Category: Compliance Programs

Charging Fund Investors For In-House Legal Staff

In house lawyers fall into two sections of typical fund documents. On one had, fund documents usually state that the fund pays for legal expenses. Another section states that the general partner is responsible for employee expenses.

Cash in the grass.

Can you charge in-house legal staff as a fund expense?

It depends.

This was mentioned by Marc Wyatt, Deputy Director – Office of Compliance Inspections and Examination, US Securities and Exchange Commission, at .

It’s not that a fund manager is prohibited from charging its fund clients for in-house legal counsel. As with any fee or expense, it needs to be properly disclosed and properly documented.

I have heard that at least one real estate private fund manager has received a deficiency letter after an examination because of the way it treated legal expenses. The fund manager charged internal legal staff compensation and expenses to the fund.

The SEC relied on the provisions in the fund documents stating that overhead, including compensation of personnel, is to be paid by the general partner / fund manager.

The general partner / fund manager pointed to other language that stated it could charge the funds for legal expenses.

I think the SEC thinks that in the case of a tie, the fund investors should win.

If you charge in house legal fees to fund investors, there are some steps a fund manager should take:

  • Disclose it on Form ADV.
  • Disclose it in the financial statements for the funds. To be in accordance with GAAP, related party transactions must be included in the notes to the financial statements.
  • Maintain timesheets and other documents to support the time or work of in-house legal staff.
  • Maintain written policies and procedures to address when the expenses should be paid by the fund and when they should be paid by the fund manager.

It may not actually be costing the fund any more for in-house versus outside cost. In fact, it may actually be cheaper.  But it is extra revenue to the fund manager. The SEC has indicated that it cares about that difference.

Private Equity Fund Managers and Broker Dealer Registration

The Securities and Exchange Commission has been poking around fees earned by private equity firms and found many to its distaste. One item the SEC has highlighted in the past was fees for acting as a broker dealer. I’ve been waiting to see if the SEC’s distaste would be enough to bring an enforcement action. The SEC has brought that case.

broker dealer

Blackstreet Capital Management paid itself transaction based compensation in connection with acquisition and disposition of portfolio companies. The fund documents permitted this fee.

Blackstreet purchased and sold securities on behalf of its private equity fund and earned a transaction based fee for those services. Those services included soliciting deals, identifying buyers or sellers, negotiating and structuring transactions, arranging financing, and executing the transactions. Those transactions would have largely been securities that Blackstreet was buying and selling for its private equity fund.

The problem is that those services look a lot like the services of a broker dealer. By collecting transaction based compensation, it seems to fall right into the definition of broker dealer.

“The rules are clear: before a firm provides brokerage services and receives compensation in return, it must be properly registered within the regulatory framework that protects investors and informs our markets,” said Andrew J. Ceresney, Director of the SEC Enforcement Division. “Blackstreet clearly acted as a broker without fulfilling its registration obligations.”

The charge is not for improperly charging fund investors. The fee was disclosed in the fund documents and presumably Blackstreet was charging an appropriate fee. The SEC charge is merely because Blackstreet was not registered as a broker dealer.

There are other issues disclosed in the order, so its not clear if the SEC would bring an enforcement action solely because of this issue.  It is clear that the SEC is sending a signal.

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Delaying Losses To Earn Current Fees

Fee structure is a guiding force for how fund managers operate and a keystone for compliance professionals. A compliance professional needs to focus on ways that a fee structure could cause the fund manager to act to the detriment of fund investors. The Securities and Exchange Commission just charged a fund manager for using distorted timing to generate more fees.

Cash in the grass.

According the SEC complaint, Hope Advisors and its principal owner, Karen Bruton, distorted the trading patterns of its hedge fund it managed to maximize fees to the detriment of fund investors. Hope Advisors and Ms. Bruton are challenging the charges so I’m looking at the complaint as an example of problematic behavior and not that they actually did these things.

Hope was entitled to an incentive fee of 20% of any realized gains during the previous month. But first the fund needed to make up for any realized losses. Unrealized gains and unrealized losses were not used in calculating the incentive fee.

The PPM for the fund discloses that the incentive fee may be paid even though the fund is experiencing unrealized losses.

According to the SEC, Hope was causing the fund to realize gains currently by deferring current unrealized losses through options. The fund would sell call options in the current month, earning a fee, and buy an equivalent set of options that expired in the next month. The SEC claims that there was no economic substance to the trades because there was little chance to make or lose money regardless of the market’s direction.

The fund would keep kicking the unrealized losses into the next month, while still taking fees. The fund had an NAV of $136 million, with unrealized losses of $57 million.

According to the statements in the complaint, it seems that Hope was acting to the detriment of fund investors. However, this behavior and risk is disclosed in the PPM.

Is disclosure enough for this circumstance?

I think trades that have no economic benefit (or risk) to the fund investors but are done merely to increase a fund managers compensation are suspect. Compliance professionals should look closely to see if the trade is merely done to benefit the fund manager.

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TRID: The Reason I Drink

The Wall Street Journal dedicated some front page space to compliance professionals: Inside Enforcers Shake Up Bank Culture. It paints a stark picture of the regulatory pressure on banks.

private placement

There were many factors that lead to the 2008 Great Recession. Most people agree that a lack of oversight by regulators on the banks under their supervision contributed to the crash and the government bailout. The 2010 Dodd-Frank law was supposed to make the banking system safer than it was.

It has made banking harder and more complex.

Dodd-Frank was 200 pages of law that has lead to another 22,000 pages of regulatory requirements. Those requirements have spawned the fastest-growing component of the financial sector. Banks have hired tens of thousands of new compliance staff to implement and operate within in the new regulatory environment. The six largest U.S. banks spent at least $70.2 billion on regulatory compliance in 2013 which is double the $34.7 billion spent in 2007, according to a study by Federal Financial Analytics Inc.

Among the new federal banking regulations there is one that financial wonks call “TRID,” the TILA-Respa Integrated Disclosure rule.

Attendees at a recent training school here for bank compliance staff, who must learn and enforce such rules, said they deciphered TRID’s true meaning: “The reason I drink.”

According to the story, regulators sometimes struggle to decipher new rules the same way bank and their compliance professionals do. An interviewee discusses  a months long discussion between the bank and regulators over whether it should let customers pay ahead on mortgages. And if they did, would the bank consider borrowers delinquent if they later missed a month?

Another bank official noted  that it isn’t uncommon for regulators from different agencies to issue conflicting opinions. One of that bank’s regulators requested an exam.  Two weeks later, another regulatory agency requested an exam. The two regualtors came back with different results.

TRID

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Nuns With Guns: The Strange Day-to-Day Struggles Between Bankers and Regulators by Kristen Grind and Emily Glazer in the Wall Street Journal

Dodd-Frankly, My Dear, I Don’t Give..

Perhaps one day there’ll be another famous movie line: “Dodd-Frankly, my dear, I don’t give…” But probably not. Its not clear if Dodd-Frank has been a success or a failure.

GoneWiththeWind1

It certainly has been a change.

From the regulated side, I think the failure or success depends on which part of Dodd-Frank affects you. New regulations make winners and losers. Most research shows that it makes it harder for new firms to enter the regulated space.

From 2009 to 2013 only 7 new banks were formed, fewer than 2 per year. From 1990 to 2008, over 2,000 new banks were formed, more than 100 per year. Its easy to blame that on Dodd-Frank, but the economy has been weak and interest rates low.

Certainly, big banks are not any smaller and few believe that too big to fail is gone. It brief glance at bank credit ratings, you can see a boost in the ratings for an implied government bail-out.

It also depends on how you rate size: amount of deposits, amount of assets, amount of lending activity.

We have seen the reach of the non-bank too big to fail labeled and then removed. The firms may be important, but not systemically important.

One of the clear winners is the compliance profession. Dodd-Frank clearly requires more compliance efforts and people to take on those efforts.

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Does Compliance Work?

This has been an existential question for a long time. How do you measure compliance success? How do you know if it’s working?

Folder with the label Compliance

Sean Griffith, director of the Corporate Law Center at Fordham University in New York casts a skeptical eye on compliance through the lens of corporate governance in a new law review article: Corporate Governance in an Era of Compliance. He concludes there is not enough data to prove that compliance works.

That part is true. It is hard to measure successful compliance.

The first goal of compliance is to prevent bad acts from happening. Part one is education to let employees know what is good and what is bad. Part two is detection so that an employee making a bad act will have a fear of getting caught.

For most organizations few bad acts ever happen. The occurrence is an outlier with no data to measure against. It is only the biggest of organizations that will have an ongoing occurrence of bad acts to measure.

For those biggest of organizations, they can measure a decrease in the occurrence of bad acts as a measure of success. But that decrease can be for one of two reasons. One reason is an actual decrease in bad acts. A sign that compliance is working. The second reason could be that the bad acts are not being caught. Employees knowing that they may get caught take extra steps to avoid their bad acts from being detected. In the second reason, compliance is not being effective. Yet the data is the same.

It’s hard to prove that something didn’t happen because of compliance.

As  Professor Mike Koehler, the FCPA Professor, responded to my note, “nobody knows whether #compliance really works”, with

“Same can be said for lots of things in life – but how can one truly measure compliance success stories?”

The other problem with measuring compliance success is that “compliance” means different things to different industries and different firms.

Compliance in financial services is different from compliance in health care and different from extractive industries. You can’t find a meaningful measure of compliance across those industries.

None of this is meant to say that compliance doesn’t work. I feel strongly that it does work. The issue is merely measuring that success.

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Alternative Funds and Valuations

It should come to no surprise that alternative funds have an extra level of scrutiny when it comes to valuations. RD Legal Capital is under scrutiny by the Securities and Exchange Commission according to a story in the Wall Street Journal.

Valuation

RD Legal is in litigation finance with a strategy to to buy stakes in a judgment at a discount to the likely settlement. The firm bankrolls lawsuits hoping to collect if damages are paid. It took a big stake in a lawsuit against Iran, buying claims at a steep discount.

Apparently RD Legal has been writing up the value of that stake even though no settlement has been paid.

Valuation, whether right or wrong, is more subjective when it comes to illiquid assets. Real estate fund managers and other alternative fund managers are aware of this. The fairness question and therefore the regulatory question is what the effect of the valuation is on the investors and the fund manager. If the fund manager can take an extra fee on unrealized gains, the valuation should be subject to extra scrutiny.

The SEC is accusing RD Legal of taking cash at the expense of investors based on the increased valuation.

I fear the outcome will be one based on hindsight. If the settlement gets paid, the increased valuation will be justified. If it never appears, then the firm will be subject to even greater scrutiny.

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Private Equity Real Estate Top 50 – 2016 Edition of Who is Registered

Private Equity Real Estate has released its ranking of the top 50 real estate private equity fund managers. As I have done in the past, I parsed the list to see which managers are registered with the Securities and Exchange Commission as investment advisers.

pere 50

Rank Firm Headquarters Registration
1 The Blackstone Group New York  Registered
2 Lone Star Funds Dallas  Registered
3 Brookfield Asset Management Toronto  Registered
4 Global Logistic Properties (GLP) Singapore  Exempt Reporting
5 Starwood Capital Group Greenwich  Registered
6 Tishman Speyer New York  Registered
7 The Carlyle Group Washington DC  Registered
8 Oaktree Capital Management Los Angeles  Registered
9 Westbrook Partners New York  Registered
10 Rockpoint Group Boston  Registered
11 KSL Capital Partners Denver  Registered
12 Ares Management Los Angeles  Registered
13 Angelo Gordon New York  Registered
14 LaSalle Investment Management Chicago  Registered
15 Fortress Investment Group New York  Registered
16 Invesco Real Estate Dallas  Registered
17 Colony Capital Santa Monica  Registered
18 GreenOak Real Estate New York  Registered
19 CBRE Group Los Angeles  Registered
20 CIM Group Los Angeles  Registered
21 Northwood Investors New York  Registered
22 Walton Street Capital Chicago  Registered
23 PW Real Assets London  Exempt Reporting
24 Crow Holdings Capital Partners Dallas  Registered
25 Meyer Bergman London  Exempt Reporting
26 Tristan Capital Partners London  Overseas
27 Hines Houston  Registered
28 GTIS Partners New York  Registered
29 Partners Group Baar-Zug, Switzerland  Exempt Reporting
30 Almanac Realty Investors New York  Registered
31 Harrison Street Real Estate Capital Chicago  Registered
32 Carmel Partners San Francisco  Registered
33 Pramerica Real Estate Investors Madison, NJ  Registered
(Prudential)
34 Rialto Capital Management Miami  Registered
35 Hemisferio Sul Investimentos São Paulo, Brazil  Overseas
36 Shorenstein Properties San Francisco
37 Square Mile Capital Management New York  Registered
38 Kayne Anderson Capital Advisors Boca Raton  Registered
39 Greystar Real Estate Partners Charleston
40 DRA Advisors LLC New York  Registered
41 Och-Ziff Capital Management New York  Registered
42 Related Companies New York  Registered
43 KingSett Capital Toronto  Overseas
44 Gaw Capital Partners Hong Kong  Exempt Reporting
45 Tricon Capital Group Inc. Toronto  Registered
46 TA Realty Boston  Registered
47 Fir Tree Partners New York  Registered
48 Bridge Investment Group Partners Salt Lake City  Registered
49 AEW Boston Registered
50 ECE Real Estate Partners Hamburg, Germany  Overseas

 

On this year’s list, 39 of the top 50 are registered with the SEC as investment advisers. Of those not registered, four are overseas, likely outside the scope of SEC registration requirements. Five overseas firms filed as exempt reporting advisers. That leaves two firms that are not registered as investment advisers.

There are good arguments to be made on both sides of the registration debate for real estate funds. The core requirement under the Investment Advisers Act is that the manager is giving investment advice about “securities.” Most of these real estate fund managers are truly focused on real estate and not securities. However, the discussion between what is and is not a security may be fun for the first week of your securities law class in law school. It’s not a fun discussion when trying to comply with regulatory requirements.

The PERE 50 measures capital raised for direct real estate investment through commingled vehicles, together with co-investment capital, over the past five years. This edition measures from January 1, 2011 to March 2016 for direct investment through closed-end commingled real estate funds. It excludes core and core-plus funds.

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Custody Failure Pinned On the Gatekeepers

I remember the SFX case because the CCO was charged for compliance failures. Now the auditors of SFX have been been charged for their failures.

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SFX Financial Advisory Management Enterprises is wholly-owned by Live Nation Entertainment and specializes in providing advisory and financial management services to current and former professional athletes. The SEC charged SFX’s former president Brian J. Ourand with misusing his control over client accounts to steal approximately $670,000 over a five-years. The SEC charged the CCO for failing to supervise Ourand, violating the custody rule and making false Form ADV filings.

Continuing to pursue the failure, the SEC went after the SFX auditors. The SEC’s order finds that Santos, Postal & Co. P.C. and Joseph A. Scolaro conducted deficient surprise custody examinations of SFX Financial Advisory Management Enterprises.

In one instance the SEC charged the audit firm for stating that it complied with certain procedures to verify client assets when it did do the verification. In another instance the audit firm stated that client assets were held with a qualified custodian when in fact they were not.

The SEC imposed the custody rule and the surprise exam for adviser-controlled accounts specifically to prevent the kind of fraud that occurred at SFX.

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Designated Lenders Counsel and Compliance

If you own a home, there was likely a lawyer sitting at the closing table. Who paid for the lawyer and who did the lawyer represent? You paid, but the lawyer worked for the bank. She or he was there to make sure the bank’s interests were protected. There was recent coverage of a similar situation in the context of private equity loans, starting with a story by Andrew Ross Sorkin in the New York Times.

person's female hand signing an important document

This conflict has been in place for a long, long time. Banks make the borrowers pay for the bank’s lawyers’ fees. This is true when buying a home and is true in complex private equity loans.

As the borrower, you are worried about the cost of the bank’s lawyers and the lawyers’ ability to get the deal done on time.

Since private equity firms are serial borrowers and their loans are complex, having lawyers involved who are familiar with the firm can be a big savings of time and fees. Simple things like knowing the key personnel at the private equity firm can save a great deal of time. And time is money.

The issue raised by Mr. Sorkin was “designated counsel.” Some private equity firms have lists of law firms that the lender must chose among in making the loan. The lender must use one of the designated counsel or the private equity firm may look for a different lender.

The designated counsel list is usually a list of top shelf law firms. Private equity firms don’t want unqualified firms working on their deals.

The coverage was aimed at private equity firms. But I think that is misplaced. Private equity firms should be seeking ways to lower the legal bill because the investors are the ones paying those legal bills. I don’t see a conflict or compliance issue with private equity firms using a designated counsel list, as long as those on the list are firms that a bank might otherwise use.

As for the banks, I see them as the ones who are in a potential conflict. If the bank is not comfortable with the list of law firms, then it has a problem. Compliance professionals at the lenders should be aware of the issue and make sure they are taking steps to address the risk.

Of course there is a conflict with the law firm. That too is a conflict that has been in place for decades. The bank’s lawyers know they represent the bank. They also know the borrower is paying their bill. Until banks start paying for their own lawyers, there will be no resolution to this conflict.

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