Year: 2011

The SEC, “Spousal Equivalents” and the Family Office

The SEC now recognizes “spousal equivalents” defined as “cohabitants occupying a relationship generally equivalent to that of a spouse.” Before wondering if the federal government is making big strides, keep in mind that this recognition is limited to the new Family Office Rule (.pdf).

Dodd-Frank created a new exemption for Family Offices. Previously they typically operated under the 15 clients rule that was repealed by Dodd-Frank or a private ruling from the SEC. Dodd-Frank left it up to the SEC to define a “family office.”

Rule 202(a)(11)(G)-1 contains three general conditions to fitting into the Family Office Exemption. First, the family offices may only provide advice about securities to certain “family clients.” Second, family clients must wholly own the family office and family members and/or family entities must control the family office. Third, a family office cannot hold itself out to the public as an investment adviser.

Th rule inevitably leads to a definition of “family.” Too narrow and many family offices would be excluded. Too broad and every investor will find an ancestor from the Mayflower. The SEC decided on a 10 generation limit.

The rule treats lineal descendants and their spouses, spousal equivalents, stepchildren, adopted children, foster children and persons who were minors when another family member became their legal guardian as family members.

I think it was bold move of the SEC to include spousal equivalents. They brush aside the Defense of Marriage Act argument: Because the term “spouse” is not defined in the rule and a “spousal equivalent” is identified as a category of person, separate and distinct from a “spouse,” that meets the definition of a “family member”….  DOMA provides that in “determining the meaning of any Act of Congress, or of any ruling, regulation, or interpretation of the various administrative bureaus and agencies of the United States…the word ‘spouse’ refers only to a person of the opposite sex who is a husband or wife.” 1 U.S.C. 7.

The failure of a family office to be able to meet the conditions of the new rule will not preclude the office from providing services to family members. But, the family office will need to find another exemption, register under the Advisers Act or seek an exemptive order from the SEC.

Sources:

The image is the Spousal Equivalent Badge available from Zazzle.

Compliance Lessons from the Tour de France

I would guess that most of you reading this story do not share my love of the Tour de France. It can be a confusing mix of skinny guys, tarted up with sponsors like a NASCAR racer, with hard to pronounce names, following tactics unusual outside of cycling. But I since I became a fan a decade ago, I continue to be enthralled by drama and athletic heroism on display.

I also saw compliance lessons.

Stage 18 was a brutal day of riding up big mountains in the Alps. The riders started with the Col Agnel, a climb of almost 24km, averaging 6.6 percent, but most importantly averaging 10 percent for the final 9km. Down, then up the Col d’Izoard 15km at 7.1 percent gradient. Down and then up to the 23km to the finish on top of the Col du Galibier. A moonscape at 8,678 feet that had a fresh snowfall just days before the cyclists arrived.

One of the rules of the Tour is that riders who finish too far behind the winner get eliminated from the race. In these big mountain stages the non-climbers fall off the back of the peloton and form a group of riders form that just hopes to finish the stage. Their primary concern is beating the elimination time to ensure the can ride the next day. effectively, the riders self-organize to fight the rule.

At the end of stage 18, 80 riders (nearly half the racers) arrived in the grupetto more than 35 minutes after the winner. This was after the cut-off time. They were not kicked out of the rice, but some were given meaningless penalties.

Stage 19 was another brutal climbing day, going up the Col du Telegraph, back up Galibier, and then scampering up the legendary Alp d’Huez. For the second day in a row, the huge grupetto finished beyond the time cut, with 82 riders crossing the line beyond the limit. The day’s time cut was set at 13 percent of the winner’s time. The race officials allowed the group to remain in the race. All riders in that group were penalized 20 points in the points classification, but both green jersey contenders, Mark Cavendish and Jose Rojas, were in the group. The one poor victim was Bjorn Leukemans, who finished well behind the grupetto and was eliminated.

A rule was broken by almost half the participants but there was no meaningful discipline. How would that work inside your company? If the rule is being broken by that many people, maybe it’s a bad rule?

Photo: Casey B. Gibson | www.cbgphoto.com

Compliance Bits and Pieces for July 22

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

Source: World Gold Council
Credit: Alyson Hurt

The Gold Boom, Then and Now by Jacob Goldstein in Planet Money

[o]n Jan. 21, 1980, gold hit what is still its all-time high in inflation-adjusted dollars. To match that high in today’s dollars, gold prices would have to rise by another 50 percent, to more than $2,400 an ounce.The core themes driving up the price were the same then as now: Inflation fears, global instability, and a lack of faith in governments and the currencies they back.

News Corp. May Be On Its Way To Voluntarily Disclosing Its Worst Secrets To The U.S. Government by Nathan Vardi in The Jungle

Now the independent directors of News Corp. have hired former Manhattan U.S. Attorney Mary Jo White, former U.S. Attorney General Michael Mukasey, and their law firm, Debevoise & Plimpton, to advise them. News Corp. itself has hired Mark Mendelsohn, who ran the Justice Department’s FCPA unit and helped turn the statute from a backwater into a prosecution machine and a gold mine for lawyers and accountants. Mendelsohn reportedly has been hired to advise on a potential investigation.

Private sector joins calls for anti-corruption mechanisms in arms trade treaty by Maria Gili in Space for Transparency

Last week, the 192 member states of the United Nations (193 from mid-week onwards, as South Sudan was admitted on July 14) met in New York to continue their negotiations towards an “Arms Trade Treaty” (ATT). States are keen to agree on an ATT in 2012, reaching a long overdue international agreement to finally regulate the global trade in arms. We represented Transparency International’s Defence and Security Programme and participated along with more than 100 other NGO representatives.

Happy Birthday Dodd-Frank!

This happened one year ago:

Since then, it’s been a whirlwind of regulatory production. It was a huge bill. (My copy goes on for 848 pages.) The Regulations it requires are many times more massive that the bill itself.

We will experience the repercussions for years. So we may as well keep count.

Dodd-Frank Wall Street Reform and Consumer Protection Act (.pdf 2MB)

Private Equity Exemption Bill Moves Ahead

The Small Business Capital Access and Job Preservation Act, H.R. 1082, took another step forward this week when it was approved by the House Committee on Financial Services. It still has a long way to go before coming law so this is no time to stop getting your compliance infrastructure in place.

The bill still defers the definition of “private equity fund” to the Securities and Exchange Commission and gives the SEC six months to come up with that definition. Even assuming the bill passes and passes quickly, you would not know if you fit into this exemption until very close to the March 30, 2011 filing deadline under the Investment Advisers Act.

The bill has been revised and now imposes a leverage limitation.

“provided that each such fund has not borrowed and does not have outstanding a principal amount in excess of twice its invested capital commitments.”

I think that limitation would prohibit the use of a subscription secured credit facility by a private equity fund if they wanted to take advantage of this exemption. That borrowing is used prior to calling capital and to provide liquidity without calling capital. It makes it easier for the fund manager to smooth out capital calls to investors.

Beyond that facility, It’s not clear to me whether that limitation would include debt at the portfolio level. In reading the minority view at the end of the committee report (.pdf), they think the leverage limitation excludes leverage in the portfolio companies.

Unfortunately, the committee report comes across as very partisan and attacks Dodd-Frank as a whole. To me that would only seem to decrease the likelihood that the House as a whole will take the bill seriously.

Sources:

Who Caught Them? Compliance or the SEC?

The SEC announced they had obtained an emergency freeze against three Swiss-based traders under an allegation of insider trading. The SEC claims that Compania International Financiera S.A., Coudree Capital Gestion S.A., and Chartwell Asset Management Services purchased more than a million common shares of Arch Chemicals just prior to the announcement that it was going to be purchased by Lonza Group Ltd.

It does not take much detective work to look at this chart and see that there was some suspicious trading leading up to the July 11 announcement date.

You see the stock price rising and an increase in trading volume. According to the SEC complaint, about 1 million shares in that increased volume came from three defendants. The average trading volume for Arch leading up to the merger announcement was just under 200,000 shares per day.

The hard part will be the SEC proving that the defendants had material, non-public information and used it in breach of some obligation. Clearly, their trading looks suspicious. Proving it was illegal will take more work.

The big question I have, and that compliance professionals that deal with insider trading should have, is how did the trades get flagged?

The SEC has said they are increasing market surveillance and market intelligence to spot suspicious activity. Did the SEC catch this on their own?

Was it compliance? It would seem that the activity coincided very closely with the merger and could easily have been flagged as suspicious by a vigilant broker/dealer compliance department. When a stock usually only trades 200,000 per day, seeing hundreds of thousands of shares being purchased with big public news should be a red flag.

Was it a whistleblower? The SEC has created a new bounty program. Perhaps an insider discover the activity and alerted the SEC in hopes of a financial windfall.

Was it a wiretap? It’s clear from the case against the Galleon Group and Raj Rajaratnam that the government is suing wiretaps to investigate insider trading.

To me the most interesting part of this case will be finding out how the trades got flagged. The rest of the case tied to proving insider trading is not interesting.

Sources:

Anti-Money Laundering Obligations For Private Funds

The Financial Crimes Enforcement Network, Treasury’s financial intelligence unit has been trying to impose anti-money laundering obligations on private funds for years. On September 26, 2002, FinCEN issued a notice of proposed rulemaking, proposing to require unregistered investment companies to establish and implement anti-money laundering programs. (Anti-Money Laundering Programs for Unregistered Investment Companies, 67 FR 60617 (Sep. 26, 2002))

In that notice of proposed rulemaking, FinCEN proposed to define the term “unregistered investment company” as (1) an issuer that, but for certain exclusions, would be an investment company as that term is defined in the Investment Company Act of 1940, (2) a commodity pool, and (3) a company that invests primarily in real estate and/or interests in real estate. FinCEN proposed requiring these companies to file a notice so that FinCEN could readily identify such companies and require them to establish and implement anti-money laundering programs.

I think most real estate fund managers and other private fund managers keep an eye on the parties to see if there is a reason to be wary and to see if they on the Specially Designated Nationals and Blocked Persons List. But I had some concern that FinCEN could extend the “know your customer” rules deep into transactions, imposing lots of administrative overhead for little benefit.

In November of 2008, FinCEN filed a notice of Withdrawal of the Notice of Proposed Rulemaking for Anti-Money Laundering Programs for Unregistered Investment Companies . In that notice, FinCEN stated that they were not abandoning the possibility of pursing the rulemaking. Given the six year span since the notice, they feel it has gone stale. If (or when) they decide to proceed with an anti-money laundering program requirement for unregistered investment companies, they will publish a new notice.

The “when” seems to be coming closer.

Senator Levin introduced the Stop Tax Haven Abuse Act. Section 203 of that bill would require the Department of Treasury to require

unregistered investment companies, including hedge funds or private equity funds, to establish anti-money laundering programs and submit suspicious activity reports under subsections (g) and (h) of section 5318 of title 31, United States Code.

The bill defines an “unregistered investment company” as one that would be an investment company but is exempt under 3(c)(1) or 3(c)(7).

Hedge funds may be an attractive source for money-laundering (I’m not sure), but private equity can’t be very enticing. Cash is called as investments are made over the course of the investment period and then slowly returned as investments are realized. I don’t generally think of terrorists and drug lords as patient capital sources.

Nonetheless, most private equity fund managers I’ve talked to investigate the background of their investors. It’s a long term relationship on both sides and managers don’t want to have the headache of having a bad investor. The repercussions of having a blocked-person would be tremendous, both from the legal fallout as well as the damage to the sponsor’s reputation. Most lenders require the fund to warrant that there are no blocked persons in their funds.

The Levin bill would technically leave out real estate fund companies, assuming they are taking advantage of the 3(c)(5) exemption. I sense more regulatory overhead approaching.

Sources:

Compliance Bits and Pieces for July 15

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

A snapshot of this year’s disclosure avalanche by Theo Francis in Footnoted

But the biggest filings are also getting bigger: While the top 20 filings in the first half of 2010 totaled 52,514 pages, the top 20 so far this year add up to 56,571 pages, an increase of just under 8%. And the most prolific filers are sending the SEC more documents: 16,412 of them from the top 20 companies, up 9% from the first half of 2010, when the figure was 15,028 filings. With that kind of growth, among other factors, you can imagine why Mary Schapiro wants a budget increase.

Corporate hospitality – The SFO’s five factors in the Bribery Act .com

In response to these continuing uncertainties the SFO have told us that they will be looking at five factors when considering corporate hospitality in the context of the Bribery Act.

“Social Checks” Come of Age: What Does It Mean for Employers? by Philip Gordon in Littler’s Workplace Privacy Counsel

Last month, the Federal Trade Commission (FTC) published a letter closing its investigation into whether an “Internet and social media background screening service used by employers in pre-employment background screening” complied with the Fair Credit Reporting Act (FCRA). At first blush, the letter appears to be a non-event. The FTC did not impose a penalty but also admonished that its “action is not to be construed as a determination that a violation may not have occurred.” While not much can be drawn from this equivocal result, the FTC’s letter does contain the following important conclusion: the “social check” service in question, known as Social Intelligence, “is a consumer reporting agency because it assembles or evaluates consumer report information that is furnished to third parties that use such information as a factor in establishing a consumer’s eligibility for employment.” Put into plain English, employers that rely on a social check service, like Social Intelligence, to search social media for information about job candidates must comply with the FCRA.

Image of file cabinets is by redjar

Chief Compliance Officer and General Counsel Supervisory Responsibility and Liability Brian L. Rubin, Partner

ACA Compliance sponsored this webinar on Thursday. Brian L. Rubin, Partner, Sutherland Asbill & Brennan LLP was the presenter. These are my notes.

Section 203(e) of the Advisers Act:

If an investment adviser fails to reasonably supervise an employee or any other person subject to the adviser’s supervision, and that person violates the federal securities laws, then the SEC may take action against such investment adviser

In the Matter of Pegasus Investment Management, LLC, Peter Bortel, and Douglas Saksa (.pdf) (June 15, 2011) Pegasus VP Peter Bortel, under the supervision of President and CCO Douglas Saksa, allegedly did not disclose the arrangement to their fund investors and retained retained broker rebates for Pegasus, rather than passing it along to the investors. The SEC stated that Saksa failed to reasonably supervise Bortel within the meaning of Section 203(e)(6)

Direct Liability

CCO has direct liability for:

–Aiding and abetting, and causing firm violations such as:

•Responding to regulatory inquiries
•Responding to deficiency letters
•Adopt/implement policies and procedures
•Failing to file

– Permitting unregistered individuals to act

As an example the they cited In the Matter of the Buckingham Research Group, Inc., Buckingham Capital Management, Inc., and Lloyd R. Karp (.pdf) (November 17, 2010). The CCO allegedly represented in deficiency letter response that certain corrective action would occur (new policies/monitoring). The SEC claimed CCO was liable because he was responsible for establishing and administering the policies at issue and he “was aware of the compliance weaknesses and failures and either failed to act or failed to correct them”

Are you a supervisor?

Some factors are whether you have the ability to hire, fire, discipline, affect compensation. You would have the requisite degree of “responsibility, ability or authority” to “affect” the conduct of the employee whose behavior is at issue.

You can still be held liable as the SEC if you are overruled by superiors. (Scary!!)

In the Matter of Theodore W. Urban (.pdf), Adm. Proc. File No. 3-13655, Initial Decision (Sept. 8, 2010) Urban was General Counsel and headed Compliance, HR and Int. Audit. Urban had no authority to hire or fire employees outside of these departments, but he served on the board of directors and the firm’s credit and risk committee as a full voting member. SEC alleged that Urban was bad rep’s supervisor because of the role he played in monitoring bad rep’s actions. SEC also alleged that Urban failed to follow up on numerous red flags and took inadequate action regarding other red flags. As General Counsel, his opinions on legal/compliance matters were “viewed as authoritative and his recommendations were generally followed” by all business units.

The Administrative Law Judge found that Urban was a bad rep’s supervisor, but he had not failed to supervise because he performed his supervisory responsibilities “in a cautious, objective, thorough and reasonable manner”. The decision has been appealed to the SEC. So this ruling may change.

Combination/Separation of Legal and Compliance Functions

Some advantages to combining the roles:

  • Federal Sentencing Guidelines call for adoption of a compliance program overseen by senior personnel
  • Compliance is represented at senior management level
  • GC is actively involved in strategic business decisions, offering exposure to potential compliance issues
  • May be better positioned to push the firm toward appropriate actions/conclusions
  • Direct or tangential experience with regulations
  • “Noisy Withdrawal” trigger
  • Reduced headcount
  • GC is generally consulted on key compliance matters by senior management

Why separate the roles?

  • Respects the differing goals of legal versus compliance (legal protects the firm; compliance prevents and detects violations
  • Allows firms to acquire necessary skill set in each area
  • Avoids misplaced privilege claims
  • Creates necessary bandwidth to execute each role fully
  • Allows each person to serve appropriate stakeholders
  • Avoids conflicts at the board level/recusals
  • Compliance gets same standing as legal in organization charts

Reporting

How about the CCO Reporting to GC?

  • Centralizes legal and compliance in a single functional area. There is overlap.
  • Matters identified can be more quickly resolved due to combination of functions
  • GC may be in a good position to muster resources or provide a platform
  • Gives clout to the compliance function. To the extent legal has clout.

How about an Independent CCO

  • Highest degree of independence
  • Decisions to report matters up to senior management or to regulators not subject to approval by GC
  • CCO does not have to go outside reporting structure to raise matters to senior management
  • GC does not need to create time to supervise the CCO
  • Consistent with ICA 38a-1 and FINRA Rule 3130

As a case study, they used the Wunderlich case.

Avoiding Supervisory Responsibility

  • Document with written supervisory policies and procedures
  • Identify the direct supervisors of all employees
  • Specifically state that compliance personnel are limited to offering advice and recommendations and do not have the responsibility, ability or authority to affect the conduct of employees outside of their departments
  • Where misconduct is addressed, document which business-line supervisor is handling the issue and how
  • Make it clear that the role on committees and boards is only advisory in nature

Compliance and Google+

google-plus

Over the past few weeks, Google+ has exploded as a new social web platform. We had friends on Facebook and followers on Twitter. Now there are Circles on Google+.

What does this mean from a compliance perspective?

Not much for right now. Google+ does not seem to present any new issues that we haven’t already seen in social media. My general impression is that it’s a hybrid of Twitter and Facebook. This is both in terms of privacy and the way communications flow.

I expect there will be a few hiccups with the privacy settings as we have already seen with Facebook. The use of “circles” allows you limit who can see your communications. But since anyone in that circle can then share it with people in their circle, any message can easily become public. If you want to keep you message a bit more private, there is a button that can check to prevent sharing.

To the extent you have a social media or communications policy you should make sure it takes into account Google+. To the extent you need to archive and preserve messages, you will need to take Google+ into account. Hopefully Smarsh and the other vendors will get access to the API so they can find a way to preserve the messages.

If you block access to social networking sites, Google+ is a little trickier to deal with. It looks like it operates as a subdomain on Google.com. I don’t think too many c0mpanies want to block access to Google.com. Your blocking software will need to make sure it only limits the plus.google.com subdomain. And it’s https:, not http:.

Will Google+ live long enough to be a concern for compliance? Maybe. I have a hard time believing people will use Facebook, Twitter and Google+. I suspect that Google+ will need to take users away from Facebook and Twitter to be successful.

I don’t suspect it will cause many people to abandon Facebook. Google+ is slicker, but Facebook has the bigger user base. As Andrew McAfee once told me, the new tool can’t just be a little better, it has to be many times better for people to switch.  I don’t find Google+ to be that much better than Facebook. Most importantly for me, Facebook has the largest collection of close friends and family. (My “Family” circle on Google+ is empty, my “Friends” only has a few handfuls of people, and my “compliance” circle has a single person.)

Twitter is the most likely victim of Google+. It removes the 140 character shackle and threads conversations together. Twitter still has better integration with other platforms. On the other hand, there is the possibility that Google+ could tie together many of Google’s other platforms.

It will be hard to kill Twitter. All of the news coverage about placing the valuation of Twitter in the billions of dollars are tied to Twitter’s latest round of raising money from investors. I would guess that the company is sitting on a big pile cash that will take a long time to burn through, leaving them plenty of cash to improve the product and find ways to generate revenue.

Google+ will cause more compliance headaches. For now, it doesn’t appear to create any new headaches.

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