Category: Compliance Programs

Lessons from Wunderlich

I don’t take pleasure from others’ failings, but I do try to learn lessons. The recent settlement between Wunderlich Securities and the Securities and Exchange Commission is full of lessons to be learned.

  • overcharged advisory clients for commissions and other transactional fees in violation of Section 206(2) of the Advisers Act
  • failed to satisfy the disclosure and consent requirements of Section 206(3) of the Advisers Act when WSI engaged in principal trades with advisory clients;
  • failed to adopt, implement and review written policies and procedures as required by Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder; and
  • failed to establish, maintain, and enforce a written code of ethics as required by Section 204A of the Advisers Act and Rule 204A-1 thereunder.

It seems some of the failings, at least according to the order was that Wunderlich hired a CCO with a background in Broker-dealer compliance, but at the same time, the firm moved from a broker-dealer model to an investment adviser model. That left the CCO in a new regulatory scheme.

Under Section 206(3) of the Advisers Act, an investment adviser must disclose to its clients in writing before the completion of each transaction that it acts as a principal. Wunderlich failed to follow this rule in over 3,00 instances according to the order. The issue is that the investment adviser can both collect a fee and realize a difference between its cost of the security and the price it’s sold to the the client. That difference in price is a conflict that needs to be managed. Wunderlich even hired a consultant to to review their operations who highlighted the principal trading problem. That still did not lead to a correction.

Wunderlich failed to have written compliance policies or a written code of ethics. That leads to the follow up failure of an annual review of the written compliance policies and procedures. Its hard to update something that is not in place. Wunderlich was using its broker-dealer manual and failed to update it to meet the requirements under the Investment Advisers Act. Once again, this failure was highlighted in a consultant’s report and the firm failed to fix the problem.

A long true lesson in compliance is when a problem is highlighted, you need to fix it. The spotlight is on the problem.

Sources:

Controls on Political Contributions

In the face of some pay-to-play scandals involving investment advisers and government sponsored investment fund officials, the Securities and Exchange Commission slapped restrictions on the ability of investment advisers and fund managers to make political contributions. Rule 206(4)-5 prohibits an investment manager or fund manager from collecting fees for two years if the firm or “covered associates” make a political contribution to certain elected officials. The ban applies to politicians who can directly or indirectly influence the decision to hire or can directly or indirectly appoint the person who can make the decision.

In talking with other compliance officers, firms are all over the place on how they are putting restrictions and controls in place to prevent the disastrous results that come from violating the rule.

  1. Complete ban on political candidates
  2. Pre-clear all political contributions
  3. Pre-clear any contributions in excess of the de minimis amount of $350/$150
  4. Here’s the rule don’t break it

Regardless of the restrictions, the SEC Rule also imposes a record-keeping obligation on the compliance program. “Covered associates” must report all political contributions.

You can do a periodic certification of the contributions they have made. Since political contribution are in the public records, theoretically you can check the records to make sure that they are not failing to report.

I decided to try some public record searches to see if this was a realistic control.

I assumed the federal databases would be the best so I went to the Federal Election Commission’s Advanced Transaction Query By Individual Contributor. It allows you to search by company name. That makes it easy to run a broad search to find who in the organization has made campaign contributions.

That was a good start, but the least relevant. For the most part, federal elected officials do not control government-sponsored retirement funds. The big exception is if the candidate is currently a state or local official looking to go to Washington.

I turned next to Massachusetts Office of Campaign and Political Finance. Their OCPF Searchable Campaign Finance Database & Electronic Filing System makes it easy to search by employer.

Then I tried California, New York, and Virginia. They were both terrible and I could not find a way to search by employer.

Washington State’s Public Disclosure Commission allows you to search by employer.

The SEC rule just went into effect in March, so I get the sense that compliance programs are evolving as they work with the restrictions and controls. I’m interested to hear you are doing, whether you are searching campaign databases, and the resources you are using. Feel free to leave a comment (anonymous if you like) or send a confidential email to [email protected].

Near Misses, Catastrophes, and Compliance

The theme of the April edition of the Harvard Business Review is “Failure.” As scary as that term is in the world of compliance, “catastrophe” is even scarier. That means that the failure resulted is real, significant damage.

But you can learn from failures. You can especially learn from others’ failures.

In How to Avoid Catastrophe, Catherine H. Tinsley, Robin L. Dillon, and Peter M. Madsen look at “unremarked small failures that permeate day-to-day business but cause no immediate harm.” Their research has revealed a pattern: “Multiple near misses preceded (and foreshadowed) every disaster and business crisis we studied, and most of the misses were ignored or misread.” (Sorry, you need a subscription to read the entire HBR article.)

They come up with seven strategies that can help an organization recognize near misses and root out the error behind them. These seem very applicable to compliance programs.

  1. Heed high pressure. The greater the pressure to meet performance goals, the greater likelihood that managers will discount near miss signals.
  2. Learn from deviations. Don’t just recalibrate operations, focus on the significance of the change.
  3. Uncover root causes. Don’t just correct the symptoms.
  4. Demand accountability. Require managers to justify their assessments of near misses.
  5. Consider worst-case scenarios. people tend to not think of the possible negative consequence of a near miss. Walk through a situation where the near-miss does not miss.
  6. Evaluate projects at every stage. Take a look at your successful projects, not just your failures.
  7. Reward owning up. Don’t punish errors, but reward those who uncover near misses.

The authors:

Failure and Compliance

The theme of the April edition of the Harvard Business Review is “Failure.” That’s a scary term in the world of compliance. Generally, that means you’ve got government regulators or enforcement personnel sitting in your offices. And they are not happy. Failure and compliance can mean disciplinary action, fines, or jail time.

But you can learn from failures. You can especially learn from others’ failures.

Ethical Breakdowns by Max H. Bazerman and Ann E. Tenbrunsel takes an insightful look at ethical breakdowns and comes up with five barriers to an ethical organization. (Sorry, you need a subscription to read the entire HBR article.)

  • Ill-conceived goals
  • Motivated blindness
  • Indirect blindness
  • Slippery slope
  • Overhauling outcomes

An ill-conceived goal is the classic failure seen in sales targets, revenue projections, and stock price targets. If you give mechanics a sales goal of $147 hour they can very easily lapse into fixing things that were not broken rather than being more efficient. Sears encountered this problem in the 1990s.

The authors lump a few things into the motivated blindness category, but most notably included are conflicts of interest. They use the failure of rating agencies during the financial collapse as one example. Since the rating agencies are paid by the issuer instead of the buyer of securities, they have a misalignment of motivation. They end up serving the one who pays them, leading to lax ratings and competition for business. That means they may have rated something higher than they should have. (That’s a big understatement.)

Indirect blindness is when third parties are involved. What caught my eye was an experiment examining perceptions of an increase in the cost of a pharmaceutical drug. In the first scenario, the drug company raises the price from $3 to $9. In the second scenario, the drug company sells the rights to a smaller company who then increases the price to $15. The first scenario was judged more harshly, even though it resulted in a lesser price.

We’ve all been concerned about the slippery slope. Little lapses lead to a culture of lapses, eventually leading a big failure. The authors present some interesting research showing how this works and that it is a real problem. From a compliance perspective, they focus on auditors and how good accountants can do bad audits.

The final category is the one I found the most intriguing: overvaluing outcomes. The author’s research showed an inclination to judge actions based on outcomes rather than the behavior. One example is a research failure.

In the scenario A, a researcher pulls four subjects back into the results after they were removed for technicalities. However, the researcher thinks their data is appropriate. When adding them back in, the results shift and allows the drug to go to market. Unfortunately, the drug ends up killing six people and is pulled from the shelves.

In scenario B, a researcher makes up four more data points for how he believes subjects are likely to behave. The drug goes to market, becomes profitable and effective.

The participants in the author’s experiment judged the researcher in scenario A much more critically than the researcher in scenario B. The problem is that the person B had the bigger ethical lapse and worse behavior. It’s just that the outcome, largely by luck, was worse in A than B.

They extrapolate the findings to the situation where a manager is overlooking ethical behaviors when outcomes are good and unconsciously helping to undermine the ethical culture of an organization.

Compliance Bits and Pieces for April 29

Here are some recent compliance-related stories that caught my eye:

SFO GC resigns: SFO future cast into further doubt in The Bribery Act .com

We’re delighted to congratulate Vivian Robinson QC on his reported move today from the SFO to join a US law firm, Richmond Virginia headquartered McGuire Woods, in the near future. We’ve enjoyed working together with Vivian over recent months and look forward to doing so during the remainder of his time at the SFO.

Vivian’s move places in the spotlight once again the current uncertainty surrounding the future of the SFO.

Examining Bernie Madoff, ‘The Wizard Of Lies’ on NPR’s Fresh Air

The first journalist to interview Bernie Madoff after the money manager was sentenced to 150 years in prison says she was struck that Madoff hadn’t fundamentally changed.

Even behind bars, says New York Times financial writer Diana Henriques, Madoff was a “fluent liar.”

“The magic of his personality is how easy it is to believe him — almost how much you want to believe him,” she tells Fresh Air’s Terry Gross. “For example, he assured me in that first interview — and in emails subsequently that we exchanged — that he wasn’t going to talk to other writers. … Of course, it wasn’t true, he was talking to others. It was all a lie.”

Whistleblower Rules May Not Be Ready Until Summer by Joe Palazzolo in WSJ.com’s Corruption Currents

After missing an April deadline, the Securities and Exchange Commission said it now expects to finalize rules for its whistleblower program by July, reports Dow Jones’ Jessica Holzer. Congress had given the SEC until April 21 to write rules for the program, which was created in the Dodd-Frank law nine months ago. The commission plans to adopt rules sometime between now and the end of July, according to a revised schedule on the agency’s website.

Compliance Bits and Pieces – Good Friday Edition

The stock markets are closed, but most banks are open. I’m taking the day off from work, but wanted to highlight a few compliance-related stories that caught my eye.

Justice is served, but more so after lunch: how food-breaks sway the decisions of judges by Ed Yong in Discover’s Not Exactly Rocket Science

There’s an old trope that says justice is “what the judge ate for breakfast”. It was coined by Jerome Frank, himself a judge, and it’s a powerful symbol of the legal realism movement. This school of thought holds that the law, being a human concoction, is subject to the same foibles, biases and imperfections that affect everything humans do. We’d love to believe that a judge’s rulings are solely based on rational decisions and written laws. In reality, they can be influenced by irrelevant things like their moods and, as Frank suggested, their breakfasts.

Chief Compliance Officers: The Evolving Picture by Michael Volkov in White Collar Defense & Compliance

In the next five years, the position of CCO will take on a new and more dynamic role in every company. With the rise of enforcement, it is inevitable that the importance of the CCO will increase in every organization. CCOs are likely to rise in organizations to a level equal to General Counsels and Chief Financial Officers.

How Do I Know If My Company Is Compliant If I Don’t Know Every Applicable Law and Regulation? by Ted Polakowski in Corporate Compliance Insights

This is one of the hardest questions to answer since you just don’t know what you don’t know. … This is because within any country, there exist – in addition to the governmental body that creates law – many regulatory agencies that are chartered with putting the rules of operation into play. Just trying to find out who those agencies are and where they list their regulations can be a daunting task in itself.

The housing boom and bust, part 2 by Russ Roberts in Cafe Hayek

Once the price of housing started rising dramatically, it became profitable to bet on the rise continuing. So a lot of people, smart and stupid, tried to ride that meteor as it shot upward. And that’s where the shadow banking system and the low interest rates come in. The shadow bankers pumped trillions into that market via all those innovative new assets (CDO’s, CDO squared etc). They use borrowed money because they could. The lenders lent the money because the government had signaled that lenders would get made whole even when the bets their loans financed were worthless.

Richard Ford on the Meaning of Work in the Wall Street Journal’s Speakeasy

Work, after all — to me, anyway — signifies something hard. And while writing novels can be (I love this word) challenging (it can also be tedious in the extreme; take forever to finish; demoralize me into granite and make me want to quit and find another line of work), it’s not ever what I’d call hard. A hard job, okay, would have to be strenuous and pressurized (writing’s almost never that way). It would have to be obdurate, never offering me a chance to let up (I can quit writing any time I want to and come back tomorrow, or never). And it would have to be skimpy on personal-spiritual rewards (I’m always trying to do what Chekhov did…change the way some reader sees the world; so big rewards are always out there). In my view, being a first-year law student at Harvard would not be hard; but being a non-partnered associate at Skadden, Arps would be. Learning to play “The Flight of the Bumble Bee” on a Sousaphone would not be hard; but working on the dashboard assembly team for the Ford-150 would most certainly be. You see what I mean. Hard is staring into one of those mind-corroding x-ray machines at LaGuardia. Or taking tolls on the Jersey Turnpike.

Patriots’ Day and Compliance

Patriots’ Day is a Massachusetts holiday honoring the anniversary of the Battles of Lexington and Concord, the first battles of the Revolutionary War. Since Maine was once part of Massachusetts, it is also a holiday in Maine. Although they switch the possessive to Patriot’s Day.

That means Paul Revere and William Dawes mount their horses to re-create the warning: “The British are coming!” That means battle re-enactments in Lexington. That means the Boston Marathon passes through. That means a Red Sox home game.

That means a holiday for me from thinking too much about compliance.

Sources:

Image of the Minuteman Statue in Lexington Massachusetts is by Daderot
CC BY-SA 3.0

Possible Extension to Registration for Private Fund Managers

Dodd-Frank put enormous pressure on the Securities and Exchange Commission to create dozens of new rules. Tile IV of the law, the Private Fund Investment Advisers Registration Act of 2010, shifts thousands of mid-sized investment advisers from federal to state registration. It also repeals the private adviser exemption, causing most private fund managers to register with the SEC.

Section 419 of Dodd-Frank pegs the transition period at one year. That means there is July 21, 2011 registration deadline. The SEC may be bending on that deadline for the registration of private fund advisers.

In an April 8, 2011 letter to the president of the North American Securities Administrators Association, the SEC indicated it may try to push back that July 21 deadline to the first quarter of 2012.

The letter states that the SEC intends to have the necessary rulemaking done by July 21. Of course, that means the subjects of the rules need to get in line. Since there is only three months until that deadline, the clock is ticking very loudly.

The SEC also needs to get the computer systems in place. Once the rules and forms are finished, they need to update the Investment Adviser Registration Depository System. Back in November, the SEC proposed big changes to the Part 1 of Form ADV to address these new registration and reporting requirements. The final form has not been released. I thought the release may have been because they were re-programming IARD to deal with the new form, allowing them to release the final Form ADV and the registration at the same time. According to this letter, that is not the case. The SEC does not expect IARD to be re-programmed until the end of 2011.

Obviously, this letter merely indicates that at least one person inside the SEC thinks the deadline could be extended. That is a long way from actually extending the deadline. I still have a question about whether the SEC can extend the deadline without some sort of legislative action.

Sources:

Compliance Bits and Pieces for March 26

Here are some compliance related stories that recently caught my eye:

PEI Media’s Private Fund Compliance Forum

Don’t miss your last chance to attend the essential event for compliance professionals in 2011 at a discounted price. Book your place before midnight on Friday March 25 and save $355 off the full delegate price.

(I will be speaking on a panel on the new rules governing fundraising.)

Ethics, Compliance, and Company Size by Matt Kelly

Ethics is not about compliance; ethics is about the discipline to follow a certain code of conduct. Where compliance is mandatory (someone else forces you to obey the code), ethics is voluntary (you choose to obey the code). I go back to that word “discipline” because it’s important: you the employee, you personally, must exercise the discipline to behave a certain way. Nobody can compel you to behave in that certain way; you must, as the cliché goes, buy into that code of behavior willingly.

The Truth About Hedge Funds and the Financial Crisis by Veronique de Rugy in Reason.com

Myth 2: The hedge fund industry’s tendency to take excessive risks, combined with a lack of regulation, was an important cause of the financial crisis.

Fact 2: Not only did hedge funds not precipitate the financial crisis, they did nothing to exacerbate it. If anything, hedge funds have helped the economy to recover more quickly.

Commitment From the Top by Howard Sklar in Open Air

I’ve been told that “tone from the top” has been replaced by a meatier phrase, “commitment from the top.” I would still define it in the same way. Essentially the entire discussion around tone/commitment from the top revolves around the same thing: which comes first, revenue or ethics, when you can’t have both? Compliance officers will tell you that their job is to be a creative solutions vendor for the business (at least, good compliance officers will tell you that). To get to “yes.” Sometimes, however, the answer is “no.” Sometimes, it’s “not only no, but ‘hell no.’” Ethics is what happens next.

Although not compliance-related, as a web publisher I was very interested in The Latest in Style from the New York Times with some revisions to their style guide:

  • We no longer have to write about people sending “an e-mail message” — we can call it “an e-mail.” The term is also acceptable as a verb. (For now, at least, we are keeping the hyphen for this and similar coinages like e-commerce and e-reader.)
  • For now, we’ll continue to capitalize Web and Internet, and we’ll keep “Web site” as two words.
  • A revised entry on Web addresses underscores the need for external linking from our online stories.
  • the ubiquitous “app” is now acceptable in all references to software applications, particularly for mobile.
  • We have eased our guidance on “girlfriend” and “boyfriend.” While traditionalists still view these terms as informal, and even a bit awkward for adults, there’s no ignoring that we live in a city where a mayor of a certain age has a girlfriend of a certain age.

The Small Business Capital Access and Job Preservation Act

With the House of Representatives’ change in political control, the Republicans are taking some steps to cut back on Dodd-Frank. Earlier this week the House Committee on Financial Services distributed a press release about five potential bills that would revise the financial service legislation:

  • The Asset-Backed Market Stabilization Act
  • The Small Company Capital Formation Act
  • The Small Business Capital Access and Job Preservation Act
  • The Business Risk Mitigation and Price Stabilization Act
  • The Burdensome Data Collection Relief Act

Besides the sensationalist graphics, the Small Business Capital Access and Job Preservation Act caught my attention because it is targeted at private equity fund managers:

The Financial Services Committee has received testimony regarding the role private equity firms play in preserving existing jobs and creating new ones by providing capital to struggling and growing companies.  The Dodd-Frank Act requires most advisers to private investment funds to register with the SEC, including advisers to private equity funds. The Small Business Capital Access and Job Preservation Act exempts advisers to private equity funds from the registration requirements. The draft legislation will be sponsored by Representative Robert Hurt.

It sounds like a nice bill. But I’m skeptical that it could enacted before the July 21 deadline for private equity fund managers to register under Dodd-Frank (assuming it could pass at all).

The Committee is holding testimony on Wednesday, March 16 at 2 p.m. in room 2128 Rayburn. Scheduled to appear are:

  • Kenneth A. Bertsch, President and CEO, Society of Corporate Secretaries & Governance Professionals
  • Tom Deutsch, Executive Director, American Securitization Forum
  • Pam Hendrickson, Chief Operating Officer, The Riverside Company
  • David Weild, Senior Advisor, Grant Thornton, LLP
  • Luke Zubrod, Director, Chatham Financial

The text of the proposed legislation is just in the form of discussion drafts and I  have not been able to find copies. I’m sure much will hinge on the definition of “private equity fund managers” just as Dodd-Frank created a new category of venture capital fund managers.

Sources: