Category: Compliance Programs

Compliance and the South Pole

We reckoned now that we were at the Pole. Of course, every one of us knew that we were not standing on the absolute spot; it would be an impossibility with the time and the instruments at our disposal to ascertain that exact spot. But we were so near it that the few miles which possibly separated us from it could not be of the slightest importance. 

Roald Amundsen – December 14, 1911

The South Pole is a harsh and isolated environment. It’s bit more plush now that when man first stepped on the location 100 year ago. Amundsen slept in a small tent. Today visitors can take it a bit easier in the Amundsen-Scott South Pole Station. You can even see a picture of the day from the South Pole.

At least during the Antarctic summer when the average high is a balmy -15°F with near endless daytime. From mid-April to mid-August, the only natural light comes from the moon and the aurora australis. Those settled in for the Antarctic winter don’t see the sun for months and the average high drops to a bone-chiling -68°F

The current station is on jacks so it can battle the 8 inches of snow that accumulates each year by raising its elevation. Since it’s sitting on a moving glacier it moves about 10 meters each year. It’s in constant movement, battling the forces of nature that kept in uninhabited until modern technology was able to fight back against the elements.

There are many comparisons you can draw between the South Pole and a compliance program.  I’ll let you draw your own.

 

SEC Targeting Suspicious Investment Returns

Last week, the SEC announced THREE actions against investment advisers for compliance failures. The Securities and Exchange Commission has turned the dial a little higher and announced FOUR enforcement actions against multiple hedge funds by identifying abnormal investment performance. (Does their dial turn all the way up to 11?)

The SEC launched an initiative to combat hedge fund fraud by identifying abnormal investment performance — the Aberrational Performance Inquiry. Back in March, SEC Enforcement Director Robert Khuzami revealed during congressional testimony that the SEC had launched an initiative that would focus on funds that consistently outperform the market.  Enforcement is now focusing on hedge funds that outperform “market indexes by 3% and [are] doing it on a steady basis.” Khuzami referred to such performance as “aberrational,” and stated that Enforcement is “canvassing all hedge funds” for such “aberrational performance.” The SEC Enforcement Division’s Asset Management Unit uses proprietary risk analytics to evaluate hedge fund returns. Performance that appears inconsistent with a fund’s investment strategy or other benchmarks can form a basis for further scrutiny. This initiative came directly from from the Madoff scandal. If they had focused on Madoff’s consistent and aberrational returns, the SEC may have caught him sooner.

Half a year later, Khuzami is crediting Aberrational Performance Inquiry initiative with these four enforcement actions.

Michael Balboa and Gilles De Charsonville

These two were nabbed for overvaluing the reported returns and net asset value of the Millennium Global Emerging Credit Fund, organized to invest in sovereign and corporate debt instruments from emerging markets. Among the fund assets were Nigerian payment adjusted warrants and Uruguayan value recovery rights.

In October 2008, the hedge fund’s reported assets were $844 million. The SEC’s complaint alleges that Balboa, the fund’s former portfolio manager, schemed with two European-based brokers including Gilles De Charsonville to inflate the fund’s reported monthly returns and net asset value by manipulating its supposedly independent valuation process.

Apparently the SEC found Balboa’s action particularly egregious because the the U.S. Attorney’s Office for the Southern District of New York announced the arrest of Balboa and filing of a criminal action against him.

According to the SEC complaint, from at least January to October 2008, Balboa provided De Charsonville and another broker with fictional prices for two of the fund’s illiquid securities holdings for them to pass on to the fund’s outside valuation agent and its auditor. The scheme caused the fund to  overvalue these holdings by as much as $163 million in August 2008.  That meant falsely-positive monthly returns, millions of dollars more in management fees, another $410 million in new investments, and the avoidance of  about $230 million in redemptions.

The SEC is crediting their new initiative with this enforcement action, but the fund has been in liquidation since October of 2008.

