Year: 2011

Parking and Compliance

Do you pull into a parking space or back in? Does it matter? Do you need a rule?

The other day I pulled into a parking lot and saw one of these “head in parking only” signs. It bothered me. Why does it matter whether I parked with my headlights in or my taillights in?

Of course you need some order to a parking lot for it to function. You paint lines to designate where people can park and where they can’t park. If you are charging a fee, you need some way to collect the fee and enforce its payment. Maybe you paint some lines for traffic flow and to show people the way to the exit.

If the lot requires a window sticker to prove you are authorized to park in the lot, then it may make sense to require cars be in a certain direction. The enforcement personnel can then just patrol the lot, looking at the same place on each space to make sure the vehicle is authorized. You could also argue that it’s a bit lazy. Enforcement can look around the vehicle. After all, vehicles are all shapes and sizes. A window sticker on the back window of a station wagon is in a very different place than a pickup truck.

Why does it matter whether I back into the space or back out of the space? You have to take the time to back up either way.

I admit that I usually back into parking spaces. That is why the sign bothered me. I have my reasons for backing in. I have terrible lines of sight to the back of my truck and it’s very long. (Yes, I drive a pick up truck.) So parking takes more effort. I prefer to look into the space to make sure there are no obstacles, especially people, in the way, then swing around to back in. Yes, it takes longer getting in, but it would take just as long getting out. Backing out means I have to look for passing people and cars on the way out with poor vision. I think it’s safer to back in, instead of pulling in.

I’m pretty sure there are some lessons in here for a compliance professional.

  • Are there reasons for your rule?
  • Can you be flexible?
  • Are you making people do things just because it’s easier for you?
  • Does your rule reduces risks?

I’m sure there are more.

Sources:

You’re Parking Wrong: Why it’s almost always better to back into a space than pull into it head-on by Tom Vanderbilt in Slate

A Question of Parking by Tom Vanderbilt in his How We Drive the companion blog to his New York Times bestselling book, Traffic: Why We Drive the Way We Do (and What It Says About Us)

SEC Is Serious About Expert Networks and Gets a New Logo

The Securities and Exchange Commission charged a hedge fund and four hedge fund portfolio managers and analysts with illegally traded on confidential information obtained from technology company employees moonlighting as expert network consultants.

Even bigger news is that the SEC came up with this fancy new logo to brand its expert network investigations and prosecutions.

“It is illegal for company insiders who moonlight as consultants to sell confidential information about their companies to traders, and it is equally illegal to buy that corruptly obtained information and trade on it,” said Robert Khuzami, Director of the SEC’s Division of Enforcement.

Expert networks are not inherently illegal. Of course it’s legal to obtain advice and analysis through experts. It becomes illegal to trade when that material nonpublic information is obtained in violation of a duty to keep that information confidential.

It would be perfectly legal to have someone look at the traffic count for a store to use as a measure of whether sales are up or down. Legend has it that some investors used satellite photos of Wal-Mart parking lots to help with their earnings estimates.

In this case, the SEC is accusing the experts of leveraging insiders to reveal sales forecasts, revenues, and other detailed inside information about their companies. There will be questions about the information: is it material nonpublic information? and did the parties have a duty to keep the information confidential?

The cases should be interesting as an evolution of insider trading prosecutions. The new logo just makes it more interesting.

Thanks to Dominic Jones of IR Web Report for pointing out the new logo in one of his Twitter updates.

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Complying with Regulations and Ethics

If you are running a compliance program you spend a lot of time reading regulations and trying to figure out how they apply to your company. Some are very clear and make it easy to understand what you need to do. Unfortunately, many are not.

Are there corruption and ethical issues tied to your interpretation?

In my experience, the laws and regulations are often not so clear that you can draw a bright line around what is legal and what is illegal. In those instances where the rules are very clear, you end up having to implement some internal routines that seem obtuse. More often, you decide whether your approach to complying with the law is conservative or aggressive. Usually, that posture on your company’s approach is a matter of corporate culture.

A recent Harvard Business School Working paper by Malcolm Salter caught my eye: Lawful but Corrupt: Gaming and the Problem of Institutional Corruption in the Private Sector.

In the business world, gaming society’s “rules of the game” refers to subverting the intent
of socially mandated or legislated rules for private gain without resorting to blatantly illegal
acts.

He breaks “gaming” into two forms:

The Rule-Making Game involves influencing the writing of society’s rules by legislative or regulatory bodies, so that loopholes, exclusions, and ambiguous language provide future opportunities to “work around” or circumvent the rules’ intent for private gain. The Rule-Making Game is an influence game.

The Rule-Following Game involves the actual exploitation of these gaming opportunities. This game involves following the letter of the law but not necessarily its intent or spirit, as well as violating grey areas of the law in ways that are not easily understood or recognized as violations. The Rule-Following Game is thus a compliance game.

I end up disagreeing with Salter on many of his points.

On the Rule-Making side, I think there are really two distinct paths: the statutory and the regulatory. Certainly the statutory side is full of gamesmanship in setting the legislative framework. Political influence can be corrosive. There are few who think that political lobbying is a good thing. Most of the American population thinks poorly of Congress, often rating Congressman below car salesman in their perception of ethical standards.

I’ve written about the problems of pay-to-play many times. On the other hand, a company should not have to sit on its hands when faced with adverse laws being proposed in the legislature.

Look at one example in the recent Dodd-Frank Act. Section 403 of Dodd-Frank eliminated the Private Adviser Exemption used by many private fund companies to be exempt from registration as an investment adviser. But section Section 407 of Dodd-Frank created a new exemption for venture capital fund advisers. On one hand you could follow Salter’s argument and use this an example of “gaming.” On the other hand, you could argue that venture capital funds are inherently different from other types of private funds, don’t pose the same risks, and don’t need as much oversight. Clearly, the venture capital industry lobbied for this exemption. I expect your view on whether this was “gaming” depends on your view of venture capital.

The other half of rule-making is the regulatory bodies. You will get a spread of quality and respectability, but they are generally not subject to the same level of gamesmanship as elected officials. Sure, some agencies are subject to excessive influence by the industry they regulate. More often than not, the regulatory bodies are dedicated professionals who are looking to do the right thing for the long term success of the industry while protecting the interests of the consumer, the investor and the economy.

When it comes to following the rules, a company’s approach can be indicative of underlying issues.

Like violations of fairness norms and conflicts of interests, the Rule-Following (or
compliance) Game is often fueled by self-serving interpretations of appropriate conduct.
Many business people and their lawyers and accountants view testing the outer limits of the
law as a natural and acceptable feature of U.S. capitalism—as “American as apple pie.”
Herein lies the particular insidiousness of gaming—and the major difference between it and
clearly illegal conduct.

As I said earlier, rules are often not so clear. I agree with Salter when he points out that “inconsistent management style by institutional leaders—coupled with perverse incentives, breakdowns in internal controls, ineffective board oversight, and an absence of transparency—can quickly neutralize published codes, grease the wheels of ethical drift, and encourage gaming of society’s rules of the game.”

Of course the core goal of compliance programs is to prevent that kind of drift. You want to prevent your company from spending too much time close to the line of legal conduct. Spending that much time may make it too easy to stick a toe over into the land of illegality and be seduced by the ways of easy profit (fake profit) and magical gains (fake gains).

UPDATE: For another take at rule-making, NPR’s Planet Money published a story a yesterday on this topic: Writing the Rules.

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Popping the Irish Bubble

In compliance, you need to learn from your mistakes so you can prevent future problems. There were many mistakes that lead to the 2008 financial crisis, not just in the United States, but also abroad. Michael Lewis wrote The Big Short, taking a look at the Unites States financial crisis and has written great stories on the financial crises in Iceland and Greece.

His latest story in Vanity Fair focuses on the troubles in Ireland: When Irish Eyes Are Crying.

He makes this one look easy. Ireland’s banks made too many bad real estate loans and the Irish government foolishly guaranteed the obligations of the Irish banks.

Lewis quotes Theo Panos, a London hedge fund manager: “Anglo Irish was probably the world’s worst bank. Even worse than the Icelandic banks.” The bank faced losses of up to 34 billion euros. A big number, but the sum total of loans made by Anglo Irish was only 72 billion euros. This one Irish bank had lost nearly half of every dollar it invested.

The signs of an immense real estate bubble sound obvious. A fifth of the Irish workforce was employed building houses and the construction industry had become a quarter of the country’s GDP. As for prices, since 1994 house prices in Dublin had risen more than 500 percent. As a measure of affordability, rents had fallen to less than 1 percent of the purchase price. Your $833 in rent would be for a home with a sales price of a $1 million.

There was a tight link between the Irish banks and Irish real estate. Lending to construction and real estate has risen from 8% to to 28% since 2000.

The Irish government stepped in to help save the banks from their poor underwriting and poor investments. Instead of merely standing behind the deposits at the Irish banks, the government guaranteed all of their obligations. Investors who were looking to dump bonds issued by the banks for pennies on the dollar, were rewarded for holding on to them.

There are plenty critics of TARP and the bailout of the US banks. But it was a significantly smaller intervention than what happened in Ireland.

It’s worth your time to take a few minutes and read When Irish Eyes Are Crying.

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Private Fund Compliance Forum

Thousands of private equity firms are scrambling to meet the July deadline to register with the SEC. New disclosure rules are being proposed for private equity managers with more than $1bn in assets. PEI Media is producing its second annual PEI Private Fund Compliance Forum 2011 to help prepare you prepare for the new wave of regulations.

I will be speaking on a panel on the new rules governing fundraising. Here is the rest of the agenda:

Day One: Wednesday, May 3, 2011

8:50 – 9:00
PEI welcome & Chairman’s introduction

9:00 – 10:00
Expert panel:  Brave new world – Impact of SEC registration on finance and operations
– Creating a culture of compliance
– Getting buy-in from the GPs and other key stakeholders
– What does it mean to take on the role of a Chief Compliance Officer?
– Defining the function for your organization
– Budgeting for staff, outside consultants, technology
– Who do you appoint to be the CCO – CFO, GC or COO?

10:00 – 10:30
Keynote Speaker
Carlo V. di Florio, Director, United States Securities and Exchange Commission, Office of Compliance Inspections and Examinations

10:30 – 10:50
Networking break

10:50 – 12:00
Panel: The new form ADV 2 part 2
– Most important required elements for the brochure
– Addressing the  most challenges aspects i.e. confidential information and fees
– Handling updates and brochure supplements
– Effective delivery

12:00 – 1:00
Panel: CCO Clinic
What does it take to be an effective chief compliance officer?

1:00 – 2:15
Luncheon

2:15 – 3:15 – Workshop Session I

Workshop A: For new SEC registrants
– What to expect during the first year as a RIA
– ADV I and II forms
– Formalizing the code of ethics
– Custody rule compliance

Workshop B: For multi-strategy PE firms and  hedge fund affiliates
– Whether or not to have information barriers
– What  types of controls need to be put in place
– How do you prevent the misuse of information
– Conflicts of interest
– Flows of information

3:15 – 3:30
Refreshments

3:30 – 4:30 – Workshop Session II

Workshop C: Stepping up your internal compliance program
– Creating a firm compliance manual and training your staff
– Administering the terms of the limited partnership agreement
– Building a risk matrix and conducting an annual review
– Identifying risks; conflicts and fees

Workshop D: International Tax issues
– Recent tax changes and new regulatory frameworks in China, Australia, South Korea, India
– FATCA
– How do these changes impact returns?
– Modifying fund structures for tax efficiency

4:30- 5:30
Panel: What to do when the SEC knocks on your door?
– SEC hot buttons in an audit
– Disclosure issues
– Top 10 deficiencies for private funds

5:30 – 7:00
Cocktail Reception

Day Two: Thursday May 4, 2011

8:50 – 9:00
Chairman’s welcome

9:00 – 9:50
Panel: Update from Washington
– Hedge Fund Transparency Act
– Regulation of venture capital firms
– New initiatives on the horizon

9:50 – 10:35
Panel: The new due diligence regime – meeting requirements from LPs and regulators
– Presentation and documentation of track record
– Monitoring of trading activities
– Increased scrutiny around valuation
– Importance of integrity of reporting
– Compensation of operating partners

10:35 – 10:55
Coffee break

10:55 – 11:45
Panel: New rules governing fundraising
– Presentation materials and being compliant
– State procurement lobbying laws and their effect on raising money from public pensions
– Monitoring your employees’ political contributions•   Presentation materials and being compliant
– Coordination of global offering to US and non-US investors
– Monitoring your employees’ political contributions – prohibit vs. preclear?

11:45 – 12:40
Panel:  Effective and appropriate marketing materials
– Consider your audience – presentation to existing LPs, prospective LPs and portfolio companies
– Making sure that presentations are reviewed by compliance
– Interpreting rules governing marketing and advertising
– Web sites and other marketing materials
– Guidelines regarding talking to the press

12:40-1:15
Panel: Regulatory issues beyond Dodd Frank
– FCPA and UK Bribery Act compliance

1:15 – 2:15
Closing Luncheon

Compliance Bits and Pieces for February 4

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

Leadership (as told by the Pointy-Haired Boss)

Dilbert.com

Paper Lion Ahead for SEC’s Pay-to-Play Exemption? by Allix Magaziner in the Pay to Play Blog

On March 14, the SEC’s pay-to-play rule will come into effect and there is growing concern that the rule’s exemption for accidental violations will result in an administrative hailstorm. The rule allows an advisor to apply to the SEC for an order exempting it from application of the two-year ban. Under such provision, the SEC can exempt advisers from the time out requirement where the adviser discovers triggering contributions after they have been made, and when imposition of the prohibition is unnecessary to achieve the rule’s intended purpose. An exemption would be based on the facts and circumstances of each applicant, including the SEC’s consideration of factors such as whether the adviser had a compliance program in place.

Chancery Allows Claim to Enforce “Agreement to Negotiate in Good Faith” by Francis G.X. Pileggi in Delaware Corporate and Commercial Litigation Blog

The Court explained that “an agreement to negotiate in good faith may be binding under Delaware law,” and specific performance could, in theory, be an appropriate remedy for breach of such a provision. In practice, however, “the problems with ordering parties to negotiate in good faith are significant.”

Smarsh is conducting a survey on the attitudes and opinions of compliance professionals in the financial services industries regarding the oversight of electronic communications (such as email, instant messaging, social media, etc.) at www.smarsh.com/compliancesurvey

Barney Frank will Seek Reelection

Frank identified as his top two issues defending the Wall Street Reform and Consumer Protection Act, which he called “under attack by those who oppose meaningful regulation and who would undermine it” and addressing “excessive military spending.”  Frank said, “My second national priority is to reduce significantly America’s swollen, unnecessary, worldwide military footprint – this is the only way to reconcile the need for us to spend wisely, to promote our economy and to accomplish significant deficit reduction.”  Frank also flagged fishing industry protections, low-income housing and “fighting for full legal equality for all citizens” as priorities.

A Criminological Perspective on Business Ethics

White-collar crime has a strong influence on business ethics. Joseph Heath uses a criminological perspective to help illuminate some traditional questions in business ethics in his paper: “Business Ethics and Moral Motivation: A Criminological Perspective”

Heath starts off with the premise that the ‘‘ethics scandals’’ in the early years of the twenty-first century was not a business ethics failure. What really took place at companies like Enron, Worldcom and Parmalat was high-level, large-scale white collar crime. Their illegal acts were probably surrounded by unethical conduct. But their core actions all involved a failure to comply with the law.

The bulk of the paper is spent looking at the techniques of neutralization that offenders use to deny the criminality of their actions. When white collar crime is viewed from the perspective of techniques of neutralization you can see why bureaucratic organizations such as large companies and the market, might constitute “peculiarly criminogenic environments.”

These are institutional contexts that generate a very steady stream of rather plausible (or plausible-sounding) excuses for misconduct. This is the result of a confluence of factors: first, corporations are typically large, impersonal bureaucracies; second, the market allows individuals to act only on the basis of local information, leaving them in many cases unaware of the full consequences of their actions; third, widespread ideological hostility to government, and to regulation of the market in particular, results in diminished respect for the law; and finally, the fact that firms are engaged in adversarial (or competitive) interactions gives them broader license to adopt what would otherwise be regarded as anti-social strategies.

Denial of responsibility

The offender claims that conditions of responsible agency were not met: it was unintentional; he was insane, he was provoked, he had ‘‘no choice’’ but to do it, it was all an accident, etc.

In a company, an employee can blame his boss for telling him to do something wrong. The boss can pass the blame back down to the worker saying they acted independently.  The competitiveness of the marketplace and the workplace means that if one individual refuses to perform an illegal act, he may feel that he could simply be replaced by someone else who would.

Denial of injury

The offender seeks to minimize or deny the harm done.

Most white collar criminals never meet or interact with those they harmed.  In many cases they wouldn’t even know how to find their victims.  “In these cases, there is potential confusion as to the identity of the individuals who are harmed by the criminal’s actions. In other cases, the mere fact that there is diffusion of the harm over a very large number of persons is appealed to as grounds for denial that anyone was injured by the person’s actions.”

Denial of the victim

The offender acknowledges the injury, but claims that the victim is unworthy of concern because he deserved it.

The underpayment inequity is common. It’s hard to find an employee who believes that an enhancement of  justice in society would require a reduction of his compensation package. On the other hand workers may feel undercompensated, ignoring the difference between the ease with which they can be replaced that determines their wage rate, and their contribution to the company.

It is really easy for workers to convince themselves that they are not stealing. Instead they believe they taking what they are owed, or they are punishing the company for treating employees poorly.

Condemnation of the condemners

The offender attempts to ‘‘turn back’’ the charges by impugning the motives of those who condemn his actions.

The classic examples in corporate crime are the charges fired back at Eliot Spitzer during his time as Attorney General when he exposed a wide range of  practices in the financial services industry. His political ambitions were often discussed side-by-side with his prosecutions.

Appeal to higher loyalties

The offender claims that the action was done out of obedience to some moral obligation that conflicted with the law.

You often hear “I did it for my family.” The offender can see the company as a proxy and serve as an object of higher loyalty. One theory with Ken Lay and Jeffrey Skilling at Enron is that they misled investors for the sake of the company, insisting that it was a great company. There is also the more common business ethics excuse that it was done for profit and the benefit of the shareholders.

Everyone else is doing it

The mere fact that others are breaking the law is used to suggest that it is unreasonable for society to expect compliance.

This is an excuse for all kinds of crime, but it is very common in a business context because of the competitiveness of the business environment.

Claim to entitlement

An offender claims he was acting ‘‘within his rights’’ and that the legal prohibition of his conduct constituted unjust or unnecessary interference.

One of the big differences between corporate crime and street crime is how often white collar criminals deny the authority of the laws that they have broken. The argument is that the government should not regulate certain forms of private transactions.

Folk Tales of Moral Motivation

Heath argues that the focus on these techniques of neutralization are more effective in addressing business ethics and corporate crime than theories of “moral motivation.” The field of criminology has largely discredited those theories as folk tales. It’s not about character, greed, and values.

A criminologist does not think it’s mysterious that some people commit crimes. They find it mysterious that more people do not commit crimes. Only a small percentage of people chose to advance their interests through criminal activity. Even though criminal activity is punished, the chances of getting caught are usually small and the threat of punishment distant.

There are lots of lessons to be learned from this paper by compliance professionals.

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Do Hedge Funds Create Criminals?

Lynn Stout takes the recent charges against arrest of Raj Rajaratnam, founder of the Galleon Group, and the recent raids on expert networks as an indictment of the entire hedge fund industry. She makes the mistake of using a few bad apples to state the whole industry is corrupt. The vast majority of hedge funds operate completely in compliance with the law and ethical obligations. You would not say the entire energy industry is corrupt because of the failures of Enron.

The expert networks Stout mentions are not your classic cases of insider trading. The involved parties were trying to get information about how a company is doing. By getting access to orders for computer chips you can make some estimates about how many computers a company is producing. Depending on the type of information, some should have been protected and some is just business intelligence.

After all, there is nothing wrong with looking at satellite photos of a shopping center to see how many cars are in the parking lot. Compare the photos from year to year and you may have a good indication of whether sales are up or down.

There is plenty of evidence demonstrating that bad environments contribute to bad behavior. That is backbone for compliance. Create an environment where there is more pressure to follow the rules than to break the rules.

Stout lays out three social signals that have been repeatedly shown in formal experiments to suppress pro-social behavior:

Signal 1: Authority Doesn’t Care About Ethics.
Signal 2: Other Traders Aren’t Acting Ethically.
Signal 3: Unethical Behavior Isn’t Harmful.

Signal 1 is the classic call for a tone from the top. Signal 2 is the classic call for corporate culture. Signal 3 is the classic call for regulatory (and criminal) enforcement.

No. Hedge funds do not create criminals. Unethical work environments create criminals. It’s a problem not just at hedge funds, but every industry.

Lynn Stout is the Paul Hastings Professor of Corporate and Securities Law at the UCLA School of Law and the author of Cultivating Conscience: How Good Laws Make Good People.

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The Case for Professional Boards

If you want to improve governance at a corporation, do you need professional directors? Did SOX merely add a layer of legal obligations of board, and do little to improve the quality of those serving as directors?

Robert C. Pozen makes the case in The Case for Professional Boards in the December issue of the Harvard Business Review.

Pozen starts by limiting the size of the board to seven people: the CEO plus six independent directors. He points to research that groups of this size are optimal for decision-making. Bigger groups can result in “social loafing”, relying on others to take the lead and ceding decision-making. Six also gives you enough people to populate the three key committees: nominating, compensation and audit.

The greatest need in a board is expertise. Pozen expects an accounting expert to head the audit committee. He also allows for one generalist to provide a broad perspective on the company’s strategy. But the rest should be experts in the company’s main line of business. That is not easy. Independent experts are most likely working for company’s competitors. He expects that most professional directors would be retired executives in the company’s industry. That would also lead to the elimination of mandatory retirement ages for directors.

Pozen makes a strong case. “To improve corporate oversight we need not more legal procedures but a culture of governance in which directors commit to the role as their primary occupation.” It’s just very radical strategy for companies who have grown and gathered their directors organically.

The SEC Wants to Know if You Are Systemically Important

The Securities and Exchange Commission proposed a new rule that would require advisers to private funds to report information for use by the Financial Stability Oversight Council in monitoring risk to the U.S. financial system. Sections 404 and 406 of the Dodd-Frank Wall Street Reform and Consumer Protection Act requires the SEC to gather this information.

The SEC is proposing a new Rule 204(b)-1 under the Investment Advisers Act that would require SEC-registered investment advisers to report systemic risk information on Form PF if they advise one or more private funds.

Each private fund adviser would report basic information about the operations of its private funds on Form PF once each year. Large Private Fund Advisers would be required to submit this basic information each quarter along with additional systemic risk related information required by Form PF concerning certain of their private funds.

“Large Private Fund Advisers” would be

  • Advisers managing hedge funds that collectively have at least $1 billion in assets as of the close of business on any day during the reporting period for the required report;
  • Advisers managing a liquidity fund and having combined liquidity fund and registered money market fund assets of at least $1 billion as of the close of business on any day during the reporting period for the required report; and
  • Advisers managing private equity funds that collectively have at least $1 billion in assets as of the close of business on the last day of the quarterly reporting period for the required report.

The SEC estimates that approximately 4,450 advisers would be required to file Form PF. Of those, approximately 3,920 would be smaller private fund advisers not meeting the thresholds for reporting as Large Private Fund Advisers.

It looks like the definition of private equity fund for purposes of the Large Private Fund Adviser reporting requirements will exclude real estate funds.

Private equity fund:

Any private fund that is not a hedge fund, liquidity fund, real estate fund, securitized asset fund or venture capital fund and does not provide investors with redemption rights in the ordinary course.

Under the proposed rule, real estate private equity funds will be subject to the annual reporting, but not subject to the more detailed quarterly reporting. This is just a proposed rule, so the final requirements and definitions may change in the final rule when it is issued. In the meantime, you can make comments.

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