SEC Takes a Look at the “accredited investor” definition

The Securities and Exchange Commission left a new Report on the Review of the Definition of “Accredited Investor” as an early Christmas present under your compliance tree. [Feel free to replace Christmas with New Years or the year end celebration of your choice.] We will need to keep an eye on what happens with this report.

 

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The accredited investor definition falls right into battle zone of the SEC where it needs to balance capital formation on one side and investor protection on the other. I expect there will a Festivus feats of strength contest to see who wins the battle over the definition.

Section 413(b)(2)(A) of Dodd-Frank requires the SEC to study the accredited investor definition every four years.  This is the first study. It’s not a SEC inspired review, but one mandated by Congress.

SEC Chair Mary Jo White encourages “investors, companies and other market participants to provide comments as public input will be very valuable as the Commission considers the definition.” The report considers alternative approaches to defining “accredited investor,” provides staff recommendations for potential updates and modifications to the existing definition and analyzes the impact potential approaches may have on the pool of accredited investors.

Few people think that the current income and net worth tests for an accredited investor have much to do with the ability to judge the risks of a private investment. Of course, it also does not mean that non-accredited investors can judge a publicly listed security either.

But the current tests do offer a bright-line than makes it easy toe evaluate a potential investor’s eligibility to participate in the offering.

“Clarity and certainty in the accredited investor definition foster greater confidence in unregistered markets and ultimately could reduce the cost of capital, thereby promoting increased capital formation, particularly for small businesses.”

Given that Regulation D offerings still raise more money than registered offerings, you have to wonder if Congress and the SEC have made it more palatable to stay private.

As for private placements being more risky than registered investments, I will disagree. They may be more or less risky on whether the investment will produce a return. The risk is not in the return. The risk is one of liquidity. A private placement by Exxon may not be any more risky than the public stock. The risk is that there is no market to resell the security. If you suddenly need the cash back from the investment you may have no ability to get it until a liquidation event.

Here are the two groups of recommendations from the Report:

The Commission should revise the financial thresholds requirements for natural persons to qualify as accredited investors and the list-based approach for entities to qualify as accredited investors. The Commission could consider the following approaches to address concerns with how the current definition identifies accredited investor natural persons and entities:

  • Leave the current income and net worth thresholds in place, subject to investment limitations.
  • Create new, additional inflation-adjusted income and net worth thresholds that are not subject to investment limitations.
  • Index all financial thresholds for inflation on a going-forward basis.
  • Permit spousal equivalents to pool their finances for purposes of qualifying as accredited investors.
  • Revise the definition as it applies to entities by replacing the $5 million assets test with a $5 million investments test and including all entities rather than specifically enumerated types of entities.
  • Grandfather issuers’ existing investors that are accredited investors under the current definition with respect to future offerings of their securities.

The Commission should revise the accredited investor definition to allow individuals to qualify as accredited investors based on other measures of sophistication. The Commission could consider the following approaches to identify individuals who could qualify as accredited investors based on criteria other than income and net worth:

  • Permit individuals with a minimum amount of investments to qualify as accredited investors.
  • Permit individuals with certain professional credentials to qualify as accredited investors.
  • Permit individuals with experience investing in exempt offerings to qualify as accredited investors.
  • Permit knowledgeable employees of private funds to qualify as accredited investors for investments in their employer’s funds.
  • Permit individuals who pass an accredited investor examination to qualify as accredited investors.

Personally, I think some increase in the income and asset tests are okay if it also includes an ability for an investor to prove financial sophistication to gain access to private offerings.

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Wrapped Gifts Under Tree is by Jimmie
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The Compliance of the Winter Solstice

The winter solstice marks the longest night and shortest day of the year with the latest dawn and the sun at its lowest point in the sky. Its the shortest day of the year. But that is not entirely true and we see a problem of scope, bias, and definition.

solsitice

The solstice happens at the same instant for all of us, everywhere on Earth. This year the solstice occurs on Tuesday December 22nd at 04:49 GMT (Universal time).

The first problem with my opening paragraph is bias. It’s not winter for everyone. In the Southern Hemisphere its summer. Explorers in the Antarctic are enjoying long, long hours of sunlight.

The second problem is using a singular time to define something else. The December Solstice marks a single point in time. The longest day or night may fall on either side of the event time.

