Month: June 2011

Insider Trading: A Dirty Business

One of the major tactics of hedge funds is to “arbitrage reality”, operating with a better understanding of a company and its stock price than other participants in the market. In a legitimate operation, that means lots of research. On the wrong side it means getting inside information about a company’s earnings, upcoming deals, and other inside information.

The hedge fund most notably found to be operating on the wrong side was the Galleon Group run by Raj Rajaratnam. On May 11th he was found guilty on all fourteen counts of securities fraud and conspiracy to commit securities fraud. His sentencing is scheduled for July 29th. His appeals will go on for years.

George Packer puts together an insightful look at the Rajaratnam as a lens to explore the difficulties in getting a guilty verdict for insider trading and for prosecutions coming out of the financial crisis in a long article in The New Yorker: A Dirty Business.

I don’t think Rajaratnam’s guilty verdict was a surprise to anyone. Maybe it was a surprise to him and his lawyer. The feds had wiretaps and what appeared to me to be very solid evidence. One of the biggest difficulties is showing the flow of information to show that the trade happened based on material, non-public information. For a company insider or company adviser that is more straightforward than finding that information with a third-party trader. Without the flow of information you can’t show that the use of the information was in breach of a duty.

The death blow in the Rajaratnam trail was Rajat Gupta, a member of the Goldman Sachs’ board of directors. At a board meeting they discussed Warren Buffett’s proposed investment of five billion dollars in Goldman Sachs. The meeting ended at 3:54 P.M. Sixteen seconds later, Gupta called Rajaratnam’s office. At 3:58, just two minutes before the markets closed, Rajaratnam gave an order to buy three hundred and fifty thousand shares of Goldman stock. Fit him for a pinstripe jumpsuit.

Goldman Sachs chairman and chief executive, Lloyd Blankfein was in the witness stand at the Rajaratnam trial. But he was merely there to say that Rajat Gupta had violated the company’s confidentiality rules.

Did insider trading cause the 2008 financial crisis? Did it even play a role?

I’m in the camp with Charles Ferguson, the director of Inside Job, that the financial crisis was caused primarily by shoddy mortgages and trading of those bad loans. But unlike Ferguson, I think the ultimate crisis was caused by greed and stupidity.

The top executives of financial institutions were likely unaware or perhaps willfully ignorant of the low-level players who were originating the toxic mortgages and the packaging of the toxic mortgages into even more toxic mortgage-back securities. Delusion, stupidity and greed are not illegal.

Going back to insider trading, the push for information arbitrage is really a push to the edges of ethical and legal operation. Pushing back from the edge is a person’s morality, their sense of right and wrong. The hammer to that morality is potential prosecution for going past the edge. Packer refers to a 2007 of twenty-five hundred Wall Street professionals.

They were asked if they would use inside information to make ten million dollars if the chances of getting caught were fifty per cent. Seven per cent said yes. But, if there was zero chance of getting caught, fifty-eight per cent said that they would break the law.

That is the real problem with under-funding of the SEC. Without sufficient resources, their hammer of prosecution seems like a negligible risk. If traders see their peers trading on inside information and not getting caught, they are more likely to push past that legal edge. The  Rajaratnam is an important signal that you can get caught.

To be effective the SEC needs more cases, not just bigger cases.

Sources:

Nobody Expects The Spanish Inquisition

The most dangerous parts of managing risk are the risks you don’t expect. Looking back at my old four-box analysis, there are really two types of unexpected risks, the risk that you know that you don’t know and the risk that you don’t know that you don’t know. In the first case you know there is an unexpected risk. In the second, you missed that there was an even a risk.

The second case has been labeled the Black Swan. Those type of risks are well written about by Taleb.

While staying up late and watching some Monty Python, I came to the conclusion that the first case is the “Spanish Inquisition.” You know the Spanish Inquisition is out there roaming the countryside. You just don’t now when or where they will appear.

You also don’t know the danger. Their two weapons are fear and surprise…and ruthless efficiency.

What do Wyoming, New York, and Minnesota Have in Common?



They don’t examine investment advisers.

Wyoming has long been on this list because it does not have a law regulating investment advisers. In Item 2 of Form ADV there was a box to check if your principal office and place of business was Wyoming. That kept you in SEC registration.

The importance of whether a state does exams affects mid-sized advisors. Dodd-Frank allows mid-sized advisors to stay with SEC registration instead of state registration if their home state doesn’t do exams.

At last week’s SEC Open Meeting on the new investment adviser act rules, Bob Plaze, associate director of the SEC’s Division of Investment Management, revealed that New York did not respond in writing to the SEC’s question about investment adviser examinations. The SEC took the position that a non-response was a statement that the state doesn’t examine investment advisers.

Minnesota responded that they don’t conduct exams.

This means mid-sized advisers in Wyoming, New York, and Minnesota won’t have to switch to state supervision if they have between $25 million and $100 million in assets under management.



Will Private Equity Fund Managers Register or be Exempt?

The SEC extended the deadline for private fund managers to register with the Securities and Exchange Commission as investment advisers from July 21, 2011 to March 30, 2012. That’s a long enough period of time for legislation to intervene and grant a new exemption for private equity fund managers.

Dodd-Frank has a new exemption for venture capital fund managers.  There was an exemption for private equity fund managers in early drafts of the legislation, but that exemption never made it into the final law.

Now the Republican-controlled House is trying to re-create the exemption.

The Small Business Capital Access and Job Preservation Act was approved by a House Committee on Financial Services.

“Given the costs of registration and compliance, subjecting private equity advisers to this regulation diverts capital, time, talent and effort from activities that result in job creation. By tailoring registration requirements to exempt advisers to private equity funds, the bill strikes a better balance between the benefits of adviser registration and its costs.”

The bill is not without its critics. The North American Securities Administrators Association sent a comment letter to the committee.

First, NASAA attacks the failure to define the term “private equity fund.” The bill delegates this task to the SEC. This was the same approach used for venture capital fund managers in Dodd-Frank. However that common label is better understand than the broad range of investment strategies and risks that fall under the private equity label.

Second, NASAA is concerned that the bill is unclear as to what, if any, reporting requirements would be required for this new defined group of private equity fund advisers. The bill exempts “private equity” from the registration and reporting requirements. That means venture capital would have some reporting obligations, but private equity would not. NASAA believes that the proposed exemption contained in Section 203(o)(1) would likely have the unintended consequence of depriving the SEC of regulatory information critical for assessing risk and protecting investors.

Third, NASAA observed that the bill’s scope appears to cover all investment advisers who advise “private equity funds.” The exemption is not limited to those who solely advise private equity funds. Theoretically, an adviser could set up a private equity fund and cover all of its operations that would otherwise be exempt.

I have an interest in this bill so my opinion is biased. I think many private equity fund managers are a poor fit under the requirements of the Investment Advisers Act. Registration and reporting will impose a regulatory burden that will do little to reduce risk or protect investors.

However, the bill is taking such a blatantly partisan and over-broad approach to a sensible exemption. It also seems to be packaged with the Small Company Capital Formation Act (H.R. 1010) and the Burdensome Data Collection Relief Act (H.R. 1062). The Small Company Capital Formation Act would raise the regulatory thresholds for exemption for registration with the SEC from $5 million to $50 million. The Burdensome Data Collection Relief Act repeals the obligations under Section 953(b) of Dodd-Frank for public companies to disclose the ratio of executive compensation to the median compensation of all corporate employees.

Two other bills, the Asset-Backed Market Stabilization Act and the Business Risk Mitigation and Price Stabilization Act were originally introduced with these three, but I haven’t seen any further action of those two.

Sources

Image of Washington DC – Capitol Hill: United States Capitol is by Wally Gobetz
CC BY-NC-ND 2.0

Compliance Bits and Pieces for June 24

These are some recent compliance-related stories that caught my eye:

What ‘Inside Job’ got wrong by Ezra Klein in the Washington Post

And ultimately, that’s what makes the financial crisis so scary. The complexity of the system far exceeded the capacity of the participants, experts and watchdogs. Even after the crisis happened, it was devilishly hard to understand what was going on. Some people managed to connect the right dots, in the right ways and at the right times, but not so many, and not through such reproducible methods, that it’s clear how we can make their success the norm. But it is clear that our key systems are going to continue growing more complex, and we’re not getting any smarter, or any less able to ignore risks that we know we should be preparing for. “Inside Job” may have missed that story, but the rest of us can’t afford to.

Flawed Incentives and Dubious Morals: JPMorgan & CDOs That Were “Built to Fail” by Matthew Philips in Freakonomics

See, the bankers at JPMorgan who sold these CDOs got paid regardless of how the things performed, whether every one of the thousands of mortgages stuffed into them paid off, or whether they all defaulted. So the incentive for the bankers was to sell as many CDOs as possible, even if they knew they were going to blow up in a year or two. It wasn’t their problem because it wasn’t their money. This raises an obvious moral question: were bankers morally remiss in pumping these mortgage bombs out into the world when they knew the wreckage they would cause? Or were they simply being good at their job?

Private Equity: compliance risk for portfolio company bribery? in The Bribery Act .com

Richard Alderman, Director of the SFO, has confirmed that in the SFO’s view Private Equity could have liability for the conduct of its investment portfolio businesses under the Bribery Act. … Speaking to an audience of Private Equity professionals Richard Alderman said that he assumed that those in the Private Equity industry have “a level of knowledge and due diligence that is very high because of the nature of what you do. You are, therefore, very well informed investors  with a high degree of knowledge of what happens in the companies you invest in. In any dealings we have with you on cases we are likely to start from that assumption.”

What Does The SEC FCPA Unit Chief Do? in the FCPA Professor

Given Cheryl Scarboro’s recently announced departure from the FCPA Unit Chief position (see here for the prior post), the SEC recently posted (here) the opening for the position. The “Major Duties” portion of the job posting is actually an interesting and informative read. Want proof that the SEC executes “targeted sweeps and sector-wide investigations.” It is in the job description.

SEC Extends Deadline and Adopts Rules for Advisers and Private Funds

At an open meeting on June 22, the Securities and Exchange Commission adopted new rules under the Investment Advisers Act of 1940 aimed at investment advisers, private fund managers, venture capital funds, and family offices.

Based on the statements at the meeting, there will be three new rules would:

Delay Registration Deadline and a New Form ADV. The new registration/reporting deadline for new Advisers Act registrants and “exempt reporting advisers” will be March 30, 2012. Previously exempt private advisers, particularly those to hedge funds and private equity funds, will not be required to register until March 30, 2012. All advisers will be required to make a filing in the first quarter of 2012. Those previously registered advisers who no longer qualify for SEC registration will be required to withdraw by June 28, 2012.

The SEC staff pointed out that 2012 is a leap year, so the 90 day deadline is March 30 instead of March 31 in 2012.

Form ADV is going to change. No surprise. Under the amended adviser registration form, advisers to private funds will have to provide:

  • Basic organizational and operational information about each fund they manage, such as the type of private fund that it is (e.g., hedge fund, private equity fund, or liquidity fund), general information about the size and ownership of the fund, general fund data, and the adviser’s services to the fund.
  • Identification of five categories of “gatekeepers” that perform critical roles for advisers and the private funds they manage (i.e., auditors, prime brokers, custodians, administrators and marketers).
  • More information about conflicting or potential conflicting relationships.

Define Venture Capital Funds. Under the definition, a venture capital fund is a private fund that:

  • Invests primarily in “qualifying investments” (generally, private, operating companies that do not distribute proceeds from debt financings in exchange for the fund’s investment in the company); may invest in a “basket” of non-qualifying investments of up to 20 percent of its committed capital; and may hold certain short-term investments.
  • Is not leveraged except for a minimal amount on a short-term basis. Borrowing is limited in time as well.
  • Does not offer redemption rights to its investors.
  • Represents itself to investors as pursuing a venture capital strategy.
  • Is not registered under the Investment Company Act.

There will be a rule on grandfathering substantially as proposed in November, with the three conditions that the fund had been represented to be a “venture capital fund,” that the first closing was prior to December 31, 2010 and that no new capital commitments are made after July 21, 2011.

The new category of venture capital fund advisers and other “exempt reporting advisers” will file portions of Part 1 of Form ADV. Commissioner Schapiro noted that there was no current intention to subject exempt reporting advisers to routine examinations, while also noting that the SEC retains the authority to examine those advisers in its discretion. The Staff noted that the Form ADV will include a uniform calculation for “assets under management.”

Family Office Exemption. This exemption should be consistent with no-action relief previously provided and the proposed rule. It sounds like there will be some expansion to address a broader universe of permitted family clients and ta longer transition period (through December 31, 2013) for the termination of relationships with charitable entities that were not exclusively funded by the family.

These rules will have completed most of the rulemaking required under Title IV of Dodd-Frank, the Private Fund Investment Advisers Registration Act.

My printer is still cranking out the text of the new rules and I need to dive deeper into the details.

Sources:

Sometimes You Get Stuck and Can’t Get Out

Finally, the SEC is going to take some action today on the regulation of investment advisers, venture capital funds, and private fund managers.

For years, they’ve been trying to get regulatory control of private funds. Now they are going to get it.

Do they really want it?

Sometimes what you want to do is not a good a choice. As a case in point, I give you a kitten crawling inside a hamster ball.

Sure it’s cute. But you end up with a pissed-off kitten.

The Open Meeting for June 22 is all about the Investment Advisers Act.

Agenda:

Item 1: The Commission will consider whether to adopt new rules and rule amendments under the Investment Advisers Act of 1940 to implement provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act. These rules and rule amendments are designed to give effect to provisions of Title IV of the Dodd-Frank Act that, among other things, increase the statutory threshold for registration of investment advisers with the Commission, require advisers to hedge funds and other private funds to register with the Commission, and address reporting by certain investment advisers that are exempt from registration.

Item 2: The Commission will consider whether to adopt rules that would implement new exemptions from the registration requirements of the Investment Advisers Act of 1940 for advisers to venture capital funds and advisers with less than $150 million in private fund assets under management in the United States. These exemptions were enacted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The new rules also would clarify the meaning of certain terms included in a new exemption for foreign private advisers.

Item 3: The Commission will consider whether to adopt a rule defining “family offices” that will be excluded from the definition of an investment adviser under the Investment Advisers Act of 1940.

The word I’ve heard is that the July 21, 2011 deadline will be extended to March 31, 2012.

Enterprise 2.0 – Regulatory and Compliance Concerns

I’m once again speaking at the Enterprise 2.0 Conference.

Social Media & Social Networking: Some Cautionary Tales (Location: Room 312)

Social media (Twitter, LinkedIn) and enterprise social networking solutions (profiles, activity streams, social analytics) can deliver compelling business value. However, benefits do not come without risks. This panel discussion with experts and practitioners will provide insight as to the policy, governance, and security issues warranted to mitigate risks.

Moderator – Mike Gotta, Senior Technical Solution Marketing Manager for Enterprise Social Software, Cisco
Panelist – Julie LeMoine, Enterprise Collaboration, Innovation Expert
Panelist – Doug Cornelius, Chief Compliance Officer, Beacon Capital Partners LLC
Panelist – Stew Sutton, Principal Scientist, Knowledge Management, The Aerospace Corporation
Panelist – Suzanne McGann, Social Media Program Manager, Global Interactive Strategy, Medtronic

The session is Tuesday afternoon, 2:30 to 3:30 in Room 312 at the Hynes Convention Center. Stop by if you can.

Be Mindful of Compliance Costs

That story is title does not come from me; it’s a quote from  Commissioner Troy A. Paredes of the Securities and Exchange Commission.

We cannot simply focus on the costs and benefits of a single rule change on a stand-alone basis. It is the totality of the regulatory infrastructure that impacts the private sector. As part of this analysis, we need to be mindful of compliance costs. It is costly for firms to comply with the regulatory obligations they confront both in terms of out-of-pocket expenditures, as well as the opportunity cost of the time and effort of personnel that could have been directed toward other productive endeavors. Indeed, the compliance burden on investment advisers has increased of late due to, for example, the need to comply with the new “pay-to-play” rule restricting political contributions; the recent amendments to Part 2 of Form ADV concerning the preparation and delivery of a “brochure” and “brochure supplements” to advisory clients; and the recent amendments to the custody rule.

The Commissioner was giving a speech to the Hedge Fund Regulation and Current Developments symposium at the Center for Law, Economics & Finance at the The George Washington University Law School on June 8.

There was lots of blame thrown at the hedge fund industry after the financial crisis of 2008 with very little data to support the accusations.  Commissioner Parades also addressed this point:

Regulatory decision making should be supported by data, to the extent available, and economic analysis. This is particularly important to stress insofar as the SEC is concerned, because the SEC is an agency that traditionally has overwhelmingly been comprised of lawyers. Empirical analysis must be much more central to decision making at the SEC than has been the case.

Commissioner Parades is just one of five commissioners, so his position is not necessarily a controlling influence. But it’s still good to see that at least part of the SEC is focusing on there being better regulatory, not just more regulatory control

Sources:

Compliance Bits and Pieces for June 17

These are some  compliance-related stories that caught my attention:

Still Writing, Regulators Delay Rules by Louise Story in the New York Times

Regulators overseeing financial reform are delaying many of the planned changes in the immense market for complex securities known as derivatives because they are running drastically behind schedule in writing their new rules.

The Road To Corruption by Richard E. Messick in The FCPA Blog

A new World Bank study on corruption in the roads sector shows the challenges contractors and engineering firms working in developing countries face when trying to avoid being drawn into schemes that violate the Foreign Corruption Practices Act or the anti-corruption laws of other nations or both.

What Codes of Conduct Should Really Achieve by Matt Kelly in Compliance Week‘s The Big Picture

If you’ve read any news coverage of Straus-Kahn and the IMF, you’ve already seen the startling fact that the IMF actually had two codes of conduct: one for senior executives, another for everyone else. The sheer stupidity of that should be self-evident to anyone who cares about corporate governance and conduct. It strikes anyone, even the rest of the world that doesn’t care about corporate compliance on a daily basis, as a double-standard that encourages all employees to ignore both codes.

The SEC Releases its 29th Annual Small Business Capital Formation Report in 100 F Street

Earlier today the Securities and Exchange Commission released its Final Report from the 29th Annual Forum on Small Business Capital Formation held in November 2010. This year’s forum yielded 36 recommendations from three working groups and a number of written recommendations submitted by organizations concerned with small business capital formation.