Compliance Bits and Pieces for October 7

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

How Well Do Financial Markets Separate News from Noise? Evidence from an Internet Blooper by Carlos Carvalho, Nicholas Klagge, and Emanuel Moench in Liberty Street Economics

How efficiently do financial markets process news of unexpected events? This question becomes particularly salient now, as multiple events across the globe drive market movements. Do these gyrations reflect responses to fundamental news or to “noise”? In general, it is very difficult to discern how well markets process information, because there is no objective way for observers to separate fundamental news from noise components when markets react to a news report. In this post, however, we examine an unusual episode involving a false news report that provides a unique look into this question. We find that even when noise can be clearly identified, markets may take as long as a week to fully process the “signal,” or relevant information, component of news.

Subcommittee Advances 5 Bills to Promote Job Growth

Five bills that ease the regulatory burden on small businesses and emerging growth companies were approved by a Financial Services subcommittee yesterday. The proposals make it easier for entrepreneurs and small businesses to access capital so their companies can grow and create jobs.

Cozy relationships and ‘peer benchmarking’ send CEOs’ pay soaring by Peter Whoriskey in The Washington Post

This is how it’s done in corporate America. At Amgen and at the vast majority of large U.S. companies, boards aim to pay their executives at levels equal to or above the median for executives at similar companies.

The idea behind setting executive pay this way, known as “peer benchmarking,” is to keep talented bosses from leaving.

But the practice has long been controversial because, as critics have pointed out, if every company tries to keep up with or exceed the median pay for executives, executive compensation will spiral upward, regardless of performance. Few if any corporate boards consider their executive teams to be below average, so the result has become known as the “Lake Wobegon” effect.

Overview of the Latest Corruption by American Companies by Mike Koehler in Corruption Currents

On a weekly basis – or so it seems – media allegations surface of corruption by or related to American companies. This article highlights three such instances: Koch Industries, Motorola Solutions, and Chevron.

Reckless Endangerment

So what caused the 2008 financial crisis? We know that the direct cause was the meltdown in the US housing market. I think we are still trying to put together the pieces and point the finger of blame. It was a big bubble and the explosive reaction when the bubble burst. It took many different forces to get the bubble so big.

In Reckless Endangerment, Gretchen Morgenson and Joshua Rosner take their turn looking at the outsized ambition, greed, and corruption that lead up to the crisis. They point the finger of blame directly at Fannie Mae and its executives.

The authors portray a company that ruthlessly leveraged the implicit government guarantee to create billions of dollars of shareholder wealth and millions of dollars in executive compensation. They beat the drumbeat of housing as the American Dream. Everyone should get a chance to own their own home. Fannie Mae used their version of the American Dream to bully Congress and their regulators to let them have a very thin capital reserve and to keep their finances very opaque. The authors pin the blame squarely on James Johnson, the CEO of Fannie Mae during the 1990s and his successor, Franklin Raines.

The rating agencies also get some of blame by the authors. I think the rating agencies have not received enough of the blame. Their shoddy rating of debt instruments let them get AAA ratings that they did not deserve. Only a handful of companies and a handful of countries get the top rating. But when it came to real estate backed securities, the rating agencies were handing them out like cotton candy at the state fair.

Institutional investors were looking for safe place for their money that could still earn a coupon. US treasury bonds were paying a very low interest rate. Pension funds and insurance companies determine their funding levels based on a projected rate or return. Many were limited to only invest in the highest quality asset either by regulation or internal policies. That meant they would only buy the top rated bonds.

Banks has to maintain their capital levels based on the quality of the loans/bonds/assets they held. With top-rated bonds, the banks had to retain very little capital. By holding AAA ratted bonds, the banks could retain less capital and put more to work.

The rating agencies were telling them that these mortgage-backed securities were top rated. (They were wrong.)

The vast majority of the book is spent sticking pins in Fannie Mae, their lobbying efforts, and their executives. I agree that Fannie Mae abused its position. I agree that Fannie Mae helped create an attitude that everyone should be a homeowner and everyone should be able to afford to buy a home. But their story comes to crashing halt in 2004 when Fannie Mae gets caught in large scale accounting fraud. Most of the manipulation can be tied directly to triggers for executive compensation.

In 2005 the first signs of bad mortgages were popping up and the buyers for the lower rated pieces of mortgage debt were not buying them. Without those buyers, the mortgage securitization would fail. Fannie Mae was leading the charge up until that point. But it didn’t stop there. That’s why have a problem pointing the finger at Fannie Mae. The mortgage/housing boom kept going.

The authors pull some of the dubious lenders into the book. Countrywide, Novastar, and Fremont all get ripped apart.

It’s not until the last chapter that they hit upon the issue that hyper-inflated the real estate bubble. The buyers for the lowest rated pieces of mortgage-backed securities were not buying as much. In part, this was because the increased quantity of junk they saw ending up in the pools. In part, it may be because they saw the bubble. Then the magic happened.

Wall Street firms packaged the lower rated pieces into new pools and sold those securities. These were the toxic assets. Somehow they convinced the rating agencies that some tranches of this pile of junk could still get the top ratings. Those high rated tranches were sold off to the institutional investors and the real nasty stuff was sold off to more speculative investors. This kept the mortgage securitization pipeline going for two more years.

Why keep going when you could see the bubble? It was their job. There were thousands of jobs tied to originating the mortgages, the warehouse lines that funded them, the organization of the pools and the selling of the final securities. It was not their job to assess the bubble and just stop working. There was no brakeman in the system. The regulators do not have the oversight, the power, or the willingness to stop an asset bubble. (Let’s see what happens with the price of gold.)

The brakes were slammed on when the Wall Street firms realized they were holding on to the lowest rated tranches of the securitizations and they couldn’t get rid of them. They stopped the production. They stopped it fast. In early 2007 warehouse lines were cut off and underwriting standards were suddenly raised to higher (more sensible?) levels.

With the pipeline cutoff, the hyper-inflated housing bubble reached the bursting point. Then mortgage-backed securities investors stopped getting their checks. They realized that their coupon-paying beauty queen was just a pig with lipstick.

I think All the Devils Are Here did a better job of putting all the pieces together and The Big Short did a better job explaining the mechanisms of the mortgage-backed securities industry. If you don’t like Fannie Mae or want to read a story of how corporate greed exploited American politics then Reckless Endangerment should be on your reading list.

Lifting the Ban on General Solicitation

From a  securities compliance perspective, when you  see an advertisement or an email seeking capital for an investment opportunity there is most likely a problem. Now there is a bill in Congress that would change that view.

When selling a security, you need to register the security or find an appropriate exemption from registration. Most likely a private fund or an entrepreneur would try to fall under one of the exemptions under Regulation D. If the company is seeking over $1,000,000 they are prohibited from offering to sell the securities “by any form of general solicitation or general advertising“. Before asking someone to make an investment, you need to have a preexisting, substantive relationship.

“The types of relationships with offerees that may be important in establishing a general solicitation has not taken place are those that would enable the issuer (or a person acting on its behalf) to be aware of the financial circumstances or sophistication of the person with whom the relationship exists or that otherwise are of some substance and duration.” Mineral Lands Research & Marketing Corp., S.E.C. No-Action Letter, 1985 WL 55694 (Dec. 4 1985).

Representative Kevin McCarthy (R-CA) introduced the Access to Capital for Job Creators Act (HR 2940) which require the Securities and Exchange Commission to revise its rules to permit general solicitation in offerings under Rule 506 of Regulation D.

In my view, I don’t think there should be an elimination of the ban on general advertising and general solicitation. That would just expose large segments of the population to potential securities fraud. Currently, ads for investment opportunities are red flags for state and federal regulators.

However, I do think it needs to a little easier for entrepreneurs to raise capital. The SEC should offer some better guidance on the limitation. They could also offer some programs and safe harbors. I assume the SEC is waiting for someone to approach them with examples. They continue to be too underfunded and too understaffed to be proactive.

Will the Access to Capital for Job Creators Act be enacted? I doubt that it would pass in its current form. It takes away some investor protection and warning system for securities regulators. That would seem a bad position when the country is stealing trying to recover from the massive losses of 2008.

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Crowdfunding

It’s hard to raise capital. The regulatory restrictions imposed by securities laws make it harder to do so. As any bright-eyed entrepreneur with a dream project will tell you, the lawyers and the securities laws make it very expensive and time consuming to raise capital for a small project.

The central goal of the Securities and Exchange Commission is to facilitate companies’ access to capital while at the same time protecting investors. More often than not, the securities laws and regulations are put in place due to some prior malfeasance. Limitations on the sale of securities are in place because there were (and still are) lots of shady characters trying to make a quick buck by de-frauding investors.

The Obama administration and the Congress think the regulatory burdens need to be removed to encourage small business capital formation. I’m going to guess that they are fans of Kickstarter, a website that allows entrepreneurs and artists to raise capital for their projects. (I’m also a fan and have contributed to some projects.)

SEC Rule 504 allows a public offering to investors (including non-accredited investors) for securities offerings of up to $1 million. There is no limit on the type of investors, so they need not be accredited investors.  There are no prescribed disclosures and no limitations on resales of the securities. The Rule generally does not allow companies to solicit or advertise their securities to the public.(Of course, the antifraud and other civil liability provisions of the federal securities laws are still applicable.)

However, these offerings are subject to state “blue sky” regulation. That means having to jump through the patchwork of state securities laws, depending where your target investors are located.

How does Kickstarter get around this? It doesn’t. Capital for Kickstarter projects cannot be for securities or lending. As a patron, you do not get your capital returned. Often, you’ll get the end product that the artist or entrepreneur was hoping to produce. (My son is patiently waiting for our pack of trebuchettes to arrive.)

Generally, the term “crowdfunding” is used to describe a form of capital raising whereby people pool money, generally as small individual contributions, to support a specific goal. Since the capital raising did not provide an opportunity for profit participation, initial crowdfunding efforts did not raise issues under the federal securities laws.

The Entrepreneur Access to Capital Act would create a new exemption for small companies, allowing them to raise up to $5 million. The limitation would be that investments are limited to the lesser of $10,000 or 10% of the investor’s annual income.

President Obama cheered for crowdfunding as part of the American Jobs Act unveiling. I failed to find and proposed legislative changes in his proposed bill.

I’m for fueling entrepreneurial growth in this country. I’m concerned that the changes could lead to an onslaught of fraud. I think Kickstarter works well because you are funding the effort. You are not seeing dollars signs.

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Stealing Private Equity Investment Opportunities

Private equity transactions are not outside the scope of enforcement by the Securities and Exchange Commission. The SEC filed a case against a former principal of an investment adviser that manages private equity funds. The charge is that he “usurped …[a] lucrative investment opportunity in a private company.” At this point, the SEC has only filed for a cease and desist order and has not proven the allegations against Matthew Crisp.

Crisp worked for Adams Street Partners, a private equity firm registered with the SEC as an investment adviser. In 2006 and 2007, Adams Street was looking at investing in TicketsNow. Crisp was assigned as the lead sponsor of the possible investment. They decided to go ahead, but the investment was greater that their typical investment amount so Crisp decided to syndicate a portion of the committed investment.

Crisp decided to create his own investment fund and take a portion of the  syndication. Adams Street contends that Crisp was not authorized to syndicate the investment to his own fund. He also increased the size of his fund’s allocation.

The SEC contends that the resulting decrease in the size of the Adams Street’s collective investment in TicketsNow was a misappropriation of a lucrative investment opportunity that should have gone to Adams Street. The SEC alleges that Crisp did not disclose his involvement to Adams Street. That would include failing to report the involvement on his periodic compliance disclosures. Failure to disclose such information was a violation of the Adam Street’s fiduciary duties and of it’s policies.

It turned out to be a good investment because TicketsNow was sold to a competitor a year later.The investment tripled their invested capital.

The SEC alleges that this was not a single instance of malfeasance. They claim that Crisp tried again with an investment in Sherman’s Travel. He took a syndication in that investment in his own investment fund.

Adams Street discovered the problem and, after conducting an internal investigation, terminated Crisp. Thy also took the next step and self-reported the matter to the SEC.

The SEC alleges that Crisp violated Sections 206(1), 206(2), and 206(4) of the Advisers Act. They extend this through Rule 206(4)-8 which prohibits fraudulent activity by advisers to pooled investment vehicles with respect to investors or prospective investors.

In the alternative, the SEC contends that Crisp aided and abetted Adams Street’s violation of Sections 206(1), 206(2), and 206(4) of the Advisers Act, extended through Rule 206(4)-8.

Further, the SEC alleges that pursuant to the actions outlined above, Crisp willfully violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder.

The cease and desist proceeding is being instituted to determine whether the allegations noted are true and what remedial action is appropriate. Crisp already returned a large portion of his returns to Adams Street.

As more private equity fund managers are going to be registered with SEC in the next six months, I found this case to be an interesting example of SEC enforcement in the industry. Assuming that Crisp actually did what the SEC alleges, such activity should be a violation of the firm’s conduct policy and a violation of it’s funds’ partnership agreements. Investors generally will impose a contractual obligation on the fund manager to not divert investment opportunities to employees and principals of the fund manager.

So how does SEC enforcement help in this area? I suppose it adds the scare factor of a government investigation on top of losing your job and professional reputation.

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Robbery Not Allowed is by Anders Sandberg

Compliance Bits and Pieces for September 30

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

“Is there anything connected with this accelerator that involves the security of the country?” by Chris Yeh in Adventures in Capitalism

“It has only to do with the respect with which we regard one another, the dignity of man, our love of culture. It has to do with: Are we good painters, good sculptors, great poets? I mean all the things we really venerate in our country and are patriotic about. It has nothing to do directly with defending our country except to make it worth defending.” – physicist Robert Rathburn Wilson

California and Bust by Michael Lewis in Vanity Fair

The smart money says the U.S. economy will splinter, with some states thriving, some states not, and all eyes are on California as the nightmare scenario. After a hair-raising visit with former governor Arnold Schwarzenegger, who explains why the Golden State has cratered, Michael Lewis goes where the buck literally stops—the local level, where the likes of San Jose mayor Chuck Reed and Vallejo fire chief Paige Meyer are trying to avert even worse catastrophes and rethink what it means to be a society.

At SEC, Strategy Changes Course by Jean Eaglesham in the Wall Street Journal

In a major shift from the agency’s traditional enforcement strategy, the SEC could file more civil cases in which defendants are accused of negligence only, rather than harder-to-prove charges of intentional wrongdoing or recklessness, according to SEC officials.

Ethisphere and the New York Stock Exchange

This morning, the Ethisphere Institute is ringing The Opening Bell at the New York Stock Exchange with some of the NYSE-listed 2011 World’s Most Ethical Companies. I guess the NASDAQ companies are not invited.) The purpose is to recognize the connection between ethical business practice and increased business performance.

NYSE-listed 2011 World’s Most Ethical Companies that will ring the bell with Ethisphere include

  • AECOM
  • Ford
  • General Electric
  • International Paper
  • Jones Lang LaSalle
  • Marriott
  • PepsiCo
  • Salesforce.com

The Bell ringing is followed by Ethisphere’s NYSE Bell Ringing & Ethics Drives Performance™ Conference.

The World’s Most Ethical Companies, if indexed together, have significantly outpaced the S&P 500. I found it interesting that the companies outperform going forward once they are recognized, not just leading up to the recognition.

Ethisphere numbers seem to take the current list of companies and look at their performance. I expect that companies getting onto the list are well run and should perform well. But would it last going forward? I took the companies from the original 2007 and tracked them forward.

The companies on the 2007 list, as a group outperformed the broader S&P 500 and Dow Jones Industrial Average.  They were not all winners.

Ethisphere is now accepting nominations for the 2012 World’s Most Ethical Companies. To learn more about the World’s Most Ethical Companies recognition and selection process and to nominate your organization for consideration visit:http://ethisphere.com/nominations/.

The Echoes of Madoff at the SEC

The Madoff scandal is one of the low points in the history of the Securities and Exchange Commission. Every Congressional hearing or SEC-basher inevitably uses the failure to catch Madoff as evidence of the ineffectiveness of the SEC.

In a continuing journey down the rabbit hole, the SEC’s Inspector General David Kotz released his 123-page report (.pdf) on former SEC General Counsel David Becker and his involvement with Madoff. Kotz has made a referral to the Department of Justice under a criminal conflict of interest provision.

Mr. Becker’s late mother had an account with Madoff. If Mr. Becker were to be involved in mopping up the Madoff matter, there would be potential conflict of interest.

David Becker seems to have done the correct thing. He sought an answer from the SEC Ethics Counsel as to whether he should work on Madoff matters.

“I did precisely what I was supposed to do. I identified a matter that required legal advice from the SEC’s Ethics Office. I sought that advice, received it, and followed it.” Testimony of David Becker September 22, 2011

He fully disclosed the fact that he had been a beneficiary of his mother’s estate which had invested in Madoff funds. The Ethics Counsel told him he did not need to recuse himself. His boss, SEC Chair Mary Shapiro, knew of the investment.

Nonetheless, the SEC’s Inspector General is referring its results to the Department of Justice for criminal investigation.

Personally, I don’t think Mr. Becker actually did anything wrong. I believe he joined the SEC as a white hat, wanting to resume his role in public service.

The problem is that it looks like he did something wrong. That’s the problem with conflicts of interest. Even if you do the right thing, it will look like you were improperly influenced or tainted.

Becker did seek guidance from the SEC’s Ethics Counsel. Unfortunately, the Ethics Counsel is part of the Office of the General Counsel. As General Counsel, Becker was the advice-giver’s boss. Another conflict.  I’m not saying that Becker actually unduly influenced the Ethics Counsel. It’s just looks bad and layers another conflict of interest onto the existing conflict of interest.

The SEC knew that Madoff was toxic and high-profile. They should have been more vigilant and not allowed Becker to participate. I would guess that Becker was so good at his job and so enthusiastic to help that he and the SEC failed to see his weaknesses. It would be hard to make him sit on the sidelines while the Commission was trying to clean-up after one of its biggest failure. But that is what they should have done.

They let the conflict of interest stay in place. That should have known that it would subject them to a later review and attack on their decision to keep Becker involved. They should have known that it would have led to something like the Inspector General’s report.

I don’t think Becker should be subject to criminal charges and hopefully the Department of Justice will drop the matter after a brief investigation.

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But the Computer Did It!

The Securities and Exchange Commission brought charges of securities fraud for concealing a significant error in the computer code of the quantitative investment model. I found this case to be interesting because it was not flawed human decisions, but flawed computer decisions. However, we still live in the age where computers do what we tell them to do. So, if the computer is doing something wrong, then a person is behind it.

Barr M. Rosenberg developed complex automated models and an “optimization” process to create and manage client portfolios. Barr Rosenberg Research Center LLC was the registered investment adviser. In April 2007, BRRC put into production a new version of the Risk Model, one component of its quantitative trading program. Two programmers linked the Risk Model to the Optimizer, a second component of the quantitative trading program. However, they made an error in the Optimizer’s computer code.

In June 2009, an employee noticed some unexpected results when comparing the new Risk Model to the existing one that was rolled out in April 2007. Some Risk Model components sent information to the Optimizer in decimals while other components reported information in percentages. That meant the Optimizer had to convert the decimal information to percentages in order to effectively consider all the information. That screwed up the inputs and the outputs resulting in the Optimizer not giving the intended weight to common factor risks.

As with most mistakes that lead to SEC action, the error caused the portfolios to underperform. The error impacted more than 600 client portfolios and caused approximately $217 million in losses. Obviously, this is a bad result.

The problems came, as they usually do, when someone tried to hide the problem. Mr. Rosenberg concealed the error and told his employees not to disclose the error to the investment officers or managers of the firm. That meant the firm was making material misrepresentations and omissions concerning the error to their clients, including:

(i) omitting to disclose the error and its impact on client performance,
(ii) attributing the Model’s underperformance to market volatility rather than the error, and
(iii) misrepresenting the Model’s ability to control risks.

The SEC charged Rosenberg with willful violations of  Sections 206(1) and 206(2) of the Investment Advisers Act. Section 206(1) prohibits any investment adviser from, directly or indirectly, “employing any device, scheme, or artifice to defraud any client or prospective client.” Section 206(2) prohibits any investment adviser from engaging in any “transaction, practice or course of business which operates as a fraud or deceit upon any client or prospective client.”

Rosenberg was aware of the problems, but did not disclose the error and directed others not to disclose. As a result, the firm misrepresented that the underperformance was attributable to factors other than the error and inaccurately stated that the model was functioning when in fact it was not. In addition, Rosenberg’s caused a delay in fixing the error leaving it uncorrected for several additional months. Rosenberg caused his clients to continue sustaining losses from an error that could have been promptly fixed.

Rosenberg has to pay the $2.5 million penalty fine and he received the ban from the SEC. He is barred from association with any broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization and prohibits him from serving as an officer, director or employee of a mutual fund.

Lesson learned. If the computer is broken, fix it right away. And don’t lie about it.

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