Author: Doug Cornelius

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

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

Are Liquor Licenses Securities?

San Diego-based ANI Development LLC, its principal, Gina Champion-Cain, raised hundreds of millions of dollars from investors to make short-term, high-interest loans to parties seeking to acquire California alcohol licenses. The SEC alleges, the investment opportunities were shams and diverted directed significant amounts of investor funds to other uses.

Under California state law, liquor license applicants are required to escrow an amount equal to the license purchase price while their application remains pending with the State. Cain told investors that this regulatory requirement presented an investment opportunity.

She directed investors to deposit their money into specified escrow accounts maintained by ANI Development, and represented to them that their funds were being loaned to liquor license applicants at a high interest rate. That escrow agent allowed Cain to move the money around instead of keeping it safe in escrow.

Were those loans securities? If not, then its not securities fraud. The SEC addressed this is issue in the complaint using the Howey test.

60. As directed by defendants, investors’ funds were pooled in a common escrow account, which defendants claimed was being used to fund the transfer of California state liquor licenses.
61. Whether investors would profit from their investment was dependent on the success of defendants’ represented liquor license funding program.
62. Cain and ANI Development’s efforts in identifying liquor license escrow participants who were appropriate for investment, executing the loans to those entities, and collecting the purported interest payments from those participants, were critical to the enterprise’s success, as investors were not allowed to play an active role in managing ANI Development’s investment decisions under the claimed liquor license funding program.

Sounds like it passes the test because Cain pooled money into the escrow accounts instead of keeping them separate.

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Pair of Ponzis with Real Estate

Real estate related fraud cases with the Securities and Exchange Commission catch my attention. Two real estate-ish cases popped up in a flurry of cases filed before Labor Day weekend. One was for timber and the other for mobile home parks.

Timber operates in a gray area between real estate and extraction. Clearly, the land has value for capital and the trees have value as product. Of course you have to own the land or have the right to harvest the trees.

In the case of Madison Timber Properties, LLC, the SEC claims that the company and its principals didn’t own the land or have the harvesting rights. In other instances, the SEC claims the company would pledge the same tracts to more than one investor. Instead of using the money to acquire land or harvesting rights, the company diverted investor capital for other uses.

Last week, the SEC brought charges against Terry Wayne Kelly and his company for selling the notes that funded Madison Timber. At the base level, Kelly and his firm were not registered as broker-dealers. The Madison Timber notes were not registered nor did the sales properly use an exemption from registration.

Further, the SEC charged that Kelly was aware of the red flags at Madison Timber. At a meeting with unnamed financial institutions, Kelly and Madison were confronted about the business practices at Madison. The SEC charged that Kelly is civilly liable for negligently and recklessly selling the securities.

In a separate action, the SEC accused Tytus Harkins and the Hartman Wright Group with defrauding investors in connection with mobile home parks. They misrepresented the

Unlike Madison, Hartman Wright owned the real estate. But according to the SEC, Madison overstated the purchase price for the mobile home parks.

In both cases, the firms used some of the cash provided by later investors to redeem or make payments to earlier investors. That gives each scheme the label of a Ponzi scheme.

The question that I’m left with is how the firms expect to exit from these schemes. There would not be enough cash to pay off investors at the end of the day. Eventually the scheme would unravel.

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Form SHL: Report by U.S. Funds on Foreign Ownership

Hopefully, if this form filing is applicable to your firm, you’ve already sent it in. It’s due on August 30. The penalty for failing to submit the form is a civil penalty of not less than $2,500 and not more than $25,000.

The form is required if your firm was the recipient of a mailing of the form or if you have more than $100 million in foreign investors in your fund.

The filing is part of a mandatory survey conducted under the authority of the International Investment and Trade in Services Survey Act (22 U.S.C. 3101) and Executive Order 11961 of January 19, 1977. The Act specifies that the authority to secure current information on international investment, including (but not limited to) such information as may be necessary for computing and analyzing the balance of payments accounts and the international investment position of the United States.

This report collects information on securities issued by U.S.-residents that are owned by foreign residents, including U.S. equities (including shares in funds), U.S. short-term debt securities (including selected money market instruments), U.S. long-term debt securities, and U.S. asset-backed debt securities.

The standard includes foreign ownership of private funds. Often foreign investors use blockers of domestic subsidiaries to invest. The form’s instructions indicate that you can use the standard of whether the investor gave you a W-8 instead of a W-9 to determine that the investors is “foreign.”

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Blame It On the Junior Compliance Associate

“The compliance associate had no trading experience and no formal training to conduct the review required by the rule, such as training related to the analysis of financial statements and other information.”

Rule 15c2-11 of the Exchange Act requires broker-dealers to obtain, review and maintain information about the issuer before initiating or resuming the publication or submission of a quotation for an OTC and non-exchange listed security. The broker-dealer must have a reasonable basis for believing that the information it has obtained is accurate and reliable. FINRA Rule 6432 requires a broker-dealer to demonstrate compliance with Rule 15c2-11 by filing the Form 211, reviewed and signed by a principal of the firm.

Canaccord Genuity LLC had written policies and procedures that said the right things about complying with those rules.

In practice, it failed to follow its written policies and procedures and violated the rules, according to the SEC order.

Canaccord put one of its compliance associates in charge of the process and have the associate the responsibility to obtain and review the information required by Rule 15c2- 11. The associate fill out the Form 211s and placed the electronic signature of the designated principal on the filings. The Rule 15c2-11 files were stuck in a compliance filing cabinet and could not be independently accessed by the traders or the firm’s designated principal without requesting them from the compliance department.

Of course, this case caught my attention because the headlines implicated compliance as part of the problem. The SEC order did not impose a separate penalty on the compliance associate. The associate, as you read in the opening paragraph, was not qualified to conduct the review.

The unanswered question is whether the compliance associate knew the policy and knew that he or she was violating the policy?

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