Center of town. Woodstock, Vermont. “Snowy night” (1940) by Marion Post Wolcott
Published by the Library of Congress
Month: December 2012
Compliance Bricks and Mortar for the End of 2012
It’s been a slow week in compliance. The highways and trains have been near empty during my commute. It seems there are more seagulls than people in the Financial District. But a few compliance-related stories caught my attention.
Why a Popular Subsidy for Banks Died in the Senate by John Carney in CNBC’s NetNet
The program, which is known as TAG, was launched during the financial crisis to support liquidity and bank stability. The basic idea was to cover non-interest bearing deposit accounts used for things like payrolls that exceeded the normal FDIC insurance limits. Banks could opt-in and pay a fee that was supposedly based on estimates of the program’s costs.
SEC v. Schooler: Real Estate Investment Fraud Shut Down by Sarah Emery in The Race to The Bottom
To obtain a preliminary injunction granted, the SEC must establish a prima facie case that the Defendants violated securities law and a reasonable likelihood that the violations will be repeated. Defendants asserted that the interests in the general partnerships were not securities.
The definition of security does not explicitly include interests in general partnerships. The SEC, however, asserted that the interests were investment contracts. An investment contract is a “a contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”
The Financial Planning Flowchart by Nick Summers and Karen Weise in Bloomberg
Take a deep breath and answer honestly:
I’m going to end with some grammar humor from my favorite comic Saturday Morning Breakfast Cereal:
The Physics of Wall Street and its Failures
Warren Buffett famously warned, “beware of geeks bearing formulas.” After the Great Panic of 2008, many pundits placed the blame on derivatives and other “complex financial instruments.” That would lead one to believe that the blame lies with the physicists and mathematicians who dreamed them up. James Owen Weatherall decided to look behind that blame and explore the history of how physicists came to Wall Street. The result is The Physics of Wall Street: A Brief History of Predicting the Unpredictable.
The book is an engaging exploration of the men who took turns trying to create mathematical formulas to explain stock price movement, with the hope of predicting that movement.
The early models always failed. Weatherall pins the crashes in 1987, 1997, and 2008 on the failure of the models. Although he shifts the blame from the physicists to the heads of the Wall Street firms. Their failure came about because they failed to think like physicists. Models, whether in science or finance, have limitations. They break down at the edges and under certain conditions. In each of those financial crises these sophisticated models fell into the hands of people who didn’t understand their limitations.
Don’t think the book is focused on financial models and mathematical derivatives. It’s focused on the individuals, their stories, the steps they took before creating their models, how their models ere adopted (or not), and, ultimately, how their models failed.
One item I found fascinating was that most of the physicists starring in the book took their first steps towards wealth creation in gambling, and not finance. You can make your own joke about that. Each took an attempt to better define probabilities so they could make better wagers. Early on, it was dice games. Blackjack was popular. One gentleman even tried to devise a computer to predict roulette. Ultimately, they each discovered that there was more money to be made on Wall Street.
Each model got better and better. But each ultimately failed. Some of that can be traced back to success causing a failure. As more firms adopted the model, their behavior changed and therefore the model became based on outdated behavior. Ultimately, the book seems to lend credence to Taleb’s Black Swan theory. The improbable will happen and all the financial models fail to account for the improbable financial calamities happening more often than the models predict.
I have to admit that I thought the book might be a dry slog on finance and probability. But, it was surprisingly enjoyable to read. If you have any interest in the quant side of Wall Street or probability theories, this book provides a great historical background.
The publisher was nice enough to send me preview in hopes that I would write about the book. It goes on sale January 2, 2013.
Happy Holidays
May you receive all the compliance gifts you’ve dreamed of.
Cats Decorating Christmas Tree by Louis Wain in the Detroit Publishing Company Collection at the Library of Congress
Compliance Bricks and Mortar – Mayan Apocalypse Edition
If you’re reading this, then the Mayan Apocalypse didn’t happen. (At least not yet.) That means back to work and a look at some of the compliance stories that caught my attention recently.
Dispatches From the Front Lines of the Ethics & Culture Wars by Matt Kelly in Compliance Week
Does your organization know what its values actually are? That was the first question I asked at our roundtable, playing to the cynics who say most companies either don’t have clearly articulated values beyond the profit motive, or don’t bother telling employees what those values are. More than a few roundtable participants reluctantly agreed that the cynics have a point.
Cole-Frieman & Mallon LLP 2012 End of Year Checklist
December is the busiest month of the year for most hedge fund managers. In addition to all of the administrative details involved in closing out the year, the regulatory landscape has shifted dramatically over the past year. As a result, year-end processes and 2013 planning are particularly important, especially for General Counsels, Chief Compliance Officers and key operations and financial personnel. We have updated our own year-end checklist to help managers stay on top of these priorities.
More on “Chaos in the SEC’s Inspector General’s Office: ‘He Said, They Said'” in CorporateCounsel.net
The latest is that former Assistant Inspector General Weber has filed a $20 million lawsuit alleging he was fired for being a whistleblower. And the complaint is full of juicy details (which may – or may not – be true). Here are some articles on this development: …
Banks Behaving Badly or Brother Can You Spare A Billion (or Two)? by Tom Fox
Remember when a billion dollars was real money? Over the past couple of weeks there have been some mammoth fines paid by financial institutions for conduct, which would appear to fall under the category of “Banks Behaving Badly”. Last week HSBC agreed to pay a fine of $1.92 billion for its transgressions involving money laundering. UBS is in the final stages of negotiations to pay $1.5 billion to resolve allegations that it tried to rig interest rate benchmark (i.e. ‘Libor’) to boost trading profits. Finally, on December 10, coming in at a paltry $327 million are our old friends Standard Chartered, which admitted processing thousands of transactions for Iranian and Sudanese clients through its American subsidiaries; subsequently to avoid having Iranian transactions detected by the US Treasury Department computer filters, Standard Chartered deliberately removed names and other identifying information, according to the authorities. All in all, it’s not been a bad couple of weeks for the US Treasury, given the current stalemate over the ‘fiscal cliff’ and the need to reduce the US deficit.
Does The Victims Of Corporate Fraud Compensation Fund Deny Due Process? by Keith Paul Bishop in California Corporate & Securities Law blog
Under SB 1058, a person who obtains a final judgment against a corporation based upon the corporation’s fraud, misrepresentation, or deceit, made with intent to defraud, may after “diligent collection efforts” submit a claim to the Secretary of State for payment from the fund. Cal. Corp. Code § 2282. The Secretary of State is required to give notice to the corporation (which may contest granting of the application for payment). Cal. Corp. Code § 2282.1 The Secretary of State may deny or grant the application or may enter into a compromise with the claimant to pay less in settlement than the full amount of the claim. Cal. Corp. Code § 2284. The legislation expressly authorizes only the judicial review of a denial of a claim. Cal. Corp. Code § 2287. If the Secretary of State grants the application, she is subrogated to the claimant’s rights. Cal. Corp. Code § 2293.
The SEC Launches a Private Equity Initiative
Bruce Karpati, Chief of the SEC Enforcement Division’s Asset Management Unit, disclosed the launch of a Private Equity Initiative in a speech on Tuesday. While speaking to the Regulatory Compliance Association, Karpati spoke about the Enforcement Division’s and in particular the Asset Management Unit’s priorities in the hedge fund space.
The Private Equity Initiative is coordination between RiskFin, the Division of Investment Management, and OCIE to identify private equity fund advisers that are at higher risk for certain specific fraudulent behavior. Karpati mentioned two behaviors that cause concern.
With Zombie Funds, managers delay the liquidation of the fund because the management fee is their only source of revenue. The SEC had mentioned back in June that it was hunting down zombie funds.
The second area is valuations. The SEC is rightly focused on valuations when it comes to private equity. The assets are inherently hard to value. Even the best valuation process will lead to an internal judgment on the value the fund. Karpati claims that the SEC uses “certain data sources” as part of the SEC’s risk analytic initiative to identify those private equity fund advisers that may be improperly failing to liquidate assets, or have been misrepresenting the value of their holdings to investors.
Karpati finished the speech by ask fund managers to be nice to examiners:
Finally, I think all investment advisers need to be alert and prepared for exam inquiries. It is important to be cooperative with exam staff while an examination takes place. It is also important to implement any necessary corrective steps if the SEC identifies violations or possible violations. Taking these steps will help the examination process to proceed more efficiently and reduce the likelihood of more formal inquiries by Enforcement or AMU staff.
I didn’t find anything new in the speech. That’s a good thing. The SEC has made it clear what they are looking for in their welcome to the SEC letter, enforcement actions, and speeches for many month now. I give them credit that it sounds like the SEC better understands the risk and compliance problems for private fund advisors in a way they did not understand 12 months ago.
Sources:
- Enforcement Priorities in the Alternative Space speech by Bruce Karpati, Chief, SEC Enforcement Division’s Asset Management Unit U.S. Securities and Exchange Commission
- Best Practices for Hedge Funds to Navigate Their Own ‘Misaligned Incentives’ by Bruce Carton in Compliance Week
- SEC Enforcement Division’s Private Equity Initiative in Compliance Avenue
- Dawn of the Zombie Funds
Do You Have Skin in the Game?
If you tell investors that you have skin in the game, you need to have skin in the game. For the second time this year, the SEC has brought an enforcement action against a private fund for falsely informing investors that the Managers had skin in the game. Most investors want a manager’s executives to invest in the fund right alongside investors.
Don’t say it, if you don’t do it.
The most recent enforcement action was brought against Aladdin Capital Management, Aladdin Capital and a former executive, Joseph Schlim. All parties consented to the administrative orders, but neither admit nor deny the charges.
“[w]hy is an investor better off just investing in Aladdin sponsored CLOs and CDOs?” Aladdin answered by emphasizing that the “most powerful response I can give to your question is that Aladdin co-invests alongside MAST investors in every program. Putting meaningful ‘skin in the game’ as we do means our financial interests are aligned with those of our MAST investors.”
An inherent conflict in the transactions is that Aladdin was collecting a placement fee for much of the equity going into the deal. By reserving 10% for itself, it was losing 10% of its potential commission. Presumably, they could have taken that commission as equity in the deal instead of cash. But the product was packed with sub-prime mortgages and garbage debt.
Back in May, the SEC brought a similar administrative proceeding against Quantek Asset Management LLC for misleading investors about whether its executives had personally invested in its fund.
The two cases show that the SEC is will not tolerate misrepresentations in this area:
“If you sell an investment with the pitch that you are co-investing and have ‘skin in the game,’ then you better actually have ‘skin in the game…. Such a representation by an investment adviser or broker-dealer is an important consideration to investors in complex products.” Robert Khuzami, Director of the SEC’s Enforcement Division
Sources:
Valuations and the New Presence Exams
I’ve come across a new document request list for a presence exam from the SEC’s Atlanta Regional Office. The exam period for the letter begins March 31, 2012 – the Dodd-Frank deadline for new advisers to register with the SEC. The SEC has said presence exams will target new advisers or those that manage private funds. The exams also may focus on just one or two topics.
Previously, I posted an examination letter that focused on fees. This new letter focuses on valuations.
The letter requests investment committee minutes, valuation policies and procedures, any models used in valuing investments, and any third party valuation reports.
Time to sit down and run through a mock document request again.
Sources:
Newtown
No post today. I’m a bit lost from this horrible tragedy.
Compliance Bricks and Mortar for December 14
These are some of the compliance related stories that recently caught my attention.
‘Tis the Season When Gifts Become Bribes by Alexandra Wrage in Corporate Counsel
People who are otherwise serious about the global scourge of bribery get frustrated when anyone raises the issue of gifts as bribes. Surely, most people will say, we haven’t reached the point where holiday gift-giving is so risky that we can’t hand out bottles of wine or silks tie and scarves.
Do Lanny Breuer And Robert Khuzami Actually Read FCPA Enforcement Actions? by the FCPA Professor
At the Guidance press conference (see here) Khuzami said that he was “interested in companies spending compliance dollars in the most sensible way” and he hoped that the guidance and the hypotheticals provided would help companies as to where they can “minimize investment and where they can maximize it.” Breuer added that the DOJ wants compliance programs “to address real matters of concern.”
Against this backdrop, the question must be asked: do Breuer and Khuzami actually read FCPA enforcement actions?
Recent Foreign Corrupt Practices Act enforcement actions have involved, to name just a few, allegations about a bottle of wine (see here), a Cartier watch (see here), a camera (see here), kitchen appliances and business suits (see here), television sets, laptops and appliances (see here), and tea sets and office furniture (see here).
You Need a “Shadow” If You Want to be a RIA Today by Ernest E. Badway in Securities Compliance Sentinel
The SEC, recently, sued a private equity fund adviser for, among other things, allegedly violating Investment Advisers Act of 1940 Rule 206(4)-7, for failing to have procedures requiring verification of client signatures and instructions by a second person. See http://www.sec.gov/litigation/complaints/2012/comp-pr2012-244.pdf.
Dickering Over The Price by Scott Greenfield
The reason is that HSBC is too big to fail. If indicted or convicted of money laundering for drug cartels and terrorists, as alleged, London based HongKong Shanghai Banking Corporation could have toppled the banking system, with devastating consequences. It would have been a disaster for the economy, both ours and the worlds. Too big to fail.
So the government decided, in an exercise of discretion, to take whatever spare change they had in their pocket and call it even.
SEC Charges Eight Mutual Fund Directors for Failure to Properly Oversee Asset Valuation in the Securities Law Blog
The funds, which were invested in some securities backed by subprime mortgages, fraudulently overstated the value of their securities as the housing market was on the brink of financial crisis in 2007. The SEC and other regulators previously charged the funds’ managers with fraud, and the firms later agreed to pay $200 million to settle the charges.