Author: Doug Cornelius

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New Restrictions on Foreign Ownership of Real Estate

On September 17, 2019, the U.S. Department of the Treasury issued proposed regulations to implement the Foreign Investment Risk Review Modernization Act of 2018 (FIRRMA). The proposed regulations would expands the jurisdiction of the Committee on Foreign Investment in the United States (CFIUS) to review foreign investments and mitigate any potential national security concerns regarding some technology and real estate

The proposed regulations extend CFIUS jurisdiction to cover the purchase or lease by, or a concession to, a foreign person of real estate in and/or around specific airports, maritime ports and military installations. The locations are listed in an annex to the proposed rules. 

The description of the rights given to the foreign person or entity under the definition of a real estate transaction reads like a law school class on property. The foreign person must be given three or more of the following property rights:

  • the right to physically access,
  • the right to exclude others from access,
  • the right to improve or develop or
  • the right to affix permanent structures or objects.  

The specific restricted areas are:

  1. Within one mile of any of the 100 identified military installations
  2. Within 99 miles of any of 32 identified military installations
  3. Any county or other geographic area identified in connection with certain Air Force bases located in Colorado, Montana, Nebraska, North Dakota, and Wyoming;
  4. Any part of 23 identified military installations and located within 12 nautical miles of the U.S. coast
  5. Located within or will function as part of an airport or maritime port

Looking at my headquarters in New England, Hanscom Air Force Base is listed in Part 1, restricting subjecting any foreign ownership within 1 mile of the base to CFIUS oversight. I have to admit that I don’t know the exact boundaries of the base, just the general area. But just staring at the map, it looks like there is a whole lot of real estate, including a stretch of Interstate 95 that will fall into that review area.

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Not Even Trying To Be Compliant

I don’t like compliance officers being dragged into enforcement actions. If they are involved in the wrongdoing or are just a wholesale failure at compliance, I understand why.

Elliot Daniloff a/k/a Ilya Olegovich Danilov was the chief compliance officer of ED Capital Management, LLC, and its managing member and owner. The firm was a registered investment adviser. The parties consented to the SEC Order,

According to the SEC’s order, from fiscal years 2012 through 2016, the firm failed to distribute annual audited financial statements prepared in accordance with Generally Accepted Accounting Principles, to the investors in the largest private fund that it advised. Without the audited financial statements, the firm was repeatedly violating the Custody Rule.

It’s not that the firm didn’t try. It had engaged a PCAOB-registered firm for a few years to conduct an audit. The auditor couldn’t complete the audit and stated that it was “not able to obtain sufficient appropriate audit evidence to provide a basis for an audit opinion” and therefore did “not express an opinion” on whether the fund’s financial statements were prepared in accordance with GAAP. A disclaimer of opinion does not constitute the performance of an audit in accordance with Generally Accepted Auditing Standards and therefore doesn’t meet the compliance obligations of the Custody Rule.

The firm didn’t want to flag that deficiency in its Form ADV by failing to check the box that it sent out audited financial statements. The SEC’s order finds that Daniloff, on behalf of ED Capital, signed and filed annual Forms ADV that falsely stated that ED Capital did distribute audited financial statements to the fund’s investors.

The SEC’s order also finds that ED Capital failed to have written policies and procedures reasonably designed to prevent violations and failed to conduct the requisite annual reviews of its written policies and procedures. It’s not clear if it had any.

The mention to Daniloff as CCO is in part because he was also the firm’s principal and wearing more than one hat. It seems like he should have given the CCO hat to someone else.

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Compliance Bricks and Mortar for September 20

These are some of the compliance-related stories that recently caught my attention.

How to Ace Compliance Interviews: Advice for the Next Generation of Compliance Officers
by Mary Shirley
Corporate Compliance Insights

Your hard work tailoring applications to the job and company has paid off and you’ve been invited to interview. Congratulations on being shortlisted! How do you increase your chances of clinching an offer? Here are share some tips for how to maximize this opportunity to shine and avoid common issues experienced in the interview process that may detract from your talents.

https://www.corporatecomplianceinsights.com/advise-compliance-interviews/

The Problem of Algorithmic Corporate Misconduct
by Mihailis E. Diamantis
NYU Law’s Compliance & Enforcement

Technology will soon force broad changes in how we conceive of corporate liability.  The law’s doctrines for evaluating corporate misconduct date from a time when human beings ran corporations.  Today, breakthroughs in artificial intelligence and big data allow automated systems to make many business decisions like which loans to approve,[1] how high to set prices,[2] and when to trade stock. [3]  As corporate operations become increasingly automated, algorithms will come to replace employees as the leading cause of corporate harm.  The law is not equipped for this development.  Rooted in an antiquated paradigm, the law presently identifies corporate misconduct with employee misconduct.  If it continues to do so, the inevitable march of technological progress will increasingly immunize corporations from most civil and criminal liability.

https://wp.nyu.edu/compliance_enforcement/2019/09/16/the-problem-of-algorithmic-corporate-misconduct/

Accounting Firms, Private Funds, and Auditor Independence Rules
by David E. Wohl
Harvard Law School Forum on Corporate Governance and Financial Regulation

The SEC recently charged a large public accounting firm (Accounting Firm) with violations of its auditor independence rules (Independence Rules) in connection with more than 100 audit reports involving at least 15 audit clients, including several private funds. [1] According to the SEC’s order, the Accounting Firm represented that it was “independent” in audit reports issued on the clients’ financial statements. However, the SEC found that the Accounting Firm or its affiliates provided prohibited non-audit services to affiliates of those audit clients (including to portfolio companies of the private funds), which violated the Independence Rules. The prohibited non-audit services included corporate secretarial services, payment facilitation, payroll outsourcing, loaned staff, financial information system design or implementation, bookkeeping, internal audit outsourcing and investment adviser services. The SEC also found that certain of the Accounting Firm’s independence controls were inadequate, resulting in its failure to identify and avoid these prohibited non-audit services.

https://corpgov.law.harvard.edu/2019/09/18/accounting-firms-private-funds-and-auditor-independence-rules/

Financial planners join battle over SEC’s Regulation BI
by Mark S. Nelson, J.D.
Jim Hamilton’s World of Securities Regulation

XYPN’s complaint, filed in the federal court in the Southern District of New York, tells a remarkably similar story to the complaint by eight state attorneys general filed days earlier. Both complaints lament that the distinctions between investment advisers and broker-dealers have become increasingly blurred and that Regulation BI does little to clarify those differences. Both complaints note that a majority of the Commission, in adopting Regulation BI, disregarded the recommendation of SEC staff who conducted the Dodd-Frank Act-mandated study that the Commission impose a uniform fiduciary duty without regard to the financial interests of a broker-dealer. 

https://jimhamiltonblog.blogspot.com/2019/09/financial-planners-join-battle-over.html

Is Fraud Contagious Among Financial Advisors?

Yes.

Perhaps it’s useful to have some data behind that “yes.”

Stephen G. Dimmock, William Christopher Gerken, and Nathaniel Graham looked at 477 financial firm mergers between 1999 and 2011 with multiple branch offices in overlapping cities. They used Form U4 to identify mass transfers of employees in the same city. They also used the disciplinary data from the U4 to measure misconduct in the newly merged offices where there had been overlapping offices. They could use the non-merged offices as control groups.

The study found evidence of co-worker influence on misconduct committed by financial advisors, controlling for merger-firm fixed effects and using changes to an advisor’s co-workers due to a merger. They determined that a financial advisor is 37% more likely to commit misconduct if his new co-workers have a history of misconduct.

Additional tests show that co-worker influence is asymmetric. There is evidence of contagion in misconduct, but no significant evidence of contagion in good conduct.

Bad seeds spread their badness.

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More Insight on 3(c)5

Dodd-Frank created a new legal definition for a “private fund” as pooled investment vehicles that are excluded from the definition of “investment company” under the Investment Company Act of 1940 by section 3(c)(1) or 3(c)(7) of that Act. Real estate funds managers have used these standards because they are bright-line tests. It also skirts around the issue of whether the fund is investing in “securities” and “what is a security”.

Real estate fund managers have also looked at 3(c)5 and wondered if they can rely it as an exclusion under the Investment Company Act:

(5) Any person who is not engaged in the business of issuing redeemable securities, face-amount certificates of the installment type or periodic payment plan certificates, and who
is primarily engaged in one or more of the following businesses:
… (C) purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.

In 2017, Redwood Trust obtained a no-action letter from the SEC that the credit risk transfer certificates that the firm held would be allowed under 3(c)5.

On August 15, 2019, Redwood Trust, Inc. obtained another no-action letter for their mortgage servicing rights (MSRs) and cash proceeds.

In reviewing eligibility for the Real Estate Exception, the SEC has

taken the position that the exclusion in Section 3(c)(5)(C) may be available to an issuer if: at least 55% of its assets consist of “mortgages and other liens on and interests in real estate” (called “qualifying interests”) and the remaining 45% of its assets consist primarily of “real estate-type interests;” at least 80% of its total assets consist of qualifying interests and real estate-type interests; and no more than 20% of its total assets consist of assets (“miscellaneous assets”) that have no relationship to real estate (these factors together, the “Asset Composition Test”). .

In a no-action letter issued to Great Ajax Funding, the SEC staff acknowledged that an issuer that acquires whole mortgage loans may acquire certain other assets as a direct result of being engaged in the business of acquiring whole mortgage loans and that those assets might also be indicative of the issuer being in the business of acquiring whole mortgage loans.

For Redwood, the SEC staff ruled that the MSRs could be qualifying interests for purposes of the Asset Composition Test in utilizing Section 3(c)(5)(C) because “such assets are acquired as a direct result of the issuer being engaged in the business of purchasing or otherwise acquiring whole mortgage loans. “

The other problem that Redwood asked for no-action on was cash proceeds from selling the real estate interests. The SEC state that:

“An entity may treat cash proceeds from asset dispositions as Qualifying Real Estate Assets or Real Estate-Related Assets if, prior to such dispositions, such assets were themselves Qualifying Real Estate Assets or Real Estate-Related Assets, respectively. “

The Staff did qualified the cash proceeds. The relief applies only if the company only holds it for less than 12 months from receipt. The company then needs to reinvest it or distribute it.

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Compliance Bricks and Mortar – JDRF Edition

I want to thank the many readers of Compliance Building who donated to my Pan Mass Challenge ride that raised money to fight cancer.

jdrfThis weekend I’m entered in another charity bike ride. This 100-mile ride in Saratoga Springs is to raise money for the Juvenile Diabetes Research Fund. My teenage son was hospitalized and diagnosed with Juvenile (Type 1) Diabetes last year. This auto-immune disease makes him insulin dependent. JDRF was incredibly helpful in getting him, and my family adjusted to treating this disease. JDRF is also instrumental in funding research to treat and someday, hopefully, to find a cure. If you are interested in donating to this cause, you can do so here: http://www2.jdrf.org/goto/dougcornelius

Here are some of the compliance-related stories that recently caught my attention.

Seven States Sue SEC on Concern Broker Rule Is Weak
by Dave Michaels
Wall Street Journal

The lawsuit, filed in Manhattan federal court by the states’ Democratic attorneys general, illustrates how a rule intended to protect mom-and-pop investors has become a political lightning rod for the Securities and Exchange Commission. The states and consumer advocates generally insist the rule is too weak to help clients, while the SEC says it improves investor protections while preserving the broker-dealer industry’s business model.

https://www.wsj.com/articles/seven-states-sue-sec-on-concern-broker-rule-is-weak-11568085859?shareToken=stcedbf5af4b864c7cb3da065fd94f41b4

How Kim Kardashian Helped Get Ex-Billionaire Raj Rajaratnam Out Of Jail
by Lisette Voytko

About two years before the end of his 11-year prison sentence for insider trading, ex-billionaire hedge fund manager Raj Rajaratnam was quietly released to house arrest, thanks to a new federal law that Kim Kardashian had lobbied President Trump to sign.

https://www.forbes.com/sites/lisettevoytko/2019/09/10/how-kim-kardashian-helped-get-ex-billionaire-raj-rajaratnam-out-of-jail/#66fc79b77a5f

The Current State of the Compliance and Internal Audit Partnership
by Matt Stankiewicz
SCCE’s

Compliance officers and internal auditors are natural partners and allies in the compliance governance landscape.  As the compliance profession and influence grew, compliance officers often leaned on internal auditors for help in assessing risks, uncovering financial misconduct, and assessing compliance functions and controls.  Recently, however, I have noticed some changes in their relationship, suggesting that they both are maturing and gaining independence from each other.

http://complianceandethics.org/the-current-state-of-the-compliance-and-internal-audit-partnership/

SEC Chairman Talks Main Street Investors, Foreign Corruption, and Market Issues at the New York Economic Club

My remarks will proceed in three parts.  First, an overview of some of our recent initiatives.  Second, some observations on our efforts to combat offshore corruption, including the undesirable effects of a continuing lack of global coordination and commitment in this area.  And third, a discussion of some of the current market issues we are monitoring.  In addition, because this is the “Economic” Club, and more because I enjoy acknowledging the insights the field of Economics has provided us, I will mention some of the economic tenets and related luminaries we reference from time to time.  For example, when we discuss issues of leverage and capital structure more generally, I will turn to our Chief Economist, S.P. Kothari, and say something like “Miller Modigliani.”  Generally, S.P. smiles back.  I know better than to ask if he’s just humoring me.   

https://www.sec.gov/news/speech/speech-clayton-2019-09-09

The Whistleblower Whisperer
by Jacob Goldstein
NPR’s Planet Money

Jordan Thomas is one of the top whistleblower lawyers in the country. When people on Wall Street see some kind of financial wrongdoing and want to report it, they can work with him to bring evidence to the SEC anonymously. Tips his clients have brought to the SEC have led to huge cases against some of the biggest banks in the world.

https://www.npr.org/2019/05/29/728001911/episode-916-the-whistleblower-whisperer

Study Law to Advance Compliance Career?
by Matt Kelly
Radical Compliance

The other day I was speaking with a compliance professional who had taken a few years to pursue other ventures, and is now looking to get back into the field. She’s been having some frustrations with her job search, and asked: Is there a new trend of companies demanding a law degree for compliance work? Would it be wise for her to return to law school for a non-JD program if she wants to resume her career? 

http://www.radicalcompliance.com/2019/09/05/study-law-advance-compliance-career/

Live Well by Marking Up Your Assets

Live Well Financial found a great way to make money. Mark up your assets, gets loans on the inflated values, buy more assets, mark them up, gets loans on the inflated values, buy more assets, and so on and so on. But it’s only great until a lender wants its money back.

Live Well Financial, Inc., is (was?) a reverse mortgage originator and the owner of an investment portfolio of bonds. It’s CEO came up with scheme that he called, in his own words: “a self-generating money machine.”

The Securities and Exchange Commission didn’t like the scheme and brought charges. Live Well is disputing the charges. I’m taking the SEC’s charges at face value so that I (and also you) can see what the SEC doesn’t like.

Live Well used a lot of leverage, 80%-90% of the value of its bond holdings. With so much leverage, its banks would issue margin calls when the values decreased. Those values were determined by an unnamed third party pricing service who determined them independently.

To give some financial stability and to avoid margin calls, Live Well somehow convinced the Pricing Service to use the prices Live Well supplied to them. Of course, that stopped the pricing fluctuations and margin calls. It seems the lender were not informed of this change in pricing determination.

According to the SEC, Live Well abused that new pricing relationship by inflating the valuations. At times Live Well was able to obtain financing that exceeded the market value of the bonds. Live Well’s lenders thought that the Pricing Service independently determined the values of the bonds, and that the lenders were not aware that the Pricing Service had become a mere pass-through for Live Well’s purported valuations.

After Live Well began submitting its valuations to the pricing service, Live Well’s reported value of its portfolio grew from $71 million to $324 million after eight months, and then $570 million two months later. This growth was in part the result of new bond purchases that Live Well had made with loan proceeds without contributing its own capital.

It all came to a crashing end when Live Well’s lenders wanted to get repaid.

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New Guidance On Proxy Voting Responsibilities

Investment advisers are often stuck with voting of equity securities on behalf of their clients. This falls under the investment advisers’ duties of care and loyalty with respect to services undertaken on the client’s behalf, depending on the authority granted to the adviser. The Securities and Exchange Commission issued two sets of interpretive guidance last month on proxy voting: one targeted at proxy advisory firms under the proxy solicitation rules, and the other targeting investment advisers and their proxy voting responsibilities.

In the first, proxy voting advice provided by proxy advisory firms will generally constitute a “solicitation” under the federal proxy rules.

The second is guidance to Rule 206(4)-6.

[I]t is a fraudulent, deceptive, or manipulative act, practice or course of business within the meaning of section 206(4) of the Act (15 U.S.C. 80b-6(4)), for you to exercise voting authority with respect to client securities, unless you: (a) Adopt and implement written policies and procedures that are reasonably designed to ensure that you vote client securities in the best interest of clients …

According to the guidance, the Rule requires when an an investment adviser has assumed the authority to vote on behalf of its client, the investment adviser must have a reasonable understanding of the client’s objectives and must make voting determinations that are in the best interest of the client. Therefore, an investment adviser has to form a reasonable belief that its voting determinations are in the best interest of the client, by conducting an investigation reasonably designed to ensure that the voting determination is not based on materially inaccurate or incomplete information.

An investment adviser is not required to vote on every matter presented to stockholders.

Using proxy advisory firms, may mitigate an investment adviser’s potential conflict of interest, it does not relieve that investment adviser of (1) its obligation to make voting determinations in the client’s best interest, or (2) its obligation to provide full and fair disclosure of the conflicts of interest and obtain informed consent from its clients.

It’s worth noting that this is formal guidance from the Commission and not guidance from the Investment Management Division or other staff guidance. It’s also not a new rule. It’ formal guidance further explaining the Rule.

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SEC Is Not Happy With How Firms Are Handling Principal Trading and Agency Cross Trading

The SEC’s Office of Compliance Inspections and Examinations issued a Risk Alert describing failures by investment advisers to comply with regulatory requirements when engaging in principal and agency-cross transactions.  OCIE found that many advisers did not even recognize that they were engaging in (1) a principal transaction by buying or selling to a client or (2) an agency cross transaction when the adviser is acting as a broker for other than the client. 

Advisers Act Section 206(3) makes it unlawful for any investment adviser, directly or indirectly, acting as principal for his own account knowingly to (a) sell any security to a client or (b) purchase any security from a client (“principal trades”), without disclosing to such client in writing before the completion of such transaction the capacity in which the adviser is acting and obtaining the consent of the client to such transaction. Section 206(3) requires an adviser entering into a principal trade with a client to satisfy these disclosure and consent requirements on a transaction-by-transaction basis. Blanket disclosure and consent are not permitted.

Two of the items mentioned related to private funds. Advisers that effected trades between advisory clients and an affiliated pooled investment vehicle, but failed to recognize that the advisers’ significant ownership interests in the pooled investment vehicle would cause the transaction to be subject to Section 206(3).

Staff in the Division of Investment Management has stated its view that Section 206(3) does not apply to a transaction between a client account and a pooled investment vehicle of which the investment adviser and/or its controlling persons, in the aggregate, own 25% or less. If the adviser owns more than 25% of the fund, it’s likely considered to a “principal” of the adviser under 206(3)

Second, OCIE noted advisers that effected principal trades between themselves and pooled investment vehicle clients, but did not obtain effective consent from the pooled investment vehicle prior to completing the transactions. The SEC has brought charges against an adviser to a pooled investment vehicle failed to obtain effective consent to principal trades because the review committee established by the adviser to approve the pricing of the trades in an attempt to satisfy the requirements of Section 206(3) was itself conflicted.

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Compliance Bricks and Mortar for September 6

These are some of the compliance-related stories that recently caught my attention.

The Houston Texans and (How Not To Do) Long Term Compliance Strategy
Tom Fox
FCPA Compliance & Ethics

Yet as idiotic as the giveaway of Clowney was, it was only the opening move. Later that day, the Texas traded not one No. 1 pick, not two No. 1 picks but two No. 1s and one No. 2 for two players from Miami. The first was Laremy Tunsil, a starting left tackle (i.e. the blind side), a backup receiver, and a fourth and sixth round pick. According to Albert Breer, writing in Sports Illustrated’s MMQB, “barring more big trades, Houston will go through three draft cycles in four years (2018, ’20, ’21) without picks in the first two rounds.”

http://fcpacompliancereport.com/2019/09/houston-texans-not-long-term-compliance-strategy/

Compliance is a Team Sport
by Mike Fabrizius
SCCE’s The Compliance & Ethics Blog

Team sports provide us with many organizational analogies, and none better than football. The successful elements of the defensive dimension of football provide some strong parallels to healthcare compliance. In both cases the goal is to improve the chances of success by preventing costly mistakes that can damage the team’s record and standing.

http://complianceandethics.org/compliance-is-a-team-sport-2/

Killing LIBOR: A Victory for Irrational Rectitude
by Rick Jones
Crunched Credit

The US economy is about to pay the butcher’s bill for a massive disruption of worldwide financial markets resulting from the elimination of the London Interbank Offered Rate, or LIBOR.  And, we are doing this on purpose.  It seems the denizens of the heights of our international financial fabric felt they had to do this in light of the discovery that a handful of bankers had unlawfully colluded to cause LIBOR to be mispriced for their personal advantage.  As Captain Renault said, “I’m shocked, shocked!”  This was so bad that we had to blow up the LIBOR index upon which trillions of dollars of financial assets are based?  While bankers behaving badly is a problem, why are we punishing markets because our banking regulatory cadres failed to prevent bad behavior?  At best, this is a monument to irrational rectitude.

https://www.crunchedcredit.com/2019/08/articles/libor/killing-libor-a-victory-for-irrational-rectitude/

Verifying Accredited Investors in a Rule 506(c) Offering
by Taylor Wilkins
Strictly Business

Generally, Rule 506(c) provides an exemption from registering an offering of securities when the company issuing securities (usually called an “issuer”) only sells securities to accredited investors (previously defined here) and the issuer takes reasonable steps to ensure that each purchaser is an accredited investor. The benefit of Rule 506(c) compared to Rule 506(b), is that, under Rule 506(c), an issuer may generally solicit potential investors, which allows issuers to engage in a variety of public solicitations, such as internet postings, presentations at conferences, or other forms of advertisement. Under a Rule 506(b) offering, engaging in any such activity could result in a loss in the ability of the issuer to rely on the exemption.

https://www.strictlybusinesslawblog.com/2019/08/27/verifying-accredited-investors-in-a-rule-506c-offering/

20% of Big 4-audited IPOs report weaknesses in financial-reporting controls
by Francine McKenna
Marketwatch

A MarketWatch analysis of SEC filing data provided by research firm Audit Analytics shows 100 IPO filings in 2019 year-to-date by companies that use a Big 4 audit firm — Deloitte, Ernst & Young, PricewaterhouseCoopers or KPMG. MarketWatch’s analysis of S-1 disclosures for those companies found 20 that have voluntarily disclosed serious issues with internal controls over accounting, financial reporting and the systems.

https://www.marketwatch.com/story/20-of-big-4-audited-ipos-report-weaknesses-in-financial-reporting-controls-2019-09-04