Author: Doug Cornelius

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Best Practices for Presenting Model and Hypothetical Performance

These are my notes from an ACA Compliance Webcast on this subject. I’m sure you can find a replay on the ACA website.

There were three great presenters:

  • Alicia Hyde, Partner, ACA Performance Services
  • Mike Sonnenburg, CIPM, Managing Director, ACA Performance Services
  • Kim Daly, Managing Director, ACA Compliance Group

Definitions

The first topic was what these terms mean:

Model–A list of investments and transactions for an investment strategy that are not actually held by the portfolio but can be backtested over historical periods and/or run contemporaneously. Model portfolios are typically constructed using individual securities (stocks and bonds), ETFs, pooled funds, or other investment products. Also known as a paper portfolio, a policy portfolio, or a target portfolio.

Hypothetical–Performance of a model or synthetic portfolio (i.e., non-actual performance). Hypothetical performance can be ex-post and/or ex-ante.

Backtested–Ex-post testing of an investment model to see how it would have performed historically. Backtesting attempts to demonstrate how an investment strategy, constructed with the benefit of hindsight, would have performed as if it had been implemented historically.

Simulated –Same as backtested; non-actual performance and can be ex-post or ex-ante.

Theoretical–Same as backtested; non-actual performance and can be ex-post or ex-ante.

Ex-ante–Projected future performance. Ex-ante performance is non-actual and, as such, is hypothetical.

Ex-post –Performance over historic (after the fact)periods. Ex-post may be non-actual or actual performance.

Contemporaneous (Live) Model–Performance derived from a live, or contemporaneous model, where investment decisions occur in real time. Live model performance is still considered non-actual.

Synthetic Portfolio–The ex-post combination of actual portfolio returns. For example, taking an actual equity portfolio and combining it with an actual fixed income portfolio to create a synthetic balanced portfolio. The underlying performance is that of actual portfolios, but they are synthetically combined according to a prescribed asset allocation. Synthetic performance is considered to be hypothetical performance.

The Law

The main limitation is section 206 that prohibits you from being fraudulent, deceptive or manipulative. That has been further extrapolated by the SEC in Rule 206(4)-1, the advertising rule. That rule has been further elaborated in the Clover No Action Letter.

All of this has been heightened by the F-Squared cases that failed to properly disclose that the adviser and the firms that used its services were not based on actual performance.

Presenting Model Performance

  1. Model portfolio performance must not be presented in a false or misleading manner.
  2. Model performance should not be linked to actual performance.
  3. ‘White-labeling’ third party model performance requires sufficient due diligence.
  4. Model portfolio performance must include specific, accurate, and robust disclosures.

Model Performance Disclosures

Disclosures should address these items:

  • The limitations inherent in model results,particularly the fact that such results do not represent actual trading and that they may not reflect the impact that material economic and market factors might have had on the adviser’s decision-making if the adviser were actually managing clients’ money
  • Any material changes to the conditions, objectives, or investment strategies of the model portfolio during the time period portrayed and, if so, the effect of any such change on the results portrayed
  • As applicable, that the adviser’s clients had investment results materially different from the results portrayed in the model

Include the following disclosures:

  1. The results do not represent the results of actual trading using client assets but were achieved by means of the retroactive application of a model that was designed with the benefit of hindsight.
  2. The returns should not be considered indicative of the skill of the adviser
  3. The client may experience a loss.
  4. The results may not reflect the impact that any material market or economic factors might have had on the adviser’s use of the back-tested model if the model had been used during the period to actually manage client assets.
  5. The adviser, during the period in question, was not managing money at all, or according to the strategy depicted.
  6. The back-testing is for a strategy that the client accounts will follow or, if not, what difference there will be.

You can show projected returns

Sources:

Weekend Reading: Brothers at War

With the threat of war (or the crazy rantings about war) with North Korea, I thought I should learn more about the history of the conflict. I realized that most of what I knew about Korea and the Korean War I had learned from MASH. In browsing through books to read on the issue, I came across Brothers at War: The Unending Conflict in Korea by Sheila Miyoshi Jager in a review in The Economist.

The book starts with the end of World War II. Japan had invaded the Korean peninsula in 1910. With Japan’s loss of the WWII, the Soviet Union and US divided the spoils and each took half of Korea, with the 38th parallel as a dividing line. Japanese troops to the North of this line were to surrender to the Soviet Union and troops to the South of this line would surrender to the United States.

The division was not intended originally to be a partition. But the Cold War between the US and  the USSR made negotiations difficult. The separate administration quickly led to two separate governments arising. In the North, the Soviets were happy to allow a communist government to take control. The US was not wiling to let the South turn to communism and kept control.

In June 1950, troops from North Korea invaded South Korea to free it from American imperialism. China encouraged the confrontation with the United States. The Soviet Union also supported the invasion, but less enthusiastically. It was this triad of communism that continued in the North for decades.

After three years of fighting, the war ended with an armistice agreement. The cease fire line was back to the 38th parallel. No peace treaty was signed, nor has one been signed.

For a decade after the war, the North was more prosperous than the South. It was not until the 1980s that the countries’ prosperities turned sharply in different directions. North Korea had devoted too much of its production to the military, causing stagnation. Then the Soviet Union, its financial benefactor, collapsed. The South was under autocratic leadership until a democracy movement resulted in an elected president in 1987.

The South continued on a path of democracy and capitalism.

Meanwhile, the North turned into a dynastic communist state. When Kim Il-sung died in 1994, his son, Kim Jong-il, continued the dynasty. When he died in 2011, his son, Kim Jong-un, took control. That dynasty became focused on developing nuclear weapons to ward off the perceived threat from the United States to attack the North and once again occupy the South.

That leaves us 67 years later still dealing with a poorly thought out post-war division of the Korean peninsula, where the threat of war has persisted over those decades.

If you are interested in learning more about the Korean War and how that legacy of that war has continued to toady, this is an excellent book to add to your reading pile.

Compliance Bricks and Mortar for October 20

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

6 Trends in AML Compliance by Ambreesh Khanna

Anti-money laundering regulations (AML), including Know Your Customer (KYC) requirements, are hardly a new concept in the world of financial services. Over the years, financial institutions have largely mastered the mechanics of compliance. There is, however, significant opportunity for improvement, especially when it comes to boosting accuracy, efficiency and productivity. Banks that embrace innovation around their AML strategies stand to leapfrog the competition when it comes to stronger performance, growth and customer relationships.

Here are the trends shaping today’s AML reality. [More…]

What happens when the corrupt regime is gone? by Angela Barkhouse in the FCPA Blog

Showing political will in combating corruption is essential not only for rule of law and social cohesion but for the reconciliation of the truth and for ensuring justice. This has been increasingly absent in a number of efforts to investigate gross human rights violations and corrupt acts in Tunisia.

Created through the Transitional Justice Law adopted on December 24, 2013 the Truth and Dignity Commission (TDC) or Instance de Verite & Dignity (IVD) was mandated with investigating these violations since its independence in 1955 to December 2013 and incredibly the IVD received over 60,000 cases for investigation.   [More…]

A Broken Windows Theory of International Corruption by Roger P. Alford

The Article re-conceptualizes corruption through the lens of the broken windows theory of community policing, focusing on the root consequences of corruption as well as its secondary effects. [More…]

Does Your Board Make a Difference in Compliance? by Ben DiPietro in the WSJ.com’s Risk & Compliance Journal

A board of directors can make a difference in its organization’s compliance program by making sure the compliance function has autonomy, has stature within the C-suite and by making sure board members are informed about what is happening in compliance and why it matters to the business, said Erica Salmon Byrne, executive vice president and executive director of business ethics advocacy group Ethisphere Institute’s Business Ethics Leadership Alliance. The group brings together global companies to work together on ethics and compliance issues. [More…]

Senate Panel Sets Hearing Next Week on Pair of SEC Nominees

The Senate Banking Committee is set to hold a confirmation hearing next week for the Trump administration’s two nominees to fill vacancies at the Securities and Exchange Commission, according to person familiar with the matter.

The hearing is a key development in the nominations of Hester Peirce, a Republican, and Robert Jackson, a Democrat, since President Donald Trump nominated the pair earlier this year. [More…]

Is a TIC a security?

TIC refers to Tenancy in Common, not the blood-sucking insect. A TIC is a completely legal way of owning real estate that has been around for hundreds of years. When one of the parties owning real estate dies, that ownership interest passes to that owner’s heirs. The alternative is joint tenancy, in which case when the part owner dies, the remaining owners get that ownership interest. If you’re married, you probably own your home in a joint tenancy. (There is also a tenancy by entirety for married couples that operates like a joint tenancy, but also limits the sale of an interest without your spouse’s consent.)

There is a market for TICs in commercial real estate because of Section 1031 of the tax code that allows for tax-deferred exchanges. If you sell commercial real estate and don’t want to pay taxes immediately on the gain, you can buy a replacement piece of real estate and defer the gain. The problem is finding a replacement and finding one at an equivalent price. Fractional TICs were developed allowing an owner to more easily achieve tax-deference.

The problem with TICs has always been avoiding the treatment of the interest as a security. This goes back to the Howey definition of a “investment contract” as “investment in a common enterprise with the expectation of profit to be derived through the essential managerial efforts of someone other than the investor.”

For a fractional TIC, there is a common enterprise. The investor’s ownership interest is combined with the other fractional owners. There is an expectation of profit. Given that the real estate needs to be managed, there is generally some sponsor exerting some level of control over the real estate on behalf of the TIC owners. A lessee does not want to have to negotiate of dozens of TIC owners when entering into a lease.

The key is giving the TIC owners enough control so that they are not solely relying on the “managerial efforts of others” for the real estate investment to be successful.

Many TIC investments involve real estate with a long lease to a credit tenant. So even though the TIC owners have a say in management, there is little management that needs to be done.

One of the dangers to the sponsor is that the TIC owners will claim that the TICs are securities, giving the TIC owners additional right, if the investment goes south.

That is what happened in the Highwoods case in Durham, North Carolina. NNN Realty bought a property, largely leased to a credit tenant and set up a TIC syndication.

To avoid the treatment of the TICs as securities, the affiliated agreements granted some control to the TIC owners. The Management Agreement for the Durham Property gave the TICs the ability to hire and fire the property manager, the leasing agent, and the asset manager. It also allowed the TICs to control the Durham Property’s expenditures by approving budgets. However, firing the asset manager, an affiliate of the sponsor, involved paying expenses and would trigger a default under the mortgage loan.

The TIC owners claim that they were induced to purchase interests in the Durham Property by materially false statements or omissions in a private-placement memorandum concerning the probability that the Durham Property’s primary credit tenant would renew its leases. The primary credit tenant’s leases were critical to the Durham Property’s value, as demonstrated when that tenant later terminated its leases and the Property went into foreclosure.

The lawsuit was filed in North Carolina so the challenge to the TICs as securities was based on North Carolina law.

North Carolina’s Rule 06A.1104(8)(a) requires both a “common enterprise” and “the expectation of profit to be derived from the essential managerial efforts of someone
other than the investor.” “Essential” management does not necessarily connote “exclusive” management. 18 N.C. Admin. Code 06A.1104(8)(a) (emphasis added). Rule 06A.1104(8)(b) does not expressly require a “common enterprise,” but it contemplates a scenario where at least a portion of the value provided by the investor is subjected to the risk of an enterprise in which the investor “does not receive the right to exercise practical and actual control over the managerial decisions of the enterprise.”

The PPM stated as a risk-factor on reliance on management:

[a]ll decisions regarding management of the Company’s affairs . . . and the management of the Property, will be made exclusively by the Manager, the Property Manager and their Affiliates, and not by any of the Members or the Purchasers. Accordingly, no person should purchase LLC Units unless that person is willing to entrust all aspects of management of the Company to the Manager and management of the Property to the Property Manager.

The court realized that the documents around the ownership of the TIC gave the TIC more control than that risk factor warns.

The court looked to SEC v. Merchant Capital, LLC  (483 F.3d 747) involving the treatment of general partnership interests as investment contracts under the federal securities laws. That court came up with six factors that would make a general partnership interest more like a limited partnership interest or investment contract:

(1) the partners’ ability to elect the managing general partner was not meaningful, because the vote had to be made at the time of investment, and the promoter was the only nominee;

(2) the limitation on removing the managing general partner for cause by unanimous vote effectively meant that the managing general partner could not be removed;

(3) the various investors were geographically diverse and had no meaningful opportunity to develop relationships;

(4) the investors’ potential liability was limited to the amount that each investor invested, with no vicarious liability for the acts of other investors;

(5) the right to approve expenditures, while facially significant, was diluted by the managing general partner’s ability to control information;

(6) the investors had no particular expertise in the business in which they invested.

The NNN court found these factors instructive and ruled the TIC interests could qualify as securities. The court denied the summary judgment on this issue request by the sponsor.

On appeal, the North Carolina Secretary of State and the North American Securities Administrators Association want the appellate court to rule that the TICs are securities in this case.

So clearly, TICs can be securities.

Sources:

Hoodoo Spells Fails to Ward Off the Feds

According to the SEC Complaint and Criminal Complaint, Dawn Bennett lived the life a classic ponzi schemer who got in over her head and continued to lie and cheat, perhaps hoping to find a way out. The story caught my attention for two reasons. The first was the implication that Ms. Bennett used a voodoo spell to ward off attorneys from the Securities and Exchange Commission. The second was reference to an influential blog post.

To prove how egregious her fraud was, the criminal complaint highlight two well-worn stories of fraud. One was that she defrauded elderly investors. To prove that point, there are several emails in the criminal complaint that tell the sad story of elderly investors sending all of their retirement savings to Ms. Bennett for investment in her company.

The second story is that of a luxurious lifestyle. To prove that point, there is a picture of her large collection of shoes taken during the FBI search of her home.

The criminal complaint notes that Ms. Bennett had read a blog post on whether a note is a security. Based on that blog post, she changed her documents in an attempt to make them look more like a loan than a security. The blog post sounded familiar: “Is A Promissory Note A Security?” I searched Compliance Building and found this blog post: Is a Note a Security? I was ready to be self congratulatory and tout my influence. But a quick internet search found a more likely blog post: Is Our Promissory Note A Security? by A. O. Headman. It’s also much better written. <sigh>

But there was still the voodoo to keep my attention. The FBI agents found Ms. Bennett’s freezer to be full of unusual jars.

The FBI agents found documents with instructions on how to place individuals under hoodoo spells. (Hoodoo is the less religious take on Voodoo.) The jars contained identifying information for the SEC attorneys that were investigating Ms. Bennett and I suppose other items that were part of the hoodoo spell. The FBI believes it was the beef tongue shut up hoodoo spell that involveds beef tongue and had-written notes.

Sources:

Compliance Bricks and Mortar for October 13

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

In Defense of Compliance Checklists by Michael Volkov in Corruption, Crime & Compliance

If a compliance officer can persuade the business side to take responsibility for compliance, compliance officers should develop simple checklists and other mechanisms to support the business. For example, the CCO could prepare a checklist for the onboarding of a new third party under the company’s due diligence policy, or a checklist for sponsoring a government official’s trip to company headquarters for product marketing and demonstration sessions. In these cases, the CCO can make the process transparent to the business managers and employees and provide them a clear and concise tool they can use to ensure that they follow company compliance tools. [More…]

Should hedge funds be concerned about the risk of insider trading on alternative data? by Ian Allison in IBT

But the brave new world of big data-driven investing is something of a regulatory grey area. At what point does some exclusive, real time look through into a company’s performance constitute insider trading? In legal terms this means trading on material, non-public information received in violation of a duty to keep it confidential. [More…]

So You Want to Buy a Stake in a Private Equity Manager? by John Amorosi, Ron Cami, and Louis Goldberg, Davis Polk & Wardwell LLP, in Harvard Law School Forum on Corporate Governance and Financial Regulation

Two weeks ago [on September 11, 2017], the Wall Street Journal reported on the intense interest in purchases of stakes in private equity managers. Presumably, this interest has been prompted, in part, by the consistent successes of private equity as an asset class over a sustained period of time, and the opportunity for market players to buy in to private equity firms at a time of relatively low market returns elsewhere. Further, with the inevitable likelihood of generational change in top management at many sponsors on the horizon, there are many reasons to believe that M&A activity involving private equity firms will continue at notable levels for the foreseeable future. [More…]

Harvey Weinstein shows sexual harassment is a big cost to businesses by Heidi N. Moore

These sudden reversals of fortune for predatory executives are not just moral reckonings. They are financial as well, for the the company, its board of directors and the thousands of other employees who work there: lost advertising revenue, mass firingsand instability, fleeing investors, broken deals, reputational damage, expensive lawsuits and in some cases even police investigations. Fox News lost 75% of its primetime hosts after Ailes resigned, and six of its eight top executives. (It has eventually stabilized, with Herculean effort.) The Weinstein Companies is throwing away its name in order to escape. [More…]

Compliance Jobs Report: Oct. 13 by Matt Kelly in Radical Compliance

The Compliance Jobs Report starts with big news in the banking world: Wells Fargo has a new chief compliance officer, lured away from Barclays. Cognizant Technologies also has a new head of ethics and compliance, and we have other personnel moves at Deutsche Bank, Siemens, Société Générale, and more. Also, the head of audit at Walmart is now famous back at her high school. Read on… [More…]

Paper as a Sanctions Violation

The United States has a long arm in imposing financial restrictions. U.S. companies cannot assist their foreign subsidiaries or affiliates with sales to sanctioned countries or persons on the blocked persons list. A US company got caught doing this.

White Birch was accused of facilitating the sale and shipment of Canadian paper from White Birch’s Canadian subsidiary to Sudan. Sudan was subject to a U.S. embargo under the Sudanese Sanctions Regulations, 31 C.F.R. part 538. The Office of Foreign Asset Control determined that White Birch personnel from both its U.S. headquarters and Canadian subsidiary “were actively involved in discussing, arranging, and executing the export transactions to Sudan.” Assistance is prohibited under OFAC’s regulations that bar U.S. persons from “facilitating” transactions between non-U.S. companies (such as foreign subsidiaries) and sanctioned countries.

I’m not sure “discussing” by itself is enough to trigger a sanctions violation. Many companies discuss how to deal with potential transactions that implicate sanctions. The discussion will generally end in “no.” It was taking the steps to help with arranging and executing that are the problem.

This was not a little paper. It was over 500 metric tons of paper worth over $300,000 when the sale and shipment happened in 2013.

As with the recent diamond case, FinCEN was short on details. The enforcement information did note that White Birch tried to conceal the ultimate destination of the paper shipment from its bank. The bank was involved as the confirming bank on the letter of credit for the export. I would assume that the bank would have filed a suspicious activity report that caught FinCEN’s attention.

FinCEN brought the charges even though the Sudan ban has now been lifted. Effective January 17, 2017, all transactions prohibited under the Sudanese Sanctions Regulations are authorized pursuant to the general license (31 C.F.R. § 538.540). In the enforcement action, FinCEN made it clear that this general license does not affect past, present, or future OFAC enforcement investigations or actions related to any apparent violations of the Sudanese Sanctions Regulations relating to activities that occurred prior to the effective date of the general license.

Sources:

Home Court Advantage

One of the arguments made by Lynn Tilton in her battle against the administrative law judges of the Securities and Exchange Commission was the inherent unfairness of that judicial system compared to the federal courts. She failed in her battle against the system, but won on the merits.

From October 2010 through May 2015, 90 percent of cases that the SEC brought before ALJs were decided in favor of the SEC. In federal court, the SEC only has an 84 percent success rate. [Cite].

The SEC changed its rules in 2016 to give more discovery to defendants in administrative proceedings. So that discrepancy may be out of date.

As a compliance professional, my job is to keep me and my firm far away from having to appear in an administrative proceeding. So, I have no expertise on the differences between the two judicial systems and why one is more fair than the other.

I got hung up on why have two separate systems at all?

On one side is the administrative remedies for those registered with the SEC. That made sense to revoke licenses and stop securities fraud. Quick actions would protect investors and hopefully provide a quick resolution for a registrant unjustly accused.

The SEC’s powers have grown over the years, particularly with Dodd-Frank. The SEC has been slow to provide some of the federal court protections to civil litigants to those who stood before an SEC tribunal.

The SEC administrative judges provide subject-matter expertise that may lead to better results than with a federal district court.

The SEC’s Division of Enforcement provided a framework for its approach on forum selection. On the basis of that framework, cases with novel or difficult issues are steered to the federal courts. That may account for the different rates of success between ALJs and federal courts.

It’s probably time for the SEC to once again review the procedures in administrative law proceedings to reduce or remove the claim that the ALJ system provides home court advantage.

Sources:

Weekend Listening: Lincoln in the Bardo

George Saunders’s first novel is a weird, wonderful and woeful book about young Willie Lincoln, son of the President, who is trapped in the “bardo.” That is a Tibetan term for the intermediate state or gap we experience between death and our next rebirth. 

Willie has died and been taken to Oak Hill cemetery, buried in a marble crypt. Based on true historical data, on at least two occasions the president visits the crypt to mourn the loss of his son. The cemetery is populated by the spirits of the dead who have been unwilling to complete their journey to the afterlife and in the bardo. They have continued to remain near their corpses.

The spirit’s narrative is interspersed with quotations from primary and secondary sources about Lincoln’s life. They paint conflicting depictions of the president and his mental state. The spirits themselves are conflicted, referring to their coffins as “sick boxes”, as part of their strategy to avoid facing the reality of their deaths.

The spirits are motley assortment: soldiers, rapists, slaves, drunks and a hundred others. Their advice is also an assortment of conflicting advice on whether to stay or go.

I’ve been consuming a great number of books year as audiobooks. Lincoln in the Bardo is one of the best produced audiobooks. It has a cast of dozens voicing the spirits who are the main characters of the book. That includes the wonderful Nick Offerman and David Sedaris as the lead spirits. There are different voices for the main historical quotes. In total the audiobook production has a 166-person cast.

The narrative readings are as compelling as the words in the novel themselves. This a book you should add to your to-read stack or to-listen library.

Compliance Bricks and Mortar for October 6

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

The Effectiveness of SEC Enforcement in Deterring Financial Misconduct by Shiu-Yik Au

This paper examines how the Securities and Exchange Commission’s (SEC) enforcement actions and whom they target deter future financial misconduct. An enforcement action reduces the incidence of misconduct in other firms in the same industry and metropolitan statistical area (MSA) in the future. Furthermore, an enforcement that punishes a guilty company has a larger deterrence effect on future misconduct than punishing an officer, auditor, attorney, or other entity. In addition, the results are robust to using alternative measures of financial misconduct such as restatements and Fscore. These results have several policy implications on how regulatory agencies can maximize the value of their enforcements. [More…]

Simple Ethics Lesson of Tom Price by Matt Kelly in Radical Compliance

More than anything else, Price’s misconduct is an object lesson in where compliance policies come from. Someone does something stupid, everyone else recognizes it as stupid, and the ensuing clamor results in a new control. The control applies to everyone, makes the organization less efficient, and leaves employees grumbling. [More…]

Annual Reviews and Compliance’s Role: Annual Reviews of Policies and Procedures by Bailey Naples

One option, if you have the support, is to set up a policy review committee. If you are fortunate enough to have a Compliance Committee already established you can tie this right into your normal routine. The committee can divide up the policies between members to review and then they’ll report back to the committee at the next meeting. Forming a committee divides the work-load and holds all members to the deadline of review keeping the process moving along. [More…]

The lay of the law and private funds risk by Rebecca Akrofie in PFM

There’s no doubt private fund managers are becoming increasingly exposed to legal action, with portfolio company-related litigation being the most common. So far this year, big names like Benchmark Capital, Sycamore Partners and Apollo Asset Management have all become involved in lawsuits related in some way to the assets they own.
Marco Pierettori, general counsel at InvestIndustrial, a Europe-focused private equity firm, and Timothy Mungovan, a partner at Proskauer, an international law firm, share their thoughts on this trend, and the other legal headwinds fund managers should be aware of.

Concern: Fund liability for portfolio company problems …

Concern: Conflicts in co-investments …

Concern: Unicorn valuation mis-steps ….

Concern: Cybersecurity …

[More…]

From Saturday Morning Breakfast Cereal:

This comic’s author has a new book coming out:
Soonish
Ten Emerging Technologies That’ll Improve and/or Ruin Everything
By Kelly and Zach Weinersmith
From a top scientist and the creator of the hugely popular web comic Saturday Morning Breakfast Cereal, a hilariously illustrated investigation into future technologies–from how to fling a ship into deep space on the cheap to 3D organ printing. Order it today