Year: 2011

The Cost of Regulating Fund Managers and Investment Advisers

A group of organizations with Investment Adviser stakeholders engaged the Boston Consulting Group to conduct an economic analysis of IA oversight scenarios (.pdf) in the Securities and Exchange Commission’s study released in January 2011. The analysis came down solidly in favor of increased funding of the SEC as the solution for increased oversight of investment advisers.

BCG looked at the three options in the SEC’s 914 study: (1) enhancing the SEC’s ability to oversee advisers (2) allowing FINRA to oversee RIAs and (3) creating a new IA-only SRO. The first option was examined in two segments: (a) giving the SEC enough examiners to do the job and (b) full resources. The costs represented what it would take for each option to examine every registered investment adviser firm at least once every four years.

Estimates from BCG study of costs for 3 top choices for examining RIAs

Topic Enhanced SEC FINRA New IA SRO
Annual cost per RIA $11,300-$27,300* $51,700 $57,400
Set-up costs $6m-$8m (Increasing OCIE) $200m-$255m $255m-$310m
Set-up time 6-12 months 12-18 months 18-24 months
Mandate costs from fees $100m-$270m $460m-$510m $515m-$565m
SEC Oversight of SRO $0 $90m-$100m $95m-$105m
Total annual costs $100m-$270m $550m-$610m $610m-$670m

The study provides some interesting insight as to staffing. The average examiner productivity is assumed to be 3.0 examinations per examiner per year, based on the five year SEC average of 3.0 IA examinations per examiner per year.31 In order to achieve an average examination frequency of once every four years, with examiner productivity of 3.0 examinations per examiner per year, 787 examiners are required.

The parties who requested the study are the Investment Adviser Association, Certified Financial Planner Board of Standards, the Financial Planning Association, the National Association of Personal Financial Advisors and TD Ameritrade Institutional in commissioning the study.Given that the vast majority of investment adviser firms do not want FINRA as their regulator/examiner it should come as no surprise as to the results of the study.

I expected to see the additional costs of SEC oversight of an SRO. It’s a bit unfair that the SEC costs are only for examination and not enforcement. The SRO figures include that additional cost.

It should also come as no surprise that FINRA disputed the findings. Rumor has it that they are pushing hard to become the SRO for investment advisers.

In any event, it will take legislation from Congress to implement any of these scenarios. The typical Congressman’s knee-jerk reaction to this seems to be “Madoff.” That does not bode well for increased resources for the SEC.

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Rudy – Securities Fraud

Who cares how much effort I put in, if it doesn’t produce any results.

In a sad turn of event, Daniel “Rudy” Ruettinger was charged by the SEC with securities fraud. Ruettiger and 10 of the scheme’s other participants have agreed to settle the SEC’s charges without admitting or denying the allegations. (I guess they can still do that if you’re not in front of Judge Rakoff.)

I guess he thought his effort was better spent pumping up the stock of the penny-stock company that ran his sport drink company. I guess I have to cross Rudy off the list of inspirational sports movies to show my kids.

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Compliance Bits & Pieces for December 16

These are some compliance related stories that caught my attention:

Dodd-Frank Rules Will Crush Employment, Banks Warn by Paul Sperry for Investors Business Daily

Job-killing bank regulations threaten to wipe out all the gains in private-sector employment since the recovery began, the industry warns. Washington, however, is hiring thousands more bureaucrats to enforce the rules. Signed into law last year, the Dodd-Frank Act is the biggest rewrite of financial regulations since the New Deal. It was intended to rein in Wall Street “excesses.” But the banking industry says burdensome red tape is hurting economic growth and jobs in a still-sluggish labor market.

The SEC’s Plan of Operations In the Event of a Government Shutdown by Vanessa Schoenthaler in 100 F Street

Faced, yet again, with the possibility of a government shutdown (tomorrow at midnight), the Securities and Exchange Commission has published its latest Plan of Operations During a Lapse in Appropriations.

SEC Reform After Dodd-Frank and the Financial Crisis by Commissioner Daniel M. Gallagher

The Dodd-Frank Act presented an opportunity to make changes that could have served the U.S. capital markets very well. Indeed, the 2,319 pages of legislation were meant to address the problems associated with the Financial Crisis. It was both expected and necessary that Congress respond to those events. Although the full impact of the legislation will not be known for years as regulators toil on the implementation of the Act, it is becoming clear that the SEC will need to focus on a number of issues within the Commission’s core competencies that were not addressed in the legislation.

Feds Probe Richardson For Alleged Pay-To-Play Scheme by in the Christopher Matthews WSJ.com’s Corruption Currents

A federal grand jury in Albuquerque has been looking into “pay to play” complaints from former and current state officials, people familiar with the matter told the Journal. The officials contend in court filings and interviews that Richardson’s close allies steered more than $2 billion of public money into investment funds run by money managers who in turn agreed to pay millions of dollars in consulting fees to high-profile Democratic fund-raisers and other supporters of Richardson.

FCPA Conviction Upheld

There are few court cases involving the Foreign Corrupt Practices Act. Most of those accused quickly settle and move on. With few court cases that means the appellate decisions helping to interpret the FCPA are rare. Yesterday we had one of those rare sightings.

Frederic Bourke was convicted of FCPA violations in 2009. Bourke co-founded the fashion accessory company Dooney & Bourke, but considers himself an inventor, investor and philanthropist. Unfortunately he fell into business with Viktor Kozeny, the Pirate of Prague. The government charged Kozeny and Bourke with conspiring in a scheme to illegally purchase the state-owned oil company of Azerbaijan, SOCAR, by bribing the Azerbaijani president and other government officials.

Bourke’s main defense to the charges was that he did not have explicit knowledge of the bribery.  The government took the position that Bourke had “conscious avoidance”.

Under those circumstances, a jury might conclude that no actual knowledge existed but might nonetheless convict, if it believed that the defendant had not tried hard enough to learn the truth.

However, the government had some statements from Bourke stepping around the bribery issue. Unfortunately, Bourke also got some advice from his attorney “that if Bourke thought there might be bribes paid, Bourke could not just look the other way.” That was in 1999 and before the current era of FCPA enforcement. I think you would be hard-pressed to find an attorney who make that statement today. The Sergeant Schultz defense does not work any more when it comes to bribery.

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Compliance and the South Pole

We reckoned now that we were at the Pole. Of course, every one of us knew that we were not standing on the absolute spot; it would be an impossibility with the time and the instruments at our disposal to ascertain that exact spot. But we were so near it that the few miles which possibly separated us from it could not be of the slightest importance. 

Roald Amundsen – December 14, 1911

The South Pole is a harsh and isolated environment. It’s bit more plush now that when man first stepped on the location 100 year ago. Amundsen slept in a small tent. Today visitors can take it a bit easier in the Amundsen-Scott South Pole Station. You can even see a picture of the day from the South Pole.

At least during the Antarctic summer when the average high is a balmy -15°F with near endless daytime. From mid-April to mid-August, the only natural light comes from the moon and the aurora australis. Those settled in for the Antarctic winter don’t see the sun for months and the average high drops to a bone-chiling -68°F

The current station is on jacks so it can battle the 8 inches of snow that accumulates each year by raising its elevation. Since it’s sitting on a moving glacier it moves about 10 meters each year. It’s in constant movement, battling the forces of nature that kept in uninhabited until modern technology was able to fight back against the elements.

There are many comparisons you can draw between the South Pole and a compliance program.  I’ll let you draw your own.

 

I’m an NFL Owner

Sort of.

The Green Bay Packers want to expand Lambeau Field by 6,700 seats, add new gates and new video boards. To finance the improvements, the team ownership decided to sell additional stock in the ownership corporation. Since the Kraft family is unlikely to be selling the Patriots anytime soon, I was willing to part with some football loyalty and some cash to get my own piece of the NFL pie.

Unlike the rest of the National Football League franchises, the Green Bay Packers franchise is owned by non-profit, community-based organization, Green Bay Packers, Inc. The corporation is required to be nonprofit sharing and that no shareholder may receive any dividend or pecuniary profit by virtue of being a shareholder in the corporation. Any increase in value or operating profits and any proceeds upon liquidation of the corporation will go to community programs, charitable causes or other similar causes. If you add in limitations in stock ownership and transfer restrictions, it’s virtually impossible for anyone to recoup the amount initially paid to acquire the stock. That makes it a completely non-economic investment.

Is it a security?

Here is what the offering document says:

Because the Corporation believes Common Stock is not considered “stock” for securities laws purposes, it believes offerees and purchasers of Common Stock will not receive the protection of federal, state or international securities laws with respect to the offering or sale of Common Stock. In particular, Common Stock will not be registered under the Securities Act of 1933, as amended, or any state or international securities laws. The Common Stock will not be approved by the Securities and Exchange Commission or any state or international regulatory authority nor will the
Securities and Exchange Commission or any state or international regulatory authority approve the Offering or the terms of the Offering.

Under the Howey definition of an investment contract, you need (1) a common enterprise and (2) to depend “solely” for its success on the efforts of others. Certainly, the Packers’ stock meets those two prongs. The third prong is an expectation of profits. That is not true. However the definition of “security” in the Securities Exchange Act of 1934 includes “any note, stock, treasury stock…” The interests in the Packers are clearly stock and seem to fall into the definition of security.

What do you get?

A certificate:

The certificate is designed in the timeless tradition of classic stock certificates. The 12 inch by 8 inch certificate is printed on exquisite paper using a classic engraved steel plate process. It features an artistic representation of heritage. The record of your ownership will be secure, and you will be able to display your ownership with pride.

Is this Crowdfunding?

This is the current state of crowdfunding. You can’t offer securities without going through the registration process or finding an exemption. But you can still raise funds from a large group of people. Just don’t offer a share of the profits or stock. That’s how the kickstarter crowdfunding platform works. You get an over-priced product or a t-shirt or some other token of appreciation. As a backer, you do not have visions of early retirement because you just bought a piece of ownership in a multi-million dollar idea.

A Packers’ alternative would be to have merely offered a certificate of appreciation or tufts of grass from Lambeau field. But they offered the ability to say “I’m an NFL owner.”

I’m supporting a multi-million dollar idea. On Any Given Sunday, any team in the NFL can beat another. A team from tiny Green Bay, Wisconsin can still generate the revenue to field a competitive team and win the Super-Bowl.

I still prefer that the Patriots win the Super Bowl.

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Compliance Bits & Pieces for MF Global Edition

MF Gloabl clearly took a big bet on European sovereign debt. It looks like Jon Corzine, the head of the company, essentially went “all-in” and bet the company on the trades.  He lost. His counterparties called collateral and the company quickly lost liquidity and solvency. On Halloween, MF Global filed for bankruptcy, listing $39.7 billion in debt and $41 billion in assets and put thousands of people out of work.

Unfortunately, it looks like some of the customer accounts were tied up in the company’s proprietary trading. It looks like $1.2 billion is missing from customer accounts.

MF Global and the great Wall St re-hypothecation scandal by Christopher Elias in Thomson Reuters

Under the U.S. Federal Reserve Board’s Regulation T and SEC Rule 15c3-3, a prime broker may re-hypothecate assets to the value of 140% of the client’s liability to the prime broker. For example, assume a customer has deposited $500 in securities and has a debt deficit of $200, resulting in net equity of $300. The broker-dealer can re-hypothecate up to $280 (140 per cent. x $200) of these assets.

But in the UK, there is absolutely no statutory limit on the amount that can be re-hypothecated. In fact, brokers are free to re-hypothecate all and even more than the assets deposited by clients. Instead it is up to clients to negotiate a limit or prohibition on re-hypothecation. On the above example a UK broker could, and frequently would, re-hypothecate 100% of the pledged securities ($500).

Statement of Jon S. Corzine before the US House of Representatives Committee on Agriculture (.pdf)

Recognizing the enormous impact on many peoples’ lives resulting from the events surrounding the MF Global bankruptcy, I appear at today’s hearing with great sadness. My sadness, of course, pales in comparison to the losses and hardships that customers, employees and investors have suffered as a result of MF Global’s bankruptcy. Their plight weighs on my mind every day – every hour. And, as the chief executive officer of MF Global at the time of its bankruptcy, I apologize to all those affected.

Before I address what happened, I must make clear that since my departure from MF Global on November 3, 2011, I have had limited access to many relevant documents, including internal communications and account statements, and even my own notes, all of which are essential to my being able to testify accurately about the chaotic, sleepless nights preceding the declaration of bankruptcy. Furthermore, even when I was at MF Global, my involvement in the firm’s clearing, settlement and payment mechanisms, and accounting was limited.

Corzine Rebuffed Internal Warnings on Risks by Aaron Lucchetti and Julie Steinberg in the Wall Street Journal

MF Global Holdings Ltd.’s executive in charge of controlling risks raised serious concerns several times last year to directors at the securities firm about the growing bet on European bonds by his boss, Jon S. Corzine, people familiar with the matter said.

The board allowed the company’s exposure to troubled European sovereign debt to swell from about $1.5 billion in late 2010 to $6.3 billion shortly before MF Global tumbled into bankruptcy Oct. 31, these people said. The executive who challenged Mr. Corzine resigned in March.

The disagreement shows that concerns about the big bet grew inside the company months before the trade rattled regulators, investors and customers. The executive, Michael Roseman, whose title was chief risk officer, also expressed concerns directly to Mr. Corzine in meetings of just the two men and with other people present, people familiar with the situation said.

The Corzine lesson on executive departures by Theo Francis in Footnoted*

The only other indicator that something might be wrong was the fact that MF Global paid Roseman $1.35 million as he left. But this is all MF Global’s July proxy had to say on the subject:

“Mr. Michael Roseman’s employment with the Company ended effective March 31, 2010. In connection with his separation from the Company, Mr. Roseman was paid severance totaling $1,350,000 under his employment agreement. Mr. Roseman’s severance payment was calculated by adding his fiscal 2011 target cash bonus amount ($500,000), his fiscal 2011 target equity bonus amount ($500,000) and his fiscal 2011 salary ($350,000). All of Mr. Roseman’s unvested restricted stock units vested as of March 31, 2011.”

This is where reading between the lines becomes so critical. Executives who quit of their own volition, especially non-CEOs, rarely get big bucks on their way out the door. Often, that’s a sign that they went unwillingly. And yet, it offers no hint as to why he left: Poor performance? Personality conflict? Someone’s brother-in-law needed a job? There are a million potential reasons, good and bad, for easing someone out, and investors shouldn’t be left to guess.

Paperwork Dotted with Legal-Sounding Gibberish

Whenever you hear about a “prime bank” investment opportunity, walk away. A prime bank opportunity generally is described by the sponsor as an international investing program involving complex financial instruments that are too technical and complicated for non-experts to understand. If it’s too technical for you to invest why would you? – Astronomical returns are promised in exchange for secrecy about this lucrative international banking platform.

The SEC’s case against Frank L. Pavlico and his firm, The Milan Group, was just another prime bank scheme. It caught my eye because the SEC also brought charges against a lawyer involved in the scheme, Brynee K. Baylor.

What kept my attention was this quote from Stephen L. Cohen, Associate Director of the SEC’s Division of Enforcement:

“Pavlico and Baylor produced paperwork dotted with legal-sounding gibberish designed to deceive investors into believing this is a highly-sophisticated investment opportunity.”

And in the complaint:

“These documents were legal-sounding gibberish dotted with meaningless legal and financial terms that were designed to deceive investors into believing they were participants in a legitimate investment.”

A complaint by one of the deceived investors (.pdf) lays out what the scheme was offering. if the investor would deposit $325,000 into Baylor’s trust account Milan would provide a leased instrument with a value of $10 million. This would then be monetized and the resulting funds would be used to acquire a larger instrument.

These are just allegations, nothing has been proven and the defendants have not settled the charges.

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SEC Targeting Suspicious Investment Returns

Last week, the SEC announced THREE actions against investment advisers for compliance failures. The Securities and Exchange Commission has turned the dial a little higher and announced FOUR enforcement actions against multiple hedge funds by identifying abnormal investment performance. (Does their dial turn all the way up to 11?)

The SEC launched an initiative to combat hedge fund fraud by identifying abnormal investment performance — the Aberrational Performance Inquiry. Back in March, SEC Enforcement Director Robert Khuzami revealed during congressional testimony that the SEC had launched an initiative that would focus on funds that consistently outperform the market.  Enforcement is now focusing on hedge funds that outperform “market indexes by 3% and [are] doing it on a steady basis.” Khuzami referred to such performance as “aberrational,” and stated that Enforcement is “canvassing all hedge funds” for such “aberrational performance.” The SEC Enforcement Division’s Asset Management Unit uses proprietary risk analytics to evaluate hedge fund returns. Performance that appears inconsistent with a fund’s investment strategy or other benchmarks can form a basis for further scrutiny. This initiative came directly from from the Madoff scandal. If they had focused on Madoff’s consistent and aberrational returns, the SEC may have caught him sooner.

Half a year later, Khuzami is crediting Aberrational Performance Inquiry initiative with these four enforcement actions.

Michael Balboa and Gilles De Charsonville

These two were nabbed for overvaluing the reported returns and net asset value of the Millennium Global Emerging Credit Fund, organized to invest in sovereign and corporate debt instruments from emerging markets. Among the fund assets were Nigerian payment adjusted warrants and Uruguayan value recovery rights.

In October 2008, the hedge fund’s reported assets were $844 million. The SEC’s complaint alleges that Balboa, the fund’s former portfolio manager, schemed with two European-based brokers including Gilles De Charsonville to inflate the fund’s reported monthly returns and net asset value by manipulating its supposedly independent valuation process.

Apparently the SEC found Balboa’s action particularly egregious because the the U.S. Attorney’s Office for the Southern District of New York announced the arrest of Balboa and filing of a criminal action against him.

According to the SEC complaint, from at least January to October 2008, Balboa provided De Charsonville and another broker with fictional prices for two of the fund’s illiquid securities holdings for them to pass on to the fund’s outside valuation agent and its auditor. The scheme caused the fund to  overvalue these holdings by as much as $163 million in August 2008.  That meant falsely-positive monthly returns, millions of dollars more in management fees, another $410 million in new investments, and the avoidance of  about $230 million in redemptions.

The SEC is crediting their new initiative with this enforcement action, but the fund has been in liquidation since October of 2008.

ThinkStrategy Capital Management and Chetan Kapur

The SEC charged ThinkStrategy Capital Management LLC and its sole managing director Chetan Kapur with fraud in connection with two funds. ThinkStrategy Capital Fund was an equities-trading fund that ceased operations in 2007.  TS Multi-Strategy Fund was a fund of hedge funds. At its peak in 2008, ThinkStrategy managed approximately $520 million in assets.

The SEC’s complaint alleges that ThinkStrategy and Kapur engaged in a pattern of deceptive conduct designed to bolster their track record, size, and credentials. They materially overstated the performance of the Capital Fund and gave investors the false impression that the fund’s returns were consistently positive and minimally volatile. ThinkStrategy and Kapur also repeatedly inflated the firm’s assets, exaggerated the firm’s longevity and performance history. In 2008 they reported a 4.6% return when they actually had a -89.9% return. It looks like the trouble started in June of 2006.

They also made claims about the quality of their due diligence checks. Unfortunately, they ended up invested in the Bayou Superfund, Valhalla/Victory Funds and Finvest Primer Fund, each of which was revealed to be engaged in serious fraud.

ThinkStrategy also faked a management team, listing several individuals as principals or directors who had no affiliation with the firm. A few were Kapur’s classmates at Wharton. Kapur himself claimed to have an MBA from Wharton, even though he only had an undergraduate degree. Kapur claimed to have over 15 years of experience as an “investor, money manager, researcher, and system designer”. That means he would have started his career in 1988 at the age of 14.

As with most SEC settlements, these are merely allegations against Kapur and ThinkStrategy which they neither admit or deny.  The funds wound down over a year ago and other investors brought suit. In this case, I’m not sure you can credit the SEC with shutting down a bad fund using this Aberrational Performance Inquiry initiative.

Patrick Rooney and Solaris Management

According to the SEC’s complaint, Rooney and Solaris made a radical change in the fund’s investment strategy, contrary to the fund’s offering documents and marketing materials, by going all in for Positron Corp. In late 2008, Solaris held over 1.1 billion shares of Positron stock and had liquidated all of its non-Positron investments.

That’s certainly a risky binary bet on one company. You don’t usually see concentrated, undiversified, and illiquid position in a cash-poor company with a lengthy track record of losses.

The big problem was that Rooney was also the Chairman of Positron  and received salary and stock options from Positron.  Rooney and Solaris hid the Positron investments and Rooney’s relationship with the company from the fund’s investors for over four years. Although Rooney finally told investors about the Positron investments in a March 2009 newsletter, he allegedly lied by telling them he became Chairman to safeguard the fund’s investments.

It’s hard to see how Solaris would have been outperforming the market by more than 3% and fallen under the watchful eye of the new initiative.

LeadDog Capital Markets, Chris Messalas and Joseph LaRocco

The SEC instituted administrative proceedings against LeadDog Capital Markets LLC and its general partners and owners Chris Messalas and Joseph LaRocco. The charges were for misrepresenting or failing to disclose material information to investors in the LeadDog Capital LP fund.

The Fund was almost entirely invested in illiquid penny-stocks or other micro-cap private companies, each of which had received “going concern” opinions from their auditors, all but one of which had a consistent history of net losses, and most of which they or their affiliates owned or controlled

In addition, LeadDog, Messalas, and LaRocco allegedly misrepresented to, and concealed from, existing and prospective investors the substantial conflicts of interests and related party transactions that characterized the fund’s illiquid investments. For example, to induce one elderly investor to invest $500,000 in the fund, LeadDog, Messalas, and LaRocco represented falsely that at least half of the fund’s assets were liquid and could be marked to market each day, and that the investor could exit the fund at any time. In February 2009, the SEC alleges that 92% of the fund’s non-cash assets were illiquid and could not be marked-to-market on a daily basis.

In October 0f 2009, the fund’s auditors learned about some of the problems, resigned, and issued a retraction letter. Let’s assume that the date the problems were discovered. We could credit the initiative with taking action in this case. It would just be two years before charges were filed.

Assuming the allegations are true, these four cases are good cases for SEC enforcement. The consistent out performance initiative is a good one. However, these four just don’t seem to fit in the right time frame for the new enforcement initiative. Since these fund managers were not registered with the SEC, there is no good database for the SEC to check returns and easily find the outliers. Perhaps once Form PF reports start flowing, the SEC will have a better database to go looking for problems.

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Compliance Bits and Pieces for December 2

Here are some recent compliance-related stories that caught my attention.

The Enron cast: Where are they now? by Richard Partington in Financial News

The leading characters in the Enron saga have had varied fortunes since the disgraced trading giant collapsed into Chapter 11 bankruptcy a decade ago this week. A few went to prison, a couple have since died, while another employee went on to become a hugely successful billionaire trader. Financial News has ploughed through newspaper reports, personal and company websites and – where possible – contacted those involved to see where they are all now.

SEC Examines Internal Watchdog’s Interview By Robert Schmidt and Joshua Gallu in Bloomberg

The U.S. Securities and Exchange Commission’s internal watchdog has come under scrutiny for comments he made in a 75-minute videotaped interview about the agency and the stock market to a man who markets a “crash-proof retirement” plan through the Internet and a paid radio program. SEC Inspector General H. David Kotz has been contacted about the matter by the agency’s general counsel’s office, which also has briefed the SEC’s commissioners over concerns the interview could be construed as investment advice or an endorsement of financial services, according to two people briefed on the situation.

For Wall Street Watchdog, All Grunt Work, Little Glory by Ben Protess in DealBook

In an office park 20 miles outside Washington, the Financial Industry Regulatory Authority, Wall Street’s nonprofit self-regulator, has quietly built a small army of market police. Since Wall Street’s financial crisis in 2008, this fledgling fraud task force has entered the front lines of fighting insider trading, even if the group rarely earns the credit. Finra’s fraud group is akin to being the sous chef to the S.E.C. and other government regulators: the team prepares evidence against America’s most-wanted traders, but receives little of the glory when the cases are served.