Category: Compliance Programs

Some Relief for a Fund Manager Under the Political Contributions Rule

Politician: Holding Out a Stack of Money

SEC Rule 206(4)-5 for investment advisers and fund managers limits the ability of a firm’s employees to make political contributions. It’s a nasty rule. Violation of the rule does not require any bad intent. The breadth of affected political candidates is long, diverse, and hard to discover.

Anthony Yoseloff worked at Davidson Kempner Capital Management which ran a private investment fund. Three of the investors in the fund were Ohio public pension plans. Under the SEC Rule, Yoseloff would be limited in making political contributions to politicians who could directly or indirectly influence the decision to invest in the private investment fund.

Yoseloff gave a $2500 donation to the federal senate campaign of Joshua Mandel. Yoseloff though federal elections were exempt from the political contributions limit. He was wrong. Mandel was the Ohio Treasurer and had the power to appoint trustees to the Ohio pension plans. Yoseloff had violated the rule and the firm was at risk of losing two years worth of management fees from Ohio pension plans.

The firm applied for exemption from the SEC, hoping the innocent mistake would not cost them thousands of dollars. (tens of thousands? hundreds of thousands?)

The rule does provide for exemptive relief. This case may be the first such relief.

Here’s what the SEC said mattered in the ruling granting the relief:

  • The Ohio pension plans established the investment relationship on a arms’ length basis prior to the date of the contribution
  • Only one investment was made after the contribution
  • The firm had pay-to-play policies and procedures compliant with the rule’s requirements and implemented compliance testing
  • After discovering the contribution, the firm requested it’s return from the candidate
  • The firm set up an escrow account to hold the fees.
  • The contribution was consistent with Mr. Yoseloff’s past contributions.
  • Mr. Yoseloff mistakenly thought the contribution policy was not applicable to federal candidates.

Thankfully, the SEC is showing some relief from this oppressive rule that distorts political campaigns. Mr. Yoseloff could have given the $2500 to Sherrod Brown, the other candidate in the election, and there would have been no problem. In the 2012 republican presidential primaries, of the 10 candidates only Rick Perry was limited by the SEC rule.

On the other hand, there was a long history of pay-to-play in the municipal finance industry that was snuffed out by the MSRB rules. (This SEC rule was based on those.) We have several instances of politicians and investment advisers/fund managers doing bad things to steer investments. I understand the need.

Clearly the firm is trying to run tests on political contributions. It found the contribution because the federal database allows you to search by “employer name.” The Ohio state database does not. If the contribution was made to the treasurer’s state campaign, the firm may never have discovered it. Most of the state election finance databases that I’ve reviewed do not allow you to search by employer. This effectively limits the ability to monitor contributions. Yet another problem with the rule.

References:

JOBS Act 2.0

Im-just-a-bill -schoolhouse rocks

It was an unusual show of bipartisan support when the original JOBS Act was passed in the Spring of 2012. Congress is following in the footsteps of movie studios and looking to produce a sequel. Financial Services Committee Chairman Jeb Hensarling has promoted a group of bills that he thinks will comprise the JOBS Act 2.0.

Here is the pitch:

H.R. 1800 Small Business Credit Availability Act will increase the ability of Business Development Companies to lend to small businesses and help ensure the flow of capital to Main Street.

H.R. 2274 the Small Business Mergers, Acquisitions, Sales, and Brokerage Simplification Act will streamline and simplify regulations so that small business owners can sell their small businesses when they retire, rather than perhaps be forced to close them up.

H.R. 3448 The Small Cap Liquidity Reform Act will make small companies more attractive to investors and, in turn, produce higher rates of capital formation and jobs.

Here is what the legislation actually does.

The Small Business Credit Availability Act amends the Investment Company Act of 1940 to allow a business development company to own interests in the business of a registered investment adviser or an adviser to an investment company. It also reduces from 200% to 150% the asset coverage requirements applicable to BDCs and allows a BDC to issue stock. BDCs have been become the hot topic for financing. I have to admit my ignorance about the benefits of using a BDC. Clearly, this bill is trying to clear a bunch of the obstacles to the use of this type of financing. I did notice that the SEC recently issued a no action letter allowing a BDC, Main Street Corporation, to own an investment adviser.

The Small Business Mergers, Acquisitions, Sales, and Brokerage Simplification Act creates a new regulatory framework for “Mergers & Acquisition Brokers” who are in the business of effecting the transfer of ownership of an eligible privately held company. That is a complication in the sale of a small company. If it’s structured as an asset sale, the broker does not need SEC registration. But if transaction is structured as the sale of securities, the broker does need to be registered.

The Small Cap Liquidity Reform Act will provide a pilot program allowing certain emerging growth companies to increase the tick size of their stocks. That’s been a quest for Wall Street ever since decimalization was introduced. It’s killed the profit margin for market makers. That it’s tied to emerging growth companies is just an added bonus. That status allows the company to file privately with the SEC while working on the IPO. It will make this designation more attractive for the deal runners who stand to make a better profit by acting as a market maker on the stock.

Like most movie sequels, this legislative sequel is not as good as the first. Clearly, Congressmen Hersarling recognizes the importance of good marketing to get a bill passed that changes the financial services regulatory regimes. These are three very specific bills that are unlikely to catch the attention of the rest of Congress.

The original JOBS Act flew through Congress with enticing tidbits that would make IPOs easier and enable crowdfunding (sort of). I can’t see JOBS Act 2.0 getting the same kind of interest, even with the positive spin given the bills.

The Monsters of Compliance – Monster Mash

monster mash and compliance

I was working in the lab late one night
When my eyes beheld an eerie sight
For my monster from his slab began to rise
And suddenly to my surprise

He did the mash
He did the monster mash
The monster mash
It was a graveyard smash
He did the mash
It caught on in a flash
He did the mash
He did the monster mash

Even if you mix all of the monsters together, you can still get a good result. The vast majority of fund managers and investment advisers have good intentions are focused on delivering the best returns they can for their investors. They may have conflicts and alternative streams of income. That doesn’t mean they are doing anything wrong. The monsters are not always scary.

You need to remember that the monsters are out there. That means you need to make good decisions. Take lessons from Hell No: the Sensible Horror Film.

  • Don’t sneak into the abandoned insane asylum with your Ouija board.
  • Don’t watch the cursed tape that kills you in five days.
  • Don’t split up.
  • Call for backup

You can deal with the monsters. Just don’t ignore them. Maybe you can even dance with them.

The Monsters of Compliance – Dracula

dracula and compliance

The pumpkins and garish Halloween decorations are out on my front lawn. With the Halloween season upon us, my mind has become stuck on movie monsters and been mixed with compliance. This is the terrible result.

Vampires have taken many forms, mixing mythologies, weaknesses and desires. There is the regal version played by Bela Lugosi, the tortured soul of Angel, the vicious version played by Christopher Lee, the superhero version of Blade, the numerology of Count von Count, and the delicious Count Chocula. (Vampires don’t sparkle.)

Dracula has remained as the most vampirish of vampires. Unlike lesser vampires, Dracula glows with a veneer of aristocratic charm. He has supernatural strength, the ability to charm you into doing something you don’t want to do, and perhaps the ability to turn into a bat. With all those strengths come many weaknesses: crosses, holy water, garlic, and daylight. He would seem easy to defeat if he were not so charming.

When trying to draw a compliance comparison, one person came to mind when I thought of the Count: Bernie Madoff. His charm was his power, leading a flock believers, while all long he sucked the life out of them. He drained their money for his own use. It was daylight that killed hill. He pulled back the curtain of secrecy and exposed his operations to the sunlight. All of the wealth and all of the power turned to dust.

Ponzi schemers are the vampires of compliance. It’s relatively easy to repel them with a few splashes of garlic flavored due diligence. But once under their charm, they drain you. The Securities and Exchange Commission can try to swoop in like Van Helsing, but by then the ponzi scheme will have already claimed some victims.

The Monsters of Compliance – Freddy Krueger

freddy kruger and compliance

The pumpkins and garish Halloween decorations are out on my front lawn. With the Halloween season upon us, my mind has become stuck on movie monsters and been mixed with compliance. This is the terrible result.

Freddy Krueger terrorizes the kids of Springwood, Ohio, attacking them when they sleep. He seeks revenge for the dark actions of their parents long ago. The first it the series, A Nightmare on Elm Street, terrified me. I had to watch it in the middle of the day so I could shake off the fear before falling asleep. (I found the rest of the series less scary.)

For fund managers and investment advisers, falling asleep and missing the problems can get you in trouble. The SEC announced sanctions against three firms for falling asleep when it comes to the custody rule.

For one firm, it was victimized by a hack of its client’s email account, but it’s internal procedures were inadequate to stop the fraud. The firm received an email purportedly from one of its clients asking to wire $290,000 to a foreign bank account. The firm complied. Unfortunately, someone had hacked into the client’s email, falsified the wire request and directed it into its criminal hands.

The weakness was that the firm did not obtain its clients’ authorizations before transferring funds to third party accounts.The SEC order also has a strange tale of pre-signed letters of authorization and copying clients’ signatures to transfer funds.

The firm also failed to conduct surprise audits for the accounts as required by the rule. Those were violations of the rule, but did not lead to the problem nor could the audits have prevented the problem.

The firm fell asleep and Freddy launched his nightmare at the firm for their past failures.

References:

The Monsters of Compliance – The Mummy

mummy

Ignore the warning at your peril. The archaeologists were told to be careful with the Imhotep’s mummy. He had been punished for trying to resurrect his forbidden lover. In the 1932 version, Boris Karloff’s Imhotep was mummified alive for his crime. The archaeologists had been warned not to read the Scroll of Thoth. It brought Imhotep back to life. Then the horror begins.

A firm is at peril for ignoring the warnings of the Securities and Exchange Commission. The clearest warning is when you get a deficiency letter. The SEC will sanction investment advisory firms for repeatedly ignoring problems with their compliance programs. Last week the SEC sanctioned three firms for failing to fix identified problems.

“After SEC examiners identified significant deficiencies, these firms did little or nothing to address them by the next examination. Firms must fix deficiencies identified by our examiners.” – Andrew Bowden, director of the SEC’s National Exam Program

According to the SEC’s orders against New Orleans-based Equitas Capital Advisers, the firm failed to adopt and implement written compliance policies and procedures and conduct annual compliance reviews to satisfy the Compliance Rule. Equitas made false and misleading disclosures about historical performance, compensation, and conflicts of interest, and it inadvertently yet repeatedly overbilled and underbilled its clients. Many of these violations occurred despite warnings by SEC examiners during examinations of Equitas in 2005, 2008, and 2011. The firm failed to disclose these deficiencies to potential clients in response to questions in certain due diligence questionnaires or requests for proposals.

The SEC has said many times that the first thing the examiners will do when they return is to verify that the firm has fixed the deficiencies identified in the last examination. The only surprise with the Equitas case is that it took so long to bring sanctions given the three prior visits.

The warnings are there for a reason. Comply with them or beware the consequences.

Monsters of Compliance – Werewolf

werewolf and compliance

The pumpkins and garish Halloween decorations are out on my front lawn. With the Halloween season upon us, my mind has become stuck on movie monsters and been mixed with compliance. This is the terrible result.

The werewolf is old and widespread legend. Lycanthropes gain the ability to turn from human form into a wolf or wolf/human hybrid. Depending on the legend, there are various methods for becoming a werewolf. In The Wolfman, Claude Raines is bitten in a wolf attack. Unfortunately, that wolf was actually a werewolf and the bite passed on the curse of lycanthopy to him. But other legends have it being a hereditary trait or passed by disease. To kill a werewolf, you need silver. At least that is one of the most popular features of the legends. In The Wolfman, the werewolf is killed by silver topped cane. Later pop culture typically has a silver bullet as the fatal cure.

Two features of the werewolf made we think of compliance.

The first is finding the cause. When it comes to investment fraud or corporate crime, it’s rare that the bad guy (and it usually is a guy) starts off bad. At some point, something goes wrong and the guy steps over the line to be the bad guy. When Claude Raines is bitten, he doesn’t know that the bite was the turning point. But it was, and it lead him down a dark path that eventually leads to his own death.

Enron started out as a legitimate company before it embraced widespread accounting fraud. I believe Bernie Madoff started out as legitimate investment manager before he crossed the line and turned his business into a Ponzi scheme. In reading the story of Sam Israel, you can point to the event that turned him from a struggling investment manager into a fraudster. To make the numbers for his annual report he used an accounting trick to rebate back his brokerage fees to improve the fund’s return. That lie was the bite of the werewolf.

Once bitten, the ordinary man becomes evil. For a compliance professional, the key is to recognize the bite and to recognize when someone has been bitten.

The second feature of the werewolf that makes me think of compliance is the cure.

The “silver bullet” is a straightforward solution with extreme effectiveness. Unfortunately for the werewolf, the silver bullet is death. That’s a bit extreme for compliance professionals. Unfortunately, it’s rare to find a silver bullet when it compliance issues, whether it’s preventing a problem or trying to remedy the problem. If prevention were so straightforward, there likely would not be a compliance profession.

One of the goals of a compliance professional is to prevent someone from shooting your company with a silver bullet because it has turned into a werewolf.

The Monsters of Compliance – Frankenstein’s Monster

Frankenstein and compliance

The pumpkins and garish Halloween decorations are out on my front lawn. With the Halloween season upon us, my mind has become stuck on movie monsters and been mixed with compliance. This is the terrible result.

Victor Frankenstein builds a creature in his laboratory with a mixture of surgery, chemistry, and alchemy. His creation horrifies Dr. Frankenstein and he disavows the experiment. The abandoned monster wanders through the wilderness searching for kindness and acceptance, unaware of his own identity.

I expect we will see this metaphor in the crowdfunding rules expected to be released today. The rules will likely be a mess of cobbled together parts. That’s because the Doctor designed the framework that way. In this case, the Doctor is Congress.

The SEC will be stuck wandering the wilderness being chased by pitchfork-wielding entrepreneurs who wanted a simple platform for getting equity funding from the masses. The problem was not of the monster’s creation, but of its master’s doing. Congress created an unworkable framework and the SEC is stuck with its design, trying to get its pieces to work together.

In many ways, the ills of the Securities and Exchange Commission can be blamed on its master. Congress limits its budget. The SEC is not self-funded like the Federal Reserve, the bank regulators, or FINRA. As Robert Kaiser points out in his book, 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 SEC must heed the mandates of Congress and the cobbled together pieces of legislation that make up our securities laws.

UPDATE:

The proposed rules were published shortly after the post was published. Although I have not read it, the release proposal is 585 pages long. The text of the regulations is 50 pages long and includes several additional pages of proposed forms. That makes it a big monster.

The Monsters of Compliance – Zombies

CDC_zombie

I finally grabbed some pumpkins and put some garish Halloween decorations on my front lawn. My mind has become stuck on movie monsters and been mixed with compliance. This is the terrible result.

What happens when the dead won’t die? The zombie apocalypse.

Zombies in pop culture can be traced back to George Romero’s The Night of the Living Dead and the sequel, Dawn of the Dead. Romero was able to make statements about race and consumerism in the context of the dead rising. (I’ll avoid the argument over whether zombies should be able to run, or merely shuffle.)

In compliance culture, the current zombies are private equity funds that won’t die. Most private equity funds are set up with a definitive end date so the investors can be sure to get their capital (or whatever remains of it) by some date in the future. Otherwise, the investment is very illiquid.

“We’re looking at zombielike funds that potentially have stale valuations.”  “The investigation into zombie funds is an important effort being driven across the country.” – In a 2012 interview of Bruce Karpati, former co-head of the SEC’s asset-management enforcement unit

Instead of achieving realizations and returning capital, the SEC is looking at a small number of funds that may be sitting on investments merely to earn investment fees. The fund should be dead but it won’t die.

It’s more likely that the fund manager can’t make the shot to the head to kill the last investments. Some of the bottom of the barrel investments may have a limited market or their business plans are taking longer to implement. Many fund managers are sympathetic to that after the economic disruption of 2008.

The danger is looking like a zombie when the shotgun wielding white hat comes into view. If you have that unhealthy pallor and look like you’ll scream “brains”, you may end up being dead instead of undead.

The Monsters of Compliance – Gremlins

gremlins-movie-image

I finally grabbed some pumpkins and put some garish Halloween decorations on my front lawn. My mind has become stuck on movie monsters and been mixed with compliance. This is the terrible result.

Mogwai, the gremlin was sold subject to three rules:

  1. Never expose it to sunlight.
  2. Never get it wet.
  3. Never, ever feed it after midnight.

Billy, the young owner, violates the first rule when he accidentally spills a glass of water on Mogwai. The result is five new gremlins, each more mischievous than Mogwai. This was the start of trouble.

Billy learned the rule about water in a vacuum, not knowing the results. Perhaps if he knew that spilling water on Mogwai would create such trouble he would have been more careful. Perhaps he would not have kept a glass of water on his nightstand next to Mogwai.

I think there is an obvious compliance lesson there. Rules can’t be promulgated without some explanation about the consequences of violating the rule. You need to let your people know that there is a good reason for having the rule and the bad things that can be prevented by following the rule.

Billy breaks the third rule when he is tricked. The mischievous gremlins bit through the power cord of his clock, tricking him into believing that their request for food was coming well before midnight. Billy knew he was not supposed to feed the gremlins after midnight and tried to comply with the rule. After seeing the result of breaking the second rule he knew strange things could happen by breaking the rules.  He did not know how bad it could be. The cute fuzzy gremlins metamorphosed into terrible scary monsters.

Billy had a control failure. If he knew the result of breaking the rule, he probably would have put a stronger control in place to prevent breaking the rule. If he knew that double checking the time could save his town from destruction, I bet he would have put more effort into confirming the time before feeding the gremlins.

The first rule ends up saving Billy and his town. He had learned his lesson when accidentally exposing Mogwai to a glimpse of sunlight. It hurt the creature. He ended up using that rule to his advantage and killed the leader of the gremlins with sunlight. He knew the consequences of breaking that first rule.

In the end, Billy was not worthy of Mogwai because he was unable to follow the rules. He was subject to sanctions when the Mogwai was taken away. There are consequences for breaking the rules in horror movies.