Doug Cornelius on compliance for private equity real estate
“The Securities and Exchange Commission today announced that it will close its Salt Lake Regional Office (SLRO) later this year, reducing its regional footprint from 11 regional offices to 10.”
The SEC’s Salt Lake City office has always stood out for covering such a small area. According to the press release, it has been the SEC’s smallest regional office. It has not housed examination teams for many years.
We’ve seen a few cases of trading on material, non-public information sprouting from spouses working at home. We just got another one, with a twist.
Most recently, we had the case of a BP manager having her spouse spy on the merger activity she was working on for her company. That husband is tied up with criminal charges and a divorce. [The One with the Divorce]
In today’s case, Ms. Perez de Madrid checked out her husband’s computer screen while he was out of the room. He was a lawyer for an international, research-focused biopharmaceuticals private company in connection with its acquisition of global, commercial-stage biopharmaceutical company with ADS shares listed on NASDAQ. She promptly bought shares in the acquisition target. A few weeks later the value of the shares doubled when the acquisition was announced.
What to do with a $300 thousand windfall? Rather than go on a secret spending spree she told her husband. Since he was a lawyer, I assume he immediately knew there was a problem. He knew she could face jail time.
They kept the money in the account and reported the illegal activity to the Securities and Exchange Commission. Clearly, the SEC likes problems to be self-reported. The penalty was only disgorgement of the gains and a small interest payment. No jail time. No penalty.
Sources:
Film production is risky. There is need for capital to make the films and there are investors who want to say they helped fund a film. Christopher Conover had clients and investors who wanted to make those investments.
Mr. Conover disclosed that he “receives fees related to Mr. Conover’s role as an Executive Producer for film and television productions” and “a conflict of interest exists to the extent Hudson has an incentive to recommend investments in films and television productions for which Mr. Conover serves as Executive Producer.”
For two years, Hudson failed to disclose the producer compensation in its Form ADV. When it did update the disclosure is failed to disclose that the compensation was based solely on the amounts of money loaned to the Production Company for these films. The SEC felt the disclosure was inadequate.
The real problem is that the investments went bad. Mr. Conover made the mistake of allowing one investor to redeem and take money out while preventing other investors from doing so. According to the fund documents, partners who wanted to redeem their interest had to give at least 90 days’ notice and were capped at a withdrawal of 50% on a quarterly basis. Hudson and Mr. Conover deviated from their practice of satisfying limited partner redemptions on a pro rata basis when it lacked liquidity and redeemed a single investor in full ahead of other simultaneously submitted redemption requests from other investors. That special treatment was a violation of Mr. Conover’s fiduciary duty in the eyes of the SEC.
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These are some of the compliance-related stories that caught my attention this week.
By Sean Dowd, Rich Kando, and Chris Crovatto, AlixPartners LLP
Harvard Law School Forum on Corporate Governance
Risk assessments take on many forms, but there are three critical components of a risk assessment that, when consistently applied, help to compartmentalize a company’s often highly complex risk environment and measure progress. A risk assessment requires (1) the identification of the inherent risks present within a company’s operations, in this case a company’s GenAI program and its use case, (2) the effectiveness of a company’s existing safeguards in addressing those inherent risks, and (3) the remaining residual risks after the application of those safeguards.
by David Lynn
The Corporate Counsel .net
On Monday, the PCAOB adopted two new standards. First, the PCAOB adopted a new audit quality control standard, replacing the existing AICPA standard that pre-dated the creation of the PCAOB. The new standard requires all PCAOB registered firms to identify their specific risks and design a quality control system that includes policies and procedures to address those risks.
By Hamid Mehran and Chester Spatt
The CLS Blue Sky Blog
We argue that bank regulation and supervision interfere with pricing risk by creating opacity. Given that market disclosures enhance the efforts of supervisors, and vice versa, more disclosure could enhance financial stability (see Spatt, 2010)[1]. In addition, we believe that disclosure would provide information on the competence and performance of regulators and supervisors (reducing adverse selection about regulators) and increase their incentives (reducing moral hazard). This would make capital markets more effective in addressing future banking problems and reducing reliance on bank regulators who have arguably failed the public. We question the value of withholding vast amounts of banks’ privileged information and argue that, although this unique regulatory practice has a long history, it is not ethical in the context of fair treatment of investors in public entities. Indeed, firms are required under the securities laws to disclose material nonpublic information, at least when they raise capital.
Consumer Financial Protection Bureau v. Community Financial Services Association of America, Limited __ US ___ (2023)
The Bureau’s funding statute satisfies the requirements of the Appropriations Clause. The statute authorizes the Bureau to draw public funds from a particular source—“the combined earnings of the Federal Reserve System”— in an amount not exceeding an inflationadjusted cap. 12 U. S. C. §§5497(a)(1), (2)(A)–(B). And, it specifies the objects for which the Bureau can use those funds—to “pay the expenses of the Bureau in carrying out its duties and responsibilities.” §5497(c)(1). The Bureau’s funding mechanism also fits comfortably within the historical appropriations practice described above. P. 15– 16.
The Securities and Exchange Commission published its 2024 report on Form ADV data for investment advisers.
The number of advisers and total assets have increased dramatically.
From 2012 when Dodd-Frank implemented a change requiring fund managers to register the number of registered investment advisers and Exempt Reporting advisers has increased by 60% from 13,222 to 21,203. The Regulatory assets under management has increased 138% from $55 trillion to $128.8 trillion.
The number of private funds has tripled from 33 thousand to over 100 thousand, with gross assets also tripling from $9 trillion to $27 trillion.
For real estate funds, there 658 registered advisers with over $1.1 trillion in gross assets for the 5,215 real estate funds. Those are increases from 371 advisers, $0.3 trillion in gross assets in 1,827 funds in 2012.
Sources:
The Securities and Exchange Commission and the U.S. Department of the Treasury’s Financial Crimes Enforcement Network (FinCEN) jointly proposed a new rule that would require SEC-registered investment advisers and exempt reporting advisers to have customer identification programs (CIPs). The proposed rule is designed to prevent illicit finance activity involving the customers of investment advisers. The proposal is generally consistent with the CIP requirements for other financial institutions, such as brokers or dealers in securities and mutual funds.
This proposed rule complements the separate FinCEN proposed from February 2024 to designate RIAs and ERAs as “financial institutions” under the Bank Secrecy Act and subject them to AML/CFT program requirements and suspicious activity report filing obligations.
I think most fund managers are already taking steps to make sure they are not doing business with terrorists, drug-dealers and other sanctioned people. The proposed rule is going to require more paperwork for low-risk customer/clients/investors.
At this point its just a proposed rule. I think it will eventually be put in place and largely unchanged. It’s really just a question of timing. I assume they will try to put this rule in place with the same compliance deadline as the February proposal. There is a 60-day comment period and then time to address the comments. I’d guess fourth quarter of 2024 for publication of the final rule and 2025 year-end for a compliance deadline.
Sources:
These are some compliance-related stories that recently caught my attention.
by Geoff Schweller
Whistleblower Network News
The SEC order further clarifies that while the whistleblower learned of the misconduct in a role where their principal duties involve compliance or internal audit responsibilities, they were eligible for an award because “Claimant reported the information internally to Claimant’s supervisor and to the Chief Compliance Officer or its equivalent, and then waited at least 120 days to report the information to the Commission.”
SEC Rule 240.21F-4(b)(4)(iii)(B) provides for this 120-exception for compliance and audit whistleblowers.
The SEC Whistleblower Program had a record setting year in the 2023 Fiscal Year. The program issued nearly $600 million in whistleblower awards, the most ever in a fiscal year, including a $279 million award, the single largest award in program history. The whistleblower program also received a record 18,000 whistleblower tips over the course of the fiscal year.
by Jaison R. Abel, Richard Deitz, Jonathan Hastings, and Joelle Scally
Liberty Street Economics
Employment fell nearly 15 percent in the United States between February 2020 and April 2020—a shockingly large decline in such a short period of time. The country had dug itself out of this massive hole by the summer of 2022, recovering all of the jobs that were lost, and employment is now nearly 4 percent above pre-pandemic levels. As the map below shows, however, the recovery has been uneven and remains incomplete in many places. Indeed, while most metro areas have recouped the jobs that were lost during the recession (shown as blue dots), more than 25 percent still have not (shown as red dots). Most of these areas are concentrated in the Rust Belt along the Great Lakes, though clusters are present in parts of the South—Louisiana in particular—as well as in California, Oregon, and Hawaii. In fact, employment is still more than 5 percent below pre-pandemic levels in New Orleans, and more than 3 percent below in Honolulu and San Francisco. Likewise, sizable job shortfalls remain in Cleveland, Detroit, and Pittsburgh. At the other end of the spectrum, employment in fast-growing parts of the country such as Austin, Boise, Phoenix, Raleigh, Charleston, and Sarasota is now more than 10 percent above pre-pandemic levels.
By Mark Maurer
The Wall Street Journal
“That’s an issue that we have definitely heard, and it’s under consideration,” Public Company Accounting Oversight Board Chair Erica Williams told The Wall Street Journal, referring to investor feedback. “There have been previous boards that have focused on that issue, and so we’re looking at the work that they’ve done there.”
PCAOB staff are looking into this issue as it has for years under previous boards, Williams said. No formal consideration is under way, meaning the staff could recommend the issue be added to the agenda or drafted as a proposal for the board to vote on, but hasn’t yet, she said.
By David Yaffe-Bellany and Emily Flitter
The New York Times
On a trip to Nigeria in January, Tigran Gambaryan, a compliance officer for the giant cryptocurrency exchange Binance, received an unsettling message: The company had 48 hours to make a payment of roughly $150 million in crypto.
Mr. Gambaryan, a former U.S. law enforcement agent, understood the message as a request for a bribe from someone in the Nigerian government, according to five people familiar with the matter and messages reviewed by The New York Times. He and a group of his Binance colleagues had just met with Nigerian legislators, who accused the company of tax violations and threatened to arrest its employees.
By David Yaffe-Bellany
The New York Times
But the recoveries come with a caveat. The amount owed to customers was calculated based on the value of their holdings at the time of FTX’s bankruptcy in November 2022. That means customers won’t reap the benefits of a recent surge in the crypto market that sent the price of Bitcoin to a record high. A customer who lost one Bitcoin when FTX imploded, for example, would be entitled to less than $20,000, even though a Bitcoin is now worth more than $60,000.
You’re sitting poolside sipping on margaritas with your buddy. You’ve always wanted to work together and your buddy says that now would be a good time to do so. You ask, what about your current position. Your buddy, with a few margaritas in his gut, tells you that his current position is uncertain because the company is going to get sold.
What should you not do?
(A) Buy you buddy another margarita
(B) Buy some nachos
(C) Buy stock in your buddy’s company
Steven Masterson chose (C) and that was the wrong answer.
His buddy worked at Dover Motorsports, a public company. The information that the company was getting sold is Material, Non-Public Information. He should have known that the information was confidential and he shouldn’t trade on it.
Instead Mr. Masterson called his investment adviser and directed a purchase of $100,000 worth of stock in Dover Motorsports. Two months later the acquisition was announced and Mr. Masterson made a tidy profit.
At least until the Securities and Exchange Commission got involved and accused Mr. Masterson of insider trading. He disgorged his tidy profit and paid a fine equal to that profit.
Sources:
With the issuance of the Marketing Rule for Investment Advisers (Rule 206(4)-1) decades of interpretations and guidance were wiped out. We’ve been waiting to see what falls under those seven general prohibitions in the Marketing Rule. We’ve been thirsting for more guidance.
We’ve gotten some additional clarification on the performance aspects of marketing. We know we can’t put hypothetical performance on a website. We know the net and gross returns have to be calculated in the same manner. (see FAQ 4).
The Division of Examinations released a Risk Alert with the Initial Observations Regarding Advisers Act Marketing Rule Compliance that provides some of that additional guidance of what not to do. It’s mostly a hit list of what not do.
These dozen are just some of the anecdotes mentioned in the Risk Alert. Most of these are very obvious failures.
Sources:
Another fund manager was heavily fined for an employee making a political contribution. Wayzata Investment Partners had to pay a $60,000 fine.
The Minnesota State Board of Investments made $300 million in commitments to Wayzata funds from 2007 to 2013. In 2022 a Wayzata employee made a $4000 campaign contribution to a Minnesota elected official who was up for re-election. The board of the Minnesota State Board of Investments consists of the Governor, State Auditor, Secretary of State, and Attorney General. All are elected offices. Neither the name of the employee or the politician are named in the SEC action.
Under SEC Rule 206(4)-5 a covered associate of a registered investment adviser can not make a contribution of more than $150 to a elected official who can directly or indirectly influence investment decisions. The Minnesota State Board of Investments falls under the coverage of the Rule.
The $60,000 fine was levied even though the funds were closed-end funds with no opportunity for withdrawal. The contribution was years after the commitments were made. There was no finding that there was a connection between the government investment and the political contribution. Under the Rule, the SEC does not have to prove any connection.
The fine is much less than the full penalty under the SEC rule which would be forfeiture of 2 years of management fees and carried interest.
As with some other political contribution fines, Commissioner Peirce dissented from the decision in this case. She points out the stifling of political participation.
I’ll point out the magnitude of the fine. In most SEC cases the subject ends up paying a fine that matches the damage. In these political contribution cases, the subject is paying over a 10x penalty.
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