Month: February 2017

Compliance Failure at the Oscars

PwC had a public failure last night, in the worst possible way, during the Oscars telecast. After running nearly 45 minutes over schedule, the final remaining award was for best picture. Warren Beatty and Faye Dunaway were on stage with a red envelope. The duo was presenting the best picture award in celebration of the 50th anniversary of Bonnie and Clyde. 

Mr. Beatty looked confused, perhaps trying to be funny. He passed the envelope to Ms. Dunaway who quickly looked at the movie title on the card and blurted out “La La Land”. She failed to note the mistake that had confused Mr. Beatty.

As Beatty explained onstage:

“I opened the envelope and it said, “Emma Stone, ‘La La Land.’ That’s why I took such a long look at Faye and at you ― I wasn’t trying to be funny.”

The producers and cast of La La Land took the stage and began giving speeches. They managed to get through their speeches before a stage hand jumped into the fray and started looking at envelopes.

PwC has handled the balloting process at the Academy Awards for over 80 years. The failure came in the last step in the process: handing the correct envelope to the correct presenter for the correct award.

It seems clear that Mr. Beatty had the wrong envelope. He realized he had the wrong message inside the envelope. Re-watching the video, he looks into the envelope a second time realizing the card says Emma Stone for LaLa Land. He turned to Ms. Dunaway apparently looking for help, but she plunged ahead.

He didn’t know where to turn to when he had a problem.

PwC failed to monitor delivery of the envelope and failed to put a stop before things went too far. I’m sure critics of audit firms will be able to draw many parallels.

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Can a California Note Be A Security?

Debt instruments can be securities. Section 3(a)(10) of the Securities Exchange Act of 1934 explicitly includes “notes” in the definition of a security, but does not include loans. Federal law uses some variation of the factors stated in S.E.C. v. Howey Co., 328 U.S. 293 (1946) n analyzing whether an instrument is an “investment contract” and therefore a security.

California also has a “risk capital test” to test whether an investment is a security.  That test came out of Silver Hills Country Club v. Sobieski, 55 Cal.2d 811 (1961).

The risk capital test, articulated by the California Supreme Court in Silver Hills Country Club v. Sobieski (1961) 55 Cal.2d 811, 815 describes:

  1. an attempt by an issuer to raise funds for a business venture or enterprise;
  2. an indiscriminate offering to the public at large where the persons solicited are selected at random;
  3. a passive position on the part of the investor; and
  4. the conduct of the enterprise by the issuer with other people’s money.

The test reflects the court’s assessment that the term “security” is defined broadly in order “to protect the public against spurious schemes, however ingeniously devised, to attract risk capital.” (Id. at p. 814.)

The instrument in question in the Black  case was a note that provided:

“(a) In the event the real property located at 177 and 200 North Edgewood Lane, Eagle, Idaho is sold by Borrower, the amount of interest shall be based on the percentage of profits minus expenses Borrower receives from the sale; or “(b) In the event Borrower develops said real property, Lender shall receive two (2) lots based on the tentative map to be selected by Lender. “(c) In the event that neither (a) or (b) take place before one year from the making of this note, the principal together with interest at the rate of ten percent (10%) shall become due and payable at the election of Lender.”

Mr. Black was arguing that the note failed the risk capital test because it was a heavily negotiated agreement and not one that was intended to offered to the public at large. It failed the second prong of the risk capital test.

According to California’s Sixth Appellate District in People v. Black (page 12):

“It is generally accepted that both the risk capital and federal tests may be applied, either separately or together; a transaction is a security if it satisfies either test.”

Black’s argument that it was not a security under Silver Hills failed to find traction. But the court still found that the note was not a security under the Howey test.

The California court found that repayment of the note was not wholly dependent on the efforts of Mr. Black. There was other collateral that may have allowed for some repayment of the note.

Surprisingly, the court comes back to include the nature of the transaction being individually negotiated and not being intended for wide distribution as factor in reaching its conclusion. Although the court rejected Mr. Black’s argument that the Silver Hills risk capital test is muted mooted by the federal Howey test, it seems to still include it in reaching its conclusion.

Perhaps, the court and Mr. Black should have looked at the formula used by the United States Supreme Court in Reves v. Ernst & Young (.pdf). That decision limits the Howey four part analysis of securities to “investment contracts”. Instead, it creates a new framework to determining if a note is a “note” under section 3(a)(10), and therefore a security. This is the Family Resemblance test.

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Can Compliance Be Cool?

John Glenn passed away at the end of 2016. He was a Senator, an astronaut, and distinguished pilot in the World War II and the Korean War. The picture below struck me as one of ultimate cool.

Astronaut John Glenn Relaxing on Deck

Mr. Glenn had just finished orbiting the Earth on February 20, 1962. Doing so in a tin can with less computing than your smart phone. He was the first American to orbit the Earth, the third American in space, and just the fifth human in space. Chunks of his Friendship 7 had been turned to flaming debris, flying past his window on the descent back to the surface, being sacrificed to keep his heat shield in place.

There he is in the picture above, Chuck’s on his feet, aviators, keeping the sun from his eyes and his collar popped, looking like nothing could bother him.

Post Dodd-Frank, compliance became cool. … Okay, maybe not cool, but better embraced. Organizations needed help to navigate the byzantine regulatory frameworks to ensure their organizations were in compliance with the thick rules coming rapid-fire from Washington. Compliance could prevent missteps and protecting their organizations from being turned into flaming debris by regulators and prosecutors.

The Trump Administration looks to be rolling back regulations and whatever “cool” compliance may have gathered could be smashed on the rocks of de-regulation. We still don’t know how far the administration and Congress may go in de-regulation.

The gains of the compliance profession are likely to erode and will never be as cool as John Glenn looks in that picture.

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Weekend Reading: Black Edge

The 2009 arrest of Raj Rajaratnam of the Galleon Group was the start of a long trail of insider trading prosecutions that culminated in the prosecution of SAC Capital. The SEC had identified Steve Cohen as the worst of the insider trading hedge funds and the SEC put his SAC Capital in its cross-hairs. It convinced the Justice Department to prosecute the offenders with criminal charges.

Sheelah Kolhatkar tells the tale in Black Edge.

Ms. Kolhatkar was a hedge fund analyst and is now a staff writer at The New Yorker, where she writes about Wall Street, Silicon Valley and politics among other things. She shows a keen understanding of traders and regulators, and conveys the story into a page-turner.

I know what happens in the end to SAC Capital and Steve Cohen. I knew some of the insider trading prosecutions. I never appreciated how all of those prosections from 2009 to 2014 were tied together.

Matthew Martoma plays one of the biggest roles in the story. He was a former trader at SAC Capital who was caught red-handed on insider information about negative results from a drug trial. His source, a doctor working on the trial, passed Martoma the information. Martoma made SAC Capital a lot of money on that information and Steve Cohen profited handsomely. What the feds really wanted was for Martoma to implicate Cohen in exchange for a lesser sentence. I won’t spoil the end for you.

Besides Rajaratnam and Maratoma, the feds brought cases against Michael Steinberg, a portfolio manager at SAC, Anthony Chaisson of Level Gobal and Todd Newman of Diamondback Capital.

It was this last one that lead to the undoing of some of the ability to prosecute insider trading. The Newman appellate decision slapped tighter requirements on the government when trying to prosecute an insider trading case.

Black Edge is well worth the time if you have any interest in the area.

Compliance Bricks and Mortar for February 17

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

Court to Reconsider Authority of SEC Administrative Law Judges by Dave Michaels and Brent Kendall in the Wall Street Journal

The U.S. Court of Appeals for the District of Columbia Circuit said it would reconsider an appeal that argues the SEC’s administrative courts are unconstitutional. The argument was made by Raymond Lucia, a California financial adviser and radio personality who was accused of misleading investors about an investing strategy he called “Buckets of Money.”

The appeals court’s decision wipes out what was an earlier SEC victory in the case. In August, a panel of judges found in the SEC’s favor and dismissed Mr. Lucia’s appeal. In a separate ruling in December, an appeals court in Denver ruled the in-house courts don’t meet constitutional requirements. [More…]

SEC Chief Scales Back Powers of Enforcement Staff by Dave Michaels in the Wall Street Journal

The new Republican leader of the Securities and Exchange Commission has imposed fresh curbs on the agency’s enforcement staff, scaling back their powers to initiate investigations of alleged financial misdeeds. The move by Michael Piwowar—named acting head of the agency in late January by the Trump administration—narrows actions launched during the Obama administration designed to make it easier for the Wall Street regulator to launch probes in the wake of the financial crisis and a series of colossal investment scandals.[More…]

Microsoft’s New Cyber Assessment Tool Just Dropped by Matt Kelly in Radical Compliance

Just in time for everyone gathering at the RSA Conference in San Francisco this week, Microsoft has announced plans to rate the effectiveness of customers’ cybersecurity efforts—and at least one insurance company will start using that score to set prices for its cyber-insurance policies. [More…]

Ninth Circuit: Ethics Code Violations Insufficient to State Securities Law Claim by Kevin LaCroix in The D&O Diary

The Ninth Circuit, in a recent case arising out the departure of former H-P CEO Mark Hurd for alleged misconduct, examined whether a senior official’s violation of a company’s ethics code, after having touted the company’s high standards for ethics and compliance, may state a claim for violation of the federal securities laws. [More…]

Throwing Away a Legal Career for $310,000 by Peter J. Henning in DealBook

It appears that Jeffrey A. Wertkin may have tried to do just that by passing a copy of a sealed whistle-blower complaint against a Silicon Valley company to one of its employees in exchange for that amount. Unfortunately, he never actually got the money because he was met instead by an F.B.I. agent, who arrested him. Mr. Wertkin responded “My life is over,” according to a complaint filed in the Federal District Court in San Francisco. [More…]

Counterarguments to SEC Statistical Analysis in Enforcement Actions and Inquiries by Tiago Duarte-Silva and Nicolas Morgan in the CLS Blue Sky Blog

In an April 2016 action, the SEC showed that “proprietary accounts averaged a first-day gain of 0.26% while client accounts averaged a first-day loss of 1.02%” and supported its allegations by showing that the “difference between the allocations [by another investment adviser] of profitable trades to proprietary accounts as compared to profitable trades allocated to the client accounts is statistically significant; the probability of observing such an uneven allocation of profitable trades by chance is less than one-in-one-million.”  Another April 2016 action provided similar arguments. [More…]

Compliance Lessons from Super Bowl LI by Tom Fox in the FCPA Compliance Report

At one point in the fourth quarter, Atlanta had a 99.7% chance of winning the game. This means New England had a .3% chance of winning. While pollsters were drubbed for their abysmal predictions surrounding the Brexit vote and US presidential election, this number from the Super Bowl would seem to be of a magnitude as to simply being beyond belief. How could such a number be both so high and so wrong at the same time? [More…]

Image is Parallel Stripes by Mary Crandall
CC BY NC SA

Wealth Building by Stealing From Your Investors

Jim Toner wants to help you get rich investing in real estate. He has a “simple 3 step method the ‘experts’ and ‘gurus’ don’t want you to know about creating lasting wealth with real estate…” According to an SEC complaint those steps are lying to investors, taking undisclosed fees, and pocketing some of the capital.

Mr. Toner consent to the court order, but did not admit or deny the allegations. We will have to rely on the SEC complaint and assume that the facts are mostly correct.

Mr. Toner’s main business is selling his instructions on how invest in real estate. On the side, he also solicits investments. Some of those investments in Arizona went bad and resulted in these SEC charges.

Mr. Toner pitched the investments as pooled investments in residential properties. He would manage and oversee renovations and then quickly resell the properties for a profit. Some of the investments were notes and some were partnership interests. He pulled together almost $1 million for three properties in Arizona.

He claimed he was the manager and would be running the deals. But he turned over control to an unnamed real estate broker who had already purchased two of the properties and sold them to the investors for “handsome profits” according to the SEC.

Mr. Toner claimed that he would be investing his own assets in the investments. According to the SEC complaint he told different investors different statements about how much he would be investing. The SEC claims he had no intention to make the investment. It points out that Mr. Toner was in protracted bankruptcy and had no assets to invest.

Lastly, Mr. Toner took management fees. In the offering documents, Mr. Toner would only be paid management fees after the partners received profits from the investments. He took $31,000 up front from the proceeds and received another $21,000 before the investors had realized any returns.

Later, as the investments were going poorly, Mr. Toner solicited another investor. Instead of adding this Investor B to the investor roll, he pocketed her $20,000. Given that the SEC is focusing on elderly investors, the complaint points out that Investor B was elderly.

At the end, Mr. Toner had raised almost $1 million from investors and ended up selling the properties for $256,000. Mr. Toner pocketed almost $70,000 through unauthorized management fees and theft.

He also failed to determine that the investors were accredited or told them to lie about being accredited.

This seemed like good wealth building for him, but not for his investors.

In the end, it was bad deal for him. Mr. Toner has to come up with over $500,000 in disgorgement and penalties.

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If You Say It, You Have To Do It

If your marketing materials say that you have “never, not once, taken even so much as a nickel” from potential referrals, you have to put that policy in place and enforce it. Jeffery Slocum & Associates told is clients this. Then some of its employees accepted golf tickets. The Securities and Exchange Commission is pretty sure that tickets to the Masters Golf Tournament are worth more than a nickel.

This was a self-inflicted mistake.

Jeffery Slocum & Associates provided investment counseling services to institutional clients including recommending investment managers. It wanted to avoid taking gifts from those possible investment managers to avoid an appearance of favoring one over the based on anything but performance.

As part of its advertising, Jeffery Slocum & Associates proclaimed that it had “never, not once, taken even so much as a nickel from an investment manager.” The problem was that the statement wasn’t true.

Slocum’s gift policy only prohibited gifts in excess of $100. In practice, employees could get waivers of that $100 limit.

Slocum’s CCO discovered that four employees had accepted tickets to the Masters from an investment manager. The proposed response was to repay the value of the tickets to the investment manager. The head of the firm stepped in and waived off that requirement.

So even though Slocum had adopted a written policy regarding the acceptance of gifts, this policy, as written and as implemented, conflicted with representations contained in Slocum’s marketing materials.

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The Next Real Estate Fund Manager To Fall

Scott M. Landress sponsored funds to invest in real estate private equity secondary transactions in 2006. When one of the funds got into trouble, Landress asked for additional fees. The fund advisory board said no. Landress later charged unauthorized fees for services provided by an affiliate.

SLRA’s fund management fee was based on the net asset value of the fund’s underlying investments. If you bought real estate in 2006, your net asset value dropped for a few years. The Liquid Realty Partners fund saw its net asset value decline by 94%.

Landress and SLRA were stuck with declining values and increased costs to manage those assets through the financial crisis. They had to deal with loan defaults and foreclosures and attempts at recapitalization.

Between 2009 and 2011 Landress asked the fund limited partners for more compensation. It should come as no surprise that they said no.

In early 2014, Landress withdrew £16.25 million from the fund for service fees related to acquisitions, dispositions and financing work performed by an affiliate of the general partner. The charge was 1.25% of thirteen transactions.

The service was provided through an oral agreement. It did not appear in the fund documents. It was not approved by the fund’s advisory board which is required for related party transactions. The charges were not shown as accumulated on the fund’s financial statements or disclosed to the auditors.

Landress wrote a letter to the fund’s limited partners telling them he was taking the fee. They were understandably upset. Both sides went into negotiation over these fees. The LPs tried removing the GP and stopping the payment.

Surprisingly, Landress sued the LPs for declaratory relief that he was entitled to the fees. The argument was that SLRA had to do all that additional work that was outside the scope of the management fee paid to the fund’s general partner. The LPs lawyered up and notified the SEC of the problem.

Landress and SLRA ended up returning the cash and Landress got barred from the industry.

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Compliance Bricks and Mortar for February 10

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

 

WHY SHOULD I GIVE A %$#@! ABOUT OVERSEAS BRIBERY? by Matt Kelly in the FCPA Blog

This is on my mind thanks to a recent column in the legal blog Above the Law, “Is Trump the End of FCPA Enforcement?” The author, a white-collar defense lawyer, speculated about the need for all this attention to corporate bribery and FCPA enforcement. [More…]

Uncertainty Looms Over SEC Enforcement Staff by Sean T. Prosser in Perkins Coie’s White Collar Briefly

The air of uncertainty was palpable as current and former members of the U.S. Securities and Exchange Commission’s (SEC) Division of Enforcement spoke at the Securities Regulation Institute’s 44th Annual Conference in Coronado, California earlier this week. Important questions went largely unanswered about the impact of the recent resignations of both SEC Chair Mary Jo White and Enforcement Director Andrew J. Ceresney, and the future direction of the enforcement program under the new presidential administration and proposed SEC Chair Jay Clayton. SEC Enforcement staff in attendance steered clear of prognostications, and instead used the conference as an opportunity to reiterate the agency’s ongoing enforcement initiatives and successes from the past year. [More…]

The Nuts & Bolts of SEC Investigations & Enforcement by Ted Carleton and Tammy Yuen of the Skarzynski Black law firm and John Sikora of the Latham & Watkins in the D&O Diary

The scope and process of the Commission’s activities can be confusing and opaque to practitioners who do not frequently encounter these procedures. This article provides a basic outline of the Commission’s process and protocols with respect to investigations and enforcement proceedings, and highlights some current issues relevant to parties who may become enmeshed in a regulatory action, as well as to the D&O or other professional liability carriers who may provide insurance for the legal fees incurred in such an action. This article also looks ahead to possible changes that may occur under the new Trump administration. [More…]

Kellyanne Conway tells America to ‘buy Ivanka’s stuff,’ may have violated federal law

Your taxpayer dollars just paid for a “free commercial” for the President’s daughter’s business. [More…]

President Trump’s Two for One Regulatory Reduction Is Headed to Court

It seems like just a week ago that President Donald Trump signed an Executive Order requiring two regulations be repealed for every new one adopted.  It was. And this week a lawsuit has been filed challenging that executive order.

The lawsuit was filed by Public Citizen, the Natural Resources Defense Council and the Communications Workers of America. In addition to President Trump, the lawsuit tags the Acting Director of the OMB and the current or acting secretaries and directors of many government agencies.

The Securities and Exchange Commission is noticeably absent from the list of defendants. I guess the plaintiffs concluded that the SEC is independent and not subject to the Executive Order.

The plaintiffs are asking the court to prevent the agencies from implementing the order and to kill the executive order because it cannot be lawfully implemented.

According to the complaint, the executive order to repeal two regulations for the purpose of adopting one new one, based solely on a directive to impose zero net costs and without any consideration of benefits, is “arbitrary, capricious, an abuse of discretion, and not in accordance with law.” The complaint spells out the three big reasons the plaintiffs think so:

There is no statute that tells agencies to withhold regulations because of cost. Of course there is the cost-benefit requirement for some regulations. But that is different than saying there are no costs imposed by the regulation.

Second, the Executive Order forces agencies to repeal regulations that have gone through the administrative process and concluded that they comply with the enabling statute and advance the purpose of the statute. The complaint stops short, but in my view the argument is that the Executive Order is trying overturn legislation passed by Congress authorizing regulation.

Third, no governing statute authorizes an executive agency to base its decision making on there being zero net cost across multiple regulations.

The second argument is certainly applicable to many of the financial regulations imposed by Dodd-Frank. The SEC is taking steps to rollback the Extraction Disclosure Rule.  A rule that was specificaly required by Dodd-Frank.  (Of course, the SEC is not specifically subject to the Executive Order.)

The two big problems with the lawsuit are standing and ripeness.

Two of the causes of action are violations of the constitution, violating the separation of powers and the Take Care Clause. That last one is new one for me. Under Article II, Section 3, the President has duty to “Take Care that the Laws be faithfully executed.” I’m skeptical that individual citizens have standing under these provisions. Congress is not about to bring suit.

The other causes of action would seem to not be ripe for suit until an agency actually starts trying to repeal regulations because of this order.

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