Author: Doug Cornelius

You can find out more about Doug on the About Doug page

Compliance Bricks and Mortar – Post Halloween Edition

These are some of the compliance-related stories that I read recently while getting ready for Halloween.

It’s the Great Pumpkin: Lessons in Process Validation Through Monitoring
by Tom Fox
FCPA Compliance & Ethics

The compliance lesson from Linus’ adventure; it is process validation. Unlike Santa Claus, who we have been repeatedly told “Yes, Virginia there is a Santa Claus”; there has been no process validation for the Great Pumpkin. Linus faints when he thinks he sees the Great Pumpkin rising from his pumpkin patch; unfortunately it is only Snoopy. In the compliance world, process validation comes through oversight. Two of the seven compliance elements in the 1992 US Sentencing Guidelines call for companies to monitor, audit and respond quickly to allegations of misconduct. 

http://fcpacompliancereport.com/2019/10/its-the-great-pumpkin-lessons-in-process-validation-through-monitoring/

Enforcement Co-Director Peikin touts self-reporting, creative remedies at Securities Docket conference
by Amanda Maine, J.D.
Jim Hamilton’s World of Securities Regulation

Regarding self-reporting in general, former SEC Enforcement Director William McLucas, now at Wilmer Hale, said that the lack of guidance about self-reporting from the SEC can result in tough discussions with clients because there are no guarantees for self-reporting in contrast to the detailed guidelines from the Department of Justice. George S. Canellos, formerly of the SEC’s Enforcement Division and currently at Milbank, agreed, stating that without formal guidelines for cooperation credit, the SEC is “all over the map.”

https://jimhamiltonblog.blogspot.com/2019/10/enforcement-co-director-peikin-touts.html

Compliance Job Interview Questions and Answers
by Corporate Compliance Insights

At CCI, we know what questions reveal a candidate’s qualifications, and we know what answers a hiring authority is looking for. If you’re hiring a compliance officer, you need to ask these questions.  If you’re interviewing for a compliance position, you need to be prepared to answer them.

https://www.corporatecomplianceinsights.com/compliance-job-interview-questions-and-answers/

Corporate Oversight and Disobedience
by Elizabeth Pollman

Over a decade has passed since landmark Delaware corporate law decisions on oversight responsibility, and only a small handful of cases have survived a motion to dismiss. Scholars have puzzled over what it means to have the potential for corporate accountability lodged within the duty of good faith, but almost never brought to fruition in terms of trial liability. …

Under current Delaware case law, courts have allowed Caremark claims to proceed where evidence exists to infer that the board utterly failed to implement a compliance monitoring system or that the directors engaged in disobedience by knowingly managing legal risk or flouting, violating, or ignoring the law.

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3474337

Is the SEC up to its $84-trillion RIA challenge?
by Tobias Salinger
Financial Planning

Agency officials have said as much: The SEC’s latest annual performance review cites the notable rise in the share of RIAs receiving exams but also two missed goals around enforcement. This month, the agency’s inspector general took it to task over those findings.
The average time it takes the SEC to start an enforcement action after opening an investigation is two years and one month. Only 49% of the time was the agency able to file cases within two years of starting its investigation. The figures came nowhere near the SEC’s own targets.

https://www.financial-planning.com/news/sec-enforcement-cases-of-rias-take-two-years-ig-says

CCO Indicted for Obstruction of Justice

I don’t like compliance officers being dragged into enforcement actions. If they are involved in the wrongdoing or are just a wholesale failure at compliance, I understand the desire for regulators to take aim at a CCO. The charges against Michael Cohn as a CCO are extremely bad.

Mr. Cohn was the managing director and chief compliance officer at GPB Capital Holdings. Just prior to joining GPB he was compliance examiner at the Securities and Exchange Commission.

Mr. Cohn was charged with obstruction of justice and unauthorized access of a government computer for accessing information about an investigation into GPB. While talking with GPB for the CCP job , Mr. Cohn told GPB that he had inside information about the SEC’s investigation into the firm, according to an indictment filed in the U.S. District Court for the Eastern District of New York.

According to the Department of Justice press release, Mr. Cohn accessed information on SEC servers relating to an Enforcement Division investigation into GPB.  During discussions with GPB personnel about obtaining a job there, Cohn advised them that he had inside information about the SEC’s investigation, and on several occasions he disclosed information to members of GPB’s senior management about that investigation. 

Yeah, that’s bad.

Of course, Mr. Cohn is merely charged with crimes and has not an opportunity to defend himself from the charges.

But the indictment should serve as a warning not to engage in this type of bad behavior.

Sources:

Reg BI and Form CRS Checklist

FINRA released some needed guidance to help firms comply with the new broker investment advice standards and disclosure requirements of Regulation Best Interest and the new client disclosure document Form CRS.

The checklist is available on the FINRA website:
https://www.finra.org/sites/default/files/2019-10/reg-bi-checklist.pdf .

If you have responsibility for broker-dealer compliance the checklist looks like a great tool.

Boards Must Rigourously Exercise Their Oversight Function

“[T]o satisfy their duty of loyalty, directors must make a good faith effort to implement an oversight system and then monitor it.”

Marchand v. Barnhill, 212 A.3d 805 (Del. 2019)

Clovis Oncology’s stock dropped sharply in 2015 when it disclosed poor clinical trial results for Rociletinib a promising experimental drug for the treatment of lung cancer. That meant the FDA was unlikely to approve Rociletinib to enter the market. Shareholder lawsuits ensued. The claim was that board breached its fiduciary duties by disregarding red flags that reports of the drug’s performance in clinical trials were inflated.

Delaware’s Caremark line of cases impose a responsibility on corporate boards to have a compliance program, but with a great deal of discretion to design it for the corporation’s context, industry, and resources. However, that compliance obligation is heightened when the corporation operates in an area of mission-critical regulatory compliance risk.

In the recent decision of In re Clovis Oncology, Inc. Derivative Litigation, the court highlighted the two components required of corporate compliance. First, you have to have an oversight system in place. Second, you have to monitor the oversight system. In area of mission-critical regulatory compliance, board oversight responsibility is heightened.

If you fail to do either, the corporation risks fiduciary litigation when bad news comes out.

Sources:

Credit Lines and Fund Performance

Dr. Christoph Jäckel, a Director of Montana Capital Partners AG, wades into the discussions about fund credit facilities with some new research he published in Private Funds CFO. His findings? A credit line increases IRR for most funds by only one percentage point.

Of course, it’s a bit more complicated than that. The average in his findings was 4%, but that was inflated by a few, very well-performing funds. The study looks at funds from 1990 to 2007 using quarterly cash flow data from Prequin. As for the equity multiple, he only found a small effect.

This is all against the back-drop of the ILPA guidance encouraging more disclosure on the use of credit lines. Around the same time, Howard Marks of Oaktree Capital took a deep but practical dive into the use of lines.

Another research study in the works by James Albertus and Matthew Denes found that use of credit lines increased performance by 6.1%. They used a different data set with a focus on data from 2014 to 2018. Unlike the Jäckel study, they only report the average effect, so it could be skewed by highly successful funds, similar to his report. As with Jäckel, they found an effect on the equity multiple, but it was small. They also note that younger funds skewed the data, presumably since the short time frame would have relatively more on the credit line and less returned to investors.

What about compliance? It has become an industry best practice to disclose in performance marketing that the fund used a credit line and the performance would be different without use of the line.

Sources:

Compliance Bricks and Mortar for October 11

These are some of the compliance-related stories that recently caught my attention.

The Cost to Retail Investors and Public Markets of “Harmonizing” Securities Offering Exemptions
By Erik F. Gerding
The CLS Blue Sky Blog

Investing in private securities would pose considerable additional risks for retail investors, relative to investing in public securities, and existing research suggests that these additional risks would not be sufficiently offset by higher expected returns.  In fact, if retail investors are given more direct access to the private markets, they are likely to earn lower risk-adjusted returns overall than they do in the public markets, for several reasons: …

http://clsbluesky.law.columbia.edu/2019/10/01/the-cost-to-retail-investors-and-public-markets-of-harmonizing-securities-offering-exemptions/

ANALYSIS: Lack of Removal Power Could Threaten SEC ALJ Regime
by Peter Rasmussen
Bloomberg Law

Are the job security provisions enjoyed by SEC administrative law judges unconstitutional? The Supreme Court majority kicked that question down the line in its 2018 Lucia v. SEC decision. The Fifth Circuit may just have picked it up, as a three-judge panel enjoined an administrative rehearing of a pre-Lucia accounting violations case against Michelle Cochran. It is too early in the process to read too much into a preliminary injunction, but the Fifth Circuit’s action does indicate that Lucia has not yet been laid to rest.

https://news.bloomberglaw.com/bloomberg-law-analysis/analysis-lack-of-removal-power-could-threaten-sec-alj-regime

Some Places Are Much More Unequal than Others
by Jaison R. Abel and Richard Deitz
Liberty Street Economics

Economic inequality in the United States is much more pronounced in some parts of the country than others. In this post, we examine the geography of wage inequality, drawing on our recent Economic Policy Review article. We find that the most unequal places tend to be large urban areas with strong economies where wage growth has been particularly strong for those at the top of the wage distribution. The least unequal places, on the other hand, tend to have relatively sluggish economies that deliver slower wage growth for high, middle, and lower wage earners alike. Many of the least unequal places are concentrated in the Rust Belt. These differences in the degree of wage inequality are tied to powerful economic forces arising from technological change and globalization, which have pushed up wages strongly for high-skilled workers in locations that have become the most unequal. Yet those same forces have kept wage growth compressed within a fairly narrow range for workers in places that are the least unequal.

https://libertystreeteconomics.newyorkfed.org/2019/10/some-places-are-much-more-unequal-than-others.html

Attorney General Barr Speaks at SEC’s Criminal Coordination Conference

I’ll begin with our coordination to punish wrongdoers and to protect investors. As I have mentioned, the white-collar crime, financial fraud, and corruption cases that our agencies handle are some of the most complex and difficult cases to uncover, investigate, and prosecute. Together, however, through information sharing and open dialogue, we are able to overcome those challenges.

http://clsbluesky.law.columbia.edu/2019/10/07/attorney-general-barr-speaks-at-secs-criminal-coordination-conference/

Compliance and Careers Amid Corporate Upheaval
by Matt Kelly
Radical Compliance

This week I was in Denver attending the Converge 2019 conference hosted by Convercent, and as one might expect, lots of the sessions there focused on how to apply technology to compliance programs. 
For my money, however, the most interesting session explored something quite different: how compliance officers can navigate their careers amid upheaval at your company — a merger, breakup, restructuring, or some other ordeal that leaves everyone on edge. Including you.

http://www.radicalcompliance.com/2019/10/04/compliance-careers-amid-corporate-upheaval/

A new (and more transparent) way to calculate SEC whistleblower awards
by Amanda M. Rose
The FCPA Blog

How should SEC whistleblower awards be calculated? In a working paper, I address this timely question.

…

My analysis suggests that the controversial proposed amendments are warranted, but incomplete. For reasons that I explain, a hybrid percentage-dollar approach that ties a whistleblower award to the value of the punishment imposed on the wrongdoer, while also taking into account the costs a whistleblower anticipated incurring by coming forward, makes sound policy sense.

…

A full copy of my paper can be downloaded here.

https://www.fcpablog.com/blog/2019/10/9/a-new-and-more-transparent-way-to-calculate-sec-whistleblowe.html

The One Who Was Bored at Work

We all have hobbies. Me?: Cycling, reading, kayaking. Some people have finance as a hobby. Sure you can spout off about finance. But, eventually you step into the world of financial regulation if your spouting off turns into financial advice.

Marcos Tamayo of Las Vegas was an airline baggage handler by day and, apparently, became an investment adviser by night. Tamayo learned about investing by taking classes at work and reading books during breaks at work. His fellow baggage handlers must have believed the financial advice he spewed forth on the tarmac and terminal. They gave him online access to their airline retirement accounts, which he used to select investments and make trades. He only charged a $300 annual fee.

Spot the issue? …. Correct, he was operating as an investment adviser and would have to register himself and his business.

He even had a name for the business: “Bored at Work”. But didn’t register.

Mr. Tamayo’s business took off in 2015 when he posted a doctored image purporting to be his account statement which showed a balance over $800,000. The fake image worked and sparked the interest of his fellow baggage handlers, seeking his investing acumen. By the end of 2016 he had over $110 million in client assets under management.

The Nevada Secretary of State got wind of his moonlighting as an investment adviser and brought a cease and desist order. The State wanted him to stop operations until he was properly licensed.

He may have actually tried to go legitimate at this point. He filed a Form ADV with the Securities and Exchange Commission. He even came up with a more conservative name for the business: BAW Retirement Services.

He made a fatal mistake in the filing. He checked the “no” box on Form ADV Items 11.D.(1)-(5) which ask whether there were prior investment-related actions, including by a state regulatory agency. That means he filed a registration that contained a material misrepresentation.

Sources:

Can Cattle Be a Security?

The Security and Exchange Commission filed a complaint alleges that Mark Ray, a Denver resident, was the mastermind of a scheme for the purported purchase and immediate resale of large numbers of cattle. I don’t recall cattle showing up in the definition of a “security.”

The first part of the scheme is labeled a Ponzi scheme in the complaint. Mr. Ray told investors they were investing in wholesale, commercial cattle trades. They were often told the specifics about the cattle and which ranch the they were located. The SEC contacted the ranches and confirmed they had not engaged in any cattle trading with Mr. Ray.

Mr. Ray had no cattle to support his supposed investments. He used later investors’ money to repay prior investors. Classic Ponzi scheme.

Big Hat, No Cattle.

Mr. Ray later got more sophisticated and sold promissory notes to investors that were supposed to be used in cattle trading. It’s hard to argue that those notes are not securities

The direct investments in cattle are not clearly securities. Mr. Ray settled with the SEC so we won’t see the argument.

The SEC broadly states that the agreement called for the investor to make an investment of money with the expectation of profit. The investors relied on Mr. Ray’s purported skill and knowledge to generate profits. Many of the investors knew little of the industry.

The SEC made the classic Howey test argument about the nature of the transactions. It was good enough for Mr. Ray’s lawyers to agree to settlement, rather than fight the SEC.

Sources:

The One With the Failure of Auditor Independence

The Securities and Exchange Commission charged PricewaterhouseCoopers LLP and one of its partners with violating auditor independence rules for running a project to upgrade the client’s GRC software while also doing its audit work.

Using the “one” in the title is deceiving. This is the third auditor independence case that the Securities and Exchange Commission has brought this year. In August, the SEC charged RSM International with violating the SEC’s auditor independence rules on at least 100 audit reports. In February this year, the SEC charged Deloitte Touche Tohmatsu LLC, when its consulting affiliate maintained a business relationship with a trustee serving on the boards and audit committees of three funds it audited. You can also add the sanctions by PCAOB against PricewaterhouseCoopers in another matter and another against Marcum LLP.

I found this PwC case to be more egregious.

In 2014, PwC performed non-audit services for the unnamed company “Issuer A” to implement new Governance Risk and Compliance software. GRC systems are used by companies to coordinate and to monitor controls over financial reporting, including employee access to critical financial functions. Issuer A intended to use the GRC software to generate information as part of the company’s control environment and to provide data to assist personnel in forming conclusions regarding the effectiveness of internal controls related to financial information systems.

PwC would be implementing the system that it would ultimately opine on as being effective. It would be a shame if the Issuer A paid all that money to PwC to install the system and then PwC found it was an effective control environment.

Rule 2-01(c) of Regulation S-X sets forth a non-exhaustive list of non-audit services which an auditor cannot provide to its audit clients and be considered independent. See 17 C.F.R. § 210-2.01(c)(4)(i)-(x)

Auditor conflict is not just about money or which revenue stream rules the nest. The intent is to allow the auditor to act an impartial third-party reviewer. It’s the reason that auditors are not allowed to prepare the financial statements and then opine on them.

If the auditors do the books, then they will be very reluctant to point out errors in them. If the auditor designs and implements the company’s internal control system, then of course the auditor will be very reluctant to not opine that the company has good control environment.

For fund managers who rely on auditors for compliance with the Custody Rule, auditor independence is incredibly important.

Sources:

Compliance Bricks and Mortar for September 27

These are some of the compliance-related stories that recently caught my attention.

Oversight of the Securities and Exchange Commission: Wall Street’s Cop on the Beat

The SEC’s mission is to: (1) protect investors; (2) maintain fair, orderly, and efficient markets; and (3) facilitate capital formation. The SEC oversees over 27,000 market participants, including investment advisers, mutual funds and exchange traded funds, broker-dealers, national securities exchanges, credit rating agencies, clearing agencies, the Public Company Accounting Oversight Board (PCAOB), the Financial Industry Regulatory Authority (FINRA), the Municipal Securities Rulemaking Board (MSRB), and the Financial Accounting Standards Board (FASB). The SEC also oversees over $97 trillion in securities trading annually and reviews the disclosures of approximately 4,400 exchange-listed public companies with an approximate aggregate market capitalization of $34 trillion.

Inside Airbnb, Employees Eager for Big Payouts Pushed It to Go Public
by Erin Griffith
New York Times

On behalf of more than a dozen employees, they pleaded to be able to sell their Airbnb stock options. Because Airbnb is privately held, its shares cannot be easily traded or cashed in. So the employees also asked that the company go public, a move that would let them freely sell their shares, said five people who saw or were briefed on the document and were not authorized to speak publicly.

https://www.nytimes.com/2019/09/20/technology/airbnb-employees-ipo-payouts.html#click=https://t.co/ymuwKpmf4l

Ten reasons why compliance fails
by Andrew Hayward and Tony Osborn
The FCPA Blog

This is despite the increasing ethical demands stakeholders are making of business, the exposing power of social media, the proliferating requirements of compliance laws and regulations, and the burgeoning numbers of policies, procedures and compliance officers which have been put in place in response.
So what’s going on? Why isn’t compliance working? Here are ten reasons why it can fail:

https://www.fcpablog.com/blog/2019/9/20/ten-reasons-why-compliance-fails.html

The S.E.C. brought 50 percent more Ponzi prosecutions in the decade after Mr. Madoff’s arrest than in the 10 years before, according to a New York Times analysis of the agency’s enforcement announcements.
Whether the increase is the result of enhanced enforcement or a proliferation of scammers, records show that Ponzi victims lost $31 billion in the decade beginning 2009, more than three times the amount lost in non-Madoff schemes in the previous decade. (The figures are not adjusted for inflation.)

https://www.nytimes.com/2019/09/22/business/ponzi-scheme-bernie-madoff.html

Veil-Piercing Risks for Private Equity Managers Highlighted in Recent Court Decision
By Joshua M. Newville and Alexandra V. Bargoot 

A recent case in a North Dakota district court is a reminder to private equity funds and managers that, under certain conditions, they may be held responsible for actions of a fund’s portfolio companies.  Courts allow plaintiffs to pierce the corporate veil as a check against improper abuse of the corporate form.  When one corporate entity is under such extensive control by another that the first is merely an alter ego of the second, a court may permit a plaintiff to reach through the corporate structure to gain recovery.  This is particularly true if the first entity is undercapitalized.

https://www.privateequitylitigation.com/2019/09/veil-piercing-in-private-equity-risks-for-funds-and-managers/

Minimum Wage Impacts along the New York-Pennsylvania Border
by Jason Bram, Fatih Karahan, and Brendan Moore
Liberty Street Economics

While New York began raising its minimum wage from $7.25 per hour in 2014, neighboring Pennsylvania has left its minimum wage unchanged at the federal floor. Minimum-wage variation between contiguous states has allowed researchers to evaluate the respective impacts on employment and average earnings. In this post, we gauge the effect of New York’s recent minimum-wage hikes by comparing low-wage sectors in counties along the New York-Pennsylvania border.

https://libertystreeteconomics.newyorkfed.org/2019/09/minimum-wage-impacts-along-the-new-york-pennsylvania-border.html