Month: January 2017

Add One, Take Two Away

Prior to his inauguration, President Trump promised a 75% reduction in regulations. I was left scratching my head about what he meant. Did he want the Code of Federal Regulation to be 75% shorter? How do you decide where one regulation begins and another starts? What about statutes enacted by Congress that specifically mandate the promulgation of new regulations? Isn’t repealing a regulation itself a new rule-making?

President Trump followed up on the promise and issued a new executive order. Whenever an agency publicly proposes a new regulation, it must identify at least two existing regulations to be repealed.

Additionally, the order requires the net incremental cost for fiscal 2017 to “be no greater than zero.” The cost of new regulations should be offset by existing rules that will be rescinded. I assume this add one, take away two is being put in place to achieve his 75% promise.

It looks like Dodd-Frank is the biggest target. I’m not sure the executive order will do it. Dodd-Frank mandated many new regulations. Repealing those regulations would seem to require an act of Congress.

I focus on the Securities and Exchange Commission, so I decided to take a closer look at the executive order. First up is what was meant by regulation.

“For purposes of this order the term “regulation” or “rule” means an agency statement of general or particular applicability and future effect designed to implement, interpret, or prescribe law or policy or to describe
the procedure or practice requirements of an agency…”

Wow.

I think this executive order could affect not only the promulgation of new rules, but could also affect staff guidance. I think a rule-making is general applicability and guidance is particular applicability. That could affect information updates and staff guidance. Could it even affect no-action letters? I think you can read it that way. Ultimately, it will be the SEC commissioners interpretation of the executive order that matters.

Of course, there is the argument that the SEC is an independent agency and not subject to the executive order. The order itself states that it applies to each “executive department or agency.”

Regardless of whether the order applies, President Trump has lesser power to fire the commissioners on the SEC so they may chose to ignore the executive order. Or they may embrace the concept and begin de-regulating.

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The Trump Organization’s Compliance Program Begins

Last week, the Trump Organization kicked off its compliance program by making two appointments.

Bobby Burchfield will be independent ethics adviser. He’ll be responsible for signing off on transactions that could raise ethics or conflicts of interest concerns.

George Sorial will become chief compliance counsel.

In the January 11 press conference, Sheri Dillon announced:

[T]o ensure the Trump Organization continues to operate in accordance with the highest and legal ethics standards, an ethics adviser will be appointed to the management team. The written approval of the ethics adviser will be required for new deals, actions, and transactions that could potentially raise ethics or conflicts of interest concerns.

…

“Another step that President-elect Trump has taken is he created a new position at the Trump Organization: the position of chief compliance counsel, whose responsibility will be to ensure that the Trump businesses, again, are operating at the highest levels of integrity and not taking any actions that could be perceived as exploiting the office of the presidency.”

I admit that I was skeptical that the Trump Organization would even make the appointments to these two positions and I did not expect that it would happen this quickly. Of course, it would have been better to have a compliance program in place before the inauguration.

It would seem that the Trump Organization did not have an existing compliance program. The obvious person to deal with the compliance issues related to his political office would have been the compliance head.

Mr. Burchfield is a partner in the Washington office of King & Spalding and a well respected lawyer for the Republican party. He represented George W. Bush in the 2000 Florida recount. Mr. Burchfield previously challenged the McCain-Feingold Campaign Finance Law on behalf of the Republican National Committee. He was general counsel to George H.W. Bush’s 1992 reelection campaign. He is on the board of Crossroads GPS, the Republican advocacy group started by Karl Rove.

Mr. Sorial has worked at the company since 2007 and served most recently as executive vice president and counsel. He has had roles in Trump’s international development efforts, including the building of his golf course in Aberdeen, Scotland.

As I wrote last week, Mr. Trump is currently one of the most powerful men in the world and therefore the compliance program for his business empire is one of the most important in the world.

Mr Burchfield is very experienced lawyer who does tremendous work for his clients. I’m disappointed that the ethics advisor is such a partisan attorney for the Republican party.

As for Mr. Sorial, I will have to state my bias. Like him, I came from a real estate background. I also went to law school with him. However, he is stepping into an extremely difficult position with no background in compliance.

Hopefully, compliance professionals will learn more the compliance program so we can see how one is put in place to protect one of the most powerful people in the world. Obviously, the American people deserve to know more about the program to know whether the President is directly benefiting financially from his government actions.

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Compliance Bricks and Mortar for January 27

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

Trump Gets Subtle Pre-taliation Warning by Matt Kelly in Radical Compliance

On Wednesday the Office of Special Counsel issued a reminder that any policies about communications from government employees—like, say, telling them to stop talking about climate change; or to stop talking entirely—must include language that those employees are still free to raise alarms about misconduct. [More…]

How Independent Is The SEC And How Independent Should It Be? by Keith Paul Bishop in California Corporate and Securities Law

I have previously argued that the SEC and other independent agencies are the platypodes of the federal government.  If the SEC is truly an independent agency, perhaps it is time to reevaluate its status.

For more on the SEC’s status, or lack thereof, as an independent agency, see this Harvard Law Review note: The SEC is not an Independent Agency. [More…]

Will Yahoo’s Data Breach Reporting Become the Test Case for the SEC’s Cyber Disclosure Guidelines? by Kevin LaCroix in the D&O Diary

Ever since the SEC released its cyber security disclosure guidelines in October 2011, commentators (including me) have been speculating whether the agency might try to nab a company whose disclosure practices the agency might use as sort of a test case on the guidelines’ requirements.  It now appears, at least based on media reports, the SEC is investigating Yahoo in what may yet become the long-anticipated test case. According to a front page January 23, 2017 Wall Street Journal article (here), the SEC has opened an investigation looking into Yahoo, Inc.’s disclosures of two massive data breaches the company reported last year. [more…]

No Coat, No Tie Leads to Rough Start for Accused Insider Trader by Christian Berthelsen for Bloomberg

He refused to bring his expected court attire when U.S. marshals arrested him. When he finally arrived in federal court in Manhattan late Monday, dressed in Under Armour workout gear, he tried to fire his lawyers. On Tuesday, he listened in silence as a prosecutor laid out the evidence against him — wearing a jacket, shirt, tie and pants that his mother brought him.

Thus began one of the more unusual insider-trading trials in recent memory in New York federal court. Afriyie, 29, attended Cornell University and worked as an analyst at Michael Dell’s MSD Capital LP. He’s accused of using confidential information gleaned from MSD’s computer system to score $1.5 million in illegal trading profits last year on Apollo Global Management LLC’s takeover of alarm-manufacturer ADT Security Services. [More…]

There have been just four documented cases of voter fraud in the 2016 election By Philip Bump in The Washington Post

The burden, as we’ve noted before, is on those who say rampant fraud is occurring. I can claim that there’s a burglary epidemic in my city that has gone unnoticed, but you would be justified in pointing out that no one is coming forward to say their houses were broken into. And if I point at a recent spike in sales of crowbars as evidence — voter registration fraud, in this analogy — you would be right to draw a distinction between that and my initial claim. [More…]

 

Affiliated Service Providers and Private Equity

Conflict disclosure and management of the conflicts are central to the Investment Advisers Act. Clients are supposed to come first. That means that conflicts must be disclosed and steps taken to manage the conflict must be put in place. An affiliated service provider is a common conflict.

Centre Partners Management used a service provider for the private equity funds it manages and used it to provide due diligence for potential portfolio investments. The Service Provider provided IT due diligence services with respect to potential portfolio investments for the Funds at a flat fee capped at $25,000 per engagement. Those fees are paid by the funds.

That seems straight forward until you consider that the the Service Provider is owned in part by principals of the firm.

The potential conflict could have been fixed by disclosing the ownership in the fund documents. But Centre Partners did not make that disclosure in the fund PPM or in the Form ADV. It also did not mention the affiliated party payments in the audited financial statements.

The ownership stake was not large. The three principals of Centre Partners only owned 9.6%. But two of them are on the board of directors of the service provider. The founder and majority owner of the service provider is the brother-in-law of one of the principals. (It’s always the brother-in-law that gets you trouble.)

A placement agent for one of the funds raised the conflict during fundraising in 2012. Investors apparently asked about the service provider.

An SEC exam looked at the relationship with the service provider and decided it was worthy of an enforcement action. It cost the firm a $50,000 fine. It also took almost three years to finalize the settlement. The Order states that the exam was completed in early 2014.

There is no statement that the fees paid to the service provider were excessive or above market. That does not matter if the relationship is not disclosed. To fix the problem going forward, the firm added the disclosure to the Form ADV starting in March 2014.

This seems like a good time to check to make sure that none of your fund service providers are owned by employees of the firm.

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CCO Liability for False Statements on Form ADV

Susan Diamond was Chief Compliance Officer of Saddle River Advisors. Now, Ms. Diamond is out of pocket for a $15,000 penalty and is subject to a nine-month suspension from being associated with any investment adviser or other financial services firms. After the suspension, she will be prohibited from acting in the securities industry in certain managerial and compliance capacities.

What did she do?

Diamond, on behalf of Saddle River, prepared, signed, and filed Forms ADV that contained untrue statements.

On its face, the order imposes liability for nothing other than answering questions on Form ADV incorrectly.

In Section 7.B.(1)(B) under the heading, “Service Providers” and the subheading “Auditors.”

Are the private fund’s financial statements subject to an annual audit?    Yes
Are the financial statements prepared in accordance with U.S. GAAP?  Yes
Name of Auditing Firm    SRA Funds’ Tax Preparer
Are the private fund’s audited financial statements distributed to the private fund’s investors?   Yes

None of these responses were true. Saddle River’s financial statements were not audited, prepared in accordance with U.S. GAAP, or distributed to investors. The firm identified as SRA’s “auditing firm” had prepared only tax returns and Forms K-1 for the Saddle River Funds and was never engaged by Saddle River to perform an audit.

BOOM! Diamond’s career is over.

All CCOs now need to be worried that getting a question wrong on the Form ADV will end their careers.

This is a very bad order.

The SEC does not lay out any facts in the order that shows Diamond knew the statements were incorrect. The order merely states that Diamond was in a position to answer the questions because she had signatory power on the fund accounts and made accounting entries in the general ledger.

On its face, the SEC is imposing liability on a CCO solely related to the compliance operations of a CCO. Filing the Form ADV is a core responsibility of the CCO.

The order is a terrible statement by the SEC.

It’s not that Saddle River was free of problems. It’s accused of stealing over $5 million from investors, preying on investors with a claim that it was investing their money in pre-IPO tech companies.

However, in the order against her, the SEC failed to state that Diamond was involved in any of that wrongdoing at Saddle River.

I am not surprised to see CCO liability when the CCO is involved in the wrongdoing. I am surprised to see a CCO facing liability merely on the facts stated in the order against Diamond.

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Red Hot SEC Exam Topics

IA Watch presented a webinar: Red Hot SEC Exams Topics in 2017, Plus Exam-Prep Steps from Peers Who’ve Survived Recent Exams.

The presenters were

Fred Shaw, Principal/Director of Compliance, Hamilton Lane
Adam Reback, CCO, J. Goldman & Co
Chuck Daly, Principal, Constellation Advisers
Michelle Martin, CCO, Longfellow Investment Management

These are my notes:

Even though there is great deal of change in Was, exams are expected to continue.

Based on the 2017 Exam Priorities, there seems to be an emphasis on retail investors and how advisers deal with this type of client. There will be heightened focus on seniors and the possibility of exploitation.

There is an emphasis on data for exams. Word is that the SEC is grabbing lots more than in the past to test firm practices.

One presenter is seeing an uptick on never-before-examined advisor exams. The presenter noted that different regional offices are doing these exams differently.

Money market funds are expected to be a priority based on the 2014 rules on liquidity and redemption risks.

There seems to be less emphasis on private funds. That does not mean that there will be none.

Exams are generally shorter than in the past. OCIE wants to reach more firms, given the resources, that means less time on exams. The panelist is seeing fewer on-site exams and more correspondence exams. The examiners are asking for fewer documents, in part because the request is better tailored to the advisor. Of course, there is a wide range of exam experiences.

In exam tips and experiences, one presenter noted that it was worth discussing document requests with the examiner if the request is voluminous. The examiners are unlikely to want a big data damp and are generally not expecting it.

Some of the requested items may not be for the examiners, but for others behind the scene for data and policy considerations.

Introductory presentations are very helpful.

Valuations need to be well documented. If you use the data, you need a copy of the report in the file.

 

 

Conflicts Ahead – What Can We Learn From the Early Days of the Trump Administration

President Trump has come into office as the first president in modern era to own an active business empire. One in which his name is the probably the most valuable asset. Like him or not; voted for him or not; He is the President. As we have seen in the past, scandals limit the ability of the President and Congress to govern.

I’m looking at the issue as way to reflect on things that work and don’t work for a compliance program.

The first step would be to divest from the conflicts. President Trump has already stated that he is not willing to sell the company and liquidate the proceeds into a blind trust. That leaves him with a sprawling business organization that is mostly owned by him, run by his children, and has business relationships around the world.

To be clear, President Trump is not subject to the legislated conflicts of interest laws. He is not required to divest his interests.

I think a majority of the American Public would be concerned if the President’s business interests were realizing direct financial gain from government action.

The other concern is the Emoulments Clause in the Constitution that prevents the President from receiving any “present, Emoulment, Office or Title, of any kind whatever, from and King, Prince, or foreign state.”

Within that framework, how do you establish a compliance program?

The first is the tone at the top.

President Trump has agreed to establish a compliance program. But he seems to have dismissed the concerns about conflicts:

“I have a no-conflict situation because I’m president, which is — I didn’t know about that until about three months ago, but it’s a nice thing to have. But I don’t want to take advantage of something.”

His legal counsel:

“The conflicts of interest laws simply do not apply to the president or the vice president and they are not required to separate themselves from their financial assets.”

But that was saved with:

“He instructed us to take all steps realistically possible to make it clear that he is not exploiting the office of the presidency for his personal benefit.”

There is some tone at the top. I think most compliance officers would cringe at those statements if their CEOs discussed conflicts in that manner.

Next, we would have a clearly articulated compliance program.

The Trump Organization will have an ethics advisor and a compliance counsel. So there is the start of a program.

What we don’t know is how the program is structured, how it will be administered, how it will be tested, or how it will be administered.

As a result, we have the first lawsuit filed. The Citizens for Responsibility and Ethics in Washington (“CREW”) brought the lawsuit to enforce the Emoulments clause. I think its a political ploy that will fail. I think the failure be one of standing and we will never get to the substance. That is left to the impeachment process. We won’t see a Republican Congress do that.

Even if President Trump acts completely ethically with a blind eye to how government action affects his businesses, there is the other side of the transactions.

I’m hard-pressed to believe that foreign governments, business parties and other interests will not treat the relationship more favorably now than they did last year. We have seen the wrath of President Trump on twitter affect stock prices and send businesses scrambling. He is now one of the most powerful people in the world. He wins the business argument even before you get to an argument. He is voted into office with no expectation that he would divest and carrying that conflict baggage.

In my opinion, the Trump compliance program is the most important compliance program in the world. As a compliance professional, I look forward to hearing more about the Trump compliance program so that we can all learn how we can better implement our own program or learn from its mistakes.

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Compliance Bricks and Mortar for January 20

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

Experts Ponder Role of Trump Organization Compliance Counsel by SAMUEL RUBENFELD in WSJ.com’s Risk & Compliance Journal

As compliance counsel, the person’s ethical obligation will be to the organization, not to the president, making the role less robust than retaining an independent lawyer to prevent potential conflicts, said Daniel Alonso, a managing director at compliance risk consulting firm Exiger who previously served as a member of the New York State Commission on Public Integrity. [More…]

SEC Dings BlackRock for Pre-taliation Clauses BY: MATT KELLY in Radical Compliance

Still, BlackRock did insert its pre-taliation language after the SEC adopted its whistleblower rules. That implies an awareness that employees might want to cash out by approaching regulators, and a desire to persuade employees otherwise. That annoyed the SEC enough for the $344,000 fine. [More…]

US Appeals Court Dodges Scope of Dodd-Frank Whistleblower Protection by C. Ryan Barber in the The National Law Journal

The U.S. Court of Appeals for the Sixth Circuit ruled unanimously against John Verble, a former Morgan Stanley Smith Barney financial adviser who claims he was fired in 2013 for cooperating with the FBI in an investigation. A Tennessee federal trial judge earlier ruled Verble was not entitled to whistleblower protection because he did not provide his insider-trading claims to the U.S. Securities and Exchange Commission. [More…]

MARY JO WHITE’S SEC TENURE ENDS WITH FLURRY OF ENFORCEMENT SETTLEMENTS by N. Peter Rasmussen in Bloomberg BNA

As Mary Jo White’s tenure at the helm of the Securities and Exchange Commission comes to a close, the Commission’s Enforcement Division announced the settlement of a series of actions generating more than $140 million in sanctions over four business days. Companies settled charges ranging from Foreign Corrupt Practices Act violations to improperly issued American Depository Receipts. [More…]

Compliance Is Ruff: A Dog’s Approach by by Kimberly Lansford and Carol Lansford, with special guest Gabe II.

The SEC Really Means It About Pretaliation Severance Agreements

In case you were not clear that the Securities and Exchange Commission is serious about enforcing Rule 21F-17, BlackRock is the latest to run the perp walk. The SEC accused the money management giant of improperly using separation agreements that forced employees to waive their ability to obtain whistleblower awards.

The SEC adopted Rule 21F-17, which provides in relevant part:

(a) No person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement . . . with respect to such communications.

Rule 21F-17 became effective on August 12, 2011.

On October 14, 2011, BlackRock revised its form separation agreement. That agreement did not prohibit former employees from communicating directly with the SEC or any other governmental agency regarding potential violations of law. It did include language requiring a departing employee to waive recovery of incentives for reporting misconduct. Effectively, the agreement removed the financial incentive to be a whistleblower.

Paragraph 5 of BlackRock’s separation agreement in use from October 14, 2011 through March 31, 2016 stated in relevant part:

“To the fullest extent permitted by applicable law, you hereby release and forever discharge, BlackRock, as defined above, from all claims for, and you waive any right to recovery of, incentives for reporting of misconduct, including, without limitation, under the Dodd-Frank Wall Street Reform and Consumer Protection Act and the Sarbanes-Oxley Act of 2002, relating to conduct occurring prior to the date of this Agreement.”

Over 1000 departing employees signed separation agreements with this language. BlackRock revised the agreement in March 2016 to remove that provision. BlackRock also produced a “Global Policy for Reporting Illegal or Unethical Conduct” that it distributed to employees and provides yearly training.

In the end, BlackRock a penalty of $340,000.

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SEC’s 2017 Exam Priorities

Last week the Securities and Exchange Commission issued the 2017 priorities for the Office of Compliance Inspections and Examinations. There are five main items on the list, plus some others. Private funds are still on the list.

Retail Investors –

  • Roboadvisers
  • wrap fee programs
  • ETFs – redemption and sales practices
  • Never-before examined
  • Recidivist
  • Multi-branch -(Are your smaller branches as compliant as the main office?)
  • Share class selection

Senior Investors and Retirement Investments

  • Continuing the multi-year ReTIRE initiative, focusing on investment advisers and broker-dealers along with the services they offer to investors with retirement accounts.
  • Variable insurance products
  • Target date funds
  • Public pension plan advisers. “We will examine investment advisers to these entities to assess how they are managing conflicts of interest and fulfilling their fiduciary duty. We will also review other risks specific to these advisers, including pay-to-play and undisclosed gifts and entertainment practices.

Market-Wide Risks

  • Money market funds under the new rules.
  • Payment for order flow programs
  • Clearing agencies
  • Regulation SCI and anti-money laundering rules

FINRA – Consistent with OCIE’s goal of enhancing oversight of FINRA to protect investors and the integrity of our markets, it will continue conducting inspections of FINRA’s operations and regulatory programs, and focus resources on assessing the examinations of individual broker-dealers.

Cybersecurity – OCIE will continue its ongoing initiative to examine for cybersecurity compliance procedures and controls, including testing the implementation of those procedures and controls at broker-dealers and investment advisers.

In addition to those big ones, OCIE is continuing to look at municipal advisors, transfer agents and private fund advisers.

“We will continue to examine private fund advisers, focusing on conflicts of interest and disclosure of conflicts as well as actions that appear to benefit the adviser at the expense of investors.”

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