Month: July 2017

Compliance Bricks and Mortar – John McCain Edition

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

Standardizing IRR Calculations and Related Disclosures – The SEC Continues to Focus on Private Equity Practice by Vivek Pingili, Esq.

In recent years the SEC has closely examined private equity fund performance and reporting during routine exams. The importance of this topic came to the forefront in December 2016 when the SEC subpoenaed Apollo Global Management, LLC (“Apollo”) for additional information on Apollo’s IRR calculation methodologies.[1] This SEC enquiry has caused a number of private equity firms to review their IRR calculations and disclosures. [More…]

SEC’s Reg Flex Agenda: Where Did Those Dodd-Frank Rules Go? by Broc Romanek in The CorporateCounsel.net

Normally – as I have blogged many times (here’s one) – the SEC’s Reg Flex Agendas tend to be “aspirational.” But perhaps this time is different.

As part of a federal agency-wide reveal of the new Administration’s plans for rulemaking, the SEC posted the latest version of its Reg Flex Agenda last week. This agency coordination is the Administration’s “unified agency regulatory agenda.”

This Reg Flex Agenda is notable for what it omits – get a load of what’s not on the list: …. [More…]

Cheating the Algorithm: The New “Pump and Dump” Fraud by John C. Coffee, Jr. in the CLS Blue Sky Blog

Today, an analogous new technological development is inviting new forms of fraud. The new development is algorithmic trading (which by some estimates now accounts for 30 percent of stock trading[1]). Computers are programmed to trade in a micro-second once they detect certain triggering quantitative data. Obviously, this is how high frequency traders have come to dominate the market.

But can the computer be duped? The answer is: definitely and sometimes easily. A pending SEC litigation shows how the contemporary financial world in its hunt for quantitative “Big Data” exposes itself to fraudsters. In SEC. v. Lidingo Holdings, LLC,[2] a pending action in the Southern District of New York, the defendant described itself as a “social media consultant,” but the SEC characterized it instead as a “stock promotion firm” that received high fees for commissioning and posting articles (and even tweets) about its clients written by a variety of ghost writers whom the firm commissioned and paid.  [More…]

Are We in a Compliance Arms Race? by Azish Filabi in Compliance & Enforcement

Over the past few decades, while companies have invested in building and expanding their compliance programs, researchers, practitioners and employees in some companies attest to a lack of corresponding reduction in misbehavior.[1]   Some even believe that the compliance programs may be a cause of increasing misbehavior.  This begs the question: Are we in a compliance arms race?  Mind Gym, Inc., a behavioral science oriented training firm has coined this term to refer to the cycle of increasing investment in compliance programs, which increases the demand for competent professionals, and the cost of doing business, while the levels of misbehavior remain unchanged, thus spurring calls for additional internal compliance controls.[2] [More…]

On Pan-Mass Challenge weekend, August 4 – 6, I will saddle up to ride with 6,200 other cyclists to raise money for life-saving cancer research and treatment at Dana-Farber Cancer Institute. 100% of your donation will go to cancer research and treatment at Dana-Farber Cancer Institute through its Jimmy Fund. I have made a personal commitment to raise $8000.00. I hope, that as a reader of Compliance Building, you will support my fundraising effort. You can donate through any of the following links:

Thank you,
Doug

The One With a Private Fund End-Around

Bradway Financial provides traditional investment advice. More than 75% of its clients are individuals that are not classified as high net worth. It’s owner, Brian Kimball Case must have had big dreams and wanted to also invest in private equity and run a private fund. That would require some additional compliance costs that he wanted avoid. He schemed to make an end-around on the regulatory requirements.

According to the SEC order, which the parties agreed tom, Mr. Case formed a parallel adviser, Bradway Capital, to be the adviser to two private funds he formed.

Bradway Capital filed with the SEC as an exempt reporting adviser. It took this position because it was an adviser to private funds with assets under management of less than $150 million.

The SEC disagreed with this position and took the position that Bradway Financial and Bradway Capital should be treated together. The two advisers were under common control and operationally integrated. They shared the same employees, operated in the same office, and shared the same technology systems.

Investment Advisers Act Release No. 3222 at 125 (June 22, 2011) [76 FR 39645, 39680 (July 6, 2011)]. In adopting several exemptions form the registration provisions of the Advisers Act, the Commission noted that certain commenters supported, for purposes of determining an adviser’s eligibility for an exemption from registration, treating each advisory entity separately without regard to the activities of, or relationships with its affiliates. The Commission declined to adopt this view, referring to Section 208(d) of the Advisers Act, which prohibits any person from doing indirectly or through or by any other person any act or thing which would be unlawful for such person to do directly.

The SEC took the position that Bradway Capital was not acting solely as an adviser to private funds and was not exempt.

The reason Mr. Case took this approach was to avoid the expense of complying with the Custody Rule by having to pay for an annual audit or surprise examinations.

The registration problem was just the tip of the iceberg. Obviously, the private fund failed the custody rule. There were some egregious valuations issues. Bradway failed to confirm that investors in the funds were Qualified Clients in order to be eligible for incentive payments.

The final mistake was using fund assets to pay for legal costs associated with this enforcement action. The fund documents allowed payment for costs directly relating to the ongoing activities of the fund. The enforcement action was against the adviser, not the fund, so the fund should have paid the legal fees.

Sources:

On August 4 – 6, I will saddle up to ride with 6,200 other cyclists to raise money for life-saving cancer research and treatment at Dana-Farber Cancer Institute in the Pan-Mass Challenge. 100% of your donation will go to cancer research and treatment at Dana-Farber Cancer Institute through its Jimmy Fund. I have made a personal commitment to raise $8000.00. I hope that as a reader of Compliance Building you will support my fundraising effort. You can donate through any of the following links:

Thank you,
Doug

CCO Liability: What Risks Remain and What You Can Do to Minimize Them

IA Watch produced an informative webinar on CCO Liability. These are my notes.

  • Carl Ayers (Moderator)  Publisher, Regulatory Compliance Watch
  • Brian Moran, Executive director and CCO Sterling Capital Management
  • Joseph McGill, J.D., Chief Compliance Officer Lord, Abbett & Co.
  • Kelley Howes, Counsel Morrison Foerster
  • Heidi Vonderheide of Ulmer & Berne LLP

First up was Heidi. Her firm is working on two CCO liability cases: the Robare case and the Blue Ocean Case with Jim Winkelmann.

These cases are on hold waiting for the Supreme Court to rule on the constitutionality of ALJ system.

The Robare discuss is a disclosure case. There was no evidence that there was any harm to customers.

Will the new leadership of the SEC change the CCO liability equation? It’s probably unlikely. Any case we see has likely been in the works for awhile. So any trend will take a while to show itself.

Kelley tackled what the SEC expects of CCOs. The number one item is to focus on the fiduciary duty of an investment adviser. A CCO should show a clear understanding of the firm’s business and associated risks. The CCO needs to now the regulations and how it integrates into the firm’s operations and disclosures.

The CCO should be in a position to be effective by having some independence and respect in the organization.

The SEC recognizes that the CCO role is hard and only wants to go after CCOs involved in wrongdoing or are asleep at the switch.

That being said, some of the SEC’s CCO cases don’t seem to follow the statements of the SEC.

Joseph emphasized the need for a conflicts matrix that gets reflected in the polices and procedures. The number one thing to focus on is not fixing a deficiency noted in a prior exam.

Brian highlighted the issues that arise when the CCO has other responsibilities. (A jack of all trades; a master of none.) He pointed out that many of the CCO case involved CCOs who wore more than one hat.  Most of the cases involved compliance personnel who affirmatively participated in the misconduct, misled regulators or failed to carry their responsibilities.

What about D&O insurance? It would be usual for a CCO to not be covered. A CCO is an officer of the firm. There is likely a fraud exclusion. There may be a question of whether it covers all of the enforcement and litigation costs.

Froome, Teamwork and Success

Professional cycling is not a mainstream sport in the U.S., so I would guess that few reading this story share my love of the Tour de France. (With the notable exception of Tom Fox.) The race has several different competitions going at the same time, with a confusing mix of skinny guys, tarted up with sponsors like a NASCAR racer. I became a fan two decades ago and continue to be enthralled by drama and athletic heroism on display.

On Sunday, Chris Froome was once again adorned with the “Maillot Jaune” on the Champs-Élysées as the overall winner of the 2017 Tour de France. This is his fourth win and puts him in the cycling pantheon as one of the greatest.

In his previous victories in 2013 and 2015, Mr. Froome dominated his rivals and was clearly the strongest overall contender. Last year, he seemed beatable, but still won. In 2017, Mr. Froome squeezed out his winning margin of 54 seconds on Rigoberto Uran and 2:20 on Romain Bardet during the two time trials in Dusseldorf and Marseille. He lost time to his rivals on the three mountain finishes. For one day he lost the yellow jersey to Fabio Aru in the Pyrenees when he was clearly out ridden and outwitted by his rivals. Mr. Froome completed the rare feat of winning the Tour de France without winning any of the individual stages.

Mr. Froome won this year because of teamwork. Team Sky was clearly the best team in the Tour de France. Rarely did we see Mr. Froome without teammates to support him, while his rivals were isolated on the road. In fact, his teammate Mikel Landa was only 1 second away from being on the podium in third place.

The results are a stark reminder of the importance of teamwork. It’s not good enough to be the best individual compliance officer. You need a team to win. You need the support of the compliance team around you. (Assuming you are big enough to have a team.) You need the support of the entire organization, working together, to make sure everyone works within the rules.

A typical Tour de France day will have a small breakaway of riders charge away from the main group of riders. The breakaway will be allowed to have the small wins along the stage while the main group conserves energy for the final victory. The leading riders will task their supporting riders with charging forward near the end to pass the breakaway and position them for victory.

Compliance is about teamwork and not the individual victory.

Sources:

I’ll being doing my own bike ride in a dozen days, although it will be far less of a feat than the Tour de France. On August 4 – 6, I will saddle up to ride with 6,200 other cyclists to raise money for life-saving cancer research and treatment at Dana-Farber Cancer Institute. 100% of your donation will go to cancer research and treatment at Dana-Farber Cancer Institute through its Jimmy Fund. I have made a personal commitment to raise $8000.00. I hope that as a reader of Compliance Building you will support my fundraising effort. You can donate through any of the following links:

Thank you,
Doug

 

Compliance Bricks and Mortar for July 21

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

Developments in the Asset Management Industry by Itzhak Ben-David in the HLS Forum on Corporate Governance and Financial Regulation

The rising concentration in the asset management industry and the rise of ETFs not only change the way investors invest, but also affect the character of the securities market. Large asset managers induce non-fundamental volatility through large trades, and ETFs propagate liquidity shocks originated by investors. Furthermore, arbitrageurs, and specifically hedge funds, may not always absorb and correct these shocks and may even contribute to the noise in prices. [More…]

Treasury fines Exxon Mobil $2 million for violating Russia sanctions while Secretary of State Tillerson was CEO

OF AC considered the following to be aggravating factors: (1) ExxonMobil demonstrated reckless disregard for U.S. sanctions requirements when it failed to consider warning signs associated with dealing in the blocked services of an SDN; (2) ExxonMobil’s senior-most executives knew of Sechin’ s status as an SDN when they dealt in the blocked services of Sechin; (3) ExxonMobil caused significant harm to the Ukraine-related sanctions program objectives by engaging the services of an SDN designated on the basis that he is an official of the Government of the Russian Federation contributing to the crisis in Ukraine; and (4) ExxonMobil is a sophisticated and experienced oil and gas company that has global operations and routinely deals in goods, services, and technology subject to U.S economic sanctions and U.S. export controls. [More..]

The Case Of The Wholly Owned, But Not Totally Held, Subsidiary That May Or May Not Be 100% Owned by Keith Paul Bishop in California Corporate & Securities Law

When someone says that a subsidiary is “wholly owned”, I believe that the common understanding is that the parent company owns all of the issued and outstanding equity of the subsidiary. What if the statement is that the subsidiary is “totally” or “100%” owned? I suspect that most people would not intuit a different understanding. The Securities and Exchange Commission, however, assigns different meanings to each of these terms at least so far as financial statements are concerned. Here are the three definitions:… [More…]

LEI: more than a number

Corporates trading across many asset classes in Europe using derivatives should take note that from 3rd January 2018, any firm subject to MiFID II transaction reporting obligations will not be able to execute a trade for a client who is eligible for a Legal Entity Identifier (LEI) and does not have one. [More…]

Fed Nominee Randal Quarles in His Own Words by Ryan Tracy in the Wall Street Journal

“In some ways Dodd-Frank was not ambitious enough, and in other ways it was overly ambitious and I think there are lots of ways to refine Dodd-Frank and other forms of regulatory policy in ways that would be beneficial to the economy.” [More…]

On Pan-Mass Challenge weekend, August 4 – 6, I will saddle up to ride with 6,200 other cyclists to raise money for life-saving cancer research and treatment at Dana-Farber Cancer Institute. 100% of your donation will go to cancer research and treatment at Dana-Farber Cancer Institute through its Jimmy Fund. I have made a personal commitment to raise $8000.00. I hope, that as a reader of Compliance Building, you will support my fundraising effort. You can donate through any of the following links:

Thank you,
Doug

Looking at the Direction of the New Securities and Exchange Commission

With Chairman Jay Clayton in place, the Securities and Exchange Commission is now controlled by Republican appointees. Former Chair White came from a litigation and prosecutor background. Chair Clayton comes from a deal-making and capital formation background. I think we can guess the direction of the SEC for the next few years.

Beyond the guessing, Chair Clayton gave a speech to the Economic Club of New York that offers some insight. He outlined eight principles that will guide his chairmanship:

  1. The SEC’s mission is our touchstone.
  2. Our analysis starts and ends with the long-term interests of the Main Street investor.
  3. The SEC’s historic approach to regulation is sound.
  4. Regulatory actions drive change, and change can have lasting effects.
  5. As markets evolve, so must the SEC.
  6. Effective rulemaking does not end with rule adoption.
  7. The costs of a rule now often include the cost of demonstrating compliance.
  8. Coordination is key.

Obviously, number 7 caught my attention.

“It is incumbent on the Commission to write rules so that those subject to them can ascertain how to comply and — now more than ever — how to demonstrate that compliance.  Vaguely worded rules can too easily lead to subpar compliance solutions or an overinvestment in control systems.  We must recognize practical costs that are sure to arise.”

He also pointed out the costs of compliance in number five on the evolution of the SEC:

As the SEC evolves alongside the markets, however, we must remember that implementing regulatory change has costs.  Companies spend significant resources building systems of compliance, hiring personnel to operate those systems, seeking legal advice concerning the design and effectiveness of those systems, and adapting the systems as regulations change.  Shareholders and customers bear these costs, which is something that should not be taken lightly, lest we lose our credibility as regulators.

The SEC uses cost-benefit analysis in its rule-making process. I expect we will see an emphasis on the compliance costs in those analyses.

I like the emphasis on “bright-line” rules in number 7. Fuzzy rules makes it hard to implement rules and hard to prove compliance with the rules, leaving you open to second-guessing by regulators.

The other news is that it is rumored that President Trump will nominate former Senate Republican aide and current Senior Research Fellow at the Mercatus Center, Hester Peirce, to fill one of the empty seats at the Securities and Exchange Commission. From her recent publications, it seems that she may have some big ideas for change at the SEC.

That leaves one empty seat that is supposed to go to a Democratic appointee. I would bet that this seat stays empty for a long time.

Sources:

The One With The Incriminating Internet Searches

The case against Fei Yan was a fairly straight-forward insider trading case involving leaky M&A transactions. In this case, the leaks came from a junior corporate associate working on the transactions. We can only guess that she told her husband, Mr. Yan, about her day at work and revealed too much information.

While Mr. Yan was working as a postdoctoral associate at the Massachusetts Institute of Technology’s electronics research lab. He apparently had enough free to time to trade stocks and advance into options. He did so in an account in his mother’s name, using leaked information from his wife. At least that is what the SEC and DOJ are going to try to prove.

Mr. Yan started trading in Mattress Firm just forty-five days before the announcement of its acquisition by Steinhoff International. His gifted trading netted him almost $10,000.

The next transaction was the acquisition of Stillwater Mining by Sibanye Gold. With Mr. Yan’s now advanced trading skills, he moved to the higher leverage of options. He acquired a slate of call options within 30 days of the transaction’s announcement. With the additional leverage, he generated a profit of over $100,000.

The case ended up with criminal charges as well. I was curious about what escalated it to make it worthy of criminal prosecution.

The SEC complaint noted two Google searches:

“how sec detect unusual trade”
“insider trading with international account”

And further notes the Mr. Yan reviewed several items in the search results, including “Want to Commit Insider Trading? Here’s How Not to Do It.”

That article noted the 2013 Badin Rungruangnavarat insider trading case where his trading was most of the trading activity in the options and futures involved. It also involved a lot more money.

Mr. Badin made $3.2 million which makes him a much juicier target for prosecution. Mr. Yan’s $120,000 in profits are going to cost him a much larger amount in legal fees to defend the civil case and the criminal case to keep him out of jail. According to reports, he used a court-appointed attorney at the bail hearing. If convicted, he could face up to 25 years in prison and as much as $5 million in fines for the security fraud charges, and 20 years in prison and up to a $250,000 fine for the wire fraud charge.

I assume the Google searches made the federal prosecutors see that Mr. Yan had criminal intent, clearly knowing what he was doing was illegal and taking steps to hide the trading activity.

Given the small amounts, how did he get caught? I would guess the brokerage compliance team noted the suspicious activity and reported it to the SEC.

Sources:

On Pan-Mass Challenge weekend, August 4 – 6, I will saddle up to ride with 6,200 other cyclists to raise money for life-saving cancer research and treatment at Dana-Farber Cancer Institute. 100% of your donation will go to cancer research and treatment at Dana-Farber Cancer Institute through its Jimmy Fund. I have made a personal commitment to raise $8000.00. I hope you can you will support my fundraising effort. Please give generously with one of the following links:

Thank you,
Doug

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Compliance Bricks and Mortar for July 14

When this post gets published, I will have hopefully finished a 130 mile training ride across Massachusetts in preparation for the Pan Mass Challenge. I’m leaving my house in the middle of the night to be in Becket, MA by noon for parents’ weekend at my son’s summer camp. There is still time to support my Pan-Mass Challenge ride to fight cancer. 100% of your donation goes to the Dana Farber Cancer Institute.

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

Tone at Top Gone Wrong: The Christie Example by Matt Kelly in Radical Compliance

Nothing says “America!” these days like righteous indignation at a fellow American doing something we don’t like. So as we return from our Fourth of July holiday, let’s all give thanks to one American who cultivates that spirit and gives chief compliance officers a great example to cite next time you’re talking with the CEO about tone at the top.

Chris Christie, governor of New Jersey and beachgoer extraordinaire, thank you. Compliance officers owe you a debt of gratitude for your shameless, ridiculous, preposterous tone at the top. [More..]

Justice Department ethics watchdog quits because Trump made her feel like a hypocrite by Francine McKenna in Marketwatch

Hui Chen, the first-ever compliance counsel to the U.S. Department of Justice criminal division’s fraud section, is mad as hell and has decided she is not going to take it any more.

Chen announced via LinkedIn last week that she was leaving her role consulting to the department’s prosecutors on cases involving corporate ethics and compliance crimes. In her post entitled “Mission Matters,” Chen said that she felt like a hypocrite as she sat with companies accused of ethics and compliance violations. [More…]

Shkreli’s Ex-Compliance Officer Says He Quit Over Dodgy Deals by Patricia Hurtado in Bloomberg

Jackson Su worked for Shkreli from January 2012 until December of that year and told a jury at Shkreli’s fraud trial in Brooklyn, New York, that he got so fed up watching his boss execute questionable and unethical transactions that he quit and complained to the U.S. Securities and Exchange Commission. [More…]

Conflicts and Capital Allocation by Benjamin Edwards in the CLS Blue Sky Blog

In the aggregate, retail investors allocate tremendous amounts of capital and often turn to financial advisers to help them pick the best investment opportunities. In a recently published article, I describe how financial adviser conflicts of interest now distort overall capital allocation by driving capital to investment opportunities that reward financial advisers—altering the flow of capital. [More…]

Team Kinetic Karma with its Pedal Partner, Maya, and her family:

Email Smoking Guns

Martin Lomasney created a famous saying on the importance of discretion:

“Never write if you can speak; never speak if you can nod; never nod if you can wink.”

At the time of Lomasney, it was not email or Twitter, but telegrams that were the principal method of electronic communication.

In the case of President Trump and his son, it’s email and Twitter that are causing them problems. Donald Trump Jr. gave us all an unexpected lesson on the subject by releasing what appear to be incriminating emails on Twitter. Those emails are about his meeting with a Russian operative who was offering him dirt on Hillary Clinton.

The Trump campaign has been denying collusion with Russia during the campaign. These emails clearly show that the campaign was at least tried to collude with Russia.

 “if it’s what you say I love it”

According to Junior, there was no substance to the meeting and no actual collusion. But now the burden is back on the Trump campaign to show that there was no substance, after this documented willingness to do so. Junior’s emails are the first concrete evidence that the Trump campaign was aware of Russian government effort to help elect Donald Trump. On July 24, Junior  appeared on CNN to decry the Clinton campaign’s claims that the Russians were helping Trump as “disgusting” and “phony.”

I’m not saying there was or was not a crime.

There clearly was a lack of discretion and a failure to follow Mr. Lomasney’s sage advice.

The proper response should have been “Let me check with the legal team and I’ll call you back.”

Sources:

ILPA Guidance on Subscription Lines of Credit

The Institutional Limited Partners Association (ILPA) released guidance regarding the use of subscription lines of credit facilities by private equity funds. ILPA outlines the risks and potential impact on limited partners.

As with most potential conflicts, ILPA recommends better disclosure and greater clarity for their use.

Subscription lines of credit are a great tool for a fund. It allows a quick draw on capital and gives the fund manager to give limited partners a better plan for when capital will be called.

But according to ILPA, some fund managers are starting to use the lines of credit to hold off calling capital for longer and longer periods of time.

ILPA is also concerned that disparate of use of lines of credit among different fund managers makes it hard to compare returns from one manager to another.

Some of the recommendations that caught my attention:

  1. Use the date the credit facility is drawn for calculating the waterfall instead of the capital call.
  2. Disclosure of the impact of the facility on IRR.
  3. Limit the outstanding balance to less than 25% of uncalled capital.
  4. Limit the borrowing to 180 days outstanding.

It would seem to me that if a fund agrees to the time limit for the outstanding balance, then the other 3 items are reduced. The facility is then much more about allowing the fund manager to have better speed of execution instead of a tool to manipulate returns.

Sources: