Author: Doug Cornelius

You can find out more about Doug on the About Doug page

Fund Fee Calculation Error

Calculating fund fees during the commitment period is usually easy for most private equity funds. Take the committed capital and multiply it by the applicable fee percentage. After the commitment period, the calculation often gets more complicated. Most funds have some reduction to actual capital deployed with deductions for write-downs and partial realizations.

Global Infrastructure Management got the calculation wrong for its funds. Part of the problem was an inconsistency between the funds’ PPMs and the funds’ partnership agreement in how to treat partial realizations. The PPMs stated the post-commitment management fee would be based on the capital contributions relating to the retained portion of investments. The partnership agreements said the fee would be calculated based on each limited partner’s capital contribution that was used to acquire an investment, and thus a partial disposition of the investment would not reduce management fees.

Global followed the partnership agreement and didn’t reduce the fee for partial dispositions. Unfortunately, Global employees appeared to have also told some investors that it would reduce and others that it wouldn’t.

It seems clear that the SEC view is that inconsistency works against the fund manager. The SEC made Global rebate fees back to investors based on the partial realization language in the PPMs. Fund managers need to prove that they are entitled to the fees and are may be cut short by inconsistent language.

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Compliance for 401k and a Recent Supreme Court Case

I assume some compliance officers often get involved in their firm’s retirement plans. If so, you may want to take a look at a decision last week by the US Supreme Court: Hughes v. Northwestern University. The case is a lawsuit by employees of Northwestern against the school and trustees of the school’s retirement plans. This is one of hundreds of lawsuits against big retirement plans for being mis-managed.  Since it’s a non-profit, Northwestern’s plans are not traditional 401ks, but the same standards apply to its plans as to Beacon’s 401k.

The employees claimed that Northwestern and the plan fiduciaries violated their duty of prudence by, among other things, offering needlessly expensive investment options and paying excessive recordkeeping fees.

The Northwestern plans have many options for employees to chose among. Many, many, many options. The plans had over 400 investment options during the time period. Some of those 400 investment options were low-cost index funds. Some were high-cost retail class funds.

The plan used revenue-sharing to plan expense, a completely acceptable way to pay record-keeping expenses and other costs. The funds pay some of the management fee back to the plan and the plan pays the fund administration costs with those fees. As you might expect, low cost index funds usually don’t pay a fee back to the plan and the higher cost funds pay more back to the plan.

Northwestern’s defense was that it “had provided an adequate array of choices, including the types of funds plaintiffs wanted (low-cost index funds).”

The Supreme Court ruled for the employees

“[E]ven in a defined-contribution plan where participants choose their investments, plan fiduciaries are required to conduct their own independent evaluation to determine which investments may be prudently included in the plan’s menu of options. If the fiduciaries fail to remove an imprudent investment from the plan within a reasonable time, they breach their duty.”

The case makes it clear that retirement plan sponsors have a duty to protect employees from making poor investment choices by monitoring and removing those poor choices from the plan menu. Just adding more good options does not make up for leaving bad options in the plan.

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The SEC Has Observed Your Private Funds and the SEC Is Not Happy

On January 27, the SEC’s Division of Examinations published a Risk Alert on the EXAMS staff Observations from Examinations of Private Fund Advisers. The Risk Alert is labeled as a follow up to the 2020 Observations from Examinations of Investment Advisers Managing Private Funds and the 2017 The Five Most Frequent Compliance Topics.

The EXAMS staff breaks their problematic observations into four broad categories:

  1. failure to act consistently with disclosures;
  2. use of misleading disclosures regarding performance and marketing;
  3. due diligence failures relating to investments or service providers; and
  4. use of potentially misleading “hedge clauses

Disclosures

The staff found fund managers not getting consent from their LPACs when required by the fund documents. That seems like a poor choice by those fund managers.

Fund managers were not getting the management fee calculations right during the post-commitment period. Sure, commitment period is easy, just the percentage against the commitment. Post-commitment you typically have to deal with equity invested calculations, impairments and partial sales.

Some funds were diverting from their designated strategy. I see this issue pop up during long term funds. The world ends up in a different place than when the fund originated. You still need to stay within the guard rails.

Marketing Performance

Fund managers like to think they are a unique flower and benchmarks don’t apply to them and their performance needs to be shown in a special way. (That is true.) The problem is stepping over the line and showing it in a misleading way. The Risk Alert points out failures in calculations by using the wrong dates, cherry picking, omitting information on leverage, and not including fees. This is a continuing problem with private funds. It’s been raised by the SEC many times and the SEC is raising the issue again. I don’t think the new Marketing Rule went into enough detail on what the SEC wants.

Due Diligence

“A reasonable belief that investment advice is in the best interest of a client also requires that an adviser conduct a reasonable investigation into the investment that is sufficient to ensure that the adviser is not basing its advice on materially inaccurate or incomplete information.”

Hedge Clauses

The EXAMS staff observed private fund advisers that had included hedge clauses in fund documents that waive or limit the Advisers Act fiduciary duty except for certain exceptions, such as a non-appealable judicial finding of gross negligence, willful misconduct, or fraud. That could violate Section 206(1) and section 206(2) of the Advisers Act. You can’t contract away your fiduciary obligations.

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More Compliance Changes for Private Fund Managers

On Wednesday February 9 the SEC has a full agenda for its meeting and fund managers should pay attention. Here are the matters to be considered:

  1. The Commission will consider whether to propose rules and amendments under the Investment Advisers Act of 1940 (“Advisers Act”) for private fund advisers and whether to propose amendments to the compliance rule under the Advisers Act.
  2. The Commission will consider whether to propose new rules to address cybersecurity risk management for investment advisers and investment companies as well as related amendments to certain rules regarding adviser and fund disclosures under the Investment Advisers Act of 1940 and the Investment Company Act of 1940.
  3. The Commission will consider whether to propose rules and rule amendments under the Securities Exchange Act of 1934 to shorten the standard settlement cycle for most securities transactions.  The proposed rules and rule amendments would be applicable to broker-dealers and certain clearing agencies.  The Commission also will consider whether to propose rule amendments under the Investment Advisers Act of 1940 to require investment advisers to maintain certain related records.
  4. The Commission will consider whether to propose amendments to its whistleblower rules.

For the first item, I don’t have any insight into what is cooking in the SEC’s regulatory kitchen. Whatever is in the oven is coming out hot and for private fund managers. I’m going to guess its related to fees and fee disclosure. I think the Chair Gensler’s November 10 speech at the Institutional Limited Partners Association Summit may give us some insight.

I wonder whether fund investors have enough transparency with respect to these fees. I wonder whether limited partners have the consistent, comparable information they need to make informed investment decisions.
…
That’s why I have asked the staff to consider what recommendations they could make to bring greater transparency to fee arrangements.

I’m going to guess that the SEC is going to propose some kind of standard fee disclosure table for private funds like there is in registered funds.

As for item 2 on cybersecurity, I think we can look at Chair Gensler’s January 24 speech at the Northwestern Pritzker School of Law’s Annual Securities Regulation Institute.

Next, I’d like to discuss the broader group of financial sector registrants, like investment companies, investment advisers, and broker-dealers, beyond those covered by Reg SCI.

As I mentioned earlier, this group has to comply with various rules that may implicate their cybersecurity practices, such as books-and-records, compliance, and business continuity regulations. Building upon that, I’ve asked staff to make recommendations for the Commission’s consideration around how to strengthen financial sector registrants’ cybersecurity hygiene and incident reporting, taking into consideration guidance issued by CISA [Cybersecurity and Infrastructure Security Agency] and others.

I’m guessing we will see an expansion of cybersecurity requirements and reporting of cyber incidents to clients and investors.

We’ll have to tune it find out.

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Changes to Form PF

It’s been a decade since the SEC and FSOC pushed Form PF on to private funds. The SEC has decided it wants more data and has proposed an amendment to Form PF.  

The big change is next day reporting for key events by Large Hedge Fund Advisers and Private Equity Funds 

For large Hedge Funds: 

  • certain extraordinary investment losses 
  • significant margin and counterparty default events,  
  • material changes in prime broker relationships,  
  • changes in unencumbered cash,  
  • operations events, and  
  • events associated with withdrawals and redemptions 

For Private Equity Funds: 

  • execution of adviser-led secondary transactions,  
  • implementation of general partner or limited partner clawbacks,  
  • removal of a fund’s general partner,  
  • termination of a fund’s investment period, or  
  • termination of a fund. 

The purpose is provide more timely information to the SEC and FSOC and presumably signal distress in the markets quicker than the current delayed reporting. 

Commissioner Pierce opposed the changes. She does not think it will actually provide useful information for FSOC. She thinks it’s just a grab by the SEC to enhance enforcement activity and twist the form into micro-management by the SEC. In particular, the one-day period is an incredibly short term for a firm that will likely be focused on trying to resolve issues rather than regulatory reporting.  

Chair Gensler raised the specter of Long Term Capital Management in 1998. He used this as the boogeyman for why the SEC needs such intensive and quick reporting. 

Net assets managed by private funds rose to $11.7 trillion in the first quarter of last year from $5.3 trillion in 2013, SEC data show. There were 6,910 private equity funds with $1.60 trillion in gross assets in first quarter of 2013 and 15,584 funds with $4.71 trillion in gross assets in the fourth quarter of 2020. 

The proposal would reduce the threshold that triggers reporting as a large private-equity adviser to $1.5 billion from $2 billion in assets under management. That would pull approximately 75% of private equity funds into the reporting regime. 

The Form PF still has that clunky definition of a “hedge fund” that leaves fund managers with subscription credit facilities wondering if they might considered a hedge fund.

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Insider Trading Cops

This insider trading case caught my attention because of the local setting. David Forte is an officer with the Needham Police Department. That’s the next town over from my town. I’m such a homer.

One of Forte’s brothers was the Chief Information Officer at Analog Devices. The brother discovered that Analog was going to buy Linear Technology Corporation in a transaction that would inevitably and rapidly raise the price of Linear stock. There was a phone call shortly before the merger between the brothers. Shortly after the phone call, Forte made some very aggressive trades on the stock of Linear.

What are aggressive trades?  Forte bought short-dated out-of-the-money call options on a merger target in an account that had never bought call option before or traded in that stock. I’m sure the compliance officer at Forte’s brokerage flagged the trades and reported them to the regulators as suspicious. The list of suspicious traders got shared with the companies and the shared last names were a sure giveaway.

Forte told two friends who also made aggressive trades and also got caught. All three were arrested and charged criminally for insider trading. 

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The Russian Hack of the EDGAR

A few years ago Ukranians hacked EDGAR to obtain nonpublic earnings information and used that information to trade stocks. The hackers made about $1.4 million and spread that information to associates for about $4.1 million in total profit. Now a bigger hacking plot has been discovered and it has bigger international implications.

The Securities and Exchange Commission brought fraud charges against five Russian nationals for engaging in a multi-year scheme to profit from stolen corporate earnings announcements obtained by hacking into the systems of two U.S.-based filing agent companies before the announcements were made public. These companies helped to “Edgar-ize” documents for filing in the EDGAR system. It looks like the SEC did a good job of securing its systems. This private provider did less so.

It was more lucrative. The SEC claims that the hacking group made over $80 million in profits. Maybe they made better use of the information than the Ukrainians did in their plot. Or maybe the five Russians had more capital.

The Russians hacked into the providers’ public company clients’ filings include, among other things, Forms 8-K and related exhibits, which consist of press releases containing the public companies’ earnings announcements. The Providers’ public company clients can use the platforms to create, edit, and submit their filings to the SEC through the EDGAR filing system. The weak security was at provider instead of the main database.

It looks like the hackers were not just hacking the SEC filings. Some of the five are implicated in the alleged hacking around the 2016 election.

One of them was just scooped up in Switzerland and has been extradited back to the United States for charges. Vladislav Klyushin. He had flown to Switzerland for a ski vacation at the Zermatt ski resort. It looks like US intelligence learned of the travel and had the Swiss pick up Klyushin at the airport. Russia and the US fought over extradition, with the US eventually winning and putting him on plane to face charges.

The five hackers worked at a Russian information technology firm called M-13 that specialized in penetration testing and other services. Looks like they were wearing white hats and black hats.

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The SEC Is Not Happy with Form CRS Disclosures

Before the holidays, the Securities and Exchange Commission issued a Staff Statement Regarding Form CRS Disclosures. It caught my attention because this was a weird form of letting the industry know that the SEC had concerns about practices. Then I noticed that the SEC had created a Standards of Conduct Implementation Committee and this statement was coming from the Committee. I poked around a bit to try to find who sits on the Committee, but haven’t had any luck yet.

Form CRS is the customer relationship summary required to be provided to retail clients of an investment adviser or broker-dealer. This was part of Regulation Best Interest that was adopted in June 2019 and required compliance by June 30, 2020. After a year and a half of use, the SEC is digging in deep and trying to make it work right.

The number one problem was that use of legalese and technical language in Form CRS. I’m sure most of these were written by lawyers or heavily edited by lawyers.

They Committee also found some hedging language stating that their relationship summary “does not create or modify any agreement, relationship or obligation” between the client and the firm. The rule doesn’t allow that.

One deficiency that particularly caught my eye was that some firms were using language from the proposed rule rather than the final rule. The Staff Statement highlight some particular language:

For example, many firms included the proposed conversation starters and/or proposed standard of conduct language (i.e., “We are held to a fiduciary standard that covers our entire investment advisory relationship with you.”) rather than the required language as adopted (i.e., “we have to act in your best interest and not put our interest ahead of yours”).

Regulation was a big change in disclosure for retail firms. I’m sure it is particularly hard for dually registered firms that have some of the more difficult conflicts to disclose. Everyone should expect that Form CRS will be a big focus for SEC examination for the foreseeable future.

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Happy Holidays

I hope your year is coming a happy end and that 2022 will be the best year yet. Or at least better than 2021.

Yes, this a picture of me, with a Santa hat on my bike helmet, wearing an ugly sweater, with tree lights wrapped around. me. You can see my bike in the background with a red nose and antlers mounted on it. We are posing at the famous giant Santa in Coletti-Magni Park. The only thing missing is snow. (I don’t always take myself seriously.)

The Biden Strategy on Fighting Corruption

Yesterday’s story on FinCEN planning new Real Estate Anti-Money Laundering Regulations is just part of the larger plan of the Biden administration’s plan to fight corruption. For more details check out the recently released United States Strategy on Countering Corruption.

This is full of worthy goals. The stability of the US dollar is big lure for dirty money. I have some concerns about overly weaponizing the dollar internationally for fear that some other currency will take over as the de facto currency of the world. Right now, there are no other good candidates.

As for the details on the White House plan, I focused on how it might directly affect me.

One is the return of the 2015 rulemaking to “prescribe minimum standards for antimoney laundering programs and suspicious activity reporting requirements for certain investment advisor.” This time there is a particular focus on hedge funds, trusts, private equity funds and other vehicles. In particular, it looks like there will some focus on operations of private placements.

The White House is also looking at the gatekeepers to transactions: lawyers, accountants, and registered agents. They may hit with some anti-money laundering requirements, both as recordkeepers and targets for enforcement.

As yesterday’s story on real estate pointed out that it has been a tool for laundering money, the White House strategy includes a focus on digital assets and art. Those are two areas that are believed to be exploited by illicit money.

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