Category: Compliance Programs

Excelsior!

Stan Lee, the legendary writer and publisher of Marvel comics who helped created countless superheroes, has died. He was 95. On his own and through his work with collaborators Jack Kirby, Steve Ditko, Bill Everett. and others, Mr. Lee created Spider-Man, the X-Men, the Mighty Thor, Black Panther, Iron Man, the Fantastic Four, the Incredible Hulk, Daredevil and Ant-Man and many other comic book heroes.

His catchphrase of “Excelsior!” means ever upward.

I’m looking for the Latin translation of “ever more compliant!”

The One About Blackfish

The Securities and Exchange Commission brought an action against SeaWorld Entertainment Inc. and its former CEO. They agreed to pay more than $5 million to settle fraud charges for misleading investors about the impact the documentary film Blackfish had on the company’s reputation and business. SeaWorld’s former vice president of communications also agreed to settle a fraud charge for his role in misleading SeaWorld’s investors.

The Blackfish movie sharply criticized SeaWorld’s treatment of its featured attraction: orcas. These huge, smart marine mammals were the main attraction at SeaWorld and central to the SeaWorld’s marketing.

I went to the San Diego SeaWorld a decade ago because whales were one of my son’s favorite subjects. The orca show was his favorite part of the trip. (Other than the two-foot long dolphin plushie I was lured into buying at my son’s insistence.)

The problem is that SeaWorld ignored the effects of Blackfish in its shareholder reporting.

The movie caused significant media attention on orcas in captivity as the film became widely distributed in 2013. The SEC’s complaint alleges that from approximately December 2013 through August 2014, SeaWorld and former CEO James Atchison made untrue and misleading statements or omissions in SEC filings, earnings releases and calls, and other statements to the press regarding Blackfish’s impact on the company’s reputation and business.

On Aug. 13, 2014, SeaWorld finally acknowledged in shareholder communication that its declining attendance was partially caused by negative publicity, and SeaWorld’s stock price fell by 33%. The SEC charges that SeaWorld should have said something sooner.

“This case underscores the need for a company to provide investors with timely and accurate information that has an adverse impact on its business. SeaWorld described its reputation as one of its ‘most important assets,’ but it failed to evaluate and disclose the adverse impact Blackfish had on its business in a timely manner.” – Steven Peikin, Co-Director of the SEC Enforcement Division.

In August 2013, SeaWorld noticed a drop in attendance. SeaWorld denied there was a link between the movie and the drop in attendance.

In September 2013, SeaWorld conducted a reputation study and found that its reputation had fallen by 12.8% from the proper year. That study also showed that those who were aware of the Blackfish movie had 32% less favorable opinions. Things got worse and worse.

It seems clear that SeaWorld took too long to disclose the Blackfish effect. What’s missing is when SeaWorld should have stated the connection.

One piece of the complaint that rubs me the wrong way is the SEC’s continued war on the use of “may.”

SeaWorld filed an S-1 in March 2014. It said:

Our brands and our reputation are among our most important assets. Our
ability to attract and retain customers depends, in part, upon the external
perceptions of the Company, the quality of our theme parks and services and our
corporate and management integrity. . . . An accident or an injury at any of our
theme parks . . . that receives media attention, is the topic of a book, film,
documentary or is otherwise the subject of public discussions, may harm our
brands or reputation, cause a loss of consumer confidence in the Company,
reduce attendance at our theme parks and negatively impact our results of
operations.

The SEC complaint says: By couching the reputation and business impacts as hypothetical events that “may” occur, SeaWorld made untrue or misleading statements. I’m not sure that “will” is the right word to use there. But the SEC points out that SeaWorld knew that the movie was having a negative impact and should have clarified that “may.”

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Dangers of Buying Out Limited Partners

VSS Fund Management had a fund that was getting old. VS&A Communication Partners III was in its seventeenth year and still had two portfolio companies. Several limited partners wanted a liquidity option that would get them out of the fund.

Providing that liquidity option got the firm in trouble.

In accordance with the LP Agreement for the fund, VSS prepared to make a distribution in kind to the LPs. Lots of LPs hate getting distributions in-kind.

One of the firm’s principals, Jeffrey Stevenson, must have liked those two portfolio companies because he offered to buy the LP interests from LPs who preferred cash over the distribution. The LPs knew it was Stevenson and that he was a principal of the fund manager.

In both instances, the value was based on the latest year-end NAV. VSS sent a letter to LPs in April with both options.

By the time the elections were coming in, VSS was getting some preliminary first quarter financial information from the portfolio companies.

In Mid-May, VSS decided to change course, it was going to keep the fund going for those investors that wanted to stay in and the rest could take the Stevenson cash offer. That offer was still based on the year-end NAV. The information to the investors did not provide any of the preliminary financial information. More than 80% of the LPS accepted the cash offer.

Anytime the fund manager is buying out a limited partner, the transaction is fraught with peril. There is an inherent information asymmetry. The fund manager knows a lot more about the current fund valuation and the likelihood of future returns.

VSS’s and Stevenson’s failure to include this [preliminary first quarter financial] information in connection with the May 2015 Offer represented a material omission that caused statements in the May 15, 2015 letter to be misleading.

Section 206(3) of the Investment Advisers Act makes it unlawful for any investment adviser, directly or indirectly “acting as principal for his own account, knowingly to sell any security to or purchase any security from a client, …without disclosing to such client in writing before the completion of such transaction the capacity in which he is acting and obtaining the consent of the client to such transaction.”

VSS didn’t violate that provision. The SEC found that VSS violated section 206(4) for failing to state a material fact, making the May letter misleading.

The problem is that VSS was the arbiter of the NAV. The ownership in the portfolio companies is illiquid and hard to value. There is always going to be a concern that the fund manager is going to lowball the price to get the better deal.

According to one story, that preliminary information was incomplete and turned out to be incorrect.

VSS should have made some disclosure about the first quarter results. A principal transaction like this is a tough transaction and almost no level of disclosure is enough.

I think the action is tough on VSS. It gave its partners the option to stay in the fund with the uncertainty of what the results may be. The rest chose the liquidity option. They preferred cash in the hand now, instead of the uncertainty of future returns.

The SEC chose to ignore this and focus on somewhat incomplete disclosure.

ILPA is taking a look at issue and is working on guidance.

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10 Red Flags that an Unregistered Offering May Be a Scam

Since it’s back-to-school day for my community, I thought I would go back to the basics.

The SEC’s Office of Investor Education and Advocacy 2014 Investor Alert identifies potentially fraudulent unregistered offerings with features that indicate a problem. The alert goes through 10 red flags for you to note about private placements.

Private placements are not inherently problematic. Recently, more money has been raised through private placements than through IPOs and secondary offerings.

But scammers are going to use a private placement, where there is no established market for the sale of the investment offering. You don’t have liquidity.

For me, two of the ten really stand out as the most problematic.

  1. Claims of High Returns with Little or No Risk

The basics of investing are that you get a better expected return for more expected risk and a lesser expected return for a lesser expected risk. A private placement already has more risk. You don’t have liquidity. There is no market to sell your investment.

If the proposed investment is such a good deal on risk/return basis why are they offering it to you?

  1. No Net Worth or Income Requirements 

The federal securities laws generally limit private securities offerings to accredited investors.  Be highly suspicious of anyone who offers you private investment opportunities without asking about your net worth or income.

An individual is considered an accredited investor, if he or she:

(a) earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year,
OR
(b) has a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence or any loans secured by the residence (up to the value of the residence)).

If you’re not an accredited investor, the federal securities laws say that you shouldn’t be allowed in invest in a private placement.

Here are the other eight red flags:

  1. Unregistered Investment Professionals
  2. Aggressive Sales Tactics
  3. Problems with Sales Documents
  4. No One Else Seems to be Involved
  5. Sham or Virtual Offices
  6. Not in Good Standing
  7. Unsolicited Investment Offers
  8.  Suspicious or Unverifiable Biographies of Managers or Promoters

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What’s Your Email Address?

I read about a new red flag in the Securities and Exchange Commission’s exam process for investment advisers. Examiners are looking for Chief Compliance Officers with web-based email addresses. So, if your CCO uses a gmail, or yahoo.com email address on your Form ADV filing, the SEC will treat that as a red flag.

This comes from a story in IA Watch. According to the story, a senior person in the SEC’s Office of Compliance Inspections and Examinations mentioned the email address as part of the red flags for cybersecurity sweeps.

I would guess the alternate address for a contact on the Form ADV is subject to this same red flag.

Personally, I’m not sure I completely understand why this is a red flag. Some of the web-based email are just as secure as firm-run email server. For smaller shops, it may be even more secure. I feel certain that Gmail has better tech than a small IA shop.

I can see the web-based email as indicator of an outsourced CCO. Of course, the Form ADV now requires a firm to flag that it has an outsourced CCO. Perhaps it’s a red flag to see web-based email and not state that the firm has outsourced CCO. I can also see searches of “compliance” in the email address as another way to potentially find firms that did not state their CCO role was outsourced.

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The Final Stage of the Tour de France and Compliance

It was a brutal year for the cyclists in this year’s edition of the Tour de France. It’s always a brutal three weeks of racing, but teamwork helps separate the winners from the rest. Geraint Thomas came across the finish line in Paris as the first winner from Wales. His teammate and favorite to win, Chris Froome came in third. Tom Dumoulin came in second place which is the position he finished in earlier this year in the Giro d’Italia.

The big suffering came in the group of the fast men competing for stage wins and the green jersey competition during the Tour de France. Mark Cavendish, Andre Greipel, Fernando Gaviria, Dylan Groenewegen, and Marcel Kittel never made it to Paris. Peter Sagan had a huge margin of victory in the green jersey competition, but a crash on stage 17 descending the Col de Val Louron-Azet in excess of 40 mph left him battered and bruised.

I would give the award for the most suffering to the American Lawson Craddock. He crashed hard on the first day and fractured his scapula. He finished riding that day and got on his bike every day to reach the streets of Paris. He used his suffering for good, raising money for his favorite charity, by asking donors to pledge money for each day he continued to ride.

A Long Flat Stage by Greig Leach, available for purchase here: http://www.greigleach.com/

It’s teamwork that gets the riders to the finish line. Geraint Thomas had Team Sky pacing him up the mountains for as long as they could, burying themselves to give the yellow jersey as much help as possible, then leaving him to finish strong over his rivals.

The team mechanics have the bikes in perfect condition. When a flat occurs or a crash happens, the mechanics quickly jump to help and get the rider back into the race.

The team chefs get needed nutrition into the cyclists for the brutal three weeks. Just keeping calories in your body and recharging your body for another day on the bike is a huge task.

Compliance is the same way. The lone cyclist on the road is unlikely to achieve success. It takes a team to be successful. Not just a team of compliance personnel, but a multi-disciplinary team across the whole organization.

One failing of the Tour de France is not having a female equivalent. That didn’t stop Donnons des elles au Velo Jour-1 from riding the entire route of the Tour de France. J-1 are a group of high-level amateurs riding the day before. There is a short La Course for professional racers. But it was just a single day of racing on a much shorter route than the men. It’s time to change this.

I realize that only a handful of you have likely read this far. The venn diagram between cycling and compliance is very small. (Hello Tom!)

Like Lawson Craddock, I too will be biking for charity.  I’m riding across Massachusetts to raise money in the fight against cancer. I’m only riding 300 miles over 3 days, compared to the 2,082 miles in the Tour de France. Donations can be made here: http://profile.pmc.org/DC0176

Can You Help Guide Petronia?

Alain Lille, CEO of Petronian Industries is not happy with the new government. He wants to protect his investment in the country of Petronia. His oil firm deployed a great deal of capital looking for oil in Petronia and had a contract with the government for production. A roadblock appeared in last year’s election. The new president was elected, in part, beacuse of her promise of a of a better deal for the people. She wants to make sure this newfound wealth provides the best benefits to the country.

Mr. Lille fears she will reopen negotiations hurting revenue for his company and possibly revenues for the country. The new president invited foreign “experts” to advise her.

If you’re still looking for Petronia on the map, you can stop. It’s a fictional country in a new online game created by the Natural Resource Governance Institute: https://petronia.games/. This thinktank wants to improve the management of oil, gas and mineral wealth in developing countries.

As a player in Petronia, you take on the role of that pesky foreign adviser.

Petronia is available free and on demand. It’s published to be a more accessible and less time sensitive alternative to NRGI’s in-person learning courses or the massive open online course.

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Share Class Selection Disclosure Initiative

One of the 2018 exam priorities for the Securities and Exchange Commission is “matters of importance to retail investors.” The SEC has found many problems with advisers selling their clients higher cost share classes of mutual funds that paid the adviser a fee.

It’s not that a registered investment adviser can’t take that 12b-1 fee. But it has to be fully disclosed to the clients.

The SEC found that many respondent investment advisers disclosed that they “may” receive 12b-1 fees from the sale of mutual fund shares and that 12b-1 fees “may” create a conflict of interest. However, the investment advisers failed to disclose that they had a conflict of interest because the funds offered a variety of share classes, including some that paid 12b-1 fees and others that did not for eligible clients, and failed to disclose that they were, in fact, receiving 12b-1 fees due to the mutual fund shares they bought for or recommended to their clients.

The SEC has found this to be such a widespread problem that it launched the Share Class Selection Disclosure Initiative. Under the SCSD Initiative the SEC’s Division of Enforcement will recommend favorable settlement terms for investment advisers that self-report possible securities law violations relating to their failure to make necessary disclosures concerning mutual fund share class selection.

If the adviser self-reported, it would have to disgorge the fees plus interest, enter into a cease and desist, enter into an undertaking to fix disclosure documents. But the SEC will not impose a penalty for advisers that self-report

For additional information regarding the adequacy of mutual fund share class selection disclosures see the following:

The deadline for self-reporting has passed. Now we wait to see if the SEC will report on how many firms took advantage of the SCSD Initiative.

I found it interesting to see the SEC take such a wide swing at the industry, asking them to self-report and change practices.

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2018 State of Compliance (According to PwC)

PwC released the results of its latest State of Compliance survey. In this seventh iteration, PwC polled 825 risk and compliance executives worldwide about their organizations’ compliance polices and procedures, training, monitoring and technology.

Only 17% said they are very satisfied with the effectiveness of their compliance programs. Another 45% said they were somewhat satisfied.

Personally, I don’t find that result interesting. The survey covers a large swath of organizations across different industries, different sizes, different geographies and different risks. Only a few firms, if any, are like mine and only a few, if any, are like yours.

What I found most interesting is what PwC gathered about the compliance programs at the 17% of the firms that were satisfied with the effectiveness of their compliance programs. PwC identified four ways those 17% do things differently:

  1. Invest in tech-enabled infrastructure to support a modern, data-driven compliance function
  2. Increase compliance-monitoring effectiveness through analytics and the use of technology
  3. Streamline policy management to increase responsiveness and boost policy and procedure effectiveness
  4. Take advantage of information and technology to provide targeted, engaging and up-to-date compliance training

Given that three of these four factors are technology driven, I would guess that these are focused on larger organizations that need technology to deal with larger flows of information and data than a small or mid-sized firm.

I would also guess that dashboard and data to show compliance functions helps assure that the organization is being effective.

I’ve argued in the past that determining effectiveness is hard because you are try to prove that the absence proves the point. If compliance program is 100% effective, there will be no reporting events. Of course the problem is that the lack of reportable events is either because there were none, or you were just unable to discover them.

My nay-saying aside, it’s clear that having data leads to better compliance. Good technology tools to help extract and interpret that data are incredibly helpful to compliance programs. This survey proves the point.

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Form ADV and Form PF

With the statutory changes from Dodd-Frank, the Securities and Exchange Commission started gathering basic information about private fund managers and their funds on Form ADV.

The SEC increased that information flow by requiring Form PF. Unlike Form ADV, Form PF provides detailed information about the private fund’s activities and performance. That left many reluctant to release this information.

Apparently many managers followed through on this reluctance. According to a story in IA Watch, the SEC is matching up Form ADV Filings for private funds and identifying the lack of filing in Form PF.

You need a private fund identification number for the private fund in Form ADV. That makes it easy to search through the Form PF database for those filings or lack thereof. Someone in data analytics at the SEC decided to do just that.

That has resulted in at least a few dozen firms getting a letter from the SEC explaining why they didn’t file Form PF.

I understand why some firms may have had confusion over how to identify their funds on Form PF. Those definitions are problematic. But I have not run into anyone saying that they didn’t have to file.

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