Year: 2011

Massachusetts Brings Charges Against a Hedge Fund

You need to worry about more than just the Securities and Exchange Commission when it comes to private fund fraud. State securities regulators generally have the ability to bring fraud charges. Case in point is the Massachusetts’ Secretary of the Commonwealth bringing charges against Risk Reward Capital Management, RRC Management, the RRC Bio Fund and James A. Silverman.

William F. Galvin’s office moved against the parties because the fund allegedly used the “expert network” firm, Guidepoint Global LLC, to gain inappropriate information about clinical trials for biotech drugs.

“The first year returns for the Fund were poor, losing 16.9% of its value. In early 2008 Silverman began to pay $80,000.00 a year from the Fund’s assets to retain the services of Guidepoint Global LLC, (“Guidepoint”) a so-called “expert network” firm, in an effort to make the hedge fund more profitable. With access to Guidepoint, the Fund began a dramatic resurgence, generating returns of over 55% in 2009 and 52% in 2010. These returns were generated, at least in part, upon Silverman’s receipt of material non-public information he received through Guidepoint consultations.”

The complaint focuses on two public companies for which Silverman received non-public information through Guidepoint consultants: Ariad Pharmaceuticals, Inc. and Questcor Pharmaceuticals Inc.

The complaint lays out in detail how the government sees an “expert network” in operation and how it breaks the law.

The Secretary of the Commonwealth is looking not just at the misuse of the information, but also administrative violations of the Massachusetts’ Uniform Securities Act

The Division’s books and records review of Risk Reward also uncovered a widespread pattern of non-compliance with the Act and the Regulations. The Division uncovered violations of minimum financial requirements, document retention requirements, and a myriad of dishonest and unethical business practices, including improper assessment of performance-based fees. The Division observed a disorderly office appearance during the on-site Examination. In addition to leaving client documents including sensitive financial information laying about on tables, chairs, sofas and floors, the Division discovered that the office doors did not lock, leaving client data vulnerable.

This action was brought pursuant to the enforcement authority under M.G.L. c. 110A §§204 and 407A. You may have notice that the operative agency is the Secretary of the Commonwealth, not the Secretary of State. Massachusetts is a commonwealth, not a state. Not that there is a difference.

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Lords of Finance

The financial crisis of 2008 was not the first. In reading Lords of Finance you see some of the obvious parallels from the 1920s.

Liaquat Ahamed focuses his story on Montagu Norman of the Bank of England, Benjamin Strong of the New York Federal Reserve, Hjalmar Schact of the Reichsbank and Emile Moreau of the Banque de France.

One focus of the 1920 s financial crisis was the stock market crash. Rampant speculation caused a bubble, even though it was initially rooted in economic reality. This was the “new economy” era of automobiles and radios. The old railroad based economy was being surpassed by trucking. Stock prices were rising, but so were the profits of the companies listed on the stock exchange. But then stock prices began rising out of proportion to the rise in corporate earnings.

There was clearly a speculative bubble. Investors were clamoring to find the next Google General Motors. Amateur investors were pouring in and borrowing to make their investments. The Federal Reserve did nothing and then when it decided to act it found it was unable to find a way to curb the speculation. When the Fed pulled back on the ability of banks to lend for stock speculation, non-banks stepped in to provide capital.

There was a thought that “the Fed could pierce the bubble with a surgical incision that would bring it back to earth without harming the economy. It was a completely absurd idea. Monetary policy does not work like a scalpel but more like a sledgehammer.”

As far back as the beginning of the Federal Reserve system there was the question of whether the Fed should intervene in an asset bubble.

The 1920s financial crisis was caused more than just stock speculation, just as the 2008 crisis was caused by more than just residential real estate speculation. It was fueled by debt. The world economy was trying to recover from the economic effects of World War I. Germany began the 1920 owing $12 billion ($2.4 trillion in 2011 values) in reparations to France in Britain, France owed the US and Britain $7 billion ($1.4 trillion in 2011 values)  in war time debts and Britain owed the US $4 billion ($800 billion in 2011 values).

