Compliance Bits and Pieces for February 17

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


Lessons Learned on Compliance and Ethics by Tom Fox

In [Lessons Learned on Compliance and Ethics: The Best from the FCPA Compliance and Ethics Blog ] I have collected some of my posts which I think will help guide you in your own journey through the world of anti-corruption and anti-bribery compliance. I have broken the book down into the following chapters:

  • Some Thoughts on Best Practices
  • The Nuts and Bolts of Compliance
  • Investigations, Enforcement Actions and Legal Issues
  • Summing It All Up

Compliance Rocks: Adele is Phat (And Teaches Compliance Lessons) by Paul Liebman in Corporate Compliance Insights

Sidewalks are paved but students walk where they want to walk. Makes sense to me. Students want to get where they are going as quickly and directly as possible and do not feel the need to follow a path just because it has been paved.

Upcoming 2012 SEC Regulatory Deadlines in Compliance Avenue

Congratulations to all newly registering investment advisers that have submitted their Forms ADV Part 1A and Part 2A via the Investment Adviser Registration Depository (“IARD”) in anticipation of the March 30, 2012 deadline! The Securities and Exchange Commission (“SEC”) generally has up to 45 days after receipt of the Form ADV to declare the registration effective and generally will notify an adviser via email once its registration is declared effective. Registrations may be declared effective at any time during that 45-day period. An adviser can also check on IARD under the heading “Registration/Reporting Status” to see if its registration has been declared effective. Below is a review and reminder of certain of the annual regulatory requirements that may be applicable to investment advisers…

Financing, Fundraising, Pre-Selling Are Starting to Blur… by William Carleton

It’s a reminder, as we watch some kind of crowdfunding securities law exemption develop in Congress, that there are other things to sell besides a share in the profits of a business. Does it mean that selling shares in the profits of a business are not interesting? Certainly not. But add another means to bypassing equity financing at the outset. This is not your grandfather’s bootstrapping.

Annals of private equity, Tamara Mellon edition By Felix Salmon

It’s always love and kisses when a private-equity company takes control of your firm: they promise investment, and growth, and riches beyond your wildest dreams. All of which came true for Mellon (who acquired her surname by marrying a man with 14 trust funds, but that’s another story). But then the clock strikes midnight, and your eager backers are forced — they have LPs to answer to, after all — to sell your company out from under you.

SEC to elevate role of the CCO By Jim Kim in FierceComplianceIT

In the nitty-gritty of an enforcement situation, smart companies are realizing that they will get credit from the regulators if they have appropriate compliance policies in place.

Tighter Rules on Advisory Performance Fee Charges

Under the Investment Advisers Act, an adviser can only charge a performance fee if the client was a “qualified client”. The SEC equates net worth with sophistication, so a “qualified client” had to have a level assets to prove their financial sophistication. Those levels are now officially increased.

The original standard was that the client had to have at least $500,000 under management with the adviser immediately after entering into the advisory contract (“assets-under-management test”) or if the adviser reasonably believed the client had a net worth of more than $1 million at the time the contract was entered into (“net worth test”). Those levels were increased to $750,000 and $1.5 million in 1985 to adjust for inflation.

The Dodd-Frank Wall Street Reform and Consumer Protection Act called for Section 205(e) of the Advisers Act to adjust those levels for inflation and re-adjust the levels every five years. The SEC also decided to toss out the value of a person’s primary residence, just as they did with the new accredited investor standards.

The rule now requires “qualified clients” to have at least $1 million of assets under management with the adviser, up from $750,000, or a net worth of at least $2 million, up from $1 million.

The SEC is using the same primary residence calculation they used in the new accredited investor standard. So, if you owe more on your mortgage than the value of your house, then you need to treat the overage as a negative asset. As the SEC did with the accredited investor standard, the SEC requires certain mortgage refinancings to be counted against net worth. If the borrowing occurs in the 60 days preceding the purchase of securities in the exempt offering and is not in connection with the acquisition of the primary residence, the new increase in debt secured by the primary residence must be treated as a liability in the net worth calculation. This is intended to prevent manipulation of the net worth standard, by eliminating the ability of individuals to artificially inflate net worth under the new definition by borrowing against home equity shortly before participating in an exempt securities offering. Once again, owning a house can only be a negative for the SEC standards.

While I used the CPI-I standard as the benchmark for inflation, the SEC chose to use the Personal Consumption Expenditures Chain-Type Price Index (“PCE Index”), published by the Department of Commerce. One of the questions from the SEC in the proposed rule was whether the PCE index was the appropriate measure of inflation. They’ve decided to use this index and continue to benchmark it against the original test amounts. In five years, you will be able to predict what the new levels will be.

