Category: Compliance Programs

Fund Managers, Legal Fees, and Fund Expenses

The Securities and Exchange Commission brought an action against Blackstone for failing to disclose fees received from portfolio companies and for discounts from legal firms that it worked with, but without passing these savings on to investors. The monitoring fee issue has been discussed in compliance circles for some time. The legal fees action is new and caught my eye.

Cash in the grass.

I had heard of an instance where the SEC gave a deficiency for charging in-house lawyers’ time to a fund and its investments without properly disclosing that practice. This is different.

According to the order, Blackstone received a larger discount on legal fees as fund manager than the funds received. Blackstone told investors that the differential reflected the different mix of work performed by the unnamed law firm for the fund manager and the fund.

Other items I noted on the issue is that the differential was in place between 2008 and 2011. Blackstone’s internal audit discovered the problem in 2011 and Blackstone changed practices. So this issue was discovered and corrected years ago. So why is the SEC bringing an action now? Maybe this is just a “pile-on” by the SEC to express its displeasure.

I’m confused about how the arrangement for legal fees worked. Blackstone said it was based on the mix of work.

Perhaps the law firm was offering a 25% discount on HR/employee work, 10% on fund formation, and 5% on M&A deals. The fund, the fund formation, and fund investments would use these legal services in different amount and so the discount would not be uniform. That would result in a disparate discount. Maybe that is what happened?

Clearly a fund manager cannot have its law firm provide discounted services for the fund manager in exchange for allowing full pricing for the fund. That’s shifting costs from the fund manager to the fund. (Of course if it’s disclosed ahead of time, a fund manager could do so.)

The frustrating thing about the order is that its not clear what Blackstone did. So other compliance professional cannot use it to figure out what the SEC wants fro mfund managers.

As to the monitoring fees:

“This SEC matter arose from the absence of express disclosure in marketing documents, 10 or more years ago, about the possible acceleration of monitoring fees,” Blackstone said, calling the practice common in the industry. Blackstone voluntarily made changes to the applicable policies before the inquiry began, according to a spokesperson.

Obviously, the SEC continues to focus on fees and expenses for private fund managers.

Sources:

75th Anniversary Celebration: Investment Company and Investment Advisers Acts

75th anniversary

The SEC is hosting a conference Tuesday, September 29 to commemorate the 75th Anniversary of the Investment Company Act and the Investment Advisers Act.  The event will include remarks from SEC Chair Mary Jo White and fellow commissioners, as well as a series of panel discussions featuring industry pioneers, former SEC chairmen and division directors, academics and other distinguished leaders from the asset management field.

The Investment Company Act and the Investment Advisers Act, which were signed into law by Pres. Roosevelt in August 1940, are the primary laws governing investment companies and investment advisers, and give the SEC the power to regulate these entities.  Investment companies and investment advisers are a significant part of the U.S. capital markets, and in 2015, the SEC oversees registered investment companies with a combined $17.8 trillion in assets and registered investment advisers with approximately $67 trillion in regulatory assets under management.

9:15 a.m. – 9:30 a.m.
Opening Remarks by Chair Mary Jo White
9:30 a.m. – 10:45 a.m.
Panel 1. Asset Management Industry Pioneers
Moderator: Andrew J. Donohue, Chief of Staff
Panelists:
John C. Bogle, Founder and Former Chairman, The Vanguard Group
Don Phillips, Managing Director, Morningstar
James S. Riepe, Senior Advisor and Retired Vice Chairman, T. Rowe Price Group, Inc.
11:00 a.m.
Panel Introduction by Commissioner Daniel M. Gallagher
Panel 2. The Arc of History (Former SEC Chairmen)
Moderator: Chair Mary Jo White
Panelists:
The Hon. David S. Ruder (1987 – 1989)
The Hon. Richard C. Breeden (1989 – 1993)
The Hon. Harvey L. Pitt (2001– 2003)
The Hon. William H. Donaldson (2003 – 2005)
The Hon. Elisse B. Walter (2012 – 2013)


1:15 p.m.
Panel Introduction by Commissioner Kara M. Stein
Panel 3. Diverse Perspectives on the Asset Management Industry
Moderator: David W. Grim, Director, Division of Investment Management
Panelists:
Jameson A. Baxter, Chair of the Board of Trustees of the Putnam Mutual Funds
Matthew P. Fink, Independent Director, Oppenheimer Mutual Funds and author
of The Rise of Mutual Funds: An Insider’s View
Rick A. Fleming, SEC Investor Advocate
Tamar Frankel, Professor of Law, Boston University School of Law
Thomas P. Lemke, Independent Director; Former Executive Vice President,
General Counsel, and Head of Governance, Legg Mason Inc.
2:45 p.m.

Panel Introduction by Commissioner Michael S. Piwowar
Panel 4. The Regulators’ View (Former Division Directors)
Moderator: David W. Grim, Director, Division of Investment Management
Panelists:
Allan S. Mostoff (1972 – 1975)
Joel H. Goldberg (1981– 1983)
Kathryn B. McGrath (1983 – 1990)
Marianne K. Smythe (1990 – 1993)
Barry Barbash (1993 – 1998)
Paul F. Roye (1998 – 2005)
Andrew J. Donohue (2006 – 2010)
Eileen Rominger (2011– 2012)
Norm Champ (2012 – 2015)
4:00 p.m. – 4:15 p.m.
Closing Remarks by Chief of Staff Andrew J. Donohue

 

HOW: This event is open to the public on a first come, first served basis, and will be available to watch via webcast on www.sec.gov.  Guests are asked to check in with the security desk and provide a photo ID upon arrival. Additional event details can be found at sec.gov/spotlight/75th-anniversary-iac-ica.shtml.

 

Vacation Reset For Your Compliance Program

Many of you, like me, are back from vacation or a Labor Day barbecue. I’m still washing sand out of my shoes and rubbing aloe on my skin that was in the sun too long.

Riverfront relaxation

After being away from the office, my email box is filled with messages that should be returned, issues that need to be addressed, and things to get done during this short week. Even with all that overflow, it’s a good time to take stock of what is important, what needs to be done right away, and the best way to spend your time.

Coming back into the office is one of the best times to look at the priorities in your compliance program. You’ve been away. Maybe you’ve had dreams of the perfect compliance program (or nightmares about compliance failures). In any case, you have been away from some of the day-to-day craziness of compliance.

Now that you’re back in the office, it’s time to take perspective.
Look at where you were and where you want to be.
Put it into action.

On line portals for fundraising

As part of the updates on private placements, the Securities and Exchange Commission granted a no-action letter to Citizen VC, an online venture capital firm. The main question was whether the firm was creating “substantive, pre-existing relationships” with prospective investors through its website. The firm wanted to avoid a result that its offers & sales under Rule 506(b) would be considered general solicitation or general advertising under Rule 502(c) of Regulation D.

citizen vc

For CitizenVC the first step is a generic online “accredited investor” questionnaire.

That moves into the “relationship establishment period.” During that period CitizensVC may

  1. Contact the prospective investor by telephone to discuss the prospective investor’s investing experience and sophistication, investment goals and strategies, financial suitability, risk awareness, and other topics designed to assist CitizenVC in understanding the investor’s sophistication
  2. Send an introductory email to the prospective investor.
  3. Contact the prospective investor online to answer questions they may have about CitizenVC, the Site, and potential investments.
  4. Utilize third party credit reporting services to confirm the prospective investor’s identity, and to gather additional financial information and credit history information to support the prospective investor’s suitability.
  5. Encourage the prospective investor to explore the Site and ask questions about the Manager’s investment strategy, philosophy, and objectives.
  6. Generally foster interactions both online and offline between the prospective investor and CitizenVC.

Maybe it’s just me, but only 1 and 3 seem particularly meaningful and substantive. But the rest don’t hurt. Apparently it is enough to create a “substantive, pre-existing relationship” once the potential member is admitted as a member. A prospective Member is not presented with any investment opportunity when being qualified to join the platform.

I found it more meaningful that the minimum capital investment requirement is not less than $50,000 per deal. That means they are not targeting small investors.

Sources:

A Win for Compliance Officers

Judy Wolf did a bad thing. During an insider trading investigation she fudged some documents. The Securities and Exchange Commission investigated the insider trading matter and Ms. Wolf’s log of her review. The fudging was discovered. She was fired and the SEC brought an enforcement against her.

There is some good news from that bad situation. An administrative law judge just dismissed the enforcement case against Ms. Wolf.

Newspaper page with eraser of erasing news, vector Eps10 image.

Last year, Wells Fargo paid $5 million to resolve the insider trading case that involved the acquisition of Burger King. Ms. Wolf was a compliance professional at Wells Fargo. She conducted an inquiry of trades related to the $3.3 billion Burger King acquisition by 3G Capital in 2010. The SEC launched its insider trading investigation in 2012. Wolf apparently was concerned that her compliance log was inadequate. She went back and added these two sentences:

“Rumors of acquisition by a private equity group had been circulating for several weeks prior to the announcement. The stock price was up 15% on 9/1/12, the day prior to the announcement.”

She fudged the log poorly and wrote “2012” instead of “2010.” Under questioning by the SEC she thought the change would not be discovered. Wells pulled up the document metadata and found the problem.

After the settlement with Wells Fargo, the SEC brought charges against Wolf.

SEC ALJ Cameron Elliott dismissed the enforcement action sanctions. The judge did not condone the action, but found that Wolf willfully aided and abetted and caused Wells Fargo’s violations of Exchange Act Section 17(a) and Rule 17a-4(j) and Advisers Act Section 204(a). Wolf should have known that it was improper to alter compliance records.

There is one additional consideration: the fact that Wolf worked in compliance. Obviously, compliance professionals are subject to the securities laws like everyone else. … In my experience, firms tend to compensate compliance personnel relatively poorly, especially compared to other associated persons possessing the supervisory securities licenses compliance personnel typically have, likely because their work does not generate profits directly. But because of their responsibilities, compliance personnel receive a great deal of attention in investigations, and every time a violation is detected there is, quite naturally, a tendency for investigators to inquire into the reasons that compliance did not detect the violation first, or prevent it from happening at all. The temptation to look to compliance for the “low hanging fruit,” however, should be resisted. There is a real risk that excessive focus on violations by compliance personnel will discourage competent persons from going into compliance, and thereby undermine the purpose of compliance programs in general. That is, “we should strive to avoid the perverse incentives that will naturally flow from targeting compliance personnel who are willing to run into the fires that so often occur at regulated entities.” Comm’r Daniel M. Gallagher, Statement on Recent SEC Settlements Charging Chief Compliance Officers With Violations of Investment Advisers Act Rule 206(4)-7 (June 18, 2015), available at http://www.sec.gov/news/statement/sec-cco-settlements-iaa-rule-206-4-7.html (last accessed July
7, 2015).

A good result for compliance professionals.

Sources:

Dodd-Frank Act Compliance Cost for Private Funds

Are Dodd-Frank Act compliance costs forcing smaller private investment fund advisers out of the market? Wulf Kaal, Associate Professor at the University of St. Thomas School of Law, decided to take a look at the data and see.

It should come to no surprise that the answer is likely: yes.

100 hundred dollar billThe analysis in this paper shows that the number of funds managed by private fund advisers is associated with Dodd-Frank Act compliance cost. The findings of this study demonstrate that the number of funds managed by a private investment fund adviser affect the compliance costs under Title IV of the Dodd-Frank Act.

The results of this study also show that adviser size as measured by AUM is not associated with Title IV compliance cost and other independent variables as proxies for cost, such as time, required for complying with Title IV. Smaller firms in the sample of this study have, in the aggregate, larger Title IV compliance costs than larger funds.

Sources:

Pay to Play Rule In Effect on July 31

The Securities and Exchange Commission announced the compliance date for the ban on third-party solicitation pursuant to the Pay-to-Play rule: July 31, 2015. Rule 206(4)-5 prohibits an investment adviser from providing compensated services to a government entity, following a political contribution to certain officials of that entity.

pay to play.

Rule 206(4)-5 became effective on September 13, 2010 and the compliance date for the third-party solicitor ban was set to September 13, 2011.

The third-party solicitation ban, prohibits an investment adviser from paying a third-party to solicit advisory business from any government entity, on behalf of the adviser, unless the third party is a regulated entity:

  • Registered Investment Adviser;
  • Registered Broker-Dealer; or
  • Certain Registered Municipal Advisers.

When the Commission added municipal advisors to the definition of regulated person, the Commission also extended the third-party solicitor ban’s compliance date to June 13, 2012. However, at the time the final municipal advisor registration rule was not in effect. So, the SEC extended the third-party solicitor ban’s compliance date from June 13, 2012 to nine months after the compliance date of the final rule. That date is now set at July 31, 2015.

Sources:

Compliance, Cycling and the Tour de France

For me, July starts with the red, white and blue, then quickly turns to yellow. The yellow jersey worn by the overall leader of the Tour de France.

 

compliance-and-the-tour-de-france

I’ve been a big fan of the Tour de France for the past decade and a half. I admit that it was the success of Lance Armstrong that brought me to it. The dethroned champion taught us a few compliance lessons. The cheating did not keep me from sticking with the sport.

Any fan of professional cycling knows that there is long history of drug abuse in the peleton. Many Tour de France riders had been subject to disciplinary action for doping. Only two of the podium finishers in the Tour de France from 1996 through 2005 have not been directly tied to likely doping through admission, sanctions, public investigation or exceeding the UCI hematocrit threshold.  The sole exceptions were Bobby Julich – third place in 1998, and Fernando Escartin – third place in 1999. The official records have no winners during the Lance Armstrong years.

You can’t ignore the history of cheating in the Tour de France, just as you cannot ignore the steroid era of baseball. The cheaters were ahead of the organization’s will to enforce and ahead of the organization’s ability to catch the cheaters.

Those with incentives to win are going throw resources at staying ahead of the regulators. We saw that in cycling. We saw that in baseball. We saw it on Wall Street.

It now seems that cycling’s governing bodies are serious about keeping doping out of the sport. It also appears that the science of detection has caught up to the science of cheating. There is less incentive to cheat if you think the chances of getting caught are remote. Mr. Armstrong was tested hundreds of times. The few times that an anomaly was spotted, it was washed away by the poor testing or whitewashed by the governing body.

Sports, as with finance, are filled with rules that don’t always make sense. We can look at football and the enforcement being levied against Tom Brady and the Patriots organization. Missing from all of this is whether it matters how the balls are inflated.

I think some will see some parallels between the competition of sports and the competition of finance.

Weekend Reading: A History of the World in Sixteen Shipwrecks

Shipwrecks are tragic, but have been a part of human history since we started making ships. There are an estimated three million ships sitting on the bottom of the oceans, seas, lakes, and rivers of the world. Of that staggering number, Stewart Gordon picked sixteen to tell the story of human history.

A History of the World in Sixteen Shipwrecks

A History of the World in Sixteen Shipwrecks does not tell the story of the most famous wrecks. From the cover, you may think the Titanic makes the list. It does not. There are a few shipwrecks that you will recognize, but most you will not. The book explores how small local maritime travels merged into larger and larger networks of human activity. Technology and finance are the main driving forces.

The one oversight I think is missing from the collection is a container ship. The use of containers and the ships that carry them are main driving force for international commerce. China would not be the global behemoth it has become, if not for the cheap, easy shipping through container ships.

Regardless, the book is well-written and enjoyable to read. Although I was skeptical of the premise, Mr. Gordon does a remarkable job of putting large swaths of history into focus through these sixteen shipwrecks.

The publisher provided a copy of the book for me to review.

How to Allocate Broken Deal Expenses After the KKR Case?

The Securities and Exchange Commission charged Kohlberg Kravis Roberts & Co. (KKR) with misallocating more than $17 million in “broken deal” expenses to its private equity funds as a breach of KKR’s fiduciary duty. The SEC felt that KKR should not have charged all of those broken deal expenses to the Fund.

But how should you allocate those broken deal expenses?

kkr sec

KKR incurred $338 million in broken deal or diligence expenses.  Even though KKR’s co-investors, including KKR executives, participated in the firm’s successful transactions efforts, KKR largely did not allocate any portion of these broken deal expenses to them. KKR put a policy in place in 2012 to address the allocation of expenses.

Perhaps KKR had something programatic in place, with regular co-investments. The problem for most co-investment deals is that they are put together ad-hoc. The fund is generally the primary participant and would be pursing the transaction regardless of co-investors.

The fund would be incurring the deal expenses. The fund documents provide that the fund will pay for deal expenses.

Generally, for co-investments there is no document providing for the payment of deal expenses until the transaction closes. So there is no mechanism for the payment of broken deal expenses by potential co-investors. Fairly or unfairly, that leaves the fund paying the broken deal expenses. It seems that the SEC thinks that is unfair.

According to the SEC’s order against KKR, the firm had come up with a policy for dealing with broken deal expenses. In my reading of the order, it looks like the SEC made KKR apply the policy retroactively from 2012 to the beginning of the fund and return a portion of the broken deal expenses to the fund. I would guess that KKR is not able to get those expenses from the potential co-investors, leaving the management company holding the bag for the costs.

It does not seem fair that the management company should bear the burden of the broken deal expenses when the fund documents and investor expectations would be that the fund carry the burden of broken deal expenses.

The question is “at what point does the co-investment opportunity become such a part of the transaction that the broken deal expenses should be shared?” Of course, the second question, and perhaps the answer to the first is “at what point is the co-investor so committed that it is willing to pay a portion of the broken deal expenses?” I think the answer to the second question is often “never.” That puts the answer at odds with the expectations of the SEC.

Sources: