Month: April 2010

Compliance Bits and Pieces for April 30

HALLDOR KOLBEINS/AFP/Getty Images

I was on vacation last week and apparently missed lots of big news. A volcano kept me from going to Europe, but nothing stopped the SEC from bringing a case against Goldman Sachs. Here are some recent compliance related stories that I found interesting.

The SEC and the Rogue Inspector General by J Robert Brown Jr. in Race to the Bottom

We were dismayed at the leaks that revealed confidential discussions taking place at a closed Commission meeting about the Goldman case. We are equally dismayed at the recent announcement by the SEC’s Inspector General that he intends to look into allegations that the Goldman case was deliberately timed to coincide with financial reform efforts.

Trust Quotes #10: David Gebler by Charles Green in Trust Matters

CHG: What’s the difference between ethics and compliance? And does anyone care about the former?

DG: Compliance is the adherence to prescribed standards of behavior. Compliance training educates people on what behavior is expected of them.

Ethics is the determination of whether people will engage in the desired behavior and what should be done to encourage people to do things they know they should do, but often don’t.

The SEC, The Goldman Case and Critics by Tom Gorman in SEC Actions

Sometimes the SEC is an aggressive market regulator and at other times it appears to be the gang that can not shoot straight. In filing the Goldman case, discussed here, it not only brought the most significant enforcement action in years, but also responded to critics who claim the agency can not take on the Wall Street giants, but only the little guys.

SEC versus Goldman Sachs in Ten Seconds into the Future

It is going to be hard for the SEC to establish that GS defrauded investors by its failure to disclose Paulson’s role and intentions in ABACUS. Why? Paulson wanted to make a bet. A bet is not a sure thing. If Paulson or GS could affect the outcome of the bet then that is another matter.

NYPD to Bicycles: We Got You Now by Scott Greenfield in Simple Justice

In related news, the NYPD determined that the possibility that a pipe bomb could be placed in a bicycle gave rise to the theft of hundreds along Houston Street in Manhattan, in anticipation of President Obama’s trip to Cooper Union last week in honor of Earth Day.

Hedge Fund Industry Will Be Under Close Scrutiny by SEC Division of Enforcement by Frederic D. Firestone and Miachael A. Unger of McDermott, Will & Emery

The hedge fund industry is a top programmatic priority of the U.S. Securities and Exchange Commission (SEC) Division of Enforcement. The Division is currently allocating unprecedented resources to hedge fund issues and investigations. This focus will intensify if hedge fund legislation is passed.

Bourke Appeals Ruling in Most Complex, Convoluted Case in FCPA History by Mike Koehler in Corporate Compliance Insights

An FCPA trial like Bourke’s is rare. An FCPA appeal is even more rare. An FCPA appeal to the influential Second Circuit is even more rare. …This post summarizes the FCPA related issues in Bourke’s brief.

Synthetic CDs, Explained in NPR’s Planet Money

On today’s All Things Considered: A Glossary of Financial Terms, Adam Davidson explains the difference between a mortgage-backed security, a CDO, and a synthetic CDO. Also, why shorts aren’t bad, and what a tranche is.

Who Blows the Whistle on Corporate Fraud?

It takes a village.

Alexander Dyck, Adair Morse, and Luigi Zingales found that fraud detection does not rely on standard corporate governance actors. Instead they found that employees, short sellers and analysts are the top sources in uncovering corporate fraud.

The three researchers studied reported fraud cases between 1996 and 2004 for U.S. companies with more than $750 million in assets. They ended up with a sample of 216 cases, including the high profile cases like Enron, HealthSouth and Worldcom.

They conclude that those in the best position to spot fraud are those who gather a lot of relevant information as a by-product of their normal work.  Employees, industry regulators, and analysts are at the top of the list.

Financial Reward

A monetary award, like the bounty under the Federal Civil False Claims Act, seems to be a good incentive for employees.

Short sellers are another group with a financial incentive.  The researchers looked at short selling activity prior to revelation of fraud. When that activity three standard deviations above the prior three month average they took that as indication that the short sellers had identified a fraud. If you use that benchmark, the short-sellers detected 22 of the fraud cases.

Reputation Reward

The other incentive is the reputation reward that they largely attribute to journalists. A journalist who uncovers a big fraud gets national attention and future career opportunities. It is interesting that when they weight the frauds based on size, journalists move farther up the list as the fraud detector. That seems a clear indication that reporters are more interested in the big, splashy fraud cases. That also means that we cannot expect the media to act as an effective monitor for smaller companies or for technical violations.

Auditors

I’m sure Francine McKenna, of re: The Auditors, would be interested to see their findings regarding auditors.

“We find very weak evidence of auditor’s incentives to blow the whistle. Auditing a fraudulent company is bad for reputation, but conditional on doing so, bringing this information to light has no benefit for an auditor: it is likely to cost him the account and it does not make him gain new ones.”

Compliance

On a positive note from the compliance perspective, of the 216 cases, 74 or 34.3%, were detected by internal governance. But we shouldn’t pat ourselves on the back too much. These cases are pre-2005 and therefore date before the compliance era.

Raw Data

Of the the 142 cases detected by external governance here is the breakdown:

Fraud Detector Cases Percentage
Employee 26 18.3%
Analyst 24 16.9%
Media 22 15.5%
Industry Regulator or SRO 20 14.1%
Auditor 16 11.3%
SEC 10 7.0%
Client or Competitor 9 6.3%
Equity Holder 5 3.5%
Short seller 5 3.5%
Law Firm 5 3.5%

It would be great to move the SEC higher on the list. But it seems that you want to keep as many groups interested in detecting and reporting fraud. There are lots of groups interested in detecting fraud for lots of reasons. We should make sure that all of them stay engaged and have incentives to report the fraud.

Sources:

Image is Qiqi Green Whistle by Steven Depolo under Creative Commons

FINRA Guidance on Private Placements

finra

The Financial Industry Regulatory Authority released Regulatory Notice 10-22 reminding registered firms about their obligations regarding suitability, disclosures and other requirements for selling private placements to customers.

A Broker-Dealer that recommends a security is under a duty to conduct a reasonable investigation concerning that security and the issuer’s representations about it. This is true regardless of the type of security. The “reasonable” standard for the investigation depends on many factors including the nature of the recommendation, the role of the broker-dealer in the transaction, its knowledge of and relationship to the issuer, and the issuer itself.

NASD Rule 2310 requires a broker-dealer to have reasonable grounds to believe that a recommendation to purchase, sell or exchange a security is suitable for the customer. That means they must have a reasonable basis to to determine that the recommendation is suitable for at least some investors. Then they have to determine that it is suitable for the specific customer.

The fact that an investor meets the net worth or income test for being an accredited investor is only one factor to be considered in the course of a complete suitability analysis. In a Regulation D offering the broker-dealer should, at a minimum, conduct a reasonable investigation concerning:

  • the issuer and its management;
  • the business prospects of the issuer;
  • the assets held by or to be acquired by the issuer;
  • the claims being made; and
  • the intended use of proceeds of the offering

Although the “reasonable investigation” must be tailored to each private placement, the regulatory notice provides a list of best practices gathered from member firms.

A. Issuer and Management. Reasonable investigations of the issuer and its management concerning the issuer’s
history and management’s background and qualifications to conduct the business might include:

  • Examining the issuer’s governing documents, including any charter, bylaws and partnership agreement, noting particularly the amount of its authorized stock and any restriction on its activities. If the issuer is a corporation, a BD might determine whether it has perpetual existence.
  • Examining historical financial statements of the issuer and its affiliates, with particular focus, if available, on financial statements that have been audited by an independent certified public accountant and auditor letters to management.
  • Looking for any trends indicated by the financial statements.
  • Inquiring about the business of affiliates of the issuer and the extent to which any cash needs or other expectations for the affiliate might affect the business prospects of the issuer.
  • Inquiring about internal audit controls of the issuer.
  • Contacting customers and suppliers regarding their dealing with the issuer.
  • Reviewing the issuer’s contracts, leases, mortgages, financing arrangements, contractual arrangements between the issuer and its management, employment agreements and stock option plans.
  • Inquiring about past securities offerings by the issuer and the degree of their success while keeping in mind that simply because a certain product or sponsor historically met obligations to investors, there are no guarantees that it will continue to do so, particularly if the issuer has been dependent on continuously raising new capital. This inquiry could be especially important for any blind pool or blank-check offering.
  • Inquiring about pending litigation of the issuer or its affiliates.
  • Inquiring about previous or potential regulatory or disciplinary problems of the issuer. A BD might make a credit check of the issuer.
  • Making reasonable inquiries concerning the issuer’s management. A BD might inquire about such issues as the expertise of management for the issuer’s business and the extent to which management has changed or is expected to change. For example, a BD might inquire about any regulatory or disciplinary history on the part of management and any loans or other transactions between the issuer or its affiliates and members of management that might be inappropriate or might otherwise affect the issuer’s business.
  • Inquiring about the forms and amount of management compensation, who determines the compensation and the extent to which the forms of compensation could present serious conflicts of interest. A BD might make similar inquiries concerning the qualifications and integrity of any board of directors or similar body of the issuer.
  • Inquiring about the length of time that the issuer has been in business and whether the focus of its business is expected to change.

B. Issuer’s Business Prospects. Reasonable investigations of the issuer’s business prospects, and the relationship of those prospects to the proposed price of the securities being offered, might include:

  • Inquiring about the viability of any patent or other intellectual property rights held by the issuer.
  • Inquiring about the industry in which the issuer conducts its business, the prospects for that industry, any existing or potential regulatory restrictions on that business and the competitive position of the issuer.
  • Requesting any business plan, business model or other description of the business intentions of the issuer and its management and their expectations for the business, and analyzing management’s assumptions upon which any business forecast is based. A BD might test models with information from representative assets to validate projected returns, break-even points and similar information provided to investors.
  • Requesting financial models used to generate projections or targeted returns.
  • Maintaining in the BD’s files a summary of the analysis that was performed on financial models provided by the issuer that detail the results of any stress tests performed on the issuer’s assumptions and projections.

C. Issuer’s Assets. Reasonable investigations of the quality of the assets and facilities of the issuer might include:

  • Visiting and inspecting a sample of the issuer’s assets and facilities to determine whether the value of assets reflected in the financial statements is reasonable and that management’s assertions concerning the condition of the issuer’s physical plants and the adequacy of its equipment are accurate.
  • Carefully examining any geological, land use, engineering or other reports by third-party experts that may raise red flags.
  • Obtaining, with respect to energy development and exploration programs, expert opinions from engineers, geologists and others are necessary as a basis for determining the suitability of the investment prior to recommending the security to investors.

“An increase in investor complaints regarding private placements, as well as SEC actions halting sales of certain private placement offerings, led FINRA to launch a nationwide initiative that involves active examinations and investigations of broker-dealers engaged in retail sales of private placement interests,” said FINRA Chairman and CEO Rick Ketchum.

Sources

Quon Roundup on Employee Computer Privacy

Lots of discussion about the Quon case focused on the lack of technology expertise by the Justices on the Supreme Court. Actually, most people labeled them as Luddites. DC Dicta even claims that Chief Justice Roberts writes his opinions in long hand with pen and paper.

This issue that I am hoping to see addressed is how a stated policy on the use of a company’s hardware and network can be enforced in light of an employee’s expectations of privacy.

I doubt that issue will be addressed directly. The Quon case involves a government employee so the discussion of the issue will likely focus on the Fourth Amendment protection. These protections are largely irrelevant for private employees.

Even if the Justices avoid the Fourth Amendment issues, they may decide the case under the Stored Communications Act. That’s a rather boring and technical law. It’s also largely irrelevant to the use of a company’s hardware and network. Although it may provide some insight for the use of cloud computing and web 2.0 site.

The United States Government, through the arguments of Neal K. Katyal, Deputy Solicitor General, seemed to ask the Court to adopt a bright-line rule that a company can trump the reasonableness of any employee’s expectation of privacy by issuing a policy that employees have no privacy in communications when using the company-provided hardware or network.

The Justices seemed fairly skeptical of that kind of bright-line rule in their questions of Mr. Katyal.

The problem is that tightly crafting laws to specifically address the use of particular communication technologies will fail. In the current environment, the technological advances in communications is moving much faster than the cogs of  bureaucracy in crafting regulations. The Supreme Court (well, at least Justice Alito) recognized that the expectations of privacy with new communication are in flux.

“There isn’t a well-established understanding about what is private and what isn’t private. It’s a little different from putting garbage out in front of your house, which has happened for a long time.”

The ruling in the case is expected sometime June at the end of the Supreme Court’s term. It’s certainly something for compliance professionals to keep an eye on.

Sources:

Image of P2000 Pager.JPG is by Kevster

FCPA Opinion Procedure Release 10-01

The Department of Justice released its latest Opinion Procedure Release under the Foreign Corrupt Practices Act. It’s one of the quirks of the FCPA that you can ask the Department of Justice whether a particular situation would be a violation of the FCPA.

This opinion is also quirky. The company requesting the opinion was in the odd situation of having to hire a foreign official as the director of a facility it is building in a foreign country.

Hiring a foreign official is an obvious red flag for a potential violation of the FCPA.

The quirk of the situation is that the United States government directed the company to hire the foreign official. The company is building the facility under a government contract as part of US assistance to the foreign country. The foreign country identified the individual they wanted as facility director. They told the US government, who directed the company to hire the individual.

Here are the reasons stated why this situation is not a violation of the FCPA:

  • [T]he Individual is being hired pursuant to an agreement between the U.S. Government Agency and the Foreign Country, and will not be in a position to influence any act or decision affecting the Requestor.
  • [T]he Requestor is contractually bound to hire and compensate the Individual as directed by the U.S. Government Agency.
  • The Requestor did not play any role in selecting the Individual, who was appointed by the Foreign Country based upon the Individual’s qualifications.
  • In neither position will the Individual perform any services on behalf of, or receive any direction from, the Requestor.
  • [T]he Individual will have no decision-making authority over matters affecting the Requestor, including procurement and contracting decisions.

I don’t think this release offers much insight to the FCPA. It does point out that you may be able to hire a foreign official if directed by the US government.

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Ethics and Baseball Tickets

Baseball season is here. That means businesses will be opening their boxes and seats for entertaining clients and potential clients. Of course those tickets are gifts.

How do you treat them under your company’s gifts policy or a government’s ethics policy? One typical requirement is that you pay for the tickets. Face value is the general rule.

How about if those tickets were 2004 Red Sox World Series tickets? After all, Red Sox World Series tickets used to be very rare. (Since the new ownership, they are just uncommon.) Should you pay face value or the secondary market price?

The mayor of Pittsfield Massachusetts is countering an ethics complaint for those rare tickets. He bought the tickets for $380 from someone who had business before the city. That was $190 per ticket, the face value, for Game 2 of the World Series was played on October 24, 2004, at Fenway Park between the Boston Red Sox and St. Louis Cardinals. It so happened that the person with the tickets and the business before the city was former Red Sox general manager Dan Duquette.

The Enforcement Division of the State Ethics Commission alleges that there was enormous demand for 2004 World Series tickets. They were not available to the general public at face value, and were selling on secondary market at between $600 to $2,000 per ticket.

Section 3(a) of the Massachusetts Conflict of Interest Law makes it illegal for a government official who

“directly or indirectly, asks, demands, exacts, solicits, seeks, accepts, receives or agrees to receive anything of substantial value: (i) for himself for or because of any official act or act within his official responsibility performed or to be performed by him; or (ii) to influence, or attempt to influence, him in an official act taken”

Generally, anything worth more than $50 has “substantial value.”

One problem is that it is illegal in Massachusetts to sell tickets for more than $2 about the face value plus the costs of obtaining the ticket.  So if Duquette sold the ticket to the mayor for the secondary market price, he would have broken the law. Granted the ticket scalping laws in Massachusetts are mess.

Nonetheless, the State Ethics Commission had already issued an ethics advisory that special access to purchase tickets is a special benefit and could be an “unwarranted privilege or exemption of substantial value.”The opinion cites Ryder Cup, Super Bowl and World Series tickets as examples. (Coincidentally, that advisory opinion was issued in the spring of 2004. Clearly hope springs eternal each spring in Boston.)

The big problem is that according to the press release, Duquette admitted that he sold the tickets to the mayor because he wanted influence the mayor’s official government act. Intent usually wins, so if his admission is true then he broke the law.

The mayor is in a tougher position because the value of the tickets may be tough to ascertain. The price for the tickets will vary leading up to the game and different sellers may have different prices.

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The Knowledgeable Employee Exemption for Private Funds

UPDATE: See More Guidance on Knowledgeable Employee Exemption for Private Funds

When operating under the Section 3(c)(7) exemption from the Investment Company Act, the issue then becomes how a private investment fund can provide an equity ownership to key employees.

Its unlikely that your key employees will have the $5 million in investments needed to qualify as an investor. (Each investor in a 3(c)(7) private investment fund must be Qualified Purchaser.)

The SEC established Rule 3C-5 to allow “knowledgeable employees” to invest in their company’s private fund without having to be a qualified purchaser. The rule also exempts these knowledgeable employees from the 100 investor limit under the Section 3(c)(1) exemption from the Investment Company Act.

You will still need to determine if the employee’s acquisition of the interest is exempt from the registration requirements of the Securities Act. Most likely that will mean that the knowledgeable employee will need to be an accredited investor. Meeting that $200,000 per year / $300,000 per year if married income (and a reasonable expectation of that income continuing) threshold may be the biggest impediment to offering equity interests further down the company ladder.

The first category of “knowledgeable employees” is the management of the covered company, which covers these positions:

  • director [see Section 2(a)(12)]
  • trustee
  • general partner
  • advisory board member [see Section 2(a)(1)]
  • “executive officer”

Executive Officer is defined in Rule 3C-5 as:

  • president
  • vice president in charge of a principal business unit, division or function
  • any other officer who performs a policy-making function
  • any other person who performs a similar policy-making function

The second group of knowledgeable employees are those who participate in the investment activities. Those employees need to meet these requirements:

  • Participate in the investment activities in connection with his or her regular functions or duties,
  • has been performing such functions and duties for at least 12 months, and
  • is not performing solely clerical, secretarial or administrative functions.

The 12 month limit is not limited to 12 months at the employee’s current company. The SEC concluded that it is not necessary to require that an employee work for the particular fund or management affiliate for the entire 12-month period as long as the employee has the requisite experience to appreciate the risks of investing in the fund and performed substantially similar functions or duties for another company during that 12 month period.

Whether an employee actively “participates in the investment activities” of a private fund will be a factual determination made on a case-by-case basis.  In a 1999 No Action letter sent to the ABA the SEC said the following would NOT be knowledge employees:

  • Marketing and investor relations professionals who explain potential and actual portfolio investments of a fund and the investment decision-making process and strategy being followed to clients and prospective investors and interface among the fund, the portfolio mangers and the fund’s clients.
  • Attorneys who
    • provide advice in the preparation of offering documents and the negotiation of related agreements,
    • who also are familiar with investment company management issues, and
    • respond to questions or give advice concerning ongoing fund investments, operations and compliance matters.
  • Brokers and traders of a broker-dealer related to the Fund who are Series 7 registered.
  • Financial, compliance, operational and accounting officers of a fund who have management responsibilities for compliance, accounting and auditing functions of funds.

The SEC also said that research analysts who investigate the potential investments for the fund may not be knowledgeable employees unless they research all potential portfolio investments and provide recommendations to the portfolio manager.

Sources:

Photo is of the Board of Directors and Officers of the Industrial Exhibition Association of Toronto 1930 used under Creative Commons License from the Toronto Public Library Special Collections

Qualified Purchasers under the Investment Company Act

In a private fund exempt under 3(c)(1) investors only generally need to be accredited investors (and “qualified clients” if the fund manager is SEC registered. If you have more than 100 investors in the fund you will need to fall under the 3(c)(7) exemption. That means all of your investors must be “qualified purchasers.” A qualified purchaser is a much greater requirement than an accredited investor and a qualified client.

To paraphrase the requirements under Section 2(a)(51) of the Investment Company Act, a “qualified purchaser” means:

  • a person not less than $5 million in investments
  • a company with not less than $5 million in investments owned by close family members
  • a trust, not formed for the investment, with not less than $5 million in investments
  • an investment manager with not less than $25 million under management
  • a company with not less than $25 million of investments

To that list you can also add:

  • A company (regardless of the amount of such company’s Investments) beneficially owned exclusively by Qualified Purchasers.
  • A “Qualified Institutional Buyer” under Rule 144A of the 33 Act (except that “dealers” under Rule 144 must meet the $25 million standard of the 1940 Act, rather than the $10 million standard of Rule 144A). Rule 144A generally defines a “Qualified Institutional Buyer” as institutions, including registered Investment Companies, that own and invest on a discretionary basis $100 million of securities that are affiliated with the institution, banks that own and invest on a discretionary basis $100 million in  securities and have an audited net worth of $25 million, and certain registered dealers.

“Investments” generally means the following:

  1. Securities, including stocks, bonds and notes, other than securities of an issuer that  is under common control with the qualified purchaser.
  2. Real estate held for investment purposes.
  3. Commodity futures contracts, options or commodity futures and options on physical commodities traded on a contract market or board of trade, held for investment purposes.
  4. Physical commodities (e.g., gold and silver), with respect to which futures contracts are traded on a contract market or board of trade, held for investment purposes.
  5. Financial contracts (e.g., swaps and similar individually negotiated financial transactions), other than securities, held for investment purposes.
  6. For an investment company or a commodity pool, any binding capital commitments.
  7. Cash and cash equivalents held for investment purposes. Neither cash used by an individual to meet everyday expenses nor working capital used by a business is considered cash held for investment purposes.

Sources:

Image of Coin Stacks is by Darren Hester under a creative commons license.

Private Fund Exemptions under the Investment Company Act

Private investment funds primarily use two exemptions to avoid being defined as an “investment company” under the Investment Company Act of 1940: Section 3(c)(1) or Section 3(c)(7).

Less than 100 Investors

Section 3(c)(1) of the Investment Company Act excludes from being an investment company any issuer whose outstanding securities are beneficially owned by not more than 100 persons and that is not making and does not presently propose to make a public offering of its securities. The benefit of Section 3(c)(1) is that there is no additional status requirement for the investor, such as net worth, total assets, or total investments owned beyond the “accredited investor” standard.

There are some catches in trying to count the number of investors. There are several types of investors that result in a look through their ownership.

More than 100 Investors

If your private fund will have more than 100 investors, either directly or because of a look-through, then the fund will need to fit under the Section 3(c)(7) exemption. As with Section 3(c)(1) you cannot anticipate making a public offering. Investors in 3(c)(1) fund need only be accredited investors, but investors in a 3(c)(7) fund must be “qualified purchasers.”

The higher standard of qualified purchaser limits potential investors to institutional investors, investment managers and high net worth individuals. (More on the “qualified purchaser” definition in my next post.)

Contacting lots of investors may be viewed as general solicitation so you need to pay attention to the prohibition on general solicitation or advertisement under .

You will also need to be careful in limiting future transfers of interest in the private investment funds. With more than 100 investors, you will no longer be in the safe harbor exemption from being a publicly traded partnership.

500 or more Investors

Once you have 500 or more investors and more than $10 million in assets you are subject to the reporting requirements of the Exchange Act. Effectively you are no longer a private fund.

I believe something analogous happened to Google. They had gotten so big and their shares ended up in the hands of more than 500 people. Since they would have to begin complying with the reporting requirements, they may as well let the shares trade publicly.

So if you are going to end up with more than 500 investors in a private fund, you are better off having several smaller funds to avoid the public reporting requirements under the Exchange Act.

Sources:

Image of the Twenty Dollar Bill is by Darren Hester under a Creative Commons License.

Feds Release Usable Model Consumer Privacy Notice

There was much cheering when federal regulators finally released their Final Model Privacy Notice Form back in November.

That was quickly followed by a gnashing of teeth when it turns out the regulators did not understand the concept of a form or how to use Adobe Acrobat. They merely created a static document that you would have to spend hours trying to recreate.

They finally released version of the model privacy notice that is a fillable form using adobe acrobat.

To obtain a legal “safe harbor” and so satisfy the Gramm-Leach-Bliley Act’s disclosure requirements, institutions must follow the instructions in the model form regulation when using the Online Form Builder.

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