Month: August 2014

Weekend Reading: Capital

capital thomas piketty

In Capital in the Twenty-First Century, Thomas Piketty argues that if the rate of return on capital is persistently greater than the rate of economic growth this will cause wealth inequality to increase in the future. The theory is that wealth accumulated in the past grows more rapidly than output and wages.

It’s a great macroeconomics book, rich with data and insight. But it’s still about macroeconomics. So it’s not going to keep you up late into the night turning pages to see what happens.

I came to the book with some base beliefs. I think inequality is a good thing. I believe you should be able to elevate your wealth through hard work and education. That’s the American Dream. (Conversely, I believe your wealth should decrease through a lack of hard work and a lack of education.)

Measurements of inequality are imperfect because the distribution of the have and have-nots changes over time. If you look at the Forbes 400 ranking of the wealthiest Americans from 1987 to 2013, there is a great deal of turnover. New wealth moves up and old wealth is lost through heavy spending, large-scale philanthropy, and bad investing. Only 35 people from the original 1982 list remained on it in 2013. Piketty blows up this belief.

I believe there are two problems with wealth inequality. Obviously too much of a good thing is bad thing. We should not live in a world of lords and peasants. Too much inequality is a problem. Moderate inequality should give you an incentive to strive for more. Stark inequality could lead to a violent political reaction.

The bigger problem with inequality is when the boundaries become impermeable, leaving a person unable to move up on the scale on wealth. Through hard work and education you should be able in increase your wealth. If wealth inequality becomes too extreme that mobility disappears.

There are two elements to wealth: income and capital. Trends in income are relatively easy to obtain data. Income tax filings provide a wealth of information for researchers. Capital is harder to work with because the measurements are bit less reliable.

That has been the sources of some controversy. The Financial Times looked at different data sources and came to a different position on the disparity. Piketty has made his data available: http://piketty.pse.ens.fr/en/capital21c2. He admits that the data is imperfect and incomplete. He is not trying to prove mathematical certainties, but create social science research for open debate.

Piketty’s central thesis is that we should be concerned when the concentration of capital attains extremely high levels and that we are heading towards that concentration. The western countries were approaching high levels of concentration at the beginning of the 20th Century. WWI and WWII annihilated millions of lives. The wars also destroyed accumulated wealth, crushing the accumulated inequality.

Piketty’s data indicates that in the decades since end of WWII wealth is once again concentrating. In the United States the upper decile’s share of the national income increased from 20 to 35 percent in the 1970s to 45-50 percent in the 2000s.

The data is is incomplete because there is no regular accounting of wealth on a regular basis as there is for income with income tax filings. One of the reasons Piketty proposes a tax on capital is so that wealth can be tracked.

A tax on capital is not that unusual. Most people in the United States are already subject to one: real estate property taxes. The government regularly reviews the value of real estate and levies a tax based on the value.

Obviously, a tax on securities and cash is much, much harder to implement since those forms of capital can move so easily and quickly across borders. That means a tax on capital would have to be implemented uniformly across international borders.

One interesting aspect of Piketty’s book is that so many have started reading it but not finished. As I said above, it’s a best selling macroeconomics book, but it’ still a macroeconomics book. An analysis of Amazon Kindle users found that just 2.4% of readers highlighted passages beyond the 26th page, with the Wall Street Journal proclaiming it the summer’s “Most Unread Book.” I

The first 250 pages are background and macroeconomic analysis that builds his case for the second half of the book. It’s this second half where all of his interesting ideas and analysis occur.

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Compliance Bricks and Mortar for August 22

 

laying bricks and mortar

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

Ebola tragedy is also a story of graft by Richard L. Cassin in the FCPA Blog

One reason the fatality rate is so high — up to 90% in some regions, according to WHO — is because intensive care facilities are needed to administer treatments but are “rare in west Africa.”

Although an estimated $3 trillion is spent worldwide on heath services every year, WHO said the money “is a powerful magnet for corruption.”

How Do I Respond to a Wells Notice? in The Securities Law Blog

There is no legal requirement for a regulator to provide a Wells Notice to you, however it is the practice of the SEC and FINRA to provide such notice. Procedurally, the SEC and the FINRA Staff (the people you are dealing with during the investigation) do not have the authority to commence proceedings. They need to obtain approval to commence proceedings. The approval process is handled without any input from the prospective defendant.

Dodd-Frank Anti-Retaliation Provisions Do Not Protect Overseas Whistleblowers by Kevin LaCroix in the D&O Diary

However, based on a recent Second Circuit decision, prospective foreign whistleblowers thinking about making a whistleblower report had better be prepared to watch out for themselves, as according to the appellate court’s August 14, 2014 decision in Liu Meng-Lin v. Siemens AG (here), the Dodd-Frank Act’s whistleblower anti-retaliation protections do not apply extraterritorially — that is, they do not protect whistleblowers outside the U.S. This ruling obviously could dampen the interest of prospective foreign tipsters from making whistleblower reports.

 

Compliance, Ethics and The Godfather by Adam Turteltaub in the SCCE’s Compliance and Ethics Blog

But one line from the film stands out above the rest because it’s the line that is probably the most oft-recited in business, and the line that has often permeated people’s thinking: “It’s not personal. It’s just business.” For the record, the actual line is “It’s not personal, Sonny. It’s strictly business.”

This line gets used a lot in jest, but also when people are discussing business decisions. And there’s a great deal of risk there, starting with the presumption that because Michael Corleone said it in The Godfather it’s somehow a valid rule of business. As seductive as his character is, let’s not forget that he ran a criminal syndicate, which is not a business likely to win awards for its ethics and citizenship. Last I looked, they didn’t have a compliance and ethics program that met the standards in the Federal Sentencing Guidelines.

SEC’s Municipal Advisor Exam Initiative

sec-seal

The Securities and Exchange Commission announced a new examination initiative directed at newly regulated municipal advisors. The examinations are designed to establish a “presence” with the newly regulated municipal advisors.

We’ve seen this blueprint before. It looks a lot like the presence exam initiative for newly registered private fund managers and the never before examined initiative for unexamined advisers. The SEC is trying to knock on as many doors as they can.

The SEC is working with the Municipal Securities Rulemaking Board (MSRB) and the Financial Industry Regulatory Authority (FINRA) to facilitate a coordinated approach to oversight of municipal advisors. SEC’s OCIE will examine municipal advisors for compliance with applicable SEC rules and applicable final MSRB rules once the MSRB rules are approved by the SEC and become effective.

Section 975 of Dodd-Frank added a new requirement that “municipal advisers” register with the SEC. Municipal Advisor is defined in 15 U.S.C. 78o-4(e)(4)(E)(4) as:

(A) means a person (who is not a municipal entity or an employee of a municipal entity) that—

(i) provides advice to or on behalf of a municipal entity or obligated person with respect to municipal financial products or the issuance of municipal securities, including advice with respect to the structure, timing, terms, and other similar matters concerning such financial products or issues; or

(ii) undertakes a solicitation of a municipal entity;

(B) includes financial advisors, guaranteed investment contract brokers, third-party marketers, placement agents, solicitors, finders, and swap advisors, if such persons are described in any of clauses (i) through (iii) 5 of subparagraph (A); and

(C) does not include a broker, dealer, or municipal securities dealer serving as an underwriter (as defined in section 77b(a)(11) of this title), any investment adviser registered under the Investment Advisers Act of 1940 [15 U.S.C. 80b–1 et seq.], or persons associated with such investment advisers who are providing investment advice, any commodity trading advisor registered under the Commodity Exchange Act [7 U.S.C. 1 et seq.] or persons associated with a commodity trading advisor who are providing advice related to swaps, attorneys offering legal advice or providing services that are of a traditional legal nature, or engineers providing engineering advice;

Starting later this year, OCIE in coordination with FINRA and the MSRB will hold a Compliance Outreach Program for newly regulated municipal advisors where they will learn more about the examination process and their obligations under the Dodd-Frank Wall Street Reform and Consumer Protection Act and related rules.

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Another Tale of Golf Course Stock Tips Ending Up in a Sand Trap of Insider Trading

golf insider trading compliance

The Securities and Exchange Commission brought another insider trading case where the tips were allegedly traded on the golf course.

“Country clubs or similar venues may give people a false sense of security that leads them to think they can get away with trading on unlawful stock tips,” said Paul G. Levenson, director of the SEC’s Boston Regional Office. “But as in any social setting, people who trade securities based on confidential information they receive are taking a huge risk that their illegal tipping and trading will be identified by the SEC.”

Robert Bray triggered the FINRA warning lights with a large order of a thinly traded stock. According to an SEC complaint, Bray placed an order for 25,000 shares in Wainwright Bank & Trust Company. That was several days worth of volume in that stock. He started his buying spree on June 14. It several days to accumulate that much stock for his order.

On June 28 Wainwright announced that it was going to be acquired by Eastern Bank for a share price almost double what Bray had paid. That put almost $300,000 of profit in his pocket when the acquisition closed on November 18.

Of course that kind of excessive trading close to a transaction is going to trigger a FINRA inquiry. Bray’s name was on a list of 30 individuals who purchased Wainwright stock during the pre-announcement period. That list was circulated to employees at Eastern Bank for them to disclose if they knew anyone on the list.

According to the SEC, J. Patrick O’Neill, a Senior Vice President at Eastern Bank did not respond to the initial request. O’Neill also did not respond to the second request. Then he called in sick. Finally, he met with his supervisor who demanded that O’Neill respond or be subject to employment-related discipline. O’Neill resigned the next day. He also transferred title on his house to his wife that same day.

Now the SEC had a trader in one hand and in the other hand had an employee with access to the inside information who was acting suspiciously. The SEC just needed to find the link. O’Neill had the information but did not trade. Bray had the trading profits but no direct connection or confidential obligation to the inside information.

The SEC found the connection at the country club. Both O’Neill and Bray were members of the same local county club. The SEC also found a tiny business arrangement between Bray and O’Neill’s son.

That is all the SEC had to build its case. When questioned about his relationship with Bray, O’Neill pleaded the fifth and didn’t answer the SEC questions during his testimony. Bray did the same when he was questioned by the SEC. Apparently that really annoyed the SEC because they forwarded the case on to the Justice Department who brought criminal charges against O’Neill.

Once again, the cliche is proven. But it sounds like the SEC will have a hard time proving the transfer of information from O’Neill to Bray.

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The Stability of Prime Money Market Funds

adoption money

I was critical of the Securities and Exchange Commission’s new rule on money market funds. To me it seemed like it was trying to fix a problem that didn’t exist, and in the process made things more complicated. For criticism to be correct, I need data. After review a paper on the Stability of Prime Money Market Mutual Funds, maybe I was wrong.

Steffanie A. Brady, Ken E. Anadu, and Nathaniel R. Cooper looked at money market funds from 2007 to 2011 for evidence that they could have “broken the buck.” The most famous instance was when the Reserve Primary Fund did the unspeakable in September 2008 because of its exposure to Lehman debt securities.

The authors were looking for instances where money market funds could have broken the buck, but the sponsor stepped in to prop up an ailing fund. Their paper presents a detailed view of the non-contractual support provided by sponsors during the recent financial crisis. They looked at public SEC financial statement filings to find evidence of problems.

They found at least 21 money market funds would have broken the buck without sponsor support during the Great Recession. They found frequent sponsor support during that period with at least $4.4 billion of support to 78 of the 341 funds reviewed.

The largest support relative to a fund’s AUM was the $336.8 million (6.3% of AUM) support for the Russell Money Market Fund.

“On September 14, 2009, the Lehman Securities were purchased by Frank Russell Company from the Fund at amortized cost of $402,764,934 plus accrued interest of $775,756.”

Perhaps money market funds are riskier than I thought. Fund sponsors have repeatedly, voluntarily stepped in to stabilize these funds. The SEC’s rule will make these money market funds less attractive as a safe haven for cash. But maybe they are not really as safe as I thought.

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Compliance Bricks and Mortar for August 15

nooks and crannies of bricks

GPs look for ‘sweet spot’ on co-investment disclosures by Nicholas Donato in Private Funds Management

Part of the SEC’s thinking is that co-investments are being used as marketing tools – so some investor protection is needed to ensure that promises made during fundraising are being fulfilled. Inspectors apparently want to see that every prospective LP is given a heads-up that co-investments are part of the GP’s repertoire – and, ultimately, is given the chance to take part in these deals.

The Clearest Trend in the American Workforce Is Not an Encouraging One by Andrew McAfee

So it feels to me like something else is going on, in addition to the graying of the US workforce — some other forces that are causing more and more people in recent years to go to school, stay in school, go on disability, get discouraged and stop jobhunting, stay home to raise kids or take care of a sick or elderly loved one, or do any of the other things that means they’re no longer categorized as ‘working or looking for work.’

Second Circuit affirms dismissal of compliance officer retaliation suit against Siemens by Richard L. Cassin in the FCPA Blog

Meng-Lin Liu, a Taiwan citizen, said in his lawsuit filed in January 2013 in the U.S. district court in New York that by firing him, Siemens violated the whistleblower anti-retaliation provision of the Dodd‐Frank Act (15 U.S.C. § 78u‐6(h)(1)). The trial court judge, William H. Pauley, III, granted Siemens’s motion to dismiss with prejudice, holding that the anti-retaliation provision doesn’t apply extraterritorially, and that, on the facts alleged by Liu, his civil complaint sought an extraterritorial application of the statute.

4 Reasons Why Private Equity Firms Like KKR Offer the Best of Capitalism by Jonathan Yates in TheStreet

1. Private equity enhances shareholder value – When a private equity firm buys a company, it offers a higher share price.

2. Private equity deals add to the health of the financial markets – Private equity transactions improve the efficiency, and thus the health, of markets by injecting liquidity…[and] capital to entities of all sizes and types, too.

3. Private equity allows companies to better compete – When a private equity group acquires a business, that firm gains access to high-quality resources for managerial, financial, and legal matters. That naturally leads to companies that are managed much more efficiently with access to much more capital and other vital business resources.

4. Private equity opens opportunities for investors – For many private equity transactions, taking the company public is the exit strategy. That offers a greater selection to investors, which leads to more diversity and enhanced risk management, two of the most important considerations for any portfolio.

New York brokerage CEO criminally charged with obstructing SEC by Jonathan Stempel in Reuters

The chief executive of a New York brokerage was criminally charged on Friday with lying to the U.S. Securities and Exchange Commission and faking documents to disguise how his firm did not have enough capital.

 

Nooks and Crannies is by Phil Shirley
CC BY ND NC

Proposed Regulations on Customer Due Diligence Requirements

fincen logo

The U.S. Treasury Department’s Financial Crimes Enforcement Network has proposed revisions to its customer due diligence rules. Of course, the proposed rule would affect financial institutions that are currently subject to FinCEN’s customer identification program requirement: banks, brokers-dealers, and mutual funds. However, FinCEN suggested that it may be considering expanding these customer due diligence requirements to other types of financial institutions. FinCEN names money services business, casinos and insurance companies. Investment advisers and private fund managers are not specifically mentioned.

According to FinCEN, an Anti-Money Laundering program should have four elements:

  1. Identify and verify the identity of customers;
  2. Identify and verify the identity of beneficial owners of legal entity customers
  3. Understand the nature and purpose of customer relationships; and
  4. Conduct ongoing monitoring to maintain and update customer information and to identify and report suspicious transactions.

Please notice number 2. The definition of “beneficial owner” is proposed as have two prongs:

  • Ownership Prong: each individual who, directly or indirectly, through any contract, arrangement, understanding, relationship or otherwise, owns 25% or more of the equity interests of a legal entity customer, and
  • Control Prong: An individual with significant responsibility to control, manage, or direct a legal entity customer, including an executive officer or senior manager (e.g., a Chief Executive Officer, Chief Financial Officer, Chief Operating Officer, Managing Member, General Partner, President, Vice President, or Treasurer); or (ii) any other individual who regularly performs similar functions.

For identifying ownership of an entity, FinCEN has proposed a form of certification. I find the certification to be overly simplistic. It only asks for individuals with ownership in the entity. This would clearly miss ownership of the account holder by other entities who could be “bad guys.” The certification also only requires one senior officer.  That makes it too easy to appoint a straw man as executive officer to hide the underlying control by a “bad guy.”

On the other hand, it makes it really easy for the financial institution to check the boxes with requirements and confirm compliance.

The rule does not specifically contemplate investment advisers or private fund managers. For many investment advisers, the underlying broker-dealer or custodian will end up with KYC responsibilities. The investment adviser will have to be a conduit for that information.

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Lawsuit Against SEC’s Political Contribution Rule

USDC for DC Meade_and_Prettyman_Courthouse

The New York Republican State Committee and the Tennessee Republican Party brought suit against the Securities and Exchange Commission challenging its political contributions rule for investment advisers, . The complaint seeks an injunction against the enforcement of the rule’s political contribution restrictions on contributions to federal candidates.

The first attack on the rule is that Federal Election Campaign Act gave the Federal Election Commission exclusive jurisdiction over federal campaigns. I don’t know enough about that law to opine on that argument.

The second attack is that the rule exceeds the SEC’s statutory authority. They look to the release for Rule 206(4)-5 and the SEC’s own statement that the rule may prohibit acts that are not themselves fraudulent. The problem is that the SEC is confusing payments to state officials as a quid pro quo for business with legal campaign contributions.

As for expertise, the parties point out that the SEC has no specialized knowledge of campaign finance or elections.

The third attack is that the rule violates the First Amendment to the US Constitution. One focal point of the argument is that the rule distorts the ability to give to candidates running for the same office. I pointed this out in the 2012 Republican presidential primaries. Contributions were limited to Rick Perry, but none of the other candidates.

Although some of the arguments could be used to take down the entire rule, the parties are only seeking to exclude it from application to federal candidates. In my view that would be an improvement. It would make it a much clearer rule. The only published relief under the rule was when the Ohio State Treasurer was running for US Senate. The employee thought the rule did not apply to federal candidates.

I don’t like the political contributions rule. It takes innocent, legal behavior, with no fraudulent intent, and turns it into a regulatory violation. Campaign finance is a problem, but the SEC rule does little to help the problem.

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Meade and Prettyman Courthouse by AgnosticPreachersKid
CC BY-SA 3.0

FinCEN Emphasizes a Culture of Compliance

Compliance Secrets Advice Following Rules Yellow Envelope

The US Financial Crimes Enforcement Network has finally come around to realizing that US financial institutions should promote a culture of compliance. FinCEN does not point to any specific problem, but mere notes that “Shortcomings identified in recent Anti-Money Laundering enforcement actions confirm that the culture of an organization is critical to its compliance.”

FinCEN’s mission is to safeguard the financial system from illicit use and combat money laundering and promote national security through the collection, analysis and dissemination of financial intelligence and strategic use of financial authorities.

I don’t think that that anyone believes that these roadblocks in the financial system will prevent terrorism, drug sales or other illegal activities. But it should prevent law-abiding financial institutions from helping illegal activities.

The FinCEN’s advisory (.pdf) comes off as a bit stale since the culture of compliance mantra has been echoing throughout financial institutions for many years.

One piece of the FinCEN guidance did catch my eye:

Compliance should not be compromised by revenue interests

Again, this guidance is not novel, but rarely have I seen it so specific. AML compliance should operate independently and be able to take appropriate actions to mitigate risk and investigate possible inappropriate activity.

When BNP Paribas SA, compliance staff gave warnings but then assisted with misconduct, you understand the need for FinCEN to be more explicit about compliance culture.

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