Author: Doug Cornelius

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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.

Robbing Peter to Pay Paul

In browsing the charges against Michael Barry Carter, it seemed like a typical case of a financial adviser stealing from his clients. The total amount was large. The math of how much he stole from his clients and how much he pocketed confused me in browsing the two press releases.

The US Attorney’s headline has Mr. Carter stealing $6 million and the SEC’s story says he transferred millions. After reading through the complaint, it seems clear that he was stealing to enrich himself and repay some of the thefts to cover his tracks. The classic scenario of robbing Peter to pay Paul.

Mr. Carter has plead guilty to the US Attorney for the criminal charges. The SEC investigation is continuing.

According to the SEC complaint, Mr. Carter started his misdeeds, sadly, by stealing from an elderly relative in 2007. He accomplished this by falsifying authorization forms, diverting the real account statements and producing fake account statements.

He continued pilfering from other clients.

It ended when one of Mr. Carter’s victims applied for loan and the credit review discovered that an $800,000 line of credit has established at Mr. Carter’s brokerage firm without the victim’s knowledge or permission. The brokerage firm investigated and found that Mr. Carter had transferred millions from his clients without authorization.

In the end, Mr. Carter stole over $6.1 million and pocketed at least $4.3 million of that. The rest was used to pay his other victims to cover his misdeeds, robbing Peter to pay Paul.

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New Risk Alert for Private Funds Probably Portends Coming Exams

The SEC’s Office of Compliance Inspections and Examinations issued a new Risk Alert: Observations from Examinations of Investment Advisers Managing Private Funds.

OCIE highlights three areas of noncompliance in the Risk Alert:

  1. conflicts of interest,
  2. fees and expenses, and
  3. misuse of material nonpublic information.  

OCIE lays out some of the conflicts that are particular to private funds. Allocation of opportunities takes the first spot. A bad thing is allocating limited opportunities to higher fee-paying clients. An ancillary bad thing is not disclosing that allocation policy to investors.

Along with allocation comes co-investment. The Risk Alert notes that some fund managers were not following their co-investment procedures are were not adequately disclosing policies on co-investment.

Some of the more significant deficiencies include unfair allocations of investment opportunities, inequitable fees, insider transactions with service providers and portfolio companies, preferential liquidity rights, secondary transactions, impermissible expenses, valuation, and unlawful access to proprietary systems.   

Fees and expenses have long been a focus for examinations of private funds. To some extent, that was the fault of fund managers. They were less clear about fees and related-party transactions than they should have been. The Risk Alert runs through the typical list of items that fund manager compliance professionals have been focusing on for the last several years.

I would guess that OCIE published the Risk Alert because OCIE is planning to start another round of fund manager exams.  

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SEC and LIBOR Transition

Early this year, the SEC’s Office of Compliance Inspections and Examinations announced its 2020 examination priorities. One item was “Risk, Technology, and Industry Trends.” One risk mentioned was LIBOR transition.

[A]s our registrants and other market participants transition away from LIBOR as a widely used reference rate in a number of financial instruments to an alternative reference rate, OCIE will be reviewing firms’ preparations and disclosures regarding their readiness, particularly in relation to the transition’s effects on investors. Some registrants have already begun this effort and OCIE encourages each registrant to evaluate its organization’s and clients’ exposure to LIBOR, not just in the context of fallback language in contracts, but its use in benchmarks and indices; accounting systems; risk models; and client reporting, among other areas. Insufficient preparation could cause harm to retail investors and significant legal and compliance, economic and operational risks for registrants

https://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2020.pdf

OCIE has followed up with this initiative and released a Risk Alert on LIBOR transition. OCIE indicates that it is starting a sweep of examinations of to assess firms’ preparedness for the discontinuation of LIBOR.

  • The firm’s and investors’ exposure to LIBOR-linked contracts that extend past the current expected discontinuation date, including any fallback language incorporated into these contracts;
  • The firm’s operational readiness, including any enhancements or modifications to systems, controls, processes, and risk or valuation models associated with the transition to a new reference rate or benchmark;
  • The firm’s disclosures, representations, and/or reporting to investors regarding its efforts to address LIBOR discontinuation and the adoption of alternative reference rates;
  • Identifying and addressing any potential conflicts of interest associated with the LIBOR discontinuation and the adoption of alternative reference rates; and
  • Clients’ efforts to replace LIBOR with an appropriate alternative reference rate.

OCIE also included a sample document request list.

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New SEC Commissioner to be Nominated

Commissioner Robert J. Jackson Jr. stepped down from the SEC when his term expired in February, 2020. President Trump had identified his replacement to serve on the Securities and Exchange Commission: Caroline Crenshaw.

Ms. Crenshaw currently serves in the Army JAG Corps and as senior counsel to the SEC. When she first joined the SEC in 2013, she served in the Office of Compliance and Examinations in the Division of Investment Management.

Is she the first SEC examiner to become SEC Commissioner?

From the New York Times

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