The book goes further back  and focuses on the gold standard as one of the core underlying economic problems that helped cause the Great Depression. Up until this point there was an “almost theological belief in gold as the foundation for money.” Gold was the international currency. Each country’s currency was pegged to the value of gold. The ability to convert paper money into gold instilled confidence in the currency.

By coincidence, the discovery of gold through the late nineteenth century kept pace with economic growth. Then came World War I. The largest economic powers in the world met in the battlefield. Pound Sterling and Franc versus the Mark. The United States and the Dollar came in eventually. After spending the first few years sitting on the sidelines and supplying the Allies, the United States had accumulated an enormous trough of reserves.

One of the problems with the gold standard is that it gives people the option to cash in that paper money for actual gold. That obviously creates some faith in the currency. But it has opposite effect in times of crisis. people will lose faith in the paper money and redeem it for gold. That drains the system of gold, causing a tightening of credit. To counter, the banking system will need to raise interest rates to encourage people to keep money in the bank instead of gold in their mattress. Raising interest rates during a financial crisis will make things worse. You want to be able to reduce interest rates to encourage the flow of capital.

The other contributing factor was the failure of banks. This was before the days of the FDIC and insured deposits. So if you thought your bank was going under, you pulled your money out. This lead to bank runs and banks hoarding cash instead of investing the cash in loans that would grow the economy.

In the end, each economy began its recovery after it suspended the gold standard.  Is some ways the gold standard is just about digging up gold and re-burying it. The huge treasure of US gold was sitting underground, literally underneath Wall Street. France’s gold reserves were underwater; its vaults sat beneath a subterranean aquifer.

As George Santayana wrote: “Those who cannot remember the past are condemned to repeat it.” Ben Bernanke was a scholar of the Great Depression. He saw what the four Lords of Finance did, leading them to the subtitle of the book: The Bankers who Broke the World. It’s worth your time to read the book.

The SEC Continues to Investigate Side Pockets and Valuations

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

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

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

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

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

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

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

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Custody and Private Funds

Last year, the Securities and Exchange Commission put a new rule in place restricting an investment adviser’s ability to have custody of its clients’ assets. Given that many private fund managers are going to have to register as investment advisers they need to figure out how to comply with this rule.

The rule is the anti-Madoff rule. The SEC wants client assets separate from the manager’s control and for the manager to safeguards in place to prevent a manager from sending out false statements to investors. This includes having a third party custodian and having the custodian send statements directly to investors and subjecting the accounts to a surprise inspection by an auditor.

Safekeeping required

Rule 206(4)-2(a) If you are an investment adviser registered or required to be registered under section 203 of the Act, it is a fraudulent, deceptive, or manipulative act, practice or course of business within the meaning of section 206(4) of the Act for you to have custody of client funds or securities unless:

(1) A qualified custodian maintains those funds and securities:

(i) In a separate account for each client under that client’s name; or

(ii) In accounts that contain only your clients’ funds and securities, under your name as agent or trustee for the clients.

If your fund has securities, then you need a “qualified custodian” holding those securities. There is an exception for “privately offered securities” that will make life much easier for private equity funds and real estate funds.

Use of a Qualified Custodian

So who can you use as a “qualified custodian“?

(d)(6) Qualified custodian means:

(i) A bank as defined in section 202(a)(2) of the Advisers Act or a savings association as defined in section 3(b)(1) of the Federal Deposit Insurance Act (12 U.S.C. 1813(b)(1)) that has deposits insured by the Federal Deposit Insurance Corporation under the Federal Deposit Insurance Act (12 U.S.C. 1811);

(ii) A broker-dealer registered under section 15(b)(1) of the Securities Exchange Act of 1934, holding the client assets in customer accounts;

(iii) A futures commission merchant registered under section 4f(a) of the Commodity Exchange Act (7 U.S.C. 6f(a)), holding the client assets in customer accounts, but only with respect to clients’ funds and security futures, or other securities incidental to transactions in contracts for the purchase or sale of a commodity for future delivery and options thereon; and

(iv) A foreign financial institution that customarily holds financial assets for its customers, provided that the foreign financial institution keeps the advisory clients’ assets in customer accounts segregated from its proprietary assets.

