Affiliated Service Providers and Private Equity

Conflict disclosure and management of the conflicts are central to the Investment Advisers Act. Clients are supposed to come first. That means that conflicts must be disclosed and steps taken to manage the conflict must be put in place. An affiliated service provider is a common conflict.

Centre Partners Management used a service provider for the private equity funds it manages and used it to provide due diligence for potential portfolio investments. The Service Provider provided IT due diligence services with respect to potential portfolio investments for the Funds at a flat fee capped at $25,000 per engagement. Those fees are paid by the funds.

That seems straight forward until you consider that the the Service Provider is owned in part by principals of the firm.

The potential conflict could have been fixed by disclosing the ownership in the fund documents. But Centre Partners did not make that disclosure in the fund PPM or in the Form ADV. It also did not mention the affiliated party payments in the audited financial statements.

The ownership stake was not large. The three principals of Centre Partners only owned 9.6%. But two of them are on the board of directors of the service provider. The founder and majority owner of the service provider is the brother-in-law of one of the principals. (It’s always the brother-in-law that gets you trouble.)

A placement agent for one of the funds raised the conflict during fundraising in 2012. Investors apparently asked about the service provider.

An SEC exam looked at the relationship with the service provider and decided it was worthy of an enforcement action. It cost the firm a $50,000 fine. It also took almost three years to finalize the settlement. The Order states that the exam was completed in early 2014.

There is no statement that the fees paid to the service provider were excessive or above market. That does not matter if the relationship is not disclosed. To fix the problem going forward, the firm added the disclosure to the Form ADV starting in March 2014.

This seems like a good time to check to make sure that none of your fund service providers are owned by employees of the firm.

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CCO Liability for False Statements on Form ADV

Susan Diamond was Chief Compliance Officer of Saddle River Advisors. Now, Ms. Diamond is out of pocket for a $15,000 penalty and is subject to a nine-month suspension from being associated with any investment adviser or other financial services firms. After the suspension, she will be prohibited from acting in the securities industry in certain managerial and compliance capacities.

What did she do?

Diamond, on behalf of Saddle River, prepared, signed, and filed Forms ADV that contained untrue statements.

On its face, the order imposes liability for nothing other than answering questions on Form ADV incorrectly.

In Section 7.B.(1)(B) under the heading, “Service Providers” and the subheading “Auditors.”

Are the private fund’s financial statements subject to an annual audit?    Yes
Are the financial statements prepared in accordance with U.S. GAAP?  Yes
Name of Auditing Firm    SRA Funds’ Tax Preparer
Are the private fund’s audited financial statements distributed to the private fund’s investors?   Yes

None of these responses were true. Saddle River’s financial statements were not audited, prepared in accordance with U.S. GAAP, or distributed to investors. The firm identified as SRA’s “auditing firm” had prepared only tax returns and Forms K-1 for the Saddle River Funds and was never engaged by Saddle River to perform an audit.

BOOM! Diamond’s career is over.

All CCOs now need to be worried that getting a question wrong on the Form ADV will end their careers.

This is a very bad order.

The SEC does not lay out any facts in the order that shows Diamond knew the statements were incorrect. The order merely states that Diamond was in a position to answer the questions because she had signatory power on the fund accounts and made accounting entries in the general ledger.

On its face, the SEC is imposing liability on a CCO solely related to the compliance operations of a CCO. Filing the Form ADV is a core responsibility of the CCO.

The order is a terrible statement by the SEC.

It’s not that Saddle River was free of problems. It’s accused of stealing over $5 million from investors, preying on investors with a claim that it was investing their money in pre-IPO tech companies.

However, in the order against her, the SEC failed to state that Diamond was involved in any of that wrongdoing at Saddle River.

I am not surprised to see CCO liability when the CCO is involved in the wrongdoing. I am surprised to see a CCO facing liability merely on the facts stated in the order against Diamond.

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Red Hot SEC Exam Topics

IA Watch presented a webinar: Red Hot SEC Exams Topics in 2017, Plus Exam-Prep Steps from Peers Who’ve Survived Recent Exams.

The presenters were

Fred Shaw, Principal/Director of Compliance, Hamilton Lane
Adam Reback, CCO, J. Goldman & Co
Chuck Daly, Principal, Constellation Advisers
Michelle Martin, CCO, Longfellow Investment Management

These are my notes:

Even though there is great deal of change in Was, exams are expected to continue.

Based on the 2017 Exam Priorities, there seems to be an emphasis on retail investors and how advisers deal with this type of client. There will be heightened focus on seniors and the possibility of exploitation.

There is an emphasis on data for exams. Word is that the SEC is grabbing lots more than in the past to test firm practices.

One presenter is seeing an uptick on never-before-examined advisor exams. The presenter noted that different regional offices are doing these exams differently.

Money market funds are expected to be a priority based on the 2014 rules on liquidity and redemption risks.

There seems to be less emphasis on private funds. That does not mean that there will be none.

Exams are generally shorter than in the past. OCIE wants to reach more firms, given the resources, that means less time on exams. The panelist is seeing fewer on-site exams and more correspondence exams. The examiners are asking for fewer documents, in part because the request is better tailored to the advisor. Of course, there is a wide range of exam experiences.

In exam tips and experiences, one presenter noted that it was worth discussing document requests with the examiner if the request is voluminous. The examiners are unlikely to want a big data damp and are generally not expecting it.

Some of the requested items may not be for the examiners, but for others behind the scene for data and policy considerations.

Introductory presentations are very helpful.

Valuations need to be well documented. If you use the data, you need a copy of the report in the file.

 

 

Conflicts Ahead – What Can We Learn From the Early Days of the Trump Administration

President Trump has come into office as the first president in modern era to own an active business empire. One in which his name is the probably the most valuable asset. Like him or not; voted for him or not; He is the President. As we have seen in the past, scandals limit the ability of the President and Congress to govern.

I’m looking at the issue as way to reflect on things that work and don’t work for a compliance program.

The first step would be to divest from the conflicts. President Trump has already stated that he is not willing to sell the company and liquidate the proceeds into a blind trust. That leaves him with a sprawling business organization that is mostly owned by him, run by his children, and has business relationships around the world.

To be clear, President Trump is not subject to the legislated conflicts of interest laws. He is not required to divest his interests.

I think a majority of the American Public would be concerned if the President’s business interests were realizing direct financial gain from government action.

The other concern is the Emoulments Clause in the Constitution that prevents the President from receiving any “present, Emoulment, Office or Title, of any kind whatever, from and King, Prince, or foreign state.”

Within that framework, how do you establish a compliance program?

The first is the tone at the top.

President Trump has agreed to establish a compliance program. But he seems to have dismissed the concerns about conflicts:

“I have a no-conflict situation because I’m president, which is — I didn’t know about that until about three months ago, but it’s a nice thing to have. But I don’t want to take advantage of something.”

His legal counsel:

“The conflicts of interest laws simply do not apply to the president or the vice president and they are not required to separate themselves from their financial assets.”

But that was saved with:

“He instructed us to take all steps realistically possible to make it clear that he is not exploiting the office of the presidency for his personal benefit.”

There is some tone at the top. I think most compliance officers would cringe at those statements if their CEOs discussed conflicts in that manner.

Next, we would have a clearly articulated compliance program.

The Trump Organization will have an ethics advisor and a compliance counsel. So there is the start of a program.

What we don’t know is how the program is structured, how it will be administered, how it will be tested, or how it will be administered.

As a result, we have the first lawsuit filed. The Citizens for Responsibility and Ethics in Washington (“CREW”) brought the lawsuit to enforce the Emoulments clause. I think its a political ploy that will fail. I think the failure be one of standing and we will never get to the substance. That is left to the impeachment process. We won’t see a Republican Congress do that.

Even if President Trump acts completely ethically with a blind eye to how government action affects his businesses, there is the other side of the transactions.

I’m hard-pressed to believe that foreign governments, business parties and other interests will not treat the relationship more favorably now than they did last year. We have seen the wrath of President Trump on twitter affect stock prices and send businesses scrambling. He is now one of the most powerful people in the world. He wins the business argument even before you get to an argument. He is voted into office with no expectation that he would divest and carrying that conflict baggage.

In my opinion, the Trump compliance program is the most important compliance program in the world. As a compliance professional, I look forward to hearing more about the Trump compliance program so that we can all learn how we can better implement our own program or learn from its mistakes.

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Compliance Bricks and Mortar for January 20

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

Experts Ponder Role of Trump Organization Compliance Counsel by SAMUEL RUBENFELD in WSJ.com’s Risk & Compliance Journal

As compliance counsel, the person’s ethical obligation will be to the organization, not to the president, making the role less robust than retaining an independent lawyer to prevent potential conflicts, said Daniel Alonso, a managing director at compliance risk consulting firm Exiger who previously served as a member of the New York State Commission on Public Integrity. [More…]

SEC Dings BlackRock for Pre-taliation Clauses BY: MATT KELLY in Radical Compliance

Still, BlackRock did insert its pre-taliation language after the SEC adopted its whistleblower rules. That implies an awareness that employees might want to cash out by approaching regulators, and a desire to persuade employees otherwise. That annoyed the SEC enough for the $344,000 fine. [More…]

