Current Trends Impacting the Private Fund Compliance Community

private fund compliance forum

These are my notes from this session at PEI’s Private Fund Compliance Forum.

The SEC is developing an approach of zero tolerance for non-compliance. Private funds are challenging because there are some that have been registered fro many years and many that have only been registered for two years.

The SEC is learning more about the private fund space and will increasingly be taking a more detailed look.

Some funds that have been registered for a longer period time are increasing their compliance staff and increasing the scope of compliance oversight. Firms that have CCOs wearing two hats have been splitting the role and putting a dedicated CCO in place. There is increasing SEC oversight and a rapidly changing regulatory landscape.

In looking at compliance risks versus business risks, one key is whether you are willing to have a compliance weakness in that area potential be exposed in a deficiency letter from an SEC exam.

One area particular for private equity is the use of related party service providers. The panel provided the example of a portfolio company doing an executive search and used a recruiting company that was another portfolio company controlled by the private fund.

The panel discussed JOBS Act compliance when it comes to meeting the new standard for taking reasonable steps to ascertain that an investor is an accredited investor. Funds are not using general solicitation and advertising because of the uncertainty around the requirements. The safe harbors are inappropriate for private funds. The audience voted that 25% would not use it because of the reputation risk. But half the audience confirmed that it was the uncertainty. Too many risks for too little gain.

The next topic was changes in the business practices of the fund after closing. Obviously the first analysis is whether the change is permitted by the LP Agreement. IF not, make sure that you get the appropriate consent from the LPs.

The next topic was pitchbooks and marketing materials. The SEC has expressed displeasure with one-on-one meeting materials that merely switch cover pages from investor to investor. That converts the materials into marketing materials.

The next topic was AIFMD compliance. Do we think the SEC will focus on this topic? Probably not. But you need to deal with the foreign regulatory authorities. Unfortunately it’s a rapidly evolving landscape. Many firms are saying that it’s not worth the effort to figure it out and are ignoring Europe at a source for investors. The term “marketing” varies from country to country in the EU. That means you may have multiple version of marketing materials to meet the multiple requirements.

Cybersecurity. The SEC document request for cybersecurity is incredibly complex and most private funds are going to have trouble with it. One area to focus on is the potential vulnerabilities in service providers that link into your systems. You should put together a plan and start a review to at least show that you are focused on the issue. (Because the SEC is focused on the issue.) Should compliance own this? Probably not. Most CCOs are not going to have the expertise. It’s probably better to have IT own it. One discussion is who should pay for it. Should cybersecurity be a fund expense or a management company expense. The audience and panel overwhelming took the position that it is a management company expense.

The next topic was FCPA. Make sure you do your diligence on foreign investments. With a focus on expenses, bribes and corrupt payments could end up in exam review.

The last topic was what keeps you awake at night. From the panel:

  • The rapidly changing regulatory landscape
  • Cybersecurity – that SEC doc request is scary
  • FCPA – it’s hard to find the bad activity
  • AIFMD

Lawyers and Prime Bank Investments

scams

If someone approaches you about investing in a Prime Bank investment program, walk away. Do not give them your time or money. It’s a scam.

The Securities and Exchange Commission shut down another one of these scams. Unfortunately, the investors lost at least $1.2 million before the SEC could step in.

According to the complaint, attorney Allen Ross Smith leveraged his title and position as an attorney to convince investors. The scheme was orchestrated by Switzerland-based MALOM Group AG, a company named with an acronym for “Make A Lot Of Money,” through individuals in Zurich and Las Vegas. Smith acted as MALOM’s attorney as well as its escrow agent and “paymaster.”

The SEC previously charged Malom Group AG, its principals, and agents in SEC v. Malom Group AG, et al, 2:13-cv-2280 (D. Nev. Dec. 16, 2013) and SEC v. Erwin et al., 2:14-cv-623 (D. Nev. Apr. 23, 2014). The principals of MALOM, Martin U. Schläpfer and Hans-Jurg Lips, are incarcerated in Switzerland.

The facts of the case are a mess, with various promises of funds coming from many different sources. At one point there was the lure of H-series Brazilian Letras do Tesouro Nacional (“LTNs”) – bonds issued by the Brazilian government in 1972 that were purportedly worth in excess of $200 million.

It looks like Smith was scammed into using his attorney escrow account to funnel investor money into the scam and out to MALOM’s principals. According to the complaint, Smith was making easy money, taking 1% of the incoming funds, by acting as the paymaster.

