Year: 2011

Data Privacy Day

Data Privacy Day is January 28, 2011.

There have events throughout the week to inform and educate us all about our personal data rights and protections.

Here are some key reminders:

  1. Never Post or Share Personal Information such as a date of birth, personal address, or maiden name because identity thieves now friend as many people as possible and join networks solely for the purpose of harvesting information to use to commit identity fraud.
  2. Always Update Your Software
  3. Use Complex Passwords
  4. Don’t Download Just Any Application
  5. Avoid Peer-to-Peer File Sharing

Read more:

Compliance Bits and Pieces for January 28

Here are some recent compliance-related stories that caught my eye:
Compliance Professionals Ask Justice Department for Data Showing Programs Pay Off

Corporate ethics and compliance officers want the U.S. Department of Justice to provide data “that identifies how often an effective ethics and compliance program yields a direct return in enforcement decisions,” according to three leading professional organizations. In a letter to the Department of Justice (DOJ), the three organizations – the Ethics Resource Center (ERC), Ethics & Compliance Officer Association (ECOA), and the Society of Corporate Compliance and Ethics (SCCE) – said that recent surveys of 1,223 ethics and compliance officers indicate “disappointment” with DOJ statements on past cases which linked favorable treatment for offenders to their cooperation with investigators yet ignored the value of existing ethics and compliance programs.

Real estate managers’ co-investments no comfort to investors by Arleen Jacobius in Pensions & Investments

Real estate managers have been sampling their own cooking for decades, but that didn’t make losses among the largest co-investments any more palatable to outside investors after the economic meltdown of 2008-“09.

Institutional Limited Partners Association Publishes New Private Equity Fund Guidelines by Michael Wu in the Investment Law Blog

Earlier this month, the Institutional Limited Partners Association (“ILPA”) published Version 2.0 of its Private Equity Principals (the “Principals”). The Principals set forth the ILPA’s take on the best practices in establishing private equity partnerships between limited partners (“LPs”) and the general partner (“GP”). The Principals focus on three guiding tenets for developing effective partnership agreements: Alignment of Interest Between LPs and GP, Fund Governance and Transparency to Investors. The revised version of the Principals incorporate feedback from GPs, LPs and third parties in the industry to increase “focus, clarity and practicality.”

California Commissioner Expresses Concern About Proposed Venture Capital Fund Definition by Keith Paul Bishop in California Corporate & Securities Law blog

As I wrote in this early posting, California is ground zero for the venture capital industry.  Many of our most succesful and innovative companies have been funded by the venture capital industry.  Thus, it is good to see that Commissioner Preston DuFauchard has submitted this letter of comment with respect to the Securities and Exchange Commission’s proposed rule defining “venture capital fund”.

SEC looks at Cahill, Goldman Sachs link by Frank Phillips in the Boston Globe

The US Securities and Exchange Commission has delivered subpoenas to the state treasurer’s office in a wide-ranging request for documents concerning dealings between investment banking giant Goldman Sachs and former treasurer Timothy P. Cahill, onetime top staff members, and former campaign aides, according to an official briefed on the document request.The agency’s subpoenas, which seek e-mails, phone records, schedules, files, and memorandums, come just over a month after Goldman Sachs removed itself from two state bond deals in Massachusetts following the disclosure that a vice president at the firm, Neil Morrison, was active in Cahill’s 2010 gubernatorial campaign, which could violate federal securities regulations. Morrison had previously served as a top deputy to Cahill in the treasurer’s office.

How to Find Answers Within Your Company – Would Quora Work?

Making sure that people get the right answer to questions is vital to the success of a business. From a compliance perspective, it’s important that questions in the compliance domain get answered correctly. It’s just as important that compliance professionals can find the correct answers to their questions.

On one side you have GRC, trying to answer questions related to governance, risk and compliance  in an integrated platform. But lots of questions will still be ad hoc and outside the information in the GRC systems.

One of the latest Web 2.0 darlings is Quora. It’s a continually improving collection of questions and answers created, edited, and organized by the community.

Quora

I found Quora mildly interesting, but a compliance nightmare.

From the perspective of a lawyer, answering legal questions in a public platform is fraught with peril. I found most of the legal questions to be vague and incomplete. It’s an easy trap for a less-careful lawyer to inadvertently create an attorney-client relationship or legal liability. For financial professionals, you can easily trip over the requirements for record-keeping and preapproval if the answer related to financial advice. (I have only answered questions about snowboarding.)

