Compliance Bricks and Mortar for September 9

compliance bricks and mortar

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

Bad news. You’re promoted to compliance officer by Michael Scher in The FCPA Blog

It’s not right to lump together all compliance officers. We have to recognize that those working in America are nearly on another planet from COs working in Asia, Africa, Latin America, Russia and many other countries. While all compliance officers may be speaking the “same language,” the conditions of speaking truth to management or regulators are incomparably different.

Where is Crowdfunding? by Dave Lynn in The CorproateCounsel.net

Well over a year after the enactment of the JOBS Act, we still await movement on the SEC’s rulemaking under Title III, which provides the framework for exempt crowdfunding offerings to non-accredited investors, subject to a $1 million cap over a rolling 12-month period and dollar limits based on an investor’s financial position. As this Washington Post article notes, the SEC Staff has indicated that crowdfunding rules can be expected sometime this fall, however these would presumably be proposed rules, meaning that final rules could not be expected until well into 2014 at the earliest when you factor in the need for FINRA to also create a regulatory system for funding portals. As a result, the ability to do exempt crowdfunding offerings remains limited, except that many are anticipating the ability to do more accredited investor-only crowdfunding offerings once general solicitation is permitted under Rule 506 after the September 23, 2013 effective date of those JOBS Act mandated rule changes.

More Questions About General Solicitation by Joe Wallin in Startup law Blog

There is a lot of confusion about the SEC’s new rules that will allow, starting September 23rd, the general solicitation and general advertisement of private company securities offerings under Rule 506(c) of Regulation D.

Send in the Clowns – the NCAA and its Investigation of Johnny Football by Tom Fox in FCPA Compliance and Ethics Blog

How can you determine if an organization charged wijth compliance is corrupt or simply incompetent? It is hard today to answer that question when it comes to the National Collegiate Athletic Association (NCAA) and its enforcement division. For those of you do not know the story, the NCAA was investigating last year’s Heisman Trophy winner, Johnny Manziel a/k/a Johnny Football, for allegedly signing autographs for money, which is a violation of the near slavery conditions that NCAA scholarship athletes find themselves in today.

Discovering Empty Mansions

empty mansion

If you’ve ever been house hunting, you’ve likely spent some time looking at houses way out of your price range. Bill Dedman did the same thing. He discovered Le Beau Chateau, a $24 million mansion containing almost 15,000 square feet on 52 acres. The property taxes alone were $161,000 per year. But what really caught his eye was that the property had been unoccupied since the owner bought it. In 1951.

Dedman, a Pulitzer Prize–winning journalist, smelled a story.

He discovered the owner of the property was Huguette Clark, and she owned another, bigger mansion in Southern California that had also sat vacant for decades. There was definitely a story here. It became Empty Mansions.

Ms. Clark’s father was W.A. Clark, a copper miner, railroad entrepreneur, and a U.S. Senator. In the early 20th century he was one of the wealthiest men in America.

Ms. Clark’s homes had not sat vacant because she was dead. Dedman found her alive, “happily” living for the prior two decades in a New York City hospital room.

Dedman puts together a great history of W.A. Clark, how he amassed his fortune, and how he extravagantly spent some of that wealth. The middle of the story focusing on the decades of Huguette’s life runs a bit flat. That would seem to happen because she lived such an intensely private life and lived as a recluse. The story loses some flair because there is no flair there.

The story once again gets interesting as Ms. Clark gets admitted to the hospital after her health deteriorated, her staff had all retired, and there was no one to take care of her. She seemed to enjoy the hospital and took up permanent residence, even though there seemed to be no medical reason to stay.

Ms. Clark is over 100 years old by the time the her story comes out. Everyone starts wondering what will happen to her fortune and many want a piece of it. Many of the likely beneficiaries want a bigger piece. Her relatives had little contact with her over the prior decades. It’s a mess that I’m sure a trust and estates lawyer could use as a learning tool for recalcitrant clients.

The ethical and compliance issues come to the front. Ms. Clark begins giving millions to her nurse. It seems to be a violation of hospital policy. Dedham portrays the hospital to be itself looking to be a recipient of Ms. Clark’s generosity. Perhaps they are even hiding her from auditors who would question why she has not been discharged.

I think Dedham pulls some punches at the end because the estate is still unsettled and the potential liability is still in play. It’s hard tell if Ms. Clark was of sound mind when she was writing her will or whether she was unduly influenced by her advisers and caregiver.

It’s an interesting story and a well-written book.

Picking Cherries

cherry picking

As an investment adviser, you can’t take the best investments for yourself and leave the lesser ones for your clients. That’s exactly what the Securities and Exchange Commission is accusing J.S. Oliver Capital and Ian O. Mausner of doing.

The SEC’s Enforcement Division is alleging that J.S. Oliver and Mausner engaged in a cherry-picking scheme that awarded more profitable trades to favored clients. Meanwhile they doled out less profitable trades to other clients, including a widow and a charitable foundation. (You have to love the SEC’s highlighting a widow and a charity as victims. If only the charity were for orphans, then the cliche would be perfect.)

Mausner financially benefited from the cherry-picking scheme because he and his family were personally invested in the hedge funds. Plus, he earned additional fees from one of the hedge funds based on the boost in its performance as a result of the cherry-picking. Mausner profited by more than $200,000 in fees earned from one of the hedge funds based on the boost in its performance from the winning trades he allocated.

This cherry-picking scheme is the classic failure to allocate trades before they are made. Mausner made block trades in omnibus accounts at various broker-dealers. The block trades were reported to J.S. Oliver’s prime broker and then Mausner allocated the shares among the client accounts. According to the SEC complaint Mausner often delayed allocating trades until after the close of trading or the following day, allowing him to determine which securities had appreciated or declined in value.

Even if Mausner was trying to allocate trades on a fair and equitable basis, the mere fact that trades were not allocated until after they made makes the process suspect. Then you have the uphill battle of proving you were fair, when in hindsight better trades ended up in favored accounts.

Sources:

Finding the Signal Though the Noise

signal and the noise

Nate Silver came into fame for his forecast of the presidential election in 2012. That matched his success in 2008 for also getting the presidential election correct. His book, The Signal and the Noise, is built upon that success.

We learn that Silver is not a political pundit, but a numbers geek. He started with statistical analysis of baseball while toiling away for the accounting firm KPMG. The next step was online poker, using his analysis to be a better poker player. That made him a lot of money, for a while. Then he turned to political analysis where he caught broader attention.

But the book is not a biography, or pages of Silver trumpeting his own horn. It’s a book about the success and failures of using data to forecast future events. Silver slices the data into two categories. The Signal is the truth and the Noise it what distracts us from the truth. In today’s market, information is not a scarce commodity. However, we perceive it selectively and subjectively. Our biggest failure is not paying attention to our own distortion. We never make perfectly objective predictions. They are always tainted by our subjective point of view.

Silver looks at the statistical analysis used in several fields:

  • the housing bubble and mortgage securities crisis
  • television political pundits
  • baseball
  • weather
  • earthquakes
  • economic forecasts
  • flu epidemics
  • poker

Taken from a scientific perspective, predictions can be tested. Silver tests them.

For example, look at weather forecasts. If the forecast calls for a 20% chance of rain, it should rain on 20% of the days that have that prediction. Silver backtests the performance of weather forecasters. He finds that some consistently over-forecast rain, raising a 5% chance to 20%. That way the audience will be less disappointed if it rains. Silver also compares long term forecasts to average conditions for that day. It turns out that the long term forecast is more likely to be wrong than merely relying on the historic average.

But weather forecasting has improved. Hurricane prediction is an area that has seen measurable improvement. Over the past 25 years the hurricane landfall prediction for three days in advance has decreased from a 350 mile radius to a 100 mile radius.

There is plenty in this book for compliance professionals. The first topic in The Signal and the Noise is the rating agencies and the financial crisis of 2008. He uses an example of S&P’s rating of CDO tranches. In achieving the AAA rating, S&P predicted that there was only a 0.12% probability that it would fail to pay out in the next five years. The reality is that the failure was 28%. The actual default rate was more than 200 times higher than predicted.

The Dog Days of Summer and Compliance

Dog Days of Summer and Compliance

The phrase “dog days” refers to the sultry days of summer, the months of July and August in the Norther Hemisphere. The Romans referred to the dog days as diēs caniculārēs. The Dog Days were the days when the star Sirius rose just before or at the same time as sunrise. They considered Sirius to be the “Dog Star” because it is the brightest star in the constellation Canis Major (Large Dog).

Like many things Roman, the term “Dog Days” was adopted from its earlier use by the Greeks. It may even be traced back to the ancient Egyptian astronomer-priests who noted that Sirius rose with the Sun just prior to the annual flooding of the Nile.

The lazy days of summer can be great days to sit back and relax with a cold glass of iced teas to cool you down. With fewer people in the office, you may have some free time to catch up on lagging projects. or you may have some free time to spend out of the office.

For me it’s a bit of both. But currently, I’m looking forward to some vacation days coming up. That means things will likely be quiet on Compliance Building until September.

How Good Is Your Business Continuity Plan?

compliance and hurricane sandy

The Securities and Exchange Commission wants it to be better.

In the aftermath of Hurricane Sandy, the Securities and Exchange Commission joined the Commodity Futures Trading Commission and the Financial Industry Regulatory Authority in issuing a joint staff advisory on business continuity and disaster recovery planning.

The advisory follows a review by the regulators after Hurricane Sandy closed U.S. equity and options markets for two days in October 2012. Many firms had a hard time dealing with such a widespread area of severe impact.

When considering alternative locations (i.e., back-up data centers, back-up sites for operations, remote locations, etc.) firms should consider the implications of a region wide disruption. Firms are encouraged to consider geographic diversity when determining the physical location of alternative sites. An alternative site, particularly a system back-up location, in close proximity to the primary site may not sufficiently protect the firm from the effects of a region wide event. Firms should consider whether their primary site and alternative sites rely on the same critical utility services, such as electricity, transportation and telecommunications.

That is a somewhat achievable goal for big firms, but not one for smaller firms.

The alert ignores that reality of the physical location of people, their homes, and their families. It would be great to have a fully redundant backup site located a thousand miles away from the main location. But you’re not going to be able to quickly get people there in the event of such a widespread event.

Not only are businesses affected by a disaster, but so are homes. Many (most?) employees are not going to abandon their families, stuck with limited access to power, food, and other needs.

Of course, firms need a solid business continuity and disaster recovery plan. It should be tested and evaluated regularly. A firm needs to plan for small disruptions and big disruptions. Small disruptions are more likely and need to be well addressed.

It’s much harder to have a bullet-proof plan for an event like Sandy that disrupts power to huge parts of the urban center, knocks out power to a huge swath of residential areas, floods office buildings, floods thousands of homes, disrupts transportation, and does so over hundreds of miles.

References:

Compliance Bricks and Mortar for August 16

bricks header

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

SEC Charges Two J.P. Morgan Traders With Fraudulently Overvaluing Investments to Conceal Losses

The SEC alleges that Javier Martin-Artajo and Julien Grout were required to mark the portfolio’s investments at fair value in accordance with U.S. generally accepted accounting principles and JPMorgan’s internal accounting policy. But when the portfolio began experiencing mounting losses in early 2012, Martin-Artajo and Grout schemed to deliberately mismark hundreds of positions by maximizing their value instead of marking them at the mid-market prices that would reveal the losses. Their mismarking scheme caused JPMorgan’s reported first quarter income before income tax expense to be overstated by $660 million.


BREAKING: Serious Fraud Office lays its first Bribery Act charges.

“Four men connected to Sustainable AgroEnergy plc have today been charged with offences of conspiracy to commit fraud by false representation and conspiracy to furnish false information, contrary to section 1 of the Criminal Law Act 1977, in connection with the investigation by the Serious Fraud Office into the promotion and selling of “bio fuel” investment products to UK investors.

SEC’s Andrew Ceresney to Join Historic ‘Directors’ Panel’ at Securities Enforcement Forum 2013

Don’t miss the historic “Directors’ Panel” that will be one of the highlights of Securities Enforcement Forum 2013, which will be held on Wednesday, October 9 at the Mayflower Hotel in Washington, D.C. For perhaps the first time, five current and former SEC Enforcement Directors will come together on a panel to discuss today’s most important securities enforcement issues from their own unique perspectives.

Please register here!

Bad Things Come In Threes for CCOs

Whatever the origin of this folkloric belief, all I can say is that over the past couple of weeks, Chief Compliance Officers (CCOs) have taken it on the chin three times and, once again, the job of the CCO just got quite a bit harder and more challenging.

What AngelList is doing about the proposed SEC rules to overhaul startup financing

AngelList has set up a webpage to educate everyone on the SEC’s proposed rules that would impose pre-filing, information filing and mandatory legend requirements on Rule 506(c) offerings.

THE SEC’S PROPOSED REG D RULES: WHY WE CARE

The proposed rules, if they go into effect as the SEC has proposed them, will change many practices that have grown up and evolved over the last several years that are beneficial to the early stage company ecosystem.

Action Against a Crowdfunding Platform

somoLend

SoMoLend – which stands for Social Mobile Local Lending – is a crowdfunding platform that allows small businesses to borrow money from a network of lender. The State of Ohio claims that SoMoLend failed to meet the regulatory hurdles currently in place for crowdfunding. It’s also claiming that SoMoLend acting fraudulently when seeking its own investment capital.

There are many entrepreneurs and wantapreneurs trying to jump on the crowdfunding bandwagon. For those willing to take the time to understand the securities laws, there are ways to enter the field. For some, the upcoming gate opening on general solicitation and advertising will allow them to jump on board. Others are looking to the Securities and Exchange Commission to issue rules on crowdfunding under the JOBS Act.

Just by looking at that web of requirements, the regulatory landscape for crowdfunding is complicated and currently in flux. That likely means that fraudsters are circling for easy targets and well intentioned businesses can easily make a mistake.

The State of Ohio says that SoMoLend made a mistake when working for lending sources and crossed the line when soliciting its own investors.

The Ohio action is not against the crowfunding aspect, it’s against the way SoMoLend raised its own capital and its business model. Ohio has an exemption from registration for securities offerings that comply with the SEC’s Regulation D. Until September 23, 2013 that means the securities can’t be offered through general solicitation and advertising. Ohio is claiming that SoMoLend violated that ban and therefore does not qualify for the exemption from registration under Ohio law.

On top of that violation, Ohio is also claiming fraud for SoMoLend using financial projections in investor pitches that depicted a more profitable company. The company projected millions in revenue and profits. Those projections lacked any meaningful disclosure about the assumptions that went into the projections and lacked cautionary risk factors for investors.

In a March 2013 article, SoMoLend claimed:

Since the beta site launched in May 2012, SoMoLend has facilitated some 100 small-business loans totaling nearly $3.5 million. Loans range from $500 to $1 million, with interest rates ranging from 3 to 22 percent and terms spanning six weeks to five years, depending on a business’s needs and creditworthiness. SoMoLend also charges a 4 percent transaction fee on funds borrowed.

Ohio claims the true amount of lending activity was 13 loans to 9 businesses for $94,000. According to the Ohio filing, the company has brought in only $3404 in revenue.

On top of that, SoMoLend met with the Ohio regulators who pointed out that the firm would need to be registered as broker-dealer if it was going to collect transaction-based fee for selling notes through the platform. That 4% transaction fee is effectively a commission on the sales of securities. You can compare that to Funder’s Club that took a different approach to crowdfunding by taking a promote on the back-end. Funder’s Club even obtained a No Action letter from the SEC validating its business model.

Finally, the state gets to the crowdfunding piece and alleges that some, or all, of the promissory notes offered through SoMoLend were not registered or exempt from registration. Ohio seems a bit sympathetic to the note issuers when it says SoMoLend “exposed approximately 200 small business issuer to potential liability”.

I decided to take a look at the platform. To start, I saw this warning:

If you are an accredited investor, we require you attest to your status prior to viewing borrowers on the platform.

I still have not gotten any more for verification and am still blocked from seeing any investment opportunities. I assume the business has come to grinding halt, even though the hearing on the order is not until October. SoMoLend’s CEO, Candace Klein recently resigned because of the regulatory action.

According to a story on Cincinnati.com:

Klein is a passionate entrepreneur who was honest about the company’s finances with investors and board members, but consistently lacked discipline and precision when discussing and presenting the company’s actual performance.

A combination of those missteps and the state’s apparent concerns about crowdfunding, lead to trouble.

References:

 

Failing to Turn Real Estate Into a Security

hrsd_logo

Fee simple ownership of the “bricks and mortar” of real estate is not a security. “The offer of real estate as such, without any collateral arrangements with the seller or others, does not involve the offer of a security.” As you move further away from that model, you move closer and closer to the ownership a security than the ownership of real estate. The line between the two is not a bright line.

A transaction that looks nothing like a sale of stock and involving such diverse items as citrus groves and vacation homes may qualify as a sale of a security under federal law.

There has been a recent ruling in case battling over that line. In Salameh v. Tarsadia Hotels, the purchasers of real estate are suing the developer of the Hard Rock Hotel in San Diego. The project was a condominium- hotel ownership structure to help provide capital.  The purchase/investment turned out to be a bad one, so the purchasers sued the developer.

Their claim was that a series of documents, including the Purchase Contract, the Unit Maintenance and Operations Agreement, and the Rental Management Agreement turned the ownership of the hotel/condo interest into a “security” and not the mere ownership of real estate. Since the securities were not registered, they could seek rescission. In this case, the ownership and control issues were not just split into separate documents, some of the documents were entered into at significantly different times.

The purchasers lost the case and appealed. They just lost the appeal.

The Ninth Circuit Court of Appeals affirmed the ruling from the district court.  The Court distinguished these facts from Hocking v. Dubois, 885 F.2d 1449 (9th Cir. 1989)  in which it had found that there was a general issue of material fact whether the sale of a condominium along with a rent-pooling arrangement constituted a security.

In Hocking, the the purchaser would not have made the real estate investment but for the availability of the rental pool arrangement. The sale of the real estate was coupled together with the management and income sharing that made the real estate investment look more like a security.

In contrast, the Salameh plaintiffs failed to allege facts showing that the real estate was coupled together with the management and income sharing as a package. The hotel developer pointed out in its pleading that the rental management agreements were executed eight to fifteen months later.

The ruling is another loss for the SEC in this edge between real estate and securities. The SEC had filed an amicus brief that relied on its 1973 Guidelines as to the Applicability of the Federal Securities Laws to Offers and Sales of Condominiums or Units in a Real Estate Development (Securities Act Release No. 33-5347 (Jan. 4, 1973) as the standard.

References:

Ignoring Changes to Regulation D

compliance and ignore this sign
While many embraced lifting the ban on general solicitation and advertising, most despised the additional mess that the SEC added in. Fortunately, you can probably ignore much of that mess. At least for a few months.

We knew that the SEC was going to require that firms selling public private-placements were going to have to take some reasonable steps to confirm that the purchasers were actually accredited investors. Congress wrote that into the JOBS Act. (Although I suspect they would have written it differently if they knew the end result.)

Based on the July 10 SEC meeting, 506(c) and 506(d) go into effect on September 23. The dreaded changes to Form D and Rule 156 do not. Those are only proposed rules.

SEC Chairman Mary Jo White made this obvious in a recent letter response to Congressman McHenry.

It’s clear that funds can use the public private-placement regime under Rule 506(c) on September 23, 2013. The current rules on filing the Form D are in place. There will be no requirement to file the advertisements with the SEC. There will be no required legends on the advertisements.

For now.

The changes to Form D and the advertising legends are merely in a proposed rule. The SEC may abandon its concerns and not issue a final rule. (unlikely) The SEC may make significant changes to the rule. (possibly)

Chairman White makes it clear that there will need to be some transitional guidance for offerings that commence before the effective date of the final rule. So you can ignore the proposals.

But the proposed rule is clearly a signal that the SEC wants to do something more for private placements. I would guess that some form of the rule will be adopted before the end of the year. The mutual fund industry will be furious that their product advertisements are weighed down with disclaimers, while cowboy hedge funds are all over the place and grabbing bigger fees.

There are signs ahead. But we can ignore them for now.

References:

Ignore This Sign, 2004
Marietta, Georgia, USA
Hacking the City, by Brad Downey