Compliance Bricks and Mortar for January 31

bricks curvy

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

Five Golden Rules of What Works – The Internal Marketing of Compliance by Tom Fox

I am attending the ACI Foreign Corrupt Practices Act (FCPA) Boot Camp in Houston. … One of the presentations was on how to tell your compliance story. It presented several interesting aspects of how to not only communicate your internal compliance story but how to also market compliance within your organization. Céline Gearson, Chief Ethics and Compliance Officer at Cameron International, had an interesting perspective on how she internally markets her compliance function. She termed these as “The Five Golden Rules of What Works”.

1. Socialize, Socialize, Socialize
2. Communicate metrics and near misses
3. Create engagement and excitement
4. Become a marketing guru and IT expert
5. Embed your initiatives into business processes

Did Dennis Rodman violate the FCPA? By Richard L. Cassin in the FCPA Blog

Among the more than $10,000 in gifts Dennis Rodman delivered to North Korea dictator Kim Jong Un in Pyongyang this month were “hundreds of dollars’ worth of Irish Jameson whiskey, European crystal, an Italian suit, a fur coat, and an English Mulberry handbag for Kim’s wife, Ri Sol-ju,” the Daily Beast said Friday. The U.S. government is now investigating whether Rodman violated the law against importing luxury goods into North Korea.

Keep emergency plans updated, or face disastrous consequences from regulators in Investment News

Financial advisory firms need to think seriously about disaster planning and should be conducting annual tests of their preparedness plans if they want to stay out of hot water with regulators. Each year, registered investment advisers need to document the testing of their continuity plan, as well as any updates to these plans, Les Abromovitz, a senior consultant at National Compliance Services Inc., said at a pre-conference session at TD Ameritrade Institutional’s national conference in Orlando on Wednesday.

SEC’s turf threatened, Commissioner Michael Piwowar says by Dina ElBoghdady in the Washington Post

In one of his first public speeches since joining the SEC in August, Republican Commissioner Michael Piwowar said that the Financial Stability Oversight Council is “reaching into the SEC’s realm” and posing “an existential threat” to the agency and other regulators. The council, also known as the FSOC, was charged by Congress with heading off risks to the financial system. It consists of regulators from the Federal Reserve, the Federal Deposit Insurance Corp. and others — including the SEC. Each of the top regulators on the council has a voting member, and for the SEC, that’s been the commission’s chairman.

Clifford Chance Adopts Continuous Improvement Program by Ron Friedmann in Prism Legal

This week Clifford Chance, one of the largest law firms in the world, published a white paper called Applying Continuous Improvement to high-end legal services.  I view it as a potential turning point in BigLaw. A few other law firms, especially Seyfarth Shaw with SeyfarthLean, have promoted process improvement, a sibling of continuous improvement.  But Clifford Chance is a Magic Circle with much bigger throw weight than most firms.

Facebook debunks Princeton study in Flowing Data

Researchers at Princeton released a study that said that Facebook was on the way out, based primarily on Google search data. Naturally, Facebook didn’t appreciate it much and followed up with their own “study” that debunks the Princeton analysis, blasted with a healthy dose of sarcasm. They also showed that Princeton is on their way to zero-enrollment.

SEC Compliance Outreach Program National Seminar

SEC Seal 2

The SEC’s Office of Compliance Inspections and Examinations (OCIE), Division of Investment Management, and the Asset Management Unit of the Division of Enforcement jointly sponsor the compliance outreach program. On January 30, 2014, there was a national meeting.

These are my notes.

Welcoming Remarks from Chair Mary Jo White

Investors and the SEC relies on compliance officers. OCIE has only 450 dedicated who have to look over 11,000 registered investment advisers. The top goal is getting firms to express a dedication to compliance throughout the organization. She highlighted the exam priorities for 2014.

Introductory Remarks

Speakers:

  • Drew Bowden, Director, Office of Compliance Inspections and Examinations
  • Norm Champ, Director, Division of Investment Management
  • Andrew Ceresney, Director, Division of Enforcement

Andrew started off as the person you don’t want to meet. If your talking to enforcement, you are being accused of doing something seriously wrong. One focus is firms with past problems. The first thing examiners will do is look at the deficiencies from an exam and see if the firm has fixed those noted problems. Custody is a critical rule because its focus is on the safety of client assets.

He highlighted a case his group brought under Rule 38a-1(c) of the 1940 Investment Company Act. That rule makes it unlawful to mislead or obstruct a firm’s CCO in the performance of his or her duties. Andrew also highlighted the Convergex case for failing to highlight markups and markdowns.

Norm highlighted the guidance and updates issued by the SEC. The initiative came out of failed no-action letters. The SEC would deny the relief, but that denial was rarely public. He highlighted the guidance update on misleading fund names and the guidance on the custody rule for private stock certificates.

He also highlighted some facts on the new public private-placement rules under 506(c). He is not seeing a lot of use of the new regime.

The SEC’s goals are to be transparent. The vast majority of investment advisers are trying operated in a proper and ethical way. The panel clearly highlighted custody as an item subject to close scrutiny.

Panel I: Program Priorities

Speakers:

  • Jane Jarcho, National Associate Director, National Exam Program
  • David Grim, Deputy Director, Division of Investment Management
  • Julie Riewe, Co-Chief, Division of Enforcement, Asset Management Unit

Julie highlighted the aberrational performance inquiry initiative. The mismatched performance usually lead to to a large cache of other misdeeds at the adviser. On the private fund side of things, the SEC is looking at conflicts of interest, allocations of opportunities, mis-allocations of expenses.  She highlighted multiple funds investing in the same opportunity. (Are you using the second investment to prop up the first?)

David focused on the floating NAV for money market funds (I hate that idea.) and other mutual fund reporting issues.  He expects a new rule-making proposal on target date funds.

Jane talked about the selection of priorities and the priorities for the upcoming year and rest of the panel joined in.

  1. Wrap fee program
  2. JOBS Act
  3. Cybersecurity
  4. IA-BD harmonization

Examiners are looking at certain aspects of wrap fee programs. It starts with a suitability policy and procedure. Do you have one and is it being followed?

There is a clear focus on the issues that will arise from lifting the ban on general solicitation. He acknowledged the murkiness caused by releasing the proposed rules for investor protection on the same day as the adoption. This will be a big priority for 2014.

Question & Answer Session (Advisers with $1 Billion or Less in Regulatory AUM)

25% of the registered advisers have more than $1 billion under management’ 62% have less than $500 million and 12% are between $1 billion and $500 million.

Panel II: Private Fund Adviser Topics

Speakers:
  • Ashish Ward, Exam Manager, National Exam Program, Los Angeles Regional Office
  • Alpa Patel, Senior Counsel, Division of Investment Management
  • Igor Rozenblit, Specialist, Division of Enforcement, Asset Management Unit
  • James Capezzuto, General Counsel & Chief Compliance Officer, Cornerstone Capital Management LLC
  • Barbara Burns, Chief Compliance Officer, AEA Investors SBF LLC
Key focus areas in presence exams: (1) investment conflicts of interest, which includes allocation of opportunities and fees, (2) Marketing, in particular performance marketing, (3) valuation and (4) custody. The SEC has conducted about 250 exams and found numerous issues in these areas.
Fees need to be disclosed, including fees charged to portfolio companies and expenses charged for back-office operations. Are you generating additional revenue for the management company while reducing cash to the funds.
The panel pointed out Rule 206(4)-8 that looks through the fund to investors in the fund for fraudulent, deceptive or manipulative acts.

Panel III: Registered Investment Company

This was not relevant to me, so I skipped this session.

Panel IV: Valuation Issues

Speakers:
  • Matthew O’Toole, Senior Special Counsel, National Exam Program, San Francisco Regional Office
  • Leo Chan, Senior Specialized Examiner, National Exam Program, San Francisco Regional Office
  • Sarah ten Siethoff, Senior Special Counsel, Division of Investment Management
  • Jaime Eichen, Chief Accountant, Division of Investment Management
  • Jeffrey Blockinger, Chief Legal Officer & Chief Compliance Officer, Och-Ziff Capital Management Group
The big theme is that there is no one-size-fits-all approach for valuation. There was discussion about whether the SEC would offer some guidance on valuation expectation. That sounded unlikely.
Mutual funds and BDC are required to use GAAP financing. Advisers are not as limited. However, a panelist pointed out that for private funds to comply with the custody rule, it must have GAAP financials.

Panel V: Chief Compliance Officer Obligations

Speakers:
  • Mark Dowdell, Assistant Director, National Exam Program, Philadelphia Regional Office
  • Janet Grossnickle, Assistant Director, Division of Investment Management
  • Marshall Sprung, Co-Chief,Division of Enforcement, Asset Management Unit
  • Chris Marzullo, General Counsel & Chief Compliance Officer, Brandywine Global Investment
  • Management LLC
  • Judy Werner, Executive Director, National Society of Compliance Professionals
I missed this session.

Closing Remarks

by Drew Bowden, Director, National Exam Program
I missed this session.

Materials

NEAT and MIDAS: The SEC’s New Tools

univac

“This is not your father’s SEC – or your mother’s or even your older brother or sister’s.”

Securities and Exchange Commission Chair Mary Jo White is proud of two new technology tools the Commission is rolling out. She spoke about the new tools at the 41st Annual Securities Regulation Institute.

The first is NEAT, the National Exam Analytics Tool. This new tool is designed to analyze trading data, looking for potential insider trading by comparing trades against significant corporate events. That will be fun. But then the SEC needs to find the connection between the suspicious activity and now connection with an obligation to hold material non-public information confidential. That’s the hard part.

NEAT will also be able to find signs of front running, improper allocations, and other misdeeds by investment advisers. Chair White told the tale of running NEAT against an adviser’s 17 million transactions. Sounds scary. Mostly because of the headache it will be trying to match a trade blotter against the format required by NEAT to input the data.

MIDAS, the Market Information Data Analytics System, collects one billion records of trading data, time-stamped to the microsecond, every day. MIDAS is focused on market stability. It should help the SEC monitor and understand mini-flash crashes, reconstruct market events, and to develop a better understanding of long-term trends.

Both of these tools will create a tremendous amount of data. But that’s just the first step. It’s about understanding the data and finding the signal through the noise.

References:

Due Diligence for Alternative Investments

sec-seal

The Securities and Exchange Commission published a new risk alert on investment advisers and alternative investments. It’s a rambling piece that spends most its time laying out the OCIE’s observations on due diligence practices. To the extent there is any focus, it’s focus is on the perspective of advisers to pension funds and managers of funds of private funds.

I skipped over the industry practices to the compliance section in Section II. The SEC highlights some deficiencies that caught my attention.

The first is the inclusion of due diligence policies and procedures as part of the annual review. This struck me as a bit odd. It didn’t strike me that diligence procedures are necessarily part of ensuing compliance with securities laws.

That odd bit comes back into the picture in the disclosure issues. The OCIE staff found that advisers were making statements about their disclosure practices, but then operating in a different manner. This goes back to the Hennessee Group case where a fund manager touted its expansive diligence process, but failed to conduct the diligence. Hennessee ended up investing in Sam Israel’s Bayou Fund. Hennessee’s touted diligence practices, if they had followed them, should have spotted Bayou as a fraud and not invested.

The last tidbit on compliance was allowing adviser’s employees to invest along side the client. However, some advisers were allowing employees to have preferential treatment on liquidity and fees.

From that perspective, the industry practices in Section I make more sense. OCIE is painting a picture of best practices on diligence procedures for investing in alternative investments. This is what OCIE is going to be looking for from pension fund advisers and fund of fund managers.

References:

Fees and Conflicts

adoption money

I sat down with a few people last week to discuss various fee structures with fund managers and investment advisers. One fee was raised as potentially problematic. “I’m not sure if this fee is a conflict.”

My thought is that every fee is an inherent conflict. You are taking money from the fund investor or client and putting it into the hands of the fund manager / adviser.

The first step of the fee analysis is whether it is disclosed. One of the primary commands of the Investment Advisers Act is disclosure. You must make your clients and investors aware of the fees you charge. Compliance must make sure that the fee information is clearly disclosed in accordance with the regulations and SEC actions.

The second step is the analysis of whether the fee could cause a distortion in behavior that could cause the fund manager / adviser to act in a different way because of the fee income.

If the fund charges an acquisition fee, then the fund may be more likely to make acquisitions because it gets extra income when it does so.

Even the asset based management fee that most people think keeps the fund manager and investor most aligned can cause distortions. In June 2012, the SEC announced its pursuit of zombie funds. It was concerned that fund managers are keeping portfolios together merely to collect the management fee instead creating realizations to return capital to investors.

Fees are always a conflict. You must disclose them and understand the distortions so you can keep your fund’s interest aligned with the investor’s interest.

Compliance Bricks and Mortar for January 24

bricks ancient compliance

It’s been a busy week with guests in the house. I haven’t been able to publish any stories, but these are a few that caught my eye.

Finders Are Not Always Keepers! in the Word of Wisdom Blog from Latham & Watkins Capital Markets Group

Let’s start with the basics. Section 15(a) of the Exchange Act requires that persons engaged in “broker” or “dealer” activity must register with the SEC unless an exemption is available. In general, a “broker” is any person “engaged in the business of effecting transactions in securities for the account of others” and a “dealer” is any person “engaged in the business of buying and selling securities for such person’s own account.” Based on no-action guidance from the SEC Staff, activities that may be deemed (alone or in combination) to confer “broker” status include: …

Where are the Jobs in the Jobs Act? An Examination of the Uneasy Connection between Securities Disclosure and Job Creation by Ian K. Peck on SSRN:

The JOBS Act, passed in April 2012, is designed to produce American jobs through removing various regulatory barriers for small companies to access investor capital. As the regulations continue to be implemented, commentators have dissected the various ways in which the JOBS Act attempts to achieve this goal. One of the methods involves making the IPO process initially less burdensome, through scaling back financial and corporate governance disclosures. Crowdfunding, which will eventually permit companies to raise investor capital through an online “funding portal”, has garnered both deep criticism from regulators and praise from small business owners. Yet little attention has been paid to the notion that the very reason for disclosure reform is job creation. This matters because job creation has not historically played a direct role in the reform of securities disclosure statutes and regulations. This Article analyzes what role, if any, job creation should occupy in the reform of securities disclosure laws. After establishing the normative baseline for disclosure theory and reform, this Article highlights various unintended consequences of using job creation as a justification for reform and proposes a framework for understanding job creation-based disclosure reforms going forward.
(Pointed by Securities Law Prof Blog)

Odds Raised Slightly SEC Will Knock on Your Door This Year in fi360 Blog

In past years OCIE has typically focused on higher risk RIAs – those with custody or the larger complexes that pose more risk to the markets. The vast majority of adviser firms registered with the Commission, however, have 10 or fewer non-clerical employees. Over the next two years, OCIE plans to inspect 1,000 of these rarely or never-inspected RIA firms. In recent years, the SEC has inspected roughly 9 percent of all firms annually.

The fault lies not in our agencies, but in our Congresses by William Carleton

There’s nothing the SEC can do to make non-accredited crowdfunding under Title III of the JOBS Act cost-efficient. The essential problem is that Congress wrote a mini-registration law, rather than authorizing the agency to craft a crowdfunding exemption.

Image is from Vault of Roman Bath in Bath – England by Heinz-Josef Lücking
CC BY SA

Compliance Bricks and Mortar for January 17

bricks 13

It’s been a busy week at the office, but a few compliance-related stories caught my eye.

Compliance Networks as Knowledge Networks by Tom Fox

As compliance programs mature, they become less top down driven and more inculcated into the DNA of a company. The more doing business ethically and in compliance becomes part of the way your company does business, the better off you will be down the road. One of the methods that you can use is to set up a compliance network within your organization. I recently read an article in the Fall issue of the MIT Sloan Management Review, entitled “Designing Effective Knowledge Networks”, by Katrina Pugh and Laurence Prusak, in which they discussed knowledge network design as a mechanism to facilitate desired behaviors and outcomes. I found their ideas very useful in the compliance context.

What Can an Ethics Course Really Do? by Chris MacDonald

Typically, skepticism about ethics education is rooted in a mistaken view of what the goals of such education are. If you think that giving students a course in ethics is supposed to “make them into good people,” then of course you’re going to think it’s useless. An ethics professor can’t turn bad people into good ones, any more than she can turn water into wine. Luckily, that’s really not what’s needed, and so doing so it’s not the aim of any sane ethics course.

Gold dust for compliance officers by Richard L. Cassin

What’s the first thing compliance officers need to do? We’d say it’s convincing management and board members they need an effective compliance program. That’s not easy. It takes advocacy, and advocacy takes credibility.

Jury Gives SEC Split Verdict In Insider Trading – Front Running Trial by Thomas O. Gorman

The Commission was handed a split verdict in its insider trading – front running case against Siming Yang and his investment company, Prestige Trade Investments Limited by an Illinois jury yesterday. SEC v. Yang, Case No. 12-cv-02473 (N.D. Ill. Filed April 4, 2012). The jury found for the defendants and against the Commission on an insider trading claim but in favor of the SEC and against defendant Yang on a front running charge and two false filing claims.

What Was It Called Before Mr. Ponzi Did It?

ponzis scheme zuckoff

When Bernie Madoff’s fraud was exposed it was labeled a Ponzi scheme. Madoff was not investing the money as promised. He was using new investment money to pay old promised returns. I thought it would useful to look back at the original Ponzi scheme to see if offered insight to today’s world of compliance. I just finished reading Ponzi’s Scheme: The True Story of a Financial Legend by Mitchell Zuckoff.

When Charles Ponzi sailed from Italy in 1903, his father told him that America’s streets were paved with gold. Ponzi had landed in America at the end of the Gilded Age. He thought he could earn a fortune. He looked for one one get-rich-quick scheme after another and that lead to two stints in prison before settling in Boston.

He tried setting up a international listing of import-export companies and selling advertisements. One respondent requested information and included an international reply coupon. This coupon was effectively a return stamp for foreign correspondence. Ponzi realized that he could theoretically arbitrage the difference in foreign currencies to generate big returns. It was a theoretic return because he would have to find someone to buy the coupons overseas and someone to sell them to here in the U.S. to convert the coupon back to cash.

The idea was solid enough that he could convince investors to give him money. In exchange, he promised a fifty percent return in three months. Eventually, he had investors lined up to give him money. Unlike Madoff, Ponzi carried out his scheme in the open. It was even briefly approved by Boston’s newspapers and financial sector. (If you wonder why private placements could not be advertised for decades, you need to look no further.)

Perhaps it was the wealth of media coverage that got Mr. Ponzi famous enough for the fraud that now bears his name. Of course, he couldn’t have been the first.

In one of the court pleadings, Ponzi’s lawyer states that his client was not a “520 percent Miller.” This was a recall of an earlier fraud by William Miller and his Franklin Syndicate. Mr. Miller was promising a 10% return each week during his heyday of 1899. It was a Ponzi scheme before it was called a Ponzi scheme.

What about before 520 percent Miller? Mr. Zuckoff uses the older expression of “robbing Peter to pay Paul.” That expression refers back to the Reformation when taxes had to be paid to St. Paul’s church in London and to St. Peter’s church in Rome, so people would neglect the Peter tax in order to have money to pay the Paul tax.

Mr. Zuckoff provides a detailed look at the life of Charles Ponzi. Although it is non-fiction, Mr. Zuckoff has written the story in the narrative form, imposing some insight into the thoughts of Mr. Ponzi and those involved. The result is a nuanced and insightful look into a fraud.

 

SEC Exam Priorities for 2014

SEC National Exam Program

Last year the Office of Compliance Inspections and Examinations at the Securities Exchange Commission laid out their examination priorities for 2013. Apparently, it is now an annual event. OCIE published its 2014 Examination Priorities.

For advisers and fund managers the priorities list three core risks:

  1. Safety of Assets and Custody
  2. Conflicts of interest in the business model
  3. Marketing and performance

There are six new and emerging issues and initiatives.  For most private equity and real estate funds, there is nothing new here.

  1. Never-before examined advisers
  2. Wrap fee programs
  3. Quantitative trading models
  4. Presence exams
  5. Payments for distribution
  6. Fixed income investment companies

We know the SEC has been trying to get in the door at lots of newly registered fund managers and has been using the presence exams model. As of September 30, the SEC had conducted over 200 presence exams, which apparently is on track to touch 25% of the newly registered advisers. A commendable goal.

Under the Policy topics there is something that caught my eye:

“Alternative” Investment Companies. The staff will continue its assessment of funds offering “alternative” investment strategies, with a particular focus on: (i) leverage, liquidity and valuation policies and practices; (ii) the staffing, funding, and empowerment of boards, compliance personnel, and back-offices; and (iii) the manner in which such funds are marketed to investors. The staff will additionally review the representations and recommendations made regarding the suitability of such investments.

There is no color to the term “alternative” so it could encompass private equity and real estate funds.

References:

Weekend Reading: Year Zero

It was December and I needed a “Y” book to finish off my A-to-Z reading challenge. I had my eye on Year Zero by Ian Baruma. But I couldn’t get my hands on a copy and the year was coming to a close. I noticed a different Year Zero by Jeff Long. I had read one of his novels many years ago and remembered enjoying it. I didn’t enjoy it that much, and a friend on Goodreads recommended a different Year Zero by Rob Reid. So I read that also. Then the first Year Zero came in, so I read it.

That’s the tale of why I read three books called Year Zero in a month.

Year Zero by Ian Baruma explores the history of 1945. The book covers a huge spectrum of topics, from the revenge on Germans to the re-education of Japanese students under General MacArthur. 1945, was start of a new world. Germany had been defeated. Japan had been defeated. The colonies in Africa and especially Asia saw that their European overlords were capable of defeat.

The problem was that the book tackled too much. That leaves vignettes of the problems faced in 1945 and what happened as a result. It lacks a narrative because the book stays focused on 1945 and does not trace the problems forward.

Year Zero by Jeff Long is a tale of an apocalyptic disease triggered by the opening of an ancient Christian artifact. The novel held promise of exploring themes of Christianity, the collapse of civilization, revenge, and redemption. But it fell well short of saying anything meaningful or interesting.

Year Zero by Rob Reid is a fun sci-fi farce, with aliens and lawyers. The universe has fallen in love with Earth’s music, but illegally pirated all of it. Then trouble and misadventures follow. It’s a great diversion away from reading about compliance