Author: Doug Cornelius

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

How to do a Fundraising Incorrectly

Ettro Capital developed real estate. It’s principal, Peter Ettro must have thought that using a private fund to raise some of the capital to finance the investments would be a good idea. He raised over $4 million from 13 investors in ECM Opportunity Fund. The problem is that he made some big fundraising mistakes.

The first category of mistakes was lying to prospective investors.

From April through October 2017, Ettro claimed that the Fund’s net return since inception ranged from as low as 26.4% to as high as 56%, its blended net return since inception exceeded 20%, its realized yield was 18.67%, and its total return was 43.67%. In truth, the fund didn’t have any returns until November 2017 and it wasn’t that good.

Ettro send another investor a description of the projects the fund had in its portfolio. It listed two completed projects that had gained over $900,000 and six projects in progress. It left out a third completed project that had lost over $1.1 million.

Ettro also inflated the size of the portfolio, claiming to invested in over $50 million of real estate projects. The truth was closer to $1.5 million.

The second category of problems was engaging in general solicitation.

Ettro had filed a Form D for the fundraising and checked the “Rule 506(b)” box. That makes it a private offering and prohibits general solicitation and general advertising. Ettro made the fundraising material available on a website. THat included target returns and investor testimonials that all visitors could access.

Ettro tried to fix the problem by filing an amendment to Form D, switching to the “Rule 506(c)” box. That public-private offering allows general solicitation. The big requirement is that you have to take steps to verify the accredited investor status of your investors. Ettro had not done so. At least one investor was not accredited.

Ettro voluntarily returned the management fees back to the fund investors and has to pay a $60,000 fine to the SEC.

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Got Thoughts on Form PF or Private Fund Registration Requirements?

The Securities and Exchange Commission published a list of rules to be reviewed pursuant to the Regulatory Flexibility Act. The publication invites comments on whether the rules should be amended or continued without change. Two items caught my attention.

The first is Form PF. It was adopted in October 2011. The second is the registration requirement imposed on private funds and other Dodd-Frank requirement. That rule and rule amendments was adopted in June 2011.

Does this mean changes are coming?

The Regulatory Flexibility Act (5 U.S.C. 601-612) requires an agency to review its rules that have a significant economic impact upon a substantial number of small entities within ten years of the publication of such rules as final rules. 5 U.S.C. 610(a). The purpose of the review is “to determine whether such rules should be continued without change, or should be amended or rescinded . . . to minimize any significant economic impact of the rules upon a substantial number of such small entities.”

The SEC notes that there were no comments on its initial Regulatory Flexibility Analysis for either rule.

The publication of these opening for comments seems like a pro forma step by the SEC to comply with the Regulatory Flexibility Act and not movement to make regulatory changes. But if the SEC gets comments, maybe it will think about making changes. The link to leave comments is on this page: https://www.sec.gov/rules/other.htm.

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Ignoring Iranian Red Flags

There are a few places around the world that you know you can’t do business with. Iran and North Korea have very strict limitations. If it pops up that your business partner wants to ship your products to one of these countries, it’s time to get legal and compliance on the phone before you agree to that sale.

UniControl, Inc., a manufacturer of process controls, airflow pressure switches, boiler controls, and other instrumentation, based in Ohio ran into this problem and violated the Iranian Transactions and Sanctions
Regulations.

From 2013 to 2017, UniControl exported 21 shipments of air pressure switches, valued at $687,189,
to European company that were subsequently reexported the shipments to Iran. U.S. Department of the Treasury’s Office of Foreign Assets Control took action against UniControl because it failed to take appropriate steps in response to multiple warning signs that its goods were being reexported to Iran.

Early in their relationship, one of these European trade partners told UniControl that it had a significant market for UniControl’s goods in Iran and inquired whether UniControl could serve as a supplier. UniControl rightfully said “no.” It otherwise didn’t take any steps to ensure the re-shipment to Iran would not actually happen.

UniControl really screwed up when it entered into a sales representative agreement with a European trade partner that explicitly listed Iran as a target for sales. UniControl employees met with the partner at a trade conference and met with Iranian nationals at the partner’s booth.

The last step was a request from the trade partner to remove the “Made in the USA” label from the products. “The European trade partner explained that the Iranian end-user may have problems with the stated origin of the products.” The company engaged outside counsel to figure out how much trouble it was in. Sadly, it still sent some of the shipments.

What saved the company was largely self-reporting the problem and investing in a more robust compliance program.

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Subscription Credit Facility Fraud

Lots of private equity funds use a line of credit to fund acquisitions. It’s quicker to draw on the line than to call equity from investors. That line of credit is secured by the capital commitments to the private equity fund. Later the private equity fund calls the capital for the acquisition and pays down the line of credit. According to a criminal complaint a private equity fund manager is accused of forging subscription documents and an audit letter to get a line of credit.

JES Global was registered with the Securities and Exchange Commission as an Exempt Reporting Adviser. Its principal, Elliot Smerling, committed blatant fraud. It may have future implication for private funds and the work that will go into setting up a credit facility.

Elliot Smerling had an empire of private equity funds and reportedly lived a lavish lifestyle, with homes in Florida, New York and Brazil with a collection of luxury cars. Smerling is accused of committing fraud to keep his complex financial operation afloat, according to the criminal charges.

He set up a credit facility with Silicon Valley Bank for one of his funds. He handed the bank two subscription agreements. One purported a $45 million commitment from a New York University endowment and a second purported to be $40 million from an investment manager. The criminal complaint did not identify the two purported investors. Smerling is also accused of submitting a forged audit letter and a falsified bank statement showing a wire transfers from the purported investors.

According to the criminal complaint, Smerling produced fake documents. The University endowment has no record of the document or the wire and the signature does not match the CIO of the endowment. The investment manager has no record of the document or the wire and the signature does not match. The audit firm named on the audit letter was not engaged by Smerling or the fund. The address on the letterhead of the audit letter is an address that the firm has not operated at for several years.

This is the first time that I’ve heard of subscription facility fraud. I expect that there may be changes to the lending process

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Affiliate Funds Shuffling Funds

George Heckler, of Charleston, South Carolina, operated a decade-long fraud through three private hedge funds, Cassatt Short Term Trading Fund LP (Cassatt), CV Special Opportunity Fund LP (CV Special), and Conestoga Holdings LP (Conestoga). This fraud caught my attention because my brother and mom both live in South Carolina.

Heckler’s initial fund was Conestoga, which was formed in 1998. Unfortunately, the fund had a big investment in an illiquid investment and that investment went south, resulting in millions of dollars in losses.

Rather than admit to the problem, Heckler raised new cash to pay off Conestoga investors looking to exit. He raised the additional funds, in part, to repay the Conestoga investors. He convinced a fund administrator to help him with the fraud. He used the Cassat and CV Special capital raises to pay off investors in Conestoga. He falsely stated in those fund financial statements that the funds were properly invested.

Although Heckler has not agreed to the SEC charges, he did plead guilty to the criminal charges brought by the Department of Justice.

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SEC’s ESG Task Force


The Securities and Exchange Commission announced the creation of a Climate and ESG Task Force in the Division of Enforcement. The Division of Corporate Finance announced an enhanced focus on climate-related disclosures in public filings. The Division of Examinations announced a focus on climate-related risks as part its 2021 examination priorities. Sounds like all of the SEC has turned to ESG and climate issues over the last two weeks.

Or not.

Commissioner Hester M. Peirce and Commissioner Elad L. Roisman issued a joint public statement calling into question these climate/ESG initiatives.

“What does this ‘enhanced focus’ on climate-related matters mean?  The short answer is: it’s not yet clear.  Do these announcements represent a change from current Commission practices or a continuation of the status quo with a new public relations twist?  Time will tell.”

As the two commissioners point out, the Commission has not voted on any new standards or expectations relating to climate-related disclosure. They also point (as I did) although there is a big headline for climate issues in the press release for the 2021 examination priorities, there is little mention of it in the actual publication. As for the Enforcement Task Force, its clear these two commissioners are not on board.

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Investment Adviser Marketing Rule Finally Published

After sitting in limbo for three months, the Securities and Exchange Commission finally published the Investment Adviser Marketing Rule in the Federal Register on March 5, 2021. That makes the effective date May 4, 2021 and the compliance date 18 months after that (October November 4, 2022).

So far I’ve not heard any information on why the extended delay. There were rumors of changes to the rule under the new Chair of the SEC. There were rumors of combing the publication with the rescission of some of the 50 years worth of no-action letters and other guidance. The rumors were apparently not true.

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Risk Alert on Digital Asset Securities

The Securities and Exchange Commission’s Division of Examination has been visiting firms that have been involved in digital assets. The Division published a Risk Alert that you should read if your firm has digital assets in client accounts.

Right off the bat, the risk alert hedges on its definition of “digital assets” to say that it a particular digital asset may or may not be a security. I believe the SEC’s current position is that BitCoin is not a security. Everything else it potentially a security.

There is the usual expected requirements for investment advisers and fund managers: books and records, disclosure and custody.

Custody continues to be one of the most difficult aspects of putting digital assets in client accounts. Have fun trying to meet the custody rule requirements. Even if you do, the security around digital asset keys should keep you up at night. That’s true for Bitcoin as well, even though its not a security.

One highlight was due diligence and evaluation of the risks involved in digital assets. You really need to vet these investments like you would any other investment recommendation. I like this example of required diligence:

“that the adviser understands the digital asset, wallets, or any other devices or software used to interact with the relevant digital asset network or application, and the relevant liquidity and volatility of the digital asset)”

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Division of Examination 2021 Examination Priorities

The Securities and Exchange Commission’s Division of Examinations has published its 2021 examination priorities.

The big headline is a greater focus on climate-related risks as part of information security and operational resiliency.

“Building on the efforts noted above concerning our business continuity plan outreach related to the pandemic, the Division will shift its focus to whether such plans, particularly those of systemically important registrants, account for the growing physical and other relevant risks associated with climate change. The scope of these examinations will be similar to the post-Hurricane Sandy work of the Division and other regulators, with a heightened focus on the maturation and improvements to these plans over the intervening years. As climate-related events become more frequent and more intense, we will review whether systemically important registrants are considering effective practices to help improve responses to large-scale events.”

The other big focus looks like it will be Regulation BI and Fiduciary Duty compliance.

“The Division will focus on compliance with Regulation Best Interest, Form CRS, and whether registered investment advisers have fulfilled their fiduciary duties of care and loyalty. The Division will examine whether firms are appropriately mitigating conflicts of interest and, where necessary, providing disclosure of conflicts that is sufficient to enable informed consent by retail investors.” 

The new addition to the priorities is looking at LIBOR.

“The Division will continue to engage with registrants through examinations to assess their understanding of any exposure to LIBOR, their preparations for the expected discontinuation of LIBOR and the transition to an alternative reference rate, in connection with registrants’ own financial matters and those of their clients and customers.”

The rest looks like perennial items that a carry-over from the 2020 Examination Priorities.

Private funds are still on the list. The Division will always been focused on the disclosure of fees and conflicts for private fund managers. The Division detailed some very specific types of funds that are in its crosshairs.

One is private funds that invest in structured products, such as collateralized loan obligations and mortgage backed securities. The Division wants to see if these funds have higher risk of non-performing loans and loans with higher default risk. Fund mangers need to be sure that the default risk is being disclosed to investors. Sounds like the Division is going to be very focused on those disclosures.

The Division highlighted four other private fund specific items:

  1. preferential treatment of certain investors by advisers to private funds that have experienced issues with liquidity, including imposing gates or suspensions on fund withdrawals;
  2. portfolio valuations and the resulting impact on management fees;
  3. adequacy of disclosure and compliance with any regulatory requirements of cross trades, principal investments, or distressed sales;
  4. conflicts around liquidity, such as adviser led fund restructurings, including stapled secondary transactions where new investors purchase the interests of existing investors while also agreeing to invest in a new fund.

That last one looks very specific. I suspect the SEC has found some fund restructurings that it doesn’t like. Those may be more prevalent as a result of the pandemic.

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The New Advertising Rule for Private Funds and Investment Advisers Is Still Sitting

As an early Christmas present, the Securities and Exchange Commission approved a new marketing rule on December 22, 2020. This was after a vote on the rule was suddenly canceled at an open meeting the week prior.

Now we are two months after approval of the rule, but it hasn’t yet been published in the Federal Register. So it’s not effective yet and the long runway for compliance has not been laid out.

What’s going on?

The Biden administration imposed a regulatory freeze. It’s not legally binding on Securities and Exchange Commission. Perhaps the SEC is embracing the freeze even though its not required.

In connection with the new Marketing Rule the SEC stated that it was reviewing the 60 years of guidance and no-action letters that have governing marketing under the old advertising rule. Perhaps the erasure of that guidance will be part of the final publication.

Otherwise, the SEC is giving us time to re-read the new Marketing Rule and thinking about the roadmap.

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