Create an Introduction for the SEC

Welcome SEC Examiners

The chances are greater than ever that the Securities and Exchange Commission will show up in your lobby. Be prepared and have an introductory presentation for them.

The SEC’s Office of Compliance Inspections and Examinations is continuing on its presence exam initiative. Those exams are shorter which means the examiners can get to more fund managers. For those fund managers that registered before Dodd-Frank, OCIE is rolling out its new .

An introductory presentation is your chance to tell the examiners the story of your firm and the story of your compliance program. If done well, it can show the examiners that you are thoughtful about compliance and keep the examination focused on the right issues.

It’s not an investor pitch. You’re not trying to convince the examiners to invest with you. You are trying to convince them that there is no fraud, deception or manipulation at your firm.

Organize the presentation around a powerpoint and use it as your storyboard. The Chief Compliance Officer should lead the presentation. It may be useful to have one or two key employees present who are involved in the compliance program to help answer questions and take notes.

Put the powerpoint together today. Don’t wait for the SEC document request letter. You will be too busy gathering documents to put together the presentation. You can update the presentation each quarter to keep it up to date. When the SEC says they are coming, you merely need to polish the presentation and not create it from scratch.

Two good starting points are an investor pitch and annual meeting materials. Those should have background information and current investment information that you will want to include. Then you can layer in the compliance program information.

 

Are Oil and Gas Investments “Securities”?

oil well and compliance

The Securities and Exchange Commission brought an enforcement action against Jeffory D. Shields, GeoDynamics, Inc., and several other business entities affiliated with Mr. Shields, alleging securities fraud. The businesses are oil and gas exploration and drilling ventures and Mr. Shields, as managing partner of GeoDynamics, marketed the interests Joint Venture Agreements. The district court granted defendants’ motion to dismiss and the SEC appealed. The point of contention was that despite their labels, are the JVs actually “investment contracts” and therefore “securities” subject to federal securities regulations.

The District Court dismissed the action because it concluded that the JVs were not investment contracts. The appeals court was not willing to draw a bright line in the sand that the JVs were not “investment contracts.” The SEC wins the appeal and goes back to court to prove that the JVs are securities.

It sounds like Mr. Shield’s strategy was fraudulent. Even the appeal court call his business a “boiler room” making hundreds of calls a day promising annual returns between 256% and 548%. But the SEC does not have jurisdiction over all frauds. It only has jurisdiction over securities fraud.

The investment was structured as a general partnership with GeoDynamics as the managing venturer. The offering documents state that the interests are not securities. The partners grant broad powers to GeoDynamics with the sole power to bind the partnerships.

Investors had the right, by 51% vote to remove GeoDynamics as the managing venturer and to terminate the partnership. The investors also had certain right to call meetings and to inspect records.

The court goes back to the Howey test of “whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.” (328 U.S. at 301). It uses the variation on the third prong of whether the investment was “premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.” Hous. Found., Inc. v. Forman, 421 U.S.  at 852.

The court starts with a strong presumption that a general partnership interest is not a security. But then goes on to three examples of when a general partnership interest can be a security:

(1) an agreement among the parties leaves so little power in the hands of the partner or venturer that the arrangement in fact distributes power as would a limited partnership; or

(2) the partner or venturer is so inexperienced and unknowledgeable in business affairs that he is incapable of intelligently exercising his partnership or venture powers; or

(3) the partner or venturer is so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that he cannot replace the manger of the enterprise or otherwise exercise meaningful partnership or venture powers.

The appeals court found enough to state that the presumption that investments were not securities. It did not go so far as state that the investments were securities or that they were not securities. It’s back to court with a small victory for the SEC. The case offers a great summary of the testing of general partnership interests as securities.

References:

Image is Pumpjack located south of Midland, Texas by Eric Kounce

Occupy Boston is Back…..

Occupy Boston - Not

No, it’s not.

“March 1st and March 2nd, NBC Studios will be in Norman B. Leventhal Park to film large crowd scenes for the pilot of their television series “Odyssey”. While filming will only be on the weekends, certain production work will take place during the week. Any set design or props in the Park are part of the “Odyssey” set.”

Apparently, the “crowd scenes” must be an Occupy Boston or Occupy Wall Street scene for the story.

Compliance Bricks and Mortar for February 28

curling and compliance

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

Are You a “Rat Trader?” by Bruce Carton in Compliance Week

Today I stumbled up on the following headline from the Chinese publication, Global Times: “Rat trader faces 5-10 years for insider dealing.” Rat trader?? It turns out that in China, at least, “rat trading” is the phrase used to describe what we would call “front-running” in the U.S.

Commitment to Compliance: the Compliance Committee by Tom Fox

One of the commitments I believe can enhance a compliance program is the creation of a compliance committee. As far back as in the 2005 Monsanto Corporation Deferred Prosecution Agreement (DPA) the compliance committee concept appears to have found favor with the Department of Justice (DOJ). In Appendix B to the DPA, Monsanto agreed to, among other things, “the establishment and maintenance of a committee to supervise the review of (I) the retention of any agent, consultant, or other representative for purposes of business development or lobbying in a foreign jurisdiction”, or a Compliance Committee. Later, this concept was used in the settlement of Halliburton’s shareholder action around its Foreign Corrupt Practices Act (FPCA) enforcement action.

SEC’s Newest Enforcement Weapon: Powerful Software in Money News

Officials expect Palantir’s platform to help the SEC find evidence of illegal activity more quickly and easily by linking trading records and personal contact information from paid databases with tips, complaints and referrals the agency has received, said the sources, who were not authorized to speak publicly about the matter.

A human-readable explorer for SEC filings in Flowing Data

Maris Jensen just made SEC filings readable by humans. The motivation:

But in the twenty years since, despite hundreds of millions invested in rounds of contracted EDGAR modernization efforts and interactive data false starts, the SEC’s EDGAR has remained almost untouched. In 2014, the SEC is quite literally doing less with SEC filings than their predecessors had planned for 1984. Data tagging is the red-headed stepchild of the Commission — out of hundreds of forms, only about a dozen are filed as structured data — and the first program to automate the selection of SEC filings for review, the Division of Economic and Risk Analysis (DERA)’s ‘Robocop’, has been ‘aspirational’ for years. The academics in the division responsible for the SEC’s interactive data initiatives write papers about information asymmetry, using EDGAR data they repurchase in usable form for millions each year, but do nothing to fix it. Companies are chastised for insufficient and inefficient disclosure, while the SEC fails to help retail investors navigate corporate disclosures at all.

How Grocery Bags Manipulate Your Mind by Carmen Nobel in HBS’ Working Knowledge

People who bring personal shopping bags to the grocery store to help the environment are more likely to buy organic items—but also to treat themselves to ice cream and cookies, according to new research by Uma R. Karmarkar and Bryan Bollinger. What’s the Quinoa-Häagen-Dazs connection?

Above is a photograph of outdoor curling in Central Park in New York City. I love this picture, so I thought I would share it. More 1890s curling photos.

Are SEC Employees Profiting from Enforcement Actions?

SEC Seal 2

Emory University accounting professor Shivaram Rajgopal points an accusatory finger at Securities and Exchange Commission employees and proclaims a pattern of selling stocks of companies subject to enforcement actions. His study finds “significant abnormal returns of (i) about 4% per year for all securities in general; and (ii) about 8.5% in U.S. common stocks in particular. The abnormal returns stem not from the buys but from the sale of stock ahead of a decline in stock prices.”

Rajgopal throws the big rock:

Most of these returns stem from the timely sale of these stocks, suggesting that a regulator’s employees are most likely to know about sanctions against companies before the market as a whole.

The study is based on reported securities trades by 3,500 SEC employees during late 2009, and for all of 2010 and 2011. However, the data is severely constrained. Rajgopal merely had a list of transactions and no ability to compute the profits or losses. There is also no data on holdings. The study only looks at what was bought and sold. Rajgopal constructs a synthetic hedge model in an attempt to model the trading.

I’m going to assume his analysis is correct and that SEC employees were more likely to sell in companies that become subject to SEC enforcement actions. Rajgopal claims this is illegal trading before public announcements. I think it’s just SEC employees over-emphasizing SEC actions as a reason to sell the stock.

One fault in Rajgopal’s accusation is how limited the news about an enforcement action may be. The SEC is a huge organization. But even if the news of an enforcement action is leaky, only a small percentage of the 3,500 employees would have that information and be able to make the illegal trade. That small number would not be as statistically significant as Rajgopal finds in his study.

The only meaningful part of the report is its focus in Table 3 of 87 trades of the 7,200 employee trades studied. Those 87 trades are in Bank of America, General Electric, Citi, Johnson & Johnson, JP Morgan, and General Electric in the period prior to the announcement of enforcement actions.

The trades highlight the need for preclearance. An organization may have material non-public information. But the information is only seen by a subset of employees. Clearly, you can track document and email traffic to prove that someone knew that information. That’s what the SEC does in its insider trading investigations. The tough part is defending from an accusation of having the knowledge.

It’s hard to prove that you didn’t know something.

The SEC is stuck with an accusation and little way of proving that those 87 trades were not made on material non-public information. Clearly, the information existed within the SEC. Perhaps the SEC can find a smoking gun that proves that some of those 87 were made by employees who knew about the enforcement action. I would guess that majority were made without that knowledge and no way to prove that they lacked the knowledge.

The SEC should have a pre-clearance requirement or a planned sell window so that the SEC and its employees can avoid the taint of accusations like Rajgopal’s accusation. That’s why public companies have 10b-5 plans and registered investment advisers have pre-clearance requirements.

References:

SEC Charges Private Equity Fund Manager with Misallocation of Expenses

clean energy capital

In the presence exam initiative, the Securities and Exchange Commission identified conflicts of interest as a high risk area. Included in that high risk area is the allocation of fees and expenses. The SEC just brought charges against a private equity fund manager for the improper allocation of fees and expenses.

The SEC charged Scott A. Brittenham and his company, Clean Energy Capital LLC, with paying more than $3 million of the firm’s expenses from its funds. Brittenham did not consent to the order, so I can only rely on the SEC’s view of the facts.

The SEC order states that the $3 million in expenses was primarily employee compensation and office expenses for Clean Energy Capital. That includes executive bonuses, health benefits, retirement benefits and rent. The SEC goes for the kitchen sink when it also mentions “group photos, legal fees for estate planning maintenance costs on CEC’s offices, CEC checks and letterheads, office and mobile telephone, bottled water, office lunches, car washes and insurance, holiday cards, CEC’s registration expenses, and business cards, and charges relating to transporting Brittenham’s daughter to and from school.”

Theoretically, a fund manager could charge these expenses to the fund if properly disclosed. (I doubt investors would line up to invest in such a fund.) But the Clean Energy Capital funds did not disclose these expenses. The limited partnership agreements described the expenses to be borne by the funds as “reasonable” partnership expenses “related to the acquisition or disposition of securities.”

The SEC charges that CEC treated all of its funds equally when it came to the expense reimbursement. However, that means that CEC did not make an effort to allocate the actual expense to the fund that benefited.

On top of the alleged improper allocation, CEC was making loans to the funds because they had insufficient cash reserves to pay their expenses. The SEC claims the interest rate on these internal loans ranged from 11.86% to 17.38%. That’s a high rate in this low interest rate environment.

The SEC order goes on to describe other alleged compliance failures, including violation of the custody rule, lying about the GP investment amount, and failure to disclose previous disciplinary actions.

References:

The Darth Vader Defense to Insider Trading

luke i am your father

Frank Hixon Jr. is trying to evade insider trading charges by denying he knew his father. His father is not a malevolent cyborg. His name is even easier to decipher than Darth Vader; It’s Frank Hixon Sr.

Hixon is challenging the charges so I have only the government’s version of the facts. Perhaps he has some better explanations or perhaps the SEC and DOJ do not have the evidence to back up their charges.

Hixon was investment banker focusing on the mining, metals and materials industries. According to the SEC complaint, there was suspicious trading around a few of the deals he worked on, including his own company’s earnings announcements. FINRA inquired and his firm circulated a list of suspicious traders. Frank Hixon Sr. of Duluth, Georgia and Destiny Robinson of Austin, Texas were on the list.

According to the SEC, Hixon denied realizing that those two people on a list of suspected transactions were his father and the mother of his child.

His father had lived in the same home for two decades. In 2006, the area incorporated as Johns Creek. Hixon claimed that “Hixon” was a common name in the South and that his father lived in Johns Creek, not Duluth. Duluth and Johns Creek share a zip code.

Vader: No, I am your father.
Skywalker: No. No! That’s not true! That’s impossible!
Vader: Search your feelings; you know it to be true!
Skywalker: NOOOOOOO! NOOOOOOOO!!!

As for Ms. Robinson, Hixon claimed he only knew her as Nicole, not Destiny. The SEC complaint de-bunks this lame defense because it has text messages that makes it clear he knew her by both names. The FBI also found checks he had written to her using “Destiny” name. The SEC alleges that Hixon was using the insider trading profits to pay child support to Ms. Robinson. The trading logs tie many of the suspicious trades back to the IP address of Hixon’s firm.

Hixon was fired by his firm. The Department of Justice must have thought that Hixon’s lies were egregious because the U.S. Attorney has also brought criminal charges. The DOJ brought seven charges of securities fraud and a false statement charge.

References:

California’s Public Disclosure of Private Fund Investments

top secret

One of the challenges with having a government pension plan investor is the potential disclosure obligations under the states’ sunshine laws. A similar problem exists with Securities and Exchange Commission. The SEC is subject to the Freedom of Information Act and exam information is potentially subject to some level of disclosure.

But the state level equivalents of FOIA are worded a bit differently. You also have the situation where the state’s pension fund is an investor. So the performance of an investment is somewhat relevant to the public, since public tax dollars are at work.

A recent ruling came out of California. That case involves the efforts by a news publication to obtain individual private fund information for investments made by the Regents of the University of California. Reuters made the request under the California Public Records Act, Gov. Code, § 6250 et seq. The Regents refused to provide the information. Reuters sued.

The Superior Court ruled in favor of Reuters and found that the Regents were required to use “objectively reasonable efforts” to obtain individual fund information for the Regents’ current investments even though the Regents had not prepared, owned, used, or retained this fund information.

The First District Court of Appeal reversed in Regents of the University of California v Superior Court, (Cal. App. 1st Dist. Dec. 19, 2013).  The Court held that

unless a writing is related “to the conduct of the public’s business” and is “prepared, owned, used, or retained by” a public entity, it is not a public record under the Public Records Act, and its disclosure would not be governed by the Act.

Clearly, the private fund information is related to the public’s business because tax dollars are being invested.

The decision made in Coalition of University Employees v. The Regents of the University of California (Super. Ct. Alameda County, 2003, No. RG03-089302) (the CUE Case) made it clear that private fund reporting on investments by the Regents is subject to California’s Public Records Act. That case involved a request for the internal rate of return for 94 separate private fund investments.

As a result, some of the fund managers stopped reporting to the Regents.

Subsequently, the Public Records Act was amended and California Government Code Section 6254.26 carves out specific pieces of information about private funds. Although the fund documents, meeting materials and financial statements are not part of the public record, fund return information is still within the bounds of disclosure.

Some of the Regents’ fund managers provided minimal information because they did not want it disclosed to the public. In the discussion, the Court makes it clear that it is not ruling on whether it is proper for private fund managers to withhold the information or whether the Regents should continue to do business with private fund managers who withhold information because of the sunshine law.

References:

Compliance Bricks and Mortar for February 21

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

SEC claims drunk lawyer had insider tipple By Kara Scannell in FT.com

The SEC sued Tibor Klein, a New York investment adviser, in September for allegedly buying securities of King Pharmaceuticals after learning from one of his clients that the drug company was in talks to be acquired by Pfizer. Mr Klein’s client and friend, Robert Schulman, a patent attorney at Washington law firm Hunton & Williams, allegedly became intoxicated after drinking several glasses of wine over dinner and “blurted out to Klein, ‘It would be nice to be King for a day,’” according to the SEC complaint filed in a Florida court.

Chasing Compliance: JPMorgan has paid out billions in penalties. Did it fix the problems? by Sue Reisinger in Corporate Counsel

A spokesman said bank officials would not comment for this story. But under pressure from regulators, the bank hired more than 3,000 employees last year to enhance its risk and compliance efforts. It also hired a new compliance chief and removed the compliance function from the purview of general counsel Stephen Cutler. In statements to shareholders and employees, chairman and chief executive Jamie Dimon expressed humiliation over bank mistakes. He said the bank spent over $1 billion in 2013 on reforms, and he vowed, “Our control agenda is now priority No. 1.”

Turning Blind Eye to Tippers No Protection From Charges by Patricia Hurtado in Bloomberg

U.S. prosecutors may bring charges for ignoring the source of illegal information used for trading, an appeals court ruled in its second decision in as many days widening the scope and penalties for insider cases

The Uneasy Connection Between Securities Disclosure and Job Creation by Ian K. Peck in the CLS Blue Sky Blog

The Jumpstart Our Business Startups Act (the “JOBS Act” or “the Act”) was signed into law in the spring of 2012, amidst the ongoing fallout from the 2008 financial crisis as well as a hotly-contested presidential election. Having received uncharacteristic bi-partisan support, the JOBS Act’s explicit goal is “To increase American job creation and economic growth by improving access to the public capital markets for emerging growth companies”. In order to accomplish this goal, the Act seeks to reduce the perceived regulatory burden that U.S. securities laws place on companies, mostly firms in the early stages of existence. This lessened burden focuses primarily on the amount and timing of required disclosure firms owe investors and potential investors.

Mark Cuban Visits D.C. to Speak About SEC Case, Enforcement Policy by Bruce Carton in Compliance Week

Cuban repeated a criticism that he also made from the courthouse steps in October following his victory at trial: that the securities laws, including the insider trading laws, are ineffective because the public often has no idea what is legal and what is illegal. How can a “Broken Windows” strategy work for the SEC, has asked, if people don’t even know what a broken window is in the securities law context?

Take Two Video: “The SEC’s Disclaimer” by Broc Romanek in The Corporate Counsel.net

Did you know that the disclaimer that SEC Staffers give when they speak is actually required by law? [Broc] recently learned that on my own even though I gave that disclaimer many times when I spoke in my capacity as a Staffer. Here is a 1-minute video about the disclaimer’s origins – [Broc] tried to inject some humor at the end:

Image of Brick work, Belconnen, Canberra is by Rebecca Dominguez
CC BY NC SA

 

Never Been Examined by the SEC? Look in the Lobby

SEC Seal 2

With the flood of new registered investment advisers after the enactment of Dodd-Frank, the Securities and Exchange Commission launched the presence exam program. The goal was to get to a big chunk of the newly registered fund managers. What got left out was the big chunk of investment advisers who had never been examined. That is about to change.

The SEC announced a new initiative directed at never-before examined registered investment advisers. It looks a lot like the presence exams.

The letter highlights five high-risk areas that are likely to be the focus of the exam:

  1. Compliance program
  2. Filings/disclosure
  3. Marketing
  4. Portfolio management
  5. Safety of Client assets

The presence exam initiative was planned to have a two year life and that life is just about expired. The SEC’s exam priorities for 2014 identified the never-before examined as a priority area for the SEC this year. So it’s no surprise that this new initiative is being rolled out.

The only surprising thing is that it lacks a snappy title like “presence exam.” The “Never-Before Examined Initiative” lacks pizazz.

Letters were sent out this week. So if you fit into that category of advisers who registered before 2011 and have not had an SEC exam, look in the mail for your letter.

What can you do if you get one of the letters? Prepare for the exam. Grab one of the sample SEC request letters and give yourself a week to pull the information together.

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