Category: Compliance Programs

SEC Says “NO” to Cryptocurrency ETFs and Mutual Funds

When Bitcoin was rapidly increasing in value, there were lots of people looking to invest in that space. The SEC has repeatedly raised concerns about fund sponsors creating a fund or ETF focused on cryptocurrency. In a letter to the Investment Company Institute and Securities Industry and Financial Markets Association, the SEC said don’t even think about it.

Actually, it said you can think about it, but what about all of these issues. These issues are very compliance-related so I thought it was interesting to look at these compliance issues in light of this new asset class.

Valuation

Proper value of a fund assets is critical. For Bitcoin and various crypto-currencies there are multiple exchanges that are often far apart in the exchange rate. Bitcoin itself has little ascertainable value. Few merchants accept it as payment and few holders are willing to part with it, instead holding it as an investment. The value is determined as other currencies, based on the exchange rate into dollars. That exchange rate can vary significantly from provider to provider.

The SEC lays out out a long list of questions that would have to be addressed in a valuation policy.

Custody

This is the big problem. Most of the successful hacking of crypto-currency has been a a hack into the depositories/wallets that hold the crypto-currency. Investment advisers have regualtory custody requirements and ’40 Act funds have a stricter set of rules.

The SEC points out that it is not aware of any custodian providing custodial services for crypto-currencies.

The problem with custody is that you have to have the private crypto key as well as the record in the blockchain.

Arbitrage

For ETFs that trade during the day, you have problems with differing price movement at the different exchanges for crypto-currencies.

Market Manipulation

As I pointed out yesterday, cypto-currencies seem to targets for market manipulation. That also means that any derivatives from the crypto-currencies are also subject to market manipulation.

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Disclosing Private Fund Expenses to Investors – You Can’t Fix it With Form ADV

Private Fund CCOs have been focused on the disclosure and reporting of fund expenses for years. The Securities and Exchange Commission made it a centerpiece of exams of private fund managers. A handful of cases came out in 2015-2016 on that first wave of private equity fund manager exams:

  • Blackstone failed to fully inform investors about benefits it received from accelerated monitoring fees.
  • Apollo failed to adequately disclose the acceleration of monitoring fees upon the sale or initial public offering of portfolio companies.
  • WL Ross failed to disclose to funds and their investors certain fee allocation practices that resulted in the funds paying the manager approximately additional, undisclosed management fees.
  • First Reserve failed to disclose conflicts of interest related to fees and expenses charged to funds under its management, and other undisclosed benefits.

Last month, TPG Capital was the latest firm to fall under the wrath of the SEC for what the SEC decided was inadequate disclosure on fees. The focus was on acceleration of portfolio company monitoring fees.  The SEC has stated that it does not like these fees unless they are fully disclosed.

TPG charges each of its portfolio companies an annual fee in exchange for rendering a consulting and advisory services. These monitoring fees paid by each Portfolio Company to TPG are in addition to the annual management fee paid by the Funds’ limited partners to TPG. However, a certain percentage of the monitoring fees are used to offset a portion of the annual management fees that the Funds’ limited partners would otherwise pay to TPG. The standard agreement for the monitoring fee was for 10 years, with full acceleration on the sale of the company.

The SEC acknowledge that TPG disclosed its ability to collect monitoring fees to the Funds’ limited partners prior to their commitment of capital, it did not disclose its receipt of accelerated monitoring fees in the PPMs and LPAs. TPG did make fee disclosures LPAC reports, portfolio company Form S-1 filings, and TPG’s Form ADV. But the SEC took the position that by the time these disclosures were made, the limited partners had already committed capital to the Funds.

One point that had been rolling around compliance circles was how to remedy fund documents for legacy funds that did provide the level of detail on fees and expenses that the SEC now seems to require. One method was to make the disclosure in the ADV Part 2 Brochure. This case seems to blow-up that tactic.

Regardless, it would seem as a result of this action, TPG’s Form ADV Part 2 Brochure has one of the lengthiest and most detailed fee disclosure I have seen.

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The 7-11 Compliance Conondrum

Immigration and citizenship employee compliance requirements are fairly straightforward, although awkward. You can’t usually ask whether or not a job applicant is a United States citizen before making an offer of employment. But you do need to verify the identity and employment eligibility of all employees, by completing the Employment Eligibility Verification (I-9) Form, and reviewing documents showing the employee’s identity and employment authorization. Then you need to hold onto the I-9 while the person is employed.

U.S. Immigration and Customs Enforcement agents targeted nearly 100 of 7-Eleven stores in 17 states before dawn Wednesday to deliver audit notifications of their I-9 paperwork. In the process, it made 21 arrests of employees on suspicion of being in the U.S. illegally.

But why 7-11?

A press release from 7-11 HQ pointed out:

“7-Eleven Franchisees are independent business owners and are solely responsible for their employees including deciding who to hire and verifying their eligibility to work in the United States.”

So effectively, ICE deployed hundreds of agents at almost 100 locations at what are essentially each a separate business. I would guess that each location employs a few dozen employees at the most. That seems like a huge deployment of resources for a small amount of potential targets.

I suppose this does send a message to franchisees and franchisors of all industries to make sure they follow the I-9 requirements because ICE is willing to dedicate a ludicrous amount of resources to make a statement.

ICE indicated that this sweep was a “follow-up” of a 2013 ICE action that resulted in the arrests of nine 7-Eleven franchise owners and managers in New York and Virginia on charges of employing undocumented workers. That was one of the largest criminal immigrant employment investigations ever conducted.

Meanwhile the Office Inspector General released a report the raised concerns about ICE detainee treatment and care at detention facilities and ICE’s Screening Protocol of Aliens Who May Be Known or Suspected Terrorists is Limited and Risks National Security.

It still looks a huge of amount of resources deployed against the 7-11 franchises. In contrast, ICE raided an Iowa meatpacking plant in 2008 and detained nearly 400 undocumented workers. That plant owner, Sholom Rubashkin, recently had his prison sentence commuted by President Trump.

You can look at the 7-11 raid as a follow-up to a prior action.

“Today’s actions send a strong message to U.S. businesses that hire and employ an illegal workforce: ICE will enforce the law, and if you are found to be breaking the law, you will be held accountable,” said Thomas D. Homan, ICE Deputy Director and Senior Official Performing the Duties of the Director. “Businesses that hire illegal workers are a pull factor for illegal immigration and we are working hard to remove this magnet. ICE will continue its efforts to protect jobs for American workers by eliminating unfair competitive advantages for companies that exploit illegal immigration.” –  ICE Deputy Director Thomas D. Homan

So according to ICE statement, 7-11 draws illegal immigrants into the US and those illegal workers are taking away jobs from Americans who want to work at 7-11.

For those in compliance like me, our job is not to question the wisdom of the rule, but make sure our companies are following the rule. That means running the I-9 process and keeping the paperwork to avoid an ICE raid.

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Start Your Compliance Year Right

After a long weekend, and perhaps a vacation, compliance professionals are coming back into the office with 2018 on the calendar. It’s a clean slate. The possibilities are endless.

Where to start?

I don’t have the answer. There is so much to get done and so many challenges ahead.

No organization has has the same risks, regulatory requirements, or challenges as any other organization. It would be foolish for me to tell you where to start the year.

I can give the simple advice to start. I’m sure you have plenty of things left from 2017 that need to be completed on top of all the other things coming down the pipeline. Start doing something. Get it done and move on to the next. Repeat as necessary.

Compliance is different things to different people, to different organizations, and to different regulators.

But getting something done is always a good step.

So go get something done today.

SEC’s Regulatory Agenda

A few months ago, Securities and Exchange Commission Chairman Jay Clayton stated that the SEC had been hard at work on developing its rule-making agenda for the upcoming year.

In the coming weeks and months, I expect the SEC’s near-term rulemaking objectives to be fully reflected in our upcoming Regulatory Flexibility Act Agenda. As a general matter, I believe it is important that these publicly available agendas provide the necessary transparency and accountability for agency matters. If these plans are to meet their intended purpose, they must be streamlined to inform Congress, investors, issuers and other interested parties about what the SEC actually intends – and realistically expects – to accomplish over the coming year.

The SEC released its Regulatory Flexibility Act Agenda for 2017 and grouped the agenda into two categories: Proposed Rules and Final Rules and Long Term Actions.

The “Existing Proposed & Final Rule Stages” are rule-makings the the SEC intends to address during 2017. For those rule-makings that have progressed to some extent, there is a prediction as to when a final rule might occur. The “Long-Term Actions” rule-makings are supposedly that the SEC isn’t likely to tackle in the near term.

In going though the proposed rules and final rules, I didn’t see much that would directly affect private funds.

I did see that the dreaded proposed changes to Form D and private placements is not on the agenda and was formally withdrawn in September.

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Compliance Lessons from Star Wars – Man Versus Machine

With the release of Episode VIII – The Last Jedi, I’m joining Tom Fox in tying compliance and the Star Wars franchise together in some posts this week. (I saw the movie last night, but I will refrain from revealing anything other than it was terrific.) One of the central themes of the Star Wars franchise is man versus machine.

Luke turns off his targeting computer and relies on the Force during his photon torpedo run on the Death Star. Obi Wan Kenobi describes Darth Vader as more man than machine. It’s primitive Ewoks that crush the technology driven imperial forces at the Battle of Endor. It is when Vader once again finds his humanity that he lives up to the prophecy as the one that will bring balance to the Force.

The Star Wars does not say that technology is bad. How could that be with the beloved R2-D2 and C-3PO, the only characters to appear in all of the movies. In the prequels, it is the rise of robot army that leads to the deployment of the clone troopers and the beginning of the Empire.

Compliance professionals are trying to deal with its own robot uprising: robo-advisers. How to do you regulate a robot or an algorithm that goes bad? How do you create a compliance program from preventing them from going bad? (For a good book on the dangers of algorithms and big data, add Weapons of Math Destruction to your reading list.)

The Securities and Exchange Commission brought an action against AXA Rosenberg in 2011 for a failure in the computer code for its investment model. The SEC did not bring charges against the computer for the fault in the program. It brought it against the people who controlled the model. In this case, it was the fund managers who hid the problem. The computer had done what it was told and it was told to do the wrong thing.

Earlier this year, the SEC released guidance on Robo Advisers.

Robo-advisers, like all registered investment advisers, are subject to the substantive and fiduciary obligations of the Investment Advisers Act. This presents some complications and uncertainties under the Act. Robo-advisers rely on algorithms and likely offers little, if any, human interaction with their advisory clients. The SEC guidance focused on three distinct areas identified by the SEC, with suggestions on how robo-advisers may address them:

1. The substance and presentation of disclosures to clients about the robo-adviser and the investment advisory services it offers;
2. The obligation to obtain information from clients to support the robo-adviser’s duty to provide suitable advice; and
3. The adoption and implementation of effective compliance programs reasonably designed to address particular concerns relevant to providing automated advice.

Can a robo-adviser even meet the duty of care under the Investment Advisers Act? It’s clear what that duty of care is or how personalized the service needs to be. The biggest element is conflicts of interest. As with most conflicts, they can be dealt with by disclosures and robust policies and procedures.

Even with the concerns, robo-advisers are rising in assets under management. They are providing a good service at a low cost, allowing humans to oversee the process. Robots are helping humans succeed.

Improperly Allocating Broken Deal Expenses

The Securities and Exchange Commission has been looking at fees and expenses at private equity funds for several years. Two years ago it brought a case against Kohlberg Kravis Roberts & Co. for misallocating more than $17 million in “broken deal” expenses to its private equity funds. An SEC investigation found that from 2006 to 2011, KKR incurred $338 million in broken deal or diligence expenses.  Even though KKR’s co-investors, including KKR executives, participated in the firm’s successful transactions efforts, KKR largely did not allocate any portion of these broken deal expenses to them.

The SEC just brought a similar case against Platinum Equity. According to the SEC’s order, from 2004 to 2015, Platinum’s funds invested in 85 companies, in which co-investors connected with Platinum also invested. Platinum incurred broken deal expenses that were paid by the funds. While the co-investors participated in Platinum’s successful transactions and benefited from Platinum’s sourcing of the transactions, Platinum did not allocate any of the broken deal expenses to the co-investors.

Platinum did not have a standing co-investment vehicle. Platinum used a separate investment vehicle to co-invest in each transaction. While there was some overlap in the co-investors from deal to deal (officers, directors, executives, and employees of Platinum), the co-Investors varied from transaction to transaction. The co-investment vehicles required payments of a pro-rata share of expenses related to the investment. There was no arrangement for Platinum to charge co-investors for broken deal expenses.

It’s tough to address the broken deal expenses for co-investments. There is no vehicle to create the contractual obligation for reimbursement. Of course, it is not right for the fund investors to bear all of the costs if the fund manager is having so many co-investments.

At least it’s not right if it’s not disclosed in the fund documents. That is what the SEC pointed out in the order. The allocation of the broken deal expenses to the fund was not disclosed in the fund documents. That could be fixed by stating that the fund pays for the broken deal expenses even when there are co-investors. Assuming you can get investors to agree to that.

This is also the first case I have noticed that the SEC has self-imposed the Kokesh limitation on disgorgement. The Kokesh case said the the SEC’s power of disgorgement was limited to going back five years. Even though Platinum was improperly allocating expenses back to 2004, the disgorgement only goes back five years to 2012.

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World Champions

Peter Sagan, for an historic third time in a row, earned the rainbow stripes of men’s road cycling world champion. And Chantal Blaak earned the rainbow stripes of women’s road cycling world champion. Over the weekend they competed on a thrilling course in Bergen, Norway. Salmon Hill, only 10 kilometers from the finish, splintered the peloton of leading riders, leaving only the best of the best for the run into the finish line.

Peter Sagan, beat Alexander Kristoff at the finish line by half of a wheel length after 267 kilometers of racing, with Michael Matthews coming in third. These are not the names you hear as the winners of the grand tours: the Tour de France, the Vuelta de Espana or the Giro d’Italia. Those three week stage races are very different than the one day races like the world championship. They are on bikes, but the racing involves different skills.

The same is true about compliance across firms and industries. There are similar concepts and similar goals. But the execution and implementation of the compliance program will be different. There are different regulatory requirements. There are different risks.

Can you be successful in compliance across different industries and firms? Of course.

Just as a bike race involves a bike. You can get to the finish line.

The One With the Scalping

An investment adviser should not buy positions on their own behalf shortly before recommending that position to its clients. Nor should the adviser make recommendations to buy when the adviser is selling in the adviser’s personal accounts. Mark A. Gomes was doing just that.

The test case came against Capital Gains Research Bureau. The firm produced a monthly newsletter recommending securities. In 1960 the firm purchased securities before recommending them in its report for long-term investment. On each occasion, there was an increase in the market price and the volume of trading of the recommended security within a few days after the distribution of the Report. Immediately thereafter, the firm sold its position at a profit.

As you might expect, it’s the internet that has replaced the monthly newsletter. “Stock analysts” are making claims on SeekingAlpha, Twitter, and other websites.

Mr. Gomes distributed his recommendations through his own website and a third party website. He had a premium subscription that gave subscribers more access. He never disclosed that he held positions in some of the stocks he was discussing.

On at least five occasions between February 2014 and July 2014, (1) Gomes purchased shares in a stock (2) recommended buying that stock, and then (3) sold shares in his personal accounts within days of his recommendation. In at least one instance, Gomes began selling shares only a few hours after posting his recommendation.

By recommending investments, but failing to disclose that he would trade in the opposite direction of his recommendations, Gomes omitted material information necessary in order to make his recommendations not misleading. A reasonable investor would consider Gomes’s intention to sell his shares as an important factor in assessing the objectivity and credibility of his descriptions.

I did find it interesting that the complaint skipped over the fact that Mr. Gomes was not registered as an investment adviser. According to Section 202(a)(11):

‘‘Investment adviser’’ means any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities;…”

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