Month: November 2012

Compliance Bricks and Mortar for November 30

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

What’s the Solution for Boring and Ineffective Compliance Training? by Joe Murphy in Corporate Compliance Insights

My experience, having worked in depth with both live and online training, is that both have the potential to be done poorly and to fail in their missions. If online training is designed so it is boring and easy to click through, or has the opposite fault of being all fun with no lasting learning, it will fail. On the other side, online training, when done well, is unmatched in its ability to reach large numbers of employees and to use advanced adult learning techniques to have a dramatic impact. It is also excellent in assuring that all employees receive a consistent message and that the employees’ participation is measured and recorded. If live training is done poorly it can result in employees getting bad advice or being subjected to painfully boring and legalistic lectures that only breed resentment.

His Last Bow: Sherlock Holmes and Embracing Chaos To Build Compliance Programs by Tom Fox

First, the hierarchical model of leadership will not work, but more importantly “There exists no single model that leads to success.” This means that compliance leadership must be ready to throw aside previous assumptions and “embrace hierarchical top-down leadership and bottom-up systems.” But this requires time for reflection both by the leadership teams and those below who are on the ground. Companies must recognize the diversity in their companies on a global basis. Not everything can be accomplished by the corporate office in the US nor can everything be run from the home office, wherever that may be. Safian ended his article by stating that “”Deciders find it really hard to accept failure, but tinkerers and engineers are undeterred by it. Failure is part of the process. We can’t run from it.” Nor should we.”

Is The SEC’s Ponzi Crusade Enabling Companies To Cook The Books, Enron-Style? by Francine McKenna in Forbes

So what happened? Call it the Bernie Madoff effect. Embarrassed that it missed the Ponzi King’s $65 billion scheme, the SEC reorganized its enforcement division, eliminating an accounting-fraud task force and adding new units to pursue crooked investment advisors and asset managers, market manipulations and violations of the Foreign Corrupt Practices Act. Since then Pfizer, Oracle, Aon, Johnson & Johnson and Tyson Foods have all paid fines to settle foreign-payoff charges.

Private Equity Fund Is Not a “Trade or Business” Under ERISA by Morgan Lewis

In a significant ruling that directly refutes a controversial 2007 opinion by the Pension Benefit Guaranty Corporation (PBGC) Appeals Board, the U.S. District Court for the District of Massachusetts held in Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pension Fund that a private equity fund is not a “trade or business” under the Employee Retirement Income Security Act (ERISA) and therefore is not jointly and severally liable for millions of dollars in pension withdrawal liability incurred by a portfolio company in which the private equity fund had a substantial investment.

Bank of America CEO Brian Moynihan Apparently Can’t Remember Anything by Matt Taibbi in Rolling Stone

Thank God for Bank of America CEO Brian Moynihan. If you’re a court junkie, or have the misfortune (as some of us poor reporters do) of being forced professionally to spend a lot of time reading legal documents, the just-released Moynihan deposition in MBIA v. Bank of America, Countrywide, and a Buttload of Other Shameless Mortgage Fraudsters will go down as one of the great Nixonian-stonewalling efforts ever, and one of the more entertaining reads of the year.

Attorney Liable for Aiding Securities Fraud by Drafting False Opinion Letter by Barbara Black in Securities Law Prof Blog

According to the SEC’s summary judgment motion, in early 2006, Sourlis intentionally authored a materially false and misleading legal opinion, which Greenstone used to illegally issue over six million shares of stock in unregistered transactions. Among other things, Sourlis falsely described promissory notes, note holders, and communications with those holders, none of which actually existed. The SEC asserted that, contrary to Sourlis’ fraudulent opinion letter, the stock issuance did not qualify for an exemption from registration under the federal securities laws.

SEC Charges Chicago-Based Investment Adviser With Defrauding Investors In Failing Private Equity Fund

The SEC alleges that Joseph J. Hennessy and Resources Planning Group (RPG) raised more than $1.3 million by misrepresenting the Midwest Opportunity Fund (MOF) as a viable private equity fund that could offer high returns. Hennessy failed to tell investors about the fund’s poor financial condition or that their money was being used to repay MOF promissory notes that he had personally guaranteed. He therefore misappropriated client funds to make payments on the notes and prop up the fund. Hennessy used at least $641,408 to make partial payments to certain note holders, substantially reducing his personal liability on the notes.

What is a Commodity Pool?

The CFTC stretched when it said that a fund entering into even a single swap used purely for hedging purposes — will hold “commodity interests” and accordingly could be viewed as commodity pools by the CFTC. The CFTC has construed the concept of commodity pool broadly and has consistently maintained that there is no minimum trading threshold for qualification as a CPO.

The big complication is that interest rate derivatives are now considered commodity interests and subject to CFTC oversight. Up until a few weeks ago, foreign exchange derivatives were also considered a commodity interest. On November 16, 2012, the US Department of the Treasury issued a final determination  that foreign exchange swaps and certain foreign exchange forwards are not commodity interests.

In looking closer at the statutory definition of “commodity pool” it seems that single swap should not turn a private fund into a commodity pool.

Title 7 of the US Code Section 1(a)

(10) Commodity pool

(A) In general
The term ‘‘commodity pool’’ means any investment trust, syndicate, or similar form of enterprise operated for the purpose of trading in commodity interests, including any—
(i) commodity for future delivery, security futures product, or swap;
(ii) agreement, contract, or transaction described in section 2(c)(2)(C)(i) of this title or section 2(c)(2)(D)(i) of this title;
(iii) commodity option authorized under section 6c of this title; or
(iv) leverage transaction authorized under section 23 of this title.

From the statutory definition, the fund needs to operated for the purpose of trading in commodity interests.

One argument is that the fund is an end user and therefore not organized for the “purpose of trading in commodity interests.” Under the new end user exception to the swap clearing requirement, the key test is whether the entity is “using the swap to hedge or mitigate commercial risk.”

What is a swap used to hedge or mitigate commercial risk?

(c) Hedging or mitigating commercial risk.

For purposes of section 2(h)(7)(A)(ii) of the Act and paragraph (b)(1)(iii)(B) of this section, a swap is used to hedge or mitigate commercial risk if:

(1) Such swap:

(i) Is economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise, where the risks arise from:

(A) The potential change in the value of assets that a person owns, produces, manufactures, processes, or merchandises or reasonably anticipates owning, producing, manufacturing, processing, or merchandising in the ordinary course of business of the enterprise;

(B) The potential change in the value of liabilities that a person has incurred or reasonably anticipates incurring in the ordinary course of business of the enterprise;

(C) The potential change in the value of services that a person provides, purchases, or reasonably anticipates providing or purchasing in the ordinary course of business of the enterprise;

(D) The potential change in the value of assets, services, inputs, products, or commodities that a person owns, produces, manufactures, processes, merchandises, leases, or sells, or reasonably anticipates owning, producing, manufacturing, processing, merchandising, leasing, or selling in the ordinary course of business of the enterprise;

(E) Any potential change in value related to any of the foregoing arising from interest, currency, or foreign exchange rate movements associated with such assets, liabilities, services, inputs, products, or commodities; or

(F) Any fluctuation in interest, currency, or foreign exchange rate exposures arising from a person’s current or anticipated assets or liabilities; or

(ii) Qualifies as bona fide hedging for purposes of an exemption from position limits under the Act; or

(iii) Qualifies for hedging treatment under:

(A) Financial Accounting Standards Board Accounting Standards Codification Topic 815, Derivatives and Hedging (formerly known as Statement No. 133); or

(B) Governmental Accounting Standards Board Statement Accounting and Financial Reporting for Derivative Instruments; and

(2) Such swap is:

(i) Not used for a purpose that is in the nature of speculation, investing, or trading; and

(ii) Not used to hedge or mitigate the risk of another swap or security-based swap position, unless that other position itself is used to hedge or mitigate commercial risk as defined by this rule or Sec. 240.3a67-4 of this title.

I think most private equity funds and real estate private equity funds would be using interest rate derivatives to hedge or mitigate commercial risk.

The tough part of this argument is that a “financial entity” is not an end user.