But then he stepped further over the line when he began taking a more active role in selling MALOM’s securities. Lawyer gone bad.

References:

Compliance Bricks and Mortar for May 2

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

Kara Stein Takes On Mary Jo White in the Corporate Crime Reporter

In a 3 to 2 decision last week, Mary Jo White joined the SEC majority and overturned the automatic disqualification of the Royal Bank of Scotland from eligibility as a Well-Known Seasoned Issuer (WKSI)…
And out of left field comes a new SEC commissioner, one Kara Stein, to take on White and the SEC majority.

CCOs On the Hook: FinCEN Seeking Fine Against Moneygram CCO by Michael Volkov in Corruption, Crime & Compliance

Chief Compliance Officers should take notice – the Treasury Department’s Financial Crimes Enforcement Network is proposing to fine Moneygram’s Chief Compliance Officer for Moneygram’s failure to police transactions for illicit activity. The CCO faces a potential fine of up to $5 million.

SEC Enters into First Non-Prosecution Agreement with an Individual by David Smyth in Cady Bar the Door

One of the main questions I get from potential insider trading defendants is some variation of Well, what are we looking at here? That is, if the SEC is able to prove its case, what could the consequences be?  Unfortunately, the answer is usually that it depends on a lot of things.

Stock Promoter Charged with Fraud in Florida Real Estate Venture by Mark Astaria in the Securities Law Blog

The SEC’s complaint filed in U.S. District Court in the Southern District of Florida alleges that Robert J. Vitale defrauded investors in a Florida real estate venture, sold unregistered securities, and acted as an unregistered broker-dealer. Vitale and his firm Realty Acquisitions & Trust Inc. raised at least $8.7 million from investors, including many senior citizens. Vitale allegedly told investors their funds were “100% protected” when they were not, and he claimed to be a financial expert with a business degree from Notre Dame when he never attended college after graduating from Notre Dame High School in West Haven, Conn.

What Yoda Knows by Mary Abraham in Above and Beyond KM

“The fear of loss is a path to the Dark Side.”  This insight of Yoda’s can be read as a warning about many of our information management (or, more properly, information mismanagement) practices. The fear of loss of critical data or documents can lead to over-zealous security measures that hobble the reasonable flow of information inside and outside an organization. It also can lead to information hoarding by individuals or the desperate creation by KM personnel of ad hoc databases and document collections.

Congress Tries to Fix the JOBS Act

house financial services

I’m still surprised that the Jumpstart Our Business Startups Act flew through Congress two years ago. It’s surprising to see bi-partisan support for anything. Unfortunately, the law was flawed and has accomplished little that it set out to accomplish.

The Title III Crowdfunding law was wildly hailed as monumentally changing the way small businesses could raise capital. However, the law was deeply (fatally?) flawed. The law handed the Securities an impossible framework to craft regulatory control. The SEC has not produced the new regulations because of the deep flaws in the law. That fact is clearly acknowledged in a recent legislative cover memo. Plus there is a titanic clash between the consumer protection and capital formation goals of the the SEC.

Title II demanded a lifting of the ban on general solicitation. Congress added a caveat that the company raising the capital take reasonable steps to ascertain that the investor is an accredited investor. That’s a bad hurdle, but not insurmountable. However, the SEC’s consumer protection goal produced a nasty set of proposed regulations that has scared off many firms from taking advantage of the new possibilities for advertising and solicitation.

Congress is trying to fix the problem. There is a hearing today on three bills that offer technical fixes to the JOBS Act.

The first is rebuilding of the Crowdfunding platform. This bill repeals the old law and replaces it with a modified version of the original House bill proposed by Rep. McHenry.

The second is an improvement to the oft-forgotten Regulation A exempted offerings. The proposal would raise the offering amount to 10 million and makes a few other tweaks.

The third blows up the SEC’s proposed regulatory changes to Form D and otherwise makes advertising and solicitation more palatable for private offerings.

Hearing entitled “Legislative Proposals to Enhance Capital Formation for Small and Emerging Growth Companies, Part II”
Thursday, May 1, 2014 9:30 AM in 2128 Rayburn HOB

Witnesses:

  • Mr. Benjamin Miller, Co-Founder, Fundrise
  • Ms. Annemarie Tierney, Executive Vice President and General Counsel, SecondMarket
  • Mr. William Beatty, Director of Securities, Securities Division, Washington State Department of Financial Institutions
  • Mr. Jeff Lynn, Chief Executive Officer, Seedrs Limited

These are well-thought out changes that would improve capital formation. I fear that the House Financial Services Committee has become too partisan to effectively legislate.

Form PF Filing Day

Form PF

If you run a private fund, today is deadline for the annual Form PF filing with the Securities and Exchange Commission. Depending on the type of fund, you have different reporting requirements. The SEC gets bogged down with poor definitions trying to distinguish among the types of funds.

In the glossary to Form PF, a Real estate fund is

Any private fund that is not a hedge fund, that does not provide investors with redemption rights in the ordinary course and that invests primarily in real estate and real estate related assets.

That sounds right, but I still need to look at the definition of Hedge fund:

Any private fund (other than a securitized asset fund):

(a) with respect to which one or more investment advisers (or related persons of investment advisers) may be paid a performance fee or allocation calculated by taking into account unrealized gains (other than a fee or allocation the calculation of which may take into account unrealized gains solely for the purpose of reducing such fee or allocation to reflect net unrealized losses);

(b) that may borrow an amount in excess of one-half of its net asset value (including any committed capital) or may have gross notional exposure in excess of twice its net asset value (including any committed capital); or

(c) that may sell securities or other assets short or enter into similar transactions (other than for the purpose of hedging currency exposure or managing duration).

That definition talks about getting performance fees on unrealized gains. That would be unusual for a real estate fund or private equity fund. The borrowing standard in part (b) may cause some people to pause on the definition and get entwined in a rabbithole of definition.

The form also has more detailed requirements for large private equity advisers. For purposes of Form PF, “private equity fund” is

any private fund that is not a hedge fund, liquidity fund, real estate fund, securitized asset fund or venture capital fund and does not provide investors with redemption rights in the ordinary course.

So a real estate fund is not a private equity fund and not subject to the additional reporting requirements.

Being a member of the “all other advisers” category, the filing is due with 120 days after the end of the fiscal year. Assuming calendar year is my fiscal year, the first filing is due by April 30, 2013.

Sources:

Cybersecurity and Private Funds

hacker

The Securities and Exchange Commission has off-an-on expressed concerns about cybersecurity for broker-dealers and registered investment advisers. Now it’s officially concerned. The SEC’s Office of Compliance Inspections and Examinations has announced a new cybersecurity initiative. The Risk Alert follows the announcement of a technology element in OCIE’s 2014 examination priorities and the SEC’s March 26, 2014 Cybersecurity Roundtable.

As part of the initiative, OCIE will conduct cybersecurity examinations of registered investment advisers. These examinations will be conducted as a ”sweep exam” to assess cybersecurity risks. The Risk Alert states the sweep will be of more than 50 registered broker-dealer and registered investment advisers.

In anticipation of the sweep exams, the SEC included a sample request list for the Identification of Risks/Cybersecurity Governance.

I would anticipate that the sweep exam will be targeted at the big BDs and retail investment adviser shops and not be focused on private fund managers. However, I plan to sit down and go through the sample letter to make sure I can answer all of the questions.

References:

Hacker is by Dani Latore
CC BY SA

Cleaning Up An Oil Spill Is Insider Trading

oil platform and compliance

Keith A. Seilhan was 20-year employee of BP and a senior responder during the 2010 Deepwater Horizon oil spill. Seilhan directed BP’s oil skimming operations and its efforts to contain the expansion of the oil spill. What he saw scared him so he sold his entire portfolio of BP stock.

The Securities and Exchange Commission charged him with insider trading. The SEC’s view was that he had confidential information about the magnitude of the disaster. BP was telling the public that the spill was only 5,000 barrels of oil per day. Seilhan obtained information that the magnitude of the oil spill and BP’s potential liability and financial exposure, was likely to be greater than had been publicly disclosed. The truth was more than ten times that publicly reported amount.

This case reminded of the railroad case where workers in the railroad yard noticed unusual activity around the railyard and came to the conclusion that the railroad was up for sale. They made a stock bet on their conclusion and won. But the SEC charged them with insider trading, but lost the case.

In the oil case, Seilhan knew the company was lying about the scope of the spill. The information was not publicly available because BP was purposefully deceiving the public and regulators.

You could argue that the information is more like the counting of cars in a retailers parking lot to see how business in doing. Anyone could jump in a plane and see the scope of the oil spill. The news organizations were doing just that. I assume it would take a trained eye to notice that the spill was being misjudged by an order of magnitude.

Regardless of my thoughts about the case, Mr. Seilhan felt it was better to settle the charges than fight the SEC. A month after the trade he received a reminder memo from BP legal to not trade on the stock based on an employee’s possession of price sensitive information. That prohibition was in BP’s code of conduct. Seilhan replied to legal and wanted to discuss his trade, but never followed up or disclosed.

Seilhan agreed to return $105,409 of allegedly ill-gotten gains, plus $13,300 of prejudgment interest, and pay a civil penalty of $105,409.

References:

Image is Thunder Horse Semisub by Andyminicooper
CC BY SA

Happy Patriots’ Day

patriots day compliance

The Redcoats are coming!
The Redcoats are coming!

Patriots’ Day is a Massachusetts state holiday commemorating the opening battles of the American Revolutionary War in Lexington and Concord in April, 1775.  The more modern day event is the running of the Boston Marathon, starting in Hopkinton and ending 26.2 miles later in Copley Square.

Last year’s marathon was horribly marred by two homicidal psychopaths. This marathon is being taken back this year.

In the morning there is a battle reenactment on the Lexington Green of the early-morning engagement between the town’s militia and the British regulars. If you remember back to U.S. history class, that battle was the shot heard round the world.

There is also a re-enactment of the rides of Paul Revere and William Dawes from Boston out to Lexington. (You don’t know about Hawes because Longfellow didn’t write a poem about him.) That ride started out with the “one if by land, two if by sea” signal to Charlestown in case Revere and Dawes were captured.

What does this have to do with compliance or business ethics? Nothing. It’s a holiday here in Massachusetts so I am out of the office.

Compliance Bricks and Mortar for April 18

bricks curvy

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

Quantity does not equal quality: Expanding ‘disclosure events’ on BrokerCheck a bad idea: Brokerage industry is only one in which professionals as deemed guilty until proven innocent by S. Lawrence Polk in Investment News

Under the current version of Form U4, brokers and their firms are required to disclose any written customer complaint, no matter how frivolous, as long as it somehow relates to a sales practice issue, even if the broker is not named in the complaint. The broker that is the subject of the complaint has it reported on his or her CRD and can remove the disclosure only by going through an expensive and time consuming expungement action, in which the broker bears the burden of proving the complaint is false.

In other words, the broker is deemed guilty until he or she proves his or her innocence. No other profession has a reporting system where the mere filing of a complaint, even if it is later withdrawn, remains part of the public record for years afterward.

Massachusetts Regulators Allege TelexFREE Is $1 Billion Ponzi Scheme by Jordan D. Maglich in Ponzitracker

Massachusetts securities regulators have initiated civil proceedings accusing a Massachusetts and Nevada company of operating a massive pyramid andPonzi scheme targeting Brazilian-Americans that, through the promises of guaranteed annual returns exceeding 200%, raised more than $90 million from Massachusetts residents alone and nearly $1 billion worldwide.  TelexFREE, Inc., a Massachusetts corporation, and TelexFREE, LLC, a Nevada limited liability company (collectively, “TelexFREE”), were accused of violations of the Massachusetts Uniform Securities Act by engaging in the fraudulent offering and sale of unregistered securities.  The Massachusetts Enforcement Section of the Massachusetts Securities Division is seeking, in relevant part, a permanent cease-and-desist order, an accounting, restitution to victims, and disgorgement of profits and ill-gotten gains.

Was the Conflict Minerals Ruling a “Win” for SEC Rulemaking? by Dave Lynn in CorporateCounsel.net

With this outcome, the rule writers at the SEC are no doubt breathing a sigh of relief, as they still have a relatively full plate of Dodd-Frank Act and JOBS Act mandated rulemakings that continue to percolate. After a string of high profile losses in this Court and the U.S. District Court for the District of Columbia, this outcome is probably the best that the SEC and the Staff could have hoped for and may serve to pave the way for moving forward with the rest of the rulemaking agenda.

The High Cost of Procrastination by Dan Ariely

This is what procrastination is all about. When we think about our life in general we see the benefits of getting our work done on time, saving for retirement, eating better and other good habits. Yet when we face the decision about right now, we get tempted and too often follow our immediate desires and not what it is good for us in the long-term.