Month: February 2013

No Extra Time for the SEC

Compliance, the SEC and the Supreme Court

The United States Supreme Court adopted a strict interpretation of the five-year period in which the Securities and Exchange Commission may seek to impose a civil penalty on a registered investment adviser. In Gabelli v. SEC the Supreme Court ruled that when the government acts in an enforcement capacity seeking civil penalties, it cannot benefit from the more lenient “discovery rule” standard available to private plaintiffs. That means the SEC needs to bring the case within five years of the fraud, not five years after the fraud is discovered.

In 2008, the SEC brought a civil enforcement action against Bruce Alpert and Marc Gabelli under the anti-fraud provisions of the Investment Advisors Act. The SEC sought civil monetary penalties based on market timing that it claimed had taken place from 1999 to 2002. Mutual fund manager Marc Gabelli and a colleague, Bruce Alpert, permitted the market timing, allowing select investors to buy shares at favorable prices to take advantage of pricing disparities in the securities held by mutual funds. As a result, the preferred investor reaped significant profits and ordinary investors suffered large losses.

The relevant statute of limitations 28 U.S.C. § 2462 states:

“Except as otherwise provided by Act of Congress, an action… for the enforcement of any civil fine, penalty or forfeiture… shall not be entertained unless commenced within five years from the date when the claim first accrued.”

Gabelli argued that the clock started running when the fraud happened, not when the SEC discovered the fraud. If Gabelli wins the argument, then the SEC took too long to bring the case.

The SEC argued for the benefit of the discovery rule, which had been used in Merck & Co. v. Reynolds, the private securities fraud class-action suit . “[S]omething different was needed in the case of fraud, where a defendant’s deceptive conduct may prevent a plaintiff from even knowing that he or she has been defrauded.”

The SEC did not agree with the SEC’s argument.

“[W]e have never applied the discovery rule in this context, where the plaintiff is not a defrauded victim seeking recompense, but is instead the Government bring ing an enforcement action for civil penalties. Despite the discovery rule’s centuries-old roots, the Government cites no lower court case before 2008 employing a fraud-based discovery rule in a Government enforcement action for civil penalties.”

The SEC looked to a 1918 case where the the government was entitled to the benefit of the discovery rule, Exploration Co. v. United States, 247 U. S. 435 (1918). However, in that case the government was the victim of the fraud. The government was not bringing an enforcement action for penalties.

The ruling points to the examination power of the SEC and its resources to root our fraud. The Supreme Court also found that proving the date of discovery would be difficult in a federal agency as big as the SEC.

The ruling is clearly a black eye for the SEC.

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Image of James Earle Fraser’s statue The Authority of Law, which sits on the west side of the United States Supreme Court building, on the south side of the main entrance stairs is by Matt Wade.
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Don’t Secretly Change Your Fund Structure

new stream capital logo

New Stream Capital took the unusual step or restructuring its fund structure in secret. The restructuring put its biggest investor into a preferred position, to the disadvantage of its other investors. At least according to the complaint filed by the Securities and Exchange Commission.

The SEC alleges that New Stream’s co-owners David Bryson and Bart Gutekunst secretly revised the fund’s capital structure to placate its largest investor. Secretly changing the priority structure is bad for your existing investors. The firm took it a step further and continued marketing the fund as though all investors were on the same footing when that was not true. New Stream raised an additional $50 million after the restructuring and received additional management fees, but left the investors with nearly worthless holdings when the fund failed.

New Stream had a structure that bifurcated investors, with US investors investing directly in the master fund and offshore investors contributing capital through a Bermuda feeder fund. The Bermuda moved capital into the master fund in the form of secured notes. In 2007, New Stream proposed a restructuring with a new onshore feeder fund for US Investors and new Cayman feeder fund for offshore investors.

The trick was moving the offshore investors out of the old Bermuda note feeder into the new Cayman feeder. As an incentive, New Stream gave equal priority to new Cayman feeder and the old Bermuda note feeder.

Gottex Fund Management had $300 million in the old Bermuda note feeder, which represented almost 40% of the capital in the entire fund structure. Gottex did not like the new structure and I assume was upset that New Stream made the change without their consent.

According to the complaint, New Stream lied to Gottex and told them that the Bermuda Feeder was senior to the new feeders. Then New Stream defrauded the other investors by actually making the Bermuda feeder senior. The marketing of the fund failed to disclose the structure to new investors. Also, the debt appears to have been mischaracterized in the fund’s financial reports.

