Monday’s East Coast earthquake was far from a disaster. I just thought I had too much coffee, until I heard others in the hallway say “Do you feel that?” Then I realized the shaking was not just because I was over-caffeinated.
Even though significant earthquakes are rare on the East Coast, hurricanes are not. Irene, the first big hurricane of the season is also approaching the East Coast.
Perhaps these are some good reminders to blow the dust off your disaster recovery plan. As a registered investment adviser, you need to have a plan. Each of the thousands (hundreds?) of private fund managers getting ready to register as investment advisers with the Securities and Exchange Commission will need a plan.
It’s easy to miss the requirement for having a business continuity plan. It’s in Rule 206(4)-7. Oh, you don’t see anything about business continuity in the rule? It’s not in the rule, it’s in the Release for Rule 206(4)-7:
We believe that an adviser’s fiduciary obligation to its clients includes the obligation to take steps to protect the clients’ interests from being placed at risk as a result of the adviser’s inability to provide advisory services after, for example, a natural disaster or, in the case of some smaller firms, the death of the owner or key personnel. The clients of an adviser that is engaged in the active management of their assets would ordinarily be placed at risk if the adviser ceased operations. [SEC Release No. IA-2204]
At least one of the hedge funds being investigated for its use of expert networks in based in Massachusetts. In an unusual instance of the state regulators acting before Securities and Exchange Commission, the Massachusetts securities regulators are proposing a new regulation to address the use of expert network services. They are proposing a new section under 950 CMR 12.205(9)(c)(16) to the existing list of dishonest and unethical practices:
16. a. To retain consulting services, for compensation that is provided either directly to the consultant or indirectly through a Matching or Expert Network Service, unless the adviser obtains a written certification, signed by the consultant that:
(i) describes all confidentiality restrictions that the consultant has, or reasonably expects to have, regarding Confidential Information; and
(ii) affirmatively states that the consultant will not provide any Confidential Information to the adviser.
b. Notwithstanding section (a) an investment adviser who comes into possession of material Confidential Information through a consultation is precluded from trading any relevant security until such time as the Confidential Information is made public.
c. Definitions. For purposes of this section:
(i) “Confidential Information” means any non-public information, which one is bound by a confidentiality agreement or fiduciary (or similar) duty not to disclose.
(ii) “Matching or Expert Network Service” means a firm that for compensation matches consultants with investment advisers.
As alleged in In the Matter of Risk Reward Capital Management Corp., RRC Management LLC, RRC BioFund LP, and James Silverman, Docket No. E-2010-057, some investment advisers have paid expert networks and consultants to access confidential information about publicly traded companies.
Massachusetts wants additional measures to ensure that confidential information is not being accessed and traded upon. The proposed regulations do not alter an investment advisers’ existing duty not to trade on insider information. The goal is to provide investment advisers with greater clarity as to what is impermissible conduct when paying consultants for information.
In the end, it seems like it is just a record-keeping exercise to me.
Section 918 of Dodd-Frank Act required a study on mutual fund advertising. The Government Accountability Office delivered that report before the 18 month deadline to the designated Congressional committees. The Report’s objectives were “to examine (1) what is known about the impact of mutual fund advertisements on investors, (2) the extent to which performance information is included in mutual fund advertisements, and (3) the regulatory requirements that exist for mutual fund advertisements and how they are administered and enforced.” Just for fun, the GAO included ETFs in the study given their popularity and some similar legal structures
The GAO reviewed Securities and Exchange Commission and Financial Industry Regulatory Authority (FINRA) rules and studies related to mutual fund advertising’s impact on investors. They also reviewed a random sample of 300 fund advertisements.
The most interesting finding (at least most interesting to me) is that they did not find a clear harm from advertisements that included performance results. Traditionally, research has shown that past performance generally does not persist and is not predictive of future performance. Therefore performance advertisements would be inherently misleading. Under Rule 482, mutual fund advertisements that includes performance data have to point out that past performance does not guarantee future results.
However, the GAO found some studies illustrate that investors who are influenced by performance advertising may still achieve returns that exceed market indexes or other funds.
The main recommendation that came out of the report was to ensure the “FINRA develops sufficient mechanisms to notify all fund companies about changes in rule interpretations for fund advertising.” Both SEC and FINRA agreed with the recommendation.
From Federal Reserve's Section 946 Risk Retention Study
There is no doubt that securitization helped fuel the residential housing bubble that lead to the Great Panic of 2008. Lenders found ready buyers for their loan portfolios, could sell them, then lend the money out again to create new loan portfolios to resell. One of the issues is that the lenders became purely loan originators, selling off 100% of their interest. So their focus was on generating new loans and not making sure the loans were re-paid. Their lending standards consequently grew more and more lax.
That’s an oversimplification of the process, but shows the general problems of not “having any skin in the game.” By removing the credit risk, securitization may reduce an originator’s incentives to properly underwrite and evaluate borrowers. In addition, since the investor in the securitization is generally several steps removed from the loan origination, there is an information asymmetry.
Section 941 of Dodd-Frank requires securitizers to retain economic interest of at least five percent of credit risk of assets they securitize. As with much of Dodd-Frank, it’s up to the regulators to figure this all out and promulgate the rules. The idea is that properly structured risk retention can address some of the inherent risks of securitization.
Although risk retention may be good for bondholders, it may be bad for the amount of credit and liquidity available. It may also result in higher costs for borrowers. The banks need to retain some its capital in the form of retention. That capital will just be sitting there until the underlying debt obligations are repaid.
On April 29, 2011, the OCC, Board, FDIC, Commission, FHFA and HUD published a joint notice of proposed rulemaking for public comment to implement the credit risk retention requirements of section 15G of the Securities Exchange Act of 1934 (15 U.S.C. § 78o-11), as added by section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
The rule will inevitably affect the amount credit available for deal flow and re-investment. There will likely be higher borrowing costs and barriers to execution.
The rule will also affect the residential real estate market since it creates a new category of “Qualified Residential Mortgages” that are exempt from risk retention requirements. I assume that loans that fall outside the exemption will be more expensive for the borrowers and limit the availability of credit for home purchases.
The proposed regulations extend for about 100 pages. That’s a big chunk of new law that will have profound effects on the lending industry.
For commercial mortgage backed securities, the sponsor must retain a “horizontal residual interest” of at least 5% of the par value. There is an option to hold a cash reserve account instead of equity. There is an exception to the risk retention requirements for commercial real estate loans with a laundry list of requirements:
Secured by a first lien on the commercial real estate.
Verified and documented the current financial condition of the borrower;
Obtained a written appraisal of the real property securing the loan that
Qualified the borrower for the CRE loan based on a monthly payment amount derived from a straight-line amortization of principal and interest over the term of the loan (but not exceeding 20 years);
Conducted an environmental risk assessment to gain environmental information about the property securing the loan and took appropriate steps to mitigate any environmental liability determined to exist based on this assessment;
Conducted an analysis of the borrower’s ability to service its overall debt obligations during the next two years, based on reasonable projections;
Determined that, based on the previous two years’ actual performance, the borrower had:
(A) A DSC ratio of 1.5 or greater, if the loan is a qualifying leased CRE loan, net of any income derived from a tenant(s) who is not a qualified tenant(s);
(B) A DSC ratio of 1.5 or greater, if the loan is a qualifying multi-family property loan; or
(C) A DSC ratio of 1.7 or greater, if the loan is any other type of CRE loan;
Determined that, based on two years of projections, which include the new debt obligation, following the origination date of the loan, the borrower will have:
(A) A DSC ratio of 1.5 or greater, if the loan is a qualifying leased CRE loan, net of any income derived from a tenant(s) who is not a qualified tenant(s);
(B) A DSC ratio of 1.5 or greater, if the loan is a qualifying multi-family property loan; or
(C) A DSC ratio of 1.7 or greater, if the loan is any other type of CRE loan.
The loan documents require the borrower to provide financial statements and supporting schedules on an ongoing basis.
The loan documents impose prohibitions on:
(A) The creation or existence of any other security interest with respect to any collateral for the CRE loan;
(B) The transfer of any collateral pledged to support the CRE loan; and
(C) Any change to the name, location or organizational structure of the borrower, or any other party that pledges collateral for the loan.
The loan documents require the borrower to maintain insurance that protects against loss on any collateral.
The loan documents require the borrower to pay taxes, charges, fees, and claims, where non-payment might give rise to a lien on any collateral for the CRE loan.
The loan documents require the borrower take any action required to perfect or protect the security interest and to defend such collateral against claims adverse to the originator’s or subsequent holder’s interest.
The loan documents require the borrower to allow inspection the collateral for the CRE loan and the books and records of the borrower or other party relating to the collateral for the CRE loan.
The loan documents require the borrower to maintain the physical condition of the collateral for the CRE loan;
The loan documents require the borrower to comply with all environmental, zoning, building code, licensing and other laws, regulations, agreements, covenants, use restrictions, and proffers applicable to the collateral.
The loan documents require the borrower to comply with leases, franchise agreements, condominium declarations, and other documents and agreements relating to the operation of the collateral, and to not modify any material terms and conditions of such agreements over the term of the loan without the consent of the originator or any subsequent holder of the loan, or the servicer.
The loan documents require the borrower not materially alter the collateral.
The loan prohibits the borrower from obtaining a loan secured by a junior lien on any property that serves as collateral for the loan
The CLTV ratio for the loan is:
(i) Less than or equal to 65 percent; or
(ii) Less than or equal to 60 percent, if the capitalization rate used in an appraisal that meets the requirements set forth in paragraph (b)(2)(ii) of this section is less than or equal to the sum of:
(A) The 10-year swap rate, as reported in the Federal Reserve Board H.15 Report as of the date concurrent with the effective date of an appraisal that meets the requirements set forth in paragraph (b)(2)(ii) of this section; and
(B) 300 basis points.
All loan payments required to be made under the loan agreement are based on straight-line amortization of principal and interest over a term that does not exceed 20 years; and
Loan payments made no less frequently than monthly over a term of at least ten years.
Maturity of the note occurs no earlier than ten years following the date of origination.
The borrower is not permitted to defer repayment of principal or payment of interest.
The interest rate on the loan is:
(A) A fixed interest rate; or
(B) An adjustable interest rate but the borrower obtained a derivative that effectively results in a fixed interest rate.
The originator does not establish an interest reserve at origination to fund all or part of a payment on the loan.
At the closing of the securitization transaction, all payments due on the loan are contractually current.
That is big set of regulations for commercial loan documents. A positive result of the rules would be to have a more standardized set of loan documents used for loans. That could help offset some of the additional costs that may result from the rules.
I would guess that most of you reading this story do not share my love of the Tour de France. It can be a confusing mix of skinny guys, tarted up with sponsors like a NASCAR racer, with hard to pronounce names, following tactics unusual outside of cycling. But I since I became a fan a decade ago, I continue to be enthralled by drama and athletic heroism on display.
I also saw compliance lessons.
Stage 18 was a brutal day of riding up big mountains in the Alps. The riders started with the Col Agnel, a climb of almost 24km, averaging 6.6 percent, but most importantly averaging 10 percent for the final 9km. Down, then up the Col d’Izoard 15km at 7.1 percent gradient. Down and then up to the 23km to the finish on top of the Col du Galibier. A moonscape at 8,678 feet that had a fresh snowfall just days before the cyclists arrived.
One of the rules of the Tour is that riders who finish too far behind the winner get eliminated from the race. In these big mountain stages the non-climbers fall off the back of the peloton and form a group of riders form that just hopes to finish the stage. Their primary concern is beating the elimination time to ensure the can ride the next day. effectively, the riders self-organize to fight the rule.
At the end of stage 18, 80 riders (nearly half the racers) arrived in the grupetto more than 35 minutes after the winner. This was after the cut-off time. They were not kicked out of the rice, but some were given meaningless penalties.
Stage 19 was another brutal climbing day, going up the Col du Telegraph, back up Galibier, and then scampering up the legendary Alp d’Huez. For the second day in a row, the huge grupetto finished beyond the time cut, with 82 riders crossing the line beyond the limit. The day’s time cut was set at 13 percent of the winner’s time. The race officials allowed the group to remain in the race. All riders in that group were penalized 20 points in the points classification, but both green jersey contenders, Mark Cavendish and Jose Rojas, were in the group. The one poor victim was Bjorn Leukemans, who finished well behind the grupetto and was eliminated.
A rule was broken by almost half the participants but there was no meaningful discipline. How would that work inside your company? If the rule is being broken by that many people, maybe it’s a bad rule?
[o]n Jan. 21, 1980, gold hit what is still its all-time high in inflation-adjusted dollars. To match that high in today’s dollars, gold prices would have to rise by another 50 percent, to more than $2,400 an ounce.The core themes driving up the price were the same then as now: Inflation fears, global instability, and a lack of faith in governments and the currencies they back.
Now the independent directors of News Corp. have hired former Manhattan U.S. Attorney Mary Jo White, former U.S. Attorney General Michael Mukasey, and their law firm, Debevoise & Plimpton, to advise them. News Corp. itself has hired Mark Mendelsohn, who ran the Justice Department’s FCPA unit and helped turn the statute from a backwater into a prosecution machine and a gold mine for lawyers and accountants. Mendelsohn reportedly has been hired to advise on a potential investigation.
Last week, the 192 member states of the United Nations (193 from mid-week onwards, as South Sudan was admitted on July 14) met in New York to continue their negotiations towards an “Arms Trade Treaty” (ATT). States are keen to agree on an ATT in 2012, reaching a long overdue international agreement to finally regulate the global trade in arms. We represented Transparency International’s Defence and Security Programme and participated along with more than 100 other NGO representatives.
But the biggest filings are also getting bigger: While the top 20 filings in the first half of 2010 totaled 52,514 pages, the top 20 so far this year add up to 56,571 pages, an increase of just under 8%. And the most prolific filers are sending the SEC more documents: 16,412 of them from the top 20 companies, up 9% from the first half of 2010, when the figure was 15,028 filings. With that kind of growth, among other factors, you can imagine why Mary Schapiro wants a budget increase.
In response to these continuing uncertainties the SFO have told us that they will be looking at five factors when considering corporate hospitality in the context of the Bribery Act.
Last month, the Federal Trade Commission (FTC) published a letter closing its investigation into whether an “Internet and social media background screening service used by employers in pre-employment background screening” complied with the Fair Credit Reporting Act (FCRA). At first blush, the letter appears to be a non-event. The FTC did not impose a penalty but also admonished that its “action is not to be construed as a determination that a violation may not have occurred.” While not much can be drawn from this equivocal result, the FTC’s letter does contain the following important conclusion: the “social check” service in question, known as Social Intelligence, “is a consumer reporting agency because it assembles or evaluates consumer report information that is furnished to third parties that use such information as a factor in establishing a consumer’s eligibility for employment.” Put into plain English, employers that rely on a social check service, like Social Intelligence, to search social media for information about job candidates must comply with the FCRA.
It’s clearly wrong to break the law. How close should you come to the limit of what is legal and what is illegal? Let’s hear from a federal prosecutor:
[I]f you are single-mindedly focused on walking the line, you are bound to end up afoul of regulators, and God forbid, criminal prosecutors. Even more dangerous perhaps, you are sending a message to every other person at the firm that line-walking is a good idea. That can work for a while, but people will invariably miscalculate and bad things will invariably follow.
– Preet Bharara, United States Attorney for the Second Circuit
A recent ruling in favor of the Janus mutual funds’ adviser in the Supreme Court is continued fall out from the mutual fund market timing scandal from almost a decade ago. The prospectuses for several Janus funds represented that the funds were not suitable for market timing and could be read that Janus Capital Management LLC, the mutual fund’s investment adviser, would implement policies to curb market timing. They didn’t and certain traders were able to engage in market timing.
First Derivative Traders represented a class of plaintiffs who owned the stock of the Janus Capital Group, the publicly traded company that owned the investment adviser. After the allegations of market timing surfaced the share price of Janus fell precipitously.
First Derivative alleges that JCG and JCM “caused mutual fund prospectuses to be issued for Janus mutual funds and made them available to the investing public, which created the misleading impression that [JCG and JCM] would implement measures to curb market timing in the Janus [mutual funds]. … Had the truth been known, Janus [mutual funds] would have been less attractive to investors, and consequently, [JCG] would have realized lower revenues, so [JCG’s] stock would have traded at lower prices.
That sounds like very tentative claim to me, especially when you insert the legal fiction that a mutual fund is separate from the fund’s advisers.
The issue is whether the adviser can be held liable in a private action under Rule 10b-5 for false statements in the mutual fund’s prospectus. Under Rule 10b–5, it is unlawful for “any person, directly or indirectly, . . . [t]o make any untrue statement of a material fact” in connection with the purchase or sale of securities. 17 CFR §240.10b–5(b). To be liable, the adviser must have “made” the material misstatements in the prospectuses.
The US Supreme Court says no. It was the fund itself that made the false statement, not the investment adviser. They are legally separate entities with separate boards. In fact, the board of the Janus fund was more independent than required by statute. Only the fund, not the adviser, has the obligation to file the prospectuses with the SEC.
This rule follows from Central Bank of Denver, N. A. v. First Interstate Bank of Denver, N. A., 511 U. S. 164 (1994). The Court held that Rule 10b–5’s private right of action does not include suits against aiders and abettors. Suits against entities that contribute substantial assistance to the making of a statement may be brought by the SEC. Private parties can only bring suit for direct statements. A broader reading of “make,” including persons or entities without ultimate control over the content of a statement, would substantially undermine Central Bank, said the Court, If persons or entities without control over the content of a statement could be considered primary violators who “made” the statement, then aiders and abettors would be almost nonexistent.
It’s not that Janus didn’t suffer for allowing market timing. In 2004, Janus reached a settlement with the SEC for market timing allegations Janus paid $100 million in disgorgement and civil penalties. A big chunk of that cash was returned to the fund shareholders.
The Supreme Court decision merely draws the line at a derivative lawsuit by the adviser’s corporate shareholders.
Just about every compliance certification has the employee sign at the bottom. We have been signing letters and contracts at the end for millenia.
But maybe there is a way to increase ethical performance by moving that signature to the top.
Lisa L. Shu, Nina Mazar, Francesca Gino, Dan Ariely, and Max H. Bazerman recently published a paper that found differences in compliance/ethical performance depending on whether the participant signed first or at the end.
In one experiment, the subjects took a test and scored it themselves. They would be paid based on their performance and reimbursed for their expenses incurred in attending the test. After self-scoring the test they went into another room to self report their income on a tax form. There were three forms:
One with a certification at the beginning that all information is true
A second with the same certification, but at the end
A third with no certification
The test and reporting was set up to be very easy to cheat, with a simple and immediate cash reward for cheating. You should not be surprised that cheating was rampant.
With the third form, with no certification, cheating occurred 64% of the time. With the certification at the bottom, the cheating actually rose to 79%. The winner, with the certification at the beginning, only had a 37% cheat rate.
Moving the certification to the beginning had a dramatic, positive effect on reducing cheating.
The paper includes several other similar experiments with the same results. A slightly different test involved word puzzles. Those that signed an honesty pledge before engaging in the cheating experiment ended up solving more of the ethics-related words than the others.
The authors theorize that the certification at the top pre-sets the person to start thinking more ethically. If they don’t hit the certification until the end, they have already supplied the information with whatever ethical slant they may have.
I’m going to re-think how I design my certification. At the top will be a certification that all of the information is true and correct, before they start filling in the information.
Just about every compliance certification has the employee sign at the bottom. We have been signing letters and contracts at the end for millenia.