ThinkStrategy Capital Management and Chetan Kapur

The SEC charged ThinkStrategy Capital Management LLC and its sole managing director Chetan Kapur with fraud in connection with two funds. ThinkStrategy Capital Fund was an equities-trading fund that ceased operations in 2007.  TS Multi-Strategy Fund was a fund of hedge funds. At its peak in 2008, ThinkStrategy managed approximately $520 million in assets.

The SEC’s complaint alleges that ThinkStrategy and Kapur engaged in a pattern of deceptive conduct designed to bolster their track record, size, and credentials. They materially overstated the performance of the Capital Fund and gave investors the false impression that the fund’s returns were consistently positive and minimally volatile. ThinkStrategy and Kapur also repeatedly inflated the firm’s assets, exaggerated the firm’s longevity and performance history. In 2008 they reported a 4.6% return when they actually had a -89.9% return. It looks like the trouble started in June of 2006.

They also made claims about the quality of their due diligence checks. Unfortunately, they ended up invested in the Bayou Superfund, Valhalla/Victory Funds and Finvest Primer Fund, each of which was revealed to be engaged in serious fraud.

ThinkStrategy also faked a management team, listing several individuals as principals or directors who had no affiliation with the firm. A few were Kapur’s classmates at Wharton. Kapur himself claimed to have an MBA from Wharton, even though he only had an undergraduate degree. Kapur claimed to have over 15 years of experience as an “investor, money manager, researcher, and system designer”. That means he would have started his career in 1988 at the age of 14.

As with most SEC settlements, these are merely allegations against Kapur and ThinkStrategy which they neither admit or deny.  The funds wound down over a year ago and other investors brought suit. In this case, I’m not sure you can credit the SEC with shutting down a bad fund using this Aberrational Performance Inquiry initiative.

Patrick Rooney and Solaris Management

According to the SEC’s complaint, Rooney and Solaris made a radical change in the fund’s investment strategy, contrary to the fund’s offering documents and marketing materials, by going all in for Positron Corp. In late 2008, Solaris held over 1.1 billion shares of Positron stock and had liquidated all of its non-Positron investments.

That’s certainly a risky binary bet on one company. You don’t usually see concentrated, undiversified, and illiquid position in a cash-poor company with a lengthy track record of losses.

The big problem was that Rooney was also the Chairman of Positron  and received salary and stock options from Positron.  Rooney and Solaris hid the Positron investments and Rooney’s relationship with the company from the fund’s investors for over four years. Although Rooney finally told investors about the Positron investments in a March 2009 newsletter, he allegedly lied by telling them he became Chairman to safeguard the fund’s investments.

It’s hard to see how Solaris would have been outperforming the market by more than 3% and fallen under the watchful eye of the new initiative.

LeadDog Capital Markets, Chris Messalas and Joseph LaRocco

The SEC instituted administrative proceedings against LeadDog Capital Markets LLC and its general partners and owners Chris Messalas and Joseph LaRocco. The charges were for misrepresenting or failing to disclose material information to investors in the LeadDog Capital LP fund.

The Fund was almost entirely invested in illiquid penny-stocks or other micro-cap private companies, each of which had received “going concern” opinions from their auditors, all but one of which had a consistent history of net losses, and most of which they or their affiliates owned or controlled

In addition, LeadDog, Messalas, and LaRocco allegedly misrepresented to, and concealed from, existing and prospective investors the substantial conflicts of interests and related party transactions that characterized the fund’s illiquid investments. For example, to induce one elderly investor to invest $500,000 in the fund, LeadDog, Messalas, and LaRocco represented falsely that at least half of the fund’s assets were liquid and could be marked to market each day, and that the investor could exit the fund at any time. In February 2009, the SEC alleges that 92% of the fund’s non-cash assets were illiquid and could not be marked-to-market on a daily basis.

In October 0f 2009, the fund’s auditors learned about some of the problems, resigned, and issued a retraction letter. Let’s assume that the date the problems were discovered. We could credit the initiative with taking action in this case. It would just be two years before charges were filed.

Assuming the allegations are true, these four cases are good cases for SEC enforcement. The consistent out performance initiative is a good one. However, these four just don’t seem to fit in the right time frame for the new enforcement initiative. Since these fund managers were not registered with the SEC, there is no good database for the SEC to check returns and easily find the outliers. Perhaps once Form PF reports start flowing, the SEC will have a better database to go looking for problems.

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Compliance Officer Banned in the United Kingdom

As a compliance officer, I often find that many lessons come from enforcement actions. Those actions imposed on compliance officers are especially instructive. The latest to catch my attention comes from the United Kingdom.

The Financial Services Authority levied a £14,000 fine and banned a compliance officer from performing any significant influence function in regulated financial services. The circumstances arose from an employee’s attempt to conceal losses after the collapse of Lehman Brothers in 2008.

Dr Sandradee Joseph was Compliance Officer at Dynamic Decisions Capital Management (DDCM), a hedge fund management company based in London. One of DDCM’s funds suffered catastrophic losses during the fall of 2008, losing 85% of its assets under management. A fund employee, rather than report the losses, decided to enter into a complicated bond transaction to create false profits. Essentially, the employee was buying bond units at a steep discount, but reporting a much greater value when calculating the fund’s NAV. The fund had lost $255 million, but the employee booked a $268 million gain on the bond transaction. A bond that the fund had only paid $5 million.

Three problems arose that the FSA thinks were instances of the compliance officer not doing her job.

The first was that the fund’s prime broker terminated its agreement with the fund because of the bond transaction. Any trade that causes the prime broker to leave should be a big red flag.

The second was an unhappy investor. The investor had put $48 million into the fund. The bond happened to violate some of its investment restrictions: maturity greater than 12 months, issued by an unlisted entity, no option to convert equity, and greater than 3% of the fund’s NAV. Violations of an investor’s investment guidelines should be a big red flag for a compliance officer.

The third problem was another unhappy investor. The bond transaction also violated this investor’s permitted investments limitation. A second big red flag that the compliance officer failed to remedy. This investor dug a bit deeper and felt that the bond may have been fraudulent.

The compliance officer tried a few defenses that sound weak to me. They sounded weak to the FSA as well.

  • The compliance officer’s role was a reporting function and it was up to individual employee to ensure compliance.
  • The compliance officer was not the fund’s lawyer and she could take a back seat on legal matters.
  • The compliance officer felt enough advisers were looking at the issue.
  • The compliance officer did not understand the bond and was relying on external lawyers to review it. (However, she never instructed a  law firm to to carry out due diligence on the bond.)
  • The compliance officer believed the bond was legitimate. (Even though she disclosed that she didn’t understand it.)

The FSA lays out the lesson learned: “In her role, if [the compliance officer] became aware of concerns that the firm was not complying with its regulatory obligations, she should have taken steps to ensure that these concerns were investigated, to verify if the concerns appeared to be legitimate, and if so to take appropriate action.”

As a compliance officer, I initially found the punishment to be on the harsh side especially since it seems to single out the compliance officer. Then I dug a little deeper and saw that criminal investigations were started by the SFO and the investors filed suit against DDCM.

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Outsourcing Compliance and the CCO

One of the requirements of registration as a registered investment adviser is the appointment of a Chief Compliance Officer and the establishment of a formal compliance program. The SEC stated that a firm need not hire a new person to be the CCO. However, there will be a substantial time commitment.

You can spread some of the compliance work to multiple people in the firm, though the CCO will ultimately be responsible for oversight. Another option is to send some of the work outside the firm that would outsource some or most of the compliance functions.

Insider trading monitoring is one of the candidates for outsourcing. There is a lot of data and a lot of paperwork to track. Even for a private equity firm that does not regularly trade in public securities, there is plenty to keep a person occupied during the week. For a private equity firm, some trade tracking software will go a long way to help the CCO (and the employees) deal with the invasive and tedious requirement to track employee trading.

The SEC rules also require an annual review and update of the compliance policies and procedures. This too is a likely area for outsourcing. A third party can provide additional insight to the firm as to what your peer firms are doing and what issues the regulators are focusing on.

Some New Financial Legislation is Moving Along

Four bills made their way through the Capital Markets and Government Sponsored Enterprises Subcommittee of the House Financial Services Committee.

The Private Company Flexibility and Growth Act, introduced by Rep. David Schweikert, raises the shareholder threshold for mandatory registration with the SEC from 500 to 1,000 shareholders. I’m surprised it’s not called the Google/Facebook Act. The 500 shareholder limit is most famous for forcing Google to go public and is close to forcing Facebook to do the same.

The Access to Capital for Job Creators Act removes the regulatory ban that prohibit general solicitation and advertising in private placements. There were two amendments to the bill during the mark-up session. Maxine Waters (D-CA) included and amendment that the revised SEC rules allowing a general solicitation under Regulation D must require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors using methods determined by the SEC. Scott Garrett (R-NJ) included an amendment that Section 4(2) of the Securities Act be revised to add the language: “whether or not such transactions involve general solicitation or general advertising.”

The Entrepreneur Access to Capital Act permits “crowdfunding” to finance new businesses by allowing companies to accept and pool donations up to $5 million without registering with the SEC. It would limit individual investments to the lesser of $10,000 or 10% of an investor’s annual income. An amendment requiring a notice filing with the SEC was rejected as was an amendment that would have barred felons from being involved.

The Small Company Job Growth and Regulatory Relief Act would expand the exemptions available to small companies from the Section 404(b) auditor attestation reporting requirements to small and mid-size companies with a market capitalization of less than $500 million. The exemption is currently at the $75 million cap set by the Dodd-Frank Act. During the mark-up, the House panel amended the bill to lower the market float from $500 million to $350 million.

Will these go anywhere? The votes seemed to very partisan with Republicans voting yes and Democrats voting no. That does not bode well for moving up the chain through the house, through the Senate and on to the President’s desk.  However, President Obama has already indicated an interest in the crowdfunding idea.

These are not the grand, sweeping changes of Dodd-Frank. These are small tweaks to the regulations on the capital markets.

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2011 LexisNexis Corporate and Securities Law Blog Nominees

For the second year, LexisNexis is seeking your input in choosing the top blogs for their Corporate and Securities Law Community.

(Warning, this post post contains blatant self-promotion.)

Looking at the list of candidates, I see many blogs that I read regularly. But there are several on the list that I had not heard of before and need to take a look at. If you are looking for a list of business law blogs to read, the list of nominees is a great place to start.

I think many more than 25 of the nominated blogs are much better than mine, whether its on quality, popularity, or some other factors. I doubt I will make it into the top 25 so I will sit back and take the consolation prize: the honor of being nominated. (Although, I thought the same last year, but still managed to squeak into the top 25.)

Lexis Nexis invites you to comment on the announcement post:

Top 25 Business Law Blogs 2010 – Corporate & Securities Law Community

To comment, you have to register. Registration is free and supposedly does not result in sales contacts. The comment period for nominations ends on October 25, 2011. They don’t say how they will end up selecting the top 25 out of the nominees, other than it’s based on their review and your comments.

As I said last year I’m also not sure how the Lexis-Nexis Communities fits in with the Martindale Hubbell Connected platform. There seems to be whole lot of substantive information in Communities that is missing in Connected. They should still get these two sites together.

Vote for the business law blogs you feel are the best or at least look through the list to add some new sites to your reading list. Go ahead and include Compliance Building.

NOMINEES FOR THE LEXISNEXIS CORPORATE & SECURITIES LAW
TOP 25 BLOGS FOR 2011

Alston & Bird’s “M&A Blog”
by Alston & Bird’s Corporate Transactions and Securities Practice

Alston & Bird’s Securities Lit. Blog
By Alston & Bird’s Securities Litigation Group

BD Law Blog
By Joel Beck

Boardmember.com

The Business Law Blog (Dryanlaw)
by Daniel J. Ryan

Business Law Post
By Arina Shulga

Business Law Prof Blog
By Multiple Authors

California Corporate & Securities Law
By Keith Bishop

Commercial Law Blog
By by Jennifer S. Martin, L. Ali Khan, Jason J. Kilborn, Robyn Meadows, Marie T. Reilly, Marc L. Roark, Keith A Rowley, Steven Semeraro, Anthony Schutz and Jim Chen discussing a variety of Commercial Law related topics.

Compliance Building
by Doug Cornelius

Conference Board Governance Blog
Editor, Gary Larkin

The Conglomerate
By Seven Law Professors blog about business, law, economics and society, including Gordon Smith, BYU Law School, Christine Hurt, Univ. of Illinois College of Law, Vic Fleischer, Univ. of Colorado Law School, Fred Tung, Emory Law School, Lisa Fairfax, George Washington Univ. Law School, David Zaring, Wharton School Legal Studies and Business Ethics Department, and Usha Rodrigues, University

Connecticut Employment Law Blog
by Daniel A. Schwartz of Pullman & Conley, LLC b

Consumer Law & Policy
Coordinators, Deepak Gupta and Jeff Sovern

Contracts Prof Blog
By Jeremy Telman

CorpGov.net
By James McRitchie

Corporate & Securities Law Blog
By Sheppard Mullin

Corporate Compliance Insights

TheCorporateCounsel.net
By Broc Romanek and Dave Lynn

Corporate Finance Law Blog
By Davis Wright Tremaine

Corporate Law and Governance
By Robert Goddard, a U.K. based Senior Lecturer at Aston Law, part of Aston Business School

The Corporate Library Blog–GMI
Published by GMI

Corporate Tool
By Josh King

Credit Slips
By Multiple Authors

David Tate’s Blog

DealLawyers.com Blog
By Broc Romanek

Delaware Corporate and Commercial Litigation Blog
By Francis G. X. Pileggi

The D&O Diary
Published by Kevin M. LaCroix

The Emerging Business Advocate
By Seaton M. Daly III

FCPA Compliance and Ethics Blog
by Thomas Fox

FCPA Professor
By Mike Koehler

Fraud Bytes
By Mark Zimbleman and Aaron Zimbleman

Harvard Corporate Governance Blog
By Harvard Law School Program on Corporate Governance

Hedged.biz
By Brian Goh, Burnham Banks, Mark Martyrossian, Mark Fleming

Hedge Fund Law Blog
by Bart Mallon

Indiana Commercial Foreclosure Law
By John Waller

Indian Corporate Law Blog
By Multiple Authors

nHouseBlog
Albish Publishing

Investor Relations Musings
by John Palizza

The Investment Fund Law Blog
by Pillsbury Winthrop Shaw Pittman

Jim Hamilton’s World of Securities Regulation

LFNP Blog
By Arthur Ryman

M&A Law Prof Blog
By Brian JM Quinn, Boston College Law School Professor

Marks on Governance
by Norman Marks

Marler Blog
By Bill Marler

Metropolitan Corporate Counsel
Publisher, Martha Driver

Nancy Rapoport’s BlogSpot
By Nancy Rapoport

NC Business Litigation Blog
By Mack Sperling of Brooks Pierce LLP

New York Business Law
Frederic R. Abramson

New York Business Litigation and Employment Attorneys Blog
By David S. Rich

No Funny Lawyers
By Jim Thomas

Northwest Litigation Blog
By Ater Wynne LLP

Perkins Coie’s MergerViewpoints
Publisher, Scott B. Joachim

PLI Securities Law Practice Center
By Kara O’ Brien

ProfessorBainbridge.com
by Stephen M. Bainbridge

Race to the Bottom (Corp Governance Blog)
a faculty and student collaborative blog published By J. Robert Brown, Jr.

retheauditors.com
By Francine McKenna

Reverse Merger Blog
By David Feldman

Robert A. G. Monks’ Blog
by Robert Monks

SEC Actions
By Thomas O. Gorman of Porter Wright

SEC Tea Party
By Robert Fusfeld

Securities Law Prof Blog
By Barbara Black

SEC Whistleblower Program
By Nick Fasulo

Small Business Trends
By Anita Campbell

Startup Company Lawyer
By Yoichiro Taku

Strictly Business
by Alexander Davie

10Q Detective
By David Phillips

The 10b-5 Daily
By Lyle Roberts

Truth on the Market
By Geoffrey Manne and Multiple Authors

UCC Food Ind. Law, Food Liability Law Blog
By Richard Goldfarb, Stoel Rives LLP

Uniform Commercial Code Litigation
By Robinson & Robinson LLP

USA Inbound Deals
by Bill Newman

US PIRG
By Ed Mierzwinski

The Venture Alley
Editors Trent Dykes, Asher Bearman of DLA Piper

Virginia Business Litigation Lawyer
By Lee Berlik

What About Clients
By Dan Hull

Workplace Prof Blog
By Richard Bales & Multiple Authors

WSJ Deal Journal

Crowdfunding

It’s hard to raise capital. The regulatory restrictions imposed by securities laws make it harder to do so. As any bright-eyed entrepreneur with a dream project will tell you, the lawyers and the securities laws make it very expensive and time consuming to raise capital for a small project.

The central goal of the Securities and Exchange Commission is to facilitate companies’ access to capital while at the same time protecting investors. More often than not, the securities laws and regulations are put in place due to some prior malfeasance. Limitations on the sale of securities are in place because there were (and still are) lots of shady characters trying to make a quick buck by de-frauding investors.

The Obama administration and the Congress think the regulatory burdens need to be removed to encourage small business capital formation. I’m going to guess that they are fans of Kickstarter, a website that allows entrepreneurs and artists to raise capital for their projects. (I’m also a fan and have contributed to some projects.)

SEC Rule 504 allows a public offering to investors (including non-accredited investors) for securities offerings of up to $1 million. There is no limit on the type of investors, so they need not be accredited investors.  There are no prescribed disclosures and no limitations on resales of the securities. The Rule generally does not allow companies to solicit or advertise their securities to the public.(Of course, the antifraud and other civil liability provisions of the federal securities laws are still applicable.)

However, these offerings are subject to state “blue sky” regulation. That means having to jump through the patchwork of state securities laws, depending where your target investors are located.

How does Kickstarter get around this? It doesn’t. Capital for Kickstarter projects cannot be for securities or lending. As a patron, you do not get your capital returned. Often, you’ll get the end product that the artist or entrepreneur was hoping to produce. (My son is patiently waiting for our pack of trebuchettes to arrive.)

Generally, the term “crowdfunding” is used to describe a form of capital raising whereby people pool money, generally as small individual contributions, to support a specific goal. Since the capital raising did not provide an opportunity for profit participation, initial crowdfunding efforts did not raise issues under the federal securities laws.

The Entrepreneur Access to Capital Act would create a new exemption for small companies, allowing them to raise up to $5 million. The limitation would be that investments are limited to the lesser of $10,000 or 10% of the investor’s annual income.

President Obama cheered for crowdfunding as part of the American Jobs Act unveiling. I failed to find and proposed legislative changes in his proposed bill.

I’m for fueling entrepreneurial growth in this country. I’m concerned that the changes could lead to an onslaught of fraud. I think Kickstarter works well because you are funding the effort. You are not seeing dollars signs.

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Was Full Tilt Poker a Ponzi Scheme?

The United States Government forced online poker sites to the fringes of the financial system. The U.S. government has long argued that online poker gambling is illegal under the Wire Act, a 1961 law that explicitly prohibits sports betting conducted over electronic communication. In 2006, Congress made it illegal for financial institutions to process funds for online gambling.

It should be no surprise that an online poker site would run into legal problems. The complaint against Full TItle Poker caught my eye because

“By March 31, 2011, Full Tilt Poker owed approximately $390 million to players around the world, including approximately $150 million to United States players. However, the company had only approximately $60 million in its bank accounts.”

Many Ponzi schemes started off as legitimate enterprises. When funding shortfalls or an unexpected loss hits, the managers try to hide the bad news. This creates a spiraling downfall leading from poor management to criminal behavior. In this case, Full Tilt was having trouble moving the cash around the financial system to collect wagers from players and make payments to the winners. It sounds like Full Tilt was funding winnings without withdrawing initial bets from the player accounts.

But was it a Ponzi scheme? While there is no official definition of a Ponzi scheme, these are what I think are the elements:

(1) A promise of financial reward.

(2) Current contributions to the scheme are not invested, but are spent to make good on returns promised to earlier contributors.

(3) The manager of the scheme maintains his ability to pay the returns only by getting other contributors.

(4) The contributors think the manager is investing their contributions to make the return (not necessarily in a fully legal way).

(5) If future contributors do not arrive in sufficient numbers, the Ponzi scheme will have too little money to pay current returns/redemption.

Full Tilt was not an investment scheme. Sure you can argue about whether poker success is based on skill or luck, with luck being a key element of gambling. (I think it’s a combination of both.) But it’s not an investment and you are not buying a security. The contributors did not think the manager was doing anything with the money other than keeping it safe. They were winning or losing based on the hands the contributors played.

It does seem that current winnings were being paid from new contributions. According to the complaint, the mangers were taking more cash out than the business could support. The company had a funding shortfall because it was having trouble moving the wagers and winnings through the financial system.

You would hope that a leading federal prosecutor would know the difference between different types of fraud. Full Tilt was not a Ponzi scheme. As good as you may be at poker, your wagers are not investments.

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Miscommunication

Are you speaking the same language as the rest of your firm?

Do they understand your questions?

Do they understand your answers?

Miscommunication is at the root of many problems. Many compliance policies are written by lawyers, for lawyers. That may work fine once there is an investigation or a problem. But they do little to prevent the problem. Outside of compliance and legal, the rest of the firm can’t grasp the language used.

One of the goals of compliance should be translate complex legal requirements into easy to understand rules.

There are only 10 types of people in the world: Those who understand binary, and those who don’t.

Comic is from xkcd 1 to 10.

The Slow Rulemaking on Swaps and Derivatives

One of the strange splits in US financial regulation is that many swap and derivatives are regulated by the Commodities Futures Trading Commission instead of the Securities and Exchange Commission. I think of the CFTC, I think of Trading Places and with the SEC I think of Wall Street.

The Commodity Futures Trading Commission has delayed its rollout of regulations under the Dodd-Frank Wall Street Reform and Protection Act has been pushed back until at least early 2012. This delay is the second time the CFTC has put the brakes on its new rules that will govern the over-the-counter derivatives market. In my view, taking longer to get the rules right is better than pushing through bad rules just to meet some arbitrary deadline. The question will be whether the CFTC will succeed in creating rules that will make the derivatives market one that is more transparent and easier to oversee for lines of trouble.

As for trouble, take a look at Greek bonds as an example. The Credit Default Swaps cost a record $5.8 million upfront and $100,000 annually to insure $10 million of Greece’s debt for five years using credit-default swaps. That means the market is saying it’s about a 58% chance that Greece will default in the next five years. But how extensive is that exposure in the US? How many people are on the hook for payouts if Greece defaults?

If your firm uses derivatives or swaps for dealing with debt risks or foreign exchange risks, you should pay attention to the CFTC rulemaking. They are likely to change the process and the cost of dealing with these risks.

Gary Gensler, Chairman of the CFTC, says that “until the CFTC completes its rule-writing process and implements and enforces these new rules, the public remains unprotected. That’s why the CFTC is working so hard to ensure that swaps-market reforms promote more open and transparent markets, lower costs for companies and their customers, and protect taxpayers.”