Category: SEC News

New SEC Rule to Protect Investors from Identity Theft

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The Securities and Exchange Commission adopted new rules requiring investment advisers, broker-dealers, mutual funds, and certain other entities regulated by the agency to adopt programs to detect red flags and prevent identity theft.

In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act amended the Fair Credit reporting Act to add the SEC to the list of federal agencies that must adopt and enforce identity theft red flags rules. In February 2012, the SEC proposed for public notice and comment identity theft red flags rules and guidelines and card issuer rules. Yesterday, the SEC issued the final rule.

Originally, it looked like investment advisers (and therefore private fund managers) might escape the rule. However, the final rule explicitly includes registered investment advisers as being subject to the rule.

Investment advisers who have the ability to direct transfers or payments from accounts belonging to individuals to third parties upon the individuals’ instructions, or who act as agents on behalf of the individuals, are susceptible to the same types of risks of fraud as other financial institutions, and individuals who hold transaction accounts with these investment advisers bear the same types of risks of identity theft and loss of assets as consumers holding accounts with other financial institutions. If such an adviser does not have a program in place to verify investors’ identities and detect identity theft red flags, another individual may deceive the adviser by posing as an investor.

The SEC concluded that the red flag program of a qualified custodian that maintains custody of an investor’s assets would not adequately protect individuals holding transaction accounts with an adviser. The adviser could give an order to withdraw assets, but at the direction of an impostor. However, an adviser that has authority to withdraw money from an investor’s account solely to deduct its own advisory fees would not hold a transaction account, because the adviser would not be making the payments to third parties.

Does this apply to private funds?

Private fund managers may directly or indirectly hold transaction accounts. According to the SEC rule, if an individual invests money in a private fund, and the adviser to the fund has the authority to direct the individual’s investment proceeds (such as distributions) to third parties, then that adviser would indirectly hold a transaction account. The SEC concludes that a private fund adviser would hold a transaction account if it has the authority to direct an investor’s redemption proceeds to other persons upon instructions received from the investor.

I’m not sure that I agree with the SEC conclusion. However, I do agree that funds need to make sure that distributions are not re-directed improperly. Private fund managers will have to put some effort into this.

This rule is going to take some time to figure out how it applies in the context of fund operations. The subscription agreement and partnership agreement for a fund may not explicitly address if an investor can direct distributions to a third party account. I think that would be an unusual restriction.

The SEC-mandated program under rule should include policies and procedures designed to:

  • Identify relevant types of identity theft red flags.
  • Detect the occurrence of those red flags.
  • Respond appropriately to the detected red flags.
  • Periodically update the identity theft program.

The rules require entities to provide such things as staff training and oversight of service providers. The rules include guidelines and examples of red flags to help firms administer their programs.

The final rules will become effective 30 days after publication in the Federal Register. The compliance date for the final rules will be six months after their effective date.

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The SEC and Social Media

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Netflix chief executive Reed Hastings got into trouble on July 3, 2012 when he used his personal Facebook page to announce that Netflix had more than one billion hours of online viewing in June. That trouble came from an SEC rule implemented in August of 2000: Regulation FD. That rule was implemented to stop the egregious practice of some companies delivering company news to select recipients ahead of a general announcement. Those select recipients would be able to make money from getting the news ahead of time and trading on the upcoming stock movement.

The SEC issued its report on the investigation of Mr. Hastings and determined not to pursue an enforcement action against him. The SEC publicly released its Report of Investigation to help provide some guidance on the use of social media for public company disclosure.

Personally, I thought Mr. Hastings made a bad decision in using his personal Facebook page to make a company announcement. The information had already been released, but in more technical releases. His personal Facebook page did have 200,000 friends who could see the news, but it was still gated and not available to the general public in a broad and non-exclusionary manner. It was a poor choice, but not one that should subject him or the company to an enforcement action.

Regulation FD is written to be platform neutral. You can release “important” company information as long as it available to everyone at the same time. It applies equally to press releases, company websites, Twitter, Facebook, or the big rock in front of your headquarters.

The key for correct distribution is to let people know where the news will be distributed. You could argue that Steve Jobs’ annual display of the latest gadget from Apple is a distribution channel that everyone knows about. A company could carve company announcements into the stone in front of its headquarters if it so chose.

Mr. Hastings foot-fault was that Netflix had not previously used his personal page as a platform for releasing company news. In early December 2012, Hastings stated for the public record that

“we [Netflix] don’t currently use Facebook and other social media to get material information to investors; we usually get that information out in our extensive investor letters, press releases and SEC filings.”

Hastings errant Facebook post was probably not “important” enough and the Facebook page was probably just public enough that the SEC thought it could not win an enforcement action. I’m sure Hastings and Facebook paid quite a bit in legal fees to address the repercussions of that errant post.

It’s not big news that the SEC has embraced social media. The SEC merely reminded companies that they need to go through the Regulation FD analysis when using social media platforms. The SEC embraced social media a long time ago.

I think Facebook is terrible primary platform for important corporate disclosures. It lacks the workflow and content management tools that any corporate communication professional would want to have. The same is even more so with Twitter. It’s hard to do much with 140 characters, except direct the reader to another website.

To de-emphasize the importance of the SEC guidance, it’s not even released as SEC guidance, a risk alert, or other typical SEC regulatory rulings. It merely restates what Regulation FD says and drops in the word Facebook. Too many social media specialists will merely read the headline.

Even Facebook does not use Facebook for company announcements. This announcement will not change that. Maybe Facebook will see the potential for including content management and compliance tools that will allow companies to embrace Facebook and be in compliance with securities laws.

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Challenging the SEC on the New Five Year Limit

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illustration by Steve Brodner in D Magazine

 

It didn’t take long for defendants to take advantage of the Gabelli decision. That Supreme Court decision enforced the strict five year statute of limitations on enforcement actions by the Securities and Exchange Commission. The SEC is not entitled to the “discovery rule” which would have allowed the SEC’s five-year time bar to start running until the SEC discovered the fraud.

In 2010, the SEC brought an enforcement case against Samuel E. Wyly and his brother, Charles J. Wyly, Jr., claiming the brothers had engaged in a 13-year fraudulent scheme to trade tens of millions of securities of public companies while they were members of the boards of directors of those companies, without disclosing their ownership and their trading of those securities. One fraudulent claim by the SEC involved the Wylys making a massive and bullish transaction in Sterling Software in October 1999 based upon the material and non-public information that they, the Chairman and Vice-chairman of Sterling Software, had jointly decided to sell the company.

A little math would place the statute of limitations on an enforcement of that case after five years at October 2004. It sounds like the SEC was six years too late in bringing that claim.

In a court filing yesterday the Wylys’ attorney swung at the SEC with the Gabelli hammer.

“Summary judgment should be granted for Defendants on nearly all the SEC’s claims for penalties because they are barred by applicable statutes of limitation and the SEC cannot establish that equitable tolling is warranted.”

Unfortunately for Mark Cuban, the SEC managed to file its case against him in four years, so he will not be able to swing the Gabelli hammer.

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The SEC Is Not Happy with Custody Compliance

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The Securities and Exchange Commission issued a Risk Alert on compliance with its custody rule for investment advisers. Beyond the warning to investment advisers, it also issued an Investor Bulletin to protect advisory clients from theft or misuse of their funds and securities.

After a review of recent examination, the SEC’s Office of Compliance Inspections and Examinations found significant deficiencies in custody-related issues in about one-third of the firms examined that had serious deficiencies.

  • Failure to recognize that they have custody, such as situations where the adviser serves as trustee, is authorized to write or sign checks for clients, or is authorized to make withdrawals from a client’s account as part of bill-paying services
  • Failure to meet the custody rule’s surprise examination requirements
  • Failure to satisfy the custody rule’s qualified custodian requirements, for instance, by commingling client, proprietary, and employee assets in a single account, or by lacking a reasonable basis to believe that a qualified custodian is sending quarterly account statements to the client.
  • For fund managers, failures to (1) meet requirements to engage an independent accountant and (2) demonstrate that financial statements were distributed to all fund investors.

In the Risk Alert, the SEC is shares some of the custody deficiencies observed in order to assist investment advisers in complying with the custody rule.

Private Equity Enforcement Concerns

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Bruce Karpati, chief of the SEC’s Enforcement Division’s Asset Management Unit laid out a clear picture of the SEC’s expectations and concerns about private equity in a recent speech. He was speaking at Private Equity International’s annual CFOs and COOs Forum. The speech was centered around five main questions.

Q1:  How has the creation of the Asset Management Unit impacted the Commission’s activities in the private equity space?

Q2: The Commission hasn’t traditionally brought many private equity enforcement actions. Do you expect that to change?

Q3: What are some of the Unit’s concerns about practices in the private equity industry?

Q4: You’ve spoke before about AMU’s Risk Analytic Initiatives. What are they and are there any currently under way in the private equity industry?

Q5: What can a private equity COO or CFO do to reduce the risk of inquiry by the Division of Enforcement?

It seems clear that the SEC is focused on two area: valuations and fees.

Private equity investments are inherently illiquid and therefore requires the fund manager to make judgment calls about pricing. Poor judgment can lead to poor valuations. Fraudulent judgment can lead to fraudulent valuations.

Fees and revenue generation are always a focus of the SEC for investment advisers and funds, whether private or public mutual funds. Private equity merely has some additional ways of generating revenue. It seems clear from Karpati’s speech that that SEC has been looking closely at those revenue streams.

  • The shifting of expenses from the management company to the funds including utilizing the funds’ buying power to get better deals from vendors — such as law and accounting firms — for the management company at the expense of the fund.
  • Charging additional fees especially to the portfolio companies where the allowable fees may be poorly defined by the partnership agreement.
  • Broken deal expenses rolled into future transactions that may be ultimately paid by other clients.
  • Improper shifting of organizational expenses, where co-mingled vehicles foot the bill for preferred clients.

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The SEC Launches a Private Equity Initiative

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Bruce Karpati, Chief of the SEC Enforcement Division’s Asset Management Unit, disclosed the launch of a Private Equity Initiative in a speech on Tuesday. While speaking to the Regulatory Compliance Association, Karpati spoke about the Enforcement Division’s and in particular the Asset Management Unit’s priorities in the hedge fund space.

The Private Equity Initiative is coordination between RiskFin, the Division of Investment Management, and OCIE to identify private equity fund advisers that are at higher risk for certain specific fraudulent behavior. Karpati mentioned two behaviors that cause concern.

With Zombie Funds, managers delay the liquidation of the fund because the management fee is their only source of revenue. The SEC had mentioned back in June that it was hunting down zombie funds.

The second area is valuations. The SEC is rightly focused on valuations when it comes to private equity. The assets are inherently hard to value. Even the best valuation process will lead to an internal judgment on the value the fund. Karpati claims that the SEC uses “certain data sources” as part of the SEC’s risk analytic initiative to identify those private equity fund advisers that may be improperly failing to liquidate assets, or have been misrepresenting the value of their holdings to investors.

Karpati finished the speech by ask fund managers to be nice to examiners:

Finally, I think all investment advisers need to be alert and prepared for exam inquiries.  It is important to be cooperative with exam staff while an examination takes place.  It is also important to implement any necessary corrective steps if the SEC identifies violations or possible violations.  Taking these steps will help the examination process to proceed more efficiently and reduce the likelihood of more formal inquiries by Enforcement or AMU staff.

I didn’t find anything new in the speech. That’s a good thing. The SEC has made it clear what they are looking for in their welcome to the SEC letter, enforcement actions, and speeches for many month now.  I give them credit that it sounds like the SEC better understands the risk and compliance problems for private fund advisors in a way they did not understand 12 months ago.

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Recent SEC Document Request for Private Equity

It appears the Securities and Exchange Commission has started its initial examination program for newly registered investment advisers, including private equity fund managers. This is a recent document request list sent by Boston’s regional office:
August Boston document request (.pdf).

The request list is shorter than the typical request letter. This seems to be in line with the earlier announcement that the SEC intended to make brief visits to lots of newly registered advisers.

Let me know if you have been visited by the SEC under this new program.

 

What Will the SEC Do About Advertising and Solicitation?

UPDATE: The SEC will wait a week. A new meeting has been scheduled for August 29.

At today’s meeting the Securities and Exchange Commission is set to consider a rule on lifting its longstanding ban on general solicitation and advertising for privately-issued securities.

Item 3: The Commission will consider rules to eliminate the prohibition against general solicitation and general advertising in securities offerings conducted pursuant to Rule 506 of Regulation D under the Securities Act and Rule 144A under the Securities Act, as mandated by Section 201(a) of the Jumpstart Our Business Startups Act

Personally, I would welcome better information about what the SEC considers a general solicitation or general advertisement in connection with the private placement of securities. I don’t think lifting the ban is necessarily a good idea. The appearance of an ad for a private security has been a prominent red flag for an offering. Either it’s a fraud or the company is ignoring the advice of its legal counsel.

The bigger concern is what the SEC will do about verifying that the potential investor meets the accredited investor standard. Currently, most fund manager use a certification filled out by the investor. In addition to meeting the accredited investor standard, the questionnaire will typically include many other items of disclosure.

This process has worked well for decades. Hopefully the SEC won’t mess it up.

If you are wondering what changes the SEC could make, McGuire Woods put together an excellent Preview of New SEC Provisions Permitting Advertised Private Placements. The report tries to summarize the numerous comments submitted to the SEC.

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Wait a Bit Longer for Removing the Ban on General Solicitation and Advertising

On June 28 Securities and Exchange Commission Chairman Mary L. Schapiro testified that the SEC will not make the deadline for lifting the ban on general solicitation and advertising and the reasonable process for verification of accredited investors. Title II of the JOBS ACT gave the SEC 90 days to craft the regulation.

“As I stated to Congress prior to the passage of the Act, time limits imposed by the JOBS Act are not achievable. Here, the 90 day deadline does not provide a realistic timeframe for the drafting of the new rule, the preparation of an accompanying economic analysis, the proper review by the Commission, and an opportunity for public input.”

Since there has not even been a proposed rule available for comment, there was no doubt the SEC was going to miss the deadline.

The regulation will likely be a key change for private fund managers.

I don’t expect private funds to engage in bulk email or late night television commercials. I would expect more advertising in trade publications and more engagement with the media.

For me the bigger concern is what the SEC is going say about the “reasonable steps to verify that purchaser of the securities are accredited investors…” that the SEC has been empowered in include in this new regulation. The SEC has been empowered to implement requirements for years. It has just chosen not do any thing. The JOBS Act has given the SEC a little nudge to act.

Perhaps the SEC will not act.

The current method of self-certification for accredited investors seems to work for now. Imposing some requirement to gather financial information would dramatically increase the amount of sensitive personal information being transmitted and stored. That will mean firms will need to beef up their data security and deal with this new source of personal information. Inevitably, there will be a breach and investors identity’s will be stolen.

The current process of self-certification of investors seems to work well. Of course, I could see how the failure to review a potential investor could lead to fraud. It would seem to hurt the investor, committing to an investment he or she could not afford. perhaps it would be a red flag to regulators that the adviser is not conducting the diligence to conclude that an investor is accredited, and is therefore preying on unsophisticated investors.

However, for private funds the minimum investment amount is usually equal to or in excess of the standard for being an accredited investor. If the fund requires a minimum investment of $1 million, then the investor presumably has the $1 million net worth required by the accredited investor standard. Hopefully, the rule will contemplate that situation and not overly burden private funds.

 

 

Faking Your Returns

Some Securities and Exchange Commission enforcement actions catch my attention in looking for lessons on what not to do. The SEC recently charged a Boston-based father-son duo of fund managers and their firms with securities fraud for misleading investors about their investment strategy and past performance. This case caught my attention because it came out of Boston and the father is a professor at MIT. The respondents have consented to the SEC’s administrative order, but neither admit nor deny the findings in the order. For the discussion below, I’m assuming the findings are true so we can learn some lessons on what fund managers should not do.

Gabriel Bitran founded GMB Capital Management LLC in 2005 for the stated purpose of managing hedge funds using quantitative models he developed based on his academic optimal pricing research. Gabriel and his son Marco Bitran solicited potential investors with three selling points that ultimately ended up not being true:

(1) very successful performance track records purportedly based on actual trades using real money from 1998 to the inception of the hedge funds;
(2) the firm’s use of Gabriel’s proprietary optimal pricing model to trade ETFs; and
(3) Gabriel’s pedigree and his involvement as the founder and portfolio manager of the hedge funds.

They managed to raising over $500 million for eight funds and various managed accounts. But in the process made misrepresentations to investors and made at least two disastrous investment decision.

First, they told potential investors that the pre-inception performance track records since 1998 were based on actual trades using real money. That was not true. Their track record was based on back-tested hypothetical simulations. It was a great performance, showing an average annual return of over twenty percent without a single calendar year of investment losses since 1998.

Second, they solicited investors to two funds by promising that GMB would use Gabriel’s optimal pricing models to trade liquid securities such as ETF.  But those funds were actually invested almost entirely in other hedge funds and funds of funds.

Third, in May 2008, Gabriel and Marco divided GMB’s business. Marco started advising the hedge funds under a new entity, GMB Capital Partners LLC, and Gabriel managed the other clients through GMB Management. Although Gabriel had no involvement in the GMB Partners’ hedge funds, GMB Partners and they continued to tell potential investors that they were managed by Gabriel.

When the SEC’s Boston Regional Office examined GMB Management and they provided a document that supposedly was a contemporaneous record of Gabriel’s trades since 1998. They provided this document in response to the exam staff’s request for books and records that supported GMB Management’s claims in its marketing material of a successful track record since 1998. In fact, the document was not true or accurate and was created solely for the purpose of responding to the staff’s books and records request.

Using hypothetical backtested performance is not inherently false and misleading, but it is highly suspect. It’s all too easy to continually tweak the formulas as market conditions evolve in the present day to meet your needs.

It turns out that one of GMB’s funds has a significant interest in funds that had invested in the Petters Group Worldwide and Bernard L. Madoff Investment Securities LLC.

The Bitrans released this statement:

“The Bitrans invested the vast majority of their (and their family’s) net worth in the GMB funds, alongside other investors, and had great confidence in GMB’s quantitative models. To be sure, 2008 was a difficult year for the markets and for the investment industry as a whole. That aside, the majority of GMB’s funds and managed accounts either made money for investors, or significantly outperformed the S&P 500 over their operating lifetime. This strong relative performance was delivered during one of the most challenging market environments of the last several decades. The Bitrans are pleased to have reached a settlement with the SEC, on these issues which date back several years, and to put this matter behind them.”

Gabriel Bitran’s optimal pricing model is the basis for airline prices and their constant fluctuations. Bitran’s models estimate optimal pricing by assessing the factors that create demand and make supply available in the marketplace. The parallel in the financial markets is willingness to pay. Bitran’s models focuses on the value market participants place on securities at different points in time. Based on this data, they theoretically can anticipate capital flows into various markets and instruments.

This is another one of the cases that makes me scratch my head and wonder how a smart, reasonable person could make such mistakes. Clearly, the full background and key facts are missing from the news stories and SEC order. Some could be simple footfaults or a failure to under stand regulatory requirements. A few of the statements indicate more overt action that seems wrong. Given that the Bitrans are likely subject to other claims, it’s unlikely we will ever learn what lead them down the dark corridors of fraud and deceit.

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