Year: 2011

Paying a Bribe? There’s an App for that

Can you crowdsource the fight against corruption? An international team coming from Estonia, Lithuania, Finland and Iran thinks you might. They created a smartphone app that allows people to anonymously report incidences of bribery and later see the data visualized on an interactive map.

Bribespot is an app that allows you to see how much corruption is going on around. Using your smartphone (or a website) you can report locations where bribes are requested/paid, indicate the size of a bribe and area of government affected by it.

At the moment you can use Bribespot on Android, but they have not finished the iPhone app. There is no mention of a blackberry app.

In poking around the data, I found three reports in the United States.

  • Made to pay $100 (~75 euro) to get a fake ID back from a bouncer at Fat Tuesday
  • 35 EUR To cut the line at Pianos
  • 70 EUR for 3 guys to cut the line at Southside

Those are not exactly riveting incidents.

On the other hand, there are many reports coming in from Lithuania and Romania in Bribespot’s Check-in Stream.

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Revisiting the Fabulous Fab

Last summer, Fabrice Tourre didn’t turn around fast enough to see the bus coming at him. Goldman Sachs had given him a big push and put him in the front and center of their big bet on a crash in the residential mortgage securities market.

Tourre ended up as the Fabulous Fab after giving himself that nickname in a series of colorful emails. In one he wrote, “The whole building is about to collapse anytime now,” according to the complaint. “Only potential survivor, the fabulous Fab.”

I still use Tourre as part of my records management policy and education.

The Fabulous Fab Rule: Don’t write emails so provocative that they wind up reproduced on the front page of the Wall Street Journal.

What has happened to Tourre and his colleagues at Goldman Sachs?

Goldman settled the matter for $550 million, with $250 million going to investors and $300 million going to the SEC.

Louise Story and Gretchen Morgenson of the New York Times took another look at the Goldman mortgage desk and the prosecutions against it: S.E.C. Case Stands Out Because It Stands Alone.

According to the article, the SEC looked at Jonathan M. Egol who worked closely with the Fabulous Fab. “But Mr. Egol, now a managing director at the bank, was not named in the case, in part because he was more discreet in his e-mails than Mr. Tourre was, so there was less evidence against him, according to a person with knowledge of the S.E.C.’s case.” That just seems to reinforce the Fabulous Fab Rule.

Also, the story points out that Torre’s trading desk was using a shared email account or listserv to share the messages with the larger group.

The story about the Fabulous Fab Rule gets worse. The New York Times obtained additional information from a lost laptop.

[The information was] provided to The New York Times by Nancy Cohen, an artist and filmmaker in New York also known as Nancy Koan, who says she found the materials in a laptop she had been given by a friend in 2006.  The friend told her he had happened upon the laptop discarded in a garbage area in a downtown apartment building. E-mail messages for Mr. Tourre continued streaming into the device, but Ms. Cohen said she had ignored them until she heard Mr. Tourre’s name in news reports about the S.E.C. case.  She then provided the material to The Times.

That just makes the nightmare worse. An employee is sending out provocative emails, they are going to mass distribution list, and an unsecured laptop is getting the messages.

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Felons and Fund Managers

Most private funds rely on a Rule 506 exemption under Regulation D to sell their limited partnership interests to investors. A new SEC rule amending Rule 506 should catch the eye of private fund compliance officers. The concept it fairly straight-forward: felons should not be allowed to take advantage of the private offering exemptions.

Dodd-Frank

Section 926 of Dodd-Frank requires the SEC to adopt rules disqualifying an offering from reliance on Rule 506 of Regulation D when certain felons or other “bad actors” are involved in the offering. Rule 506 is the most widely claimed exemption under Regulation D. For the 12 month period ended September 30, 2010 the Commission received 17,292 initial filings for offerings under Regulation D, of those 16,027 claimed a Rule 506 exemption.

What types of felonies?

The  proposal is not for all felonies, just those related to the securities industry. So you could be a convicted Under the proposed rule, a “disqualifying event” would include:

  • Criminal convictions in connection with the purchase or sale of a security, making of a false filing with the SEC or arising out of the conduct of certain types of financial intermediaries. The criminal conviction would have to have occurred within 10 years of the proposed sale of securities (or five years, in the case of the issuer and its predecessors and affiliated issuers).
  • Court injunctions and restraining orders in connection with the purchase or sale of a security, making of a false filing with the SEC or arising out of the conduct of certain types of financial intermediaries. The injunction or restraining order would have to have occurred within five years of the proposed sale of securities.
  • Final orders from state securities, insurance, banking, savings association or credit union regulators, federal banking agencies or the National Credit Union Administration that bar the issuer from:
    • associating with a regulated entity.
    • Engaging in the business of securities, insurance or banking.
    • Engaging in savings association or credit union activities.
  • Or orders that are based on fraudulent, manipulative or deceptive conduct and are issued within 10 years before the proposed sale of securities.
  • Certain Commission disciplinary orders relating to brokers, dealers, municipal securities dealers, investment companies and investment advisers and their associated persons, which would be disqualifying for as long as the order is in effect;
  • Suspension or expulsion from membership in a “self-regulatory organization” or from association with an SRO member, which would be disqualifying for the period of suspension or expulsion;
  • Commission stop orders and orders suspending the Regulation A exemption issued within five years before the proposed sale of securities; and
  • U.S. Postal Service false representation orders issued within five years before the proposed sale of securities.

Who is covered?

The proposed rule would cover

  • the issuer (i.e. the fund)
  • its predecessors and affiliated issuers
  • Directors, officers, general partners and managing members of the issuer.
  • 10 percent beneficial owners and promoters of the issuer (i.e. the fund manager).
  • Persons compensated for soliciting investors
  • the general partners, directors, officers and managing members of any compensated solicitor (i.e. employees of your placement agents).

The rule is bit fuzzy on how this would apply to fund manager, since it is not legally the issuer. Under the investment advisers registration you already need to disclose criminal activity. That disclosure is broader than what is proposed under the new rule. This is just disclosure, not a bar from use of the offering exemption.

Reasonable Care Exception

The proposed rule would provide an exception from disqualification when the issuer can show it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed.

Paragraph (c)(1) of this section shall not apply:

(i) Upon a showing of good cause and without prejudice to any other action by the Commission, if the Commission determines that it is not necessary under the circumstances that an exemption be denied; or

(ii) If the issuer establishes that it did not know, and in the exercise of reasonable care could not have known, that a disqualification existed under paragraph (c)(1) of this section.

Instruction to paragraph (c)(2)(ii). An issuer will not be able to establish that it has exercised reasonable care unless it has made factual inquiry into whether any disqualifications exist. The nature and scope of the requisite inquiry will vary based on the circumstances of the issuer and the other offering participants.

Here is where compliance steps in. The rule has no explicit record-keeping, reporting or disclosure requirements. But if you want make sure you can take advantage of the “reasonable care exception” you will need to keep records.  It looks like we will need a new form for employees to fill out asking for a disclosure of events under the rule. It also looks like you will need to run criminal background checks on your principals and key employees.

In the release the SEC said: “The steps required would vary with the circumstances, but we anticipate may include such steps as making appropriate inquiry of covered persons and reviewing information on publicly available databases.”

Comments

This is still a proposed rule, but time is short. Under Dodd-Frank, the disqualification rules need to be in place by July 21, 2011. There is time to Submit Comments.

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Compliance Bits and Pieces for May 27

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

Gold is Not an Investment by Carl Richards in the NY TImes.com’s Bucks

Gold is not an investment. It’s a speculation. Investments are made by evaluating underlying value. Speculative bets are made by looking at the price of something and simply hoping the price goes up. Investing is about value; gambling is about price. Gold has no real underlying value. I know there is a market for it. I know it is real, just like real estate was real in 2007.

Historical Echoes: Communication before the Blog… in the Liberty Street Economics blog of the Federal Reserve Bank of New York

Over the years, the Federal Reserve System has used many methods to communicate about the role it plays in support of stable prices, full employment, and financial stability. Current communication tools include the new press conferences by the Chairman, speeches by Bank presidents, public websites, economic education programs, local outreach efforts, publications, and blogs like this one.

Ninety years ago, however, the options were more limited. The Fed was still new and the nation’s economy was plagued by a growing number of bank failures. The five posters below (from the mid-1920s), with their images of strength and stability, were part of a larger series designed for display at member banks. They were likely intended to inform the public about the Federal Reserve System and foster confidence in its member banks.

Hedge Funds and Advertising: “No advertising” rules more confusing than ever by Judy Gross in Hedge Rows

In the category of “Laws that Haven’t Caught Up with the 21st Century”, the internet aspects of the rules that prohibit hedge fund advisers from “advertising” may come in first place. The SEC rules only allow hedge funds to be offered on a “private placement” basis. This means no general solicitations are allowed. While this is understandable in regard to some venues (think giant billboard in Times Square), when it comes to the internet, these rules may leave you scratching your head.

Failing to Clarify: The Courts Try to Define “Foreign Official” in FCPA Cases by Michael Volkov in the FCPA Compliance and Ethics Blog

In three separate cases, Lindsey Manufacturing, O’Shea and Carson, defendants filed motions to dismiss challenging the DOJ’s interpretation of “foreign official” under the FCPA. Two of these cases have now been resolved and the Justice Department’s position has been upheld. While doing so, the courts have launched separate fact-specific tests to “guide” actors in resolving how the law applies to state-owned enterprises.

The SEC Proposes Rules for Disqualification of Felons and Other Bad Actors from Rule 506 Offerings in 100 F Street

Section 926 requires the adoption of rules disqualifying an offering from reliance on Rule 506 of Regulation D when certain felons or other “bad actors” are involved in the offering. Rule 506 is by far the most widely claimed exemption under Regulation D. For the 12 month period ended September 30, 2010 the Commission received 17,292 initial filings for offerings under Regulation D, of those 16,027 claimed a Rule 506 exemption.

The New SEC Whistleblower Rule

In a blow to the efforts of internal compliance, the SEC will let corporate whistle-blowers collect a percentage of penalties when they report financial wrongdoing, even when they bypass companies’ internal complaint systems.

“For an agency with limited resources like the SEC, it is critical to be able to leverage the resources of people who may have first-hand information about violations of the securities laws,” said SEC Chairman Mary L. Schapiro. “While the SEC has a history of receiving a high volume of tips and complaints, the quality of the tips we have received has been better since Dodd-Frank became law. We expect this trend to continue, and these final rules map out simplified and transparent procedures for whistleblowers to provide us critical information.”

The small life ring the SEC threw to internal compliance is that the amount of the amount will be affected by how the person dealt with internal compliance. The amount of the award can be increased if the person reported the problem through internal compliance procedures and decreased if the person interfered with internal compliance or reporting systems.

A May 4 opinion from Judge Leonard Sand held that Dodd-Frank says a person has to report wrongdoing to the SEC — or be able to seek protection under other laws — before receiving legal sanctuary.

The final rule won’t provide protections to those who don’t report to the SEC, reinforcing the court’s interpretation.

While there is lots of discussion around provision providing the incentive to go to the SEC, there is also a question of the anti-retaliation protections. In the recent Egan v. TradingScreen case, a court found that the employee needs to go to the SEC get the statutory anti-retaliation protection.

For private companies, the Egan case also emphasized the point that the whistleblower provisions of Section 806 only apply to public companies subject to the Exchange Act. The employee alleged that Trading Screen was planning to public and should be subject. That didn’t work. He tried to another tactic that since it was a SEC registered broker-dealer it should be subject. The judge didn’t accept that argument either.

Sources:

Image: Qiqi Green Whistle 8-16-09 3 by Steven Depolo
CC BY 2.0

Learning Lessons From Gaffken & Barriger

I read through an occasional SEC complaint looking for lessons to be learned. Those involving real estate funds particularly catch my eye. I found the complaint against Lloyd V. Barriger (.pdf) and his management of his Gaffken & Barriger Fund to be full of lessons.

I don’t have any independent facts and am accepting the complaint at face value. Barringer has not settled with the SEC so I’m sure he has a different view of the events and disagrees with some of the statements. In large part it looks like he was trying to make it through the collapse of the housing market and the liquidity crunch of 2007 & 2008 by stretching his funds and his investments. Ultimately, his fund could not hold out any longer and collapsed.

“In the midst of the credit crisis, Barriger chose to lie about the solvency and liquidity of his fund rather than admit the somber truth of a collapsing business,” said George Canellos, Director of the SEC’s New York Regional Office. “He continued to solicit new investor funds based on the same misrepresentations up until the day before the fund collapsed.”

Gaffken & Barriger started off by investing in microcap securities. Then it, like many investors, was lured by the outsized returns of the real estate in 1998. Effective August 1,2005, the Fund’s stated purpose was “investing, holding, and trading in real estate, real estate loans, real estate securities, other securities and other financial instruments and rights thereto[.]” According to the PPM, the Fund’s primary strategy was “hard money lending”making high interest short-term bridge loans to real estate developers.

As you might guess with hindsight, the fund started experiencing higher delinquencies in 2005 and started experiencing losses. I would guess that he started stretching the truth hoping his investments would bounce back, only be trapped into bigger lies as the losses grew instead of decreasing.

I found it interesting that the SEC focused on the preferred returns to the limited partners in the fund. This is a practice that is common in many real estate funds. Investors often get a preferred return and the sponsor gets an over-sized portion of the profit above that return. I think the SEC got caught up in the tax allocations of the fund and took it as a bad fact. I’m not sure that warranted.

Another lesson to take away is that Dodd-Frank will not do anything to prevent this type of fraud. Given the size of Gaffken & Barriger it would not be SEC registered, but would be state registered. The SEC would still be able to investigate, but would not be the examiner.

That is a common theme I have noticed in SEC complaints against investment advisers and fund managers. They are mostly below the $100 million threshold for SEC registration. These troublemakers will need to be caught by state examiners. The SEC may be able to come riding in on its white horse to round up the bad guys, but will not be in a position to make an early intervention to prevent the fraud.

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Have You Set Up Your IARD Account?

With the impending deadline for filing Form ADV to register as an investment adviser, you need to jump through some hoops before you can do the filing. First step is visiting the Investment Adviser Registration Depository. Form ADV needs to be filed electronically and this is the electronic mailbox.

But first you need an account. To get an account you need an IARD Super Account Administrator. To get an IARD Super Account Administrator, you need to fill out the SEC Registrant Entitlement Packet (.pdf). It’s a simple form, but you need to mail it back to get your account. (There is an overnight delivery address.)

Once IARD gets the form they are supposed to send you emails with your username and password. Then you need create a financial account. To fund the account you need to use bank wire or check and that has a two day delay in funding.

I’m not trying to give you a tutorial. I’m just pointing that it will take at least a few days for you to get the mechanics set up to file.

There are only eight business days left until the June 6 filing deadline for fund managers. (Unless the SEC acts to extend the deadline.) Seems like its time to get the mechanics moving.

Time for the SEC to Extend a Deadline

Dodd-Frank set a July 21 deadline for changes to the Investment Advisers Act in Title IV:  The Private Fund Investment Advisers Registration Act. This included the  expiration of the private adviser exemption from registration under the Investment Advisers Act, the addition of an new exemption for “venture capital fund advisers” and the increase in the threshold for registration with the SEC to $100 million.

The SEC proposed a new Form ADV in November to deal with these changes. But the final form has not been published.

The SEC proposed a definition of “venture capital fund adviser” in November. The final definition has not been published.

With the increase in the registration threshold to $100 million, about 4,000 investment advisers will be moved to the state authorities for supervision. Many states are still in the middle of revising their statutes and regulations to deal with the changes.

Since the SEC has a 45 day review period on the Form ADV, the filing deadline in June 6. That’s just two weeks away. Throw in Memorial Day weekend in the middle of that to lose a few more days.

In April, the SEC hinted that they would extend the July 21 deadline.  The IARD registration system would not be ready for the new Form ADV until the end of 2011. It sounded like the SEC is not ready.

I think it’s unrealistic for the SEC to release the new regulations and forms in the next two weeks and expect their regulated constituents to be able to pull the pieces together. Actually, it’s probably unrealistic to expect that the SEC will be ready in the next two weeks. They keep talking about have the regulations in place by July 21. That’s 45 days too late. Looking at this week’s SEC meeting, the subject is not on the agenda.

This week, I’m sitting down to start registering on the old Form ADV. The boxes don’t fit very well and some of the dollar amounts are wrong. It may be a waste of time, but we are out of time.

To entertain myself in the face of this deadline, I present the deadline post-it video

Compliance Bits and Pieces

Here are some recent compliance related stories that caught my eye.

My Attorney Just Shattered My Crowdfunding Dreams by Christopher Hytry Derrington and Charles Hertlein in the Huffington Post

In February 2011, I announced on the Huffington Post that my company was going to try to raise investment capital via crowdfunding. Using online social networks, crowdfunding enables entrepreneurs to pitch their businesses to large pools of potential investors. But when I mentioned crowdfunding to my attorney, he said it would be virtually impossible for me to do because the SEC prohibits private business owners from soliciting funds from individual investors.

20 Questions Directors Should Ask about Compliance Committees by Tom Fox

What are some of the questions that the Board of Directors should be asking? We posit that a large public company should have Compliance Sub-Committee of Board members. We list 20 questions below which reflect the oversight role of directors which includes asking senior management and themselves. The questions are not intended to be an exact checklist, but rather a way to provide insight and stimulate discussion on the topic of compliance. The questions provide directors with a basis for critically assessing the answers they get and digging deeper as necessary.

California Extends IA Exemption for Hedge Fund Managers in Hedge Fund Law Blog

California currently has an exemption from the registration requirements for certain fund managers with more than $25M of AUM (Rule 260.204.9).  Back in March California requested input from the investment management community on how they might change the registration requirements when the SEC finalizes its IA registration rules as a result of the Dodd-Frank act.  At that time it was expected that the SEC would finalize its IA registration rules in time for managers to register before the July 21, 2011 registration deadline.  However, the SEC subsequently indicated that it would likely extend the registration deadline until the first quarter of 2012.  From this story by IA Watch, it looks like the Division of Investment Management is moving closer to officially moving the registration deadline to next year.

Whistleblower skirmish: Battling the SEC over how to rat out corp. fraud by Kaja Whitehouse in the New York Post

The US Chamber of Commerce is leading the fight for one side, demanding Schapiro force corporate whistleblowers to report wrongdoing first to executives at their workplace. In the opposite corner is a group of lawyers representing whistleblowers, who have formed the National Whistleblowers Center. They are demanding that Schapiro allow corporate whistleblowers to snitch wherever they feel is best — so they won’t be scared of reporting wrongdoing.

Controls on Political Contributions

In the face of some pay-to-play scandals involving investment advisers and government sponsored investment fund officials, the Securities and Exchange Commission slapped restrictions on the ability of investment advisers and fund managers to make political contributions. Rule 206(4)-5 prohibits an investment manager or fund manager from collecting fees for two years if the firm or “covered associates” make a political contribution to certain elected officials. The ban applies to politicians who can directly or indirectly influence the decision to hire or can directly or indirectly appoint the person who can make the decision.

In talking with other compliance officers, firms are all over the place on how they are putting restrictions and controls in place to prevent the disastrous results that come from violating the rule.

  1. Complete ban on political candidates
  2. Pre-clear all political contributions
  3. Pre-clear any contributions in excess of the de minimis amount of $350/$150
  4. Here’s the rule don’t break it

Regardless of the restrictions, the SEC Rule also imposes a record-keeping obligation on the compliance program. “Covered associates” must report all political contributions.

You can do a periodic certification of the contributions they have made. Since political contribution are in the public records, theoretically you can check the records to make sure that they are not failing to report.

I decided to try some public record searches to see if this was a realistic control.

I assumed the federal databases would be the best so I went to the Federal Election Commission’s Advanced Transaction Query By Individual Contributor. It allows you to search by company name. That makes it easy to run a broad search to find who in the organization has made campaign contributions.

That was a good start, but the least relevant. For the most part, federal elected officials do not control government-sponsored retirement funds. The big exception is if the candidate is currently a state or local official looking to go to Washington.

I turned next to Massachusetts Office of Campaign and Political Finance. Their OCPF Searchable Campaign Finance Database & Electronic Filing System makes it easy to search by employer.

Then I tried California, New York, and Virginia. They were both terrible and I could not find a way to search by employer.

Washington State’s Public Disclosure Commission allows you to search by employer.

The SEC rule just went into effect in March, so I get the sense that compliance programs are evolving as they work with the restrictions and controls. I’m interested to hear you are doing, whether you are searching campaign databases, and the resources you are using. Feel free to leave a comment (anonymous if you like) or send a confidential email to [email protected].