Author: Doug Cornelius

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

Hiring Relatives Government Officials Can Be an Illegal Bribe

Back in 2015, the Securities and Exchange Commission made it clear that providing jobs to family members of foreign government officials could be a violation of the Foreign Corrupt Practices Act. That SEC investigation found that BNY Mellon did not evaluate or hire the family members in accordance with its hiring standards and require a minimum grade point average and multiple interviews. The family members did not meet the criteria yet were hired with the knowledge and approval of senior BNY Mellon employees in order to corruptly influence foreign officials and win or retain contracts to manage and service the assets of the sovereign wealth fund.

It turns out that BNY Mellon was not the only one doing that. The SEC and DOJ brought charges against Credit Suisse for doing the same thing.

From 2007 to 2013, Credit Suisse provided valuable employment to the relatives and friends of certain foreign government officials in the “Asia-Pacific region” as a personal benefit to the requesting officials in order to obtain or retain investment banking business or other benefits for Credit Suisse. According to the SEC Order, this was a violation of the bank’s policy. The Order describes three separate instances when Credit Suisse did not hire a relative of a government official because of the FCPA risk.

But there were instances where managers wetn around the process and sneaked those relatives into the hiring process. The SEC found plenty of “smoking gun” emails and documents.

Credit Suisse maintained spreadsheets that listed “referral hires” or “relationship hires.” These spreadsheets included information identifying the referring client or relationship when the relationship was with a government regulator. Some of these spreadsheets identified the “[c]ontribution” of the referral hire, including in at least three instances, deals specifically attributable to the relevant relationship. In an email to colleagues, a Credit Suisse employee explained: “Relationship hires have to translate to $” or “the relationship is worthless to our organization.” This email was forwarded to a senior Credit Suisse banking official in the U.S. In a different email, a senior Credit Suisse banker stated that a referral hire “will get us a US$1bn bond deal. . . . His family requested to change his status to permanent with CS. Given [] the level of importance of this deal, we will decide to renew his contract for another 24 months instead of permanent.”

Some of these relatives may have been well- qualified (or at least marginally qualified) for the positions. But some were clearly not qualified and should have been fired for their behavior during the onboarding. During her probationary period one such relative referred to “Referral Hire A”, she exhibited unprofessional behavior.

  • She failed to attend a mandatory boot camp.
  • Brought her mother to training events, and left early.
  • She received the worst grade in the class on an assessment, commenting that “from the looks of her assessment she didn’t even try (she filled in a pattern of 5As in a row, 5 Bs in a row, etc. on the answer key).”
  • Referral Hire A “has been leaving at 4 pm right after every lecture every day this week while the rest of the class is working until at least 9pm, 10 pm.”

Not only was Referral Hire A approved as a employee after her probationary period, she was promoted a year later.

She was clearly unqualified to be a junior investment banker.

But as Matt Levine points out in his newsletter, she is qualified to be a senior investment banker.

When banks hire senior bankers from their competitors, they don’t quiz them on Excel shortcuts; they hire them for their Rolodexes, their books of business, their reputation and relationships with clients.

She did make the deal possible for Credit Suisse. One transaction with her relatives state-owned enterpise generated approximately $2,680,733 in revenue for Credit Suisse. That is what a senior investment banker does.

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The One With Cross-Fund Transactions

United Development Funding and its investment platforms have been under attack for a few years. It looks it has finally come to grips with its mistakes. UDF is closing out investigations into its funding of real estate investments from multiple investment platforms.

The attacks started in 2015 when Kyle Bass, who runs Dallas-based hedge fund Hayman Capital Management LP, bet against UDF IV shares and publicly raised questions about UDF. Bass called the company a billion-dollar house of cards and a Ponzi Scheme, using newly raised capital to pay off old investors. Bass detailed projects that were funded for more than a decade without any noticeable development, projects without impairments being recorded and loans being paid off without an obvious cash flow.

Bass noticed the October 2014 that the UDF III partnership, a non-traded, publicly registered REIT announced that it had formed a special committee comprised of independent advisors to evaluate potential strategic alternatives.

