The US Supreme Court is likeley to come out shortly with its ruling on same sex marriages. The ruling may have an impact on fundraising for private funds and other private placements.

One of the standards for private placements of securities is that the investors generally need to meet the definition of “accredited investors.” For individuals that means a (1) net worth, excluding the primary residence, of $1 million, or (2) annual income in excess of $200,000 in each of the two most recent years or joint income with a spouse in excess of $300,000.

That word “spouse” is the one being addressed by the Supreme Court.  Section 3 of the Defense of Marriage Act (DOMA) states that in determining the meaning of “any ruling, regulation, or interpretation of the various administrative bureaus and agencies of the United States,…the word ‘spouse’ refers only to a person of the opposite sex who is a husband or a wife.” (1 U.S.C. § 7 (1997)

William Carleton picked up on the wrinkle in Rule 506 that same-sex marriages were not treated equally for purposes of the accredited investor standard.

Here in my home state of Massachusetts, “spouse” is not limited to a man and a woman. In the landmark Goodridge decision that made same-sex marriage legal, the Massachusetts Supreme Judicial Court went through a laundry list of legal rights that couples enjoy once they are married. Those were rights not available not available to same-sex couples.

You can add the accredited investor standard to that big pile of legal rights.

The accredited investor concept was included in Regulation D “based on the presumption that accredited investors can fend for themselves without the protections afforded by registration.” I’m not sure how gender plays a role in determining the financial ability of a couple. But currently it does.

What happens if the Supreme Court strikes down the DOMA restriction? I assume the SEC will not do anything and let the term “spouse” sit in the definition. They have enough political landmines to deal with, I don’t see the SEC jumping out with a rulemaking embrace of same-sex marriage when it still has not yet removed the ban on general advertising or issued rules on crowdfunding.

That will leave it up to the issuers, the fund managers, the start-up companies, and their lawyers to wrestle with the definition of “spouse.” I expect a few intrepid offerings will get an extra investor or two. I expect many conservative issuers will wait for more guidance from the SEC.

Sources:

• The accredited investor definition, after the Supreme Court strikes down DOMA
• A Story by Joe Wallin
• “Spouse” Abuse: Regulation D And The Defense Of Marriage (.pdf) by Ryan J. Kretschmer, Walton International Group in the Blue Sky Bugle
• United States v. Windsor on the SCOTUS Blog
• Goodridge v. Dept. of Public Health (.pdf)
• The New Accredited Investor Standard – prior post

The Securities and Exchange Commission recently published a compendium describing the regulation of investment advisers: Regulation of Investment Advisers. It’s not light reading, but the 59-pages provide a helpful overview of investment adviser regulation.

It comes from the Staff of the Investment Adviser Regulation Office in the Division of Investment Management. So it carries a bit different take than the Office of Compliance and Inspections, whose examiners will show up your doorstep. OCIE focuses a bit more on the nuts and bolts, while this compendium is more like the architectural drawings for compliance.

One interesting aspect of the compendium is the document file: rplaze-042012.pdf

I assume that it means it was one of the last actions of long-time SEC staffer Robert Plaze. Mr. Plaze retired as the Deputy Director of the Division of Investment Management at the end of August, 2012. It looks like he did not quite hang up his white hat and worked on this compendium. I’m glad he did.

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

Investor Alert—Don’t Trade on Pump-And-Dump Stock Emails

FINRA and the SEC’s Office of Investor Education and Advocacy are issuing this Investor Alert to warn investors to be on the lookout for email spam promoting “pump-and-dump” stock scams.

SEC Compliance Program Annual Reviews: A Guide for Newly Registered Advisers by Nathan J. Greene, Jesse P. Kanach of Shearman & Sterling

Many newly registered investment advisers will need to complete their first annual compliance review this year. This article describes SEC requirements regarding annual reviews of compliance programs and, in particular, covers who should conduct the review, planning and documenting the review, reporting review findings and responding to problematic conduct identified by the review.

SEC’s Cohen Predicts Major Whistleblower Awards Soon in Corporate Crime Reporter

In its three years of existence, the Securities and Exchange Commission’s (SEC) whistleblower program has produced only one $50,000 payout. But within the next couple of months, it will produce “incredibly impactful cases” with “some extremely significant whistleblower awards.” That’s the take of Stephen Cohen, Associate Director of the SEC’s Division of Enforcement.

If DOMA is overturned, will the discrimination in the accredited investor definition go away? by William Carleton

To address the problem of the insidious discrimination in the accredited investor definition, either the term “spouse” will need to be removed, or a constructive definition arrived at.

I’m not sure which solution is better.

I am sure, however, that there will be broad consensus in the angel investing community that the sexual orientation discrimination in the SEC rule is repugnant.

To learn more about this issue, go to http:\\startupequality.com.

On December 21, 2009, Sanofi-Aventis, a French pharmaceutical company, announced a tender offer for Chattem, a Tennessee-based distributor of over-the-counter pharmaceutical products, at the price of $93.50 per share. Shares of Chattem closed 32.60% higher than the prior trading day’s close of $69.98 and volume increased more than 3,000% to 10.3 million shares. This may be one of the leakiest M&A transactions. So far the SEC has brought 8 insider trading cases that came from this transaction. The latest case is against Andrew W. Jacobs and his brother Leslie J. Jacobs II.

Andrew met with his brother-in-law who was the vice-president of marketing for Chattem. The brother-in-law leaked the news that Chattem was going to be acquired in the near future. He was apparently looking for career advice since the transaction was likely to affect his employment. Andrew had been through a similar experience when his company was acquired by a European company.

Even though the brother-in-law required Andrew to keep the conversation confidential, the SEC alleges that Andrew leaked the information to Leslie. He saw the opportunity and purchased 2,000 shares of Chattem and made a tidy profit of almost $50,000.

That’s not going to cover his legal bills.

The SEC charged Leslie with insider trading and Andrew for tipping the material non-public information. The brother to brother connection is a lot easier to prove than the Facebook friends sources of inside information the SEC used in the Badin Rungruangnavarat insider trading case.

Chattem was a leaky company when it came to information about the transaction.

Most of the insider trading cases are sourced to one conversation. A Chattem board member told his accountant, Thomas D. Melvin about the transaction. Melvin tipped a bunch of friends who traded on Chattem stock. Melvin, his friends, neighbors and brokers have all been charged with insider trading.

Sources:

• SEC Complaint against Andrew W. Jacobs and his brother Leslie J. Jacobs II (.pdf)
• SEC v. Lazorchak, et al., Lit. Rel. No. 22535
• SEC v. Coots, et al, Lit. Rel. No. 22466
• SEC v. Jackson, Lit. Rel. No. 22467
• SEC v. Berry, Lit. Rel. No. 22465
• SEC v. Melvin, et. al, Lit. Rel. No. 22468; SEC v. Rooks, Lit. Rel. No. 22469
• SEC v. Condroyer, et al., Lit. Rel. No. 21347

Robert Kaiser was granted rare access to the action behind the scenes of the creation of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Act of Congress is an enjoyable study of the enactment of that law, used as tool to explore how Congress works, and largely how it it doesn’t work.

Kaiser was already an associate editor and senior correspondent with the Washington Post and had just finished a book on lobbying and money in Washington. He proposed to Congressman Frank that Kaiser become the historian of the congressional response to the Great Crash of 2008. Frank was planning a big legislative changes to the financial services industry and the new president shared this goal. Senator Chris Dodd and Representative Barney Frank let Kaiser talk on the record with staff.

Act of Congress lives by the famous remark “Laws are like sausages, it is better not to see them being made.” The book’s goal is to be both entertaining and educational as it sneaks behind the curtain to watch the sausage production.

“Of the 535 members of the House and Senate, those who have a sophisticated understanding of the financial markets and their regulation could probably fit on the twenty-five man roster of a Major League Baseball team.”

Kaiser lets the stupidity of some Congress make it to the pages. He lets their public statements stand for themselves, although he tosses the phrase “intellectual lightweight” at a few. I sense he had a lot of personal perspective some of the congressmen that did not make it to the pages.

I found the book to be well-written and interesting. I suspect the interesting part may be governed more by my interest in the Dodd-Frank Act. It’s an enormous piece of legislation with profound impact on the financial services industry. In places it is poorly written and in others it’s full of exemptive holes. This books will enlighten you to some of the compromises that were made to get the law enacted.

I suspect those who have that interest may be limited. If you have made it this far, perhaps you share that interest. In which case you should add Act of Congress to your reading list.

Sources:

• Buy Act of Congress from Amazon
• How a Bill Becomes a Mess in the Wall Street Journal

Badin Rungruangnavarat was very lucky. He invested a bunch of cash from May 21 to May 28. When the market closed on May 29 he had unrealized gains of over $3 million and had achieved a return in excess of 3000%. Now he is unlucky because the Securities and Exchange Commission froze his investment gain and labeled it the illegal fruits of insider trading.

Badin had put all of his money into derivatives based on the stock price of Smithfield Foods, Inc. On May 29, there was a public announcement that Shanghui International Holdings had agreed to acquire Smithfield. As you might expect, Shangui paid a premium on the traded stock price.

So maybe Badin wasn’t lucky. Maybe he had some material non-public information and was illegally trading on that information.

Badin opened the account at Interactive Brokers on May 10. Badin deposited $920,000 and only traded in Smithfield derivatives. All of the call options he purchased were out of the money. He purchased 80% of Smithfield’s options for the month of May. Through those derivatives, he controlled roughly 25% of the average daily volume of Smithfield’s stock.

The facts stink of insider trading. What’s missing is the inside information.

The SEC turned to Facebook to identify the source of insider information. (It looks like the SEC does not ban access to Facebook.) In the complaint, the SEC states that Badin has a Facebook friend who is an associate director at the investment bank that advised another bidder for Smithfield. That may not be the source, but at least it something for the SEC to grab a hold of in hopes of making its case.

This is at least the third time that Interactive Brokers has flagged an account for insider trading. See Zhongpin and Potash. The firm’s compliance surveillance seems to working for these egregious cases.

Sources:

• SEC Freezes Assets of Thailand-Based Trader for Insider Trading Ahead of Smithfield Foods Acquisition Announcement
• SEC Complaint (.pdf)
• SEC Sues Rungruangnavarat for Insider Trading in Smithfield Foods Acquisition by David Smyth in Cady Bar the Door

Red flags by Rutger van Waveren CC BY ND

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

Madoff: Don’t let Wall Street scam you, like I did By Sital S. Patel in MarketWatch

After all those years of racing to remain a step ahead of the authorities, Madoff has a few ideas about how the market can be made more fair for retail investors. Among them: The Securities and Exchange Commission should be beefed up, hedge funds need to be registered and brokerages should have independent custodians.

The Separation of Investments and Management by John Morley in the CLS Blue Sky BLog

Every type of enterprise that we commonly think of as an investment fund—including hedge funds, private equity funds, venture capital funds, mutual funds and closed-end funds—adopts a pattern of organization that I call the “separation of investments and management.” These enterprises place their securities, currency and other investment assets and liabilities into one entity (a “fund”) with one set of owners, and their managers, workers, office space and other operational assets and liabilities into a different entity (a “management company” or “adviser”) with a different set of owners. Investment enterprises also radically limit fund investors’ control. A typical hedge fund, for example, cannot fire and replace its management company or its employees—not even by unanimous vote of the fund’s board and equity holders.

National Financial Capability Study from the FINRA Investor Education Foundation

The 2012 National Financial Capability Study (NFCS) presents new survey findings that underscore the need to ensure all Americans have access to the education, resources and tools they need to manage their money with confidence. This second iteration of the study builds on the findings and benchmarks established in 2009 and adds to the growing conversation about how individuals can best manage and make decisions about their financial resources.

Sen. Warren Asks SEC for Any Research on Benefits of ‘No Admission’ Settlements by Bruce Carton in Compliance Week

At the hearing, new SEC Chair Elisse Walter began to testify about how the SEC “look[s] at the distinction between what we could get if we go to trial, and what we could get if we don’t,” but she was shut down by Sen. Warren who apparently did not want to get sidetracked. In a letter (via World of Securities Regulation) dated May 14, 2013, however, Sen. Warren asked White, as well as the heads of the Federal Reserve and the DOJ, to provide more information on this point. Reiterating her concern that a regulator that is unwilling to actually take large financial institutions to trial has far less leverage in settlement negotiations, Warren asked White, Ben Bernanke and Eric Holder to answer the following question:

Have you conducted any internal research or analysis on trade-offs to the public between settling an enforcement action without admission of guilt and going forward with litigation as necessary to obtain such admission and, if so, can you provide that analysis to my office?

Codes of Conduct: what are they good for? by Catherine Choe in FCPA Compliance and Ethics Blog

I had an interesting and frustrating conversation with a relative about the work that I do, which includes working with companies on refreshing their Codes of Business Conduct. Despite working at a large, publicly traded, multinational corporation, I had to describe the Code twice before he recalled having certified reading the one at his company. It got me thinking about why we have Codes and whether they’re doing an adequate job serving their purposes.

When a CCO becomes a Whistleblower (It Usually Ends in Tears) by Donna Boehme in the Whistleblowers Protection Blog

This story is about Paul Moore, the former chief risk and compliance officer for HBOS, fired in 2004 for his warnings to the bank’s C-Suite and Board of its excessive risk taking culture. Paul says the release of the Parliamentary report, plainly called “An Accident Waiting to Happen,” was like the “parting of the Red Sea” for him. Paul is Exhibit A for why former federal prosecutor Michael Volkov called the CCOs the “Person of the Year” in 2011 and has described this difficult role as the “unsung hero” of the corporate landscape

On Wednesday, the Securities and Exchange Commission proposed several reforms to money market funds. Changes to money market funds has been in the works since 2008 after the Reserve Primary Fund “broke the buck” at the height of the financial crisis.

The SEC published two proposals.

Under the first alternative, prime institutional money market funds would be required to transact at a floating net asset value (NAV), not at a $1.00 stable share price. The floating NAV alternative is designed primarily to address the share redemption in times of financial stress. It also is intended to improve the transparency of money market fund risks through more visible valuation and pricing methods.

Government and retail money market funds would be exempt and allowed to maintain a stable share price. A government money market fund would be defined as any money market fund that holds at least 80 percent of its assets in cash, government securities, or repurchase agreements collateralized with government securities. A retail money market fund would be defined as a money market fund that limits each shareholder’s redemptions to no more than $1 million per business day.

Under the second alternative, money market funds would continue to transact at a stable nav, but would be able to use liquidity fees and redemption gates in times of stress.

Personally, I think these are both terrible ideas. With the expiration of the Transaction Account Guarantee program, companies have had to take a closer look at where they park cash for both short term and long term needs. The Transaction Account Guarantee program provided a safe place, even though the account earned no interest. With the expiration of that program, accounts are only insured up to $250,000. Money market funds provide an easy place to park cash and get a diversification of risk.

Sources:

• SEC Proposes Money Market Fund Reforms
• Opening Statement at the SEC Open Meeting by Chairman Mary Jo White
• Text of Proposal (.pdf)

I’ve seen some poorly drafted compliance policies. The source of the problem is usually that they were written by lawyers, for lawyers. That is good when it comes to defending your firm against a lawsuit. But it’s a bad thing if the policy does not clearly tell the employees what they can do and what they can’t do.

This problem has been running through the legal industry for years. The Securities and Exchange Commission even published A Plain English Handbook: How to Create Clear SEC Disclosure Documents. The SEC was hoping a non-lawyer could read a corporate filing. There is still little hope of that five years later.

I don’t think it’s the fault of law schools. Like many young lawyers, I was taught in law school to avoid most of the archaic legalisms and to write in a manner closer to plain English.

But for most young lawyers, that writing style is discarded as they start practicing as a junior associates. You quickly realize that you need to write in way that pleases the partner or senior associate you are working for. You are in no position to tell the more senior lawyer that the contract would be better with less legalese and more plain English. You are responsible for one little piece of the transaction. Whatever you draft or edit needs to look and read like the rest. That means lots of legalese.

As you gain experience, you get more direct contact with clients and take the next step of writing to please the client. But clients don’t like having their forms changed. That implies that something was wrong with the old forms. Clients generally don’t want to pay for a lawyer to re-draft the form that they had already paid to have drafted years ago. They especially do not want to pay for style changes or removal of legalese.

Eventually you become senior enough that you can start making changes, but it’s generally on the fringes. You may get a bespoke agreement to draft that is not based on a precedent or form. You don’t have the free time to recreate the form documents to remove the legalese and adopt a more sensible legal writing style.

Ken Adams advocates a more sensible approach to contract drafting. I’m not sure when I became a fan of Ken’s thoughts on contract drafting. It was probably during some wasted time arguing over whether a contract performance standard should have “reasonable efforts”, “best efforts“, or “commercially reasonable best efforts”. I studied his approach and tried using some of his well-reasoned and well-researched approaches. But it was mostly at the fringes.

Now that I have left corporate law to join the world of compliance, there are still many useful aspects of his thoughts on contract drafting that apply to compliance. When he offered me a review copy of his latest, A Manual of Style for Contract Drafting, I thought it would useful to look at his style approach in the context of compliance.

There are lots of lessons in the book for compliance professionals who are tasked with drafting policies and procedures. There is the obvious lesson of not using a dollar word to do a “nickel’s worth of work.” Policies and procedures need to be clearly written and easy to understand. You want to avoid the problem that could lead to a law suit. You don;t want to have to rely on a lawyer for interpretation.

For compliance, you probably don’t need to spend much time in Chapter 8 exploring “reasonable efforts and its variants.” Here’s the spoiler: U.S. courts have overwhelmingly rejected the notion that best efforts represents a more onerous standard than reasonable efforts.

Chapter 12 is full of great lessons on syntactic ambiguity that will improve your policies. While there are a few chapters that are applicable only to contracts, the bulk of the book has lessons applicable to drafting policies and procedures.

Many lawyers will disagree with some (or many) of the approaches that Ken proposes. His substantive positions are backed up by legal research and grammar expertise. It’s hard to argue with facts

My biggest disagreement is on a style approach. I prefer more depth to my numbering scheme. Ken stops at the second level. You can see that approach in the layout of  A Manual of Style for Contract Drafting. Each paragraph is numbered. But with the flat numbering, concepts appear scattered. For example I would have preferred the MCSD enumeration scheme to be section 4.53, with each of the paragraphs discussing the scheme to be 4.53.1, 4.53.2, …, instead of 4.53, 4.54.

Even if you don’t adopt Ken’s approach you should at least learn about the substance behind the approach. You can purchase A Manual of Style for Contract Drafting from the American Bar Association.

I continue to look at the margins where real estate  and securities meet, so any case brought by the SEC against an real estate firm catches my eye. The latest to catch my attention was an investigation into Robert J. Vitale and his investment company, Realty Acquisitions & Trust. While there might be some argument as to whether the SEC had jurisdiction, that didn’t matter once Mr. Vitale lied to the Securities and Exchange Commission examiners.

The SEC was conducting an official investigation into allegations that Vitale engaged in violation of the securities laws. The SEC attempted to identify assets and bank accounts attributable to Vitale and asked for a statement of accounts. Vitale provided a “Background Questionnaire” form to the SEC purporting to list bank accounts and other assets attributable to him. But shortly before completing the questionnaire, Vitale transferred $100,000 from an account that was disclosed on the form, to a separate account that he controlled.

The Department of Justice stepped in and charged Vitale with willfully failing to disclose the existence of those funds and the bank account. To compound the problem, Vitale lied about the accounts and the cash during sworn testimony in an SEC investigation.

Vitale was likely a target because he had previously run into trouble with the SEC and been barred from the brokerage industry as a result.

As the blue fairy said to Pinocchio: “A lie keeps growing and growing until it’s as plain as the nose on your face.” That makes it really easy for the Feds to charge you with obstruction of justice, even if you may not have been guilty of the underlying crime.

Sources:

• Florida-Based Stock Promoter Charged with Lying to SEC Investigators
• Ft. Lauderdale Man Charged with Obstruction of Proceedings and Providing False Testimony Before the U.S. Securities And Exchange Commission
• Lauderdale-by-the-Sea broker pleads guilty to lying to the SEC