2(h)(7)(C)(i)‘‘financial entity’’ means—

(I) a swap dealer;
(II) a security-based swap dealer;
(III) a major swap participant;
(IV) a major security-based swap participant;
(V) a commodity pool;
(VI) a private fund as defined in section 80b–2(a) of title 15;
(VII) an employee benefit plan as defined in paragraphs (3) and (32) of section 1002 of title 29;
(VIII) a person predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature, as defined in section 1843(k) of title 12.

In case you have forgotten about the definition of private fund under Dodd-Frank:

The term “private fund” means 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.

The end user exemption excludes private funds. That seems bad and is going to kick all of the newly registered private equity and real estate private equity funds out of the end-user exemption.

On top of that, there is a de minimis exemption from registration under the terms of Rule 4.13(a)(3). Under these requirements, either:

  • Initial margin and premiums for commodity interest transactions must be less than 5% of the liquidation value of the fund; or
  • Aggregate net notional value of commodity interest transactions must be less than 100% of the liquidation value of the fund.

That still leaves me stuck with trying to figure out when an entity becomes a commodity pool. The regulations provide no further guidance. One case that addresses the definition is Lopez v. Dean Witter Reynolds 805 F.2d 880 1986. Unfortunately for my purposes it focuses on whether separate accounts are aggregated enough to be a pool.

In CFTC v. Heritage Capital Advisory Services, Ltd. (Comm. FUT. L. REP. (CCH) 21,627, 26,377 (N.D. Ill. 1982).) the ruled that a fund investing in Treasuries and hedging the risk was a commodity pool. The defendants had solicited and pooled public funds with the stated intention of investing approximately 97% of the proceeds in United States Treasury bills, and using the remainder to hedge the account by trading futures contracts on Treasury bills. The ruling concluded that “[t]he risk to the funds of the defendants’ investors far exceeded the 3% discount which was supposedly to be committed to the futures markets” because of the possibility of a rapid decrease in the applicable market or of the pool being required to take delivery of costly Treasury bills pursuant to a future contract.

That does not provide much help for private equity funds and real estate private equity funds.

 

 

Beverly Hillbillies Ciphering for Assets Under Management

It was a case of math failure. Where exactly should that decimal place go? The Barthelemy Group of New York and New Jersey calculated assets under management as $26.28 million. But it looks like the decimal point was in the wrong place and the firm actually had $2.628 million under management.

Evens Barthelemy, the founder, sole owner, managing director, and chief compliance officer of the firm, wanted to be registered with the SEC and did so in June 2011. At the time, that meant having at least $25 million under management. Otherwise, the firm would have to register with the state regulators. (Unless the firm would have to register in at least 30 states, which would then allow the firm to register with the SEC instead of the states.)

On the firm’s Form ADV, Barthelemy stated that the firm had $26.5 million in assets under management and between seventy and ninety accounts. In the first four months after registration, the firm had no client assets that would qualify for AUM, never had more than $5 million in AUM, and only had about 30 clients at its peak.

This all fell apart during an SEC exam.

In response to an initial request from exam staff, Barthelemy provided an Excel spreadsheet listing all his clients and the assets he managed for each, which assets he totaled as $26.28 million. The exam staff later learned from BG’s independent custodian, however, that BG’s assets totaled only $2.6 million, and that the assets in BG’s spreadsheet were inflated ten-fold. Barthelemy had downloaded client account values from the custodian’s online platform, and then manually moved the decimal point for each client one place to the right.

That should be enough, but the SEC also had a laugh after looking at the compliance manual for BG. Barthelemy apparently prepared his firm’s 2010 written Compliance, Supervisory Procedures and Policies Manual by copying  a 2009 version he obtained from his prior employment at a registered broker-dealer. He merely substituted the term “investment adviser” for “registered representative” and substituted “client” for “customer.” That means he omitted most of the requirements under the Investment Advisers Act.

On one hand I feel bad for Barthelemy. I would guess that he was trying to switch his business model from a commission-based broker dealer to the AUM fee model as an investment adviser, better aligning his interests with his clients. But he clearly failed to seek out good advice on what he would need to legally do under this new business model.

If he felt he was better serving his clients, it’s very hard to justify the outright fraud of changing a spreadsheet and handing that lie to an SEC examiner.

Sources:

Now We are Talking About Real Money – SEC Brings $250 Million Insider Trading Case

On Tuesday, the Securities and Exchange Commission released news of an alleged insider-trading scheme that reaped profits and avoided losses of more than $276 million. The SEC brought the charges against (1) CR Intrinsic Investors LLC, (2) its former portfolio manager, Mathew Martoma, and (3) a medical consultant for an expert network firm, Dr. Sidney Gilman. The insider trading scheme involving a clinical trial for an Alzheimer’s drug being jointly developed by two pharmaceutical companies. The illicit gains generated in this scheme make it the largest insider trading case ever charged by the SEC.

Dr. Gilman has agreed to settle with SEC and cooperate. The Department of Justice has brought criminal charges against Mr. Martoma and tossed a non-prosecution agreement to Dr. Gilman.

According to the complaint, Dr. Gilman chaired a committee that oversaw a clinical trial for an Alzheimer’s drug that Elan Corporation and Wyeth were developing. Dr. Gilman, a professor of neurology at the University of Michigan Medical School served as the chairman of the Safety Monitoring Committee overseeing the clinical trial of the Alzheimer’s drug. Elan and Wyeth selected him to present the final clinical trial results at a July 29, 2008 medical conference. This would coincide with the after-market hours public announcement of the trial results by the two companies.

CR Intrinsic is a unit of Steven A. Cohen’s SAC Capital Advisors LP, the firm at the center of the expert network cases being brought by the SEC. Mr. Martoma met Dr. Gilman through an expert network firm. During consultations, the SEC alleges that Dr. Gilman provided Martoma with material nonpublic information about the ongoing clinical trial, including the actual, detailed results in advance of the July 29 Announcement.

According to the complaint, Mr. Martoma used the information to reposition almost a billion dollars in Elan and Wyeth stock, reaping profits and avoiding losses of over $276 million. At one point Elan and Wyether wer over 10% of the fund’s portfolio. At the end of 2008 Mr. Martoma pocketed a bonus of $9.3 million. CR Intrinsic paid Dr. Gilman $100,000 for his information.

The complaint does not identify the expert network firm, but the Wall Street Journal points to Gerson Lehman.

The facts look very bad for the parties. I assume that is why Dr. Gilman settled. Why is Mr. Martoma fighting the charges? He is subject to criminal charges and I assume the prosecutors wanted more prison time than Mr. Maroma was willing to serve.

The big question is whether the trades were illegal insider trading. The prosecutors will need to prove that Dr. Gilman had material non-public information and had a duty to keep that information confidential. They will need to prove that Mr. Martoma knew or should have known that the information should not be traded upon. That will be the test of this case and other expert network cases. These are likely to be the key issues to prove in this case:

61. Martoma knew, recklessly disregarded, or should have known, that Gilman owed a fiduciary duty, or obligation arising from a similar relationship of trust and confidence, to keep the information confidential.

63. Martoma and CR Intrinsic each knew, recklessly disregarded, or should have known, that the material nonpublic information concerning the Phase II Trial that each received from their respective tippers was disclosed or misappropriated in breach of a fiduciary duty, or similar relationship of trust and confidence.

There is no doubt that fund managers were using expert networks to gain an information edge on the markets. As Gordon Gecko said: “The most valuable commodity I know of is information.” The issue is finding the line between legitimate information gathering and illegally using material non-public information.

According to the SEC press release: “Since October 2009, the SEC has filed more than 170 insider trading actions charging more than 410 individuals and entities. The defendants in these actions are alleged to have made more than $875 million in illicit gains comprised of profits and the avoidance of losses.”

Sources:

Will the CFTC Extend the Registration Deadline?

Private equity funds with interest rate swaps or foreign exchange hedges have been wringing their hands over registration with the Commodities Futures Trading Commission. Dodd-Frank has brought those derivative instruments into the oversight of the CFTC. Shortly, they will be considered commodities. That means funds that previously did not consider themselves to be trading in commodities could be subject to CFTC registration.

The CFTC decided to provide no guidance as what would make a fund a commodity pool. In a regulatory release earlier this year, the CFTC said that even a single interest rate or foreign exchange trade could make a fund a commodity pool.

The downside to registration is that it will likely prohibit the fund from being able to take advantage of the “end-user” exemption for commodity trading. A commodity pool would be considered a financial entity and would be subject to the new clearing requirements.

The other troubling part of the CFTC regulatory framework is that it is at odds with the JOBS Act. The likely exemption for most private funds would require the fund to not engage in general solicitation or advertising. The JOBS Act started the process for lifting that ban for Regulation D offerings, the usual method for investments in private funds.

On top of that fund of funds are scrambling because of the look-through requirement. In deleting an old exemption the CFTC also delete the guidance used by fund of funds.

Let’s add some of the confused reasoning of the CFTC when it released the NAREIT guidance letter stating that REITs are not commodity pools. Rumor has it that there are some additional guidance letters in the works.

All of this confusion still exists with just a month left for compliance. The Investment Adviser Association and Managed Funds Association have thrown their hands up in the air and asked the CFTC to extend the compliance deadline.

Compliance Bricks and Mortar: FCPA Guidance Edition

The big news in compliance this week was the release of the  Resource Guide to the U.S. Foreign Corrupt Practices Act (.pdf). But I have only had a chance to glance at it briefly. I’m underwhelmed, even after having low expectations. Since I have not read much, I’m posting the views of many others:

Guidance Roundup by the FCPA Professor

This post provides a roundup of commentary (law firm, individuals, and civil society organizations) relating to this week’s FCPA guidance issued by the DOJ and SEC.

Guidance; Courtesy of the Government by Scott Greenfield in Simple Justice

All of which means we know absolutely nothing more than before. Well played, government. Well played.

The guidance? Of course it’s non-binding by Richard L. Cassin in the FCPA Blog

On the inside front cover of the joint DOJ and SEC guidance released Wednesday, there’s a disclaimer that what follows is non-binding. ‘As such,’ the disclaimer continues, ‘it is not intended to, does not, and may not be relied upon to create any rights, substantive or procedural, that are enforceable at law by any party, in any criminal, civil, or administrative matter. . . It does not in any way limit the enforcement intentions or litigating positions of the U.S. Department of Justice, the U.S. Securities and Exchange Commission, or any other U.S. government agency.’

SEC’s Khuzami: We’re not interested in small potatoes by The FCPA Blog

It’s an ambitious effort to lay out how the government interprets and applies the FCPA, in order to educate companies about how to prevent their employees from violating the law, and educate employees about the limits of permissible conduct.

The Guidance: The FCPA Bar Reacts by Samuel Rubenfeld, Joe Palazzolo and C.M. Matthews in WSJ.com’s Corruption Currents

After waiting waiting roughly a year for guidance on the Foreign Corrupt Practices Act, everyone and their lawyer had something to say about it Tuesday. Here’s a sampling of the initial reactions: …

Feds Declined to Prosecute Dozens of FCPA Cases Over Past Two Years in the Corporate Crime Reporter

“To protect the privacy rights and other interests of the uncharged and other potentially interested parties, the Department of Justice has a long-standing policy not to provide, without the party’s consent, non-public information on matters it has declined to prosecute,” the authors write. “There are rare occasions in which, in conjunction with the public filing of charges against an individual, it is appropriate to disclose that a company is not also being prosecuted.”

FCPA Declination Opinions? SEC and DOJ Sort of Have Them by David Smyth in Cady Bar the Door

One of the things the guidance does at least scratch the surface of are instances in which the two agencies have come across FCPA violations that they have declined to prosecute.  As we have covered in this space before – and certainly others as well – the SEC and DOJ have been notoriously tight-lipped about those cases.  They exist, of course.  We learned yesterday that the Justice Department has declined several dozen potential FCPA cases against companies in just the last two years.  And the agencies might figure out a way to describe them discreetly, with a view toward defining (1) the contours of appropriate conduct and (2) productive self-reporting to and cooperation with the government.
___________________________________________

The New Resource Guide to the FCPA

The Securities and Exchange Commission and the Department of Justice jointly released A Resource Guide to the U.S. Foreign Corrupt Practices Act (.pdf). The 120-page guide provides a detailed analysis of the U.S. Foreign Corrupt Practices Act and closely examines the SEC and DOJ approach to FCPA enforcement.

The guide addresses a wide variety of topics including who and what is covered by the FCPA’s anti-bribery and accounting provisions; the definition of a “foreign official”; what constitute proper and improper gifts, travel, and entertainment expenses; facilitating payments; how successor liability applies in the mergers and acquisitions context; the hallmarks of an effective corporate compliance program; and the different types of civil and criminal resolutions available in the FCPA context. On these and other topics, the guide takes a multi-faceted approach toward setting forth the statute’s requirements and providing insights into SEC and DOJ enforcement practices. It uses hypotheticals, examples of enforcement actions and matters that the SEC and DOJ have declined to pursue, and summaries of applicable case law and DOJ opinion releases.

The Resource Guide is a  response to the Phase 3 review by the OECD Working Group on Bribery. That report from that review recommended that the US anti-bribery efforts could be enhanced by consolidating publicly available information on the application of the FCPA. This Resource Guide is that consolidation.

Compliance Bricks and Mortar for November 9

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

Fighting corruption with bumper stickers and public toilets: ambient accountability by Dieter Zinnbauer in Space for Transparency

Take for inspiration this passenger bill of rights, displayed literally right in your face at the backrest of the driver’s seat in New York taxis.

Imagine how much more effectively you can claim your rights and how much more hesitant a corrupt driver will be to try to take advantage of you, even if you are not from New York and have no idea how this place works.

Or think about how much easier it is for you to report unsanitary conditions in this public toilet at Seoul airport when you are presented with a sign like the below.

Convicted Ponzi Schemer Balks At Proposed 225-Year Prison Sentence by Jordan D. Maglich in PonziTracker

Durham’s trial was somewhat unique in that prosecutors unveiled wiretaps of Durham and others allegedly confirming their knowledge that they were engaging in criminal activities. The use of wiretap evidence is unique in that it is typically seen in instances of organized crime and violent offenses.

Another Guilty Plea in Madoff Probe by Reed Albergotti in the Wall Street Journal

Irwin Lipkin, 74 years old, is the ninth person to plead guilty to criminal charges in the government’s probe, which is approaching its fifth year…..

Mr. Lipkin, the firm’s former controller, allegedly helped oversee the growth of Mr. Madoff’s company from a two-man operation in 1964 to a business with billions under management, according to a lawsuit filed in November 2010 by Irving Picard, the trustee seeking to recover assets on behalf of Mr. Madoff’s victims.

Mr. Lipkin pleaded guilty to making false statements in regulatory filings and conspiracy to commit securities fraud and other crimes. He faces up to 10 years in prison on the two counts. Sentencing is set for March 22.

Committee created by Dodd-Frank at odds with JOBS Act startup financing reforms by William Carleton

Dodd-Frank impacted the startup and emerging company ecosystem at its angel-financing source, as it amended the accredited investor definition to provide that the $1 million individual net worth threshold should exclude the value of the investor’s principal residence. (It could have been worse, but angels got organized and stopped the more draconian proposals.)

Now, another Dodd-Frank provision, seemingly not pertinent to angel or venture capital investing, looks like it could have an impact on the innovation economy.

This other provision is Section 911 of Dodd-Frank, which establishes an “Investor Advisory Committee,” the purpose of which is to: …

Translating the Election Results Into Compliance Change by Matt Kelly in Compliance Week

Well, thank the lord we don’t have to go through that again for another few years.

As we all sift through election results this morning, tip your hat to the Democrats, who won big last night, and spare some sympathy to Republicans, who must feel like they were hit by a truck. And let’s spend a bit of time pondering what this will all mean for compliance executives in the next year, stuck on that perch between corporate behavior and public policy.