Quon Roundup on Employee Computer Privacy

Lots of discussion about the Quon case focused on the lack of technology expertise by the Justices on the Supreme Court. Actually, most people labeled them as Luddites. DC Dicta even claims that Chief Justice Roberts writes his opinions in long hand with pen and paper.

This issue that I am hoping to see addressed is how a stated policy on the use of a company’s hardware and network can be enforced in light of an employee’s expectations of privacy.

I doubt that issue will be addressed directly. The Quon case involves a government employee so the discussion of the issue will likely focus on the Fourth Amendment protection. These protections are largely irrelevant for private employees.

Even if the Justices avoid the Fourth Amendment issues, they may decide the case under the Stored Communications Act. That’s a rather boring and technical law. It’s also largely irrelevant to the use of a company’s hardware and network. Although it may provide some insight for the use of cloud computing and web 2.0 site.

The United States Government, through the arguments of Neal K. Katyal, Deputy Solicitor General, seemed to ask the Court to adopt a bright-line rule that a company can trump the reasonableness of any employee’s expectation of privacy by issuing a policy that employees have no privacy in communications when using the company-provided hardware or network.

The Justices seemed fairly skeptical of that kind of bright-line rule in their questions of Mr. Katyal.

The problem is that tightly crafting laws to specifically address the use of particular communication technologies will fail. In the current environment, the technological advances in communications is moving much faster than the cogs of  bureaucracy in crafting regulations. The Supreme Court (well, at least Justice Alito) recognized that the expectations of privacy with new communication are in flux.

“There isn’t a well-established understanding about what is private and what isn’t private. It’s a little different from putting garbage out in front of your house, which has happened for a long time.”

The ruling in the case is expected sometime June at the end of the Supreme Court’s term. It’s certainly something for compliance professionals to keep an eye on.

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Image of P2000 Pager.JPG is by Kevster

FCPA Opinion Procedure Release 10-01

The Department of Justice released its latest Opinion Procedure Release under the Foreign Corrupt Practices Act. It’s one of the quirks of the FCPA that you can ask the Department of Justice whether a particular situation would be a violation of the FCPA.

This opinion is also quirky. The company requesting the opinion was in the odd situation of having to hire a foreign official as the director of a facility it is building in a foreign country.

Hiring a foreign official is an obvious red flag for a potential violation of the FCPA.

The quirk of the situation is that the United States government directed the company to hire the foreign official. The company is building the facility under a government contract as part of US assistance to the foreign country. The foreign country identified the individual they wanted as facility director. They told the US government, who directed the company to hire the individual.

Here are the reasons stated why this situation is not a violation of the FCPA:

  • [T]he Individual is being hired pursuant to an agreement between the U.S. Government Agency and the Foreign Country, and will not be in a position to influence any act or decision affecting the Requestor.
  • [T]he Requestor is contractually bound to hire and compensate the Individual as directed by the U.S. Government Agency.
  • The Requestor did not play any role in selecting the Individual, who was appointed by the Foreign Country based upon the Individual’s qualifications.
  • In neither position will the Individual perform any services on behalf of, or receive any direction from, the Requestor.
  • [T]he Individual will have no decision-making authority over matters affecting the Requestor, including procurement and contracting decisions.

I don’t think this release offers much insight to the FCPA. It does point out that you may be able to hire a foreign official if directed by the US government.

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Ethics and Baseball Tickets

Baseball season is here. That means businesses will be opening their boxes and seats for entertaining clients and potential clients. Of course those tickets are gifts.

How do you treat them under your company’s gifts policy or a government’s ethics policy? One typical requirement is that you pay for the tickets. Face value is the general rule.

How about if those tickets were 2004 Red Sox World Series tickets? After all, Red Sox World Series tickets used to be very rare. (Since the new ownership, they are just uncommon.) Should you pay face value or the secondary market price?

The mayor of Pittsfield Massachusetts is countering an ethics complaint for those rare tickets. He bought the tickets for $380 from someone who had business before the city. That was $190 per ticket, the face value, for Game 2 of the World Series was played on October 24, 2004, at Fenway Park between the Boston Red Sox and St. Louis Cardinals. It so happened that the person with the tickets and the business before the city was former Red Sox general manager Dan Duquette.

The Enforcement Division of the State Ethics Commission alleges that there was enormous demand for 2004 World Series tickets. They were not available to the general public at face value, and were selling on secondary market at between $600 to $2,000 per ticket.

Section 3(a) of the Massachusetts Conflict of Interest Law makes it illegal for a government official who

“directly or indirectly, asks, demands, exacts, solicits, seeks, accepts, receives or agrees to receive anything of substantial value: (i) for himself for or because of any official act or act within his official responsibility performed or to be performed by him; or (ii) to influence, or attempt to influence, him in an official act taken”

Generally, anything worth more than $50 has “substantial value.”

One problem is that it is illegal in Massachusetts to sell tickets for more than $2 about the face value plus the costs of obtaining the ticket.  So if Duquette sold the ticket to the mayor for the secondary market price, he would have broken the law. Granted the ticket scalping laws in Massachusetts are mess.

Nonetheless, the State Ethics Commission had already issued an ethics advisory that special access to purchase tickets is a special benefit and could be an “unwarranted privilege or exemption of substantial value.”The opinion cites Ryder Cup, Super Bowl and World Series tickets as examples. (Coincidentally, that advisory opinion was issued in the spring of 2004. Clearly hope springs eternal each spring in Boston.)

The big problem is that according to the press release, Duquette admitted that he sold the tickets to the mayor because he wanted influence the mayor’s official government act. Intent usually wins, so if his admission is true then he broke the law.

The mayor is in a tougher position because the value of the tickets may be tough to ascertain. The price for the tickets will vary leading up to the game and different sellers may have different prices.

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The Knowledgeable Employee Exemption for Private Funds

UPDATE: See More Guidance on Knowledgeable Employee Exemption for Private Funds

When operating under the Section 3(c)(7) exemption from the Investment Company Act, the issue then becomes how a private investment fund can provide an equity ownership to key employees.

Its unlikely that your key employees will have the $5 million in investments needed to qualify as an investor. (Each investor in a 3(c)(7) private investment fund must be Qualified Purchaser.)

The SEC established Rule 3C-5 to allow “knowledgeable employees” to invest in their company’s private fund without having to be a qualified purchaser. The rule also exempts these knowledgeable employees from the 100 investor limit under the Section 3(c)(1) exemption from the Investment Company Act.

You will still need to determine if the employee’s acquisition of the interest is exempt from the registration requirements of the Securities Act. Most likely that will mean that the knowledgeable employee will need to be an accredited investor. Meeting that $200,000 per year / $300,000 per year if married income (and a reasonable expectation of that income continuing) threshold may be the biggest impediment to offering equity interests further down the company ladder.

The first category of “knowledgeable employees” is the management of the covered company, which covers these positions:

  • director [see Section 2(a)(12)]
  • trustee
  • general partner
  • advisory board member [see Section 2(a)(1)]
  • “executive officer”

Executive Officer is defined in Rule 3C-5 as:

  • president
  • vice president in charge of a principal business unit, division or function
  • any other officer who performs a policy-making function
  • any other person who performs a similar policy-making function

The second group of knowledgeable employees are those who participate in the investment activities. Those employees need to meet these requirements:

  • Participate in the investment activities in connection with his or her regular functions or duties,
  • has been performing such functions and duties for at least 12 months, and
  • is not performing solely clerical, secretarial or administrative functions.

The 12 month limit is not limited to 12 months at the employee’s current company. The SEC concluded that it is not necessary to require that an employee work for the particular fund or management affiliate for the entire 12-month period as long as the employee has the requisite experience to appreciate the risks of investing in the fund and performed substantially similar functions or duties for another company during that 12 month period.

Whether an employee actively “participates in the investment activities” of a private fund will be a factual determination made on a case-by-case basis.  In a 1999 No Action letter sent to the ABA the SEC said the following would NOT be knowledge employees:

  • Marketing and investor relations professionals who explain potential and actual portfolio investments of a fund and the investment decision-making process and strategy being followed to clients and prospective investors and interface among the fund, the portfolio mangers and the fund’s clients.
  • Attorneys who
    • provide advice in the preparation of offering documents and the negotiation of related agreements,
    • who also are familiar with investment company management issues, and
    • respond to questions or give advice concerning ongoing fund investments, operations and compliance matters.
  • Brokers and traders of a broker-dealer related to the Fund who are Series 7 registered.
  • Financial, compliance, operational and accounting officers of a fund who have management responsibilities for compliance, accounting and auditing functions of funds.

The SEC also said that research analysts who investigate the potential investments for the fund may not be knowledgeable employees unless they research all potential portfolio investments and provide recommendations to the portfolio manager.

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Photo is of the Board of Directors and Officers of the Industrial Exhibition Association of Toronto 1930 used under Creative Commons License from the Toronto Public Library Special Collections

Qualified Purchasers under the Investment Company Act

In a private fund exempt under 3(c)(1) investors only generally need to be accredited investors (and “qualified clients” if the fund manager is SEC registered. If you have more than 100 investors in the fund you will need to fall under the 3(c)(7) exemption. That means all of your investors must be “qualified purchasers.” A qualified purchaser is a much greater requirement than an accredited investor and a qualified client.

To paraphrase the requirements under Section 2(a)(51) of the Investment Company Act, a “qualified purchaser” means:

  • a person not less than $5 million in investments
  • a company with not less than $5 million in investments owned by close family members
  • a trust, not formed for the investment, with not less than $5 million in investments
  • an investment manager with not less than $25 million under management
  • a company with not less than $25 million of investments

To that list you can also add:

  • A company (regardless of the amount of such company’s Investments) beneficially owned exclusively by Qualified Purchasers.
  • A “Qualified Institutional Buyer” under Rule 144A of the 33 Act (except that “dealers” under Rule 144 must meet the $25 million standard of the 1940 Act, rather than the $10 million standard of Rule 144A). Rule 144A generally defines a “Qualified Institutional Buyer” as institutions, including registered Investment Companies, that own and invest on a discretionary basis $100 million of securities that are affiliated with the institution, banks that own and invest on a discretionary basis $100 million in  securities and have an audited net worth of $25 million, and certain registered dealers.

“Investments” generally means the following:

  1. Securities, including stocks, bonds and notes, other than securities of an issuer that  is under common control with the qualified purchaser.
  2. Real estate held for investment purposes.
  3. Commodity futures contracts, options or commodity futures and options on physical commodities traded on a contract market or board of trade, held for investment purposes.
  4. Physical commodities (e.g., gold and silver), with respect to which futures contracts are traded on a contract market or board of trade, held for investment purposes.
  5. Financial contracts (e.g., swaps and similar individually negotiated financial transactions), other than securities, held for investment purposes.
  6. For an investment company or a commodity pool, any binding capital commitments.
  7. Cash and cash equivalents held for investment purposes. Neither cash used by an individual to meet everyday expenses nor working capital used by a business is considered cash held for investment purposes.

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Image of Coin Stacks is by Darren Hester under a creative commons license.

Private Fund Exemptions under the Investment Company Act

Private investment funds primarily use two exemptions to avoid being defined as an “investment company” under the Investment Company Act of 1940: Section 3(c)(1) or Section 3(c)(7).

Less than 100 Investors

Section 3(c)(1) of the Investment Company Act excludes from being an investment company any issuer whose outstanding securities are beneficially owned by not more than 100 persons and that is not making and does not presently propose to make a public offering of its securities. The benefit of Section 3(c)(1) is that there is no additional status requirement for the investor, such as net worth, total assets, or total investments owned beyond the “accredited investor” standard.

There are some catches in trying to count the number of investors. There are several types of investors that result in a look through their ownership.

More than 100 Investors

If your private fund will have more than 100 investors, either directly or because of a look-through, then the fund will need to fit under the Section 3(c)(7) exemption. As with Section 3(c)(1) you cannot anticipate making a public offering. Investors in 3(c)(1) fund need only be accredited investors, but investors in a 3(c)(7) fund must be “qualified purchasers.”

The higher standard of qualified purchaser limits potential investors to institutional investors, investment managers and high net worth individuals. (More on the “qualified purchaser” definition in my next post.)

Contacting lots of investors may be viewed as general solicitation so you need to pay attention to the prohibition on general solicitation or advertisement under .

You will also need to be careful in limiting future transfers of interest in the private investment funds. With more than 100 investors, you will no longer be in the safe harbor exemption from being a publicly traded partnership.

500 or more Investors

Once you have 500 or more investors and more than $10 million in assets you are subject to the reporting requirements of the Exchange Act. Effectively you are no longer a private fund.

I believe something analogous happened to Google. They had gotten so big and their shares ended up in the hands of more than 500 people. Since they would have to begin complying with the reporting requirements, they may as well let the shares trade publicly.

So if you are going to end up with more than 500 investors in a private fund, you are better off having several smaller funds to avoid the public reporting requirements under the Exchange Act.

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Image of the Twenty Dollar Bill is by Darren Hester under a Creative Commons License.

Feds Release Usable Model Consumer Privacy Notice

There was much cheering when federal regulators finally released their Final Model Privacy Notice Form back in November.

That was quickly followed by a gnashing of teeth when it turns out the regulators did not understand the concept of a form or how to use Adobe Acrobat. They merely created a static document that you would have to spend hours trying to recreate.

They finally released version of the model privacy notice that is a fillable form using adobe acrobat.

To obtain a legal “safe harbor” and so satisfy the Gramm-Leach-Bliley Act’s disclosure requirements, institutions must follow the instructions in the model form regulation when using the Online Form Builder.

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Compliance Bits and Pieces for April 16

Here are some interesting compliance stories from the past week:

Chief Compliance Officers, SEC-style by Matt Kelly in Compliance Week‘s The Big Picture

Griffin is the SEC’s first-ever chief compliance officer, and her arrival is long overdue. It stems from news that broke last May of an insider-trading scandal within the SEC, which is pretty scandalous considering these are the folks who enforce laws against insider trading at public companies. The SEC’s inspector general published a report painting an ugly picture of SEC compliance efforts, which boiled down to this: “The Commission lacks any true compliance system to monitor employees’ securities transactions.” The report suggested that perhaps the SEC should, you know, have one, and put a single executive in charge of it.

SEC’s new adviser exam schedule: ‘We simply show up’ by Jed Horowitz in Investment News

The SEC has indefinitely dropped its goal of inspecting some 11,000 registered investment advisers on a regular schedule, and is instead focusing its examination resources on advisers who are the subject of tips and complaints, an official said. “We simply show up, because if there are allegations of wrongdoing we don’t want to give firms a good deal of lead time to clean up,” Gene Gohlke, associate director of the SEC’s Office of Compliance, Inspections and Examination said at a Practising Law Institute investment management conference on Friday.

Electronic Systems Policy After ‘Stengart’ by Kristin Sostowski in the New Jersey Law Journal

The Stengart decision obviously has serious implications both for companies that seek to limit and monitor employees’ use of company computers and for attorneys who discover arguably privileged communications between an employee and the employee’s lawyer on a company’s computer systems. In the wake of the Stengart decision, New Jersey employers should re-examine their current electronic systems policies and e-discovery practices in collaboration with employment counsel, keeping in mind the following best practices….

XBRL U.S. Shows Common Errors, Checks Consistency by Melissa Klein Aguilar in Compliance Week‘s The Filing Cabinet

Information that might be of interest for those public companies preparing to comply with the Securities and Exchange Commission’s XRBL mandate for the first time: A new white paper detailing some of the most common errors companies make related to XBRL U.S. GAAP Taxonomy rules.

Taxonomy and Compliance

Compliance often has to deal with a great big piles of data. When tackling a big pile of data, it helps to organize the data into a taxonomy. The taxonomy helps with analysis.

Of course, just by choosing the nodes in the taxonomy you are influencing the view of the data.

I was struck by how hard it is to work with a taxonomy in a recent article in the Economist: In Quite a State. The article looked at the many different lists of countries in the world and the many different ways of defining a country.

The US Department of Homeland Security offers 251 choices when you apply online for a visa-free entry. That list includes Bouvet Island, uninhabited Antarctic volcanic island belonging to Norway in the South Atlantic.

Hotmail offers a menu 242 countries/regions when you register an e-mail account. The United Nations has 192 member states.

One of the most interesting examples is Taiwan or Chinese Taipei. During the days of the Cold War many countries recognized Taiwan as a separate country because it was the non-communist regime exiled from China. Now that mainland China has become an economic titan, only 23 countries have formal diplomatic ties with Taiwan.

I am always struck by the treatment of Taiwan during Olympics, when their athletes walk behind a generic Olympic flag instead of the traditional Taiwan flag.

Adding an item or deleting an item to a taxonomy affects your view of the underlying data and affects the prominence of that item. It’s hard to “flag” a problem if it is not properly identified.

The Similarites Between WaMu and GM

Never stop the production line!

Yesterday, evidence came out that Washington Mutual knew about fraud in its residential mortgage originations. No surprise. There was lots of fraud in the heyday of the residential mortgage boom.

What was surprising was that WaMu allowed these loans to be sold to investors and packaged into residential mortgage backed securities.

“Washington Mutual built a conveyor belt that dumped toxic mortgage assets into the financial system like a polluter dumping poison into a river.” – Senator Carl Levin (D-Mich)

Since Senator Levin is from Michigan it reminded me of a similar story from a GM plant. They never stopped line in the GM plant. Even if someone had put a Regal front end on the a Monte Carlo, nobody would push the button to stop the production line and fix the problem.

The GM plant managers were paid to get cars off the end of the production line, regardless of what condition they were in or even if they were driveable.

The Washington Mutual loan officers were paid to get loans to the end of the production line, regardless of whether there was fraud or if the loan could be repaid by the borrower.

Both WaMu and GM ended up insolvent. The workers and the managers were paid on quantity, not quality.

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