Category: Compliance Programs

Modernization of Auditor Independence Rules

For private funds to comply with the Custody Rule, they usually rely on the annual, independent audit prong for compliance. That rule requires an audit from an auditor that is subject to audit as defined in Regulation S-X. The SEC has proposed some changes to Regulation S-X that affect the auditor independent framework.

“Many of the current independence requirements have not been updated since their initial adoption in 2000 and amendments in 2003.  Since that time, the Commission and our staff have, through several consultations per year, continued to learn about the application of our independence rule set and the efficiency and effectiveness of our independence requirements as market conditions and industry practices have changed.  The proposed amendments to Rule 2-01 are designed to respond to these changes, reflect the SEC staff’s experience administering the independence requirements, and incorporate consideration of the recent and longer term feedback received from the public. “

The changes look like they will mostly be at the edges of compliance and not have a significant impact on auditor independence for fund managers.

I had some questions about auditor independence a few years ago and found the decision-making about independence to be very opaque with almost no public guidance. This modernization may help improve this process.

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Form CRS for Private Fund Managers

As part of Regulation BI package of regulatory changes, the Securities and Exchange Commission created a new Form CRS that needs to be delivered to “retail investors.” Of course there are questions from the industry. The SEC’s Division of Investment Management and Division of Trading and Markets created a website that answers Frequently Asked Questions on Form CRS. The question for pooled funds whether whether the rule would look through to retail investors in a fund.

Pursuant to new rules adopted by the SEC under the Securities Exchange Act of 1934 and the 1940 Act in connection with Regulation BI, registered broker-dealers and registered investment advisers will be required to deliver a relationship summary to retail investors. This summary is Form CRS.

Form CRS will require a firm to provide information about the relationships and services the firm offers to retail investors, fees and costs that retail investors will pay, specified conflicts of interest and standards of conduct, and disciplinary history.

One FAQ addresses a question I had regarding pooled funds:

Q: My firm is an investment adviser to pooled investment vehicles, such as a hedge funds, private equity funds and venture capital funds.  The investors in these funds include natural persons who may be “retail investors” as defined in Form CRS. Am I required to deliver a relationship summary to these funds?

A:  An investment adviser must initially deliver a relationship summary to each retail investor before or at the time the adviser enters into an investment advisory contract with the retail investor.  “Retail investor” is defined as “a natural person, or the legal representative of such natural person, who seeks to receive or receives services primarily for personal, family or household purposes.” In the staff’s view, the types of pooled investment vehicles described above would not meet this definition and a relationship summary would not be required to be delivered.

So, the manager doesn’t have to deliver a Form CRS to the fund itself. It’s less clear if you have to deliver it to the “retail investors” in the fund. Does Rule 206(4)-8 pass the Form CRS requirement through the pooled investment vehicle?

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Boards Must Rigourously Exercise Their Oversight Function

“[T]o satisfy their duty of loyalty, directors must make a good faith effort to implement an oversight system and then monitor it.”

Marchand v. Barnhill, 212 A.3d 805 (Del. 2019)

Clovis Oncology’s stock dropped sharply in 2015 when it disclosed poor clinical trial results for Rociletinib a promising experimental drug for the treatment of lung cancer. That meant the FDA was unlikely to approve Rociletinib to enter the market. Shareholder lawsuits ensued. The claim was that board breached its fiduciary duties by disregarding red flags that reports of the drug’s performance in clinical trials were inflated.

Delaware’s Caremark line of cases impose a responsibility on corporate boards to have a compliance program, but with a great deal of discretion to design it for the corporation’s context, industry, and resources. However, that compliance obligation is heightened when the corporation operates in an area of mission-critical regulatory compliance risk.

In the recent decision of In re Clovis Oncology, Inc. Derivative Litigation, the court highlighted the two components required of corporate compliance. First, you have to have an oversight system in place. Second, you have to monitor the oversight system. In area of mission-critical regulatory compliance, board oversight responsibility is heightened.

If you fail to do either, the corporation risks fiduciary litigation when bad news comes out.

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SEC Is Not Happy With How Firms Are Handling Principal Trading and Agency Cross Trading

The SEC’s Office of Compliance Inspections and Examinations issued a Risk Alert describing failures by investment advisers to comply with regulatory requirements when engaging in principal and agency-cross transactions.  OCIE found that many advisers did not even recognize that they were engaging in (1) a principal transaction by buying or selling to a client or (2) an agency cross transaction when the adviser is acting as a broker for other than the client. 

Advisers Act Section 206(3) makes it unlawful for any investment adviser, directly or indirectly, acting as principal for his own account knowingly to (a) sell any security to a client or (b) purchase any security from a client (“principal trades”), without disclosing to such client in writing before the completion of such transaction the capacity in which the adviser is acting and obtaining the consent of the client to such transaction. Section 206(3) requires an adviser entering into a principal trade with a client to satisfy these disclosure and consent requirements on a transaction-by-transaction basis. Blanket disclosure and consent are not permitted.

Two of the items mentioned related to private funds. Advisers that effected trades between advisory clients and an affiliated pooled investment vehicle, but failed to recognize that the advisers’ significant ownership interests in the pooled investment vehicle would cause the transaction to be subject to Section 206(3).

Staff in the Division of Investment Management has stated its view that Section 206(3) does not apply to a transaction between a client account and a pooled investment vehicle of which the investment adviser and/or its controlling persons, in the aggregate, own 25% or less. If the adviser owns more than 25% of the fund, it’s likely considered to a “principal” of the adviser under 206(3)

Second, OCIE noted advisers that effected principal trades between themselves and pooled investment vehicle clients, but did not obtain effective consent from the pooled investment vehicle prior to completing the transactions. The SEC has brought charges against an adviser to a pooled investment vehicle failed to obtain effective consent to principal trades because the review committee established by the adviser to approve the pricing of the trades in an attempt to satisfy the requirements of Section 206(3) was itself conflicted.

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Blame It On the Junior Compliance Associate

“The compliance associate had no trading experience and no formal training to conduct the review required by the rule, such as training related to the analysis of financial statements and other information.”

Rule 15c2-11 of the Exchange Act requires broker-dealers to obtain, review and maintain information about the issuer before initiating or resuming the publication or submission of a quotation for an OTC and non-exchange listed security. The broker-dealer must have a reasonable basis for believing that the information it has obtained is accurate and reliable. FINRA Rule 6432 requires a broker-dealer to demonstrate compliance with Rule 15c2-11 by filing the Form 211, reviewed and signed by a principal of the firm.

Canaccord Genuity LLC had written policies and procedures that said the right things about complying with those rules.

In practice, it failed to follow its written policies and procedures and violated the rules, according to the SEC order.

Canaccord put one of its compliance associates in charge of the process and have the associate the responsibility to obtain and review the information required by Rule 15c2- 11. The associate fill out the Form 211s and placed the electronic signature of the designated principal on the filings. The Rule 15c2-11 files were stuck in a compliance filing cabinet and could not be independently accessed by the traders or the firm’s designated principal without requesting them from the compliance department.

Of course, this case caught my attention because the headlines implicated compliance as part of the problem. The SEC order did not impose a separate penalty on the compliance associate. The associate, as you read in the opening paragraph, was not qualified to conduct the review.

The unanswered question is whether the compliance associate knew the policy and knew that he or she was violating the policy?

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The Stop Wall Street Looting Act of 2019

United States Senators Elizabeth Warren (D-Mass.), Tammy Baldwin (D-Wisc.), and Sherrod Brown (D-Ohio), Ranking Member of the Senate Banking Committee, along with Representatives Mark Pocan (D-Wisc.), and Pramila Jayapal (D-Wash.) unveiled the Stop Wall Street Looting Act last week. I don’t think there is any chance it will become law. But it will create talking points and speeches as we continue on what will be an endless election campaign.

I took a few minutes to traipse through the bill to see if anything caught my eye.

Most of the provisions attack “private funds” and the bill uses the same definition of a “private fund” that was added to the Investment Advisers Act by Dodd-Frank:

a company or partnership that (i) would be considered an investment company under Section 3 of the Investment Company Act of 1940 but for the application of paragraph (1) or (7) of subsection (c) of such section 3; …(iii) is not a venture capital fund, as defined in 17 C.F.R. section 275.203(l)-1…

Title I imposes a piercing of the liability shields of private funds by making them jointly and severally liable for all liabilities of portfolio companies, including debt, government fines, WARN Act violations, ERISA withdrawal liability and unfunded pensions.

That doesn’t just stop “looting”; that ends the private fund business. If you can’t isolate liabilities, it makes investing nearly impossible. With the fund manager responsible for the debts of the portfolio companies, the manager will have trouble obtaining third-party capital for the portfolio companies. That capital would have to underwrite not only the target, but also the fund manager and all of its other portfolio companies.

The isolation of corporate liability has been the core of capitalism for a few centuries allowing tremendous growth in technology, manufacturing. It allows you to make riskier bets knowing that only your invested capital is at risk.

The bill relies on that murky definition of “private fund.” I would fear that conglomerate operating companies could get pulled into the definition.

Assuming the private fund business found a way to continue after Title I, Title II stops certain activities labeled as “looting.”

The portfolio company can’t make a capital distribution to the private fund during the first two years after a change in control. Another section bans monitoring fees by imposing a 100% tax on monitoring fees.

Section 204 attacks excessive debt by reducing the ability to deduct interest if the debt to equity ratio for a portfolio company exceeds 1.

Title III imposes greater worker protection and limits executive compensation during bankruptcy, gives greater rights under the WARN Act, and gives priority to gift cards in bankruptcy.

Title IV tries to close the “carried interest loophole.” Of course, it’s not a loophole; it’s a feature of partnership taxation for all types of partnerships and the disparate treatment of ordinary income and capital gains.

In the case of an “investment services partnership interest”, any net capital gain is treated as ordinary income and net capital losses are treated as ordinary losses. The definition of “investment services partnership interest” is broad enough to capture any type of partnership, not just private equity funds, but also real estate funds, hedge funds and venture capital funds. It’s probably broad enough to beyond that as well.

Title V creates a whole new disclosure regime for private funds. Here are some of the disclosure highlights:

  • names of each limited partner in the fund
  • debt held by the fund
  • Gross performance
  • Performance net of fees
  • Income statement
  • balance sheet
  • cash flow statements
  • Total amount of debt of each portfolio company
  • Disclosure of all fees paid to the fund manager

All of that information would be publicly available.

It’s obvious that the bill’s proponent are lumping all private funds into the category of highly leveraged buyout firms. There is a broad spectrum of funds with different investing styles, different levels, different uses of debt and different fee structures. In my view, this bill would kill the entire private fund industry.

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Looking Ahead to Regulatory Changes

The Securities and Exchange Commission published its Reg Flex Agenda for the Spring of 2019. This gives us some insight to what regulatory changes are in the works. Three items caught my eye as likely to apply to private funds.

Harmonization of Exempt Offerings. Chairman Clayton had previously noted that the regulations around exempt offerings is a mess.

The Division is considering recommending that the Commission seek public comment on ways to harmonize and streamline the Commission’s rules for exempt offerings in order to enhance their clarity and ease of use.

Amendments to the Custody Rules for Investment Companies and Investment Advisers . The Custody Rule is full of footfaults. Most CCOs I’ve talked to have run into problems trying to figure out how the Rule applies to some particular circumstance. The abstract does not provide much insight into what aspect of the Rule is being discussed.

The Division is considering recommending that the Commission propose amendments to rules concerning custody under the Investment Company Act of 1940 and the Investment Advisers Act of 1940.

Amendments to the Marketing Rules Under the Advisers Act. Changes to the marketing regulations have been mentioned by the Commissioners several times. The regulations are well out of date from the age of digital communication. Plus, there is well of practice and unofficial law buried in No-action letters. It sounds like there is a lot of support to formalize that unofficial through a formal rulemaking.

The Division is considering recommending that the Commission propose amendments to rules 206(4)-1 and 206(4)-3 under the Investment Advisers Act of 1940 regarding marketing communications and practices by investment advisers.

These are merely items the Commission are working on or thinking about for regulatory action. It will take a consensus of the Commissioners to agree to start the rulemaking and agree to language. That may not happen. But at least they are thinking about them.

PMC 2019
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Failed Algorithms

Isaac Asimov’s Three Laws of Robotics, designed to prevent robots from harming humans:

  • A robot may not injure a human being or, through inaction, allow a human being to come to harm.
  • A robot must obey the orders given it by human beings except where such orders would conflict with the First Law.
  • A robot must protect its own existence as long as such protection does not conflict with the First or Second Laws.

How does this work when the robot is a financial adviser? The Securities and Exchange Commission brought cases against two robo-advisers.

Wealthfront Advisers is an online robo-adviser that provides software-based portfolio management, including a tax-loss harvesting program for clients’ taxable accounts. The SEC alleged that Wealthfront falsely represented to its clients that the robot would monitor their accounts to avoid transactions that might trigger a wash sale. The SEC alleged that Wealthfront failed to conduct such monitoring. That made Wealthfront’s representations misleading.

In a separate case, the SEC alleged that Hedgeable Inc., a robo-adviser, misleadingly compared its results to performances of other robo-advisers. According to the SEC, Hedgeable calculated its returns based on a small subset of client accounts. Further it miscalculated its competitors’ trading returns by using approximations based on information on the competitors’ websites.

While the headlines sound groundbreaking because they involved robo-advisers, the two rob-adviser actions were human misconduct, not malfunctioning algorithms. Those algorithms were fairly basic.

Samathur Li Kin-kan is suing a robo-adviser for not being as sophisticated as promised. Tyndaris Investments’ K1 supercomputer was supposed to comb through online sources like real-time news and social media to gauge investor sentiment and make predictions on U.S. stock futures. It would then send instructions to a broker to execute trades, adjusting its strategy over time based on what it had learned.

Li is suing Tyndaris for about $23 million for exaggerating what the supercomputer could do.  It managed to lose $20 million in one day. THe loss was due to a failed stop-loss order. Li’s lawyers argue that the order wouldn’t have been triggered if K1 was as sophisticated as Tyndaris led him to believe.

For how, it’s the humans being blamed for robots’ shortcomings.

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DOJ’s New Evaluation of Corporate Compliance Programs

The Justice Department released a refreshed set of guidelines on how prosecutors should evaluate corporate compliance programs.

The Principles of Federal Prosecution of Business Organizations in the United States Attorney’s Manual describe factors that prosecutors should consider in conducting an investigation of a corporate entity, determining whether to bring charges, and negotiating plea or other agreements. One of these factors is “the existence and effectiveness of the corporation’s pre-existing compliance program” and the corporation’s remedial efforts “to implement an effective corporate compliance program or to improve an existing one.” The Guidelines are meant to assist prosecutors in making informed decisions as to whether, and to what extent, the corporation’s compliance program was effective.

For those of us involved in compliance for high-regulated companies in finance, I take the guidance with a word of caution. Regulators are the first line of compliance program creation. If you screw up badly, they pull in the agency’s lawyers. It’s only when you end up in the super serious list, like criminal charges, that you end up with the Department of Justice where these Guidelines are operative.

So what has changed in the Guidelines document?

It’s bigger. The original guidance was only four pages. The new guidance blossoms up to 19 pages.

It’s written for non-compliance people. The previous guidelines were written more like a checklist for those with a compliance background. I heard the new guidelines were released in a training session for DOJ attorneys. I guess it will be the front-line prosecutors using these guidelines to help in their decision-making process.

I need to take a deeper dive into the guidelines. More to come.

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