Accredited Investors under the Restoring American Financial Stability Act

Senator Dodd

One of the surprises in the Restoring American Financial Stability Act of 2010 is that it proposes to raise the standard for being an accredited investor. Section 412 of the bill would require the SEC to increase the dollar thresholds to be qualified as an accredited investor. Section 413 would require the GAO to study the appropriate criteria.

The current standards come from Section 2(a)15 of the Securities Act of 1933

ii. any person who, on the basis of such factors as financial sophistication, net worth, knowledge, and experience in financial matters, or amount of assets under management qualifies as an accredited investor under rules and regulations which the Commission shall prescribe.

In 1982, the SEC prescribed the standard in Rule 501 of Regulation D:

5. Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his purchase exceeds $1,000,000;

6. Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;

If you adjust for inflation from 1982, those levels could increase to $459,000 if single and $688,000 if married, with the net worth requirement becoming $2.29 million. The bill is not clear on what to use as an inflation index. I used the Consumer Price Index for All Urban Consumers (CPI-U) comparing March 1981 (94.5) to February 2010 (216.741).

The Private Fund Investment Advisers Registration Act passed by the House in the Wall Street Reform and Consumer Protection Act of 2009 (H.R.4173) required the SEC to start increasing the asset levels. The Dodd bill (still not in the Thomas system) takes the issue on more forcefully.

The result is that there will be fewer investors for private investment funds. Under and , you are limited to 35 non-accredited investors in a private fund offering, with an unlimited number of accredited investors.

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Incentives, Productivity and NUMMI

I recently listened to a great show from This American Life. They covered the story of New United Motor Manufacturing Inc. (NUMMI). General Motors and Toyota opened NUMMI in 1984 as a joint venture so Toyota could start building cars in the US. Toyota showed GM the secrets of its production system and how Toyota made cars of much higher quality and much lower cost than GM.

There are some great lessons in the story for compliance professionals. In part because the story can be seen through the lens of incentives and corporate culture. Two topics that are important to compliance.

For GM plant managers, their pay was based on productivity. They needed to get lots of cars out the door at the end of the assembly line. It didn’t matter whether the car could drive off the line or had to be towed. Workers told the story of cars coming off the line with a Monte Carlo having the front end of a Regal. They would just let them run down the line and out into the yard. Then they were fixed out there (with overtime). The emphasis was on quantity. At GM, the production line could never stop.

The Toyota system empowered the line workers to stop the line if there was a problem they couldn’t fix. The emphasis was to fix the problem at its source and not defer it for later. The emphasis was on quality. (Some of the recent problems at Toyota can be blamed on changing their focus to quantity. They wanted to be the biggest car company in the world.)

In spreading the Toyota system, there was resistance from both the company and the union. The union was opposed because the system was more efficient and would reduce the workers at a plant by 25%. The NUMMI plant was the re-opening of a shut down GM plant. The union was out of work and was more open to change. It was either change the way you work or don’t work at all.

GM had trouble empowering its worker and changing the corporate culture that comes along with the Toyota production line. They thought workers would just stop the line to play cards and get coffee.

Its worth an hour of your time to listen to the story.

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Weekend Book Review: The Informant

I’ve had Kurt Eichenwald’s The Informant on my reading list for a long time. It dropped farther down the list after seeing the previews for the Steven Soderbergh movie. Why read the book when you can watch the movie?

What raised my interest was hearing a great radio segment from This American Life that tells some of the background of the price fixing conspiracy and FBI cooperating witness Mark Whitacre: The Fix is in.

I have to admit that while reading the book, I had the image of Matt Damon in my mind as the character of Mark Whitacre. The other image that stands out is the scene in the movie previews with Damon (playing Whitacre) as he is fiddling with the hidden tape recorder in his briefcase. As you can see from a video of the meeting, Whitacre really did open open up the hidden compartment and check out the tape recorder.

The true story in the book is a crazy tale. Whitacre came forward as a cooperating witness to the FBI, telling them that his company, Archer Daniels Midland (ADM), was engaged in price-fixing for the global market for lysine. The allegations quickly spread to other products and to kickbacks. Whitacre was a great witness, eagerly taping conversations of illicit activity and clearly willing to take down his colleagues and management of the company.

The story wanders a bit, periodically gets stagnant, then explodes as new secrets are revealed. The author, Kurt Eichenwald, tells the story from the perspective of the FBI. If the story were not true, it could have been streamlined and the characters could have been explored in more depth. But it’s a true story with real people. So you have to let the story evolve as the FBI uncovers more and more of the activity of ADM, and unfortunately more and more of the activity of Whitacre.

Whitacre had problems. These problems become apparent and worsen as the story progresses. The perfect witness ends up not being so perfect. Inconsistencies begin to appear and then grow worse.

Kurt Eichenwald covered the story for The New York Times and interviewed most of the participants in writing the book. He tells the story by methodically recording the six-year investigation and deconstructing the disturbed Whitacre.

Add the book to your reading list and move it towards the top.

The SEC Drinks Its Own Champagne

The SEC has named its first chief compliance officer: Kathleen Griffin.

She will be tasked with oversight of employee securities transactions and financial disclosure reporting. The creation of a compliance program to prevent insider trading came from last year’s insider trading scandal at the SEC. The Office of the Inspector General reported that “the Commission lacks any true compliance system to monitor SEC employees’ securities transactions and detect insider trading.”

Ms. Griffin will have her hands full. From the SEC OIG Report:

The current disclosure requirements and compliance system are based on the honor system. and there is no way to determine if an employee fails to report a securities transaction. There are no spot checks conducted and the SEC does not obtain duplicate brokerage account statements. In addition. there is little to no oversight or check;ing of the reports that employees file to determine their accuracy or even whether an employee has reported at all. Moreover. different SEC offices receive each of those reports and do not routinely share that information with each other.

It’s good to see the SEC drinking its own champagne and hiring someone to focus on their own internal compliance issues. (Doesn’t “drinks its own champagne” sound better than “eat its own dog food.”)

Since the announcement came on April 1, I thought it was an April Fool’s Day joke. Why would the SEC hire the comedian Kathy Griffin? Clearly, I was being overly cautious about my news intake. I was not alone in this confusion and I’m sure will not be the last to draw the comparison between the two.

I’m sure Kathleen’s comments to the SEC employees will be less controversial than Kathy’s comments at the Emmy Awards.

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Compliance Bits and Pieces for April 2

Here are some recent stories that caught my eye:

Q&A with Ethisphere Executive Director Alex Brigham in Corporate Compliance Insights

The Ethisphere Institute recently announced the 2010 World’s Most Ethical Companies, highlighting 100 organizations that lead the way in promoting ethical business standards. These companies go beyond legal minimums, introduce innovative ideas benefiting the public and force their competitors to follow suit.

My Commentary Part 1: Ernst & Young’s Letter To Audit Committee Members from Francine McKenna in re: The Auditors

This is my commentary on the letter that Ernst & Young recently sent to Audit Committee members defending themselves against the findings in the Lehman Bankruptcy Examiner’s report. The Bankruptcy Examiner, Anton Valukas, found “colorable claims” against EY.

Q4 Whitepaper: The Current State of Social Media & Investor Relations

In a continuing effort to share how public companies are using social networks, Darrell Heaps, Co-Founder and CEO took a large audience of IR professionals on a guided tour of “The Current State of Social Media & Investor Relations”. Participants were provided with over 50 examples and case studies of how companies are using Twitter, Facebook, LinkedIn and IR blogs to mitigate share value, dramatically increase web site traffic and broaden their reach to potential investors.

WISPs Beyond Massachusetts by Joseph Lazzarotti in the Workplace Privacy, Data Management & Security Report

Over the past few months, many businesses, particularly in the Northeast Region, have been focusing on creating a written information security program (WISP) to comply with Massachusetts identity theft regulations that went into effect March 1, 2010. For many, this has been a significant effort, reaching most, if not all, parts of their organizations. However, it is important to remember that although Massachusetts may be the state with the most comprehensive set of rules for securing personal data, other states have enacted similar protections, and compliance with Massachusetts does NOT necessarily mean compliance with other states.

Broken Windows Fix Our Understanding by Don Boudreaux in Cafe Hayek

Do disasters help the economy? No, along with a video explanation: Disastrous Economic Fallacies – Terror as Stimulus?

Some of My Favorite April Fool’s Day Items on the Web

The web is full of surprises today. Here are some of my favorites

April Fool’s Day

April Fool’s Day is celebrated with hoaxes and practical jokes. I’m hesitant to post anything today for fear that a serious story would be seen as a joke or a joke would be seen as a serious story.

A few years ago, if I had told you that Bear Stearns, Lehman Brothers, AIG, General Motors and Chrysler would be bankrupt, out of business or owned by the US Government, you would have laughed. Today, you just cry when you look at your tax bill.

So I will sit motionless today, unsure if anything is real.

Yes, that is a Dharma Initiative Alarm Clock.

N.J. Supreme Court upholds privacy of personal e-mails accessed at work

The New Jersey courts have been handling a case that squarely addressed a company’s ability to monitor employee email.

Back in April of 2009, I mentioned a New Jersey case that found e-mail, sent during work hours on a company computer, was not protected by the attorney-client privilege: Compliance Policies and Email. That later was overturned: Workplace Computer Policy and the Attorney Client Privilege.

The New Jersey Supreme Court has ruled on the appeal and found that the employee

“could reasonably expect that e-mail communications with her lawyer through her personal, password-protected, web-based e-mail account would remain private, and that sending and receiving them using a company laptop did not eliminate the attorney-client privilege that protected them.”

The court went a step further and chastised the company’s lawyers for reading and using privileged documents.

The court’s decision focused on two areas: the adequacy of the company’s notice in its computer use policy and the importance of attorney-client privilege.

Computer use policy

The court was not swayed by the company’s arguments about its computer use policy. The company took the position that its employees have no expectation of privacy in their use of company computers based on its Policy. The court found that the policy did not address personal email accounts at all and therefore had no express notice that the accounts would be subject to monitoring. Also, the policy did not warn employees that the contents of the emails could be stored on a hard drive and retrieved by the company.

Attorney Client Communication

The bigger problem was that the communications between attorneys and their client are held to a higher standard. They were not “illegal or inappropriate material” stored on the company’s equipment that could harm the company. The e-mails warned the reader directly that the e-mails are personal, confidential, and may be attorney-client communications.

In my opinion, the nature and content of these emails made this an easy decision for the court.

Key Considerations

The decision does not mean that a company cannot monitor or regulate the use of workplace computers.

  • A policy should be clear that employees have no expectation of privacy in their use of company computers.
  • A policy needs to explicitly not address the use of personal, web-based e-mail accounts accessed through company equipment.
  • A policy should warn employees that the contents of e-mails sent via personal accounts can be forensically retrieved and read by the company.

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Child Climbing Mount Everest

Jordan Romero is thirteen years old. And he is departing on April 5 for his trip to climb Mount Everest.

That would be an extraordinary feat. But is it ethical to allow such a young person to put himself in such a dangerous situation?

(In case you are wondering, the current record for the youngest person to climb Mount Everest is held by Ming Kipa Sherpa, a 15-year-old Sherpa girl.)

How young is too young to take on such a dangerous task? I don’t think many people would be concerned about a 21 year old trying the climb. Maybe a few more would be concerned about an 18 year old and probably many more would be concerned for 16 year old.

One issue ethical issue is the death rate on Everest. By the end of 2009, Everest had claimed 216 lives. You can probably add in hundreds of lost toes and some lost fingers if you are inclined to include permanent maiming as part of the consequences.

On the other hand, young Mr. Romero has already reach the summit of 19,340-foot Kilimanjaro (Africa), 7,310-foot Mount Kosciusko (Australia), and 18,510-foot Mount Elbrus (Europe), 22,834-foot Aconcagua (South America) and 20,320-foot Denali (North America). If Jordan can climb Everest and Antarctica’s Vinson Massif, he will become the youngest person to have climbed the Seven Summits, the highest points on each continent. He has some experience and skill.

I would guess that if he succeeds he will be lauded. If he commits the ultimate failure and dies on Mount Everest then there will be an enormous outcry.

He is not climbing alone. His father, Paul, and Paul’s partner, Karen, are part of his climbing team. Both of them are adventure racers.

Age has been a problem before. They needed to get a court order to allow them to climb Mount Aconagua. Apparently Argentina has a strict age requirement of 14.

You have to wonder what the motivation is? Is it the young Mr. Romero’s passion to climb? Or is his father pushing him too far?

From a business ethics perspective, you might lay fault with the team’s guide for Mount Everest. A guide would want to make sure that the client has sufficient high altitude climbing knowledge and experience to succeed on the mountain. A good guide would be a gatekeeper, keeping unqualified people off the mountain. Of course there is an ethical issue since they don’t get paid when they say no.

Unfortunately, Romero’s team is climbing alone. In order to save money, they are not using a professional guide.

For me, the failure to use a guide is completely unacceptable. That shows that ambition is outweighing common-sense. Romero is clearly going to be in the most dangerous situations he as ever encountered. Mount Everest is substantially higher and more dangerous than the other peaks. A responsible parent would insist on proper safety precautions. Having an experienced guide should be one of those safety precautions.

It sounds like they are going to attempt the climb, so I wish them good luck and good health. I just wish they wouldn’t go.

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Supreme Court Rules on When Mutual Fund Fees are too High

The Supreme Court issued its opinion in Jones v. Harris Associates, addressing the standard for when mutual fund fees are too high.

Background

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.

Judge Easterbrook in the Seventh Circuit rejected the Gartenberg standard and crafted a new one.  The court adopted a standard that an allegation that an adviser charged excessive fees for advisory services does not state a claim for breach of fiduciary duty under § 36(b), unless the adviser also misled the fund’s board of directors in obtaining their approval of the compensation.

Decision

The Supreme Court concludes that

“Gartenberg was correct in its basic formulation of what §36(b) requires: to face liability under §36(b), an investment adviser must charge a fee that is so disproportionately large that it bears no reasonable relationship tothe services rendered and could not have been the product of arm’s length bargaining.”

They also make it clear that the burden of proof is on the party claiming the breach, not the fiduciary.

The Supreme Court found fault is looking almost entirely at the element of disclosure. The result is that the Supreme Court overturned the Seventh Circuit and remanded it back for further proceedings.

What does the standard mean?

The Investment Company Act does not necessarily ensure fee parity between mutual funds and institutional clients. Courts need to look at the similarities and differences in the the services being provided to different clients.

Courts should not rely too heavily on comparing fees charged by other advisers. Fees may not be the product of arm’s length negotiations.

A court should give greater deference to fund fees when a board’s process for negotiating and reviewing compensation is robust. “[I]f the disinterested directors considered the relevant factors, their decision to approve a particular fee agreement is entitled to considerable weight, even if a court might weigh the factors differently.” If a fund adviser fails to disclose material information to the board, the court should use greater scrutiny.

“[A]n adviser’s compliance or non-compliance with its disclosure obligations is a factor that must be considered in calibrating the degree of deference that is due a board’s decision to approve an adviser’s fees.”

The result is that courts should defer to the “defers to the informed conclusions of disinterested boards” and hold “plaintiffs to their heavy burden of proof.”

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