It’s not true that it’s the earliest sunset and latest sunrise of the year. Earth’s orbit is not round so sunsets have already begun to be later in the North Hemisphere.

What does this have to do with compliance?

Are you describing things accurately in your program? Sometimes you need to rethink the description to make things work and meet your obligations.

It also means that the we are coming out to of the darkness. Hopefully you will have some time to celebrate the end of the year and the longer daytime hours. At least if you are North of the Equator.

Compliance Bricks and Mortar for December 18

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

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Star Wars Week Part I – How do You Evaluate a Risk Assessment? by Tom Fox in the FCPA Compliance Report

Today I begin a series of Star Wars themed blog posts to celebrate the upcoming release of the next entry in the Star Wars franchise, Episode VII – The Force Awakens. Please note that I will only use the first three movies, now known as Episodes IV-VI, for the themes this week. So if you are a millennial and the prequels are your Star Wars sorry but you can write about them as the first three are my Star Wars movies.

Star Wars Week Part II – The Empire Strikes Back – Levels of Due Diligence

Star Wars Week, Part III – VI – Return of the Jedi-Moderating Training

Star Wars Week Part IV – Disruption Innovation in Compliance

 

Five Predictions for 2016 in Private Funds Management

SEC wrist-slaps real estate GPs: After completing a ‘sweep’, or coordinated inspection review, the US Securities and Exchange Commission (SEC) needs about two years to evaluate its findings before bringing enforcement action. With private equity firms, a sweep was finished in 2012 that led to more than a dozen enforcement cases in 2015 and more expected next year. A similar sweep of real estate advisors began a year or so after the private equity exams started, so if the timeline stays true, 2016 will be when real estate enforcement cases begin coming through. Already senior SEC officials have sounded the alarm on real estate GPs charging fees for certain ancillary services like property management without proper disclosure. [More…]

Section 12(g)(1)(A) – How The SEC Is Putting Words In Congress’ Mouth by Keith Paul Bishop

That, however, is not what Section 12(g)(1)(A) literally states.  Congress was quite specific.  The shareholder trigger is either 2,000 persons or 500 persons who are not accredited investors.  There is no “or more” in the statute.  Read literally, an issuer would have to have a class of equity security (other than an exempted security) held of record by either exactly 2,000 persons or 500 non-accredited persons.

Surely, Congress did not intend such an odd rule.  It must have meant, as the SEC states, 2,000 or more or 500 or more. [More…]

Regulation Crowdfunding: The Long Wait Is Over, But Is Equity Crowdfunding D.O.A.? by by Sam Effron and Kristin Gerb in Mintz Levin’s Securities Matters

What we think will make Reg. CRWD offerings particularly burdensome and expensive, however, will be the compliance requirements for issuers and intermediaries. The SEC has created new “Form C”, which issuers utilizing Reg. CRWD will be required to file for all filings related to a Reg. CRWD, including an initial offering statement (and updates thereto) and ongoing annual reports. The initial Form C will need to be filed at least 21 days before any offering commences, and the disclosure requirements for a Reg. CRWD offering are extensive. [More…]

CFTC Brings First Insider Trading Case by Bruce Carton in Compliance Week

Until last week, the CFTC had never been brought an insider trading case for commodities trading. Indeed, the only example of insider commodities trading that most lawyers (or anyone else) could probably point to would be the ill-fated effort of the Duke brothers in the Eddie Murphy movie Trading Places.[More…]

 

Jedi Training and Compliance Training

As I was gently caressing my tickets for tonight’s early premier of Star War: The Force Awakens, another compliance thought came to mind. The Star Wars saga shows three examples of Jedi training. One of which falls far short of the compliance standard.

yoda

We see glimpses of the younglings training at the Jedi Temple. That was the standard method at the time, giving their plastic young minds the right message from early on. We don’t know how well the training went because Anakin slaughtered them in Episode III.

In Episode V, we see Yoda’s training of Luke in the swamps of Dagobah. That seems to work, even though the training seem incomplete. At the end of Episode VI, Luke is tempted by the Emperor to come to the Dark Side. Doing so will save his friends. Luke is tempted, but does not cross the line.

We see Obi-Wan Kenobi’s training of Anakin Skywalker in Episodes II and III. Young Anakin was already too old for the Jedi Council’s standards, but they relented to Obi Wan’s plea to take Anakin under his wing.

He is beloved as a character, but Obi Wan falls short in compliance training.

He pushed the Jedi Council to break its rules and allow Anakin to begin training. As we see in Episode III, he was too old and had become too attached to his mother.

The one key to Jedi training is to avoid the Dark Side. Obi-Wan failed to see the signs and put Anakin into remedial training.  Anakin is tempted to the Dark Side and crosses the line.

The key goal to compliance training is teaching employees where the line of good and bad is and to stay away from the line. The employee may perform well or not, but you don’t want the employee to cross the line to the dark side.

Obi Wan was lured by the prospect that Anakin was supposed to be the “chosen one,” restoring balance to the Force. He broke the rules to get him into Jedi training. He overlooked Anakin’s shortcomings and misteps because he thought he was the “chosen one.”  In the end, the training failures lead to the destruction of the Jedi, the rise of the Galactic Empire and the loss of millions of lives.

The Compliance Failure of the Death Star

The Death Star was touted as the “ultimate power in the universe.” But a few proton torpedoes managed to destroy the entire station. It didn’t make into the trilogy, but I assume there would have been an ensuing investigation that would have looked at the failures that lead to loss. At least I imagined there must have been while my family was re-watching the Star Wars movies in anticipation of this week’s premiere of Episode VII.

death star

The entire series starts with Darth Vader pursuing Leia Organa because she has gotten her hands on the technical readouts for the Death Star. If the Empire was so sure that the battle station was invincible, it would not have been so concerned. At least you would think so. But perhaps it’s just a plot device.

Grand Moff Tarkin, who had overseen the construction of the Death Star, dismisses the idea that the moon-sized battle station is at risk from an attack by small fighters. He is right. The risk is very small. It was a small, shielded exhaust port. he shot “was impossible, even for a computer.”

The first attack run resulted in the destruction of the fighters. The second attack run hit the target but merely impacted on the surface. It is only the Luke Skywalker with his Force assisted attack that manages to hit the difficult target correctly. T

Of course the outcome is catastrophic so there was clearly a mistake in the design of the station.

The Emperor was not happy and began a culling at the highest ranks of the Empire, executing officials such as Moff Coovern and Minister Khemt, believing that their incompetence was partly to blame for the station’s annihilation. That does not sound like great way to run a “lessons learned” post-action review.

We don’t know if the design was improved for the Death Star II. It too was destroyed, but under different circumstances. It was, in part, constructed as trap to destroy the Rebel Alliance. The Emperor left it appearing vulnerable, when it was in fact fully operational, with the a huge portion of the Imperial Fleet hidden nearby. The flaw was in the Emperor’s plan by overlooking the capabilities of the local Ewoks.

In the end, I say it was not a compliance failure, it was a governance failure. The Emperor ran his organization through fear, using Darth Vader to intimidate of kill those dared question the Emperor. Grand Moff Tarkin executed the Emperor’s orders, creating a massive battle station that could destroy planets and star cruisers. But they overlooked the small things. And that lead to their downfall.

I don’t think the Emperor would have tolerated a compliance program. Unless you view Darth Vader as the CCO.

It was the arrogance of the top leadership failed to see the risks and thought they could see everything, unaware of their blind spots.

If you want more Star Wars and compliance mash-ups, check out Tom Fox’s posts this week:

The Jedi and Compliance Failures

My family has been re-watching the Star Wars movies in anticipation of this week’s premiere of Episode VII. While watching Episodes I-III, I wondered if the Jedi could have used some compliance strategies to help prevent their downfall.

come to the dark side we have cookies

Two of the goals of compliance are (1) to deter people in your organization from doing bad things and (2) to identify a fed flag that could indicate something bad has happened or is about to happen.

Obviously, going to the dark side is a bad thing. You can tell, because they wear black. The Jedi needed to takes steps to prevent its members from being tempted by the power of the dark side of the force.

The obvious first steps in compliance are periodic certifications:

  • I have not been tempted by the dark side this quarter.
  • I am not interested in galactic domination
  • I am not experiencing any of negative emotions: fear, anger, hatred and rage
  • I am not in a romantic relationship

I suppose having Mace Windu sit down and fill out a form would be kind of silly.But it could be a deterrent.

The Jedi Master seem to able to detect variations in the force.Maybe a periodic review with the Jedi Council would be a good way to see if anyone is being tempted by the dark side.

The Jedi knew that Anakin Skywalker was having troubles. He was at risk of being a rogue Jedi.

The Jedi Council had a compliance failure form the beginning. Young Anakin was older than what was allowed by the Jedi code to become a padawan and begin Jedi training. The Jedi violated their own policies and procedures.

The Jedi Council failed to take actions to discipline Mr. Skywalker. They  saw his small digressions, but took no actions to discipline him for his mistakes.

The result was a rogue member of the organization destroyed the entire organization. In this case, that also meant dissolving the Galactic Senate, the rise of an evil galactic empire and the loss of billions of lives.

Maybe a Jedi compliance warrior could have helped prevent the downfall.

If you want more Star Wars and compliance mash-ups, check out Tom Fox’s posts this week:

If you like the image at the beginning, you can get it on a T-Shirt at Woot!. (My son has one.)

Do As I Say, Not As I Do

As financial firms are the recipients of more and more reporting obligations from government regulators, I find it amusing to note when the lawmakers fail in their own reporting obligations. The Wall Street Journal is reporting that Senator Bob Corker failed to disclose millions of dollars in his financial reports.

senator bob corker

The senator is the third-ranking Republican on the Senate Banking Committee, which oversees the real-estate and financial-services sectors. This is the committee that oversees the Securities and Exchange Commission and is, at least in part, the architect of the reporting obligations of fund managers and investment advisers.

“I am extremely disappointed in the filing errors that were made in earlier financial disclosure reports,” Mr. Corker said in a statement to the Wall Street Journal.

I don’t think the SEC would be as receptive to that statement when made during an examination.

Or for blaming the accountants for using the wrong method.

I’m not accusing the Senator for any wrongdoing. He relies on his team of advisers to follow the rules imposed on him.

Of course the same can be said for many investment advisers. Do As I Say, Not As I Do

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Compliance Bricks and Mortar for December 11

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

merry christmas brick

A Compliance Plan or a Compliance Idea? by John Nocero in SCCE’s The Compliance & Ethics Blog

Much of what we do is dictated by our compliance plan. But we also need to be able to react based on arising risks or incidental findings. Often, being able to reprioritize is most important. I write a goal list of what I am going to get done each week, but some weeks are impossible to predict. You often need to make changes in real-time. Very rarely you can ever say you are totally locked in to a particular plan. Maybe it is better to characterize the compliance plan as a compliance idea – you are pointed in the right direction, but you are ready to make an adjustment if needed. [More…]

GP charged for failing to disclose portfolio company loans By: Katherine Bucaccio in Private Funds Management

The US Securities and Exchange Commission (SEC) has charged San Francisco-based private equity firm JH Partners for failing to disclose loans that the firm made to its portfolio companies, according to an SEC order filed at the end of last month.

The SEC claims that JH Partners and some of its principals provided approximately $62 million in direct loans to portfolio companies across three of its funds from 2006 to 2012. Through the loans, the firm acquired interests in the portfolio companies that were senior to the equity interests held by the funds, however, JH Partners did not disclose the loans or the potential conflict of interest to its LPs. [More…]

Unfair & Unbalanced Podcast with Tom Fox & Roy Snell – Episode #1

Taped at SCCE’s 2015 Compliance & Ethics Institute at the ARIA in Las Vegas. In this first episode, noted FCPA lawyer and blogger Tom Fox, and Society of Corporate Compliance & Ethics CEO, Roy Snell, discuss the importance of an independent compliance officer, misconceptions about compliance in general (hint: it’s not that hard), updating the Federal Sentencing Guidelines, the most important word in the Yates Memo, and some of the immediate effects of the Volkswagen scandal. [More…]

Brick in front of Belly Timber by Eli Christman
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The State of CCO Enforcement Actions

I was at the IA Watch conference titled “Coping with Regulatory Change” and several presenters from the Securities and Exchange Commission in different panels took a fair amount of time saying that the SEC is not targeting CCOs for enforcement actions. This was in light of several SEC actions against compliance officers in the last few years.

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The SEC party line is that it will defer to the good-faith determinations of the CCOs. Of course, CCOs are not granted immunity from enforcement actions. The SEC has put for the three categories for when CCOs are subject to actions by the SEC.

1.  Participating in the wrongdoing

The first area of liability is when the compliance officer is participating in the wrongdoing. This is an obvious area of liability. Compliance title is not an absolute shield.

There was the Yue Han case in last few weeks where a compliance associate at Goldman Sachs was accused of trading on inside information on pending deals. He found the inside information while conducting email surveillance in his compliance role.

2. Hindering the SEC examination or investigation

The second area is not doing the bad acts, but effectively helping to cover them up.Lying to the SEC or submitting knowingly false documents is known area liability.

The example is the Wells Fargo case. Judy Wolf was a compliance professional at the firm. When an SEC investigation in insider trading came to light, Ms. Wolf went back and altered the documents around her own review of the particular trades.

Even though this was an enforcement action, the SEC administrative law judge dismissed the action this last August.

3. Wholesale failure

The third are of liability is when there is a “wholesale failure” by the compliance officer.  This level of failure seems to be a high standard, but the recent SEC actions makes me wonder how high that standard is. It doesn’t seem to be as such a high bar as you might think.

Shortly after the conference a new action was released that included separate charges against the CCO. The Sands Brothers case involved repeated violations of the custody rule. After SEC deficiency letters and a prior enforcement action, the firm continued to fail to deliver audited financial statements as required by the custody rule. Surely a failure.

“Wholesale failure”? Sure. I would not want to defend the CCO by saying it was not a wholesale failure. Sadly, the order did not use this term.

The SEC has been inconsistent with its interpretation of the “wholesale failure” of the CCO. In the BlackRock case, the CCO was blamed for inadequate policies and procedures.

The SEC’s order found that BlackRock and its then-chief compliance officer Bartholomew A. Battista caused the funds’ failure to report a “material compliance matter”.  Rice failed to report violations of BlackRock’s private investment policy to the boards of directors.  BlackRock additionally failed to adopt and implement policies and procedures for outside activities of employees, and Battista caused this failure.  Battista agreed to pay a $60,000 penalty to settle the charges against him.

In SFX, the SEC charged the CCO for failed to supervise the president of the firm who stole $670,000, for violation of the custody rule, and for making a false statement in a Form ADV filing.  The CCO negligently failed to conduct reviews of cash flows in client accounts, which was required by the firm’s compliance policies, and did not perform an annual compliance review.  Mason also was responsible for a misstatement in SFX’s Form ADV that client accounts were reviewed several times each week.

Another was a technical interpretation case. In the Delaney case, the CCO was charged because the firm was failing to meet the requirements of 204T related to stock loans and execution of close-outs. The charges were for failing to give proper guidance on the rule, implementation of technology to comply with the Rule. The SEC position was that Delaney was that he knew the firm was violating the rule and did not take steps to stop it.

The SEC has said that CCOs are not targets. However, actions speak louder than words.

PRI finalizes ESG questionnaire

The Principles for Responsible Investment Initiative has launched the Limited Partners’ Responsible Investment Due Diligence Questionnaire to encourage standardized due diligence on environmental, social and governance considerations in private equity.

UN-PRI

The LP Responsible Investment DDQ was developed in consultation with a working group composed of 41 LPs, funds of funds and GPs.

There are 21 questions proposed to standardize the diligence framework in four categories:

  1. WHAT ARE YOUR ESG-RELATED POLICIES AND HOW DO ESG FACTORS INFLUENCE YOUR INVESTMENT BELIEFS?
  2. HOW DO YOU IDENTIFY AND MANAGE MATERIAL ESG-RELATED RISKS AND USE ESG FACTORS TO CREATE VALUE?
  3. HOW DO YOU CONTRIBUTE TO PORTFOLIO COMPANIES’ MANAGEMENT OF ESG-RELATED RISKS AND OPPORTUNITIES?
  4. HOW CAN LPS MONITOR AND, WHERE NECESSARY, ENSURE THAT THE FUND IS OPERATING CONSISTENTLY WITH AGREED-UPON ESG-RELATED POLICIES AND PRACTICES, INCLUDING DISCLOSURE OF ESG-RELATED INCIDENTS?

The LP Responsible Investment DDQ is accompanied by a guidance document.

Expect to start see these question on your investor DDQs.

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