Compliance Bricks and Mortar – Blizzard Edition

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I’m bunkered down waiting for a blizzard to unleash its wrath on Boston. While my snowblower is waiting for the flakes to fall from the sky, these are the compliance-related stories I’m reading.

‘Without Wheels’: Sometimes Circumstantial Evidence Can Be Quite Powerful by Bruce Carton in Compliance Week

The SEC alleged that Vance learned about the merger when he was asked to help Clear One’s CEO resolve an e-mail issue and saw confidential merger documents, and tipped Wellington. The agency also alleged some extraordinary steps that Vance and Wellington took so that they could have the funds to purchase Clear One shares the very next day:

  • Wellington allegedly obtained a $25,000 loan from an “online peer lending site.”
  • Vance allegedly borrowed $5,285 from his 401(k) retirement account, but also “sold personal computer equipment, and sold his truck to finance his purchases of Clear One shares.”

SEC Charges Husband With Insider Trading Using Wife’s Information by Thomas O. Gordon in SEC Actions

The action centers on the acquisition of National Semiconductor Corporation by Texas Instruments, announced after the close of the market on April 4, 2011. Defendant James Balchan, an IT specialist, is married to a partner in a law firm. One of her partners, called Partner A in the complaint, was a close friend of the general counsel of National Semiconductor. In honor of his friend the general counsel, the Partner A organized a “wine and dine” weekend. Mr. Balchan and his wife were invited.

Carried Interest Explained in Latest PEGCC Whiteboard Video

Judge: “Carried interest is commonly misunderstood in public discourse. Our newest whiteboard video demystifies the topic and answers questions about what carried interest really is, how it works and why it’s appropriately taxed at the capital gains rate.”

Annual Compliance Obligations — What You Need to Know in Pillsbury’s Investment Fund Law Blog

As the new year is upon us, there are some important annual compliance obligations Investment Advisers either registered with the Securities and Exchange Commission (the “SEC”) or with a particular state (“Investment Adviser”) should be aware of.

Two Hedge Fund Managers Charged in Alleged $311 Million Fraud Case by Debbie Cai in WSJ.com’s Corruption Currents

Two hedge fund managers were indicted for alleging defrauding institutional investors and causing total losses of more than $311 million, the U.S. Department of Justice said. …

The charges state between March 2005 and December 2008, Kiener led Bear Stearns entities to believe, under his management, Bear Stearns investment funds would be diversified and independently managed. However, Kiener allegedly funneled Bear Stearns money from K1 through the Oceanus Funds and back to K1, giving the false impression the funds were growing in size and were viable investments.

Have You Disclosed Your Derivatives Positions?

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The Securities and Exchange Commission filed charges against a fund manager and its subadviser for their extensive use of derivatives. From April 2007 through October 2008, the Fiduciary/Claymore Dynamic Equity Fund engaged in derivative strategies to supplement the Fund’s primary investment strategy. But the Fund failed to include adequate disclosure about the risks to the Fund arising from the Fund’s use of derivatives, either in its annual report or in an amended Fund registration statement.

The Fund’s primary investment strategy was to invest in equities and write call options on a substantial portion of those equities. This covered call strategy trades upside potential in the equities held in the portfolio for current income from option premiums received.

Things changed in April 2007 when the Fund supplemented its income and returns by writing out-of-money S&P 500 put options. The Fund collected a premium from the purchaser of the option, and in exchange agreed to compensate the purchaser for any declines in the S&P 500 beyond the strike price of the option. Between April 2007 and August 2008, the Fund collected $9.6 million in premiums from written put options. For the six months ending May 31, 2008, written put options  added approximately 2.1% to the Fund’s return.

Then the financial markets collapsed in October 2008. The Fund lost  $45,396,878, or 45% of the Fund’s NAV in its undisclosed derivates strategy.

The Fund was a registered investment company so some of the violations stem from the failure to make proper disclosures under the Investment Company Act. The SEC also found violations under the anti-fraud provisions of the Investment Advisers Act, Section 206(4) and Rule 206(4)-8. Those provisions prohibit the making of any untrue statement of a material fact or the omission of a material fact necessary to make statements made not misleading, or to otherwise engage in any act, practice, or course of business that is fraudulent, deceptive, or manipulative with respect to any investor or prospective investor in a pooled investment vehicle.

If derivatives are substantial part of a fund’s portfolio, it sounds like the SEC expects you to disclose that fact to investors.

Sources:

S & P and the SEC

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The Securities and Exchange Commission took the bold step of filing charges against Standard and Poor’s, one of the three giant rating agencies. Personally, I think the role of rating agencies in the run up to the 2008 financial crisis has been under-appreciated. Without the the top AAA rating they bestowed on securitized mortgage bonds, the flow of cash into those toxic instruments would have stopped much earlier and decreased the size of the bubble.

The SEC complaint claims that S&P continued to give subprime mortgage securities high ratings as the the securities looked increasingly fragile and financial crisis began to bubble to the surface. In the first half of 2007, S&P rated a large number of large mortgage-backed securities, bestowing top grades on the investments. It then quickly downgraded the securities, which defaulted in months.As a result, federally insured banks incurred losses. That gives the SEC jurisdiction.

As with any government investigation, the SEC found emails saying stupid things. In one case there is a March, 2007 satire in an email based on the Talking Heads song “Burning Down the House”:

“Watch out
Housing market went softer
Cooling down
Strong market is now much weaker
Subprime is boi-ling o-ver.
Bringing down the house.”

The SEC claims that S&P knew that the performance of non-prime residential mortgage backed-securities was bad and getting worse. The firm expected deals to rush in before those packaging the mortgages were stuck with them on their books.  The SEC takes individual instances of ratings failures by S&P and ties them to losses sustained by the banks that bought them.

Another e-mail from an analyst in response to a question about how his new job was going reads:

“Job’s going great. Aside from the fact that the M.B.S. world is crashing, investors and the media hate us and we’re all running around to save face … no complaints.”

But then went on to state the central part of the case:

“The fact is, there was a lot of internal pressure in S&P to downgrade lots of deals earlier on before this thing started blowing up. But the leadership was concerned of p*ssing off too many clients and jumping the gun ahead of Fitch and Moody’s.”

….

This might shake out a completely different way of doing biz in the industry. I mean come on, we pay you to rate our deals, and the better the rating the more money we make?!?! Whats [sic] up with that? How are you possibly supposed to be impartial????

There is an unforgiving conflict in the way mortgage bonds were rated. The issuer pays for the ratings work. So there is an incentive by the ratings agency to met the issuer’s expectations, keep them happy, and retain their business.

Finally, in July, 2007, S&P downgrades 612 classes of RMBS, totaling $12 billion in securities. Of course it was too late for the securities that S&P had favorably rated just days and weeks earlier. It is the ratings issued between March and July of 2007 that the SEC is focused on this complaint. The SEC claims that S&P could see the walls crumbling, but held back saying anything to appease the pipeline of deals in the works.

My big unanswered question is whether the SEC is going to make a similar case against Moody’s and Fitch.

Sources:

Revisiting the SEC’s Stance on When Real Estate is a Security

Compliance and real estate

After last week’s charges against Cay Clubs, I remembered that I wanted look at an old SEC Release on the applicability of the federal securities laws to condominiums and real estate development. Back in 1973 The Securities and Exchange Commission issued a release describing situations where a real estate offering could become a securities offering. At least according to the SEC.

SEC Release 33-5347 (pdf) discusses situations when the sale of condominium units, or other units in a real estate development, coupled with an agreement to perform rental or other services for the purchaser would become the offering of a security in the form of an investment contract or a participation in a profit sharing arrangement within the meaning of the Securities Act of 1933 and the Securities Exchange Act of 1934.

The offering of real estate units in connection with any the following will cause the offering to be viewed as an offering of securities in the form of investment contracts:

  1. The condominiums, with any rental arrangement or other similar service, are offered and sold with emphasis on the economic benefits to the purchaser to be derived from the managerial efforts of the promoter, or a third party designated or arranged for by the promoter, from rental of the units.
  2. The offering of participation in a rental pool arrangement; or
  3. The offering of a rental or similar arrangement whereby the purchaser must hold his unit available for rental for any part of the year, must use an exclusive rental agent or is otherwise materially restricted in his occupancy or rental of his unit.

In all of the above situations, investor protection requires the application of the federal securities laws.

Sources:

Image is Western shot of Edgehill Condominiums in Edgewater NJ by Tguless. http://commons.wikimedia.org/wiki/File:Edgehill_Condominium.JPG

Compliance Bricks and Mortar for February 1

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

SEC Charges Former Jefferies Executive with Defrauding Investors in Mortgage-Backed Securities by Mark Astarita in the Securities Law Blog

According to the SEC’s complaint filed in federal court in Connecticut, the former executive arranged trades for customers as part of his job as a managing director on the MBS desk at Jefferies. The SEC alleges that the former executive would buy a MBS from one customer and sell it to another customer, but on many occasions he lied about the price at which his firm had bought the MBS so he could re-sell it to the other customer at a higher price and keep more money for the firm. On other occasions, he misled purchasers by creating a fictional seller to purport that he was arranging a MBS trade between customers when in reality he was just selling MBS out of his firm’s inventory at a higher price. Because MBS are generally illiquid and difficult to price, it is particularly important for brokers to provide honest and accurate information.

Floyd Landis’ Whistleblower Lawsuit Against Lance Armstrong and Others

I’m sure you have heard about the whistleblower lawsuit initiated by Lance Armstrong’s former teammate, Floyd Landis, but if not, where have you been? In this suit Landis has targeted several others that were part of the U.S. Postal Service team for being a part of or knowing of teammates using banned substances for performance enhancement.

What’s in a Name? Speculation, Hedging, They Are Not the Same Thing by Ernest E. Badway in Securities Compliance Sentinel

Recently, in a settled SEC enforcement action, a mutual fund manager allegedly used an option strategy, but the SEC believed it was more speculative than hedging.  See http://www.sec.gov/litigation/admin/2012/33-9377.pdf.

Raising a Deaf Puppy in GeekDad

When we moved into our new house last year, we wanted to expand our family. It was time to get a dog. I grew up with a dog in my family and wanted my kids to have the same experience. I expected that would mean random items around the house would get destroyed by the playful puppy. What I didn’t expect was having to learn sign language.

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SEC Charges Real Estate Executives with Investment Fraud

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The Securities and Exchange Commission brought charges against Cay Clubs Resorts and Marinas and several of its executives for defrauding investors. The case caught my eye because it involved real estate and would likely play a role in my continuing quest to figure out what’s a security.

The defendants have not settled with SEC, so I’ll be assuming the allegations in the complaint are true for this analysis.

Executives of Cay Clubs Resorts and Marinas raised more than $300 million from investors to develop resorts in Florida and Las Vegas. They promised investors a guaranteed 15% return through a two-year leaseback agreement and future income through a rental program. The developments didn’t succeed, so the investment turned to a ponzi scheme. New investments were used to ay the 15% return to earlier investors.

A with most investment frauds, the executives spent lavishly with the investors’ money. They bought homes, planes, cars, and boats. At least they diversified and spent some of the cash on buying gold mines, coal refining machinery, and a rum distillery.

That all sounds like investment fraud. But the charges are under sections 5(a), 5(c), and 17(a) of the Securities Act and 10(b) of the Exchange Act. The SEC is saying that the defendants sold securities, and did so fraudulently. They were selling real estate interests, or at least what looked like real estate.

According to Cay Clubs’ marketing materials, the Company would finance the purchase of the properties, renovation of the units, and development of the luxury resorts with funds raised from investors through the sale of units, which ranged in price from $300,000 to more than $1 million, and a required membership fee ranging from $5,000 to $35,000 per unit.

Cay Clubs promised a 15% return by leasing back the units from the buyers. The materials stated the leaseback was optional, but 95% of the investors entered into the arrangement. To participate, purchasers would have to pay a membership fee in excess of $5,000. The 15% return would be needed by the investors to cover carrying costs. Cay Clubs even managed to find lenders who would provide 100% mortgage financing.

During the leaseback, purchasers were restricted from using their units. They could only use the units for 14 days per year. Cay Clubs owned the common areas and controlled access to the units. Cay Clubs had a right of first refusal on the sale of a unit. Cay Clubs controlled the renovation of the resorts and the units. Under the master leasing program, Cay Clubs would rent out the units, with 65% going to the unit owner.

You can go back to the Howey case and use the four part test to determine if there is an investment contract, where there is

  1. an investment of money,
  2. a common enterprise,
  3. a reasonable expectation of profits, and
  4. a reliance on the entrepreneurial or managerial efforts of others.

This reminds me of the Boutique Hotel case. In that case the judge found that the investment was not an investment contract because the owners were not required to participate in the rental program. An owner could chose to not rent out its condominium or rent it out on its own. That means the business arrangement did not have a reliance on the entrepreneurial or managerial efforts of others. Therefore it was not an investment contract.

That distinguishes the Boutique Hotel arrangement from the one being contested in the Salameh / Hard Rock San Diego case. Hard Rock San Diego restricted the rental program to the one run by the seller/issuer. That was found to be an investment contract.

The Hard Rock case is still under appeal and the Boutique Hotel case is still running its course, so those are ones to keep en eye on.

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How Well is the SEC’s Whistleblower Program Working?

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Section 922 of the Dodd-Frank Wall Street Reform and Consumer Protection Act created the SEC’s whistleblower program, awarding cash to individuals who report misdeeds that result in successful SEC cases. If the SEC collects more than $1 million, the whistleblower can receive between 10% and 30% of the award. Section 922 also required the Office of Inspector General to conduct a review of the whistleblower program within 30 months.

Surprisingly, the Inspector General had only good things to say about the program, with only two minor recommendations. I say ‘surprisingly’ because the reports from the Inspector General have recently been harsh criticisms. Not this time.

The implementation of the final rules made the SEC’s whistleblower program clearly defined and user-friendly for users that have basic securities laws, rules, and regulations knowledge. The whistleblower program is promoted on the SEC’s website and the public can access OWB’s website from the site in four or more possible ways to learn about the whistleblower program or to file a complaint with the SEC. Additionally, OWB outreach efforts have been strong and the SEC’s whistleblower program can be promptly located using internet search engines such as Google, Yahoo, and Bing.

The two recommendations from the OIG are both related to adding metrics to in the program to better monitor program performance. For example there is no standard on how long a filing should stay in the manual “triage” step in the program. The average is 31 days. By adding thoughtful metrics and performance goals the SEC could help to avoid degradation in performance and longer response times.

One key finding in the report is that there is no current need to create a private right of action based on the facts of a whistleblower complaint. The OIG report points to a possible reduction of the government’s ability to shape and develop the law. Private suits could lead to wasteful, detrimental developments that are inconsistent with executive and judicial interpretations.

But the concept is not dead. The OIG promises to revisit the private action concept in a few years after there is more data from the new whistleblower program.

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How Effective is Your Gate?

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Does your compliance program sometime feel like this gate? A tool working alone is not necessarily effective. It may be a great tool, but still not be effective.

If it’s easy to get around then it’s not effective. Do you even know if people are going around? Is it even possible to know if they are going around?

Sometimes you have a great tool, but the tool does not work for your organization.

Image from There I Fixed It.

Private Equity Enforcement Concerns

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Bruce Karpati, chief of the SEC’s Enforcement Division’s Asset Management Unit laid out a clear picture of the SEC’s expectations and concerns about private equity in a recent speech. He was speaking at Private Equity International’s annual CFOs and COOs Forum. The speech was centered around five main questions.

Q1:  How has the creation of the Asset Management Unit impacted the Commission’s activities in the private equity space?

Q2: The Commission hasn’t traditionally brought many private equity enforcement actions. Do you expect that to change?

Q3: What are some of the Unit’s concerns about practices in the private equity industry?

Q4: You’ve spoke before about AMU’s Risk Analytic Initiatives. What are they and are there any currently under way in the private equity industry?

Q5: What can a private equity COO or CFO do to reduce the risk of inquiry by the Division of Enforcement?

It seems clear that the SEC is focused on two area: valuations and fees.

Private equity investments are inherently illiquid and therefore requires the fund manager to make judgment calls about pricing. Poor judgment can lead to poor valuations. Fraudulent judgment can lead to fraudulent valuations.

Fees and revenue generation are always a focus of the SEC for investment advisers and funds, whether private or public mutual funds. Private equity merely has some additional ways of generating revenue. It seems clear from Karpati’s speech that that SEC has been looking closely at those revenue streams.

  • The shifting of expenses from the management company to the funds including utilizing the funds’ buying power to get better deals from vendors — such as law and accounting firms — for the management company at the expense of the fund.
  • Charging additional fees especially to the portfolio companies where the allowable fees may be poorly defined by the partnership agreement.
  • Broken deal expenses rolled into future transactions that may be ultimately paid by other clients.
  • Improper shifting of organizational expenses, where co-mingled vehicles foot the bill for preferred clients.

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Compliance Bricks and Mortar for January 25

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

The SEC at a Crossroads: Can Things Be Turned Around? by Broc Romanek in the CLS Blue Sky Blog

Over the past fifteen years, the SEC’s reputation has been routinely sullied – in the press, by the Courts and certainly in the halls of Congress. Although the mud slung at the SEC has intensified since the 2008 financial crisis and revelations of the Bernie Madoff Ponzi scheme, the Commission’s problems began well before then.  Particularly, the Enron and World.com scandals forced editors to move journalists into the financial realm where bashing the SEC became good copy. More and more, the SEC has been losing major decisions in the Courts.  Professor John Coffee of Columbia Law School recently indicated that “the SEC’s batting average is close to ‘zero for 2008’ in the few cases that it has taken to trial stemming from th[e] financial crisis.”   And the SEC’s major case losing streak extends well before the 2008 crisis. In addition, recently departed SEC Chairman Mary Schapiro was asked by Congress to testify at what is likely a record rate for a SEC official. Those hearings almost never went well for poor Mary.

Chesapeake Lighthouses and Lighting the Way for Compliance by Tom Fox

I thought about the story of these lighthouses and how they literally lit the way for sailors for over 200 years when I read an article in the Q2 issue of Ethisphere Magazine, entitled “Imagination Working with Integrity: How General Electric Creates a Global Culture of Ethics”, by Michael Price. Price discusses how General Electric (GE) has made “ethics and compliance a benchmark of its operations around the world, and is, in many ways the gold standard that other companies look to when it comes to modeling global compliance and ethics programs.”

SEC Faces A Swarm Of Legal Issues In Considering The Investor Advisory Committee’s Recommendations Concerning General Solicitation by Keith Paul Bishop in California Corporate and Securities Law

The SEC’s Investor Advisory Committee held another meeting last week with Elisse B. Walter making her first public appearance as SEC Chairman.  She and Commissioner Luis A. Aguilar had many kind words for the Committee’s recommendations with respect to lifting the ban on general solicitations in Rule 506 offerings.  The insouciance of their remarks, however, was in sharp contrast with the missed deadlines and many legal issues swirling around the Committee and its recommendations.

Final FATCA Regulations Released in Compliance Avenue

While the Final Regulations will be effective when published in the Federal Register (expected to occur on January 28, 2013), the timelines for the various due diligence, reporting and withholding provisions incorporate the delayed deadlines set out in IRS Announcement 2012-42 and are being phased in to allow firms to develop the necessary systems and procedures and to align them with any intergovernmental agreements.  For example, withholding agents, which may be U.S. or non-U.S. entities, will not be required to implement U.S. account verification procedures prior to January 1, 2014, and the deadline for foreign financial institutions (“FFIs”), generally including offshore investment vehicles, to file any required FATCA reports for fiscal years 2013 and 2014 will be March 31, 2015.

The Danger of a “Paper” Compliance Program by Michael Volkov in Corruption, Crime & Compliance

The FCPA Guidance contains many important compliance reminders which should be incorporated into every anti-corruption compliance program. Perhaps the most important observation included in the FCPA Guidance was the statement that:

DOJ and SEC have often encountered companies with compliance programs that are strong on paper but that nevertheless have significant FCPA violations because management has failed to effectively implement the program even in the face of obvious signs of corruption.

DOJ/SEC’s observation should be taken seriously. Every company should ask itself this basic question: Have we “effectively” implemented our compliance program?

Science Ruining Everything Since 1543
Science: Ruining Everything Since 1543

Saturday Morning Breakfast Cereal is a daily-updated comic strip that’s a GeekDad favorite. The author, Zach Weiner, announced a new collection of his science related comics are being published in a single book: Science: Ruining Everything Since 1543. He’s creating this book as a Kickstarter project. Give him money now, and you get the book when he’s done. Plus there’s more great stuff if you want to open your wallet a bit wider.