Compliance Building

Comey and Compliance

The firing of FBI Director has set off a firestorm. Obviously, there is a great deal of partisan tilt to the action. I wanted to focus on the lesson we can see from a compliance perspective. It is an example of the need for independence of compliance and investigations.

President Trump fired someone who was investigating him or his circle of supporters for violations. The Attorney General recused himself from probe into Russia and President Trump because he was potentially involved. But the Attorney General recommended firing the person leading the probe into Russia and President Trump.

Perhaps, Director Comey was issuing subpoenas and continuing an investigation that would have been adverse to President Trump. That would be a problem, a cover-up.

Perhaps, President Trump legitimately thought Director Comey was unfit for his job. It would not be the first time a President has fired the FBI Director. President (Bill) Clinton fired FBI Director William Sessions for serious ethical lapses.

The problem is that it looks like a cover-up. Without independence, the motives for firing or disciplining an employee for investigating his boss is always going to look suspicious. If it looks like a cover-up, many people are going to assume there is a cover-up.

It’s better to structure a compliance program so that it has some independence operationally. For a firm with a board of directors, the compliance program should have a way to report to the board of directors. Compliance officers should have alternative reporting structures in case they have to investigate a boss.

For an private fund adviser, there should be mechanisms for the CCO to report to a compliance committee instead of a single individual.

What you want to avoid is having to investigate your boss. That is an irreconcilable conflict. People are always going to question the end result. People are especially going to question why the investigator was fired in the middle of an investigation.

Real Estate Fund Information from the SEC

The Securities and Exchange Commission has been acquiring troves of data about private funds through the Form PF filing requirement. Some, including myself, have been skeptical that the SEC will figure out what to do with the data as a tool to protect investors. But, the SEC has been able to compile statistics and published a suite of new data and analyses of private fund statistics and trends. The SEC released the third quarter private fund statistics.

The number of real estate funds reporting on Form PF has increased.
The number of real estate funds reporting on Form PF has increased.

period	2014Q4	2015Q1	2015Q2	2015Q3	2015Q4	2016Q1	2016Q2	2016Q3
Funds	1,802	1,800	1,801	1,806	2,056	2,093	2,091	2,108
Advisers	262	263	264	265	288	290	288	290
Net NAV ($billions)	280	280	281	319	323	323	323	323

The rise from 1802 to 2108 in advisers is a big increase. There is only a small rise of 52 from the end of 2015 to the end of the third quarter in 2016. It’s the larger multi-platform Form PF filers who file quarterly.

Pure real estate fund advisers are only filing quarterly. Given that, I didn’t expect to see much change intra-year, and that held true.

There is a wealth of information in the SEC’s report. I’m still looking for some trends.
Sources:

Weekend Reading: Bourbon Empire

I went on Spring vacation to Kentucky with Mrs. Doug and the compliance nuggets. There was a lot of bourbon and horses. For vacation reading, I dug into my ever-growing tower of books to read and brought along Bourbon Empire by Reid Mitenbuler to read. It seemed appropriate.

Reid Mitenbuler portrays bourbon as a balance of Jefferson and Hamilton’s ideas, still being argued today in politics. On one side is the small agrarian culture championed by Jefferson, in opposition to the capitalist growth of Hamilton. Bourbon is Jefferson on the outside, with Hamilton on the inside.

In Kentucky, bourbon finds that its color. History collides with myth, filling in the recorded gaps with burnt oak.

I found the origins of “proof” to be a fascinating relic of taxation. Ever since President Washington imposed the whiskey tax, distillers have tried to work around taxes for profit. Tax collectors would measure the strength of the whiskey by mixing it with gunpowder and setting it on fire. If the flame sputtered, the alcohol content was low and if it flared up it, there was too much alcohol. A steady flame proved that the alcohol content was proper. This proof came at about 50% alcohol. So if the whiskey was 100% proved, it was was about 50% alcohol.

There was little government oversight of what could be put in the bourbon bottle or put on the label. The biggest first step of regulation was the 1897 Bottled-in-Bond Act that required the whiskey be made a single distillery by a one distiller, aged for at least four years, unadulterated and bottled at exactly 100 proof. The bottle’s label had to identify the distillery where the whiskey was distilled and bottled. If it met those standards, the whiskey would have the right to bear the green stamp of approval featuring the image of John G. Carlisle, a Kentucky congressman.

Whiskey, like all alcohol, was scrubbed out of existence by Prohibition. Okay, so that is clearly an overstatement. It went from local farmers and big distillers, to the underground criminal element. One interesting loophole of prohibition was an exception for medicinal whiskey. (Medicine has come a long way in the last few decades.) If you are going to dispense medicine, you need pharmacies. Walgreens grew from 20 stores in Chicago to over 525 stores during the era of prohibition. Mr. Mitenburger points to The Great Gatsby in which Daisy describes the mysterious bootlegging Mr. Gatsby as having “owned some drugstores, a lot of drugstores.”

Bourbon and Kentucky are linked. My tourguide at the Woodford Reserve distillery point to Kentucky limestone, with its removal of iron from the water, as the key to Kentucky bourbon. Whatever may be the truth or the myth or marketing, 95% of the world’s bourbon is made in Kentucky.

With the fall of Prohibition, government regulation of alcohol increased. That was especially true in labeling and identification of what was inside the bottle. To earn the “straight” identification, the whiskey needs to be aged in brand-new charred oak barrels for at least two years.

It was the rise of Maker’s Mark in the 1980s that turned bourbon towards its “craft” status, embracing quality over mass-production in its marketing. It was the embracing of the Kentucky mystery and Jeffersonian small-batch aesthetics that define most bourbon today. Behind the scenes, a handful of distilleries make the vast majority of bourbon and pour different variations into long line of product labels.

I enjoy a good bourbon and I enjoyed Bourbon Empire.

Compliance Bricks and Mortar for May 5

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

House Panel Approves Plan to Undo Parts of Dodd-Frank Financial Law by Rachel Witkowski

The House Financial Services Committee launched a Republican-supported rollback of Obama-era financial regulations, voting 34-26 along party lines Thursday for a plan to undo significant parts of the 2010 Dodd-Frank law.

The committee vote sent the Financial Choice Act to the full House, where it likely will be approved in the coming weeks. [More…]

SEC Staff Reports On “Real Estate Funds”, But What Exactly Are They? by Keith Paul Bishop

The SEC gathers the data from Form PFs. You are required to file a Form PF if, among other things, you manage a “private fund”. The Form PF does require disclosures from “real estate funds” and it defines these as “any private fund that is not a hedge fund, that does not provide investors with redemption rights in the ordinary course and that invests primarily in real estate and real estate related assets.” A “private fund” is defined as “Any issuer that would be an investment company as defined in section 3 of the Investment Company Act of 1940 but for section 3(c)(1) or 3(c)(7) of that Act.” Notably missing from the definition of “private fund” is a fund that relies on the exclusion in section 3(c)(5) of the ICA but not either section 3(c)(1) or 3(c)(7). [More…]

SEC Probes Solar Companies Over Disclosure of Customer Cancellations by Kirsten Grind

The Securities and Exchange Commission is examining whether San Francisco-based Sunrun Inc. RUN -0.63% and Elon Musk’s San Mateo, Calif.-based SolarCity Corp. have adequately disclosed how many customers have canceled contracts after signing up for a home solar-energy system, the person said. Investors use that cancellation metric as one way to gauge the companies’ health. Companies typically give customers a few days after signing a contract, or even up until the time of installation, to back out of a deal. [More…]

Trump Pick for SEC Chairman Assembling Top Agency Staff by Dave Michaels

Mr. Clayton has considered at least two well-known defense attorneys for enforcement director, typically the SEC’s highest-profile staff position. The lawyers include Steven Peikin, a former prosecutor who works with Mr. Clayton at Sullivan & Cromwell LLP. Mr. Peikin represented Goldman Sachs Group Inc. in its dealings with prosecutors and SEC lawyers over claims a former member of its board, Rajat Gupta, had leaked inside information to a hedge-fund manager. . . .Another candidate for the top enforcement job is Matthew Martens, a partner at Wilmer Cutler Pickering Hale and Dorr LLP, who was the SEC’s top trial attorney from 2010 to 2013. [More…]

In S.E.C.’s Streamlined Court, Penalty Exerts a Lasting Grip by Gretchen Morgensen

A money manager settled his case with the S.E.C. thinking he could go back to work in a year. Nearly five years later, he is still waiting.

Mr. Wanger, who now calls himself the $2,200 Man on a website he has created, said his experience with the S.E.C.’s in-house court system did not feel like he was in America. “I’ve spent the last seven years fighting for the right to defend myself in a real court in front of a real judge,” he said. “Constitutional rights have no meaning unless you’re willing to extend them to people you don’t necessarily like. [More..]

A Classic Example of a General Solicitation Failure

The SEC opinion in KCD Financial Inc. (SEC Opinion 34-80340, March 29, 2017) affirms a fine and disciplinary action against KCD for selling securities in a private placement when no exemption from registration was available under Rule 506. The KCD opinion makes clear that you can’t fix the general solicitation failure by then only selling only to people had a prior relationship with issuer.

The action is against KCD, a broker-dealer, for selling the unregistered securities of Westmount Realty Finance’s WRF Distressed Residential Fund 2011. The offering’s PPM stated that the securities were being made in reliance on an exemption from the registration requirements of the Securities Act and that interests in the Fund were being offered only to persons who were accredited investors as set forth in Regulation D. In 2011, that meant no general solicitation or advertising.

Westmount screwed up and issued a press release that ended up being published in two local newspapers. Westmount screwed up even further by linking to those newspaper articles from Westmount’s website.

As long ago as 1964, [the SEC] has held that the statutory definition of “offer to sell” included “any communication which is designed to procure orders for a security,” and that even a communication that did not on its face refer to a particular offering could nonetheless constitute an offer as long as it was “designed to awaken an interest” in the security. [Gearhart & Otis, Inc., Exchange Act Release No. 7329, 1964 SEC LEXIS 513, at *59 (June 2, 1964), aff’d on other grounds, 348 F.2d 798 (D.C. Cir. 1965)]

The articles reported that “Dallas-based Westmount Realty Finance LLC announced Tuesday that it launched a $10 million real estate fund to acquire bank-owned residential properties and nonperforming, discounted residential loans.” (Yes, the article is still visible online.) That seems to clearly be general solicitation.

The argument from KCD was that it did not generally solicit any of the actual investors in the WRF Fund. When prospective new investors called, KCD asked if they had seen the article. If yes, they were not allowed to invest.

This argument was rejected. Once you engage in a general solicitation in violation of Rule 502(c), the Rule 506 exemption is not available for any subsequent sales of the securities regardless of limiting the sales only to investors who did not see the general solicitation. SEC guidance in 1983 pointed out that soliciting people with a pre-existing relationship and had reasonably believed that the recipients had the knowledge and experience in financial and business matters that he or she was capable of evaluating the merits and risks of the prospective investment is not general solicitation. “The mere fact that a solicitation is directed only to accredited investors will not mean that the solicitation is in compliance with Rule 502(c). Rule 502(c) relates to the nature of the offering not the nature of the offerees.”

Some of this has gone away since the SEC changed the general solicitation rules. Most firms do not want to check the box that says they engaged in general solicitation, fearing it will create greater SEC scrutiny.

Sources:

Headline Risk

On Thursday, The Wall Street Journal published an article on conflicts between the top executives of some private equity firms and their personal investments: “Fund Kings Open Family Offices.”

The article focused on two aspects of the executives’ wealth management: (1) distractions from activities outside the funds and (2) conflicting investments with the funds.

On the distraction issue, the article provided conflicting views from investors. One view is that executives should have all of their own money in the firms’ funds. The other view is the more pragmatic approach that diversification makes sense as long as the outside investments are not a distraction. Primarily, the concern is that the fund is the primary beneficiary of investment ideas and the executives’ time.

The second issue comes from those “distractions.” Personal investments may intersect with the fund investments. The article identifies instances where there was an overlap and a potential conflict. The article mentions the use of “family offices” by some fund executives. Some of these family offices also invest in private equity and other opportunities that may be opportunities that also interest the fund.

I think the article is a compilation of “headline risk.” There are no wrongdoings outlined in the article. There is just the appearance of conflicts.

The private equity firms require the investments of executives to be run through compliance and a conflicts review process. I have little doubt that big private equity firms that Blackstone, Apollo and TPG would have thoughtful review processes to make sure that the potential conflicts are resolved in a way that protects the funds.

The conflict review process is internal and the transaction is private so there is little disclosure made available to the public or to reporters that may be interested. That leaves the firms open to this type of headline risk.

The more high profile the outside investments, the greater media scrutiny they attract and the greater the headline risk.

One of the Fortress Investment Group executives bought a professional sports team, one of the most high profile investments you can make.

Compliance Bricks and Mortar for April 28

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

District Court Rules Plaintiff Failed To Plead Real Estate Investment Was A “Security” by Keith Paul Bishop in California Corporate & Securities Law

In ruling on the defendants’ motion, Judge Benitez correctly observed that the plaintiff’s securities law claims require that there be a “security”. He then analyzed the plaintiff’s allegations in light of the U.S. Supreme Court’s definition of an “investment contract” in SEC v. Howey, 328 U.S. 293, 66 S. Ct. 1100, 90 L. Ed. 1244 (1946) (“whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others”). Applying Howey, Judge Benitez ruled that the plaintiffs had failed to allege adequately the existence of a security [More…]

Sessions Dodges, Weaves, Promises on FCPA by Matt Kelly in Radical Compliance

Then again, Sessions also danced around the question of whether zealous U.S. enforcement of anti-corruption laws puts U.S. companies at a competitive disadvantage on the global stage. At one point in his speech, he praised anti-corruption enforcement as a vehicle to reward the many good companies out there that don’t bribe their way to success. [More...]

An app that pinpoints white-collar criminals works like predictive-policing software by Jack Smith IV, Mic

A new app and website called White Collar Crime Risk Zones , which goes by the initials WCCRZ, shows exactly what neighborhoods are chock full of financial criminals, how much damage they’re doing and even what they might look like.

Using data from the Financial Industry Regulatory Authority, a team of technologists affiliated with the left-wing magazine New Inquiry created the open-source tool so that anyone can put a face on the labyrinthian world of white collar crime hidden in their own home town. [More…]

Yates Memo – Time for Reassessment? by Sharon Oded in NYU Law’s Compliance & Enforcement

While other U.S. authorities have recognized individual accountability as an important enforcement goal, the DOJ’s policy as promulgated by the Yates Memo demonstrates a more rigorous approach. In contrast to the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), which consider a company’s disclosure of individuals’ involvement in the misconduct as an important factor in their analysis,[[iii]] the Yates Memo has adopted an “all-or-nothing” approach: it requires corporations to disclose to the DOJ all relevant facts about individuals’ involvement in the misconduct in order to qualify for any cooperation credit. Accordingly, regardless of whether the company has voluntarily reported the misconduct and fully cooperated with the investigation—e.g., by sharing relevant information, facts, analyses and internal investigation reports, making employees available for interviews and facilitating their representation, or taking state-of-the art remediation action to prevent reoccurrence—it cannot benefit from any credit unless it has ‘sacrificed’ the involved employees. [More…]

Does your team botch the NFL draft? Find out here: How every team’s draft picks since 1996 lived up to expectations. by Reuben Fischer-Baum in the Washington Post

By comparing how much value teams should get given their set of picks with how much value they actually get, we can calculate which franchises make the most of their draft selections. Approximate Value (AV), a stat created by Pro Football Reference that measures how well a player performed overall in a season, is useful here. Based on this metric, we find that the Browns draftees have underperformed in the NFL given their draft position, especially when compared to the draftees of a team like, say, the Seahawks .[more…]

The One With The Options Pricing Theft

Some financial fraud is easy to spot. Some is hard to spot. Some I barely understand. Kevin Amell was very clever in hiding his alleged fraud and I’m not sure I understand exactly how he pulled it off.

Mr. Amell was a fund manager at Eaton Vance for its Risk-Managed Diversified Equity Income Fund. The fund used options to hedge some of its positions and Mr. Amell had some responsibility for the purchase or sale of call options. According to the complaint, on at least 265 occasions, Mr. Amell pre-arranged the purchase or sale of call options between the Fund’s brokerage accounts and his personal brokerage account at prices that were disadvantageous to the Fund and advantageous to Amell. He generated almost $2 million in profits for himself.

Mr. Amell carried out the fraud by placing orders in his personal brokerage accounts to buy specific options at a specific price and at the same time placed orders on behalf of the funds to sell the same options at the same price. He took advantage of the trades with wider spreads and exploited the spread. The fund order was just outside the midpoint of the spread so the market would not take the trade. He took the trade in his personal account and then sold for the difference in the market.

It seems like one of those frauds where the scammer just takes a little bit each time.

One thing hanging out there for me, from a compliance perspective, is how did he get caught.

He did not report the account to Eaton Vance and did not tell the brokerage that he was an employee of Eaton Vance. That means it would be hard for the firm to find the fraud. He clearly violated the firm’s policies.

In paragraph 28 of the complaint, the SEC notes that the initial brokerage account he used for the fraud was closed by the brokerage. I assume the broker’s compliance noted something was fishy. Mr. Amell opened an account at a different broker-dealer and resumed the fraud for another year. Perhaps that second brokerage noted the weird trades and decided to report it to the regulators instead of just closing the account.

Sources:

Financial Choice Act 2.0 for Private Fund Managers

The Republican agenda is moving ahead to unwind much of the Obama Administration’s legislative and regulatory achievements. The first attempt to repeal the Affordable Care Act failed. Next up is raising the debt ceiling, tax reform and Dodd-Frank appeal. (I question how much Congress can take on at one time.)

Jeb Hensarling, Chairman of the House Financial Services Committee, had a law he was ready to move forward with and now has a second version in a discussion draft. There are good things in the Financial CHOICE Act of 2017.

General solicitation

It narrows the meaning of general solicitation. Section 452 provides that a presentation at the following is not an act of general solicitation:

College or University
Non-profit
Angel investor group
Venture forum, or
trade association

provided the advertising for the event does not reference a securities offering, and the event sponsor does provide investment advice to attendees, does not charge a fee other than for administrative costs, and the issuer limits the information provided.

Clearly, this is trying to get the regulatory regime in line with industry practice for venture capital. Issuers don’t want to be engaged in general solicitation, but the definition is too narrow.

Venture exchange

The bill contemplates the creation of marketplace for buyers and sellers of venture securities. The issuer would not have gone through an IPO. It must have a market cap of at less than $1 billion. It seems strange to use the definition of a market cap, when there is no existing market for the securities.

Regulation D and Form D

The bill slams the door on the SEC’s proposed changes to Form D. Those changes have been sitting on the SEC’s agenda for over two years.

Accredited Investor

Section 860 of the bill changes the definition of “Accredited Investor.” It keeps the two current brightline tests of income and net worth. I think those are key tests given the illiquid nature of private placements. It fixes those standards and removes Dodd-Frank’s requirement that the SEC adjust the amounts every four years.

The bill adds in a third test, allowing anyone licensed as a broker or investment adviser to also be an “accredited investor.” It adds a fourth test, allowing the SEC to create a regulatory regime for individuals to prove that the knowledge, education or job experience to allow them to invest in private placements.

We have seen from SEC Acting Commissioner Piwowar that he on board with opening up the definition of accredited investor.

Private equity fund exemption

The bigger change for private equity funds and probably for real estate funds is that it exempts “private equity fund” managers from the registration and reporting obligations of the Investment Advisors Act.

As you might expect, the bill does not take the time to define “private equity fund.” It gives the SEC six months to issue a rule for the definition.

The arguments are that private equity should be treated like venture capital. Private equity does not pose systemic risk. Private equity investors are generally sophisticated. The SEC would be more effective focusing its exam efforts on retail investment advisers.

What next?

Obviously this bill is a long way from being enacted. Chairman Hensarling is working on the pitch and has come up with the Top 10 wins for American People with the Financial Choice Act.

Sources:

Weekend Reading: Evicted

Matthew Desmond took a deep dive into poverty and housing. He published the story of what he saw in Evicted: Poverty and Profit in the American City. The book follows several people in deep poverty living and being evicted from terrible housing in Milwaukee. Mr. Desmond lived among them in 2008 and 2009. He split his time between the poor, white College Mobile Home Park full of the white poor on one side of town and a rooming house on the poor black side of town.

The housing problems did not appear to discriminate based on race. However, Mr. Desmond found that the vast majority of evictions were against black women. Regardless, the problem was a lack of money. Most of the subjects were scrapping by without any meaningful work or on public assistance. That assistance paid for the rent, but left little remaining after rent. They pay a crushing share of their income for rent. The book’s subjects were paying 75%+ of their income for rent. That left little for food, health care, clothing, furniture, and transportation.

Part of book’s story is that evictions are much more common than previously thought. More than one in eight Milwaukee renters faced a forced move in the course of three years. A forced move includes a larger selection of reasons beyond formal evictions, including strong arm tactics, building condemnation, and paying unwanted tenants to leave. In Milwaukee, 16 families lose their homes each day: 16,000 people being forced out of 6,000 housing units every year.

Mr. Desmond also included the two landlords in the book. They were doing better financially than their tenants, but they were not fat cats rolling in cash. There is money to be made from renting to the poor. But it also means an uneven flow of cash when rent goes unpaid, properties are damaged, and the court fees for getting an eviction. The biggest financial windfall for the landlord was when one of the buildings caught on fire. She pocketed the insurance money and bulldozed the charred remains.

The landlord are overlooking the convictions and evictions to rent to tenants that would be excluded from other mainstream housing. In exchange, the tenants overlook the poor housing conditions.

There are no easy answers in the book. In the epilogue, Mr Desmond offers some direction. It requires money. More government assistance for the poor to get housing.

The book is compelling. While not necessarily enjoyable to read, it is well written and easy to digest, as distasteful as it may be. The book has won many awards, including the Pulitzer Prize.

Publishers occasionally send me books in exchange for a review. That was the case the here.