Getting Ready for Your SEC Exam – Introductory Presentation

presentation

The phone rings and the caller ID pops up with US Securities and Exch… You swallow hard. They are coming. What now?

One thing a private fund manager can do to smoothly take the SEC through an exam is to have an introductory presentation when they walk in the door.

The SEC examiners will have read your firm’s Form ADV and looked at your firm’s website. They may also have run a quick web search for any stories. That three things are unlikely to give them much insight into the operations of your firm. The better they understand your firm, the less likely they are to be concerned. (Assuming you are not actually lying, cheating or stealing.)

The goal of the presentation should be to provide an understanding of the firm, that your firm is treating its investors well, that your firm understands the regulatory requirements, and that your firm is serious about compliance.

These are some things I have in my opening presentation:

  • History of the firm
  • Ownership of the firm
  • Overview of each fund: closing date, investment period, size
  • Investment strategy for each fund
  • Types of investors (look at Form PF filing)
  • Case study for an investment: why we bought it, what we plan to do with it, how to make money from it
  • Key personnel
  • Overview of compliance program
  • Fees and revenue paid to the firm and how calculated
  • Custody and how you comply with the custody rule
  • Valuation policy and procedures
  • Marketing
  • Conflicts in the firm and how they are managed
  • Address key regulatory compliance requirements
    • Code of ethics
    • Political contributions
    • Disaster recovery/business continuity
    • Placement agents
    • Anti-money laundering

The presentation is not a pitch to investors, so it’s not time to sell the firm or use a pitchbook. (You likely could take some elements from the pitchbook for this opening presentation.) You want to sell compliance.

I recommend putting together the opening presentation now and updating it every quarter. Once that call comes from the SEC you are going to be crunched for time. It’s much easier to update the presentation than create a new one.

More on the SEC and Funds’ REIT Subsidiaries

reit stock certificate

I discovered some additional information about the SEC’s position on the application of the Custody Rule to the REIT subsidiaries of private real estate funds. A few months ago, a real estate fund was undergoing an SEC exam and the examiners focused on custody. The examiners used the June 2014 Guidance on SPVs to take the position that the fund must issue audited financial statements to the accommodation shareholders in the REIT subsidiaries.

I discovered that the SEC office involved in the exam was the Philadelphia office. So real estate funds in Delaware, Maryland, Pennsylvania, Virginia, West Virginia, and the District of Columbia should be especially focused on this issue.

Second, I discovered that the firm disagreed with the SEC’s position (obviously) and fought the deficiency through several rounds. Ultimately, the firm apparently decided to cede to the SEC’s position. I assume the firm decided the cost of obeying was less than the cost of fighting. Too bad.

The IM Guidance Update 2014-07 was a poorly put together document from the SEC. The key problem with the Guidance is Scenario 4 when a fund invests in another investment vehicle. Unlike the three previous scenarios in the Guidance, this clearly is not an SPV. The investment vehicle could be another fund, a joint venture or co-investment. The Guidance reaches the conclusion that the fund manager should get audited financial statements for the investment vehicle to comply with the custody rule because it is a separate advisory client.

Many people (and apparently SEC examiners) skip over footnote 10 that states that the SEC assumes that the SPVs in the four scenarios are investment advisory clients. But in many situations, that investment vehicle may not be an investment advisory client. The assumption in footnote 10 drives you directly to the conclusion in the Guidance

The Guidance also makes the mistake of stating that compliance with the Custody Rule can only be be achieved through providing audited financial statements. A fund manager can use the standard Custody Rule method of having information sent directly to investors by a third-party custodian and a surprise exam.

I don’t have the details on how that firm used REITs in its structure. The deficiency jumps right into the position that the REITs are advisory clients. But it also makes an overly broad statement:

“[T]his guidance indicates that Registrant must distribute the audited financial statements of all pass-through entities or special purpose vehicles that are controlled by Registrant or a related person and have outside investors to each such entity’s beneficial owners.”

That is not what the Custody Rule requires and it is not what the Guidance on the Custody Rule requires.

I would be interested to hear what other real estate fund managers are doing with their REIT subsidiaries for the Custody Rule. You can email me directly at my office or at [email protected].

Sources:

Related Party Mistakes with Private Funds

800px-Revised_Plain_Dealing,_LA,_sign_IMG_5163

Related party transactions are rife with problems in all areas of the financial services industry. It’s hard to know if someone is looking out for your best interest, if they have interests on the other side of a transaction. Most private equity funds have some structure set up in the organizational documents to deal with affiliate transactions. A recent SEC action highlights the need to have that structure.

According to the Securities and Exchange Commission action, VERO Capital Management cause one of its sponsored funds to purchase notes from an affiliate without providing notice or consent to the fund’s investors.

Section 206(3) of the Investment Advisers Act prohibits an investment adviser from acting as a principal on its own account or acting as a broker for the sale to a client unless the adviser obtains the client’s consent to the transaction before completion. Rule 206(4)-8 applies the anti-fraud provisions to investors in a fund.

On one hand you have the agreements with your fund investors on how to address related party transactions. On the other hand, you must comply with the SEC’s requirements. It’s worth taking a look as the requirements to make sure you are complying with both your investor requirements and the regulatory requirements.

According to the SEC, VERO went further and tried to hide the transactions from investors. But that is just the SEC’s side of things. VERO has not agreed to the charges and has not had a chance to refute the charges.

Sources:

Image of Plain Dealing is by Billy Hathorn
cc by sa

Weekend Reading: Book de Tour

Do you like cycling?
Do you like watercolors?

Then Book de Tour is the perfect book for you. For the past few years, Greig Leach has been painting watercolors of key events from the Tour de France. This year he decided to compile all of the artwork with a narrative description into a single book.

I’m a big fan of his artwork and have a handful of his pieces. In the book, I have the original of Vincenzo Nibali’s win on Stage 13 on the top of Chamrousse. (See page 128).
Victorious - The Art of Cycling

The book is great addition to your library if you like cycling.

Backtesting Performance Failure

f squared

One area of performance advertising that the Securities and Exchange Commission has given great scrutiny, but not banned, is using backtested performance. Since, backtesting only shows theoretical past trades, it does not involve market risk. That means it’s inherently suspect. You can just keep fine-tuning the model to maximize results, with no ability to carry that forward to maximize returns going forward.

The SEC delivered a Christmas enforcement present to F-Squared Investments and its co-founder Howard Present for failures with back-tested performance.

There were two failures. One was that F-Squared failed to disclose that the past performance advertised was based on back-tested performance and not actual trading. Second, the past performance was incorrectly calculated. In reading the settlement documents for the case it looks like the problem originated with the data sources for the F-Squared AlphaSector index. It relied on a third-party data provider to generate the trading models.

F-Squared advertised that $100,000 invested on April 1, 2001 would have been worth $235,000 on August 24, 2008.

There were two problems with that statement. F-Squared was not in existence until 2006 and did not use this trading model until 2008. F-Squared failed to disclose that the performance was based on backtested performance.

The second problem was that the calculation was incorrect. In compiling the past performance the data provider was off by a week on each trade. That actual performance would only have been $138,000 if the past performance was calculated correctly. (Merely taking the broad bet by investing in S&P 500 ETFs would have resulted in $128,000.)

According to the complaint, Mr. Present tried to get better back up for the past performance methodology. That arose again during a 2012 mock audit. When he sought the information again, he discovered that the data model was created by a 20 year old former intern who would have only been 14 in 2001. It was at that time that Mr. Present discovered the dating problem with the past performance.

The SEC has not come out and said the backtested performance is not allowed by investment advisers and fund managers. It has addressed the issue in at least four other enforcement cases. In the F-Squared case, the SEC did not say that the backtesting was by itself was fraudulent, deceptive or manipulative. It was the incorrect calculations and disclosure failure that was fraudulent, deceptive or manipulative.

Sources:

Weekend Reading: Boys in the Boat

TheBoysintheBoat

Do you hate Hitler?
Do you like sports?

Then Boys in the Boat is a book to add to your “To Read” list.

In the middle of the Great Depression, Joe Rantz is a farmboy from the Pacific Northwest who was literally abandoned as a child and rarely had two pennies to rub together. He scrapes together the money to attend the University of Washington during the Great Depression. At school he joins a pack of strong, young men looking to make it onto the crew team.

It’s not going to be a surprise, but Joe makes the team. That’s just the first step. His crew needs to beat their rivals at Berkeley, then travel East to battle the rowing elites of the east coast. If his crew comes in first, then it’s off to Berlin to battle the Nazi’s crew for Olympic glory.

This is a tremendously enjoyable story, full heart, soul, and determination.

193614

Happy Holidays From Compliance Building

 

2014 Holiday 2

I hope you have a happy and joyous holiday season. Whether it be Christmas, Hanukkah, Kwanza, Festivus, Feast of Winter Veil, Saturnalia, or New Year’s Eve, I hope you get to spend some extra time with friends and family.

I will be trying to spend some extra time with my friends and family so there will likely be no published stories until January.

Doug

Train Fares, Integrity, and Financial Services

Stonegate_Railway_Station

On Monday Britain’s financial regulator banned a senior financial services professional from the industry for life. His transgression was the failure to pay his train fare. BlackRock director Jonathan Paul Burrows was caught by inspectors at Cannon Street station last year.

Mr Burrows has admitted that, on a number of occasions, he deliberately and knowingly failed to purchase a valid ticket to cover his entire journey whilst traveling on he Southeastern train service between Stonegate Railway Station, East Sussex, and Cannon Street Station, London.

Based on Mr Burrows’ admission, the Authority considers that Mr Burrows is not fit and proper to conduct any function in relation to any regulated activity carried on by any authorised or exempt persons … because he lacks honesty and integrity.

That means his has failed to meet the FCA’s Fit and Proper Test for Approved Persons.

The fare he failed to pay was £21.50. That’s an expensive train ticket. Mr. Burrows avoided paying the fare by boarding the London-bound train at Stonegate, a rural station with no turnstiles. Without the turnstiles, there is no control to make sure passengers have a ticket.

But it was not just the one time. He was alleged to have failed to pay for his ticket on almost 2,000 occasions. He settled with the transit authority for £42,550.

Sources:

Stonegate Railway Station photograph is by Simon Carey
cc by sa

Real Estate Crowdfunding

Picture1

Real estate investing has a long history of crowdfunding. Prior to the 1986 changes to the tax code, there was a large syndication business for getting investors into real estate. Although the investment was usually more for the tax breaks involved instead of income and capital appreciation.

With the surge of product crowdfunding through sites like Kickstarter, the regulatory changes for equity crowdfunding from the SEC, and state-level implementation of crowdfunding, investors and sponsors are once again looking to crowdfunding for real estate. Currently, it’s largely limited to accredited investors due to SEC limits or limited to state specific projects and investors.

Goodwin Procter put together a publication full of real estate crowdfunding articles: A Guide to Real Estate Crowdfunding Today.

The guide hits one major theme: crowdfunding is new and there are few success stories. No one site has been very successful at pulling investors and meaningful projects together.

Real estate investing is capital-intensive. It should be a natural area for crowdfunding. The big concern is fees. The crowdfunding platforms I’ve looked at are expensive. It’s expensive for the sponsor and its expensive for the investor.

The other concern is execution. To purchase or sell real estate, you need to decide quickly on the best deals and convince the other side that you can close. If you are buying a property and sourcing the capital with crowdfunding, there is the possibility that you won’t raise the money and not be able to close. You would have to include the successful crowdfunding as a closing condition, or have a backup source of more expensive capital to cover the failed crowdfunding. As a real estate seller, why would you accept an offer contingent on crowdfunding?

The alternative is that the crowdfunded real estate is already warehoused with the sponsor and is looking to lay off some of the equity or fund capital improvements. The sponsor is looking to crowdfunding as a cheaper source of capital or a quicker source of capital. So far, crowdfunding does not seem cheaper or faster than other sources of capital. And if other sources of capital are not interested in the investment, perhaps that is an indication of the investment’s quality.

Sources:

Compliance Bricks and Mortar for December 12

bricks

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

Mark Cuban vs. The SEC in WealthManagement.com

The only way to reform what ails the Securities and Exchange Commission is to “burn it down and start again,” says Mark Cuban, billionaire entrepreneur, host of the television show “Shark Tank,” and the owner of the Dallas Mavericks.

Corruption Allegations Lead to Securities Lawsuits by Kevin LaCroix in The D&O Diary

I was on a panel at a law firm event last week during which I was asked to make some predictions for 2015. Among other things, I said that I thought we would see an increase of securities class action lawsuit filings following in the wake of regulatory investigations, especially bribery investigations. I also said that many of these lawsuits next year will involve bribery investigations being led by governments other than that of the United States. Well, we not yet into the new year, but there has already been a flurry of activity consistent with my predictions.

Forum Selection For SEC Cases – District Court or Administrative Proceeding? by Thomas O. Gorman in SEC Actions

Under this approach the seven insider trading cases filed as administrative proceedings since September would not represent a new trend or a move toward bringing these actions as administrative proceedings rather than the traditional civil injunctive action. At the same time the filing of so many insider trading cases as administrative proceedings in a brief period does represent a significant departure from prior practice. That is particularly notable for an agency which frequently looks for consistency. No doubt, the Director is correct that selecting the administrative forum quickly ends the matter – there is no district court to seek the assistance of or to ask questions and delay the entry of the settlement.

SEC Chief Is Not Pleased Over Insider Trading Decision by Michelle Celarier in the NY Post

Securities and Exchange Commission chief Mary Jo White is none too pleased about Wednesday’s landmark federal appeals court ruling that overturned two insider trading convictions. “My initial sense is that it is an overly narrow view of the insider trading law, and that is a concern,” she said at a conference in New York on Thursday.

Brick Pattern is by AGF81 at DeviantArt