Compliance Bits and Pieces for November 5

Here are some interesting compliance related stories that caught my eye recently:

Does that Pass the Smell Test by Eilene Zimmerman in the New York Times‘ Career Couch

Q. Your boss has asked you to do something that seems unethical. How can you determine whether your suspicions are correct?

Ethisphere’s 20 Ethics & Compliance Officers ‘Who Matter’ by Bruce Carton in Compliance Week‘s Enforcement Action

Are you an attorney who matters in the world of ethics and compliance? Find out by checking Ethisphere’s Second Annual “Attorney Who Matter” list, which includes a section listing the top ethics and compliance officers of major companies. Ethisphere states that the attorneys chosen in the ethics and compliance category are people who are “using their positions to advance the cause of ethics and corporate compliance both inside and outside of their organizations.”

Naming and Shaming in the Economist

Congressmen working late into the summer nights to overhaul America’s system of financial regulation were surprised when Bono started lobbying them. Yet the rocker-cum-campaigner helped to insert a far-reaching change into the legislation they were drafting. It has nothing directly to do with America’s financial mess, but it will push forward the fight against corruption in the developing world, a cause which has made some much-needed progress recently.

Russian police uncovered 35,000 cases of corruption in Bloomberg

Major bribe-taking increased by 17.5 percent from January to September compared with the same period of 2009, the Interior Ministry said in a statement distributed to reporters today. The average size of a bribe increased 1.5 times to around $1,400.

Is Protecting Our Brand A 24×7 Responsibility? by Kathleen Edmond.

My point in telling this story is not to make Best Buy look like heroes. Rather, I’m more interested in the underlying ethical implications of the scenario. As individual employees, what is our responsibility to the Best Buy brand? When it comes to our ability to impact the brand perception of Best Buy, are we ever truly “off the clock?”

Proposed Whistleblower Rules Promote Internal Reporting by Bruce Carton in Compliance Week‘s Enforcement Action

In determining the amount of the award, one factor the SEC will consider is whether the whistleblower reported the potential violation through “effective internal whistleblower, legal or compliance procedures before reporting the violation to the Commission.” The proposed rule explains that the SEC will consider higher percentage awards for whistleblowers who first report violations through their compliance programs because “corporate compliance programs play a role in preventing and detecting securities violations that could harm investors.” The higher award is therefore intended to encourage whistleblowers to first report securities violations to their corporate compliance programs.

NLRB Alleges that Connecticut Company Illegally Fired Employee Over Comments on Facebook by Daniel Schwartz in the Connecticut Employment Law Blog

In an unprecedented case, the NLRB is pushing all in over the battle on social media. And its press release today leaves little doubt where it is placing its chips — strongly in the employee’s favor.

Violent Video Games and the Supreme Court in Wired.com’s GeekDad

It’s not often you hear something like this said in court:

“Would a video game that portrayed a Vulcan as opposed to a human being, being maimed and tortured, would that be covered by the act?”

That question was asked in the highest court in the United States when Justice Sotomayor asked Zackery Morazzini, California’s Supervising Deputy Attorney General about a California law that bans the sale or rental of violent video games to minors.

What is a Security? Is Real Estate a Security?


Previously, I went through the analysis that a fund manager is considered an investment adviser. But left open the question of “what is a security?” That’s a key question for fund managers with alternative investments, like real estate.

The Investment Advisers Act gives a very broad definition of a security:

any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security (including a certificate of deposit) or on any group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guaranty of, or warrant or right to subscribe to or purchase any of the foregoing. [202(a)(18)]

What’s missing from that definition is hard assets (collectibles, like baseball cards), futures contracts relating to commodities (but not future contracts relating to securities), and real estate (but not shares in real estate companies).

Pure bricks and mortar are not securities. So private equity funds that invest directly in hard real estate assets are not giving advice regarding securities.  As you start adding additional levels of ownership and holding companies, things get a bit grayer as you have more and more organizational boxes between the fund and the real estate.

One of the early seminal Supreme Court cases on the definition of a security involved a real estate deal. In 1946, SEC v W.J. Howey Co. (328 U.S. 293) involved an offering of units of a citrus grove development, coupled with a contract for cultivating, marketing, and remitting the net proceeds to the investor. They held that it was an offering of an “investment contract” within the meaning of that term as used in the provision of § 2(1) of the Securities Act of 1933 defining “security” as including any “investment contract,” and was therefore subject to the registration requirements of the Act.

For purposes of the Securities Act, an investment contract (undefined by the Act) means a contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.

There are three components:

  1. expectation of profits
  2. a common enterprise
  3. depends “solely” for its success on the efforts of others.

So passive investments, where investors do not have any decision-making power are securities. Investments made by the principals who are actively involved in the management of the enterprise are not securities. Of course, that leaves a whole lot of business arrangement in between.

Shares of stock in a corporation do not have enough involvement to get them out of the characterization of securities. Most real estate is owned in partnership or partnership-like entities to take advantage of some favorable tax treatment.  There is an expectation of profits and it’s going to be a common enterprise. That leaves the “success on the efforts of others” as the key test for investment entities.

Traditionally, limited partnership interests are generally securities because limited partners rely on the general partners to manage the partnership. Since Delaware and other states have given limited partners to have more power in the management of the partnership and still retain their liability shield, the analysis has gotten harder.

For a general partnership, those interests are generally not securities because they fail to satisfy the “solely from the efforts of others” part of the test. Usually all general partners have decision making power with respect to the affairs of the partnership.

Limited liability company interests are tougher to make a general statement. If the LLC is member-managed, then each member is involved in management of the enterprise  and therefore their interests would generally not be securities. On the other hand, if the LLC is manager-managed, then members are may be just passive investors, and their LLC interests are more likely to be securities.

When it comes to real estate joint ventures, the managing interest is not going to be a security. The non-managing interest is more likely to be a security.

Notes, debt, and debt-to-own interests are likely to be considered securities. You can see notes listed right in the definition of securities. Given the continuing distress in the real estate debt markets, many fund managers are looking at buying distressed debt instead of pure bricks and mortar. That’s going to push them into the role of giving “advice about securities” and force them to look at registration as an investment adviser.

Deal structure may influence the analysis. It’s common in some jurisdictions to structure the transaction as a sale of interests in the owner of the real estate instead of a sale of the asset itself. That transaction structure could be viewed as a sale of securities, instead of a sale of real estate.

Image of Glass office building in downtown Los Angeles is by Ricardo Diaz

Proposed Rules for Implementing the Whistleblower Provisions From Dodd-Frank

The SEC has released the text of its proposed new rules for implementing the whistleblower provisions of Section 21F of the Securities Exchange Act of 1934: Release No. 34-63237.

In fashioning these proposed rules, the Commission has considered and weighed a number of potentially competing interests that are presented in implementing the statute. Among them was the potential for the monetary incentives provided to whistleblowers by Section 21F of the Exchange Act to reduce the effectiveness of a company’s existing compliance, legal, audit and similar internal processes for investigating and responding to potential violations of the federal securities laws. With this possible tension in mind, we have included provisions in the proposed rules intended not to discourage whistleblowers who work for companies that have robust compliance programs to first report the violation to appropriate company personnel, while at the same time preserving the whistleblower’s status as an original source of the information and eligibility for an award. At the same time, the proposed rules would not prohibit a whistleblower in a compliance function from reporting information to the Commission where the company did not provide the information to the Commission within a reasonable time or acted in bad faith.

At this point, it is merely a proposed rule. Comments should be submitted on or before December 17, 2010.

There will be a new Form TCR for submitting a tip, complaint or referral and a new Form WB-DEC, Declaration Concerning Original Information Provided Pursuant to §21F of the Securities Exchange Act of 1934, signed under penalty of perjury, for submission to the SEC to meet the standards of the new regulations.

Is a Fund Manager an Investment Adviser?

Yes, for private investment funds, the general partner is generally considered an investment adviser under the Investment Adviser Act.

Let’s start with the definition of an investment adviser from the Investment Advisers Act:

“any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities…” [202(a)(11)]

You can parse three elements out of that definition:

  1. Compensation
  2. Advice concerning securities
  3. In the business

Compensation

The first one is the easiest. I don’t think you’re going to find a fund manager who is not getting paid. It may be a combination of management fees or carried interest, but it’s still compensation. You could look at some academic arguments about who would fall in and out of the definition, but those arguments are irrelevant to fund managers.

Advice concerning securities

If you are giving recommendations to buy or sell, then you are giving advice. In addition, if you are telling people when to switch between different investments or how to select investment advisers then you are giving advice. The fund manager is making the decision about what to buy, sell and finance so the fund manager is giving advice. [I’m writing about the “securities” side in another post.]

In the business

Lastly, you need to be “in the business” of giving advice. That’s going to rule out your shoeshine boy, but clearly fund managers are in the business of giving advice. Again, there are some academic questions that could make this prong of discussion interesting. But for a fund manager, it’s very straightforward.

Abrahamson

It’s not just me making this interpretation. The Second Circuit answered this question in 1978. [See: Abrahamson v. Fleschner, 568 F.2d 862 (2d Cir. 1977) , overruled in part on other grounds by Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11 (1979)] “These provisions reflect the fact that many investment advisers ‘advise’ their customers by exercising control over what purchases and sales are made with their clients’ funds.”

Exclusions

There are six exclusions in the definition of the “Investment Adviser” [202(a)(11)]but they are inapplicable to most fund managers:

  1. banks
  2. lawyers, accountants, teachers and engineers
  3. Certain broker/dealers
  4. publishers of bona fide newspapers and magazines in general circulation
  5. government securities advisers
  6. Nationally recognized statistical rating organization

Registration

That means fund managers are typically going to be considered to investment advisers. That also means that they may have to register with the SEC, unless there is an exemption from registration. Up until the Dodd-Frank Act, there was the 15 client exemption. That’s gone.

Voting and Compliance

The midterm elections are upon us, which means you get to vote for your next congressman and about a 1/3 of the senators are up for election and most of you get to vote for your senator. Don’t forget the state and local elections.

In many states that means employers must allow their employees to have time off to vote. In 31 states, voting takes legal precedence over work.

Make sure that you vote and that your employees have time to vote.

For each polling place here in my Commonwealth of Massachusetts:

  • They must display the national flag. [MGL c.54, §25A]
  • They can’t serve alcohol in the any portion of the building designated as a polling place. [MGL c.54, §24]
  • You also carry intoxicating liquor into the polling place. [MGL c.54, §73]
  • Voting machines have to suitably lighted so you can read the ballot. [MGL c.54, §33A]
  • You can’t smoke at the polling place. [MGL c.54, §73]

So if you’re trying to vote in Massachusetts and you just bought a drink, the lights are dim, you’re smoking a cigar and you can’t salute the flag, then your polling place is not in compliance.

Sources:

Image is from Woot! Shirts

Updated to correct my voting miscalculation.

Legal Enterprise 2.0 Success Story

Penny Edwards of Headshift shares a Legal Enterprise 2.0 Success Story.

Matthew Arnold & Baldwin LLP, a regional firm in the United Kingdom, put the firm’s intranet, “The Cube”, up for the Law Society’s Excellence in Innovation Awards. The firm came away with a Shortlisted Award.

The Cube is Matthew Arnold & Baldwin LLP’s adoption of Enterprise 2.0 principles.

Heloïse Paull, the firm’s marketing director and the project’s sponsor, witnessed that as the firm grew, “People relied heavily on email communication, which created exclusivity on certain knowledge. Information and knowledge became diluted in information silos. Accurate CRM and cross selling suffered. There was a decline in the social aspect of the firm.”

Mark Weston, the partner responsible for the project, explains that email is not necessarily a bad thing: It works just fine when clients email instructions to the firm for new matters. But when those instructions and other matter related communication is drowned out by internal conversation in a way that makes it hard to share valuable insights then there is a clear need to move that conversation to a different platform.

Investment Advisers and Business Continuity Plans

When an investment adviser is designing its policies and procedures you need to identify the risks for their firm so they address those risks. A big risk is missing an applicable requirement under the regulatory scheme. So you sit down with the regulations and tie them to your specific policies and procedures.

An easy one to miss is 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]

There is not much in the release to help you understand what is required, but there are two good places to help you.

One is to look at an intragency paper published by The Federal Reserve Board, the Office of the Comptroller of the Currency and the Securities and Exchange Commission on business continuity objectives. They lay out four broad sound practices for core clearing and settlement organizations and firms that play significant roles in critical financial markets:

  1. Identify clearing and settlement activities in support of critical financial markets.
  2. Determine appropriate recovery and resumption objectives for clearing and settlement activities in support of critical markets.
  3. Maintain sufficient geographically dispersed resources to meet recovery and resumption objectives.
  4. Routinely use or test recovery and resumption arrangements.

The other source (more practical source) is the disaster recovery requirements of broker/dealers. FINRA Rule 4370 is their emergency preparedness rule. They have a template for small introducing firms to help start designing a plan.

Sources:

Compliance Bits and Pieces for October 29

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

Take A Seat, and Other Bribes by Scott Greenfield in Simple Justice

And if you don’t think the FCPA matters to you, who do you think it paying the many millions of dollars forked over to lawyers and government, not to mention the opportunity costs of doing business overseas where only American corporations are subject to a constraint that flies against local culture and custom. Nobody is suggesting that actual bribery is a good thing and should be tolerated. It would be nice if this was pervasive attitude, but regardless, we can hold our corporations to a higher standard. However, the FCPA has put everyday business practices, with no quid pro quo to even the most fertile of young government lawyer minds, at risk. It’s going to be awfully hard for the United States to regain its position as an economic engine in the world with two hands and a foot tied behind its back.

Technology talk at ACC Annual Meeting by Susan Hackett in In-House ACCess

Brad Smith, the general counsel of Microsoft, and Kent Walker, the general counsel of Google were the featured speakers at the Chair’s Choice luncheon at the ACC Annual Meeting in San Antonio. A packed house of over 1,000 were on hand to listen to their vision of the future of technology and its impact on our clients and the legal practice. The session, hosted and moderated by ACC 2010 Chair Pat Hatler, was fed livestream and is available on the ACC website.

EU Agrees to Stronger Hedge Fund Regulation in Compliance Avenue

European Union finance ministers in Luxembourg reached unanimous agreement on a new set of rules regulating hedge funds in Europe.  The deal will create a single “passport” that allows approved hedge funds operating in one EU country access to investors across all other EU countries in exchange for more stringent regulation, which is to be governed by the European Securities and Markets Authority (“ESMA”).

Placement Agents Confused over Rule by Doug Halonen in Pensions & Investments

Many third-party placement agents were caught by surprise by the Oct. 1 deadline to register with the Securities and Exchange Commission. Some also were unclear whether they had to register, period.

FINRA Starts Social Media Audits from SocialWare

This past week we’ve heard multiple stories of FINRA starting to audit social media usage across regulated firms. The most interesting example we heard was of a FINRA auditor delivering printouts of LinkedIn profiles from registered reps of a firm. Attached to those was a letter instructing them to get usage “under control.”

Accessing an Adversary’s Public Social Networking Information — N.Y. Professional Ethics Opinion 843 by Robert D. Brown, Jr. in E-Discovery Law Alert

In Professional Ethics Opinion 843, issued on September 10, 2010, the New York State Bar Association’s Committee on Professional Ethics concluded that an attorney representing a party in pending litigation may access the public pages of another party’s social networking website to obtain publicly available information about that party.

Congressmen Dingell Bungles the FCPA by Mike Koehler in the FCPA Professor

In his letter Dingell asks Krafcik two FCPA related questions. The first – “[g]iven your comments about Hyundai’s being more American than U.S.-based automakers […] will Hyundai publicly commit to complying with all applicable parts of U.S. statute, including the Foreign Corrupt Practices Act (FCPA)?” Newsflash – Hyundai Motor America Corporation, a subsidiary of Hyundai Motor Co. of Korea, is a Florida corporation (see here) headquartered in Fountain Valley, California. In other words, it is a “domestic concern” under the FCPA and subject to the FCPA. Given this, I don’t see why Hyundai would be the least bit hesitant to publicly commit to complying with a law it is subject to.

Legal Implications of Cloud Computing — Part Five (Ethics or Why All Lawyers-Not Just Technogeek Lawyers Like Me-Should Care About Data Security) in the Information Law Group Blog

Here’s the reality:  Technology – whether we are talking cloud computing, ediscovery or data security generally – IS very much the business of lawyers.  This is true both from a legal ethics point of view and from a best practices data security point of view. …  [T]his post focuses on three recent documents, ranging from formal opinions to draft issue papers, issued by three very prominent Bar associations — the American Bar Association (ABA), the New York State Bar Association (NYSBA), and the State Bar of California (CA Bar).

Investment Advisor Registration Under Dodd-Frank: Implications For Securities Class Action Claimants by Luke Green of RiskMetrics

However, Dodd-Frank Act changes related to investment advisor registration may also have a notable impact on securities class actions, especially for private equity and hedge funds that currently enjoy exemption from registration. Generally speaking, many of these firms will be required to register with the SEC as investment advisors. Additionally, the regulatory oversight for firms that are already registered with the SEC will become more strenuous. The focus of this post is the impact that advisor registration changes will have particularly with regard to the securities class action claims filing process.

Learn from the Boy Scouts: be prepared by Jack Vinson

The Boy Scout motto is “Be Prepared.”  This idea shows up again and again in life and business.  For some reason, I pick up on it  right away when I am reading something new or hearing new ideas about how to organize or plan or get something done.  It’s usually in the form of “to succeed at _____, you must be prepared.”

Coffee and Compliance

I just sat down with a fresh cup of coffee from Green Mountain Coffee Keurig brewer. The smell of coffee mixed with stench of compliance failures coming from Green Mountain Coffee Roasters, Inc.

You know there is trouble when Sam Antar, the convicted felon and criminal CFO of Crazy Eddie, has you in his sights.

SEC inquiry

On September 20, 2010, the staff of the SEC’s Division of Enforcement informed the Company that it was conducting an inquiry and made a request for a voluntary production of documents and information. Based on the request, the Company believes the focus of the inquiry concerns certain revenue recognition practices and the Company’s relationship with one of its fulfillment vendors. The Company, at the direction of the audit committee of the Company’s board of directors, is cooperating fully with the SEC staff’s inquiry.

That’s from GMCR’s September 28 8-K filing.

When the SEC starts poking around your revenue recognition, it’s generally bad news for the company. The Motley Fool noticed that GMCR’s accounts receivables was growing faster than revenue growth. That increase in accounts receivables is seen when a company is trying to boost sales by giving its customers overly generous payment terms or aggressively trying book sales at the end of the quarter.

Then there is the timing of the disclosure. GMCR was notified on September 20, but did not file the report until 6 business days later on September 28. A 8-K report is supposed to be filed or furnished within four business days after occurrence of the event.

To top it off, there is the possibility of insider trading. Michelle Stacy, the president of the Keurig division sold some shares and options recently. On September 21, 2010, she exercised 5,000 options and then sold those shares for $37 per share.

The expiration dates for those options were not until November of 2018 and March of 2019. It seems a bit early to realize on those shares, but maybe she needed the cash. She had been exercising options.  On August 13 she exercised 30,000 options and exercised 5,000 options on September 13.

The problem is that she exercised options on the day after the company was informed of the SEC inquiry. It could just be a case of bad timing or it could be an illegal sale after acquiring material, nonpublic information.

That is the big problem with insider trading. It’s going to be hard to prove that she did not know about the SEC inquiry. With insider trading, there may be some email that contains a smoking gun. Or you could just be in an entirely implausible scenario.

Hopefully, GMCR has a program in place for corporate directors and employees to sell stock and exercise options. Then Ms. Stacy can show that she had started the program for exercising her options well before the SEC inquiry. Then she can prove that she did not know. Otherwise…..

Sources