Year: 2011

Pillow Talk at Playboy Leads to Insider Trading

playboy logo by Kaptain Kobold

The headline was too hard to ignore. I suppose there must be some compliance lessons to be learned. But first, the facts:

William A. Marovitz, who is married to former Playboy Enterprises Inc. Chief Executive Officer Christie Hefner, made $100,952 on the trades, according to an SEC complaint. The SEC alleges that on five occasions between 2004 and 2009, Marovitz traded based on confidential information that he misappropriated from Hefner, in his own brokerage accounts ahead of public news announcements. In November 2009, Marovitz learned about Iconix’s potential acquisition of Playboy and used that confidential information to buy Playboy stock in advance of a public announcement of a potential merger, which caused a 42% increase in Playboy’s stock price. When Iconix ended its efforts to acquire Playboy in December 2009, Marovitz sold Playboy stock before the news became public, resulting in a 10% decrease in Playboy’s stock price.

The case illustrates a tough area for compliance officers: family securities trading. According to the complaint:

Hefner also asked Playboy’s general counsel, Howard Shapiro, to talk to Marovitz about the implications of any trading by him in Playboy stock. Shapiro complied with Hefner’s request by faxing a memorandum to Marovitz’s home and office on September 4, 1998 warning Marovitz of the “serious implications” of Marovitz trading in Playboy stock. Among other things, Shapiro warned Marovitz that “all SEC rules governing Christie’s sale or purchase of stock are equally applicable to you, particularly the rules governing insider trading” and “your purchase is imputed to Christie.” Shapiro requested that Marovitz consult with him before executing any trades in Playboy stock. Marovitz never contacted Shapiro to discuss any of his trades in Playboy.

There are two main reasons for clearing trades. One is to avoid insider trading. The other is to avoid the appearance of insider trading. The trade could be done because he learned of material, non-public information or could be done without having obtained it. (Either way, it looks bad.)

On the adviser side, with the pre-clearance you could be alerted not to trade because of something you are not aware of. If the material, non-public information is in the building your trade is automatically going to be suspicious.

With a public company, like Playboy, there are generally narrow windows of trading to avoid the same set of problems.

The rules are in place to prevent you from accidentally having the appearance of trading on material, non-public information.

The other item in the case that caught my eye was the origination of the case. It came during a SEC examination of a broker-dealer, with assistance of the Internal Revenue Service. It sounds like the different parts of the federal regulators are doing a better job of sharing information.

Sources:

Image is by Kaptain Kobold

Compliance Bits and Pieces for August 5

Is it August already? The summer is flying by (as usual). There are still some interesting compliance-related stories floating by on the interwebz.

Don’t know if you’re carrying on business in the UK, or not? What do you do? in The Bribery Act .com

The key to its long arm jurisdiction rests in its application to any organisation which can be said to carry on part of a business in the UK. The Bribery Act does not elaborate on what carrying on business equates to and it remains one of our most frequently asked questions.

Revolving Door at S.E.C. Is Hurdle to Crisis Cleanup in Dealbook

A senior lawyer for the Securities and Exchange Commission recently took center stage in a major case involving a controversial mortgage security sold by Goldman Sachs. There was just one slight twist in the legal proceedings. The S.E.C. lawyer was not the prosecutor taking the deposition. He was the witness.

In response:
I Think I’ve Said This Before in The Epicurean Dealmaker

But I also say: What about it? Where would you propose we find adequately qualified people to staff the regulatory bodies of our fair if somewhat befuddled commonwealth?

Report on Mutual Fund Advertising

Section 918 of Dodd-Frank Act required a study on mutual fund advertising. The Government Accountability Office delivered that report before the 18 month deadline to the designated Congressional committees. The Report’s objectives were “to examine (1) what is known about the impact of mutual fund advertisements on investors, (2) the extent to which performance information is included in mutual fund advertisements, and (3) the regulatory requirements that exist for mutual fund advertisements and how they are administered and enforced.” Just for fun, the GAO included ETFs in the study given their popularity and some similar legal structures

The GAO reviewed Securities and Exchange Commission and Financial Industry Regulatory Authority (FINRA) rules and studies related to mutual fund advertising’s impact on investors. They also reviewed a random sample of 300 fund advertisements.

The most interesting finding (at least most interesting to me) is that they did not find a clear harm from advertisements that included performance results. Traditionally, research has shown that past performance generally does not persist and is not predictive of future performance. Therefore performance advertisements would be inherently misleading. Under Rule 482, mutual fund advertisements that includes performance data have to point out that past performance does not guarantee future results.

However, the GAO found some studies illustrate that investors who are influenced by performance advertising may still achieve returns that exceed market indexes or other funds.

The main recommendation that came out of the report was to ensure the “FINRA develops sufficient mechanisms to notify all fund companies about changes in rule interpretations for fund advertising.” Both SEC and FINRA agreed with the recommendation.

Risk Retention and Funding Private Equity Deals

From Federal Reserve's Section 946 Risk Retention Study

There is no doubt that securitization helped fuel the residential housing bubble that lead to the Great Panic of 2008. Lenders found ready buyers for their loan portfolios, could sell them, then lend the money out again to create new loan portfolios to resell. One of the issues is that the lenders became purely loan originators, selling off 100% of their interest. So their focus was on generating new loans and not making sure the loans were re-paid. Their lending standards consequently grew more and more lax.

That’s an oversimplification of the process, but shows the general problems of not “having any skin in the game.” By removing the credit risk, securitization may reduce an originator’s incentives to properly underwrite and evaluate borrowers. In addition, since the investor in the securitization is generally several steps removed from the loan origination, there is an information asymmetry.

Section 941 of Dodd-Frank requires securitizers to retain economic interest of at least five percent of credit risk of assets they securitize. As with much of Dodd-Frank, it’s up to the regulators to figure this all out and promulgate the rules. The idea is that properly structured risk retention can address some of the inherent risks of securitization.

Although risk retention may be good for bondholders, it may be bad for the amount of credit and liquidity available. It may also result in higher costs for borrowers. The banks need to retain some its capital in the form of retention. That capital will just be sitting there until the underlying debt obligations are repaid.

On April 29, 2011, the OCC, Board, FDIC, Commission, FHFA and HUD published a joint notice of proposed rulemaking for public comment to implement the credit risk retention requirements of section 15G of the Securities Exchange Act of 1934 (15 U.S.C. § 78o-11), as added by section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

The rule will inevitably affect the amount credit available for deal flow and re-investment. There will likely be higher borrowing costs and barriers to execution.

The rule will also affect the residential real estate market since it creates a new category of “Qualified Residential Mortgages” that are exempt from risk retention requirements. I assume that loans that fall outside the exemption will be more expensive for the borrowers and limit the availability of credit for home purchases.

The proposed regulations extend for about 100 pages. That’s a big chunk of new law that will have profound effects on the lending industry.

For commercial mortgage backed securities, the sponsor must retain a “horizontal residual interest” of at least 5% of the par value. There is an option to hold a cash reserve account instead of equity. There is an exception to the risk retention requirements for commercial real estate loans with a laundry list of requirements:

  • Secured by a first lien on the commercial real estate.
  • Verified and documented the current financial condition of the borrower;
  • Obtained a written appraisal of the real property securing the loan that
  • Qualified the borrower for the CRE loan based on a monthly payment amount derived from a straight-line amortization of principal and interest over the term of the loan (but not exceeding 20 years);
  • Conducted an environmental risk assessment to gain environmental information about the property securing the loan and took appropriate steps to mitigate any environmental liability determined to exist based on this assessment;
  • Conducted an analysis of the borrower’s ability to service its overall debt obligations during the next two years, based on reasonable projections;
  • Determined that, based on the previous two years’ actual performance, the borrower had:
    (A) A DSC ratio of 1.5 or greater, if the loan is a qualifying leased CRE loan, net of any income derived from a tenant(s) who is not a qualified tenant(s);
    (B) A DSC ratio of 1.5 or greater, if the loan is a qualifying multi-family property loan; or
    (C) A DSC ratio of 1.7 or greater, if the loan is any other type of CRE loan;
  • Determined that, based on two years of projections, which include the new debt obligation, following the origination date of the loan, the borrower will have:
    (A) A DSC ratio of 1.5 or greater, if the loan is a qualifying leased CRE loan, net of any income derived from a tenant(s) who is not a qualified tenant(s);
    (B) A DSC ratio of 1.5 or greater, if the loan is a qualifying multi-family property loan; or
    (C) A DSC ratio of 1.7 or greater, if the loan is any other type of CRE loan.
  • The loan documents  require the borrower to provide financial statements and supporting schedules on an ongoing basis.
  • The loan documents impose prohibitions on:
    (A) The creation or existence of any other security interest with respect to any collateral for the CRE loan;
    (B) The transfer of any collateral pledged to support the CRE loan; and
    (C) Any change to the name, location or organizational structure of the borrower, or any other party that pledges collateral for the loan.
  • The loan documents require the borrower to maintain insurance that protects against loss on any collateral.
  • The loan documents require the borrower to pay taxes, charges, fees, and claims, where non-payment might give rise to a lien on any collateral for the CRE loan.
  • The loan documents require the borrower take any action required to perfect or protect the security interest and to defend such collateral against claims adverse to the originator’s or subsequent holder’s interest.
  • The loan documents require the borrower to allow inspection the collateral for the CRE loan and the books and records of the borrower or other party relating to the collateral for the CRE loan.
  • The loan documents require the borrower to maintain the physical condition of the collateral for the CRE loan;
  • The loan documents require the borrower to comply with all environmental, zoning, building code, licensing and other laws, regulations, agreements, covenants, use restrictions, and proffers applicable to the collateral.
  • The loan documents require the borrower to comply with leases, franchise agreements, condominium declarations, and other documents and agreements relating to the operation of the collateral, and to not modify any material terms and conditions of such agreements over the term of the loan without the consent of the originator or any subsequent holder of the loan, or the servicer.
  • The loan documents require the borrower not materially alter the collateral.
  • The loan prohibits the borrower from obtaining a loan secured by a junior lien on any property that serves as collateral for the loan
  • The CLTV ratio for the loan is:
    (i) Less than or equal to 65 percent; or
    (ii) Less than or equal to 60 percent, if the capitalization rate used in an appraisal that meets the requirements set forth in paragraph (b)(2)(ii) of this section is less than or equal to the sum of:
    (A) The 10-year swap rate, as reported in the Federal Reserve Board H.15 Report as of the date concurrent with the effective date of an appraisal that meets the requirements set forth in paragraph (b)(2)(ii) of this section; and
    (B) 300 basis points.
  • All loan payments required to be made under the loan agreement are based on straight-line amortization of principal and interest over a term that does not exceed 20 years; and
  • Loan payments made no less frequently than monthly over a term of at least ten years.
  • Maturity of the note occurs no earlier than ten years following the date of origination.
  • The borrower is not permitted to defer repayment of principal or payment of interest.
  • The interest rate on the loan is:
    (A) A fixed interest rate; or
    (B) An adjustable interest rate but the borrower obtained a derivative that effectively results in a fixed interest rate.
  • The originator does not establish an interest reserve at origination to fund all or part of a payment on the loan.
  • At the closing of the securitization transaction, all payments due on the loan are contractually current.

That is big set of regulations for commercial loan documents. A positive result of the rules would be to have a more standardized set of loan documents used for loans. That could help offset some of the additional costs that may result from the rules.

Sources:

What is the SEC Looking For With Private Fund Managers

IA Watch published a few recent document request letters in connection with SEC examinations of investment advisers. One is a document request letter sent to a private fund manager (sub. required).

These are some of the items requested that caught my attention:

  • Organizational chart showing ownership percentages
  • investment strategy
  • Amount of adviser’s equity interest
  • Amount of adviser’s affiliated person’s interest
  • Specific exemptions from registration under the Securities Act
  • Services the adviser is providing
  • Amount of leverage, both explicit (on-balance sheet) and off-balance sheet (futures and certain other derivatives)
  • Account statements sent to investors
  • Names of investors who purchased and redeemed an interest in the fund during a specific period
  • Description of all positions held in side pockets or special situation accounts
  • Side agreements in which investors are participants

It’s clear from the letter that examiners are focused on custody issues and side pocket issues.

The SEC has been up front about this. The custody rule may be a headache, but its intended to prevent another Madoff. By getting account statements directly from the custodian instead of the adviser, you have a control in place to prevent fraud.

Sources:

Report on Self-Regulatory Org. for Private Fund Advisers

Section 416 of the Dodd-Frank Act require the Government Accountability Office to study the feasibility of forming a Self-Regulatory Organization to oversee private funds. With the removal of the 15 clients exemption, many private fund managers will have to register for the first time by March 30, 2011. The GAO beat Congress’s deadline by 10 days when it released the report on July 11.

In Private Fund Advisers: Although a Self-Regulatory Organization Could Supplement SEC Oversight, It Would Present Challenges and Trade-offs (.pdf), the GAO does not break any new ground. The big problem is obvious: the SEC lacks the resources to examine advisory firms on a regular basis. Congress seems to be willing to put a chokehold on funding as a way of limiting the effectiveness of the Securities and Exchange Commission.

Of the 11,505 investment advisers registered with the SEC on April 1, 2011, 2,761 advisers had private funds. But only 863 of those exclusively had private fund clients.  These numbers will change dramatically on April 1, 2012 when mid-sized advisers get kicked out of SEC registration and private fund advisers are dragged in.

Challenges

Legislation would be needed to create an SRO for advisers. I think most players are unsure whether it would be a good thing or a bad thing. Given that the SRO has no form, functions, membership or governance, it’s hard to have an opinion. Private fund advisers may not like registration with the SEC, but at least it’s a known regulatory regime.

“Some of the challenges of forming a private fund adviser SRO may be mitigated if the SRO were formed by an existing SRO, such as FINRA, but other challenges could remain,” the GAO states. As for FINRA, no private fund adviser I’ve spoken to wants to be under their oversight. They don’t like the overly rule-based approach.

Rules versus principles

The GAO report highlights one of the big differences between FINRA’s approach and the SEC’s approach. SROs, like FINRA, traditionally use a rules-based approach, in part, to address the inherent conflicts of interest that exist when an industry regulates itself by minimizing the degree of judgment an SRO needs to use when enforcing its rules. The SEC regime for investment advisers is primarily principles-based, focusing on the fiduciary duty that advisers owe to their clients. That fiduciary duty has been interpreted through case law and enforcement actions. Given the diverse business models among private funds, adopting detailed or prescriptive rules to capture every fact and circumstance possible under the fiduciary duty would be difficult.

Advantages of private fund adviser-only SRO

Through its membership fees, a private fund adviser SRO could have “scalable and stable resources for funding oversight” of its members. That would mean it could conduct earlier examinations of newly registered advisers and more frequent examinations of seasoned advisers than SEC could do with its current funding levels. With improved resources, an SRO could better technology to strengthen the examination program, provide the examination program with increased flexibility to address emerging risks associated with advisers, and direct staffing and strategic responses that may help address critical areas or issues.

Theoretically, the SRO could impose higher standards of conduct and ethical behavior on its members than are required by law.  It could also provide expertise and knowledge than SEC, given the industry’s participation in the SRO.

Disadvantages of private fund adviser-only SRO

The GAO listed these disadvantages:

  1. An increase the overall cost of regulation by adding another layer of oversight.
  2. Conflicts of interest because of the possibility for self-regulation to favor the interests of the industry over the interests of investors and the public.
  3. Limited transparency and accountability, as the SRO would be accountable primarily to its members rather than to Congress or the public.

Although the formation of an SRO could increase demand for CCOs, making it potentially good for me personally, I think it would be a terrible idea for the industry.

Sources:

 

Weekend Humor: Dodd-Frank Update

Jon Stewart helps celebrate the one year anniversary of Dodd-Frank (for those of you who grew up on Schoolhouse Rocks.)

Compliance Bits and Pieces for July 29

These are some compliance-related stories that recently caught my attention.

Backyard Hens: A Trend Coming Home to Roost? by James McWilliams in Freakonomics

These anecdotes remind us that, when it comes to the safety of chicken eggs, what matters is not so much the setting in which the birds are raised (factory or backyard), but rather quality control and managerial acumen. To thus boldly assert that the eggs of backyard hens are safer–something I hear all the time– is to place faith ahead of evidence. Again, we might very well, based on personal experience, have the grounds to claim that the backyard hen is a safe hen. But, by this measure, anyone who regularly eats factory eggs and avoids sickness can say the same thing about factory eggs. Bottom line is that we just don’t know.

Bribery, Legal Clarity, and Lame Excuses by Chris MacDonald in The Business Ethics Blog

Bribery is quite probably among the very oldest of unethical business practices, right up there with short-changing your customers and adulterating your products. Many modern economies have recognized that bribery has no place in a fair and efficient market, and have rightly taken action to prohibit what is widely acknowledged to be a pernicious practice. But not everyone is consistently appreciative of legislative efforts at curbing bribery. Take the U.S. Chamber of Commerce, for example. To see why the Chamber isn’t altogether happy about the U.S. government’s anti-bribery efforts, see this story from the Washington Post’s David S. Hilzenrath: “Quandary for U.S. companies: Whom to bribe?”

SEC Charges Liquor Giant Diageo with FCPA Violations

The SEC found that London-based Diageo plc paid more than $2.7 million through its subsidiaries to obtain lucrative sales and tax benefits relating to its Johnnie Walker and Windsor Scotch whiskeys, among other brands. Diageo agreed to pay more than $16 million to settle the SEC’s charges. The company also agreed to cease and desist from further violations of the FCPA’s books and records and internal controls provisions.

Image is backyard chicken by Steven Johnson /
CC BY 2.0

Twitter Fail and Compliance


FINRA has long regulated and limited the ability of broker/dealers to communicate with the public. One of their missions is to protect the investing public from unscrupulous securities brokers. Twitter is a communications tools and any messages posted to Twitter will need to be in compliance.

It was inevitable that we would see a FINRA regulated party make a mistake using Twitter. The time has come.

FINRA also found that during eight months in 2009, the registered representative maintained a Twitter account and had more than 1,400 followers. Without notifying a principal of her employer firm, the registered representative posted 32 “tweets” related to a particular security. The tweets were unbalanced, overly positive and often predicted an imminent price increase. In the tweets, the representative failed to disclose that she and her family held a significant number of shares of the security. FINRA concluded that this conduct violated NASD Rules 2210 (communications with the public) and IM-2210-1 (guidelines to ensure that communications with the public are not misleading), and FINRA Rule 2010 (ethical standards).

To me, this sounds exactly like the behavior FINRA is trying to prevent by imposing Rule 2210 on financial representatives.

I don’t want to overstate the effect of this Twitter failure on the discipline. The registered representative was doing some other things in violation of the rules. I would guess that once a registered representative is under investigation FINRA takes a look at that person’s social networking activity to see if they have been doing other bad things.

Sources:

Image is 2008wmonroe by Liza P
CC BY-NC-ND 2.0

Soros Doesn’t Want Your Money

In one of the most visible moves as a result of the new SEC regulations on investment advisers, George Soros is closing his $25 billion Quantum Endowment Fund to outside investors and returning their money.

Why?

“We have relied until now on other exemptions from registration which allowed outside shareholders whose interests aligned with those of the family investors to remain invested in Quantum. As those other exemptions re no longer available under the new regulations, SFM will now complete the transition to a family office….”

The Soros fund management company would have to register as an investment adviser and it doesn’t want to do that. They are kicking out non-family money and using the family office exemption to avoid registration.

Is this a good thing? Soros is a controversial figure, reviled for some because of his currency bets. For his investors, he returned about 20 percent a year, on average, since 1969. If some of those investors invest your retirement money, then you may be worse off.

It’s clear that the regulatory regime changes resulting from Dodd-Frank are going to change the business models for many money managers. Some, like Soros, will pull back operations to avoid the regulatory oversight.

Sources:

Image is George Soros – World Economic Forum Annual Meeting Davos 2010
DAVOS/SWITZERLAND, 27JAN10 – George Soros, Chairman, Soros Fund Management, USA, captured during the session ‘Rebuilding Economics’ of the Annual Meeting 2010 of the World Economic Forum in Davos, Switzerland, January 27, 2010 at the Congress Centre.
Copyright by World Economic Forum.
swiss-image.ch/Photo by Sebastian Derungs