Doug Cornelius on compliance for private equity real estate
New Year’s Eve is a time to reflect on the past and look forward to the future. You may also add an excessive amount of alcohol, an expensive dinner in a crowded restaurant, or a long wait for Chinese food delivery.
I’m sure there is a compliance story in there somewhere, but I’m just going to enjoy taking some time off during the long weekend. Enjoy the end of your year and the start of the next.
Thinking about making a payment or giving “anything of value” as part of a business meeting and wondering if you could be prosecuted for it under the Foreign Corrupt Practices Act or the Travel Act? Just reach into your briefcase and pull out a handy-dandy decision tree to help you through this difficult process.
T. Markus Funk put together a decision tree to help walk you through the FCPA and Travel Act’s Anti-bribery provisions (.pdf).
The Securities and Exchange Commission and federal banking regulators have extended the comment period on the Volcker Rule proposed regulations from January 13, 2012 to February 13, 2012. In Release No. 34-66057, the regulators noted that the extension of the comment period is appropriate “due to the complexity of the issues involved and to facilitate coordination of the rulemaking among the responsible agencies as provided in section 619 of the Dodd-Frank Act.” The proposed rule was released in October. The Volcker Rule is scheduled to go into effect July 21, 2012.
The extension’s Release cites comment letters from the Center for Capital Markets Competitiveness of the U.S. Chamber of Commerce (November 17, 2011); American Bankers Association et al. (November 30, 2011); and Representative Neugebauer (R-TX) (December 20, 2011). The ABA letter points out the 1400 questions asked in the proposed regulations.
The Dodd-Frank Act put the Volcker Rule in place to restrict the ability of bank and non-bank financial companies to engage in proprietary trading and to limit their ability to have interests in, or relationships with, a hedge fund or private equity fund. The concept is simple, but difficult in execution. All banks and financial institutions engage in some form of proprietary trading to hedge the risks in their loan portfolios. Add in the extensive use of securitizations. Sprinkle in the decision by the remaining Wall Street firms to become bank holding companies after the 2008 crisis to get part of the bailout. Whip it all up with the difficulties in defining a non-bank financial company.
Feel free to add handfuls of industry lobbying to the mix, depending on your level of cynicism. For example, Representative Schweikert is asking the regulators to exclude venture capital investing under Section (d)(1)(J)
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After thinking about it for almost year, the Securities and Exchange Commission has finalized the new definition of “accredited investor.” On January 25, 2011, the SEC proposed amendments to the accredited investor standards in the rules under the Securities Act of 1933 to implement the requirements of Section 413(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
Section 413(a) of the Dodd-Frank Act required the SEC to adjust the accredited investor net worth standard that applies to natural persons individually, or jointly with their spouse, to “more than $1,000,000 . . . excluding the value of the primary residence.” Previously, this standard required a minimum net worth of more than $1,000,000, but permitted the primary residence to be included in calculating net worth. Under Section 413(a), the change to remove the value of the primary residence from the net worth calculation became effective upon enactment of the Dodd-Frank Act. This rule merely clarifies a few points.
Section 415 of Dodd-Frank requires the Comptroller General of the United States to conduct a “Study and Report on Accredited Investors” examining “the appropriate criteria for determining the financial thresholds or other criteria needed to qualify for accredited investor status and eligibility to invest in private funds.” The SEC lets us know that they may take a more thorough revision of the accredited investor standard after that report comes out in July 2013.
Under the rule, owning a home can only decrease your net worth. To the extent your mortgage debt is less than the fair market value of your house, you can’t include that equity in calculating net worth. To the extent your mortgage is in excess of the value of your house, the amount underwater is counted against net worth.
Just to really screw up things, the SEC requires certain mortgage refinancings to be counted against net worth. If the borrowing occurs in the 60 days preceding the purchase of securities in the exempt offering and is not in connection with the acquisition of the primary residence, the new increase in debt secured by the primary residence must be treated as a liability in the net worth calculation. This is intended to prevent manipulation of the net worth standard, by eliminating the ability of individuals to artificially inflate net worth under the new definition by borrowing against home equity shortly before participating in an exempt securities offering.
This new 60 day rule will be a pain in the neck. On the other hand, I saw some shady operators touting the ability to leverage up your home to get you over the threshold into accredited investor land. That scheme would seem to be targeted right at the vulnerable class of “house-poor”. Apparently state securities regulators were also concerned about advising investors to use equity in their home to purchase securities.
One of the other comments was that mortgage debt in excess of the home value should not count when the loan is non-recourse or the lender is prohibited by state law from collecting a shortfall after foreclosure. The SEC dismissed that idea as being too complicated and requiring a detailed legal analysis. They also counter with some data from a 2007 Federal Reserve Board Survey that suggests that the number of households nationwide that qualify as accredited investors is not affected by whether the net worth calculation includes or excludes the underwater portion of debt secured by the primary residence.
The rule ends up amending:
The rule is adopted with only a limited grandfather provision. The old accredited investor net worth test will apply to purchases of securities in accordance with a right to purchase such securities, only if
Otherwise, the new rule goes into effect 60 days after it’s published in the Federal Register. That will the rule will be effective by the end of February 2012.
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W.A. Rogers Editorial cartoon from 1902 published in Harper’s Weekly
Uncle Sam standing smiling at Christmas tree laden with warships, telephones, an automobile, a fat man labeled “The Trusts,” and skyscrapers; with bags of money at its base.
(The things that make Uncle Sam happy have not changed much over the last 100 years.)
Here are some recent compliance-related stories that caught my attention.
The Saga of MF Global – Don’t Shoot the Messenger, Fire the Chief Compliance Officer by Tom Fox
Both the DOJ minimum best practices and the amendment to the US Sentencing Guidelines, giving the CCO direct access to a company’s Board of Directors, would seem to provide the profile that would mandate that a Board wants to know the reason why a CCO (or Chief Risk Officer) would suddenly resign, particularly after he “repeated clashed” with a CEO over compliance issues. The universal corporate blanket “resigned to pursue other opportunities” is a white-wash that a Board should look beyond, if indeed that reason was given to the MF Board. The bottom line is that when a CCO leaves, particularly if it was due to a clash with the CEO, the Board had better take a close look into the reasons as it may be that the CEO wants to take risks which could put the company at grave risk.
The SEC Issues Disclosure Guidance on RELPs and REITs by Vanessa Schoenthaler in 100 F Street
The Securities and Exchange Commission’s Office of Investor Education and Advocacy published an Investor Bulletin on real estate investment trusts (REITs) and, at the same time, the Division of Corporation Finance issued informal disclosure guidance detailing the comments it most frequently raises when reviewing sales materials submitted by real estate limited partnerships (RELP) and REITs pursuant to Securities Act Industry Guide 5.
Legal bloggers are eligible for free passes to attend the LegalTech conference in New York, Jan. 30 to Feb. 1, 2012. This is a full-access pass, covering all programs and the exhibit hall. There is also a Blogger’s Breakfast on Tuesday, Jan. 31, at 9 a.m. in the Petit Triannon room at the New York Hilton. To reserve your free pass, send an email to Carl Seering at [email protected]. Be sure to include your name, company or firm, address, email and phone number.
There has always been a theoretical discussion that there could be insider trading on private company shares. I have not seen the theory tested in court. However, a recent enforcement case by the SEC gets close to the theory. The case involves a company re-purchasing shares from employees at a discounted price.
The SEC makes the bold charge that from November 2006 through April 2009, Stiefel Laboratories Inc. defrauded shareholders out of more than $110 million, at the direction of Defendant Charles W. Stiefel, its then chairman and CEO. For example, in late 2008 and early 2009 while purchasing shares for less than $16,500 a share, Steifel did not inform them that the company was in the midst of negotiating the sale at a price of more than $68,000 per share.
The Stiefel family founded Stiefel Labs in 1847 and began to develop some of the world’s first medicated soaps and dermatology products in 1946. The Company has been privately-held, and since 1952 the Stiefel family has been the majority shareholder. Beginning in approximately 1975, Stiefel Labs’ employees began acquiring Stiefel Labs common stock as part of a defined contribution plan. All Stiefel Labs employees located in the United States became participants in the Plan after their first year of employment. Each year, Stiefel Labs made discretionary contributions to the Plan in the form of Stiefel Labs stock or cash. From 1975 to 2008, the Company made contributions of stock, but in 2008, for the first time in its history, the Company contributed only cash. At the time the company was the world’s largest private manufacturer of dermatology products. Charles W. Stiefel also served as the trustee of the plan.
Each year, the company would engage a third-party accountant to determine the price the company would pay shareholders for stock buy backs. According to the SEC complaint, this is where the trouble began. The SEC alleges that accountant used a flawed methodology and was not qualified to perform valuations. The SEC also alleges that Stiefel failed to disclose crucial information about offers and valuations the company received from investment firms. The valuation was only conducted once year.
According to the SEC complaint, the real trouble began in October 2008 when the company was at risk of violating some debt covenants. A part of the austerity measures, the company started buying back stock from current employees, not just from former employees. It’s also around this time that the company started seriously entertaining offers to purchase the company or at least a big chunk of the company.
From December 2008 to April 2009, while seeking bids for its sale the company purchased stock from employees at a price of $16,469 per share. An April 20, 2009 the company announced its sale to Glaxo and closed on July 22, 2009 resulting in a price of $68,131 for shares held in the retirement plan.
Assuming the facts in the SEC complaint are correct, I have some sympathy for the Stiefel. The negotiations with buyers had non-disclosure provisions that likely prevented them from disclosing the purchase price. On the other hand, some of the messages disclosed in the complaint indicate a grab for cash.
This does show that the SEC’s anti-fraud rule in 10b-5 of the Exchange Act can apply to private company transactions. That would prevent a party with material, non-public information from buying or selling those securities. In this case the private company had the information and the employees in the plan did not. Reliance on a third-party valuation is not enough.
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The Federal Trade Commission is continuing to pursue bloggers who fail to disclose that they received incentives to discuss a company’s products. Back in December, the Federal Trade Commission released new guidelines that specifically required bloggers to disclose any material connections to a product or company they are writing about. The FTC is focusing its efforts on the company.
The latest company snared in the failure to disclose is Hyundai. The FTC took a close look at a promotion in which bloggers were given gift certificates as an incentive to include links to Hyundai videos in their posts or to comment on Hyundai’s Super Bowl ads. One focus was whether the bloggers were told to disclose or were told not to disclose that they had received compensation.
It seems Hyundai’s first defense was that it wasn’t their fault, but he fault of their advertising agency. The FTC won’t take that defense and pointed out that advertisers are legally responsible for the actions working directly or indirectly for them.
What saved Hyundai is that their established social media policy calls for bloggers to disclose the receipt of compensation. What saved Hyundai’s advertising agency was that their established social media policy calls for bloggers to disclose the receipt of compensation.
By having the policies in place, Hyundai and the advertising agency were able to establish that the bad actions were those of rogue employee operating outside the established policies of the firms. That’s compliance in action.
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The local retirement boards in Massachusetts are subject to new regulations regarding placement agents. That means if you have one of the boards as investor in your fund or a client in your advisory business, you need to supply new information to your clients/investors.
Public Employee Retirement Administration Commission is the umbrella regulatory organization that oversees the dozens of local retirement boards in the Commonwealth. Last month they issued Memorandum #34 that implements the new PERAC Placement Agents Policy (.pdf).
As a manager you will need to provide:
(a) a statement whether you used a placement agent
(b) a resume detailing education, professional designations, regulatory licenses and investment and work experience. If he or she is a current or former member of a retirement board, employee or consultant or immediate family of such a person that fact should be specifically noted.
(c) a description of any and all compensation of any kind provided or agreed to be provided to a placement agent, including the nature, timing and value thereof;
(d) a description of the services to be performed by the placement agent
(e) a written copy of any and all agreements between the manager and the placement agent
(f) in the event that any current or former Massachusetts public pension system board members, employees, consultants or other service providers have suggested the retention of the placement agent, the names of that person
(g) a statement that the placement agent has a minimum of three years experience in the investment field
(h) a statement that the placement agent is registered with the Securities and Exchange Commission or the Financial Industry Regulatory Authority, or, if appropriate, the Commodity Futures Trading Commission
The pension board will have to include a provision in the investment management agreement that in the case of a breach will allow the board to terminate the agreement and have two years of management fees returned.
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