The Stability of Prime Money Market Funds

adoption money

I was critical of the Securities and Exchange Commission’s new rule on money market funds. To me it seemed like it was trying to fix a problem that didn’t exist, and in the process made things more complicated. For criticism to be correct, I need data. After review a paper on the Stability of Prime Money Market Mutual Funds, maybe I was wrong.

Steffanie A. Brady, Ken E. Anadu, and Nathaniel R. Cooper looked at money market funds from 2007 to 2011 for evidence that they could have “broken the buck.” The most famous instance was when the Reserve Primary Fund did the unspeakable in September 2008 because of its exposure to Lehman debt securities.

The authors were looking for instances where money market funds could have broken the buck, but the sponsor stepped in to prop up an ailing fund. Their paper presents a detailed view of the non-contractual support provided by sponsors during the recent financial crisis. They looked at public SEC financial statement filings to find evidence of problems.

They found at least 21 money market funds would have broken the buck without sponsor support during the Great Recession. They found frequent sponsor support during that period with at least $4.4 billion of support to 78 of the 341 funds reviewed.

The largest support relative to a fund’s AUM was the $336.8 million (6.3% of AUM) support for the Russell Money Market Fund.

“On September 14, 2009, the Lehman Securities were purchased by Frank Russell Company from the Fund at amortized cost of $402,764,934 plus accrued interest of $775,756.”

Perhaps money market funds are riskier than I thought. Fund sponsors have repeatedly, voluntarily stepped in to stabilize these funds. The SEC’s rule will make these money market funds less attractive as a safe haven for cash. But maybe they are not really as safe as I thought.

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Compliance Bricks and Mortar for August 15

nooks and crannies of bricks

GPs look for ‘sweet spot’ on co-investment disclosures by Nicholas Donato in Private Funds Management

Part of the SEC’s thinking is that co-investments are being used as marketing tools – so some investor protection is needed to ensure that promises made during fundraising are being fulfilled. Inspectors apparently want to see that every prospective LP is given a heads-up that co-investments are part of the GP’s repertoire – and, ultimately, is given the chance to take part in these deals.

The Clearest Trend in the American Workforce Is Not an Encouraging One by Andrew McAfee

So it feels to me like something else is going on, in addition to the graying of the US workforce — some other forces that are causing more and more people in recent years to go to school, stay in school, go on disability, get discouraged and stop jobhunting, stay home to raise kids or take care of a sick or elderly loved one, or do any of the other things that means they’re no longer categorized as ‘working or looking for work.’

Second Circuit affirms dismissal of compliance officer retaliation suit against Siemens by Richard L. Cassin in the FCPA Blog

Meng-Lin Liu, a Taiwan citizen, said in his lawsuit filed in January 2013 in the U.S. district court in New York that by firing him, Siemens violated the whistleblower anti-retaliation provision of the Dodd‐Frank Act (15 U.S.C. § 78u‐6(h)(1)). The trial court judge, William H. Pauley, III, granted Siemens’s motion to dismiss with prejudice, holding that the anti-retaliation provision doesn’t apply extraterritorially, and that, on the facts alleged by Liu, his civil complaint sought an extraterritorial application of the statute.

4 Reasons Why Private Equity Firms Like KKR Offer the Best of Capitalism by Jonathan Yates in TheStreet

1. Private equity enhances shareholder value – When a private equity firm buys a company, it offers a higher share price.

2. Private equity deals add to the health of the financial markets – Private equity transactions improve the efficiency, and thus the health, of markets by injecting liquidity…[and] capital to entities of all sizes and types, too.

3. Private equity allows companies to better compete – When a private equity group acquires a business, that firm gains access to high-quality resources for managerial, financial, and legal matters. That naturally leads to companies that are managed much more efficiently with access to much more capital and other vital business resources.

4. Private equity opens opportunities for investors – For many private equity transactions, taking the company public is the exit strategy. That offers a greater selection to investors, which leads to more diversity and enhanced risk management, two of the most important considerations for any portfolio.

New York brokerage CEO criminally charged with obstructing SEC by Jonathan Stempel in Reuters

The chief executive of a New York brokerage was criminally charged on Friday with lying to the U.S. Securities and Exchange Commission and faking documents to disguise how his firm did not have enough capital.

 

Nooks and Crannies is by Phil Shirley
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Proposed Regulations on Customer Due Diligence Requirements

fincen logo

The U.S. Treasury Department’s Financial Crimes Enforcement Network has proposed revisions to its customer due diligence rules. Of course, the proposed rule would affect financial institutions that are currently subject to FinCEN’s customer identification program requirement: banks, brokers-dealers, and mutual funds. However, FinCEN suggested that it may be considering expanding these customer due diligence requirements to other types of financial institutions. FinCEN names money services business, casinos and insurance companies. Investment advisers and private fund managers are not specifically mentioned.

According to FinCEN, an Anti-Money Laundering program should have four elements:

  1. Identify and verify the identity of customers;
  2. Identify and verify the identity of beneficial owners of legal entity customers
  3. Understand the nature and purpose of customer relationships; and
  4. Conduct ongoing monitoring to maintain and update customer information and to identify and report suspicious transactions.

Please notice number 2. The definition of “beneficial owner” is proposed as have two prongs:

  • Ownership Prong: each individual who, directly or indirectly, through any contract, arrangement, understanding, relationship or otherwise, owns 25% or more of the equity interests of a legal entity customer, and
  • Control Prong: An individual with significant responsibility to control, manage, or direct a legal entity customer, including an executive officer or senior manager (e.g., a Chief Executive Officer, Chief Financial Officer, Chief Operating Officer, Managing Member, General Partner, President, Vice President, or Treasurer); or (ii) any other individual who regularly performs similar functions.

For identifying ownership of an entity, FinCEN has proposed a form of certification. I find the certification to be overly simplistic. It only asks for individuals with ownership in the entity. This would clearly miss ownership of the account holder by other entities who could be “bad guys.” The certification also only requires one senior officer.  That makes it too easy to appoint a straw man as executive officer to hide the underlying control by a “bad guy.”

On the other hand, it makes it really easy for the financial institution to check the boxes with requirements and confirm compliance.

The rule does not specifically contemplate investment advisers or private fund managers. For many investment advisers, the underlying broker-dealer or custodian will end up with KYC responsibilities. The investment adviser will have to be a conduit for that information.

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Lawsuit Against SEC’s Political Contribution Rule

USDC for DC Meade_and_Prettyman_Courthouse

The New York Republican State Committee and the Tennessee Republican Party brought suit against the Securities and Exchange Commission challenging its political contributions rule for investment advisers, . The complaint seeks an injunction against the enforcement of the rule’s political contribution restrictions on contributions to federal candidates.

The first attack on the rule is that Federal Election Campaign Act gave the Federal Election Commission exclusive jurisdiction over federal campaigns. I don’t know enough about that law to opine on that argument.

The second attack is that the rule exceeds the SEC’s statutory authority. They look to the release for Rule 206(4)-5 and the SEC’s own statement that the rule may prohibit acts that are not themselves fraudulent. The problem is that the SEC is confusing payments to state officials as a quid pro quo for business with legal campaign contributions.

As for expertise, the parties point out that the SEC has no specialized knowledge of campaign finance or elections.

The third attack is that the rule violates the First Amendment to the US Constitution. One focal point of the argument is that the rule distorts the ability to give to candidates running for the same office. I pointed this out in the 2012 Republican presidential primaries. Contributions were limited to Rick Perry, but none of the other candidates.

Although some of the arguments could be used to take down the entire rule, the parties are only seeking to exclude it from application to federal candidates. In my view that would be an improvement. It would make it a much clearer rule. The only published relief under the rule was when the Ohio State Treasurer was running for US Senate. The employee thought the rule did not apply to federal candidates.

I don’t like the political contributions rule. It takes innocent, legal behavior, with no fraudulent intent, and turns it into a regulatory violation. Campaign finance is a problem, but the SEC rule does little to help the problem.

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Meade and Prettyman Courthouse by AgnosticPreachersKid
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FinCEN Emphasizes a Culture of Compliance

Compliance Secrets Advice Following Rules Yellow Envelope

The US Financial Crimes Enforcement Network has finally come around to realizing that US financial institutions should promote a culture of compliance. FinCEN does not point to any specific problem, but mere notes that “Shortcomings identified in recent Anti-Money Laundering enforcement actions confirm that the culture of an organization is critical to its compliance.”

FinCEN’s mission is to safeguard the financial system from illicit use and combat money laundering and promote national security through the collection, analysis and dissemination of financial intelligence and strategic use of financial authorities.

I don’t think that that anyone believes that these roadblocks in the financial system will prevent terrorism, drug sales or other illegal activities. But it should prevent law-abiding financial institutions from helping illegal activities.

The FinCEN’s advisory (.pdf) comes off as a bit stale since the culture of compliance mantra has been echoing throughout financial institutions for many years.

One piece of the FinCEN guidance did catch my eye:

Compliance should not be compromised by revenue interests

Again, this guidance is not novel, but rarely have I seen it so specific. AML compliance should operate independently and be able to take appropriate actions to mitigate risk and investigate possible inappropriate activity.

When BNP Paribas SA, compliance staff gave warnings but then assisted with misconduct, you understand the need for FinCEN to be more explicit about compliance culture.

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Compliance Bricks and Mortar for August 8

brick walls

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

Lawyers as SEC Enforcement Targets, What a Fund Manager Needs to Know by Jay B. Gould in the Investment Fund Law Blog

In a move that should place securities lawyers and their clients on notice, Commissioner Kara Stein of the Securities and Exchange Commission (“SEC”) recently indicated that lawyers may become targets of SEC enforcement actions when a registrant has been poorly advised by its attorney and the result of that advice ends up harming investors or violating regulatory standards. The SEC has the ability to sanction, fine and bar attorneys and accountants from practicing before the SEC pursuant to SEC Rules of Practice 102(e). As a practical matter, a bar pursuant to Rule102(e) precludes an attorney or an accountant from representing a regulated entity, such as an investment adviser or broker dealer, in any further dealings with the SEC or otherwise.

White & Case discusses DC Circuit’s CFIUS Ruling by Richard J. Burke, Cristina Brayton-Lewis, Tanya Hanna and Ziad Haider in the CLS BLue Sky Blog

The DC Circuit’s ruling constitutes an important albeit narrow victory for foreign investors who have sought greater transparency in the CFIUS review process. While the ruling grants certain due process protections to investors, the CFIUS legal regime remains intact, and the due process to be accorded will still need to be balanced against other interests.

Not Securities Fraud By Reason of Insanity

insanity

Some investment fraud schemes sound crazy, but leave just a enough truthful-sounding bits to catch people. But Thomas Lawler’s scheme sounds completely bonkers. He established the Freedom Foundation to offer investors the chance to erase their debts and collect lucrative profits through the purchase of “administrative remedies”.

Never heard of profit-making “administrative remedies”? Lawler can sell you the secret.

Lawler investigated the banking system and discovered the startling “truth.” At birth, we each have an account established in our name. When you borrow from the bank, you are actually borrowing your own money that resides in your account. For a mere $1000, Lawler will prepare notices to the creditors, using the Uniform Commercial Code, international admiralty law, and papal decree to cancel the debt.

At least that is according to the SEC’s complaint. I checked out the Freedom Club USA website to find more information. The website is a big collection of crazy.

Here is a snippet:

The Vatican created a world trust using the birth certificate to capture the value of each individual’s future productive energy. Each state, province and country in the fiat monetary system, contributes their people’s value to this world trust identified by the SS, SIN or EIN numbers (for example) maintained in the Vatican registry. Corporations worldwide (individuals became corporate fictions through their birth certificate) are connected to the Vatican through law (Vatican to Crown to BAR to laws to judge to people) and through money (Vatican birth accounts value to IMF to Treasury (Federal Reserve) to banks to people (loans) to judges (administration) and sheriffs (confiscation)

The website includes ramblings about a lost 13th amendment to the Constitution, the illegality of the 1040, the Cosmic Time Plan, and an audio recording from the Prime Creator.

In sorting through the crazy, it’s hard to tell if it’s a securities fraud issue. It’s certainly a fraud. Anyone giving money to this kind of full-blown crazy is throwing their cash away. It sounds like Lawler may be selling a service and not an investment. There is too much crazy on the website for me to discern what Lawler is actually selling.

You can look to the Howey four-part definition of an investment contract. There is certainly an investment of money and the reliance on others. There is a reasonable expectation of profits. Cancelling debt is income, so the SEC can probably get over that hurdle.

But I’m not sure there is a “common enterprise.” Lawler’s scheme seems more like fraudulent credit reduction scheme than a securities investment.

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Image of Insanity by Albert Einstein by Marla Elvin
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Another Real Estate Ponzi Scheme From 2008

compliance building

The 2008 financial crisis caused many real estate investment funds to run into trouble. Some fund managers stepped over the line hoping to wait out the turmoil and recover. The Securities and Exchange Commission finalized charges against a fund manager who hoped to divert funds to stay liquid during the turmoil.

According to the SEC’s complaint, the Walter Ng, his son Kelly Ng, and Bruce Horwitz promoted Mortgage Fund 08 during the 2008 financial crisis as a new opportunity to invest in conservatively underwritten commercial real estate loans. But the Ngs and their advisory firm, The Mortgage Fund LLC, immediately began transferring money raised by MF08 to an older fund that had run into trouble. Their R.E. Loans fund was in trouble exactly because of the 2008 financial crisis.

R.E. Loans was a high-risk debt fund, charging high interest to real estate projects and developers who could not obtain traditional financing. From 2002 through 2006 the fund appeared to be successful. The Ngs raised hundreds of millions of dollars from investors and distributed hundreds of millions back to investors. But the fund ran into cash flow difficulties in 2007. It was the harbinger of the upcoming financial crisis.

From December 2007 to March 2008, the Ngs transferred almost $39 million from MF08 to R.E. Loans. I’m an optimist so I assume that the Ng were hoping some short-term affiliate loans would be enough to get R.E. Loans through the financial crisis. But delinquencies continued to rise from 15% in March 2008 to 74% by June 2008.

The Ngs lied to their investors and doubled down on the earlier fund.

The NGs were also subject to criminal investigation and charges. Kelly is serving 18 months while his elderly father is merely on probation. The charges were light because it took too long to discover and investigate the fraud. The statute of limitations limited government action.

As we have passed the five year mark for the 2008 financial crisis the frauds that happened during the time will not be prosecuted.

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The SEC is Late to a Real Estate Fraud

Company Theft

The Securities and Exchange Commission charged M. “Shi” Shailendra with making false representations to investors, misappropriating money, and acting as an unregistered broker. Shailendra was selling interests in his Interstate North 5 Acres fund known as Shi Six. He was purportedly using the money to acquire distressed real estate. Instead, he was pocketing most of the capital.

Shailendra had plans to create a massive real estate empire built with capital from the Indian community. His plans got derailed by the 2008 financial crisis and his own misdeeds.

According to news reports, the unraveling of his misdeeds has been happening for several years. Shi Investments One sued the Shailendra Group back in early 2011 for the diversion of investor funds to personal accounts and other self-dealing.

It’s good that the SEC caught him, but it seems that his investors had already grabbed him. Among the SEC’s penalties, Shailendra was ordered to disgorge over $2 million in ill-gotten gains and penalties. But the SEC waived that amount based on his inability to pay.

The fund is handed over to investors to try and regain whatever capital may remain. From the accusation in the complaint it sounds like most of the investors’ capital went to Shailendra for personal use or to fund affiliate transactions.

At a minimum, Shailendra is permanently barred from association with any broker-dealer, investment adviser or other firm under the jurisdiction of the SEC. However, lots of real estate investment operates outside that jurisdiction.

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Weekend Reading: Flash Boys

flash boys

I admit to being a Michael Lewis fanboy. I consider him one of the best business writers. He has a knack for using characters as a lens to explain an issue.

The issue in Flash Boys is high frequency trading. Or high speed trading. Or electronic trading. It’s a bit of a confusing mix. Uncharacteristically, Lewis seems to stumble a bit around what the problem is. I think that is in part because the problem is complicated in a technical, legal and financial directions. Many of the people involved don’t fully understand it. Those that do fully understand it don’t want to explain it. They are too busy making money exploiting the issue.

Based on the speed you receive information, you can trade on that information and make money if you find out faster and trade faster than others. That has been true since markets existed.

For stock exchanges, the days of floor pits and individuals yelling buy and sell orders are long gone. It all happens in server stacked on top of each other with an algorithm matching buy orders and sell orders. There are multiple exchanges where trades can take place. That’s good for competition and innovation.

But those exchanges are located in different places. Not necessarily far apart, but milliseconds or microseconds apart. Just far enough that watching trades happen in one exchange can give a strong indication about what will happen in another exchange a bit further away. High speed traders exploit that information and make money. Lots of money if they are fast enough.

Lewis explores the issue in great detail and provides a good understanding. He uses Brad Katsuyama, a trader at the Royal Bank of Canada, as the focal point of his story.

The most disappointing part of the book is that it ends without resolution. The problems with high speed trading are still in the system and its hurting investors not involved in high speed trading.