Supervision and the Urban Case, with Ted Urban

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These are my notes from the NRS Fall Compliance Conference.

Who better to talk about supervision than Ted Urban himself. He was the general counsel and chief compliance officer. One of the firm’s registered representatives went rogue. He and other line supervisors were charged by the SEC for failure to supervise.

Urban pushed for the registered representative to be fired, but his supervisor merely put him under special supervision.

The SEC’s theory was that Urban could affect the rep’s behavior. The SEC took the position that even if Urban’s action were not authoritative, they could be viewed as authoritative. However even though Urban recommended the firing, he did not have the power to fire.

In the administrative decision, the ALJ found that Urban was a supervisor, but that his supervision was reasonable. The charges would have been dismissed. Urban appealed the decision that he was a supervisor and the SEC appealed the decision that the supervision was reasonable.

The Commission was responsible for hearing the appeal. However, two of the commissioners recused themselves and the other two came down on opposite sides.  Urban pointed out that he had no idea why the commissioner recused themselves and there seemed to be no obvious reason why they would. (That is apart from  the commissioners being the ones to have authorized the enforcement action in the first place.)

The Urban case has been hanging over compliance officers heads. If you are considered a supervisor then you are at risk for your positions not being followed. Mr. Urban provided a prior case that dealt with CCO supervisor liability.

In Gutfreund (1992) four senior managers got together to discuss a compliance problem, they all left the room and no one did anything. The SEC took the position that all are liable, including the head of legal and compliance.  The standard was that legal and compliance can be supervisors when they have “the requisite degree of responsibility, ability or authority to affect the conduct of the employee whose behavior is at issue.”

On February 24, 2012, Commissioner Dan Gallagher gave a speech about compliance and supervision. He said the issue of when compliance equals supervision has been
raised in cases, but never answered in the “clear and definitive” manner it deserves.  The question “remains disturbingly murky.” He posed the question: how do we distinguish “robust engagement” in a culture of compliance from supervision and avoid the perverse incentives created by an overbroad definition of supervision.

SEC Examination and Enforcement Priorities

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These are my notes from the NRS Fall Compliance Conference.

John Walsh, Sutherland
Karol Pollock, SEC Deputy Associate Regional Director (Exams)

Karol outlined the examination process.

1. You get a phone call. But prior to the phone call, the examiners will have done some background research, looking at the firms ADV, public website and an internet search.

2. You get a document request. The examiners will try to tailor it to the particular firm. A quick response is a good sign. A delay in getting materials is a red flag.

3. After the exam you will get a summary letter. This used to be called the deficiency letter. The SEC may go back to calling it a deficiency letter.

4. Post exam the examiners will work with the Division of Investment Management. The goal is to get a bigger enforcement footprint.

OCIE has expanded its mission. It is not a branch of enforcement. It acts as the eyes and ears of the Commission. It’s the first to see new trends. It also comments on rulemakings.

Here is a preview of the 2015 exam priorities. These are not final yet, but are likely to end up in this year’s disclosure.

Perennial priorities

  • Safety of client assets and custody
  • Conflicts inherent in IA firms
  • Marketing and performance disclosure

Initiatives

  • Never before examined
  • Fixed income investment companies. The SEC is looking ahead to rising interest rates. The SEC wants to make sure these investment products are making proper disclosures about what may happen with rising rates.
  • Private fund advisers. The exam staff finds them “interesting.” There is a clash with organizations that are not used to regulatory exams.
  • Retirement vehicles and rollovers
  • Dual registrants. Is each side aware of the different compliance requirements. BDs “gone wild” when they switch to IA and are no longer oppressed by the FINRA manual.

Potential New Initiatives

  • ETFs – They increasing have a narrow niche and increasing complexity. The SEC wants to make sure that there are proper disclosures and sales suitability,
  • Accuracy of ADV. The SEC is seeing adviser inflate assets to stay registered with the SEC and avoid the transfer to state regulation.
  • False Addresses. The SEC is seeing adviser use a false Wyoming address to get SEC registration.
  • Proxy adviser. Reviewing recommendations and voting for investors.

There was a discussion of the “may” versus “will” case. If you are actually doing something all the time, don’t say you may do it.

Regulatory Roundtable at the NRS Compliance Conference

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These are my notes from the NRS Fall Compliance Conference

Lance Burkett, District Director for FINRA
Michelle Wein Layne, Regional Director for the SEC
Andrew Hartnett, Securities Commissioner in Missouri and representing NASAA

Each panel member went through list of enforcement and risk priorities that are currently high on their organization’s list.

NASAA

  • Broker Dealer Fee disclosures. There is a working group trying to come up with a model fee disclosure.
  • Model disaster recovery plan and guidelines
  • Cybersecurity
  • Senior clients – over 60% of his state investment fraud cases involve seniors

FINRA

  • Implementing a new risk-based exam program
  • “Exams that matter”
  • Suitability. Does the firm understand the product?
  • Recidivist brokers

SEC

  • Visit SEC.gov and review the rich trove of information
  • Broken windows. The SEC is not just pursuing big problems. The SEC will consider a discovery of a small problem to be an indication of undiscovered bigger problems.
  • Identify who at the firm is at higher risk for getting into trouble.
  • Cybersecurity
  • “Don’t tolerate liars, cheaters or stealers in your organization, no matter how much revenue they generate.

All mentioned a higher focus on fraud aimed at seniors. The baby boomers are rapidly becoming the retiring boomers looking to manage their assets as they enter retirement.

More than one mentioned a focus on high-yield products. They want to make sure that there is proper disclosure of the higher risks that come with the bigger coupon.

More than one mentioned a focus on ETFs. As they become more exotic, there will be a increased focus on suitability and risk disclosure.

Beyond Compliance – Effectively Managing Risk

private fund compliance forum

These are my live notes from PEI’s Private Fund Compliance Forum.

They are likely to be incoherent and full of typos.

Expert networks. The risk in using them came to the surface in 2010 when an insider trading case came out with and expert network involved in the distribution of information. Law enforcement has come out and said that expert networks are not inherently illegal. They must abide by the same rules on confidentiality and material non-public information. Expert network firms have increased their internal compliance programs to address some of the issues. Firms that use expert networks firms have also put controls and compliance in place.

FCPA enforcement continues. There is a tension with taking over the FCPA compliance for portfolio companies. They may be better able to identify their risks and train their employees.

CCO Liability. There is likely to be no liability if you are doing your job. There is almost liability if you are doing a good job. (That means tailoring the program to your firm, staying knowledgeable, being diligent.)

Fund Expenses. (Everyone is talking about Bowden’s speech.) Compliance should oversee some aspects of the expenses charged to the fund. Perhaps fund expenses are approved by the CFO and portfolio company charges are approved by the responsible investment manager.

The risk alerts from the SEC generally precede enforcement actions. Expect to see several enforcement actions related to private equity fund expenses being revealed in the near future.

Political Contributions. Send out frequent reminders. Seek regular confirmations from employees.

Addressing Regulatory Challenges On The Horizon

private fund compliance forum

These are my live notes from PEI’s Private Fund Compliance Forum.

They are likely to be incoherent and full of typos.

Panel Member:
Jason Mulvihill, General Counsel, Private Equity Growth Capital Council
Joel Wattenbarger, Partner, Ropes and Gray

A bill has passed the House that would exempt private equity fund advisers from registration. It’s unlikely to pass the Senate and unlikely to pass a presidential veto.

The CFTC is working on various rules related to private funds. One is a rule on position limits. The rule proposes to aggregate positions in subsidiaries. The CFTC is still providing some temporary relief for fund of fund managers having to register as a CPO/CTA based on investments by the underlying funds.

The SEC has a private funds working group at OCIE. In the long run that should be a benefit because it should eventually get examiners more educated on the private funds industry. But in the short-term there may be some difficult gyrations as the SEC finds practices it does not understand and also fails to grasp industry practices. (A little knowledge can be a dangerous thing.) As a new group, they may want to make a name for themselves and could be out looking to make the news.

The SEC indicated that it understood that the Investment Advisers Act may not been a great fit for private funds given the current regulatory framework. However, there has been little movement to better adapt the regulatory framework.

There is concern about the statistics cited in Bowden’s speech. The SEC is not distinguishing between a $1000 accounting error in a multi-billion dollar fund and serious cases of theft and abuse of funds.

The audience is overwhelmingly not using general solicitation as part of their private placements. The proposed rules are scaring people away. The rules are a mistake. The House Committee on Financial Services is even working on a bill that would repeal the proposed rule. But the SEC publicly stated that it did not like the JOBS Act.

Broker-Dealer issues seem to have waned. That grenade was thrown last year. The question is still being asked in some exams. The issue is not dead. Expect a rule to come out and the issue to come roaring back. The SEC may be providing some relief for private funds and their fundraising platform.

Carried interest will stay on the plate. But, it’s unlikely for anything to happen during this election year. The debate will continue.

International Regulatory Landscape For Private Funds

private fund compliance forum

These are my live notes from PEI’s Private Fund Compliance Forum.

They are likely to be incoherent and full of typos.

AIFMD is a difficult topic.

Transitional regime. It’s just about over; it expires at the end of July 2014. They don’t work in France. They work well in the UK. Germany is in the middle. For an upcoming fund, it may be better to start marketing now to take advantage of the transitional rules.

The rules are different for non-EU funds and managers than for EU-based ones.

How does co-investment work in the “marketing” definition for AIFMD. It’s possible to set up a co-investment policy and procedure that shoehorns it into reverse solicitation.

One panelists view on the criteria to make reverse solicitation work:

  1. Talking to institutional investors
  2. Talking to investors that you have some previous relationship with
  3. Keep to a minimum number of investors. (A handful of investors)
  4. Don’t do it in France

After the transition period, you may still have a runway to close. Don’t let it go beyond the end of the summer. Get contact and some communication during the transition period.

Soft marketing. You don’t want to register if you won’t have any investors in that country. Pitchbooks may not be marketing. It’s better if you have not completed the PPM or have not yet had a first closing. You need a fund to be in existence before you can register.

Depositories in Germany and Denmark is more than a custodian. It is intrusive and will check the investments. The marketplace for depositories is still developing.

Registration is expensive; Who will pay for it? Management company? All investors? Just EU investors? Country by country allocation?

There is no single solution for all EU countries. It is a patchwork.

AIFMD enforcement is coming from a country’s regulatory authority. Failure to register is a criminal offense. If you need a legal opinion on compliance, a fund’s legal counsel may force registration or stricter compliance.

Not AIFMD:

  • Joint venture
  • Managed account – single investor fund
  • Co-investments- The UK has specifically stated as such (other countries may take a different view)

The panel moved on to corruption and compared the FCPA to the UK’s Bribery Act. The UK’s version is stricter so it’s better to set any anti-corruption policies to the stricter UK requirements.

For private equity firms, it is possible that the bribery actions in a portfolio company could be passed through, putting liability on the fund manager. The UK enforcers are prepared to bring an action even where the nexus to the UK is tenuous.

 

Testing Your Compliance Program

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These are my notes, live from the conference.

One of the best tests is a mock exam. See how you stand up to simulated fire. It’s a good practice to see how people respond under the interview process from a regulator (or mock regulator). How often should you do a third party review? Annually is probably too often. Ever other year can be too much. It’s a good idea to run one after a change in business practices or other major event.

The SEC is asking for a risk inventory as part of the exam process. You should put one together. Of course the SEC will use the risk inventory as a roadmap, so design it accordingly.

Test based on risk. Given the nature of private equity funds, you probably don’t need to run tests on best execution. Maybe you spend more time on valuations. It’s probably a good idea to sit on the valuation committee (I agree, but it’s better to be a non-voting member.)

Documentation is key to testing. You need to be able to hand the SEC a piece of paper if you want to prove that you did it. Of course if you state that there is a problem that needs to be fixed, it should be fixed.

How do you document violations of the compliance manual? (It’s a common question on the SEC document request letters.) You need a log of violations, employee, the policy violated and most importantly, the action taken. The SEC will not be surprised to see violations.

Do you share the testing with clients? Most attendees said they do not share at all. A small percentage are willing to share a summary.

View from the SEC

private fund compliance forum

These are my notes, live from the conference. Please excuse a more numerous supply of typos.

Drew Bowden, the Director of the SEC’s Office of Compliance Inspections and Examinations

(These are his views and not necessarily the views of the SEC. His speech is posted on the SEC website: Spreading Sunshine in Private Equity.)

He started off thanking Amtrak for the swift and timely travel from D.C.

OCIE is working on the best way to exam private funds and the private equity industry. There are 11,000 registered advisers and least 10% have a private equity fund. OCIE has a team of private equity experts to help with exams and provide training.

The private fund presence exam initiative is nearly over. The SEC is starting to wok on compiling its findings. The SEC was very upfront with the initiative because it thinks the majority of private funds are doing the right thing and OCIE is not trying to play “gotcha.”

OCIE has found LP Agreements to be lacking. In particular it feels that the LP Agreement needs to be clearer about what expenses are to be borne by the manager and which are borne by the fund investors. OCIE thinks LP Agreements can lead to opaqueness to investors instead of transparency.

OCIE is also concerned about the limited rights of investors with regards to the fund and the manager. This is especially true after the capital has been contributed.

OCIE is concered about Zombie Funds

He raised concerned about the allocation of expenses among co-investment vehicles in an investment. OCIE is concerned about fee and expense shifting.

He shared some findings from the 150 exams completed.

The number one problem is fees and expenses. He found violations of law or material weaknesses in over 50% of the exams. (This confirms the Bloomberg story: The SEC Expresses Its Displeasure on Fund Fees.

“When we have examined how fees and expenses are handled by advisers to private equity funds, we have identified what we believe are violations of law or material weaknesses in controls over 50% of the time. ”

He expressed concern about “consultants” who work exclusively for the adviser/fund manager, but they charge all of their time to the portfolio companies. If they look and act like employees, they should be treated as employees. This is especially egregious when an employee is terminated but then re-hired as a consultant, with expenses charged to the funds.

He expressed displeasure with charging investor reports to the investors instead of the management company. For example charging the portal software costs that replaced an investor relations person.

He noted fees charged to portfolio companies that extended beyond the life of the fund. For example a 10-year monitoring agreement for a 7-year fund. Then the remaining balance becomes due upon the exit from the investment.

He noted a particular concern about valuations during fundraising. He noted cases where the fund manager was using different valuation methods for marketing materials than for investor reporting. Or shifting to a new valuation methodology during fundraising to raise returns. The SEC is not looking to second-guess valuations, but instead looking to make sure the valuation process matches the process disclosed to investors.

“Ultimately, a healthy compliance program should make your firm and the entire private equity industry more attractive to investors.”

Mr. Bowden’s discussion of OCIE’s concerns with private funds was a quantum leap forward in expertise than past year’s discussions with the prior Director of OCIE. Clearly, the SEC is rapidly learning about private funds and the area of conflicts and compliance.

Current Trends Impacting the Private Fund Compliance Community

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These are my notes from this session at PEI’s Private Fund Compliance Forum.

The SEC is developing an approach of zero tolerance for non-compliance. Private funds are challenging because there are some that have been registered fro many years and many that have only been registered for two years.

The SEC is learning more about the private fund space and will increasingly be taking a more detailed look.

Some funds that have been registered for a longer period time are increasing their compliance staff and increasing the scope of compliance oversight. Firms that have CCOs wearing two hats have been splitting the role and putting a dedicated CCO in place. There is increasing SEC oversight and a rapidly changing regulatory landscape.

In looking at compliance risks versus business risks, one key is whether you are willing to have a compliance weakness in that area potential be exposed in a deficiency letter from an SEC exam.

One area particular for private equity is the use of related party service providers. The panel provided the example of a portfolio company doing an executive search and used a recruiting company that was another portfolio company controlled by the private fund.

The panel discussed JOBS Act compliance when it comes to meeting the new standard for taking reasonable steps to ascertain that an investor is an accredited investor. Funds are not using general solicitation and advertising because of the uncertainty around the requirements. The safe harbors are inappropriate for private funds. The audience voted that 25% would not use it because of the reputation risk. But half the audience confirmed that it was the uncertainty. Too many risks for too little gain.

The next topic was changes in the business practices of the fund after closing. Obviously the first analysis is whether the change is permitted by the LP Agreement. IF not, make sure that you get the appropriate consent from the LPs.

The next topic was pitchbooks and marketing materials. The SEC has expressed displeasure with one-on-one meeting materials that merely switch cover pages from investor to investor. That converts the materials into marketing materials.

The next topic was AIFMD compliance. Do we think the SEC will focus on this topic? Probably not. But you need to deal with the foreign regulatory authorities. Unfortunately it’s a rapidly evolving landscape. Many firms are saying that it’s not worth the effort to figure it out and are ignoring Europe at a source for investors. The term “marketing” varies from country to country in the EU. That means you may have multiple version of marketing materials to meet the multiple requirements.

Cybersecurity. The SEC document request for cybersecurity is incredibly complex and most private funds are going to have trouble with it. One area to focus on is the potential vulnerabilities in service providers that link into your systems. You should put together a plan and start a review to at least show that you are focused on the issue. (Because the SEC is focused on the issue.) Should compliance own this? Probably not. Most CCOs are not going to have the expertise. It’s probably better to have IT own it. One discussion is who should pay for it. Should cybersecurity be a fund expense or a management company expense. The audience and panel overwhelming took the position that it is a management company expense.

The next topic was FCPA. Make sure you do your diligence on foreign investments. With a focus on expenses, bribes and corrupt payments could end up in exam review.

The last topic was what keeps you awake at night. From the panel:

  • The rapidly changing regulatory landscape
  • Cybersecurity – that SEC doc request is scary
  • FCPA – it’s hard to find the bad activity
  • AIFMD

PERE CFO Forum 2013

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I spent most of yesterday in New York at PERE’s CFO Forum. I came to speak about the evolution and revolution of regulation in the private equity real estate industry. I thought I would share a few items.

The opening panel focused on the changing role of the Chief Financial Officer. A big change is the avalanche of regulations and business requirements. Compliance is expensive when you add together the direct costs, the indirect costs, and the lost opportunity costs. It’s a cost of doing business.

Fund managers are fiduciaries. Exceed your investors expectations.

There is the rise of the new “F” words: FATCA, FIRPTA, FBAR, and FCPA.

The second panel focused on valuations. They put forth three items to focus on during valuations: consistency, transparency, and independence. You should have a consistency in the process, regardless of product type or geography.

Transparency allows someone to see good work product to get to the final fair value. As with third grade math, it’s not just about getting the right answer, it’s also about showing your work.

Independence is important to show that the decision makers are not influenced by other factors in trying to reach fair value. A person compensated based on an increase in fair value should not sit on the valuation committee.

As markets recovered from the 2008 financial panic we entered an era of price discovery. Nobody was quite sure where pricing would be post-crisis. With rising interest rates, we may be entering a new phase of price discovery.

The third panel was on tax reform and tax policy developments. There is a general sense in Washington that there could be a major tax code reform. As a result some changes are being held up based on the possibility of becoming part of a larger piece of legislation.

  • Carried interest remains under attack. The latest is the Cut Loopholes Act S. 268.
  • Rate equalization would likely reduce the disparate treatment between capital gains and ordinary income.
  • Business interest expense could be reduced to avoid the tax incentive in favor of leverage over equity.
  • FIRPTA is being found to discourage inbound investments in real estate. One proposed reform is the Real Estate Jobs and Investment Act S. 1181 that would repeal IRS Notice 2007-55.
  • Entity choice and pass through legislation would impose corporate taxation on “large” pass through entities.
  • Like-kind exchanges could be tightened to limit the deferral to direct swaps and application of a stricter standard of “like.”

My panel was on regulation: evolution or revolution for real estate.

According to some informal polls, most of the audience had registered last year as a result of Dodd-Frank. A few had been registered prior and a few were not registered.

As much as we are dealing with dramatic changes in the regulatory environment, the Securities and Exchange Commission is dealing with a dramatic change in their oversight of investment advisers. Dodd-Frank moved thousands of small retail investment advisers from the SEC to state registration. In exchange, the SEC got lots more hedge fund, private equity  funds, and real estate funds. The SEC has as much to learn about private fund operations as we do to learn about SEC oversight.