Author: Doug Cornelius

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Compliance Bricks and Mortar for May 25

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

Does Profanity at Work Create a Hostile Work Environment? (Maybe.) by Daniel Schwartz in the Connecticut Employment Law Blog

The court’s decision focuses on the difference between profanity of the general type, which it calls “general, indiscriminate vulgarity” (presumably, words like “sh**”), and “gender-specific, derogatory comments made about women on account of their sex.” [More…]

Review: Complete Compliance Handbook by Matt Kelly in Radical Compliance

The book is divided into 12 chapters that constitute the major challenges of building a compliance program: operationalizing compliance through HR, for example; or crafting written standards, or improving third-party risk management. Each chapter is divided into “days” — as in, 21 days to better written standards — where the day’s content is a single essay that you could read in one sitting, with time left to stare out the window and ponder how to put that day’s lesson to work in your specific organization. [More…]

GOP Senate Aide Considered for SEC Post by Andrew Ackerman in the Wall Street Journal

Elad Roisman, the chief counsel to the banking panel led by Mike Crapo (R., Idaho), is a top contender to succeed Michael Piwowar at the top U.S. markets regulator, these people said. Mr. Piwowar plans to leave the SEC by July.

If nominated and confirmed, Mr. Roisman, 37 years old, would join a long list of former banking committee staffers who have filled top slots at the five-member commission, including Mr. Piwowar and two other sitting commissioners: Kara Stein, a Democrat, and Hester Peirce, a Republican. [More…]

Potholes in Compliance: Hidden Risks Under Rule 506(d)’s Bad Actor Disqualification by Joshua Pirutinsky in NYU Law’s Compliance & Enforcement blog

Blue Sand Securities, a small private placement agent, nearly lost their core business due to a simple compliance breakdown which may have resulted in their being deemed a Bad Actor under Rule 506(d). The potential fatality of Blue Sand should alarm any compliance officer, as their demise would have been attributed to a minor and unrelated infraction rooted in a failure to adequately appreciate risks associated with their business. While compliance professionals are wise to allocate resources to issues that have a high likelihood of occurrence or sensitivity to their business line, they must also be wary of overlooking important but minor interstitials, such as the 506(d) Bad Actor Disqualification, that may bear outsized costs on their firm. There is much to learn from the example of Blue Sand Securities, and one should be sure to discover and prepare for the unknown before an employee puts their firm at risk. [More…]

The Why Behind the No: Remarks at the 50th Annual Rocky Mountain Securities Conference by Commissioner Hester M. Peirce

 am here today, though, to talk about the small part of our enforcement work that is controversial. Some of you may have read an article earlier this week that suggested that I have “a penchant for saying, ‘No,’ when it comes to [the Commission’s] enforcement work.”[5] The article noted that my “yes” votes are above 85 percent, but my 15 percent no rate is higher than the rate at which any other Commissioner votes against recommendations from the Enforcement Division.[6] Without touching on any particular enforcement matter, I hope today’s remarks will help to explain the why behind my no’s. [More…]

 

2018 State of Compliance (According to PwC)

PwC released the results of its latest State of Compliance survey. In this seventh iteration, PwC polled 825 risk and compliance executives worldwide about their organizations’ compliance polices and procedures, training, monitoring and technology.

Only 17% said they are very satisfied with the effectiveness of their compliance programs. Another 45% said they were somewhat satisfied.

Personally, I don’t find that result interesting. The survey covers a large swath of organizations across different industries, different sizes, different geographies and different risks. Only a few firms, if any, are like mine and only a few, if any, are like yours.

What I found most interesting is what PwC gathered about the compliance programs at the 17% of the firms that were satisfied with the effectiveness of their compliance programs. PwC identified four ways those 17% do things differently:

  1. Invest in tech-enabled infrastructure to support a modern, data-driven compliance function
  2. Increase compliance-monitoring effectiveness through analytics and the use of technology
  3. Streamline policy management to increase responsiveness and boost policy and procedure effectiveness
  4. Take advantage of information and technology to provide targeted, engaging and up-to-date compliance training

Given that three of these four factors are technology driven, I would guess that these are focused on larger organizations that need technology to deal with larger flows of information and data than a small or mid-sized firm.

I would also guess that dashboard and data to show compliance functions helps assure that the organization is being effective.

I’ve argued in the past that determining effectiveness is hard because you are try to prove that the absence proves the point. If compliance program is 100% effective, there will be no reporting events. Of course the problem is that the lack of reportable events is either because there were none, or you were just unable to discover them.

My nay-saying aside, it’s clear that having data leads to better compliance. Good technology tools to help extract and interpret that data are incredibly helpful to compliance programs. This survey proves the point.

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Form ADV and Form PF

With the statutory changes from Dodd-Frank, the Securities and Exchange Commission started gathering basic information about private fund managers and their funds on Form ADV.

The SEC increased that information flow by requiring Form PF. Unlike Form ADV, Form PF provides detailed information about the private fund’s activities and performance. That left many reluctant to release this information.

Apparently many managers followed through on this reluctance. According to a story in IA Watch, the SEC is matching up Form ADV Filings for private funds and identifying the lack of filing in Form PF.

You need a private fund identification number for the private fund in Form ADV. That makes it easy to search through the Form PF database for those filings or lack thereof. Someone in data analytics at the SEC decided to do just that.

That has resulted in at least a few dozen firms getting a letter from the SEC explaining why they didn’t file Form PF.

I understand why some firms may have had confusion over how to identify their funds on Form PF. Those definitions are problematic. But I have not run into anyone saying that they didn’t have to file.

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Compliance Bricks and Mortar for May 18

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

The Impact of Compliance –Another Reversal For a Jefferies Trader by T. Gorman in SECActions

The key role of compliance threads through the continuing saga of Jefferies & Co. trader Jesse Litvak as well as a series of similar cases. Mr. Litvak is one of a number of traders who were indicted by the U.S. Attorney’s Office for allegedly making misstatements to counterparties while trading residential mortgage backed securities or RMBS. Although those markets are largely opaque, the traders and counterparties are highly sophisticated, employing complex pricing models to guide their transactions. Mr. Litvak, who was initially indicted in 2013, was just freed from prison following the second reversal of his conviction by the Second Circuit Court of Appeals. U.S. v. Litvak, No. 17-1464 (2nd Cir. May 3, 2017). [More…]

Volcker Rule Rewrite Is Said to Drop Key Trading Burden on Banks by Jesse Hamilton and Benjamin Bain

In a much anticipated overhaul of Volcker, the Federal Reserve and other regulators are planning to drop an assumption written into the original rule that positions held by banks for less than 60 days are speculative — and therefore banned, the people said. Instead, banks would have leeway to conclude that their trades comply with the rule, putting the onus on regulators to challenge such judgments, the people said. [More…]

Can Sophisticated Investors Be Defrauded? Two Cases Raise Hurdles by Peter J. Henning in the NYTimes.com’s Dealbook

So do parties in a negotiation get a free pass on what they say, even if it is not the truth? An April 2016 decision by the federal appeals court in Chicago in United States v. Weimert answered that question in the affirmative. The court overturned the conviction of David Weimert for wire fraud for misleading both sides in a real estate transaction. The judges pointed out that in a negotiation the two sides “will often try to mislead the other party about the prices and terms they are willing to accept. Such deceptions are not criminal.” [More…]

Disgorgement After Kokesh – Evidence from SEC Insider Trading Actions (FY2005-FY2015) by Verity Winship in NYU Law’s Compliance & Enforcement blog

For about 50 years – at least since Texas Gulf Sulphur – the SEC has ordered defendants to disgorge their profits from transactions that violated the securities laws.  Despite disgorgement’s long history, in its 2017 opinion in Kokesh v. SEC, the US Supreme Court put two aspects of the remedy on the table.  It applied a five-year statute of limitations to disgorgement.  It also reopened old debates over agencies’ power to seek remedies not specified in statute.  My article, Disgorgement in Insider Trading Cases: FY2005-FY2015, provides data to inform these debates over the agency’s use of disgorgement and the effects of Kokesh.  It reports the results of an empirical study of ten years of the remedies ordered by the SEC in insider trading actions, with particular emphasis on the agency’s reliance on disgorgement.  [More…]

How do we reconcile UBO due diligence and GDRP obligations? by Lindsay Columbo in The FCPA Blog

What all this means is that financial institutions face new challenges to reconcile their compliance obligations. On one hand, their obligations are increasing to conduct customer due diligence to verify UBO information, among other things. On the other hand, the data processors at the same institutions are obligated to limit circumstances in which personal data can be collected, and when it is collected, to ensure it’s adequately protected according to EU standards. [More…]

Buyer Beware: Hundreds of Bitcoin Wannabes Show Hallmarks of Fraud By Shane Shifflett and Coulter Jones in the Wall Street Journal

In a review of documents produced for 1,450 digital coin offerings, The Wall Street Journal has found 271 with red flags that include plagiarized investor documents, promises of guaranteed returns and missing or fake executive teams. [More…]

 

HoweyCoins – The ICO I Have Been Waiting For

Initial coin offerings have been a new wave of financing.. and scams. One offering that you should look at for some lessons about coin offerings is the soon to be released Howey Coin.

HoweyCoins are the cryptocurrency for the travel industry. According to the white paper, HoweyCoins partner agreements lock in an average initial discount of 30% for airfare and 42% for hotel room rates for all HoweyCoin-denominated transactions. The agreements are not final, but once the offering is complete, they will be revealed.

This is a can’t miss investment opportunity. HoweyCoins are officially registered with the U.S. government and will trade on an SEC-compliant exchange where you can buy and sell them for profit. According to the ICO team, they “forecast a minimum growth rate of between 7% to 15% annualized, making HoweyCoins attractive for long-term investment. In addition, HoweyCoins can serve as a GUARANTEED hedge against inflation and market loss.”

…

Hopefully, you have noticed a few things that might make you not click on the the button to buy the HoweyCoins. Bonus points if you recognized “Howey” as the seminal court case that sets the test for whether an investment is a security. Hopefully you noticed the “registered with US government” as red flag that this company is doing something wrong with this offering. Of course the high returns, and guarantee of success are hallmarks of problematic offerings. But if not, go ahead and click on the button.

This is a new type of performance education by the Securities and Exchange Commission. Clearly, the SEC is focused on the fraud and securities-law violations of coin offerings. If you are involved in such an offering, you should be worried. The SEC spent some time, money and energy on putting together the HoweyCoins website. You can be certain that the SEC is devoting much more time, energy and money into investigating ICO fraud and securities law violation.

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Vindication for Yorkville (mostly)

Back in 2012, the Securities and Exchange Commission filed suit against Yorkville Advisors for valuation failures.  According to the SEC complaint, the failure was two-pronged: one of misstatements and a second failure to follow the funds’ own policies and procedures on valuation. Yorkville denied the charges.

Legal action has continued and Yorkville has been largely vindicated in a motion for summary judgement.

The SEC lost virtually all claims in the asset valuation case brought against a fund and two of its officials.

As with most private fund managers, Yorkville’s ability to understand the valuation of its investments is critical to its strategy and results. So you would expect some discretion to be granted to the manager, without the SEC second-guessing the valuation. The SEC second-guessed the values and lost.

The key should be precision ahead of accuracy. Precision is getting close to the same result consistently. Accurate is getting close to the right target. You can be precise and inaccurate, and you can be accurate but imprecise.  With a hard to value asset, where its hard to know the correct target, precision is more important.

The SEC case was focused on 15 privately negotiated, customized securities in its portfolio that had little to no market activity.

Yorkville was using GAAP in calculating the net worth of each fund and marking the funds’ investments to fair value. It used one valuation adviser to help value some of those 15 positions. Yorkville ended up rejecting most of the first attempts because it thought the valuations were too high. Yorkville hired a second valuation company to help with some of the investments it had to foreclose on. Yorkville’s audit form signed off on the valuations. The auditor re-examined the work after the SEC was filed, discovered that it did not have some the draft valuation work, but concluded that it could still stand behind the audits.

Prior to 2008, the firm marked positions at the lower of cost or market value until gains were realized. The firm would recognize unrealized losses but not unrealized gains. Yorkville adopted FASB Statement 157 in 2008 which changes to the treatment to always be fair market value accounting.

The SEC claimed that Yorkville overvalued the 15 investments by at least $50 million as of December 2008 and $47 million as of the end of December 2009. The over valuations inflated the value of the funds which attracted investors and increased the fees that Yorkville charged.

The opinion starts with precluding a big chunk of the testimony of the SEC valuation expert. The court found that the Uniform Standards of Professional Appraisal Practice call for a review to be one of the quality of the of the valuation process and not to create a new value based on the review.

Then the court moves on to deciding if there was evidence to support a finding of scienter or intent to deceive. The SEC used three theories as to why the Yorkville principals had the motive and opportunity to commit fraud.

First, the court rejected the claim that motive and opportunity could be established from the Yorkville’s compensation structure. The court refers to established law that the mere desire to earn management fees is not sufficient to allege a concrete and personal benefit resulting from the fraud.

Second, although Yorkville was in a tough financial position (it was 2009-2009) and would be better off it could raise more funds from investors, it was not enough to prove an intent. The SEC was claiming that Yorkville kept the valuations high to attract more investors. That did not meet the test.

Thirdly, the principals redemption of interests in the fund did not have the facts to show fraud. Yorkville was actively marking the Fund down by $33 million at the time of the redemption request. .

The Court also rejected the SEC’s claim that the Yorkville principals had fraudulent intent because they failed to disclose key documents to the outside auditors and made affirmative misrepresentations regarding the 15 positions to the investors and auditors. The court rejected that, noting that the auditors still stood behind their audits. Although, the audit partner claims that a dozen documents, out of hundreds of others, were not provided to the auditors.

It looks like Yorkville was a bit sloppy in its statements regarding its use of outside consultants to help in valuations. Some of these sloppy statements were in investors’ DDQs. Some of those charges survived the summary judgment order and ill have to be contended. So, Yorkville did not come out of this case completely vindicated.

The Yorkville case  was one of several brought as part of the Commission’s Aberrational Performance Inquiry which was tied to about a half dozen cases.The Inquiry is supposed to use performance metrics to identify outlying performance and use that to suggest suspicious conduct.

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Compliance Bricks and Mortar for May 11

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

It’s On! Federal Judge to Hear First Ever Oral Argument Asserting ICOs are NOT Securities. Read Legal Briefs From SEC, DOJ and Defense Here . . by John Reed Stark

This week the ICO/SEC battle is finally on: The first ever oral argument before a federal judge on the issue of whether initial coin offerings (ICOs) are securities offerings and are therefore subject to SEC jurisdiction. Below are the details and all of the relevant court filings in one place, neatly organized for quick and easy review. [More…]

Enforcement Co-Chief Offers Tips on Meeting with the SEC by Steven R. Peikin in the CLS Blue Sky Blog

At the SEC, we frequently confront issues that are novel, complex, or both. For the staff, productive communication with defense counsel can often provide a better understanding of complicated businesses, markets, and financial products. Effective communication allows us to tailor our theories, focus our inquiries and get to the end of our investigations efficiently.

I believe that the benefits of this communication flow in both directions. That is, effective dialogue can also yield significant benefits for defense counsel and their clients. In some instances, defense counsel will persuade us that we have gotten something wrong, leading us to abandon a charge, recommend different relief, or decline to pursue a matter entirely. Even where that isn’t the case, effective communication often helps defense counsel to better understand our thinking, which in turn allows them to provide better advice to their clients. [More…]

AT&T, foreign corporations risk legal action for payments to Michael Cohen firm by Francine McKenna in MarketWatch

The payments made to the personal attorney of President Donald Trump raise questions as to whether these companies violated anti-bribery rules, experts in federal bribery laws say.

The lawyer for the adult film star suing the president revealed that three companies, AT&T, Switzerland’s Novartis and Korea Aerospace Industries, made payments to Michael Cohen. Each company has confirmed the payments that the lawyer, Michael Avenatti, disclosed. AT&T said its $200,000 was for insights into understanding the new administration, Korea Aerospace said its $150,000 was for legal insights on U.S. accounting standards and Novartis said it paid $1.2 million for insights onto Trump’s stance on health policy. [More…]

Cyber Matters: The Unintended Consequence of GDPR? Spam by Rob Sloan, cybersecurity research director, WSJ Pro

One of the unintended consequences of GDPR, is that internet registrars no longer will be able to share information, known as ‘WHOIS’ data, that includes names, physical addresses, phone numbers, and email addresses related to the registered owners of websites or domains. Under GDPR, discrete registrars that collect the data when domains are purchased no longer will be able to share it, because it will be classified as “personally identifiable information.”

This likely will result in a significant uptick in junk email and a rise in malware being distributed via websites and could severely hamper cyber investigations. Companies that rely on this data to deliver certain security services, such as spam-filtering, could even find their business models threatened. [More…]

It’s Harder To Pay Off Foreign Governments Than The US One by Matt Kelly in Buzzfeed (yes, Buzzfeed)

As we learn that AT&T, Novartis, and other large companies paid millions of dollars to Michael Cohen’s company while he was serving as President Trump’s legal counsel, it’s worth remembering that there is a whole subset of professionals embedded in every headquarters in corporate America who work to prevent exactly this type of shady business.

These ethics and compliance officers exist to keep corporations on the right side of a strict anti-corruption law. A big portion of their work is specifically to prevent companies from paying money to intermediaries — like, say, the personal lawyer and long-time confidant of a government official — to influence government officials’ behavior in favor of the company.

But there’s a catch: The law outlined above applies to foreign governments. It’s called the Foreign Corrupt Practices Act, and the Justice Department enforces it on a regular basis. [More…]

 

Notes from the Private Fund Compliance Forum 2018

I attended PEI Media’s Private Fund Compliance Forum 2018.

As I typically do at conferences, I typed up my notes. Many sessions asked to be off the record and I’m complying and not publishing them. Everything  is “Chatham House Rule” so I don’t attribute any of my notes to any particular speaker.

Keynote Interview with David Sorkin

A discussion between the General Counsel and Chief Compliance Officer of a public company is fraught with disclosure and they asked the session be off record. The discussion was interesting and provide a great insight to the evolution of private fund compliance.

Restructuring the compliance function

My notes: Restructuring the compliance function at the Private Fund Compliance Forum 2018

SEC exams—what do they look like now?

This session was off the record. A general note is that examiners have not stopped looking at private equity firms. Many of those exams are the second time around. But the exams are shorter than they have been. In another session’s poll, it appeared that about 20% of the attendees indicated that they had not been examined.

Fees and expenses: allocation and regulation

My notes: Fees and expenses: allocation and regulation at the Private Fund Compliance Forum 2018

Assessing the influence of tax reform on private funds and portfolio companies

This session was off the record. The overall thoughts were that there are good things and bad things in the tax law. It definitely makes things more complicated.

Secondary Sales in Private Funds

My Notes: Secondary sales in private funds – at the Private Fund Compliance Forum 2018

Portfolio company risk management

My Notes: Portfolio company risk management – at the Private Fund Compliance Forum 2018

Assessing the current regulatory environment and navigating its impact on your compliance program

This session was off-the-record

International compliance for managers with a global presence in Europe

My notes: International compliance for managers with a global presence in Europe – at the Private Fund Compliance Forum 2018

Identifying conflicts at your firm – at the Private Fund Compliance Forum

This session was off the record.

Strategies for marrying ESG implementation and compliance

My notes: Strategies for marrying ESG implementation and compliance – at the Private Fund Compliance Forum 2018

Regulatory considerations for the use of subscription lines and borrowing

My notes: Regulatory considerations for the use of subscription lines and borrowing – at the Private Fund Compliance Forum 2018

Regulatory considerations for the use of subscription lines and borrowing – at the Private Fund Compliance Forum 2018

Funds use a lines of credit to fund capital. The most common is a bridge between funding an investment and calling capital from investors. Based on a poll the audience indicated a wide range of uses and durations for their credit lines. Some indicated that they use the credit line to fund capital to portfolio companies.

Investors are asking questions about credit line use, but their does not seem to be a consensus on how a credit line should be used. Limited partners generally like to get their assets to work. There are also investors who like the lines because it can deflect some of the J curve effect.

Do you notify investors about the use of the credit facility as you go. According to a poll, about 20% of the attendees sent a notice to limited partners when they draw on the line of credit. Some of the audience indicated that they report on the line balance quarterly.

According to an audience poll, 15% of the attendees allowed LPs to opt out of use of the line of credit. The opt out creates an accounting headache.

ILPA has issued guidance on the use of lines of credit.  The guidance has a 6 months term limit. Many investors seem comfortable with a longer term, up to 12 months.

There seemed to be a lot of disdain for running the waterfall as if the capital call was made instead of the draw from the line of credit.

There are many ways to calculate returns and investors have different ways for calculating net returns. Of course, use of the line affects performance. The bigger effect is on IRR, not on the equity multiple. It may make sense to have a prepared response on how your firm’s use of a credit line differs from the ILPA guidance.

One key to avoid regulatory problems is disclosure around use of the credit line. The ability to use the line should be disclosed in the PPM. You should note that the returns in marketing materials may be affected by the use of the line of credit.

Can you use the line to make distributions? Everybody seemed uncomfortable with this. It seems better to wait and let the sale happen. People noted that they have run into situations where they realized on an investment before they called capital.

You should pay attention to how the use of the credit line has changed over time and may affect a history of funds’ performance in a marketing track record.

(This session was subject to the Chatham House Rule so I have not identified the participants and have not attributed any of the statements to anyone.)

Strategies for marrying ESG implementation and compliance – at the Private Fund Compliance Forum 2018

Investors have increased their focus on Environmental, Social and Governance issues. This panel focused on the compliance role in ESG.

According to a poll at the conference, about half of the attendees have a written ESG policy and consider ESG as part of their strategy. There is the balance between wanting to invest for good and to invest for returns. There is a larger push to just block investments in particular areas such as tobacco, pornography, arms manufacturers, etc.

Investors are specifically asking for a written ESG policy. The policies have a great deal of discretion. Investors often do not have specific requirements for the substance of the ESG policy. Investors want to know that you are thinking about these issues.

Fund limited partners are reporting their ESG goals, or at least those issues they are most interested in, as part of their reporting. So they are expecting their funds to report on these issues. The challenge is that investors are asking a wide range of questions on a wide range of issues. It’s a challenge to gather the disparate data and put together quantitative numbers.

The #MeToo issue is a current hot topic. Fund managers are pushing down to their portfolio companies to implement ESG policies, as well as implementing them at the fund manager.

Compliance can help by doing what compliance does: drafting policies, implementing procedures to effectuate the policy, and track the data in the implementation.

There are many ways to approach ESG, pick one and try it out if you haven’t yet. Get someone in senior management to sponsor the effort. It’s not just about being a treehugger, it’s about creating value in your portfolio companies and value in your fund management.

(This session was subject to the Chatham House Rule so I have not identified the participants and have not attributed any of the statements to anyone.)