Month: June 2012

Compliance Bits and Pieces – Viva Le Tour

Saturday is the start of Tour de France as most of the world’s best cyclist queue at the starting line in Liège, Belgium. This week’s gathering of compliance stories starts with my story in Wired.com.

A Geek’s Guide to the Tour de France

The 99th edition of the Tour de France starts Saturday in Liège, kicking off three weeks of bicycle racing. Twenty-one teams of nine riders each will have to endure 3,497 kilometers of racing and 25 high mountain passes to reach the finish line on the Champs-Élysées in Paris. It’s an event full of incredible human achievement and endurance. Although it’s one of the largest sporting events in the world, it’s not widely watched in the US. It’s worth your time to watch it. Here is a geek’s guide to the Tour de France to help you get started: …

French Legislation Taxing Non-Resident Investment Funds While Exempting Domestic Funds Violated EU Law on Free Movement of Capital in Jim Hamilton’s World of Securities Regulation

French legislation taxing dividends paid to non-resident collective investment funds at 25 percent, while exempting domestic funds from the tax, violated EU law prohibiting restrictions on the movement of capital between Member States and between Member States and the US, ruled the European Court of Justice. A difference in the tax treatment of dividends according to an investment fund’s place of residence may discourage non-resident funds from investing in French companies and also discourage French investors from buying shares in non-resident funds.

2012 First Half FCPA Enforcement Round-Up: Part I and 2012 First Half FCPA Enforcement Round-Up: Part II from fellow cyclist Tom Fox

The first half of 2012 is reaching to a close and we have had several significant enforcement actions so far this year. So to commemorate all those June Bride and Bride-Grooms out there, including my parents who celebrate their 56th wedding anniversary on June 30, I have put together a couple of posts reviewing my top 6 Foreign Corrupt Practices Act (FCPA) enforcement actions for the first 6 months of 2012. At this point I cannot see any clear trends but there are some key points that provide solid advice for the compliance practitioner going forward.

How Giro Made a Cooler, Faster Helmet by Chuck Squatriglia in Wired.com’s Playbook

When it comes to bicycle helmets, protection is paramount. Everything else — cooling, aerodynamics, light weight — is a compromise. If you want more of one, you’ll surrender a little of the others. But Giro says it has achieved an ideal combination of excellent cooling, low drag and light weight in a bicycle helmet that actually makes you faster.

Bernard Madoff’s Brother Expected to Plead Guilty to Criminal Charges by Chad Bray in WSJ.com’s Law Blog

The brother of convicted Ponzi scheme operator Bernard Madoff will plead guilty to criminal charges Friday, marking the first time a family member has admitted guilt since the massive fraud came to light three-and-a-half years ago.

Pedaling and Charging by Daniel Hamermesh in Freakonomics

People multitask (in economists’ language, “engage in joint production”) in a surprising variety of ways. A neat example appeared in Brussels Airport, with a sign saying “charge your phone and laptop.” But the charging was done by you sitting on a saddle and pedaling a machine that generated the power charging your device.

Wandering Cape Cod bear captured in Boston suburb by Ros Krasny for Reuters

He’s baaack: A male black bear captured on Cape Cod earlier this month, where it was tranquilized and moved to central Massachusetts, showed up again on Tuesday just six miles from downtown Boston.

Goodbye SAS 70; Hello SSAE 16

Apparently I missed this big change. Statement on Auditing Standards No. 70 (SAS 70) was a widely used reporting tool for service organizations all throughout the globe. However, the migration towards more globally accepted accounting principles has put SAS 70 in the rearview mirror. Statement on Standards for Attestation Engagements (SSAE) No. 16, Reporting on Controls at a Service Organization completely replaces SAS 70, effective for reports with periods ending on or after June 15, 2011.

SOC 1: SSAE 16 Type 1 Examination
A SSAE 16 Type 1 examination is a report on management’s description of a service organization’s system and the suitability of the design of controls.

SOC 1: SSAE 16 Type 2 Examination
A SSAE 16 Type 2 examination is a report on management’s description of a service organization’s system and the suitability of the design and operating effectiveness of controls.

One of the biggest differences introduced by SSAE 16 is that the service auditor is required to obtain a written assertion from management of the organization about the matters the CPA is reporting on. The organization’s management provides the auditor with a written assertion to be included in the SSAE 16 examination report. The written assertion states the following:

  • Management’s description of the service organization’s system fairly presents the service organization’s system that was designed and implemented as of a specified date (or for a Type 2 – throughout the specified period);
  • The controls related to the control objectives stated in management’s description of the service organization’s system were suitably designed to achieve those control objectives as of the specified date (or for a Type 2 – throughout the specified period);
  • The controls related to the control objectives stated in management’s description of the service organization’s system operated effectively throughout the specified period to achieve those control objectives (Type 2 only).

I’ll need to dive deeper into the changes. For now, I need to make sure I say “SSAE 16” instead of “SAS 70”.

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Another Real Estate Ponzi Scheme

The Securities and Exchange Commission is claiming that Wayne L. Palmer and his firm, National Note of Utah, were operating a real estate-based Ponzi scheme that bilked $100 million from investors. U.S. District Judge Bruce Jenkins issued a temporary restraining order, froze the assets of National Note, and appointed attorney Wayne Klein as a receiver to take over the company’s operations.

So far, the statements in the SEC complaint have not been proven and Mr. Palmer is contesting the charges. As I have with other cases, I look at lessons from the filings, assuming they are true, to highlight issues that should be warning.

A first warning is the use of bank account names.

National Note investors initially deposit their funds into an account at JP Morgan Chase Bank titled “investor trust account.” National Note immediately wires nearly all these investor funds to an account at Wells Fargo titled “investor interest account.” National Note’s internal accounting classifies the investor funds as income upon transfer to the Wells Fargo investor interest account. From the Wells Fargo investor interest account, the funds are used to pay returns to other investors.

Why the need to fund interest payments? According to the SEC complaint, the Palmer companies only generated $300,000 in revenue and was obligated to pay $1 million in interest to not holders. Palmer was selling notes that paid a 12% interest rate.

Another warning sign is that the notes were marketed as guaranteed, with a complete safety of principal. The safest investment is US treasuries and it pays less than 2%. You can’t expect a 12% return to not have significant risk.

Another is his use of EMS  and CCFMB after his name. They are impressive acronyms, but I can’t figure out what they stand for. EMS typically stands for Emergency Medical Services, but that doesn’t sound right for a real estate professional. I searched LinkedIn for CCFMB and Mr. Palmer was the only person who came back.

Another warning is where the money from the sale of notes is being deployed. The claim is that it purchases real estate notes and real estate equity that generates returns of 15% to 20 annually. According to the complaint all of the capital is being deployed into related entities controlled by Palmer.

It looks like Palmer’s scheme unraveled in October 2011 when it failed to make interest payments. The complaint does not point out when Palmer’s business went from legitimate to Ponzi. The SEC goes as far back at 2009 when the scheme raised $18.6 million while paying back $14 million in investors.  Palmer has been in the real estate business for many years. So I’m skeptical that his operation has been a fraud from the outset. I would guess that he ran into trouble in 2008, just like everyone else on the planet. Rather than be honest and open about losses, he tried to cover them up and hope things would recover fast enough to dig him out of his hole.

Scott Frost, Paul Feindt, Matthew Himes and Alison Okinaka of the SEC’s Salt Lake Regional Office conducted the investigation; Thomas Melton will lead the litigation.

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Compliance Bits and Pieces for June 22

SEC Charges Florida Broker in Astrology-Based Ponzi Scheme

“Persaud preyed on people who trusted him by promising high and steady returns while hiding his unconventional trading strategy,” said Eric I. Bustillo, Director of the SEC’s Miami Regional Office. “When Persaud blatantly lied to investors and hid their losses through a Ponzi scheme, he should have known that an SEC enforcement action was in the stars.”

SEC Builds Money Fund Case by Andrew Ackerman and Kirsten Grind in the Wall Street Journal

Money market mutual funds have been rescued from financial trouble by their parent companies more than 300 times since the 1970s, about 100 more than previously reported, according to a new Securities and Exchange Commission study.

Trial is Not a Crime in America by Scott Greenfield in Simple Justice

[T]hese trials are the ones that test us.  As much as we may revile an alleged crime, and empathize with the purported victims, we have a system by which people accused of crimes are entitled, entitled as in it is their absolute right, to challenge their accusations before we punish them.  The right to a trial isn’t protected for those we favor and denied to those we don’t.  It isn’t limited to those about whom the public thinks a doubt may exist and denied to those we don’t.

Social power and morality by Dan Ariely

The following is taken from the graduation speech of Michael Lewis at Princeton in 2012. In it, he discusses an experiment that explores the relationship between power and morality.

“…… a pair of researchers in the Cal psychology department staged an experiment. They began by grabbing students, as lab rats. Then they broke the students into teams, segregated by sex. Three men, or three women, per team. Then they put these teams of three into a room, and arbitrarily assigned one of the three to act as leader. Then they gave them some complicated moral problem to solve: say what should be done about academic cheating, or how to regulate drinking on campus.

Exactly 30 minutes into the problem-solving the researchers interrupted each group. They entered the room bearing a plate of cookies. Four cookies. The team consisted of three people, but there were these four cookies. Every team member obviously got one cookie, but that left a fourth cookie, just sitting there. It should have been awkward. But it wasn’t. With incredible consistency the person arbitrarily appointed leader of the group grabbed the fourth cookie, and ate it. Not only ate it, but ate it with gusto: lips smacking, mouth open, drool at the corners of their mouths. In the end all that was left of the extra cookie were crumbs on the leader’s shirt.

This leader had performed no special task. He had no special virtue. He’d been chosen at random, 30 minutes earlier. His status was nothing but luck. But it still left him with the sense that the cookie should be his.”

California Redefines “Private Fund”

I’ve spent a great deal of brain power on the definition of “private fund” under the Investment Advisers Act. California has added its own twist on the definition. It’s a twist that is very important to real estate fund managers.

Working through the definition of “private fund” requires wading through the Investment Company Act. Congress chose to define it as a “an issuer that would be an investment company, as defined in section 3 of the Investment Company Act of 1940 (15 U.S.C. 80a-3), but for sec­tion 3(c)(1) or 3(c)(7) of that Act”. Then it requires a re-visit to the first week of discussion in a securities law class over what is a security.

Most private funds, including real estate funds, have looked at the exclusions under sec­tion 3(c)(1) or 3(c)(7) as safe harbors from registration under the Investment Company Act. They have very clear requirements fro compliance. With the new definition of “private fund” under the Investment Advisers Act, many real estate fund managers have looked at the exclusion under Section 3(c)(5) and wondered if that will work as an exclusion.

California is the first state to recognize the loophole and proposed changes to its definition of private fund in the proposed changes to Rule 260.204.9:

“Qualifying private fund” means an issuer that qualifies for the exclusion from the definition of an investment company under section 3(c)(1), 3(c)(5), or 3(c)(7) (or any combination thereof) of the Investment Company Act of 1940, as amended….[my emphasis]

Given the twisted definitions under the Investment Advisers Act, fund managers could classify themselves out of the federal level of registration and into the state level. At the state level, a fund manager could find other exemptions and exclusions from registration. Although, the state level definitions are continuing to change and catch up to the changes brought by Dodd-Frank.

I have not worked through the implications of this new definition of “private fund”. I decided I’d rather deal with the Securities and Exchange Commission than a collection of state regulators. For a real estate fund manager with operations in California who didn’t register with the SEC, you may need to re-visit the analysis for your exemption.

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Tipping and Insider trading

I didn’t follow the trial of former Goldman Sachs Group Inc. director Rajat Gupta. It seemed like a fairly straight-forward case under the current jurisprudence for insider trading. He possessed material, non-public information. He had that information because he sat on the board of directors of Goldman Sachs. Because he was a board member he had a duty not to disclose the information. He disclosed the information in violation of that duty.

The interesting part is that Gupta did not receive a direct financial benefit from tipping the information. He did not trade on the securities and did not get a piece of the financial reward gained by the person he gave the information to. The government put some indirect benefit into evidence and that was enough.

The easy lesson is to make sure that your policies and training point out that tipping material, non-public information can have the same consequences as trading on that information.

Sources:

Image of Rajat Gupta by Sebastian Derungs

Anti-Money Laundering Program and Procedures

The Foreign Corrupt Practices Act has taken center stage in the headlines for international finance problems. But last week the regulators let us know that the PATRIOT Act has not gone away. ING Bank agreed to forfeit $619 million after admitting that it covered up billions of dollars in transfers that violated U.S. sanctions on Iran and Cuba.

That was a record settlement under the OFAC regime. The settlement resolves OFAC’s investigation into ING Bank’s intentional manipulation of information about U.S.-sanctioned parties in more than 20,000 financial and trade transactions routed through third-party banks located in the United States between 2002 and 2007.

From the Settlement Agreement it looks like ING was trying to isolate some banking relationships with Cuba. It tried to isolate money originating from Cuba from the rest of the international banking world, at least so far as that money is banned from the international banking world. According to the Settlement Agreement, the bank and its employees went too far and altered transaction information to hide the evidence that money was coming from Cuba.

ING also deleted origination information for transactions involving Iranian money. The problem was that some of the transactions used US dollars, which meant the transactions were cleared through New York and subject to US jurisdiction.

Private fund managers are subject to OFAC restrictions and are otherwise prohibited from dealing with “bad guys.” FINRA has provided a template for small brokerage firms: Anti-Money Laundering (AML) Template for Small Firms.

The world of private equity is probably not very attractive for money laundering. The investments are long term and require the contribution of cash over many years. The investment is illiquid and will take years to be returned. Most money laundering transactions look for a more liquid transfer of cash. Since their illegal funds are isolated, they are already illiquid.

Sources:

Amsterdam Zuidoost ING-Bank is by Pieter Delicaat

Click to access 06122012_ing_agreement.pdf

Compliance Bits and Pieces for June 15

Setting the Career Path for Compliance Officers by Matt Kelly in Compliance Week‘s Big Picture blog

I asked these half-dozen conference attendees to sit down with me over breakfast and explain why workforce development is such a challenge for this field. The problem has its roots in two fundamental tensions, they told me. First is the lack of any sweeping, cross-industry standards for compliance professionals. Lawyers need an advanced degree from a law school and a license from the local bar association—but once they have them, the legal tasks most companies face (lawsuits, investigations, document preparation) are largely the same from one company to another. Accountants need a degree in accounting and a license from the state accounting board—but once they have those, the financial reporting tasks they face are largely the same as well.

Court Says 1st Amendment Protects Lawyer’s Blogging by Robert Ambrogi in LawSites

A three-judge panel in Virginia has issued a decision that is important for lawyer-bloggers everywhere. The panel ruled that a lawyer has a First Amendment right to blog about his own cases, at least with regard to information that is already available on the public record. (Needless to say, you should never blog about privileged client information.)

Will The Pilot Know When A Corporation Has “Crost the Bar”? by Keith Paul Bishop in California Corporate & Securities Law Blog

While it is tempting to think that the test is now 2,000 record holders, a more realistic assessment would be to consider the test unchanged unless the issuer is able to keep track of the accredited investor status of its shareholders. This could be a real problem because the status of investors may change or the securities may be transferred to different investors.

ING Bank Forfeits $619 Million In Largest-Ever OFAC Settlement by Samuel Rubenfeld in WSJ.com’s Corruption Currents

The ING Bank NV unit moved billions of dollars from the early 1990s until 2007 through the U.S. financial system on behalf of Cuban, Burmese, Sudanese, Libyan and Iranian clients by stripping out data embedded in payment messages that would have identified the illegal nature of the transactions, according to the settlement agreement signed by the bank and the U.S. Treasury Department.

Flatiron Building (New York City) seen from Empire State Building in September 2004 photographed by Bernd Schubart

Pay to Play and Cash Solicitations

The Securities and Exchange Commission extended the date by which registered investment advisers must comply with the ban on third-party solicitation in Rule 206(4)-5 under the Investment Advisers Act. The SEC is extending the compliance date in order to ensure an orderly transition. Since solicitors will need to registered as an investment adviser or a broker/dealer or a municipal advisor.

Part of the rule was reliant on FINRA coming up with a rule to meet the requirements under the definition of “registered person” in 206(4)-5(f)(9)(ii)(B) for broker-dealers. FINRA has not done that yet. (Isn’t FINRA supposed to be more effective than the SEC?)

It’s not just FINRA, the the Municipal Securities Rulemaking Board has not finished its rules for municipal advisers under 206(4)-5(f)(9)(iii).

My IACCP symposium also raised the limitations in Rule 206(4)-3. That rule prohibits the use of solicitors in fundraising unless certain requirements are met. The rule specifically refers to “clients” with no further elaboration. For a private fund, that raises the distinction between the fund as a client and the fund investors as limited partners in the fund.

Fortunately, there is an interpretative letter ruling on the topic

We believe that Rule 206(4)-3 generally does not apply to a registered investment adviser’s cash payment to a person solely to compensate that person for soliciting investors or prospective investors for, or referring investors or prospective investors to, an investment pool managed by the adviser.

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Preliminary Results of Dodd-Frank Act Changes to Investment Adviser Registration Requirements

The Securities and Exchange Commission has released some statistics on the effect of Dodd-Frank on the registration of investment advisers (.pdf). March 30, 2012 was the compliance date for several provisions of the Dodd-Frank Act that amended the registration provisions of the Investment Advisers Act.

Registered private fund advisers advise 30,617 private funds with total assets of $8 trillion, which is 16% of total assets managed by all registered advisers. Approximately 31% of private fund total assets are attributable to advisers that registered since the effective date of the Dodd-Frank Act. Hedge funds (53%) and private equity funds (24%) comprised the majority of private fund assets managed by registered advisers. Real estate funds are in the other 23% along with liquidity funds and venture capital funds.

A total of 1,950 exempt reporting advisers filed Form ADVs with the SEC. 41% are foreign advisers. Exempt reporting advisers account for 6,702 private funds with total assets of $1.5 trillion. Of that mix, 17% are venture capital funds.

There are currently 12,623 advisers registered with the SEC with total assets under management of $48.8 trillion. The SEC expects expects that 2,400 mid-sized advisers will switch to state registration by June 28, 2012, resulting in approximately 10,000 advisers with $48.6 trillion in assets under management registered with the SEC.

Using these projections, the SEC anticipates that the cumulative impact of the Dodd-Frank Act registration changes will be a 25% decrease in the number of advisers registered with the Commission, but a 12% increase in the total assets under management of those registered advisers.