Impact of Foreign Regulations on Private Equity Firms Doing Business Abroad

PEI PFC Forum 2013

These are my notes from the Private Fund Compliance Forum 2013. They are live from the forum, so please excuse my typos.

James V. Gaven, Senior Compliance Counsel,Welsh, Carson, Anderson & Stowe
Alan K. Halfenger, Chief Compliance Officer, Bain Capital LLC
Greg Pusch, SVP, Director of Global Regulatory Compliance & CCO, HarbourVest Partners, LLC

The US loaded up funds with the new regulatory framework imposed by Dodd-Frank. Foreign jurisdictions have also imposed tough new regulations.

There is a July deadline for dealing with the AIFMD in the EU that imposes restrictions on private placements.

EU is a mess. The regulations are not in place, so you can’t register yet and don’t know exactly what you need to do to register. It’s going to be a county by country analysis, requiring county by country registration.

You will also need to specifically address how advice is given and where the investment decisions are being made. You need to focus on the granting of discretionary decision making.

It’s not just the EU, other countries have restrictions on marketing within the country to investors in the country.

The EU AIFMD comes into full force in 2018. There is a political overlay that may affect things. There is a lot of uncertainty. The UK has not created the application form yet to apply for private placement clearance.

Know Your Customer and AML procedures become important when marketing to overseas investors. You don’t want “bad guys” as investors. Foreign investors will be a red flag for examiners. It’s okay to use a risk-based approach to investor diligence. The standard is disclosure of significant ownership, ranging from 10% to 25% of the ownership.

The Middle East is a problem. Their regulations make it very difficult to market in Saudi Arabia. Korea has some tough regulations affecting private fund marketing.

You need to be concerned about placement agents from the perspective of FCPA and supervision. You need to audit periodically about any changes they are making to the marketing materials.

There is some thought about setting up parallel funds for EU investors. However, the EU regs tie back to the main fund and still requires registration.

 

Successfully managing the resources of your office

PEI PFC Forum 2013

These are my notes from the Private Fund Compliance Forum 2013. They are live notes from the forum, so please forgive my typos.

Jason E. Brown, Partner, Ropes & Gray LLP
Reuben B. Ackerman, Chief Compliance Officer, Berkshire Partners LLC
Terry E. Everett, Chief Financial Officer & Chief Compliance Officer, Rockland Capital, LLC
Daniel H. Weintraub, Managing Director & General Counsel, Audax Group

The CCO should not be the sole person in the firm responsible for compliance. It requires all employees to care and all managers to take responsibility.

Engage accounting. They see the flow of cash, employee expenses, political contributions and entertainment expenses. They would also be on the frontline for money laundering risks.

The investor relations team should see it as an extension of their role. Investors want to see compliance and see it as necessary for their investment choices.

Put a candy bowl in your office, it’s a great way to lure employees in with questions.

Technology tools are important to improve productivity.

Email surveillance? It’s not required by SEC rules, but it seems to always come up in SEC audits. Use keywords. You will need to deal with lots of false positives.

Personal securities trading is difficult. Employees will want that information to be limited to one or a very few people. You should not disclose that information to other employees. You need to be concerned about the privacy concerns.

Should all employees be access employees? You need to have access to non-public information and need to be a supervised person. All employees are supervised persons. Most likely you do not have effective barriers to prevent employees from getting non-public information. For example, an administrative assistant may see a memo about an upcoming transaction.

When thinking about pushing the boundaries of SEC rules think about the disclosure to investors when they ask about a deficiency letter.

Should you monitor personal email accounts on third party email platforms like gmail, or yahoo mail. Have them certify that they do not use personal email accounts for work email.

Conducting your annual review to ensure compliance

PEI PFC Forum 2013

These are my notes from the Private Fund Compliance Forum 2013. They are live notes, so please forgive the typos.

Brian Kawakami, Partner, Ascendant Compliance Management
Charles Lerner, Principal, Fiduciary Compliance Associates LLC, and Editor, The US Private Equity
Fund Compliance Guide and The US Private Equity Fund Compliance Companion
Jim O’Connor, Chief Compliance Officer, Golden Gate Capital

Rule 206(4)-7 specifically requires an annual review of the compliance program. The release identifies 10 points for review.

What is annually? There is no clear requirement. It is fine to have it run during a time that people are available. End of year can be a bad time. April 15 is a bad time.

The Commission has stated that it expects your policies and procedures, at a minimum, to address the following issues to the extent that they are relevant to your business and therefore would expect them to be included in the annual review:

  • Portfolio management processes, including allocation of investment opportunities among clients and consistency of portfolios with clients’ investment objectives, your disclosures to clients, and applicable regulatory restrictions;
  • The accuracy of disclosures made to investors, clients, and regulators, including account statements and advertisements;
  • Proprietary trading by you and the personal trading activities of your supervised persons;
  • Safeguarding of client assets from conversion or inappropriate use by your personnel;
  • The accurate creation of required records and their maintenance in a manner that secures them from unauthorized alteration or use and protects them from untimely destruction;
  • Safeguards for the privacy protection of client records and information;
  • Trading practices, including procedures by which you satisfy your best execution obligation, use client brokerage to obtain research and other services (referred to as “soft dollar arrangements”), and allocate aggregated trades among clients;
  • Marketing advisory services, including the use of solicitors;
  • Processes to value client holdings and assess fees based on those valuations; and
  • Business continuity plans.

Valuation is at the top of the list for private equity. You want consistency and you want adherence to the policies.

Charles recommended that you have the annual review include an outside person. It’s hard to review yourself. (He added a self-promotion disclaimer.)

There was a disagreement about the use of outside parties in the annual review. A gap analysis can be protected by attorney-client privilege. A written annual review cannot.

How do you show “tone at the top”? It’s key to have senior management in compliance training. It’s good to have a regular meetings between heads of the firm and the CCO. The CCO should regularly send out regular compliance remainders.

Conflict analysis should include allocation of expenses. Are expenses being reasonable allocated to the funds and to the manager.

A warning sign of a problem is people who are unwilling to offer up the requested information.

Charles shared a story over the use of the company plane. From a compliance standpoint you should review the flight log to make sure the  plane went to business locations and not to personal travel. One SEC examiner raised an issue that the plane should be subject to competitive bidding.

An annual review should look closely at co-investments and compare to the policy and procedures. Make sure the selection of co-investment meets the procedures.  You should not base that choice solely on the basis of the size of an investor’s interest in the fund. You don’t just want to have the biggest if others want to invest.

The SEC will want to know how you make money. How you make money will lead a path to business operations and conflicts.

Charles recommended that you don’t rely just on the personal trading software platform to identify red flags. It’s good to grab the statements and see the holdings more holistically.

Part of the annual review should include a risk matrix so you can produce something in response to enterprise risk management. Presence exams are, in part, focused on high risks. Plot how the risks are relevant to your firm and rate them.

 

What to expect from the SEC in the year ahead

PEI PFC Forum 2013

Carlo V. di Florio, Director, United States Securities and Exchange Commission, Office of Compliance Inspections and Examinations

I expect the full text of his remarks will be published in the next few days, but these are my notes. They are live from the forum, so please excuse the typos.

It’s been a busy year for the SEC, with a big influx of private equity funds and other private fund managers. The SEC had lots of internal training in anticipation of private fund managers. They have many industry experts who are helping them analyze risk and train examiners.

The goal is still to subject most of the new registrants to presence exams. They have run about 140 exams so far.

DiFlorio_Carlo

The SEC still plans to publish a risk alert based on the findings from presence exams. We should expect it in the next 12-18 months.

In the marketing area, there are many firms with a very robust formal process for review. Others are informal and need some work.

In the portfolio management area, it’s allocation that is most problematic. You need a good process to show why you made an allocation to a particular fund.

In conflicts, it’s about fees that go to the fund manager instead of the portfolio company or being charged to the portfolio companies. There is also an allocation issue related to conflicts.

Valuation is another hot button. The SEC wants to see a good process. They want checks and balances. They want consistency in valuation procedures. Variations in process may be an indication of manipulation of valuations.

Zombie funds are a concern. The SEC does not want to see funds hanging on to assets merely to collect fees.

Private funds are moving into the retail space. As funds get exposed to retail investors, the SEC becomes more concerned.

Sometimes enforcement attorneys will accompany OCIE personnel on examinations. It’s a very small percentage of times. Usually, it’s for training purposes. Sometimes it’s to get a specialist from the investment management unit to help provide expertise. BUT sometimes, there has been a complaint and the enforcement person is looking at a specific issue.

Broker-dealer registration issues for fund managers is on the OCIE radar. He noted the David Blass speech on private funds and broker-dealer registration. They are seeing larger managers using an affiliate broker-dealer. Smaller funds are within the bounds of the issuer exemption. It’s fund managers in the middle that are falling afoul of broker-dealer registration issues. Dedicated marketing departments that get paid a commission are suspect.

He is seeing certain fund compensation as potential broker-dealer activity. If the fund manager is collecting a fee for raising debt or equity for a portfolio company, that could be an activity requiring broker-dealer registration.

Custody is an important focus in a post-Madoff world for the SEC. The SEC has found that private funds are struggling with the custody rule. For example, auditors are not PCAOB registered.

OCIE is impressed with how well many of the firms have put formal compliance plans in place. They are seeing that most private funds are taking the obligation very seriously. It’s the smaller firms that have more challenges when the CCO is wearing multiple hats.

OCIE really likes it when the CCOs are in the information flow. It’s great to see them in key meetings when decisions are being made. Crafting compliance to the business process is important.

He also mentioned that it’s great to see CCOs connecting with each other, like at this forum.

OCIE realizes that fund managers come in many shapes and sizes. They want to see meaningful compliance. They recognize that it can be more of a challenge at smaller firms.

SEC has submitted a budget request for 250 more examiners, most who would be dedicated to adviser examination. OCIE feels that there needs to be more examinations of advisers and fund managers. There is examination fee bill in Congress, sponsored by Maxine Walters. There has been an SRO bill on the floor, but it expired. He was not willing to place a wager on which option will come to fruition, if any.

Co-investment raises a conflict issue. The SEC is concerned about fair treatment. You should be concerned when fees are paid by the fund and not the co-investor or when opportunities are offered to a co-investor instead of the fund.

All firms received the presence exam welcome letter. Receipt of that letter was not an indication that the fund manager was on a review list. There was a rumor in the audience that only selected fund mangers received the letter.

Form PF will be part of the exam process. The market intelligence unit will use Form PF to identify risk and to highlight forms to exam. Examiners will have Form PF and be able to craft exam investigations around the information disclosed in the form.

To make an exam go smoother, what can a firm do. OCIE has tried to make the process more efficient. Make sure you have ready access to the information and people in the firm. Engage with the examiners and ask them questions.  OCIE imposes a 180-day limit on examinations. Generally, OCIE will reply back with 45 days after a response to a deficiency letter. OCIE will also commonly follow back to see if the changes have been implemented.

Dodd-Frank a year on: Where is the compliance industry now?

PEI PFC Forum 2013

These are my notes from the Private Fund Compliance Forum 2013. They are live notes, so excuse the typos.

David Smolen, Chief Compliance Officer, Silver Lake
Brynn Peltz, Partner, Goodwin Procter LLP
Roman A. Bejger, Counsel and Chief Compliance Officer, Providence Equity Partners, LLC
Michael Barnes, Senior Manager, Financial Services, Ernst & Young LLP

Fund managers fell into four categories: 1. those who accepted, 2. those who are still kicking and screaming, and 3. Those who are fighting and trying to find ways to escape, and 4. Those who registered and restructured to escape registration.

The panel felt that it’s inevitable that carried interest will be taxed differently. Of curse it’s felt inevitable for a few years and nothing has been implemented. In perspective, the change in tax of carried interest is estimated to be between $1.3 billion and $1.6 billion per year.

As a result of the Volcker Rule, we are seeing more business development companies coming on line to address bank’s trading activity. Whenever the rule comes out it may have broad impact on funding and capital commitments for private funds.

There is an uncertainty about marketing rules with the changes mandated by the JOBS Act.

There is increased focus on fees as part of examinations. The SEC is trying to re-label fees, other than advisory fees, as compensation that could require broker-dealer registration. Brynn has seen this in several deficiency letters over the last few months. The SEC is asking examinees to explain why they do not have to register as a broker-dealer. Acquisition fees, disposition fees and other transaction based fees could trigger the question of broker-dealer registration. A marketing department is suspect if the employee compensation is tied to successful placement of interests in a fund.

The SEC does not seem to be using the term “presence exam” when initiating an exam. The panelists seem to think that the SEC is still robustly conducting regular exams and presence exams are not being conducted as widely as expected.

What additional responsibilities have you taken on post-registration?

  • Lobbyist registration
  • International blue sky law analysis
  • Review of secondary transfers
  • Form PF
  • Internal marketing of compliance
  • Tracking regulatory changes
  • EU’s AIFMD
  • FCPA

Is there personal liability for CCOs?

We are looking for more guidance in this area. Keep the CCO from having supervisory liability. If the CCO hands out discipline, then the CCO could be considered a supervisor and be held liable for the bad act. However, the cases imposing supervisory liability on CCO generally are at the extreme, involving fraud or other egregious acts.

Presence exams generally last a few days. Union examiners leave right at 5. Non-union may stay longer. Generally it’s 2 to 3 people, with a junior person, a mid-level manager, and a senior person who usually does not stay all day. Sometimes there will be a group of trainees. Sometimes enforcement will also come, but it may be just a learning experience and not an indication of wrongdoing. Ask for an exit interview. If it’s refused then the exam may not be over.

 

Are Your Private Fund Employees Licensed?

compliance and licensing

I think many real estate fund managers and private equity fund managers may be concerned that there are some additional licensing requirements now that they are registered with the Securities and Exchange Commission as an investment adviser. If you didn’t require licensing with your current business model before Dodd-Frank you likely don’t require licensing post-Dodd Frank. Obviously there are many business models and internal compensation structures and each changes the analysis. Of course, a fund manager may have missed the licensing requirement in the first place.

David W. Blass Chief Counsel, Division of Trading and Markets U.S. Securities and Exchange Commission mentioned in a speech earlier this month that the SEC is focusing on this issue. Absent an available exemption or other relief, a person engaged in the business of effecting transactions in securities for the account of others must generally register under Section 15(a) of the Exchange Act as a broker.

A firm needs to be very focused on this issue if it is paying compensation to its employees that depends on the outcome or size of the securities transaction:  transaction-based compensation. The SEC views the receipt of transaction-based compensation is a hallmark of being a broker.

There is an “issuer exemption” in Exchange Act Rule 3a4-1 that provides a non-exclusive safe harbor under which associated persons of certain issuers can participate in the sale of an issuer’s securities in certain limited circumstances without being considered a broker. One key aspect of that rule is that the employee

Is not compensated in connection with his participation by the payment of commissions or other remuneration based either directly or indirectly on transactions in securities. Rule 3a4-1 (a)(3)

Beyond that threshold requirement, there are several other hurdles under the rule.  Blass summarizes those hurdles:

A person must satisfy one of three conditions to claim the issuer exemption from broker-dealer registration:

  • the person limits the offering and selling of the issuer’s securities only to broker-dealers and other specified types of financial institutions;
  • the person performs substantial duties for the issuer other than in connection with transactions in securities, was not a broker-dealer or an associated person of a broker-dealer within the preceding 12 months, and does not participate in selling an offering of securities for any issuer more than once every 12 months; or
  • the person limits activities to delivering written communication by means that do not involve oral solicitation by the associated person of a potential purchaser.

On the bright side, Blass indicates that the he would consider a rule providing a broker-dealer registration exemption written specifically for private fund advisers.

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Compliance Bricks and Mortar – One Heart Boston Edition

heart boston

One Heart Boston: All proceeds beyond the direct material costs, postage and applicable taxes from the sale of One Heart Boston merchandise will benefit The One Fund Boston, created to raise money to help those families most affected by the tragic events that unfolded during this year’s Boston Marathon.

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

Rep. Waters Introduces Investment Adviser Examination Improvement Act

Representative Maxine Waters (D-Cal.), along with Representative John Delaney (D-MD), again introduced legislation that would allow the SEC to charge user fees to fund examinations of investment advisers, the Investment Adviser Examination Improvement Act of 2013.  …  The proposed legislation also has the backing of a number of organizations including NASAA, which issued a supporting statement.  Nevertheless, the likelihood of action in the foreseeable future is remote.

House Panel Examines SEC Failure to Meet JOBS Act Rulemaking Deadline, Comm. Walter Says Accredited Investor Definition Is Outdated in Jim Hamilton’s World of Securities Regulation

At a hearing of the Subcommittee on Oversight and Investigations of the House Financial Services Committee examining the failure of the SEC to meet the statutorily imposed deadline for implementing Title II of the Jumpstart Our Business Startups Act (JOBS) Act, SEC Commissioner Elisse Walter testified that the Commission will move ahead to adopt final regulations implementing Title II as expeditiously as possible. This is a top priority for the SEC, she emphasized. During the hearing, Commissioner Walter said that she favors a revision to the definition of accredited investor to focus more on the amount of money a person already has invested.

Scott London Subverted Sarbanes-Oxley: Big Four Mock Audit Partner Rotation in re: The Auditors

The rest of the column goes on to explain that London seems to have subverted the intent of Sarbanes-Oxley Section 203 that requires lead engagement partner rotation off engagements to promote objectivity, independence and professional skepticism. But he’s not alone. The more I looked into this the more I realized it’s probably pretty common in the firms. After ten plus years of Sarbanes-Oxley, we’ve probably got quite a few of these roll off, roll back on partners out there. An early draft of a paper by four academics, including former PCAOB academic fellow Brian Daughtery, says almost everyone does it.

Financial Analyst Survey: “Chinese Wall? Reg FD? Never Heard of Them…” in The Corporate Counsel .net

Meanwhile, in this survey of hedge fund professionals – commissioned by Labaton Sucharow, HedgeWorld and the Hedge Fund Association – 46% said they believe that their competitors engage in illegal activity, 35% have personally felt pressure to break the rules, and 30% have witnessed misconduct in the workplace. When asked if they would blow the whistle or report the misconduct, 87% of respondents said they would report wrongdoing given the protections and incentives such as those offered by the SEC Whistleblower Program.

The First Enforcement Action Under the JOBS Act

SEC Enforcement Logo

I believe the Securities and Exchange Commission has taken its first enforcement action under the JOBS Act. The SEC announced fraud charges against a Spokane Valley, Wash., company and its owner for misleading investors with claims to raise billions of investment capital under the Jumpstart Our Business Startups (JOBS) Act and invest it exclusively in American businesses.

Every critic has some concerns about investor protections in a post-JOBS Act securities world. There has been a whirlwind of entrepreneurs and wanta-preneuers who want to take advantage of the crowdfunding rules and the removal of the ban on general solicitation for private offerings.

“The JOBS Act is intended to help small businesses raise capital, not to legalize fraud or give unscrupulous entrepreneurs a right to make false claims to fleece investors.”
– Michael S. Dicke, Associate Director in the SEC’s San Francisco Regional Office.

According to the SEC complaint, Daniel Peterson sold his USA Real Estate Fund 1 securities, raising more than $400,000 based on false and misleading statements.  According to the business plan, the fund could invest in real estate, mortgage notes and technology companies. I consider all of these to be high risk investments. But the website touts that investors won’t lose their money.

Q: How do you assure the investor that they will not lose their investment?
A: Our protection works much the same as flood insurance or earthquake or tornado insurance. We buy Financial Instruments comprised of US Government treasuries, Top Rated US and World Insurance and Reinsurance Companies (GIC and Annuity) contracts. The fund reserves the right to invest up to 5% of its assets in other Debt securities, such as but not limited to, high yield securities, foreign bonds, and money market instruments, when to do so would be considered within the strategy of the fund and in the best interest of its investors. These are the financial instruments that will provide the money to insure against loss.

I’m not quite sure how to reconcile that answer with the investment strategy.

According to the SEC complaint, the firm claimed it would offer additional securities and raise more investment capital, made possible by the Jumpstart Our Business Startups Act. Again, its not clear to me how passage of the JOBS Act would create value for the fund investors. I suppose that’s one of the reasons the SEC is making a claim against the fund for false and misleading statements.

It is clear that this is not a case of legitimate fundraising trying to take advantage of the JOBS Act before the JOBS Act regulations are put in place. If you, like me, were looking for a juicy and sordid tale instead of mere fraud you will be disappointed with the headline.

Equity crowdfunding portals are not yet legal because the regulations have not been enacted. General solicitation for Rule 506 private placements is not yet legal, because the regulations have not been enacted. Of course there are legal ways to use exemptions in these situations, but they are all pre-JOBS Act.

Anyone currently touting ways to get rich using the JOBS Act should be viewed as suspect. They are merely speculating on what the SEC may do and how entrepreneurs would take advantage of the potential new regimes.

You need to draw the distinction between entrepreneurs and wanta-preneuers.

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Don’t Overstate Assets Under Management

over inflate

I’ve said it before: Don’t overstate assets under management. You need to keep records on your calculations and be able to prove the calculations.

Umesh Tandon ran Simran Capital Management and was trying to land California Public Employees’ Retirement System (CalPERS) as a client. The problem was that CalPERS required prospective investment advisers to have at least $200 million in assets under management.

According to the SEC Order,  Tandon lied and stated that his firm met that test. In reality, the firm had only $80 million in assets under management. The Firm’s Form ADV stated that the firm had $102 million in assets under management.

Once that line was crossed, the firm used overinflated statements of assets under management when pitching other clients.

Then the SEC examiners showed up and popped the bubble. Now Tandon is barred from the securities industry and has to pay a substantial fine.

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