Author: Doug Cornelius

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SEC’s Regulatory Agenda

The Securities and Exchange Commission has published the Spring update to its agency rule list: Agency Rule List – Spring 2023 Securities and Exchange Commission. While none of this is carved in stone it does give us some sense of what the SEC is working on, what it has given up on, and when things may come out.

The first item on my mind is the proposed Private Fund Rule. That was first proposed in the first quarter of 2022 with a Buffet of Private Fund Regulations piled into one proposed rule. I have heard little about what end up in the rule. It’s still on the agenda and has a proposed final action in October 2023.

Cybersecurity for investment advisers is also still on the agenda. This was another of the first quarter 2022 rulemaking. My biggest concern is that the rule would likely make a cyber breach a fraud violation. Seems like that’s a problem given that the US government is noting a widespread cyberattack today: US government agencies hit in global cyberattack. Nonetheless, the rule still on the agenda and has a proposed final action in October 2023.

Outsourcing by investment advisers remains on the agenda. Any final action is pushed off to April 2024. I think the SEC is struggling with how to scope the rule.

“A covered function is defined in the proposed rule as a function or service that is necessary for the adviser to provide its investment advisory services in compliance with the Federal securities laws, and that, if not performed or performed negligently, would be reasonably likely to cause a material negative impact on the adviser’s clients or on the adviser’s ability to provide investment advisory services.”

If I hire a bad elevator contractor for my private real estate fund’s assets and all the elevators stop working, I think that makes it a “covered function” that would be subject to the proposed rule.

The new Safeguarding Advisory Client Assets rule looks like it its on the fast track. It was just published in the first quarter of 2023 and is scheduled for final action in October 2023. That rule is targeting at killing crypto. In the process, it’s taking a sledgehammer to all alternative investments.

It looks like we’ve got three big regulatory changes coming out this fall. Sounds like we should rest up this summer to get ready.

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New Risk Alert on the Marketing Rule

The Division of Examination released a risk alert on additional areas of emphasis during examinations focused on the new Marketing Rule (Rule 206(4)1): Examinations Focused on Additional Areas of the Adviser Marketing Rule. This is identified as a follow up to the September 19, 2022, Risk Alert describing the initial areas of review related to examining advisers for compliance with the Marketing Rule: Examinations Focused on the New Investment Adviser Marketing Rule.

The new areas of focus are:

  1. Testimonials and Endorsements
  2. Third-Party Ratings
  3. Form ADV

Testimonials and Endorsements

The focus seems to be just on the key compliance areas. You need to make sure you have good disclosures about whether the person is an actual client/investor, whether the person is compensated and any material conflicts of interest.

I’m seeing placement agents struggling with how to disclose their role in the marketing and fundraising. They all have good disclosures and procedures. I assume there will some move towards standardization in the industry.

Third-Party Ratings

Compliance needs to keep a close eye on these and the substance behind them. The Risk Alert makes it clear that the SEC wants the time frame to be clear, who did the rating and whether there was any compensation.

An interesting note is that the SEC wants to see that the:

“adviser has a reasonable basis for believing that such questionnaire or survey is structured to make it equally easy for a participant to provide favorable and unfavorable responses, and is not designed or prepared to produce any predetermined result.”

Form ADV

The SEC wants to make sure you are checking the right boxes in the new Form ADV questions regarding marketing. Not much substance here, just easy for the SEC to review and grade. I assume the examiners have seen a bunch of advisers who checked the wrong boxes.

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Back from a hiatus on the blog. I thought it prudent to shut down during an examination. The end result was just fine. Exams are just nerve-wracking.

A New Marketing Rule FAQ

It’s been two months and the SEC finally issued a substantive FAQ on the Marketing Rule for investment advisers. https://www.sec.gov/investment/marketing-faq

Gross and Net Performance

Q. When an adviser displays the gross performance of one investment (e.g., a case study) or a group of investments from a private fund, must the adviser show the net performance of the single investment and the group of investments?

A. Yes. The staff believes that displaying the performance of one investment or a group of investments in a private fund is an example of extracted performance under the new marketing rule.[1] Because the extracted performance provision was intended, in part, to address the risk that advisers would present misleadingly selective profitable performance with the benefit of hindsight, the staff believes the provision should be read to apply to a subset of investments (i.e., one or more). Accordingly, an adviser may not show gross performance of one investment or a group of investments without also showing the net performance of that single investment or group of investments, respectively.[2] In addition, the adviser must satisfy the other tailored disclosure requirements as well as the general prohibitions, including the general prohibition against specific investment advice not presented in a fair and balanced manner, when showing extracted performance.[3]

This has been an issue that private equity fund managers have been trying to clarity on for over a year. There has been conflicting advice from consultants and lawyers about the best way to deal with case studies that highlight the type of investing and managing by the private equity fund manager.

I think showing the net overall returns for the fund is more important that coming up with some jiggered calculation of net return for a single investment. But the SEC clearly thinks the opposite.

This will impact many fund managers who took the opposite advice from the SEC position. Marketing materials will need to be revised. Policies and procedures will need to be re-written. A formula for estimating net returns for an individual investment will need to be created.

Happy Marketing Rule Day

The new Marketing Rule for Registered Investment Advisers takes effect today. (Nov 4) Hopefully you’ve got your policies and procedures in place and operational, if the rule applies to you.

Many were hoping for some clarifications and updates. Only two questions were ever answered.

  1. An adviser may choose to comply with the amended marketing rule in its entirety any time starting on the effective date, May 4th, 2021. Until an adviser transitions to the amended marketing rule, the adviser would continue to comply with the previous advertising and cash solicitation rules and look to the staff’s positions under those rules. The staff believes an adviser may not cease complying with the previous advertising rule and instead comply with the amended marketing rule but still rely on the previous cash solicitation rule.
  2. The staff would not object if you are unable to calculate your one-, five-, and ten-year performance data in accordance with rule 206(4)-1(d)(2) immediately following a calendar year-end and you use performance information that is at least as current as the interim performance information in an advertisement until you can comply with the calendar year-end requirement. 

There are several unanswered questions out there. I’ve seen two floating around with lots of discussion these last few weeks.

One is for private equity fund managers using extracted performance in a case study for a fund. I’ve seen conflicting advice from different consultants and law firms about whether you need to generate some kind of a net return for that single investment or whether you can use the net return for the fund.

The second is whether you need to update Form ADV Part 2 Question 14 regarding placement agents or solicitors right away to comply with the Marketing Rule. The SEC has said conflicting things about this update.

The Division of Examinations has already stated it will start a sweep exam on compliance with the Marketing Rule. (See the Risk Alert) Keep an eye on your phone Monday morning.

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Custody Crackdown

Earlier this year, the SEC’s Division of Examinations published its priorities for 2022. There was a significant focus area on private funds. In particular, looking at:

“compliance with the Advisers Act Custody Rule, including the “audit exception” to the surprise examination requirement and related reporting and updating of Form ADV regarding the audit and auditors that serve as important gate-keepers for private fund investors”.

Earlier today the SEC announced a swath of actions against firms for custody rule failures. The charged advisors advisers failed to have audits performed or to deliver audited financials to investors in private funds in a timely manner, thereby violating the Investment Advisers Act’s Custody Rule.

The SEC added on a technical filing violation as well.

Firms are strongly encouraged to ensure their compliance with the Custody Rule and the related Form ADV reporting and amending obligations. In particular, private fund advisers registered with the SEC are reminded that per the instructions to Form ADV, Part 1A, Schedule D, Section 7.B.23.(h), “If you check ‘Report Not Yet Received,’ you must promptly file an amendment to your Form ADV to update your response when the report is available.”

The Custody Rule for private funds have some bright lines, making it easy to comply with (if you ignore the costs of audits). It also makes failure to comply with the Custody Rule very obvious. You either deliver the audited financial statements on time or you don’t.

If you don’t deliver on time, the SEC is going to notice.

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The One with the Miscalculated Fees

The Securities and Exchange Commission has made it clear that one of its primary points of interest with private funds is fees and expenses. Some of that is well-deserved. Some private funds had a history of being opaque about fees and expenses.

A recent enforcement case by the Securities and Exchange Commission highlights mistakes that could easily be made by a fund manager if not paying attention to what the fund documents say. The case against Energy Innovation Capital Management, LLC is illustrative of items to pay attention to when checking management fee calculations.

The first thing to note is that Energy Innovation is a venture capital firm and is an exempt reporting adviser. Those types of firms are not subject to routine examination. I’m intrigued how the SEC came across the fee calculation problems at the firm.

As with most non-hedge private funds, the fund management fee calculation changes after the equity commitment period ends. During the commitment period, the fee is a percentage of committed capital while the fund deploys the capital. Once the commitment period ends, the fund is limited in its ability to make investments and the fee basis is reduced to an amount that generally equates to the amount of capital deployed.

In the Energy Innovation fund the commitment period ended in the first quarter of 2020. The firm changed the calculation as of the end of the quarter. That was inaccurate. The fee should have been pro-rated as of the actual date. Of course, by waiting until the end of the quarter the firm had a higher fee basis for a longer time.

The second problem was that the firm included accrued, but unpaid, interest attributed to certain individual portfolio company securities in the fee basis. Without the language of the fund agreement its hard to tell what went wrong. It may be that the fund documents did not specifically allow it to be included so the SEC took the position that it can’t be included.

The biggest problem is that the firm wrote down individual portfolio company securities and wrote off certain others for valuations, but did not incorporate any of these write-downs into its post-commitment period fee basis.

The final corollary issue was that the firm aggregated invested capital at the portfolio company level in fee basis, instead of at the individual portfolio company security level. The fund documents did not permit aggregation of invested capital at the portfolio company level. I assume this is tied to the treatment of write-downs.

The net result of these problems was that the firm earned $678,861 in excess management fees. Interestingly, the the order did not require repayment of those excess fees. The order notes that “the Commission considered remedial acts promptly undertaken.” I assume the firm had already repaid the excess fees during the examination.

This enforcement action is a warning to other firms that the SEC is laser focused on management fees.

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The One with the Fixing and Flipping

Angel Oak Capital Advisers sponsored a fund to securitize “Fix and Flip” loans. These loans were targeted at borrowers for the purpose of purchasing, renovating, and selling residential properties. It looks like Angel Oak didn’t get the underwriting correct. Angel Oak saw an unexpected increase in late mortgage payments delinquencies. The securitization had a covenant that required early amortization payments to investors in the securitization if there was a greater than 15% delinquency for two consecutive months.

The “Fix and Flip” loans had escrow accounts to pay draws to borrowers after completion of renovations the properties. The securitization documents said these escrow accounts would be used for renovations and repairs. The documents did not specifically allow the use of the escrow to reduce delinquencies.

Angel Oak divert escrowed renovation funds to bring delinquent mortgage loans into current status and reduce delinquencies. According to the SEC complaint this was not consistent with disclosures made to investors in the certification. Angel Oak contacted delinquent borrowers and instructed them to make requests for escrow funds to reimburse for renovations, with the understanding that the funds would instead be used to pay off delinquent balances. There were email documenting the process with borrowers.

There are emails documenting the decision to seek the diversion of funds.

“We have to keep the 3 month average of 60+ dq [delinquencies] under 15% to avoid an early amortization trigger to trip. This trigger tripping would be extremely negative for our prospects of doing further securitizations and will also negatively impact our broader AOMT shelf.”

The additional problem you can see from that quote is that the early amortization would hurt effort to pull in investors for the next securitization. It’s not just a question of defrauding the current investors, but using the fraud to raise more capital.

As an additional conflict, Angel Oak held a junior position in the securitization. The early amortization trigger would have a substantial, negative impact on that junior position.

Blame was also placed on Ashish Negandhi, a loan portfolio manager responsible for purchasing loans to be securitized by Angel Oak as well as monitoring the securitizations’ performance after their sale to investors.

As a result of the SEC action, Angel Oak agreed to pay a $1.75 million penalty and Mr. Negandhi agreed to a $75,000 penalty.

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The One with Valuation Malfeasance

After a hiatus for the heat of the summer, here is a compliance case of valuation malfeasance. It comes from the biggest collapse of a private equity fund manager. The Abraaj Group and its CEO, Arif Naqvi, were vanguards in emerging markets investments. After some early success buying and transforming Inchcape Shipping Services and Jordanian Express Mail, Mr. Naqvi became a prolific fundraiser. The Abraaj Group at one point managed almost $14 billion, with holdings in health care, clean energy, and real estate across Africa, Asia, Latin America and Turkey.

The Abraaj fundraising was based on the purported success of the prior funds’ private company investments which were very illiquid. Mr. Naqvi also claimed that his investments were doing good for people while making money for the investors.

It turns out that wasn’t true. There are currently many pending actions against the Abraaj Group, Mr. Naqvi and the firm’s personnel in several countries.

The latest action is a case brought by the Securities and Exchange Commission against Mark Alan Bourgeois who was responsible globally for fundraising and investor relations and was a member of Abraaj’s Management Executive Committee. Mr. Bourgeois recommended that Abraaj not apply write-downs (or delay doing so) for investments made by prior funds to avoid the negative impact on the fundraising for its sixth fund. Abraaj did delay applying the write-downs. The result was that investors and potential investors in its sixth fund received an inflated performance track record while Abraaj and Mr. Bourgeois actively solicited investments for the sixth fund.

Mr. Bourgeois agreed to pay a $2 million fine in this case. Mr. Naqvi is currently free on bail in London while contesting extradition for financial fraud charges.

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The One With The CCO Illegally Selling Securities

Enforcement cases against a Chief Compliance Officer always catch my attention. The latest to catch my eye is against A.G. Morgan Financial Advisors, LLC (“AGM”) of Massapequa, New York, AGM’s owner Vincent J. Camarda, and AGM’s former Chief Compliance Officer James McArthur.

The SEC Commissioners and senior Division of Examination staff have usually stated three circumstances that lead to CCO liability:

  1. when the CCO is affirmatively involved in misconduct;
  2. when the CCO engages in efforts to obstruct or mislead the Commission; or
  3. when the CCO exhibits “a wholesale failure to carry out his or her responsibilities”

AGM, Mr. Camarda and Mr. McArthur got involved with an unregistered securities offering with a lending company called Complete Business Solutions Group, that was doing business as Par Funding. The company was making short term loans to small businesses that were supposed to be secured by receivables. Par Funding was raising capital by selling unregistered securities in the form of promissory notes. Nothing illegal as long as the firm and its agents are following the the private placement rules.

According to the SEC compliant, Mr. McArthur was actively involved in the selling of the Par Funding securities to the AGM clients. This would put the nature of the SEC CCO action into the exception 1: affirmatively involved in the misconduct. (And still its CCO.)

In this case I’m not sure why Mr. McArthur is identified in the complaint as “its former Chief Compliance Officer”. There is no mention of him acting in a compliance role in the complaint. According to the firm’s website and the firm’s Form ADV filing, Mr. McArthur is also the firm’s president.

As for the alleged wrongdoing, AGM was also a client of Par Funding. The firm owed par as much as $750,000 at times and some which was personally guaranteed by Mr. Camarda. The Securities and Exchange Commission accuses AGM of telling investors that it was a safe investment, while failing to disclose that his company AGM was in debt to Par Funding and that Mr. Camarda was a guarantor on that debt to Par Funding. The SEC claims that existence of the debt was a material conflict that should have been disclosed to the AGM investors and failing to disclose the existence of the debt was a breach of fiduciary duty under the Investment Advisers Act. AGM was apparently paying down its debt to Par Funding by selling the promissory notes.

The SEC also claims that the sale of promissory notes did not fit any exemption from registration. It’s a little light on that claim. It at least three instances, the complaint notes that the respective investor had completed an “Accredited Investor Questionnaire.” It does reference a television commercial for the investment, so that could be a general advertisement in violation of the private placement rules.

Of course, the main problem was that the Par Funding investments were duds. Par Funding ended up in receivership. It’s under investigation for illegally selling securities. From news reports, Par Funding engaged in some shading lending practices, poor underwriting and had some shady characters under its employ. Investors lost money.

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The One With the Gambling Edge

Buying and selling securities is often equated with gambling. (The differences are that you can hold your securities and keep winning without making any bets.) Gamblers and investors are always looking for an edge to increase their odds of success. When it comes to investing, that edge can be the misuse of insider information.

The headline of SEC Charges Former Employee of Online Gambling Company with Insider Trading jumped out at me. Finally, the intersection of gambling and investing in an enforcement case.

It turns out to be a fairly standard insider trading case. David Roda worked at Penn Interactive Ventures, a subsidiary of Penn National Gaming, as a programmer for its online sportsbook application. He heard from a co-worker that Penn was working on an acquisition. Mr. Roda got himself added to the acquisition team and found out about the target.

According to the SEC complaint, Mr. Roda quickly acquired some call options on the target. Penn sent a message warning employees not violate the insider trading policy. That apparently spooked Mr. Roda so he sold those options. Or maybe it didn’t spook him, because he then bought more options on the target.

As you might expect, the trades looked suspicious. They were short duration options that were “out of the money.” Since the options were just above the current trading price with little time left for the price to rise, they were cheap. It would be very aggressive to buy these, unless you had a gambler’s edge. Or insider knowledge.

According to the SEC complaint, Mr. Roda’s $21,000 purchase of those options netted him over $580,000 in profits in less than two weeks. I’m sure that triggered warning lights for compliance at whatever firm he had used for the trading.

Obviously, this is just the government’s side of the case. The Department of Justice has stepped in with criminal charges as well. Mr. Roda may or may not be guilty.

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