US Appeals Court Dodges Scope of Dodd-Frank Whistleblower Protection by C. Ryan Barber in the The National Law Journal

The U.S. Court of Appeals for the Sixth Circuit ruled unanimously against John Verble, a former Morgan Stanley Smith Barney financial adviser who claims he was fired in 2013 for cooperating with the FBI in an investigation. A Tennessee federal trial judge earlier ruled Verble was not entitled to whistleblower protection because he did not provide his insider-trading claims to the U.S. Securities and Exchange Commission. [More…]

MARY JO WHITE’S SEC TENURE ENDS WITH FLURRY OF ENFORCEMENT SETTLEMENTS by N. Peter Rasmussen in Bloomberg BNA

As Mary Jo White’s tenure at the helm of the Securities and Exchange Commission comes to a close, the Commission’s Enforcement Division announced the settlement of a series of actions generating more than $140 million in sanctions over four business days. Companies settled charges ranging from Foreign Corrupt Practices Act violations to improperly issued American Depository Receipts. [More…]

Compliance Is Ruff: A Dog’s Approach by by Kimberly Lansford and Carol Lansford, with special guest Gabe II.

The SEC Really Means It About Pretaliation Severance Agreements

In case you were not clear that the Securities and Exchange Commission is serious about enforcing Rule 21F-17, BlackRock is the latest to run the perp walk. The SEC accused the money management giant of improperly using separation agreements that forced employees to waive their ability to obtain whistleblower awards.

The SEC adopted Rule 21F-17, which provides in relevant part:

(a) No person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement . . . with respect to such communications.

Rule 21F-17 became effective on August 12, 2011.

On October 14, 2011, BlackRock revised its form separation agreement. That agreement did not prohibit former employees from communicating directly with the SEC or any other governmental agency regarding potential violations of law. It did include language requiring a departing employee to waive recovery of incentives for reporting misconduct. Effectively, the agreement removed the financial incentive to be a whistleblower.

Paragraph 5 of BlackRock’s separation agreement in use from October 14, 2011 through March 31, 2016 stated in relevant part:

“To the fullest extent permitted by applicable law, you hereby release and forever discharge, BlackRock, as defined above, from all claims for, and you waive any right to recovery of, incentives for reporting of misconduct, including, without limitation, under the Dodd-Frank Wall Street Reform and Consumer Protection Act and the Sarbanes-Oxley Act of 2002, relating to conduct occurring prior to the date of this Agreement.”

Over 1000 departing employees signed separation agreements with this language. BlackRock revised the agreement in March 2016 to remove that provision. BlackRock also produced a “Global Policy for Reporting Illegal or Unethical Conduct” that it distributed to employees and provides yearly training.

In the end, BlackRock a penalty of $340,000.

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SEC’s 2017 Exam Priorities

Last week the Securities and Exchange Commission issued the 2017 priorities for the Office of Compliance Inspections and Examinations. There are five main items on the list, plus some others. Private funds are still on the list.

Retail Investors –

  • Roboadvisers
  • wrap fee programs
  • ETFs – redemption and sales practices
  • Never-before examined
  • Recidivist
  • Multi-branch -(Are your smaller branches as compliant as the main office?)
  • Share class selection

Senior Investors and Retirement Investments

  • Continuing the multi-year ReTIRE initiative, focusing on investment advisers and broker-dealers along with the services they offer to investors with retirement accounts.
  • Variable insurance products
  • Target date funds
  • Public pension plan advisers. “We will examine investment advisers to these entities to assess how they are managing conflicts of interest and fulfilling their fiduciary duty. We will also review other risks specific to these advisers, including pay-to-play and undisclosed gifts and entertainment practices.

Market-Wide Risks

  • Money market funds under the new rules.
  • Payment for order flow programs
  • Clearing agencies
  • Regulation SCI and anti-money laundering rules

FINRA – Consistent with OCIE’s goal of enhancing oversight of FINRA to protect investors and the integrity of our markets, it will continue conducting inspections of FINRA’s operations and regulatory programs, and focus resources on assessing the examinations of individual broker-dealers.

Cybersecurity – OCIE will continue its ongoing initiative to examine for cybersecurity compliance procedures and controls, including testing the implementation of those procedures and controls at broker-dealers and investment advisers.

In addition to those big ones, OCIE is continuing to look at municipal advisors, transfer agents and private fund advisers.

“We will continue to examine private fund advisers, focusing on conflicts of interest and disclosure of conflicts as well as actions that appear to benefit the adviser at the expense of investors.”

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A New Level of Compliance Officer Concern: Getting Arrested

Oliver Schmidt is the former top emissions compliance manager for Volkswagen in the United States. The FBI arrested him on Saturday as part of the Volkswagen emissions scandal. He was denied bail, pending a court appearance later this week.

Perhaps, the case is not one of a compliance officer missing a problem, but a compliance officer actively engaged in the wrongdoing. The charges are for conspiracy to :

  1. Defraud the US by impeding the EPA’s function of approving certificates of conformity for vehicles
  2. Commit wire fraud
  3. Violate the Clean Air Act

In this case, it looks like Schmidt was involved in the wrong-doing and the cover-up according to the criminal complaint.

One piece of evidence was that Mr. Schmidt produced a slidedeck regarding the emissions problem. In a meeting with the California Air Resources Board he identified two outcomes: 1- positive, then VW gets approval for 2016 model cars; 2-no explanation for the emission problem=indictment. I’m guessing, he may not have realized that indictment would be aimed at him.

Schmidt was a manager in charge of the Environmental and Engineering Office which is the group in VW that is responsible for communicating and coordinating with regulators. That sounds like a compliance role, but not in the way that most compliance professionals think of the role.

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The New Administration’s Pick for the Chair of the SEC

Wall Street lawyer Jay Clayton is slotted to head the U.S. Securities and Exchange Commission in the Trump administration.

This is a big change from Chair White whose background was in prosecution. Chair White had a long list of prosecutions from serving a decade as the U.S. Attorney for the Southern District of New York. (She is the only woman to have held that position.) Then served another decade as a litigator in private practice.

Mr. Clayton has a wide-ranging corporate practice spanning mergers and acquisitions, IPOs, corporate governance, and investment advice. He is respected lawyer and will likely do a great job with the SEC.

But he is a very different kind of lawyer than Ms. White. He is a deal lawyer, largely working on corporate transactions and governance.

Perhaps that marks a change in the SEC from one of enforcement to one of enhancing the capital markets. Chair White was saddled with the rule-making imperatives from Dodd-Frank. With most of those in place, the SEC will have more bandwidth to focus its agenda. The appointment of Mr. Clayton seems to be an indication that the SEC may focus more on the other prongs of its mission: maintain fair, orderly, and efficient markets, and facilitate capital formation.

The front page of the Wall Street Journal laments the loss of public companies: America’s Roster of Public Companies Is Shrinking Before Our Eyes. I think most people are guessing that Mr. Clayton will try to fix that issue.

With the appointment of Mr. Clayton, that still leaves two open slots to be filled. No word on whether the stalled nominations of Lisa Fairfax and and Hester Peirce will proceed or whether there will be new candidates.

The Latest Word on the SEC’s Administrative Judges

There have been several challenges to the constitutionality of the in-house administrative judges at the Securities and Exchange Commission. The problem is that the judges are appointed by an internal panel instead of by the President or the SEC Commissioners. The SEC has fended off attacks. Now there is break in wall. The 10th Circuit found the use to be unconstitutional.

The Constitutional question is whether the SEC’s ALJs are “Officers of the United States,” including principal and inferior officers, who must be appointed under the Appointments Clause. U.S. Const. art. II, § 2, cl. 2.

For some reason, the SEC does not appoint the ALJ’s directly. If it did so, it could probably erase this problem going forward. I assume the legal advice is that the change would put past cases into jeopardy.

In August, the U.S. Court of Appeals for the D.C. Circuit in Raymond J. Lucia Cos. v. SEC, accepting the SEC’s argument that ALJs are mere “employees,” and not officers at all. This seemed to be the accepted stance when the US Supreme Court in September denied hearing the appeal of Lynn Tilton in her case arguing on roughly the same issue.

The 10th Circuit Court of Appeals came to the opposite conclusion last week in  Bandimere v. SEC. The Bandimere may differ slightly from prior cases. Unlike some of the other attacks, Mr. Bandimere raised the constitutional question before the SEC, which rejected it. The 10th Circuit put the other attacks in the bucket of collateral lawsuits attempting to enjoin the administrative enforcement actions.

The 10th Circuit, based on Freytag v. Commissioner of Internal Revenue, 501 U.S. 868 (1991), concluded that the SEC ALJ who presided over an administrative enforcement action against Mr. Bandimere was an inferior officer who was not constitutionally appointed. The Freytag analysis has three parts to determine if an ALJ is an “inferior officer”:

(1) the position of the SEC ALJ was “established by Law,”;

(2) “the duties, salary, and means of appointment . . . are specified by statute,”.; and

(3) SEC ALJs “exercise significant discretion” in “carrying out . . . important functions,” .

The Bandimere decision rejected the argument in the Lucia case that ALJs do not have final decision-making power. They have enough power to make them an “inferior officer.”

I would place a bet that the SEC will appeal this case to the Supreme Court. Given the split in the circuit courts of appeal, it makes the case more likely to be heard.

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