How Does Your Hotline Compare?

Does your hotline ring off the hook with complaints? Is it silent? Are the complaints mostly that the employee thinks his boss is a jerk?

The Network and BDO Consulting published their 2010 Corporate Governance and Compliance Hotline Benchmarking Report. The 2010 report provides an analysis of compilation of more than 500,000 reports from over 4,000 organizations throughout the five-year period covering 2005 to 2009.

Most of the report deal with a per 1,000 employee standard so you can do the math to figure out where your organization sits compared to other companies. They break the employee size into 5 groups: (0-5,000;5,001-10,000;10,0001-20,000; 20,001-50,000; and 50,000+). One interesting item is that report frequency is greater for the smallest organizations than it is for the largest organizations.

Retail has lost its crown as having the most reports to transportation, communication & utilities.

Industry 2005 2009
Construction 2.66 6.96
Finance, Insurance & Real Estate 5.61 8.28
Manufacturing 3.40 4.10
Mining 2.32 3.81
Public Administration N/A 8.66
Retail Trade 18.00 11.09
Service Industries 7.33 10.52
Transportation, Communication & Utilities 9.67 12.80
Wholesale Trade 11.67 7.67
Overall 9.44 8.58

One item that has remained steady is that in 71% of the reports, the participant did not notify management before making the report. Personnel management still takes up about half of the reports. Posters are still the top source for creating awareness about the hotline.

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Mixed Messages from H-P

On Friday, Hewlett-Packard fired its CEO because he violated the company’s code of conduct. Mark Hurd had submitted inaccurate expense reports.

That sounds like a good message from the Board. Anyone can be fired for violating the code.

However, Mr. Hurd was given a severance package that may be worth more than $35 million, including a cash payment of $12.2 million. He violated the code, but was not fired “for cause” so he gets to keep his severance package.

That sounds like a bad message from the board. If it is company policy to fire someone for violating policy, then you should fire him and deny him severance.

However, as a top executive, Hurd had an employment agreement that better defined “cause for termination.” Cause involves “material neglect” of an individual’s duties or conduct “that is not in the best interest of, or is injurious to, H-P.” Mr. Hurd’s $20,000 of inaccurate expenses probably did not meet that standard.

Mr. Hurd stepped into the role of CEO after the poorly handled corporate espionage investigations by the prior CEO Carly Fiorina. He talked about improving the ethics of H-P.

Hewlett-Packard’s Standards of Business Conduct starts off with the headline test: “Before I make a decision, I consider how it would look in a news story.”

Mr. Hurd should have taken his own test.

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Compliance Bits and Pieces for August 6

Here are some recent stories that I found interesting:

The FCPA’s Long Tentacles by FCPA Professor

One reason is that mere existence of an FCPA inquiry can significantly throw a wrench into a company’s ability to sell itself. Another reason is that mere existence of an FCPA inquiry can cause an analyst to downgrade a company’s stock.

How to Fail as a Compliance Officer by Frank Sheeder in the Healthcare Compliance Blog

In my view, compliance professionals must establish themselves as leaders, whether formal or informal, in their organizations. If they don’t, they are destined to fail. Here are some ways to botch the effort to become a leader: …

Changes in Securities Enforcement Thanks to Dodd-Frank by Bruce Carton in Securities Docket

Only a portion of the Dodd-Frank Act is directed at enforcement of securities laws by the Securities and Exchange Commission. Nevertheless, that portion contains numerous important provisions that will affect public companies, regulated entities, and professionals in the enforcement and compliance areas. Let’s take them all in turn.

No Good Deed Goes Unpunished from the FCPA Blog

As a part of a yet unpublished paper, [Bruce Hinchey considers] the data from 40 FCPA cases from 2002 through 2009 and the differences between bribes paid and penalties levied against companies that do and do not self-disclose.

Squid is by Laughing Squid and used under a Creative Commons License.

SEC Finally Catches Up With Former Deloitte Vice Chairman

Back in November, 2008, Deloitte sued its former vice chairman for trading in securities of the firm’s audit clients. The SEC has filed its case against Thomas Flanagan and included his son, Patrick Flanagan.

The SEC alleged Flanagan traded in the securities of multiple Deloitte clients on the basis of inside information that he learned through his duties as a Deloitte partner, resulting in profits of more than $430,000. Flanagan also tipped his son Patrick, who earned profits of more than $57,000 based on the inside information.

“21. Between 2003 and 2008, Flanagan made 71 purchases of stock and options in the securities of Deloitte audit clients. Flanagan made 62 of these purchases in the securities of Deloitte audit clients while serving as the Advisory Partner on those audits.

22. On at least 9 occasions between 2005 and 2008, Flanagan traded on the basis of material nonpublic information. Flanagan traded on the basis of material nonpublic information about Best Buy, Motorola, Sears, and Walgreens. On at least 4 occasions, Flanagan tipped Patrick who also traded based on this material nonpublic information.”

What took the SEC so long?

The insider trading problem had already been uncovered at least eighteen months ago. Flanagan had violated the Deloitte policy on trading on audit clients’ securities. He failed to report his trading activity and failed to include some brokerage accounts in Deloitte’s trade tracking system.

Since he used Deloitte Tax for his personal returns, he falsified the names of the securities on his tax returns. (I wonder if Deloitte tax would have run the tax return’s securities against the restricted list?)

The Flanagans agreed to pay more than $1.1 million to settle the SEC’s charges. Thomas Flanagan paid disgorgement with prejudgment interest of $557,158, a penalty of $493,884, and is banned from appearing or practicing before the SEC as an accountant.  Patrick Flanagan paid a disgorgement with prejudgment interest of $65,614, and a penalty of $57,656.

How could you catch them?

One question is how could you improve your insider trading policy and procedures to stop this?

If someone is going to conceal their trading activity in clear and knowing violation of the insider trading policy, it’s hard to catch them. You can’t find the account if the employee does not tell you about the account. You need to make them aware of the insider trading policy and that their job is on the line for violation of the policy.

The next step is to review tax returns and tie them back to trades. The employee is then at risk for failure to report income to the IRS. (That’s how they got Al Capone.) In Flanagan’s case he went so far as to fake his tax returns.

How Did Flanagan Get Caught?

According to the Deloitte complaint (.pdf) the SEC investigated trading activity for a particular client who had announced an acquisition of a public company in July 2007. I assume the SEC saw an uptick in trading and options activity.  Looking back at the SEC complaint, it looks like that incident was when Walgreens’ purchased Option Care. It’s typical in a public M&A deal for the SEC to question the companies’ advisers when the see unusual trading activity around the time of the deal. That exposed Flanagan’s activity to Deloitte in August of 2008.

Did Flanagan not think that he would eventually get caught? Francine McKenna places the blame a compliance failure at Deloitte.

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Dealing with Losses From the Madoff Fraud

Charles Ponzi

One of the many repercussions of the Madoff fraud is how to treat investors who had money in his Ponzi scheme.

There has been plenty written about how the trustee is treating the direct investors. He is only treating net cash. If you took out more cash than you put in, you are on the hook. That is regardless of how massive your paper losses may be. This clearly hurts the early investors with Madoff.

The other aspect is how the feeder funds or other investment funds treat the losses and pass them through to their investors. The case of Beacon Associates caught my eye when it popped up. (There is no connection to my employer.)

Beacon Associates had placed a big chunk of its assets with Mr. Madoff. That has lead to a class actions suit by its investors and ERISA lawsuits.

The losses have also left the fund in the lurch as to how to treat the losses and which period to attribute the losses. Between 1995 and December 2008, Beacon issued monthly financial statements reporting substantial gains on Beacon’s investments. Beacon allocated those gains to its members in proportion to each member’s interest in Beacon and reflected those gains in its financial statements. As we have now discovered, Madoff never invested the capital and those gains allocated by Beacon never existed.

As a result, Beacon ended up commencing liquidation and needed to figure out how to distribute its remaining assets to its investors. Beacon lost approximately $358,000,000 through investments with Madoff and had just $113,283,785 of remaining assets.

One way to treat the loss is the valuation method. You treat the losses to have occurred on December 2008 when the Madoff fraud was uncovered. Any investor who was fully redeemed before then would not be allocated any loss.

An alternative treatment would be the restatement method. They would treat the losses to have occurred when Beacon made each of its investments with Madoff. That would allocate the Madoff losses over a much longer period of time.

Not surprisingly, the different methodologies “provided dramatically different results.” While the capital account of one member was calculated at $4,750,866 using the Valuation method, it had a balance of $2,735,636 under a Restatement method. Another member’s capital account was valued at $1,815,576 under the Valuation method, but exceeded $3,000,000 under a Restatement method. Beacon polled its investors. Eight-two percent preferred the Valuation Method, 10% preferred a Restatement Method, and twenty-five (8%) did not make a selection.

The court ended up ruling:

“Because Beacon’s Operating Agreement requires that capital accounts be maintained in accordance with Federal Treasury rules, and because the IRS has ruled that losses attributable to Ponzi schemes be reported in the year they are discovered, Beacon’s Operating Agreement must be read as requiring that Madoff theft losses, including those losses owing to “fictitious profits,” be allocated among its members’ capital accounts in proportion to their interest in Beacon as recorded in December 2008, when Madoff’s fraud was discovered.”

The net investment method is similar to the one being used by the Madoff and is appropriate for Ponzi scheme cases. Here, the court points out that Beacon itself was not a Ponzi scheme. The valuation method is the proper choice.

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The First Attack on the Accredited Investor Standard

Many of the provisions in the merely provide for future regulatory framework. That it is in part true for the changing definition of “accredited investor” under the Securities Act. The other part is that the definition changed once President Obama signed the bill into law ten days ago.

The definition of accredited investor now excludes the value of the primary residence from the calculation of net worth. Angel investors who poured too much of their wealth into a new swimming pool and cabana may get excluded from future private placements.

The SEC has also shown that it intends to be aggressive in setting the new accredited investor definition through the rule-making called for in Section 413 of Dodd-Frank. Last week, as part of their regular Compliance and Disclosure Interpretations the SEC gave an opinion on valuing the primary residence.

Question 179.01

Section 413(a) of the Dodd-Frank Act does not define the term “value,” nor does it address the treatment of mortgage and other indebtedness secured by the residence for purposes of the net worth calculation. As required by Section 413(a) of the Dodd-Frank Act, the Commission will issue amendments to its rules to conform them to the adjustment to the accredited investor net worth standard made by the Act. However, Section 413(a) provides that the adjustment is effective upon enactment of the Act. When determining net worth for purposes of Securities Act Rules 215 and 501(a)(5), the value of the person’s primary residence must be excluded. Pending implementation of the changes to the Commission’s rules required by the Act, the related amount of indebtedness secured by the primary residence up to its fair market value may also be excluded. Indebtedness secured by the residence in excess of the value of the home should be considered a liability and deducted from the investor’s net worth. [July 23, 2010]

So you get no benefit to your net worth calculation for your home. Even worse, if you are underwater on your home then that excess debt is eating into your net worth calculation.

I think it’s easy to argue with this interpretation. By excluding “value” you can argue that it should exclude positive value as well as negative value. You could also argue that in some states (and some loan documents) the mortgage is non-recourse so the excess of debt over the value of the home should be excluded.

You can make those arguments when the SEC begins its rule-making to create a new definition for “accredited investor.” For now, you need to live by this interpretation while you are privately raising capital.

I expect the SEC is going to continue to be aggressive in establishing the new standards. As I said early this month:

Looking into my crystal ball, I expect the SEC to adjust the income standards based on inflation. That would put them at around $459,000 if single and $688,000 if married. I would also expect the standard to include some sort investment expertise and knowledge standard. Having a big pile of cash or a big paycheck will likely no longer be the only standard.  At least that’s my guess.

Now you will need a bigger pile of cash if your home mortgage is underwater.

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Snow and Ice in August

It’s August, but here in Massachusetts we need to start thinking about snow and ice. Not because of climate change, but because of the Supreme Judicial Court. They just issued a ruling that changes the standard of liability for snow and ice hazards.

The standard in the Massachusetts had been that a property owner could not be held liable for injuries on the property arising from a natural accumulation of snow and ice. The law was based on old standards for different duties of care owed by a property owner to tenants, licensees, and trespassers. That was further tied to the question of whether the injury was caused by a defect existing on the property (First year of law school and bar exam flashback.)

The “Massachusetts Rule” was that “the law does not regard the natural accumulation of snow and ice as an actionable property defect, if it regards such weather conditions as a defect at all.” That particular statement came from a case where the homeowner had been away, leaving his driveway unshoveled and covered in snow. The injured person walked across the unshoveled driveway, fell down, was injured, and sued the property owner. She apparently left empty-handed.

The result of the Massachusetts was that most wintery slip and fall cases hinged on whether the snow and ice was a natural or unnatural accumulation of snow and ice. If it was natural, the landlord escaped liability and could get the case dismissed at summary judgment without a trial.

I should point out my bias. I have a sidewalk in front of my house (that I dutifully shovel). My employer owns commercial property in Massachusetts.

In Papadopoulos v. Target Corp., the Supreme Judicial Court announced that the state has abandoned the Massachusetts Rule and “discarded the distinction between natural and unnatural accumulations of snow and ice, which had constituted an exception to the general rule of premises liability that a property owner owes a duty to all lawful visitors to use reasonable care to maintain its property in a reasonably safe condition in view of all the circumstances.”

The new standard:

We now will apply to hazards arising from snow and ice the same obligation that a property owner owes to lawful visitors as to all other hazards: a duty to act as a reasonable person under all of the circumstances including the likelihood of injury to others, the probable seriousness of such injuries, and the burden of reducing or avoiding the risk. … If a property owner knows or reasonably should know of a dangerous condition on its property, whether arising from an accumulation of snow or ice, or rust on a railing, or a discarded banana peel, the property owner owes a duty to lawful visitors to make reasonable efforts to protect lawful visitors against the danger.

That means the jury will have to determine what snow and ice removal efforts are reasonable in light of the expense they impose on the landowner and the probability and seriousness of the foreseeable harm to others.

I think the end result is going to be more lawsuits filed against property owners. We can take Mr. Papadopoulos as an example. He had lost his case in summary judgment. Now he gets to go back to court and try again to get some money for his injuries.

Coming back to compliance, this is a rule where you act to avoid getting sued. Many communities have a local ordinance that makes the failure to clear sidewalks subject to a fine. I think most homeowners clear their sidewalks because its the neighborly thing to do. (Of course others, begrudgingly clear their sidewalks. You can get a good sense about them by seeing if they clear their driveway first or their sidewalk first.)

The goal is get property owners to clear their sidewalks and driveways so that people don’t fall down and hurt themselves. It seems there are several different ways to encourage this behavior. I could go a little deeper, but it’s still summer and I’m not ready to give more thought to snow and ice.

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Image is Austin shoveling snow by oddharmonic.

Compliance Bits & Pieces for July 30

Here are some recent stories that I found interesting:

When Compliance and Legal Functions Collide by Matt Kelly in Compliance Week‘s Big Picture

The general counsel is still the boss. Yes, I know, the revised U.S. Sentencing Guidelines say companies should have an independent compliance function, with a chief compliance officer who answers to the CEO or (ideally) the board. Well, that’s not happening yet. Fourteen of our 20 attendees said they report into the legal function; only two reported directly to the audit committee.

SEC Expects Massive Staff Increase Needed to Implement FinReg in Compliance Avenue

SEC Chairman Mary Schapiro, during her Testimony Concerning Oversight of the U.S. Securities and Exchange Commission: Evaluating Present Reforms and Future Challenges, which she gave before the United States House of Representatives Committee on Financial Services Subcommittee on Capital Markets, Insurance and Government-Sponsored Enterprises, stated that the Commission expects to hire approximately 800 new positions during the course of the implementation.

Criminal Provisions in the Dodd-Frank Dodd-Frank Wall Street Reform & Consumer Protection Act by NACDL’s White Collar Crime Section

That’s a $h!#ty Policy

On the front page of today’s Wall Street Journal is story about one of the fallouts from Goldman Sachs’ recent problems with the SEC: George Carlin Never Would’ve Cut It at the New Goldman Sachs.

One of the most sensational bits of Goldman Sachs fiasco was an email from a Goldman executive “[B]oy that, timberwolf was one $h!#ty deal.” Apparently, Goldman thinks the solution is to ban profanity in electronic messages.

Of course, everyone needs to pay closer attention to what is written down in email. They are often reviewed and taken out of context during litigation. Saying it was “$h!#ty deal” is more sensational than saying it was a “bad deal.”

Monitoring language in email has been part of financial service compliance for years. The SEC requires that compliance monitor for improper activity and advice. It will be easy enough to have the monitoring program also search for George Carlin’s “Seven Words You Can Never Say on Television” and their variants.

The big problem will be false positives once you start getting into the variants. That means frontline employees and deal flow will be get emails bounced back or blocked. Inevitably, compliance will get the blame for messing up a deal.

The other problem is enforcement. The first line of enforcement will probably be to block messages from being sent with profanity in them. That works as long as you can eliminate false positives. The alternative is to notify compliance when a message has profanity. Compliance can then keep track of the number of messages and report back to management for discipline.

“Employee A had 354 message with “$h!#ty”, 1,567 with F@(k, and 456 with this word which I don’t know but sounds dirty.”

Sounds like a $h!#ty policy and $h!#ty role for the compliance department.

What Do You Get For Cooperation with the SEC?

Rebecca Files

  • More likely to get sanctioned.
  • Reduction of $30.3 million in penalties when you initiate your own investigation.
  • Reduction of $609,000 in company penalties for each week earlier the statement is announced the public.
  • Reduction of $112,000 in personal penalties for each week earlier the statement is announced the public.

We in the compliance field have often heard from federal regulators that cooperation will get you benefits. Although when asked how much, it’s merely a “trust us” reply. Back in the beginning of 2010, the SEC launched a new enforcement cooperation initiative. The SEC’s 2001 Seaboard Report lists several criteria that SEC staff evaluate before making enforcement decisions, including whether ―the company cooperated completely with the appropriate regulatory and law enforcement bodies‖ and whether ―the company promptly, completely, and effectively disclosed the existence of the misconduct to the public [and] to regulators

I figured some academic would spend the time to sit down and see how much benefit really accrues when you cooperate. Rebecca Files of the University of Texas at Dallas did just that.

Dr. Files dove into a set of the 2443 press releases announcing an earnings restatements compiled by the General Accounting Office (GAO 2003, 2006a,b) during the 1997-2005 time period. She ended up culling the list down to 1,249 for a variety of reasons. Of those, 127 received a formal sanction by the SEC.

Individuals were sanctioned in 115 of the 127 cases, paying an average of $3.9 million in fines. Companies were sanctioned in 109 of the cases with an average fine of $35.5 million.

When the company had independently investigated their restatements, they paid an average of $30.3 million less in penalties than those that did not.

Dr. Files concludes that the end result is mixed. “[C]ompany-initiated investigations significantly increase the likelihood of an SEC enforcement action, but decrease firm-level penalties associated with a sanction. … Regarding forthright disclosures, I find somewhat mixed results. Headline disclosure of a restatement increases the likelihood of an SEC sanction, suggesting that SEC staff is influenced by the visibility of press release disclosures when choosing its enforcement targets. However, individuals pay significantly smaller fines when the restatement is disclosed prominently in a press release or on a Form 8-K or amended filing. Placing restatement information in a Form 8-K or amended filing also significantly reduces the likelihood of an SEC sanction, but only in the post-2001 period. Consistent with the Seaboard Report, timely disclosure of a restatement reduces the likelihood of being sanctioned and results in lower individual and firm penalties.”

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