Month: April 2010

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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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.
Sources:

  • 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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