Doug Cornelius on compliance for private equity real estate
FINRA released some needed guidance to help firms comply with the new broker investment advice standards and disclosure requirements of Regulation Best Interest and the new client disclosure document Form CRS.
The checklist is available on the FINRA website:
https://www.finra.org/sites/default/files/2019-10/reg-bi-checklist.pdf .
If you have responsibility for broker-dealer compliance the checklist looks like a great tool.
On September 17, 2019, the U.S. Department of the Treasury issued proposed regulations to implement the Foreign Investment Risk Review Modernization Act of 2018 (FIRRMA). The proposed regulations would expands the jurisdiction of the Committee on Foreign Investment in the United States (CFIUS) to review foreign investments and mitigate any potential national security concerns regarding some technology and real estate
The proposed regulations extend CFIUS jurisdiction to cover the purchase or lease by, or a concession to, a foreign person of real estate in and/or around specific airports, maritime ports and military installations. The locations are listed in an annex to the proposed rules.
The description of the rights given to the foreign person or entity under the definition of a real estate transaction reads like a law school class on property. The foreign person must be given three or more of the following property rights:
The specific restricted areas are:
Looking at my headquarters in New England, Hanscom Air Force Base is listed in Part 1, restricting subjecting any foreign ownership within 1 mile of the base to CFIUS oversight. I have to admit that I don’t know the exact boundaries of the base, just the general area. But just staring at the map, it looks like there is a whole lot of real estate, including a stretch of Interstate 95 that will fall into that review area.
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The SEC charged Commonwealth Equity Services, LLC (d/b/a Commonwealth Financial Network), a registered investment adviser and broker-dealer, with failing to disclose material conflicts of interest related to revenue sharing Commonwealth received for certain client investments. According to the SEC’s complaint, Commonwealth had a revenue sharing agreement with its clearing broker for trades in their accounts. Under the agreement, Commonwealth received a portion of the money that certain mutual fund companies paid to the clearing broker to be able to sell their funds through the clearing broker’s programs, if Commonwealth invested its clients’ assets in certain share classes of those funds.
Commonwealth has not agreed to settle the SEC’s charges. At this point we just have the SEC’s side of the case. I thought it would be useful to look at the charges to see what bothered the SEC.
The SEC’s complaint alleges that Commonwealth negligently breached its fiduciary duty to its clients because Commonwealth failed to tell its clients that there were (i) mutual fund share class investments that were less expensive to clients than some of the mutual fund share class investments that resulted in revenue sharing payments to Commonwealth, (ii) mutual fund investments that did not result in any revenue sharing payments to Commonwealth, and (iii) revenue sharing payments to Commonwealth under the clearing broker’s “transaction fee” program.
There is no inherent problem with revenue sharing as long as it properly disclosed. Using different share classes are okay as long as there disclosure and the reason for choosing the different classes. What savings you get from lower cost shares may be eaten up my more brokerage and custody costs.
The SEC alleges that Commonwealth’s advisory clients invested without a full understanding of the firm’s compensation motives and incentives. The complaint also alleges that Commonwealth violated Section 206(4) and rule 206(4)-7 because it failed to adopt and implement policies and procedures reasonably designed to ensure that Commonwealth identified and disclosed these conflicts of interest.
Here is the disclosure that the SEC didn’t like:
Additionally, NFS offers an NTF [no transaction fee] program composed of noload mutual funds. Participating mutual fund sponsors pay a fee to NFS to participate in this program, and a portion of this fee is shared with Commonwealth. None of these additional payments is paid to any advisors who sell these funds. NTF mutual funds maybe purchased within an investment advisory account at no charge to the client. Clients, however, should be aware that funds available through the NTF program may contain higher internal expenses than mutual funds that do not participate in the NTF program and could present a potential conflict of interest because Commonwealth may have an incentive to recommend those products or make investment decisions regarding investments that provide such compensation to Commonwealth.
The SEC didn’t like it because it used the world “may” indicating a potential instead of an actual conflict. I wish the SEC would get away from its hatred of “may” in disclosures.
Secondly, the SEC felt that the disclosure failed to point out that there were instances when lower fee funds were available but Commonwealth had an incentive to put investor into higher fee funds and would get revenue sharing.
The disclosures evolved and the arrangements got more complicated. The case will drag on. It’s far from a slam-dunk for the SEC. There does some seem to ways that Commonwealth’s disclosure could have been clearer.
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“It pays to invest with managers who invest in their funds. ” – Russel Kinnel of Morningstar
I think this statement will come as no surprise to most investors. Mr. Kinnel did some research on mutual funds to prove the point. It turns out that manager investment is correlated to better performance.
Mr. Kinnel was able to group mutual funds into bands required by the SEC based on manager investment. For US equity funds, there was a 10% improvement in success rates between managers who had $0 invested and those who had over $1 million invested.
The sad part is that the success rate for the better managers was still only 39% over the five year period of the study. It dropped to 29% for those not “eating the soup.” Success rate is defined in his study as a mutual fund that survived and outperformed their category peers.
This seems to end up advocating index funds for public equity exposure instead of actively managed funds.
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One of the critical moments of the 2008 financial crisis was caused by Lehman Brothers and its effect on the Reserve Fund, a money market fund. The fund had a significant amount of short-term debt issued by Lehman. Enough that the fund had to ‘break the buck.’ Now even “cash” was not a safe place to invest capital.
The Securities and Exchange Commission has been looking at this problem for years and issued final rules yesterday in an attempt to fix the problem.
The first fix is removing the fiction that a money market fund has a share price of $1. Money market funds had an exemption from valuation and could keep a stable net asset value. To appease retail investors, the change only affects institutional class funds.
Second, the SEC granted money market funds the right to impose redemption restrictions. The fund can charge a liquidity fee or suspend redemptions if the fund encounters liquidity problems. The SEC wants to stop any potential bank run like events on money market funds.
I have to admit that I have not finished reading the rule. It’s an 869 page behemoth of a regulatory release.
I’m trying to figure out the implications for cash management operations. A company needs to hold onto a stockpile of cash to help fund future operations. Bank deposits are only insured up to $250,000. Any stockpile bigger than $250,000 was a risk if the bank failed. We have been in a period where bank failure was at the forefront of everyone’s mind.
Dodd-Frank alleviated that concern by granting unlimited protection for non-interest bearing checking accounts. That’s any easy choice. Interest rates are excruciating low for cash deposits. (Fantastically low if you are borrowing.)
That unlimited protection expired at the end of 2012. It was easy to get diversification and reduce exposure to bank failure by putting the cash in a money market fund. There is little interest earned, but the diversification reduces risk.
There are other alternatives to money market funds, but they take more resources to manage, cost more, or carry more risk. In this low interest rate environment there is little gain in trying to more actively manage the cash. Any interest rate gains will be chewed up by transaction costs.
The SEC has made the lives of corporate treasury groups more difficult. I don’t think they feel any safer and I don’t think the financial markets are any safer.
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As an investment adviser, you can’t take the best investments for yourself and leave the lesser ones for your clients. That’s exactly what the Securities and Exchange Commission is accusing J.S. Oliver Capital and Ian O. Mausner of doing.
The SEC’s Enforcement Division is alleging that J.S. Oliver and Mausner engaged in a cherry-picking scheme that awarded more profitable trades to favored clients. Meanwhile they doled out less profitable trades to other clients, including a widow and a charitable foundation. (You have to love the SEC’s highlighting a widow and a charity as victims. If only the charity were for orphans, then the cliche would be perfect.)
Mausner financially benefited from the cherry-picking scheme because he and his family were personally invested in the hedge funds. Plus, he earned additional fees from one of the hedge funds based on the boost in its performance as a result of the cherry-picking. Mausner profited by more than $200,000 in fees earned from one of the hedge funds based on the boost in its performance from the winning trades he allocated.
This cherry-picking scheme is the classic failure to allocate trades before they are made. Mausner made block trades in omnibus accounts at various broker-dealers. The block trades were reported to J.S. Oliver’s prime broker and then Mausner allocated the shares among the client accounts. According to the SEC complaint Mausner often delayed allocating trades until after the close of trading or the following day, allowing him to determine which securities had appreciated or declined in value.
Even if Mausner was trying to allocate trades on a fair and equitable basis, the mere fact that trades were not allocated until after they made makes the process suspect. Then you have the uphill battle of proving you were fair, when in hindsight better trades ended up in favored accounts.
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One of the many scary events in 2008 was that money had nowhere safe to go. The failure of the Reserve Fund meant cash was not safe and the banks were teetering, leaving corporate treasuries with no place to safely park the cash they would need to weather the financial crisis. Congress stepped in and created the Transaction Account Guarantee program which provided a safe haven. The Transaction Guarantee Program extended FDIC insurance to an unlimited amount for non-interest bearing checking account.
One could argue that this is a gift to banks. They get free deposit money. Normally FDIC insurance stops at $250,000 for an account. Anything in excess of that is at risk. With TAG, the cash is not at risk so long as the account does not earn interest. In these days of extremely low interest rates, a no interest account is enticing if it offers no counterparty risk.
With the expiration of TAG program scheduled for January 2013, that cash would likely flee some banks. There is a lot of that cash. It’s estimated that there is $1.6 trillion in account deposits covered by TAG. That means corporate treasuries would have to start spreading the risk among different banks or different types of investments.
To stay safe, that may mean an uptick in demand for US treasuries. But those are already paying close to zero. A big influx in demand could push rates below zero. It could also mean bank runs as depositors move their emergency cash our of bank accounts.
For compliance that means a new task of keeping cash investments within permitted investments, monitoring risk, and securities trades.
This week, Senator Reid introduced S.3637 — To temporarily extend the transaction account guarantee program, and for other purposes. There is no indication how well this will do in the lame duck Congress. Failure to extend the program will clearly inject more risk into the financial services sector at a time when risk is a four letter word.
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“Understanding the needs of investors is critical to carrying out the Commission’s investor protection mission,” said SEC Chairman Mary L. Schapiro. Section 917 of Dodd-Frank required the SEC to study the existing level of financial literacy among retail investors. The study was recently released and paints an ugly picture.
Here’s a key quote:
These studies have consistently found that American investors do not understand the most basic financial concepts, such as the time value of money, compound interest and inflation. Investors also lack essential knowledge about more sophisticated concepts, such as the meaning of stocks and bonds; the role of interest rates in the pricing of securities; the function of the stock market; and the value of portfolio diversification…
Perhaps a few decades ago this was less of a problem when big unions were at their most powerful position and big businesses were offering pensions to retirees. With the rapid decline in pensions in favor of 401(k)s and other defined contribution plans, more and more people are responsible for their own investment decisions. It seems they do not have the skills or literacy to do so.
What to do? Neal Lipschutz suggests:
Here’s a modest suggestion: make passing a course in the basics of personal finance a requirement for a high school diploma. You can teach about credit cards, checking accounts, mutual funds and the like. You might even throw in how to vet an investment adviser.
I expect this problem will soon get worse. Private funds will soon be able to start advertising. That means investors that meet the minimal standard of accredited investor will be barraged with opportunities to invest in the once secretive world of hedge funds. That advertising will be limited by the false, misleading or deceptive standard of investment advisers, not by the more strict standards for mutual funds under the Investment Company Act.
I suspect, as does Felix Salmon, that it will not be the excellent funds that advertise. It will be the those that want the flash of the media spotlight.
Private funds will not be held to a uniformity standard allowing potential investors to better compare fund to fund. They’ve gotten accustomed to the relative uniformity with the highly regulated mutual fund products.
It was very obvious that the SEC was not happy with the JOBS Act and is washing its hands of the problems by doing exactly what Congress demanded, and nothing more. At some point there will be a backlash and some additional legislation to deal with the problems that will inevitable arise. Good firms, doing the right thing will likely be subject to further oppressive regulation because of the unrestrained actions of a few bad actors.
Being an accredited investor just means that you have money, not that you understand how to invest your money. I suspect many more will start making bad investments as they hear the siren song of hedge funds.
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The Transaction Account Guarantee program was originally launched in 2008 by the Federal Deposit Insurance Corp. to help banks hold on to liquidity. The program gives unlimited federal guarantees to zero-interest bank deposits. This allows companies to park cash and not worry about the bank failure. Given the current low interest environment, giving up the token amount of interest can offset the worry about about the underlying bank’s failure.
However, the program is set to expire at the end of 2012.
As you might expect, banks are eager to have the program extended. The American Bankers Association has endorsed allowing the program to run for an additional two years. The Independent Community Bankers of America, a trade group for small banks, is pressing lawmakers for a five-year extension.It’s estimated that over $1 trillion is sitting in zero-interest bank deposits.
Money-market mutual-fund industry want to see the program end. They want a piece of that $1 trillion and think the Transaction Guarantee Program would shift several hundred billion dollars out of the zero interest bank accounts and into money-fund accounts. Of course a big chunk of that money would be funneled bank into the banks when the money-funds bought bank CDs and short term paper.
From an operations standpoint, the Transaction Account Guarantee program removes a risk from the matrix. You don’t need to worry about your operating account being in jeopardy for a bank failure.
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Don’t stray from your investment strategy. Don’t chase yields. Make sure your investment strategy follows your marketing materials.
According to SEC charges, Charles Schwab failed to do this with its YieldPlus Fund in 2007. The fund was marketed as a Short Term Bond fund and described the Fund as a cash “alternative” that generated a higher yield with slightly higher risk than a money market fund.
The Fund was not “slightly riskier” than money market funds, CDs and other cash alternatives to which it was compared. CDs are insured. Investments in the Fund were not insured. The maturity and credit quality of the Fund’s securities were significantly different than those of a money market fund.
The big problem was that the fund was mostly invested in mortgage-back securities. That means its investments got hammered in late 2007. That was coupled with widespread redemptions. Only 6% of the funds assets were scheduled to expire in those six months meaning they also had a liquidity crunch.
The SEC claims that executives made misstatements about the fund’s performance and the amount of redemptions. That makes the problem worse.
They made it even worse, according to the SEC by allowing insiders and other Schwab funds to redeem their shares in the Fund before the extent of the decline was disclosed to the public. Essentially, they had inadequate procedures to prevent insider trading.
There are some good lessons in this case for CCOs.
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