Author: Doug Cornelius

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

A Court Rules that an ICO was not a Securities Offering

Last month, I wrote about the complaint filed by Securities and Exchange Commission against Reginald Ringgold and his Blockvest initial coin offering. One of the Blockvest’s marketing ploys was to note its membership in the Blockchain Exchange Commission.

The SEC managed to obtain an emergency court order to halt a planned initial coin offering of Blockvest, which falsely claimed that it was approved by the SEC. The order also halts ongoing pre-ICO sales.

After a hearing and Mr. Ringgold’s presentation of his side of the story, the court decided to deny the SEC’s motion for a preliminary injunction. The court found that there are disputed facts about the nature of Blockvest’s status that makes it unclear if the tokens were securities.

The main defense of Mr. Ringgold is that Blockvest was only in the test stage. The 32 “purchasers” of the Blockvest tokens were test users. It was not clear that the test users had an expectation of profit or that their purchase were actually at risk while Blockvest was testing.  The SEC and Mr. Ringgold had different stories of what documents were made available to these testers that induced them to buy the Blockvest tokens.

The “Buy Now” button on the Blockvest website didn’t work.

My reading of the decision is that Blockvest was not yet an ICO so there was no securities offering. The SEC action has stopped it. The Court found that it’s unlikely that Mr. Ringgold will make the offering.

While there is evidence that Ringgold made misrepresentations shortly after the complaint was filed and prior to having retained counsel, Ringgold, with counsel, now asserts he will not pursue the ICO and will provide SEC’s counsel with 30 days’ notice in the event they decide to proceed. By agreeing to stop any pursuit of the ICO, Plaintiff does not oppose the preliminary injunction concerning compliance with federal securities laws. Therefore, Plaintiff has not demonstrated a reasonable likelihood that the wrong will be repeated.

It looks like it’s a win for both sided. The SEC stopped Blockvest before it could take money from the public and Mr. Ringgold managed to avoid immediate SEC action.

Sources:

Do Private Equity Funds Manipulate Reported Returns?

Some do, and it backfires.

In a working paper by Gregory W. Brown, Oleg R. Gredil, and Steven N. Kaplan they studied cash flows and NAV reports for a sample of 2,071 buyout and venture funds. The study was motivated by the potential incentive for fund managers to exaggerate performance to attract investors to a follow-on fund. They looked for evidence consistent with funds manipulating their self-reported net asset values around the time commitments are raised for a next fund.

The results of this analysis suggest that exaggerated NAVs are associated with lower probability of raising a follow-on fund. When they examined performance of funds that are unsuccessful at raising a follow-on fund, they observed clear evidence of performance reversals toward the end of fund life that is consistent with investors seeing through attempts of performance manipulation. Furthermore, they saw that conservative reporting and credible signaling (via distributing capital back to investors) have, on average, stronger effects on fundraising-odds than market-adjusted performance. The results were similar for both buyout and venture funds.

The study concludes that top-performing fund managers may try to safeguard their long-term reputation from bad luck by reporting conservative NAVs.  They are more likely to do this when it does not jeopardize their high relative performance rank. Correspondingly, limited partners punish fund managers for the appearance of overstated performance by not providing capital to subsequent funds.

The findings corroborate the evidence in another study that private equity fundraising outcomes are largely determined by sophisticated counterparties.

Sources:

The Pre-Holiday Regulatory Axe

While I was preparing for Thanksgiving on Wednesday, the Securities and Exchange Commission put 43 of its rules on the chopping block.

As you know, it’s not so simple to just eliminate a rule. Eliminating a rule is itself a rulemaking, requiring notice and comment periods. Of course, the SEC would also need to justify why the rule which was at one time deemed to work, no longer works.

The Regulatory Flexibility Act requires requires federal agencies to review regulations for their impact on small businesses and consider less burdensome alternatives. Sec did its part and provided 43 rules. The list is not binding. It’s just notice that the SEC is thinking about making changes to these rules and invite comment. The rules may be continued without change, or could be
“amended or rescinded to minimize any significant economic impact of the rules upon a substantial number of such small entities.”

I’m not sure where private funds and real estate fund managers might fit into the size and scope of a “small entity.”

I found two rules to be the most applicable to private fund managers on the list:

  1. 206(4)-8 Prohibition of fraud by advisers to certain pooled investment vehicles.
  2. 206(4)-2 Custody Rule 

The applicability of fraud to investors rule is a bit a remnant from the SEC trying to breach the old small adviser exception to registration. There is always an inherent conflict between a fund manager looking out for the best interest of the fund and looking out for the best interest of a certain investor. Fund investors are going to have different tax, liquidity and diversity requirements. I’m not sure what is wrong with the rule that has caused the SEC to put it on this list.

The Custody Rule is full of land mines and foot faults for fund managers. I’m sure many fund managers and investment advisers would like clarification on many aspects of the rule and to clean up the messy guidance that has followed since the rule was last amended in 2009.

In a recent conversation with some SEC folks, we discussed the Chairman’s reminder that guidance is not binding. Word is that the SEC would like to roll up guidance into officially approved rules. It seems like the Custody Rule and its followup guidance fit into that category.

Sources:

A Focus on Residential Real Estate and Money Laundering

The Financial Crimes Enforcement Network announced the issuance of revised Geographic Targeting Orders. The threshold for reporting has been reduced down to $300,000 for all-cash purchases of residential real estate. The geographic scope has been expanded to now include nine cities: Boston; Chicago; Dallas-Fort Worth; Honolulu; Las Vegas; Los Angeles; Miami; New York City; San Antonio; San Diego; San Francisco; and Seattle.

The GTO requires U.S. title insurance companies to identify the natural persons behind all-cash purchases of residential real estate over that dollar threshold in those markets.

“All cash” means “[s]uch purchase is made, at least in part, using currency or a cashier’s check, a certified check, a traveler’s check, a personal check, a business check, or a money order in any form, a funds transfer, or virtual currency.”

I have no problem with virtual currency purchases having to be reported when used by a company buying residential real estate.

I think that threshold is going to be too low for those jurisdictions and overwhelm the FinCEN reporting structure.

I’m speaking a bit from personal experience. The GTO now covers my town. The definition of “Boston” includes all of Middlesex and Suffolk County. Suffolk is Boston proper and its various neighborhoods. Middlesex County, I assume, is targeted to Cambridge. But Middlesex county includes over fifty towns, stretching from Hopkinton, to Newton, to Ashby to Lowell.

There are lots of old houses and lots of developers buying those old houses and fixing them up. Like any good business, they use entities to limit liability and to meet lender single-purpose entity requirements.

Almost any residential purchase ends up using a check to cover part of the final purchase price. I expect the GTO will sharply increase the reports flowing into FinCEN. More so than expected.

I just think the GTO is too broad geographically and the dollar amount is too low. That can be fixed.

The GTO is effective. A study found a 95 percent drop in how much cash shell companies and other corporate entities spent on homes. The decline began immediately after the fist GTO rule took effect in March 2016. Before the rule, corporate entities bought an average of $111 million worth of homes with cash in Miami-Dade per week, or 29 percent of all residential transactions, according to the study. But almost immediately after the reporting requirement began, that number plummeted to $5 million per week, or 2 percent of all transactions.

Sources:

Compliance Bricks and Mortar for November 16

These are some of the compliance-related stories that recently caught my attention. Little bits to grow your building knowledge base.

Steve Cohen Will Pay Extra for Compliance Tips by Matt Levine

How did this happen, you might well ask. There are some obvious answers. For one thing, a culture of compliance at Point72 really might be a delicate bud that needs to be carefully nurtured with constant cheerleading and incentive programs. 1 For another, I mean, it’s not impossible that Steve Cohen spends an hour a day thinking up ways to annoy everyone, is it? [More…]

A Tribute to the Fantastic Four: Part I- Four Questions for Goldman Sachs by Tom Fox

The Fantastic Four introduce four questions that Goldman Sachs will have to answer around its role in the 1MDB scandal. While the company has tried to separate itself from its former partner Tim Leissner and former Managing Directors Roger Ng and Andrea Vella; given Leissner’s remarks about company culture and the company’s expectations at his guilty plea hearing this past summer. [More…]

New Company Policy: Don’t pay bribes by Richard L. Cassin

Could a company ever replace a 50-page anti-corruption policy with three words: Don’t pay bribes?

Would supervisors, managers, and executives take ownership of a three-word policy? [More…]

NAVEX Global Research Demonstrates Correlation Between Business Performance and Hotline System by Michael Volkov

In an interesting new report (here), NAVEX Global enlisted Professor Kyle Welch from George Washington University’s Business School to analyze years of NAVEX Global’s hotline data.  Professor Welch was given access to over ten years (2004 to 2017) of NAVEX Global’s hotline data …. The study shows a correlation between increased use of internal hotline reporting systems and improved business performance.  The benefits to a company increase with use of the hotline reporting system. [More…]

Time Limits and SEC Enforcement Actions by Thomas O. Gordon in SEC Actions

In Kokesh the Supreme Court held that the statute of limitations applies to disgorgement in SEC enforcement actions. Accordingly, if the agency fails to initiate its action in a timely fashion requests for disgorgement may be time barred. No such time limit applies, however, once the case is brought. To the contrary, the action may continue for years. The point is well illustrated by a case the Commission recently partially settled which traces to 2009. [More…]

How Co-investments continue to evolve by Lisa Fu in PERE

Meanwhile, managers are also reevaluating how some investors take part in co-investments. A manager may agree to let investors commit to a co-investment opportunity without taking part in the main fund, according to a fourth panelist. His own firm brought on third-party investors for co-investments based on their unique capabilities to help grow a particular platform, he said. However, because of the increasing demand for co-investments and the fact that such opportunities are “too valuable” to offer to investors without receiving a fund commitment in exchange, he believes there will be a trend toward limiting co-investment opportunities to investors in the primary vehicle. The one exception would be an investor that possesses a unique attribute that can help execute on an investment plan, he said. [More…]

Highlighting the “SEC” in cybersecurity: Continued regulatory focus on preparedness and response by Jennifer Achilles and Jim Barbuto

The SEC appears to be focused on the importance of well-designed policies and procedures and training. Two elements of compliance that the Report emphasizes are the importance of procedures to authorize wire transfers (including the requirement for multiple levels of approval and verifying changes in counterparties) and the need for continued training of employees to familiarize them with common cyberattack strategies. These focal points serve as useful action items for companies to evaluate their own risk profiles. Although the SEC refrained from suing the companies mentioned in the Report, the attention paid to internal controls and cybersecurity in particular is a shot across the bow that the SEC will not be as generous in the future. [More…]

Sentences upheld in double jeopardy dispute by R. Jason Howard, J.D.

On the heels of the Supreme Court holding in Kokesh v. SEC that disgorgement, “as it applied in SEC enforcement proceedings, operates as a penalty,” the Sixth Circuit, in a criminal sentencing appeal, held that SEC civil disgorgement is not a criminal punishment (U.S. v. Dyer, November 13, 2018, Suhrheinrich, R.). [More…]

 

Exam Initiatives Focused on Registered Investment Companies

The SEC’s Office of Compliance Inspections and Examinations has issued a risk alert announcing its intention to conduct a series of examination initiatives focused on issues affecting certain registered investment companies and investment advisers. According to the Risk Alert, examiners have six initiatives:
  1. Index funds that track custom-built indexes
  2. Smaller ETFs and/or ETFs with little secondary market trading volume
  3. Mutual funds with aberrational underperformance relative to their peer groups
  4. Mutual funds with higher allocations to certain securitized assets
  5. Side-by-side management of mutual funds and private funds
  6. Funds managed by advisers that are relatively new to managing registered investment companies

Given my areas of interest, number 5 interested me the most. OCIE is stating that managing a private fund and a mutual fund is a risk indicator.

The Risk Alert points to three main issues: Allocation of investments, allocation of expenses and proper disclosures.

If a manager is getting paid more for performance in one investment platform over the other, there is an incentive to put the best investment opportunities in the higher paying platform. That is a compliance concern for all fund managers with more than one investment platform. Everyone needs good allocation policies and procedures.

As for expenses, different platforms may have different agreements on the investors willingness to pay some expenses. Compliance needs to be focused on making sure the manager is not putting all of an expense on the platform that can pay that expense when it should be allocated to more platforms. If the platform does not pay the expense, then the manager pays.

Of course, disclosure is key to investment adviser compliance. A manager needs to disclose and operate within that disclosure.

Sources:

Excelsior!

Stan Lee, the legendary writer and publisher of Marvel comics who helped created countless superheroes, has died. He was 95. On his own and through his work with collaborators Jack Kirby, Steve Ditko, Bill Everett. and others, Mr. Lee created Spider-Man, the X-Men, the Mighty Thor, Black Panther, Iron Man, the Fantastic Four, the Incredible Hulk, Daredevil and Ant-Man and many other comic book heroes.

His catchphrase of “Excelsior!” means ever upward.

I’m looking for the Latin translation of “ever more compliant!”

Cryptocurrency Problems Roundup

Crypto Currency can be a Commodity

A federal judge in Massachusetts agreed with the Commodity Futures Trading Commission’s view that virtual currencies are commodities under the Commodity Exchange Act and subject to federal regulation. See CFTC v. My Big Coin Pay, Inc., (D. Mass. Sept. 26, 2018). The CFTC sued a virtual currency company and several affiliated companies and individuals alleging fraud and misappropriation in the sale of the virtual currency “My Big Coin.” The CFTC claims that defendants perpetrated the fraud by falsely representing to purchasers that My Big Coin was “backed by gold,” could be used anywhere Mastercard was accepted, and was being “actively traded” on several currency exchanges.

My Big Coin Pay is the second federal court decision to embrace that virtual currencies are commodities under federal law. In CFTC v. McDonnell, (E.D.N.Y. Mar. 6, 2018), the court found that the term “commodity” encompasses virtual currency “both in economic function and in the language of the statute” because virtual currencies are “‘goods’ exchanged in a market for a uniform quality and value.”

Unregistered national securities exchange

The SEC brought its first enforcement action against a cryptocurrency trading platform for operating as an unregistered national securities exchange. EtherDelta is an online platform for secondary market trading of ERC20 tokens used by Etherium based crypto. Over an 18-month period, EtherDelta’s users executed more than 3.6 million orders for ERC20 tokens, including tokens that are securities under the federal securities laws. Almost all of the orders placed through EtherDelta’s platform were traded after the Commission issued its 2017 DAO Report, which concluded that certain digital assets, such as DAO tokens, were securities and that platforms that offered trading of these digital asset securities would be subject to the SEC’s requirement that exchanges register or operate pursuant to an exemption. EtherDelta offered trading of various digital asset securities and failed to register as an exchange or operate pursuant to an exemption.

The Environment

If you’re an environmentalist you also need to think about the energy of cryptocurrency mining. The amount of energy required to “mine” one dollar’s worth of bitcoin is more than twice that required to mine the same value of copper, gold or platinum.

You Can’t Hide Overseas

The Tezos blockchain project established a Swiss non-profit stiftung to oversee the ICO and control the proceeds. No surprise that the ICO was bad for those who bought and they a class action. The court found the tokes to be securities. The meant the sale was an unregistered security transaction. The only question was whether the ICO and its sponsors were subject to US securities laws.  The court listed several factors that contributed to its determination that the sale of Tezos tokens had occurred in the United States, including that:

  • US investors bought Tezos tokens
  • a website that sold the tokens was hosted in the US and run by a person located in the US
  • marketing efforts targeted US residents
  • payments made in Ether for the Tezos tokens were validated by a network of Ethereum nodes clustered more densely in the US than in any other country.

Unregistered Broker-Dealer

The Securities and Exchange Commission imposed sanctions against TokenLot LLC, an “ICO Superstore,” for its sales of digital tokens to the general public through a website. The SEC found that TokenLot acted as unregistered broker-dealers in violation of Section 15(a) of the Securities Exchange Act of 1934 and engaged in unregistered securities offerings in violation of Section 5 of the Securities Act of 1933.

Summary

It’s clear the SEC and CFTC have some easy targets in ICOs and their sponsors. I expect there are many more cases in the pipelines.

Sources:

Compliance Bricks and Mortar for November 9

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

Time to Renew Registrations for RIAs and BDs; SEC Allows Mutual Fund Boards to Rely on CCOs, and NFA kicks out Members for Failure to Pay Dues: Regulatory Update for November 1, 2018
by Hardin Compliance Consulting LLC

Annual Renewal Program for IARD System: Get out your checkbooks!  It is time for the annual renewal of investment adviser (IA) firms and their IA representatives’ (IARs) registrations with jurisdictions/states. Preliminary renewal statements for the IARD system will be available November 12, 2018, and the deadline for the receipt of preliminary statement payment is December 17, 2018. [More…]

A Simple Way to Explain the Difference Between Legal and Compliance by Ricardo Pellafone in SCCE’s Compliance and Ethics blog

So, here’s an analogy that we think gets the job done: the next time someone asks you to explain the difference between legal and compliance, put it in terms of safety and insurance.

Preventing liability versus preventing fire. [More…]

Compliance officers as entrepreneurs? by Jeff Kaplan in Conflict of Interest Blog

In a paper recently published by Boston University School of Law – The Law Office (LO) and Compliance Officer (CO): Status, Function, Liabilities, and Relationship  – Emerita Professor Tamar Frankel of that school quotes a former SEC official (John Walsh, then Chief Counsel, Office of Compliance Inspections and Examinations) as noting the following:

[C]ompliance officers have the characteristics of entrepreneurs. They have the “what next” mentality. They are excited about change and interested in the unknown; perhaps because the unknown is where their opportunities lie. They are not afraid of what they do not know and are eager to learn. With continuous learning come recognizing problems and ideas for solutions. They focus on creating and implementing new ways of doing things. Often, they are more interested in the future than in the present or the past, particularly if the future promises better methods and results. This process and the ideas it brings, are the exciting for entrepreneurs. In this respect COs are similar to entrepreneurs. [More…]

Insider Trading: Are Insolvent Firms Different? by Andrew Verstein

One difference is the level of regulation of trading in the residual claims of the firm. In solvent firms, the residual claims are equity securities, and equity securities are subject to the full ambit of trading restrictions. In insolvent firms, non-equity claims such as trade credit or bank loans typically constitute the residual claims. These non-equity residual claims are subject to less stringent regulation precisely because they are not equity and they may not even be securities. [More…]

The Fonzie…er ah…Ponzi Scheme by Jennifer L. Abernathy, Esq., CAMS in SCCE’s Compliance and Ethics blog

Not only did the internet produce one definition for a Fonzie scheme – it actually produced two! The first consists of defrauding a restaurant owner from earning money from a jukebox by playing songs on it for free. The second involves dating more than one girl in the same night. [More…]