Month: September 2011

Compliance Bits and Pieces for September 30

These are some compliance-related stories that recently caught my eye:

“Is there anything connected with this accelerator that involves the security of the country?” by Chris Yeh in Adventures in Capitalism

“It has only to do with the respect with which we regard one another, the dignity of man, our love of culture. It has to do with: Are we good painters, good sculptors, great poets? I mean all the things we really venerate in our country and are patriotic about. It has nothing to do directly with defending our country except to make it worth defending.” – physicist Robert Rathburn Wilson

California and Bust by Michael Lewis in Vanity Fair

The smart money says the U.S. economy will splinter, with some states thriving, some states not, and all eyes are on California as the nightmare scenario. After a hair-raising visit with former governor Arnold Schwarzenegger, who explains why the Golden State has cratered, Michael Lewis goes where the buck literally stops—the local level, where the likes of San Jose mayor Chuck Reed and Vallejo fire chief Paige Meyer are trying to avert even worse catastrophes and rethink what it means to be a society.

At SEC, Strategy Changes Course by Jean Eaglesham in the Wall Street Journal

In a major shift from the agency’s traditional enforcement strategy, the SEC could file more civil cases in which defendants are accused of negligence only, rather than harder-to-prove charges of intentional wrongdoing or recklessness, according to SEC officials.

Ethisphere and the New York Stock Exchange

This morning, the Ethisphere Institute is ringing The Opening Bell at the New York Stock Exchange with some of the NYSE-listed 2011 World’s Most Ethical Companies. I guess the NASDAQ companies are not invited.) The purpose is to recognize the connection between ethical business practice and increased business performance.

NYSE-listed 2011 World’s Most Ethical Companies that will ring the bell with Ethisphere include

  • AECOM
  • Ford
  • General Electric
  • International Paper
  • Jones Lang LaSalle
  • Marriott
  • PepsiCo
  • Salesforce.com

The Bell ringing is followed by Ethisphere’s NYSE Bell Ringing & Ethics Drives Performance™ Conference.

The World’s Most Ethical Companies, if indexed together, have significantly outpaced the S&P 500. I found it interesting that the companies outperform going forward once they are recognized, not just leading up to the recognition.

Ethisphere numbers seem to take the current list of companies and look at their performance. I expect that companies getting onto the list are well run and should perform well. But would it last going forward? I took the companies from the original 2007 and tracked them forward.

The companies on the 2007 list, as a group outperformed the broader S&P 500 and Dow Jones Industrial Average.  They were not all winners.

Ethisphere is now accepting nominations for the 2012 World’s Most Ethical Companies. To learn more about the World’s Most Ethical Companies recognition and selection process and to nominate your organization for consideration visit:http://ethisphere.com/nominations/.

The Echoes of Madoff at the SEC

The Madoff scandal is one of the low points in the history of the Securities and Exchange Commission. Every Congressional hearing or SEC-basher inevitably uses the failure to catch Madoff as evidence of the ineffectiveness of the SEC.

In a continuing journey down the rabbit hole, the SEC’s Inspector General David Kotz released his 123-page report (.pdf) on former SEC General Counsel David Becker and his involvement with Madoff. Kotz has made a referral to the Department of Justice under a criminal conflict of interest provision.

Mr. Becker’s late mother had an account with Madoff. If Mr. Becker were to be involved in mopping up the Madoff matter, there would be potential conflict of interest.

David Becker seems to have done the correct thing. He sought an answer from the SEC Ethics Counsel as to whether he should work on Madoff matters.

“I did precisely what I was supposed to do. I identified a matter that required legal advice from the SEC’s Ethics Office. I sought that advice, received it, and followed it.” Testimony of David Becker September 22, 2011

He fully disclosed the fact that he had been a beneficiary of his mother’s estate which had invested in Madoff funds. The Ethics Counsel told him he did not need to recuse himself. His boss, SEC Chair Mary Shapiro, knew of the investment.

Nonetheless, the SEC’s Inspector General is referring its results to the Department of Justice for criminal investigation.

Personally, I don’t think Mr. Becker actually did anything wrong. I believe he joined the SEC as a white hat, wanting to resume his role in public service.

The problem is that it looks like he did something wrong. That’s the problem with conflicts of interest. Even if you do the right thing, it will look like you were improperly influenced or tainted.

Becker did seek guidance from the SEC’s Ethics Counsel. Unfortunately, the Ethics Counsel is part of the Office of the General Counsel. As General Counsel, Becker was the advice-giver’s boss. Another conflict.  I’m not saying that Becker actually unduly influenced the Ethics Counsel. It’s just looks bad and layers another conflict of interest onto the existing conflict of interest.

The SEC knew that Madoff was toxic and high-profile. They should have been more vigilant and not allowed Becker to participate. I would guess that Becker was so good at his job and so enthusiastic to help that he and the SEC failed to see his weaknesses. It would be hard to make him sit on the sidelines while the Commission was trying to clean-up after one of its biggest failure. But that is what they should have done.

They let the conflict of interest stay in place. That should have known that it would subject them to a later review and attack on their decision to keep Becker involved. They should have known that it would have led to something like the Inspector General’s report.

I don’t think Becker should be subject to criminal charges and hopefully the Department of Justice will drop the matter after a brief investigation.

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But the Computer Did It!

The Securities and Exchange Commission brought charges of securities fraud for concealing a significant error in the computer code of the quantitative investment model. I found this case to be interesting because it was not flawed human decisions, but flawed computer decisions. However, we still live in the age where computers do what we tell them to do. So, if the computer is doing something wrong, then a person is behind it.

Barr M. Rosenberg developed complex automated models and an “optimization” process to create and manage client portfolios. Barr Rosenberg Research Center LLC was the registered investment adviser. In April 2007, BRRC put into production a new version of the Risk Model, one component of its quantitative trading program. Two programmers linked the Risk Model to the Optimizer, a second component of the quantitative trading program. However, they made an error in the Optimizer’s computer code.

In June 2009, an employee noticed some unexpected results when comparing the new Risk Model to the existing one that was rolled out in April 2007. Some Risk Model components sent information to the Optimizer in decimals while other components reported information in percentages. That meant the Optimizer had to convert the decimal information to percentages in order to effectively consider all the information. That screwed up the inputs and the outputs resulting in the Optimizer not giving the intended weight to common factor risks.

As with most mistakes that lead to SEC action, the error caused the portfolios to underperform. The error impacted more than 600 client portfolios and caused approximately $217 million in losses. Obviously, this is a bad result.

The problems came, as they usually do, when someone tried to hide the problem. Mr. Rosenberg concealed the error and told his employees not to disclose the error to the investment officers or managers of the firm. That meant the firm was making material misrepresentations and omissions concerning the error to their clients, including:

(i) omitting to disclose the error and its impact on client performance,
(ii) attributing the Model’s underperformance to market volatility rather than the error, and
(iii) misrepresenting the Model’s ability to control risks.

The SEC charged Rosenberg with willful violations of  Sections 206(1) and 206(2) of the Investment Advisers Act. Section 206(1) prohibits any investment adviser from, directly or indirectly, “employing any device, scheme, or artifice to defraud any client or prospective client.” Section 206(2) prohibits any investment adviser from engaging in any “transaction, practice or course of business which operates as a fraud or deceit upon any client or prospective client.”

Rosenberg was aware of the problems, but did not disclose the error and directed others not to disclose. As a result, the firm misrepresented that the underperformance was attributable to factors other than the error and inaccurately stated that the model was functioning when in fact it was not. In addition, Rosenberg’s caused a delay in fixing the error leaving it uncorrected for several additional months. Rosenberg caused his clients to continue sustaining losses from an error that could have been promptly fixed.

Rosenberg has to pay the $2.5 million penalty fine and he received the ban from the SEC. He is barred from association with any broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization and prohibits him from serving as an officer, director or employee of a mutual fund.

Lesson learned. If the computer is broken, fix it right away. And don’t lie about it.

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Compliance Bits and Pieces for September 23

These are some compliance related stories that recently caught my attention:

Forgotten Bookmarks: Investment in Reading Pays Off by Michael Popek in Forbes

I come across a lot of interesting items left behind in books, but I’d say that most of them don’t interest Forbes readers all that much. I hope this find will pique your interest:

Watch out: Blogger uses web to uncover suspected corruption in thebriberyact.com

This week the Daily Telegraph reported that a Chinese blogger has been running through the picture archives of Chinese State officials on the web and clocking the watches they wear.

The result.

The blogger reports that Chinese officials earning c.£10k a year appear to be sporting collections of watches valued at tens of thousands of pounds, including gold rolexes, cartiers and the like.

Inside Straight: Avoiding E-Mail Stupidity By Mark Herrmann in Above the Law

There’s one guy in your outfit who understands the need not to write stupid e-mails: That’s the guy who just spent all day in deposition being tortured with the stupid e-mails that he wrote three years ago.

That guy will control himself. He’ll write fewer and more carefully phrased e-mails for the next couple of weeks. Then he’ll go back to writing stupid stuff again, just like everyone else.

Was Full Tilt Poker a Ponzi Scheme?

The United States Government forced online poker sites to the fringes of the financial system. The U.S. government has long argued that online poker gambling is illegal under the Wire Act, a 1961 law that explicitly prohibits sports betting conducted over electronic communication. In 2006, Congress made it illegal for financial institutions to process funds for online gambling.

It should be no surprise that an online poker site would run into legal problems. The complaint against Full TItle Poker caught my eye because

“By March 31, 2011, Full Tilt Poker owed approximately $390 million to players around the world, including approximately $150 million to United States players. However, the company had only approximately $60 million in its bank accounts.”

Many Ponzi schemes started off as legitimate enterprises. When funding shortfalls or an unexpected loss hits, the managers try to hide the bad news. This creates a spiraling downfall leading from poor management to criminal behavior. In this case, Full Tilt was having trouble moving the cash around the financial system to collect wagers from players and make payments to the winners. It sounds like Full Tilt was funding winnings without withdrawing initial bets from the player accounts.

But was it a Ponzi scheme? While there is no official definition of a Ponzi scheme, these are what I think are the elements:

(1) A promise of financial reward.

(2) Current contributions to the scheme are not invested, but are spent to make good on returns promised to earlier contributors.

(3) The manager of the scheme maintains his ability to pay the returns only by getting other contributors.

(4) The contributors think the manager is investing their contributions to make the return (not necessarily in a fully legal way).

(5) If future contributors do not arrive in sufficient numbers, the Ponzi scheme will have too little money to pay current returns/redemption.

Full Tilt was not an investment scheme. Sure you can argue about whether poker success is based on skill or luck, with luck being a key element of gambling. (I think it’s a combination of both.) But it’s not an investment and you are not buying a security. The contributors did not think the manager was doing anything with the money other than keeping it safe. They were winning or losing based on the hands the contributors played.

It does seem that current winnings were being paid from new contributions. According to the complaint, the mangers were taking more cash out than the business could support. The company had a funding shortfall because it was having trouble moving the wagers and winnings through the financial system.

You would hope that a leading federal prosecutor would know the difference between different types of fraud. Full Tilt was not a Ponzi scheme. As good as you may be at poker, your wagers are not investments.

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Miscommunication

Are you speaking the same language as the rest of your firm?

Do they understand your questions?

Do they understand your answers?

Miscommunication is at the root of many problems. Many compliance policies are written by lawyers, for lawyers. That may work fine once there is an investigation or a problem. But they do little to prevent the problem. Outside of compliance and legal, the rest of the firm can’t grasp the language used.

One of the goals of compliance should be translate complex legal requirements into easy to understand rules.

There are only 10 types of people in the world: Those who understand binary, and those who don’t.

Comic is from xkcd 1 to 10.

Conflicts of Interest and Securitizations

The Big Short highlighted some of the difficulties of taking an investment position in a real estate downturn. The situation was taken a step further with Goldman Sachs’ help in putting together mortgage backed securities with the primary purpose of helping a client take an investment position that the securities will default. It turned out very well for Goldman’s client and terrible for the purchasers of the securities.

Section 621 of the Dodd-Frank Wall Street Reform and Consumer Protection Act prohibits an underwriter, placement agent, initial purchaser, or sponsor, or any affiliate or subsidiary of any such entity, of an asset-backed security from engaging in a transaction that would involve or result in certain material conflicts of interest. It then leaves it up to the Securities and Exchange Commission to issue rules for the purpose of implementing this new prohibition.

The SEC published a proposed rule at its Open Meeting on Sept. 19, 2011: Prohibition against Conflicts of Interest in Certain Securitization (.pdf).

The proposed rule could — if certain conditions are otherwise met — prohibit a firm from packaging Asset Backed Securities, selling them to an investor, and subsequently shorting the Asset Backed Securities to potentially profit at the same time as the investor would incur losses.

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What Does a Criminal Look Like?

A group of Kentucky men would prefer to spend time in jail time rather comply with vehicle safety rules.

As you can see from their booking photos, the men are Amish and belong to the Old Order Swartzentruber Amish group. They say their religious beliefs forbid the placement of bright orange safety triangles on the backs of their buggies. They believe that displays of “loud” colors should be avoided, along with the use of “worldly symbols.” Swartzentruber Amish believe such symbols indicate the user no longer trusts fully in God.

The orange triangles are required on all slow-moving vehicles, according to Kentucky state law. The Swartzentruber Amish use along with lanterns and red reflector lights, but refuse to use the orange triangle.

Is this a case of a bad rule, over-zealous enforcement, or criminal behavior? The compliance aspect of the situation caught my attention. The ethical, religious, and legal aspects of the situation are numerous.

The goal is to make sure that all vehicles on public roads are visible, especially slow-moving vehicles. That seems to be a reasonable goal.

This is not the first time the Amish community has clashed over this issue. In 2003, the Swartzentruber families in Nicktown Ohio successfully appealed after they refused to put orange reflective triangles on their horse-drawn buggies. They were allowed to mount less gaudy gray tape. Other states already accommodate the religious beliefs of conservative Amish groups by allowing the use of reflective tape instead of triangles.

I fall on the side of the Amish on this one. Suppose the rule was not for a triangle, but a six-pointed star. SOme would argue that it is merely an icon. Others will argue that it has obvious religious implications. The triangle symbol does not mean much to me, but it does to this Amish sect.

They don’t like bright colors. That seems to conflict with the need for visibility. One of the failings in the orange triangle rule is that the regulators had no studies to show that the orange triangle decreased the rate of collisions more than gray reflective tape the Amish were willing to use.

From a compliance perspective, it’s always better to have a clear, simple rule. When the situation gets complicated by deeply held beliefs that conflict with the rule, it’s time to revise the rule or allow deviations from the strict rule.

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