Best Practices Under the FCPA and Bribery Act

FCPA Compliance

Tom Fox is prolific writer on the Foreign Corrupt Practices Act. He publishes the excellent FCPA Compliance and Ethics Blog. One of the downsides to a blog is that it’s a running commentary and not a narrative guide. Blogs are great for sharing ideas among practitioners. But a blog does not come together as a nuts and bolts tool.

Tom took action and organized some of his best posts into Best Practices Under the FCPA and Bribery Act. Now you can pull a comprehensive collection off your shelf to help you create and manage a world class compliance program for bribery and corruption.

The book is a “best of” collection, but organized topically, making it a great resource for the FCPA practitioner.

I was not an unbiased reader of the book. I’ve spoken with Tom many times and spent some time with him at the Compliance Week conference in 2010. Tom kindly mentioned me in the acknowledgements and sent me a copy of the book.

My only demerit on the book is that there is little new material that did not appear on his blog.

The SEC Expresses Its Displeasure on Fund Fees

money penny

A few days ago, Bloomberg published a story that the Securities and Exchange Commission has examined about 400 private equity firms and found that more than half charged “unjustified fees and expenses without notifying investors”. The SEC followed through with that story and recently charged Total Wealth Management with improperly disclosing fee revenue.

Total Wealth sponsored a series of private funds that invested in other funds. Total Wealth had revenue sharing arrangements in place with several of the funds in which it invested, paying Total Wealth a fee when it placed client investments in those funds. Total Wealth would split the revenue sharing income among the firm’s principals.

Revenue sharing is not illegal  and not necessarily misleading, deceptive, or fraudulent. The key is disclosure. If properly disclosed, the SEC would have little basis for bringing charges.

According to the SEC order, the funds’ offering memoranda failed to adequately disclose the revenue sharing arrangement. One of document stated”

“Some Private Funds may pay the General Partner or its affiliates a referral fee or a portion of the management fee paid by the Private fund to its general partner or investment adviser, including a portion of any incentive allocation” (emphasis added).

The revenue sharing arrangement was not disclosed in the “other fees and expenses” summary portion of the offering document.

The SEC argues that Total Wealth should have disclosed that it was already receiving the fee income and not merely that it “may” receive the income.

Stopping at this point, the SEC charges leave me unsettled. The argument over the definitive nature of the fees seems to be over-reaching to me. I think many fund disclosures use “may” when describing other revenue sources.

The other aspect of fee arrangements is the distortion in behavior. Disclosure of the fees alone may be enough, but not if the fee distorts behavior so the fund manager might not be acting in the best interest of its investors.

Here is where the SEC’s case is stronger. About 92% of Total Wealth’s fund assets were invested in entities that had revenue sharing arrangements. Total Wealth’s behavior was apparently distorted because it was more likely to invest in funds with a revenue sharing arrangement. Some of these arrangements also had lock-ups that prevented investors from withdrawing money.

The SEC also accused Total Wealth of deliberately burying the revenue sharing arrangement. The revenue was shared through two entities and labeled the fees as consulting fees, even though the entities did not do any consulting work. Total Wealth fired an experienced compliance consultant who drafted a Form ADV Part 2 that very clearly disclosed the revenue sharing arrangement. The next consultant was much less experienced and used the “may” language instead.  The SEC also accused Total Wealth of hiring an inexperienced accountant who inadequately investigated the revenue sharing.

Total Wealth has not agreed to the charges, so we only have the government’s side of the story. The SEC also threw in charges of failing to comply with the Custody Rule and Total Wealth’s failure to meet its own diligence standard.

I’m troubled by the SEC’s position in this case over the use of “may.” (Of course, there are other issues in the case.) If this truly is the SEC’s position, then I understand why the SEC thinks 50% of private fund managers have problematic fees. And if it this truly is the SEC’s position then there will be lots of fund managers going back through and revising their documents.

References:

Real Estate Investing and Crowdfunding

crowdfunding real estate

Real estate investing is capital-intensive. It should be a natural area for crowdfunding. The big concern is fees and conflicts.

With a tech startup, you are investing in an idea and the people with the idea. It may grow exponentially or blow up, leaving little behind. Part of the investment is paying the people to run the business. With real estate, the cost of managing the investment may be an additional expense beyond the investment. The people managing the investment may be connected with the people selling the investment. That can work well, or be a conflict.

The Wall Street Journal highlighted crowdfunding opportunities in real estate: Real-Estate Crowdfunding Finds Its Footing. The Securities and Exchange Commission has not enacted crowdfunding regulations yet, so the investments will have to be limited at accredited investors, or otherwise exempt from securities registration. Of course, if the investor has enough rights, it’s possible that the investment might not be a security.

The stories highlights three real estate crowdfunding platforms:

  • RealtyMogul
  • Fundrise
  • Prodigy Network

So I decided to take a closer look.

Realty Mogul

After logging in, the site asks for self-reporting of income and net worth to determine if the user is an accredited investor. The final step is a click wrap agreement that:

“By checking this box, you represent that you have such knowledge and experience in financial and business matters that you are capable of evaluating the merits and risks of this investment, and you are able to bear the economic risk of this investment including the risk of complete loss.”

Then the site imposes a 21 day delay. I presume that this is set up to distance the site registration from a general solicitation. By coming back 21 days later, I assume the firm is trying say that there is now a relationship.

Even with the delay, you can browse available investments. There were 5 available when I viewed the site, ranging from $510,000 to $760,000 of equity sought. Each sets up a Realty Mogul subsidiary to invest alongside a property operator/co-investor. The site discloses the operator’s compensation and Realty Mogul’s compensation.  The available assets all had a $10,000 minimum investment.

Fundrise

This site also has you self-certify as an accredited investor. I was surprised to see the no option as “No – most people choose this option”. I chose this first, then went back to switch it to accredited investor.

Apparently, Fundrise has seen the SEC rule on general advertising and requires verification that you are accredited. The site requires a verification letter from a broker-dealer, registered investment adviser, attorney, or CPA before granting you status as an accredited investor.

The platform has regulation A offerings available for non-accredited investors, but limited by state. The documentation is substantial. The offering document for one investment was over 100 pages.

Fundrise is less transparent about fees than Realty Mogul. The Reg A investment allowed an investment as little as $100. The private placements required a minimum of $5000.

Fundrise has a social network aspect, allowing you to see the investors in an investment and to join investment network within the platform.

Prodigy Network

Offered little detail behind its introductory pages.

Summary

Here is the big problem with real estate crowdfunding. To purchase or sell real estate, you need to act 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. Presumably 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 seller, why would you accept an offer contingent on crowdfunding?

The alternative is that the real estate is already warehoused with a party and is looking to lay off some of the equity or fund capital improvements.  Then you are looking to crowdfunding as a cheaper source of capital or a quicker source of capital. I have a hard time believing that crowdfunding is 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.

However, I applaud the efforts of these sites and think they offer an interesting opportunity to make an alternative investment.  I had only a short opportunity to see what these platforms have to offer and how they go about offering their investments. There is lots more to see and learn.

References:

Compliance Bricks and Mortar for April 11

ponzi bricks and mortar

Charles Ponzi’s former home up for sale by Erin Ailworth

For the first time, the butter-colored stucco house with the slate roof and second-story balustrades, is going on the broader real estate market, available to anyone willing to take a run at the $3.3 million asking price. All previous sales have been private.

One of the biggest selling points, of course, is Ponzi’s one-time ownership — although he occupied the property for only about six weeks in 1920 before he was arrested on charges of mail fraud. The home has only changed hands three times since Ponzi bought the house from the previous owner, paying him initially with one of his company’s worthless securities.

Introducing Cybersecurity Docket!

Cybersecurity Docket, the “Global Cybersecurity and Incident Response Report,” seeks to be the most comprehensive and timely source of news and commentary on the exploding fields of cybersecurity, data breach and incident response. Continuously updated throughout the day, Cybersecurity Docket delivers important news and developments as they occur – not days or weeks later. Lawyers, executives, compliance officers, consultants, regulators and other professionals throughout the cybersecurity industry rely on Cybersecurity Docket as their “one-stop” way to quickly and easily stay informed.

Answering the questions high-frequency trading raises by Brian Schreiner in Investment News

There has been a media firestorm over high-frequency trading since Michael Lewis appeared on “60 Minutes” on March 30 to discuss his new book Flash Boys. But HFT is nothing new. It has been around since at least 1999 when stock exchanges became fully electronic. HFT is a complex and nuanced issue, which requires more than a cursory overview to gain an informed opinion.

Trust Hero: Brad Katsuyama, on CBS 60 Minutes by Charles H. Green in Trust Matters

Of course, it is anything but crazy. As Michael Lewis says, “When someone walks in the door who is actually trustworthy, he has enormous power. And this is about trying to restore trust to the financial markets.”

Exactly. As anyone who’s been reading this blog for years knows, trust sells. Trust scales. Trust creates value. Trust is an enormous competitive advantage.

Do Compliance Professionals Have to Be Lawyers? by Michael Volkov in Corruption, Crime & Compliance

As compliance professionals enjoy the rise of their profession, lawyers are sensing a decline in importance.  I am hearing from compliance professionals a new and disturbing trend – companies are requiring compliance professionals to be trained attorneys.

 

Pay to Play and the Supreme Court

Supreme Court

The US Supreme Court struck down some campaign finance limitations in McCutcheon v. Federal Election Commission. My first question was whether this court ruling would impact the Securities and Exchange Commission’s Rule 206(4)-5. The answer is “no.”

Mr. McCutcheon wanted to contribute $1776 dollars to a long list of political candidates. Each individual contribution is less than the $2600 federal limit. But the sheer number of candidates and political groups he targeted would violate the aggregate limits.

It was this aggregate limit that the Supreme Court struck down. The case did not strike down the individual limit.

The First Amendment protects political campaign contributions as a type of free speech. Therefore, any restrictions on political contributions must promote a compelling state interest and undertake the least restrictive means to further the state interest.

The Supreme Court has found that the government can regulate campaign contributions that target “quid pro quo” corruption or its appearance. Individual campaign contributions can be limited to prevent the dollars for political favors problem. That is a compelling state interest.

SEC Rule 206(4)-5 is specifically targeted at the corruption or appearance of corruption problem. The SEC can point to specific instances of government investments being tied to political contributions. It’s unlikely that the SEC’s pay-to-play rule will be overturned anytime soon.

References:

Image of the Supreme Court is by Matt H. Wade

Can a Vending Machine Be a Security?

virtual concierge and compliance

The Securities and Exchange Commission brought charges against Joseph Signore and Paul Lewis Schumack, II in connection with an alleged investment fraud concerning the sales and marketing of a “Virtual Concierge” machine. The machine looks like an ATM, but carries advertising and can print tickets and coupons. It looks shady, but a machine alone is not a security. Does the SEC have jurisdiction?

According to the SEC complaint, Signore and Schumack offered two investment options. The first is the aggressive option. The investor is responsible for placing the machine. The second option is the passive option where the investor makes an investment and lets the company do the work in exchange for a guaranteed payment of $300 per month.

Under the passive option, the investment arrangement could be considered an “investment contract” under the definition of a security. I assume the court will use some derivation of the Howey case to determine if there is an investment contract, and look at whether there is

  1. an investment of money,
  2. a common enterprise,
  3. a reasonable expectation of profits, and
  4. a reliance on the entrepreneurial or managerial efforts of others.

I would guess that the aggressive option would not meet the test. But the passive option is likely to meet the test. The virtual concierge investors pay $3500, do nothing, and get $300 per month. It sounds like the investors are relying on the managerial efforts of others to generate profits.

The virtual concierge contractual arrangement sounds a lot like the orange grove investment in Howey. The actual investment is in real estate or a tangible good. But the investment is wrapped with a management contract that turns the investment into a passive investment that is likely to meet the definition of an “investment contract.”

From the criminal complaint, it sounds like Schumack and Signore were very good at convincing people to make the investment. A confidential witness states that they sold approximately 16,000 units. However, the company was only able to place 46 machines.

Of course, this story is based solely on the government’s accusations and the defendants have not had an opportunity to respond the charges. The story caught my eye as part of my continuing to quest to define a “security.”

References:

The SEC Has Seen Your Private Equity Fees And Is Not Happy With Them

money penny

According to a story in Bloomberg, the Securities and Exchange Commission has examined about 400 private equity firms and found that more than half have charged “unjustified fees and expenses without notifying investors”. The editor decided to change the headline from “unjustified” to “bogus”.

Fees and expenses charged by a fund manager to investors in the fund is always a conflict. The manager is taking cash from the limited partners.

The first question is whether the fees and expenses are adequately disclosed in the private placement memorandum or the partnership agreement. Most funds give the manager broad discretion to charge expenses for managing the investments to the investors in the fund. I have a hard time believing that over 50% of fund managers are charging expenses that are not permitted by the fund documents.

The story used “unjustified” when disclosing what the “person with knowledge of the SEC’s findings” stated about the fees. That may be more about the SEC not being happy with the fees charged, not necessarily that the fund manager is not legally entitled to the fees.

The second issue to think about with fees is whether the fees distort behavior. Certainly, a fund manager could be tempted to operate its private equity investments in a way that maximizes its fee revenue. That may cause the manager to make decisions that are in its best interest and not necessarily in the best interest of the fund investors. If a fund manager earns a fee for raising additional debt for a portfolio company, but not for raising additional equity. You might think the fund manager would be inclined to more often raise debt instead of equity.

To counter that inclination, private fund mangers earn the best returns by deliver great returns to their investors. Most managers earn a carry, taking an extra piece of the profit for good returns to investors. Taking a fee in the short term would hurt the long term, bigger return.

Compliance has a role to monitor fees to make sure they comply with the disclosures and legal agreements. It also has a role to monitor whether the nature of the additional fees distorts behavior in a way that could be perceived as adverse to investors.

The story mentions three types of bogus fees:

  1. miscalculating fees,
  2. improperly collecting money from companies in their portfolio and
  3. using the fund’s assets to cover their own expenses

One is failing to comply with the documents. Two is a potential disclosure failure. Although, the SEC may be expecting more specific disclosure than exists in the fund documents. Three may be a difference of opinion by the SEC over what should be a fund expense and what should be a management company expense.

As for expenses, the story mentions the Clean Energy Capital case where the SEC has accused the fund manager of grossly over-allocating expenses to the fund instead of the management company.

References:

What Are the Implications of the SEC’s New Private Fund Exam Unit

SEC Seal 2

Greg Roumeliotis and Sarah N. Lynch are reporting in Reuters that the Securities and Exchange Commission has formed a new group dedicated to the exam of private equity and hedge funds. This new private fund unit will be co-chaired by Igor Rozenblit and Marc Wyatt. Rozenblit is coming from the asset management unit of the SEC’s enforcement division and is a former private equity professional. Wyatt joined the SEC in 2012 as a private funds examiner and formerly worked for hedge funds.

Based on the private fund managers I have spoken with that have been subject to a SEC exam, nearly all have found that the examiners knew little about private equity, real estate, or more exotic hedge funds. Examiners’ knowledge seems mostly limited to retail investment advisers, mutual fund advisers, and basic hedge funds.

I assume the new unit will be largely focused on education. I’ve heard Rozenblit speak and he certainly understands how private equity works and where enforcement should focus. I think he will offer great insight for examiners.

Assuming this story is true, I expect there will be significant changes to the exam process for private fund managers. The document request letters have often been a poor fit for private equity funds. Some even show a complete misunderstanding of how a private equity fund operates. That leads to lots of time wasted by examiners and fund managers subject to examination.

References:

Compliance Bricks and Mortar for April 4

bricks 15

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

Small Banks Look to Sell as Rules Bite by Michael Rappaport in the Wall Street Journal

In a period when low interest rates are squeezing small banks, the costs of adhering to new regulations are taking a toll. Executives from at least a half-dozen small banks that have agreed to be acquired in recent months said the increasing regulatory burden was a factor in their decisions.

Just How Binding Are SEC Statements In An Adopting Release? by Keith Paul Bishop in California Corporate and Securities Law

The really important question is what is the legal effect, if any, of preambles to rules?  One might argue that since a preamble is not subject to notice and comment, it is not legally binding under the Administrative Procedure Act (5 U.S.C. § 551 et seq.).  However, the Ninth Circuit Court of Appeals held earlier this week that an administrative law judge could consider the regulatory preamble.  Peabody Coal Co. v. Dir., Office of Workers’ Comp. Programs, 2014 U.S. App. LEXIS 5996 (9th Cir. Apr. 1, 2014).

Paul Ryan’s Plan for the SEC: Slash & Burn by Broc Romanek in TheCorporateCounsel.net

Not sure why Rep. Paul Ryan chose the SEC as an example of a federal agency with “duplication, hidden subsidies, and large bureaucracies” in his budget plan released yesterday, but he did. This is the 4th year in a row that Ryan has proposed a plan – but the first time he has focused on the SEC specifically. Remember that the SEC is not only deficit neutral and doesn’t count against the new-fangled Congressional budget caps, but is an independent agency that brings in more money to the US Treasury than it costs. Ryan’s proposal doesn’t specify exactly how much he would cut from the SEC (rather there are budget cuts for a group of agencies as a whole on pages 38-39).

Michael Lewis’s flawed new book by Felix Salmon

I’m halfway through the new Michael Lewis book – the one that has been turned into not only a breathless 60 Minutes segment but also a long excerpt in the New York Times Magazine. Like all Michael Lewis books, it’s written with great clarity and fluency: you’re not going to have any trouble turning the pages. And, like all Michael Lewis books, it’s at heart a narrative about a person — in this case, Brad Katsuyama, the founder of a small new stock exchange called IEX.

Dear Virginia: Do better by Jessica Tillipman in The FCPA Blog

Last summer, I wrote a series for the FCPA Blog about Virginia’s “Shamefully Inadequate Ethics Laws” (see here, here and here). I was not alone in criticizing what has been deemed one of the least effective ethics regimes in the country.

Accredited Investor Verification

rich accredited investor

When Congress imposed a lifting of the ban on advertisements for private placements, it also imposed a mandate that the fundraiser “take reasonable steps to verify that purchasers of the securities are accredited investors.” The methods for verification were to be determined by the Securities and Exchange Commission.

The SEC, to its credit, did not impose impose strict methods for verification. It largely decided to allow fundraisers to use a principles-based approach. The SEC did include four non-exclusive safe harbors for verification.

Congress thought that lifting the ban would invigorate fundraising. But funds and companies have been reluctant to use it. According to a speech by Keith Higgins, only 10% of private placements have used the Rule 506(c) methods. Since September 2013, there were 900 offerings that raised $10 billion under Rule 506(c). But there were over 9,200 offerings that raised $233 billion under the old Rule 506(b) regime.

With the verification requirement, the outcome and backlash has been that fundraisers should only use one of the four methods. That of course, is silly. It’s safe, but overly cautious. The SEC did specifically state that reliance on an investor’s self-answered questionnaire alone is not taking reasonable steps. You will need to look at your potential investor and find out some additional information.

That investigation adds time and and energy. For private equity funds, it’s probably a step that should be taken anyhow. Investor defaults on capital calls is a bad thing. You want to make sure that your potential investor will be able to make the contributions over course of the expected timeline of capital calls. That’s a bit different than a one time contribution to a hedge fund or private company investment.

Minimum investment goes a long way to meeting the reasonable steps. If an investor is making a $1 million investment then presumably the investor has the $1 million new worth which is the accredited investor baseline test. The SEC did not specifically endorse this standard. The concern is that the investor may have borrowed the money to make the investment. The SEC is clearly worried about shady operators getting little old ladies to mortgage their homes to make risky investments.

For me, the biggest concern is the overhang of the proposed changes to Regulation D that were put up for comment at the same time the SEC lifted the ban. That injects too much uncertainty into the fundraising process. The SEC stated that there will likely be a grace period and some transitional relief. But its hard to plan a fundraising that could take 12 months with that kind of uncertainty.

I was interested in using Rule 506(c) because of the uncertainties around the definition of general solicitation and advertising. It would be great to eliminate potential foot-faults. I could sleep better at night, not worrying about whether an employee would mention fundraising at an industry event. The company could respond to media requests and could correct misinformation in the media about the fundraising.

But the SEC has left too much uncertainty in the process to fully embrace a Rule 506(c) offering.

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