Revisions to U.S. Sentencing Guidelines for Compliance Programs

At their April meeting, the U.S. Sentencing Commission voted to adopt changes to Chapter 8 of the Sentencing Guidelines Manual. That chapter defines an effective compliance and ethics program and has been one of the sacred texts of the compliance profession.

Here is my summary of the changes:

Changes to §8B2.1

In defining an Effective Compliance and Ethics Program, they are inserting a new Note 6 that focuses on the steps to take after the detection of criminal conduct.

First, the organization must respond appropriately to the criminal conduct, including restitution to the victims, self-reporting and cooperation with authorities.

Second, the organization must assess its program and modify it to make the program more effective. They seem to encourage the use of an independent monitor to ensure implementation of the changes.

Changes to §8C2.5(f)

In calculating the culpability score for having an effective compliance and ethics program, they have removed the near automatic disqualification if the bad actor was  a high level executive. You can get credit, provided you meet the new criteria:

  • the head of the compliance program must report directly to the governing authority or appropriate subgroup (for example, the audit committee of the board of directors),
  • the compliance program must discover the problem before discovery outside the organization was reasonably likely,
  • the organization must promptly report the problem to the government, and
  • no person with operational responsibility in the compliance program participated in, condoned or was willfully ignorant of the offense.

Changes to §8D1.4

The amendment simplifies §8D1.4 (Recommended Conditions of Probation – Organizations) (Policy Statement) on the recommended conditions of probation for organizations. The new section consolidates the list of conditions that are appropriate conditions for probation.

Status of Changes

The changes have to be submitted to Congress and won’t take effect until November 1, 2010. (Unless Congress votes to reject the changes.)

Publication of Changes

You would think that the Sentencing Commission would publish this change on their website or publish a press release. No information about the amendment, the submitted comments or meeting minutes have yet made their way to the website for the United States Sentencing Commission.

Fortunately Susan Hackett of the Association for Corporate Counsel and Melissa Klein Aguilar of Compliance Week were able to alert us and publish a copy of the changes.

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April 15 is Tax Day, Except for Flooding

With the recent flooding in Eastern Massachusetts, several counties were declared federal disaster areas. The bonus is that you have an automatic extension for filing your taxes.

If you live in Bristol, Essex, Middlesex, Norfolk, Plymouth, Suffolk or Worcester County in Massachusetts, you have until May 11 to file your income taxes. that applies for both Federal and Massachusetts filings.

Massachusetts is not alone. These parts of the country were also granted extensions:

  • New Jersey: Atlantic, Bergen, Cape May, Essex, Gloucester, Mercer, Middlesex, Monmouth, Morris, Passaic, Somerset, and Union counties
  • Rhode Island: Bristol, Kent, Newport, Providence and Washington counties
  • West Virginia: Fayette, Greenbrier, Kanawha, Mercer and Raleigh counties

The automatic extension applies regardless of whether you were underwater or high and dry.

Good news for me. I suffered no damage, but can still procrastinate in finishing my taxes.
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  • TIR 10-7: Extension of Time for Certain Tax Filings and Payments for Taxpayers Affected by March 2010 Severe Storms and Flooding

Nobody Saw It Coming? Magnetar Saw it Coming

After reading Michael Lewis’ The Big Short this weekend, it’s clear that some people saw the collapse of the residential mortgage market coming.

This American Life had a story this weekend about another investor who also saw it coming: Magnetar Capital.

(A magnetar is a neutron star with a magnetic field 100-1000 times stronger than that of an ordinary neutron star.)

The story paints the picture of Magnetar buying the most risky tranche of subprime CDOs while at the same time buying credit default swaps against less risky tranches of the same subprime CDOs.

The equity tranche is the last to get paid, the riskiest portion of the CDO and the hardest to sell. Without someone to buy the equity a CDO was less likely to be put together in the first place. Also keep in mind that CDOs were often composed of the equity and junkier pieces of mortgage backed securities as a well as a kitchen soup of mortgage securities.

Pro Publica and This American Life interpret Magentar’s trade as one to sustain the volume of subprime CDOs, which sustained the volume of subprime mortgage backed securities, which sustained the origination of subprime mortgage loans, which sustained the bubble in housing prices. They claim that Magnetar’s trades made the bubble worse. By buying the equity tranche, they enabled the creation of the entire subprime CDO and had more to bet against.

Magnetar denies that was their intent. They were merely combining long positions with short positions.

I assume they saw a weakness in the pricing of CDOs and CDO CDSs and made trades to exploit the weakness. Others, like the people in The Big Short saw weaknesses in CDOs and took bets on their downfall. I doubt any of them realized that the collapse of the CDOs would result in something as catastrophic as the Great Panic.

That didn’t stop This American Life from comparing the Magnetar trades to the plot of The Producers. In the movie, a theatrical producer and his accountant attempt to cheat their investors by deliberately producing a flop show on Broadway. They realize they can oversell the shares in the production and make more money if it the show flops than if it becomes successful.

They even made a song parody based on the Broadway musical adaptation of the movie: Bet Against the American Dream.

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SOX Whistleblower Protections at Mutual Fund Companies

We know that Sarbanes-Oxley offers protections to employees at public companies, but does it also protect employees at mutual fund companies?

Yes. At least according to Judge Woodcock of the Massachusetts U.S. District Court.

The Employees

The decision is for two cases that were combined because of the common defendant. According to the decision, Jackie Hosang Lawson worked at Fidelity for more than a decade, before she questioned (1) an expense for “Guidance Interactions”, (2) the improper retention of 12b-1 fees, (3) the methodology that affected fund profitability models, (4) issues with a new source system, (5) allocations of internet expenses, and (6) errors in a back office group. She claims to have received poor job performance ratings, missed a promotion and other bad acts as a result of her raising the issues. She filed four separate whistleblower complaints with OSHA that ended up as this federal district court case.

Jonathan M. Zang started at Fidelity in 1997 as an equity research analyst and eventually became a portfolio manager. Zang objected to what he saw as inaccurate disclosure of portfolio manager compensation in an SEC filing for one of his funds. Zang contended that Fidelity retaliated by giving him poor performance ratings and ultimately fired him.

The Mutual Funds

The Fidelity mutual funds are publicly traded, but do not have any employees. The mutual funds hired FMR LLC and other Fidelity affiliates to act as advisers to the funds and those advisers have the employees. (This is the typical arrangement for mutual funds.)

The fund company took the position that Lawson and Zang were employees of a private company (FMR is private) and are not covered by the SOX whistleblower protection. Lawson and Zang argue that SOX protections are not only for employees of public companies but also for employees of private companies, particularly those that act as investment advisers to public investment companies.

The Statute

The statutory provision in question [18 U.S.C. §1514A(a)]provides:

No company with a class of securities registered under section 12 of the Securities Exchange Act of 1934 … or any officer, employee, contractor, subcontractor, or agent of such company, may discharge, demote, suspend, threaten, harass, or in any other manner discriminate against an employee in the terms and conditions of employment because of any lawful act done by the employee ….

The Reasoning

If Zang or Lawson were direct employees of the mutual fund there is little question that they would be protected.

Judge Woodlock looked at the broader provision of Sarbanes-Oxley and found that the intent was to address the problems of shareholder fraud in the public markets.  The judge feels that the protections applies to employees of  “any related entity of a public company.”

The Lawson and Zang are either contractors, subcontractors, or agents of publicly held investment companies. “If the Funds did not
have investment advisers as their agents, the only activity that could take place on the Funds’ behalf would be actions taken by the Board of Trustees.”

Judge Woodlock did not rule on the substance of the plaintiffs’ claims. He did side with Fidelity and dismissed wrongful discharge claims under state law.

The Future

I expect we will hear more about this case on appeal.

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Weekend Book Review: The Big Short

Michael Lewis has put together a great book on subprime loans, home mortgage bonds and how their crash led to the Great Panic.

The Big Short starts with this quote:

The most difficult subjects can be explained to the most slow-witted man if he has not formed any idea of them already; but the simplest thing cannot be made clear to the most intelligent man if he is firmly persuaded that he knows already, without a shadow of doubt, what is laid before him. – Leo Tolstoy, 1897

That was the challenge in 2006. To not be considered insane when standing apart from the mass hysteria to say the financial news is wrong and “the most important financial people are either lying or deluded.” People were quitting their jobs to become real estate investors. House buyers, lenders and the purchaser of home mortgage bonds seemed to think that house prices in the United States would never decrease.

I really enjoyed The Blind Side: Evolution of a Game. (The book not the movie. The book was about the evolution of football, using the unusual background of Michael Oher as a lens. It was not the sappy family story that was in the movie.) That turned me into a Michael Lewis fan. (Even though Liar’s Poker and Moneyball have not yet risen to the top of my reading list.)

In The Big Short, Lewis uses two people who saw the problems to act as the lens for the story. Michael Burry is a one-eyed hedge fund manager with Asperger’s syndrome. Burry liked to remain isolated from public opinion and human contact. He focused on hard data and the incentives involved in the human behavior in the financial markets. Steve Eisman was another money manager. Eisman was convinced that the subprime mortgage market was full of corruption and exploitation.

Lewis points out how Wall Street was gaming the rating agencies. One example is that the agencies were looking at an average credit score of the borrower, not each individual borrower. So Wall Street would package a barbell of loans. Throw together a bunch of credit scores that are horrible and very likely to default. Then sprinkle in enough loans with high credit scores to get the average credit score just right.

The rating agencies has flawed formulas and Wall Street knew it. After all, Wall Street helped create the formulas. Lewis paints a very dim view of rating agencies.

The rating agencies gave bonds full of floating rate loans a higher rating than those with fixed interest rates. The flawed logic was that borrowers would be just as likely to make payments at 12% as they were at 8%. Obviously, the bigger problem was that borrowers couldn’t make the payments at 8% in the first place.

Eisman and Bury both saw the flaws in the system and made big bets against sub-prime mortgage bonds using credit default swaps. They saw lots of subprime loans being made with loan interest rate teasers that would reset in two years. The borrowers couldn’t afford the property at the teaser rate and would clearly default when the rate reset unless property values continued their astronomical increases.

Lewis did write a great article in Vanity Fair on Iceland’s Financial Metldown if you need a taste of his writing. That story paints a similar of tale of over-exuberance in the financial markets.

The Big Short does a great job of explaining how loans are packaged into commercial mortgage backed securities (CMBS), then sliced up into tranches and sold as bonds, repaid by the cash flow from underlying mortgages. The tranches that get paid first receive the highest rating of AAA, labeling them as nearly risk free as US Treasury bonds.

Then Lewis focuses squarely on collateral debt obligations (CDOs) that repackage the poorly rated tranches of CMBS into new mortgage bonds. As with the CMBS, the tranches that got repaid first received the AAA rating. That was the alchemy, turning garbage into gold.

Lewis does a good job of explaining how all of these mortgage bonds work. If you want more detail on the market for subprime mortgage-backed CDOs read the thesis from A.K. Barnett-Hart, a Harvard undergraduate: The Story of the CDO Market Meltdown: An Empirical Analysis. Lewis cites her thesis as being more interesting than any Wall Street research on the topic.

The Tolstoy quote points out that many on Wall Street did not understand how they worked and did not understand the risks involved.

I recommend that you add The Big Short to your reading list and move it to the top of the list.

Compliance Bits and Pieces for April 9

Here are some recent compliance related stories that I found interesting:

Bribe Fighter: The strange but true tale of a phony currency, shame, and a grass-roots movement that could go global By Jeremy Kahn in the Boston Globe

What good is a currency that is not even worth the paper it’s printed on? That’s the intriguing question raised by the new “zero rupee note” now circulating in southern India. It looks just like the country’s 50 rupee bill but with some crucial differences: It is printed on just one side on plain paper, it bears a big fat “0” denomination, and it isn’t legal tender.

OIG Issues Recs to Overhaul SEC Bounty Program by Melissa Klein Aguilar in Compliance Week’s The Filing Cabinet

The Securities and Exchange Commission’s bounty program for rewarding whistleblowers is sorely in need of an overhaul, according to the agency’s Inspector General, which issued nine recommendations for improving the program.

Staffer One Day, Opponent the Next by Tom McGinty in the Wall Street Journal

The revolving door can turn swiftly at the Securities and Exchange Commission. … Others argue that employees of every government agency leave for the private sector and that the rules in place guard against conflicts of interest. An SEC spokesman said the disclosures required of former employees constitute an extra precaution by the agency to ensure that the law and ethics considerations are followed.

My Commentary Part 2: Ernst & Young’s Letter To Audit Committee Members by Francine McKenna in re: The Auditors

Unfortunately for Ernst & Young, even before the release of the Lehman report, too many things had already gone wrong. Their credibility is, pretty much, shot to hell. Their only hope may be that both civil and criminal proceedings take so damn long that they’ll instead die a slow and painful death by litigation and suffocating legal fees than by the swift sword of an Arthur Andersen-type criminal indictment by the US Department of Justice.

Facebook Tells Employees Not to Sell Shares by Mark J. Astarita, Esq in SEClaw.com

Facebook has an interesting problem – it is in danger of having too many shareholders, an outcome that is being made possible by online trading sites like Sharespot.com, which allows shareholders in private companies to sell their shares to others. … Facebook is concerned that the expansion of its number of shareholders to 500 will force it to go public before management decides that it is time to do so, and has enacted a policy to attempt to forestall that event.

Nanny Sam To The Rescue: Stop the Startups! by Bob Rice in the Huffington Post

One of George Bush’s most memorable lines was his complaint that the French had no word for “entrepreneur”. Well, if Senator Dodd’s new financial reform bill becomes law, we may well have the word, but no longer any need for it. Dodd’s changes would disqualify about 75% of the individuals who currently fund our country’s early-stage ventures from making further investments. It would also impose brand new SEC filing requirements and long waiting periods on fledgling businesses before they can accept what is often desperately needed capital. If the idea is to strangle American innovation in its crib, the bill is a masterstroke.

SEC faces setbacks, skepticism in trying to reform its enforcement image by Zachary A. Goldfarb in the Washington Post

A year-long effort by the Securities and Exchange Commission to overhaul its enforcement of laws against corporate crime has run into courtroom setbacks and internal skepticism, underlining how difficult it is for the agency to remake itself as a get-tough cop.

FINRA and Placement Agents

Will FINRA step in to prevent a ban on placement agents working with government investors?

You may remember that last August, the SEC published a proposed rule that would create a prohibition on paying a third party, such as a placement agent, to solicit a government client on behalf of the investment adviser: IA-2910. The rule has generated lots of comments. The intent of the proposed rule is to prevent “pay-to-play” scandals. A noble and worthy goal.

The SEC seems to be softening its position on the placement agent ban. In a December 18 letter, the SEC asked FINRA if they would interested in crafting some rules for registered broker-dealers in dealing with government investors. Legitimate placement agents (such as FINRA-registered broker-dealers) “could be subject to separate regulations that might restrict their ability to engage in pay to play activities on behalf of their investment adviser clients.”

It took three months, but FINRA responded to the SEC with a “yes“.

“I am delighted to state that we are in a position to promulgate such a rule. We believe that the FINRA proposal should impose regulatory requirements on member broker-dealer placement agents as rigorous and as expansive as would be imposed by the SEC on investment advisers. We believe that a regulatory scheme targeting improper pay to play practices by broker-dealers acting on behalf of investment advisers is both a viable solution to a ban on certain private placement agents serving a legitimate function.”

It sounds like SEC is getting closer on making a decision about its pay to play rule. Perhaps the FINRA rule will make it easier to deal with.

In the interest of disclosure, my company uses placement agents in its dealings with investors, including government investors.

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Are Private Equity-Backed Companies More Likely to Default?

During the Great Panic, there was some grumbling that private equity-backed companies were posing a great risk to the economy.

The Private Equity Council has done some research and came to the conclusion that the opposite is true. They are less likely to default.

Of course, there are lots of caveats and distinctions in the report. Of course, there is my own disclosure since I work in private equity.

One issue is how you define a “default.” The Private Equity Council use the the ISDA’s definition in credit default swap contracts: (1) a missed payment or (2) a bankruptcy filing.

They exclude exchanges where the borrower buys back debt at a discount or swap the debt for equity. You can make an argument that these types of exchanges are opportunistic, and not a genuine attempt to avoid a bankruptcy filing. After all, if the company were really in such bad shape, why would the private-equity backers pour more money into the deal by buying the debt or diluting their equity.

The Private Equity Report was largely in response to a report from the Boston Consulting Group and a second report from Moody’s Investor Service.

Get Ready for the Private Equity Shakeout

The problem with the Boston Consulting Group’s study, Get Ready for the Private Equity Shakeout, is that they used the credit spreads in November 2008. They found that 60% of the private equity portfolio companies had their debt trading at distressed levels.

I have to agree with the Private Equity Council when they find fault with that calculation. Credit spreads were huge for every company in November 2008. The economy was in the grips of the Great Panic for liquidity.

The PEC’s chart shows that the default rates have not held up to the BCG estimate.

$640 Billion & 640 Days Later

The big issue with the Moody’s report is that it includes “distressed exchanges” in their definition of default. More than half of the defaults in the Moody’s study fell into this category. Of those, about 70% were exchanges at less 15¢ on the $1. I would be hard-pressed to say at debt purchase at 90% of par should be considered a default. At 15% you are looking more like a default.

However, the Moody’s report ended up concluding that the 186 LBO deals in the study had roughly the same default rate as similarly rated companies.  Where Moody’s found the biggest problem was the biggest LBO deals from January 2008 to September 2009. Six of the ten were considered distressed or defaulted.

On the other hand, the study’s time frame was during the most tumultuous period in the financial markets for decades. Things are much calmer now than they were in September 2009.

What’s Ahead

How should I know? I’m just a compliance guy banging away on his keyboard. But it is hard to ignore upcoming debt maturities. Even though companies may be current on their debt service, all of that cheap debt is going to be hard to replace when it matures.

It is clear to me that we should be skeptical about statements that private equity transactions pose an exceptional risk to the financial system. Those statements are not backed up by the data.

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Accredited Investors under the Restoring American Financial Stability Act

Senator Dodd

One of the surprises in the Restoring American Financial Stability Act of 2010 is that it proposes to raise the standard for being an accredited investor. Section 412 of the bill would require the SEC to increase the dollar thresholds to be qualified as an accredited investor. Section 413 would require the GAO to study the appropriate criteria.

The current standards come from Section 2(a)15 of the Securities Act of 1933

ii. any person who, on the basis of such factors as financial sophistication, net worth, knowledge, and experience in financial matters, or amount of assets under management qualifies as an accredited investor under rules and regulations which the Commission shall prescribe.

In 1982, the SEC prescribed the standard in Rule 501 of Regulation D:

5. Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his purchase exceeds $1,000,000;

6. Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;

If you adjust for inflation from 1982, those levels could increase to $459,000 if single and $688,000 if married, with the net worth requirement becoming $2.29 million. The bill is not clear on what to use as an inflation index. I used the Consumer Price Index for All Urban Consumers (CPI-U) comparing March 1981 (94.5) to February 2010 (216.741).

The Private Fund Investment Advisers Registration Act passed by the House in the Wall Street Reform and Consumer Protection Act of 2009 (H.R.4173) required the SEC to start increasing the asset levels. The Dodd bill (still not in the Thomas system) takes the issue on more forcefully.

The result is that there will be fewer investors for private investment funds. Under and , you are limited to 35 non-accredited investors in a private fund offering, with an unlimited number of accredited investors.

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Incentives, Productivity and NUMMI

I recently listened to a great show from This American Life. They covered the story of New United Motor Manufacturing Inc. (NUMMI). General Motors and Toyota opened NUMMI in 1984 as a joint venture so Toyota could start building cars in the US. Toyota showed GM the secrets of its production system and how Toyota made cars of much higher quality and much lower cost than GM.

There are some great lessons in the story for compliance professionals. In part because the story can be seen through the lens of incentives and corporate culture. Two topics that are important to compliance.

For GM plant managers, their pay was based on productivity. They needed to get lots of cars out the door at the end of the assembly line. It didn’t matter whether the car could drive off the line or had to be towed. Workers told the story of cars coming off the line with a Monte Carlo having the front end of a Regal. They would just let them run down the line and out into the yard. Then they were fixed out there (with overtime). The emphasis was on quantity. At GM, the production line could never stop.

The Toyota system empowered the line workers to stop the line if there was a problem they couldn’t fix. The emphasis was to fix the problem at its source and not defer it for later. The emphasis was on quality. (Some of the recent problems at Toyota can be blamed on changing their focus to quantity. They wanted to be the biggest car company in the world.)

In spreading the Toyota system, there was resistance from both the company and the union. The union was opposed because the system was more efficient and would reduce the workers at a plant by 25%. The NUMMI plant was the re-opening of a shut down GM plant. The union was out of work and was more open to change. It was either change the way you work or don’t work at all.

GM had trouble empowering its worker and changing the corporate culture that comes along with the Toyota production line. They thought workers would just stop the line to play cards and get coffee.

Its worth an hour of your time to listen to the story.

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