Author: Doug Cornelius

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

Exchange-Traded Products Initiative

The Securities and Exchange Commission announced a new initiative focused on complex products: The Exchange-Traded Products Initiative. It’s led by the Division of Enforcement’s Complex Financial Instruments Unit. It was developed by Armita Cohen and data analytics specialists Daniel Koster and Jonathan Vogan and has been coordinated by Ms. Cohen.

The first inkling of this initiative was the Morgan Wilshire case in late September. That firm was selling inverse ETFs to its clients. The firm’s representatives were not knowledgeable about the products. The inverse ETF tries to create the opposite returns of an index over a short period of time, typically one day. If held longer, the product stop achieving the originally targeted results.

Like with the earlier case, the five cases announced as part of the Exchange-Traded Products Initiative were complex products but had the patina of simplicity because they were exchange-traded. The products were designed be held in the short-term for limited use.

Instead, the firms were marketing to a broader set of clients and not getting them back out of the product in the short-term. Of course, this means that customers lost money.

The compliance failure was the firms failing to determine if the product was suitable for the client, a lack of training on the product and a lack of appropriate review of the transactions.

Some of this will be increasingly problematic under the new Reg BI standards instead of the older standards for broker-dealers.

Sources:

What’s Wrong at Branch Offices?

The SEC’s Office of Compliance Inspections and Examinations ran a sweep it called the Multi-Branch Initiative. It published a risk alert on November 9 with its findings.

The Risk Alert is mostly a collection of typical compliance problems:

  • Custody of client assets
  • Fees and expenses
  • Oversight and supervision of supervised persons
  • Advertising
  • Code of ethics
  • Portfolio Management
  • Oversight of investment recommendations
  • Mutual fund share class selection and disclosure issues
  • Wrap fee program issues
  • Rebalancing Issues
  • Conflicts of Interest Disclosures
  • Trading and allocation of investment opportunities

A few things were related to the multi-branch or heightened by that geographic spread of offices. The big issue is that policies and procedures were inconsistently applied across offices. That makes me think that the physical presence of compliance personnel may be a positive factor of compliance. A compliance professional once called this “Compliance by walking around.”

Sources:

Combined Financial Statements and the Custody Rule

Advisers to private funds, usually rely on the audited financial statement method to satisfy the Custody Rule. The Chief Accountant’s Office of the Division of Investment Management released a “Dear CFO Letter” last week that raises issues about using combined financial statements to satisfy the custody rule.

You may have missed this possibly important compliance change because this is not a usual source for compliance. Frankly, it’s not easy to find on the SEC Website. Go to the Accounting Matters Bibliography and scroll to the bottom of the page. Let me know if you can otherwise find it on the SEC website.

Paragraph (b)(4) of the Custody Rule permits an adviser to comply with certain aspects of the Custody Rule if an account of a limited partnership (or limited liability company, or another type of pooled investment vehicle) is subject to an annual audit and that audit is distributed to investors within120 days of fiscal year end.

Here is what seems to be the meat of the Dear CFO Letter:

“For purposes of compliance with the audit exception, however, we do not believe an investment adviser can prepare combined financial statements for multiple PIVs in reliance solely on the common management basis in ASC 810-10-55-1B. For example, in the staff’s view, if the economics of each PIV are different and not pro rata (e.g., certain PIVs only participate in certain investments or have differing fee arrangements or rights), the combined financial statements may provide less clarity about an investor’s ownership than if separate financial statements were provided to all limited partners (or members or other beneficial owners) in each PIV.

“The staff believes that if an investment adviser uses combined financial statements to rely on the audit exception, the investment adviser should consider whether:

  • Each PIV has the same management;
  • There is clear evidence of legal ownership of each investment individually with each PIV or there are contractual agreements which clearly show the assignment of investments held on a combined basis to each PIV;
  • Investments and investment gains and losses, including income and expenses, are allocated pro rata to each PIV;
  • Each PIV has the same management fee and performance fee structure (e.g., allocations work on a combined basis, calculated based on one hurdle on the combined basis, including combined fair values and contributions/distributions);
  • The financial highlights are the same for each PIV; and
  • The combined financial statements will
    • Present a statement of changes for each PIV separately and a combined aggregate total; and
    • Provide clear disclosure of each PIV’s pro rata percentage ownership of the combined basis, total commitments of each PIV, and aggregated commitments on a combined basis.”

I think this means that many private fund managers are going to have to revisit their custody analysis. This is going to add on some legal costs and audit costs.

Sources:

Van Halen and Compliance

With the passing of Eddie Van Halen, I thought it appropriate to re-publish this great story about Van Halen and Compliance that I first wrote in 2009. [Spoiler alert] Those brown M&M’s served a real purpose.

You may have heard the story about Van Halen’s banning of brown M&M’s from its dressing room. I chalked it up to the pampered life of rock stars. (Especially, when compared to the more mundane life of a chief compliance officer.)

I just listened to the latest episode of  This American Life which revealed that the provision was not about pampering. It was about compliance.  Host Ira Glass talked with John Flansburgh (from the band They Might Be Giants) and he explained why the M&M clause was actually an ingenious business strategy. They recounted an except from David Lee Roth’s autobiography, Crazy from the Heat:

Van Halen was the first band to take huge productions into tertiary, third-level markets. We’d pull up with nine eighteen-wheeler trucks, full of gear, where the standard was three trucks, max. And there were many, many technical errors — whether it was the girders couldn’t support the weight, or the flooring would sink in, or the doors weren’t big enough to move the gear through.The contract rider read like a version of the Chinese Yellow Pages because there was so much equipment, and so many human beings to make it function. So just as a little test, in the technical aspect of the rider, it would say “Article 148: There will be fifteen amperage voltage sockets at twenty-foot spaces, evenly, providing nineteen amperes . . .” This kind of thing. And article number 126, in the middle of nowhere, was: “There will be no brown M&M’s in the backstage area, upon pain of forfeiture of the show, with full compensation.”

So, when I would walk backstage, if I saw a brown M&M in that bowl . . . well, line-check the entire production. Guaranteed you’re going to arrive at a technical error. They didn’t read the contract. Guaranteed you’d run into a problem. Sometimes it would threaten to just destroy the whole show. Something like, literally, life-threatening.

Van Halen used the candy as a warning flag for an indication that something may be wrong. I see some lessons to be learned.

Diamond Dave talking about those Brown M&Ms

References:

Do What You Said You Would, Or You’re No Longer a CCO

Rule one following a regulatory examination is to implement the changes you told the regulators you said you would. GGHC failed to do so and it was the CCO’s fault. Then the CCO did the worst thing in compliance.

GGHC was duly registered as a broker-dealer and an investment adviser. It used both transaction based fees and annual fees for different accounts.

“As disclosed in its new account documents, GGHC “uses an aggressive growth style of investing . . . . [which] results in significant fluctuations and at times will result in significant losses in the short term.” GGHC also discloses that this type of investment style may involve active portfolio changes and therefore a high turnover, and as a result, the effective annual fee GGHC charges its advisory clients is often higher than the fees charged by comparable advisers. GGHC discloses commissions charged on each of its trades in trading confirmations provided to its clients, either as a separate line item or embedded in the price of the relevant security.”

Churn is a concern with the accounts using the transaction fee model. During a FINRA exam, the regulator wanted GGHC to beef up its review of cost-to-equity ratio and turnover ratios. GGHC agreed and amended its procedures to review cost-to-equity ratios monthly, document the reviews and escalate all accounts with a cost-to-equity ratio above 6%.

The firm amended its procedures but didn’t conduct the reviews. None of the accounts with cost-to-equity above 6% was escalated.

The SEC came in the following year for an examination. As you would expect, the SEC examiners focused on the cost-to-equity reviews. Rather than admit that she didn’t conduct the reviews, the CCO lied and produced doctored documents.

The exam resulted in a referral to enforcement. The CCO also sent doctored documents to the enforcement lawyers lying about the reviews. The CCO was finally subject to sworn testimony and admitted to altering the documents by whiting out the as of date and making later handwritten annotations.

Bad actions. Bad result for the firm and the CCO. The firm got hit with a $1.7 million fine and the CCO got barred.

Sources:

Buy Assets From a Foreign Bank Without Violating the FCPA

A quirky feature of the Foreign Corrupt Practices Act is that you can ask the Department of Justice to opine on whether your proposed action would violate the FCPA. Generally, one or two of these FCPA opinions pop up each year. It’s been a six-year drought since the last one.

Some of the FCPA opinions have provided great insight into how the DOJ thinks about FCPA compliance. This latest is not one of those. I scratch my head wondering why the Requestor even bothered.

The Requestor planned to buy some assets from a state-owned foreign bank. Another subsidiary of that state-owned foreign bank helped with the transaction and wanted to get paid a fee. The opinion was on whether it was okay to pay that fee.

Sure, the parties are state-owned and the people working at them should be treated as government officials under the FCPA for compliance purposes. The FCPA doesn’t prevent US firms from entering into transactions with foreign companies, even if the company is state-owned. You just can’t pay a bribe to the people involved.

There is nothing in the facts that says any individual is getting paid a fee. The money is all going to a company. The opinion includes a statement that the Requestor has no belief that any of the money will be diverted to an individual.

The Requestor received legitimate services from the company, the payment is commensurate with the services and there is no indicia of corrupt offers.

The latest release notes that three prior releases all addressed this topic: 09-01, 97-02, and 87-01. They each had a declination when the payment was going to the government entity and not to an individual.

The fee to be paid was only $237,500. I would guess that the Requestor paid almost as much in legal fees to get the FCPA opinion.

Whatever uncertainty the Requestor had in making the payment I guess has been erased. We can pile this fact pattern into the stack of things that are okay to do.

Sources:

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.

Sources:

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.

Sources:

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.

Sources:

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.

Sources: