Do You Have Skin in the Game?

skin in the game

If you tell investors that you have skin in the game, you need to have skin in the game. For the second time this year, the SEC has brought an enforcement action against a private fund for falsely informing investors that the Managers had skin in the game. Most investors want a manager’s executives to invest in the fund right alongside investors.

Don’t say it, if you don’t do it.

The most recent enforcement action was brought against Aladdin Capital Management, Aladdin Capital and a former executive, Joseph Schlim. All parties consented to the administrative orders, but neither admit nor deny the charges.

“[w]hy is an investor better off just investing in Aladdin sponsored CLOs and CDOs?” Aladdin answered by emphasizing that the “most powerful response I can give to your question is that Aladdin co-invests alongside MAST investors in every program. Putting meaningful ‘skin in the game’ as we do means our financial interests are aligned with those of our MAST investors.”

An inherent conflict in the transactions is that Aladdin was collecting a placement fee for much of the equity going into the deal. By reserving 10% for itself, it was losing 10% of its potential commission. Presumably, they could have taken that commission as equity in the deal instead of cash. But the product was packed with sub-prime mortgages and garbage debt.

Back in May, the SEC brought a similar administrative proceeding against Quantek Asset Management LLC for misleading investors about whether its executives had personally invested in its fund.

The two cases show that the SEC is will not tolerate misrepresentations in this area:

“If you sell an investment with the pitch that you are co-investing and have ‘skin in the game,’ then you better actually have ‘skin in the game…. Such a representation by an investment adviser or broker-dealer is an important consideration to investors in complex products.” Robert Khuzami, Director of the SEC’s Enforcement Division

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Valuations and the New Presence Exams

sec-seal

I’ve come across a new document request list for a presence exam from the SEC’s Atlanta Regional Office. The exam period for the letter begins March 31, 2012 – the Dodd-Frank deadline for new advisers to register with the SEC. The SEC has said presence exams will target new advisers or those that manage private funds. The exams also may focus on just one or two topics.

Previously, I posted an examination letter that focused on fees. This new letter focuses on valuations.

The letter requests investment committee minutes, valuation policies and procedures, any models used in valuing investments, and any third party valuation reports.

Time to sit down and run through a mock document request again.

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Compliance Bricks and Mortar for December 14

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

‘Tis the Season When Gifts Become Bribes by Alexandra Wrage in Corporate Counsel

People who are otherwise serious about the global scourge of bribery get frustrated when anyone raises the issue of gifts as bribes. Surely, most people will say, we haven’t reached the point where holiday gift-giving is so risky that we can’t hand out bottles of wine or silks tie and scarves.

Do Lanny Breuer And Robert Khuzami Actually Read FCPA Enforcement Actions? by the FCPA Professor

At the Guidance press conference (see here) Khuzami said that he was “interested in companies spending compliance dollars in the most sensible way” and he hoped that the guidance and the hypotheticals provided would help companies as to where they can “minimize investment and where they can maximize it.”  Breuer added that the DOJ wants compliance programs “to address real matters of concern.”

Against this backdrop, the question must be asked:  do Breuer and Khuzami actually read FCPA enforcement actions?

Recent Foreign Corrupt Practices Act enforcement actions have involved, to name just a few, allegations about a bottle of wine (see here), a Cartier watch (see here), a camera (see here), kitchen appliances and business suits (see here), television sets, laptops and appliances (see here), and tea sets and office furniture (see here).

You Need a “Shadow” If You Want to be a RIA Today by Ernest E. Badway in Securities Compliance Sentinel

The SEC, recently, sued a private equity fund adviser for, among other things, allegedly violating Investment Advisers Act of 1940 Rule 206(4)-7, for failing to have procedures requiring verification of client signatures and instructions by a second person.  See http://www.sec.gov/litigation/complaints/2012/comp-pr2012-244.pdf.

Dickering Over The Price by Scott Greenfield

The reason is that HSBC is too big to fail. If indicted or convicted of money laundering for drug cartels and terrorists, as alleged, London based HongKong Shanghai Banking Corporation could have toppled the banking system, with devastating consequences. It would have been a disaster for the economy, both ours and the worlds. Too big to fail.

So the government decided, in an exercise of discretion, to take whatever spare change they had in their pocket and call it even.

SEC Charges Eight Mutual Fund Directors for Failure to Properly Oversee Asset Valuation in the Securities Law Blog

The funds, which were invested in some securities backed by subprime mortgages, fraudulently overstated the value of their securities as the housing market was on the brink of financial crisis in 2007. The SEC and other regulators previously charged the funds’ managers with fraud, and the firms later agreed to pay $200 million to settle the charges.

Private Placement of Fund Interests and Rule 5123 Filings

Under the new FINRA rule 5123, FINRA member firms that sell securities in certain private placements to submit a notice filing with FINRA.  That means your placement will likely have to file a fund’s private placement memorandum with FINRA. FINRA recently released FAQs and a user guide related to Rule 5123 filings. The notice filing must include a copy of any private placement memorandum, term sheet or other offering document, including any materially amended versions thereof, used in connection with such sale.

Submissions must be made within 15 calendar days of the first sale.

The FAQs answer practical questions regarding filing requirements, such as:

  • how members file a notice with FINRA
  • when does the 15-day period commence for filing with FINRA
  • What exemptions are there to form Rule 5123

Exemptions

1. Are private placements sold to institutional accounts exempt from the filing requirements of Rule 5123?

Private placements sold solely to institutional accounts (as defined in Rule 4512(c)) are exempt from the filing requirements of the rule (see Rule 5123(b)(1)(A)).

2. Are private placements sold to accredited investors exempt from the filing requirements of Rule 5123?

No, unless the sales are solely to entities that satisfy the definition of accredited investor under Rule 501(b)(1), (2), (3), or (7). Sales to accredited investors that are natural persons are not exempt from the filing requirements of the rule (see Rule 5123(b)(1)(J)).

If your fund uses a placement agent and is marketing to high-net worth individuals, it looks like the marketing materials will end up being filed with FINRA.

Mortgage REITs Get Relief from the CFTC

The CFTC continues the journey out of the hole it dug itself. In February the CFTC stated that one swap contract would be enough to trigger the registration requirement. This runs with the CFTC long standing narrow interpretation of the commodity pool definition. The CFTC retreated from this position with respect to REITs in October. The CFTC has also retreated from this position for Mortgage REITs.

Mortgage REITs are a bit trickier because the underlying assets are real estate loans instead of real estate. There is likely to be more financial engineering with derivatives to mange the risks in the portfolio.

The CFTC lays out four tests for relief:

  1. No more than 5% of assets are for initial margin and premiums
  2. Net income from derivatives is less than 5% of income
  3. Interests in the mortgage REIT are not marketed as a commodity pool
  4. The company has made or will make the IRS filing as a mortgage REIT

Unlike the REIT relief, the mortgage REIT relief is not self-executing. The Mortgage REIT needs to send an email no-action relief claim.

In footnote 19, in bold type, the CFTC continues to backpedal:

The Division notes that we remain open to discussions with mREITs to consider the facts and circumstances of their mREIT structures with a view to determining whether or not they might not be properly considered a commodity pool.

The CFTC also release an interpretative letter offering no action relief for securitization vehicles. Word is that there may be a few more letters providing relief in the works.

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New Document Request List for Presence Exams

We’ve had the first siting of the new document request letter for the new presence exams. IA Watch has obtained a copy of the letter issued from the Atlanta Regional Office.

This letter sets the exam period to start on March 30, 2012. That addresses some concerns that the SEC would look at period prior to a firm’s registration as an investment adviser.

It’s clear from the request list that the examiners will be looking closely at fees. Among the items is a “schedule of fees earned by the Adviser from each portfolio company and whether they were credited back to clients. It goes on to ask for all compensation received by the adviser, besides management and performance fees. Further, it asks for the total expenses reimbursed by each portfolio company.

Notably missing from the letter are items related to marketing, custody, portfolio management, and valuation. You may remember that the SEC’s Presence Exams are set to concentrate on five areas:

  • marketing
  • portfolio management
  • conflicts of interest
  • safety of client assets
  • valuation

It looks like this Atlanta RO letter is focused on conflicts of interest.  I’m going to guess that this document request is just one of several versions, with each version concentrating on different area.

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Compliance Bricks and Mortar for December 7

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

High-Speed Trades Hurt Investors, a Study Says by Nathaniel Popper and Christopher Leonard in the New York Times

A top government economist has concluded that the high-speed trading firms that have come to dominate the nation’s financial markets are taking significant profits from traditional investors.

The chief economist at the Commodity Futures Trading Commission, Andrei Kirilenko, reports in a coming study that high-frequency traders make an average profit of as much as $5.05 each time they go up against small traders buying and selling one of the most widely used financial contracts.

The Encyclopedia of Ethical Failure… by Dan Ariely

Wondering whether you can ask someone to give you a PhD in exchange for a kickback? Curious whether you can get away with stuffing ballot boxes? Allow me to introduce you to the Encyclopedia of Ethical Failure. Every couple years the Department of Defense publishes the Encyclopedia (Word doc), which is likely the most sarcastic government document out there. Interestingly, golf and taxes seem to turn up a lot.

An introduction to behavioral ethics

A quarter of a century ago, as a young criminal defense lawyer, I began to be struck by how different the causes of many white collar crimes were from the then (and still) traditional view. The latter saw (sees) white collar crimes as based largely on rational calculations by profoundly bad individuals – what was then the Ivan Boesky model and now is best associated with Bernie Madoff. Although there are certainly offenses of this sort, many of the crimes of which I became aware seemed based more on environmental factors than on the indelibly bad characters of those involved. While the field did not exist at the time, this turned out to be my introduction to what was to become “behavioral ethics.”

Phone Calls Can Get You Caught Insider Trading

The insider trading prosecution of Raj Rajaratnam was centered around phone calls. Prosecutors were able to get a recording of those calls. Can you get a conviction merely by tying phone calls to trades, without knowing the content of the calls? The Securities and Exchange Commission is hoping that old-fashioned phone call logs will be enough.

In bringing an insider trading case against John Femenia and group of his friends, the SEC merely lays out a series of trades made after Femenia called his friends. Pursuant to the complaint, Femenia was the source of information based on his position in the Investment Bank Group of Wells Fargo Securities.  Femenia and his friends have not had a chance to publicly respond to the charges, so I just looking at what the SEC is saying and why the SEC thinks there is enough evidence for insider trading charges.

Femenia Tips Wens Who Trades on the Inside Information.
96. Prior to May 27, 2010, Wens had no history of trading in ATC.
97. On May 27,2010 at approximately 12:04 a.m., Femenia called Wens. The call lasted approximately 32 minutes.
99. On May 27,2010 at approximately 9:31a.m., Wens made his first purchase of ATC in a TD Ameritrade brokerage account.
100. Between May 27,2010 and June 29,2010, Wens bought thousands ofATC shares. During this time  period, Wens exchanged frequent telephone calls with Femenia, including calls often on the same day or the days before the trading in A TC securities.

Wells Fargo provided financing to GENCO to help in its acquisition of ATC. The complaint goes on and on linking phone calls to the times the group made trades.

The complaint charges Femenia with knowledge of the underlying capital transaction, but does not link it to specific pieces of information or internal emails. Similarly, the SEC does not have recordings of the phone calls. (At least Femenia and his group were smarter than these guys who communicated about insider trading on internal IM that gets archived.)

Will it be enough?

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Image of a 1896 Telephone is from Wikimedia

Airport Use as Illegal Inside Information

I’m a bit confused by the big story in Bloomberg about David Slaine, a key informant for the recent crackdown on insider trading. It starts off with Slaine trying to claim that a money manager was illegally using airplane flight information into Teterboro Airport to profit on stocks. The claim was that his tipsters would let him know when bankers came in and out of the airport, presumably to talk to one of the numerous pharmaceutical companies in the area.

Let’s start off with whether the information is even non-public information. Perhaps the FBI has not heard of the internet. The FAA aircraft registration database is available online. You can easily search for a company’s planes. There are databases and services like FlightAware.com that will track flights based on the plane’s tail number.

There has been some privacy added back to the databases. You may be surprised that privacy push and concerns came from sport teams. Avid fans had been tracking owners’ plane flights to see who they are trying to sign as free agents or coaches.

If you lost the fight over whether the information was non-public, you also need to pass a materiality standard. You have no way to predict how the travel activity will relate to stock activity. If you mix up the target with acquirer you may get a drop in stock price. The Slaine story talks about bankers. Those bankers could just easily be coming to offer bankruptcy financing as they could be to trigger an event that would increase the stock price.

Lastly, you need to prove some obligation to keep the information confidential. I don’t see how that obligation exists for airport personnel.

The information sounds a lot like the old story of fund managers who would count cars in a retailer’s parking lot as a way to estimate sales. Lots of cars would likely mean better sales numbers.

This leads back to the tricky part of expert network firms. At one extreme, fund managers were explicitly paying for and extracting confidential, material, non-public information from company insiders. The complaint against Martoma is an example of the illegal kind. On the other extreme is a fund manager merely trying to get a better understanding of the industry, the issues, the opportunities, and the companies involved in an area. This is perfectly legal. From this side, the fund manager may be able to find some external factors of correlation that could lead to movements in a company’s stock price. The retail parking lot is an example.

But airport use? That does not seem to offer much insight. I guess the FBI was desperate to get any sort of insight into insider trading, even if it was not insider trading.

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