Author: Doug Cornelius

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

Harmonization of Securities Offering Exemptions

or all you ever wanted to know about private placements

The Securities and Exchange Commission is stepping into the meeting point of its mandates by looking to “simplify, harmonize, and improve” the framework for private placements. The SEC is looking to expand investment opportunities while balancing investor protections and the promotion of capital formation.

The 200+page release provides a summary of the various private placement regimes in one handy guide. As Chairman Clayton noted, its an “elaborate patchwork.”

Note that twice as much capital is raised from private placement than capital raised through registered offerings. On page 16, the SEC notes:

In 2018, registered offerings accounted for $1.4 trillion of new capital compared to approximately $2.9 trillion that we estimate was raised through exempt offering channels.

Exemption2018 Amount Raised
Rule 506(b) of Regulation D $1,500 billion
Rule 506(c) of Regulation D $ 211 billion
Regulation A: Tier 1 $ 0.061 billion
Regulation A: Tier 2 $ 0.675 billion
Rule 504 of Regulation D $ 2 billion
Regulation Crowdfunding; Section 4(a)(6) $0.055 billion
Other exempt offering$1,200 billion

This has been true for at least the past decade, despite the elaborate patchwork. 506(b) offerings alone exceeded registered offerings last year.

As I’ve said in the past, private placement investments are not necessarily more risky than investments in registered offerings. The risk is one of liquidity. There is no market to buy or sell the investment so there is no ready exit.

If you had invested in Uber prior to the public offering, you had little choice but to sit and wait for a liquidity event. Now, you can liquidate your Uber position the same day.

The Concept Release is a great document to summarize the various ways to raise money privately, with the pros, cons and limitations of each.

The SEC has limited abilities to make wholesale changes. Many of the exemptions are driven by statute and would take Congressional approval. Nothing is passing in the Congress right now.

The SEC can make some changes around Regulation D that could be useful. The SEC should be careful that it does not disrupt the most widely used way to raise capital.

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Can a Real Estate Lot Be a Security?

Of course the lawyerly answer is: “maybe.”

Ronald Duane Dunham challenged his criminal conviction for securities fraud, arguing that the Cherokee Village lots he sold did not qualify as securities under the California Corporation Code.

Mr. Dunham got in this position by persuading a number of elderly victims to invest over a million dollars with him, ostensibly to purchase undeveloped “lots” of land in Cherokee Village, Arkansas, and/or support Dunham’s real estate development efforts there between 2004 and 2007. The lots were sold to the victims at an inflated price and marketed at times in conjunction with Ed McMahon.

The crash of 2008 happened and the victims sued to get their money back. The victims lawyer after reviewing documents from discovery thought Dunham’s actions were bad enough to warrant a criminal investigation and the District Attorney agreed. Dunham was eventually convicted.

Keith Paul Bishop highlighted this case last week: Court Rules Lot Sales Were Sales Of Securities.

” U.S. District Court Judge Gonzalo P. Curiel denied Dunham’s petition.   Citing SEC v. Schooler, 905 F.3d 1107 (9th Circ. 2018), Judge Curiel reasoned that a reasonable jury could have concluded that lots sold by Dunham were not independent real estate transactions but the sale of securities “

Mere “lots” as securities? Usually, these cases involve some form of management company, investment fund or partnership. The Denial of Habeus Corpus even cites the Schooler case where a general partnership in real estate was considered a security.

Dunham’s trial court jury had found that lots represented the victims’ “shares in [the] enterprise.”

None of the California victims had any ability to develop homes in Arkansas, and they expected “Dunham and company” to sell their lots for them. The victims were relying on Dunham to bring professional management, homebuilding, and financing experience to the project. They had no desire to live in Arkansas themselves, except possibly Marilyne who would consider it after first realizing a profit. The victims sought a return on their investment, and a profitable retirement community required a certain volume of lots to succeed. On a whole, and considering the purpose of our securities laws to protect the public from fraudulent investment schemes, the Cherokee Village lot transactions qualified as investment contracts.

Page 56 of the Writ of Habeus Corpus

The federal court agreed. There didn’t seem to be any formal agreement for the Dunham to manage the investments. But, all of the victims testified they
were told they were purchasing lots in order to be part of and profit from a future retirement development in the area. Dunham held events where he presented plans for the development and marketing campaigns after the development of the area. There was some evidence that Dunham himself thought there was a common enterprise.

This is a big extension of the Howey test to real estate. The sale of dirt in a remote area, coupled with a seller’s promises are enough to bring the transaction into the definition of “investment contract.”

Sources:

Toga! Toga! Toga!

I grabbed the SEC case against Syed Arham Arbab for the headline and obvious jokes. Mr. Arbab is accused of running a fake investment scheme out of his college fraternity.

He formed a fund called Artis Proficio Capital Investments, LLC with a business address of 558 W. Broad Street, Athens, GA 30601. (Go ahead and clink on the address link. Yes, it’s a picture of the fraternity house at that address, complete with big Greek letters.)

According to the complaint, it’s a run-of-the-mill investment scam. Mr. Arbab never set up a custody account, never really invested the money and really made fake promises. Mr. Arbab had not settled with the SEC so we only have the Commission’s side of the story. He doesn’t think it’s over. Just like it wasn’t over “when the Germans bombed Pearl Harbor.”

Jeff

The other reason the case caught my attention because today would have been the birthday of my friend Jeff. We spent great years together in high school and college, and many great years thereafter.

We often called him Belushi because he was one of Jeff’s idols. There was some physical resemblance and lots of resemblance when it came to fun.

But cancer killed Jeff a few years ago. I raise money for cancer research in his memory. I’m riding almost 300 miles during the first weekend of August in the Pan Mass Challenge.

If you enjoy reading Compliance Building, please donate a few dollars. 100% of your donation goes to cancer research.

Thank you,
Doug

Weak Valuation Procedures Result in Private Fund Fine

An SEC investigation found that Colorado-based investment adviser Deer Park Road , in connection with one of its funds, failed to have policies and procedures to address the risk that its traders were undervaluing securities and selling for a profit when needed.  The SEC fined a hedge fund $5 Million, and its Chief Investment Officer another $250,000, for failing to properly value portfolio securities.

In the order, the SEC maintains that the firm failed to sufficiently address how to conform the firm’s valuations with GAAP. In addition, they were not designed for its own business practices, given the firm’s models and potential conflicts.

Even worse, Deer Park Road didn’t follow its existing, yet deficient, policy. The policy was important because the fund focused on thin-traded mortgage-backed securities.

Another aspect of its deficiency was the membership of the firm committee that was responsible for making sure valuations were in compliance with the firm’s pricing source protocol. The members were:

  • CCO – a former geochemist with no relevant experience in bond valuation
  • CFO – former bookkeeper and tax accountant with no experience in bond valuation
  • Untitled person – an attorney with no experience in bond valuation.

Of course there are messages noting the failure to mark assets to the market price.

“we are fundamental oriented, and price them based on future cash flow . . . . Mkt seems to be willing to buy at lower yield, which is only a technical issue, but we may sell our bonds at mkt price, only to take realized profits then rather than mark them up to book unrealized profits.”

and

“don’t you know me at all / I don’t mark stuff up / stay as conservative as possible.”

and

“[w]e mark it low. it can trade much higher . . .” and “undervalued, can trade low60s…. can sell it for profit if needed.”

Wait a second…. This is a different type of valuation case. Based on the order, the manager was staying conservative with fund valuations. The assets were not over-valued; they were UNDER-VALUED.

The SEC order does not allege any harm to investors. The SEC does not accuse the firm of making extra money by keeping the values low. The SEC accuses the firm of allowing its traders to “mark assets up gradually instead of marking them to market.”

Of course, valuation is important. You can’t ignore obvious market indicators on value.

I have to assume there are other matters that didn’t make it into the Order that caused the SEC to pursue this case and seek a $5 million fine.

Sources:

Compliance Bricks and Mortar for June 7

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

Tuesday: Tax transparency, the myth of the unlevered IRRs
Private Funds Management

LPs want to know what effect this has on IRR. ILPA recommends that net IRR should be presented both with or without use of the credit facility, as referenced in this video from one of our sponsors Withum. This sensible-seeming suggestion may not be as simple as it seems. “Speed to close and ability to close all cash are becoming more important in this competitive environment. Without a line we would need to call capital in advance and leave cash on the balance sheet,” said Blue Wolf Capital CFO Josh Cherry-Seto. “We would at least a few times call large amounts of capital for investments that do not consummate. It is not such a simple exercise and I don’t think, if calculated honestly, the results would be favorable.” Cherry-Seto was speaking at Private Funds CFO’s fund finance roundtable, which will be published in July.

