A Cliche Is Proven

golf insider trading compliance

One cliche thrown around is that tipping a golf buddy to material non-public information is an insider trading violation. The Securities and Exchange Commission just filed a case that proved that cliche true.

Eric McPhail learned the expected earnings and major pending corporate developments at American Superconductor through a friend who is (was?) an executive at that company. They were good friends and golfed together at the same country club. Confidentiality was expected.

However, Mr. McPhail took that information and tipped it to six of his other golfing buddies. At least according to the SEC complaint. Four of the golfing buddies consented to judgement, returned their trading profits, and paid fines.

Mr. McPhail is not accused of trading in the stock. He is charged with illegal tipping.

Unfortunately for the golfing buddies, their communication about the stock was not limited to the golf course. The SEC complaint is full of email messages discussing the stock and material non-public information. In one email, Mr. McPhail hopes to be paid back by his golfing buddies with pinot noir and steak.

The American Superconductor executive is not named in the complaint.

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Weekend Reading: A Time to Attack

a time to attack

What should we do about the nuclear weapon program in Iran? The country is not complying with the Treaty on the Non-Proliferation of Nuclear Weapons. Iran has four main sites being used to create weapons-grade uranium. The country has stopped short of further purifying the uranium to the concentration needed for a bomb. But once it decides to, Iran can produce the uranium needed for a bomb in two to six months.

Besides the uranium, Iran needs to develop the weapon and means of delivery. The weapon is still a year away and the delivery method could be longer than that.

But once Iran gets the uranium it’s game over. Once the uranium in produced we lose the way to track it.

I didn’t know any this last week until I picked it up from Matthew Kroenig’s A Time to Attack: The Looming Iranian Nuclear Threat. The book’s publisher sent me copy to review and I was looking to learn more about the Iran nuclear issue.

Iran is spinning centrifuges to enrich uranium. There is no civilian purpose for this uranium. The only purpose is to create a nuclear weapon. Iran is working on ICBMs. No country has placed conventional weapons on an ICBM. The only use has been to mount a nuclear device to launch across vast distances.

We know where the four key sites are located. The toughest is Qom which is built into the side of a mountain and protected by almost 300 feet of rock. No really, google the Qom Uranium enrichment facility. It’s right on Google maps.

Matthew Kroenig offers a few possible courses of action. There is only one that he thinks will work: Attack once Iran passes the point of no return. It’s not a good approach and does not have a good outcome. But the other outcomes are worse.

Would any other country believe that the US would go to war with a nuclear-armed Iran, if the US was not willing to go to war with a nonnuclear Iran. Once Iran has a nuclear weapon, the rest of region will start their own programs out of fear of Iran and the lack of faith in the US.

Yes, it has to be the US. Israel does not have a bunker-busting bomb powerful enough to destroy the Qom facility or even the lesser protected facility at Natanz. Even for the US, the B-2 bomber is the only aricraft capable of delivering the Massive Ordnance Penetrator bomb.

Kroenig puts together well reasoned arguments in an easy to read book. It leaves even a liberal dove like me agreeing with his position.

Compliance Bricks and Mortar for July 11

rough bricks and mortar

These are some of the compliance-related stories that recently caught my attention.

Firms Withdraw as MAs Ahead of Final Rule by Kyle Glazer in The Bond Buyer

Nathan Howard, an attorney who works with municipal advisors, said the many withdrawals are the result of guidance that has made it more clear who is likely to be an MA in the view of the SEC staff. In recent months, the SEC has published two sets of interpretive guidance in the form of “frequently asked questions.” That guidance explained that firms could be exempted from having to register as MAs under some circumstances, including if an issuer had retained its own independent MA, if the firms were responding to a legitimate request for proposals, or if they were offering certain types of advice permissible for their professions. Bond lawyers, for example, would not have to register as MAs as long as they do not cross the line from providing traditional legal services to providing professional financial advice or holding themselves out to be financial experts.

Immigrants From Latin America and Africa Squeezed as Banks Curtail International Money Transfers by Michael Corkery in Dealbook

As government regulators crack down on the financing of terrorists and drug traffickers, many big banks are abandoning the business of transferring money from the United States to other countries, moves that are expected to reverse years of declines in the cost of immigrants sending money home to their families.

New Article Examines Overcriminalization, Plea Bargaining, And The FCPA Africa Sting Case by Lucian Dervan in the FCPA Professor

The Africa Sting Case is one in which a number of defendants proceeded to trial to challenge the government’s theory of the case. Such challenges, however, have become a rarity in today’s criminal justice system. As the Computer Associates case illustrates, even where the government’s aggressive application of broad criminal statutes draws wide attention, most defendants succumb to the powerful incentives plea bargaining offers to forgo trial.

Ethics Creep by Roy Snell in SCCE’s Compliance and Ethics Blog

My point is simple. If you decide to call something or someone unethical every time you disagree with them, you have broadened the definition of ethics to the point the word is now worthless. If you are a compliance and ethics officer and you focus your attention on social cohesion, overtime, and capital punishment, etc., you will become ineffective. We need to focus on preventing, finding, and fixing business ethics issues not management or leadership strategy.

Image of Brick and Plaster Texture is by David Gunter

Narrowing the Safe Harbors

narrow safe harbor compliance

The Securities and Exchange Commission rolled out the accredited investor verification requirement and made it principle-based for purposes of Rule 506(c). You have to take reasonable steps to verify that an investor meets the accredited investor standard. In the same release it created four non-exclusive safe harbors that would deemed to be taking “reasonable steps.”  The SEC recently released six new Compliance and Disclosure Interpretations on the verification of prospective investors as accredited investors.

One safe-harbor method is to review the IRS filings for the two most recent years. That seems straightforward. Just deliver me the two latest tax filings. But the SEC has made that safe harbor nearly  impossible to navigate during the first part of a calendar year. In Question 260.35, the SEC takes a very strict view of the safe harbor. The filings must be for the two most recent years. So if you were to use that safe harbor in 2014, the issuer must get the 2013 and 2012 tax filings.

For most potential investors this safe harbor is inaccessible in January and may extend further into the year depending on when the investor files his or her tax return. I’ve filed an extension for the past few years and don’t get my taxes done until August. I couldn’t prove myself to be an accredited investor using the safe harbor until that point in the calendar year.

The SEC’s solution is to switch to the principles-based approach by reviewing the two most recent available years and getting written representations from the potential investor that:

(i) an Internal Revenue Service form that reports the purchaser’s income for the recently completed year is not available,
(ii) specify the amount of income the purchaser received for the recently completed year and that such amount reached the level needed to qualify as an accredited investor, and
(iii) the purchaser has a reasonable expectation of reaching the requisite income level for the current year.

The SEC is clearly making it hard to navigate the investor verification requirement. It seems to laying mines around the entrances to the safe harbor.

Sources:

Image is US Navy 060628-N-4776G-144 The Nimitz-class aircraft carrier USS Ronald Reagan (CVN 76) navigates its way through the narrow strait that make up the inlet to Pearl Harbor for a port visit.jpg

 

Compliance and the Tour de France

tour de france

For me, July starts with the red, white and blue, then quickly turns to yellow. The yellow jersey worn by the overall leader of the Tour de France.

I’ve been a big fan of the Tour de France for the past decade and a half. I admit that it was the success of Lance Armstrong that brought me to it. The dethroned champion taught us a few compliance lessons.

You can’t ignore the history of cheating in the Tour de France, just as you cannot ignore the steroid era of baseball. The cheaters were ahead of the organization’s will to enforce and ahead of the organization’s ability to catch the cheaters.

It now seems that cycling’s governing bodies are serious about keeping doping out of the sport. It also appears that the science of detection has caught up to the science of cheating. There is less disincentive to cheat if you think the chances of getting caught are remote. Mr. Armstrong was tested hundreds of times. The few times that an anomaly was spotted, it was washed away by the poor testing or whitewashed by the governing body.

You can’t have compliance if the rules are not backed by testing and enforcement.

If you like the watercolor above, there is a kickstarter project for a book of these paintings: Book de Tour. The artist, Greig Leach, painted that scene from the 2013 edition of the Tour de France and I purchased it from him. Mr. Leach is painting key scenes from the 2014 edition of the Tour de France and compiling them in Book de Tour. If you like cycling, it’s a great project to sponsor.

Group Purchasing Programs and Compliance

group purchase and compliance

Can a fund manager save the investors money, but still be doing the wrong thing? That’s the issue presented by the Securities and Exchange Commission’s look at group purchasing programs for private equity firms.

Buying in bulk usually results in cost savings. A private equity firm, with a collection of companies in its portfolios, should be able to save money by pooling the purchasing power of the combined companies.

That’s savings to the portfolio companies and savings to the investors in the funds. But the fund manager may be earning fees from the group purchasing program. That’s good for the fund manager and does not affect the investors.

A recent article in the Wall Street Journal highlights the SEC’s Concern: Buyout Firms’ Fees Come Under Review. A group purchasing provider charges a fee to vendors and may share a portion of the fee with the private equity firms. According to the article, Blackstone saved over $700 million for its portfolio companies over the last seven years. Blackstone between 2011 and 2013 received roughly $7 million in fees from a company that negotiates those discounts for its portfolio companies.

The first problem is one of disclosure. If the extra fee income is disclosed to investors in the funds, then the problem largely goes away. If the extra income to the fund manager is not disclosed, then there is a potential problem. But just a potential problem. The SEC needs to prove that the fee violated the Investment Advisers Act or is somehow fraudulent, deceptive or manipulative. Earning money from investors that is not disclosed is a problem. Even if it saves investors money.

The other group purchasing issue is having the portfolio companies buy products and services from each other. The bigger problem there may be companies selling across funds managed by the private equity firm. That’s moving money from fund to fund.

The second prong after disclosure (or lack thereof) is putting a control in place to ensure each company is getting the best product at the best price. If the portfolio company is forced to buy an improper product at an inflated price, that’s a problem.

Proving cost savings will make the fund manager look better in the eyes of its investors and regulators. But update the documents to disclose the extra fee income.

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NRS 29th Annual Compliance Conference

nrs compliance conference

I’m trying out a new compliance conference this fall: the NRS 29th Annual Fall Investment Adviser & Broker-Dealer Compliance Conference.

I have to admit that I’m attending mostly because they asked me to speak. My session is on Issues on Private Fund Management on Day Two.

One of the challenges of staying up-to-date on compliance is learning about the new requirements as they come into effect. The second challenge is learning how your peers are interpreting the new requirements and putting them into effect at their organiztions. A compliance conference is a great way help with both of those challenges.

The NRS Conference is tied to my designation as an Investment Adviser Certified Compliance Professional. NRS is the organization that runs the certification program. With the designation comes continuing education requirements. (I have met most of my requirements at non-NRS events.) Attending the conference will help also help me finish off my requirements for the year.

Life, Liberty and the Pursuit of Happiness

Declaration_independence

IN CONGRESS, July 4, 1776.
The unanimous Declaration of the thirteen united States of America,

When in the Course of human events, it becomes necessary for one people to dissolve the political bands which have connected them with another, and to assume among the powers of the earth, the separate and equal station to which the Laws of Nature and of Nature’s God entitle them, a decent respect to the opinions of mankind requires that they should declare the causes which impel them to the separation.

We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness.–That to secure these rights, Governments are instituted among Men, deriving their just powers from the consent of the governed, –That whenever any Form of Government becomes destructive of these ends, it is the Right of the People to alter or to abolish it, and to institute new Government, laying its foundation on such principles and organizing its powers in such form, as to them shall seem most likely to effect their Safety and Happiness. Prudence, indeed, will dictate that Governments long established should not be changed for light and transient causes; and accordingly all experience hath shewn, that mankind are more disposed to suffer, while evils are sufferable, than to right themselves by abolishing the forms to which they are accustomed. But when a long train of abuses and usurpations, pursuing invariably the same Object evinces a design to reduce them under absolute Despotism, it is their right, it is their duty, to throw off such Government, and to provide new Guards for their future security.–Such has been the patient sufferance of these Colonies; and such is now the necessity which constrains them to alter their former Systems of Government. The history of the present King of Great Britain is a history of repeated injuries and usurpations, all having in direct object the establishment of an absolute Tyranny over these States. To prove this, let Facts be submitted to a candid world.

He has refused his Assent to Laws, the most wholesome and necessary for the public good.
He has forbidden his Governors to pass Laws of immediate and pressing importance, unless suspended in their operation till his Assent should be obtained; and when so suspended, he has utterly neglected to attend to them.
He has refused to pass other Laws for the accommodation of large districts of people, unless those people would relinquish the right of Representation in the Legislature, a right inestimable to them and formidable to tyrants only.
He has called together legislative bodies at places unusual, uncomfortable, and distant from the depository of their public Records, for the sole purpose of fatiguing them into compliance with his measures.
He has dissolved Representative Houses repeatedly, for opposing with manly firmness his invasions on the rights of the people.
He has refused for a long time, after such dissolutions, to cause others to be elected; whereby the Legislative powers, incapable of Annihilation, have returned to the People at large for their exercise; the State remaining in the mean time exposed to all the dangers of invasion from without, and convulsions within.
He has endeavoured to prevent the population of these States; for that purpose obstructing the Laws for Naturalization of Foreigners; refusing to pass others to encourage their migrations hither, and raising the conditions of new Appropriations of Lands.
He has obstructed the Administration of Justice, by refusing his Assent to Laws for establishing Judiciary powers.
He has made Judges dependent on his Will alone, for the tenure of their offices, and the amount and payment of their salaries.
He has erected a multitude of New Offices, and sent hither swarms of Officers to harrass our people, and eat out their substance.
He has kept among us, in times of peace, Standing Armies without the Consent of our legislatures.
He has affected to render the Military independent of and superior to the Civil power.
He has combined with others to subject us to a jurisdiction foreign to our constitution, and unacknowledged by our laws; giving his Assent to their Acts of pretended Legislation:
For Quartering large bodies of armed troops among us:
For protecting them, by a mock Trial, from punishment for any Murders which they should commit on the Inhabitants of these States:
For cutting off our Trade with all parts of the world:
For imposing Taxes on us without our Consent:
For depriving us in many cases, of the benefits of Trial by Jury:
For transporting us beyond Seas to be tried for pretended offences
For abolishing the free System of English Laws in a neighbouring Province, establishing therein an Arbitrary government, and enlarging its Boundaries so as to render it at once an example and fit instrument for introducing the same absolute rule into these Colonies:
For taking away our Charters, abolishing our most valuable Laws, and altering fundamentally the Forms of our Governments:
For suspending our own Legislatures, and declaring themselves invested with power to legislate for us in all cases whatsoever.
He has abdicated Government here, by declaring us out of his Protection and waging War against us.
He has plundered our seas, ravaged our Coasts, burnt our towns, and destroyed the lives of our people.
He is at this time transporting large Armies of foreign Mercenaries to compleat the works of death, desolation and tyranny, already begun with circumstances of Cruelty & perfidy scarcely paralleled in the most barbarous ages, and totally unworthy the Head of a civilized nation.
He has constrained our fellow Citizens taken Captive on the high Seas to bear Arms against their Country, to become the executioners of their friends and Brethren, or to fall themselves by their Hands.
He has excited domestic insurrections amongst us, and has endeavoured to bring on the inhabitants of our frontiers, the merciless Indian Savages, whose known rule of warfare, is an undistinguished destruction of all ages, sexes and conditions.

In every stage of these Oppressions We have Petitioned for Redress in the most humble terms: Our repeated Petitions have been answered only by repeated injury. A Prince whose character is thus marked by every act which may define a Tyrant, is unfit to be the ruler of a free people.

Nor have We been wanting in attentions to our Brittish brethren. We have warned them from time to time of attempts by their legislature to extend an unwarrantable jurisdiction over us. We have reminded them of the circumstances of our emigration and settlement here. We have appealed to their native justice and magnanimity, and we have conjured them by the ties of our common kindred to disavow these usurpations, which, would inevitably interrupt our connections and correspondence. They too have been deaf to the voice of justice and of consanguinity. We must, therefore, acquiesce in the necessity, which denounces our Separation, and hold them, as we hold the rest of mankind, Enemies in War, in Peace Friends.

We, therefore, the Representatives of the united States of America, in General Congress, Assembled, appealing to the Supreme Judge of the world for the rectitude of our intentions, do, in the Name, and by Authority of the good People of these Colonies, solemnly publish and declare, That these United Colonies are, and of Right ought to be Free and Independent States; that they are Absolved from all Allegiance to the British Crown, and that all political connection between them and the State of Great Britain, is and ought to be totally dissolved; and that as Free and Independent States, they have full Power to levy War, conclude Peace, contract Alliances, establish Commerce, and to do all other Acts and Things which Independent States may of right do. And for the support of this Declaration, with a firm reliance on the protection of divine Providence, we mutually pledge to each other our Lives, our Fortunes and our sacred Honor.

The 56 signatures on the Declaration appear in the positions indicated:

Button Gwinnett
Lyman Hall
George Walton
William Hooper
Joseph Hewes
John PennEdward Rutledge
Thomas Heyward, Jr.
Thomas Lynch, Jr.
Arthur Middleton
John HancockSamuel Chase
William Paca
Thomas Stone
Charles Carroll of Carrollton

George Wythe
Richard Henry Lee
Thomas Jefferson
Benjamin Harrison
Thomas Nelson, Jr.
Francis Lightfoot Lee
Carter Braxton

Robert Morris
Benjamin Rush
Benjamin Franklin
John Morton
George Clymer
James Smith
George Taylor
James Wilson
George RossCaesar Rodney
George Read
Thomas McKean
William Floyd
Philip Livingston
Francis Lewis
Lewis MorrisRichard Stockton
John Witherspoon
Francis Hopkinson
John Hart
Abraham Clark
Josiah Bartlett
William WhippleSamuel Adams
John Adams
Robert Treat Paine
Elbridge Gerry

Stephen Hopkins
William Ellery

Roger Sherman
Samuel Huntington
William Williams
Oliver Wolcott

Matthew Thornton

Guidance on Accredited Investor Verification

The Securities and Exchange Commission revised the private placement rules last year to permit public private-placements. Of course it took some prodding from Congress in the JOBS Act to get that change. The law and the new regulation require the issuer to take “reasonable steps” to determine that the investor is an “accredited investor.”

The SEC rule has four non-exclusive safe harbor methods which meet the verification requirement. One of those methods is to rely on the written confirmation of accredited investor status issued by a registered broker-dealer or investment adviser. The Securities Industry and Financial Markets Association has put together guidance on that verification method.

For individuals, SIFMA recommends that the investor have been a client for at least six months so the firm has sufficient knowledge. Second, SIFMA recommends that the broker or adviser obtain a representation from the investor that he or she is not borrowing money to make the investment.

To make the determination, SIFMA has two methods. In the account balance method, the investor must have at least $2 million with the broker or adviser. This assumes $1 million liabilities. If the investor discloses debt greater than this, obviously the account balance threshold will increase.

The second method is the investment amount method. In this situation, the investor must commit at least $250,000 to the investment and represent that it is less than 25% of the investor’s net worth.

I’m not sure the guidance breaks new ground, but its good to see some filling in the holes. The SEC safe harbor also permits CPAs and lawyers to issue the accredited investor verification. It will be interesting to see if the bar association and PCAOB offers any guidance to its members.

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