Author: Doug Cornelius

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Compliance Bricks and Mortar for June 15

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

Is Over-Regulation Really the Reason There are Fewer IPOs? by Kevin LaCroix

There is one aspect of Coffee’s analysis that in my mind warrants further consideration. In discussing the advantages for smaller companies of raising money through venture capital or private equity rather than by going public, he notes that in the private markets “litigation risk is lower.” In a later section of his paper, Coffee notes that many of the costs of going public are “hidden,” noting, for example, the concerns small companies considering an IPO may have that when public “a stock price drop might spur litigation.” Coffee does not further elaborate on the possible impact that litigation fears could be having on smaller companies’ decisions to go public, nor does he suggest what might be done to address these concerns. However, it is noteworthy (and to me it rings true) that litigation fears could be among the reasons holding back smaller companies from going public. [More…]

Why Law Firms Should Never Accept Their Fees in Cryptocurrency by John Reed Stark

But having said all of the above, the risks for a law firm that accepts cryptocurrency run a perilous gamut of legal, regulatory, financial, ethical and reputational dangers. Simply stated, accepting cryptocurrency as a fee payment in today’s crypto-manic environment is, despite all of the bus dev allure, just not worth it.  [More…]

Wall Street’s Top Cop Chases Loose Change by Stephen Gandel

But 13 months in, Clayton’s SEC appears to be giving quality short shrift, at least as measured by the settlements it is reaching. According to a recent, previously unreported study conducted by Urska Velikonja, a professor of law at Georgetown University, the SEC’s monetary punishments plunged 93 percent in the period from October 2017 to March 2018 — the first half of the SEC’s 2018 fiscal year — compared with the amount in the period a year earlier. The total of $102 million was down from $1.4 billion and was the lowest of any similar period for at least the past 12 years. The number of cases in the same period was down by a quarter. That suggests Clayton has refocused the SEC’s lens on either smaller fish or smaller frauds. [More…]

Insiders Pocket Gains on Buybacks, Vexing Regulator by Gretchen Morgenson and Tom McGinty

Taking advantage of price bumps that often accompany share-repurchase announcements, company executives have been selling significantly more of their stock immediately after the news than they do beforehand, according to an analysis by Robert J. Jackson, Jr. , a commissioner at the Securities and Exchange Commission. [More…]

FAQs on ZTE’s Compliance Settlement by Matt Kelly

The settlement calls for ZTE to hire a “special compliance coordinator,” who will be selected by the U.S. Bureau of Industry and Security. The “SCC” will have a term of 10 years, and report both to ZTE’s chief executive and board of directors; and to BIS. This person will “coordinate, monitor, assess, and report on” all compliance activities by ZTE. He or she will also have authority “to employ at ZTE’s expense as many assistants and other professional staff… as are reasonable.” The agreement mentions a minimum of six assistants. [More…]

The Pay to Play Rule and Political Endorsements

It’s not often that I open The Boston Globe and see a front page story about compliance with Security and Exchange Commission’s Rule 206(4)-5: Patrick stays quiet as his former aide runs for governor. Jay Gonzalez was the former Secretary of Administration and Finance for the state of Massachusetts under Governor Deval Patrick. Mr. Gonzalez is now running for governor.

Former Massachusetts Governor Deval Patrick states that he is barred under federal “pay-to-play” rules from saying anything about any candidates for state or local office because he now works a firm that is registered with the Securities and Exchange Commission as a registered investment adviser. I’m sure the firm has many investors that are state or local pension funds. That makes the firm subject to the pay-to-play rule.

Rule 206(4)-5 was put in place to prevent political support from driving investment choices made by government investors. In that article, the reporter cites a lawyer and professor that both take a much tighter interpretation of the rule. They both say that the rule is limited to monetary contributions. They both say that the rule should not prohibit the ability of someone to voice his or her preference for a candidate.

In the release for Rule 206(4)-5, the SEC states in footnote 154 that:

“it is our intent that, under the rule, advisers and their covered associates ‘are not in any way restricted from engaging in the vast majority of political activities, including making direct expenditures for the expression of their views, giving speeches, soliciting votes, writing books, or appearing at fundraising events.'”

That would seem to fall in favor of the legal experts and conclude that Mr. Patrick and his firm are being too conservative in their interpretation of the rule.

But let’s take a closer look at the rule. A contribution is defined to include a “gift, subscription, loan, advance, deposit of money, or anything of value made for the purpose of influencing an election for a federal, state or local office…” Contributions are limited to the de minimis amounts of $150, or $350 if you can vote for the candidate.

Certainly, my endorsement of a candidate has little to no value. I don’t have a following of political supporters and campaign backers. But Deval Patrick does. I don’t know the value of his endorsement. But I would say that it is worth much more than $350. The SEC rule does not anticipate a high profile person like Deval Patrick at a firm subject to the pay-to-play rule.

You can also credit the “further prohibition” section of the rule that prohibits a covered associate from doing “anything indirectly which, if done directly, would result in a violation of” the rule. Would Deval Patrick’s endorsement be an indirect call for giving campaign contributions to Jay Gonzalez?

I have heard an SEC official state that putting a yard sale on your lawn is a violation of the pay-to-play rule. She was wrong and other senior SEC officials emphatically stated that she was wrong. But we all heard that there is a willingness of the SEC to take a hard position under the pay-to-play rule.

I think the position of Deval Patrick and his firm is correct under the rule. It’s the rule that has problems.

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The Sergeant Shultz View on Inadvertent Custody

There has been a problem floating around for custody for investment advisers. Custody agreement between the client and qualified custodian may permit the adviser to do things with the assets in the account that create a custody problem. The Securities and Exchange Commission had been noticing this problem and last February issued a Guidance Update that flagged it.

The SEC has issued new guidance to address the problem. And the new standard is:

The SEC has updated its Frequently Asked Questions About the Custody.

Back to the substance, it’as all about the adviser not knowing about the inadvertent custody.

“An adviser that does not have a copy of a client’s custodial agreement, and does not know, or have reason to know whether the agreement would give the adviser Inadvertent Custody, need not comply with the custody rule with respect to that client’s account if Inadvertent Custody would be the sole basis for custody.”

It seems best for an adviser to stick its head in the sand or act like Sergeant Schultz and see nothing. The adviser is not a party to the custodial agreement so the powers granted to the adviser may be outside the scope of its knowledge. This new guidance seems like an adviser can purposefully not get a copy of the agreement and shield itself from the custody rule.

With inadvertent custody, the client could force a custody violation on the adviser without its knowledge.

Now, ignorance is a defense.

The other item that caught my attention is that this was released through a new thing called an Information Update.

IM Information Updates are recurring notices regarding the activities of the Division.
The Division generally issues IM Information Updates to alert the public—including
investors and industry participants—to key developments, such as updates to Frequently
Asked Questions, technical improvements to SEC forms, and certain other staff actions.
IM Information Updates may also explain administrative and procedural matters, such as
how to most effectively communicate with the staff.
This IM Information Update does not constitute staff legal guidance and is not a rule,
regulation, or statement of the Securities and Exchange Commission. The Commission
has neither approved nor disapproved its content.

This is somehow different than the Guidance Updates that we have seen from the Division of Investment Management.

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Restructuring and Adviser Performance Track Record

The Securities and Exchange Commission has been skeptical of registered investment advisers using advertisements. The default position is always that it’s likely to be fraudulent, deceptive or manipulative and therefore a violation of Section 206 of the Investment Advisers Act. The level of skepticism has been even higher for performance advertisements and even higher for performance advertisement of a predecessor.

That has lead to the problem of an investment adviser carrying over his or her performance when joining a new firm. Since this happens often, the industry has been able to get the SEC to commit to some clear standards.

The SEC has laid out a five part test for an advertisement that includes prior performance results of accounts managed by a predecessor entity

  1. The person or persons who manage accounts at the adviser were also those primarily responsible for achieving the prior performance results
  2. The accounts managed at the predecessor entity are so similar to the accounts currently under management that the performance results would provide relevant information to prospective clients
  3. All accounts that were managed in a substantially similar manner are advertised unless the exclusion of any such account would not result in materially higher performance,
  4. the advertisement is consistent with staff interpretations with respect to the advertisement of performance results, and
  5. the advertisement includes all relevant disclosures, including that the performance results were from accounts managed at another entity.

The latest guidance from the SEC on this involves a restructuring of an investment adviser firm. South State Bank owned South State Advisory and Minis & Co., each of which were separately registered as investment advisers. The Bank wants to merge Minis and South State Advisory together for some operational efficiency. This triggers the performance advertisement from a predecessor entity concerns.

The Bank proposed that Minis would merge into the other advisor, but operate as a division within it. The SEC said it was okay to keep the performance track record based on the facts.

  1. the Minis Division will operate in the same manner and under the same brand name as Minis
  2. the Minis investment personnel, as well as the management, culture, and processes that helped to give rise to Minis’ track record, will continue after the merger
  3. The same management team that currently manages Minis would manage the Minis Division
  4. the Minis investment committee would continue to have responsibility for the Minis Division’s investment decisions and recommendations
  5. Minis’ performance track record by the Minis Division would be accompanied by appropriate disclosure

Minis pointed out the obvious flaw in the SEC position with the performance track record.  Personnel, management, culture and processes will evolve over time at any firm. Minis merely point out that none of those things are happening immediately as part of the restructuring.

