Weekend Reading: A History of the World in Sixteen Shipwrecks

Shipwrecks are tragic, but have been a part of human history since we started making ships. There are an estimated three million ships sitting on the bottom of the oceans, seas, lakes, and rivers of the world. Of that staggering number, Stewart Gordon picked sixteen to tell the story of human history.

A History of the World in Sixteen Shipwrecks

A History of the World in Sixteen Shipwrecks does not tell the story of the most famous wrecks. From the cover, you may think the Titanic makes the list. It does not. There are a few shipwrecks that you will recognize, but most you will not. The book explores how small local maritime travels merged into larger and larger networks of human activity. Technology and finance are the main driving forces.

The one oversight I think is missing from the collection is a container ship. The use of containers and the ships that carry them are main driving force for international commerce. China would not be the global behemoth it has become, if not for the cheap, easy shipping through container ships.

Regardless, the book is well-written and enjoyable to read. Although I was skeptical of the premise, Mr. Gordon does a remarkable job of putting large swaths of history into focus through these sixteen shipwrecks.

The publisher provided a copy of the book for me to review.

ReTIRE Initiative

The SEC said it would focus on matters relating to retail investors saving for retirement and the SEC followed through with the new exam focus: the ReTIRE Initiative.

risk alert

We’ve seen this coming. The National Exam 2015 priorities list stated that OCIE will focus on how retail investors at or nearing retirement are being served by investment advisers and broker-dealers.

Unlike some of the past initiatives, this one seems to look in a different direction than private funds. Unless of course the private fund is being marketed to retirement accounts.

(On a side note, I have mixed feelings about the forced acronym for the initiative. I admit that I said the “Never-Before Examined Initiative” lacked pizazz and a snappy title like “presence exam.”)

SEC examiners will be looking for signs of harm to these investors, in particular with retirement accounts, on four areas:

  1. Reasonable basis for recommendations
  2. Conflicts of interest
  3. Supervision of compliance controls
  4. Marketing and disclosure

These areas are not different or new compared to past initiatives. It just seems the focus is on advice around retired investors and retirement accounts.  That may be an interesting challenge if a firm is not tracking the types of accounts.

For private funds, the Form PF asks a breakdown of fund investors in 14 different categories. Retirement accounts is not one of those categories in Question 16. I’m not sure this is a category that many private funds actually track.

Perhaps the focus may be for self-directed IRAs and the risk of fraud seen in other cases for alternative investments.

Sources:

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Compliance Bricks and Mortar for the July Fourth Weekend

These are some of the compliance-related stories I set aside to read this holiday weekend.

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What Do Rating Agencies Think about “Too-Big-to-Fail” Since Dodd-Frank? by Gara Afonso and João Santos in Liberty Street Economics

Is it possible that, while S&P still expects support for some BHCs, the perceived strength of support has decreased and is now negligible? A look at the chart below reveals a mixed picture. According to S&P, the strength of government support has weakened (as indicated by progressively lighter shading for the uplift measure). However, as the black line suggests, the number of BHCs that could receive support has remained unchanged. In S&P’s view, four large U.S. BHCs (representing 31 percent of the total BHC assets) still retain one notch of uplift relative to their main commercial bank, two notches down from the height of the crisis. [More..]

 

The Role of Chief Compliance Officers Must be Supported by Luis A. Aguilar in the Harvard Law School Forum on Corporate Governance and Financial Regulation

Recently, a fellow Commissioner issued a public dissent in two recent enforcement actions against CCOs of investment advisers. While I respect the views of my fellow Commissioners, based on what I’m hearing from the CCO community, the dissent, and the resulting publicity, has left the impression that the SEC is taking too harsh of an enforcement stance against CCOs, and that CCOs are needlessly under siege from the SEC.

