Category: Compliance Programs

Lawsuit on SEC’s Political Contribution Rule Hits Some Snags

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The New York Republican State Committee and the Tennessee Republican Party brought suit against the Securities and Exchange Commission challenging its political contributions rule for investment advisers, . The complaint seeks an injunction against the enforcement of the rule’s political contribution restrictions on contributions to federal candidates.

The US District Court for the District of Columbia dismissed the case. But not all is lost in Mudville. The decision hinged on whether the District Court or the Court of Appeals should have jurisdiction over the case.

The District Court found that the political contributions rule is an “order” for purposes of the Investment Advisers Act. That means the proper venue is the Court of Appeals. That means that the New York Republican State Committee and the Tennessee Republican Party merely have to refile the case in the Court of Appeals.

However, the District Court raised the issue of standing that may come to haunt the New York Republican State Committee and the Tennessee Republican Party. As political organizations, they are not directly affected by the rule. It’s really the candidates and the regulated advisers who are hurt by the rule. The party organizations failed to allege any specific facts that show a decline in contributions because of the political contributions rule.

The party organizations did point to State Senator Lee Zeldin, a candidate for the U.S. House of Representatives as an individual who was harmed by the rule.

I thought this would be a tough case to win on the merits. It may never get to the merits because of the jurisdiction and standing issues.

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First Enforcement Action for Private Equity Fund Expense Allocation

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The Securities and Exchange Commission has been making lots of noise about how its unhappy with how private equity firms are allocating expenses to portfolio companies. And it has finally hit its first target. The SEC charged a a private equity fund manager with breaching its fiduciary duty to a pair of private equity funds by sharing expenses between a company in one fund’s portfolio and a company in the other fund’s portfolio in a manner that improperly benefited one fund over the other.

Lincolnshire’s Fund I bought Peripheral Computer Support, Inc. in 1997. PCS primarily serviced and repaired computer hard disk drives. In 2001, PCS thought an acquisition of Computer Technology Solutions Corp. would be a great strategic acquisition. CTS serviced and repaired laptop computers and handheld devices.

But by 2001 Fund I’s commitment period had expired. So Lincolnshire had Fund II acquire CTS. Lincolnshire integrated PCS and CTS together and sold them together in 2013 to a single buyer.

Commingling investments across different funds is tricky. You need to be concerned about different expectations for investors in the different funds with different investment horizons for the exit. Operationally, you need to be careful how fees and expenses are allocated to treat each fund fairly.

Lincolnshire did set an unwritten policy where it tried to treat each fairly. Generally, shared expenses were allocated based each company’s revenue. So, PCS, the smaller company, paid 18% of the shared expenses. However, PCS and CTS had no written agreements about how to share expenses or the company’s rights and obligations toward each other.

Even though the revenue-basis sharing was the general practice, there were variations. Lincolnshire failed to document why some shared expenses were allocated differently.

Lincolnshire was in a tricky situation and mishandled it.

The SEC based its enforcement action on a violation of Section 206(2) as a “transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client.” The SEC is quick to point out that a violation of 206(2) can be based on a finding of simple negligence. The SEC does not need to prove scienter.

The SEC made no charges that Lincolnshire benefited from the misallocation. The SEC makes no charges that either Fund I or Fund II was harmed by the misallocation. Although, presumably, Lincolnshire did benefit and one fund did end paying more than its fair share of expenses.

The SEC merely charges that Lincolnshire was negligent in not having a written policy on the allocation of expenses and not following that policy.

Without any charges that it intended to defraud its investors, Lincolnshire has to pay $2.3 million to the SEC.

Private equity fund managers should take this as a warning to properly document investments combined across more than one fund and to take extra steps to ensure that they are treating each fund fairly.

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Compliance Bricks and Mortar for September 19

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These are some of the compliance-related stories that recently caught my eye.

The NFL’s True Problem: Misplaced Priorities Trumping Ethics & Compliance by Matt Kelly in Compliance Week

Contrary to what you might believe lately, the National Football League does have an ethics & compliance program. What’s more, the program actually looks pretty good.

Except, of course, for that small bit about deciding to have high standards in the first place.

Is Funny Really the Right Tone for your Compliance Program? by Joel A. Rogers in Communicating Compliance

For the past few years the debate has raged: Is it OK to use humor to communicate compliance? What sparked this dialogue was a series of very funny compliance videos produced by one of the world’s premiere comedy brands. These guys know humor and many of those videos have been genuinely funny.

To Be Clear, SEC Reviewers Want Filings in Plain English, Period by Theo Francis in the Wall Street Journal

Meet the stock market’s punctuation police. Corporate securities filings are plagued by some of the world’s most impenetrable prose, but it isn’t for lack of effort. Every year, SEC lawyers and accountants review several thousand of the more than half-million documents that companies file with the agency. And while they are primarily on the prowl for accounting inconsistencies and breaches of securities regulations, they also chase down typos, sentence fragments, jargon, puffery and sloppy punctuation.

Compliance, groundskeepers, and chalk lines by Jason B. Meyer in LeadGood

So as I raked, I wondered: is there a parallel between the Compliance Officer and the Groundskeeper?

I mean, compliance is in large part about winning while staying inside the lines. But for an organization, who paints those lines?

Controls on Fee Deductions and Disbursements

Company Theft

A recent action by the Securities and Exchange Commission caught my attention. The SEC charged a hedge fund manager with taking excess management fees. For a more exciting headline, the SEC press release says the excess fees were to “make lavish purchases.”

Sean C. Cooper improperly withdrew more than $320,000 from a hedge fund he managed for San Francisco-based investment advisory firm West End Capital Management LLC. West End disclosed to clients that a 1.5% management fee is applicable and taken from their capital account balance. But Cooper took more than the permitted 1.5%.

It’s no surprise that Cooper was charged. He was stealing money from his investors. (I don’t care what he spent it on.) Cooper owned West End with two other partners. The other two had little involvement in the day-to-day operations of the hedge fund.

West End was also charged because the firm failed to have controls in place to prevent Cooper from making improper withdrawals. The fund documents provided quarterly management fee payments. Cooper made eleven fee withdrawals in 2010. Cooper continued this behavior through 2011 and only stopped in April 2012 because of a SEC examination.

In June 2012, the Fund’s independent auditors determined that West End’s lack of monitoring and approval of Cooper’s withdrawals in excess of the amounts permitted by the Fund’s governing documents was a significant deficiency in internal controls. I think the auditors were a bit late in coming to that determination.

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The SEC Is Serious About Section 16 Filings

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Section 16(a) of the Exchange Act and the rules promulgated thereunder apply to every person who is the beneficial owner of more than 10% of any class of any equity security of a public company, and any officer or director of a public company. The Securities and Exchange Commission announced a sweeping group of charges against 34 officers, directors and major shareholders for failing to make their section 16 reports.

Apparently, the SEC had an initiative underway to review filing deficiencies and identified individuals and companies with especially high rates of filing deficiencies. These ownership reports can give investors the opportunity to evaluate whether the holdings and transactions of company insiders could be indicative of the company’s future prospects.

Andrew M. Calamari, Director of the SEC’s New York Regional Office, added, “The reporting requirements in the federal securities laws are not mere suggestions, they are legal obligations that must be obeyed.  Those who fail to do so run the risk of facing an SEC enforcement action.”

Clearly, the SEC is making  a statement by announcing these 34 sets of charges. (33 of the 34 have already agreed to settle.) Time to review filings if you are subject to these reporting requirements.

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Do You Need to Know Enforcement Cases for Compliance?

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Are you familiar with SEC investigations pertaining to the following companies?

  1. Aladdin Capital
  2. Diamondback Capital
  3. Liquidnet
  4. Paradigm Capital
  5. SAC Capital
  6. Galleon Capital

I admit that I only recognized SAC Capital and Galleon Capital. In a recent survey about half of alternative investment managers said that they were also familiar with those two cases. Half said they were not familiar with any of them.

Private Equity International pointed out this survey by Cipperman Compliance Services. Cipperman cited unfamiliarity with the cases as a indicator of adequate resources to address increased regulatory obligations.

I scratched my head a bit to figure out if I missed the cases or merely didn’t link the substance of the case with the firm name.

I searched the Compliance Building website to see if had mentioned the four cases.

It turns out that I wrote about Paradigm Capital in June 2014. The substance of the case was a whistleblower claim by a trader against his firm, Paradigm Capital. The firm was engaged in some principal trades that were violating 206(3)-2. The trader reported the problem to the SEC and the firm handled it poorly.

I also wrote about the Aladdin case in December 2012. It involved a false claim by the fund manager that its principals were investing in the fund alongside investors. I don’t remember the case being particularly remarkable. They were lying to investors.

Diamondback Capital was linked to SAC Capital and was allegedly involved in insider trading. The firm settled by paying a fine and entering into a non-prosecution agreement. The firm ultimately returned investor’s capital and dissolved. This was one of the expert network abuse cases. I remember the expert network investigations and still get questions from investors about the use of expert networks. I remember the issue, but not the case.

Liquidnet is a dark pool high speed trading case. The exchange settled the charges that it allowed outside traders to have access to the trading inside the dark pool. It’s an interesting look into the complex world of high-speed trading and dark pools. I don’t remember the case.

Circling back to the original question, I’m not sure knowing the case name is particularly necessary to understand compliance concerns. I find cases to be instructive on what is found to be bad acts. That’s why I write about them.

Yes, it’s a good thing for compliance officers to read the SEC’s enforcement actions. But I don’t think you need to be quizzed on cases.

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The Stability of Prime Money Market Funds

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I was critical of the Securities and Exchange Commission’s new rule on money market funds. To me it seemed like it was trying to fix a problem that didn’t exist, and in the process made things more complicated. For criticism to be correct, I need data. After review a paper on the Stability of Prime Money Market Mutual Funds, maybe I was wrong.

Steffanie A. Brady, Ken E. Anadu, and Nathaniel R. Cooper looked at money market funds from 2007 to 2011 for evidence that they could have “broken the buck.” The most famous instance was when the Reserve Primary Fund did the unspeakable in September 2008 because of its exposure to Lehman debt securities.

The authors were looking for instances where money market funds could have broken the buck, but the sponsor stepped in to prop up an ailing fund. Their paper presents a detailed view of the non-contractual support provided by sponsors during the recent financial crisis. They looked at public SEC financial statement filings to find evidence of problems.

They found at least 21 money market funds would have broken the buck without sponsor support during the Great Recession. They found frequent sponsor support during that period with at least $4.4 billion of support to 78 of the 341 funds reviewed.

The largest support relative to a fund’s AUM was the $336.8 million (6.3% of AUM) support for the Russell Money Market Fund.

“On September 14, 2009, the Lehman Securities were purchased by Frank Russell Company from the Fund at amortized cost of $402,764,934 plus accrued interest of $775,756.”

Perhaps money market funds are riskier than I thought. Fund sponsors have repeatedly, voluntarily stepped in to stabilize these funds. The SEC’s rule will make these money market funds less attractive as a safe haven for cash. But maybe they are not really as safe as I thought.

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Another Real Estate Ponzi Scheme From 2008

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The 2008 financial crisis caused many real estate investment funds to run into trouble. Some fund managers stepped over the line hoping to wait out the turmoil and recover. The Securities and Exchange Commission finalized charges against a fund manager who hoped to divert funds to stay liquid during the turmoil.

According to the SEC’s complaint, the Walter Ng, his son Kelly Ng, and Bruce Horwitz promoted Mortgage Fund 08 during the 2008 financial crisis as a new opportunity to invest in conservatively underwritten commercial real estate loans. But the Ngs and their advisory firm, The Mortgage Fund LLC, immediately began transferring money raised by MF08 to an older fund that had run into trouble. Their R.E. Loans fund was in trouble exactly because of the 2008 financial crisis.

R.E. Loans was a high-risk debt fund, charging high interest to real estate projects and developers who could not obtain traditional financing. From 2002 through 2006 the fund appeared to be successful. The Ngs raised hundreds of millions of dollars from investors and distributed hundreds of millions back to investors. But the fund ran into cash flow difficulties in 2007. It was the harbinger of the upcoming financial crisis.

From December 2007 to March 2008, the Ngs transferred almost $39 million from MF08 to R.E. Loans. I’m an optimist so I assume that the Ng were hoping some short-term affiliate loans would be enough to get R.E. Loans through the financial crisis. But delinquencies continued to rise from 15% in March 2008 to 74% by June 2008.

The Ngs lied to their investors and doubled down on the earlier fund.

The NGs were also subject to criminal investigation and charges. Kelly is serving 18 months while his elderly father is merely on probation. The charges were light because it took too long to discover and investigate the fraud. The statute of limitations limited government action.

As we have passed the five year mark for the 2008 financial crisis the frauds that happened during the time will not be prosecuted.

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LRN’s 2014 Ethics and Compliance Program Effectiveness Report

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For the past seven years, LRN has conducted its annual survey of Ethics and Compliance programs in search of benchmarking data, suggestions of leading practices, and trends. In 2012 LRN adopted the Program Effectiveness Index as a tool to determine the impact of compliance programs.

The challenge with index is figuring out the difference between correlation and causation.  The report is quick to point out the difference. For example, the public celebration of ethical leadership is a characteristic of programs with extremely high Program Effectiveness Indexes.  But having a public celebration will not necessarily make your compliance program more effective.

I found the spending and staffing section useful. The average spend on compliance was $100 per employee, with highly regulated industries such as financial services averaging $130 per employee. As for headcount the average was 2.3 FTE per one thousand in highly regulated industries, above the 1.4 FTE overall average. You should note that the survey did not find a correlation between spending/staffing and effectiveness.

Annual assessments were highly correlated with effective programs. Of course if you are registered as an investment adviser, you are compelled conduct an annual assessment under the Compliance Rule 206(4)-7.

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