As a compliance officer, I often find that many lessons come from enforcement actions. Those actions imposed on compliance officers are especially instructive. The latest to catch my attention comes from the United Kingdom.
The Financial Services Authority levied a £14,000 fine and banned a compliance officer from performing any significant influence function in regulated financial services. The circumstances arose from an employee’s attempt to conceal losses after the collapse of Lehman Brothers in 2008.
Dr Sandradee Joseph was Compliance Officer at Dynamic Decisions Capital Management (DDCM), a hedge fund management company based in London. One of DDCM’s funds suffered catastrophic losses during the fall of 2008, losing 85% of its assets under management. A fund employee, rather than report the losses, decided to enter into a complicated bond transaction to create false profits. Essentially, the employee was buying bond units at a steep discount, but reporting a much greater value when calculating the fund’s NAV. The fund had lost $255 million, but the employee booked a $268 million gain on the bond transaction. A bond that the fund had only paid $5 million.
Three problems arose that the FSA thinks were instances of the compliance officer not doing her job.
The first was that the fund’s prime broker terminated its agreement with the fund because of the bond transaction. Any trade that causes the prime broker to leave should be a big red flag.
The second was an unhappy investor. The investor had put $48 million into the fund. The bond happened to violate some of its investment restrictions: maturity greater than 12 months, issued by an unlisted entity, no option to convert equity, and greater than 3% of the fund’s NAV. Violations of an investor’s investment guidelines should be a big red flag for a compliance officer.
The third problem was another unhappy investor. The bond transaction also violated this investor’s permitted investments limitation. A second big red flag that the compliance officer failed to remedy. This investor dug a bit deeper and felt that the bond may have been fraudulent.
The compliance officer tried a few defenses that sound weak to me. They sounded weak to the FSA as well.
- The compliance officer’s role was a reporting function and it was up to individual employee to ensure compliance.
- The compliance officer was not the fund’s lawyer and she could take a back seat on legal matters.
- The compliance officer felt enough advisers were looking at the issue.
- The compliance officer did not understand the bond and was relying on external lawyers to review it. (However, she never instructed a law firm to to carry out due diligence on the bond.)
- The compliance officer believed the bond was legitimate. (Even though she disclosed that she didn’t understand it.)
The FSA lays out the lesson learned: “In her role, if [the compliance officer] became aware of concerns that the firm was not complying with its regulatory obligations, she should have taken steps to ensure that these concerns were investigated, to verify if the concerns appeared to be legitimate, and if so to take appropriate action.”
As a compliance officer, I initially found the punishment to be on the harsh side especially since it seems to single out the compliance officer. Then I dug a little deeper and saw that criminal investigations were started by the SFO and the investors filed suit against DDCM.