Author: Doug Cornelius

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Trust and Financial Regulation

colombo

Ronald J. Colombo of Hofstra University School of Law wrote a great paper on The Role of Trust in Financial Regulation.

Trust is an important part of our financial markets. Scandals, massive incompetence, massive irresponsibility, massive fraud, have shaken trust in the financial markets. Commentators, policy makers, and industry leaders have all recognized the need for trust’s restoration.

Consistent with financial scandals in the past, the public officials are looking for increased regulation to restore trust in the markets. The last round of financial scandals in the Enron-WorldCom era brought us Sarbanes-Oxley.

Professor Colombo thinks the advocates for increased regulation have it half right.

“A critical set of questions should be considered. Can regulation serve to bolster and repair relationships dependent upon trust? And in the absence of trust, can regulation serve as an effective substitute to trust? In short, are there limits to the ability of regulation to resuscitate an economy that has suffocated due to lack of trust?

Conversely, can regulation work to “crowd out” trust, effectively transforming relationships that once were close and trustworthy to arm’s length and legalistic? Could regulation serve to displace relationships of trust with transactions subject merely to the “morals of the marketplace”?”

The Role of Trust in Financial Regulation applies trust scholarship to examine the current U.S. financial regulatory regime and some of the proposed reforms. I focused on a few sections.

Private Offering Regulation

In addressing the difference in treatment between the regulation of public offerings and private offerings, Mr. Colombo thinks the difference can be justified on grounds relating to the issue of trust.

A private offering is more like a personal contract between the issuer and the investor, free of public advertising. Also, a private offering is more likely to have a pre-existing relationship. “Interpersonal relationships and communications are conducive to such trust, and such relationships and communications are often found among the parties to a private offering.”

He concludes that the current regulation of private offering strikes the correct balance from a trust-favoring perspective.

Regulation of Investment Advisers

I found it interesting that Mr. Colombo spends some time focused on the 15 client rule exemption from registration. He finds that much of the investment adviser regulation has developed a heavy band of regulation that “can crowd out trust in a relationship, converting expectations and behavior based upon honor and integrity to those based on the letter of the law.”

Investment advisers with a small number of clients can have “closer, more personal and more lasting relationships with their small number of clients than those advisers with a much larger client base.” The small adviser exemption from regulation when you have fewer than 15 clients facilitates the trust aspect.

The Private Fund Investment Advisers Registration Act, just approved by the House Financial Services Committee, eliminates this exemption.

Hedge Funds

From a trust perspective, Mr. Colombo thinks the lack of hedge fund regulation seems sensible. As with the world of investment advisers, the hedge fund industry is marked by repeat players. Frequent and historical interactions among the parties can “lay the foundation for affective and generalized trust to develop.” After all, the original legislative intent of the U.S. securities laws was to protect the layperson, unfamiliar with the financial markets, with sophisticated investors fending for themselves. Give the high financial thresholds for investment in private funds, the investors are either sophisticated or have easy access to sophisticated investment advice.

Regulatory Reforms

Mr. Colombo does not seem to like the removal of the small adviser exemption from investment adviser regulation. For larger advisers, the increased disclosure and reporting requirements may be a good things.

As for hedge funds he thinks that hedge funds currently operating successfully on the basis of trust, with little regulation, have little to benefit their investors by registering with the SEC  and submitting themselves to the regulatory oversight. However, for funds that have not been able to develop that trust, voluntarily registering and submitting themselves to the regulatory oversight could help develop that trust. (I’m skeptical that investors think SEC registration carries any value in the world of private funds.)

The paper concludes that the existing financial regulatory regimes do a pretty good job with our understanding of trust. Greater regulation is imposed upon those sectors of the financial services industry where such regulation is trust enhancing, and lesser regulation is imposed upon those sectors where such regulation is trust defeating.

“In those areas where high quality trust relationships exists (or have the greatest potential to exist), we have, relatively speaking, the lowest levels of regulation: private offerings, investment advisers, and hedge funds. In those areas where only lower quality trust relationships are likely to exist (that is, relationships of cognitive and specific trust), we witness the highest levels of regulation: public offerings, secondary market trading, and banking.”

He also points out the more important areas of the capital markets are more heavily regulated. After all, we cannot wait to see if trust can be developed if the failure will lead to a systemic breakdown. The turbulence after the Lehman collapse was in part caused by the lack of trust. Nobody was sure if they could trust the stated financial stability of their counterparty.

References:

Colombo, Ronald J., Trust and Financial Regulation (October 1, 2009). Villanova Law Review, Forthcoming; Hofstra Univ. Legal Studies Research Paper No. 09-22. Available at SSRN: http://ssrn.com/abstract=1481327

Some other references from The Role of Trust in Financial Regulation:

Copyright and Compliance

strange maps

I am a big fan of maps. I work for a real estate company, so that should not be surprising. Pictures can usually put information into better context than mere words.

Frank Jacobs, just published a book: Strange Maps: An Atlas of Cartographic Curiosities.

In an interview with Annika Mengisen on the Freakonomics blog, Mr. Jacobs pointed out an interesting compliance technique to deal with copyright and piracy.

When asked about any strange facts about maps that most people might not know?, he replied:

“I don’t know how obscure this fact is, but the London A-Z contains a fictional street on each of its pages, in order to catch out copycats.”

The authors used a little counter-intelligence to ferret out content thieves.

References:

OFAC has Released its Economic Sanctions Enforcement Guidelines

treasury

The final Office of Foreign Assets Control. This rule sets forth the Enforcement Guidelines that OFAC will follow in determining an appropriate enforcement response to apparent violations of the U.S. economic sanctions programs that OFAC enforces.

The final rule will appear as an Appendix to the Reporting, Procedures and Penalties Regulations, 31 C.F.R. Part 501.

These are the new General Factors that OFAC will consider in determining the appropriate administrative response:

  • Willful or Reckless Violation of Law
    • Willfulness
    • Recklessness
    • Concealment
    • Pattern of Conduct
    • Prior Notice
    • Management Involvement
  • Awareness of Conduct
    • Actual Knowledge
    • Reason to Know
    • Management involvement
  • Harm to Sanctions Program Objectives
    • Economic or Other Benefit to the Sanctioned Individual, Entity, or Country
    • Implications for U.S. Policy
    • License Eligibility
    • Humanitarian activity
  • Individual Characteristics
    • Commercial Sophistication
    • Size of Operations and Financial Condition
    • Volume of Transactions
    • Sanctions History
  • Compliance Program
  • Remedial Response
  • Cooperation with OFAC
  • Timing of apparent violation in relation to imposition of sanctions
  • Other enforcement action
  • Future Compliance/Deterrence Effect
  • Other relevant factors on a case-by-case basis

The Guidelines are the final rule and replace the Guidelines previously promulgated as an interim final rule with request for comments on September 8, 2008.

References:

International Fraud Awareness Week

International Fraud Awareness Week

November 8-14, 2009 is International Fraud Awareness Week. This weeklong campaign, sponsored by the Association of Certified Fraud Examiners, encourages business leaders and employees to proactively take steps to minimize the impact of fraud by promoting anti-fraud awareness and education.

Test your knowledge about fraud with this Fraud IQ Test, which includes 20 actual questions from the CFE Exam

Fraud Prevention Check-uppdf-icon
How vulnerable is your company to fraud? Do you have adequate controls in place to prevent it? Find out by using the ACFE’s Fraud Prevention Check-Up, a simple yet powerful test of your company’s fraud health.

Managing the Business Risk of Fraud: A Practical Guide
This guidance paper, developed jointly by the ACFE, IIA and AICPA, provides key principles for proactively establishing an environment to effectively manage an organization’s fraud risks. It also provides tools, recommendations and real-life examples of how fraud risk management principles are applied.

Compliance Bits and Pieces for Nov. 6

The FCPA’s Imperialist Myth from The FCPA Blog

Why aren’t law professors training their students on the issue?  The answer, says Elizabeth Spahn, is tied up with false notions in the West about legal imperialism. Elizabeth Spahn’s article, “International Bribery: The Moral Imperialism Critiques,” 18 Minn. J. Int’l L. 155 (2009).

Conducting Ethical Corporate Investigations by Jaclyn Jaeger for Compliance Week

The ACC presented a panel discussion on internal investigations during its annual conference in Boston last week, and posed the following hypothetical: One of the company’s office managers has received an anonymous e-mail, where the writer claims to have compromised the salary and bonus information of several executives. The writer also claims to have stolen proprietary software from the company, whose customers are mostly manufacturers, and plans to give it to a competitor.

You, the general counsel, must investigate. How do you proceed?

ACC: The Use of Lawful and Ethical Strategies (Oct. 20, 2009)pdf-icon

Octopussy and the Golden Goose by Bruce Carton for Enforcement Action

If you are in an insider trading ring and your ring-buddies are using a “nickname” of any kind for you or others involved, it is all but certain that the nickname is going to be prominently mentioned when the SEC issues its press release about the case.

Google’s New Privacy Dashboard

google Dashboard

Have you ever wondered what data is stored with your Google Account?

Over the past 11 years, Google has focused on building innovative products for our users. Today, with hundreds of millions of people using those products around the world, we are very aware of the trust that you have placed in us, and our responsibility to protect your privacy and data.

…

In an effort to provide you with greater transparency and control over their own data, we’ve built the Google Dashboard. Designed to be simple and useful, the Dashboard summarizes data for each product that you use (when signed in to your account) and provides you direct links to control your personal settings. Today, the Dashboard covers more than 20 products and services, including Gmail, Calendar, Docs, Web History, Orkut, YouTube, Picasa, Talk, Reader, Alerts, Latitude and many more. The scale and level of detail of the Dashboard is unprecedented, and we’re delighted to be the first Internet company to offer this — and we hope it will become the standard. Watch this quick video to learn more and then try it out for yourself at www.google.com/dashboard.

I think it’s great that Google makes available all this privacy data in a single place.

You might be surprised how much Google knows in case you’ve already forgotten a service or two you’ve signed up with. Keep a close eye for the items on the page with this little blue icon meaning “this bit is public”. At the bottom of the page, Google disclaims that 16 additional products are not yet available in this dashboard.

Massachusetts Amends Its Strict Data Privacy Law (Yet, Again)

Massachusetts-State-House

Massachusetts has revised its data privacy regulations one more time. The revised regulations are less demanding that the original version released over a year ago. But this law is the strictest in the country and will be the de facto law of the land for many companies.

Office of Consumer Affairs and Business Regulation released a press release announcing that revised regulations have been filed with the Secretary of State and published on the OCABR website.

Fortunately, Gabriel M. Helmer of Foley Hoag’s Security & Privacy practice produced a redline showing the changes.

There are very few changes to the regulations that were released in August:

  • The Massachusetts Data Privacy regulations apply to anyone who “stores” personal information, in addition to those who receive, maintain, process, or otherwise have access to personal information.
  • Service Providers include anyone who “stores” personal information through their provision of services to anyone is subject to the regulations, in addition to those who receive, maintain, process, or otherwise are permitted access to personal information.
  • The U.S. Postal Service is no longer expressly excluded from the definition of “Service Providers.”
  • Service Provider agreements entered into before March 1, 2010 do not have to be amended to comply with these regulations until March 1, 2012.

The effective date is still March 1, 2010.

The regulations apply to personal information of Massachusetts residents. The reach of the regulations is not limited to businesses in Massachusetts.

References:

Will the Supreme Court Affect Mutual Fund Fees?

supreme court

On Monday, the Supreme Court heard the arguments on a case involving mutual fund fees. The case is trying to reconcile the standard for when mutual fund fees are too high.

Under §36(b) of the Investment Company Act of 1940 the “the investment adviser of a registered investment company shall be deemed to have a fiduciary duty with respect to the receipt of compensation for services, or of payments of a material nature, paid by such registered investment company.”

The traditional standard was that a breach of fiduciary duty occurs when the adviser charges a fee that is “so disproportionately large” or “excessive” that it “bears no reasonable relationship to the services rendered and could not have been the product of arm’s-length bargaining.” Gartenberg v. Merrill Lynch, 694 F.2d 923 (2nd Cir. 1982)

The Jones v. Harris case starts with the claim that the fees are excessive because they far exceed those charged to independent clients. Like many investment advisers, Harris charges less for institutional clients that invest in funds similar to its Oakmark funds. The plaintiffs take the position that a fiduciary should not charge a different price to its controlled clients than it does to its independent clients.

The parties argued their positions Monday in front of the Supreme Court. I was not there, but I thought I could collect some coverage and Tuesday Morning Quaterbacking of the arguments.

According to the coverage, neither party supported Chief Judge Easterbrook’s ruling in the Seventh Circuit. He had found that the marketplace may be trusted to curb excessive fees and that mutual fund investors unhappy with the fees they are charged could withdraw their money and invest it elsewhere.

The mutual fund side argued for the Gartenberg standard: Fees must be “within the range of what would have been negotiated at arm’s length in the light of all of the surrounding circumstances.”

The plaintiff side argued:

“It surely cannot be the case that where you are dealing with a fiduciary duty — which is a higher standard recognized in the law — that you can charge twice as much as what you are obtaining at arm’s length for services that you are providing.”

William Birdthistle thinks:

“If, as some of today’s questions seem to indicate, the eventual decision from the Court in Jones v. Harris will read like Gartenberg with just one additional factor included in an already long and nebulous evaluation, we might have to wait for the next wave of litigation in trial courts to see whether the new Jones standard makes any practical difference on fees. If, on the other hand, the justices highlight and strongly emphasize the institutional/individual fee comparison in an opinion that reads like Posner’s dissent or Ameriprise v. Gallus, the pressure upon the industry to lower fees could be more acute and immediate.”

Anna Christensen thinks:

There did not seem to be five votes for adopting the Seventh Circuit’s market-based approach. The Court may reject that standard and decide little else, perhaps adopting the basic Gartenberg test with some degree of explication, and sending the case back to the court of appeals for application of the test. On the other hand, the Court may decide that as the argument in this case demonstrates, the terms of Gartenberg test do not provide significant guidance on how to identify an unfairly large fee, and use the facts of this case to provide an object lesson to lower courts.

It sounds like the Supreme Court is unlikely to come out with a ruling that dramatically affects the industry. Inevitably, it will require additional work for compliance.

References:

The One Year Club: Five Things Companies Learn After a Year of Enterprise 2.0 Adoption

enterpise 2.0

I’m attending the Enterprise 2.0 Conference in San Francisco. I’m sharing my notes from this session. At the outset, organizations are often eager and excited about the benefits they anticipate from cultivating adoption and use of social and collaborative tools. But talk to those same organizations six months or one year after they’ve started, and you’ll hear a different story. Some organizations have experienced measurable success, others are struggling with a range of adoption and use issues, but all will tell you to watch out for several factors they didn’t anticipate.

  • Stewart Mader, Founder and Senior Consultant, Future Changes
  • Thomas Vander Wal, Principal & Senior Consultant, InfoCloud Solutions (speaking, just briefly, from a remote, undisclosed location.)

The issue of lack of capacity is re-thinking how you use the space. He used some urban design analogies, including community adoption and reliability. (Stewart’s wife is a landscape architect.)

Stewart advocates focusing on solving small day-to-day issues instead of trying to change the enterprise. Changing the enterprise is scary to most people. Mass collaboration is not the right way to go. (Wikipedia is a bad model for Enterprise 2.0.) Smaller groups of people who trust each other works better for collaboration.

Collective, community, collaborative, sharing listening and holding onto are each different activities. Different Enterprise 2.0 tools are better at some of these activities and not so good at others.

When focusing on the group, you need to know what type of interaction they need.

Never underestimate how busy people are and how easily they may dismiss a new tool.

Another myth is the 1-9-90 rule (1% create most of the content, 9% do some, and 90% are passive.). Its true for the internet, but not true inside the enterprise. (I also found this to be true. There is much more contribution when focused on a group.) Tools focused at the enterprise as whole, as opposed to working groups, will have fewer contributors. The tools will not have a hockey stick adoption curve that you see on the web. You will see steps of adoption inside the enterprise. You may see spikes of activity, especially after a presentation their use. But that use is merely exploratory.

Rules are for impatient people. See what works and adapt to the use. A pilot is the stepping stone to demonstrate utility and value. Case studies are nice, but internal use stories are much better. Adoption happens at the lunch table. Hearing it helped solve a problem for a person they know is the best sale tool.

Enterprise 2.0 tools are like swiss army knives. They do lots of things. You need to find the best uses. Give people permission and encouragement to find the best uses.

A wholesale replacement can often been seen as being out in left field. People do not like big changes. People have an easier time adopting tools that ease an obvious pain point. You need to fix a problem. The problem is a need. Focus on day-to-day problems.

Tools are the foundation. You need them. But you need to know how to use them.

Stewart ended with his analogy to dog “messaging.” See more: What Can Location-based Social Networks Learn From Dogs? Stewart seems to learn a lot about messaging from his dog.

Straight from the Horses’ Mouths

enterpise 2.0

I’m attending the Enterprise 2.0 Conference in San Francisco. I’m sharing my notes from this session. The 2.0 Adoption Council presents the market’s first in-depth research on a representative sample of early adopters in large organizations. This session will cut to the chase on issues that have plagued pundits and vendors alike.

Dan and Carl conducted a survey of large companies that have been adopting Enterprise 2.0 tools. The companies all had over 10,000 employees. None have deployed to 100% of employees. But of course many, many companies do not even have email deployed to 100% of their employees. Most shop floor employees do not have email.

Resistance is real. Most of the resistance comes from users. In the survey 49% encountered IT resistance and 64% experienced management resistance, but 72% experienced resistance from users. Of those 38% overcame IT resistance, 40% overcame and only 32% overcame user resistance. So the user resistance was the strongest and harder to overcome.

Looking at management issues, the biggest issue is measuring ROI: 69% experienced issues with ROI, but only 12% overcame it.

The biggest issues with IT was the immaturity of the technology. 54% experienced resistance from IT, but only 17% overcame this resistance.

Lessons learned:

  • Enterprise 2.0 isn’t free
  • Driving adoption isn’t magic, it requires
    • resources
    • time
    • focus
    • money

The ROI is there. It’s just hard to measure.