Header graphic for print

Cady Bar the Door

Insight & Commentary on SEC Enforcement Actions and Related Issues

Keeping Internal Investigations Independent and Conflict-Free

By David Smyth on Posted in Accounting Fraud, Auditors, Financial Fraud, Investigations

Internal investigations can arise in a number of different ways and can concern a number of different subjects.  Allegations of financial misconduct, employment-related missteps, and breaches of fiduciary duty, among others, can all lead a company in that direction.  Grand jury subpoenas, search warrants, target letters, media reports, whistleblower claims, audit reports, and routine risk assessments can often require senior management, the board of directors, or a board’s audit committee to begin an internal review.  If the concerns are serious enough, an internal investigation may be necessary to determine: (1) what happened, (2) if wrongdoing occurred, and (3) what the company’s potential exposure may be.

If conducted intelligently, a strong internal investigation can minimize damage from an ethical breakdown and convince regulators or prosecutors that corporate misconduct is under control.  But to make that happen, it is critical that conflicts of interest not undermine the work a bulletproof investigative report can do.  Two matters in 2013 have made the point plainly.

Le-Nature’s, Inc.

In March, the U.S. Court of Appeals for the Third Circuit affirmed the conviction of Le-Nature’s, Inc.’s former executive vice president, who had participated in a $660 million accounting fraud scheme.  The scheme was missed by an internal investigation that was hopelessly conflicted and had no real chance of identifying the financial irregularities that ultimately sank the company.

Here’s how the investigation played out, according to the Superior Court of Pennsylvania.  As part of standard quarterly audit procedures, the engagement partner at Le-Nature’s auditor solicited the concerns of three senior managers regarding the company’s financial activities, and asked whether they suspected fraudulent activity.  The CFO, chief administrative officer, and vice president of administration all expressed concerns about the accuracy of Le-Nature’s sales figures, and resigned shortly thereafter.  In their resignation letters, the officers said they suspected CEO Greg Podlucky’s potential misconduct with the company’s vendors, suppliers, and customers.  The CFO, John Higbee, noted in particular that Podlucky had denied him access to documentation supporting   Le-Nature’s general ledger details.  Higbee explained that by conducting business transactions “without any normal review by others, such as the CFO,” Podlucky had rendered it impossible for Higbee to discharge his responsibilities to Le-Nature’s.

The auditor soon requested that Le-Nature’s hire “competent independent legal counsel to conduct a thorough and complete investigation of the allegation made by the” senior managers.  The company’s board of directors then appointed a special committee to do just that.  The special committee hired an outside law firm, which in turn hired a forensic accounting firm to assist in the investigation.

Three months later, the law firm provided a draft of its report to Podlucky, who was not a member of the special committee and whose conduct was the subject of the investigation.  The special committee had not received a copy of the draft report, but Podlucky immediately called a meeting of the board of directors to discuss it.  Podlucky also provided comments to the law firm on the draft report.  About ten days later, the law firm provided the draft report to the special committee.

The accounting firm and the law firm approved the report.  Unsurprisingly after the filter put on it by Podlucky, the report “found no evidence of fraud or malfeasance with respect to any of the transactions” subject to the investigation.  As the Pennsylvania Superior Court said, Podlucky and his senior managers used this stamp of approval to retain their positions at Le-Nature’s and to continue to “loot” the company, “incurring further corporate debt and wasting corporate funds on avoidable transactions.”

The internal investigation, ostensibly designed to root out an ongoing fraud, instead became a tool of the fraud.  Compromising the investigation’s independence led to hundreds of millions in losses at Le-Nature’s and criminal convictions of seven company executives and consultants.  The defendants were convicted in the U.S. District Court for the Western District of Pennsylvania for mail fraud and money laundering violations.

Chesapeake Energy Corp.

For now, the second instance is less dramatic.  In February, the audit committee of the board of directors of Chesapeake Energy Corporation concluded an internal investigation into (1) whether CEO Aubrey McClendon had engaged in misconduct by privately borrowing hundreds of millions of dollars from some of the company’s biggest financiers; and (2) potential antitrust violations during Chesapeake’s acquisition of drilling rights in a Michigan shale formation.  The investigation by the committee and another outside law firm lasted ten months and involved more than 50 interviews with executives from Chesapeake and other companies.  The probe found no intentional misconduct by McClendon.

Unfortunately for McClendon and Chesapeake, government regulators were not placated.  Michigan Attorney General Bill Schuette, who had begun an antitrust inquiry into Chesapeake, was especially unimpressed with the supposed independence of the internal investigation that had cleared McClendon.  Shortly after Chesapeake announced the results of its internal probe, his spokeswoman said: “The importance of independent – rather than internal – investigations cannot be emphasized enough in a case involving antitrust bid-rigging allegations.  Our thorough, independent investigation into these serious allegations will continue.”

Chesapeake’s internal investigation also did not deter the SEC.  Nine days after the supposed all-clear, the SEC escalated its investigation into the company, converting its informal inquiry into a formal investigation, complete with subpoena power.

“I’m now confused because the board just said everything was fine,” said Fadel Gheit, an oil analyst at Oppenheimer. “I really thought the board had an iron-clad, air-tight grip on the situation.  Unfortunately, the saga continues.”

It is unclear exactly what factors led the SEC to disregard the results of Chesapeake’s internal probe.  But the independence of the investigation certainly seemed compromised to the Michigan Attorney General’s Office.

The lessons from these two episodes should be clear.  When conducting internal investigations, outside counsel should bear in mind who is being represented.  In most instances, the client is the company and not the CEO or any particular member of senior management.  Remembering that should keep investigators’ eyes on the ball and lead to a result that will optimize results and minimize costs for the company.

The SEC Does Not Care about Your FINRA Document Request

By David Smyth on Posted in Broker-Dealers, FINRA

If you are a broker-dealer or a registered representative at one, you sign on for some meddling by FINRA.  The self-regulatory organization is responsible for overseeing your securities business and even for your outside business activities.  So if FINRA asks you for documents related to those activities, you pretty much have to turn them over.  Gregory Evan Goldstein found this out the hard way in an SEC administrative opinion in February.

Facts and Procedure

FINRA began investigating one of its member firms, Marquis Financial Services, Inc. and its employees, including Goldstein, in 2010 after receiving a referral about suspicious trading in penny stocks at Marquis.  During the investigation, FINRA learned that Goldstein had been operating an outside consulting business called Wall Street at Home.com, Inc., since at least 2005, but had failed to report that activity as FINRA Rule 3270 requires.

As Goldstein stipulated, Wall Street at Home is an indirect owner of Marquis: Wall Street at Home owns 100 percent of a holding company called Steven Gregory Securities, which in turn owns at least 95 percent of Marquis.  Goldstein also stipulated that he is the president of all three companies and the sole officer and voting stockholder of Wall Street at Home and that neither Steven Gregory Securities nor Wall Street at Home ever had any employees.

On January 9, 2012, FINRA staff conducted an on-the-record interview of Goldstein pursuant to Rule 8210, during which FINRA staff asked Goldstein questions about his activities at Wall Street at Home, including the company’s ownership structure.  Goldstein declined to identify any minority shareholders or to acknowledge whether Wall Street at Home had any investment accounts.  Goldstein also declined to identify any customer for whom he provided consulting work or to specify an industry in which he had performed such work.  After the interview, FINRA sent Goldstein a written request for information and documents pursuant to Rule 8210, and again zoned in on the ownership of Wall Street at Home.  Goldstein refused to respond to the written requests, claiming FINRA had no authority to require an associated person to produce documents relating to a third party.

The FINRA staff did not love this response, and issued a notice of suspension to Goldstein on March 13, 2012.  A FINRA hearing panel suspended Goldstein on January 4, 2013, finding that he had failed to respond to FINRA’s requests as he was required to do under Rule 8210.

Goldstein’s Appeal

Goldstein appealed his suspension and moved to stay the imposition of any sanctions.  He argued that by asking for documents and information about an unrelated third party, FINRA engaged in an impermissible fishing expedition and violated his due process rights.  FINRA opposed Goldstein’s motion, arguing that its rules expressly require associated persons to disclose outside business activities “precisely for the purpose demonstrated here – to enable both member firms and FINRA to oversee and, if necessary, investigate associated persons’ activities away from member firms.”  FINRA added that, because of Wall Street at Home’s close connections to both Goldstein and Marquis, Wall Street at Home is not an unrelated third party.  “Indeed,” FINRA argued, “the business and financial affairs that Goldstein operates through Wall Street At Home have a direct relationship to Marquis Financial’s customers because they purchased minority interests in Wall Street At Home through Marquis Financial.”

The SEC’s Decision

As for Goldstein’s motion, the SEC was not impressed.  As the opinion noted, Rule 8210 expressly requires associated persons to provide information and testify “with respect to any matter involved in [a FINRA] investigation, complaint, examination, or proceeding.”  The rule also says flatly, “No member or person shall fail to provide information or testimony or to permit an inspection and copying of books, records, or accounts pursuant to this Rule.”  Here, the SEC did not find FINRA to be seeking information from an unrelated third party but, rather, information about Goldstein himself.  Wall Street at Home was simply not an unrelated party, as it had close ties to both Goldstein and Marquis.  Goldstein also did not establish that FINRA’s requests raised “privacy and confidentiality issues,” as FINRA investigations are non-public and confidential.  The SEC also said Goldstein appeared unlikely to succeed on his due process claims because FINRA is not a state actor.  Under Exchange Act Section 15A(b)(8), FINRA is required only to “provide a fair procedure for the disciplining of members and persons associated with members.”

Again, if you’re a broker-dealer or registered representative, you can’t dance around your obligations to provide documents and testimony when FINRA asks for them.  Your securities business is under scrutiny.  Even your non-securities business is under scrutiny.  Answer the call or get into another line of work.

SEC Dings Investment Adviser for Custody Violations, Failure to Supervise

By David Smyth and Elizabeth E. Spainhour on Posted in Compliance, Investment Advisers, Non-scienter-based Violations

Readers of this space – and SEC observers generally – will recall a March 4 risk alert designed to warn investors about the ways U.S. investment advisers had recently been found to have violated the SEC’s asset custody rule.  The number and variety of violations were legion.  Advisers were not assuring themselves that clients were receiving quarterly account statements.  They weren’t subjecting themselves to surprise examinations designed to assure compliance with the rule.  The list went on, and the Commission’s Office of Compliance Inspections and Examinations closed with a polite reminder that “[a]dvisers may want to consider their policies and procedures and their compliance with the custody rule in light of the deficiencies noted in this Alert.”

Apparently the memo came a bit too late for Vector Wealth Management.  On April 18th, the SEC brought a settled enforcement action against the Minnesota-based investment advisor for alleged violations of the custody rule and for failing to properly supervise an employee who misappropriated client funds.

Facts

According to the administrative order, Vector discovered that one of its clerical employees, Charles Fee, misappropriated $33,147 of dividends owed to four clients over a period of about 2½ years.  A Vector principal had check-signing authority over particular investment pools but had delegated to the clerical employee the responsibility to prepare distribution checks.  Fee allegedly wrote checks to himself and – somehow . . . Jedi mind trick? – had the principal sign them.  Vector learned about the scheme while trying to reconcile an unrelated, potentially erroneous payment, and then quickly self-reported Fee’s conduct to the SEC’s staff.  The Commission charged Fee separately with violations of Section 10(b) of the Exchange Act.

Unfortunately, Vector had not prepared itself for such a scenario.  Before discovering the scheme, Vector had failed to adopt or implement procedures reasonably designed to prevent violations of the custody rule.  Specifically, the adviser had not ensured that investors in its pooled vehicles were receiving quarterly account statements or audited financial statements on an annual basis.  Vector also failed to conduct an annual compliance review of its advisory activities.

Custody Rule

Rule 206(4)-2 generally provides that it is “fraudulent, deceptive, or manipulative” for any registered investment adviser to have custody of client funds or securities unless, among other things, the adviser has a reasonable basis for believing that a qualified custodian is sending quarterly account statements to each of the clients for which it maintained funds or securities.  The rule is designed to protect advisory clients from the misuse or misappropriation of their funds and securities.  Vector failed to send any quarterly statements related to the investment pools at issue during the relevant period.

The rule also required Vector to undergo a surprise examination by an independent public accountant at least once a year, but Vector failed to do so for the investments pools at issue.

Finally, Vector’s alleged failure to adopt policies and procedures reasonably designed to prevent violations of the custody rule violated Rule 206(4)-7.

Failure to Supervise

Section 203(e)(6) of the Advisers Act authorizes the Commission to impose sanctions on an investment adviser if it “has failed reasonably to supervise” those subject to its supervision.  Here, Vector allegedly failed to reasonably supervise its employee Charles Fee in a manner that would have prevented his misappropriation scheme.

For this string of violations, the SEC censured Vector and imposed a rigorous compliance regime, including the appointment of an independent compliance consultant and reporting obligations.

Our Take

Several lessons arise from this case.  First, advisers have to keep a close watch on all of their client assets.  This was not a huge amount of money, and Vector notified its clients of the scheme and repaid them with interest.  But the SEC cares very much about custody rule breakdowns like this, and will punish violators and their supervisors.  Second, advisers have to be aware of the conduct of their investment adviser representatives and their clerical employees, especially if they have access to client funds.  Advisers should consider whether their routine procedures for check writing and other instances where money could leave the building are sufficiently rigorous.  If a firm’s principal cannot figure out that checks are being written directly to lower-level staff, think about whether checks should be double-signed by firm management.  Finally, Vector avoided a civil penalty here based on its cooperation, but the independent compliance consultant will not be much fun to pay for.  Investment advisers should get a handle on their custody rule obligations or they will pay, one way or the other.

Ralph Lauren Escapes FCPA Problems with Minimized Damage

By David Smyth on Posted in FCPA

Often, enforcement officials at the SEC and the Justice Department express their wish that securities law violators own up to their (mis)conduct as soon it comes to light.  That is, come to the government and explain what has happened.  Almost as often, though, those officials have a difficult time describing the tangible benefits of doing so.  Even for responsible corporations, it can be hard to know when to self-report, and, in truth, it is a minefield.  On one hand, disclosing a potential issue when the government may never learn of it can seem too hasty.  On the other hand, companies would rather present potential issues on their own terms, and without responding to subpoenas if the government does find out.  What to do.

Companies received at least a bit of data on this score this morning, when the SEC and DOJ released non-prosecution agreements addressing potential FCPA violations by Ralph Lauren Corporation in Argentina.

Underlying Facts

From approximately 2005 through approximately 2009, Ralph Lauren Argentina’s general manager and others allegedly approved bribe payments to be made to Argentine customs officials through a third party customs broker to assist in improperly obtaining paperwork necessary for Ralph Lauren products to clear customs, to permit clearance of items without the necessary paperwork, to permit the clearance of prohibited goods, and to avoid inspection of products by Argentine customs officials.  These alleged payments were not exactly for the purpose of obtaining or retaining business, as is required for violations of the FCPA’s anti-bribery provisions, but at $568,000, the payments were too high to fit well into the FCPA’s exception for facilitating payments.

In addition to the customs-related payments, allegedly the Argentina general manager directly provided or authorized that several gifts be made to Argentine government officials to secure the importation of Ralph Lauren products.  The gifts to three different officials included perfume, dresses and handbags valued at between $400 and $14,000 each.

The SEC’s non-prosecution agreement also found that Ralph Lauren Corp. failed to devise and maintain a system of internal controls sufficient to provide reasonable assurances that such payments could be caught and prevented.

Ralph Lauren Corp.’s Reaction

From the government’s perspective, the important part of all of this was how the payments were discovered and what Ralph Lauren did in reaction to them.  As part of a general tightening of its corporate compliance programs, in 2010 the company adopted a new FCPA policy.  Several months later, Argentina employees reviewed the policy and raised concerns about the company’s customs broker in Argentina.  An internal investigation discovered the payments and gifts to Argentine. Within two weeks of uncovering the payments and gifts, RLC self-reported its preliminary findings to the both the SEC and the DOJ.

Upon discovering the bribes, Ralph Lauren Corp. fired its customs broker.  It also thoroughly reviewed and enhanced its pre-existing compliance program with (1) an amended anticorruption policy and translation of the policy into eight languages, (2) enhanced due diligence procedures for third parties, (3) an enhanced commissions policy, (4) an amended gift policy, and (5) in-person anticorruption training for certain employees.

As part of its “extensive, thorough, real-time cooperation” with the staff of the SEC and DOJ, the company also agreed to

  • produce documents and disclose information to the government;
  • provide accurate translations of documents;
  • make witnesses available for interviews; and
  • conduct a risk assessment of certain other world-wide operations.

My Take

Another thing Ralph Lauren Corp. chose to do was cease retail operations in Argentina.  The company can obviously make its own decisions, and perhaps it did not view the reward from doing business there as worth the corruption risk.  But I hope withdrawal from Argentina was not a condition of the non-prosecution agreements.  The agreements themselves don’t say that it was, but it would be an unfortunate result if companies heard the message that staying out of global markets was a prerequisite for compliance with the FCPA.

Separately, this matter is a significant data point for those counseling for early disclosure to the government.  The company was subject to financial sanctions – $700,000 to the SEC and an $882,000 criminal penalty to the Justice Department – but escaped other penalties.  The penalties might have been much worse if the company had waited until it was forced to respond on the government’s terms.

SEC Highlights Compliance and Ethics for Broker-Dealers

By David Smyth on Posted in Broker-Dealers, Compliance

On Tuesday the SEC held a National Compliance Outreach Program for Broker-Dealers at an open meeting at its D.C. headquarters.  The first panel – titled The Role of Compliance and Ethics – was nominally targeted to broker-dealers, but its lessons could be applied to any businesses under significant regulatory scrutiny.

The participants were:

  • Merri Jo Gillette, Director, SEC’s Chicago Regional Office, SEC (Moderator)
  • Alan Cohen, Head of Global Compliance, Goldman Sachs & Co.
  • John Hanson, Founder and Executive Director, Artifice Forensic Financial Services, LLC
  • Chris Mahon, SVP and Head of Broker-Dealer Legal and Regulatory, AllianceBernstein/Sanford C. Bernstein, and
  • Allen Meyer, Head of Compliance, Barclays Corporate and Investment Banking

What is Compliance?  What is Important to It?

Alan Cohen started the conversation by defining compliance as reputational and legal risk management.  He said the most important thing for compliance officers is to be embedded in the right places.  That is to say, you can’t be a risk manager if you don’t know what’s going on in your business and are not included where decisions are made.  Barclays’ Allen Meyer added it is also important for compliance personnel to document what their roles are and have early input into new product creation.

John Hanson’s perspective was a bit different from others on the panel.  His company, Artifice Forensic Financial, often functions as an independent corporate monitor after the government has penalized a company for some sort of misconduct.  Hanson said that ethics are critical to any compliance program.  Paraphrasing Hanson’s metaphor, a compliance program without substantial ethical underpinnings is like a Ferrari without an engine.  It looks great but will not get you anywhere.

Along the same lines, Hanson said what he often sees is a lack of “spiritual” compliance.  That is to say, he sees companies who focus only on checking boxes to fulfill legal obligations.  Do we have an FCPA policy?  Check.  Have our employees gone through training?  Check.  But they don’t adopt it spiritually.  This pattern even crops up after the company has settled with the government and supposedly learned its lesson from the sanctions imposed.  In those cases, Hanson often becomes a sort of teacher or guide to companies who have not internalized lessons that might have seemed more obvious.  He plays a similar role to government attorneys who may have imposed significant undertakings on a company but might not understand what compliance programs really mean for those in the private sector.

“Tone at the Top”

Many discussed the appropriate compliance “tone at the top.”  Cohen said one of the worst things a company can do is have the compliance message delivered solely by compliance officers.  Senior management has to care about the company’s ethical culture and impress that point on lower-level staff.  AllianceBernstein’s Chris Mahon said he would like to see the phrase “tone at the top” transformed to “tone at the top and throughout.”  If the message stops at the top, it’s not helpful.  Companies have to be sure they engage business personnel on these issues throughout the organization.  Cohen added that a company’s CEO can occasionally lead compliance training for small groups, and that a chief compliance officer can have a seat on the firm’s management committee.  These sorts of actions are bright signals to other staff that obeying the law matters to the company.

Hanson noted that at times a “compliance advisory council” made up of senior executives meeting two-to-four times a year under the leadership of the CCO can be effective.  Such meetings can draw out emerging issues and a general conversation about ethical issues that can be enlightening for the participants.

Failure to Supervise for Compliance Officers

Merri Jo Gillette added a tacit reference to the Theodore Urban matter, in which the SEC sought sanctions against an investment bank’s general counsel for allegedly failing to supervise a rogue broker.  The case was dismissed early last year, but it has worried compliance professionals, who have argued the enforcement effort inappropriately expands the scope of who can be considered a supervisor in the securities industry.  Gillette said if the industry thinks regulators are targeting compliance professionals for doing their work, that is not the case.  If a case alleges failure to supervise by a chief compliance officer, she said, that person almost certainly would have been charged with the same failure had they not been a compliance officer.  The fact that the defendant is in compliance is not what leads to enforcement action.  Above all, Gillette said, the SEC does not want compliance personnel to be afraid to do their work because of liability fears.

Both Cohen and Mahon expressed dissatisfaction with the legal standard as it has evolved over the last 20 years.  Since 1992, the SEC’s position has been that in certain circumstances, legal and compliance personnel can become “supervisors” even if they do not have the ability to hire or fire employees and the employees do not report to legal or compliance. Rather, in the Commission’s view, the test is whether that person has “a requisite degree of responsibility, ability or authority to affect the conduct” of the employee at issue.  In this view, once a legal or compliance officer becomes involved in formulating management’s response to a problem, that person becomes responsible for taking reasonable and appropriate action, and must either discharge those responsibilities or know that others have taken appropriate action. Failure to take such steps may constitute failure to supervise on the part of the legal or compliance officer.  Cohen and Mahon expressed the view that ability to hire and fire should be the test, and that a lesser standard imposes too much risk on compliance personnel.

Other Issues

Mahon impressed the importance of understanding one’s business.  He doesn’t pass himself off as a credit-risk professional, for example, but said he needs to understand those issues at AllianceBernstein so he can be a better participant in credit-risk discussions that implicate compliance questions.  Along the same lines, Meyer noted that it was important for compliance personnel to maintain an ongoing dialog with internal auditors so compliance staff could understand emerging issues.  Cohen also said the compliance perspective needs to be represented on important firm committees.

The agenda for the full program can be viewed here.

SEC Publishes Report on Reg. FD and Social Media – Joy, Vexation Follow

By David Smyth on Posted in Insider Trading

You probably remember a dustup from a few months ago when the SEC threatened to sue Netflix for violations of Regulation FD.  Basically, the rule says that when a public company gives material nonpublic information to anyone, the company must also publicly disclose the same information to all investors.  Netflix’s CEO, Reed Hastings, had arguably broken the rule last July when he posted on his personal Facebook account that for the first time Netflix viewers had consumed one billion hours of video in a month.  In December, staff in the SEC’s San Francisco office sent Netflix a Wells notice to say it was considering recommending enforcement action for releasing this information to only a limited set of Netflix investors.

The problem for the SEC was, Hastings’s Facebook account had over 200,000 followers at the time of his post.  He wasn’t exactly leaking this billion-hour number to a tiny club.  But the post also was not accompanied by a parallel Form 8-K and press release, the safest way for a public company to release information and ensure, from the SEC’s perspective, that the company is putting all recipients on an equal footing.  Reaction to the Wells notice was not positive.  Broc Romanek, a former CorpFin staff member and an eminently sensible voice in this space, said flatly at the time, “This is a hard one for me to swallow.”  The consensus from many was that the SEC needed to get with the times and consider that in the right circumstances, dissemination of material, nonpublic information by social media outlets could be sufficiently general disclosure for Reg. FD.

To the SEC’s credit, it recognized the legal uncertainty and decided not to sue Netflix.  Instead, on Tuesday it released a somewhat rare Report of Investigation with an accompanying press release titled, SEC Says Social Media OK for Company Announcements if Investors Are Alerted.  The report laid out the facts surrounding the Netflix matter and reminded “issuers that disclosures to persons enumerated in Regulation FD, even if made through evolving social media channels, must still be analyzed for compliance with Regulation FD.”  The reaction from many was, “Yay!”  After all, the press release title said what it said.  Social Media OK!

Others were less sanguine.  Sure, Netflix is off the hook for now, but the report was notably free of clear guidance on exactly how public companies could delve into social media and stay on the right side of Reg. FD.  The SEC’s press release is telling.  In the first paragraph the SEC says “companies can use social media outlets like Facebook and Twitter to announce key information in compliance with Reg. FD so long as investors have been alerted about which social media will be used to disseminate such information.”  The second paragraph reminds us of 2008 guidance “clarifying that websites can serve as an effective means for disseminating information to investors if they’ve been made aware that’s where to look for it.”  As Broc noted yesterday, this “guidance” doesn’t seem terribly new.

What I Think

While the SEC’s report is not the green light for corporate social media use that many have been hoping for, I think it is a fairly reasonable reaction as companies get deeper into these waters.  It would be terribly difficult to write a rule outlining exactly what is okay and what is not.  Reed Hastings’s post to 200,000+ followers seems reasonable to me, especially given that those followers would quickly re-post the same information to others.  If he opened a brand new Twitter account and tweeted material, nonpublic Netflix information to three followers who then traded and profited on that information, it’s safe to say enforcement action would follow.  Any rule or definitive guidance would have to take into account, at least, numbers of followers, the network at issue, whether investors recognized it as a place to learn corporate information, and frequency of updates on the network.  But the ship has sailed on SEC enforcement actions against companies who thoughtfully (1) let investors know to expect to see corporate information on particular social media sites; (2) post information with some regularity; and (3) do not try to game the system with posts on obscure accounts.  I cannot imagine the Enforcement Division wanting to take a case with those facts to a jury.

Accounting Fraud Not Just for Public Companies Anymore

By David Smyth on Posted in Accounting Fraud, Investment Advisers, Non-scienter-based Violations, Private Equity

One of the salient features of the SEC’s enforcement program in recent years has been a dearth of accounting fraud cases.  While those cases used to be the SEC’s bread and butter, and hovered around 200 actions per year, they have dropped off dramatically since 2007, and hit a low of 79 last year.  Only a small part of the drop is attributable to breaking out FCPA cases from the “Financial Fraud/Issuer Disclosure” category.  Where have these cases gone?

It is not a complete answer by any means, but some of them may be moving to the private equity space.  On March 11, the SEC demonstrated as much when it charged two investment advisers at Oppenheimer & Co. with misleading investors about the valuation policies and performance of a private equity fund they manage.  Briefly, the Oppenheimer Global Resource Private Equity Fund I (“OGR”) was invested in four investment vehicles by September 2009.   One of these was Cartesian Investors A, LLC.  Cartesian was formed for the purpose of purchasing shares in a Romanian government entity known as Fondul, a holding company set up to compensate citizens whose property was seized by the communist regime.

The problems came this way: From October 2009 through 2010, two investment advisers in the Oppenheimer family allegedly disseminated market, materials to prospective investors and quarterly reports to existing investors that contained material misrepresentations and omissions concerning Respondents’ valuation policies and OGR’s performance.   The marketing materials, including a pitch book, said OGR’s asset values were “based on the underlying managers’ estimated values.”  For Cartesian, though, that allegedly wasn’t true.  Starting in October 2009, while OGR was being marketed to new investors, OGR’s portfolio manager changed Cartesian’s value, using a different valuation method than that used by Cartesian’s underlying manager.  The SEC says the new numbers were a lot higher than the old numbers.  Investors did not know about the change or that the new valuation method resulted in a significant increase in the value of Cartesian over that provided by Cartesian’s underlying manager.

The SEC charged Oppenheimer’s advisers with violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act, Section 206(4) of the Investment Advisers Act, and Rules 206(4)-8 and 206(4)-7.  The last rule requires investment advisers to have written policies and procedures reasonably designed to prevent violations of the Investment Advisers Act, which the SEC says these advisers did not do.  The advisers have undertaken to distribute over $2.2 million to OGR investors.  That amount represents the management fees collected from October 2009 through September 2012 and an amount for reasonable interest.

Private equity managers should understand that their responsibilities to their investors include providing an accurate picture of their underlying assets’ true values.  Saying they’re based on one set of criteria, when they are actually based on another, lower valuation, are really just accounting misconduct in slightly different form.  While the SEC is going after this sort of conduct less and less with public companies, it regulates securities, and not just public companies.  And private equity funds’ limited partnership interests are certainly securities.

Given the conduct described in the order, the advisers at issue may have been fortunate to escape with negligence-based charges.  But such are the benefits of settling before litigation ensues.  Finally, it seems worth noting that that the SEC brought this case in administrative court, and will thus avoid scrutiny of the settlement from judges in the Southern District of New York that it cannot seem to escape.

SEC Ramps Up Its Private Equity Parade

By David Smyth on Posted in Broker-Dealers, Investment Advisers, Non-scienter-based Violations, Private Equity

Bruce Karpati, chief of the SEC’s Asset Management Unit, promised us several weeks ago that enforcement actions against private equity firms were about to heat up.  He wasn’t kidding.  Last Monday, the SEC filed two sets of settled administrative proceedings against private equity firms.  We’ll discuss one of them today, and the second in a later post.

Fans of Michael Lewis’s Liar’s Poker will remember the subject of the first action.  A central character from that hilarious book is Lewis Ranieri, a former head of the mortgage bonds desk at Salomon Brothers and considered by many to be the godfather of mortgage securitization.  He now runs Ranieri Partners, a New York-based private equity firm, and has therefore apparently walked into Karpati’s plans for the SEC’s Enforcement Division.

Facts

In the first set of cases, In re Ranieri Partners LLC, Admin. Proc. File No. 3-15234, and In re Williams Stephens, Admin. Proc. File No. 15233, the SEC charged Ranieri Partners; Donald Phillips, a former senior managing partner of the firm; and William Stephens, an independent business generator, with violations related to Stephens’s actions as an unregistered securities broker.

According to the SEC’s order, while working as an independent consultant for Ranieri Partners from February 2008 through March 2011, Stephens actively solicited investors on behalf of private funds managed by Ranieri Partners’ affiliates.  He allegedly raised over $500 million and, in return, received transaction-based compensation totaling approximately $2.4 million.  The SEC’s order says Stephens’ solicitation efforts specifically included:

  1. sending private placement memos, subscription documents, and due diligence materials to potential investors;
  2. urging an investor to adjust its portfolio allocations to accommodate an investment with Ranieri Partners;
  3. providing potential investors with his analysis of Ranieri Partners’ funds’ strategy and performance track record; and
  4. providing potential investors with confidential information relating to the identity of other investors and their capital commitments.

Sadly for Stephens, one cannot do those things without being registered as a securities broker.  Doing so amounts to violating Section 15(a) of the Exchange Act.  Because Phillips provided Stephens with key documents and information related to Ranieri Partners’ private equity funds, and Ranieri Partners basically allowed it to happen, they are also on the hook.  Phillips for aiding and abetting Stephens’s violations, and Ranieri Partners for “causing” them.

Lessons from the Case

If you are a private equity fund seeking investors, remember that the limited partnership interests you’re selling are securities.  The people who generate that business for you are likely acting as securities brokers, especially if they are receiving commissions based on the investments they bring in.  If appropriate, get registered as a broker-dealer.  Get your people registered.  The SEC’s Trading & Markets Division truly dislikes this activity, and it is looking more and more as though they are convincing the Enforcement Division that it should be punished as well.

Also, Stephens was ordered to pay disgorgement of $2.4 million and prejudgment interest of $410,000, but he is not actually paying a dime.  Here’s the reason:  the SEC hates letting defendants walk away for nothing, but it also hates spending resources chasing down judgments that are impossible to collect. On occasion the SEC will allow defendants to demonstrate an inability to pay a proposed judgment, and then waive the financial sanctions on that basis, which is what happened here.  The waiver process is quite tedious, and involves producing tax returns, bank statements, and a lot of other information.  Enforcement staff packages the information and presents it to the Commissioners when seeking approval to file the settled matter.  At that point, the staff is essentially advocating for the defendant.  From time to time various Commissioners will say aloud that they have had it up to here with financial waivers and they are not inclined to approve any more of them.  But at least as of March 11, 2013, these waivers are alive and well.  If they are in severe financial straits, settling SEC defendants should consider advocating for them.

SEC Issues Risk Alert on Investment Adviser Custody Rule

By David Smyth on Posted in Auditors, Compliance, Investment Advisers, Non-scienter-based Violations

The SEC can express its displeasure with a particular securities practice in a number of different ways, with increasing levels of fun for the alleged malefactor.  Here’s a non-exhaustive list:

  1. One thing it can do is file an enforcement action in federal or administrative court.  This option is not fun at all.  It’s not as bad as a criminal action, but in the SEC context, it doesn’t get worse than a public accusation that one has broken the law and must pay, one way or the other.
  2. The SEC can also issue what it calls a “Report of Investigation” under Section 21(a) of the Exchange Act.  This option, somewhat rare, is a little bit more fun.  It happens when the legal context of an investigation is not sufficiently clear to file an enforcement action, but the SEC still thinks it important to address the (mis)conduct publicly.  Here, the SEC identifies the people and entities involved, publicly pronounces the problems it sees with the conduct, and essentially says, sin no more.  No sanctions are imposed, and the people can go on their way.
  3. Another thing the SEC can do is issue a Risk Alert.  The Commission specifically addresses a securities practice that bothers it, tells everyone to stop it, and moves on.  This option is, all told, pretty fun.  The conduct described can be fairly serious, but none of the potential wrongdoers are identified, and everyone can pretend the bad eggs are other people.  Fun!

The SEC took the third option on Monday, when its Office of Compliance, Inspections, and Examinations issued a Risk Alert titled Significant Deficiencies Involving Adviser Custody and Safety of Client Assets.  At issue was the investment adviser custody rule, Rule 206(4)-2 under the Investment Advisers Act of 1940.  Notably, about a third of recent examinations revealed significant deficiencies among registered investment advisers in their compliance with the rule.  Hence, the risk alert.

What the Custody Rule Requires

As the alert noted, an investment adviser has custody of client assets if it holds client funds or securities or has any authority to obtain possession of them.  If so, what does the adviser have to do?  The custody rule’s function is basically preventative.  The idea is that compliance with it will keep misappropriation or other misconduct from ever happening in the first place.  To that end, the custody rule prescribes a number of key safeguards:

  • Use of “qualified custodians” to hold client assets.  Assets generally must be maintained at a bank or broker-dealer, in an account that is not commingled with the adviser’s assets;
  • Notice to clients.  An adviser that opens a client account at one of those qualified custodians must let the client know about it;
  • Account statements.  An adviser must reasonably believe that the qualified custodian is sending the client account statements at least quarterly;
  • Annual surprise exams.  Advisers with custody of client assets must undergo an annual surprise exam by an independent public account that verifies those assets;
  • Additional protections for related qualified custodians.  If the adviser’s related person acts as the qualified custodian, the annual surprise exam must be conducted by an accountant registered with the PCAOB, who each year must report on the internal controls relating to custody of client assets.
  • Audit approach for pooled investment vehicles.  With this approach, the adviser distributes annual audited financial statements to investors.  This approach obviates compliance with account statement delivery obligations, as well as the surprise exam requirement.

Deficiencies Identified by the SEC

The SEC’s staff found many problems in its recent exams of investment advisers, and grouped them into four general areas.

  1. Adviser’s failures to recognize they have custody.  These failures took many forms.  One listed example notes that an adviser that serves as the general partner of a pooled invest investment vehicle generally has custody of client assets because the position gives legal ownership or access to client funds and securities.
  2. Surprise exam requirement.  The SEC found evidence that some of these “surprise” exams were not really surprises at all.  That is to say, if you know your exam is going to happen on June 1st of each year, it isn’t a surprise.
  3. Qualified custodian requirements.  Again, the deficiencies were legion.  At times, advisers held paper stock certificates in a safe deposit box controlled by the adviser at a local bank.  In other instances, the advisers commingled client, proprietary, and employee assets in one account.
  4. Audit approach issues.  Some advisers relying on the audit approach failed to demonstrate that audited financial statements were distributed to all fund investors.  Others’ audited financial statements were not prepared in accordance with GAAP.  Here, too, advisers found other ways to violate the rule as well.

If you are a registered investment adviser, read the alert, figure out your weaknesses, and take steps to fix them.  If you do not, an enforcement action might be waiting right around the corner.  And that won’t be fun at all.

SEC Enforcement Coming to a Private Equity Firm Near You

By David Smyth on Posted in Investment Advisers, Private Equity

Bruce Karpati, chief of the SEC’s Asset Management Unit (“AMU” or the “Unit”), recently spoke at the Private Equity International Conference in New York, and opened a window into the Unit’s views toward the industry.  In short, watch out, because the SEC is coming.  And given the recent expansion of the private equity space and corresponding decline in the number of publicly traded companies, the SEC really can’t afford not to.

The Asset Management Unit

Karpati began by explaining his own group.  The Asset Management Unit has 75 staff in 11 offices across the United States.  It has hired industry specialists with asset management industry experience to help the SEC’s staff identify problematic transactions and gauge whether particular disclosures would be important to investors.  As we have previously noted in this space, the Unit is also closely collaborating with the SEC’s exam staff to enhance its understanding about private equity firms and their practices.

Why Private Equity Cases Could Increase

Though the Commission has not traditionally had a heavy docket of private equity cases, for several reasons Karpati expects that to change, at least to a degree.  First, private equity experienced a significant growth spurt in the run-up to the financial crisis, and now rivals the hedge fund industry in size, with perhaps $2.0 trillion in assets under management.  Second, many private equity managers have only recently registered as investment advisers.  Third, in contrast to publicly traded companies, private equity managers can control their portfolio companies in a way that is not completely transparent to investors.  Karpati also highlighted a number of recent cases that he thought exemplified what could be a coming trend.

  •  For example, the Advanced Equities case from September 2012 concerned alleged misstatements made to investors about the performance of a portfolio company.  Such representations about portfolio companies happen as a matter of course in the private equity world, and Karpati thinks the case highlights the importance of these statements.
  • In the Resources Planning Group case from November 2012, a private equity principal allegedly used fund assets to repay previous investors and misrepresented his fund as a viable entity while misappropriating investor funds to repay loans from other investors.
  • The KCAP valuation case involved alleged overstatements of the value of certain debt securities held in an investment portfolio, highlighting the SEC’s emphasis on pursuing valuation cases

Particular Concerns of the AMU

Karpati noted the recent rapid growth in assets under management and the subsequent contraction in the amount of capital available to new funds.  He said many funds still have a significant amount of uninvested capital that was raised during the boom times.  As this capital will expire if it’s not put to work, more capital is chasing the same number of deals, which puts extra pressure on returns. These dynamics, he said, may incentivize managers to engage in aggressive marketing and could lead some to cross the line into inappropriate behavior.

The AMU also looks closely at illiquid asset valuations and conflicts of interest that arise in the private equity space.  These conflicts include:

  • The conflict between the profitability of the management company and the best interests of investors, especially at publicly-listed firms;
  • The shifting of expenses from the management company to the funds including utilizing the funds’ buying power to get better deals from vendors for the management company at the expense of the fund;
  • Charging additional fees especially to the portfolio companies where the allowable fees may be poorly defined by the partnership agreement;
  • Conflicts arising from managing different clients, investors and products under the same umbrella; and
  • Conflicts with a manager’s other business which may be run in parallel with the adviser and may incentivize managers to usurp investment opportunities or enter into related party transactions at investors’ expense.

AMU’s Risk Analytic Initiatives

The Unit is also trying to implement what it calls “risk analytic initiatives” to detect problematic conduct through the use of data and quantitative methods.  The Private Equity Initiative seeks to identify private equity managers who have assets under management but are unable to raise follow-on vehicles. The AMU’s idea is that the rapid growth of the industry, combined with the current difficult fundraising environment and converging need for steady private equity returns, will naturally push certain managers out of the business. “Zombie managers” result when private equity holdings are not designed for quick liquidity. Since zombie managers are unable to raise new capital, their incentives may shift from maintaining good relations with their investors to maximizing their own revenue using the assets that they have.  In exams and investigations of the target funds, the SEC looks for misappropriation from portfolio companies, fraudulent valuations, lies told about the portfolio in order to cause investors to grant extensions, and unusual fees, among other things.

How to Stay out of the Crosshairs

Karpati says that private equity COOs and CFOs are critical in making sure that clients’ interests are placed ahead of the interests of the management company and its principals.  To that end, here are specific things you can do:

  • Integrate compliance risk into your overall risk management process and ensure that COOs, CFOs, CCOs and other risk managers are able to proactively spot and correct situations where conflicts of interest may arise.
  • Implement a set of compliance procedures that are appropriate for your business model. Given the transactional focus of most private equity shops, it may make sense to assign an experienced deal professional who has some understanding of compliance issues to help review and implement some of these procedures.
  • Be sure that (1) transactions are executed at arm’s length and in accordance with the firm’s stated strategy, and (2) valuations are fairly represented, and (3) investors are accurately informed of their investment’s status.  This could work to a firm’s business advantage, as implementing such procedures might help attract and retain sophisticated institutional investors.
  • Put your Limited Partnership Advisory Committee to work.  Having the advisory committee vet and vote on potential conflicts will go a long way toward demonstrating good faith.
  • Finally, be alert and prepared for exam inquiries, cooperative with the exam staff while an exam takes place, and nimble enough to take necessary corrective steps.

Given that the total number of public companies has been in decline for some time, corporate finance is shifting a bit in private equity’s direction.  The assets under management are still a small fraction of the total market capitalization of public companies, but private equity is not an area that the SEC can ignore.  Enforcement is coming.  Be prepared.