Preemption of state securities laws
by Eversheds

With the recent announcement by the Securities and Exchange Commission (SEC) that it will hold an open meeting on June 5, 2019, to consider adopting Regulation Best Interest, one of the major issues that the SEC may clarify is its view of whether Regulation Best Interest preempts state securities regulations that impose a fiduciary duty on broker-dealers.

Boeing and More Compliance Lessons Learned: Silos, Risk and Training
by Tom Fox
FCPA Compliance Report

I was stuck by an extraordinary above the fold article in the Sunday New York Times (NYT), entitled The Late Change, and Fatal Flaws in Boeing’s Plane by a plethora of reporters including Jack Nicas, Natalie Kitroeff, David Gelles and James Glanz. (The physical location of the article in the print edition was also significant as it reminded me of when the NYT broke the story of Wal-Mart’s corruption allegations in Mexico, in the same place, right hand column above the fold in an edition of the Sunday Times back in 2012). Matt Kelly wrote a great blog post on the article and his interpretation of it in Radical Compliance, entitled Another Lesson from Boeing: Silos. Kelly was spot on regarding his analysis of the siloed nature of Boeing’s design and construction process that caused or contributed to the catastrophic failure of the 737 Max due to the failure of the Maneuvering Characteristics Augmentation System (MCAS).

http://fcpacompliancereport.com/2019/06/boeing-compliance-lessons-learned-silos-risks-training/

Carnival Dinged $20M on Compliance
By Matt Kelly
Radical Compliance

Compliance professionals will be fascinated — and encouraged, really — because this case is all about Carnival failing to establish a strong, effective compliance function. That was the failure. Carnival was supposed to hire a CCO years ago to help strengthen a culture of compliance, it hasn’t done that yet, and that lack of leadership allowed a culture of non-compliance to continue.

http://www.radicalcompliance.com/2019/06/05/carnival-dinged-20m-compliance/

NASAA adopts investment adviser information security model rule package
Jay Fishman, J.D. 
Jim Hamilton’s World of Securities Regulation

The North American Securities Administrators Association, Inc. (NASAA) has adopted an information security model rule package to enhance state-registered investment advisers’ cybersecurity and privacy practices.  The package consists of: 
1.A model rule requiring investment advisers to adopt policies and procedures regarding information security (both physical security and cybersecurity) and to deliver its privacy policy annually to clients;
1. An amendment to the existing investment adviser NASAA model recordkeeping requirements rule mandating that investment advisers maintain records of their cybersecurity and privacy policies and procedures; and 
3. Amendments to the existing investment adviser NASAA Unethical Business Practices of Investment Advisers, Investment Adviser Representatives, and Federal Covered Advisers and NASAA Prohibited Conduct of Investment Advisers, Investment Adviser Representatives and Federal Covered Investment Advisers Model Rule USA 2002 502(b) model rules, to include failing to create, maintain, and enforce the cybersecurity and privacy policies and procedures.   

https://jimhamiltonblog.blogspot.com/2019/05/nasaa-adopts-investment-adviser.html
PMC 2019
Please support my ride to fight cancer. On the first weekend in August, I’ll be riding across Massachusetts to raise money for cancer research. I could use your support:
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Regulation Best Interest, Form ADV Part 3 and the Fiduciary Standard

The Securities and Exchange Commission has been working on a way for consumers to better understand the difference between securities brokers and investment advisers. The Department of Labor made an attempt with respect to retirement plans, but that is a mess.

I’m not sure how much of a mess the new Regulation Best Interest is going be for private fund managers. The devil is in the details and the details are in the 524 page release for the new FORM CRS Relationship Summary and Amendments to Form ADV and the 771 pages of the Regulation Best Interest: The Broker-Dealer Standard of Conduct.

According to the press release, the SEC

“voted to adopt a package of rulemakings and interpretations designed to enhance the quality and transparency of retail investors’ relationships with investment advisers and broker-dealers, bringing the legal requirements and mandated disclosures in line with reasonable investor expectations, while preserving access (in terms of choice and cost) to a variety of investment services and products.  Specifically, these actions include new Regulation Best Interest, the new Form CRS Relationship Summary, and two separate interpretations under the Investment Advisers Act of 1940. “

The bigger burden is likely to be on broker-dealers. But changes are required for investment advisers and private fund managers.

One piece of good news is that Regulation BI attempts to clarify the fiduciary standard for investment advisers. That standard is not in the text of the Investment Advisers Act. It’s been developed through court cases.

The SEC published a new Commission Interpretation Regarding Standard of Conduct for Investment Advisers codifies an Investment Advisers’ Fiduciary Duty:

  • Duty of Loyalty
  • Duty of Care
    • Duty to Provide Advice that is in the best interest of the client
    • Duty to Seek Best Execution
    • Duty to Provide Advice and Monitoring over the course of the relationship

Get set for Form ADV Part 3. This new filing is directed at registered investment advisers that offer services to retail investors. Part 3 is the new relationship summary. New Rule 204-5 will require an investment adviser to deliver an electronic or paper version of the relationship summary to each retail investor before or at the time the adviser enters into an investment advisory contract with the retail investor. You’ll also need to post it to your website.

The deadline for compliance is June 30, 2020. We’ve got a year.

Where to turn to first? I’m diving into the Commission Interpretation Regarding Standard of Conduct for Investment Advisers.

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CCO Liability and Identity Theft

I’ve gotten worked up about CCO liability cases. Many have been sloppy about using consistent standards. A recent case case caught my eye because the CCO was charged because of identity theft.

At first I thought the case might be an aggressive position to charge the CCO because a cybersecurity breach resulted in identity theft at the firm. I opened the case and was ready to be angry. Then, I discovered it was very strange case.

The CCO was the one who had stolen identity information. So that bad activity clearly fall into the “CCO is involved in the wrongdoing” standard for CCO liability.

The reasons he stole employee identities?

From November 2011 through June 2015, [the CCO] forged the signatures of ten Firm employees and used their confidential personal information to create false online bidding accounts at three auction houses in their names, and to participate in 26 auctions, without the employees’ authorization. [the CCO] engaged in this conduct after the auction houses prohibited him from participating in auctions, because he had previously failed to pay for or collect items he had won at auction.

Definitely a case where the CCO was involved in the wrongdoing. Employees were harmed. Liability is clearly appropriate.

[Updated to remove the CCO name after a request and a review of remediation]

Sources:

Looking Ahead to Regulatory Changes

The Securities and Exchange Commission published its Reg Flex Agenda for the Spring of 2019. This gives us some insight to what regulatory changes are in the works. Three items caught my eye as likely to apply to private funds.

Harmonization of Exempt Offerings. Chairman Clayton had previously noted that the regulations around exempt offerings is a mess.

The Division is considering recommending that the Commission seek public comment on ways to harmonize and streamline the Commission’s rules for exempt offerings in order to enhance their clarity and ease of use.

Amendments to the Custody Rules for Investment Companies and Investment Advisers . The Custody Rule is full of footfaults. Most CCOs I’ve talked to have run into problems trying to figure out how the Rule applies to some particular circumstance. The abstract does not provide much insight into what aspect of the Rule is being discussed.

The Division is considering recommending that the Commission propose amendments to rules concerning custody under the Investment Company Act of 1940 and the Investment Advisers Act of 1940.

Amendments to the Marketing Rules Under the Advisers Act. Changes to the marketing regulations have been mentioned by the Commissioners several times. The regulations are well out of date from the age of digital communication. Plus, there is well of practice and unofficial law buried in No-action letters. It sounds like there is a lot of support to formalize that unofficial through a formal rulemaking.

The Division is considering recommending that the Commission propose amendments to rules 206(4)-1 and 206(4)-3 under the Investment Advisers Act of 1940 regarding marketing communications and practices by investment advisers.

These are merely items the Commission are working on or thinking about for regulatory action. It will take a consensus of the Commissioners to agree to start the rulemaking and agree to language. That may not happen. But at least they are thinking about them.

PMC 2019
Please support my ride to fight cancer. On the first weekend in August, I’ll be riding across Massachusetts to raise money for cancer research. I could use your support:
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Compliance Bricks and Mortar for May 31

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

The Troika Laundromat
The Organized Crime and Corruption Reporting Project

Laundromats are complex systems for moving money that allow corrupt politicians, organized crime figures, and wealthy business people to secretly invest their ill-gotten millions, launder money, evade taxes, and fulfill other goals.
OCCRP has previously exposed three such schemes: The Proxy Platform, the Russian Laundromat, and the Azerbaijani Laundromat.
Now, OCCRP and its reporting partners reveal a unique new Laundromat, created by a prestigious financial institution. This time, the work shows not only its beneficiaries but also exposes its mastermind and operator — Troika Dialog, once Russia’s largest private investment bank.

https://www.occrp.org/en/troikalaundromat/

A common complaint about insider trading law is that there is no statute that expressly sets forth the requirements to prove insider trading. That can make it difficult to determine whether a violation has occurred.
The House Financial Services Committee is seeking to remedy that. It recently passed a bill that would — for the first time — set forth what is required to prove insider trading.

https://www.nytimes.com/2019/05/24/business/dealbook/insider-trading-act.html

DC Circuit Opinion Reaffirms Fiduciary and Disclosure Obligations of Advisers While Rejecting SEC Finding of “Willful” Violations
By Joshua M. Newville, Samuel J. Waldon, Anthony Drenzek and Ariella Muller

The DC Circuit recently released an opinion addressing the SEC’s administrative findings against registered investment adviser The Robare Group (TRG) for failure to disclose alleged conflicts of interest. Although the court affirmed the SEC’s finding of a violation of Section 206(2) of the Advisers Act, it held that Commission could not find willful violations under Section 207 based on the same negligent conduct.

https://www.privateequitylitigation.com/2019/05/dc-circuit-opinion-reaffirms-fiduciary-and-disclosure-obligations-of-advisers-while-rejecting-sec-finding-of-willful-violations/

Crypto Assets and Insider Trading Law’s Domain
by Andrew Verstein 
Harvard Law School Forum on Corporate Governance and Financial Regulation

Insider trading doctrine clearly applies to most familiar crypto assets and their traders. The legal requisites for insider trading regulation—jurisdiction, material non-public information, breach of duty—are frequently conjoined. The most obvious examples of this concern misappropriation by employeesof crypto asset trading venues about the venue’s plans to support a crypto asset; allegations of this sort of insider trading have already ended up in federal court. But there are many more examples, such as misappropriation by government officials and members of mining pools. Ultimately the question is not whether insider trading law applies to crypto assets; it is whether we want it to.

https://corpgov.law.harvard.edu/2019/05/29/crypto-assets-and-insider-trading-laws-domain/

Interesting Action From OFAC
by Matt Kelly
Radical Compliance

Compliance officers might want to take a close look at the wrist-slap that State Street Corp. received from the Office of Foreign Assets Control on Tuesday, for violations of sanctions against Iran. It’s a small but telling example of how a robust compliance program brings benefits, OFAC or otherwise.
OFAC did cite State Street for violating Iran sanctions, because the bank acted as custodian for a customer’s retirement plan and processed $11,365 worth of pension payments to the customer, a U.S. citizen, while he was residing in Iran in the mid-2010s.

http://www.radicalcompliance.com/2019/05/28/interesting-action-from-ofac/
PMC 2019
Please support my ride to fight cancer. On the first weekend in August, I’ll be riding across Massachusetts to raise money for cancer research. I could use your support:
https://profile.pmc.org/DC0176

Affiliate Transactions as a Ponzi Scheme

Actions by the Securities and Exchange Commission against real estate companies will catch my attention. A recent complaint against Robert Morgan and his affiliated real estate funds did just that.

The SEC complaint is just charges, so we don’t know if the statements are true or what Morgan’s response will be. I’m just using it as a learning tool.

The main charge against Morgan is a criminal complaint for mortgage fraud. In a Department of Justice press release:

The defendants provided false information to financial institutions and government sponsored enterprises overstating the incomes of properties owned by Morgan Management or certain principals of Morgan Management. The false information induced financial institutions to issue loans: (1) for greater values than the financial institutions would have authorized had they been provided with truthful information; and (2) that the financial institutions would not have issued at the time of issuance had they been provided with truthful information.

The SEC grabbed a piece of the action when it was discovered that Morgan has raised four private funds from investors to finance Morgan properties. The funds, managed by Morgan, made what look like mezzanine loans to the properties owned by Morgan.

See if you if you can spot the conflict? Yes it’s obvious.

According to the complaint, Morgan did not treat these as third-party loans in terms of documentation or valuation of the underlying assets. Morgan also used funds to pay off loans that were maturing and owed to other funds.

Lots of conflicts for sure. According to the complaint, the offering materials stated that the loans from the funds would be going to affiliates managed by the funds’ manager. According to the complaint, one fund’s loan to a Morgan affiliate was often used to fund the repayment of another fund’s loan. The SEC labels these pay-off as “Ponzi scheme-like payments.”

The SEC brought its charges for violating the anti-fraud provisions of the Securities Act and Exchange Act.

Numerous affiliate transactions like those in the Morgan empire are full of conflicts and issues. It can be done, with lots of controls and documentation in place. The SEC complaint makes it sound like those were not in place.

Sources: