June 2016 – Compliance Building

How Good Is Your Business Continuity and Transition Plan?

The Securities and Exchange Commission had indicated that it was going to tackle operational issues at investment advisers. It just released a proposed rule on business continuity and transition plans for registered investment advisers. The proposed rule would require SEC-registered investment advisers to have written business continuity and transition plans reasonably designed to address operational and other risks related to a significant disruption in the investment adviser’s operations.

SEC Seal 2

First some stats. According to the release:

“[T]here are approximately 12,000 investment advisers registered with the Commission that collectively manage over $67 trillion in assets, an increase of over 140% in the past 10 years.” – Based on data from IARD as of 1/4/2016

The SEC is proposing a new Rule 206(4)-4 that makes it unlawful for registered investment advisers to provide investment advice unless it has a written business continuity plan and transition plan that is reviewed at least annually.

The easy one is business continuity planning requirement. That requirement was tucked into the release for Rule 206(4)-7. It should not come as a surprise to fund managers and investment advisers that they should have a continuity plan. The SEC has found many BCPs are inconsistent and lacking robustness across those 12,000 advisers.

The SEC is requiring that a BCP have at least the following elements:

maintenance of critical operations and systems, and the protection, backup, and recovery of data
pre-arranged alternate physical location(s) of the adviser’s office(s) and/or employees;
communications with clients, employees, service providers, and regulators;
identification and assessment of third-party services critical to the operation of the adviser.

The transition plan is a bit trickier and much more vague. Frankly, in my opinion, I don’t think the two should be included in the same rule.

The transition plan covers a broad swath of possibilities. The pool of registered investment advisers is very broad, from small retail investment advisers, large financial services companies and private fund managers. The SEC alludes to the “resolution plans” in Dodd-Frank, a/k/a the living wills.

These are the five elements the SEC is looking for in the transition plan:

policies and procedures intended to safeguard, transfer and/or distribute client assets during transition;
policies and procedures facilitating the prompt generation of any client-specific information necessary to transition each client account;
information regarding the corporate governance structure of the adviser;
the identification of any material financial resources available to the adviser; and
an assessment of the applicable law and contractual obligations governing the adviser and its clients, including pooled investment vehicles, implicated by the adviser’s transition.

I think the transition plan is very important for a small retail adviser that is reliant on a single person. I think it’s a bit tougher to see how this would work for a medium-sized or larger private fund manager that is not reliant on a single person or a few people to safeguard and manage the fund assets.

Hopefully, the SEC will carve out the transition plan to a separate rule for a longer and more thoughtful rule-making process.

The business continuity part of the rule is no-brainer. Frankly it’s long over due to have been elevated from a paragraph in s rule release to a its own rule.

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Broker-Dealer Customer Protection Rule versus Investment Adviser Custody

A recent enforcement case highlighted the stark difference between the custody requirements of a broker-dealer and an investment adviser. Merrill Lynch was smacked with over $400 million in disgorgement and penalties for putting customer assets at risk.

Custody hands holding cahs in handcuffs

Private fund managers and investment advisers are well aware of the limits on the custody. The purpose is to keep customer assets safe in the event the investment adviser goes out of business or its malfeasance.

On the broker-dealer side it’s the Customer Protection Rule under Section 15(c)(3) of the Securities Exchange Act and Rule 15c3-3 thereunder. The Customer Protection Rule is designed to protect clients in the event of a broker-dealer failure from a delay in returning a customer’s securities or a shortfall in which customers are not made whole. Rule 15c3-3(e) requires a broker-dealer to maintain a reserve of funds or qualified securities in an account at a bank that is at least equal in value to the net cash owed to customers.

Fortunately, Lehman Brothers was in compliance with the rule in the fall of 2008 so its customers were made whole.

Merrill Lynch was not in compliance with the rule at times between 2009 and 2015. By violating the rule, the firm was able to finance its own trading activities by keeping fewer reserves for customer cash. The SEC dismissed some options trade that it deemed to lack economic substance allowing the firm to artificially reduce the amount of customer cash required in the firm’s reserve accounts.

“The rules concerning the safety of customer cash and securities are fundamental protections for investors and impose lines that simply can never be crossed,” said Andrew J. Ceresney, Director of the SEC’s Division of Enforcement. “Merrill Lynch violated these rules, including during the heart of the financial crisis, and the significant relief imposed today reflects the severity of its failures.”

Merrill Lynch did not lose any customer cash. But the cash was at risk if the firm failed. It was at risk because the firm failed to follow the rules for protecting that cash.

Both the Customer Protection Rule for broker-dealers and the Custody Rule for investment advisers are complex. Most of that complexity is at the edges to deal with specific situations. One should not get lost in following the the reason behind the rules: protecting the clients’ funds and assets.

Sources:

If you enjoy Compliance Building, please support my Pan-Mass Challenge ride to fight cancer. You can read more and donate here: https://www2.pmc.org/egifts/DC0176

Compliance Bricks and Mortar for the Brexit

These are some of the compliance-related stories that caught my attention while waiting for the results from the Brexit vote.

brexit

BEST PRACTICES FOR TODAY’S CCO by Julie DiMauro in the FCPA Blog

In addition to knowing their regulatory-reporting obligations, compliance officers should understand what their managers do, what products and services their company offers and the systems that sustain these products and services.

If a compliance officer lacks this background, it can be acquired through research, on-the-job training, observing business associates, and asking for outside educational opportunities. [More…]

General Solicitation Under Rule 506(b) After Citizen VC: Guiding Principles and Best Practices by Richard M. Leisner in the D&O Diary

It is too soon to know the-long term compliance effects of Citizen VC and the Companion C&DIs. Today is a good time, however, for careful analysis of these recent SEC pronouncements and their underlying rationale and regulatory provenance.

With this analytical foundation, this article suggests how best practices for conventional issuers might evolve for permissible general solicitation activities in future Rule 506(b) private offerings that will not violate the prohibitions of Rule 502(c). [More…]

HERE ARE THE TOP 5 SONGS ABOUT COMPLIANCE by Nicole Rose

The fastest way to change someone’s state is through music. The rhythm and pitch are managed in areas of the brain that deal with emotions and mood. Even the thought of a song is actually enough to stimulate the senses and ignite a positive response. For example, if I mention “You’ll Never Walk Alone” by Rodgers & Hammerstein or “For once in my life” by Stevie Wonder, you’ll probably have it in your head for at least a few minutes. [More…]

Four Points on AML Compliance by Matt Kelly in Radical Compliance

We might dismiss contradictory regulators as a fact of life in compliance, but beware the larger point: if compliance officers get mixed messages about what regulators expect, you cannot develop a sound strategy to implement global AML programs. You can’t easily place big bets on new technology, or adopt global policies and procedures. Instead, you’re trapped reacting to one regulator’s request after another. And without an effective strategy, you can’t implement cost-effective techniques to manage compliance—you just throw bodies and money at the problem of the day. [More…]

SEC Charges Fund Administrator as a Failed Gatekeeper

The Securities and Exchange Commission charged Steven Zoernack and his firm EquityStar Capital Management with fraud for stealing investor money and hiding his criminal past. The SEC brought fraud charges against ClearPath Wealth Management and its principal, Patrick Evans Churchville, for operating a fraudulent scheme that resulted in at least $11 million in losses to investors. One thing in common between the two firms was that both used the same fund administer.

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SEC investigations found that Apex Fund Services missed or ignored clear indications of fraud while record-keeping and preparing financial statements and investor account statements for funds managed by ClearPath Wealth Management and EquityStar Capital Management.

This is another case of the SEC charging a gatekeeper for failing to identify and stop fraud.

The SEC’s order finds that in regard to ClearPath Apex failed to act appropriately after detecting undisclosed brokerage and bank accounts, undisclosed margin and loan agreements, and inter-series and inter-fund transfers made in violation of fund offering documents. Apex failed to correct previously issued accounting reports and capital statements and continued to provide materially false reports and statements to the funds’ independent auditor. Apex should have known that ClearPath would use Apex’s false reports to communicate financial positions and performance to the ClearPath funds’ investors.

The SEC’s order finds that in regard to EquityStar and Zoernack, Apex accounted for more than $1 million in undisclosed withdrawals as receivables owed to the funds, despite no evidence that it was able or willing to repay the withdrawals. Apex confronted Zoernack about the withdrawals and concluded he was unlikely to repay the funds. But Apex still did not properly account for Zoernack’s withdrawals even as they started to consume a significant portion of the funds’ assets. Apex sent monthly account statements to investors that it knew or should have known materially overstated the investors’ true holdings in the funds.

Apex was a failed gatekeeper. The SEC will bring charges for not taking appropriate steps. In this case, Apex knew its reports were false and still sent them to investors or to the funds knowing that they would be given to investors.

Sources:

Château de Crécy-la-Chapelle: Gate by Baishiya 白石崖
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Compliance Bricks and Mortar for June 17

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

Power plants are no longer America’s biggest climate problem. Transportation is. by Brad Plumer in Vox

Here’s an important energy milestone: For the first time since 1979, America’s cars, trucks, and airplanes emit more carbon dioxide than its power plants do. … But power plants are only about one-third of America’s CO2 emissions. Transportation, another third (and now the biggest source), remains much tougher to address. In fact, since 2013, transport emissions have been creeping upward again. [More…]

You won’t believe what gets an email flagged at Goldman: CNBC has the list by Eamon Javers

CNBC has obtained a document detailing more than 180 phrases flagged for scrutiny by the monitoring system. The document was produced in 2008, and the firm has updated its search terminology since then. But the list gives a rare peek inside a large bank’s real-time compliance surveillance operation, and reveals details of how that process works that even veteran Wall Street executives may not know. [More…]

The Orlando Tragedy and the Compliance Profession by Michael Scher in the FCPA Blog

The vigil in Florida’s state capital is one of many around the world. It’s in an old church. LGBT folks and families surround me. Police are here but I still feel threatened, checking the exits just in case. Is this the way LGBT kids feel; why they go to Pulse to feel normal, have fun, not be another target after so many? It’s crazy. They shouldn’t have to live this way. Slaves from near-by plantations made the bricks and built this church long ago. America can do better. – See more at: http://www.fcpablog.com/blog/2016/6/15/mike-scher-the-orlando-tragedy-and-the-compliance-profession.html#sthash.9kYaG9mA.dpuf [More…]

SEC Morgan Stanley Cybersecurity Enforcement Action: Key Takeaways by John Reed Stark

There are a slew of important takeaways from the SEC action, especially that cybersecurity failures can, and will, happen to any financial firm. And in this instance, after recognizing its cybersecurity failures, Morgan Stanley did just about everything right. Even better than right – Morgan Stanley actually excelled in its response. [More…]

Whistleblowers: No Reasonable Belief of Violation, No Protection by T. Gorman in SEC Actions

A recent decision by the eighth circuit court of appeals now adds to the debate over who can qualify as a whistleblower. Beacon v. Oracle America, Inc., No. 15-1729 (8th Cir. Decided June 6, 2016). There the court concluded that one must “establish that a reasonable person in his [the whistleblower’s] position, with the same training and experience, would have believed . . .” that the conduct complained of violated the federal securities laws to be engaged in protected activity. [More…]

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Last weekend I rode in the B2VT. It was a grueling bike ride over 130 miles from the historic battlefields of Lexington to the Okemo Mountain in Vermont. I decided to ride because of my friend Jeff. He enjoyed big challenges and I loved taking on big challenges with him.

Jeff was diagnosed with cancer just before Thanksgiving. This terrible disease killed him just after the New Year. I’m riding the Pan-Mass Challenge raising money to fight cancer. I would appreciate your support. [Donate Here] Jeff’s birthday would have been this week. As a gift to my lost friend, I’m matching any donations I receive this week until I reach my fundraising goal.

Jeff would have loved the B2VT ride, especially once it took a turn for the worse. At mile 80, the already cool day turned cold in the mountains of New Hampshire and Vermont. Then cold rain came down in buckets and only occasionally relented to drizzle.

It reminded of the time Jeff and I competed in the Boston 24 Hour Adventure Race. In the middle of the night while trying to navigate to the waypoints in Blue Hills, it started raining. He quoted the line from Caddyshack: “I’d keep playing. I don’t think the heavy stuff’s gonna come down for quite awhile.” So we kept going and pushing on to the finish.

Back to this weekend, many riders in the B2VT were cursing the rain. Me too. It felt more like October than June. Riders were hurting. Some were starting to experience hypothermia. I pedaled on. If Jeff was still alive and along side me I know what he would have said: “I’d keep playing. I don’t think the heavy stuff’s gonna come down for quite awhile.” So I kept playing.

It’s what Jeff would have wanted.

I can’t think of a better way to remember him than to to ride for him and raise money to fight what killed him. Maybe we can help save the next person.

[Donate Here]

Compliance Lawyers and Legal Education

I had an interesting discussion on the possible role of law schools in helping train law students for jobs in the compliance field. Compliance does not require a law degree, but there seems to be a demand for compliance professionals with legal degrees in the mid and higher levels, particularly in highly regulated industries.

legal education law school

Part of the discussion was about compliance as a distinct discipline. There seemed to be little disagreement about. There were differing viewpoints about the nature of discipline and the profession. That seems normal because there are differing requirements depending on the field and the role within a particular organization.

Can law students be taught compliance? The answer, in part, depends on an approach to teaching the law.

When I was a law student, the basic approach was case law. We studied appellate case decisions. These were instances where something went wrong, someone was angry enough to bring a case, fought it out in court and then appealed the decision. To me, that seems the opposite of compliance. That teaches you how to deal with a situation and argue the positions after the bad thing happened. Compliance is about preventing the bad thing from happening.

Several people mentioned that they had gotten letters to supplement their compliance credentials. I got my IACCP^®. Others mentioned CCEP and other credentialed designations.

There is a demand for something beyond or different than a legal degree to grow a compliance professional. There is a potential role there for law schools. I know that Seton Hall has certification programs in compliance for healthcare.

I also note that several law school are involved with the Compliance Certification Board Accrediting Program:

Charlotte School of Law, Charlotte, NC

Cleveland Marshall College of Law, Cleveland, OH

Cumberland School of Law – Samford University, Birmingham, AL

DePaul University College of Law, Chicago, IL

George Washington University, Washington DC

Mitchell Hamline School of Law, St. Paul, MN

Widener University Delaware Law School, Wilmington, DE

I would guess that more law schools are looking at compliance as way to add value to the legal education. The classic role of placing graduating law students into the big law firms is a shrinking market. I heard that one law school has gone from placing 70% of its graduates into the biggest law firms to only 30%, while at the same time shrinking class size and maintaining its rankings.

UC Irvine Law School
By Mathieu Marquer
CC BY SA

Investment Fraud and Online Dating

Most good financial advisers will tell you that referrals are their best source of business. The same is true for fraudsters. Affinity fraud is just using a network to funnel new “investors” into a fraud. The Boston office of the Securities and Exchange Commission brought charges against an alleged fraudster using an unusual network.

The SEC alleges that Thomas J. Connerton told investors that his company, Safety Technologies LLC, was developing a material to make surgical gloves better resistant to cuts or punctures. He claimed that several major glove manufacturers wanted the technology and Safety Technologies was on the brink of imminent deals that would result in large payouts for investors in his company. But no deals have ever been anywhere close to materializing.

Instead, the SEC alleges that Connerton has been emptied the company’s bank accounts for his own expenses. Those expenses include a $20,000 for an engagement ring for his latest online date.

She is also an investor.

Of the 50+ investors in the company, six are women Connerton met through online dating. There are 14 others who are family or friends of those women. A third of his “investors” and half of the money are tied to Connerton’s online dating activities.

And you thought your ex had problems.

Sources:

Weekend Reading: The Fever of 1721

We are all familiar with the Founding Fathers and the events that lead to the American Revolution. Stephen Coss points to events in 1721 as the seeds of that revolution two generations later in his new book: The Fever of 1721.

The Boston of 1721 was already full of conflicts between American colonists and the British crown that would lead to the revolution 50 years later. The royal governor, Samuel Shute, quickly came into conflict with Massachusetts legislature. The crown appointed the governor, but the local legislature was in charge of his compensation. The legislators voted to pay the new governor no salary. This lead to the Massachusetts colony’s government being paralyzed by dissent. The Abenaki Indians were become actively hostile as the colony continued to grow and settle further and further into New England and the natives’ lands. War was increasingly likely. The financial markets were a mess with a crippling currency shortage. The English financial markets were suffering from the bursting of the “South Sea Bubble”.

In April 1721, the Seahorse, a British navy frigate, sailed into Boston harbor after hunting pirates. But it carried a deadly cargo: smallpox. In the 17th and 18th century, towns like Boston were struck by a smallpox epidemic ever decade or so. The Seahorse was supposed to dock at Spectacle Island to prevent infection. But the quarantine procedures failed. One fourth of Boston’s population contracted smallpox, and almost 10% of the population died.

A local clergyman heard the tale of one of his family’s African slaves about the West African method of inserting pus from a smallpox victim into an uninfected person. The recipient would gain immunity while usually suffering only a mild form of the disease. The clergyman began advocating for this treatment.

However, the clergyman was Cotton Mather, one of the main players in the Salem witch trials. He had to overcome the public’s suspicion of him and the overt racism of relying on an African method as a legitimate medical procedure.

The local papers were involved in the controversy about this medical procedure. Perhaps the biggest flamethrower of publishing in Boston was James Franklin, publisher of the New-England Courant, and his younger brother/apprentice, Benjamin Franklin. The Courant was trying to operate as an independent newspaper, published without government license. It criticized the vaccination procedure as well as Boston’s government and influential citizens. The Franklin brothers thought the medical procedure would just further spread the disease and unnecessarily kill the patients.

The Fever of 1721 pulls together these tales of medical innovation, freedom of the press, government strife, and economic crisis. I had not heard of this portion of Boston’s history and found the stories to be fascinating.

I’m a sucker for books on Boston history and took a copy from the publisher in exchange for a review.

Compliance Bricks and Mortar for June 10

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

Pigeon at Castelvecchio Verona

U.S. Offers Rare Account of Why It Didn’t Pursue Bribery Charges by Samuel Rubenfeld in WSJ.com’s Risk & Compliance Journal

As the Securities and Exchange Commission announced it reached non-prosecution agreements in two unrelated foreign-bribery cases, the U.S. Justice Department took the rare step of releasing letters sent to the companies explaining why it decided to close the cases without filing charges.

The companies — Cambridge, Mass.-based internet-services provider Akamai Technologies and Providence, R.I.-based home-security and thermostat systems-maker Nortek — both agreed to forfeit ill-gotten gains connected to bribes paid to Chinese officials by foreign subsidiaries, the SEC said. Both companies self-reported the misconduct and they cooperated extensively with SEC probes, the SEC said. [More…]

The Panama Papers and Shell Games, Part I by TOm FOx in the FCPA Compliance & Ethics Report

All of this is not simply about performing adequate due diligence so that you will know with whom you are doing business. Internal corporate investigators need to be aware of how shell corporations are set up to help detect fraud in their own organizations. In his piece Hubbs cited to a Department of Justice (DOJ) Press Release from then Deputy Assistant Attorney General Bruce Swartz around the resolution of the Hewlett-Packard (HP) FCPA resolution for the following, “Hewlett-Packard subsidiaries created a slush fund for bribe payments, set up an intricate web of shell companies and bank accounts to launder money, employed two sets of books to track bribe recipients, and used anonymous e-mail accounts and prepaid mobile telephones to arrange covert meetings to hand over bags of cash.” [More…]

The First Form 1-Ks Are Filed! by Broc Romanek in TheCorporateCounsel.net

Hat tip to Bjorn Hall of Fundrise for letting me know that the Fundrise Real Estate Investment Trust, LLC (which they lovingly call the “Income eREIT”) filed the first-ever “Annual Report on Form 1-K” back in late April. Under Rule 257(b)(1) of Regulation A, Form 1-K is the annual report now required to be filed by Tier 2 companies that conducted their offerings under Regulation A+. The form is due within 120 calendar days of fiscal year covered by the report. Only Tier 2 companies are required to file a Form 1-K, one of trade-offs for not having to register with the states. Since Fundrise made their filing back in late April, there have been four other Form 1-Ks filed. [More…]

Prostitutes, vacations and cash: The Navy officials ‘Fat Leonard’ took down by Craig Whitlock and Kevin Uhrmacher in The Washington Post

Leonard Glenn Francis, a Malaysian defense contractor, has pleaded guilty to bribing “scores” of Navy officials with cash bribes, prostitutes and other gifts – such as hotel stays, airfare and electronics – so they would feed him classified or inside information, which he used to defraud the Navy. The slowly unfolding investigation has exposed a staggering degree of corruption within the Navy. [More…]

If you enjoy Compliance Building, please support my Pan-Mass Challenge ride to fight cancer. You can read more and donate here: https://www2.pmc.org/egifts/DC0176

Pigeon at Castelvecchio, Verona by Andy Hay
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Charging Fund Investors For In-House Legal Staff

In house lawyers fall into two sections of typical fund documents. On one had, fund documents usually state that the fund pays for legal expenses. Another section states that the general partner is responsible for employee expenses.

Can you charge in-house legal staff as a fund expense?

It depends.

This was mentioned by Marc Wyatt, Deputy Director – Office of Compliance Inspections and Examination, US Securities and Exchange Commission, at PEI’s Private Fund Compliance Forum 2015.

It’s not that a fund manager is prohibited from charging its fund clients for in-house legal counsel. As with any fee or expense, it needs to be properly disclosed and properly documented.

I have heard that at least one real estate private fund manager has received a deficiency letter after an examination because of the way it treated legal expenses. The fund manager charged internal legal staff compensation and expenses to the fund.

The SEC relied on the provisions in the fund documents stating that overhead, including compensation of personnel, is to be paid by the general partner / fund manager.

The general partner / fund manager pointed to other language that stated it could charge the funds for legal expenses.

I think the SEC thinks that in the case of a tie, the fund investors should win.

If you charge in house legal fees to fund investors, there are some steps a fund manager should take:

Disclose it on Form ADV.
Disclose it in the financial statements for the funds. To be in accordance with GAAP, related party transactions must be included in the notes to the financial statements.
Maintain timesheets and other documents to support the time or work of in-house legal staff.
Maintain written policies and procedures to address when the expenses should be paid by the fund and when they should be paid by the fund manager.

It may not actually be costing the fund any more for in-house versus outside cost. In fact, it may actually be cheaper. But it is extra revenue to the fund manager. The SEC has indicated that it cares about that difference.