Author: Doug Cornelius

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Compliance Bricks and Mortar for April 5

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

Companies Need to Pay More Attention to Everyday Unethical Behavior
by Yuval Feldman
Harvard Business Review

Numerous studies have documented the prevalence of practices such as stealing office supplies, inflating business expenditures reports, and engaging in behaviors that raise conflicts of interest. While these may sound negligible, these violations reduce trust over time and alter prevailing business and legal norms. Their aggregated effect can be quite harmful.

Behavioral ethics research suggests that this type of misconduct occurs not because people are unethical or deliberately choose to act unethically, but because they fail to understand that their behavior is indeed unethical and can have harmful consequences. Studies show that employees have a “blind spot” that prevents them from seeing the ethical and legal meaning of their own behavior.

https://hbr.org/2019/03/companies-need-to-pay-more-attention-to-everyday-unethical-behavior

Insider Guessing Can Still Land You in Jail
by Caitlin M. Poe
The National Law Review

But what does it mean to learn secret company information?  Usually, this issue is also straightforward enough.  The insider has received testing results for a product, or has worked on an upcoming merger, or has seen the earnings report in advance of release.  But what if the insider hasn’t been told something, but instead makes an educated deduction that turns out to be right?  Is insider guessing illegal?

https://www.natlawreview.com/article/insider-guessing-can-still-land-you-jail

Andreessen Horowitz Is Blowing Up The Venture Capital Model (Again)
Alex Konrad
Forbes

Why? Well, venture capitalists have long traded a lack of Wall Street-style oversight for the promise that they invest mainly in new shares of private companies. It was a tradeoff firms gladly made—until the age of crypto, a type of high-risk investment the SEC says requires more oversight. So be it, says Andreessen Horowitz. By renouncing its venture capital status, it’ll be able to go deeper on riskier bets: If the firm wants to put $1 billion into cryptocurrency or tokens, or buy unlimited shares in public companies or from other investors, it can. And in doing so, the thinking goes, it’ll again make other firms feel like they have one hand tied behind their back. 


https://www.forbes.com/sites/alexkonrad/2019/04/02/andreessen-horowitz-is-blowing-up-the-venture-capital-model-again/#4163d0b27d9f

Prof. Coffee Testifies on Insider Trading Legislation Before the House Financial Services Subcommitee on Investor Protection
By John C. Coffee, Jr.
The CLS Blue Sky Blog

I have been asked to comment on several proposed bills, all of which I basically support, but I will focus my limited time today primarily on Congressman Himes’ Discussion Draft of an “Insider Trading Prohibition Act.” I want to commend Congressman Himes for having supervised the drafting of a very careful, balanced and sophisticated bill that should serve as a model for a long overdue effort to codify the law of insider trading. To date, the law of insider trading has been solely the product of judicial law-making, and courts have been confined by the words set forth in Section 10(b) of the Securities Exchange Act of 1934. In effect, insider trading is the best example of a common law crime that survives today.

http://clsbluesky.law.columbia.edu/2019/04/03/putting-investors-first-reviewing-proposals-to-hold-executives-accountable/

SEC Nominee Emerges
by Matt Kelly
Radical Compliance

[Allison] Lee previously worked at the SEC from 2005 to 2018, including a stint as counsel for former Democratic commissioner Kara Stein, who stepped down from the SEC in December. So essentially, Lee would replace her former boss. If confirmed, Lee would serve until 2022.

http://www.radicalcompliance.com/2019/04/03/sec-nominee-finally-emerges/

Leave it to Trump to show us how not to hire a CCO
By Joe Mont
Compliance Week

According to a report this week in the Wall Street Journal, George Sorial, who worked for The Trump Organization since 2007 and served as chief compliance counsel, is stepping down from that post. The stated reason: He wanted extra time to promote a new book he co-authored. 

https://www.complianceweek.com/news/opinion/leave-it-to-trump-to-show-us-how-not-to-hire-a-cco

Pre-existing, Substantive Relationships and General Solicitation

As cryptocurrency issuance declines, the Securities and Exchange Commission is continuing to clean out the fraud, mis-steps, and foolishness of coin promoters. These actions have carried over to the services and investment managers involved in coin offerings.

Usman Majeed wanted to make his money by running a fund that invests in cryptocurrency. He ran into the same mistakes and ignorance of the securities laws that coin promoters stumble over. His platform was Mutual Coin Fund, with an approach that is “purely quantitative and involves algorithmic trading with intense backtesting…” and develops “new trading strategies involving artificial intelligence and machine learning through neural networks.”

That sounds like a lot of the same gobbley-gook for a crypto-fund offering that you hear for a coin offering.

That aside, he still managed to raise over $500,000 from investors from August 2017 to May 2018. Then managed to lose 62% of it by March 2019.

From the SEC order, it sounds like enforcement decided to focus on the marketing failure. Mr. Majeed and the fund didn’t have a pre-existing, substantive relationship with the investors. The fund engaged in general solicitation through its website and media interviews.

The fund could have engaged in general solicitation if it checked the 506(c) box on its Form D. But it checked the 506(b) box.

Of course, with 506(c) the fund would have needed to take reasonable steps to confirm that investors were accredited investors. But at least one investor was not accredited according to the SEC order.

Sources:

Cross Platform Sale Leads to Trouble

It is generally bad to have one client trade with another client. Rule 206(3)-2 imposes some very specific requirements and leaves you with a final twist:

This rule shall not be construed as relieving in any way the investment adviser or another person relying on this rule from acting in the best interests of the advisory client, including fulfilling the duty with respect to the best price and execution for the particular transaction for the advisory client ….

The problem is especially enhanced when cross-trade involves illiquid, hard-to-value assets, like complex securities or real estate. Mortgage loans fall into that category. As the investment matures, you find out if the underwritten price was good or bad. One side is likely to make out better than the other.

Talimco added to the problem by acting in bad faith during the cross-trade.

According to the Securities and Exchange Commission charges against Talimco LLC and its former chief operating officer, Grant Gardner Rogers, they manipulated the auction of a commercial real estate mortgage asset on behalf of one client for the benefit of another in a cross-trade. 

Talimco was the collateral manager for a collateralized debt obligation client on one hand and a commercial real estate investment fund on the other hand.  The CDO had a defaulted mortgage loan participation that it was trying to sell.

As an investment adviser, Talimco owed a general fiduciary duty to the CDO. In addition, the CDO governing documents required Talimco to dispose of the assets in a competitive auction with at least three bids.

The real estate fund wanted the investment at a certain price, so Rogers rigged the auction. Rogers convinced two unwilling bidders to participate in the auction by giving assurances that the bidders would not win the auction.  As a result of this manipulation, Talimco’s real estate fund client was the highest bidder and acquired the asset.

To prove the problem with cross-trade, the real estate fund ended up selling the interest for a substantial profit and the CDO ended up underwater.  It was going to be a good enough investment that Rogers committed an additional $1 million to the fund during the acquisition. That may have been coincidence, but it looks bad.

Not as bad as the written messages about the rigged auction disclosed in the SEC order: 

I get it, for you guys and other people that we’ve talked to it’s like, you know it’s not that attractive. It’s small, it’s a non-controlling participation. But, you know, in order to, for us to purchase this, we need like, we need a bid from three different market makers …. And look, I won’t hit you on this, but I need a bid for it.

“By rigging the auction, Talimco and Rogers failed to fulfill their fiduciary duty to their client,” said Daniel Michael, Chief of the SEC Enforcement Division’s Complex Financial Instruments Unit.  “Investment adviser firms are expected to have controls in place to detect and disclose conflicts of interest.  This action evidences the vigilance of the SEC’s exam and enforcement staff in identifying investments advisers that exploit client relationships and harm investors.”

Notably, the case started with an examination by the Private Funds Unit, who handed the investigation over to the Complex Financial Instruments Unit and the New York Regional Office. 

Sources:

Billing Employees to the Fund

The Yucaipa Master Manager didn’t properly inform investors of all costs tied to preparing tax returns. Yucaipa resolved the case without admitting or denying the SEC’s allegations.

Under the fund documents for the Yucaipa American Alliance private equity funds, the cost of preparing the funds’ tax tax returns are an expense of the funds. Yucaipa decided to bill a portion of the costs of the fund manager’s in-house tax partner and in-house tax manager to the fund for their time spent preparing the funds’ tax returns.

The funds’ documents also provided that the fund manager/general partner bears the cost of its normal operating overhead, including “salaries, other compensation and benefits of the Manager’s employees.”

There is some conflict between the provisions in the fund documents. The in-house employees were less expensive than the outside vendors also involved in the tax work. For the funds’ it was likely a cost savings or at least not any more expensive.

The problem is not apparent when not looking from the funds’ perspective, but from the manager’s perspective. This is an extra revenue source for the manager. There is a conflict that had to be approved by investors.

It’s not that a manager can’t charge in-house employees to the fund. But to do so, it must be disclosed to the investors or otherwise approved by the investors.

Sources:

Compliance Bricks and Mortar for March 29

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

Conflicts of interest for “the little people”
by Jeff Kaplan
Conflicts of Interest Blog

The conclusion of the Mueller investigation does little to resolve the much broader set of concerns regarding President Trump’s conflicts of interest. These are too numerous to be chronicled on this site, but are being tracked on a weekly basis by the Sunlight Foundation, which even offers a searchable data base of Trump COIs. Additionally, a study recently conducted by USA Today showed that by failing to divest his various investments before taking office, Trump has created more than 1400 COIs.

http://conflictofinterestblog.com/2019/03/conflicts-of-interest-for-the-little-people.html

$50M SEC Whistleblower Award
by Matt Kelly
Radical Compliance

In other words, if you want that SEC payday — you have bring high-quality information, and bring it quickly. That’s what Claimant 2 did, Claimant 4 did not, and Claimant 1 kinda sorta did but not quite quickly enough. Rest assured, the whistleblower bar will be making that point to your employees in prompt fashion, too. Compliance officers should respond accordingly.

http://www.radicalcompliance.com/2019/03/26/50m-sec-whistleblower-award/

Deciphering Americans’ Views on Cryptocurrencies
by Sean Hundtofte, Michael Lee, Antoine Martin, and Reed Orchinik
Liberty Street Economics

Individuals who owned cryptocurrency or were interested in buying it were particularly likely to perceive cryptocurrency as being similar to gold (41 percent) and stocks or bonds (39 percent). This suggests that such individuals may think of cryptocurrencies as an investment vehicle. In addition, 37 percent of respondents within this group likened cryptocurrency to traditional money. If we think of traditional money as a means of payment, then this distribution of views is consistent with the idea that cryptocurrencies are currently perceived less as a payments mechanism than as an investment, even if they can play both roles. 

https://libertystreeteconomics.newyorkfed.org/2019/03/deciphering-americans-views-on-cryptocurrencies.html

Assessing Why Compliance Programs Fail
by Veronica Root Martinez
The CLS Blue Sky Blog

In an article recently published in the Indiana Law Journal, I argue that institutions can improve their assessments of compliance failures—and thereby their future compliance efforts—by changing the way they think about such programs in the first place. I explain that the compliance process consists of four, distinct stages: prevention, detection, investigation, and remediation.  I argue that more root-cause analyses will occur if firms ask at what stage or stages within the compliance program a failure or failures occurred. By conducting this sort of analysis when compliance failures occur, firms may be better equipped to address and prevent similar, future misconduct.

http://clsbluesky.law.columbia.edu/2019/03/26/assessing-why-compliance-programs-fail/

The Compliance Process: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3151893

SEC Employees to Get More Co-Workers, But Smaller Raises
by Benjamin Bain
Bloomberg

The Wall Street regulator will add 100 people this year after lifting a hiring freeze, Clayton said in an email to staff this week. In the same message, he said current employees would be getting pay increases averaging 2.4 percent, acknowledging that the boost might disappoint some workers because it’s less of a jump than they’ve gotten in recent years.

https://www.bloomberg.com/news/articles/2019-03-21/sec-pay-raise-plan-gets-cold-shoulder-from-agency-union-leaders

Insider Trading and Executive Overreach
By Kevin R. Douglas
The CLS Blue Sky Blog

The recent controversy over President Donald Trump’s use of his emergency authority to fund a wall on the U.S. southern border has awakened many Americans to the problem of executive overreach. Yet, what few may appreciate is that executive overreach can cause trouble in contexts far beyond immigration or border security. For example, consider U.S. securities regulation. Executive overreach was a major factor in creating confusion in the current U.S. laws against insider trading, and some reformers propose using new executive actions to correct the problem.

http://clsbluesky.law.columbia.edu/2019/03/22/insider-trading-and-executive-overreach/

Lorenzo: A Win for the SEC and All Plaintiffs
by T. Gorman
SECActions

Finally, the Court’s determination may also be a victory for the class action bar. While private litigants cannot bring fraud claims based on an aiding and abetting theory, they can now pursue even “bit” players in a securities fraud by wedging the conduct into the expansive contours of the statutes. Lorenzo is the ode to expanding securities fraud liability.

http://www.secactions.com/lorenzo-a-win-for-the-sec-and-all-plaintiffs/

Supreme Court: Even One Who Did Not “Make” a False Statement May Still be Subject to Scheme Liability
By Kevin LaCroix
The D&O Diary

The relationship the court drew between “making” and “dissemination” a false statement is interesting, particularly in the current age when so much information is shared electronically, often as an attachment or a link. The court’s conclusion that someone can be liable for disseminating a false statement even without having “made” it could potentially have some interesting implications in the current electronic age when so much information is “forwarded” in electronic communications.

https://www.dandodiary.com/2019/03/articles/securities-laws/supreme-court-even-one-who-did-not-make-a-false-statement-may-still-be-subject-to-scheme-liability/

SEC Wins at SCOTUS

Can the Securities and Exchange Commission penalize an investment banker even though he did not “make” false statements? The SEC is claiming that his distribution of those false statements constituted a “device, scheme, or artifice to defraud” or an “act, practice, or course of business which operates . . . as a fraud or deceit” under subsections (a) and (c) of Rule 10b-5.

According to the Supreme Court, the answer is yes.

Francis Lorenzo was the director of investment banking at Charles Vista, LLC, a registered broker-dealer, and his client was Waste2Energy.

Waste2Energy was trying to raise capital and Lorenzo was tasked with helping to sell $15 million of debentures. Lorenzo’s boss drafted the marketing emails that claimed Waste2Energy had $10 million in assets.

Dear Sir:

At the request of Adam Spero and Gregg Lorenzo, the Investment Banking division of Charles Vista has summarized several key points of the Waste2Energy Holdings, Inc. Debenture Offering.

…

Please call with any questions

Truly,

Francis V. Lorenzo Vice President – Investment Banking

Lorenzo had heard that the claim was incorrect and saw that the company had written off those assets in a public filing. Frank blamed his boss Gregg and others for the content of the email. They “made” the false statement. Frank merely delivered it. Frank was merely aiding and abetting, not the primary actor. Frank claims that he did not provide substantial assistance in the violation. He was merely the messenger.

The distinction is one of private party actions. The SEC can bring aiding and abetting claims, but not private plaintiffs.

The SEC thinks that knowingly distributing the false statements of others to sell an investment is a “device, scheme, or artifice to defraud” or an “act, practice, or course of business which . . . would operate as a fraud.” That makes Lorenzo a primary violator of the scheme liability provisions.

The SEC also sees the obvious loophole if it couldn’t penalize because the relevant person did not “make” the false statements. Those who distribute a statement with knowledge of its falsity would be held liable for aiding and abetting.

The Supreme Court took a pragmatic approach and agreed with the SEC.

“But using false representations to induce the purchase of securities would seem a paradigmatic example of securities fraud. We do not know why Congress or the Commission would have wanted to disarm enforcement in this way. “

Sources:

The Continued Rise of Professional Whistleblowing

The Securities and Exchange Commission announced awards totalling $50 million to whistleblowers who brought high-quality information to the SEC and assisted in bringing a successful enforcement action.

As with all whistleblower awards, the order is heavily redacted as to the company involved, what happened, and when it happened. I’m not sure I can identify which case the awards tie to.

Two things caught my attention about the awards.

One, the order discusses approval or rejection of awards for Claimant #1, Claimant #2, Claimant #4, and Claimant #7. I take it that at least seven people submitted tips to the SEC for the bad acts involved in the case. That is a lot of people sending information to the SEC. I’m not if it’s because a lot of people knew about the problem or a lot of people knew they could make money by reporting the problem.

Second, the two successful claimant had attorneys involved in the whistleblowing process.

Claimant #1 had his or her attorney approach the SEC first before formally submitting the tip. That ended up hurting the award because the SEC found the delay unreasonable and investors were continuing to be harmed. Somehow, Claimant #1 “passively financially benefited” from the misconduct during the delay.

Claimant #2 met with the SEC with his or her attorney. According to the order, Claimant #2 had the “smoking gun” evidence that indisputably showed the problem.

Claimant #2 also received a whistleblower award from another agency in connection with the action. I would guess it was this CFTC award.

Putting those two things together, lots of whistleblowing and lots of lawyers, whistleblowing is becoming a new industry and there is growing population of professional whistleblowers and their service providers.

Matt Kelly pointed out the slick graphic the SEC now seems to be appending to whistleblower award press releases. I have to be a bit snarky and point out the shortcomings of the fancy map showing the quantity of tips by state.

In my snarkiness, I’m going to point out that that the map also shows the most populous states. More people=>more companies=>more tips.

Sources:

Compliance Bricks and Mortar for March 22

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

The Federal Courts Are Running An Online Scam by Seamus Hughes in Politico

But I’m here to tell you that PACER—Public Access to Court Electronic Records—is a judicially approved scam. The very name is misleading: Limiting the public’s access by charging hefty fees, it has been a scam since it was launched and, barring significant structural changes, will be a scam forever.

The U.S. federal court system rakes in about $145 million annually to grant access to records that, by all rights, belong to the public. For such an exorbitant price—it can cost hundreds of dollars a year to keep up with an ongoing criminal case—you might think the courts would at least make it easy to access basic documents. But you’d be wrong.

https://www.politico.com/magazine/story/2019/03/20/pacer-court-records-225821

Cyber Breach Disclosures: A Mess by Matt Kelly in Radical Compliance

Craving more information about how companies are disclosing cybersecurity breaches? Audit Analytics has a new report examining what publicly traded firms have been reporting in SEC filings — and you won’t get much guidance there, because those disclosures vary so widely.

http://www.radicalcompliance.com/2019/03/20/cyber-breach-disclosures-total-mess/

The Weakness in Two-Factor Authentication—Your Lost Phone Policy by Avi Gesser, John R. Kapp, and Michelle Adler in NYU Law’s Compliance & Enforcement

Hackers always look for the weak link, and they have learned to get around MFA by exploiting gaps in companies’ lost phone protocols.  They do this by calling the IT help desk, saying they are employees who have lost their phone, so they can’t use the MFA app to login, and they have some emergency that requires them to get immediate access to the network.

https://wp.nyu.edu/compliance_enforcement/2019/03/18/the-weakness-in-two-factor-authentication-your-lost-phone-policy/

SEC Ends 2018 Signaling Its Approach to Regulating the Cryptocurrency Markets from Latham & Watkins

These orders — one against a token exchange, two against token issuers, and two against promoters — clarify the SEC’s approach for:

-Determining whether token transactions constitute unregistered securities offerings or unregistered broker-dealer or exchange activity

– Resolving unregistered token offerings

The Commission’s recent actions also signal the potential next frontier for SEC enforcement as the new year begins.

https://www.lw.com/thoughtLeadership/lw–sec-signals-its-approach-to-regulating-the-cryptocurrency-markets

The SEC, Compliance, Tone at the Top and Volkswagen by T. Gorman in SEC Actions

VW did have compliance systems. During his rise through the ranks the CEO was at one point in charge of Quality Assurance as well as head of Technical Development. Even after becoming CEO he continued to focus on the technical details of the vehicles as illustrated by photos in the complaint. Yet the scheme launched and continued. The failure of compliance here traces directly to the top. Under the circumstances here the “tone at the top” appears to have focused on something other than compliance.

http://www.secactions.com/the-sec-compliance-tone-at-the-top-and-volkswagen/

LIBOR, Again (Sorry!) by Rick Jones in Crunched Credit

A couple things are, at this point, clear. The Secured Overnight Financing Rate (SOFR) is a lock for the new and improved LIBOR. We are going to have a wide range of complex, often subjective triggers prompting the switch out of LIBOR, and regrettably, we are going to have a waterfall of prospective alternate SOFR rates to choose from when we switch. It’s pretty clear that when 2022 rolls around, we’re not going to have a single trigger or a single, easily understood, alternative rate. What we need is broadly agreed, clear, bright lined rules as to the date on which we switch rate and clear bright lined rules on what the index will be. We’re not getting it.

https://www.crunchedcredit.com/2019/03/articles/libor/libor-again-sorry

Compliance Bricks and Mortar for March 15

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

Listing Gaps, Merger Waves, and the Privatization of U.S. Equity Finance by Gabriele Lattanzio, William L. Megginson and Ali Sanati in The CLS Blue Sky Blog

The number of U.S. listed companies declined by almost half between 1996 and 2012, from 8,090 to 4,102, and had risen only slightly, to 4,336, by year-end 2017. However, the real market valuation of these listed companies tripled over the same period, from $10.2 trillion in 1996 to $32.1 trillion in 2017[1], implying that the average market valuation of a U.S. listed firm has increased six-fold over the past two decades. In other words, the U.S. public stock market has become populated exclusively by behemoths. Over the same period, the U.S. has experienced historically high levels of merger and acquisitions (M&A) activity and private investments of equity. We show that a new model of equity finance has emerged in the United States over the past quarter-century, which differs significantly from both late-20th century norms and the equity model observed in other advanced economies.

http://clsbluesky.law.columbia.edu/2019/03/11/listing-gaps-merger-waves-and-the-privatization-of-u-s-equity-finance/

What is ‘Compliance Training,’ Anyway? A Simple Explanation of What it is—and isn’t. by Ricardo Pellafone in SCCE’s The Compliance & Ethics Blog

In one sentence, compliance training is (1) a tool (2) that you use to drive behavior (3) of willing people (4) by helping them make decisions.

http://complianceandethics.org/what-is-compliance-training-anyway-a-simple-explanation-of-what-it-is-and-isnt/

Fidelity’s new cryptocurrency company is up and running despite a bear market for digital coins by Kate Rooney in CNBC


Fidelity Digital Assets, a new company created by the investing giant last year, has quietly rolled out its cryptocurrency custody and trade execution operations. In the past few months it has been up and running with institutional investors like hedge funds and family offices, according to its top executive.

https://www.cnbc.com/2019/03/08/fidelitys-new-cryptocurrency-company-is-up-and-running-despite-a-bear-market-for-digital-coins.html

Commissioner Peirce on CCO Liability

Enforcement actions by financial regulators can cause compliance professionals to rethink their career choice.

In the majority of cases the SEC brings against CCOs, (1) the compliance officers are involved in misconduct that is unrelated to their compliance function or (2) the CCOs have engaged in efforts to obstruct or mislead the investigation. Typically in these cases, the targeted compliance officers wore more than one hat.

But not always. Take a look at the Southwind Case.

Court E. Golumbic, a Participating Managing Director and the global head of Financial Crime Compliance for the Goldman Sachs Group, Inc. put it this way:

“Regardless of the cause, the resulting ‘chilling effect’ on financial sector compliance officers should raise an alarm. The level of ensuing ‘brain drain’ could diminish significantly the efficacy of financial sector compliance programs, and the integrity of the industry more generally.”

http://www.hastingslawjournal.org/wp-content/uploads/Golumbic-69.1.pdf

SEC Commissioner Hester Peirce tried to assuage fears at the National Membership Conference of the National Society of Compliance Professionals. She agreed that the SEC should tread carefully when bringing enforcement actions against compliance personnel and should not pursue enforcement actions based on strict liability for CCOs under Rule 206(4)-7.

Sources: