Compliance and Breaking Bad

compliance and breaking badI was up last night hooked into latest episode of Breaking Bad. Besides it being a great show, it highlights a focus of compliance. How do you prevent your employees from going bad?

For those of you who haven’t seen the show, Walter White, a mild-mannered high school chemistry teacher helps ends meet by making drugs. As the story progresses and Walter makes a series of bad choices, he transforms into the murderous drug lord Heisenberg.

Perhaps the evil has always been inside Walter. Perhaps it was a mid-life crisis gone horrible wrong. Perhaps it was pure greed.

Walter’s first choice was clearly across the line when he met with his former student to cook his first batch of crystal meth. As he escapes each increasingly threat to his life and his livelihood he moves progressively further from Walter to Heisenberg. The success of each bad act leads to more bad acts.

One goal of company’s compliance program is discourage an employee from going bad. And to the extent an employee goes bad, to promptly catch them to prevent further bad acts.

Compliance Bricks and Mortar for August 9

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

JOBS Act Update: Can the Genie go back in the Bottle? by Jay B. Gould in Investment Fund Law Blog

But what happens if a fund manager is initially enamored of the new rules and decides to advertise generally, but later changes his mind? Can a fund manager go back to the old “pre-existing, substantial relationship” days, and how do you do that once the fund has been “generally offered” to the public?

SEC’s Proposed Regulation D Rules Generates Wide Ranging Concern by Alexander J. Davie in Strictly Business

In my last post, I discussed new proposed Regulation D rules which impose new obligations upon issuers of securities in private placements. In that post, I expressed some concern that these new rules could be quite burdensome, especially the rule disqualifying issuers from using Rule 506 on future securities offerings for failing to file Form D in a timely fashion. Others involved with startup capital formation have also expressed similar concerns. In this post, I’ll compile the comments I’ve seen thus far.

You Can’t Tweet That by Joe Wallin in Startup Law Blog

One of the aspects of the proposed rules that hasn’t drawn a lot of attention in the blogs and press is the new legend requirement. What is a legend? A legend is a specifically required disclosure; frequently in all caps or bold, or called out in some other manner from other text in a document so that it is less likely to be missed.

When Is A ‘Whistleblower’ Not Really A ‘Whistleblower’? by Catherine Foti

Since the promulgation of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd Frank”), five federal district courts have held that employees who report suspected wrongdoing to upper management, but not to the U.S. Securities and Exchange Commission (“SEC”), are “whistleblowers” for purposes of the Act, entitled to the protection of Dodd Frank’s anti-retaliation provisions.  Going against the tide, in a recent ruling in Asadi v. G.E. Energy (USA), L.L.C., the Fifth Circuit Court of Appeals – the first Circuit Court to address this issue – has held exactly the opposite, ruling that an employee who reported a potential Foreign Corrupt Practices Act violation to his employer, G.E. Energy (USA), L.L.C., was not a “whistleblower” because he did not “provide information relating to a violation of the securities laws to the SEC.”

Colbert’s take on the SEC against the Fabulous Fab

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Is Bitcoin a Security?

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You may have noticed that I focus on SEC actions against real estate companies. At the core of that interest is a look at whether the Securities and Exchange Commission has jurisdiction. The SEC is limited to securities. Commodities get covered by the CFTC and real estate gets covered by …..

Bruce Carton pointed to another item in the news that also addresses the realm of what is and is not a security: Bitcoin.

The SEC brought charges against Trendon T. Shavers, who is the founder and operator of Bitcoin Savings and Trust (BTCST). The SEC alleged that he was running a Ponzi scheme based on a “virtual currency” arbitrage on Bitcoin. Shavers apparently used the handle Pirateat40.

Beginning in November of 2011, Shavers began advertising that he was in the business of
“selling Bitcoin to a group of local people” and offered investors up to 1% interest daily “until
either you withdraw the funds or my local dealings dry up and I can no longer be profitable” Shavers obtained at least 700,467 Bitcoin in principal investments from BTCST investors, or $4,592,806 in U.S. dollars, based on the daily average price of Bitcoin.

Shavers argued that the BTCST investments are not securities because Bitcoin is not money, and is “not part of anything regulated by the United States. Shavers also contends that his transactions were all Bitcoin transactions and that no money ever exchanged hands.

The SEC argued that the BTCST investments are both investment contracts and notes, and therefore are securities. The SEC said that Shaver returned about 500,000 Bitcoins to investors, but made off with another 200,000

Bad news for Shavers. A decision in the case this week ruled that BTCST investments meet the definition of investment contract, and as such, are securities. The court concluded that it had subject matter jurisdiction to hear the SEC’s case.

15 U.S.C. § 77b of the U.S. Code defines “security” as “any note, stock, treasury stock, security future, security-based swap, bond…[or] investment contract…”  Under the Howey line of cases, an investment contract is any contract, transaction, or scheme involving (1) an investment of money, (2) in a common enterprise, (3) with the expectation that profits will be derived from the efforts of the promoter or a third party.

Investment of money

Bitcoin can be used to purchase stuff. The only limitation (and its a big one) is that it is limited to places that accept it as currency. Bitcoin can also be exchanged for conventional currencies, such as the U.S. dollar. It was that recent spike in the exchange rate between Bitcoin and the US dollar that attracted so much attention.

Common enterprise

A common enterprise requires interdependence between the investors and the promotor, for example where the investors colelctively rely on the promotor’s expertise. The investors were giving Shaver their bitcoins and he was supposed to trade them and get more value back them.

Expectation of profits from efforts of others

In this case, the investors were not taking an active role in the investment. They were relying on Shavers.

The court’s finding that it has subject matter jurisdiction means that the SEC’s case against Shaver can  move forward. The SEC still has not proven fraud and will likely face another round of arguments on jurisdiction.  The SEC still has to prove fraud.

The interest rate Shavers gave to investors was a staggering 7% per week for large investments. That smells like a Ponzi scheme. Personally, I don’t think I’d hand any money, bitcoin or US dollars, to someone named “Pirate.”

References:

Use of Data Collected from Form PF

compliance and form pf

Many private funds struggled with getting Form PF filed. Many in fund compliance were dubious that the Securities and Exchange Commission would be able to do anything meaningful with the massive amount of data pushed through the form. Regardless, Section 404 of Dodd-Frank required the SEC to gather the data so the Financial Stability Oversight Council could assess systemic risk.

Section 404 also required an annual report on how the SEC has used the data collected in Form PF. The first report came out a short time ago.

In total, there are big numbers:

Types of Private Funds Advised by all Filers

  • 6,683 Hedge Funds ($4.061 trillion cumulative RAUM)
  • 5,928 Private Equity Funds ($1.603 trillion cumulative RAUM)
  • 2,922 Other Private Fund Type ($698 billion cumulative RAUM)
  • 1,121 Real Estate Funds ($299 billion cumulative RAUM)
  • 966 Securitized Asset Funds ($338 billion cumulative RAUM)
  • 329 Venture Capital Funds ($23billion cumulative RAUM)
  • 66 Liquidity Funds ($258 billion cumulative RAUM)

For a total of $7.280 trillion in Private Fund Regulatory Assets Under Management Reported by all Filers

The report goes on to imply that the SEC is still figuring out what to do with the data after it passes on the information to FSOC.

The mysterious Division of Economic and Risk Analysis is plugging some of the information into its black box of analytic tools.

More importantly for fund managers, the Office of Compliance Inspections and Examinations is using the information for pre-examination and research. Once selected for an exam, a fund manager should assume that the examiners have a copy of Form PF. OCIE is also working with a system to use Form PF to identify red flags that could trigger exams.

References:

Top Social Media Enforcement Issues in the Securities Industry

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Broker-dealers and investment advisers are finding access to client through social networks and providing new marketing opportunities. But they also pose the challenge of making it harder for the firms to supervise, review, maintain, and protect the information. The Securities and Exchange Commission and FINRA are struggling to keep the regulatory requirements up to date and protective as the social networks change rapidly.

In their article, “The Social Network Unhinged: #TopSocialMediaEnforcementIssuesintheSecuritiesIndustry,” which appeared in the June 2013 issue of Banking & Financial Services Policy Report, Sutherland attorneys Brian L. Rubin and Caroline A.Crenshaw review recent social media enforcement actions brought by the SEC and FINRA and discuss challenges facing the securities industry as it continues on the Internet.

The authors track the evolution from the early days of email to today.  They also dive into cyber-security.

 

Updated Guidance on the Custody Rule for Private Funds

Barnum and Bailey Limited Stock Certificate

The Securities and Exchange Commission has provided some updated guidance on the Custody Rule for private funds. It has sometimes been tricky for private funds to comply with Rule 206(4)-2.

The custody rule deems it to be a fraudulent, deceptive or manipulative act, practice or course of business for an adviser to have custody of client funds or securities unless a qualified custodian maintains those funds and securities in a separate account for each client under that client’s name. The custody rule provides an exception from the custodian requirement for a fund in the case of certain privately offered securities it holds, provided the fund’s financial statements are audited.

“Privately offered securities” are defined as securities that are: (A) acquired from the issuer in a transaction or chain of transactions not involving a public offering; (B) uncertificated, and ownership thereof is recorded only on the books of the issuer or its transfer agent in the name of the client; and (C) transferable only with the prior consent of the issuer or holders of the outstanding securities of the issuer.

This has posed a challenge for real estate fund managers and private equity fund managers that happen to have an entity that is certificated. For example, if the real estate fund has a REIT subsidiary, it may have issued stock certificates as a matter of practice. The Custody Rule would mandate that the fund hire a qualified custodian to hold that single REIT stock certificate. That custody relationship is expensive and provides little (no?) protection to fund investors.

The Investment Management Division issued an update that provides a great deal of relief.

The Division created a new category of securities for purposes of the custody rule: “private stock certificates.” These are non-transferable stock certificates or “certificated” LLC interests that were obtained in a private placement. These fail to meet the definition of “privately offered securities” because they are certificated.

“The Division would not object if an adviser does not maintain private stock certificates
with a qualified custodian, provided that:
  1.  the client is a pooled investment vehicle that is subject to a financial statement audit in accordance with paragraph (b)(4) of the custody rule;
  2. the private stock certificate can only be used to effect a transfer or to otherwise facilitate a change in beneficial ownership of the security with the prior consent of the issuer or holders of the outstanding securities of the issuer;
  3. ownership of the security is recorded on the books of the issuer or its transfer agent in the name of the client;
  4. the private stock certificate contains a legend restricting transfer; and
  5. the private stock certificate is appropriately safeguarded by the adviser and can be replaced upon loss or destruction.”

That is fantastic news.

Even better, the update adds some clarity to partnership agreements:

Partnership agreements, subscription agreements and LLC agreements are not certificates under Rule 206(4)-2(b)(2)(B) and the securities represented by such documents are privately offered securities provided they meet the other elements of Rule 206(4)-2(b)(2).

I know a few fund advisers that took a very conservative position on the Custody Rule and were shipping partnership agreements their custodians. It looks like that is not required by the Custody Rule.

References:

Compliance Bricks and Mortar for August 2

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

At SAC, Rules Compliance With an ‘Edge’ by James B. Stewart in the New York Times

Whatever else might be said about SAC’s compliance program, the bottom line is that it failed. Whether that failure can be attributed to Mr. Cohen or his top compliance officials remains to be seen. But Mr. Pitt, for one, came away from his visit to the firm unimpressed. “My sense was that it was a check-the-box mentality, not a serious commitment,” Mr. Pitt told me.

The Indictment of S.A.C. Capital Advisors: Where Was The Auditor? by Francine McKenna in re: The Auditors

Looks like investors can’t count on “independent” auditors like PwC, which was also MF Global’s “independent” auditor, to spot illegal activity either.

Sun Capital Court Ruling Threatens Structure of Private Equity by Victor Fleischer in Dealbook

Last week, the United States Court of Appeals for the First Circuit issued a ruling that will make it harder for private equity funds to walk away from the unfunded pension liabilities of companies they have bought if the company goes bankrupt.

Specifically, the court ruled that one of Sun Capital’s private equity funds was “not merely a ‘passive’ investor” but actively involved in the operations of Scott Brass Inc., a portfolio company that went bankrupt in 2008. The case was brought by the New England Teamsters and Trucking Industry Pension Fund.

Avoiding five potential traps in “new” Rule 506 offerings by David C. Scileppi in Securities Edge

The removal of the ban is a huge change in the way private offerings may be conducted and welcome relief to the thousands of issuers each year who have tapped out their “friends and family,” but yet are too small to attract private equity funds.  With these new changes, however, bring challenges in making sure you conduct a “new” Rule 506 offering (a/k/a Rule 506(c) offering) correctly.

So, with the caveat that best practices are still being developed for Rule 506(c) offerings and issuers and attorneys are still parsing through the new rules, here are five potential pitfalls to avoid: ….

Criminal Forfeiture and SAC Capital by David Smyth and Wes Camden in Cady Bar the Door

But in the event of a conviction, the criminal case does have at least one prominent feature that the SEC’s case does not: the prospect of a massive criminal forfeiture of assets gained by any criminal conduct.  In addition to the indictment, prosecutors filed a civil forfeiture complaint for what it alleges is money laundering activity by the defendants.  The Wall Street Journal reported on Thursday that the government will seek forfeiture of around $10 billion, “according to a person familiar with the matter.”

Employee Criminal History and 506(d)

baD BOYSThe bad actor rule in the new Rule 506(d) makes private placements a bit harder and will require private funds and companies to do more homework in connection with the fundraising. That’s because an issuer cannot rely on the Rule 506 exemption if the issuer or any other person covered by the rule had a “bad actor disqualification.”

An issue arises when you ask about criminal history. It’s been decades since I had to fill out a job application, but I remember the question asking if you are a convicted felon. That allows employer to quickly discard job applications filed by convicted criminals. A few states have felt that this is discriminatory and have enacted limitations on asking whether a job applicant has a criminal history.

This conflicts with the Rule 506(d) requirement that you exercise reasonable care in determining whether a covered employee is a bad actor. Some states limit your ability to run a criminal background inquiry and some limit your ability to even ask whether a prospective employee has a criminal background.

A shotgun approach will not work.

Most of these state laws allow you to eventually ask the criminal background question. If you are subject to 506(d) you need to ask the question, it can’t be one of the first questions.

References:

The SEC Tries to Make an International Case on Insider Trading

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The BHP – Potash merger in 2010 was a bit leaky. The SEC has an ongoing investigation into suspicious trading ahead of the the August 17, 210 public announcement of BHP Billiton’s acquisition of Potash Corporation. The latest SEC points the SEC’s accusatory finger at two Spanish citizens.

At first I though the SEC had merely re-published an old story. In August of 2010, the SEC brought a case against two citizens. The SEC alleged that Juan Jose Fernandez Garcia and Luis Martin Caro Sanchez had material, non-public information and purchased hundreds of “out-of-the-money” call option contracts for stock in Potash in the days leading up to the public announcement. Mr. Garcia, a former employee of the an adviser to the merger gave up and disgorged his illicit windfall. Mr. Sanchez fought and the SEC failed to find the smoking gun that turned the suspicious trade into insider trading.

The latest case pits the SEC against Cedric Cañas Maillard, who served as an executive advisor to Banco Santander’s CEO, and his close personal friend Julio Marín Ugedo.

The SEC alleges that Cañas purchased 30,000 Potash Contracts-for-Difference, a highly leveraged derivative, from August 9 to August 13 based on material, non-public information he learned about BHP’s offer to acquire Potash. Cañas liquidated his entire CFD position in Potash following the August 17 public announcement for an illicit profit of $917,239.44. Cañas also communicated frequently with Marín that month, and Marín has admitted that he and Cañas discussed investing in Potash prior to his purchase of 1,393 shares of Potash common stock through two Spain-based brokerage accounts. By trading Potash stock based on material, non-public information, Marín generated net trading profits of $43,566 (a 28.47 percent return) in just one week.

Clearly, these are suspicious trades. .

What caught my eye was a jurisdictional question. This is an area I’m a bit fuzzy on.

Neither Cañas and Marín are citizens of the United States. Neither lives in the United States. According to the SEC complaint, both travel frequently to the United States and Cañas lived periodically in the United States prior to 2008.

Cañas made his bet using Contracts-for-Difference, a highly leveraged derivative, equivalent to 30,000 shares of Potash. The Contracts-for-Difference are not traded in the United States and Cañas used a Luxemborg based trading account at Internaxx.

I’m missing the nexus to the United States that would give the SEC jurisdiction.

The SEC complaint crafts an argument that Internaxx needed to purchase shares of Potash on a US exchange to hedge its risk against the Contracts-for-Difference. That seems very shaky to me from a jurisdictional perspective.

The SEC has an easy case on the inside information aspect because Banco Santander already conducted an internal investigation, found trading in violation of its policy, and fired Cañas.

The Marín case is easier to make. He opened a foreign account, but purchased Potash stock directly. That puts his trades on the NYSE and within the grasp of the SEC.

The SEC still needs to prove the use of inside information by Marín. That will be a tough battle.

According to the SEC complaint, the trades have lots of red flags and stink of insider trading. The Cañas case caught my eye because I don’t see how a US regulator can jump overseas and bring an enforcement action when there does not seem to be a substantial US nexus.

Maybe a reader knows more about the international jurisdiction of the SEC and can pipe in with some thoughts on what the SEC can do over the border.

References:

 

SEC Compliance Outreach Program

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In May attended the SEC Compliance Outreach program hosted by the Securities and Exchange Commission’s Boston office. That was supposed to be the first in a new series from the SEC. The SEC just announced a few other program dates and locations. I highly recommend attending.

From the SEC:

The SEC’s Office of Compliance Inspections and Examinations (OCIE), Division of Investment Management, and Division of Enforcement’s Asset Management Unit (AMU) are jointly sponsoring the regional seminars for investment companies and investment advisers. The seminars highlight areas of focus for compliance professionals. They provide an opportunity for the SEC staff to identify common issues found in related examinations or investigations and discuss industry practices, including how compliance professionals have addressed such matters.

The Compliance Outreach Program was created to promote open communication on mutual fund, investment adviser, and broker-dealer compliance issues. The program, formerly known as the CCOutreach Program, was redesigned in 2011 to include all senior officers, not just CCOs, underscoring the importance of compliance throughout a firm’s business operations.

The series of regional seminars kicked off in Boston on May 16 with panel discussions on the priorities for the SEC’s National Examination Program, current topics in money management regulation, and OCIE’s process for assessing risks and selecting firms for examination.

The remaining seminars:

• Chicago – August 28: This seminar will present an overview of the examination process, including how registrants are selected for examination and the most commonly identified deficiencies. There also will be three discussion panels on traded and non-traded real estate investment trusts, on investment companies with special emphasis on alternative investment funds and money market funds, and on current enforcement actions in the investment management industry. Lastly, there will be a breakout session focusing on custody and compliance for small advisers. Register for this event.

• New York – September 13: This seminar will be most relevant to newly registered investment advisers, to dual registrants and to investment advisers affiliated broker-dealers. The topics most relevant to newly registered advisers will include the SEC’s examination process, priorities, risk surveillance, and examination selection process. In addition, the staff will discuss Form PF and other filing requirements and recent industry and regulatory developments. The topics most applicable to dual registrants or advisers with affiliated broker-dealers will address the staff’s coordinated examination process, common examination findings, and controls that some firms use to address conflicts of interest. Register for this event.

• Atlanta – September 25: This seminar will discuss the importance of enterprise risk management and effective compliance and will identify key issues noted during examinations, including conflicts of interests and issues associated with fees, such as undisclosed remuneration, miscalculation, and layering. Additional discussion topics include the changing demographics of SEC-registered investment advisers and key examination program initiatives to address such changes. Register for this event.

• San Francisco – November 6: This seminar will feature an overview of the SEC’s examination processes and procedures and a discussion of OCIE and AMU priorities. Emphasis also will be placed on valuation issues, including best practices for valuing assets by private and registered investment funds. Register for this event.

If registrations exceed capacity at an event location, investment company and investment adviser CCOs will be given priority based on the order in which their registration requests were received. Information regarding these seminars was also provided in SEC Press Release 2013-127 (see http://www.sec.gov/news/press/2013/2013-127.htm). For more information, contact: [email protected].