SEC Demanding Audited Financial Statements for Funds’ REIT Subsidiaries

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The Custody Rule is a well intentioned beast of regulation designed to prevent investment advisers from stealing money from their clients. The Rule works well for retail investment advisers and most hedge funds. It starts falling apart for private equity funds and real estate funds. The Securities and Exchange Commission tried providing some additional guidance in June with its IM Guidance Update 2014-07. Unfortunately, I think the guidance only made it more confusing for funds trying to comply with the rule and the examiners trying to do their jobs in the field.

The problem with the Guidance was 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 investmentvehicle 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 withe custody rule because it is a separate advisory client.

Many people 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.

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.

Getting back to the headline, one question for real estate funds has been what to do with REIT subsidiaries in the fund structure. This was also an issue pre-Dodd-Frank in deciding whether to include them as clients in determining whether you had reached the old 15-client threshold.

The subsidiary REITs could fit into the bucket of scenario 4. The fund is an investor in the subsidiary REIT and there are third party owners in the REIT. One of the requirement of REIT status is that you must have at least 100 shareholders. Since it’s a subsidiary, the fund manager is focused on its interest and typically uses accommodation shareholders to fill in the other 99 slots. I remember in my early years of practice that REITs would round up lawyers, accountants, family and friends to fill in the empty slots. Now, third party vendors will fill up those slots.

Those 100 accommodation shareholders get a preferred return paid to them, but have no interest in the ultimate economics of the REIT subsidiary. The accommodation shareholders collect their annual payment but have no concerns about investment performance. The current market rate is about 12% on their $1000 investment. They get their $120 a year and then the $1000 back at the end of the fund life.

In speaking with a group of real estate fund CCOs we discussed what their approach is for subsidiary REITs under the Custody Rule. We were startled to learn that the SEC had recently issued a deficiency letter to another real estate fund manager during an SEC exam for failing to issue audited financial statements for the REIT subsidiaries. From a redacted copy of the deficiency letter:

“This guidance [IM Guidance Update 2014-07] does not contemplate whether a client pays fees to the investment adviser, because entities are not required to pay advisory fees in order to be considered investment advisory clients. Accordingly, this 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.”

I think this is a shocking overreach by those SEC examiners. They seem to skip right over Footnote 10 and its assumption for purposes of the guidance that the investment vehicle, in this case the subsidiary REITs, are advisory clients.

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].

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Miscounting Residents as Securities Fraud

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A recent SEC enforcement action caught my attention because it involved defrauding a landlord and miscounting residents. That left me scratching my head over why the Securities and Exchange Commission was involved with a senior living residence.

The SEC Enforcement Division alleges that then-CEO Laurie Bebo and then-CFO John Buono made false disclosures and manipulated internal books and records when it appeared likely that their company, Assisted Living Concepts Inc., would default on financial covenants in a lease agreement. Under the leases for the facilities, ALC was required to maintain occupancy levels as well as debt service coverage levels.

Like lots of fraud, it started off with a small bad act. Bebo and Buono wanted to include ALC employees who stayed overnight at the facilities as occupants. Then it got worse and they started counting employees who never stayed at the facility, family members, friends and people they interviewed for job openings. At the end of the fourth quarter 2011, the SEC alleges that between 45 and 103 reported occupants were non-residents.

The fraud was all directed at the landlord to avoid a default. ALC had publicly traded stock so the landlord fraud turned into public company accounting fraud.

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Compliance Bricks and Mortar for December 5

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

Sherlock Holmes and Innovation in the Compliance Function, Part I – A Study In Scarlet by Tom Fox in the FCPA Compliance and Ethics Blog

First I am back with an homage to Sherlock Holmes, for it was in the magazine Beeton’s Christmas Annual that the characters Sherlock Holmes and Watson were introduced to the world in 1887, in the short story A Study in Scarlet. The second theme will be innovation in the compliance department. I will take some recent concepts explored in the December issue of the Harvard Business Review (HBR) and apply them to innovation and development of your compliance function. I hope that you will both enjoy my dual themed week and find it helpful.

Be Careful When You Are 100% Correct by Roy Snell in SCCE’s Compliance & Ethics Blog

People are often careful when they are not sure how to fix a particular problem. They do their research and bring everyone along. Everything is covered and everything is explained, when you are in doubt. However, when we are 100% correct we let our guard down. At least I do. I get indignant and ask questions like “why do I have to explain this all over again?”

2015 SEC Trial Scorecard Update: Agency is Undefeated After Two Trials by Bruce Carton in Compliance Week

To date in FY 2014 (which began on October 1, 2014), the SEC has had two trials in federal court reach a verdict. The first verdict was in the SEC’s case against iShopNoMarkup.com, Inc. in the U.S. District Court for the Eastern District of New York. In that case, the SEC charged that in 1999-2000, among other things, iShop conducted a fraudulent and unregistered securities offering.

Compliance Yesterday, Today, and Tomorrow by Matt Kelly in Compliance Week

Part of the challenge, of course, comes from the huge advances in technology that have allowed businesses to do more things, and to do them more efficiently—because once you can do something more efficiently, it’s only a matter of time before “the market” compels you to do something  more efficiently. Hence the quest to develop new products, to reach new customers, to launch new mergers, to enter new markets—more than we could ever dream of 50 years ago. All of those things bring new risks, and new ways to manage them.

Largest Derivative Lawsuit Settlements by Kevin LaCroix in the D&O Diary

My purposes in posting this list are two-fold: first, in response to several requests, to share the information I have; and two, to encourage others who may have different or additional information to share the information so that I can update or supplement the list as appropriate. Here is my list of the eight largest derivative lawsuit settlements of which I am aware:

Get the SEC Out of the PR Business by Russell G. Ryan in the Wall Street Journal (opinion section)

Given the SEC’s peculiar quasi-judicial role in these cases, you might think the agency would refrain from gratuitously stoking prehearing publicity against the accused. Think again. The SEC now routinely issues press releases when it files charges in administrative cases it will eventually decide. This practice calls into question the agency’s ability to decide those cases fairly and impartially.

Failure to Register with the SEC as an Investment Adviser

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One of the questions that come up with private funds and Dodd-Frank was what would happen if you failed to register with the SEC? HSBC Holdings Plc found out for us. HSBC  will pay $12.5 million to settle claims that its Swiss private-banking unit solicited U.S. investors without being registered.

The Securities and Exchange Commission charged HSBC’s Swiss-based private banking arm with violating federal securities laws by failing to register with the SEC before providing cross-border brokerage and investment advisory services to U.S. clients. HSBC agreed to admit its wrongdoing and paid the fine to settle the SEC’s charges.

It looks like HSBC tried to put boundaries between its Swiss bankers and US clients to stay outside the reach of US law. But its relationship managers were unwilling to comply and went around the compliance policies.

According to the SEC’s order, HSBC began providing cross-border advisory and brokerage services in the U.S. more than 10 years ago and had as many as 368 U.S. client accounts. HSBC created a dedicated North American desk to consolidate U.S. client accounts and service them in a compliant manner.  However, Swiss relationship managers were reluctant to transfer clients to the North American desk.

Personnel traveled to the U.S. on at least 40 occasions to solicit clients, provide investment advice, and induce securities transactions.  Those Swiss relationship managers were not registered to provide such services nor were they affiliated with a registered investment adviser or broker-dealer.  The relationship managers also communicated directly with clients in the U.S. through overseas mail and e-mails.

In 2010, HSBC Private Bank decided to exit the U.S. cross-border business, and nearly all of its U.S. client accounts were closed or transferred by the end of 2011.

In this case, HSBC was trying to avoid US registration and failed to control its personnel. So it’s not the same as a fund manager claiming it was not required to register.

As for punishment, the HSBC fine consists of a disgorgement of fees earned, plus interest and penalty of about 50% of the fees.

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Stealing From Investors Through Fraudulent Expenses

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The Securities and Exchange Commission charged a hedge fund manager, his investment advisory firm, and an employee with stealing from investors in two hedge funds. The theft was carried out by charging more than $1 million for fraudulent research expenses and fees.

According to the SEC complaint, Steven R. Markusen, the owner of Archer Advisors LLC, and an employee, Jay C. Cope, diverted investor’s money from the funds for fake research expenses. They have not settled with the SEC so I only have the government’s side of the case.

The SEC accused Markusen of charging fund investors twice for the same fake research expenses. First, he billed the funds directly for Cope to conduct “research” for the funds. Second, they diverted soft dollars from the hedge funds to Cope for the same “research”, claiming Cope was an independent consultant. The soft dollars were supposed to be used to buy third-party investment research that benefited the funds.

According to the complaint, Markusen was using the expense reimbursements to pay Cope’s salary. The fund documents required employees to be paid by the fund manager. Archer was trying to disguise the salary as research payable by the fund.

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Happy Thanksgiving

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Washington, D.C.
October 3, 1863

By the President of the United States of America.

A Proclamation.

The year that is drawing towards its close, has been filled with the blessings of fruitful fields and healthful skies. To these bounties, which are so constantly enjoyed that we are prone to forget the source from which they come, others have been added, which are of so extraordinary a nature, that they cannot fail to penetrate and soften even the heart which is habitually insensible to the ever watchful providence of Almighty God. In the midst of a civil war of unequaled magnitude and severity, which has sometimes seemed to foreign States to invite and to provoke their aggression, peace has been preserved with all nations, order has been maintained, the laws have been respected and obeyed, and harmony has prevailed everywhere except in the theatre of military conflict; while that theatre has been greatly contracted by the advancing armies and navies of the Union. Needful diversions of wealth and of strength from the fields of peaceful industry to the national defence, have not arrested the plough, the shuttle or the ship; the axe has enlarged the borders of our settlements, and the mines, as well of iron and coal as of the precious metals, have yielded even more abundantly than heretofore. Population has steadily increased, notwithstanding the waste that has been made in the camp, the siege and the battle-field; and the country, rejoicing in the consiousness of augmented strength and vigor, is permitted to expect continuance of years with large increase of freedom. No human counsel hath devised nor hath any mortal hand worked out these great things. They are the gracious gifts of the Most High God, who, while dealing with us in anger for our sins, hath nevertheless remembered mercy. It has seemed to me fit and proper that they should be solemnly, reverently and gratefully acknowledged as with one heart and one voice by the whole American People. I do therefore invite my fellow citizens in every part of the United States, and also those who are at sea and those who are sojourning in foreign lands, to set apart and observe the last Thursday of November next, as a day of Thanksgiving and Praise to our beneficent Father who dwelleth in the Heavens. And I recommend to them that while offering up the ascriptions justly due to Him for such singular deliverances and blessings, they do also, with humble penitence for our national perverseness and disobedience, commend to His tender care all those who have become widows, orphans, mourners or sufferers in the lamentable civil strife in which we are unavoidably engaged, and fervently implore the interposition of the Almighty Hand to heal the wounds of the nation and to restore it as soon as may be consistent with the Divine purposes to the full enjoyment of peace, harmony, tranquillity and Union.

In testimony whereof, I have hereunto set my hand and caused the Seal of the United States to be affixed.

Done at the City of Washington, this Third day of October, in the year of our Lord one thousand eight hundred and sixty-three, and of the Independence of the Unites States the Eighty-eighth.

By the President: Abraham Lincoln

William H. Seward,
Secretary of State

 

The First Thanksgiving 1621 by Jean Leon Gerome Ferris.

SEC Issues Second Exemptive Relief from Pay-to-Play

compliance politics and money

It’s been about a year since the Securities and Exchange Commission granted its first exemptive order Rule 206(4)-5 when an adviser accidentally violated the pay-to-play rule. The SEC has now issued its second relief order. Ares Real Estate Management Holdings filed for exemptive relief after a senior partner wrote a $1,100 check to Colorado Governor John Hickenlooper’s campaign.

The Colorado governor appoints members to the Board of Trustees for Colorado’s pension system. That system was investor in one of Ares’ older funds.

Ares had compliance policies and procedures that require pre-approval of all political contributions. The employee thought the limitation didn’t apply in this situation because the adviser was not seeking new investments from the Colorado public pension fund.

The Colorado system had not made a new investment in an Ares fund since 2007. That’s six years before the contribution was made and three years before Hickenlooper was elected governor.

Since it’s a closed-end private fund, the investor has no right to redeem and is locked in for the fund’s duration.

After finding the problem, Ares put the fees into escrow pending an outcome of the exemptive order. Ares also walled that employee off from the Colorado investment to avoid tainting the relationship.

A big pile of cash was at stake for Ares. Over $1 million in fees could be generated over the two year ban.

It is great that the SEC granted the relief. But the case is an example of the problem with the Rule 206(4)-5. It is too broad. The contribution amounts were relatively small and had no connection to the investment.

Money in politics is a problem. It’s noble that the SEC has taken a stance. However, it’s contrary to the current law that political contributions are considered free speech. the SEC is taking a big club to the problem.

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Weekend Reading: War of the Whales

war of the whales

Dozens of beaked whales beach themselves in the Bahamas. This leads to a legal battle against the U.S. Navy. Joshua Horwitz details the story, scientists, the legal battle, and the science in  War of the Whales.

It’s an uphill battle when the other side is the most powerful fighting machine on the seas. It’s an even steeper hill when you realize nearly all of the experts are on the navy’s payroll.

For decades the navy has been studying marine mammals for their speed through the water and especially their echolocation. A beaked whale’s ability to locate object underwater far surpasses anything the navy can do with sonar.

But the navy does have power. If it can’t fine tune its reception, it can turn the volume up. Way up. 200+ decibels of power that appears to drive marine mammals right out of the ocean.

The book also shows the malignant problems of regulatory capture. The National Marine Fisheries Service is supposed to oversee the environmental impact of the navy. But fails to do much bur rubber stamp cursory navy reports.

Some of the key reports end up getting dumped during dead spots, just like corporate bad news filings with the Securities and Exchange Commission. One key report in the book that actually points some blame at the navy was filed at 5:30 on a Friday December 21, 2001, the last day of the federal work year and start of the Christmas weekend. There is no need to impose a media blackout, when all of the media are gone.

Compliance Bricks and Mortar for November 21

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Commissioner: ‘Millionaires can fend for themselves’ by Mark Schoeff Jr. in Investment News

“This obsession with ‘protecting’ millionaires — potentially at the cost of hindering the wildly successful and critically important private markets — strains logic and reason,” said SEC member Daniel Gallagher Jr. “Millionaires can fend for themselves.”

S.E.C.’s Delay on Crowdfunding May Just Save It by Steven Davidoff Solomon in the NY Times.com’s DealBook

But the crowdfunding industry is eager for guidelines. And so it has started to go to the states to work around the S.E.C.’s inertia. Under the securities laws, an offering made in a state by company from that state is exempt from the S.E.C. rules on securities offerings. This was intentional when the Securities Act of 1933 was passed. The idea was that individual states should maintain jurisdiction of offerings limited to their borders because only their residents would be affected.

SEC Whistleblower program has historic year by Mary Jane Wilmoth in the Whistleblower Protection Blog

On November 17, 2014, the U.S. Securities and Exchange Commission’s Office of the Whistleblower released its 2014 Annual Report to Congress. According to the report, 2014 was a historic year for the SEC Whistleblower program in terms of both the number and dollar amount of whistleblower awards. The SEC issued whistleblower awards to more individuals in 2014 than in all previous years combined.

Opinion Release 14-02: Dis-Linking The Illegal Conduct Going Forward by Tom Fox

One of my favorite words in the context of Foreign Corrupt Practices Act (FCPA) enforcement is dis-link. I find it a useful adjective in explaining how certain conduct by a company must be separated from the winning of business. But it works on so many different levels when discussing the FCPA. Last week I thought about this concept of dis-linking when I read the second Opinion Release of 2014, that being 14-02. One of the clearest ways that the Department of Justice (DOJ) communicates is through the Opinion Release procedure. This procedure provides to the compliance practitioner solid and specific information about what steps a company needs to take in the pre-acquisition phase of due diligence. However, 14-02 directly answers many FCPA naysayers long incorrect claim about how companies step into FCPA liability through mergers and acquisitions (M&A) activity.

SEC: Sending Saudi Officials on ‘World Tour’ Was FCPA Violation by Bruce Carton in Compliance Week

In case there was any ambiguity that companies may not send foreign government officials on a “world tour” in order to secure business, the SEC made that clear yesterday. In an administrative proceeding filed yesterday, the SEC sanctioned two former employees in the Dubai office of U.S.-based FLIR Systems Inc. for violating the FCPA via such conduct.

Image of Kingston Brick Wall is by Nicholas Laughlin

Anti-Money Laundering Regulations are Coming for Private Funds

Money Laundering: Hiding ownership and profits in offshore jurisdictions using myriad mechanisms in Switzeland, money laundering capital of the world, & other islands and nations. Favorite tool of mega-rich arch-criminal banking & corporate investors

Investment advisers and private funds have largely not been under the strict regulatory requirements under Bank Secrecy Act. The rationale is that the custody requirements impose a custody account and the custodian is subject to those rules.

It looks like things are going to change. U.S. Treasury Undersecretary for Terrorism and Financial Intelligence David Cohen gave  speech to to the ABA/ABA Money Laundering Enforcement Conference and said changes are underway.

FinCEN, in consultation with the SEC, is working to define SEC-registered investment advisers as financial institutions and, because of their unique insight into customer and transaction information, to extend AML program and suspicious activity reporting requirements to them.

In 2012, the Federal Reserve, FDIC, OCC, NCUA, SEC, CFTC, IRS, and DOJ, formed an AML Task Force to review the AML regime.  The Task Force’s mandate was to take a close look at what was working well and what areas might need some improvement, leveraging input from the private sector through the Bank Secrecy Act Advisory Group.

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