I view Quora as another knowledge management platform placed in the public web. It’s interesting to see it work, but I’m skeptical of its viability. I’ve seen many question and answer platforms come and go. Quora adds the improvements of requiring registration, community run organization and rating of answers.

Quora seems to still be at the stage of altruism. People are asking questions and answering them out of curiosity and the willingness to share. The marketers and self-serving, underemployed consultants will come eventually and fill it full of inane answers and ads.

Once the shiny newness wears off, what will keep someone coming back to contribute content? That has always been the problem of knowledge management. It’s hard to get the experts who really know the answer to contribute their response. A recent article in the MIT Sloan Management Review drove home this point: How to Find Answers Within Your Company.

Knowledge Markets

Altruism will only last so long and a person’s willingness to contribute will wane as the next fad comes along the web. The challenges and the needs are different when you bring a knowledge market, like Quora, inside your company.

The first generation of knowledge management was all about centralized systems. They produced mixed results. They ignored the market for knowledge and just imposed a top-down centralized structure to try capturing work product.

How to Find Answers Within Your Company points out that the system failed to place a value on contributed material or, if it did, the value was fixed. The failure to gain contribution was largely a failure to understand the economics of contribution. Bebya and Van Alstyne point to three forms of incentives: spendable currency, recognition for expertise and the opportunity to have a positive impact.

You can’t fix the price. Information that is more valuable than the price is less likely to be created. Experts won’t waste their time. When information is less valuable than the price, less-expert workers will volunteer just to get compensated. This is the classic knowledge management problem, getting the experts to contribute and highlighting the best content. The paper offers examples of knowledge systems that added a marketplace to better value and price contributions.

It’s not just about cash. Take FourSquare as an example. They use gameplay to encourage people to check-in to locations. Earn a badge or try to become mayor. They also offer the cash reward of specials offered by merchants.

For anyone interested in improving their ability to capture knowledge, the article provides lots of other great insights in what works and does not work in knowledge markets.

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Proposed “New” Standard for Accredited Investor

If you are involved in the private placement of securities, then you have been waiting to hear how the SEC was going to change the definition of “accredited investor.”

Section 413(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act requires the definitions of “accredited investor” to exclude the value of a person’s primary residence for purposes of determining whether the person qualifies as an “accredited investor” on the basis of having a net worth in excess of $1 million. Previously, the standards required a minimum net worth of more than $1,000,000, but permitted the primary residence to be included in the calculation.

Other than changing the calculation of net worth change mandated by Dodd-Frank, the SEC has declined to change the definition.

The other test for determining qualification was an individual income in excess of $200,000 in each of the two most recent years (or joint income with a spouse in excess of $300,000). I expected those number to nearly double to keep pace with inflation.

Section 415 of the Dodd-Frank Act requires the Comptroller General of the United States to conduct a “Study and Report on Accredited Investors” examining “the appropriate criteria for determining the financial thresholds or other criteria needed to qualify for accredited investor status and eligibility to invest in private funds.” That study is not due for three years. The SEC indicated that they will likely use the results of that study when they once again address the accredited investor standard in 4 years, as allowed under Dodd-Frank.

It seems to me that the SEC found an opportunity to reduce its rulemaking agenda, by not significantly changing a rule. Maybe this is the first sign of the SEC creaking under the weight of the Dodd-Frank mandates.

Sources:

SEC Study on Enhancing Investment Adviser Examinations

Now that most private funds managers are required to register with SEC as investment advisers, the SEC is considering abandoning them to regulation by FINRA.

The SEC released the much anticipated report, a 40-page “ Study on Enhancing Investment Adviser Examinations” mandated by Section 914 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

The report is more a plea for resources than an abandonment. The report makes a simple statement: ” the Commission will likely not have sufficient capacity in the near or long term to conduct effective examinations of registered investment advisers with adequate frequency. The report points out that the frequency of examination is a function of the number of registered investment advisers (and their complexity) and the amount of SEC’s OCIE staff dedicated to examination. While the number of advisers and their complexity have increased, the staff of OCIE has decreased. The complexity will only increase as thousands of private fund managers come under the registered investment adviser umbrella.

The SEC staff recommended three options for Congress to consider:

  1. Self-Funding Authorize the SEC to impose user fees on registered investment advisers.
  2. Self Regulatory Organization Authorize one or more SROs, under SEC oversight, to examine all registered investment advisers.
  3. Limited SRO Authorize FINRA to examine all of its members that are also registered as investment advisers for compliance with the Advisers Act.

I read the report as a plea for more resources to oversee investment advisers.

Dodd-Frank is clearly pulling private fund managers into the domain of the Investment Advisers Act. That will require extra resources. On the other hand, they are kicking advisers with less than $100 million in assets out for SEC oversight and over to state registration and oversight. It’s unclear if that trade will result in more, less or about the same number of advisers under SEC oversight. The SEC has stated that about 3,500 advisers will go over to the states. They can only guess how many fund managers will become new registrants. (My guess is that the SEC will have a net loss.)

The report is interesting but holds not legal influence. All of the recommendations require Congressional action. My perception of Congress is that little will be done that helps Dodd-Frank during the next two years.  I doubt they will give up the appropriations as a control method over the SEC.

In addition to the official report, Commissioner Elisse Walter issued a separate dissenting opinion expressing her disappointment with the SEC’s final report and reiterating her stance in favor of an SRO, citing funding as an issue that is too great to overcome both in the short and long terms.

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What Caused the 2008 Crisis?: All the Devils are Here

Was it Fannie Mae? Was it the lack of regulatory oversight? Was it the rating agencies? Was it pure greed?

Yes, yes, yes and yes. Plus, there were lots of other factors.

Bethany McLean and Joe Nocera put together an insightful look at the many factors that created the housing bubble and amplified the destruction when it popped in All the Devils are Here: The Hidden History of the Financial Crisis. Pundits and purists have tried to pin the blame on a single element. It seems clear that many “devils” were at work. It’s not just institutions that failed in the crisis. The authors paint the pictures of key individuals who helped inadvertently build up the housing bubble or allowed for it cause mass destruction.

Certainly, Fannie Mae and Freddie Mac were part of the problem. It was their stranglehold on the securitization of conforming mortgages that lead Wall Street to look at non-conforming mortgages as a source of profits. Subprime mortgages, by definition, were outside the definition of “conforming” by Fannie Mae and Freddie Mac standards.

Wall Street’s thirst for product was an ample funding source for subprime lenders. They didn’t need the deposits of conventional banks for funding. They could just sell their loans to Wall Street for packaging into mortgage-backed securities. Wall Street would also provide the warehouse funding to help subprime lenders with capital to originate mortgage loans.

The federal government was pushing for increased home ownership. The Clinton administration announced its National Homeownership Strategy, with the goal of raising the number of homeowners by 8 million over the next 6 years. (Bush carried on a similar strategy.) The flaw is that to meet that goal, riskier borrowers would need be made homeowners.

JP Morgan developed Variance at Risk, an analytical method to analyze the risk in a bank’s portfolio. They understood that the mathematical models were merely an indicator risk. Although correct 95% of the time, they were also wrong 5% of the time. Other lenders adopted VaR, but failed to grasp its limitations.

AIG and its Financial Products division played a key role. They helped provide the back stop that helped the market accept the AAA rating of mortgage-backed securities. Eventually they also moved into credit default swaps. The authors paint a picture of AIG-FP as a collaborative workplace where employees could express their skepticism about deals. Then Hank Greenberg threw out the management and replaced them with Joe Cassano. He ran the shop in a more dictatorial manner and doled out information on a need-to-know basis.

Of course there were the rating agencies who gave the RMBS and CDOs undeserved AAA ratings. That was supposed to mean that the securities are just a little riskier than US Treasuries. It was Fitch that changed things. Moody’s and Standard & Poor’s had a business model based on subscribers. Fitch changed things by charging the issuers instead of the subscribers. That would eventually lead to the ratings shoppings that became part of the subprime bubble. Of the AAA rated subprime residential mortgage-backed securities from 2007, 91% were downgraded to junk status and 93% of those from 2006 were downgraded to junk status. That is a horrible track record.

I suppose that was a bit of a spoiler, but we all know that the financial markets came to a grinding halt in 2008, crushing big banks, speculative investors, small banks, and those just hoping for a small part of the American Dream.

There are a dozen other “devils” discussed in the book, but you should just read it yourself instead of reading my ramblings.

The worst part of the subprime crisis is that the bigger goal of increasing ownership was a failure. Between 1998 and 2006 only about 1.4 million first-time home buyers purchased their homes using subprime loans. That was only about 9% of all subprime lending. The remaining 91% of subprime lending was refinancings or second home purchases (or third or fourth …). “By the second quarter of 2010 the homeownership rate had fallen to 66.9% percent, right where it had been before the housing bubble.”

I found this book to be a great companion to The Big Short and In Fed We Trust. The Big Short does a great job of focusing on how the CMBS and CDO markets worked. In Fed We Trust focused on the events of 2008. All the Devils are Here focuses on the macro events that swarmed together into an apocalyptic mix of bad bad loans, bad underwriting, bad risk assessment, bad investing and bad goals.

Attacking Wall Street in 1920

I don’t often include fiction books in my book reviews on this site. But I was drawn to The Death Instinct because its historic fiction is centered around an event on Wall Street. So I thought the book would be interesting for a compliance professional.

A horse-drawn wagon passed through Wall Street’s lunchtime crowds on September 16, 1920. Inside the wagon was 100 pounds of dynamite and 500 pounds of cast-iron slugs to act as shrapnel. The wagon exploded in front the Morgan Bank and the US Treasury building, killed 38 people and seriously injured hundreds.

It was the most destructive terrorist attack on US soil until the Oklahoma City bombing. Jed Rubenfeld draws some analogies between the 1920 attack and the 9-11 attacks. Unlike those attacks, the 1918 attack went unsolved. There were some vague accusations of plots by Italian anarchists, but nobody was ever charged.

Rubenfeld puts together a sweeping storyline to find his explanation for the bombing. He inserts many subplots branching out from the main story line. He also includes several real-life characters, fictionalized for the book. This includes Marie Curie, Sigmund Freud, Senator Albert Bacon Fall, and former Treasury Secretary William G. McAdoo. The main protagonists are Dr. Stratham Younger, Colette Rousseau – a radium scientist, and James Littlemore a detective with the NYPD.

There is a lot going on and I thought the story might go spinning out of control at a few points, but Rubenfeld manages to keep it together.

My biggest quibble is with the title.  When the publisher offered me  copy I almost passed on it. The “Death Instinct” is one of Freud’s theories. He came to the conclusion that humans have not one but two primary instincts: the life-favoring instinct and the death instinct. In other words, humans strive for both tenderness and thrills. Personally, I found the whole Freud sub-plot to be a distraction to the story and the title merely reinforces an aspect that I did not like.

Otherwise, I enjoyed the main characters and the twisting storyline as it jumps from plot-to-plot and character-to-character. There is romance, financial intrigue, and police procedural elements all mixed in.

Compliance Bits and Pieces for January 21

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

The Swiss Compliance House: a Model for FCPA Compliance? by Thomas Fox

The Compliance House is a model which has been developed by Swiss businesses to use as the foundation of effective compliance management by ensuring that by “binding values and appropriate compliance management they can safeguard their integrity, and avoid or contain breaches of the law.” Buhr believes that it is the basic legal responsibility of any company board of directors to make certain breaches of law are either avoided or, if they occur, are detected early enough so that the company may remedy the situation.

Ex-JPMorgan banker loses whistleblower case by Jonathan Stempel for Reuters

A federal judge dismissed a whistleblower lawsuit by a former JPMorgan Chase & Co private banker who said she was fired for questioning the dealings of a lucrative client. …. In his ruling, [U.S. District Judge Robert] Sweet said the plaintiff failed to properly allege a Sarbanes-Oxley claim because she did not identify the specific illegal conduct forming the basis of her whistleblower complaint.

Why Did Goldman Blink? in DealBook

Goldman Sachs’s decision to offer shares of Facebook only to offshore investors is simple risk management. The risk here can be attributable to the scrutiny that this transaction, and Goldman Sachs generally, are now under. …. The media hoopla surrounding the announcement of the sale could be characterized as coordinated in a way to create the type of hype that the securities rules are trying to avoid. The stampede of Goldman clients seeking to invest is evidence of this hype. In other words, Goldman arranged the mechanics of this sale to create a media fury that constituted a “general solicitation.”

Advice for Young Compliance Officers by Matt Kelly in Compliance Week

Congratulations on finishing your education and entering the workforce. If corporate compliance is where you want to make your career, you’re in a superb position to attract the attention of global corporations. Those businesses are desperate for skilled labor to bolster their ethics and compliance departments. With some thoughtful career moves now, you can have a bright future for a long while.

Global Hedge Fund Association Comments on Implementing EU Hedge Fund Legislation in Jim Hamilton’s World of Securities Regulation

A global hedge fund association has called for the national implementation of the EU hedge fund adviser legislation to be flexible and proportionate and based on the principles of openness and transparency. The Alternative Investment Fund Managers Directive was passed by the European Parliament last year. The Alternative Investment Management Association (AIMA) comments were a consultation response sent to the new European Securities and Markets Authority (ESMA). The authority released a Call for Evidence ahead of the rule-making Level 2 of the legislative process. The industry was asked to respond in January to the main issues raised in the Directive and AIMA immediately established a working group of member firms to study the proposals and contribute to the response.

Image of Old Swiss House by LinksmanJD

The Role of Compliance in Criminal Cases

handcuffs

Plan Now or Pay Later.

Compliance failures are expensive. Failures result in big fines, expensive investigative costs and expensive legal fees. Plus you end up diverting valuable management resources from managing the business to managing the damage. Executives would much rather be sitting in the boardroom than in a deposition. Compliance has become a key consideration for under the federal sentencing guidelines for companies convicted of violating federal law.

Charlotte Simon of University of Houston Law Center, Ryan D. McConnell of Haynes and Boone LLP and Jay Martin of Baker Hughes, Inc. put together a paper on the role of compliance in criminal cases: Plan Now or Pay Later: The Role of Compliance in Criminal Cases

The DOJ’s focus on compliance has forced both U.S. and foreign companies that access U.S. capital markets to reevaluate their approaches toward compliance. Companies have begun to reassess, formalize, and improve what have historically been only informal or general codes of conduct. Faced with the reality that compliance is both a key federal charging consideration and a determinative factor in sentencing, companies today must ensure that their compliance programs contain carefully crafted policies and procedures tailored to minimize the risk of civil and criminal liability.

The article provides an excellent analysis and background on the role of compliance in federal criminal prosecutions.

However, they miss the point of having a compliance program. It’s to avoid ending up with criminal liability. If the case ends up with that the Department of Justice, that means the regulators found the conduct so egregious that civil liability was insufficient given the severity of the activity. Of course it also means that the activity was bad enough to catch the eyes of a regulator for action.

The authors use a chart showing that only three companies of 1349 charged from 1996 to 2009 received a culpability score reduction for having an effective compliance program. If they had an effective compliance program, they would not have ended up in the federal sentencing guidelines to begin with.

A compliance program should not be in place to reduce the sentence, it should be in place to prevent problems from occurring.

Pay to Play Rules for Placement Agents

The SEC imposed strict limitations on the ability of investment advisers to make political contributions when their clients include government bodies when it issued Rule 206(4)-5. They don’t want government investment decisions decided campaign contributions. This limitation also applies to private investment funds under the language of the rule and the changes to the Investment Advisers Act made by the Dodd-Frank Wall Street Reform and Consumer Protection Act.

The SEC carried this limitation over to placement agents used by investment advisers. The placement agent needs to be subject to similar limitations. That means the placement agent would need to be a registered investment adviser or otherwise regulated. At first the SEC expected FINRA to create a new rule to govern pay-to play. Instead, Section 975 of Dodd-Frank Wall Street Reform and Consumer Protection Act created a new category of regulated persons called a “municipal adviser.” This new category will regulated by the Municipal Securities Rulemaking Board.

The MSRB has issued a proposed draft of new Rule G-42 that would limit a placement agent’s ability to make political contributions.

One major difference between this draft of Rule G-42 and SEC Rule 206(4)-5 is the definition of de minimis political contribution. The SEC allows a contribution of $350 per election cycle for candidate you can vote for or $150 for a candidate you can’t vote for. The MSRB definition would be $250 for candidate that you can vote for.

Violating the rule means you are banned from

  • engaging in municipal advisory business with a municipal entity for compensation,
  • soliciting third-party business from a municipal entity for compensation, or
  • receiving compensation for the solicitation of third-party business from a municipal entity,

for two years after any contribution to an official of such municipal entity in excess of the de minimis amount.

Proposed Rule G-42 for municipal advisers is similar to Rule G-37 for those in the municipal securities business. I expect that comments will argue that the de minimis amount should match up with the SEC’s de minimis amount.

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