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Insider Guessing

Back a few years ago there was blue collar insider trading case. Some workers on a railroad noticed a lot of guys in suits walking around the rail yards. Their boss made some unusual requests about equipment. The two workers put to and two together and took a guess that the railroad was for sale. They backed their guess up with cash and bought some of the railroad stock.

The railroad did sell, the two made some good gains, and the Securities and Exchange Commission accused them of insider trading. They were clearly insiders because they were company  employees. The SEC failed to show that they gained access to information that betrayed company confidentiality. At least a jury determined that.

The SEC brought a white collar version of the case. The SEC (and the DOJ) accused Jun Ying, a former senior technology executive at Equifax with insider trading. He exercised his stock options and sold his Equifax stock holdings ahead of Equifax’s announcement that it had suffered a major data breach. The SEC says that Ying used confidential information to conclude that his company had suffered a massive data breach.

Ying claims that he merely guessed.

In Ying’s case, he was told about Project Sparta which was setting up a website for consumers to determine if they were affected by a breach and deploying tools for them. The discussion was that Project Sparta was for unnamed client that had experienced a breach. Ying’s boss made some weird statements and Ying got suspicious that the breach was actually of Equifax itself. He backed up his suspicions with cash and sold hie Equifax stock.

Matt Levine coined the term “insider guessing” for this type of situation and asks if it’s illegal.

It certainly looks illegal. That’s why Ying is subject to charges.

Firms have 10b5 plans to avoid this situation. Stock trading is set for pre-determined times to avoid any indication that the employee is trading on inside information.

As a company employee you have access to non-public information. It’s hard to prove that you didn’t know about a particular piece of key information. It’s hard to prove the difference between insider guessing and insider trading.

Obviously, it’s easier to prove insider trading if there is the document or email that shows the knowledge exists. You’re likely to cause the SEC to dig relentlessly to find that document or email or take a document or email out of context to prove its case. I expect the SEC is spending a bunch resources looking for the document or email that would prove that Ying did not merely guess.

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The One With the Whale Whisperer

Often there is little new to discover and learn from in securities fraud charges. The fraudster may or may not have started with good intentions. Regardless, the fraudster takes the investors’ money and spends it on things it was not supposed to be spent on. But I could not help but take a closer look at the securities fraud case where the fraudster is identified as the “whale whisperer.”

At first, I thought the case might have involved JP Morgan’s London Whale who lost the firm $6.2 billion. But it turned out to be a much more colorful character.

Paul Gilman is a New Age composer, rock music producer, and filmmaker. He made a film about using music to communicate with ocean mammals. He apparently had some solid technical skills and upgraded the sound systems for the Houston Astros and the Texas Rangers at their stadiums. He leveraged that into convincing investors to give him more capital for more installations.

He had some idea that he could use sound to lower the viscosity of oil, allowing it to flow through pipelines more efficiently. (That sounds like a evil villain plan to gain entry to an industry, then decimate others with soundwave technology.) He convinced investors to give him capital to test and develop this purported technology.

I don’t know if Mr. Gilman thought he could expand his stadium sound business and develop his oil viscosity sound system or whether he started out intending to steal people’s money. He did not agree to the charges and pleased the Fifth Amendment.

Regardless of his original intent, he did what most frausters do in the end. He spent investors’ money on his own needs instead of the company needs. The SEC points out that he spend the investors’ money on designer clothing, travel and dining, rent and home furnishings, and cash withdrawals at casinos.

In the complaint, the SEC piles on and tells the stories of a nurse in Dallas, a church minister in Tennessee and psychology professor in Houston who “invested” money in Gilman’s enterprises.

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Enforcement Actions for Failure to File Form PF

A mentioned two weeks ago that the Securities and Exchange Commission was looking at private fund managers who failed to Form PF. That is now official and the SEC announced enforcement actions against 13 private fund managers.

The SEC’s orders are against:

Each of the enforcement orders are cookie cutter and straight-forward:

  1. The private fund manager is registered with the SEC and manages private funds.
  2. Rule 204(b)-1 applies to the manager, requiring it file Form PF.
  3. The manager failed to file Form PF.
  4. The manager willful violated Rule 204(b)-1.
  5. The manager has to pay the SEC $75,000.

In each of the orders, the manager is noted as failing to file Form PF in multiple years.

As I said earlier, this is an easy violation for the SEC to catch. When filing Form ADV and listing a private fund, it gets a private fund identification number. It should be fairly easy for the SEC to search its database to see which funds in Form ADV filings were not in Form PF filings.

If you don’t want to file Form PF, you now know the result. You get subject to cease and desist, you get censured, and you pay $75,000. Since you get a cease and desist, you have to file Form PF or face even more serious consequences.

I’m not sure if the 13 orders surprises me because it’s a mistake that nobody should make (or that it’s too high and that there are many other firms out there not doing the filing). I know that there was a great deal of uncertainty about the definitions in Form PF with many funds being advised to file as hedge fund because of the poorly written definitions of the different fund types. These cases are all wholesale failures to file, not for filing the wrong form.

If you’re a private fund manager and haven’t filed a Form PF for one or more of your funds, the SEC has fired this shot across the bow. You’ve been warned. Be prepared to pay your $75,000.

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Compliance Bricks and Mortar for June 1

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

What can we learn from employee reimbursement program disasters? by Julie DiMauro

Boston-based mutual fund company Fidelity fired or let resign about 200 people during the past year after discovering that some employees misused the firm’s partial-reimbursement program, the Wall Street Journal reported, citing a source familiar with the matter. [More…]

The Irrepressible Myth That SEC Overregulation Has Chilled IPOs by John C. Coffee, Jr.

If high regulatory costs and SEC overregulation were a cause of low and decreasing IPO volume, this would be a uniquely American problem. But it is not. IPO volume has declined even more dramatically in Canada and has declined on a level comparable to the U.S. in Europe and Japan. Because Canada has no national securities regulator, the decline of IPOs in Canada cannot be blamed on an overregulating national regulator. [More…]

Whistleblowing Hotlines: A Gray Area Under EU’s New Privacy Law by Henry Cutter

“The ambiguity is there,” said Vera Cherepanova, a compliance consultant based in Milan who wrote a paper for the FCPA Blog on how GDPR will affect the whistleblowing process. “For compliance officers, the problem is that we are not the center. We are not the key concept of the GDPR and basically no one is issuing any official information for us.” [More…]

A View From Virginia: Is It Ethical for Lawyers to Accept Bitcoins and Other Cryptocurrencies? by Sharon D. Nelson and John W. Simek & Jim McCauley

Nebraska is the only state we are aware of that has issued an ethical opinion specifically for Bitcoin usage. Nebraska’s opinion states that lawyers may accept payments in digital currencies, but must immediately convert them into U.S. dollars. Any refund of monies is also made in U.S. dollars and not in digital currency. [More…]

 

Private Funds and the Economic Growth, Regulatory Relief, and Consumer Protection Act

Last week, the Economic Growth, Regulatory Relief, and Consumer Protection Act became law,  providing some revisions to Dodd-Frank and some new regulatory wrinkles. Some of those revisions apply to private funds.

Section 203 exempts Banks and Bank Holding Companies with (1) $10 billion or less in total consolidated assets and (2) total trading assets and trading liabilities of 5% or less of total consolidated assets from the Volcker Rule.

Section 204 allows hedge funds and private equity funds to share the name with a banking entity acting as its investment adviser provided that the investment adviser is not an insured depositary institution and the name does not contain the word “bank.” Interestingly, that new exemption would seem to apply to real estate funds or venture capital funds.

Section 504 Revises the exemption in 3(c)(1) of the Investment Company Act. it adds a new exemption for “qualifying venture capital funds” to have up to 250 investors instead of the 100 investors limit for other types of funds. A “qualifying venture capital funds” is a venture capital fund that has not more than $10 million in aggregate capital contributions and uncalled committed capital.

I suppose this allows venture capital fund managers to create a pool with a larger number of less wealthy investors that are making smaller commitments. Otherwise, to exceed 100 investors, a fund manager would have to use the 3(c)(7) exemption that requires investors to be Qualified Purchasers. This was a Senate amendment sponsored by Senator Heitkamp as the “Supporting America’s Innovators Act.”

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Please Welcome the Latest Contributor

I’m pleased to announce the latest addition to the Compliance Building family.

Boo has been in training for her first week, as you might expect.

So far she has passed the sleeping through the night module.

She is still working on the waste disposal training module. We expect no less than 100% compliance to pass that one. For now, she is still on high surveillance because of her performance.

We are working on the sit, stay, and come training programs. She is doing remarkably well considering this is her first real position.

Boo is clearly enjoying the food buffet at HQ. She gained four pounds in the first week. But that is expected.

Of course, interpersonal skills with co-workers is important. Senior Contributor, Ghost, is trying to teach Boo about corporate culture. That includes the importance of sleeping on the couch, barking at the mailman, and welcoming home the Compliance Building publisher.