Author: Doug Cornelius

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

Credit Lines and Fund Performance

Dr. Christoph Jäckel, a Director of Montana Capital Partners AG, wades into the discussions about fund credit facilities with some new research he published in Private Funds CFO. His findings? A credit line increases IRR for most funds by only one percentage point.

Of course, it’s a bit more complicated than that. The average in his findings was 4%, but that was inflated by a few, very well-performing funds. The study looks at funds from 1990 to 2007 using quarterly cash flow data from Prequin. As for the equity multiple, he only found a small effect.

This is all against the back-drop of the ILPA guidance encouraging more disclosure on the use of credit lines. Around the same time, Howard Marks of Oaktree Capital took a deep but practical dive into the use of lines.

Another research study in the works by James Albertus and Matthew Denes found that use of credit lines increased performance by 6.1%. They used a different data set with a focus on data from 2014 to 2018. Unlike the Jäckel study, they only report the average effect, so it could be skewed by highly successful funds, similar to his report. As with Jäckel, they found an effect on the equity multiple, but it was small. They also note that younger funds skewed the data, presumably since the short time frame would have relatively more on the credit line and less returned to investors.

What about compliance? It has become an industry best practice to disclose in performance marketing that the fund used a credit line and the performance would be different without use of the line.

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Compliance Bricks and Mortar for October 11

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

The Cost to Retail Investors and Public Markets of “Harmonizing” Securities Offering Exemptions
By Erik F. Gerding
The CLS Blue Sky Blog

Investing in private securities would pose considerable additional risks for retail investors, relative to investing in public securities, and existing research suggests that these additional risks would not be sufficiently offset by higher expected returns.  In fact, if retail investors are given more direct access to the private markets, they are likely to earn lower risk-adjusted returns overall than they do in the public markets, for several reasons: …

http://clsbluesky.law.columbia.edu/2019/10/01/the-cost-to-retail-investors-and-public-markets-of-harmonizing-securities-offering-exemptions/

ANALYSIS: Lack of Removal Power Could Threaten SEC ALJ Regime
by Peter Rasmussen
Bloomberg Law

Are the job security provisions enjoyed by SEC administrative law judges unconstitutional? The Supreme Court majority kicked that question down the line in its 2018 Lucia v. SEC decision. The Fifth Circuit may just have picked it up, as a three-judge panel enjoined an administrative rehearing of a pre-Lucia accounting violations case against Michelle Cochran. It is too early in the process to read too much into a preliminary injunction, but the Fifth Circuit’s action does indicate that Lucia has not yet been laid to rest.

https://news.bloomberglaw.com/bloomberg-law-analysis/analysis-lack-of-removal-power-could-threaten-sec-alj-regime

Some Places Are Much More Unequal than Others
by Jaison R. Abel and Richard Deitz
Liberty Street Economics

Economic inequality in the United States is much more pronounced in some parts of the country than others. In this post, we examine the geography of wage inequality, drawing on our recent Economic Policy Review article. We find that the most unequal places tend to be large urban areas with strong economies where wage growth has been particularly strong for those at the top of the wage distribution. The least unequal places, on the other hand, tend to have relatively sluggish economies that deliver slower wage growth for high, middle, and lower wage earners alike. Many of the least unequal places are concentrated in the Rust Belt. These differences in the degree of wage inequality are tied to powerful economic forces arising from technological change and globalization, which have pushed up wages strongly for high-skilled workers in locations that have become the most unequal. Yet those same forces have kept wage growth compressed within a fairly narrow range for workers in places that are the least unequal.

https://libertystreeteconomics.newyorkfed.org/2019/10/some-places-are-much-more-unequal-than-others.html

Attorney General Barr Speaks at SEC’s Criminal Coordination Conference

I’ll begin with our coordination to punish wrongdoers and to protect investors. As I have mentioned, the white-collar crime, financial fraud, and corruption cases that our agencies handle are some of the most complex and difficult cases to uncover, investigate, and prosecute. Together, however, through information sharing and open dialogue, we are able to overcome those challenges.

http://clsbluesky.law.columbia.edu/2019/10/07/attorney-general-barr-speaks-at-secs-criminal-coordination-conference/

Compliance and Careers Amid Corporate Upheaval
by Matt Kelly
Radical Compliance

This week I was in Denver attending the Converge 2019 conference hosted by Convercent, and as one might expect, lots of the sessions there focused on how to apply technology to compliance programs. 
For my money, however, the most interesting session explored something quite different: how compliance officers can navigate their careers amid upheaval at your company — a merger, breakup, restructuring, or some other ordeal that leaves everyone on edge. Including you.

http://www.radicalcompliance.com/2019/10/04/compliance-careers-amid-corporate-upheaval/

A new (and more transparent) way to calculate SEC whistleblower awards
by Amanda M. Rose
The FCPA Blog

How should SEC whistleblower awards be calculated? In a working paper, I address this timely question.

…

My analysis suggests that the controversial proposed amendments are warranted, but incomplete. For reasons that I explain, a hybrid percentage-dollar approach that ties a whistleblower award to the value of the punishment imposed on the wrongdoer, while also taking into account the costs a whistleblower anticipated incurring by coming forward, makes sound policy sense.

…

A full copy of my paper can be downloaded here.

https://www.fcpablog.com/blog/2019/10/9/a-new-and-more-transparent-way-to-calculate-sec-whistleblowe.html

The One Who Was Bored at Work

We all have hobbies. Me?: Cycling, reading, kayaking. Some people have finance as a hobby. Sure you can spout off about finance. But, eventually you step into the world of financial regulation if your spouting off turns into financial advice.

Marcos Tamayo of Las Vegas was an airline baggage handler by day and, apparently, became an investment adviser by night. Tamayo learned about investing by taking classes at work and reading books during breaks at work. His fellow baggage handlers must have believed the financial advice he spewed forth on the tarmac and terminal. They gave him online access to their airline retirement accounts, which he used to select investments and make trades. He only charged a $300 annual fee.

Spot the issue? …. Correct, he was operating as an investment adviser and would have to register himself and his business.

He even had a name for the business: “Bored at Work”. But didn’t register.

Mr. Tamayo’s business took off in 2015 when he posted a doctored image purporting to be his account statement which showed a balance over $800,000. The fake image worked and sparked the interest of his fellow baggage handlers, seeking his investing acumen. By the end of 2016 he had over $110 million in client assets under management.

The Nevada Secretary of State got wind of his moonlighting as an investment adviser and brought a cease and desist order. The State wanted him to stop operations until he was properly licensed.

He may have actually tried to go legitimate at this point. He filed a Form ADV with the Securities and Exchange Commission. He even came up with a more conservative name for the business: BAW Retirement Services.

He made a fatal mistake in the filing. He checked the “no” box on Form ADV Items 11.D.(1)-(5) which ask whether there were prior investment-related actions, including by a state regulatory agency. That means he filed a registration that contained a material misrepresentation.

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Can Cattle Be a Security?

The Security and Exchange Commission filed a complaint alleges that Mark Ray, a Denver resident, was the mastermind of a scheme for the purported purchase and immediate resale of large numbers of cattle. I don’t recall cattle showing up in the definition of a “security.”

The first part of the scheme is labeled a Ponzi scheme in the complaint. Mr. Ray told investors they were investing in wholesale, commercial cattle trades. They were often told the specifics about the cattle and which ranch the they were located. The SEC contacted the ranches and confirmed they had not engaged in any cattle trading with Mr. Ray.

Mr. Ray had no cattle to support his supposed investments. He used later investors’ money to repay prior investors. Classic Ponzi scheme.

Big Hat, No Cattle.

Mr. Ray later got more sophisticated and sold promissory notes to investors that were supposed to be used in cattle trading. It’s hard to argue that those notes are not securities

The direct investments in cattle are not clearly securities. Mr. Ray settled with the SEC so we won’t see the argument.

The SEC broadly states that the agreement called for the investor to make an investment of money with the expectation of profit. The investors relied on Mr. Ray’s purported skill and knowledge to generate profits. Many of the investors knew little of the industry.

The SEC made the classic Howey test argument about the nature of the transactions. It was good enough for Mr. Ray’s lawyers to agree to settlement, rather than fight the SEC.

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The One With the Failure of Auditor Independence

The Securities and Exchange Commission charged PricewaterhouseCoopers LLP and one of its partners with violating auditor independence rules for running a project to upgrade the client’s GRC software while also doing its audit work.

Using the “one” in the title is deceiving. This is the third auditor independence case that the Securities and Exchange Commission has brought this year. In August, the SEC charged RSM International with violating the SEC’s auditor independence rules on at least 100 audit reports. In February this year, the SEC charged Deloitte Touche Tohmatsu LLC, when its consulting affiliate maintained a business relationship with a trustee serving on the boards and audit committees of three funds it audited. You can also add the sanctions by PCAOB against PricewaterhouseCoopers in another matter and another against Marcum LLP.

I found this PwC case to be more egregious.

In 2014, PwC performed non-audit services for the unnamed company “Issuer A” to implement new Governance Risk and Compliance software. GRC systems are used by companies to coordinate and to monitor controls over financial reporting, including employee access to critical financial functions. Issuer A intended to use the GRC software to generate information as part of the company’s control environment and to provide data to assist personnel in forming conclusions regarding the effectiveness of internal controls related to financial information systems.

PwC would be implementing the system that it would ultimately opine on as being effective. It would be a shame if the Issuer A paid all that money to PwC to install the system and then PwC found it was an effective control environment.

Rule 2-01(c) of Regulation S-X sets forth a non-exhaustive list of non-audit services which an auditor cannot provide to its audit clients and be considered independent. See 17 C.F.R. § 210-2.01(c)(4)(i)-(x)

Auditor conflict is not just about money or which revenue stream rules the nest. The intent is to allow the auditor to act an impartial third-party reviewer. It’s the reason that auditors are not allowed to prepare the financial statements and then opine on them.

If the auditors do the books, then they will be very reluctant to point out errors in them. If the auditor designs and implements the company’s internal control system, then of course the auditor will be very reluctant to not opine that the company has good control environment.

For fund managers who rely on auditors for compliance with the Custody Rule, auditor independence is incredibly important.

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Compliance Bricks and Mortar for September 27

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

Oversight of the Securities and Exchange Commission: Wall Street’s Cop on the Beat

The SEC’s mission is to: (1) protect investors; (2) maintain fair, orderly, and efficient markets; and (3) facilitate capital formation. The SEC oversees over 27,000 market participants, including investment advisers, mutual funds and exchange traded funds, broker-dealers, national securities exchanges, credit rating agencies, clearing agencies, the Public Company Accounting Oversight Board (PCAOB), the Financial Industry Regulatory Authority (FINRA), the Municipal Securities Rulemaking Board (MSRB), and the Financial Accounting Standards Board (FASB). The SEC also oversees over $97 trillion in securities trading annually and reviews the disclosures of approximately 4,400 exchange-listed public companies with an approximate aggregate market capitalization of $34 trillion.

Inside Airbnb, Employees Eager for Big Payouts Pushed It to Go Public
by Erin Griffith
New York Times

On behalf of more than a dozen employees, they pleaded to be able to sell their Airbnb stock options. Because Airbnb is privately held, its shares cannot be easily traded or cashed in. So the employees also asked that the company go public, a move that would let them freely sell their shares, said five people who saw or were briefed on the document and were not authorized to speak publicly.

https://www.nytimes.com/2019/09/20/technology/airbnb-employees-ipo-payouts.html#click=https://t.co/ymuwKpmf4l

Ten reasons why compliance fails
by Andrew Hayward and Tony Osborn
The FCPA Blog

This is despite the increasing ethical demands stakeholders are making of business, the exposing power of social media, the proliferating requirements of compliance laws and regulations, and the burgeoning numbers of policies, procedures and compliance officers which have been put in place in response.
So what’s going on? Why isn’t compliance working? Here are ten reasons why it can fail:

https://www.fcpablog.com/blog/2019/9/20/ten-reasons-why-compliance-fails.html

The S.E.C. brought 50 percent more Ponzi prosecutions in the decade after Mr. Madoff’s arrest than in the 10 years before, according to a New York Times analysis of the agency’s enforcement announcements.
Whether the increase is the result of enhanced enforcement or a proliferation of scammers, records show that Ponzi victims lost $31 billion in the decade beginning 2009, more than three times the amount lost in non-Madoff schemes in the previous decade. (The figures are not adjusted for inflation.)

https://www.nytimes.com/2019/09/22/business/ponzi-scheme-bernie-madoff.html

Veil-Piercing Risks for Private Equity Managers Highlighted in Recent Court Decision
By Joshua M. Newville and Alexandra V. Bargoot 

A recent case in a North Dakota district court is a reminder to private equity funds and managers that, under certain conditions, they may be held responsible for actions of a fund’s portfolio companies.  Courts allow plaintiffs to pierce the corporate veil as a check against improper abuse of the corporate form.  When one corporate entity is under such extensive control by another that the first is merely an alter ego of the second, a court may permit a plaintiff to reach through the corporate structure to gain recovery.  This is particularly true if the first entity is undercapitalized.

https://www.privateequitylitigation.com/2019/09/veil-piercing-in-private-equity-risks-for-funds-and-managers/

Minimum Wage Impacts along the New York-Pennsylvania Border
by Jason Bram, Fatih Karahan, and Brendan Moore
Liberty Street Economics

While New York began raising its minimum wage from $7.25 per hour in 2014, neighboring Pennsylvania has left its minimum wage unchanged at the federal floor. Minimum-wage variation between contiguous states has allowed researchers to evaluate the respective impacts on employment and average earnings. In this post, we gauge the effect of New York’s recent minimum-wage hikes by comparing low-wage sectors in counties along the New York-Pennsylvania border.

https://libertystreeteconomics.newyorkfed.org/2019/09/minimum-wage-impacts-along-the-new-york-pennsylvania-border.html

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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