Category: SEC News

Proposed Rules for Implementing the Whistleblower Provisions From Dodd-Frank

The SEC has released the text of its proposed new rules for implementing the whistleblower provisions of Section 21F of the Securities Exchange Act of 1934: Release No. 34-63237.

In fashioning these proposed rules, the Commission has considered and weighed a number of potentially competing interests that are presented in implementing the statute. Among them was the potential for the monetary incentives provided to whistleblowers by Section 21F of the Exchange Act to reduce the effectiveness of a company’s existing compliance, legal, audit and similar internal processes for investigating and responding to potential violations of the federal securities laws. With this possible tension in mind, we have included provisions in the proposed rules intended not to discourage whistleblowers who work for companies that have robust compliance programs to first report the violation to appropriate company personnel, while at the same time preserving the whistleblower’s status as an original source of the information and eligibility for an award. At the same time, the proposed rules would not prohibit a whistleblower in a compliance function from reporting information to the Commission where the company did not provide the information to the Commission within a reasonable time or acted in bad faith.

At this point, it is merely a proposed rule. Comments should be submitted on or before December 17, 2010.

There will be a new Form TCR for submitting a tip, complaint or referral and a new Form WB-DEC, Declaration Concerning Original Information Provided Pursuant to §21F of the Securities Exchange Act of 1934, signed under penalty of perjury, for submission to the SEC to meet the standards of the new regulations.

SEC Complaint Reads Like a List of Things Not to Do

SEC complaints usually contain great stories about what you should not to do. A recent case involving PEF Advisors caught my eye. The SEC claimed that hedge fund managers Paul Mannion, and Andrew Reckles, and their investment advisory company PEF Advisors misappropriated investor cash and securities by using the “side pockets” in 2005.

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.

Side pockets can be abused by putting liquid investments aside to limit the damage from redemptions. That is one of the many claims by the SEC against PEF.

Stavroula Lambrakopoulos, a lawyer who represents the defendants, said her clients “strongly deny the allegations in the complaint.” Whether they are true or not, the complaint lays out a list of things you should not do.

  • Do not sell securities from your personal account while having the fund invest in that security.
  • Do not violate your valuation policy.
  • Do not overvalue assets that you know are worthless.
  • Do not dramatically overvalue assets to increase your management fee.
  • Do not exercise the fund’s warrants in your personal account.
  • Do not borrow from the fund to make personal investments.
  • Do not trade on material non-public information when you have agreed to keep the information confidential.
  • Do not sign agreement stating that you do “not hold a short position, directly or indirectly, in” a stock when you shorted the shares the prior week.

The SEC brought claims under 10(b) of the Exchange Act, 206 (1) of the Advisers Act, and 206 (2) of the Advisers Act. There were lots of bad acts in the complaint, but the press release emphasized the side pocket problems.

Back in April, the SEC Enforcement Division’s new asset management unit announced that they were looking at ‘side pocket’ arrangements. This is the first case I’ve seen focused on this issue. I expect we will see some more soon.

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The Family Office Exemption under the Investment Advisers Act

The Dodd-Frank Wall Street Reform and Consumer Protection Act wiped out the exemption enjoyed by most private funds. I’m still waiting to see how the SEC will define a “venture capital fund manager.” In the meantime, the SEC has published its proposed rule defining a “family office” and its exemption from registration under the Investment Advisers Act.

Historically, family offices have not been required to register with the SEC under the Advisers Act because of the same exemption used by private funds. The Dodd-Frank Act removed that “small adviser” exemption under section 203(b)(3) to enable the SEC to regulate hedge fund and other private fund advisers, but includes a new provision requiring the SEC to define family offices in order to exempt them from regulation under the Advisers Act.

“Family offices” are established by wealthy families to manage their wealth and provide other services to family members. That leaves the fabulously wealthy time to go yachting and leaves others to manage their securities portfolios, plan for taxes, worry about accounting services, and to directing charitable giving. The issue is the the family office management of securities.

In the past, the SEC has issued dozens of exemptive orders for family offices who requested them, removing them from the registration and supervision of the SEC. The proposed rule 202(a)(11)(G)-1 would largely codify the exemptive orders. Most of the conditions of the proposed rule are designed to restrict the structure and operation of a family office relying on the exemption to activities unlikely to involve commercial advisory activities, while still allowing family office activities involving charities, tax planning, and pooled investing.

(b) Family office. A family office is a company (including its directors, partners, trustees, and employees acting within the scope of their position or employment) that:

(1) Has no clients other than family clients; provided that if a person that is not a family client becomes a client of the family office as a result of the death of a family member or key employee or other involuntary transfer from a family member or key employee, that person shall be deemed to be a family client for purposes of this section 275.202(a)(11)(G)-1 for four months following the transfer of assets resulting from the involuntary event;

(2) Is wholly owned and controlled (directly or indirectly) by family members; and

(3) Does not hold itself out to the public as an investment adviser.

The key is how the SEC defines a family member:

(d) (3) Family member means:

(i) the founders, their lineal descendants (including by adoption and stepchildren), and such lineal descendants’ spouses or spousal equivalents;

(ii) the parents of the founders; and

(iii) the siblings of the founders and such siblings’ spouses or spousal equivalents and their lineal descendants (including by adoption and stepchildren) and such lineal descendants’ spouses or spousal equivalents.

I guess that some family offices will be cutting off some distant relations to get under this definition. For “less-beloved” family members, the family office management can use SEC regulation as an excuse to kick them out.  Of course, they can still seek and exemptive order from the SEC if they don’t fit under this definition.

The comments should involve a whole new area for the SEC: family law.

As I expected, this exemption is of no value to private funds look for a safe harbor from SEC registration.

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The SEC’s Busy Rule-Making Agenda

In many instances, the Dodd-Frank Wall Street Reform and Consumer Protection Act merely set a framework for financial reform and left much of the heavy lifting to the financial regulatory agencies. The SEC published their agenda for the implementation of Dodd-Frank.

It is a long list. Compliance leaders are going to very busy keeping track of the new regulations. The hard part is then figuring out how to implement them and get in compliance by the July 21, 2011 deadline set by the law.

Here is what the SEC wants to address in the next three months:

October – December 2010 (planned)

Diversity

  • §342: Establish new Office of Women and Minority Inclusion

Oversight of Investment Advisers

  • §§404 and 406: Propose (jointly with the CFTC for dual-registered investment advisers) rules to implement reporting obligations on investment advisers related to the assessment of systemic risk
  • §§407 and 408: Propose rules implementing the exemptions from registration for advisers to venture capital firms and for certain advisers to private funds
  • §409: Propose rules defining “family office”
  • §410: Propose rules and changes to forms to implement the transition of mid-sized investment advisers (between $25 and $100 million in assets under management) from SEC to State regulation, as provided in the Act
  • §418: Propose rules to adjust the threshold for “qualified client”

Exempt Offerings

  • §413: Propose rules to revise the “accredited investor” standard
  • §926: Propose rules disqualifying the offer or sale of securities in certain exempt offerings by certain felons and others similarly situated

Derivatives

  • §712: Propose rules, jointly with the CFTC, regarding “mixed swaps”
  • §712: Propose rules, jointly with the CFTC, further defining key terms used in the Act
  • §712: Propose rules, jointly with the CFTC, concerning record-keeping by swap data repositories with respect to security-based swap agreements
  • §712: Propose rules, jointly with the CFTC, concerning record-keeping by swap dealers and major swap participants with respect to security-based swap agreements
  • §763: Propose anti-fraud rules for security-based swaps
  • §§763 and 766: Propose rules on trade reporting, data elements, and real-time public reporting for security-based swaps
  • §763: Propose rules regarding the registration and regulation of security-based swap data repositories
  • §763: Propose rules regarding mandatory clearing of security-based swaps
  • §763: Propose rules regarding the end-user exception to mandatory clearing of security-based swaps
  • §763: Propose rules for clearing agencies for security-based swaps
  • §763: Propose rules regarding the registration and regulation of security-based swap execution facilities
  • §764: Propose rules regarding the registration and regulation of security-based swap dealers and major security-based swap participants
  • §765: Propose rules regarding conflicts of interest for clearing agencies, execution facilities, and exchanges involved in security-based swaps
  • §766: Adopt interim final rule for reporting of security-based swaps entered into before the enactment of the Act

