Category: Investment Advisers Act

Failure to Register with the SEC as an Investment Adviser

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One of the questions that come up with private funds and Dodd-Frank was what would happen if you failed to register with the SEC? HSBC Holdings Plc found out for us. HSBC  will pay $12.5 million to settle claims that its Swiss private-banking unit solicited U.S. investors without being registered.

The Securities and Exchange Commission charged HSBC’s Swiss-based private banking arm with violating federal securities laws by failing to register with the SEC before providing cross-border brokerage and investment advisory services to U.S. clients. HSBC agreed to admit its wrongdoing and paid the fine to settle the SEC’s charges.

It looks like HSBC tried to put boundaries between its Swiss bankers and US clients to stay outside the reach of US law. But its relationship managers were unwilling to comply and went around the compliance policies.

According to the SEC’s order, HSBC began providing cross-border advisory and brokerage services in the U.S. more than 10 years ago and had as many as 368 U.S. client accounts. HSBC created a dedicated North American desk to consolidate U.S. client accounts and service them in a compliant manner.  However, Swiss relationship managers were reluctant to transfer clients to the North American desk.

Personnel traveled to the U.S. on at least 40 occasions to solicit clients, provide investment advice, and induce securities transactions.  Those Swiss relationship managers were not registered to provide such services nor were they affiliated with a registered investment adviser or broker-dealer.  The relationship managers also communicated directly with clients in the U.S. through overseas mail and e-mails.

In 2010, HSBC Private Bank decided to exit the U.S. cross-border business, and nearly all of its U.S. client accounts were closed or transferred by the end of 2011.

In this case, HSBC was trying to avoid US registration and failed to control its personnel. So it’s not the same as a fund manager claiming it was not required to register.

As for punishment, the HSBC fine consists of a disgorgement of fees earned, plus interest and penalty of about 50% of the fees.

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Post – Election Day Now What?

Im-just-a-bill -schoolhouse rocks

Now that the Republicans have taken control of Congress, can we expect changes that will affect the private fund industry? Many of the Republican firebrands that now run the legislative process in both houses have spoken about repealing the Dodd-Frank Wall Street Reform and Consumer Protection Act.

A wholesale repeal of Dodd-Frank is highly unlikely. Such a bill would be vetoed by the President and the Republicans do not have the numbers to overturn a veto.

Of course Congress may still pass a repeal bill anyhow. After all, the Republican controlled House has passed a bill repealing the Affordable Care Act dozens of times over the past few years, knowing that it will never pass the Senate or the President’s veto.

A more sensible Republican strategy will be to package some changes to Dodd-Frank in a cleverly marketed bill. We saw that happen with the JOBS Act.

Congress does have control of spending, so it’s unlikely that the Securities and Exchange Commission will be getting big budget increases.

The Volcker Rule is prime candidate for changes. Although, it is a simple idea, it has been notoriously difficult to design and implement.

I would place my bets on investment adviser user fees and a Self-Regulatory Organization to regulate and enforce investment advisers. It accomplishes more oversight that is likely to favored by the Democrats and takes resources away from the Securities and Exchange Commission that is likely to be favored by Republicans.

That is assuming that there will anything other than legislative gridlock and positioning of candidates for the 2016 presidential election.

Small Business Capital Access & Job Preservation Act – Part 2

Im-just-a-bill -schoolhouse rocks

The House Financial Services Committee pushed ahead a bill designed to exempt advisers to certain private equity funds from the new registration requirements imposed by Title IV of the Dodd-Frank Act. The Small Business Capital Access & Job Preservation Act was presented last session, and Congressman Hurt has brought it back again.

Except as provided in this subsection, no investment adviser shall be subject to the registration or reporting requirements of this title with respect to the provision of investment advice relating to a private equity fund or funds, provided that each such fund has not borrowed and does not have outstanding a principal amount in excess of twice its invested capital commitments.

It’s a nice effort, but the proviso on debt makes me scratch my head. In addition, the bill leaves it up to the SEC to come up with the definition of a private equity fund. For real estate funds, the big question is whether the mortgage debt on the subsidiary assets is counted in the borrowing limit. This issue raised its head during the Form PF filings for fund managers back in April.

The other issue is the treatment of a subscription credit facility. Private equity funds will ofter enter into a loan secured by the investors’ capital commitments. The fund can draw capital from the facility and then later use capital calls to pay down the facility. The facility is a benefit to the fund and its investors. The fund has quicker and easier access to capital for transactions, through a facility draw request instead of a capital call. By the fund using the facility, the investors are subject to less frequent capital calls and the fund manager can give investors a longer plan of when capital will likely be called.

To the me, the proviso is in direct conflict with the use of a subscription credit facility. The 2x limit is based on invested capital. That would mean keeping capital calls ahead of the facility draws instead of behind the facility draws. The first investments would have to be made with capital calls to keep below the 2x limit.

Private equity lost this exemption and venture capital gained its exemption during the passage of Dodd-Frank. Too much of the discussion of private equity focused on the subset of leveraged buyouts. Private equity was hung with the label of over-leveraging companies, failure leading to bankruptcy, and workers out on the street.

The opposition view in the committee report of the bill focuses on the need for systemic risk analysis and the intersection of private equity with the JOBS Act. One proposed amendment would have limited the exemption to firms that do not use general solicitation.

I’m skeptical that this bill will go anywhere unless it gets hooked into a larger bill. The White House has threatened to veto the bill. Senate Democrats, who hold the majority in the Senate, have given no indication that they want to undo parts of Dodd-Frank.

UPDATE:

The House passed the bill 254-119.

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Best Execution Failure

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Best execution refers to the obligation of an investment adviser to ensure that the prices its orders receive reflect the optimal mix of price improvement, speed and likelihood of execution. The concern is whether the investment adviser is getting some other compensation that influences the decision to use one broker over another. This concern should be heightened when there is an affiliate involved.

In meeting the “best execution” obligation, an adviser must execute securities transactions for clients in such a manner that the clients’ total cost or proceeds in each transaction is the most favorable under the circumstances. In assessing whether this standard is met, an adviser should consider the full range and quality of a broker’s services when placing brokerage, including, among other things, execution capability, commission rate, financial responsibility, responsiveness to the adviser, and the value of any research services provided. That’s a fairly fuzzy standard.

One of the landmark decisions in this area was an administrative proceeding against Mark Bailey & Co.(.pdf). Many of the clients were referred by a third party brokerage firm. The clients would tell the firm to keep using the referral brokerage firm for their transactions. The claim was that the firm violated Section 206(2) of the Advisers Act because the firm failed to negotiate lower brokerage commissions. The SEC also took the position that the firm should have been batching transactions to lower brokerage costs and receive a volume discount. The conflict came from perception that the firm was willing to pay the higher commission to the broker in exchange for continuing referrals from the broker.

A recent case highlighted the conflict when an investment adviser is also affiliated with a fund platform. The SEC brought a case against Manarin Investment Counsel Ltd. and Roland R. Manarin claiming they violated their obligation for “best execution” by selecting higher cost mutual fund shares for the three fund clients even though cheaper shares in the same funds were available. The three funds were advised by Manarin and an affiliate of Manarin served as the broker for investments by the funds.

The SEC claims that Manarin consistently purchased Class A shares with higher fees paid to the affiliated broker instead of institutional shares that would have a lower fee structure.  In effect, this case highlights the need to look at the various classes of mutual fund shares available as part of best execution, not merely the brokerage cost involved. In this case, the conflict was heightened because the higher fees were going to an affiliate of the adviser.

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Image is Marie Antoinette’s execution in 1793 at the Place de la Révolution

Updated Guidance on the Custody Rule for Private Funds

Barnum and Bailey Limited Stock Certificate

The Securities and Exchange Commission has provided some updated guidance on the Custody Rule for private funds. It has sometimes been tricky for private funds to comply with Rule 206(4)-2.

The custody rule deems it to be a fraudulent, deceptive or manipulative act, practice or course of business for an adviser to have custody of client funds or securities unless a qualified custodian maintains those funds and securities in a separate account for each client under that client’s name. The custody rule provides an exception from the custodian requirement for a fund in the case of certain privately offered securities it holds, provided the fund’s financial statements are audited.

“Privately offered securities” are defined as securities that are: (A) acquired from the issuer in a transaction or chain of transactions not involving a public offering; (B) uncertificated, and ownership thereof is recorded only on the books of the issuer or its transfer agent in the name of the client; and (C) transferable only with the prior consent of the issuer or holders of the outstanding securities of the issuer.

This has posed a challenge for real estate fund managers and private equity fund managers that happen to have an entity that is certificated. For example, if the real estate fund has a REIT subsidiary, it may have issued stock certificates as a matter of practice. The Custody Rule would mandate that the fund hire a qualified custodian to hold that single REIT stock certificate. That custody relationship is expensive and provides little (no?) protection to fund investors.

The Investment Management Division issued an update that provides a great deal of relief.

The Division created a new category of securities for purposes of the custody rule: “private stock certificates.” These are non-transferable stock certificates or “certificated” LLC interests that were obtained in a private placement. These fail to meet the definition of “privately offered securities” because they are certificated.

“The Division would not object if an adviser does not maintain private stock certificates
with a qualified custodian, provided that:
  1.  the client is a pooled investment vehicle that is subject to a financial statement audit in accordance with paragraph (b)(4) of the custody rule;
  2. the private stock certificate can only be used to effect a transfer or to otherwise facilitate a change in beneficial ownership of the security with the prior consent of the issuer or holders of the outstanding securities of the issuer;
  3. ownership of the security is recorded on the books of the issuer or its transfer agent in the name of the client;
  4. the private stock certificate contains a legend restricting transfer; and
  5. the private stock certificate is appropriately safeguarded by the adviser and can be replaced upon loss or destruction.”

That is fantastic news.

Even better, the update adds some clarity to partnership agreements:

Partnership agreements, subscription agreements and LLC agreements are not certificates under Rule 206(4)-2(b)(2)(B) and the securities represented by such documents are privately offered securities provided they meet the other elements of Rule 206(4)-2(b)(2).

I know a few fund advisers that took a very conservative position on the Custody Rule and were shipping partnership agreements their custodians. It looks like that is not required by the Custody Rule.

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Employee Criminal History and 506(d)

baD BOYSThe bad actor rule in the new Rule 506(d) makes private placements a bit harder and will require private funds and companies to do more homework in connection with the fundraising. That’s because an issuer cannot rely on the Rule 506 exemption if the issuer or any other person covered by the rule had a “bad actor disqualification.”

An issue arises when you ask about criminal history. It’s been decades since I had to fill out a job application, but I remember the question asking if you are a convicted felon. That allows employer to quickly discard job applications filed by convicted criminals. A few states have felt that this is discriminatory and have enacted limitations on asking whether a job applicant has a criminal history.

This conflicts with the Rule 506(d) requirement that you exercise reasonable care in determining whether a covered employee is a bad actor. Some states limit your ability to run a criminal background inquiry and some limit your ability to even ask whether a prospective employee has a criminal background.

A shotgun approach will not work.

Most of these state laws allow you to eventually ask the criminal background question. If you are subject to 506(d) you need to ask the question, it can’t be one of the first questions.

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Small Business Capital Access and Job Preservation Act

Capitol Hill

Congress, or at least the the House Financial Services Committee, is proposing some relief for private equity funds. The Committee approved the Small Business Capital Access and Job Preservation Act, along with three other pieces of legislation.

The bill would exempt private equity fund managers from the registration and reporting requirements of the Investment Adviser Act. The big hurdle in the bill for the exemption is that the fund has not borrowed a principal amount in excess of twice its invested capital commitments.

That’s a terrible standard. In the early days of a fund, it may draw down on its subscription line of credit for fees and expenses before it invests its first dollar in a transaction. That means the fund will have borrowed more than twice its “invested” capital. Many private equity funds would not be able to pass this test. Dropping the word “invested” would make the exemption useful.

The other big hurdle missing in the bill is the definition of private equity. The bill leaves it up to the Securities and Exchange Commission to define a private equity fund for purposes of the bill. The bill gives the SEC 6 months to craft the definition.

The bill is notable, but I suspect it has little chance of becoming law.


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Regulation of Investment Advisers

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The Securities and Exchange Commission recently published a compendium describing the regulation of investment advisers: Regulation of Investment Advisers. It’s not light reading, but the 59-pages provide a helpful overview of investment adviser regulation.

It comes from the Staff of the Investment Adviser Regulation Office in the Division of Investment Management. So it carries a bit different take than the Office of Compliance and Inspections, whose examiners will show up your doorstep. OCIE focuses a bit more on the nuts and bolts, while this compendium is more like the architectural drawings for compliance.

One interesting aspect of the compendium is the document file: rplaze-042012.pdf

I assume that it means it was one of the last actions of long-time SEC staffer Robert Plaze. Mr. Plaze retired as the Deputy Director of the Division of Investment Management at the end of August, 2012. It looks like he did not quite hang up his white hat and worked on this compendium. I’m glad he did.

One Week Left to File Your Form ADV Update

march 2013

Most advisory firms and fund managers end their fiscal year on December 31. Under the SEC Advisers Act Rule 0-4, you have 90 days to file your Form ADV update after the end of your fiscal year.

Last year that put the filing deadline on March 30 because it was a leap year. The next leap year does not come until in 2016.

This year that 90th day falls on March 31st. But that’s a Sunday. So we have one extra day this year. The filing deadline is April 1.

“Filings required to be made through the IARD on a day that the IARD is closed shall be considered timely filed with the Commission if filed with the IARD no later than the following business day.”

Valuation Failures with a Fund of Funds

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A Securities and Exchange Commission investigation found that two funds sponsored by Oppenheimer were involved in fraudulent valuations. Oppenheimer sent out misleading quarterly reports and marketing materials stating that the fund’s holdings of other private equity funds were valued “based on the underlying managers’ estimated values.” But that was not always true. The portfolio manager actually valued one of the fund’s largest investment at a significant increase over the underlying manager’s estimated value. That change that made the fund’s performance appear significantly better.

I don’t think the problem is that the fund of funds didn’t use the valuation provided by the underlying fund manager. The big problem is that the fund manager used a valuation method different than the one disclosed to investors. That problem was exacerbated by the result being an increase in valuation which led to better performance numbers in marketing materials.

Can a fund of fund use a valuation different than the one supplied by the underlying manager? I think so. But you would need to justify the difference.

One reason for using a different valuation would be timing. Given the time the underlying manager has to provide performance results, the fund of fund manager may have to start with stale information based on the prior quarter’s financial report. Then the manager could then increase or decrease the valuation based on estimated changes during the gap between the underlying manager’s report and the fund of fund manager’s report.

Another reason would be a perceived flaw in the underlying fund manager’s valuation. This change is one in which it is easier to justify a decrease rather than an increase. The fund of fund manager may find the valuation too aggressive or disagree with the underlying assumptions that went into the valuation.

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