Borrowings and Form PF

Form PF

A question popped up during a meeting of some real estate compliance folks talking about Form PF. How do you treat subsidiary mortgage borrowings? Question 12(a) asks for the dollar amount of borrowings for the fund. Two main issues came into play: write-downs and recourse.

As many real estate funds are still recovering from the 2008 financial crisis they may have some properties that are underwater. They could have debt in excess of the value of the property. If the loan obligation is isolated at a property and the recourse is limited to the subsidiary then the investment would have a negative valuation. For accounting treatment, the loan value is likely written down to the fair value of the property. That results in a zero valuation rather than a negative valuation.

When Form PF asks for the value of the borrowing should you include the full value or the written down value? Italics means there is a definition and it refers to Instruction 15.

15. May I rely on my own methodologies in responding to Form PF? How should I enter requested information? …

for … borrowings where the reporting fund is the debtor, “value” means the value you report internally and to current and prospective investors;

So the value of a mortgage borrowing should be reported based on the value you report internally and to current and prospective investors. If you write down the mortgage in your annual report, then you can write down the value of the mortgage on Form PF.

That leads to the next question, which is whether to include the debt at all. Without recourse the borrowing is not a direct obligation of the fund. You could argue that the mortgage debt is not part of the “reporting fund’s borrowings.”

A private equity fund would likely not report the value of debt owed by portfolio companies unless the debt were recourse to the fund. I’m not sure that the position changes when the investment is a single real estate instead of an operating portfolio company.

There is the fallback in question 4 which allows you to explain any assumptions you made in responding to questions. You could include all of the debt and state that it includes non-recourse debt. Or take the opposite approach and exclude the non-recourse debt but explain that you excluded non-recourse debt from the answer.

A third question was how to treat debt on joint venture properties. Most seem to agree that you would only include your proportionate share of the debt. Again, you could make arguments either way.

Relying on the Fat Finger Excuse

compliance and fat fingers

David Miller was a big Apple enthusiast. He saw the growing stock price and must have been scheming of ways to make some extra cash by jumping on board Apple’s express train to riches. He saw the golden ticket when a client asked him to make a series of Apple stock purchases. Instead of following the client’s instructions to buy 1,625 shares, he could add a few zeroes and buy 1,625 thousand shares.

While Apple stock continued its stratospheric rise in price, Miller would share the profits from the “mistake” with his client. But the balloon popped and the train crashed. Apple had less than stellar quarterly numbers. The stock price decreased. Miler and his firm were sitting on a $5.3 million loss.

Needless to say the client was not happy about the unauthorized trade on his behalf, leaving the firm to take a sour bite and eat the loss. Apparently Miller’s excuse was supposed to be a “fat finger” excuse. Miller accidentally added a few zeroes. Maybe that was a good excuse. The message from client could be misread:

“AAPL . . . b 125 ok (per ½ hr)”

That excuse could have worked except Miller also placed another unauthorized trade to sell 500,000 shares of Apple stock. That makes it really difficult for Miller to claim the fat finger excuse. One mistake might get a pass, but the second shows bad intent. That bad intent got him a fine from the SEC and a criminal charge from the DOJ.
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A Strange Week

boat

Last week was a difficult week to be away from Boston on vacation. My family is usually out on Patriot’s Day Monday watching the Boston Marathon. We wander down our street and mingle with the other spectators, friends, and neighbors on Commonwealth Avenue at the start of the Newton hills.

Instead we spent the week in Charleston and Washington hearing about the events through the news, Facebook and Twitter. Some it was informative, and some was misinformed.

On sunny post-vacation Monday morning, everything feels the same in a city that felt such tragedy a week ago. That’s good.

I’m sure there are compliance angles about the story. You have to wonder what made the brothers go bad. You have to be concerned about investigation process. You have to be concerned about the abrogation of rights.

But today is really about getting back to normal.

Terror in Boston

boston

I’m watching the horror while on vacation instead of my office in Boston.

My heart goes out to all of the spectators and families who were affected by the blast. Patriot’s Day in Boston is usually a great day, starting with the Revolutionary War reenactments in the morning, a Red Sox home game, and the endurance of the marathon.

I’m also heartbroken by the runners who put in months of training, but were stopped short of the finish line. That finish line is a demarcation of salvation after making it the 26.2 miles from Hopkinton and up Heartbreak Hill. It should never be a crime scene.

Compliance Bricks and Mortar for April 12

SONY DSC

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

Ex-SEC Enforcement Chief Defends ‘Neither Admit or Deny’ Settlements by Emily Chasan is WSJ.com’s CFO Journal

“By admitting wrongdoing in the government investigations, which companies might well be prepared to do, they face a great deal of liability on the civil side and, in fact, the admissions may well be tantamount to conceding liability on the civil side,” Mr. Khuzami said. Those suits often seek damages well in excess of an SEC settlement, he said.

Hedge Fund Survey Shows Misconduct Believed to be Widespread by Bruce Carton in Compliance Week

A recent survey of hedge fund professionals indicates that misconduct is widespread in the industry, and that a very large percentage of professionals in the industry are prepared to report wrongdoing under a program such as the SEC’s new whistleblower program under Dodd-Frank.

Measuring Tone at the Top by Michael Volkov in Corruption, Crime & Compliance

The importance of tone-at-the-top is significant. A 2009 research report conducted by the National Business Ethics Survey found that in strong ethical cultures, the pressure to commit misconduct was reduced from 16 percent to 4 percent; rates of misconduct were reduced from 77 percent to 40 percent; failure to report misconduct was reduced from 44 to 27 percent.

The question then is how do you measure the internal perception of your company’s tone at the top? There are a number of possible measurements: ….

Will Compliance Officers’ New Favorite Tool Be … Google Glass? by Bruce Carton in Compliance Week

Given that Google Glass can, among many other things, allow the user to record conversations and take photos or video, Magrann-Wells says that perhaps it is time for banks to start forcing traders to strap computers on their heads if they want to reduce the risks associated with rogue traders

Stages in a Bubble by Jean-Paul Rodrigue, Dept. of Global Studies & Geography, Hofstra University

stages_bubble

New SEC Rule to Protect Investors from Identity Theft

sec-seal

The Securities and Exchange Commission adopted new rules requiring investment advisers, broker-dealers, mutual funds, and certain other entities regulated by the agency to adopt programs to detect red flags and prevent identity theft.

In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act amended the Fair Credit reporting Act to add the SEC to the list of federal agencies that must adopt and enforce identity theft red flags rules. In February 2012, the SEC proposed for public notice and comment identity theft red flags rules and guidelines and card issuer rules. Yesterday, the SEC issued the final rule.

Originally, it looked like investment advisers (and therefore private fund managers) might escape the rule. However, the final rule explicitly includes registered investment advisers as being subject to the rule.

Investment advisers who have the ability to direct transfers or payments from accounts belonging to individuals to third parties upon the individuals’ instructions, or who act as agents on behalf of the individuals, are susceptible to the same types of risks of fraud as other financial institutions, and individuals who hold transaction accounts with these investment advisers bear the same types of risks of identity theft and loss of assets as consumers holding accounts with other financial institutions. If such an adviser does not have a program in place to verify investors’ identities and detect identity theft red flags, another individual may deceive the adviser by posing as an investor.

The SEC concluded that the red flag program of a qualified custodian that maintains custody of an investor’s assets would not adequately protect individuals holding transaction accounts with an adviser. The adviser could give an order to withdraw assets, but at the direction of an impostor. However, an adviser that has authority to withdraw money from an investor’s account solely to deduct its own advisory fees would not hold a transaction account, because the adviser would not be making the payments to third parties.

Does this apply to private funds?

Private fund managers may directly or indirectly hold transaction accounts. According to the SEC rule, if an individual invests money in a private fund, and the adviser to the fund has the authority to direct the individual’s investment proceeds (such as distributions) to third parties, then that adviser would indirectly hold a transaction account. The SEC concludes that a private fund adviser would hold a transaction account if it has the authority to direct an investor’s redemption proceeds to other persons upon instructions received from the investor.

I’m not sure that I agree with the SEC conclusion. However, I do agree that funds need to make sure that distributions are not re-directed improperly. Private fund managers will have to put some effort into this.

This rule is going to take some time to figure out how it applies in the context of fund operations. The subscription agreement and partnership agreement for a fund may not explicitly address if an investor can direct distributions to a third party account. I think that would be an unusual restriction.

The SEC-mandated program under rule should include policies and procedures designed to:

  • Identify relevant types of identity theft red flags.
  • Detect the occurrence of those red flags.
  • Respond appropriately to the detected red flags.
  • Periodically update the identity theft program.

The rules require entities to provide such things as staff training and oversight of service providers. The rules include guidelines and examples of red flags to help firms administer their programs.

The final rules will become effective 30 days after publication in the Federal Register. The compliance date for the final rules will be six months after their effective date.

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Private Equity Funds in the Hot Seat

Debevoise & Plimpton LLP

Debevoise & Plimpton LLP put on an excellent seminar focused on enforcement actions against private equity funds.

Moderator:
Kenneth J. Berman

Speakers:
Eric R. Dinallo
Robert B. Kaplan
Shannon Rose Selden

Each fund manager is designated with a risk rating by the Securities and Exchange Commission. The Form ADV filing gives the SEC the background to assign that rating for a likelihood to be in compliance or out-of-compliance with regulatory requirements.

Registration gives the SEC the ability to just show up and ask for information. Prior to registration, the SEC would have needed a subpoena. The goal of the presence exams is to visit 25% – 50% of the new registrants over the next 2 years. The exams seems to more heavily weighted towards private equity than hedge funds. Perhaps because many hedge funds had been registered before and the SEC is more familiar with the risks with hedge funds.

Examination Priorities:

Exam Priorities in 2013 for Investment Advisers
– Conflicts of Interest Related to Compensation Arrangements
– Conflicts of Interest Related to Allocation of Investment Opportunities
– Marketing/Performance

“Presence” Exam Priorities
– Marketing
– Portfolio Management
– Conflicts of Interest
– Safety of Client Assets
– Valuation

Enforcement Priorities
• Marketing/Performance
• Valuation
• Conflicts of Interest
• Allocation of Expenses
• Fee Arrangements & Calculations
• Waterfall & Carry Distribution Calculations
• “Zombie Funds”

Marketing Cases:

• In re Oppenheimer Asset Mgmt. Inc., et al, (March 11, 2013)
• In re Ranieri Partners LLC and Donald W. Phillips (March 8, 2013) and In re Stephens (March 8, 2013)
• In re Advanced Equities, Inc. (Sept. 18, 2012)

Valuation
• In re Oppenheimer Asset Mgmt. Inc. (March 11, 2013)
• SEC v. Brantley Capital Mgmt., LLC et al. (Sep. 28, 2010)
• In re KCAP Financial, Inc., (Nov. 28, 2012)
• SEC v. Yorkville Advisors (Oct. 17, 2012)

Conflicts of Interest
• In re Crisp (Aug. 30, 2012) (Self-Dealing)
• SEC v. Resources Planning Group Inc. (Nov. 23, 2012) (Misuse of Client Funds)

Fees & Expenses

• In re Pinkas (Feb. 15, 2012) (Allocation of expenses)
• SEC v. Onyx Capital Advisors, LLC (April 22, 2010) (Improper Fee Arrangements)

State versus Federal Enforcement

States still have the ability to enforce anti-fraud laws against investment advisers and private funds. Just because you are exempt from state registration, you are not exempt from state enforcement.

Ranieri

Highlighted the Ranieri case where a finder stepped over the line and acted as a placement agent. The SEC not only brought an action against the finder, but also against the fund firm and its principal. The SEC seemed especially annoyed that the finder had been barred from acting as a broker.

Are You Systemically Important?

too_big_to_fail_poster

One of the catchphrases that came out of the 2008 financial crisis was “too big to fail.” It’s a great concept, but hard to define in a meaningful way. Many think that there is no private company that should not be allowed to fail. Dodd-Frank created a concept of systemically important, trying to create additional oversight for “financial companies” that could be too big to fail.

The trick was trying to define a “financial company.” Many companies use derivatives to hedge their business risks. Many big manufacturing companies use hedging to limit exposure to commodities they use. Companies with overseas operation use foreign exchange derivatives to hedge currency risks. The tough part was drawing the line.

The Federal Reserve Board on Wednesday announced approval of a final rule that establishes the requirements for determining when a company is “predominantly engaged in financial activities.” The requirements will be used by the Financial Stability Oversight Council when it considers the potential designation of a nonbank financial company for consolidated supervision by the Federal Reserve.

The final rule defines the terms “predominantly engaged in financial activities”, “significant nonbank financial company” and “significant bank holding company.” The FSOC must consider the extent and nature of the company’s transactions and relationships with other significant nonbank financial companies and significant bank holding companies. If designated, those nonbank financial companies will be required to submit reports to the Federal Reserve, the FSOC, and the Federal Deposit Insurance Corporation on the company’s credit exposure to other significant nonbank financial companies and significant bank holding companies as well as the credit exposure of such significant entities to the company. Consistent with the proposal, a firm will be considered significant if it has $50 billion or more in total consolidated assets or has been designated by the FSOC as systemically important.

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The SEC and Social Media

social-media-expert

Netflix chief executive Reed Hastings got into trouble on July 3, 2012 when he used his personal Facebook page to announce that Netflix had more than one billion hours of online viewing in June. That trouble came from an SEC rule implemented in August of 2000: Regulation FD. That rule was implemented to stop the egregious practice of some companies delivering company news to select recipients ahead of a general announcement. Those select recipients would be able to make money from getting the news ahead of time and trading on the upcoming stock movement.

The SEC issued its report on the investigation of Mr. Hastings and determined not to pursue an enforcement action against him. The SEC publicly released its Report of Investigation to help provide some guidance on the use of social media for public company disclosure.

Personally, I thought Mr. Hastings made a bad decision in using his personal Facebook page to make a company announcement. The information had already been released, but in more technical releases. His personal Facebook page did have 200,000 friends who could see the news, but it was still gated and not available to the general public in a broad and non-exclusionary manner. It was a poor choice, but not one that should subject him or the company to an enforcement action.

Regulation FD is written to be platform neutral. You can release “important” company information as long as it available to everyone at the same time. It applies equally to press releases, company websites, Twitter, Facebook, or the big rock in front of your headquarters.

The key for correct distribution is to let people know where the news will be distributed. You could argue that Steve Jobs’ annual display of the latest gadget from Apple is a distribution channel that everyone knows about. A company could carve company announcements into the stone in front of its headquarters if it so chose.

Mr. Hastings foot-fault was that Netflix had not previously used his personal page as a platform for releasing company news. In early December 2012, Hastings stated for the public record that

“we [Netflix] don’t currently use Facebook and other social media to get material information to investors; we usually get that information out in our extensive investor letters, press releases and SEC filings.”

Hastings errant Facebook post was probably not “important” enough and the Facebook page was probably just public enough that the SEC thought it could not win an enforcement action. I’m sure Hastings and Facebook paid quite a bit in legal fees to address the repercussions of that errant post.

It’s not big news that the SEC has embraced social media. The SEC merely reminded companies that they need to go through the Regulation FD analysis when using social media platforms. The SEC embraced social media a long time ago.

I think Facebook is terrible primary platform for important corporate disclosures. It lacks the workflow and content management tools that any corporate communication professional would want to have. The same is even more so with Twitter. It’s hard to do much with 140 characters, except direct the reader to another website.

To de-emphasize the importance of the SEC guidance, it’s not even released as SEC guidance, a risk alert, or other typical SEC regulatory rulings. It merely restates what Regulation FD says and drops in the word Facebook. Too many social media specialists will merely read the headline.

Even Facebook does not use Facebook for company announcements. This announcement will not change that. Maybe Facebook will see the potential for including content management and compliance tools that will allow companies to embrace Facebook and be in compliance with securities laws.

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