Category: Compliance Programs

Affiliated Service Providers and Private Equity

Conflict disclosure and management of the conflicts are central to the Investment Advisers Act. Clients are supposed to come first. That means that conflicts must be disclosed and steps taken to manage the conflict must be put in place. An affiliated service provider is a common conflict.

Centre Partners Management used a service provider for the private equity funds it manages and used it to provide due diligence for potential portfolio investments. The Service Provider provided IT due diligence services with respect to potential portfolio investments for the Funds at a flat fee capped at $25,000 per engagement. Those fees are paid by the funds.

That seems straight forward until you consider that the the Service Provider is owned in part by principals of the firm.

The potential conflict could have been fixed by disclosing the ownership in the fund documents. But Centre Partners did not make that disclosure in the fund PPM or in the Form ADV. It also did not mention the affiliated party payments in the audited financial statements.

The ownership stake was not large. The three principals of Centre Partners only owned 9.6%. But two of them are on the board of directors of the service provider. The founder and majority owner of the service provider is the brother-in-law of one of the principals. (It’s always the brother-in-law that gets you trouble.)

A placement agent for one of the funds raised the conflict during fundraising in 2012. Investors apparently asked about the service provider.

An SEC exam looked at the relationship with the service provider and decided it was worthy of an enforcement action. It cost the firm a $50,000 fine. It also took almost three years to finalize the settlement. The Order states that the exam was completed in early 2014.

There is no statement that the fees paid to the service provider were excessive or above market. That does not matter if the relationship is not disclosed. To fix the problem going forward, the firm added the disclosure to the Form ADV starting in March 2014.

This seems like a good time to check to make sure that none of your fund service providers are owned by employees of the firm.

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CCO Liability for False Statements on Form ADV

Susan Diamond was Chief Compliance Officer of Saddle River Advisors. Now, Ms. Diamond is out of pocket for a $15,000 penalty and is subject to a nine-month suspension from being associated with any investment adviser or other financial services firms. After the suspension, she will be prohibited from acting in the securities industry in certain managerial and compliance capacities.

What did she do?

Diamond, on behalf of Saddle River, prepared, signed, and filed Forms ADV that contained untrue statements.

On its face, the order imposes liability for nothing other than answering questions on Form ADV incorrectly.

In Section 7.B.(1)(B) under the heading, “Service Providers” and the subheading “Auditors.”

Are the private fund’s financial statements subject to an annual audit?    Yes
Are the financial statements prepared in accordance with U.S. GAAP?  Yes
Name of Auditing Firm    SRA Funds’ Tax Preparer
Are the private fund’s audited financial statements distributed to the private fund’s investors?   Yes

None of these responses were true. Saddle River’s financial statements were not audited, prepared in accordance with U.S. GAAP, or distributed to investors. The firm identified as SRA’s “auditing firm” had prepared only tax returns and Forms K-1 for the Saddle River Funds and was never engaged by Saddle River to perform an audit.

BOOM! Diamond’s career is over.

All CCOs now need to be worried that getting a question wrong on the Form ADV will end their careers.

This is a very bad order.

The SEC does not lay out any facts in the order that shows Diamond knew the statements were incorrect. The order merely states that Diamond was in a position to answer the questions because she had signatory power on the fund accounts and made accounting entries in the general ledger.

On its face, the SEC is imposing liability on a CCO solely related to the compliance operations of a CCO. Filing the Form ADV is a core responsibility of the CCO.

The order is a terrible statement by the SEC.

It’s not that Saddle River was free of problems. It’s accused of stealing over $5 million from investors, preying on investors with a claim that it was investing their money in pre-IPO tech companies.

However, in the order against her, the SEC failed to state that Diamond was involved in any of that wrongdoing at Saddle River.

I am not surprised to see CCO liability when the CCO is involved in the wrongdoing. I am surprised to see a CCO facing liability merely on the facts stated in the order against Diamond.

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Conflicts Ahead – What Can We Learn From the Early Days of the Trump Administration

President Trump has come into office as the first president in modern era to own an active business empire. One in which his name is the probably the most valuable asset. Like him or not; voted for him or not; He is the President. As we have seen in the past, scandals limit the ability of the President and Congress to govern.

I’m looking at the issue as way to reflect on things that work and don’t work for a compliance program.

The first step would be to divest from the conflicts. President Trump has already stated that he is not willing to sell the company and liquidate the proceeds into a blind trust. That leaves him with a sprawling business organization that is mostly owned by him, run by his children, and has business relationships around the world.

To be clear, President Trump is not subject to the legislated conflicts of interest laws. He is not required to divest his interests.

I think a majority of the American Public would be concerned if the President’s business interests were realizing direct financial gain from government action.

The other concern is the Emoulments Clause in the Constitution that prevents the President from receiving any “present, Emoulment, Office or Title, of any kind whatever, from and King, Prince, or foreign state.”

Within that framework, how do you establish a compliance program?

The first is the tone at the top.

President Trump has agreed to establish a compliance program. But he seems to have dismissed the concerns about conflicts:

“I have a no-conflict situation because I’m president, which is — I didn’t know about that until about three months ago, but it’s a nice thing to have. But I don’t want to take advantage of something.”

His legal counsel:

“The conflicts of interest laws simply do not apply to the president or the vice president and they are not required to separate themselves from their financial assets.”

But that was saved with:

“He instructed us to take all steps realistically possible to make it clear that he is not exploiting the office of the presidency for his personal benefit.”

There is some tone at the top. I think most compliance officers would cringe at those statements if their CEOs discussed conflicts in that manner.

Next, we would have a clearly articulated compliance program.

The Trump Organization will have an ethics advisor and a compliance counsel. So there is the start of a program.

What we don’t know is how the program is structured, how it will be administered, how it will be tested, or how it will be administered.

As a result, we have the first lawsuit filed. The Citizens for Responsibility and Ethics in Washington (“CREW”) brought the lawsuit to enforce the Emoulments clause. I think its a political ploy that will fail. I think the failure be one of standing and we will never get to the substance. That is left to the impeachment process. We won’t see a Republican Congress do that.

Even if President Trump acts completely ethically with a blind eye to how government action affects his businesses, there is the other side of the transactions.

I’m hard-pressed to believe that foreign governments, business parties and other interests will not treat the relationship more favorably now than they did last year. We have seen the wrath of President Trump on twitter affect stock prices and send businesses scrambling. He is now one of the most powerful people in the world. He wins the business argument even before you get to an argument. He is voted into office with no expectation that he would divest and carrying that conflict baggage.

In my opinion, the Trump compliance program is the most important compliance program in the world. As a compliance professional, I look forward to hearing more about the Trump compliance program so that we can all learn how we can better implement our own program or learn from its mistakes.

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The SEC Really Means It About Pretaliation Severance Agreements

In case you were not clear that the Securities and Exchange Commission is serious about enforcing Rule 21F-17, BlackRock is the latest to run the perp walk. The SEC accused the money management giant of improperly using separation agreements that forced employees to waive their ability to obtain whistleblower awards.

The SEC adopted Rule 21F-17, which provides in relevant part:

(a) No person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement . . . with respect to such communications.

Rule 21F-17 became effective on August 12, 2011.

On October 14, 2011, BlackRock revised its form separation agreement. That agreement did not prohibit former employees from communicating directly with the SEC or any other governmental agency regarding potential violations of law. It did include language requiring a departing employee to waive recovery of incentives for reporting misconduct. Effectively, the agreement removed the financial incentive to be a whistleblower.

Paragraph 5 of BlackRock’s separation agreement in use from October 14, 2011 through March 31, 2016 stated in relevant part:

“To the fullest extent permitted by applicable law, you hereby release and forever discharge, BlackRock, as defined above, from all claims for, and you waive any right to recovery of, incentives for reporting of misconduct, including, without limitation, under the Dodd-Frank Wall Street Reform and Consumer Protection Act and the Sarbanes-Oxley Act of 2002, relating to conduct occurring prior to the date of this Agreement.”

Over 1000 departing employees signed separation agreements with this language. BlackRock revised the agreement in March 2016 to remove that provision. BlackRock also produced a “Global Policy for Reporting Illegal or Unethical Conduct” that it distributed to employees and provides yearly training.

In the end, BlackRock a penalty of $340,000.

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Draining the Swamp?

One of the rallying cries for President-elect Trump was to drain the swamp of corruption. Compliance professionals could think of many things that could happen to remove conflicts or the appearance of conflicts.

Personally, as a compliance professional and a voter, I was disappointed to learn that Hillary Clinton did a poor job of walling off donations to the Clinton Foundation from her role as Secretary of State. If she had established a clear protocol, she could have easily dismissed the charges that donors were paying to gain access.

It is even more disappointing to hear President-elect Trump dismiss the concerns about conflicts between his sprawling business empire and his role as president. There are a little over two weeks until he steps into office and there has been little to show that he has taken material steps to remove the conflicts.

The latest muck in the swamp is Congress eviscerating the independent Office of Congressional Ethics.

Compliance professionals spend a great deal of energy to have independence for reviewing programs and conducting investigations. Direct contact with the board of directors allows compliance to avoid company executives from stifling a problem.

Under the ethics change pushed by Rep. Bob Goodlatte, R-Va., the non-partisan Office of Congressional Ethics would fall under the control of the House Ethics Committee. That committee is composed of sitting members of Congress, five Republicans and five Democrats.

Given the new rules, any investigation can be shut down along party lines before a review has begun.

It’s not that the OCE was fully independent. It was not authorized to sanction members, officers or employees of the House. The Ethics Committee has exclusive authority to determine if a violation has occurred and what the sanction should be. The rule change allows an investigation to shut down before it gets any traction.

This is not a theoretical problem. Through the third quarter of 2016, the OCE started 35 reviews which led to 17 referrals to the House Ethics Committee for review for the 114th Congress.

It sounds like there is little draining of the swamp and more like the swamp is filling up.

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Return of the Whistleblower

It’s been a busy week for whistleblower cases. The latest is a case against SandRidge Energy for using severance agreements that impeded employees from contacting the Securities and Exchange Commission.

In response to Dodd-Frank, the SEC adopted Rule 21F-17 in August 2011, which provides:

(a) No person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement . . . with respect to such communications.

Sandridge’s severance agreements stated that the former employee could not

at any time in the future voluntarily contact or participate with any governmental agency in connection with any complaint or investigation pertaining to the Company, and [may] not be employed or otherwise act as an expert witness or consultant or in any similar paid capacity in any litigation, arbitration, regulatory or agency hearing or other adversarial or investigatory proceeding involving the Company.

A second provision had the former employee agree  “not to make any independent use of or disclose to any other person or organization, including any governmental agency, any of the Company’s confidential, proprietary information unless [the employee] obtain[ed] the Company’s prior written consent.”

A third provision required the former employee to “not at any time in the future defame, disparage or make statements or disparaging remarks which could embarrass or cause harm to SandRidge’s name and reputation or the names and reputation of any of its officers, directors, representatives, agents, employees or SandRidge’s current, former or prospective vendors, professional colleagues, professional organizations, associates or contractors, to any governmental or regulatory agency or to the press or media.”

Three bad provisions cost SandRidge $1.4 million.

Not really SandRidge. It’s in bankruptcy. It’s creditors are going to have add this unsecured claim in the bankruptcy proceedings.

SandRidge caught the attention of the SEC because it had included a severance agreement in an SEC filing. The SEC asked the company to change the agreements and it did so. But there were still a few hundred agreements out there.

Including for one employee that the SEC tried to interview to discuss his departure. He cited the severance agreement as a reason he was unable to speak with the SEC. The bad language turned from a technical violation into an actual impediment.

It turns out that the employee had serious concerns about how SandRidge was calculating oil and gas reserves. The company ended up firing him on April 1, 2015. While negotiating the severance agreement his lawyer asked for the unlawful provisions to be removed. This was two month after the KBR case on unlawful severance agreements.

SandRidge makes four cases over the past 18 months on severance agreements that violate Rule 21F-17.

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Co-investments and Conflicts

I have seen a few indications from the Securities and Exchange Commission showing that examiners are concerned about co-investments. I have yet to see a large over-arching activity in the industry that has been identified as problematic. I saw an action last week for a fund advisor related to co-investments so it caught my eye. Upon closer inspection, the issue was less one of co-investments and more one of an affiliate transaction.

New Silk Route Advisors is registered as an investment advisor. It manages two private equity funds that primarily invest in India. those funds invested in four companies along side another unnamed fund.

That unnamed fund was managed by a separate registered investment advisor. That advisor was run and co-founded by the same person who ran and co-founded New Silk Route Advisors.

The SEC claims that the fund documents for the New Silk Road funds treated that unnamed fund as an affiliate and therefore the co-investments were affiliate transactions. According to the fund documents, New Silk Road should have disclosed the co-investments to the fund boards of advisors and obtained approval.

The misstep resulted in a fine of $275,000.

The charge does cite any specific harm to investors in the New Silk Route funds. It does note that the unnamed fund ran out of capital and was not able to make a follow up investment in one company. New Silk Route stepped in and contributed the additional capital and took a bigger chunk of the company. At the time of the unnamed fund’s dilution, New Silk Route sought the board of advisors approval for the co-investments.

Adding in a related party does create many concerns, especially if the funds have different timelines and different investment styles. It was sloppy to not treat this an affiliate transaction and seek approval.

According to my tally, these are the cases that the SEC has publicized on co-investment problems:

  1. New Silk Road – failing to treat a co-investment with an affiliate as an affiliate transaction
  2. Co-investment allocation – No cases, but concerns about luring investors with co-investments and not making them available.
  3. Improper allocation of broken deal costs with co-investments – KKR

Let me know if you aware of others.

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Compliance and Conflicts with Exxon Mobil and the Trump Administration

President-Elect Trump has many conflicts of interest as he prepares to take office. It’s been a long time since the president-elect has been so deeply involved in a active businesses. His appointment of Rex Tillerson as Secretary of State creates another batch of conflicts for the administration and for Exxon-Mobil.

As is typical with many public companies, Exxon-Mobil grants large chunks of deferred compensation to its executives. Mr. Tillerson is eligible for $175 million is stock compensation when he turns 65 in March.

The board of directors of Exxon is faced with a tough choice of granting the compensation early, before he becomes Secretary of State. That would deviate from company policy and be perceived as granting a favor as he assumes one of the most powerful posts in government.

This is not new territory. Halliburton suffered a big loss in reputation when it granted early retirement to Dick Cheney when he was elected vice-president.

If it does not grant early vesting, then Exxon will be in the position of granting a fortune to the Secretary of State while in office.

Although Mr. Trump controls his organization and can largely do what he wants at whim, Exxon is a public company and subject to tigher rules on what it can do. According to the 2016 proxy statement, Mr. Tillerson held almost 2 million shares in the company. He was granted another $18 million in stock at the end of 2015.

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What Kind of Car Does Your Fund Manager Drive?

In a new paper, researchers found that hedge fund managers who own powerful sports cars take on more investment risk and are more likely to engage in fraudulent behavior. The inverse is also true: Drivers of minivans tend to deliver less volatile returns, according to the study.

“Specifically, sports car drivers deliver returns that are 1.80 percentage points per annum more volatile than do non-sports car drivers. This represents a 16.61 percent increase in volatility over that of drivers who shun sports cars. Similarly, drivers of high horsepower and high torque automobiles exhibit 1.14 and 1.25 percentage points per annum more volatility, respectively, in the funds that they manage than do drivers of low horsepower and low torque automobiles.”

The researchers used four sets of hedge fund databases from 1994 to 2012 that included 58,068 hedge funds, of which 33,680 are still in existence. Then they tapped into vehicle purchase databases to try to match fund managers to their cars. Thye ended up with a set of 1774 vehicles to 1,144 hedge managers. Of those, they identified 163 sports cars and 101 minivans.

I’m a bit skeptical of the studies methodology at this point given how they have narrowed down the set to be studied.

But I continued on to the operational, and complaince aspects.

The study found that sports car drivers are 17.3% more likely to have a violation report on their Form ADV than the owners of other cars. Minivan owners are 44.6% less likely to a violation reported on Form ADV.

Some of this is attributable to marriage status. Minivan drivers are much more likely to be married. After looking at the impact the study still found that the results are not just a by-product of marriage.

Given limited complaince budgets, perhaps it may be useful on the next compliance report to ask your employees what kind fo car they drive to help you focus your compliance efforts on the sports card drivers.

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“May” or “Will” is Less Important Than Completeness

The Robare case popped to my attention last year because the Securities and Exchange Commission was focused on the use of the word “may” instead of “will” as adequate disclose of a fee arrangement. My eyes rolled at such distinction. The administrative law judge felt the same way and dismissed the case. Now the Commission has heard the appeal of the case and found the adviser at fault.

Cash in the grass.

According to the SEC charging order, The Robare Group would receive a fee for client funds invested in certain mutual funds. Of course, there is nothing inherently wrong with that arrangement as long as it is disclosed to clients. Obviously, the concern is that the adviser would direct clients to invest in those funds because it is good for the adviser, not necessarily because it is good for the client.

The original decision seemed centered around the SEC raising a fuss that Robare said in the Form ADV that is “may receive compensation from some mutual funds”. The SEC thought it should say “will” to highlight the conflict. The ALJ was not moved by this argument.

He also found that Robare was not negligent because it had engaged a compliance consultant to help with the disclosures. Surely this was a boon to compliance consultants.

The Commissioners overturned the ALJ. The ruling stayed away from the distinction between “may” and “will” by pointing out that the disclosure was inadequate to explain the fee sharing arrangement and how it may influence Robare to recommend one fund over another.

The disclosure mentioned individuals getting sales commissions. That was not accurate. Robare was paid based on the assets in certain funds.

The disclosure did not let clients know which funds generated the extra fee. A client would not be able to cast a skeptical eye on the arrangement of his or her portfolio. The case notes that there was no evidence that Robare’s clients were dispoportionally invested in funds that paid an extra fee to Robare.

The SEC seems moved that Fidelity reviewed the Robare Form ADV and did not find adequate disclosure and made the firm redo it.

In a blow to compliance consultants, the Commission did not allow Robare to escape a charge of negligence merely because it used a compliance consultant.

The ALJ found that Robare was not negligent in part because Robare relied on “experience and competent compliance consultants” to help ensure that it met the disclosure requirements. The Commission acknowledged that there is defense available at times for reliance on defense counsel. But there is not necessarily such a defense available for reliance on compliance consultants. Even if there were such a defense, the Commission felt than Robare did not demonstrate that the firm had met the equivalent standards.

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