Author: Doug Cornelius

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Due Diligence for Politically Exposed Persons

Anti-money laundering 101 is to lookout for for terrorists, drug kingpins and oligarchs. You don’t want to do business with these people because they are on the government enforcement lists. AML 102 is to look out for “politically exposed persons.”

The international Financial Action Task Force defines a “politically exposed person as:

“an individual who is or has been entrusted with a prominent public function. Due to their position and influence, it is recognised that many PEPs are in positions that potentially can be abused for the purpose of committing money laundering offences and related predicate offences, including corruption and bribery, as well as conducting activity related to terrorist financing.”

You’re not barred from doing business with a politically exposed. You just need to be on higher alert to make sure the person is not using pilfered money or funneling money to bad people. The mayor of a small town should probably not be depositing millions of dollars in a personal account.

Last month FinCEN issued a new FAQ on client due diligence. That FAQ eschewed any bright-line testing or standards.

Two weeks ago, FinCEN joined up with the Federal Reserve, Federal Deposit Insurance Corporation, National Credit Union Administration and the Office of the Comptroller of the Currency to issue a joint statement on due diligence for politically exposed persons.

Like the earlier FAQ, this joint release adds very little to the compliance dialog.

“Banks must apply a risk-based approach to CDD in developing the risk profiles of their customers, including PEPs, and are required to establish and maintain written procedures reasonably designed to identify and verify beneficial owners of legal entity customers. More specifically, banks must adopt appropriate risk-based procedures for conducting CDD that, among other things, enable banks to: (i) understand the nature and purpose of customer relationships for the purpose of developing a customer risk profile, and (ii) conduct ongoing monitoring to identify and report suspicious transactions and, on a risk basis, to maintain and update customer information.”

The joint statement does point out that there is no formal definition of a politically exposed person. Agreed.

The joint statement states that US public officials are not “politically exposed persons.” Disagree.

As I said above, the mayor of a small town should probably not be depositing millions of dollars in a personal account. Your financial institution should be keeping a close eye on the mayor to make sure illicit money does not come through you.

Unfortunately, this de-regulatory approach will put the burden on compliance having to push back against client relationship people. You will have to add on additional review to watch whether the politically exposed person breaks bad.

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Changes to the Definition of Accredited Investor

The Securities and Exchange Commission made some small changes to the definition of “accredited investor” last week. The changes had been first proposed last December.

The definition of “accredited investor” is at the nexus of the Securities and Exchange Commission’s missions: (1) to protect investors, (2) to maintain fair, orderly, and efficient markets, and (3) to facilitate capital formation.  If you’re an accredited investor you have access to private offerings. That enables capital formation. Private offerings are not subject to review by the SEC so they have fewer protections in place for investors. The commissioners were split on their votes to approve the changes.

Lots of arguments around the accredited investor definition are about an investor’s ability to assess risk in making the investment. I’ve long argued that the risk with a private placement is not the risk of loss, but the risk of liquidity. Some private placements are very risky and some are not. All private placements are less liquid than publicly traded securities. Tesla is at a crazy price right now, but you can sell and exit out of your position in minutes. You may not be able to exit from a private placement position for years.

The big news in the changes in the definition are the items that are missing. There were no changes to the wealth or income levels for qualification. Those levels have been unchanged for decades, broadening the pool of accredited investors with inflation.

The changes to the definition really just make some small expansions.

The SEC added a new category to the definition that permits qualification based on certain professional certifications, designations or credentials.  In conjunction with the changes, the SEC designated holders in good standing of the Series 7, Series 65, and Series 82 licenses as accredited investors. These are deemed as individuals with an ability to assess risk.

For private funds, there is an application of the “knowledgeable employee” definition over to accredited investor status. The SEC established Rule 3C-5 to allow “knowledgeable employees” to invest in their company’s private fund without having to be a “qualified purchaser”. The rule also exempts these knowledgeable employees from the 100 investor limit under the Section 3(c)(1) exemption from the Investment Company Act. However, the knowledgeable employee had to separately qualify as an accredited investor. This rule change covers that gap.

In act of progressive politics, the SEC added the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors.

“The term spousal equivalent shall mean a cohabitant occupying a relationship generally equivalent to that of a spouse.”

There were additional marginal expansions for some investment entities.

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SEC Continues to Be Concerned About COVID

The Office of Compliance Inspections and Examinations released a new risk alert last week on COVID-19 compliance risks for broker-dealers and investment advisers. OCIE broke the concerns into six categories:

  1. protection of investors’ assets;
  2. supervision of personnel;
  3. practices relating to fees, expenses, and financial transactions;
  4. investment fraud;
  5. business continuity; and
  6. the protection of investor and other sensitive information.

On first impression, that looks like a typical list of things that OCIE is concerned about and that fund managers should be concerned about, with or without trying to deal with COVID. OCIE did a good job of looking at these typical issues through the lens of disruptions caused by the COVID pandemic and fewer (or no) people in the office.

As for the protection of investor assets, OCIE wants firms to make sure someone is checking the mail for correspondence from investors. There has been a rise in phishing attacks, so firms should take additional steps to verify instructions from clients or investors.

Obviously, supervision has become more difficult as workers are now spread between the office and home. A lot of compliance comes from walking around the hallways.

As to fees, OCIE raises the issue that firms are facing financial pressure and may push fees to generate revenue.

There was a wave of fraud from companies purporting to have COVID cures and to be able to supple COVID fighting materials like PPE. Don’t sell them to your clients.

I assume most firms had some form of business continuity plan in place. I would guess that very few specifically addressed what to do during a pandemic. Office fires, people getting hit by a bus, power failures are all in the plan. Pandemics? Less likely.

Protecting personal information is just as important, regardless of where people are working. If you have someone working at home with PII, maybe they need a shredder for documents. Watch for phishing attacks. The usual.

Read all the details in the alert.

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Proration of Expenses and Proving Market Rate

The Securities and Exchange Commission will always be focused on charges to a private fund that get paid to the fund adviser or affiliate. OCIE placed this warning flag in the sand back in 2015. A fund manager has to clearly disclose affiliate fee in the fund documents. If the fee is based on a market rate, the fund manager needs to document the market rate.

The Securities and Exchange Commission fined Rialto Capital Management LLC for misallocating some affiliate costs.

The first failure stated in the SEC order is that Rialto did not properly allocate some expenses between the fund and some co-investment vehicles. It’s not clear what happened from the order. I suspect that some investments had co-investors. Some expense for the investments was paid by the fund rather than the investments. The co-investor was not getting charged for its proportional share and the fund was overpaying its share.

The second failure was not proving that some of its affiliate fees were at market rate. If the fund documents state that a fee will be at or below market rate, then its up to the fund manager to prove it so.

In 2012 Rialto conducted a market rate analysis. However, the firm did not update it from 2013 to 2017.

To compound the problem, Rialto added an 11% overhead factor to the charges for its employees to cover general expenses. Then it increased the factor from 11% to 25% and did not fully disclose this to the funds’ advisory committees.

Although this could have been an accounting oversight, the SEC added in a “willfull” standard to the violation. The SEC also added a hefty fine of $350,000.

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Proposed Regulation of “Finders” in New York

The New York Attorney General has been keeping busy. Yesterday it was a lawsuit against the National Rifle Association. There are the previous lawsuits against the Trump Foundation and the Trump Organization. I missed the April announcement of proposed changes to some of the securities regulations in New York.

One caught my eye and caught the eye of Goodwin Procter lawyers Peter W. LaVigne, Nicholas J. Losurdo, and Jana Steenholdt. New York is stepping into the gray area of regulating finders.

Finders are not quite brokers and not quite investment advisers. They don’t give financial advice. They just have a big rolodex and want it to generate some revenue.

As pointed out by the Goodwin lawyers, the classic case is in the Paul Anka No-action letter. (Yes, the crooner.) He ended up connected with ownership syndicate trying to finance the newly formed Ottawa Senators hockey team. Anka was from Ottawa and was rooting for his home team, but didn’t want to do so for free. He would hand over his rolodex but wanted a cut of the money coming in. Anka also had good lawyers and they asked the Securities and Exchange Commission to bless the arrangement.

Mr. Anka did not:

  • participate in any negotiations between the Senators and any potential investors,
  • make any recommendations to them regarding an investment in the Senators,
  • participate in any advertisement, endorsement, or general solicitation for the investment,
  • participate, in the preparation of any materials relating to the sale or purchase of the investment
  • distribute the materials to any potential investor,
  • perform any independent analysis of the sale,
  • engage in any “due diligence” activities,
  • assist in or provide financing for the investment,
  • provide any advice relating to the valuation of or the financial advisability of such an investment.

He simply let the hockey club contact the people in his rolodex.

New York is interested in finders who did a bit more than Mr. Anka. The proposed definition of a “Solicitor”:

a person who as part of a regular business, engages in the business of providing investment advice to the limited extent that such person receives compensation for introducing a prospective investor or investors to an investment adviser or federally covered investment adviser…

Solicitors are subject to the same registration and examination requirements as investment advisers, and principals and representatives of solicitors are subject to the same registration and examination requirements as investment adviser representatives…

Mr. Anka probably falls outside that definition. He wasn’t in the regular business of making introductions. It may hit many organizations that are in that business.

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SEC Reaction to Form CRS

Registered Investment Advisers had a June 30th deadline for delivery of the new Form CRS to their clients. The forms also need to be filed with the SEC. If you thought the SEC would not look at them, you were wrong.

The SEC’s new Standards of Conduct Implementation Committee has been reviewing the Form CRS submissions to assess compliance with the format and standard requirements of the Form CRS regulations.

It sounds like the Committee is not happy with what it’s seen so far.

The relationship summaries reviewed to date generally reflect effort by firms to meet the content and format requirements of Form CRS….

That sounds like they’re giving out a participation trophy to a lot of firms. A comforting coach thanking players for coming out even though they lost.

Not all are mediocre or bad. The Committee found some good examples with simple, clear disclosure. It intends to find ways to share best practices and feedback. There should be a roundtable in the fall for the Committee’s staff to share ideas.

As for private fund managers, funds are not considered natural persons who would be retail investors under the Form CRS regulation.

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Fund Fee Calculations and Compliance

For investment advisers the key is conflicts. You have to disclose them and property manage them. What is the biggest conflict for an investment adviser?

(The title probably gave it away.) Fees.

This is particularly true for private funds where the investors may not see the actual fee calculation. The basis for the calculation may be complicated to calculate.

I present to you the case of ECP Manager who was the sponsor of a private fund, ECP Africa Fund II PCC. ECP collected management fees from the Fund based on its total invested capital contributions. Under the Fund’s documents, ECP could not take fees for investments that had been written off and had to reduce the fee for investments that have been written down.

In 2010, the Fund obtained warrants on the common stock of an African mining company. The investment didn’t work out and by March 2014, the Fund had valued these warrants at zero. The warrants expired in the next quarter, definitely making them worthless.

Unfortunately for its investors, ECP Manager included $3.41 million of invested capital contributions attributable to those warrants in the three quarters after the warrants expired. Unfortunately for ECP, the SEC discovered the mistake. The SEC estimated the Fund’s investors overpaid $102,304 in management fees to ECP because of the fee calculation mistake.

ECP had to pay make the investors and pay a $75,000 penalty to the SEC.

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New FinCEN FAQs on Client Due Diligence

The Financial Crimes Enforcement Network issued its latest collection of Frequently Asked Questions on the requirements for Customer Due Diligence requirements for Covered Financial Institutions. For anyone looking for decisive answers and bright-line tests, you’ll have to look elsewhere. The answers will leave you wondering why FinCEN even bothered to publish this answers.

Private fund managers and Registered Investment Advisers are not Covered Financial Institutions under the Customer Due Diligence Rule. I believe most adhere to the guidance to make sure they don’t run afoul of FinCEN.

The 2017 Customer Due Diligence Rule did create some bright-line tests on due diligence, particularly for potential investors in private funds that are not individuals. The uncertainty before the rule was how much diligence did you need to conduct on the entity. The 2017 Rule made it clear. You have to collect information on individuals who, directly or indirectly own 25% or more of the equity interests and one individual who has managerial control of the entity.

The new FAQ answers questions in three broad general areas about whether you must conduct additional diligence at opening, risk ratings for customers, and ongoing diligence requirements.

The answers all are squishy answers. It’s up the financial institution to develop policies based on risk. One example:

“There is no categorical requirement that financial institutions update customer information on a continuous or periodic schedule. The requirement to update customer information is risk based and occurs as a result of normal monitoring.”

I’m going to guess that the answers to the questions are not going make compliance officers feel any better. It might just confirm that what they are doing is okay, or at least, not wrong.

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Lots of Private Fund CCOs Wear Multiple Hats

Read some great research by Regulatory Compliance Watch. Bill Myers wrote a story summarizing the Form ADV data for over 4500 private fund advisers. Of that, at least 2800 had more than one job at the firm.

Only 622 listed the title for their CCO as only compliance officer. The most common other hat was CFO, followed by general counsel.

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Support Compliance Building and Fight Cancer

Thank you for reading Compliance Building. It’s been quiet here on the publishing front. Not that compliance is any less important. With the pandemic, I’ve been pulled in several different directions. One direction that has not altered is my commitment to fight against cancer.

The pandemic has cancelled the organized ride part of the Pan Mass Challenge leaving it up to the fundraising riders to “re-imagine” their rides. My imagination has planned a Pan Mass Challenge Week. It kicks off on Saturday with a ride across Massachusetts from the New York border to Boston Harbor. 160+ miles.

If you enjoy Compliance Building, please support this ride and donate: https://donate.pmc.org/DC0176

100% of your donation will go the Dana-Farber Cancer Institute to help in the fight against cancer.

I’ll be back to publishing compliance stories in August.