Surprise audits and custodian statements

In addition to the requirement in (a)(1) that a qualified custodian hold the securities, there are addition requirements in (a)(2), (a)(3) and (a)(4) that you notify the client about the custodian, require separate statements be sent to the client and that the account be subject to surprise audits.

When investment funds are the clients these requirements make less sense, so (a)(5) requires funds to send the account statements to their limited partners.

There is an exception for pooled investment vehicles:

(b)(4) Limited Partnerships subject to annual audit. You are not required to comply with paragraphs (a)(2) and (a)(3) of this section and you shall be deemed to have complied with paragraph (a)(4) of this section with respect to the account of a limited partnership (or limited liability company, or another type of pooled investment vehicle) that is subject to audit (as defined in rule 1-02(d) of Regulation S-X (17 CFR 210.1-02(d))):

(i) At least annually and distributes its audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners (or members or other beneficial owners) within 120 days of the end of its fiscal year;

(ii) By an independent public accountant that is registered with, and subject to regular inspection as of the commencement of the professional engagement period, and as of each calendar year-end, by, the Public Company Accounting Oversight Board in accordance with its rules; and

(iii) Upon liquidation and distributes its audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners (or members or other beneficial owners) promptly after the completion of such audit.

If your auditor is not subject to inspection by PCAOB, you would have to switch auditing firms for your private fund to use this exception. You need to make sure your auditing firm has the horsepower to get the audited down in time for you to get financial statements out in within 120 days of fiscal year end.

Certain privately offered securities

There is a exception for having to deliver “privately offered securities” to the qualified custodian. Certain privately offered securities are:

(A) Acquired from the issuer in a transaction or chain of transactions not involving any public offering;

(B) Uncertificated, and ownership thereof is recorded only on the books of the issuer or its transfer agent in the name of the client; and

(C) Transferable only with prior consent of the issuer or holders of the outstanding securities of the issuer.

Notes and Interests in Subsidiaries and Portfolio Companies

For real estate private equity, the problem will be notes. They may be considered securities. Notes won’t meet the definition of uncertificated and they are most likely transferable.

For entities and portfolio companies, the key will be to make sure the subsidiaries under the funds are not certificated and there is requirement for consent in order to transfer. I think fund managers are going to have to back and inventory their subsidiary entity documents.

Of course you may be able to make an argument that the interest in the subsidiary is not a security. If it’s wholly-owned you can make a strong argument that the ownership is not a security since you are not relying solely on the efforts of others. But if the subsidiary is corporation you may be stuck treating it as a security. It’s generally hard to argue that shares in a corporation are not a security.

In the SEC Q&A about the custody rule:

Question II.3

Q: If an adviser manages client assets that are not funds or securities, does the amended custody rule require the adviser to maintain these assets with a qualified custodian?

A: No. Rule 206(4)-2 applies only to clients’ funds and securities.

So you don’t need to deliver all of the fund assets to the custodian. Just those that are securities and cash. Presumably, fund managers are already keeping their funds’ cash in a bank account and not in a mattress. They just need to make sure that the cash accounts are in the fund names.

At first, I thought the limited partnership exception would allow private fund managers to completely avoid the burden of this rule. That was too broad. Now I think fund managers are stuck with hiring a qualified custodian if they register with the SEC. I would guess there will lots of private fund managers looking for custodians before they register.

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ARMOR * PLATE / ptufts / http://creativecommons.org/licenses/by-nc-sa/2.0/

Compliance Bits and Pieces for March 4

Here are some recent compliance-related stories that caught my attention. But not enough attention to anything with them other post a snippet of the story.

Board Member of Goldman Sachs and Procter & Gamble Charged in Insider Trading Scheme

The Securities and Exchange Commission today announced insider trading charges against a Westport, Conn.-based business consultant who has served on the boards of directors at Goldman Sachs and Procter & Gamble for illegally tipping Galleon Management founder and hedge fund manager Raj Rajaratnam with inside information about the quarterly earnings at both firms as well as an impending $5 billion investment by Berkshire Hathaway in Goldman.

Executive Compensation, a Divided Commission, and the Consequences of Dissent (Part 2) by J. Robert Brown Jr. in The Race to the Bottom

[T]he dissent is liberating. The staff know that, by voting against the proposal, the two commissioners will likewise vote against the final rule when it is proposed, assuming the substantive requirements remain in place. That means that the rule can be written without worrying about the views of the dissenting commissioners.

Ponzi Operater Rides Phony Pedigree to Profits in Investor’s Watchdog

Sometimes, as alleged in this case, the claimed credentials are phony. Vigilant investors investigate to find that out. Sometimes, though, the scamster actually graduated from an Ivy League school. What do Marc Dreier, Kirk Wright, and Alicia Eimicke have in common? Two things. All of them ran investment frauds, and all of them graduated from Harvard. I don’t mean to pick on Harvard. There are plenty of Yale and Princeton grads who’ve also run Ponzi schemes. The point is that, while a degree from an impressive university might say something about a person’s intelligence and work ethic, it says nothing about his or her character, per se. And character is what a vigilant investor is looking for.

Chancery Declines to Dissolve LP and Declines to Appoint Receiver of Failing Investment Fund by Francis G.X. Pileggi in Delaware Corporate and Commercial Litigation Blog
The limited partner of a limited partnership sought to force a dissolution of the LP that had invested most of its assets in an investment fund based in the Cayman Islands.

What are the differences in the FCPA and Bribery Act? by Tom Fox

With the recent information coming out, largely from reports by the UK Telegraph, we thought it might a propitious time to review the differences in the Bribery Act and the Foreign Corrupt Practices Act (FCPA) so that US companies might begin to plan to acclimate their FCPA based compliance program to one which includes concepts found in the Bribery Act, if such action is appropriate.

Incentive Compensation Limitations and Disclosures for Private Fund Managers

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Greater Boston Real Estate CCO Forum

Are you running a real estate fund and wondering what do about registering with the Securities and Exchange Commission? Are you near Boston?

If your answers are yes and yes, join a group of CCOs who are getting together on an informal basis to discuss the issues. Our next meeting is Thursday, March 3 at noon in downtown Boston.

Send a message to me at [email protected] and I will give you more information.

Is Madoff a Sociopath?

The New York magazine interview with Bernie Madoff has finally been published.  Steve Fishman spoke with Madoff on the phone (collect calls from Madoff’s prison) for several hours.

And so, sitting alone with his therapist, in the prison khakis he irons himself, he seeks reassurance. “Everybody on the outside kept claiming I was a sociopath,” Madoff told her one day. “I asked her, ‘Am I a sociopath?’ ” He waited expectantly, his eyelids squeezing open and shut, that famous tic. “She said, ‘You’re absolutely not a sociopath. You have morals. You have remorse.’ ” Madoff paused as he related this. His voice settled. He said to me, “I am a good person.”

There aren’t many who would agree.

According the the interview, Madoff was already a wealthy man before he starting stealing from his clients and lying about their investments.

In the early days, Madoff mostly employed technical and fairly low-risk arbitrage techniques built around his market-making business. “I always had a good feel for the direction of the market because of the order flow I was seeing,” he said. In the eighties, he said, he produced consistent returns of 15 to 20 percent, and he insists he did it legally.

To me it sounds a bit like he was taking advantage of his trading business to help out his investment advisory business. Madoff had long been suspected of front-running trades to make money for his advisory business.

In the interview, he claims that the fraud started after the crash of 1987. Clients pulled out capital and he was forced to unwind long-term hedges on unfavorable terms. Then his trading scheme was no longer working because the market lacked the volatility needed for his arbitrage. And because trading spreads were narrowing because of the rise of electronic exchanges.

In the interview, Madoff displays some of the classic criminological behaviors of a fraudster.

He blames his victims: “Madoff says that he waved red flags, issued caveats that should have been obvious to even an unsophisticated investor.”

He denies his victims: “Everyone was greedy,” he continues. “I just went along. It’s not an excuse.” “Look, none of my clients, even if they lost every penny they put in there, can plead poverty.” In the tapes he claims that very few of the early investors will have lost their invested capital.

He condemns his condemners: “The whole new regulatory reform is a joke. The whole government is a Ponzi scheme.”

He claims everyone else is doing it: “It’s unbelievable, Goldman … no one has any criminal convictions.”

I think Madoff’s prison therapist told him the wrong answer. Or Madoff lied to Fishman about the therapist response.

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Is Your Copier in Compliance?

I remember the days of the mimeograph. In class people would inevitably sniff the newly printed pages. For a teacher, the danger was that the latent copy would fall into the wrong hands. Animal House highlighted that danger.

Current day copiers are much more advanced than the mimeograph, but the dangers of the latent copy still exist. Most modern copy machines are just special purpose computers. Like all computer they have a hard drive. On that hard drive, they store the images of the documents they copy and scan.

That’s not a problem until you give back the copier. Then you should be concerned that the next person who gets it could just pull up some of your documents from the hard drive. Last year, CBS highlighted this problem in an investigative piece by Armen Keteyian: Digital Photocopiers Loaded With Secrets.

Now the Federal Trade Commission has decided to take a stance. Not a definitive stance, but guidance. The FTC points out that companies must maintain reasonable procedures to protect sensitive information. That may include your copy machine.

When you finish using the copier:

Check with the manufacturer, dealer, or servicing company for options on securing the hard drive. The company may offer services that will remove the hard drive and return it to you, so you can keep it, dispose of it, or destroy it yourself. Others may overwrite the hard drive for you. Typically, these services involve an additional fee, though you may be able to negotiate for a lower cost if you are leasing or buying a new machine.

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Compliance Bits and Pieces for February 25

Here are some compliance-related stories that caught my eye:

A Blank Check for Cleaning Up Madoff’s Mess by Floyd Norris in the New York Times

But the Bernard L. Madoff fraud is proving to be different, and not just because Mr. Madoff ran by far the largest Ponzi scheme ever encountered. … SIPC (pronounced SIP-ick), a Congressionally chartered company that finances itself from assessments levied against brokerage industry revenue, estimates that it will spend a further $1.1 billion on the case. That is equal to the entire annual budget of the Securities and Exchange Commission.

Sean McKessy Tapped To Head SEC Whistleblower Office by Joe Palazzolo in WSJ.com’s Corruption Currents

Sean McKessy, former corporate secretary at AOL Inc. and Altria Group Inc., will head the Securities and Exchange Commission’s new whistleblower office, the agency said Friday.

FINRA Imposes Fines Totaling $600,000 Against Lincoln Financial Securities and Lincoln Financial Advisors for Failure to Protect Confidential Customer Information

Securities and Exchange Commission (SEC) and FINRA rules require every broker-dealer to adopt written policies and procedures that address safeguards for the protection of customer records and information. FINRA found that for extended periods of time – seven years for LFS and approximately two years for LFA – certain current and former employees were able to access customer account records through any Internet browser by using shared login credentials. From 2002 through 2009, between the two firms, more than 1 million customer account records were accessed through the use of shared user names and passwords. Since neither firm had policies or procedures to monitor the distribution of the shared user names and passwords, they were not able to track how many or which employees gained access to the site during this period of time. As a result of the weaknesses in access controls to the firms’ system, confidential customer records including names, addresses, social security numbers, account numbers, account balances, birth dates, email addresses and transaction details were at risk.

Does Your Company Know What It Knows? by Andrew McAfee

During times of great business change, two fundamental questions are: what kinds of companies are able to make the transition, and what happens when they do?