On top of the misleading statements to new investors, the new structure also dramatically increased the management fees charged to the funds. The structure allowed for a management fee to be charged against the gross amount invested, including the loans. In November 2007, the management fee was $34,643, which increased to $318,561 in April of 2008 after the initial restructuring.

Then the financial crisis devastated the fund and it was hit hard with redemption requests. Many of those apparently came from investors in the old Bermuda feeder. By September 30, 2008, investor redemption requests totaled approximately $545 million. The fund managed stop many redemptions, but it was too late. The fund was in a death spiral, as redemption requests increased and the fund’s assets continued to decrease as the financial crisis of 2008 continued to devastate the economy and the fund’s investments.

New Stream sent one letter to Bermuda investors assuring them that their priority position would be maintained, and a different letter to the remaining investors that failed to mentioned the priority.

An initial fund restructuring/bankruptcy was rejected in Bermuda. Then a 2011 Delaware bankruptcy filing was finalized in April 2012 with the US and Cayman investors recovering only $9.7 million for their $182 million in claims. The old Bermuda investors are expected to recover much more.

The SEC additionally charged New Stream’s former head of investor relations Tara Bryson, who is David Bryson’s sister. She agreed to settle the SEC’s charges. It’s not her first scrape with the law. According to another story, she was busted in 2010 for turning her goat farm into a marijuana farm.

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Investment Adviser Certified Compliance Professional

IACCP Certification

Just tooting my own horn today. I finally fulfilled the requirement to become an Investment Adviser Certified Compliance Professional®.

With the SEC’s registration requirement for private fund managers, I took a closer look at what the SEC requires for compliance professionals.  Rule 206(4)-7 imposes no particular requirements on a chief compliance officer. The SEC release for the rule provides a bit a more context on the professional background requirements:

“An adviser’s chief compliance officer should be competent and knowledgeable regarding the Advisers Act…”

I  looked at several compliance programs but decided the Investment Adviser Certified Compliance Professional Program co-sponsored by the Investment Adviser Association and National Regulatory Services would be the best choice.

I assume this certification and designation would give me the right to say I am “competent and knowledgeable regarding the Advisers Act.”

The program is a lot of work: 20 courses and a test. The test was hard. I did not feel confident that I had passing marks when I handed it in. But apparently I did.

This was my lineup of courses, all of which were well run:

  • Introduction to the Advisers Act
  • Books and Records Requirements for Investment Advisers
  • Insider Trading, Contracts and Form ADV Deilvery Req.
  • Understanding Fiduciary Duties, Sweep of Anti-Fraud Prov
  • Custody, Pay to Play, Solicitors and Proxy Voting Anti-Fraud Rules
  • Compliance Programs Rules
  • IA Codes of Ethics
  • Prof. Ethics: Ethical Decision-Making for Compliance
  • Form ADV Part 1- Annual Updating Amendment and More
  • Form ADV Part 2: Identifying and Disclosing Conflicts-
  • Critical Skills for High Performance Compliance Profes
  • Investment Adviser Performance and Advertising
  • Investment Adviser Regulatory Update
  • Anti-Money Laundering Risk Management and Monitoring
  • Safely Embracing the Power of Social Media
  • Defensible Due Diligence for Investment Advisers and Hedge Funds
  • A Tailored Compliance Testing Program for IAs
  • SEC Examinations for Investment Advisers
  • Trading Practices, Portfolio Compliance and Related Enforcement Cases
  • RIA Year-End Compliance Check-Up

More on the Investment Adviser Certified Compliance Professional Program.

2013 SEC Examination Priorities

SEC National Exam Program

The Securities Exchange Commission published its examination priorities for 2013. They cover a wide range of issues at financial institutions, including broker-dealers, clearing agencies, exchanges and self-regulatory organizations, investment companies, hedge funds and private equity funds, and transfer agents.

The scope of an IA examination is “generally limited to the issues and business practices of the registrant that are perceived by the staff to present the highest risks to investors and the integrity of the market. Thus, the scope of exams will vary from registrant to registrant.”

But of course there are issues that will be at the top of the list. In addition to the specific risk areas unique to each registrant, the staff will consider the following focus areas when scoping and conducting examinations in 2013 that I saw as relevant to private funds..

1. Safety of Assets.

The staff will review the measures taken by registrants to protect client assets from loss or theft, the adequacy of audits of private funds, and the effectiveness of policies and procedures in this area. Exams will focus on issues such as whether advisers are:

  • appropriately recognizing situations in which they have custody as defined in the Custody Rule;
  • complying with the Custody Rule’s “surprise exam” requirement;
  • satisfying the Custody Rule’s “qualified custodian” provision; and
  • following the terms of the exception to the independent verification requirements for pooled investment vehicles.

2. Conflicts of Interest Related to Compensation Arrangements.

The exam will look for undisclosed compensation arrangements and the conflicts of interest that they present. These activities may include undisclosed fees or solicitation arrangements, and referral arrangements. For example, some advisers that place client assets with particular funds or fund platforms are, in return, paid “client servicing fees” by such funds and fund platforms. Such arrangements present a material conflict of interest that must be fully and clearly disclosed to clients.

3. Marketing/Performance.

Marketing and performance advertising is an inherently high-risk area due to the highly competitive nature of the investment management industry. Aberrational performance of certain registrants and funds can be an indicator of fraudulent or weak valuation practices. The exam will also focus on the accuracy of advertised performance, including hypothetical and back-tested performance, the assumptions or methodology utilized, and related disclosures. Of course, the exam will test compliance with record keeping requirements by asking for the backup data.

In a surprise reference to the JOBS Act, the exam will review changes in advertising practices related to the JOBS Act, where feasible.

4. Conflicts of Interest Related to Allocation of Investment Opportunities.

Advisers managing accounts that do not pay performance fees side-by-side with accounts that pay performance-based fees face unique conflicts of interest. While reviewing portfolio management practices, the staff will confirm that the registrant has controls in place to monitor the side-by-side management of its different accounts. The exam will not want to see more profitable trades being allocated to the accounts that pay the most in fees.

5. Fund Governance.

Fund governance and assessing the “tone at the top” is a key component in assessing risk during any investment company examination.

6. New Registrants and Presence Exams.

Approximately 2,000 investment advisers have registered with the SEC for the first time as a result of Dodd-Frank. The vast majority of these new registrants are advisers to hedge funds and private equity funds that have never been registered, regulated, or examined by the SEC. The presence exam initiative is expected to run for approximately two years and consists of four phases: (i) engage with the new registrants; (ii) examine a substantial percentage of the new registrants; (iii) analyze our examination findings; and (iv) report to the industry on our observations.

7. Compliance with the Pay to Play Rule.

To prevent advisers from obtaining business from government entities in return for political “contributions”, the SEC implemented the Pay to Play rule. The staff will review for compliance in this area, as well as assess the practical application of the rule. Given that state and local elections are on tap for the next two years, the pay-to-play rule will be even more difficult for fund companies.

 

A History and Analysis of Con Artists and Victims: The Ponzi Scheme Puzzle

The-Ponzi-Scheme-Puzzle-Frankel-Tamar

Professor Tamar Frankel of Boston University School of Law tackles investment fraudsters and their victims in her book, The Ponzi Scheme Puzzle. As a scholar of investment fraud, Frankel has studied cases for years to find common themes and patterns. The books offers descriptions of the offers and red flags the ways in which fraudsters mask their deception through their methods of advertising and pitching their “product”.

There is a lot in the book. I just wish there were more. It’s hard to lump Enron, Madoff, Multi-level marketing, selling the Brooklyn Bridge, and selling fake securities fraud schemes into one book, especially one as short as this. Frankel skips from subject to subject and fraud to fraud very quickly, drawing broad conclusions.

Perhaps I’m naive, but I think many Ponzi schemes start off as legitimate investment opportunities, but derail as they grow and the strategy falters. Charles Ponzi himself saw a legitimate opportunity. He saw a potential for profit in the difference in currency for return stamps. He failed to execute on the vision and failed to tell his investors when the investments didn’t work.

Enron started off a legitimate company taking an innovative approach to energy. It became so focused on hitting its earnings that it started doctoring the books to hit the numbers. The guy on the street corner trying to sell foreign tourists an interest in the Brooklyn Bridge is a different kind of criminal.

Professor Frankel does point out some interesting ways that society views investment fraudsters and their victims. We take a much harsher view of the scam artist that convinced an elderly pensioner to invest her small amount of lifetime savings, than millionaire scam artists skimming millions from other millionaires.

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Buy the Book:

A Little Extra Ketchup on It

Heinz Ketchup

Warren buffet loves ketchup, and with his $23 billion acquisition of Heinz, he may love it even more. Apparently someone found out about the flow of ketchup before the deal was announced and profited handsomely on that knowledge. The Securities and Exchange Commission brought an emergency case when they discovered an astonishingly accurate trade that stinks of insider trading.

On February 13 the defendants paid $90,000 for 2,533 out of the money June $65 calls on Heinz stock. The stock was trading at $60. The very next day, Buffet’s Berkshire Hathaway announced the Heinz acquisition at a price of $72.50. That made the $90,000 investment worth over $1.8 million. Pretty good for one day’s trade.

To add to the suspicious nature of the trade, the account had not traded on Heinz stock in the six months prior. And those 2,533 calls are in sharp contrast to the usual volume. Over the past month, Heinz options had averaged just 1,300 contracts traded daily.

“Irregular and highly suspicious options trading immediately in front of a merger or acquisition announcement is a serious red flag that traders may be improperly acting on confidential nonpublic information,” said Daniel M. Hawke, Chief of the Division of Enforcement’s Market Abuse Unit.

The SEC has the suspicious trade. But it does not have the identity of the trader or any evidence of a relationship that would tie the trade to material non-public information. However, the emergency freeze on the big gain at least stops the money from disappearing to the overseas account that made the trade. That gives the SEC time to gather the evidence and tie the trade back to the owner and the relationship that could have yielded inside information.

One aspect missing from the story is who noticed the unusual trade: the broker’s compliance unit or the SEC. I would guess the broker’s compliance unit. That was a big pop that should have raised red flags for a compliance officer monitoring trading activity.

On the other hand, it was such a big trade on call options that the SEC could have easily taken a look at the trading before the Heinz deal was announced and noticed that trade. Supposedly the SEC now has the technology in place to better monitor trades in real time. This enforcement action could be an sign that the technology is up and running.

Either way, I assume we will hear more about this case.

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Compliance Bricks and Mortar – Russian Meteor Edition

compliance and a russian meteor

Overnight a huge meteor streaked across the skies of Chelyabinsk, Russia. What does this have to do with compliance? Apparently, Russian drivers regularly use these cameras to fight corruption.

BREAKING: Huge Meteor Blazes Across Sky Over Russia; Sonic Boom Shatters Windows by Phil Plait in Bad Astronomy

Apparently, at about 09:30 local time, a very big meteor burned up over Chelyabinsk, a city in Russia just east of the Ural mountains, and about 1500 kilometers east of Moscow. The fireball was incredibly bright, rivaling the Sun! There was a pretty big sonic boom from the fireball, which set off car alarms and shattered windows. I’m seeing some reports of many people injured (by shattered glass blown out by the shock wave). I’m also seeing reports that some pieces have fallen to the ground, but again as I write this those are unconfirmed.

Why are there so many Russian dash cam videos on the internet? by Ryan Whitwam in Geek.com

There are several hard truths that have led to the explosion in Russian dash cam videos, including poor road conditions. Those long, hard winters do serious damage to the roads and lead to really tough driving conditions when local governments can’t clear snow and ice. As a result, accidents do happen more frequently.

It’s not all the fault of the elements, though. Corruption is rampant in the Russian Federation, and that’s led most motorists to take matters into their own hands. It’s not uncommon for a driver to be pulled over by the notorious Russian Highway Patrol (GAI) and harassed into paying a bribe. Dash cams afford at least a little protection from baseless accusations.

The Temptation to Trade on Confidential Information by peter Henning in Dealbook

Everyone loves a sure thing. And in the case of insider trading, the profits may be just too tempting.

Two cases filed last week by the Securities and Exchange Commission epitomize just how quickly some have jumped at the opportunity to profit from confidential information, despite the risks of being discovered and the subsequent costs.

In one case, two information technology workers learned that their company was involved in merger negotiations when one helped the chief executive figure out how to attach confidential deal documents to an e-mail. The other involved a husband learning about a confidential acquisition from his wife, who is a lawyer, after an event with a client’s general counsel was canceled on short notice.

‘Frustrated’ Madoff Now Second Guessing His Guilty Plea by Scott Cohn in CNBC.com

Writing to me from the federal prison where he is serving a life sentence for his epic fraud, Madoff said he is not getting credit for what he calls his “instrumental” role in returning money to his victims. Madoff wrote that he is so frustrated, he is having second thoughts about having pleaded guilty four years ago.

Mary Jo White’s Latest Conflict of Interest by Jonathan Weil in Bloomberg

White is the white-collar defense lawyer and former U.S. attorney nominated by President Barack Obama to lead the SEC. Her financial disclosures say that upon leaving New York-based Debevoise & Plimpton LLP, the law firm will give her $42,500 a month in retirement pay for life, or more than $500,000 a year.

What else is needed to make change successful? by Tom Fox

I have recently been involved with two clients who are about to embark upon major change in their businesses.  They are very different and each has a very unique style or culture.  As they prepare to set off on their journey I have wondered what else is needed to succeed beyond the ‘usual suspects’?

John Kotter and others have all put forward their ideas, mostly honed after years of practice and delivery.  They are all very useful and I have many of their books on my shelf.  But I am always drawn back to the question above.  After going through some of my own success stories and taking out the usual suspects, I have identified a few things that I believe really matter.

The Dangers of Social Media and Employee Discipline by Michael Volkov in the Corruption, Crime & Compliance Blog

As if compliance officers do not have enough on their plates. I have written about this before – the risks of interfering with employees’ “protected activity” on social media. What a nightmare and what a maze of confusion!

The National Labor Relations Board, which has been re-energized under the Obama Administration, affirmed an Administrative Law Judge’s ruling that the nonprofit, Hispanics United of Buffalo, Inc. violated the National Labor Relations Act by terminating five employees for comments they made on Facebook in response to a coworker’s criticism of their job performance.

Do You Fit In?

do you fit in

Sometimes you have to feel like compliance does not fit into the overall strategy of the business.

It’s not that a business should operate out of compliance. It’s just that compliance can feel like a misaligned part of the business. The vast majority of employees want to operate within the normal boundaries of the law and good business practice.

Sometime compliance programs come from fear rather than planning. The focus of the program may be misaligned based on that fear and ignore more important risks.

Regulatory requirements may require you to focus on issues that are meaningless risks to the company. You may be stacking up paperwork in your office as a defensive wall in case the regulators suddenly knock on your door. You meet the four corners of the regulatory requirements, but miss the more important risks

You may ask for certifications that leave employees scratching their heads as to the relevance of the answers.

The sometimes elusive goal is to have compliance integrated into the structure of the firm.

Image:

View of house between two casinos – Town of Atlantic City, North end of Absecon Island, South of Absecon Channel, Atlantic City, Atlantic County, NJ by Jack E. Boucher from the Historic American Buildings Survey/Historic American Engineering Record/Historic American Landscapes Survey Collection at the Library of Congress

Cherry Picking Trades

compliance and cherry picking

A recent SEC action shows you exactly how to NOT allocate trades. The SEC brought charges against Howard Berger for not allocating trades until the end of the trading day.

Berger would routinely allocate the profitable trades to his wife’s account and the unprofitable trades to his private investment fund account. Since Berger would usually sell his positions at the end of the day, it was easy to see which trades worked and which ones lost money.

One trading platform seemed to be agnostic about allocations. When that trading platform went of business he switched to a second that better tracked the changes in allocations. That trading platform’s activity logs showed hundreds of instances where Berger switched allocations from the fund’s account to his wife’s account.

That’s a combination of theft and stupidity. he was blatantly stealing his client’s money and not bothering to notice the trail of breadcrumbs showing the theft.

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The Obnoxious LIBOR Emails

compliance and email

It seems clear that the LIBOR figures were subject to manipulation. Many banks are under investigation. The Royal Bank of Scotland agreed to pay $610 million in fines to UK and U.S. regulators for its role in the Libor rate-rigging scandal. As part of that settlement, the U.K.’s Financial Services Authority released emails and other communications between traders, employees who submitted Libor rate information, and in some cases, traders and other employees outside the three banks. They tell a sad tale of manipulation and fraud.

Trader C: “The big day [has] arrived… My NYK are screaming at me about an unchanged 3m libor. As always, any help wd be greatly appreciated. What do you think you’ll go for 3m?”
Barclays Submitter: “I am going 90 altho 91 is what I should be posting”.
Trader C: “[…] when I retire and write a book about this business your name will be written in golden letters […]”.
Submitter: “I would prefer this [to] not be in any book!”

Rarely do you find the email that exonerates you. It’s always the email with something stupid that makes you and your company look bad. Sometimes, the communication is out of context. Sometimes, it’s just the stupidity of the sender who thinks the message is as ephemeral as a nod in the hallway.

Martin Lomasney created a famous saying on the importance of discretion: “Never write if you can speak; never speak if you can nod; never nod if you can wink.”

From one trader to another broker:

“if you keep 6s [i.e. the six-month Japanese Libor rate] unchanged today… I will f***ing do one humongous deal with you … Like a 50, 000 buck deal, whatever. I need you to keep it as low as possible … if you do that … I’ll pay you, you know, 50,000 dollars, 100,000 dollars … whatever you want … I’m a man of my word.”

He may have been a man of his word. But he was not a man of honor or ethics. He sought blatant market manipulation for his own gain. Foolishly, we wrote it down, leaving his mark of dishonor for all to see.

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