As for private  funds, Rule 205-3(b) requires a look -through from the fund to the investors in the fund. Each “equity owner … will be considered a client for purposes of the” limitation.  If the fund is relying on the 3(c)(7) exemption from the Investment Company Act then the fund’s investors should be “qualified purchasers”  and you won’t need to look much further. If the fund is using the 3(c)(1) exemption, then it will need to take a closer look at its investors to make sure that each is a qualified client.

Sources:

Occupy the SEC

In jest, I wrote that we should occupy the SEC, but noted that they are very open to comments and influence by the public. One of the comments to that story was from a group organized as Occupy the SEC and they were planning to comment on the Volker Rule.

They submitted a massive comment letter attacking not only the proposed regulation. It is a 325 manifesto.

“We believe the Volcker Rule is important to the future of the banking industry and, if strongly enforced, will help move our financial system in a more fair, transparent, and sustainable direction. Prohibiting banking entities from engaging in proprietary trading and banning their sponsorship of covered funds are key elements to regulating the financial system and giving force to the Dodd-Frank Act. At its core, the Volcker Rule seeks to make sure that if a banking entity fails, it does not bring down the whole system with it. We appreciate the momentous challenges that the Agencies continue to face in effectively implementing the Rule, and we present these comments to assist them in their task.”

Like most commenters, and even Mr. Volker himself, Occupy the SEC labels the proposal a “500-page web of complexity”. But rather than complain and make some generic statements, Occupy SEC provides very detailed comments on the text of the rule, specific textual changes to the regulation, and answers to hundred of the questions presented in the proposed rule.

From the perspective of private equity funds, Occupy the SEC wants to make sure the rule is broad enough to cover a broad scope of entities by making some changes to the definition of “covered fund” and “ownership interest”.

The comment letter is an impressive piece of work.

Sources:

What the SEC Wants Next Year

It is time once again for the Securities and Exchange Commission to sing for its supper. Even though it’s an independent agency, supposedly insulating it from political pressure, it still needs to go back to Congress each year to get funding. The budget request for FY 2013 totals $1.566 billion, an increase of $245 million (19 percent) over the agency’s FY 2012 appropriation.

The SEC included several performance goals that caught my attention.

  • Percentage of firms receiving deficiency letters that take corrective action in response to all exam findings. The SEC has a goal of 93%. I still find that number shockingly low. If the regulator says you’re doing something wrong, I would expect that number to be closer to 100%.
  • Percentage of attendees at the Compliance Outreach program that rated the program as “Useful” or “Extremely Useful” in their compliance efforts. For FY 2011 the target was 80% and the actual was 86%. Apparently positive responses in SEC program evaluations could increase SEC funding.
  • Percentage of investment advisers, investment companies, and broker-dealers examined during the year. For FY 2011 the plan was to examine 11%, but the SEC only achieved 8%. The FY 2012 is 9% and the 2013 estimate is 11%.  There is a separate goal for high risk advisers, but measures have not been in place for a few years.
  • Percentage of exams that identify deficiencies, and the percentage that result in a “significant finding” This one leaves me nervous as a goal. It’s hard to parse the indicator because it covers all SEC examination, not just investment advisers. The Actual number for FY 2011 was 82% with 42% having a significant finding.  I hate to see enforcement target and deficiency targets.
  • Average Cost of Capital.  Here is a metric I would like to learn more about. The SEC states that FY 2010 was 10.99% and FY 2011 was 10.67%. Frankly, I have no idea what those percentage mean.
  • Survey on whether SEC rules and regulations are clearly understandable.  This a great goal. Unfortunately, the measure has no data, no data source and no goal.

From the SEC examination side, the Office of Compliance Inspections and Examinations is looking to add an additional 65 positions to the exam staff to “address the disparity between the number of exam staff and the growing number and complexity of registered firms; and more effectively risk target, monitor, and examine market participants.”

The Division of Investment Management is requesting 40 additional positions, largely to focus on the “major milestone” when private fund advisers begin to file systemic risk information with the SEC on Form PF in late FY 2012.

Now it’s up to Congress to decide how mush to put in the SEC’s kitty. Anyone willing to bet that the SEC gets most of what it asks for? No, I didn’t think so.

Sources:

The Clock is Ticking

With a registration deadline of March 30, 2012 and a 45 day period for the SEC to review the application, private fund managers need to file their Form ADV by February 14. I know that there are fund managers still on the fence on whether to register or not.

The trouble came from Title IV of Dodd-Frank using the new term “private fund” instead of merely removing the 15 client rule exemption. The private fund definition involves parsing the definitions and exemptions under the Investment Company Act. That puts fund managers into the first week of securities law class having a discussion on “what is a security?” That may be an interesting intellectual discussion, but not one for a business owner trying stay in compliance with the law.

You add on top of that the new exemption for “venture capital fund“, leaving VCs scratching their heads on whether they are a venture capital fund manager or not?

The big unknown is the expectation of the limited partner. In the past, limited partners have accepted the fact that fund managers were not registered with the SEC. That was the nature of the industry. After March 30, many (most?) private fund managers will be registered. How many potential investors will throw your proposal in the trash because you can’t check the “registered with the SEC” box?

The decision time is here. To register or not register?

Sources:

Blogoversary

Compliance Building went public on February 12, 2009. Since then, I have managed to publish a blog post almost every business day. Sometimes, more than one. I hope at least some of those 1500 posts were useful to you, whether you are a subscriber or one of the other 325,000 or so visitors to Compliance Building over the past three years.

Thanks for reading.

If you haven’t done so already, you can subscribe and have my posts sent to you. It’s free, except on the Kindle. (I can’t convince Amazon to change the price.)

I started my first blog, KM Space, on this day in 2007. I set up Real Estate Space a few months later. Now I’m moving into my sixth year blogging. As I do every year, I take some time to think about why I publish a blog, whether I want to continue, and what I can do better.

Why do I do this?

Mostly, I publish because the information is useful to me. This blog is a personal knowledge management tool. It’s all about trying to capture information that interest me and has relevance to my day-to-day work. I find that writing my thoughts adds some clarity to my thinking. By putting all of that information into the blog, it’s in a place where it is easy to find.

Will I continue?

The real estate private equity industry is at a turning point. There is split between companies that are filing their Form ADVs, jumping into the world of SEC regulation and those, with good reason, are not registering. Regardless, it’s good for the industry to be focused on compliance and ethics. If it’s good for the industry then it’s good for my company and good for me personally. If a fellow private equity real estate company gets into compliance or ethical trouble that will reflect poorly on the industry as a whole. Inevitably, that will make my job harder. It will likely make it harder to raise capital and to get deals done. That’s bad. So I try to share information that will benefit the industry because that benefits me.

What Can I Do Better?

It’s hard to take a strong position on many issues. I certainly don’t want to be overly critical of the SEC and have them target my company. I realize that what I say here could be attributed back to my company. They don’t want splash back from me taking a strong position. Especially, if I turn out to be wrong.

I admit this blogging experiment is self-centered, but I’m happy to have you along for the ride.  If you want more detail on this you can read my Why I Blog page.

For those of you who know me from KM Space, I will continue to publish a subset of my Compliance Building posts to the KMspace feed. No need to say goodbye. Unless I’m boring you.

Image is from Cake Wrecks: Are Anivery.

Compliance Bits and Pieces for February 10

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

The Fallout from the Latest NLRB Salvo on Social Media by Daniel Schwartz In Connecticut Employment Law Blog

[E]very pronouncement from the NLRB is treated as if it is written in stone with lots of suggestions on how to rewrite all of your policies.

The latest was an updated report last month from the NLRB on the topic again.  Rather than jump on board with a quick summary, I’ve decided to take a step back and really look at how significant this report really is.

According to Jon Hyman at the Ohio Employer’s Law Blog, it’s a ”mess.  In a mere 35 pages, the NLRB appears to have ripped the guts out of the ability of employers to regulate any kind of online communications between employees.”

Stressed-Out Compliance Officers May Soon Feel Even More Heat From SEC by Bruce Carton in Compliance Week’s Enforcement Action

Unfortunately, this stress level is about to go even higher for compliance officers at investment firms if the SEC follows through on a recent decision that such compliance officers may themselves be sued as “supervisors.” According to Investment News, the SEC “sees compliance as an area ripe for scrutiny.” At a compliance seminar in January, the SEC Enforcement Division’s Bruce Karpati, co-chief of the Asset Management Unit, said that “compliance programs are front and center for us. There’s going to be more soon on that in terms of enforcement actions.”

Crowdfunding and Other Recent Legislative Initiatives Focused on Capital Raising and Job Creation by Louis A. Bevilacqua, Joseph R. Tiano, Jr., David S. Baxter, Ali Panjwani and K. Brian Joe In Pillsbury’s Investment Fund Law Blog

This article summarizes various legislation introduced in Congress that would make it easier for smaller companies to raise capital and would lessen the regulatory burden on those companies.

2011 Annual FISMA Executive Summary Report (.pdf) from the SEC’s Office of Inspector General

The purpose of this law is to recognize the importance of information security to the economic and national security interests of the United States. The law emphasizes the need for organizations to develop, document, and implement organization-wide programs that provide security for the information systems that support the organization’s operations and assets, as well as information systems that are provided or managed by other agencies, contractors, or other sources.

Proposed FATCA Regulations Released

The Foreign Account Tax Compliance Act of 2009 was part of the Hiring Incentives to Restore Employment Act of 2010 (the HIRE Act) passed in 2010. 

If you have foreign investors or domestic investors making their investments through offshore entities, you need to pay attention to this law. It requires private funds to collect information on their foreign investors to determine if there are any US investors in the ownership that may not be paying their taxes.

An investor’s failure to meet the regulatory disclosure requirements means that the fund manager will need to withhold 30% from distributions. These withholding obligations will go into effect on January 1, 2013.

The key benchmark is to identify a substantial US owner of an entity. Substantial starts at 10%.

I’m still trying to sort through the regulations to figure out how it will work. I think I can get it to tie into an anti-money laundering program. You should check an investors background. As part of that, you want to peek under the hood of an entity to see the ownership. I have seen people set a de minimis level between 5% and 50%. FATCA would seem to set the level at no less than 10%.

I expect many fund managerS are going to need to reach out to their investors and get more information and certifications from their investors to meet the FATCA standards.

Source:

Regulations Relating to Information Reporting by Foreign Financial Institutions and Withholding on Certain Payments to Foreign Financial Institutions and Other Foreign Entities (.pdf)

New Anti-Money Laundering Requirements for Non-Bank Mortgage Lenders and Originators

Private Equity has been siting on the fringes of Anti-money laundering regulation for many years. It’s still illegal to be involved in money laundering and fund managers should be taking some steps to protect themselves and to identify problems. There’s just no set script. FinCEN is supposedly working on a new rule.

In the meantime, FinCEn has issued a new rule setting out the requirements for Non-Bank Mortgage Lenders and Originators.

The rule starts with a simple principle based approach:

Each loan or finance company shall develop and implement a written anti-
money laundering program that is reasonably designed to prevent the loan or finance company from being used to facilitate money laundering or the  financing of terrorist activities.

What do you have to do to meet this standard? The rule goes on to set minimum requirements:

(1) Incorporate policies, procedures, and internal controls based upon the company’s assessment of the money laundering and terrorist financing risks associated with its products and services.
(2) Designate a compliance officer who will be responsible for ensuring that:
(i) The anti-money laundering program is implemented effectively
(ii) The anti-money laundering program is updated as necessary; and
(iii) Appropriate persons are educated and trained

(3) Provide for on-going training of appropriate persons concerning their responsibilities under the program.
(4) Provide for independent testing to monitor and maintain an adequate program, including testing to determine compliance of the company’s agents and brokers with their obligations under the program

 The mortgage company is also now explicitly required to file suspicious activity reports.

Obviously, private equity firms are not subject to this rule. However, I would guess that the proposed rule for private equity will end up having many of these same elements.

Sources:

Crowdsourcing the Crowdfunding Exemption

There is a growing movement to create a new crowdfunding regime for raising capital. The models seem to draw inspiration from Kickstarter, a platform to fund creative projects. I say that because each time I see a draft bill it talks about an internet-based intermediary as part of the exemption.

President Obama endorsed the idea of a crowdfunding exemption. That has lead to three bills in Congress, plus a proposal being generated by NASAA as a state-run alternative.

President Obama cheered for crowdfunding as part of the American Jobs Act unveiling. The statement talks about the millions raised through Kickstarter in the form of donations. That’s not exactly right. The offering is sometimes a pure donation, but more often is linked to a product in development.

The Entrepreneur Access to Capital Act (H.R. 2930) permits “crowdfunding” to finance new businesses by allowing companies to accept and pool donations up to $5 million without registering with the SEC. It would limit individual investments to the lesser of $10,000 or 10% of an investor’s annual income. An amendment requiring a notice filing with the SEC was rejected as was an amendment that would have barred felons from being involved.

NASSA is putting together a model exemption for use at the state level. The various state level regulators are trying to craft this model.

The Democratizing Access to Captial Act (S.1791) was introduced by Senator Scott Brown. This bill is being supported by the Wefunders, who is in the business of being a platform for capital crowdfunding. Unlike Kickstarter, it’s only open to accredited investors.

Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2011 (S. 1970) was  introduced by Senator Merkley. This bill has the right acronym.

What they all have in common is some cap on the total funds that can be raised and a cap on how much someone can invest.

I’m all for making it easier for entrepreneurs to have easier access to capital. The registration and legal limits on capital-raising deter lots of projects. However, they also vet projects. To some extent, excluding the unworthy. It also tends to deter lots of worthy projects.

I like the project crowdfunding at Kickstarter. There is no expectation of riches, other than whatever trinket or completed example of the project they promise to you in exchange for your funding. I have no concerns about the dilution of shares, executive compensation, ratchets, and follow-up rounds.

Capital crowdfunding should be an interesting experiment. I predict it will create lots of new jobs and fund lots of interesting projects.

I also expect that it will be suspect to fraud. I expect that there will be many disappointed small investors who expected to reap fortunes, instead being stuck with worthless shares in failed companies or companies that existed only to funnel cash to fraudsters.  The extent of that fraud will depend on how well Congress crafts a crowdfunding bill. I expect they will come up short.

Sources: