Author: Doug Cornelius

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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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A Remarkable Decision from the Supreme Court

I’m sure many people are surprised at the decision from the Supreme Court that federal employment discrimination law protects gay and transgender employees. Title VII of the Civil Rights Act of 1964 prohibits employment discrimination “because of sex.”

Even if Congress did not have discrimination based on sexual orientation or transgender status in mind when it enacted the Civil Rights Act over a half century ago, the Supreme Court ruled that Title VII’s ban on discrimination protects gay, lesbian and transgender employees.

If you’ve been involved in discrimination training as part of your compliance program, you know that fewer than half of the states currently ban employment discrimination based on gender identity or sexual orientation. The Supreme Court decision is is a major victory for LGBT employees.

The decision is particularity remarkable given that President Trump has been able to appoint two justices during his term, giving the court what is usually a more conservative tilt, and seeming less likely to expand the interpretation of civil rights laws. President Trump’s first pick to the high court, Neil M. Gorsuch, is responsible for writing decision. I’m sure he’s quit surprised that his pick has written the most impactful ruling for gay rights since same-sex marriage was codified as a constitutional right in 2015.

Importance of Timely Audits for Private Funds under the Custody Rule

The vast majority of private funds use the audited financial statements alternative for compliance with the Custody Rule. Fund managers have custody of the fund assets. Fund investors typically demand audited financial statements from their fund managers. So the audited financial statement work well with the Custody Rule and provides some third-party verification that the manager is not misusing or misappropriating client funds or assets.

The audited financial statements alternative under the Custody Rule has three main requirements:

  1. Have the audit done by an independent public accountant that is registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board,
  2. Distribute the audited financial statements to all investors in the fund, and
  3. Deliver the audited financial statements within 120 days of the end of the fund’s fiscal year.

The SEC just brought an action against a New Jersey fund manager for failing to meet these three requirements of the Custody Rule.

TSP Capital in Summit, New Jersey, has been registered with the SEC as an investment adviser since 2004. TSP Capital was the manager of two private funds. The largest was Cameroon Enterprises.

According to the SEC Order, TSP Capital relied on the Audited Financials Alternative to the Custody Rule but failed to comply with the requirements from 2014 through 2018. For 2014, the audit report was mailed to investors 686 days late; for 2015, the audit report was mailed to investors 927 days late. For the following years, TSP Capital did not succeed in engaging an audit firm to audit the Cameroon Fund’s annual financial statements.

This was likely easy to catch by the SEC. On the Form ADV filing, TSP Capital had to provide information about the fund in question 7.B.(1) Private Fund Reporting. Question 23(a)(1) asks :

“Are the private fund’s financial statements subject to an annual audit?”

TSP Capital answered this as “No.” I’m sure that checking “no” instead of “yes” is a red flag for the SEC.

The SEC made no claim of misuse of clients funds in the order. This was treated merely as a footfault.

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Fund Board Representation and Public Stock

Part of a private equity fund’s investment strategy is getting a seat at the table for a company they own. When that company’s shares also publicly traded, there are heightened compliance concerns. The fund’s management representative is likely to end up with material non-public information. The compliance challenge is to prove that the information does not make it to the fund’s trading desks.

Ares Management just got an SEC fine for failing to stop the information leak.

Based on the SEC order, Ares had invested several hundred million dollars in a public company and had two representatives on a public company’s board. One of those was a senior member of the investment team. This representative had access to:

  • “potential changes in senior management,
  • adjustments to the Portfolio Company’s hedging strategy,
  • efforts to sell an interest in an asset,
  • the Portfolio Company’s desire to sell equity and use proceeds to retire certain debt, and
  • the Portfolio Company’s election, as allowed under the terms of the loan agreement, to pay interest “in kind” and not in cash.”

All of that would reasonably be considered material non-public information. Ares compliance group had trades in the company’s stock under special watch. It had the power to impose information walls, but apparently did not do so in this case.

Ares made follow-on purchases of the company’s stock.

Ares’ compliance staff failed, in numerous instances, to document sufficiently that they had inquired with the Ares Representative and the members of the deal team as to whether any of them had received potential MNPI from the Portfolio Company, or to apply a consistent practice to the inquiries made, resulting in ambiguity whether, or if, inquiries were made in certain instances.

This a classic compliance problem of proving that you don’t know something when the information exists within the firm. As a result, the SEC order takes the position that Ares’ compliance staff “failed to document properly whether they had assessed the extent to which Ares deal team members had any information that had the risk of being MNPI.”

Part of this appears to be the unusual circumstance. Ares does not commonly hold director seats on the boards of publicly-listed companies. The compliance policies and procedures didn’t adequately address the issue and the compliance staff did not adequately document an area of heightened risk.

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The One with the Inflated Loan Values

The Securities Exchange Commission followed up on whistleblowers’ complaints against TCA Fund Management for inflating the value of the assets in its Global Credit Master Fund. In January, investor redemption requests exceeded the liquidity of the fund and it eased operations.

The SEC complaint against TCA Global alleges that TCA was booking fees before they were received.

The SEC claims that TCA was booking loan fees as revenue at the non-binding term sheet stage, instead of when the loan closed. The SEC also claimed that the TCA was booking investment banking fees at the time the firm was engaged and not when the fee was earned . TCA would only be paid if a transaction closed. According to the SEC complaint these practices resulted in over $155 in improperly recognized revenue.

As for the value of the TCA assets, the SEC called it “grim.”

“For 2017 and 2018, the Funds’ auditor issued a qualified opinion with respect to Master Fund’s income and assets, including, for 2018, a qualified opinion with respect to 89% of Master Fund’s NAV. By May 2019, Master Fund had only 5% of its assets in cash, with most of the balance of the assets consisting of amounts owed to Master Fund on loans to thinly capitalized borrowers, a substantial amount of which are in default.”

Strangely, however, the SEC complaint does not accuse TCA of overstating its assets. The whistleblowers accuse the firm of not writing down asset value. I’m not sure why the SEC pulled its punch on the valuation issue.

The other issue that the SEC did not highlight in its complaint is that TCA would likely have been receiving excessive fees from the fund based on the inflated values. I assume the fee had some basis on NAV. With the NAV inflated, the fees would have been inflated.

According to the NBC News story, the problems first surfaced in a 2016 SEC exam. TCA had restated some values as a result of the process. The whistleblowers stepped up when they felt the SEC has missed the full extent of the fund’s misconduct.

Of course, we haven’t heard TCA’s side of the story. I’m just looking at this as a compliance lesson.

Valuation should be the number one issue for compliance in funds with illiquid assets. They are harder to value so more effort should be put into making sure the values can be justified.

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SEC Going After COVID-19 Fraud

There is no greater villain right now that fraudsters trying to profit from the COVID-19 pandemic. The Securities and Exchange Commission is more than willing to go after these bad guys.

Trading Suspension

According to speech last week by Steven Peiken, the SEC’s Co-Chief of Enforcement,  the SEC has suspended trading in the securities of more than 30 issuers as a result of questions about the adequacy and accuracy of coronavirus-related information since early February. .

Do you have masks?

Praxsyn Corporation claimed to be able to obtain large quantities of N95 masks used to protect you from COVID-19. The SEC suspended trading in the company’s shares. It turns out that that Praxsyn had been offered millions of masks from a Mexican company. Turns out the masks were no good.

Do you have test kits?

Applied BioSciences Corp. issued a press release on March 31 stating that it had begun offering and shipping supposed finger-prick COVID-19 tests to the general public that could be used for “Homes, Schools, Hospitals, Law Enforcement, Military, Public Servants or anyone wanting immediate and private results.”

No. The SEC charged that the tests were not intended for home use by the general public and could be administered only in consultation with a medical professional. The SEC further charged that Applied BioSciences had not shipped any COVID-19 tests as of March 31. And furthermore, the SEC charged the company for failing to disclose that the tests were not authorized by the U.S. Food and Drug Administration.

The SEC suspended trading in the company’s securities and is seeking relief.

Do you have a fever?

Turbo Global claimed to have a multi-national public-private partnership to sell thermal scanning equipment to detect individuals with fevers. In a press release with its supposed corporate partner, Turbo claimed the technology is 99.99% accurate.

Turbo Global had no agreement to sell the product, there was no partnership involving any government entities, and the CEO of Turbo Global’s supposed corporate partner did not make or authorize the statements attributed to him. 

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Private Fund Takes a Broadside Hit for Misleading Marketing

When using a track record in marketing materials, compliance officers will focus on the numbers and how they are used to portray prior results. The Securities and Exchange Commission will also scrutinize these results when they inevitably stop by to exam registered fund managers.

Keeping the track record straight is even more difficult for a new firm. Inevitably the principals will want to market their successful investment activity at the legacy firm.

Old Ironsides Energy ran into this problem when marketing its Old Ironsides Energy II fund.

The Securities and Exchange Commission charged the firm with using misleading marketing materials that mischaracterized a large, legacy investment with strong, positive returns. Old Ironsides identified it as an early stage “direct drilling investment” over which Old Ironsides had
direct management in partnership with project operators in its legacy portfolio. However the investment was better characterized as in interest in a private fund advised by a third party.

As you might expect, the private fund’s returns were really good. Also, Old Ironsides Fund II would not be investing in private funds.

It’s not that Old Ironsides couldn’t include that private fund in its returns. It needed to better describe that investment so that potential investors could understand it.

I found it strange that the SEC also include a charge that Old Ironsides failed to implement its policies and procedures. The P&Ps included a provision that:

“prohibited the use of performance results in Old Ironsides’ marketing materials that were false or misleading, including any misleading depictions of investment performance in both form and content leading to direct or indirect implications or inferences arising out of the context of the marketing materials.”

The SEC found that the marketing materials were misleading so the P&Ps were not followed. Is the SEC trying to say that a firm should not have language like that in its P&Ps? Or is just another charge the SEC can pile on when ti finds something it doesn’t like?

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