Compliance Programs – Page 16 – Compliance Building

Model Business Continuity Rule for Investment Advisers

dilbert-Disaster-Recovery

There is no explicit requirement that an adviser or fund manager have a disaster recovery plan. But any manager trying to fund-raise knows that investors will ask about its business continuity plan.

The SEC sort of requires SEC registered investment advisers to have a business continuity plan. It’s an easy one to miss in Rule 206(4)-7.

Oh, you don’t see anything about business continuity in the rule? It’s not in the rule, it’s in the Release for Rule 206(4)-7:

We believe that an adviser’s fiduciary obligation to its clients includes the obligation to take steps to protect the clients’ interests from being placed at risk as a result of the adviser’s inability to provide advisory services after, for example, a natural disaster or, in the case of some smaller firms, the death of the owner or key personnel. The clients of an adviser that is engaged in the active management of their assets would ordinarily be placed at risk if the adviser ceased operations. [SEC Release No. IA-2204]

State -level adviser regulators have stepped up and rolled out a model rule for state securities regulators.

NASAA’s model rule and guidance are intended to ensure that smaller advisers fulfill their responsibilities to protect their clients and mitigate any client harm in the event of a significant interruption to the adviser’s business. The NASAA membership adopted the model rule at NASAA’s Public Policy Conference on April 13.

Every investment adviser shall establish, implement, and maintain written procedures relating to a Business Continuity and Succession Plan. The plan shall be based upon the facts and circumstances of the investment adviser’s business model including the size of the firm, type(s) of services provided, and the number of locations of the investment adviser. The plan shall provide for at least the following:

1. The protection, backup, and recovery of books and records.
2. Alternate means of communications with customers, key personnel, employees, vendors, service providers (including third-party custodians),and regulators, including, but not limited to, providing notice of a significant business interruption or the death or unavailability of key personnel or other disruptions or cessation of business activities.
3. Office relocation in the event of temporary or permanent loss of a principal place of business.
4. Assignment of duties to qualified responsible persons in the event of the death or unavailability of key personnel.
5. Otherwise minimizing service disruptions and client harm that could result from a sudden significant business interruption.

There is another 18 pages of guidance to help an adviser craft a plan that meets the rule.

Of course, this is not imposed on advisers or fund managers registered with the Securities and Exchange Commission. But I bet you would find it to be a useful tool in evaluating your firm’s business continuity plan.

Sources:

NASAA Model Rule on Business Continuity and Succession Planning Model Rule 203(a)-1A or 2002 Rule 411(c)-1A
NASAA Adopts Model Business Continuity Rule for Advisers by John M. Jascob, J.D. in Jim Hamilton’s World of Securities Regulation
Investment Advisers and Business Continuity Plans

The Producers Success and Oil Wells

oil well and compliance

In The Producers, Max Bialystock and Leo Bloom realize they can make more money with a flop than a hit. No one audits a flop and the fraudsters are free to flee with their investors’ money. According to the Securities and Exchange Commission, GC Resources, LLC and Brian J. Polito was trying to run a similar scam with oil and gas wells.

Polito was running a legitimate business for years, but then his wells were not producing much. He went out to a site and saw that several nearby wells owned by another company were very successful. Rather than alter his drilling strategy, he “adopted” those wells as his own. According to the SEC complaint, Polito forged documents showing GC Resource’s interests in the wells and began selling interests to investors.

The problem came that investors were expecting to get paid on those wells. Investors could look them up on the regulatory website and see that they were doing well. Polito was hoping for some dry wells so he could stop paying those investors. Just as Max and Leo were hoping that Springtime for Hitler would close on opening night.

To stem the cash outflow, Polito tried switching to quarterly payouts instead of monthly. An investor got angry at the change, sued and the litigation uncovered the deception.

So it seems the perfect fraud is a play that fails on opening night or a dry well. But if they keep producing the fraud will be revealed.

Sources:

Failure to Disclose Loans Among Affiliated Funds

Southern Loans neon sign - Kingsport, TN

Once you hear the words “inter-fund loans”, a compliance professional is going to sit up straight and be concerned. Anything “inter-fund” is an inherent conflict. That one fund is loaning another fund money is an indicator that something has gone wrong.

Stilwell Value managed several private funds. According to the SEC order, the Stilwell funds made at least eight loans to other funds. The loans were relatively short – days to six months. At the time they were made, the loans were not documented and the terms were not memorialized.

The big problem is that the loan terms were not necessarily at market prices, so one fund was profiting from the other fund. If the rate was below market, the borrower was gaining at the expense of the lending fund. The firm should have documented the process to confirm the loans were at market rates. Of course that is assuming the fund documents permit the affiliate loan and, if so, that the conflict is disclosed.

According to the SEC order, Stilwell was taking a big position in a public company. Stilwell is known as an activist investor. It was trying to take the position to influence the company. Some funds needed liquidity, but only had the public company stock. Rather then sell some stock for liquidity, Stilwell made the inter-fund loans.

One thing to note is that the settlement order includes no findings that fund investors were harmed. Stilwell agreed to disgorge to investors of the lending funds more than $239,000 representing management fees charged to the lending funds with respect to the loans, plus pre-judgment interest.

If the name Stilwell sounds familiar, it’s because he was fighting back against the SEC for bringing the action in an administrative court instead of federal district court. In a related development, Stilwell dismissed its suit against the SEC claiming that the SEC administrative proceeding before an administrative law judge was unconstitutional.

Sources:

Goodwin Procter’s Financial Services Weekly News Roundup
In the Matter of Joseph Stilwell and Stilwell Value (.pdf)
SEC Looking Into Loans Made Between Stilwell Funds in the Wall Street Journal
Activist investor Stilwell sues SEC to stop enforcement case by Jonathan Stempel
Activist investor Stilwell settles SEC case he claimed was illegal by Nate Raymond and Jonathan Stempel

What Does the Regulatory Scheme for Financial Services Look Like?

This:

financial regulation
Click for the full PDF file

SEC Commissioner Daniel M. Gallagher drew this picture of the new rules applicable to U.S. financial services holding companies since Dodd-Frank.

“The stakes here are considerable: regulatory burdens divert capital away from the real economy—this acts as a barrier to entry for new market participants and further entrenches those institutions that are increasingly ‘too big to fail.'”

Sources:

Statement on the Aggregate Impact of Financial Services Regulations

Referral Fee Disclosure and Conflicts

Steeling puppy

The Securities and Exchange Commission brought another enforcement case involving an investment adviser and private funds. PageOne is a registered investment adviser that recommended three private investment funds to its clients. The SEC found serious conflicts the were not disclosed or materially misrepresented.

PageOne disclosed that is was paid a “referral fee” by the private funds. What PageOne failed to disclosed was

one of the private funds’ managers was in the process of acquiring at least a 49% interest in PageOne
PageOne had pledged to raise millions from its clients for the private funds, and
The fund manager was paying for the acquisition in installments tied to Page’s ability to direct the client money into the private funds.

The SEC characterized the “referral fee” as installment payments on the acquisition. I’m not sure that is a meaningful distinction, cash is cash, but it certainly seems to have annoyed the SEC.

The bigger failure is that the Form ADV disclosed the “referral fee” as being between 7% and 0.75% when it was as much as 15%. It also labeled the funds as managed by unaffiliated investment advisers. Clearly, that is not true when the fund manager has the right to buy the adviser.

PageOne’s clients invested between $13 million and $15 million in the private funds based on his recommendation and earned over $2.7 million in acquisition payments. The problem bubbled to surface because PageOne was required to raise $20 million for the acquisition to close. It turns out the “referral fees” were loan advances. When the acquisition did not close, PageOne’s owner was personally liable for repayment.

Sources:

SEC Guidance On Gifts and Entertainment Compliance

gift box

Any story about the SEC, funds, gifts will catch my attention. Last week, the Staff of the SEC’s Division of Investment Management issued IM Guidance Update No. 2015-1 on gifts and entertainment in the fund industry.

The Guidance refers to section Section 17(e)(1), which did not seem familiar to me. The reference is to the Investment Company Act, so it’s not explicitly applicable to private funds.

The Guidance makes the point that the receipt of gifts or entertainment by fund employees may implicate Section 17(e)(1) of the Investment Company Act of 1940. Therefore gifts and entertainment should be addressed by the fund’s compliance policies and procedures. I’m not sure that’s big news to anyone in complaince.

Section 17(e)(1) generally prohibits fund employees, acting as agent, from accepting any compensation from any source for the purchase or sale of any property to or for the fund, other than regular wages from the fund. That means, a fund portfolio manager accepting any gifts/entertainment from a broker-dealer for the purchase or sale of the fund’s portfolio securities would violate Section 17(e)(1).

What to do? A fund can impose a blanket prohibition on receiving gifts or entertainment. The Guidance also suggests a pre-clearance mechanism for the acceptance of gifts or entertainment.

The Lure of Wyoming

There is a long history of splitting financial regulatory oversight between state regulators and federal regulators. For investment advisers the split is based on Assets Under Management and Dodd-Frank raised the AUM level from $25 million to $100 million. Above that level you register with the SEC and below that level you register with the state regulator.

The exception is the state of Wyoming. Wyoming is the only U.S. state that does not regulate investment advisers. So if you are an adviser in that state, you register with the SEC regardless of assets under management.

The Securities and Exchange Commission published a trio of cases in involving Wyoming last week. In each of the three cases, the firm improperly claimed Wyoming as its principal office and principal place of business.

David Nagler organized New Line Capital in Santa Fe, New Mexico in 2007. In March 2012, just before Dodd-Frank’s change in registration, New Line re-organized as a Wyoming company and amended its Form ADV to reflect its new place of business.

Just changing the state of organization and renting an office in the new state does not make the new state a firm’s principal place of business.

Nagler did not direct, control, or coordinate the activities of New Line from Wyoming. During all relevant times, Nagler resided in New Mexico and used his residence there as a base of operations. Nagler never met clients in Wyoming and rarely used the small office space that New Line rented in Wyoming.

SEC Rule 222-1 For purposes of section 222 of the Act:

(a) Place of business. “Place of business” of an investment adviser means:

(1) An office at which the investment adviser regularly provides investment advisory services, solicits, meets with, or otherwise communicates with clients; and

(2) Any other location that is held out to the general public as a location at which the investment adviser provides investment advisory services, solicits, meets with, or otherwise communicates with clients.

(b) Principal office and place of business. “Principal office and place of business” of an investment adviser means the executive office of the investment adviser from which the officers, partners, or managers of the investment adviser direct, control, and coordinate the activities of the investment adviser.

Arete Ltd. d/b/a Sky Peak Capital Management initially registered with the SEC in November of 2012 claiming Cheyenne, Wyoming as its principal place of business. But all of its operations were California.

The most extraordinary of the three is Wyoming Investment Services, organized as a Wyoming limited liability company and filed with the SEC in February 2013. But its actual place of business was at the home of its president in Ft. Collins, Colorado.

All three were lured to Wyoming to gain registration with SEC and to avoid registration with state regulators.

Sources:

CCOs named in three cases involving Form ADV misrepresentations in IA Watch
SEC censures two advisers for claiming to be based in Wyoming by Jed Horowitz for Reuters
False Wyoming Registration Gets 3 Advisors in Hot Water With SEC by Danielle Andrus in ThinkAdvisor
Settlement With Wyoming Investment Services
Settlement with New Line Capital
Settlement with Arete

Testing for the Avalanche

IMG_2197[1]

As Nassim Nicholas Taleb famously explained in The Black Swan, it is the unexpected that is most unexpected. For compliance professionals, testing is one of the tools that tries to expose the unexpected.

I was thinking about testing as I was out in the snowpack in my front yard. I tried out some of the avalanche tests I remembered from my mountaineering days. As you can see from the cracks above, the snow failed the test and had a slab release. Fortunately, it was only my snowblower that fell victim to the unstable snow.

The six feet of snow in the last 30 days is pushing the infrastructure limits in Greater Boston. The subway system is failing, the roads are clogged with snow, nearly every roof has ice dams.

Perhaps the avalanche of snow is not a true Black Swan event. Huge amounts of snow are not unprecedented. Boston was subject to five feet snow in 30 days in 1978. (Of course, that event crippled Greater Boston for weeks.) It is more of a statistical anomaly than an unexpected and unforeseeable event.

How robust, or Antifragile, do you design the infrastructure to deal with an event that only happens every 30 years? How do you test your systems for an event that only happens once every few decades?

I’m not sure I have an answer. I’m sure that I have a sore back from shoveling so much snow.

Making a Bigger Compliance Mistake After Making a Big Compliance Mistake

face palm head in hands by Alex Prolmos

Total Wealth Management became one of the whipping boys for the Securities and Exchange Commission when it started its focus on private fund fees last year. The firm settled with the SEC and agreed to pay the fine. But the firm exacerbated the problem by allegedly misappropriating the money from its clients.

Last year, the SEC accused Total Wealth of wrongfully taking revenue sharing fees. It’s not that the fees themselves are wrong, but they must be disclosed and the some effort made to make sure that clients are put ahead of the revenue sharing. Total Wealth apparently failed on both counts.

The SEC accused Total Wealth of not disclosing the revenue sharing. According to the complaint, the revenue sharing severely distorted the firm’s behavior. About 92% of Total Wealth’s fund assets were invested in entities that had revenue sharing arrangements.

Total Wealth agreed to settle the charges and put $150,000 into escrow in advance of the SEC’s consideration of the order. The firm did so.

[Face to Palm]

The firm “borrowed” the $150,000 from the fund it managed.

[Head shake.]

Clearly, Jacob Cooper, the head of Total Wealth has little appreciation for conflicts of interest. There is no instance in which a loan to the fund manager is in the best interest of the fund. There is no may that the principals themselves can be the ones to make that decision because the decision-making itself is a conflict of interest.

The loan also shows that there is a lack of internal controls that prohibit the misuse of client funds.

I, and many others, thought the SEC was off-base when it brought charges against Total Wealth and headlined the action on the use of “may” instead of “will”. The firm had said in its documents that it may enter into revenue sharing arrangement. The SEC though this was a disclosure fail because the firm had actually entered into those arrangements.

I still think it was a reach by the SEC to carry that headline. But clearly, there are issues at Total Wealth and it appears it was right of the SEC to try to bring the firm in line.

Sources: