Month: September 2011

Compliance Bits and Pieces for September 16

Here are some recent compliance related stories that caught my attention:


How do You Evaluate a Risk Assessment? by Tom Fox

What is the amount of risk that your company is willing to accept? Before you even get to this question how does your company assess risk and subsequently evaluate that risk?

CEO pushes Reg FD limits on Twitter by Dominic Jones in IR Web Report

I applaud Meckler’s use of Twitter to communicate with investors. In an era where institutional investors spend billions annually to glean important information through private access to company executives, Twitter and other new media channels democratize access for all and can help to rebuild public confidence in company executives and the capital markets.

SEC Charges Former Consulting Executive and Friend with Insider Trading Ahead of Biotech Takeovers

The SEC alleges that Scott Allen learned confidential information in advance of the acquisitions of Millennium Pharmaceuticals Inc. and Sepracor Inc. through his work at a global consulting firm that was advising the acquiring Japanese companies as they made cash tender offers. Allen allegedly tipped his longtime friend John Michael Bennett, an independent filmmaker who had previously worked at a Wall Street investment bank, as each acquisition took shape. On the basis of the nonpublic information, Bennett purchased thousands of dollars in call options in the companies and also tipped his business partner at the independent film company they co-own. The insider trading by Bennett and his tippee generated more than $2.6 million in illicit profits. Allen received cash from Bennett in exchange for the tips.

Investment Adviser Oversight Act of 2011

FINRA is elbowing its way into an oversight role for investment advisers. House Financial Services Committee Chairman Spencer Bachus has introduced the Investment Adviser Oversight Act of 2011. The argument is that the SEC is too overburdened to effectively oversee investment advisors.

I find it strange that Congress wants to make the shift. If the SEC can’t handle the job, it’s because the Congress will not appropriate the money the SEC needs. If there are not enough inspections, its because there are not enough people. Effectively, it would shifting the cost of oversight from the taxpayers to the investment advisers.

The hearing on the bill can be summarized with three words: “Madoff, Madoff, Madoff.” (The one exception at the House hearing was Congressman Carson who pointed out that it was Congress who plunked down lots of new obligations on the SEC without providing funding.)

The current draft of the bill would exclude the following from oversight by a “registered national investment adviser association”:

  • Investment companies (mutual fund advisors)
  • Non-U.S. persons
  • Clients that in aggregate own at least $25 million in investments
  • Various religious, education or charitable entities
  • Stock pension plans and collective trusts
  • Private equity funds
  • Venture capital funds

Retail investment advisers would be governed by the “registered national investment adviser association” while hedge funds and private equity funds would stay with the SEC. Personally, I think the SEC has its weaknesses, but I dislike FINRA’s strict rule based approach to regulation.

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Image is by Lobstar28

Carried Interest and Obama’s American Jobs Act

The tax treatment of carried interest has been eyed as a revenue source off and on for the past few years. It’s back in the sights of the administration in the new American Jobs Act.

Subtitle B – Tax Carried Interest in Investment Partnerships as Ordinary Income

Section 411 – Partnership Interests Transferred in Connection With Performance of Services.
Current law allows service partners to receive capital gains treatment on labor income without limit, which creates an unfair and inefficient tax preference. This section would tax as ordinary income, and make subject to self-employment tax, a service partner’s share of the income of an investment partnership attributable to a carried interest because such income is derived from the performance of services.

Section 412 – Special Rules for Partners Providing Investment Management Services to Partnerships.
To the extent that a service partner contributes “invested capital” and the partnership reasonably allocates its income and loss between such invested capital and the remaining interest, income attributable to the invested capital would not be recharacterized. This subtitle would be effective for taxable years beginning after December 31, 2012.

Full text of the American Jobs Act on WSJ.com

The Slow Rulemaking on Swaps and Derivatives

One of the strange splits in US financial regulation is that many swap and derivatives are regulated by the Commodities Futures Trading Commission instead of the Securities and Exchange Commission. I think of the CFTC, I think of Trading Places and with the SEC I think of Wall Street.

The Commodity Futures Trading Commission has delayed its rollout of regulations under the Dodd-Frank Wall Street Reform and Protection Act has been pushed back until at least early 2012. This delay is the second time the CFTC has put the brakes on its new rules that will govern the over-the-counter derivatives market. In my view, taking longer to get the rules right is better than pushing through bad rules just to meet some arbitrary deadline. The question will be whether the CFTC will succeed in creating rules that will make the derivatives market one that is more transparent and easier to oversee for lines of trouble.

As for trouble, take a look at Greek bonds as an example. The Credit Default Swaps cost a record $5.8 million upfront and $100,000 annually to insure $10 million of Greece’s debt for five years using credit-default swaps. That means the market is saying it’s about a 58% chance that Greece will default in the next five years. But how extensive is that exposure in the US? How many people are on the hook for payouts if Greece defaults?

If your firm uses derivatives or swaps for dealing with debt risks or foreign exchange risks, you should pay attention to the CFTC rulemaking. They are likely to change the process and the cost of dealing with these risks.

Gary Gensler, Chairman of the CFTC, says that “until the CFTC completes its rule-writing process and implements and enforces these new rules, the public remains unprotected. That’s why the CFTC is working so hard to ensure that swaps-market reforms promote more open and transparent markets, lower costs for companies and their customers, and protect taxpayers.”

More on the Massachusetts Regulations on Expert Networks

The Massachusetts Secretary of State issued a new regulation that would affect the ability of investment advisors to use expert networks. This was a direct result of Risk Reward Capital Management being based in Massachusetts. Since the management company was registered as an investment adviser in Massachusetts they are subject to examination and enforcement by the Secretary of the Commonwealth.

The regulation highlights the continuing split between the state-lvel and federal-level of regulation of investment advisers. Dodd-Frank only widened that split by kicking thousands of advisers out of registration with the Securities and Exchange Commission and over to the various states.

Risk Reward Capital Management had just under $25 million under management. Dodd-Frank raised that level.

To clarify its new regulation, Massachusetts issued this policy statement:

The Securities Division has received several questions regarding the applicability of the expert or matching services regulation to investment advisers that are under the authority of the Securities and Exchange Commission. This notice is to restate and clarify information included in the Division’s adopting release for the regulations adopted on August 19, 2011.

The expert or matching services regulation will not be deemed applicable to investment advisers subject to Securities and Exchange Commission authority, consistent with the requirements of Section 203A(b) of the Investment Advisers Act of 1940. The Securities Division retains its authority to take enforcement action against an investment adviser or any person associated with an investment adviser with respect to fraud or deceit, consistent with Section 203A(b)(2) of the Investment.

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Compliance Bits and Pieces for September 9

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

JP Morgan explains the euro crisis with LEGO/a> by Feliz Salmon

The woman with an oversized carrot and her friend in overalls with a shovel represent the Social Democrats and Greens.

Anti-Corruption Research Paper Competition Open for Submissions

We are asking young scholars from around the world to take up the challenge of providing innovative new ways to understand and fight corruption and are offering the possibility to showcase these approaches to a global audience of corruption researchers, practitioners and policy makers.

Veto, Veto, Pass! New Governor Means New Breach Notification Law in California by Brendon Tavelli in Proskauer’s Privacy Law Blog

On Wednesday, August 31, 2011, California became the third state this year to amend its existing security breach notification law when Governor Jerry Brown signed into law Senate Bill 24 (“SB 24”). Interestingly, the bill also marks the third time (in three years) that a bill attempting to beef up the state’s breach notice law has landed on the Governor’s desk. Former Governor Arnold Schwarzenegger vetoed the previous two.

NLRB Administrative Law Judge: Facebook Firings Illegal by Daniel Schwartz in the Connecticut Employment Law Blog

Now, for the first time, an administrative law judge (in Hispanics United of Buffalo) has found that employees’ comments about their working conditions on Facebook could be protected under federal labor laws.

The SEC Overhaul

On July 11, 2011, the President issued Executive Order 13579, “Regulation and Independent Regulatory Agencies,” which states that independent regulatory agencies should promote the goals set forth in Executive Order 13563 of January 18, 2011 that applies to executive agencies. He is asking the SEC, CFTC and other independent agencies to focus on a regulatory system that protects “public health, welfare, safety, and our environment while promoting economic growth, innovation, competitiveness, and job creation.” The Securities and Exchange Commission responded to Executive Order 13579 by inviting “interested members of the public to submit comments to assist the Commission in considering the development of a plan for the retrospective review of its regulations.”

Before you get too excited and submit a comment about repealing your most hated SEC rule, the SEC’s comment request is only for general comments on what the scope and elements on the development of a plan for retrospective review of existing significant regulations. So it’s just comments on the plan to review existing regulations.

1. What factors should the Commission consider in selecting and prioritizing rules for review?
2. How often should the Commission review existing rules?
3. Should different rules be reviewed at different intervals? If so, which categories of rules should be reviewed more or less frequently, and on what basis?
4. To what extent does relevant data exist that the Commission should consider in selecting and prioritizing rules for review and in reviewing rules, and how should the Commission assess such data in these processes? To what extent should these processes include reviewing financial economic literature or conducting empirical studies? How can our review processes obtain and consider data and analyses that address the benefits of our rules in preventing fraud or other harms to our financial markets and in otherwise protecting investors?
5. What can the Commission do to modify, streamline, or expand its regulatory review processes?
6. How should the Commission improve public outreach and increase public participation in the rulemaking process?
7. Is there any other information that the Commission should consider in developing and implementing a preliminary plan for retrospective review of regulations?

The Commission is not soliciting comment in this notice on specific existing Commission rules to be considered for review. Hopefully, that will come soon.

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The EU Directive On Alternative Fund Managers Is in Effect

The chaos around the Swiss Franc may be a sign of a coming crisis in the European Union. For private fund managers, a different crisis may be the new European regulatory regimes for private funds. With all of the flux in the United States over the regulation of private funds, it’s been easy to forget that the EU has been trying to put a new regulatory regime in place.

Over the summer, the official text of the Alternative Investment Fund Managers Directive (2011/61/EU)(.pdf 73 pages) was published. The European Parliament adopted the Directive in November, 2010 and the Council of the European Union adopted it in May, 2011. The EU member states will have until July 22, 2013 to update their the national laws, regulations and administrative provisions to give effect to the AIFMD.

This new EU legislation will regulate managers of hedge, private equity
and real estate funds and other alternative investment funds. It covers almost any investment fund except funds regulated under EU legislation on Undertakings for Collective Investment in Transferable
Securities (UCITS).

There are still many moving parts. The EU regulatory regime will need to be in place and there will likely be variations from country to country in the EU.

If you have European investors or operations in Europe, you have more reading to do.

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No One Would Listen

You can’t really criticize Harry Markopolos. He was right. He had spotted something wrong with Bernie Madoff years before the biggest Ponzi scheme collapsed. Unlike many others, Markopolos contacted the Securities and Exchange Commission about his suspicions. They ignored him. Markopolos went to the press, but no meaningful article came of it.

When Madoff’s scheme collapsed and he  turned himself in, Markopolos became lauded by the press, testified in Congress about the failings of the SEC, and was even offered the job of Chairman of the SEC by an ill-informed Congressman. No One Would Listen is another step in the Markopolos victory lap.

He celebrates his brilliance in discovering the fraud and the incompetence of the SEC for not stopping it. He fills his attacks with similes:

“His returns were as reliable as the swallow returning to Capistrano.”

“As I continued examining the numbers, the problems with them began popping out as clearly as a red wagon in a field of snow.”

Markopolos lays out how he first ran into Madoff and the years he spent trying to figure out how Madoff was generating his returns. Eventually, he came to the conclusion that he couldn’t do it. Since Madoff ran a big trading organization, he could have been front-running orders to generate illicit profits. Effectively, he would be stealing from his brokerage customers and giving it to his money management operations.

The other likely possibility was that Madoff was making up his returns and using new funds coming in to redeem those leaving. Markopolos could not find any footprints of Madoff’s split-strike trading strategy. There didn’t seem to be enough options traded on the markets to support the amount Madoff had under management.

I think it’s important to see why Markopolos was focused on Madoff. The principals at his firm wanted him to reverse engineer Madoff strategy so they could offer a similar product to their clients. Markopolos could not figure out how Madoff was generating his steady returns. He first contacted the SEC as a way to get his boss off his back. If he could prove Madoff was a fraud, his boss would quit demanding that Markopolos duplicate the Madoff strategy.

Markopolos starts off  No One Would Listen by stating that he made five separate submissions to the Securities and Exchange Commission over a nine-year period. So far, I’ve only seen one, his December 22, 2005 letter. Frankly, I found the letter to be a rambling, half-coherent diatribe. It was penned by a competitor who couldn’t figure out the trading strategy of the legendary Bernie Madoff, the founder of NASDAQ.

As Chris MacDonald notes “Markopolos is a bit of a strange cat. He’s a likeable guy, and apparently a man of integrity, but also a bit paranoid-sounding.” (He had seen the new movie, Chasing Madoff, based on the book.)

Clearly the SEC was unable to stop Madoff. Was it their fault?  Yes. They relied on the well-established credentials of Madoff and dismissed the paranoid ramblings of an eccentric analyst. Markopolos’s barbs against the SEC are over-the-top and eventually got distracting. On top of that, I was often distracted by his misuse of “principle” instead of “principal” in the book. You would think that a financial analyst would know the difference.