Category: SEC News

Learning Lessons From Gaffken & Barriger

I read through an occasional SEC complaint looking for lessons to be learned. Those involving real estate funds particularly catch my eye. I found the complaint against Lloyd V. Barriger (.pdf) and his management of his Gaffken & Barriger Fund to be full of lessons.

I don’t have any independent facts and am accepting the complaint at face value. Barringer has not settled with the SEC so I’m sure he has a different view of the events and disagrees with some of the statements. In large part it looks like he was trying to make it through the collapse of the housing market and the liquidity crunch of 2007 & 2008 by stretching his funds and his investments. Ultimately, his fund could not hold out any longer and collapsed.

“In the midst of the credit crisis, Barriger chose to lie about the solvency and liquidity of his fund rather than admit the somber truth of a collapsing business,” said George Canellos, Director of the SEC’s New York Regional Office. “He continued to solicit new investor funds based on the same misrepresentations up until the day before the fund collapsed.”

Gaffken & Barriger started off by investing in microcap securities. Then it, like many investors, was lured by the outsized returns of the real estate in 1998. Effective August 1,2005, the Fund’s stated purpose was “investing, holding, and trading in real estate, real estate loans, real estate securities, other securities and other financial instruments and rights thereto[.]” According to the PPM, the Fund’s primary strategy was “hard money lending”making high interest short-term bridge loans to real estate developers.

As you might guess with hindsight, the fund started experiencing higher delinquencies in 2005 and started experiencing losses. I would guess that he started stretching the truth hoping his investments would bounce back, only be trapped into bigger lies as the losses grew instead of decreasing.

I found it interesting that the SEC focused on the preferred returns to the limited partners in the fund. This is a practice that is common in many real estate funds. Investors often get a preferred return and the sponsor gets an over-sized portion of the profit above that return. I think the SEC got caught up in the tax allocations of the fund and took it as a bad fact. I’m not sure that warranted.

Another lesson to take away is that Dodd-Frank will not do anything to prevent this type of fraud. Given the size of Gaffken & Barriger it would not be SEC registered, but would be state registered. The SEC would still be able to investigate, but would not be the examiner.

That is a common theme I have noticed in SEC complaints against investment advisers and fund managers. They are mostly below the $100 million threshold for SEC registration. These troublemakers will need to be caught by state examiners. The SEC may be able to come riding in on its white horse to round up the bad guys, but will not be in a position to make an early intervention to prevent the fraud.

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The SEC Uses a Shiny New Tool

Earlier this year the Securities and Exchange Commission announced a new initiative encouraging cooperation. They wanted to start using Cooperation Agreements, Deferred Prosecution Agreements, and Non-prosecution Agreements.

They finally got use one of their shiny new tools. The SEC announced that Tenaris S.A. entered into a Deferred Prosecution Agreement.

The SEC alleged that Tenaris, a global manufacturer of steel pipe products, violated the Foreign Corrupt Practices Act by bribing Uzbekistan government officials during a bidding process to supply pipelines for transporting oil and natural gas. Tenaris made almost $5 million in profits from those contracts. As part of the DPA, the SEC is requiring Tenaris to cough up $5.4 million.

In addition to paying cast, Tenaris needs to do the following under the DPA:

  • Cooperate with SEC in the investigation
  • Not break the law
  • Not claim a tax break or seek an insurance claim for $5.4 million penalty
  • Update its code of conduct annually
  • Require each director, officer and management-level employee to certify compliance with the code of conduct
  • Train employees on the FCPA

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Report on SEC Referrals to Enforcement

For a registered investment adviser, it’s okay to have the SEC’s Office of Compliance Inspections and Examinations visit you. It’s a big problem if the enforcement division visit. OCIE will issue a deficiency letter asking you to fix any deficiencies it finds. If your noncompliance is serious or the examiners think investor funds are at risk, OCIE can refer the case to the enforcement division.

We get to see how well this referral process works as part of a recent Inspector General Report: OCIE Regional Offices’ Referrals to Enforcement (.pdf)

This report was triggered by the fallout from the Stanford case. “The OIG found that the SEC’s Fort Worth regional office had been aware since 1997 that Robert Allen Stanford was likely operating a Ponzi scheme. The investigation also discovered that after a series of OCIE examinations of Stanford Group Company (Stanford’s registered investment advisor) in which each examination concluded that the likelihood of a Ponzi scheme or similar fraud existed, the SEC’s Fort Worth Enforcement unit did not take significant action to investigate or stop such expected fraud until late 2005.” The allegation against the Fort Worth enforcement office is that they were being judged on the number of cases they won. They wanted to stay away from Stanford because is would consume lots of resources and had an uncertain outcome. The OIG claims there was perception that they only wanted “quick-hot” or “slam-dunk”cases.

The OIG report’s objective was to determine “whether and to what extent OCIE examiners were frustrated in matters other than Stanford where Enforcement did not pursue cases identified by examiners in the SEC regional offices.”

One highlight was that the OCIE staff identified thethe SEC’s Asset Management Unit as having significantly assisted with the acceptance rate of referrals.

They also highlight the the different missions and focuses of OCIE and Enforcement: “OCIE focuses its efforts on assessing whether SEC registrants are in compliance with securities laws, while Enforcement’s mission is to protect investors and the markets by investigating potential violations of securities laws and litigating the SEC’s enforcement actions.”

More on the Proposed Limitations on Compensation for Fund Managers

There is a new joint federal rule in the works for all financial institutions. This will lump together banks, credit unions, broker-dealers and investment advisers. If you have more than $1 billion in assets under management, you need to pay attention to this rule.

Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act requires federal regulators to

“prescribe regulations or guidelines to require each covered financial institution to disclose to the appropriate Federal regulator the structures of all incentive-based compensation arrangements offered by such covered financial institutions sufficient to determine whether the compensation structure:

(A) provides an executive officer, employee, director, or principal shareholder of the bank holding company with covered financial institution with excessive compensation, fees, or benefits; or

(B) could lead to material financial loss to the covered financial institution.”

The proposed rule is tied to the proposed method of calculation for the investment advisers and private fund managers released in November 2010. Unfortunately, the Form ADV in that proposed rule has not yet been finalized, so we don’t know exactly how that assets under management will be calculated. Assuming there are not big changes to the new Form ADV, if your fund assets plus uncalled capital commitments are in excess of $1 billion, then you are a “covered financial institution.

If you are a “covered financial institution” then you must submit a new report to the SEC. In that report you will need to describe the structure of your incentive-based compensation arrangements and whether they provide for excessive compensation or could lead to to material financial loss. This report must include the following:

  1. A clear narrative description of the components of the covered financial institution’s incentive-based compensation arrangements applicable to covered persons and specifying the types of covered persons to which they apply;
  2. A succinct description of the covered financial institution’s policies and procedures governing its incentive-based compensation arrangements for covered persons
  3. If the covered financial institution has total consolidated assets of $50 billion or more, an additional succinct description of incentive-based compensation policies and procedures specific to the covered financial institution’s:
    (i) Executive officers; and
    (ii) Other covered persons who the board of directors, or a committee thereof, of the covered financial institution has identified and determined under §248.205(b)(3)(ii) of subpart C of this part individually have the ability to expose the covered financial institution to possible losses that are substantial in relation to the covered financial institution’s size, capital, or overall risk tolerance;
  4. Any material changes to the covered financial institution’s incentive-based compensation arrangements and policies and procedures made since the covered financial institution’s last report submitted under paragraph (a) of this section; and
  5. The specific reasons why the covered financial institution believes the structure of its incentive-based compensation plan does not encourage inappropriate risks by the covered financial institution by providing covered persons with:
    (i) Excessive compensation; or
    (ii) Incentive-based compensation that could lead to a material financial loss to the covered financial institution.

“Covered person” means any executive officer, employee, director, or principal shareholder of a covered financial institution.  (So, everyone.)

According to the SEC’s Office of Risk, Strategy and Financial Innovation there are about 132 broker-dealers with assets of $1billion or more and 18 with assets in excess of $50 billions. Since investment advisers do not currently report their assets so the SEC lacks hard numbers. They estimated that about 70 investment advisers meet the $1 billion asset threshold and only about 10 would be large enough to get hit by the proposed bonus retention rules. (see page 70 of the proposed draft (.pdf).)

I assume that the investment adviser counts do not take into account the thousands of hedge fund, private equity fund and real estate fund managers who will be registering with the SEC in the next few months.

The rule will not require a report on the actual compensation. But it does try to limit incentive-based compensation that is “unreasonable or disproportionate to the services performed.”

For private equity funds, this should just be a paperwork issue and not a substantive issue. Since private equity funds pay most of their performance based on the final realization of assets in the fund, there are generally few short-term incentives. Private equity fund managers get their incentive pay when their investors get paid.

Nevertheless, this rule will be a headache for registered private fund managers.

The rule has not yet been officially published by the SEC. They are waiting for the other federal regulators to formally approve the draft.

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The Buck Stops Here – Harry S. Truman Presidential Museum and Library – Independence, Missouri / Marshall Astor / http://creativecommons.org/licenses/by-sa/2.0/

The SEC Continues to Investigate Side Pockets and Valuations

The SEC brought another case against a private investment fund for misuse of side pockets. Lawrence R. Goldfarb of Baystar Capital Management agreed to pay a hefty fine to settle claims brought by the Securities and Exchange Commission for misuse of his investment fund’s assets.

When used properly, a side pocket is a mechanism that a hedge fund uses to separate illiquid investments from the liquid investments. If a fund investor redeems their investment in a hedge fund with a side pocket, the investor cannot redeem the pro-rata portion of their investment allocated to the side pocket. That portion of the redemption is delayed until the asset is liquidated or is released from the side pocket. It’s a way to protect all of the investors when the fund has a big chunk of illiquid assets. A wave of redemptions would force the sale of liquid assets, leaving those who did not redeem with the illiquid assets.

The typical abuse is to hide under-performing assets from limited partner scrutiny. The manager still collects the management fee on the over-valued assets. Without recognizing the loss, partners are less likely to redeem their capital.

The SEC complaint alleges that Goldfarb acted even more egregiously than disguising valuations. He stole profits from the fund.

The complaint states that Goldfarb’s fund invested in a real estate partnership. Since that investment was likely a very illiquid asset it would typically end up in a side pocket. Shortly after the investment was made the real estate partnership started making cash distributions. Goldfarb has these distributions sent to him instead of the investment fund. He ended up transferring the whole interest to himself, using the side pocket to hide the asset and the distributions.

At first I thought this might be an interesting action to highlight Rule 206(4)-8. From the complaint, is sounds more like a case of blatant theft from the fund. This enforcement actions shows that the SEC is focusing on private funds, valuations, side pockets and affiliate transactions.

Without admitting or denying the SEC’s allegations, Goldfarb and Baystar Capital Management consented to permanent injunctions against violations of certain provisions of the federal securities laws and to pay disgorgement of $12,112,416 and prejudgment interest of $1,967,371, which will be distributed to the fund’s investors. Goldfarb also agreed to pay a $130,000 penalty, be barred from associating with any investment adviser or broker (with the right to reapply in five years), and be barred from participating in any offering of penny stock.

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Incentive Compensation Limitations and Disclosures for Private Fund Managers

At the Wednesday March 2 Open Meeting, the Securities and Exchange Commission voted to approve a new rule that would affect incentive compensation paid to employees of investment advisers and broker-dealers. Commissioners Casey and Paredes voted against proposing the rule as drafted. The other three voted to move the proposed rule into the comment period.

Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act requires federal regulators to

“prescribe regulations or guidelines to require each covered financial institution to disclose to the appropriate Federal regulator the structures of all incentive-based compensation arrangements offered by such covered financial institutions sufficient to determine whether the compensation structure:

(A) provides an executive officer, employee, director, or principal shareholder of the bank holding company with covered financial institution with excessive compensation, fees, or benefits; or

(B) could lead to material financial loss to the covered financial institution.”

A “covered financial institution” includes investment advisers (as defined under section 202(a)(11) of the Investment Advisers Act), a broker-dealer registered under section 15 of the Securities Exchange Act of 1934, as well as banks, credit unions, FNMA, FHLMC and others designated by regulators, with assets of $1 billion of more.

If you are a private fund manager and have assets of $1 billion or more under management, then this rule would affect you. As drafted the rule applies if you are an investment adviser, regardless of whether you are registered with the SEC as an investment adviser.

Some real estate fund managers are still looking for exemptions for registering with the SEC or registering with the state based on the securities calculation, or by taking the position that they are not a “private fund” under the SEC’s definition. The choice of registration would not affect the applicability of this proposed rule.

This is a joint rulemaking so there needs to be some consistency across financial institutions. A draft of the proposal was published by the FDIC (pdf).

Only incentive-based compensation paid to “covered persons” would be subject to the requirements of this Proposed Rule. A “covered person” would be any executive officer, employee, director, or principal shareholder of a covered financial institution.

The proposed rule defines “incentive-based compensation” to mean any variable compensation that serves as an incentive for performance. It excludes fixed salary.

The first requirement is that a covered financial institution must submit an annual report “disclosing the structure of its incentive-based compensation arrangements that is sufficient to determine whether the incentive-based compensation structure provides covered employees with excessive compensation, fees, or benefits, or could lead to material financial loss to the covered financial institution.” The report must contain:

(1) A clear narrative description of the components of the covered financial institution’s incentive-based compensation arrangements applicable to covered persons and specifying the types of covered persons to which they apply;

(2) A succinct description of the covered financial institution’s policies and procedures governing its incentive-based compensation arrangements;

(3) For larger covered financial institutions, a succinct description of any specific incentive compensation policies and procedures for the institution’s executive officers, and other covered persons who the board or a committee thereof determines individually have the ability to expose the institution to possible losses that are substantial in relation to the institution’s size, capital, or overall risk tolerance;

(4) Any material changes to the covered financial institution’s incentive-based compensation arrangements and policies and procedures made since the covered financial institution’s last report was submitted; and

(5) The specific reasons the covered financial institution believes the structure of its incentive-based compensation plan does not provide covered persons incentives to engage in behavior that is likely to cause the covered financial institution to suffer a material financial loss, and does not provide covered persons with excessive compensation.

Under the SEC proposal, there would be a mandatory deferral of incentive compensation for employees of large financial institutions (over $50 billion). At least 50% of the incentive compensation must be paid over three years. It sounded like this deferral requirement was the point most disliked by the two dissenting commissioners.

This is a fairly ugly rule for private equity funds and real estate funds. Incentive compensation is usually paid upon the realization of the assets.

Under Dodd-Frank, the rule is required to be in place 9 months after enactment. That would mean an April 21, 2011 deadline.

SEC Is Serious About Expert Networks and Gets a New Logo

The Securities and Exchange Commission charged a hedge fund and four hedge fund portfolio managers and analysts with illegally traded on confidential information obtained from technology company employees moonlighting as expert network consultants.

Even bigger news is that the SEC came up with this fancy new logo to brand its expert network investigations and prosecutions.

“It is illegal for company insiders who moonlight as consultants to sell confidential information about their companies to traders, and it is equally illegal to buy that corruptly obtained information and trade on it,” said Robert Khuzami, Director of the SEC’s Division of Enforcement.

Expert networks are not inherently illegal. Of course it’s legal to obtain advice and analysis through experts. It becomes illegal to trade when that material nonpublic information is obtained in violation of a duty to keep that information confidential.

It would be perfectly legal to have someone look at the traffic count for a store to use as a measure of whether sales are up or down. Legend has it that some investors used satellite photos of Wal-Mart parking lots to help with their earnings estimates.

In this case, the SEC is accusing the experts of leveraging insiders to reveal sales forecasts, revenues, and other detailed inside information about their companies. There will be questions about the information: is it material nonpublic information? and did the parties have a duty to keep the information confidential?

The cases should be interesting as an evolution of insider trading prosecutions. The new logo just makes it more interesting.

Thanks to Dominic Jones of IR Web Report for pointing out the new logo in one of his Twitter updates.

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The SEC, Funding, and Rulemaking

There is turmoil in Congress as Republicans take control of the House of Representatives. One of their targets seems to be implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

It’s probably too late to repeal it and too early to start amending it. Too much corporate machinery has been put in place to start changing the statute at this point. It looks like Congress is going to use its control of spending to impede implementation and enforcement.

The SEC has asked for more funding and submitted a budget request of $1.258 billion for fiscal 2011. That was up from the previous year’s $1.118 billion budget. SEC Chairman Mary Schapiro said the agency would need to hire an additional 800 people to meet its expanded duties under Dodd-Frank.

Clearly, SEC will be stretched thin to deal with rule-making, enforcement, and examination if they are starved for budget dollars. More dollars means more staff and more technology to deal with the workload.

We have already seen that the SEC has missed its proposed deadlines in its rulemaking agenda and others have been explicitly delayed because of budget uncertainty.The most high-profile stalled effort is the proposed new Whistleblower office. Dodd-Frank imposed a heavy rule-making agenda on the SEC. They are likely to continue missing deadlines without the manpower and budget.

For corporate compliance, that means uncertainty about how Dodd-Frank will be implemented. If you are in a venture capital firm, you are wondering if you will have to register with the SEC as an investment adviser. There is proposed rule with the definition. There is a proposed rule with what reporting the venture capital firm will need to make. But you don’t know exactly where the definitions and rules will end up.

If you are a private fund adviser, you know you will need to file a Form ADV. The SEC has proposed a new form. It’s too early to start filling it out, because it may change. They will still need to change the online registration system to address whatever the final form will be.

We are now in 2011. That July 21, 2011 compliance deadline is getting closer and closer, but the SEC is falling further and further behind.

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Can I Be a Venture Capital Fund Manager?

That was one of the topics for the Securities and Exchange Commission Open Meeting on November 19.

In Shapiro’s opening remarks, it was clear that the SEC wants all private funds to register. Even thought venture capital funds are exempt from registration, they will need to supply information to the SEC.

The key in defining “venture capital” will be the lack of leverage in the funds and the non-public status of their investments.

They will not have to disclose the full panoply of information that is required by Part 2 of Form ADV. So they will not have to disclose compensation and conflict information.

The SEC has only been able to examine 10% of registered investment advisers each year.

They made it clear that private fund advisers will not be excluded from the “systemically important” label under Dodd-Frank. Big advisers will need to keep an eye on this rulemaking, scheduled to be released in January.

Then on to the specifics.

There are proposed changes to Form ADV to reflect the new thresholds for registration and some other changes. private funds will need to disclose key gatekeepers such as auditors and third-party marketers.

They will also include information for the venture capital funds that have to report, but not register. These exempt-reporting advisers will still be using Form-ADV. They will need to disclose information about ownership, fund structures, and disciplinary activity.

As for venture capital funds, it seemed clear that they struggled trying to come up with a definition of a “venture capital fund.” The definition in the proposed rule will include these limitations:

  • must get 80% of the shares directly from the company
  • investments must be in a private company
  • provide significant management assistance to the company
  • only borrow a portion of their fund’s capital
  • limited redemption rights to limited partners
  • self-label as a venture capital fund

They will allow a grandfathering for venture capital funds, giving them some time to restructure to fall under the definition. That should be a relief for fund wondering how they can meet the July 21, 2011 deadline and not take a hit on their illiquid investments.

Commissioner Casey did not like the approach of the rule on venture capital funds and Form ADV. She noted that the statute is ambiguous on the reporting requirements and thinks the rule is putting too much of a burden on venture capital funds.

(I missed Commissioner Walter’s remarks.)

Commissioner Aguilar focused on the valuation and leverage discussions for funds. He seemed to really be interested in having such a big database of information about private fund advisers.

Commissioner Paredes focused on the insertion of the venture capital exemption outside of the Section 203 exemptions.  To him that means they are subject to much more oversight and subject to examination. He is concerned about the distraction of the fund mangers from growing small companies. He seemed skeptical that the regulatory oversight will help investors. He was concerned about the requirement of “providing managerial assistance” and how that may affect a VC investor that does not get a board seat. He realizes that the SEC is stuck with the statutory framework enacted by Congress. (I guess that’s the problem with getting an exemption tacked on to the bill instead of a thoughtful reworking of the regulatory framework.)

As usual with the SEC, the actual text of the rules was not released as part of the meeting and we will have to wait to see the details. Of course, these are just proposed rules so there will be an opportunity to comment and the SEC may make some changes to the rules based on the comments.

Securities and Exchange Commission’s FY 2010 Performance and Accountability Report

In June 2010, the SEC approved a new strategic plan for its fiscal years 2010 – FY 2015. The plan set out the agency’s mission, vision, values, and strategic goals. It also had a detailed list the outcomes the SEC wanted to achieve and the performance measures that will be used to gauge the agency’s progress.

The SEC has released its 2010 Performance and Accountability Report, the first to measure the SEC performance against its strategic plan.

I thought it would be useful to look at some portions of the report to see if it could offer some insight into what to expect from the SEC as real estate private equity moves into the SEC registration regime.

The first that caught my eye was GoalL 1 Measure 3: Percentage of firms receiving deficiency letters that take corrective action in response to all exam findings.

The Office of Compliance Inspections and Examinations missed its target of 95%, achieving only 90%. This was a drop from 94% in FY2009. I’m not sure what factors I would attribute to the decrease. Were the examinees less afraid of SEC action?

This is one that compliance professionals need to focus on. If the SEC identifies deficiencies, you need to fix them. Failure to fix them is a big red flag that could move the problem from OCIE to enforcement.

On the education side, the SEC’s CCOutreach program failed to meet its goal of having attendees rate the program as “useful” or “extremely useful.”

I attended a 2009 edition of CCOutreach in Boston and it was excellent. Looking back at my notes, it was a spot-on roadmap for the upcoming SEC initiatives. I still hate the name.

I think it’s worth spending some time to look through the report. I would guess that the SEC is going to step up its efforts in areas where it failed to meed the goals in its strategic plan.

That would mean more inspections, more enforcement actions. It will also mean more educational efforts and quicker resolution. One measure is the percentage of non-sweep and non-cause exams concluded in 120 days. The goal was 75%, but they only achieved 48%.

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