Happy Patriots’ Day

And the shot heard ’round the world
Was the start of the Revolution.
The Minute Men were ready, on the move.
Take your powder, and take your gun.
Report to General Washington.

– Schoolhouse Rock!

Patriots’ Day is a celebration of the anniversary of the Battles of Lexington and Concord, the first battles of the Revolutionary War. (With the success of the New England Patriots over the last 15 years, some may confuse this holiday as a celebration of football.) The battle recreations on the field in Lexington Green are very different than the battles on the field at Gillette Stadium.

Patriots’ Day is a celebration of Paul Revere and William Dawes.  They mounted their horses and spread the warning: “The British are coming!” (You don’t know about Hawes because Longfellow didn’t write a poem about him.) Those rides started out with the “one if by land, two if by sea” signal from the Old North Church.

Patriots’ Day is a celebration of the Boston Marathon. Runners start their 26.2 mile journey in Hopkinton, up Heartbreak Hill by my house and into Copley Square

Patriots’ Day is a celebration of baseball, with an early Red Sox home game ending in time for baseball fans to turn into marathon fans as the runners pass near Fenway Park.

Patriots’ Day  is a celebration of being out of the office. It’s a Massachusetts holiday. Since Maine was once part of Massachusetts, it’s also a holiday in Maine. (Although Maine switches the possessive to Patriot’s Day.)

So I’m out of the office today and for the rest of the week on vacation.

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Broker Dealer Private Fund

It was four years ago that David Blass mentioned that the SEC was taking a closer look at broker-dealer requirements for private fund managers in two contexts: selling interests in the funds and earning fees from the fund for capital transactions.

Part of the problem is that the safe-harbors for selling your fund interests is much narrower than people expect:

  • the person limits the offering and selling of the issuer’s securities only to broker-dealers and other specified types of financial institutions; or
  • the person performs substantial duties for the issuer other than in connection with transactions in securities, was not a broker-dealer or an associated person of a broker-dealer within the preceding 12 months, and does not participate in selling an offering of securities for any issuer more than once every 12 months; or
  • the person limits activities to delivering written communication by means that do not involve oral solicitation by the associated person of a potential purchaser.

Mr. Blass indicated that the SEC might consider granting a new exemption for private funds. (Of course that is a new regulation and presumably, the SEC would want to revoke two other regulations before making a new one.)

A recent case before the SEC touched on this area. Gregory Smith provided insurance and retirement planning services. At one point he was a registered representative associated with a broker dealer, but was not when he started selling interests in Rampart Fund. Rampart was a private fund selling notes to fund a mezzanine debt program.

Mr. Smith sold $3.75 million worth of notes to 31 investors and received transaction based compensation.  His activities were outside of any of the three safe harbors.

The SEC barred him from the securities industry, and required disgorgement of the compensation for failing to register as a broker-dealer while selling private fund interests.

Of course this case feels different than in-house personnel selling private fund interests. I’m not sure the exemptions treat it differently. I believe many firms look to the “perform substantial duties for the issuer other than in connection with transactions in securities” safe harbor. For dedicated sales personnel, that argument may fall flat.

I suspect what put Mr. Smith in the cross-hairs of the SEC is that Rampart turned out to be a fraud. Mr. Smith raised almost half of the capital that ended up going to Rampart.

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Slapping Down Investment Research Website

The Securities and Exchange Commission took the “extreme step” of warning consumers that articles on the internet may not be objective and independent. They sent up a warning signal to deceptive promoters by announcing enforcement actions against 27 individuals and entities behind various alleged stock promotion schemes that left investors with the impression they were reading independent, unbiased analyses on investing websites while writers were being secretly compensated for touting company stocks.

From the cases, it  looks like the SEC found a rat’s nest of stock promotion companies, wiling to say great things about public companies in exchange for a fee. In total the SEC filed fraud charges against three public companies, seven stock promotion or communications firms, two company CEOs, six individuals at the firms, and nine writers.

In one case, the person engaged in the business of providing stock promotion services to publicly-traded issuers, and directed the publication on investment websites of over 400 articles about its issuer clients and the clients of an affiliated promotional services company.

“Despite being paid for their work, the writers failed to disclose their compensation in the articles and therefore misrepresented the nature of their relationship with the clients to the investing public.”

This included violating the terms on some major investment websites like SeekingAlpha and Motley Fool. Each of these require a disclaimer that the writer had not received compensation for an article.

The charges are all for fraud, deception or omitting material facts in violation of several securities laws.

