Proposed Volcker Rule Regulation Would Ease Hedge Fund and Private Equity Fund Name-Sharing Restrictions
• Proposed Revisions to Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds

As a New England Patriots Fan from the 1970s, it’s hard to imagine the current success of the franchise. The stadium was one of the worst in the NFL. Home games were rarely televised because the games didn’t sell out.

When the Patriots finally made it to the Super Bowl they lost in the most lopsided championship game up until the time. The team fell back to mediocrity, at best.

It took new ownership to change the franchise. Ownership put the right pieces in place and invested for the success of the franchise. That’s the same model of success for an organization and a compliance program.

Congratulations to Robert Kraft and the entire Patriots organization for becoming the most successful football franchise.

Perhaps the Securities and Exchange Commission saw the government shutdown coming when it published its 2019 exam priorities on December 20.

1. Compliance and Risks in Critical Market Infrastructure – Examiners will focus on entities that provide services critical to the proper functioning of capital markets, including clearing agencies, national securities exchanges, and transfer agents
2. FINRA and MSRB – The SEC will examine on FINRA’s operations and regulatory programs and the quality of FINRA’s examinations of broker-dealers and municipal advisors and MSRB’s effectiveness of select operations and internal policies, procedures, and controls for municipal advisers.
3. Digital Assets – The SEC is focused on the risks of Bitcoin and other cryptocurrency to retail investors for fraud and violations of securities laws.
4. Retail Investors– As has been the case for the past few years, examiners will focus on protecting Main Street investors. Examinations will likely include the disclosure and calculation of fees, expenses, and other charges retail investors pay, the supervision of representatives selling products and services to investors, broker-dealers entrusted with customer assets, and portfolio management and trading.
5. Cybersecurity – Each examination program will prioritize cybersecurity with an emphasis on proper configuration of network storage devices, information security governance, and policies and procedures related to retail trading and information security.
6. Anti-Money Laundering Programs – Examiners will review applicable anti-money laundering requirements, including whether firms are appropriately adapting their AML programs to address their regulatory obligations.

For private funds, there is not much on the list that should catch the attention of compliance professionals.

For retail investors, the SEC often points out that pension funds are conduits for retail investors. That means private funds with pension fund investors are not outside the scope of these exam priorities. The emphasis seems to be towards never been examined advisers in the retail space.

Many advisers and fund managers have been running robust anti-money laundering programs even though there is no specific requirement to have one in place. The anti-money laundering item in the priorities goes on to state that it is focused on broker-dealer compliance with anti-money laundering requirements.

Sources:

• SEC Office of Compliance Inspections and Examinations Announces 2019 Examination Priorities
• 2019 Exam Priorities