Category: Compliance Programs

Real Estate Investing and Crowdfunding

crowdfunding real estate

Real estate investing is capital-intensive. It should be a natural area for crowdfunding. The big concern is fees and conflicts.

With a tech startup, you are investing in an idea and the people with the idea. It may grow exponentially or blow up, leaving little behind. Part of the investment is paying the people to run the business. With real estate, the cost of managing the investment may be an additional expense beyond the investment. The people managing the investment may be connected with the people selling the investment. That can work well, or be a conflict.

The Wall Street Journal highlighted crowdfunding opportunities in real estate: Real-Estate Crowdfunding Finds Its Footing. The Securities and Exchange Commission has not enacted crowdfunding regulations yet, so the investments will have to be limited at accredited investors, or otherwise exempt from securities registration. Of course, if the investor has enough rights, it’s possible that the investment might not be a security.

The stories highlights three real estate crowdfunding platforms:

  • RealtyMogul
  • Fundrise
  • Prodigy Network

So I decided to take a closer look.

Realty Mogul

After logging in, the site asks for self-reporting of income and net worth to determine if the user is an accredited investor. The final step is a click wrap agreement that:

“By checking this box, you represent that you have such knowledge and experience in financial and business matters that you are capable of evaluating the merits and risks of this investment, and you are able to bear the economic risk of this investment including the risk of complete loss.”

Then the site imposes a 21 day delay. I presume that this is set up to distance the site registration from a general solicitation. By coming back 21 days later, I assume the firm is trying say that there is now a relationship.

Even with the delay, you can browse available investments. There were 5 available when I viewed the site, ranging from $510,000 to $760,000 of equity sought. Each sets up a Realty Mogul subsidiary to invest alongside a property operator/co-investor. The site discloses the operator’s compensation and Realty Mogul’s compensation.  The available assets all had a $10,000 minimum investment.

Fundrise

This site also has you self-certify as an accredited investor. I was surprised to see the no option as “No – most people choose this option”. I chose this first, then went back to switch it to accredited investor.

Apparently, Fundrise has seen the SEC rule on general advertising and requires verification that you are accredited. The site requires a verification letter from a broker-dealer, registered investment adviser, attorney, or CPA before granting you status as an accredited investor.

The platform has regulation A offerings available for non-accredited investors, but limited by state. The documentation is substantial. The offering document for one investment was over 100 pages.

Fundrise is less transparent about fees than Realty Mogul. The Reg A investment allowed an investment as little as $100. The private placements required a minimum of $5000.

Fundrise has a social network aspect, allowing you to see the investors in an investment and to join investment network within the platform.

Prodigy Network

Offered little detail behind its introductory pages.

Summary

Here is the big problem with real estate crowdfunding. To purchase or sell real estate, you need to act and convince the other side that you can close. If you are buying a property and sourcing the capital with crowdfunding, there is the possibility that you won’t raise the money and not be able to close. Presumably you would have to include the successful crowdfunding as a closing condition, or have a backup source of more expensive capital to cover the failed crowdfunding. As a seller, why would you accept an offer contingent on crowdfunding?

The alternative is that the real estate is already warehoused with a party and is looking to lay off some of the equity or fund capital improvements.  Then you are looking to crowdfunding as a cheaper source of capital or a quicker source of capital. I have a hard time believing that crowdfunding is cheaper or faster than other sources of capital. And if other sources of capital are not interested in the investment, perhaps that is an indication.

However, I applaud the efforts of these sites and think they offer an interesting opportunity to make an alternative investment.  I had only a short opportunity to see what these platforms have to offer and how they go about offering their investments. There is lots more to see and learn.

References:

The SEC Endorses Yelp for Investment Advisers

yelp

Investment Advisers and the Securities and Exchange Commission have been struggling with the use of social media. Advisers see it as a way to communicate with clients and potential clients. The SEC sees it as an area ripe for fraud. Both are right.

The SEC has stuck fast to rules on advertisements when it comes to social media. The SEC does not care if the social media sites cannot meet the control and record-keeping standards. The SEC does not care if it’s hard to meet the standards. Clearly, the SEC is focused on investor protection in this area. The features of social media sites keep changing so it’s hard to keep the features in line with the SEC requirements.

But the SEC listens to the complaints and keeps releasing guidance in this area. The SEC released Investment Management Guidance 2014-4 that provides some additional guidance on the intersections of testimonial and social media sites.

Rule 206(4)-1(a)(1) prohibits the use of testimonials in an investment adviser’s advertisements. The SEC considers the publication of testimonials to be inherently misleading because “they emphasize the comments and activities favorable to the investment adviser and ignore those which are unfavorable”.

The SEC did make an exception for third party rankings. See DALBAR.

The new guidance merely points investment advisers to the prior guidance on testimonials and tries to add some context to the use of social media sites. I think most advisers will not find much good news in the guidance.

In looking through the questions and answers I only see Yelp and its copycat sites being allowed by the guidance. I assume many thought the guidance would be an endorsement of Facebook pages, but that feature seems to fall outside the acceptable areas allowed by the guidance.

A Facebook page is controlled by the publisher (the adviser) and is therefore not an independent site. The SEC requires the social media site to be independent. Others may see some wiggle room in allowing ratings on a Facebook page for investment advisers. I think you need to be very cautious because the feature and controls on Facebook pages change rapidly and inconsistently.

That leaves Yelp and its copycats that rate businesses. I already see a few ratings of investment advisers in Boston.

The Guidance points out that recommendations posted by the adviser or its employees are strictly prohibited. Similarly, an adviser can’t pay for recommendations or offer discounts to clients to post commentary.

References:

Document Request List for Never-Before-Examined Advisers

aca compliance

In January, the Securities and Exchange Commission announced in its annual exam priorities for 2014 that it wanted to emphasize exams on never-before examined firms that had been registered before 2012. Then in February, the SEC officially announced its never-before-examined initiative. It looks a lot like the presence exams.

ACA Compliance got its hands on an initial document request list used by OCIE in conducting a never-before-examined exam.

Unlike other exam letters, this one explicitly states that it is part of OCIE’s never-before-examined initiative. It sounds like an on-site visit is not part of the initial protocol. But this may vary from region to region.

I’ve added this example to Compliance Building‘s collection of 13 other SEC Exam Document Request Examples. If you have an example and are willing to share it, you can send it to [email protected]. I will always delete any information about the firm and I will only publish any additional information about the letter that you consent to.

Disclosure: I’ve used ACA Compliance as a provider.

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Compliance Lessons From My Dog

Ghost and Doug

My dog has taught me a few lessons about compliance. (That’s me and Ghost taking a well-deserved nap.)

Start early. We started dog training early to focus on developing good habits at an early stage. (We did lose a few shoes while he was a puppy.) It’s never too late to unlearn bad habits, but it’s better to not have them in the first place.

He wants to do right thing. The dog does not act with malice. He just wants to be a loyal companion. He may stray from the right path because he’s presented with a new situation and doesn’t know how to act. Or he was presented with an irresistible temptation.

Remove the temptation. It would be great if Ghost didn’t grab food off the kitchen counter. He doesn’t do it when we are watching him. It only happens when he is unsupervised. We can blame the dog, but it was better to focus on removal of the temptation. We had to train ourselves to not leave food on the counter when the dog is not supervised.

Quick response. Our dog trainer taught us that we have only a few seconds to give praise for good behavior and to give a negative sign for bad behavior. Once too much time has passed the dog no longer equates his behavior with the reward or shunishment.

Appropriate Punishment. IMG_1163[1] Hitting a dog only makes him angry. If you have failed to mete out punishment quickly (see above) the punishment will not affect bad behavior. With one of my kids or one of my employees I could sit down and discuss the situation. Perhaps I could find an alternative way to get my point across.

What could I do after coming home to find a chewed up library book? It was too late for that book and it was too late for shunishment. All I could do is set a warning for others.

Consistency. Ghost is deaf so I rely on sign language and body language for communication. If I give him the “let’s go for a walk sign” I need to take him for a walk. If I give him the “come” sign, I expect him to come. If I’m half-hearted about the meaning of my signs, he’s going to be half-hearted about complying with them.

I’m sure there are more lessons to be learned from my dog.

Compliance Bricks and Mortar for February 7

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

The Financial industry – Life is Getting Tough by Michael Volkov in Corruption, Crime & Compliance

In recent statements from the Justice Department and regulatory officials, prosecutors and regulators have warned the industry that individuals may be prosecuted in the future for money laundering violations. As I always say, when the government says something – they mean it. The government does not prosecute or enforce the laws in secret.

The FCPA and Fight Against Terrorism by Tom FOx in the FCPA Compliance and Ethics Blog

I admit it took me awhile to finally get it. I have long wondered what could have caused the explosion in Department of Justice (DOJ) and Securities and Exchange Commission (SEC) enforcement of the Foreign Corrupt Practices Act (FCPA). Starting in about 2004, FCPA enforcement has not only been on the increase from the previous 25 years of its previous existence but literally exploded. Of course, I had heard Dick Cassin and Dan Chapman, most prominently among others, talk and write about FCPA enforcement as an anti-terrorism security issue post 9/11, but I never quite bought into it because I did not understand the theoretical underpinnings of such an analysis.

SEC No-Action Letter Addresses “M&A Brokers” by Keith Paul Bishop in California Corporate & Securities Law blog

Martin A. Hewitt alerted me to this no-action letter issued on January 31, 2014 by the SEC’s Division of Trading and Markets.  The letter was issued in response to a request by six lawyers, including Mr. Hewitt.  In very broad terms the letter states that the Division would not recommend enforcement “if an M&A Broker were to effect securities transactions in connection with the transfer of ownership of a privately-held company under the terms and conditions described in your letter without registering as a broker-dealer pursuant to Section 15(b) of the Exchange Act”.  The letter describes an M&A broker as “a person engaged in the business of effecting securities transactions solely in connection with the transfer of ownership and control of a privately-held company (as defined below) through the purchase, sale, exchange, issuance, repurchase, or redemption of, or a business combination involving, securities or assets of the company, to a buyer that will actively operate the company or the business conducted with the assets of the company.”

Improve Your Company’s Ethical Performance by the Markkula Center for Applied Ethics

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SEC Sanctions University Professors For Naked Short Scheme by Thomas O. Gorman in SEC Actions

Two university professors settled fraud charges brought in an SEC administrative proceeding centered on a naked short selling scheme. The scheme yielded profits of over $400,000. In the Matter of Gonul Colak, Adm. Proc. File No. 3-15712 (Jan. 3, 2014). Milen Kostov, a professor at an unidentified university, created an options trading scheme crafted to evade restrictions on naked short selling, profiting from pricing differences for hard to borrow securities and from holding the positions open. He shared the strategy with his friend Gonul Colak, also a professor at an unidentified university.

SEC Compliance Outreach Program National Seminar

SEC Seal 2

The SEC’s Office of Compliance Inspections and Examinations (OCIE), Division of Investment Management, and the Asset Management Unit of the Division of Enforcement jointly sponsor the compliance outreach program. On January 30, 2014, there was a national meeting.

These are my notes.

Welcoming Remarks from Chair Mary Jo White

Investors and the SEC relies on compliance officers. OCIE has only 450 dedicated who have to look over 11,000 registered investment advisers. The top goal is getting firms to express a dedication to compliance throughout the organization. She highlighted the exam priorities for 2014.

Introductory Remarks

Speakers:

  • Drew Bowden, Director, Office of Compliance Inspections and Examinations
  • Norm Champ, Director, Division of Investment Management
  • Andrew Ceresney, Director, Division of Enforcement

Andrew started off as the person you don’t want to meet. If your talking to enforcement, you are being accused of doing something seriously wrong. One focus is firms with past problems. The first thing examiners will do is look at the deficiencies from an exam and see if the firm has fixed those noted problems. Custody is a critical rule because its focus is on the safety of client assets.

He highlighted a case his group brought under Rule 38a-1(c) of the 1940 Investment Company Act. That rule makes it unlawful to mislead or obstruct a firm’s CCO in the performance of his or her duties. Andrew also highlighted the Convergex case for failing to highlight markups and markdowns.

Norm highlighted the guidance and updates issued by the SEC. The initiative came out of failed no-action letters. The SEC would deny the relief, but that denial was rarely public. He highlighted the guidance update on misleading fund names and the guidance on the custody rule for private stock certificates.

He also highlighted some facts on the new public private-placement rules under 506(c). He is not seeing a lot of use of the new regime.

The SEC’s goals are to be transparent. The vast majority of investment advisers are trying operated in a proper and ethical way. The panel clearly highlighted custody as an item subject to close scrutiny.

Panel I: Program Priorities

Speakers:

  • Jane Jarcho, National Associate Director, National Exam Program
  • David Grim, Deputy Director, Division of Investment Management
  • Julie Riewe, Co-Chief, Division of Enforcement, Asset Management Unit

Julie highlighted the aberrational performance inquiry initiative. The mismatched performance usually lead to to a large cache of other misdeeds at the adviser. On the private fund side of things, the SEC is looking at conflicts of interest, allocations of opportunities, mis-allocations of expenses.  She highlighted multiple funds investing in the same opportunity. (Are you using the second investment to prop up the first?)

David focused on the floating NAV for money market funds (I hate that idea.) and other mutual fund reporting issues.  He expects a new rule-making proposal on target date funds.

Jane talked about the selection of priorities and the priorities for the upcoming year and rest of the panel joined in.

  1. Wrap fee program
  2. JOBS Act
  3. Cybersecurity
  4. IA-BD harmonization

Examiners are looking at certain aspects of wrap fee programs. It starts with a suitability policy and procedure. Do you have one and is it being followed?

There is a clear focus on the issues that will arise from lifting the ban on general solicitation. He acknowledged the murkiness caused by releasing the proposed rules for investor protection on the same day as the adoption. This will be a big priority for 2014.

Question & Answer Session (Advisers with $1 Billion or Less in Regulatory AUM)

25% of the registered advisers have more than $1 billion under management’ 62% have less than $500 million and 12% are between $1 billion and $500 million.

Panel II: Private Fund Adviser Topics

Speakers:
  • Ashish Ward, Exam Manager, National Exam Program, Los Angeles Regional Office
  • Alpa Patel, Senior Counsel, Division of Investment Management
  • Igor Rozenblit, Specialist, Division of Enforcement, Asset Management Unit
  • James Capezzuto, General Counsel & Chief Compliance Officer, Cornerstone Capital Management LLC
  • Barbara Burns, Chief Compliance Officer, AEA Investors SBF LLC
Key focus areas in presence exams: (1) investment conflicts of interest, which includes allocation of opportunities and fees, (2) Marketing, in particular performance marketing, (3) valuation and (4) custody. The SEC has conducted about 250 exams and found numerous issues in these areas.
Fees need to be disclosed, including fees charged to portfolio companies and expenses charged for back-office operations. Are you generating additional revenue for the management company while reducing cash to the funds.
The panel pointed out Rule 206(4)-8 that looks through the fund to investors in the fund for fraudulent, deceptive or manipulative acts.

Panel III: Registered Investment Company

This was not relevant to me, so I skipped this session.

Panel IV: Valuation Issues

Speakers:
  • Matthew O’Toole, Senior Special Counsel, National Exam Program, San Francisco Regional Office
  • Leo Chan, Senior Specialized Examiner, National Exam Program, San Francisco Regional Office
  • Sarah ten Siethoff, Senior Special Counsel, Division of Investment Management
  • Jaime Eichen, Chief Accountant, Division of Investment Management
  • Jeffrey Blockinger, Chief Legal Officer & Chief Compliance Officer, Och-Ziff Capital Management Group
The big theme is that there is no one-size-fits-all approach for valuation. There was discussion about whether the SEC would offer some guidance on valuation expectation. That sounded unlikely.
Mutual funds and BDC are required to use GAAP financing. Advisers are not as limited. However, a panelist pointed out that for private funds to comply with the custody rule, it must have GAAP financials.

Panel V: Chief Compliance Officer Obligations

Speakers:
  • Mark Dowdell, Assistant Director, National Exam Program, Philadelphia Regional Office
  • Janet Grossnickle, Assistant Director, Division of Investment Management
  • Marshall Sprung, Co-Chief,Division of Enforcement, Asset Management Unit
  • Chris Marzullo, General Counsel & Chief Compliance Officer, Brandywine Global Investment
  • Management LLC
  • Judy Werner, Executive Director, National Society of Compliance Professionals
I missed this session.

Closing Remarks

by Drew Bowden, Director, National Exam Program
I missed this session.

Materials

Due Diligence for Alternative Investments

sec-seal

The Securities and Exchange Commission published a new risk alert on investment advisers and alternative investments. It’s a rambling piece that spends most its time laying out the OCIE’s observations on due diligence practices. To the extent there is any focus, it’s focus is on the perspective of advisers to pension funds and managers of funds of private funds.

I skipped over the industry practices to the compliance section in Section II. The SEC highlights some deficiencies that caught my attention.

The first is the inclusion of due diligence policies and procedures as part of the annual review. This struck me as a bit odd. It didn’t strike me that diligence procedures are necessarily part of ensuing compliance with securities laws.

That odd bit comes back into the picture in the disclosure issues. The OCIE staff found that advisers were making statements about their disclosure practices, but then operating in a different manner. This goes back to the Hennessee Group case where a fund manager touted its expansive diligence process, but failed to conduct the diligence. Hennessee ended up investing in Sam Israel’s Bayou Fund. Hennessee’s touted diligence practices, if they had followed them, should have spotted Bayou as a fraud and not invested.

The last tidbit on compliance was allowing adviser’s employees to invest along side the client. However, some advisers were allowing employees to have preferential treatment on liquidity and fees.

From that perspective, the industry practices in Section I make more sense. OCIE is painting a picture of best practices on diligence procedures for investing in alternative investments. This is what OCIE is going to be looking for from pension fund advisers and fund of fund managers.

References:

Fees and Conflicts

adoption money

I sat down with a few people last week to discuss various fee structures with fund managers and investment advisers. One fee was raised as potentially problematic. “I’m not sure if this fee is a conflict.”

My thought is that every fee is an inherent conflict. You are taking money from the fund investor or client and putting it into the hands of the fund manager / adviser.

The first step of the fee analysis is whether it is disclosed. One of the primary commands of the Investment Advisers Act is disclosure. You must make your clients and investors aware of the fees you charge. Compliance must make sure that the fee information is clearly disclosed in accordance with the regulations and SEC actions.

The second step is the analysis of whether the fee could cause a distortion in behavior that could cause the fund manager / adviser to act in a different way because of the fee income.

If the fund charges an acquisition fee, then the fund may be more likely to make acquisitions because it gets extra income when it does so.

Even the asset based management fee that most people think keeps the fund manager and investor most aligned can cause distortions. In June 2012, the SEC announced its pursuit of zombie funds. It was concerned that fund managers are keeping portfolios together merely to collect the management fee instead creating realizations to return capital to investors.

Fees are always a conflict. You must disclose them and understand the distortions so you can keep your fund’s interest aligned with the investor’s interest.

Volker Rule and Real Estate Funds

Paulvolcker

Five regulatory agencies adopted the final rules that implement the Volcker Rule, a provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act. It’s a big, complicated, ugly rule that will drive compliance officers at banks crazy trying to implement. Have fun reading all 964 pages. The text of the regulations themselves only run on for 70 of those pages

From the position of a private fund sponsor there is one section to pay particular attention to. Subpart C of the Volker Rule prohibits banks from owning or sponsoring a “covered fund”. That definition comes from section 13(h)(2) of the Bank Holding Company Act and is any entity that would be an investment company, but for the exclusions under sections 3(c)(1) and 3(c)(7) of the Investment Company Act. That picks up hedge funds and private equity funds. It will also likely pickup real estate funds whose managers registered as investment advisers.

The Rule also explicitly pulls in some commodity pools. There is some fine print there to focus on. Those real estate fund managers that didn’t register as investment advisers, but did file as commodity pool operators may be stuck with the Volker Rule. It’s tough to figure out what the agencies are trying to grab, but my best guess is that the rule applies if the fund relies on a 4.7 exemption, but may not apply if the fund relies on the 4.13 exemption.

The Rule does allow for a small ownership interest, as long as it does not exceed 3% of the total value of the total number or value of the outstanding ownership in the fund. (See Section 12(a)(2)(ii)(A).) From the bank’s perspective, it cannot have more than 3% of its Tier 1 capital in covered funds.

As for a real estate fund, it may still be able to be exempted from the restrictions under the Volcker Rule. It would have to rely on the nebulous section 3(c)(5)(c) exemption under the Investment Company Act. The fund may also have to limit its use of interest rate derivatives to stay outside the definition of a “commodity pool” under the Commodity Exchange Act.

The end result for real estate funds is likely minimal. Clearly the big investment bank-sponsored funds will go away. Bu that has been happening for the past few years. Just look at the PERE Charts to see those funds dropping down and off the list. They will continue to be sellers and not buyers. It does look like separate accounts and other types of real estate investments may be permitted for banks.

References:

Compliance Program Failure

failure

The SEC slapped a fund manager and its out-sourced CCO. The main charge was engaging in undisclosed principal transactions. Beyond that obvious conflict issue, the order has some interesting statements about failures in the compliance program.

Parallax Investments, LLC, a Houston based firm, registered with the SEC as investment adviser in 2010. It also had an affiliated broker-dealer, TSF,  that was partially owned by John P. Bott, II who was the sole owner of Parallax.

According to the SEC order, Parallax would buy and sell investments through TSF and TSF would transfer the investment from its inventory account. TSF would charge a mark up and Bott, a registered representative for TSF, would receive a substantial portion of the markup as compensation.  The SEC is taking the position that those trades were principal transactions. If that is the case, then Parallax failed to obtain the consent necessary to make a principal trade with an advisory client. There is inherent conflict when the investment adviser is selling to its clients from its own account.

As a CCO, I was more focused on the compliance program failures at Parallax.

Prior to registration with the SEC, Parallax was registered in Texas. The Texas regulator issued a deficiency. Parallax at least tried to improve its compliance program and bought an off-the-shelf compliance manual.  (Okay, so it sounds like it didn’t try that hard.)

But Parallax went further and and hired a CCO, F. Robert Falkenberg who reviewed the program and suggested changes. Falkenberg had worked as an examiner for the State of California and worked for FINRA before starting his compliance consulting firm.

The order does not state it directly, but it sounds like Falkenberg acted as an out-sourced CCO.

“[Falkenberg] devoted approximately nine hours per month to Parallax’s compliance program. He did not maintain a permanent office at Parallax and delegated daily compliance tasks to other employees in his absence.”

Falkenberg did write a memo to Botts that the off-the-shelf compliance manual needed to tailored to Business operations of Parallax.  However, he never did so. He also never implemented a written code of ethics.

He really made the SEC examiners angry when he fudged the 2010 annual review.

The meta data for Falkenberg’s 2010 annual compliance memo indicates that Falkenberg created and completed the memo in approximately four hours on Friday, April 8, 2011, not February 2011. Falkenberg drafted the memo after exam staff had notified Parallax of its impending exam and just three days before exam staff was scheduled to begin field work.

Don’t lie to the SEC. That increases the chances that the examiners will push the case over to enforcement and that you will end up reading about the compliance program failures here in Compliance Building.

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