Category: Compliance Programs

Compliance Failures and Performance Measure

compliance and port of los angeles

Progress Rail is under criminal investigation for failures in its railcar and locomotive repairs operation. Investigators claim that it was charging owners of rail equipment for making unnecessary repairs and replacements. There is also an environmental claim because the investigation indicates that workers were dumping parts in the ocean to hide them from auditors. That environmental claim caught the attention of what otherwise may have been a billing dispute.

Railcar owners and the railroads hire Progress Rail to make repairs or replace worn brake shoes, wheels and other components. Ten thousand railcars a month roll into the Port of Los Angeles County, the busiest port in the United States. While here, most are inspected by Progress Rail.

Progress Rail bills the railcar owners for repairs and looks to employee performance based on the billables they generate. According to early reports of investigators, managers made it clear that workers could lose their jobs if they didn’t generate enough repair revenue.

What happens on a day when the railcars coming thorugh are all in good shape? Make repair work: smash something, remove a bolt, or report a missing part you remove.

There are auditors that review operations to try to keep Progress Rail’s employees honest.

What is the issue from a compliance perspective? Culture.

Middle management was focused on increasing revenue and instilled this focus on its employees. The focus should have been on keeping the railcars well-maintained. Part of the problem is ties back to how the railcar owners structure their contracts with Progress Rail. Presumably they pay for work done, instead of a fee based on performance of their railcars.

Sources:

Compliance and Dodd-Frank at Four

Dodd-Frank-Act

It’s been four years since the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law. President Obama sat down on July 21, 2010 to sign the behemoth of a bill that was the most dramatic change to financial industry in years. Besides the hundreds of pages of text in the law itself, the law also mandated almost 400 regulatory rulemakings. All of this has made compliance professionals in the financial industry very busy.

Of the 398 rulemaking requirements in the law, 280 had specific deadlines. Of those, 127 have missed their deadlines. Of those 127, regulators have not even released proposals for 42 of the missed deadlines. There are another 54 rulemakings without deadlines that have not been proposed. Dodd-Frank is far from being implemented.

The Securities and Exchange Commission had the biggest burden placed in it. Daniel Gallagher, a Republican member of the SEC, said the commission can’t spend all of its time writing Dodd-Frank rules. “To pretend we can process the rules in a thoughtful way, in a period of a year or two, or even five or 10, I think is crazy.”

For a great book on creation of the law, try reading Robert Kaiser’s Act of Congress.

“Of the 535 members of the House and Senate, those who have a sophisticated understanding of the financial markets and their regulation could probably fit on the twenty-five man roster of a Major League Baseball team.”

The financial crisis of 2008 was catastrophic, so of course Congress had to pass a law. That allowed all kinds of other stuff to be piled into the law even if it had nothing to do with the financial crisis. (How did conflict minerals affect the financial markets?)

There is a strong push to enact some changes to Dodd-Frank, but that will likely hinge largely on the results of the upcoming election and whether the Republicans are able to gain control of the Senate. That will just mean changes to the changes.

Compliance professionals are going to be busy implementing Dodd-Frank for the foreseeable future.

Sources:

Comply With What?

Yes I'm Compliant Badge Rules Regulations Compliance

The starting point for any compliance program is to determine what you are trying to comply with. Every company has some legal requirements or contractual requirements that govern how it operates its business. Every company will place different emphasis on which of those requirements it will put under its compliance program. Every company will operate its compliance program differently.

Within the private fund industry, the most significant law will be the Investment Advisers Act. The anti-fraud provisions apply, whether the fund manager is registered or not. If the fund manager is registered, then there is another set of requirements. Since those requirements are largely principles based, it’s up to each fund manager to craft its compliance program based on the firm’s operations.

For private funds, the fund documents will be the most significant contractual requirement. The combination of the private placement memorandum and limited partnership agreement will govern fund operations. Each fund manager has crafted those documents with different provisions, so the compliance provisions will change from manager to manager.

If the private fund has overseas investors or operations, then the Foreign Corrupt Practice Act will come into the compliance program. Not because it’s the most important, but because it has been grabbing the headlines.

Overseas operations or investors will also bring the Foreign Account Tax Compliance Act into play. That means jumping through hoops with the Internal Revenue Service for overseas accounts and overseas investors.

The list will go on and on and on as you look at more and more laws.

And the end of the day, you want to be able to say you are compliant. But it still leaves the question: compliant with what?

Bad Actors on Form ADV and Under Rule 506(d)

venn diagram and compliance

The Securities and Exchange Commission has layered two tests for bad actors on to private fund managers. On Form ADV, the fund manager will need to disclose bad actor events. Then the second test comes under the new Rule 506(d) that also requires disclosure for bad actors in private placements and a bar for recent bad actors. From a compliance perspective, the question comes down to how do you deal with certifications.

Unfortunately, the employees for Form ADV disclosure are potentially different than the employees than the 506(d) disclosure and bans. For 506(d) its limited to “officers participating in the offering.”

Participation in an offering would have to be more than transitory or incidental involvement, and could include activities such as participation or involvement in due diligence activities, involvement in the preparation of disclosure documents, and communication with the issuer, prospective investors or other offering participants.

I’m not sure that helps much for fund managers. It does mean that you can exclude administrative assistants.

For Form ADV, the disclosure pertains to

Your advisory affiliates are: (1) all of your current employees (other than employees performing only clerical, administrative, support or similar functions); (2) all of your officers, partners, or directors (or any person performing similar functions); and (3) all persons directly or indirectly controlling you or controlled by you.

The Form ADV disclosure is potentially for a broader group of employees. Your organization may have employees who are not clerical, but are also not officers participating in the offering.

I think it’s probably just easier to require every employee to fill out the questionnaires. Then you can get into the weeds of the analysis if there is a disclosure event.

That leads to the next item which is the questionnaires. The main concept between the two are the same. If your employees have been involved in financial crimes, you need to disclose that information. However, the time frames, laws covered, and conviction status vary between each regulatory requirement.

I tried to sit down and create a unified questionnaire that would address disclosures for both Form ADV and Rule 506(d). In ended up being a huge pain in the neck and I gave up. I have two separate questionnaires that I require all employees to deliver.  Let me know if you have come up with a unified questionnaire.

Sources:

Spot the Fraudster

valente and eliv

One of the challenges that consumers face when dealing with a financial adviser is what it means to be a “financial adviser.” The terms financial planner, wealth consultant, stockbroker, investment adviser, financial consultant, and others get thrown around, leaving you how that person gets paid for helping you with your money. A fraudster may sling around those terms and get paid by taking your money instead of investing it.

What to do when someone claims his firm is “an accredited investment and consulting firm specializing in wealth creation and preservation”? I know to run to FINRA’s BrokerCheck and the SEC’s Investment Adviser Search for diligence. In this case, you find red flags.

The Securities and Exchange Commission alleges that Scott Valente and his firm The ELIV Group LLC fraudulently raised more than $8.8 million from 80 clients by falsely claiming they achieve consistent and outsized positive returns coupled with misrepresentations about the safety of the investments. Valente and the firm are challenging the accusation, so we only have the SEC’s view of the case.

The other view is the FINRA history. Broker Check can be controversial because brokers have a hard time fighting back against customer accusations. There is one brightline in BrokerCheck and Valente has it on his report. Valente is barred from association with any FINRA member. He was kicked out of the brokerage industry.

Apparently, he decided to switch over to “wealth creation and preservation”, instead of merely selling securities, and formed ELIV Group.

According to the ELIV website, it invests 40% of the assets into “initial public offerings.” But it then goes on to say to that “We are able to buy privately held companies before they go public at very low prices.” Well that does not sound like an IPO. That sounds live private equity or venture capital investing to me. But maybe I’m just being overly technical.

The second method is E-mini S&P 500 Futures. That’s a risky investment that requires constant trading, unlike the bread and butter S&P index funds and ETFs.

ELIV’s third method is options. Again, another volatile trading strategy.

The fourth strategy is currency trading, using seven currencies.

That’s a lot of trading and a lot of different areas of expertise. The website claims a five year average annual return of 34.5%. That’s a great result, especially considering that the firm has been around for less than five years.

Perhaps Mr. Valente can pull it off. However, the SEC says that Valente generated losses and stole money from his investors (? … clients?… victims?). The SEC claims that Mr. Valente withdrew over $2 million to pay his personal expenses, far in excess of the 1% management he was entitled to.

According to the SEC complaint at least some of the ELIV clients were Mr. Valente’s clients while he was a broker. There is the problem for consumers. How are they supposed to conduct diligence on a financial adviser when the securities laws, licensing requirements, and disclosure information sites are fractured into so many parts?

References:

Making Compliance Easier

easy

At PEI ‘s Private Fund Compliance Forum, one attendee asked how to make compliance easier. That caught the room by surprise. If compliance was easy, we would likely would not be at the Forum.

But it did get me thinking about ways to make compliance easier.

First, compliance is hard because the laws we comply with are complicated. Lots of the blame for difficulty can be pinned on Congress, the state legislatures and the regulators. The more complex the law, the harder the compliance.

The most obvious way to make compliance easier is to set simple rules. That may make it easier to comply, but more difficult for the organization.

Take political contributions as an example. For me, there is the SEC rule that limits investment adviser contributions. Layer on the state level requirement and you end up with a complicated list of what you can do and cannot do.

To make compliance easy, just ban all political contributions. Of course you run into the problem with the jurisdictions that prohibit a prohibition on political contributions. You also run into the problem of employees wanting to make political contributions. Your easy approach to compliance just got more complicated.

Or take the example of bribery and corruption. Your compliance policy could just ban all gifts and entertainment. But that leads to the awkward position of not even being able to buy a business prospect a cup of coffee as you are discussing an opportunity.

To make compliance easier, the organization and employees will need to sacrifice opportunities. The world is too competitive to sacrifice large swaths of opportunities that pose little or no risk to the organization.

That does not mean that compliance has to be hard in all areas of the business. You need to look at the risks and opportunities. Find the areas where you can make simple rules that don’t limit low-risk opportunities. Unfortunately, there are not that many.

Go back to my first point. The lawmakers and regulators keep making more and more rules. It’s rare to see a roll-back. As the laws grow, compliance requirements grow.

 

The SEC Says Be Wary of Bitcoin

bitcoin

Bitcoin has been the Dutch Tulips of investment for a few years. So of course that means the fraudsters have latched on. The Securities and Exchange Commission has piled on and issued an Investor Alert: Bitcoin and Other Virtual Currency-Related Investments.

This is the second investor alert from the SEC on Bitcoin. The first was part of an enforcement action against an alleged Ponzi scheme.

It’s not that Bitcoin is inherently illegal. It actually has an interesting approach on funds transfers. Transfers are free of transaction costs. That’s in sharp contrast to the swipe fees charged by Visa, Mastercard, and the other credit card companies.

One of the current problems with bitcoin is that the value has fluctuating wildly. That’s not what you want in a currency. You want to know that a gallon of gas costs about $4 today and will be about $4 next month. You don’t want the uncertainty that it could be $2 of $8 next month. That turns bitcoin from a currency into an investment.

The IRS recently issued guidance that it will treat Bitcoin and other virtual currencies as property for federal tax purposes. As a result, general tax principles that apply to property transactions apply to transactions using bitcoin.

Bitcoin fraud schemes look like other fraud schemes. The fraudsters use the lure of high returns in a lightly regulated asset. The growth chart of value in Bitcoin is an irresistible lure. Don’t forget to look for the red flags like “guaranteed returns” and “no risk” opportunities. If it sounds too good to be true, it probably is not true.

References:

Form PF Filing Day

Form PF

If you run a private fund, today is deadline for the annual Form PF filing with the Securities and Exchange Commission. Depending on the type of fund, you have different reporting requirements. The SEC gets bogged down with poor definitions trying to distinguish among the types of funds.

In the glossary to Form PF, a Real estate fund is

Any private fund that is not a hedge fund, that does not provide investors with redemption rights in the ordinary course and that invests primarily in real estate and real estate related assets.

That sounds right, but I still need to look at the definition of Hedge fund:

Any private fund (other than a securitized asset fund):

(a) with respect to which one or more investment advisers (or related persons of investment advisers) may be paid a performance fee or allocation calculated by taking into account unrealized gains (other than a fee or allocation the calculation of which may take into account unrealized gains solely for the purpose of reducing such fee or allocation to reflect net unrealized losses);

(b) that may borrow an amount in excess of one-half of its net asset value (including any committed capital) or may have gross notional exposure in excess of twice its net asset value (including any committed capital); or

(c) that may sell securities or other assets short or enter into similar transactions (other than for the purpose of hedging currency exposure or managing duration).

That definition talks about getting performance fees on unrealized gains. That would be unusual for a real estate fund or private equity fund. The borrowing standard in part (b) may cause some people to pause on the definition and get entwined in a rabbithole of definition.

The form also has more detailed requirements for large private equity advisers. For purposes of Form PF, “private equity fund” is

any private fund that is not a hedge fund, liquidity fund, real estate fund, securitized asset fund or venture capital fund and does not provide investors with redemption rights in the ordinary course.

So a real estate fund is not a private equity fund and not subject to the additional reporting requirements.

Being a member of the “all other advisers” category, the filing is due with 120 days after the end of the fiscal year. Assuming calendar year is my fiscal year, the first filing is due by April 30, 2013.

Sources:

The SEC Expresses Its Displeasure on Fund Fees

money penny

A few days ago, Bloomberg published a story that the Securities and Exchange Commission has examined about 400 private equity firms and found that more than half charged “unjustified fees and expenses without notifying investors”. The SEC followed through with that story and recently charged Total Wealth Management with improperly disclosing fee revenue.

Total Wealth sponsored a series of private funds that invested in other funds. Total Wealth had revenue sharing arrangements in place with several of the funds in which it invested, paying Total Wealth a fee when it placed client investments in those funds. Total Wealth would split the revenue sharing income among the firm’s principals.

Revenue sharing is not illegal  and not necessarily misleading, deceptive, or fraudulent. The key is disclosure. If properly disclosed, the SEC would have little basis for bringing charges.

According to the SEC order, the funds’ offering memoranda failed to adequately disclose the revenue sharing arrangement. One of document stated”

“Some Private Funds may pay the General Partner or its affiliates a referral fee or a portion of the management fee paid by the Private fund to its general partner or investment adviser, including a portion of any incentive allocation” (emphasis added).

The revenue sharing arrangement was not disclosed in the “other fees and expenses” summary portion of the offering document.

The SEC argues that Total Wealth should have disclosed that it was already receiving the fee income and not merely that it “may” receive the income.

Stopping at this point, the SEC charges leave me unsettled. The argument over the definitive nature of the fees seems to be over-reaching to me. I think many fund disclosures use “may” when describing other revenue sources.

The other aspect of fee arrangements is the distortion in behavior. Disclosure of the fees alone may be enough, but not if the fee distorts behavior so the fund manager might not be acting in the best interest of its investors.

Here is where the SEC’s case is stronger. About 92% of Total Wealth’s fund assets were invested in entities that had revenue sharing arrangements. Total Wealth’s behavior was apparently distorted because it was more likely to invest in funds with a revenue sharing arrangement. Some of these arrangements also had lock-ups that prevented investors from withdrawing money.

The SEC also accused Total Wealth of deliberately burying the revenue sharing arrangement. The revenue was shared through two entities and labeled the fees as consulting fees, even though the entities did not do any consulting work. Total Wealth fired an experienced compliance consultant who drafted a Form ADV Part 2 that very clearly disclosed the revenue sharing arrangement. The next consultant was much less experienced and used the “may” language instead.  The SEC also accused Total Wealth of hiring an inexperienced accountant who inadequately investigated the revenue sharing.

Total Wealth has not agreed to the charges, so we only have the government’s side of the story. The SEC also threw in charges of failing to comply with the Custody Rule and Total Wealth’s failure to meet its own diligence standard.

I’m troubled by the SEC’s position in this case over the use of “may.” (Of course, there are other issues in the case.) If this truly is the SEC’s position, then I understand why the SEC thinks 50% of private fund managers have problematic fees. And if it this truly is the SEC’s position then there will be lots of fund managers going back through and revising their documents.

References: