Author: Doug Cornelius

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

The One with Fund Custody Footfault

ECM had investment advisory clients and managed two private funds in which some of its advisory clients invested. Based on the SEC order it looks like ECM tripped over the complexities of the Custody Rule in managing the investments.

An investment adviser has custody of client assets if it holds, directly or indirectly, client funds or securities, or if it has the ability to obtain possession of those funds or securities. Under the custody rule, an investment adviser who has custody has four main obligations:

  1. ensure that a qualified custodian maintains the clients assets;
  2. notify the client in writing of accounts opened by the adviser on the client’s behalf,
  3. have a reasonable basis for believing that the qualified custodian sends account statements at least quarterly to clients, and
  4. ensure that client funds and securities are verified by actual examination each year by an independent public accountant in a surprise exam.

A private fund can comply with obligations 2, 3, and 4 by having the fund audited annually and sending the audited financial statements to the fund investors with 120 days of the fiscal year of the private fund.

You don’t have to comply with custody requirement of 1 for “privately offered securities.” Those are private placements that are uncertificated and can’t be transferred without consent of the issuer. Think limited partnerships and private funds.

One problem was with what the order called “paper memberships” in the private fund. I was a bit confused by what was going on. I think the problem was that ECM was holding on to the limited partnership agreements signed by its clients who invested in the private funds.

The privately offered securities exception is only for obligation 1 of custody. You still have to comply with obligation 4 of custody and have a surprise examination.

Of course that is if you have custody. I think the problem is solved by having the partnership agreements send to the clients so you don’t have custody.

It looks like ECM also failed to have the private funds audited.

Of course this may all change when (or if) the SEC enacts the proposed Safeguarding Rule.

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The One with the Fake WeWork Bid

The Securities and Exchange Commission brought charges against Jonathan Larmore, his real estate investment company ArciTerra and its affiliate Cole Capital, based in Phoenix. According to the charges, Mr. Larmore was siphoning million of dollars from his investors in the ArciTerra funds to pay for his lavish lifestyle.

The SEC discovered this fraud because Mr. Larmore made a bid to purchase WeWork on the Friday before WeWork filed for bankruptcy. It was an attempt at stock manipulation.

Mr. Larmore had purchased call options for over 7 million shares in the days prior, with strike prices between $2 and $5 that were scheduled to expire at 4:00 on Friday November 3. The stock was then trading around $1. Those call options would be worth $0 if the share price of WeWork did not rise about the strike prices on Friday.

On the morning of November 3, Mr. Larmore sent Schedule TO to the SEC indicating that he intended to make a tender offer for WeWork at a price of $9. He also tried to publish a press release through the business wire service that morning.

“We have consulted with God, legal, financial and other advisors to assist us with this transaction. We stand ready to proceed timely.”

Larmore was not ready to proceed timely. He and Cole Capital did not have the financial resources to acquire the shares. Nor did they have any prospects for securing capital to proceed.

Larmore also did not know how to release a press release on the wire service. It had been rejected for formatting issues and other irregularities. It wasn’t fixed and released until 5:12 pm on November 3. That was after the public markets had closed and after his call options had expired.

He botched his stock manipulation and opened himself to further SEC inquiry which highlighted his other misdeeds.

It’s not clear how much of the SEC’s case outside of the stock manipulation is coming from its own inquiries. There are several lawsuits and accusations of fraud against Mr. Larmore and his real estate company. Mrs. Larmore noted in an April filing in her divorce from Mr. Larmore that “there appears to be some sort of SEC investigation in process, potentially against the entities or Jon.”

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Corporate Transparency Act Deadline Extended

It’s coming down to crunch time on the Corporate Transparency Act. Passed as part of the National Defense Authorization Act for 202, it requires companies to submit a report of their beneficial ownership and control to the U.S. Department of the Treasury’s Financial Crimes and Enforcement Center. For new companies, this information has to be submitted at the time of formation. Existing companies will have to submit this information during 2024.

Originally, at the time of formation meant within 30 days. FinCEN just announced that it will be extended for 90 days during 2024.

I understand why FinCEN is looking for reporting on entities formed in the US. As numbered Swiss bank accounts and offshore Cayman Island trusts are falling into line with prudential KYC-ALM laws, it’s the United States that makes it really easy to create a company and not disclose ownership or control.

I don’t think FinCEN is ready to make it easy to disclose the information required by the Corporate Transparency Act. I’ve heard there are concerns about whether the new database can handle the crush of information. I’ve worked with a few vendors trying to help with solutions for filing but haven’t had the ability to access a prototype of the FinCEN database.

It’s great that the initial deadline has been extended from 30 days to 90 days. Good luck to those brave souls who are going to be the first to file after January 1, 2024.

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2024 SEC Exam Priorities

In a surprisingly early announcement, the Securities and Exchange Commission’s Division of Examinations has released its 2024 examination priorities just two weeks into the start of its fiscal year. I’m used to seeing this released months into the fiscal year.

“Since the publication of our fiscal year 2023 priorities approximately eight months ago, we have advanced our mission as reflected in this year’s priorities, which provide both continuity and change to reflect a fluid and evolving economic and regulatory landscape. Given the shorter interval in between the publication of our priorities, several initiatives and focus areas from last year remain as fiscal year 2024 priorities.”

I’m focused on the private funds section.

  1. The portfolio management risks present when there is exposure to recent market volatility and higher interest rates. This may include private funds experiencing poor performance, significant withdrawals and valuation issues and private funds with more leverage and illiquid assets.
  2. Adherence to contractual requirements regarding limited partnership advisory committees or similar structures (e.g., advisory boards), including adhering to any contractual notification and consent processes.
  3. Accurate calculation and allocation of private fund fees and expenses (both fund-level and investment-level), including valuation of illiquid assets, calculation of post commitment period management fees, adequacy of disclosures, and potential offsetting of such fees and expenses.
  4. Due diligence practices for consistency with policies, procedures, and disclosures, particularly with respect to private equity and venture capital fund assessments of prospective portfolio companies.
  5. Conflicts, controls, and disclosures regarding private funds managed side-by-side with registered investment companies and use of affiliated service providers.
  6. Compliance with Advisers Act requirements regarding custody, including accurate Form ADV reporting, timely completion of private fund audits by a qualified auditor and the distribution of private fund audited financial statements.
  7. Policies and procedures for reporting on Form PF, including upon the occurrence of certain reporting events.

Of these seven, only #3: fee calculation and #6: custody) carry over from last year.

I’m curious about Form PF. Exam staff typically have, in the past, had limited access to Form PF data.

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No More Accelerated Monitoring Fees

In the proposed Private Fund Reform Rules, the Securities and Exchange Commission had contemplated a ban on charging a portfolio investment for monitoring, servicing, consulting, or other fees in respect of any services the investment adviser does not, or does not reasonably expect to, provide to the portfolio investment. This was an attack on a practice of some private equity firms to enter into a long term agreement with a portfolio company to enter into long term contracts, then have unexpired terms paid at exit.

That ban was dropped as an explicit rule from the reforms package. Instead the SEC made it an implicit rule.

The SEC stated on page 250:

“We believe that charging a client fees for unperformed services (including indirectly by charging fees to a portfolio investment held by the fund) where the adviser does not, or does not reasonably expect to, provide such services is inconsistent with an adviser’s fiduciary duty.”

The SEC also points out that it has brought actions in the past under Section 206(2) against private fund managers for improperly charging monitoring, servicing, consulting, or other fees, which may accelerate upon the occurrence of certain events, to a portfolio investment.

It did so again this week with charges against American Infrastructure Funds because it accelerated a portfolio company monitoring fee without timely disclosure to clients or investors. The SEC’s order also finds that American Infrastructure Funds violated its duty of care by failing to consider whether the fee acceleration was in its clients’ best interest.

I’m not sure why the SEC pulled back and didn’t make the accelerated fee ban explicit. The whole purpose of the series of 206(4) rules is to allow the SEC to “define, and prescribe means reasonably designed to prevent, such acts, practices, and courses of business as are fraudulent, deceptive, or manipulative.” Instead, the SEC is relying on regulation by enforcement under the fiduciary standard.

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Another SEC Whistleblower Action

For the second week in a row, the Securities and Exchange Commission brought a “pre-taliation” charge against a company for bad provisions in its employee separation agreements. This time it was the real estate company CBRE that had a bad provision.

In response to a Congressional mandate in Dodd-Frank, the SEC adopted Rule 21F-17 in August 2011, which provides:

(a) No person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement . . . with respect to such communications.

Back in 2016 the Securities and Exchange Commission filed a series of cases against companies that restricted departing employees from contacting government authorities. Some of the language the SEC found illegal was broad non-disparagement clauses that forbid former employees from engaging “in any communication that disparages, denigrates, maligns or impugns” the company. Companies responded by adding carve-outs that explicitly stated that employees could contact government regulators to reporting possible wrongdoing.

CBRE had an appropriate carve-out:

Nothing in this Agreement shall be construed to prohibit Employee from filing a charge with or participating in any investigation or proceeding conducted by the Equal Employment Opportunity Commission, National Labor Relations Board, the Securities and Exchange Commission, the Department of Justice, or a comparable federal, state or local agency.

What the SEC did not like is a representation earlier in the form separation agreement:

Employee represents and acknowledges [t]hat Employee has not filed any complaint or charges against CBRE, or any of its respective subsidiaries, affiliates, divisions, predecessors, successors, officers, directors, shareholders, employees, representatives or agents (hereinafter collectively “Agents”), with any state or federal court or local, state or federal agency, based on the events occurring prior to the date on which this Agreement is executed by Employee.

The SEC’s view was that the carve-out was prospective in application and did not fix the representation.

Last week’s whistleblower pre-taliation case against Monolith was clearly problematic. Allowing a complaint, but disallowing any financial rewards is clearly too cute and deters a whistleblower.

The CBRE language is not so obviously problematic. Some would argue that its fair to ask an employee if they’ve filed a complaint in the exit process.

If the form had a left a blank for an employee to fill in any exceptions to the representation, would that make the form okay? Probably not, based on this case. I think the case is trying to say that even asking if the employee has filed a complaint would be a deterrent and would violate Rule 21F-17.

Will these two be the last of the whistleblower cases form the SEC? The SEC’s fiscal year is fast approaching so we should expect a flurry of cases conclusions over the next week and a half..

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What We’ve Learned About Marketing Hypothetical Performance

When the Securities and Exchange Commission enacted the Investment Adviser Marketing Rule at the end of 2020, it threw out decades of cobbled together opinions, no action letters, and informal guidance. In the 18 months it took to reach the compliance date, the SEC offered little in the way of additional guidance. The SEC made it very clear that it would be taking a closer look at investment advisers’ marketing practices shortly after the compliance date a year. There have been signs that the examiners have been doing just that.

Enforcement has begun. The SEC announced action against nine firms for improper use of hypothetical performance.

(8) Hypothetical performance means performance results that were not actually achieved by any portfolio of the investment adviser.
(i) Hypothetical performance includes, but is not limited to:
(A) Performance derived from model portfolios;
(B) Performance that is backtested by the application of a strategy to data from prior time periods when the strategy was not actually used during those time periods…

Each of the nine firms published hypothetical performance on its website. Under 206(4)-1(d)6, an investment adviser can’t use hypothetical performance in an advertisement unless the firm:

(i) Adopts and implements policies and procedures reasonably designed to ensure that the hypothetical performance is relevant to the likely financial situation and investment objectives of the intended audience of the advertisement;

(ii) Provides sufficient information to enable the intended audience to understand the criteria used and assumptions made in calculating such hypothetical performance; and

(iii) Provides (or, if the intended audience is an investor in a private fund, provides, or offers to provide promptly) sufficient information to enable the intended audience to understand the risks and limitations of using such hypothetical performance in making investment decisions; ….

In the adopting release for the Marketing Rule at page 220, the SEC points out that hypothetical performance should not be used in mass advertising:

We believe that advisers generally would not be able to include hypothetical performance in advertisements directed to a mass audience or intended for general circulation. In that case, because the advertisement would be available to mass audiences, an adviser generally could not form any expectations about their financial situation or investment objectives.

There is no higher form of general circulation than using a public webpage to broadcast hypothetical performance. There is also the additional challenge of meeting the record-keeping requirements of the Marketing Rule for a website. To of the firms failed to have tools in place to archive their websites.

The lesson learned from these nine cases is don’t put hypothetical performance on your firm’s website.

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The One with the Stoner Cats

With the onset of the crypto winter, the Securities and Exchange Commission is continuing to bring cases against crypto companies. The latest is against a funding model for animated series: Stoner Cats. The producers wanted to try finding a crypto method to fund the production.

It started off as Kickstarter mixed with Non-Fungible Tokens. The tokens were digital pictures of the animated characters on the production. I think that’s okay and the tokens would not likely to be securities. You initially buy the NFT from producer to be able to watch the series. That’s like buying a movie ticket. That funds the production of the series.

Then the producers added in a royalty feature. When the NFT is traded from the initial buyer to secondary user, the producers take a 2.5% fee that gets passed to the actors and producers. I still that’s okay and doesn’t move the tokens into the treatment as a security.

Under the Howey test, it’s clearly a pooled investment and it’s success is clearly due to the efforts of the production team. The question is there an expectation of profits required by the third prong of the Howey test?

The cash flow from re-sale fee goes to the producers, not the token holders. So, the expectation of profits does not flow directly from the success of the production.

The SEC focused on the potential increase in value of the tokens.

“[I]t led investors to expect profits from their entrepreneurial and managerial efforts, because a successful web series could cause the resale value of the Stoner Cats NFTs to rise in the secondary market.” …

“Investors were also told that “the more successful the show, the more successful your NFT” will be.”

There are plenty of securities offerings that investors look to an increase in value and not to a payment of dividends. Those equity offerings still offer investors a residual claim on the business, even if they don’t get cash flow.

The SEC seems to hang it’s charges on the marketing efforts of the producers that the NFTs could increase in value if there is demand for the series. But of course that is part of the pitch to token holders and the whole NFT eco-system. Buy these tokens and they will increase in value. NFTs occupy this space between commodities and securities.

There is probably an interesting legal analysis and this could be an interesting court case. However, the producers settled with the SEC, agreed to return funds and destroy the NFTs.

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A New Regulatory Action to Help Potential Whistleblowers

In response to a Congressional mandate in Dodd-Frank, the SEC adopted Rule 21F-17 in August 2011, which provides:

(a) No person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement . . . with respect to such communications.

Back in 2016 the Securities and Exchange Commission filed a series of cases against companies that restricted departing employees from contacting government authorities. Some of the language the SEC found illegal was broad non-disparagement clauses that forbid former employees from engaging “in any communication that disparages, denigrates, maligns or impugns” the company. Companies responded by adding carve-outs that explicitly stated that employees could contact government regulators to reporting possible wrongdoing.

Monolith Resources included that language in its separation agreements:

“nothing in this agreement is intended to limit in any way your right or ability to file a charge or claim with any federal, state, or local agency,”

But Monolith took away the financial aspect of a whistleblower by adding:

“You retain the right to participate in any such action, but not the right to recover money damages or other individual legal or equitable relief awarded by any such governmental agency.”

Monolith’s former employees could file a whistleblower complaint, but not get any cash. An interesting approach, but one that is clearly designed to impede whistleblower actions.

Monolith got hit with a $225,000 fine. There was no indication that any employee was impeded from communicating with the SEC and Monolith never enforced that provision.

Maybe there has been some prior action by the SEC on this type of pretaliation and I just missed it. Let me know.

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New Division of Examinations Risk Alert

The Securities and Exchange Commission tries to be transparent about the areas of examination. The Division of Examinations publishes its exam priorities each year. Of course, in practice it may vary from region to region and examiner by examiner. A new risk alert focuses on what an registered investment adviser should expect from an exam.

As it has stated many times over the years, the Division once again states in the Risk Alert that it takes a “risk-based approach” to selecting exam targets. The Division also adds in that a firm could be picked because of the interest in a particular compliance risk area (a sweep exam?), or a tip, complaint, or referral (a for-cause exam).

The Division does list 11 factors for selecting an adviser for examination:

  1. prior examination observations and conduct, such as when the staff has observed what it believes to be repetitive deficient practices during more than one review of a firm, significant fee- and expense-related issues, and significant compliance program concerns;
  2. supervisory concerns, such as disciplinary history of associated individuals or affiliates;
  3. tips, complaints, or referrals involving the firm;
  4. business activities of the firm or its personnel that may create conflicts of interest, such as outside business activities and the conflicts associated with advisers dually registered as, or affiliated with, brokers;
  5. the length of time since the firm’s registration or last examination, such as advisers newly registered with the SEC;
  6. material changes in a firm’s leadership or other personnel;
  7. indications that the adviser might be vulnerable to financial or market stresses;
  8. reporting by news and media that may involve or impact the firm;
  9. data provided by certain third-party data services;
  10. the disclosure history of the firm; and
  11. whether the firm has access to client and investor assets and/or presents certain gatekeeper or service provider compliance risks.

I think the key for most firms is number 5: How long has been since you’ve had an exam. If it’s been at least six years, the clock is ticking. If it’s been seven years, have a stack of documents ready.

To help you with that stack of documents, the Risk Alert includes an attachment with the staff’s typical initial request for documents and information.

I think it’s great that the SEC published this information. I do find it strange to be labeled as a “Risk Alert.” Those are usually to highlight areas where the Division is seeing problems in examinations. I find it hard to believe that registered investment advisers are being surprised that examiners are knocking on their doors or surprised at the scope of information. It can be a lot. In my recent exam I produced over 800 documents.

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