Category: Compliance Programs

It is generally bad to have one client trade with another client. Rule 206(3)-2 imposes some very specific requirements and leaves you with a final twist:

This rule shall not be construed as relieving in any way the investment adviser or another person relying on this rule from acting in the best interests of the advisory client, including fulfilling the duty with respect to the best price and execution for the particular transaction for the advisory client ….

The problem is especially enhanced when cross-trade involves illiquid, hard-to-value assets, like complex securities or real estate. Mortgage loans fall into that category. As the investment matures, you find out if the underwritten price was good or bad. One side is likely to make out better than the other.

Talimco added to the problem by acting in bad faith during the cross-trade.

According to the Securities and Exchange Commission charges against Talimco LLC and its former chief operating officer, Grant Gardner Rogers, they manipulated the auction of a commercial real estate mortgage asset on behalf of one client for the benefit of another in a cross-trade. 

Talimco was the collateral manager for a collateralized debt obligation client on one hand and a commercial real estate investment fund on the other hand.  The CDO had a defaulted mortgage loan participation that it was trying to sell.

As an investment adviser, Talimco owed a general fiduciary duty to the CDO. In addition, the CDO governing documents required Talimco to dispose of the assets in a competitive auction with at least three bids.

The real estate fund wanted the investment at a certain price, so Rogers rigged the auction. Rogers convinced two unwilling bidders to participate in the auction by giving assurances that the bidders would not win the auction.  As a result of this manipulation, Talimco’s real estate fund client was the highest bidder and acquired the asset.

To prove the problem with cross-trade, the real estate fund ended up selling the interest for a substantial profit and the CDO ended up underwater.  It was going to be a good enough investment that Rogers committed an additional $1 million to the fund during the acquisition. That may have been coincidence, but it looks bad.

Not as bad as the written messages about the rigged auction disclosed in the SEC order: 

I get it, for you guys and other people that we’ve talked to it’s like, you know it’s not that attractive. It’s small, it’s a non-controlling participation. But, you know, in order to, for us to purchase this, we need like, we need a bid from three different market makers …. And look, I won’t hit you on this, but I need a bid for it.

“By rigging the auction, Talimco and Rogers failed to fulfill their fiduciary duty to their client,” said Daniel Michael, Chief of the SEC Enforcement Division’s Complex Financial Instruments Unit.  “Investment adviser firms are expected to have controls in place to detect and disclose conflicts of interest.  This action evidences the vigilance of the SEC’s exam and enforcement staff in identifying investments advisers that exploit client relationships and harm investors.”

Notably, the case started with an examination by the Private Funds Unit, who handed the investigation over to the Complex Financial Instruments Unit and the New York Regional Office. 

Sources:

• SEC Charges Registered Investment Adviser and Former Chief Operating Officer With Defrauding Client
• SEC Order – Talimco
• SEC Order – Rogers
• SEC Scrutinizes Sale of Mortgage Interests Among Affiliated Funds by Ropes & Gray

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

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Listing Gaps, Merger Waves, and the Privatization of U.S. Equity Finance by Gabriele Lattanzio, William L. Megginson and Ali Sanati in The CLS Blue Sky Blog

The number of U.S. listed companies declined by almost half between 1996 and 2012, from 8,090 to 4,102, and had risen only slightly, to 4,336, by year-end 2017. However, the real market valuation of these listed companies tripled over the same period, from $10.2 trillion in 1996 to $32.1 trillion in 2017[1], implying that the average market valuation of a U.S. listed firm has increased six-fold over the past two decades. In other words, the U.S. public stock market has become populated exclusively by behemoths. Over the same period, the U.S. has experienced historically high levels of merger and acquisitions (M&A) activity and private investments of equity. We show that a new model of equity finance has emerged in the United States over the past quarter-century, which differs significantly from both late-20^th century norms and the equity model observed in other advanced economies.

http://clsbluesky.law.columbia.edu/2019/03/11/listing-gaps-merger-waves-and-the-privatization-of-u-s-equity-finance/

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What is ‘Compliance Training,’ Anyway? A Simple Explanation of What it is—and isn’t. by Ricardo Pellafone in SCCE’s The Compliance & Ethics Blog

In one sentence, compliance training is (1) a tool (2) that you use to drive behavior (3) of willing people (4) by helping them make decisions.

http://complianceandethics.org/what-is-compliance-training-anyway-a-simple-explanation-of-what-it-is-and-isnt/

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Fidelity’s new cryptocurrency company is up and running despite a bear market for digital coins by Kate Rooney in CNBC

Fidelity Digital Assets, a new company created by the investing giant last year, has quietly rolled out its cryptocurrency custody and trade execution operations. In the past few months it has been up and running with institutional investors like hedge funds and family offices, according to its top executive.

https://www.cnbc.com/2019/03/08/fidelitys-new-cryptocurrency-company-is-up-and-running-despite-a-bear-market-for-digital-coins.html

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The Economic Growth, Regulatory Relief, and Consumer Protection Act, enacted on May 24, 2018, amended the Bank Holding Company Act by modifying the definition of “banking entity” to exclude certain small banks from the Volcker Rule’s restrictions and permitting a banking entity to share a name with a hedge fund or private equity fund that it organizes and offers under certain circumstances.

The Volcker Rule had provided that a banking entity, including an investment adviser, that organized and offered a hedge fund or private equity fund, could not share the same name or a variation of the same name with the fund. Section 204 of the Economic Growth, Regulatory Relief, and Consumer Protection Act amended the Volcker Rule to permit a hedge fund or private equity fund organized and offered by a banking entity to share the same name or a variation of the same name as a banking entity that is an investment adviser to the hedge fund or private equity fund, if:

• the investment adviser is not an insured depository institution, a company that controls an insured depository institution, or a company that is treated as a bank holding company
• the investment adviser does not share the same name or a variation of the same name with any such entities; and
• the name does not contain the word “bank.”

The SEC, CFTC, FDIC, Federal Reserve and the Treasury submitted a joint proposed regulation that does just what the law did in allowing the name-sharing. The agencies managed to publish the regulation just before the government shutdown.

Sources:

• Happy New Year: Proposed Volcker Rule Regulation Would Ease Hedge Fund and Private Equity Fund Name-Sharing Restrictions
• Proposed Revisions to Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds

As a New England Patriots Fan from the 1970s, it’s hard to imagine the current success of the franchise. The stadium was one of the worst in the NFL. Home games were rarely televised because the games didn’t sell out.

When the Patriots finally made it to the Super Bowl they lost in the most lopsided championship game up until the time. The team fell back to mediocrity, at best.

It took new ownership to change the franchise. Ownership put the right pieces in place and invested for the success of the franchise. That’s the same model of success for an organization and a compliance program.

Congratulations to Robert Kraft and the entire Patriots organization for becoming the most successful football franchise.

Perhaps the Securities and Exchange Commission saw the government shutdown coming when it published its 2019 exam priorities on December 20.

1. Compliance and Risks in Critical Market Infrastructure – Examiners will focus on entities that provide services critical to the proper functioning of capital markets, including clearing agencies, national securities exchanges, and transfer agents
2. FINRA and MSRB – The SEC will examine on FINRA’s operations and regulatory programs and the quality of FINRA’s examinations of broker-dealers and municipal advisors and MSRB’s effectiveness of select operations and internal policies, procedures, and controls for municipal advisers.
3. Digital Assets – The SEC is focused on the risks of Bitcoin and other cryptocurrency to retail investors for fraud and violations of securities laws.
4. Retail Investors– As has been the case for the past few years, examiners will focus on protecting Main Street investors. Examinations will likely include the disclosure and calculation of fees, expenses, and other charges retail investors pay, the supervision of representatives selling products and services to investors, broker-dealers entrusted with customer assets, and portfolio management and trading.
5. Cybersecurity – Each examination program will prioritize cybersecurity with an emphasis on proper configuration of network storage devices, information security governance, and policies and procedures related to retail trading and information security.
6. Anti-Money Laundering Programs – Examiners will review applicable anti-money laundering requirements, including whether firms are appropriately adapting their AML programs to address their regulatory obligations.

For private funds, there is not much on the list that should catch the attention of compliance professionals.

For retail investors, the SEC often points out that pension funds are conduits for retail investors. That means private funds with pension fund investors are not outside the scope of these exam priorities. The emphasis seems to be towards never been examined advisers in the retail space.

Many advisers and fund managers have been running robust anti-money laundering programs even though there is no specific requirement to have one in place. The anti-money laundering item in the priorities goes on to state that it is focused on broker-dealer compliance with anti-money laundering requirements.

Sources:

• SEC Office of Compliance Inspections and Examinations Announces 2019 Examination Priorities
• 2019 Exam Priorities

Stan Lee, the legendary writer and publisher of Marvel comics who helped created countless superheroes, has died. He was 95. On his own and through his work with collaborators Jack Kirby, Steve Ditko, Bill Everett. and others, Mr. Lee created Spider-Man, the X-Men, the Mighty Thor, Black Panther, Iron Man, the Fantastic Four, the Incredible Hulk, Daredevil and Ant-Man and many other comic book heroes.

His catchphrase of “Excelsior!” means ever upward.

I’m looking for the Latin translation of “ever more compliant!”

The Securities and Exchange Commission brought an action against SeaWorld Entertainment Inc. and its former CEO. They agreed to pay more than $5 million to settle fraud charges for misleading investors about the impact the documentary film Blackfish had on the company’s reputation and business. SeaWorld’s former vice president of communications also agreed to settle a fraud charge for his role in misleading SeaWorld’s investors.

The Blackfish movie sharply criticized SeaWorld’s treatment of its featured attraction: orcas. These huge, smart marine mammals were the main attraction at SeaWorld and central to the SeaWorld’s marketing.

I went to the San Diego SeaWorld a decade ago because whales were one of my son’s favorite subjects. The orca show was his favorite part of the trip. (Other than the two-foot long dolphin plushie I was lured into buying at my son’s insistence.)

The problem is that SeaWorld ignored the effects of Blackfish in its shareholder reporting.

The movie caused significant media attention on orcas in captivity as the film became widely distributed in 2013. The SEC’s complaint alleges that from approximately December 2013 through August 2014, SeaWorld and former CEO James Atchison made untrue and misleading statements or omissions in SEC filings, earnings releases and calls, and other statements to the press regarding Blackfish’s impact on the company’s reputation and business.

On Aug. 13, 2014, SeaWorld finally acknowledged in shareholder communication that its declining attendance was partially caused by negative publicity, and SeaWorld’s stock price fell by 33%. The SEC charges that SeaWorld should have said something sooner.

“This case underscores the need for a company to provide investors with timely and accurate information that has an adverse impact on its business. SeaWorld described its reputation as one of its ‘most important assets,’ but it failed to evaluate and disclose the adverse impact Blackfish had on its business in a timely manner.” – Steven Peikin, Co-Director of the SEC Enforcement Division.

In August 2013, SeaWorld noticed a drop in attendance. SeaWorld denied there was a link between the movie and the drop in attendance.

In September 2013, SeaWorld conducted a reputation study and found that its reputation had fallen by 12.8% from the proper year. That study also showed that those who were aware of the Blackfish movie had 32% less favorable opinions. Things got worse and worse.

It seems clear that SeaWorld took too long to disclose the Blackfish effect. What’s missing is when SeaWorld should have stated the connection.

One piece of the complaint that rubs me the wrong way is the SEC’s continued war on the use of “may.”

SeaWorld filed an S-1 in March 2014. It said:

Our brands and our reputation are among our most important assets. Our
ability to attract and retain customers depends, in part, upon the external
perceptions of the Company, the quality of our theme parks and services and our
corporate and management integrity. . . . An accident or an injury at any of our
theme parks . . . that receives media attention, is the topic of a book, film,
documentary or is otherwise the subject of public discussions, may harm our
brands or reputation, cause a loss of consumer confidence in the Company,
reduce attendance at our theme parks and negatively impact our results of
operations.

The SEC complaint says: By couching the reputation and business impacts as hypothetical events that “may” occur, SeaWorld made untrue or misleading statements. I’m not sure that “will” is the right word to use there. But the SEC points out that SeaWorld knew that the movie was having a negative impact and should have clarified that “may.”

Sources:

• SeaWorld and Former CEO to Pay More Than $5 Million to Settle Fraud Charges
• SEC Complaint – SeaWorld and Atchison
• SEC Complaint – Jacobs

Since it’s back-to-school day for my community, I thought I would go back to the basics.

The SEC’s Office of Investor Education and Advocacy 2014 Investor Alert identifies potentially fraudulent unregistered offerings with features that indicate a problem. The alert goes through 10 red flags for you to note about private placements.

Private placements are not inherently problematic. Recently, more money has been raised through private placements than through IPOs and secondary offerings.

But scammers are going to use a private placement, where there is no established market for the sale of the investment offering. You don’t have liquidity.

For me, two of the ten really stand out as the most problematic.

1. Claims of High Returns with Little or No Risk

The basics of investing are that you get a better expected return for more expected risk and a lesser expected return for a lesser expected risk. A private placement already has more risk. You don’t have liquidity. There is no market to sell your investment.

If the proposed investment is such a good deal on risk/return basis why are they offering it to you?

5. No Net Worth or Income Requirements 

The federal securities laws generally limit private securities offerings to accredited investors.  Be highly suspicious of anyone who offers you private investment opportunities without asking about your net worth or income.

An individual is considered an accredited investor, if he or she:

(a) earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year,
OR
(b) has a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence or any loans secured by the residence (up to the value of the residence)).

If you’re not an accredited investor, the federal securities laws say that you shouldn’t be allowed in invest in a private placement.

Here are the other eight red flags:

2. Unregistered Investment Professionals
3. Aggressive Sales Tactics
4. Problems with Sales Documents
6. No One Else Seems to be Involved
7. Sham or Virtual Offices
8. Not in Good Standing
9. Unsolicited Investment Offers
10.  Suspicious or Unverifiable Biographies of Managers or Promoters

Sources:

• Investor Alert: 10 Red Flags that an Unregistered Offering May Be a Scam

I read about a new red flag in the Securities and Exchange Commission’s exam process for investment advisers. Examiners are looking for Chief Compliance Officers with web-based email addresses. So, if your CCO uses a gmail, or yahoo.com email address on your Form ADV filing, the SEC will treat that as a red flag.

This comes from a story in IA Watch. According to the story, a senior person in the SEC’s Office of Compliance Inspections and Examinations mentioned the email address as part of the red flags for cybersecurity sweeps.

I would guess the alternate address for a contact on the Form ADV is subject to this same red flag.

Personally, I’m not sure I completely understand why this is a red flag. Some of the web-based email are just as secure as firm-run email server. For smaller shops, it may be even more secure. I feel certain that Gmail has better tech than a small IA shop.

I can see the web-based email as indicator of an outsourced CCO. Of course, the Form ADV now requires a firm to flag that it has an outsourced CCO. Perhaps it’s a red flag to see web-based email and not state that the firm has outsourced CCO. I can also see searches of “compliance” in the email address as another way to potentially find firms that did not state their CCO role was outsourced.

Sources:

• OCIE to launch another cybersecurity sweep exam within a year in IA Watch (subscription required)