Then in February 2016, the FBI raided the offices of UDF. There were internal investigations, a threatened delisting by NASDAQ and an SEC investigation. The SEC just announced settlement of its case.

So what happened?

UDF III had loans to developments were stalled and the developers lacked capital re-pay the loans. UDF IV fund loaned money to developers who had also borrowed money from UDF III. Rather than using those funds for development projects that were underwritten by UDF IV, UDF directed the developers to use the loaned money to pay down their older loans from UDF III. Even worse, in some instances, the developer never received the borrowed funds at all, and UDF simply transferred the money between funds so that UDF III could make the distributions to its investors.

This is an example of the dangers posed by transactions between investment platforms. It looks like a Ponzi scheme. The additional problem was the lack of disclosure, the failure to right down the UDF III loans and UDF IV’s improper treatment of its capital deployment.

The investigations do not point to fraud in that UDF or its executives were pocketing the cash improperly. Certainly the fundraising for UDF IV would have been less successful if investors knew the capital was in part being used to fund investments by UDF III.

What UDF did with funding would not have been a problem if it has disclosed the information. Instead UDF hid the problem by not fully disclosing the inter-platform transactions and not writing down the value of the UDF III investments.

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2018 Global Study on Occupational Fraud and Abuse by the Association of Certified Fraud Examiners

Study 2,690 cases of occupational fraud over 18 months and you may see some trends. The Association of Certified Fraud Examiners conducted a survey of its 41,000+ certified fraud examiners to collect data on the single biggest fraud case they investigated from January 2016 to October 2017.

The study identified six behavioral red flags that have consistently been common in each of its studies (ranked by prevalence):

  1. Living beyond means (41%)
  2. Financial difficulties (29%)
  3. Unusually close association with vendor/customer (20%)
  4. Control issues/ unwillingness to share duties (15%)
  5. Divorce or family problems (14%)
  6. “Wheeler-Dealer” attitude involving shrewd or unscrupulous behavior (13%)

According to the report, the fraudster displayed at least one of these red flags in 86% of the cases and displayed more than one in 50% of the cases.

The other piece of data that jumped out at me was that employees who been with their company longer stole more. Setting the line at five years of tenure at the job, those with more stole a median of $200,000 and those with less stole $100,000.

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Changes to the SEC’s Whistleblower Program

Seven years ago the Securities and Exchange Commission opened its Office of the Whistleblower under the authorization of the Dodd-Frank Act. Since then the SEC has received over 22,000 whistleblower tips, obtained over $1.4 billion in financial remedies related to those tips, and ordered over $266 million in whistleblower awards to 55 individuals. Now, the SEC wants to tweak the program and offered up a series of regulatory revisions.

More Settlements Would Eligible

The first change is to expand the scope of actions that are subject to whistleblower awards. The current SEC whistleblower rules do not address whether the SEC can pay an award when the information that leads to a Deferred Prosecution Agreement or Non-Prosecution Agreement entered into by DOJ or a state attorney general in a criminal proceeding. The SEC is also looking for the discretion to award whistleblower claims based on public information using independent evaluation and analysis.

More for Smaller Settlements

The second change is to push for a higher award in smaller cases. According to the SEC, 60% of the whistleblower awards have been less than $2 million. The SEC is trying to set a $2 million floor, subject to the Section 922 cap of 30% of the award. The purpose of the change is to reward meritorious whistleblowers and incentivize future whistleblowers who might otherwise be concerned about the low dollar amount of a potential award.

Less for Bigger Settlements

The third change is related to the remaining 40% of funds paid out in claims. That 40% represents just three awards. For big cases, the SEC wants to be able to cap the award at $30 million, subject to the Section 922 floor of 10% of the award.

Digital Realty Fix

In the Digital Realty case decided by the Supreme Court earlier this year, the Court held that the whistleblower provisions of the Exchange Act require a person to report a possible securities law violation to the SEC in order to qualify for protection against employment retaliation.  For purposes of retaliation protection, an individual would be required to report information about possible securities laws violations to the Commission “in writing”.

Others

Besides these four big changes, there are several other smaller changes to increase the efficiency and effectiveness of the whistleblower program.

My Take

I think it’s great that the current SEC is willing re-evaluate its rules and fix them to make them work better. I bet most o fus could point to many parts of the SEC rules that need fixing. I hope they continue this process for other rules.

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Weekend Reading: What the Eyes Don’t See

Government failed Flint, Michigan. In April 2014, Flint changed its water source from treated Detroit system to the Flint River. Officials failed to apply corrosion inhibitors to the water. As a result, there was a serious public health danger. The Flint River water caused lead from aging pipes to leach into the water supply.

The city was crushed when GM closed it’s Flint plant in the 1980s. The city was in deep financial trouble in 2011 when the state stepped in to control the local government because of a blooming city budget deficit. The switch of water sources was to save money and the failure to apply corrosion control was a further cost-cutting measure.

There are plenty of sources of information on this crisis. I was interested in What the Eyes Don’t See because it is told from the perspective of a whistleblower.

Dr. Mona Hanna-Attisha is a pediatrician at Flint’s public hospital. She was an employee of the government, calling out the government for its failures. People noticed the poor quality of the water, but the city and state claimed to have run proper tests and found it to be safe.

Dr. Mona talked with an old friend at a cookout and was sent some leaked documents causing her to question whether the water was “safe.” She was able to use the hospital blood test data to identify a noticeable spike in patients’ blood lead levels after the water supply switch.  Then it was a battle against her employer, the city and the state government.

For some criticism, I think the tile of the book and the cover art totally fail to properly convey the message of the book. I failed to notice it the first time it was made available to me by the publisher. At first glance, it seemed like some existential book about hope. Only on a second look did I catch what the book it actually about. The publisher was still nice enough to send me a review copy.

The book offers a great insight in the obstacles of a whistleblower. In this case it was not for financial gain or some battle to be correct. Dr. Mona was doing her job. As a pediatrician, her job was to keep the city’s kids healthy. The city was failing. Dr. Mona had doubts about her study. She was attacked by the government, her employer. A Michigan Department of Environmental Quality spokesperson accused her of being an “unfortunate researcher” who was “splicing and dicing numbers.”

The book is worth adding to your to-read list.

Another Insider Guessing Case

The Securities and Exchange Commission and the DOJ filed another case against an Equifax employee who figured out that the breach remediation plan was actually for Equifax and not a client. Sudhakar Reddy Bonthu, like Jun Ying in the earlier case, Bonthu was working on Project Sparta which was identified as a fast-breaking opportunity for an unnamed potential client. Bonthu was tasked with developing the online user interface and tools.

The SEC makes a big jump, with little to back it up, that Bonthu knew or was reckless in not knowing that Project Sparta was actually for Equifax and that the company had suffered a massive data breach. The sole proof the SEC offered was that Bonthu received a dataset file entitled: “EFXDatabreach.postman_collection.”

It sounds to me like this case goes into the “insider guessing” bucket. According to the SEC, Bonthu had a matrix of information that lead him to conclude the true nature of his project. THe tough part will be the SEC convincing a jury.

In the earlier case The SEC against Jun Ying, a former senior technology executive at Equifax with insider trading, Ying exercised his stock options and sold his Equifax stock holdings ahead of Equifax’s announcement that it had suffered a major data breach.

Bonthu was more sophisticated. He bought put options with a September 15 expiration. Equifax announced the breach on September 7. He bought them in an account in his wife’s name instead of one with his name. Equifax had a policy that prohibited employees trading derivatives, including put options.

I think that trading looks works than Ying’s sale of his stock. So that may a jury less sympathetic if he is hoping for a result like the railroad workers.

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Share Class Selection Disclosure Initiative

One of the 2018 exam priorities for the Securities and Exchange Commission is “matters of importance to retail investors.” The SEC has found many problems with advisers selling their clients higher cost share classes of mutual funds that paid the adviser a fee.

It’s not that a registered investment adviser can’t take that 12b-1 fee. But it has to be fully disclosed to the clients.

The SEC found that many respondent investment advisers disclosed that they “may” receive 12b-1 fees from the sale of mutual fund shares and that 12b-1 fees “may” create a conflict of interest. However, the investment advisers failed to disclose that they had a conflict of interest because the funds offered a variety of share classes, including some that paid 12b-1 fees and others that did not for eligible clients, and failed to disclose that they were, in fact, receiving 12b-1 fees due to the mutual fund shares they bought for or recommended to their clients.

The SEC has found this to be such a widespread problem that it launched the Share Class Selection Disclosure Initiative. Under the SCSD Initiative the SEC’s Division of Enforcement will recommend favorable settlement terms for investment advisers that self-report possible securities law violations relating to their failure to make necessary disclosures concerning mutual fund share class selection.

If the adviser self-reported, it would have to disgorge the fees plus interest, enter into a cease and desist, enter into an undertaking to fix disclosure documents. But the SEC will not impose a penalty for advisers that self-report

For additional information regarding the adequacy of mutual fund share class selection disclosures see the following:

The deadline for self-reporting has passed. Now we wait to see if the SEC will report on how many firms took advantage of the SCSD Initiative.

I found it interesting to see the SEC take such a wide swing at the industry, asking them to self-report and change practices.

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Continuing Lucia

After last week’s Supreme Court decision in Lucia v. Securities and Exchange Commission, it’s clear that administrative law judges of the US Securities and Exchange Commission are not mere federal employees but qualify as “Officers of the United States” under the Appointments Clause of the US Constitution. That means they need be appointed by the president, courts of law, or heads of departments, in this case the SEC Commissioners.

It’s also clear that Mr. Lucia’s victory is hollow. The remedy in the decision was that Mr. Lucia was entitled to a new hearing by new administrative law judge who had been properly appointed. In December the SEC Commissioners ratified the appointment of the ALJs. That was done in anticipation of this decision. I assume that is enough to meet the requirements of the Appointments Clause. I expect that may also be challenged by Mr. Lucia if he case starts over.

There is still lots of uncertainty after the Lucia decision. Enough uncertainty that the SEC has halted all administrative proceedings for 30 days.

The Lucia decision required that the case be heard before a new ALJ. At a minimum,  the SEC is going to do a lot of shuffling of cases from ALJ to another for any case started before December. It may also decide to shift the cases over to federal courts. According to one estimate there are 100+ cases involved.

One big unanswered question is whether the SEC ALJ proceedings are the proper venue. Dodd-Frank expanded the use of administrative proceedings. Under Chair White, the SEC increased its use of administrative proceedings instead of federal court. Under Chair Clayton, the SEC seems to be increasing using federal courts instead of the administrative proceedings. This was one of the points raised in Justice Breyer’s concurring opinion in Lucia.

I expect we will hear some news from the SEC during this 30-day halt on how they are going to proceed with ALJs.

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Bitcoins Are Not Securities

In a completely unsurprising statement, a high-ranking official at the Securities and Exchange Commission said that Bitcoins are not securities. William Hinman, Director, Division of Corporation Finance at the SEC, gave detailed speech on cryptocurrency.

When we see that kind of economic transaction, it is easy to apply the Supreme Court’s “investment contract” test first announced in SEC v. Howey. That test requires an investment of money in a common enterprise with an expectation of profit derived from the efforts of others. … In articulating the test for an investment contract, the Supreme Court stressed: “Form [is] disregarded for substance and the emphasis [is] placed upon economic reality.” So the purported real estate purchase was found to be an investment contract – an investment in orange groves was in these circumstances an investment in a security.

Just as in the Howey case, tokens and coins are often touted as assets that have a use in their own right, coupled with a promise that the assets will be cultivated in a way that will cause them to grow in value, to be sold later at a profit. And, as in Howey – where interests in the groves were sold to hotel guests, not farmers – tokens and coins typically are sold to a wide audience rather than to persons who are likely to use them on the network.

In the ICOs I have seen, overwhelmingly, promoters tout their ability to create an innovative application of blockchain technology. Like in Howey, the investors are passive. Marketing efforts are rarely narrowly targeted to token users. And typically at the outset, the business model and very viability of the application is still uncertain. The purchaser usually has no choice but to rely on the efforts of the promoter to build the network and make the enterprise a success. At that stage, the purchase of a token looks a lot like a bet on the success of the enterprise and not the purchase of something used to exchange for goods or services on the network.

It seems clear that the SEC’s default position on Initial Coin Offerings is that they are securities offerings. The coin promoters are not offering oranges for sale, but interests in the orange grove.

I did find it interesting that Mr. Hinman indicated that even if the ICO was an illegal securities offering, eventually the cryptocurrency could evolve into not being a security. Eventually, you are not exchanging interests in the orange grove, but exchanging actual oranges. He went to the next biggest coin platform: Ether.

And putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions.

As for the rest of the coin and ICO universe, Mr. Hinman offered up six factors to consider:

  1. Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, the efforts of whom play a significant role in the development and maintenance of the asset and its potential increase in value?
  2. Has this person or group retained a stake or other interest in the digital asset such that it would be motivated to expend efforts to cause an increase in value in the digital asset? Would purchasers reasonably believe such efforts will be undertaken and may result in a return on their investment in the digital asset?
  3. Has the promoter raised an amount of funds in excess of what may be needed to establish a functional network, and, if so, has it indicated how those funds may be used to support the value of the tokens or to increase the value of the enterprise? Does the promoter continue to expend funds from proceeds or operations to enhance the functionality and/or value of the system within which the tokens operate?
  4. Are purchasers “investing,” that is seeking a return? In that regard, is the instrument marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network?
  5. Does application of the Securities Act protections make sense? Is there a person or entity others are relying on that plays a key role in the profit-making of the enterprise such that disclosure of their activities and plans would be important to investors? Do informational asymmetries exist between the promoters and potential purchasers/investors in the digital asset?
  6. Do persons or entities other than the promoter exercise governance rights or meaningful influence?

That is just for coins based on being able to buy some future service. If the digital coin includes some profits interest in the coin network, it’s always going to be a security.

The other factor to take into consideration is the trading platform for the digital coins. If a platform offers trading of digital assets that are securities and operates as an “exchange,” as defined by the federal securities laws, then the platform must register with the SEC as a national securities exchange or be exempt from registration. If the platform just handles Ether and Bitcoin, it’s okay based on the Hinman speech. Those two are not securities. Others are still suspect.

What is left out is the whether Bitcoin, Ether, or any of the other non-security digital coins are commodities or currency.

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The SEC’s Administrative Law Judges are “Officers of the United States”

The Supreme Court issued its decision in Lucia v. Securities and Exchange Commission.  The problem is that the administrative law judges were appointed by an internal panel instead of by the President or the SEC Commissioners. The Appointments Clause of the Constitution is there to make sure that those who wield power are subject to “political force and the will of the people.” The President appoints “Officers” who are those who exercise “significant authority pursuant to the laws of the United States.”

Radio personality Raymond J. Lucia, Sr. got in trouble with the SEC by claiming that his “Buckets of Money” strategy had been successfully backtested when in fact it had not been. Lucia was a registered investment advisor, but the SEC barred him for his transgressions. He appealed.

The Supreme Court re-affirmed a three prong test to determine if an official is an “Officer” under the Appointments Clause:

  1. Holds a continuing office established by law
  2. Exercises significant discretion when carrying out the functions of that office
  3. Issues decisions with finality

The majority opinion found all three of these to be true with the SEC’s ALJs.

The concurring opinion of Justices Thomas and Gorsuch though that the determination of an “officer” merely has to answer the first prong, proposing a much broader definition of an “officer.” The dissent by Justices Sotomayor and Ginsburg felt the finality part of the third prong was not true for the SEC’s ALJs because the SEC can overrule the decision.

What is the impact of the decision?

For Mr. Lucia, it means he is entitled to a new hearing with a different ALJ. The Supreme Court explicitly stated that Mr. Lucia is entitled to a new hearing with a different ALJ who is properly appointed.

I believe all of the SEC’s ALJs are now properly appointed directly by the SEC. In December, the SEC changed its process in anticipation of this decision. The Solicitor General had decided to agree with the argument of Mr. Lucia that the ALJs are “officers.”

The unanswered question is what happens to those cases decided by ALJs. I suppose there could be many others with adverse findings who are going to ask for new hearings with a different ALJ.

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