Thus, I am concerned that the recent public dialogue may have unnecessarily created an environment of unwarranted fear in the CCO community. Such an environment is unhelpful, sends the wrong message, and can discourage honest and competent CCOs from doing their work. [More…]

 

Frequently Asked Questions about Regulation A+ by Alexander J. Davie in Strictly Business

While there are a lot of people very excited about Regulation A+ and its possibilities, the reality is much more modest. Here are some of the common questions I receive from clients and potential clients about Regulation A+ and the answers I give in response: [More..]

FIN4 May Have Embarked on a Risky Hacking/Insider Trading Strategy by David Smyth in Cady Bar the Door

[W]e learn that the SEC and the Secret Service are investigating a sophisticated computer hacking group known as “FIN4” that allegedly “has tried to hack into email accounts at more than 100 companies, looking for confidential information on mergers and other market-moving events. The targets include more than 60 listed companies in biotechnology and other healthcare-related fields, such as medical instruments, hospital equipment and drugs.” Apparently their plan is to harvest this information and then trade on it. Nobody knows where FIN4 is from. They could be overseas, but supposedly their English is flawless and they have a deep knowledge of how financial markets work, so maybe they’re in the United States. At one level, a little terrifying! [More….]

 

Pink Flamingos and the Compliance Audit by Tom Fox in the FCPA Compliance and Ethics Blog

The creator of one of the most ubiquitous symbols of mid-century Americana died earlier this week. Don Featherstone, the creator of the pink plastic lawn flamingo, the ultimate symbol of American lawn kitsch, has died. He was 79. Featherstone, a trained sculptor with a classical art background, created the flamingo in 1957 for plastics company Union Products, modeling it after a bird he saw in National Geographic. Millions of the birds have been sold. Whether you think of the Pink Flamingo as a symbol of Miami Vice, Jon Waters and Devine or for something less salacious, here is to Featherstone, a true original.

While Featherstone created one of the ultimate symbols of the second half of the 20th century for a generation of South Floridians, the Japanese company Takata Corporation (Takata) continues to be in the news for much less prestigious reasons. As reported in the New York Times (NYT), in an article entitled “Senate Panel Says Tanaka Cut Audits on Safety”, Hiroko Tabuchi and Danielle Ivory said “In the middle of what would become the largest automotive recall in US history, the Japanese airbag manufacturer Takata halted global safety audits to save money”. Interesting (or perhaps ominously might be a better word) Takata responded by saying it had not halted safety audits for products but rather for worker safety. Doesn’t that give you some comfort? [More…]

 

DOJ Joins Instagram … Your Move, SEC! by Bruce Carton in Compliance Week

The DOJ sees your Pinterest account, SEC, and raises you an Instagram account! Today the DOJ announced on the front page of its website that it has taken the Instagram plunge. [More…]

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How to Allocate Broken Deal Expenses After the KKR Case?

The Securities and Exchange Commission charged Kohlberg Kravis Roberts & Co. (KKR) with misallocating more than $17 million in “broken deal” expenses to its private equity funds as a breach of KKR’s fiduciary duty. The SEC felt that KKR should not have charged all of those broken deal expenses to the Fund.

But how should you allocate those broken deal expenses?

kkr sec

KKR incurred $338 million in broken deal or diligence expenses.  Even though KKR’s co-investors, including KKR executives, participated in the firm’s successful transactions efforts, KKR largely did not allocate any portion of these broken deal expenses to them. KKR put a policy in place in 2012 to address the allocation of expenses.

Perhaps KKR had something programatic in place, with regular co-investments. The problem for most co-investment deals is that they are put together ad-hoc. The fund is generally the primary participant and would be pursing the transaction regardless of co-investors.

The fund would be incurring the deal expenses. The fund documents provide that the fund will pay for deal expenses.

Generally, for co-investments there is no document providing for the payment of deal expenses until the transaction closes. So there is no mechanism for the payment of broken deal expenses by potential co-investors. Fairly or unfairly, that leaves the fund paying the broken deal expenses. It seems that the SEC thinks that is unfair.

According to the SEC’s order against KKR, the firm had come up with a policy for dealing with broken deal expenses. In my reading of the order, it looks like the SEC made KKR apply the policy retroactively from 2012 to the beginning of the fund and return a portion of the broken deal expenses to the fund. I would guess that KKR is not able to get those expenses from the potential co-investors, leaving the management company holding the bag for the costs.

It does not seem fair that the management company should bear the burden of the broken deal expenses when the fund documents and investor expectations would be that the fund carry the burden of broken deal expenses.

The question is “at what point does the co-investment opportunity become such a part of the transaction that the broken deal expenses should be shared?” Of course, the second question, and perhaps the answer to the first is “at what point is the co-investor so committed that it is willing to pay a portion of the broken deal expenses?” I think the answer to the second question is often “never.” That puts the answer at odds with the expectations of the SEC.

Sources:

Allocation of Broken Deal Expenses

The Securities and Exchange Commission charged Kohlberg Kravis Roberts & Co. (KKR) with misallocating more than $17 million in “broken deal” expenses to its private equity funds. The SEC found this to be a breach of KKR’s fiduciary duty.

kkr sec

An SEC investigation found that from 2006 to 2011, KKR incurred $338 million in broken deal or diligence expenses.  Even though KKR’s co-investors, including KKR executives, participated in the firm’s successful transactions efforts, KKR largely did not allocate any portion of these broken deal expenses to them. According to the SEC Order, there was a partial allocation to certain co-investors in 2011.

The main KKR fund invested $30.2 billion in successful transaction, while co-investors put in $3.9 billion and KKR executives put in $750 million.

In June 2011, KKR began examining its allocation strategy and recognized a problem. That resulted in that first allocation in 2011. In January 2012, KKR implemented its new allocation policy and began charging less in broken deal expenses to the fund and some to co-investors and executives.

Then in 2013 OCIE knocked on KKR’s door and conducted an exam. During the exam, KKR refunded $3.26 million to the fund for mis-allocation from 2009 to 2011.  The SEC wanted more and claimed that there was another $17.4 million in broken deal expenses that were improperly allocated to the fund based on the 2012 allocation policy.

The period in question goes back to 2006. That pre-dates KKR’s 2008 registration and most private equity fund’s Dodd-Frank registration in 2008. The SEC’s claim is under 206(4) of the Adviser Act which applies regardless of whether the fund manager is registered.

Sources:

SEC Loosens the Standards in Trade Monitoring

One of the more difficult aspects of a private equity fund when it registers as an investment adviser is dealing with the Rule 204A-1 requirement of monitoring employee trading. The SEC recently issued guidance on the applicability to managed accounts when there is no direct or indirect influence or control.

im guidance update

The Guidance focuses on the code of ethics rule: Advisers Act rule 204A-1. The rule requires supervised persons to report their personal securities holdings and transactions. Subsection (b)(3)(i) offers an exception to the personal trading review requirement provided the supervised person has “no direct or indirect influence or control.”

Typically, CCOs have taken a hard line on this and the SEC has as well. For example, the hard line standard had typically been a blind trust, where the access person has no influence or control, and may not even know the holdings in the accounts. Some CCOs have take a more liberal approach. Clearly, the SEC has seem some CCOs incorrectly determine that some access persons’ trusts and third-party discretionary accounts qualify for the exception when they don’t.

Under the Guidance, the SEC is demanding more diligence.

Having “a third-party manager with discretionary authorities isn’t enough to qualify for the exception.” That does not eliminate actual or possible influence on what securities the third-party manager sells or purchases. The Guidance recommends CCOs probe deeper with managed accounts.

The Guidance states that obtaining a general certification alone is insufficient to determine if the access person exercised direct or indirect influence or control. The Guidance recommends that the CCO issues some probing questions:

“Did you suggest that the trustee or third-party discretionary manager make any particular purchases or sales of securities for account X during time period Y?”

“Did you direct the trustee or third-party discretionary manager to make any particular purchases or sales of securities for account X during time period Y?”

“Did you consult with the trustee or third-party discretionary manager as to the particular allocation of investments to be made in account X during time period Y?”

The Guidance may offer some relief for CCOs that took the hard line on the definition of managed accounts. On the other hand, it may he a tougher standard for those CCOs who took a more liberal view. In either case, there is clear guidance.

Sources:

Can a Real Estate Fund Manager Be a Venture Capital Fund Manager?

The Dodd-Frank Wall Street Reform and Consumer Protection Act split the world of fund managers into a few groups. One group that was able to grab a limited exemption from the Investment Advisers Act registration was venture capital fund managers. What does it take to be a venture capital fund manager? And could a real estate fund manager take advantage of it? I ask because I came across a real estate crowdfunding platform that took this choice.

Venture Capital - Inscription on Red Road Sign on Sky Background.

Under Rule 203(l)-1, a venture capital fund is any private fund that:

(1) Represents to investors and potential investors that it pursues a venture capital strategy;

(2) Immediately after the acquisition of any asset, other than qualifying investments or short-term holdings, holds no more than 20 percent of the amount of the fund‘s aggregate capital contributions and uncalled committed capital in assets (other than short-term holdings) that are not qualifying investments, valued at cost or fair value, consistently applied by the fund;

(3) Does not borrow…… in excess of 15 percent of the private fund‘s aggregate capital contributions and uncalled committed capital, and any such borrowing, indebtedness, guarantee or leverage is for a non-renewable term of no longer than 120 calendar day….;

(4) Only issues securities the terms of which do not provide a holder with any right, except in extraordinary circumstances, to withdraw, redeem or require the repurchase of such securities but may entitle holders to receive distributions made to all holders pro rata; and

(5) Is not registered under section 8 of the Investment Company Act of 1940 (15 U.S.C. 80a-8), and has not elected to be treated as a business development company pursuant to section 54 of that Act (15 U.S.C. 80a-53).

I gave up on this treatment because the debt limitation in (3) makes it hard to use a subscription secured credit facility. But if you’re not using a credit facility, the other provisions seem achievable for private equity funds or other funds investing in private securities, including real estate.

The big limitation would be that the fund “pursues a venture capital strategy.”

So I poked around looking for a definition of “venture capital” or “venture capital strategy” in the SEC’s rule release.

The rule and its release never bother to define “venture capital” or “venture capital strategy.” The rule merely states that the fund manager has to represent that it pursues a venture capital strategy. I found no color on what is and what is not “venture capital” or “venture capital strategy.”

I poked around on the National Venture Capital Association website. I thought the big trade association would have an easy to find definition. I was wrong. I could not find a meaningful definition of “venture capital.”

At the end of 2013, the SEC issued a guidance update on the exemption for advisers to venture capital funds. This guidance helped with some of the legal structures and the terms “qualifying investments” in part (2) of the definition. It does not discuss “venture capital strategy.”

I looked at some of the real estate crowdfunding platform’s documents and found these provisions:

In addition, the Subscriber understands that the Manager is not registered as an investment adviser under the Investment Advisers Act of 1940, as amended. The Manager is expected to be treated as an investment adviser exempt from federal or state registration under the venture capital strategy being pursued by the Company….

The Company is pursuing a venture capital strategy through investments in operating companies that manage and develop real estate.

I think it’s a bold approach to call itself a venture capital fund manager. But it kind of works. It may not make sense from a common sense perspective or a common expectation of what “venture capital strategy” is. But it’s a term that is not well defined in common practice. The SEC did not even try to define it.

The big problem is the consequences. The release for Rule 203(l)-1 says that you can’t merely state that you are pursuing a venture capital strategy; You have to actually pursue that strategy. (Again, without defining it.)

In the rule release, the SEC also states that it is a violation of the anti-fraud provisions if you merely state that you are pursuing a venture capital strategy when you are not actually engaged in that strategy.

A real estate fund with an opportunity investing style or value-add investing style could argue that it is a “venture capital strategy.” Those fund types are looking to invest in companies and get them to grow. Of course, each investment is likely a single-asset real estate company.

I would not sleep well at night, worrying that the SEC was going to challenge that regulatory choice.

Sources:

Compliance Bricks and Mortar for June 19

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

bricks and mortar

Ethisphere Announces the 2015 Attorneys Who Matter

 Honorees represent all areas of practice including federal agencies, in-house counsel, top ethics and compliance officers of major companies, and outside counsel. Each one raises the bar for ethical behavior and boasts a commendable track record of public service, legal community engagement, and academic involvement. [More…]

Never Tick Off a Redbird by Tom Fox in the FCPA Compliance and Ethics Blog

As to the Cardinals, what on earth could the Astros have that they could possibly want? Take the Astros record over the past five years; it’s the worst in baseball. You want a piece of that? How about secret information on the leadership savoir fare of the Astros owner ‘Mr. I am smarter than everyone in the room because I made a $100mm in business’ Jim Crane. Why be one of the best-run sports franchises, when you can mimic the Astros? First you can tell everyone how stupid they are because they do not understand how it is in your interest to try and lose; next why you should cut off over 70% of your fan base from even watching games on television so they will not see your joke of a team play and, finally, how to sue the prior owner who sold you the team for mis-representing the quality of the assets.

Why the SEC can’t easily solve Appointments Clause problem with ALJs by Alison Frankel for Reuters

It seems as though there ought to be an easy way for the Securities and Exchange Commission to stomp out claims that its in-house judges are unconstitutionally appointed through a bureaucratic process, a defense theory that has spread as fast among SEC defendants as viral cute-animal memes on the Internet. But the SEC has so far avoided even addressing the potential consequences of that quick fix – perhaps because the solution isn’t so simple after all. If the SEC changed the way it appoints in-house judges, the fix could call into question the outcome of scores of past and present SEC enforcement actions as well as cases at other regulatory agencies.

 

wall street

You Can Finally Spend That Extra $12,000 On A WALL ST Vanity Plate by Alexander C. Kaufman in The Huffington Post

The seller bought the plates when they first became available in 1976, and he slapped them on his brand-new Chrysler Cordoba, according to Bloomberg Business. At the time, the Saratoga Springs resident, whose name hasn’t been reported, was working at the brokerage firm E.F. Hutton.

Now, the plates are attached to his 2002 Mercedes-Benz S-Class sedan. And, yeah, you get the car if you buy the plates, per Bloomberg.

pmc-badgeIf you enjoy reading Compliance Building, please consider making a donation to my Pan-Mass Challenge bike ride. 100% of your donation goes to support cancer research.

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I Ask For Your Money

Compliance Building is a free resource I publish for me, and share with you, to help the compliance profession. It will still be free, but I’m asking for money.

I should point out that the money is not for me; It’s for charity.

I’m riding the 2015 Pan-Mass Challenge to raise money for the Dana-Farber Cancer Institute.
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Please support me.

If everyone who reads Compliance Building donated a few dollars I would exceed my fundraising goals. (Make a donation here.)

I’m really looking to the smaller group of loyal readers. A group that I think gets some value from what I publish. If you think it’s worth $1 a week. Then, please contribute $50… (Or More)

The ride is 192 miles over two days from Sturbridge to Provincetown. If I hit my fundraising goal, I’m going to add on another 100 miles and a third day of riding from the New York border over the Berkshires to Sturbridge.

Why am I riding and raising money?

1. Cancer Sucks. I’m sure that someone you know has been attacked by cancer. We are winning the war the cancer. Your donation will help win the war.

2. My Dad. He just fought a battle with cancer. And won, thanks to help from the Dan-Farber Cancer Institute. It’s a battle that my aunt and uncle, his brother and sister, did not win.

3.  Action Dave. My friend was diagnosed with metastatic oropharyngeal cancer in November of 2013. The Dana-Farber Cancer Institute helped him beat back the disease. I’ll be riding by his side during the PMC.

4.  Jack Ramsden. In 2005 I rode the Pan-Mass Challenge with Team Kinetic Karma. The Team’s Pedal Partner was Jack. In March 2004, a then seven-month-old Jack was diagnosed with Stage IV Neuroblastoma, a rare and aggressive childhood cancer. This young boy valiantly endured treatments that have been known to kill grown men. With piercing blue eyes and a contagious smile, he defied the expectations of his doctors. But in the end, he could not overcome the disease. He passed away in December 2008.

5. 41 Million. That’s how big a check the Pan-Mass Challenge wrote to the Dana Farber Cancer Institute in 2014. Every dollar you donate will help that check be bigger in 2015.

6. 100%. The Pan-Mass Challenge donates 100% of every rider-raised dollar to Dana-Farber Cancer Institute through its Jimmy Fund. (I pay an extra fee to pay for the ride expenses.) The PMC raises more money for charity than any other single event in the country.

Please Donate

Please donate to my PMC ride at one of the following links:

Thank you for your support.

Doug

The SEC Goes After the Gate Keeper

When a fraud is uncovered, the Securities and Exchange Commission no only wants to get the fraudsters, it also wants to get those who should have stopped the fraud. The SEC just brought an action against an IRA Custodian for ignoring red flags for its accounts that invested in Ponzi schemes.

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The underlying fraud was conducted by Ephren Taylor with his City Capital Corporation investment fraud, and Randy Poulson with his Equity Capital Investments fraud. Taylor was convicted and was sentenced to 235 months in prison. Poulson has been indicted but is still fighting his case.

Equity Trust is a leading provider of self-directed IRAs. The firm pushes the laudable goal of seeking diversity outside of the stock market. It’s successful, with over 30,000 clients and approximately $12 billion of assets in custody.

According to the SEC complaint, the problem is that the firm’s salespeople have goals of opening accounts. That lead at least one unnamed salesperson to enter into a cozy relationship with Taylor and City Capital. Equity Trust’s accounts were a source of new capital for its Ponzi scheme and City Capital was a source of new accounts for Equity Trust.

The relationship was too cozy for the custodian from the view of the SEC. The salesperson was pushing its client accounts at Taylor and City Capital.

For example, in an email dated January 14, 2009, Salesperson A wrote to Taylor that he learned that the broker of an Equity Trust customer recommended to the customer that she not invest in Taylor Notes. Salesperson A then told the customer, “‘how can you comment on something you know nothing about….how can this broker comment on real estate when he has never done it.’” The customer responded, “‘great point’ let’s do it.” Salesperson A concluded his email to Taylor stating: “I am on it…I will close it.” The customer then invested more than $500,000 in Taylor Notes.

The salesperson trained City Capital on the use of self-directed IRAs. The firm even hosted a webpage for potential investors. The City Capital notes came in poorly documented and started having repayment issues. The firm began escalating holds and added City Capital to the “do not process” list. The firm continued to process existing accounts and collect fees. But did not inform the account holders of the problems with City Capital.

A similar story occurred with the Poulson’s investment fraud. Accounts were open and investments made, but the documentation was poor or missing. During one review, 25 out of 25 accounts were missing proper documentation. But Equity Trust continued to process to new accounts. It was only a year later that the firm put a stop on new investments.

The description above comes from the SEC charges which Equity Trust is contesting. The SEC also re-issued an investor alert on self-directed IRAs and the risk of fraud.

In my reading of the complaint, Equity Trust is charged with not acting quickly enough to stop investments in these two fraudulent schemes. At least one of the salespeople went too far and encouraged investment in the Ponzi scheme.

Sources:

Château de Crécy-la-Chapelle: Gate is by Baishiya 白石崖
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