Don’t Charge Your Examination and Investigation Expenses to Your Funds

Most private fund documents allow the manager to charge the funds for expenses incurred in the operation of the funds. Most investors expect and most managers charge the funds for some of the legal expenses and consulting expenses. The Securities and Exchange Commission though Cherokee went too far in charging the funds for expenses related to registration with the SEC.

money

Like many private fund managers, Cherokee spent a great deal of time, money and energy in 2011 in preparing to register with the SEC as an investment adviser. According to the SEC order, Cherokee charged $171,000 of those expenses to the funds it managed. The expenses were for a third-party consultant and outside counsel, as well as registration fees.

Cherokee was subject to an exam in 2013 and incurred $239,362 of expenses that it charged back to the funds. In 2014, Cherokee got notice of an impending enforcement action and charged $45,000 to the funds for legal services incurred during the investigation.

The SEC takes the position in the enforcement action that the disclosure would need to specifically state that funds would be charged for a portion of the adviser’s own legal and compliance expenses. Cherokee’s partnership provided that the funds would be charged for expenses that in the good faith judgment of the general partner arose out of the operation and activities of the funds. That was not good enough for the SEC.
Sources:

Twitter for Stock Manipulation

Twitter is stream of random thoughts, news, insightful commentary, boring stories, humor, sadness, food pictures, hate, love, and cat pictures. The internet as a whole. At least a few traders have used Twitter as stock pricing indicator. Theoretically, that means stories could be planted that would move the stock price of a company. One trader tried to do so under false pretenses and is now subject to civil charges by the Securities and Exchange Commission and criminal charges by the Department of Justice.

twitterlogo

James Alan Craig set up a few Twitter accounts. One was modeled after Muddy Waters Research, the influential equity research company. Another was modeled after Citron Research, another influential securities research firm. In each case he stole the firm’s logo to use on the Twitter accounts.

On Jan. 29, 2013, Craig used a Twitter account to send a series of tweets that falsely said Audience, Inc. was under investigation. Audience’s share price plunged and trading was halted before the fraud was revealed and the company’s stock price recovered. On Jan. 30, 2013, Craig used another Twitter account to send tweets that falsely said Sarepta Therapeutics, Inc. was under investigation. Sarepta’s share price dropped 16 percent before recovering when the fraud was exposed.

false tweets

Craig used his girlfriend’s brokerage account to buy the companies’ shares at depressed prices, hoping to sell them later after they rebounded. He was a terrible trader and missed the low prices. He bought $13,000 worth of stock in the companies, but made less than $100 of profit.

However, there was substantial short term damage to the targeted companies. The stock drop erases $1.6 million of shareholder value for at least a short time. There was enough of an impact that the NASDAQ halted trading in one of the companies.

It’s hard to believe that an unverified Twitter account that is poorly used could dupe the market into thinking that the claims were true. But I may be underestimating how much traders are using Twitter algorithms in their trading strategy. Craig’s accounts had very few followers and brief histories. Most people would discount the quiet tweeting from such an account. The algorithms did not.

For a few tweets and $100 of profit Craig faces a maximum prison sentence of 25 years, a fine of $250,000, penalties and restitution. Of course that is only if the US authorities can get their hands on him. His whereabouts are unknown.

If the case ever makes it to trial, it would be an interesting legal examination of the intersection of social media an securities fraud.

I don’t think I could be convicted of securities fraud for standing on a street corner and telling everyone that passes that Company X is a fraud and subject to upcoming charges. I didn’t think the same would be true if I did the same thing on Twitter. But maybe I’m wrong.

Sources:

Compliance Bricks and Mortar for November 6

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

Decay: Aged brick & mortar in Puerto Rico by Rusty Long

Definition of Materiality Depends Who You Ask by Emily Chasan in the Wall Street Journal

As CFO Journal reported on Tuesday, at least half a dozen standard setters, including the accounting rule makers, Securities and Exchange Commission and stock exchanges, have some guidelines on what information must be told to investors and when.  Companies want to take a fresh look at “what disclosures are effective and necessary, and what might be obsolete,” said Tom Quaadman, vice president of the U.S. Chamber of Commerce’s Center for Capital Markets Competitiveness.

Companies are increasingly worried that so many different interpretations of materiality are part of the problem, he said.

Here are some of the definitions of materiality from five different regulators: [More…]

Compliance officers are executives and subject matter experts by Michael Scher in The FCPA BLog

Under Compliance 2.0, compliance officers aren’t in-house lawyers. They are not auditors, or human resource people, or project managers, or part of general risk management.

They are the leadership for, and subject matter experts on, all of the elements that make up the company’s compliance program. [More…]

Morrison & Foerster reports SEC Settles Charges that Investment Adviser Failed to Adequately Disclose Changes in Investment Strategy by Kelley A. Howes in the CLS Blue Sky Blog

According to the SEC, the fund originally invested in distressed debt, but in 2008, it began investing a significant portion of the fund’s assets in credit default swaps (CDS). Prior to 2008, the market value of the CDS portfolio never exceeded 2.6% of the fund’s net assets. The SEC found that by the end of the first quarter of 2009, however, the fund’s CDS portfolio grew to 25% of net assets. [More…]

J.P. Morgan Adviser Admits Stealing $22 Million From Clients by Anna Prior in the Wall Street Journal

According to federal prosecutors, Mr. Oppenheim defrauded multiple clients over a seven-year period. He claimed to have invested their money in low-risk municipal bonds and sent doctored account statements purportedly showing profits earned on those investments. However, he was using the clients’ money for his own personal benefit—including to pay for a home loan, bills and, according to his lawyer, gambling—and to pay back other investors. [More…]

Do You Speak Fluent Private Equity? Take the Quiz!

The private equity industry, like every other major industry, has plenty of jargon and industry-specific terminology. How well do you know the jargon and terminology of private equity?

Privcap Academy presents a fun challenge – take this quiz to test your command you have of the language of private equity.
[Take the Quiz!]

Another Private Equity Fee Case from the SEC

When the Securities and Exchange Commission announced last year that it was not happy with the fees private equity funds were charging and how they were disclosed (or not disclosed) to investors, we expected enforcement cases to follow. They are here. The latest is against Fenway Partners for failing to disclose conflicts of interest to a fund client and investors when fund and portfolio company assets were used for payments to former firm employees and an affiliated entity.

fenway

According to the SEC order, Fenway had management service agreements with the portfolio companies which were partially offset against the fund management fee charged to investors.

In 2011, Fenway cancelled those agreements and entered into similar agreements with a new consultant firm largely owned and operated by the principals of Fenway. Fenway did not offset these consulting fees against the fund management fee.

The SEC found several faults with the change. The SEC found the disclosure to the fund’s advisory board to be lacking in detail. The SEC also challenged the fund’s financial statements for failing to be GAAP compliant and disclose the payments to affiliates, the new Fenway consultant firm.

I assume Fenway was taking the position that the new consultant firm did not meet the definition of “affiliate” under the fund documents and could be carved out separately. Clearly, the SEC does not like this approach. KKR was challenged on taking this position last year by the SEC.

Sources:

Net of Fees Performance Figures

Last year, the U.S. Securities and Exchange Commission looked at how many private equity firms calculate net of fees internal rates of return for their funds. The focus was on whether the performance figures disclosed if general partner investments are included in or excluded from that calculation.

SEC Seal 2

General partners in a private equity fund typically do not pay management or incentive fees. So if the general partner’s capital is included in the net of fees IRR calculation, the net IRR returns would be higher than if that capital was excluded.

I think this distortion will be largely limited to situations where general partner capital is a large percentage of fund assets. One aspect is that calculation of fees in private funds is not tightly regulated as it is for mutual funds. Different strategies will require managers to sho performance in different ways.

Private equity funds have a particularly difficult time with net IRR calculations for funds that are not fully realized. The fees keep tolling as the fund continues through its life-cycle and underlying investments are realized. A fund manager cannot show the net of fees return for a particular realized investment because the standard management fee is not tied to the investment itself, but instead to the life of the private equity fund.

The concern is always that net IRR returns for such funds should not mislead prospective investors. That means inserting adequate disclosure regarding the net IRR calculation methodology.

The SEC has stated that performance should be what a typical investor will experience. A private equity fund manager should construct and show its performance as a typical investor would have its investment perform.
Sources:

KC Royals and Compliance

Congratulations to the Kansas City Royals on winning the World Series. It was their first World Series in thirty years and a year after their heart-breaking loss in Game 7. Mrs. Compliance Building is from Kansas City and ecstatic about the club’s turnaround.

KC Royals

The Mets faltered last night because of emotion. Starting pitcher Matt Harvey stymied the Royals for eight innings. Instead of replacing him with the closer, Mets coach Collins let Harvey convince Collins to keep him in for the ninth inning. As a Red Sox fan, I remember two instances of that same mistake.

Harvey walked Lorenzo Cain, who stole second, and the scored on a double by Eric Homser.  Harvey was pulled and Jeurys Familia quickly became the first man in baseball history to blow three saves in the World Series.

The 2015 Royals are a team about taking chances. After making it to third on a ground ball, Homser took the gamble and made a mad dash from third on a ground ball with one out. Not expecting this, the first baseman threw wide to home, allowing the tying run to score. Then, KC took over in extra innings.

The Royals won eleven games in the 2015 postseason. In seven of them, they trailed by at least two runs at some point, then came back to win. No team had ever done that.

It was not about big bats hitting home runs to come back. It was small-ball: stealing bases, bloops, gap-balls and line-drives.

The Royals were about taking small risks. Not “swinging for the fences.” In part, the team was designed to deal with its market. It can’t afford the big payroll of the Yankees or the Red Sox. It developed its talent in its farm system. It didn’t sign big names. It formed its own culture and groomed the players within its system.

It’s not a big risk, big reward club. It’s a small-ball club that just won the World Series.

“1989 Kansas City Royals away uniform” by Amineshaker
Licensed under CC BY-SA 3.0

Compliance Bricks and Mortar for October 30

These are some of the compliance-related stories that caught my attention while getting ready for Halloween!

Halloween background with pumpkins, frame, no gradients

The Results Are In – SCCE’s 2015 Salary Survey Report Is Now Available by Adam Turteltaub in SCCE’s Compliance & Ethics Blog

The Society of Corporate Compliance and Ethics (SCCE)® is pleased to be able to provide you with the 2015 Compliance and Ethics Officer Salary Survey report. As you will see, we have included data on compensation for both the chief compliance and ethics officer as well as for the compliance staff, giving a fuller picture of the compliance profession in one document.  [More…]

California’s Secured Promissory Note Exemption by Keith Paul Bishop in California Corporate & Securities Law

The line between real property transactions and securities transactions is not always clear. California Corporations Code Section 25100(p) provides an exemption for a promissory note secured by a lien on real property provided it is neither: (a) one of a series of notes of equal priority secured by interests in the same real property; or (b) a note in which beneficial interests are sold to more than one person or entity. However, the fact that a secured note may be exempt under Section 25100(p) will only take you so far.[More…]

“Behavioral compliance”: the will and the way by Jeff Kaplan in Conflict of Interest Blog

“Behavioral ethics” information and ideas have, to date, been used far more to identify ethical challenges than to design approaches to address such challenges. In “Behavioral Ethics, Behavioral Compliance” (which can be downloaded for free here ) Professor Donald C. Langevoort of the Georgetown University Law Center takes up this latter task, and provides a  number of practical suggestions for compliance-and-ethics (“C&E”) professionals to consider in applying this body of knowledge to their day-to-day work. [More…]

 

Are compliance officers crazy? by Richard L. Cassin in The FCPA Blog

So is it crazy to be a compliance officer?

Albert Einstein said insanity is doing the same thing over and over and expecting different results.

Expectations, then, are the key. With the verdict of history in mind, it’s crazy for a compliance officer to expect to bat a thousand against graft. Or to look for constant salutes from the C-suite. Or to think of all prosecutors, regulators, judges, and politicians as natural allies.[More…]

 

Whom Should You Suspend During an Internal Investigation? by Thomas Fox in FCPA Compliance & Ethics

Whom to suspend during any Foreign Corrupt Practices Act (FCPA) investigation is always a delicate question to answer. Unfortunately there is never an easy answer. As the Volkswagen (VW) emission-testing scandal continues to reverberate, it continues to bring up some very knotty questions, which have bedeviled the Chief Compliance Officer (CCO) or compliance practitioner in many areas. Today there is an example around internal investigations.[More…]

 

What qualities should a CCO have; here are nine. by Joshua Horn in Securities Compliance Sentinel

Andrew Donohue, SEC Chief of Staff, recently commented on what a person needs in order to be a competent CCO; he identified nine things. The overarching theme from this list is experience. According to Donahue, in no particular order, a CCO must:

  1. Have a “first hand knowledge” of the regulatory environment.
  2. Have a detailed understanding of the firm, its operations and structure.
  3. Be able to readily identify conflicts of interest, report and resolve them.
  4. Have an understanding of the firm’s business model, including knowledge of firm available products and their profitability.

[More…]

SEC Brings a Real Estate Valuation Action

Real estate is the standard for hard to value assets. But there are plenty of models to help reach a reasonable value. The Securities and Exchange Commission has apparently taken the position that it will not challenge absolute valuations, but will challenge flaws in the models that get to the value. A recent SEC case for improper valuation flaws was brought against a real estate company.

field of schemes

The St. Joe Company is Florida’s second largest private landowner, holding over 500,000 acres of land in the state. The developments in question are known as Victoria Park, Southwood, and WaterColor.

The SEC order states that St. Joe deviated from GAAP and had a flaw in its impairment testing for its real estate developments. The model failed to include some necessary non-capitalized cash outflows. If St. Joe had used the correct model, those developments would have seen impairments of $55 million in Q1 2009 and $19 million in Q4 2009. The blame seems to be on the company for using two different models.

St. Joe also failed to take the pending sales price into consideration for one of the developments. The company had a development for sale at $15 million, but it fell through and went to the second place bidder at $11 million. The company failed to reflect that change in the likely realized price as an impairment. The company also told its auditors that the chance of sale was close to nil.

St. Joe’s problems came to light when David Einhorn of Greenlight Capital thought there was a problem with St. Joe’s accounting and began shorting the stock. His take: “Field of Schemes: If you Build It, They Won’t Come.” Mr. Einhorn then began releasing presentations that St. Joe was overvaluing its real estate developments.

Once the company realized there actually was a problem, it changed its models. But, it failed to go back and review prior periods. That would have resulted in a material restatement.

St. Joe also failed to disclose changes in business strategies for its Windmark II and Southwood real estate developments. The company was halting development and planned a future bulk sale of the sites. Unfortunately, St. Joe booked the value in its 2010 10-K as if it were still planning to develop both sites.

These were big issues. When finally recorded in Q4 2011 St. Joe had a 50% reduction in the value of its real estate and reduction of its total assets of more than 35%.

The order has some exact numbers which I assume are taken from St. Joe’s new valuations. The challenge by the SEC was that the company’s procedures were flawed. That lead to the improper valuations.

St. Joe is a public company so there are some differences with the private real estate fund model. However, it seems consistent with what the SEC is saying about private fund valuations.

The SEC was not fighting over small differences in valuations with St. Joe. There were big discrepancies in values. The SEC was not charging that the values were wrong, but that the way the company got to the values was wrong.

Sources:

OptOutside: REI Taking an Ethical Stance on Black Friday

I hate Black Friday. Being at a store in a sea of sleep-deprived shoppers to find bargains would likely make me lose a little faith in humanity. REI, the outdoor retailer, decided to stand behind its core value:

“We believe a life outdoors is a life well-lived.”

While the rest of the world is fighting it out in store aisles, REI hopes to see you in the great outdoors.

optoutside

REI is closing all of its stores on Black Friday and paying its employees to be outside.

We’re passionate about bringing you great gear, but we’re even more passionate about the experiences it unlocks for all of us. Perhaps John Muir said it best back in 1901: “thousands of tired, nerve-shaken, over-civilized people are beginning to find out that going to the mountains is going home.”

We think Black Friday is the perfect day to remind people of this essential truth.

Is this a move about ethics and corporate value? It sure seems that way.

OptOutside will not be cheap for REI.

It will forego sales. Black Friday is one of its top ten days for sales.

REI will pay nearly all of its 12,000+ employees for the day off. I assume there be some employees still working to keep operations running.

It may even have to pay fines or breach its leases to its landlords at shopping malls. Many retail leases in shopping centers requires stores to be open with the rest of the stores.

Other big retailers taking an ethical stance against Black Friday are merely stopping short of opening on Thanksgiving. REI is standing behind its core values.

I think I will join the stance. I’m already planning a Black Friday bike ride, far away from shopping malls.

Sources:

Another Reminder of the SEC’s Concerns About Private Funds

You have likely heard all or some of these concerns before. Securities and Exchange Commission Chair Mary Jo White spoke at a meeting of the Managed Funds Association and pointed out areas of concern.

SEC Seal 2

One thing to note is Chair White stated that the Private Funds Unit in OCIE is completing a review of private fund real estate advisers. (I assume you would call that a “sweep.”) That particular focus is related-party service providers. SEC staff is concerned that disclosure about these related-party arrangements may be non-existent or potentially misleading, particularly with regard to whether or not the related parties charge market rates.

We have heard that before from Marc Wyatt at PEI’s Private Fund Compliance Forum. It’s generally okay to use related-party service providers if the arrangement is properly disclosed. If the fund manager is going to say that it saves the fund money because the rate is at or below market rate, you need to prove that it actually is at or below market rate.

Chair White cited several other areas of interest for private fund compliance.

  • Using marketing materials that included back-tested performance numbers, portable performance numbers, and benchmark comparisons without key disclosures.
  • Disclosing conflicts related to advisers’ proprietary funds and the personal accounts of their portfolio managers, in particular allocation of profitable trades.
  • Improperly shifting expenses away from the adviser and to the funds or portfolio companies by, for example, charging a fund for the salaries of the adviser’s employees or hiring the adviser’s former employees as “consultants” paid by the funds.
  • Advisers collecting millions of dollars in accelerated monitoring fees without disclosing the practice.
  • Advisers misallocating expenses to funds;[21]
  • Failing to disclose loans from clients;[22]
  • Using funds to pay their operating expenses without authorization and disclosure;[23] and
  • Failing to disclose fees and discounts from service providers.[24]

Sources: