Year: 2011

No One Would Listen

You can’t really criticize Harry Markopolos. He was right. He had spotted something wrong with Bernie Madoff years before the biggest Ponzi scheme collapsed. Unlike many others, Markopolos contacted the Securities and Exchange Commission about his suspicions. They ignored him. Markopolos went to the press, but no meaningful article came of it.

When Madoff’s scheme collapsed and he  turned himself in, Markopolos became lauded by the press, testified in Congress about the failings of the SEC, and was even offered the job of Chairman of the SEC by an ill-informed Congressman. No One Would Listen is another step in the Markopolos victory lap.

He celebrates his brilliance in discovering the fraud and the incompetence of the SEC for not stopping it. He fills his attacks with similes:

“His returns were as reliable as the swallow returning to Capistrano.”

“As I continued examining the numbers, the problems with them began popping out as clearly as a red wagon in a field of snow.”

Markopolos lays out how he first ran into Madoff and the years he spent trying to figure out how Madoff was generating his returns. Eventually, he came to the conclusion that he couldn’t do it. Since Madoff ran a big trading organization, he could have been front-running orders to generate illicit profits. Effectively, he would be stealing from his brokerage customers and giving it to his money management operations.

The other likely possibility was that Madoff was making up his returns and using new funds coming in to redeem those leaving. Markopolos could not find any footprints of Madoff’s split-strike trading strategy. There didn’t seem to be enough options traded on the markets to support the amount Madoff had under management.

I think it’s important to see why Markopolos was focused on Madoff. The principals at his firm wanted him to reverse engineer Madoff strategy so they could offer a similar product to their clients. Markopolos could not figure out how Madoff was generating his steady returns. He first contacted the SEC as a way to get his boss off his back. If he could prove Madoff was a fraud, his boss would quit demanding that Markopolos duplicate the Madoff strategy.

Markopolos starts off  No One Would Listen by stating that he made five separate submissions to the Securities and Exchange Commission over a nine-year period. So far, I’ve only seen one, his December 22, 2005 letter. Frankly, I found the letter to be a rambling, half-coherent diatribe. It was penned by a competitor who couldn’t figure out the trading strategy of the legendary Bernie Madoff, the founder of NASDAQ.

As Chris MacDonald notes “Markopolos is a bit of a strange cat. He’s a likeable guy, and apparently a man of integrity, but also a bit paranoid-sounding.” (He had seen the new movie, Chasing Madoff, based on the book.)

Clearly the SEC was unable to stop Madoff. Was it their fault?  Yes. They relied on the well-established credentials of Madoff and dismissed the paranoid ramblings of an eccentric analyst. Markopolos’s barbs against the SEC are over-the-top and eventually got distracting. On top of that, I was often distracted by his misuse of “principle” instead of “principal” in the book. You would think that a financial analyst would know the difference.

Compliance Bits and Pieces – UK Edition

The first case under the new Bribery Act in the United Kingdom has come down, so I’m devoting this roundup of posts to that story.

BREAKING: First Bribery Act charges brought in record time in BriberyAct.com

The Press Association is reporting that a court official in London is the first person charged under Section 2 of the Bribery Act following an expose by the Sun Newspaper.

The case is of interest because it is a domestic bribery case and the charges have been brought, not by the SFO, but by the UK Crown Prosecution Service.

First Case Brought Under UK Bribery Act Looks Nothing Like You Expected by Bruce Carton in Enforcement Action

The first-ever action under the UK Bribery Act has now been filed–but it probably doesn’t look anything like what you expected.

Court employee faces first prosecution under Bribery Act in the Blog of the Crown Prosecution Service.

We have decided that Munir Yakub Patel should be prosecuted under the Bribery Act 2010 in relation to allegations of misconduct during his employment at Redbridge Magistrates’ Court, Ilford, London. He is the first person to be prosecuted under the new Act.

Patel, an administrative clerk, faces a charge under Section 2 of the Act for requesting and receiving a bribe intending to improperly perform his functions.

Court clerk becomes first person charged under Bribery Act by Owen Bowcott in The Guardian

The first person to be charged under the new Bribery Act will be a magistrates court clerk who allegedly accepted £500 for fixing a motoring offence, according to the Crown Prosecution Service (CPS).

Limiting Redemptions by Limited Partners

part of the money

Hedge funds usually give their limited partners an ability to redeem their interests at certain periods during the investment period. That ability is often subject to a “gates provision” that limits a quick outflow of capital. The provision is general there to avoid a liquidity crisis in the hedge fund which could hurt the remaining investors in the fund.

The ability to use a gates provision was recently fought over in the Delaware Chancery Court. The facts are bit strange. The fund had one investor. The apparent intent was for this first investor to be the seed investor and the the fund manager would go out and get addition investor for the fund. The seed investor would also get a share of the revenue from later the management fees and incentive fees paid by later investors. In exchange, the seed investor agreed not to redeem its capital for three years. With only one investor, the gates provision sticks out like a sore thumb.

The fund was set up in late 2007; a bad time to start investing. The manager deployed little of the funds capital and had no success raising funds from other investors. By early 2009, the seed investor let the fund manager know that they would be redeeming their capital at the end of the three year lock-up.  The relationship turned sour.

[You] should remember that our right to raise the [G]ates ensures that we will continue to manage your money throughout the litigation….

[W]e are fully prepared to litigate this matter to the bitter end because we will continue to manage your money, and collect management and incentive fees, until this matter is resolved many years hence.

Sure enough, on the three year anniversary the fund manager returned only the 20% required under the gates provision to the seed investor.

The perceived problem was that the seed money agreement did not address the gates provision in the partnership agreement of the fund.  The investor argued that the seed money agreement acted as a waiver of the manager’s ability to apply the gates restriction on the third anniversary. The manager argued that it merely supplemented the gates provision by adding additional limitations on withdrawal.

There is some arguing over how the contract provisions work together, but the court also piles on a fiduciary duty on the fund manager. After all, the fund is a partnership and the manager is the general partner.

The gates provision had an outlet that allowed the general partner to waive or modify the conditions relating to withdrawals for certain large or strategic investors.

The fund manager never identified a justification for using the Gates in view of the Hedge Fund’s investment portfolio. The only motivation for raising the Gates was to enable the Paiges to continue to receive the management fees payable under the Seeder Agreement for a longer period.

The court found that it was the self-interest of the general partner rather than the good of the limited partner in the fund that kept the gate up.  The Delaware’s Revised Uniform Limited Partnership Act permits the waiver of fiduciary duties, but the waiver must be set forth clearly. [6 Del. C. § 17-1101(f)] The court found no provision in the Partnership Agreement that says that general partner does not owe fiduciary duties to the Fund and its investors.

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Image: PART OF THE MONEY.jpg by Damien du Toit

Enforcement of the Massachusetts Data Privacy Law

It’s been almost 18 months since the Massachusetts Data Privacy Law went into effect. Belmont Savings Bank has become one of the first charged with violating the law.

Belmont Savings Bank maintained personal information on an unencrypted backup data tape and then lost the tape. According to surveillance footage the tape was likely discarded inadvertently by the overnight clearing crew and sent to the incinerator.

There were several rounds of changes between the first version of 201 CMR 17.00 and the final one. One central element was the requirement that there be written information security plan in place if your company has “personal information” on a Massachusetts resident. Obviously, you need to comply with the plan.

In this case, Belmont Savings Bank has the plan. But they failed to comply with it. The data tape should have been locked-up overnight and not left on a desk.

The Massachusetts’ Attorney General entered into an Assurance of Discontinuance with Belmont Savings Bank. As part of the settlement, the bank has to

  • encryp, to the extent technically feasible, all personal information stored on backup data tapes
  • store backup data tapes containing personal information in a secure location
  • effectively train its workforce on the policies and procedures with respect to maintaining the security of personal information

There is no evidence indicating that any customer’s personal information has been acquired or used by an unauthorized person or used for an unauthorized purpose. The Assurance of Discontinuance states that if actual harm to customers results, the Attorney General’s Office will reopen discussions to determine appropriate restitution.

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More from FINRA on Social Media and Mobile Devices

In January 2010, FINRA issued Regulatory Notice 10-06 in an attempt to provide guidance on the application of FINRA rules governing communications with the public to social media sites. The guidance did not provide much that was new. Largely, FINRA pointed out that the existing communication and record-keeping rules applied. Too bad that the site did not allow you to take the steps needed to comply with the existing rules.

Apparently, the guidance raised enough questions that FINRA decided to provide some additional guidance. It is not intended to alter the principles or the guidance provided in Regulatory Notice 10-06. Anyone expecting something new or innovative will be disappointed.

Q1: Does determining whether a communication is subject to the recordkeeping requirements of SEA Rule 17a-4(b)(4) depend on whether an associated person uses a personal device or technology to make the communication?

A1: SEA Rule 17a-4(b)(4) requires a firm to retain records of communications that relate to its “business as such.” Whether a particular communication is related to the business of the firm depends upon the facts and circumstances. This analysis does not depend upon the type of device or technology used to transmit the communication, nor does it depend upon whether it is a firm-issued or personal device of the individual; rather, the content of the communication is determinative. For instance, the requirement would apply if the electronic communication was received or sent by an associated person through a third-party’s platform or system. A firm’s policies and procedures must include training and education of its associated persons regarding the differences between business and nonbusiness communications and the measures required to ensure that any business communication made by associated persons is retained, retrievable and supervised.

The FINRA rules came first and they are in place for a good reason. It’s up to the firm to find a may to meet the compliance standards if they want to use third-party websites to publish information, communicate with the public, or communicate with clients.  If cloud providers want to take over company-hosted communications they need to but more effort into the record-keeping and compliance requirements of the business world.

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Compliance Bits and Pieces for August 26

These are some compliance related stories that recently caught my attention:

Does the SEC’s Revolving Door Raise Conflicts of Interest? by Bruce Carton in Securities Docket

Every year about four percent of the employees working at the Securities and Exchange Commission decide for various reasons to voluntarily leave the agency and seek greener pastures. Having spent years gaining experience and connections at the nation’s top financial regulator, these lawyers, accountants, economists, and others are often in high demand when they return to the private sector.

O’Donohoe on Potato Chips and Salty Snacks on EconTalk

Should the United States be making computer chips or potato chips? In a 1992 presidential debate, then-candidate Ross Perot stated “you make more making computer chips than potato chips.”  Russ Robert takes a long look at the potato chip manufacturing and distribution process. Well worth an hour of your time

Survey Finds Compliance Chiefs Doing Little Compliance-Related Work by Samuel Rubenfeld in WSJ.com’s Corruption Currents

A survey of corporate compliance professionals in the financial services industry found that 41% of them spend less than half of their time on compliance-related issues. Conducted by National Regulatory Services, the survey found that chief compliance officers spend the least amount of time on compliance-related tasks out of all compliance professionals. Overall, 59% of a chief’s day is spent on such tasks, a slight decline since 2008. Only 25% of them spend more than 90% of their day on compliance issues, a five-point drop since 2008.

Presidential Campaign Season and the SEC’s Pay-to-Play Rule

the great seal fo the state of iowa

With the recent Iowa Straw Poll, the presidential campaign season is getting into full gear. That also means that campaign fundraising is in full gear. I thought it would be useful to apply the SEC’s new Pay-to-play for Investment Advisors to the crop of presidential contenders.

Under SEC Rule 206(4)-5, investment advisors are limited in their ability to give campaign contributions to political candidates who can directly or indirectly influence the hiring of an investment advisor by a government-sponsored investment entity. A campaign contribution in violation of the rule means the investment advisor can not collect fees from the applicable government-sponsored investor for two years. The rule applies to registered investment advisors and fund managers that had been exempt under the now-repealed, private fund manager exemption.

The president of the United States is not an office that can directly or indirectly influence the hiring of an investment advisor, so that position is not one that is limited by the SEC Rule. However, you also need to look at the candidate’s current office to see if that position is one that is limited.

That means campaign contributions to the incumbent president, Barack Obama, are not limited by the rule. Some of his potential competitors are limited.

  1. Michele Bachmann. Her current office in the US House of Representatives is not limited by the rule.
  2. Ron Paul. His current office in the US House of Representatives is not limited by the rule.
  3. Tim Pawlenty. As Governor of Minnesota, contributions to his campaign would have been limited had he still been in office. He finished his term on January 3, 2011, which pre-dates the March 13, 2011 effective date of the rule.
  4. Rick Santorum. He does not currently hold a political office and is therefore not limited by the rule.
  5. Herman Cain. He does not currently hold a political office and is therefore not limited by the rule.
  6. Rick Perry. As the current Governor of Texas, he appoints trustees to the
  7. Mitt Romney. He does not currently hold a political office and is therefore not limited by the rule.
  8. Newt Gingrich. He does not currently hold a political office and is therefore not limited by the rule.
  9. Jon Huntsman. He does not currently hold a political office and is therefore not limited by the rule.
  10. Thaddeus McCotter. His current office in the US House of Representatives is not limited by the rule.

Registered Investment Advisors, private fund managers getting ready to register with Securities and Exchange Commission, and their employees need to be very cautious about making contributions to Governor Perry if they have a Texas state sponsored fund as a client or investor, or hope to have one as a client or investor in the next two years.

The rule also applies to placement agents. They must either be a registered investment advisor subject to SEC Rule 206(4)-5 or a municipal adviser subject to MSRB Rule G-42.

It is very obvious that SEC Rule 206(4)-5 can cause significant distortions in the political campaign.

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Earthquakes, Hurricanes, and Disaster Recovery

Monday’s East Coast earthquake was far from a disaster. I just thought I had too much coffee, until I heard others in the hallway say “Do you feel that?” Then I realized the shaking was not just because I was over-caffeinated.

Even though significant earthquakes are rare on the East Coast, hurricanes are not. Irene, the first big hurricane of the season is also approaching the East Coast.

Perhaps these are some good reminders to blow the dust off your disaster recovery plan. As a registered investment adviser, you need to have a plan. Each of the thousands (hundreds?) of private fund managers getting ready to register as investment advisers with the Securities and Exchange Commission will need a plan.

It’s easy to miss the requirement for having a business continuity plan. It’s in Rule 206(4)-7. Oh, you don’t see anything about business continuity in the rule? It’s not in the rule, it’s in the Release for Rule 206(4)-7:

We believe that an adviser’s fiduciary obligation to its clients includes the obligation to take steps to protect the clients’ interests from being placed at risk as a result of the adviser’s inability to provide advisory services after, for example, a natural disaster or, in the case of some smaller firms, the death of the owner or key personnel. The clients of an adviser that is engaged in the active management of their assets would ordinarily be placed at risk if the adviser ceased operations. [SEC Release No. IA-2204]

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Image of 20111 VA Earthquake is by Frank Paynter

Massachusetts and Expert Network Services

At least one of the hedge funds being investigated for its use of expert networks in based in Massachusetts. In an unusual instance of the state regulators acting before Securities and Exchange Commission, the Massachusetts securities regulators are proposing a new regulation to address the use of expert network services. They are proposing a new section under 950 CMR 12.205(9)(c)(16) to the existing list of dishonest and unethical practices:

16. a. To retain consulting services, for compensation that is provided either directly to the consultant or indirectly through a Matching or Expert Network Service, unless the adviser obtains a written certification, signed by the consultant that:

(i) describes all confidentiality restrictions that the consultant has, or reasonably expects to have, regarding Confidential Information; and

(ii) affirmatively states that the consultant will not provide any Confidential Information to the adviser.

b. Notwithstanding section (a) an investment adviser who comes into possession of material Confidential Information through a consultation is precluded from trading any relevant security until such time as the Confidential Information is made public.

c. Definitions. For purposes of this section:

(i) “Confidential Information” means any non-public information, which one is bound by a confidentiality agreement or fiduciary (or similar) duty not to disclose.

(ii) “Matching or Expert Network Service” means a firm that for compensation matches consultants with investment advisers.

As alleged in In the Matter of Risk Reward Capital Management Corp., RRC Management LLC, RRC BioFund LP, and James Silverman, Docket No. E-2010-057, some investment advisers have paid expert networks and consultants to access confidential information about publicly traded companies.

Massachusetts wants additional measures to ensure that confidential information is not being accessed and traded upon. The proposed regulations do not alter an investment advisers’ existing duty not to trade on insider information. The goal is to provide investment advisers with greater clarity as to what is impermissible conduct when paying consultants for information.

In the end, it seems like it is just a record-keeping exercise to me.

You can review comments or submit a comment on the proposed regulation.  There is a proposed effective date of December 1, 2011.

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