The cases don’t address the line between lawfully promoting a company as part of public relations and fluff pieces that the SEC is concerned about here. It appears that the writers and scheme purposefully tried to look like impartial investors promoting their favorite stocks and doing so in places that expect impartial articles.

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The Overbooking Failure

Air travel has gotten has gotten less pleasant over the years. The TSA makes it unpleasant to get to the plane. Then the plane themselves have reduced passenger room. United took the unpleasantness to an even lower level when it forcibly removed a passenger from an overbooked flight.

“Flight 3411 from Chicago to Louisville was overbooked,” the spokesperson said. “After our team looked for volunteers, one customer refused to leave the aircraft voluntarily and law enforcement was asked to come to the gate.

“We apologize for the overbook situation. Further details on the removed customer should be directed to authorities.”

According to a passenger report:

Passengers were told at the gate that the flight was overbooked and United, offering $400 and a hotel stay, was looking for one volunteer to take another flight to Louisville at 3 p.m. Monday. Passengers were allowed to board the flight, Bridges said, and once the flight was filled those on the plane were told that four people needed to give up their seats to stand-by United employees that needed to be in Louisville on Monday for a flight. Passengers were told that the flight would not take off until the United crew had seats, Bridges said, and the offer was increased to $800, but no one volunteered.

Then, she said, a manager came aboard the plane and said a computer would select four people to be taken off the flight. One couple was selected first and left the airplane, she said, before the man in the video was confronted.

Overbooking happens. We are all used to hearing the announcements and the request for volunteers. That’s a weakness in the system. The airlines allow no-show passengers.

The failure in this instance appears to be of United’s own making since the space was needed for United’s own flight personnel.

Then it stepping into absurdity and brutality by viciously pulling a paying customer from his seat and dragging him down the airplane aisle in front of other passengers. Put the blame on both the security personnel and flight personnel for handing a situation in the worst way possible.

What should have been done differently? With a small snippet, it’s hard to tell. There are many things we don’t know from a single passenger statement and a blurry video. Obviously it should never have come to that point.

United should not have allowed passengers to board the plane. That was the proper checkpoint.

It’s hard to tell what the impact will be on United for the poor handling of this situation. I’m sure it will make some potential customers chose other airlines.

For me, it’s just another reminder of how unpleasant airline travel is. We’re driving on our next vacation to avoid this unpleasantness. I would not want a member of my family to be subjected to this treatment, nor would I want them to witness something like this.

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Compliance Bricks and Mortar for April 7

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

You Need to Know This: YTD Securities Class Action Lawsuit Filings are Off the Charts by Kevin LaCroix in the D&O Diary

Securities class action lawsuit filings have been going crazy. Securities suit filings during the first quarter 2017 set a pace that if continued would mean an unprecedented number of securities lawsuit by year end. But even more significant than the sheer number of lawsuits is the rate of litigation. The percentage of listed companies sued in the first quarter, if annualized, would mean that U.S. public companies are being sued at four times the long-term historical rate. As discussed below, three factors account for much of the upsurge in securities suit filings. [More…]

Denials and Admissions in Civil Enforcement – Looking Beyond the SEC by Verity Winship and Jennifer K. Robbennolt in NYU’s Compliance & Enforcement blog

Should agencies require admissions of guilt from the targets of civil enforcement? The SEC’s policy of letting enforcement targets settle while neither admitting nor denying allegations provoked judicial rebukes and a public debate. But the SEC is only the tip of the iceberg. Administrative agencies rely heavily on settlement as a key enforcement tool. Admissions of guilt—or, more commonly, declarations that nothing is admitted—form part of these settlement agreements and the underlying negotiations. [More…]

The Easiest Way to Help Save the Planet: Get a Bike

From eradicating health concerns linked to inactivity, to mitigating climate change, to boosting local economies and building community, biking… is an integral part of the solution. It just has some image and infrastructure issues to overcome. [More…]

The One About The Defrauding Pastor

When you run across someone trying to get you to invest risk-free with a high annual return, you know you have run into a fraudster. Unless god is on the side of the investment, there is no such thing as a high-rate, risk-free return.

Apparently, Larry Holley, the pastor of Abundant Life Ministries in Flint, Mich., thought he could cloak his securities in god’s will and pass them off to parishioners.

According to the SEC complaint, Holley and his associate Patricia Enright Gray, used faith-based rhetoric, with references to scripture and biblical figures to pitch fraudulent promissory notes from a real estate company. From February 2015 until recently, approximately 83 individuals invested with pair.

Holley labeled his church as a “place of provision” and “distributors of knowledge, wisdom, wealth & substance.” To be fair to the pastor, it looks he and the church had spent time buying and fixing up homes for those in need. It just seems he crossed the line at some point.

Holley allegedly told prospective investors that as a person who “prayed for your children,” he was more trustworthy than a “banker” with their money. He held financial presentations masked as “Blessed Life Conferences” at churches. As part of the presentation he asked congregants to fill out cards with information on their finances and he promised to pray over the cards.

Apparently, he turned over the financial information to Gray for the hustle and she would have a on-on-one meeting to help them become millionaires. During the consultations, Gray showed prospective investors a large book filled with photographs of what she represented to be some of real estate company’s properties, testimonials from satisfied investors and copies of checks paid to investors.

The real estate company, Treasure Enterprise, did exist and did own some real estate. The company did not invest the money fast enough or profitably enough to meet the payments on the promissory notes. Perhaps the goal was legitimate at first. (I don’t know.) When Treasure missed its investment marks, Holley and Gray could have broken the news to investors. Instead, it looks like they increased their fundraising efforts to cover the shortfall. (Which of course just increases the shortfall.) The pair used payments of the fresh capital to payoff earlier investors in exchange for dropping their complaints to regulators.

As of February 2017, Treasure was past due on approximately 51 promissory notes for 43 investors, totaling nearly $2 million.

The State of Michigan had caught up with them before the SEC. The Michigan Department of Licensing and Regulatory Affairs used a cease and desist order in August for selling unregistered securities, from acting as unregistered agents and from making false or misleading statements in the offer and sale of securities. Unlike the SEC, Michigan can put them in jail.

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No BitCoin ETF

I’ve said before that BitCoin is the Dutch Tulips of investments. The blockchain approach to recordkeeping is an interesting use of decentralized computed power for recordkeeping, but BitCoin units are less interesting. The main users are less than scrupulous users looking for ways to avoid things like anti-money laundering rules.

Many bankers/traders see BitCoin as a way to make money. All of those transactions and lack of regulation seem ripe for profit-making.

One tactic has been to set up an ETF to track BitCoin prices. Much a like a gold ETF means you don’t need a safe and security guard for gold bars. A BitCoin ETF would allow you profit on runaway BitCoin prices without having to get involved with all of the technical stuff of BitCoin.

I should say, at least people are trying to set up a BitCoin ETF. Two requests have been denied recently. The decisions from the Securities and Exchange Commission state that they fail to “to prevent fraudulent and manipulative acts and practices” and fail “to protect investors and the public interest.” In an identical statement for the two rejections:

The Commission believes that, in order to meet this standard, an exchange that lists and trades shares of commodity-trust exchange-traded products (“ETPs”) must, in addition to other applicable requirements, satisfy two requirements that are dispositive in this matter.  First, the exchange must have surveillance-sharing agreements with significant markets for trading the underlying commodity or derivatives on that commodity. And second, those markets must be regulated.

One problem that surfaces is that is hard to pin the value of BitCoin. The Chinese exchanges for BitCoin have become a separate market from the US. Even in the US, there are different exchanges with different values. Each of the rejected ETF planned to use a different measure for the ETF value.

The linchpin in the SEC’s denial is the lack of regulation. The very thing that attracts user to BitCoin, the lack of government oversight, is the main reason the SEC rejects the ETFs.

For the commodity-based EFTs approved so far, there have been well-established, significant, regulated markets for trading futures on the underlying commodity. Those are gold, silver, platinum, palladium, and copper.

BitCoin is not to the SEC’s liking.

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Compliance Bricks and Mortar for March 31

It’s been a busy week, getting information and drafting for the Form ADV filing. I have a big stack of stories to read and write, but these are some of the compliance-related stories that recently caught my attention.

United’s Policy Management Lessons by Matt Kelly in Radical Compliance

Compliance officers who want a glimpse of your future, look no further than the spectacle that unfolded Sunday morning at Denver International Airport: a tale of policy management mismanaged, reputation risk, and plenty of commentary on social media.

Some day, some way, a headache like this will be yours. This time the lucky company was United Airlines. Let’s taxi into this teachable moment. [More…]

The myth of the 70,000-page federal tax code by Dylan Matthews in Vox

The US tax code is definitely complicated at points, so it’s no wonder that the claim that it is 70,000 pages long has become a widely cited factoid, most recently in messaging from Republicans on the House Ways and Means Committee, the committee that’s leading the Republican effort to simplify and reform income taxes:

The only problem with this claim is that it’s clearly false. As of 2014, the tax code was only about 2,600 pages long. [more…]

SEC Private Equity Enforcement: A More Aggressive Approach by Andrew J. Lichtman and Howard S. Suskin in the Compliance & Enforcement blog sponsored by NYU Law’s Program on Corporate Compliance and Enforcement

Over the last several years, the Securities and Exchange Commission (“SEC”) has targeted private equity funds for various fee allocation arrangements and conflicts of interest.  Rather than describing the fee practices as fraudulent, which would require a showing of scienter, the SEC has concluded that the private equity advisers committed disclosure violations.  However, a recent proceeding in which the SEC secured a settlement based on both breach of fiduciary duty and fraud may foreshadow a more aggressive approach.  Some context first. [more…]

Why the SCCE and HCCA Don’t Care by Adam Turteltaub in the SCCE’s Compliance & Ethics Blog

With a combined membership of over 17,000 dues-paying individuals, the SCCE and HCCA are, obviously the go-to resource for compliance professionals. And, it’s also the go-to resource for vendors wanting to reach compliance professionals.

And, from time to time, those vendors will ask for an endorsement, to offer special discounts to our members, or want their product or work formally recognized. Inevitably, and to them dismayingly quickly, we say no. [More…]

Private Real Estate and Regulatory Assets Under Management

It’s that time of the year again. Real estate fund managers registered with the Securities and Exchange Commission are working on their Form ADV filings. I’m hearing a few questions about the right way to calculate Regulatory Assets Under Management.

The instructions to Form ADV Part 1 Appendix B provide three steps on page 9:

First, is the account a securities portfolio?
Second, does the account receive continuous and regular supervisory or management services?
Third, what is the entire value of the account?

Form ADV deems a “private fund” to be a “securities portfolio.” If you’ve gotten this far you’ve already given up on dealing with subtleties of the “private fund” definition and accepted that your real estate fund is a private fund. That gets you past the first step.

For fund managers, the second question is relatively easy since fund management falls squarely into management services.

That leaves us with the third step. The instructions provide:

In the case of a private fund, determine the current market value (or fair value) of the private fund’s assets and the contractual amount of any uncalled commitment pursuant to which a person is obligated to acquire an interest in, or make a capital contribution to, the private fund.

The first question is what to do about the subscription credit facility. As far I can tell: nothing. That leaves the likelihood that the fund RAUM is slightly high. Draws from the credit facility will be repaid with capital calls. So any investments still financed by the facility will be double counted. The value of the investment is in the value of the fund assets, but the capital has not been called to fund the investment and will be added as part of the uncalled capital.

The second question is what portion of the value of the real estate should be included as a fund asset. Some fund managers are using the gross value of all of the real estate. Others are using the net value after deducting the mortgage debt.

I’ve heard mixed messages from the SEC on which is the preferred method. One thing is clear is that the SEC wants consistency on how you come to the value and that you don’t act in a way that is deceptive.

The argument on using the net is that it better equates to the true fund value. The mortgage debt is generally isolated to the investment, so it is not fund-level debt. The fund is not leveraged.

As a comparison, it would seem strange for a private equity firm to use the gross value of a portfolio company in its fund valuation. I have not heard from any private equity fund managers that are adding the portfolio company level debt into the firm’s RAUM.

Many funds use the Investment Company Guidelines for real estate fund accounting. Those Guidelines call for the net value to be shown on the fund’s balance sheet. The Form ADV instructions say that if you calculate fair value in accordance with GAAP or another international accounting standard for financial reporting purposes you are expected to use that same basis for purposes of determining the fair value of your assets under management.

The SEC wants the registered adviser to use the same method in calculating assets under management that it uses to report its assets to clients or to calculate fees for investment advisory services. That would all seem to lead back to the equity capital in the real estate investments and not the gross value of all of the real estate investments. Investors generally look to the return on equity and capital, not the gross value of the real estate assets.

The third question is what to do about non-fund real estate investments, like direct investments,  separate accounts and joint ventures.  The general consensus seems to be that can they fall outside the scope of RAUM.

While there is still debate over whether a real estate fund is a “private fund”, these type of dirt investments generally seem to fall far away from that definition. There are few, if any, structural entities that would make one think that it is investing in a securities. There is little in the way of cash holding that may end up in a money market fund or other security investment. That means these “dirt” investments would not be a securities portfolio and don’t make it past step one in the RAUM analysis.

I’ve seen a few real estate managers address the RAUM mismatch in Form ADV Part 2. Item 5 states RAUM, then add in other measures of assets under management and how they got to those amounts. That extended assets under management would include the “dirt” investments.

I’m curious to heard what methods you are using.

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Compliance Bricks and Mortar for March 24

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

Women in banking To err is human, to get fired for it … female by Tanaya Macheel in American Banker

One of the latest studies of gender differences in financial services finds female advisers accused of wrongdoing are 20% more likely to lose their jobs than male advisers accused of wrongdoing. The women also are 30% less likely to be rehired than the men within a year following the incident, even though the women are less likely than the men to commit another offense, according to the study’s findings. The infractions cover a wide range, including misrepresenting or omitting key facts and committing fraud. But even controlling for factors like the severity of the offense — as well as qualifications and experience level — women fared worse than men. The study identified Wells Fargo Advisors as the biggest offender, saying its female advisers were 25% more likely to experience a “job separation” after misconduct than their male counterparts. That figure is about 20% for Morgan Stanley’s female advisers and close to 15% for those from Bank of America Investment Services and JPMorgan Securities. The report is titled “When Harry Fired Sally.” You can access it here. [More…]

Trump’s SEC Pick Set for Tense Reunion With Elizabeth Warren by Benjamin Bain and Elizabeth Dexheimer in Bloomberg

Two decades ago, Warren was a little-known law professor at the University of Pennsylvania. Clayton was a Penn law student at the same time. She went on to become the finance industry’s most relentless critic, while he made millions as a lawyer representing big banks and hedge funds. Their paths will cross again Thursday at Clayton’s Senate confirmation hearing, where Warren will be among the most outspoken lawmakers questioning his work on behalf of the industry. [More…]

Anthem’s Blow Against Corporate Trust by Matt Kelly in Radical Compliance

This isn’t an abstract problem. Distrust in institutions is growing, with real consequences for corporations and compliance officers charged with keeping them on a trustworthy path.

I explored this in a recent post on the NAVEX Global blog. We have the Edelman Trust Report, an annual survey of public trust in various institutions: it shows trust declining for all types of institutions, including businesses and governments, around the world. We also have the PwC CEO Survey of 2017: it cites organizational trust as an emerging risk for businesses, and noted that companies able to foster trust will have a competitive advantage in the future. [More…]

Why the Securities and Exchange Commission’s Administrative Law Judges are Unconstitutional by Linda D. Jellum in NYU’s Compliance & Enforcement

I answer these and other questions are in my recent article,[27] explaining why the SEC ALJs’ appointment violates the United States Constitution and why there is no easy fix. Further, I note that it is not just the SEC ALJs’s appointment process that is constitutionally infirm. In addition, the SEC ALJs, indeed all ALJs, are subject to multiple for-cause removal protections. In 2010 in Free Enterprise Fund v. Public Company Accounting Oversight Board, the Supreme Court held that dual for-cause removal provisions violate separation of powers.[28] Possibly, the Supreme Court will refuse to extend its holding in Free Enterprise to ALJs given the potential impact on the administrative state. However, if the Court meant what it said and if the case is to have any relevance beyond the agency involved, then the multiple for-cause removal provisions affecting the SEC ALJs specifically and all ALJs generally will need to be fixed. The constitutional challenges raised in these cases are far from inconsequential. Thousands of ALJs may be subject to unconstitutional appointment and removal provisions. Thus, the shadow of Free Enterprise looms large. [More…]

12b-1 Fees: It Is Time To Bid Them Farewell? in Kitces.com

From its start in 1980, the 12b-1 fee was controversial – a distribution charge assessed against current mutual fund investors, that the fund company can use to market the fund to new investors. In other words, the mutual fund got to use investor dollars (rather than its own money) to grow the fund’s assets under management (AUM).

In theory, this use of the mutual fund investor’s own money to market the fund company’s products was supposed to be good for the investor, because it would help grow and scale the fund and bring down its operating expense ratio. However, several decades later, subsequent analysis is finding that while mutual funds that charge 12b-1 fees are successful at incentivizing salespeople to bring in more assets under management, the 12b-1 fee isn’t living up to its promise of helping to scale up and bringing down the expense ratio as the mutual fund grows. [More…]

Cyclists Break the Law to Stay Safe, Study Finds by Joe Lindsey in Bicycling

The study (“Scofflaw Bicycling: Illegal But Rational”), just published in the Journal of Transport and Land Use, details when, how, and why cyclists decide to break traffic laws. The authors, an engineer and sociologist from the University of Colorado and an urban planning professor at the University of Nebraska-Lincoln, set out to study the subject of cyclist misbehavior, which they say has surprisingly scant research.  [More…]