Clearing & Settlement

  • §805: Propose rules regarding standards for clearing agencies designated as systemically important
  • §806: Propose rules regarding the process to be used by designated clearing agencies to provide the SEC notice of certain proposed changes

Investor Advocate

  • §915: Establish new Office of the Investor Advocate; appoint Investor Advocate

Market Oversight

  • §916: Adopt streamlined procedural rules regarding filings by self-regulatory organizations
  • §929W: Propose revisions to rules regarding due diligence for the delivery of dividends, interest and other valuable property to missing securities holders
  • §956: Propose rules (jointly with other regulators) regarding disclosure of, and prohibitions of certain, executive compensation structures and arrangements

Enforcement

  • §922: Propose rules to implement a Whistleblower Incentives & Protection Program
  • §922: Report to Congress on Whistleblower Program
  • §924: Establish Whistleblower Office

Credit Ratings

  • §932: Establish new Office of Credit Ratings
  • §939B: Revise Regulation FD to remove exemption for entities whose primary business is the issuance of credit ratings

Asset-Backed Securities

  • §621: Propose rules prohibiting material conflicts of interests between certain parties involved in asset-backed securities and investors in the transaction
  • §941(c)(1): Report by the Federal Reserve Board, after consulting with the SEC and others, regarding the impact on each class of asset-backed securities on risk retention requirements
  • §941: Propose rules (jointly with others) regarding risk retention by securitizers of asset-backed securities, and implementing the exemption of qualified residential mortgages from this prohibition
  • §943: Propose rules regarding the use of representations and warranties in the asset-backed securities market
  • §945: Propose rules regarding asset-backed securities’ issuers’ responsibilities to conduct and disclose a review of the assets

Corporate Governance & Disclosure

  • §951: Propose rules regarding shareholder votes on executive compensation, golden parachutes
  • §951: Propose rules regarding disclosure by investment advisers of votes on executive compensation
  • §952: Propose exchange listing standards regarding compensation committee independence and factors affecting compensation adviser independence; propose disclosure rules regarding compensation consultant conflicts
  • §1502: Propose rules regarding disclosure related to “conflict minerals”
  • §1503: Propose rules regarding disclosure of mine safety information
  • §1504: Propose rules regarding disclosure by resource extraction issuers

Administrative/Internal

  • §961: Report and certification to Congress regarding internal supervisory controls
  • §963: Public report on management’s assessment of the effectiveness of the agency’s internal controls over financial reporting
  • §967: Award Independent Consultant Contract

Municipal Securities

  • §975: Propose permanent rules for the registration of municipal advisors
  • §979: Establish new Office of Municipal Securities

Auditing

  • §989G: Request for public comment related to study regarding reducing the costs to smaller issuers (with market capitalization between $75 million and $250 million) for complying with §404(b) of the Sarbanes-Oxley Act of 2002, while maintaining investor protections for such companies

Hopefully there won’t be a sacrifice of quality giving that they need to deal with such a large quantity of new regulations.

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How About Working for SEC Enforcement?

The Dodd-Frank Act has created some new positions and some long occupied seats have opened up at the Securities and Exchange Commission. Maybe you have the skills to help the SEC?

Yes, the SEC dropped in the rankings of best federal workplace, slipping from 3rd in 2007 to 24th in 2010. I suspect that reflects the turmoil from the Great Panic and Madoff frauds.

The SEC has new mandates and new leadership. The Enforcement Division has some high level openings and are actively look for talented people to apply. The pay looks good (for a government job).

Chief Counsel

This position has not been available for 17 years. Joan McKown left the SEC to join law firm Jones Day as a partner in its Washington, D.C. office. She had held the Chief Counsel position since 1993. The Chief Counsel plays a key role in establishing enforcement policies at the SEC and in reviewing proposed enforcement actions before they are recommended to the Commission for approval.

“The Chief Counsel of the Division of Enforcement serves as principal advisor and consultant to the Director, and other high ranking officials of the Division, on a wide range of matters including technical, and/or precedent-setting, aspects of the federal securities laws.”

Job Posting for Chief Counsel

Associate Director – Office of Whistleblower Coordinator

This is a new position created by Dodd-Frank who will report to the Chief of the Office of Market Intelligence and to the Office of the Director of Enforcement for purposes of whistleblower advocacy.

Job Posting for Associate Director – Office of Whistleblower Coordinator

Associate Director

Chris Conte vacated the position of Associate Director in the enforcement unit to take a position with Steptoe & Johnson LLP after almost 18 years with the SEC. he had just finished an investigation of Dell’s accounting violations and obtained a $100 million penalty.

Job Listing for Associate Director

Credit Rating Agency Investigated for Fraud

The SEC brought an action against LACE Financial for issues with its independence. We also learned that the SEC had investigated whether rating agency Moody’s Investors Service, Inc. violated the registration provisions or the antifraud provisions of the federal securities laws.

Moody’s was working on a rating for some new European securities. They ended up giving the security an Aaa rating. They later discovered a problem with their model and found a coding error. After finding the error, a Moody’s rating committee met and discussed the problem.

They made no change to the outstanding credit rating. The SEC found smoking gun emails that showed rating committee members were concerned about the impact on Moody’s reputation if it revealed an error in the rating model.

“In this particular case we seem to face an important reputation risk issue. To be fully honest this latter issue is so important that I would feel inclined at this stage to minimize ratings impact and accept unstressed parameters that are within possible ranges rather than even allow for the possibility of a hint that the model has a bug.”

That does not sound like the company was living up to the principle of the Rating Agency Act to “improve ratings quality for the protection of investors and in the public interest by fostering accountability, transparency, and competition in the credit rating agency industry.”

The SEC declined to bring an enforcement action “of uncertainty regarding a jurisdictional nexus to the United States in this matter.” The rating committee responsible for the credit ratings of the rated securities met in France and the United Kingdom. The rated securities were arranged by European banks and marketed in Europe.

The Commission notes that, in recently enacted legislation, Congress has provided expressly that federal district courts have jurisdiction over Commission enforcement actions alleging violations of the antifraud provisions of the Securities Act of 1933 or the Exchange Act involving “conduct within the United States that constitutes significant steps in furtherance of the violation, even if the securities transaction occurs outside the United States and involves only foreign investors” or “conduct occurring outside the United States that has a foreseeable substantial effect within the United States.” Dodd-Frank Wall Street Reform and Consumer Protection (Dodd-Frank) Act, Pub. L. No 111-203, § 929P(b)(1), (2) (2010) (to be codified at 15 U.S.C. §§ 77v(c), 78aa(b)). NRSROs should expect that the Commission, where appropriate, will pursue antifraud enforcement actions, including pursuant to such jurisdiction.

It sure sounds like the SEC is looking hard at rating agencies and their culpability for the Great Panic of 2008.

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Credit Rating Agencies and Conflicts of Interest

Personally, I place a big chunk of blame on the Credit Rating Agencies for the Great Panic of 2008. They were throwing AAA ratings at piles of garbage. There is an inherent conflict in the rater being paid by the security issuer instead of the security purchaser. They are beholden to the customer and the customer wants a great rating for its security.

Exchange Act Rule 17g-5(c)(1) prohibits a Nationally Recognized Statistical Rating Agency from issuing or maintaining a credit rating solicited by a person that, in the most recently ended fiscal year, provided the NRSRO with net revenue equaling or exceeding 10 percent of the total net revenue of the NRSRO for the fiscal year.

“The Commission’s rules were designed to further the goals of the Rating Agency Act to “improve ratings quality for the protection of investors and in the public interest by fostering accountability, transparency, and competition in the credit rating agency industry.” To meet these goals, it is critical that firms provide accurate information to the Commission and the public in their Form NRSROs and financial reports, that they do not have prohibited conflicts, and that they establish, maintain, and enforce policies and procedures to address conflicts of interest.”

LACE Financial submitted an application to register as an NRSRO on October 31, 2007. LACE also requested an exemption from the 10 percent rule, which the SEC granted. LACE requested the exemption because LACE’s largest client (“Firm A”) provided LACE with more than ten percent of LACE’s total revenue during fiscal year 2007. Firm A managed Collateralized Debt Obligation (“CDO”) and hired LACE to prepare regular reports that Firm A distributed to investors in these CDOs.

According to the SEC Release, in an attempt to keep the 2007 revenue from Firm A as close as possible to ten percent of its total revenues for the year, LACE postponed billing Firm A for reports completed during December 2007 until January 2008. In its exemption request letter, LACE stated that its estimated annual revenues from Firm A for 2007 would be $119,000 when calculated on a cash basis and $179,000 when calculated on an accrual basis. “The total value of work performed for Firm A by LACE during 2007 was in fact $233,268.28, approximately 28 percent of LACE’s revenues for the year when properly calculated on an accrual basis as required by GAAP.”

LACE got slapped with a civil money penalty in the amount of $20,000 and an injunction not to break the law again. They also charged Damyon Mouzon, the president of LACE, blaming him for trying to shift revenue and deliberately hide the conflict of interest.

It seems clear to me that the rating agencies were not trying to protect investors. They were trying to generate revenue. That means keeping their clients, the securities issuers happy.

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SEC versus New Jersey

Fuggedaboutit!

New Jersey became the first state ever charged by the SEC for violations of the federal securities laws. They gave up without a fight and agreed to settle the case, without admitting or denying the SEC’s findings.

This matter involves the sale of over $26 billion in municipal bonds from August 2001 through April 2007. In 79 municipal bond offerings, the State misrepresented and failed to disclose material information regarding its under funding of New Jersey’s two largest pension plans, the Teachers’ Pension and Annuity Fund and the Public Employees’ Retirement System. Among New Jersey’s material misrepresentations and omissions:

  • Failed to disclose and misrepresented information about 2001 legislation that increased retirement benefits for employees and retirees those pension plans.
  • Failed to disclose and misrepresented information about special Benefit Enhancement Funds initially intended to fund the benefits, but then abandoned.
  • Failed to disclose and misrepresented that New jersey would be unable to fund the increased benefits without raising taxes or cutting services.

This case is a clear warning sign for states and cities that are running into retirement funding problems. You need to disclose those problems in the bond offering.

An interesting note is that the State Treasurer signed a 10b-5 certification that the official statement did not contain any material misrepresentations or omissions. The Treasurer was not charged.

The SEC only brings civil charges, so we don’t get to see Robert Khuzami driving up the New Jersey Turnpike trying to slap handcuffs on the state.

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Changes to the Qualified Client Standard

In addition to the changing standard for an accredited investor, the standard for a “qualified client” under the Investment Advisers Act is also changing. Section 418 of the requires the SEC to increase the standard.

SEC. 418. QUALIFIED CLIENT STANDARD.
Section 205(e) of the Investment Advisers Act of 1940 (15 U.S.C. 80b–5(e)) is amended by adding at the end the following: ‘‘With respect to any factor used in any rule or regulation by the Commission in making a determination under this subsection, if the Commission uses a dollar amount test in connection with such factor, such as a net asset threshold, the Commission shall, by order, not later than 1 year after the date of enactment of the Private Fund Investment Advisers Registration Act of 2010, and every 5 years thereafter, adjust for the effects of inflation on such test. Any such adjustment that is not a multiple of $100,000 shall be rounded to the nearest multiple of $100,000.’’.

Unlike some of the arguments over whether the accredited investor standard should be adjusted based on inflation, this standard is explicitly tied to inflation.

The definition of a qualified client is set out in Rule 205-3.

Currently, the investor has to have at least $750,000 under management with the adviser/fund.  That standard was adopted in July 1998. Using the CPI-U of 163.2 in  July 1998 and 217.965 in June 2010, the minimum investment amount should increase to $1,000,000.

The net worth amount of $1.5 million was also adopted in July 1998. Using the same ratio, I would expect the minimum net worth to rise to $2 million.

As for private  funds, Rule 205-3 requires a look -through from the fund to the investors in the fund. If the fund is relying on the 3(c)(7) exemption from the Investment Company Act then the fund’s investors should all be qualified purchasers or knowledgeable employees and you won’t need to look much further.

If the fund is using the 3(c)(1) exemption, then it will need to take a closer look at its investors to make sure that each is a qualified client.

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That fancy SEC logo appeared briefly on the SEC’s website on Monday. (Thanks for pointing this out Bruce.) It was odd enough that I thought it should be re-used.

What Do You Get For Cooperation with the SEC?

Rebecca Files

  • More likely to get sanctioned.
  • Reduction of $30.3 million in penalties when you initiate your own investigation.
  • Reduction of $609,000 in company penalties for each week earlier the statement is announced the public.
  • Reduction of $112,000 in personal penalties for each week earlier the statement is announced the public.

We in the compliance field have often heard from federal regulators that cooperation will get you benefits. Although when asked how much, it’s merely a “trust us” reply. Back in the beginning of 2010, the SEC launched a new enforcement cooperation initiative. The SEC’s 2001 Seaboard Report lists several criteria that SEC staff evaluate before making enforcement decisions, including whether ―the company cooperated completely with the appropriate regulatory and law enforcement bodies‖ and whether ―the company promptly, completely, and effectively disclosed the existence of the misconduct to the public [and] to regulators

I figured some academic would spend the time to sit down and see how much benefit really accrues when you cooperate. Rebecca Files of the University of Texas at Dallas did just that.

Dr. Files dove into a set of the 2443 press releases announcing an earnings restatements compiled by the General Accounting Office (GAO 2003, 2006a,b) during the 1997-2005 time period. She ended up culling the list down to 1,249 for a variety of reasons. Of those, 127 received a formal sanction by the SEC.

Individuals were sanctioned in 115 of the 127 cases, paying an average of $3.9 million in fines. Companies were sanctioned in 109 of the cases with an average fine of $35.5 million.

When the company had independently investigated their restatements, they paid an average of $30.3 million less in penalties than those that did not.

Dr. Files concludes that the end result is mixed. “[C]ompany-initiated investigations significantly increase the likelihood of an SEC enforcement action, but decrease firm-level penalties associated with a sanction. … Regarding forthright disclosures, I find somewhat mixed results. Headline disclosure of a restatement increases the likelihood of an SEC sanction, suggesting that SEC staff is influenced by the visibility of press release disclosures when choosing its enforcement targets. However, individuals pay significantly smaller fines when the restatement is disclosed prominently in a press release or on a Form 8-K or amended filing. Placing restatement information in a Form 8-K or amended filing also significantly reduces the likelihood of an SEC sanction, but only in the post-2001 period. Consistent with the Seaboard Report, timely disclosure of a restatement reduces the likelihood of being sanctioned and results in lower individual and firm penalties.”

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