Month: March 2009

Short Bites

Here are a few stories and items that caught my eye, but I have not had time to build-out to a full post:

Reminder to Review Insider Trading Compliance by Melissa Klein Aguilar for Compliance Week

The SEC settled an administrative proceeding this month involving Merrill Lynch based on the firm’s failure to have adequate procedures regarding its “squawk box” to prevent day traders from overhearing and using material non-public information regarding unexecuted institutional orders. That case, along with a 2008 report of an investigation issued last year regarding the Retirement System of Alabama, suggest that “the prudent approach for issuers is to carefully review the adequacy of their procedures for handling inside information,” says Gorman. Those procedures should be carefully tailored to the specific business of the company.

Madoff to Stay Behind Bars Pending Sentencing from the WSJ Law Blog

The Second Circuit earlier Friday affirmed the ruling of the federal district court judge overseeing Madoff’s case, Denny Chin, who had ordered Madoff detained for the months leading up to sentencing, currently slated for June 16. A copy of the Second Circuit’s ruling; A LB post from last week on Madoff and his prison prospects.

Risky Business Did compliance programs fail the test during the financial industry meltdown? by David Hechler for Corporate Counsel

Cox got no argument from his audience of chief compliance officers. But the rest of us may be forgiven for wondering what the compliance officers, and the risk officers, and the ethics officers were doing at the financial services firms when their colleagues were placing those dangerous wagers. Weren’t all those internal controls supposed to protect companies from catastrophe?

Placebo Ethics by Usha Rodrigues and Mike Stegemoller

While there are innumerable theories on the best remedy for the current financial crisis, there is agreement on one point, at least: increased transparency is good. We look at a provision from the last round of financial regulation, the Sarbanes Oxley Act of 2002 (“SOX”), which imposed disclosure requirements tailored to prevent some of the kinds of abuses that led to the downfall of Enron. In response to Enron’s self-dealing transactions, Section 406 of SOX required a public company to disclose its code of ethics and to disclose immediately any waivers from that code the company grants to its top three executives. These waivers offer a unique window not only into ethical practices at public U.S. companies, but also into how disclosure works “on the ground” -whether companies are actually complying with disclosure rules and whether these rules prevent self-dealing transactions.

Federal Stimulus Bill and TARP Mandate Additional Corporate Governance Requirements by Corporate Compliance Insights

After The American Recovery and Reinvestment Act was passed, the Say on Pay provisions for executive compensation received a great deal of coverage and scrutiny from the national media. Certainly, the Say on Pay provision for companies participating in the Troubled Assets Relief Program (TARP) is one of the most important corporate governance mandates in the Stimulus Bill; but it is far from the only concern for companies receiving government funding.

Internal Audit: The Board’s Agent on the Ground by Mr. David Chiang for Corporate Compliance Insights

As the board chair of a university and a member of several audit and finance committees including that of billion-dollar community not-for-profit organization, I’ve seen first-hand why it’s critical to establish and support an effective internal auditing department. Internal audit needs to comply with industry best practices and develop a strong reporting relationship to the audit committee.

Audit Committee Brief – February 2009 (.pdf) by Deloitte

A recent Deloitte survey found that current market conditions have caused audit committees to change their focus. Today, audit committees are examining liquidity, impairments, enterprise risk management, and financial reporting disclosures more closely.

How to reduce the cost of audits, operations, training and compliance with SharePoint!

These are my notes from a webinar presented by Knowledge Management Associates, Inc. that featured speaker: Sean Megley, KMA SharePoint Architect and resident “compliantist.”

What contributes to the cost of compliance?:

  • Lack of Tools
  • Ad hoc audits
  • Random frameworks
  • Unreliable results

Sean thinks we should free ourselves from the “tyranny of spreadsheets and email!”

The greater the number of people you can get involved in compliance, the better the results. You want it to be easy, you want to get lots of people involved, and you want it to be part of the workflow. He thinks using SharePoint as a central database and portal effectively centralizes the processes and information.

Being in compliance means that you have evidence of compliance. You need a log to prove the steps you have taken.

Sean went through some more theories of compliance and then moved on to display a model SharePoint portal for compliance. The portal also incorporates InfoPath for replicated business processes. The portal logs the forms and data from InfoPath.

Sean used a wiki as a way to communicate, with links to key documents and policies.

Sean notes that the heart of SharePoint is a document repository. You can store documents and wrap information around the documents.

SharePoint has an alert feature built into its lists and libraries. The alert can trigger action based around compliance. SharePoint will let you know when something is changed or added.

SharePoint has key performance indicators (KPIs) to track controls.

Knowledge Management Associates is offering to pre-package the portal with controls and regulatory requirements built-in as a starting point. For example, he has put the text of a regulation and then mapped it to the controls of the company.

Why SharePoint and not Excel? SharePoint takes information in a spreadsheet and exposes it for other people to see and to allow other inputs and logging of changes.

SharePoint can be used for project management. It has a rudimentary Gannt chart tool.

The big question is whether you want to inflict SharePoint on your co-workers and IT staff.  It can be a beast to manage and some of the 2.0 tools barely work.

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Model COBRA Subsidy Notices Released

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The American Recovery and Reinvestment Act of 2009 included some relief for laid-off employees. One of the biggest is a 65% subsidy for the payment of health plan payment from the government for certain eligible participants in COBRA health plan continuation coverage. ARRA mandates that health plans notify certain current and former participants and beneficiaries about this premium reduction.

The Department of Labor created and published model notices to help plans comply with these new requirements. Each model notice is designed for a particular group of qualified beneficiaries and contains information to help satisfy ARRA’s notice provisions.

General Notice – Full version (.doc) Plans subject to the Federal COBRA provisions must send the General Notice to all qualified beneficiaries (not just covered employees) who experienced a qualifying event at any time from September 1, 2008 through December 31, 2009, regardless of the type of qualifying event. This full version includes information on the premium reduction as well as information required in a COBRA election notice.

General Notice – Abbreviated version (.doc)  This version may be sent instead of the full version to individuals who experienced a qualifying event sometime on or after September 1, 2008, have already elected COBRA coverage, and still have it. This abbreviated version of the General Notice includes the same information as the full version regarding the availability of the premium reduction under ARRA, but does not include the COBRA coverage election information.

Alternative Notice (.doc) Insurance issuers that provide group health insurance coverage must send this Alternative Notice to persons who became eligible for continuation coverage under a State law. Continuation coverage requirements vary among States, and issuers should modify this model notice as necessary to conform it to the applicable State law. Issuers may also find the model Alternative Notice or the abbreviated model General Notice appropriate for use in certain situations.

Notice in Connection with Extended Election Periods (.doc) Plans subject to the Federal COBRA provisions must send this Notice to any assistance eligible individual (or any individual who would be an assistance eligible individual if a COBRA continuation election were in effect) who:

1. Had a qualifying event at any time from September 1, 2008 through February 16, 2009; and
2. Either did not elect COBRA continuation coverage, or who elected it but subsequently discontinued COBRA.

This notice includes information on ARRA’s additional election opportunity, as well as premium reduction information. This notice must be provided by April 18, 2009.

Unfortunately, the new information does not provide guidance on the definition of what constitutes an “involuntary termination” for purposes of the new COBRA premium subsidy. I have heard that the IRS is working on this guidance and may make it available in the next two weeks.

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Hedge Funds and Fraud: The Future of Due Diligence

Garrity, Graham, Murphy, Garofalo & Flinn and PRMIA (Professional Risk Managers International Association) sponsored a webinar that focused on the signs of fraud and what you can do detect fraud in the context of hedge funds.

The agenda and my notes:

  • The profile of a fraudster (James Tunkey, I-OnAsia)
  • The psychology of the gullible investor (Stephen Greenspan Ph.D., Clinical Professor of Psychiatry, University of Colorado)
  • Current legal and regulatory requirements for hedge funds (Philip Thomas, Esq., Garrity Graham)
  • A hedge fund insider’s view (Samuel Won and Greg Ivancich, Global Risk Management Advisors, Inc.)
  • The regulatory future for hedge funds (Philippa Girling, Esq., FRM, Garrity Graham)

James Tunkey of I-OnAsia, started off with The Profile of a Fraudster. He is a certified fraud examiner. His focus was on the incentives, structures and control systems in an organization.

James put forth the proposition that Fear, Greed, and Honor are the three drivers of fraud. In the context of private investment funds, they are driven by the fear and honor of not making investment targets. There is greed trying to make more money for themselves.

Stephen Greenspan focused on the psychology of the gullible investor. (He has a new book out Annals of Gullibility and an article in the Wall Street Journal: Why We Keep Falling For Financial Scams.) Everybody is capable of being scammed (and probably have been). Stephen has also been scammed. He was a Madoff investor. He breaks a foolish action into three different groups: (1) practically foolish act, (2) non-induced socially foolish action, and (3) induced socially foolish action. It is this induced socially foolish that is gullibility.

Stephen pointed out that investor mania is like a Ponzi scheme. The early investors tell others about how wonderful their investments performed. There is a social feedback loop that drives the mania. The scam artists are skilled manipulators at using these factors.

Phillip Thomas looked at some regulations in place and steps you can take as part of the diligence. He pointed out that in today’ s environment, it is not a good time to be cutting back on compliance.  He led a discussion through some recent court cases to highlight some of the issues.

Disclosure, potentially manipulative practices, and valuation are three hot regulatory topics. There are several rules in place limiting the sale and reconciliation of securities. As for valuation, you should have a segregation of responsibilities and oversight.

Some tools that don’t work very well.

  • The due diligence questionnaire. These are probably canned responsibilities and are unlikely to uncover problems
  • Form ADV. Also have canned answers
  • Interview of Managers. He thinks this is a good a tactic, at least as a smell test.
  • References. The problem is that they will only give you good references.

He thinks out that you should run a background investigation of the principals.

He moves on to some best practices for due diligence:

  • Don’t take anything from the fund manager at face value
  • Be suspicious of a manager limiting access to information
  • Consult specialist professionals who will be able to spot irregularities
  • Pay attention to what industry leaders are saying and doing about best practices.

Samuel Won and Greg Ivancich presented the view from inside a hedge fund. They believe people were too busy chasing returns during the extended bull market to spend time and energy on due diligence. Too many people just did check the box diligence and did not take a close look.  Investors did not look at the underlying processes and operations at their investment funds.

They also see a regulatory sea change coming, likely to be draconian and over-reaching. They expect to see changes in requirements from institutional investors. Firms may also use the existence of their risk management and compliance as competitive differentiators. There will also be some new best practices emerging.

They see a need for independence. it is important not just to have an independent audit of financial statements, but also of infrastructure, processes, controls, investment style, valuation, and risk management.

Philippa Girling looked at the global political reaction to the current crisis and how it will affect hedge fund regulation.  Germany and France are pushing for deeper regulation that the U.S. IMF is also pushing. (Any country using the term “shadow financing” wants more regulation.) The European Union as a whole is looking to regulate hedge funds.

There are several proposed laws at the federal level: The Hedge Fund Adviser Registration Act, Supplemental Anti-Fraud Enforcement Act Markets Act, and the Hedge Fund Transparency Act. There are also some proposed hedge fund laws in Connecticut.

What can we do?

  • Anticipate regulatory developments
  • Anticipate increased due diligence
  • Establish appropriate protections to meet anticipated regulations and investor demands. (We have already seen the Obama administration putting a short time line on enacting regulatory problems.)
  • Evaluate risk
  • Manage compliance
  • Ensure Anti-Money laundering procedures are in place
  • Conduct fraud assessments
  • Review current documents for improvement to current best practices
  • Be ready for enhanced due diligence visits from potential investors

Some of the more interesting questions from the Q&A sessions:

What are the most important red flags?

  • A manager not delivering information, instead standing alone on their reputation
  • Lack of third party administrator/custodian

Will regulation just lead to more avoidance?

  • SEC registration does not mean there has been an effective review
  • The UK centralized model takes away the US regulatory arbitrage (different agencies reviewing different types of investment companies)
  • Companies may flee to less-regulated places

More on Madoff’s Auditor

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Yesterday, Madoff’s auditor was arrested for falsely stating that the firm had audited the financial statements. No surprise that such a small firm could be auditing a supposedly large investment company like Madoff Investments.

Just in time, the AICPA (that’s the American Institute of Certified Public Accountants) has expelled Friehling from its membership following an ethics investigation.

“Although Mr. Friehling is not charged with knowledge of the Madoff Ponzi scheme, he is charged with deceiving investors by falsely certifying that he audited the financial statements of Mr. Madoff’s business,” said acting U.S. Attorney Lev Dassin.

Like his client, Mr. Madoff, Mr. Friehling was released on bail. He apparently post a $2.5 million bail bond and walked free, for now.

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Iceland’s Meltdown

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With all of the focus in the United States on the collapse of Bear Stearns, AIG, Lehman Brothers, and Merril Lynch, we may be a bit myopic in not noticing other issues around the world. Iceland stands out as a country that has really run into trouble. As Michael Lewis wrote in Wall Street on the Tundra: “Iceland instantly became the only nation on earth that Americans could point to and say, ‘Well, at least we didn’t do that.’”

The collapse has been so big that Iceland is abandoning its own currency to join the European Union. Until the collapse, Iceland had little interest in joining the EU. They do want the bureaucrats in Brussels messing with their fishing. Iceland put some excellent regulatory controls on fishing that have lead to stable fish populations and rich fishermen.

They failed to do the same with their financial system. They ended up having fisherman quitting the sea to engage in currency trading.

There are lots of lessons to be learned from a compliance and risk management perspective.

Legend has it that Joe Kennedy cashed out of the stock market when his shoeshine boy gave him stock tips. Maybe a warning sign should be fishermen engaging in currency trading. We saw similar events in the U.S. as people quit their jobs to be real estate entrepreneurs. I heard a success story from an acquaintance who told of buying a house for 100, putting in 10 and selling it for 120. I didn’t have the heart to tell him that house prices has risen by 15% during that same time frame. A rising market makes everyone look like a genius.

As Michael Lewis points out “One of the hidden causes of the current global financial crisis is that the people who saw it coming had more to gain from it by taking short positions than they did by trying to publicize the problem.” You saw that with Iceland’s collapse and you saw that with the collapse in the United States. The most publicity shined on Goldman Sachs for its profits in September 2007 made from shorting mortgage positions. I am sure that there were quite a few mortgage originators who knew they were peddling garbage. But they had no incentive to stop the income coming from origination fees.

The three biggest banks in Iceland, a country of only 310,000, made loans totaling over 850% of Iceland’s Gross Domestic Product.  Only 1/5 of the loans were in Iceland’s currency. They instead borrowed from their banks in cheaper currencies such as yen and Swiss francs. To compare, the balance sheet of Britain’s banking system was at 450% of GDP and the US at 350%. Clearly, carrying too much debt is a problem. Especially when their are few alternative sources of capital besides more debt.

Iceland’s debt load increased from 200% of GDP in 2003 to almost 1000% in 2008. That is an enormous growth curve. Even steeper than the rise of housing prices in the United States.

Economic cycles are part of human nature. We overbuy into good times and oversell in bad times. It easy enough to look back a few years to the Dot-Com bubble focusing on market share and eyeballs at the expense of the bottom line.

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Madoff’s Auditor Arrested

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With Madoff in jail, it is time for the rest of his crew of fraudsters to join him.  Next up….

David G. Friehling, the sole practitioner at Friehling & Horowitz, CPAs, PC, has been charged with securities fraud, aiding and abetting investment adviser fraud and four counts of filing false audit reports with the Securities and Exchange Commission. The complaint alleges that Friehling enabled Madoff’s Ponzi scheme by falsely stating that the firm had audited the financial statements. Friehling & Horowitz also made representations that Friehling reviewed internal controls, including controls over the custody of assets, and found no material inadequacies. The complaint alleges that all of these statements were materially false because Friehling did not perform a meaningful audit. The SEC alleges that (1) Friehling merely pretended to conduct minimal audit procedures to make it seem like he was conducting an audit, (2) he failed to document his findings and conclusions, and (3) if properly stated, those financial statements would have shown that Madoff owed tens of billions of dollars in additional liabilities to its customers.

“Although Mr. Friehling is not charged with knowledge of the Madoff Ponzi scheme, he is charged with deceiving investors by falsely certifying that he audited the financial statements of Mr. Madoff’s business,” said acting U.S. Attorney Lev Dassin.

If you are wondering about the Horowitz half of Friehling & Horowitz, he was apparently the Madoff auditor for many years before handing the account to his son David G. Friehling in the early 1990’s. If Madoff’s wrongdoing goes far enough back, Horowitz may need to worry about ending up in a prison cell next to his son-in-law. (UPDATE: Maybe not, since he passed away recently.)

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You’re a Victim of a Ponzi Scheme, But What About Your Taxes?

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You missed the warning signs and got suckered into a Ponzi scheme. Can the IRS help by giving you some tax relief? This is a critical issue for long-term Ponzi scheme investors (like some of the Madoff victims) who have paid taxes on gains from the investment. After all, they have been paying real taxes on fictional gains.

The IRS has stepped up with guidance on what to do. They clarified the federal tax law governing the treatment of losses in Ponzi schemes. They also set out a safe harbor method for computing and reporting the losses.

The revenue ruling (2009-9) addresses the difficulty in determining the amount and timing of losses from Ponzi schemes and the prospect of recovering the lost money.  Some of the older guidance from the IRS on these losses is somewhat obsolete.

The revenue procedure (2009-20) simplifies compliance for taxpayers by providing a safe-harbor for determining the year in which the loss is deemed to occur and a simplified means of calculating the amount of the loss.

The first question is whether a loss from a Ponzi scheme is a “theft loss” or a “capital loss” under IRC §165? With the criminal intent of a Ponzi scheme, it is a theft loss. That also results in it being an itemized deduction that is not subject to the deduction limits in IRC §67 or IRC §68. You can read further in Revenue Ruling 2009-9 for more information.

Even with the clarification in the revenue ruling there many factual issues that have to be addressed to properly take the deduction. Given the ongoing investigations, it is hard to know the facts. So the safe-harbor in the revenue procedure draws some bright lines around what you need to take the deduction.

The first thing you need to determine is whether the Ponzi scheme was a theft. The revenue procedure provides that the IRS will deem the loss to be the result of theft if:

    • the promoter was charged under state or federal law with the commission of fraud, embezzlement or a similar crime that would meet the definition of theft; or
    • the promoter was the subject of a state or federal criminal complaint alleging the commission of such a crime, and
    • either there was some evidence of an admission of guilt by the promoter or a trustee was appointed to freeze the assets of the scheme.

      That seems to work very nicely with the facts for the Madoff scheme.

      Now that you can claim the theft loss, you need to calculate the amount of the loss. It may take years to find any assets and distribute them to the victims. Therefore, you have a problem figuring out the actual amount of the loss and the prospect of recovery. The revenue procedure generally permits taxpayers to take a deduction in the tax year they discover the loss and to deduct 95% of their net investment (less the amount of any actual recovery in the year of discovery and the amount of any recovery expected). If you are an investor suing persons other than the promoter (like the Madoff feeder funds), then your deduction is reduced by substituting “75%” for “95%”.

      This new guidance seems to address the phantom income concerns, but are predicated on the victims not filing amended returns for prior tax years. Are there other concerns that the IRS did not address?

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      Can You Prevent Ponzi Schemes?

      Charles Ponzi
      Charles Ponzi

      With Madoff, Nadel and Stanford in the news, people are wondering why the government does not prevent Ponzi schemes. The government should protect us from these frauds.

      How can they?

      Ponzi scheme sponsors are thieves. Common criminals. They just wear suits instead of black masks.

      The government has not been able to prevent bank robberies, car-jackings or pick-pockets. (I lump Ponzi schemes in with these.) What government can do is deter and punish. An effective detection and prosecution program may deter some bad guys. If you feel certain you will get caught and punished then you are less likely to commit the bad act. On the other side, if you feel certain that you will not get caught or punished, then you are more likely to commit the bad act.

      The inspiration of this post is an article from Tresa Baldas summarizing some of the current steps being taken: Wave of anti-Ponzi laws coming — but will they work? The US Congress has already introduced two bills in the last few weeks trying to increase transparency and registration of private investment funds: The Hedge Fund Transparency Act and the Hedge Fund Adviser Registration Act of 2009.

      Don’t forget that Madoff and Stanford were both registered with the SEC and subject to some form of SEC oversight. Clearly registration and transparency were not effective at stopping them. They will increase the paperwork. They will make it harder for private investment funds to execute their business plans.

      I guess as a compliance professional more regulation would be good for me. More regulatory oversight means more work for compliance. But I would rather focus my efforts on helping my company execute its business plan and making sure that nobody is cutting any corners to achieve that execution.

      But with a new administration and issues in the financial marketplace, I expect to see some form of new regulatory requirements. Will they prevent Ponzi schemes? No, the government cannot prevent Ponzi schemes.

      Investors prevent Ponzi schemes. If it sounds too good to be true, it probably isn’t true. Guaranteed returns with no risk? It better be a bank with FDIC insurance (or the equivalent).

      Thanks to Bruce Carton of Securities Docket for pointing out the Baldas article in his post: Wave of “Anti-Ponzi” Legislation May be Coming.

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