Author: Doug Cornelius

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

Frequently Asked Questions Regarding Customer Due Diligence Requirements for Financial Institutions

On April 3, the Financial Crimes Enforcement Network published Frequently Asked Questions Regarding the Customer Due Diligence Requirements for Financial Institutions. The questions are about Customer Due Diligence Requirements for Financial Institutions, published on May 11, 2016, as amended on September 29, 2017. FinCEN is labeling it the CDD the Rule.

The CDD Rule requires financial institutions to identify and verify a legal entity’s “beneficial owners” when an accounts is opened. The CCD Rule’s mandatory compliance date is May 11, 2018.

I don’t think the CDD Rule applies specifically to the investors in private equity funds or to investment advisers in general. But the SEC has been threatening to impose a know-your-customer, anti-money-laundering, Customer Due Diligence requirement on investment advisers. I think it’s worth looking at the rule to see how the broader industry is addressing this.

The big change is for legal ownership of entities. The CDD requires the identification of anyone who directly or indirectly owns more than 25% of the equity interest in the entity and at individuals who have managerial control of the entity. The new FAQ makes it clear that a financial institution can dig deeper than 25%.

For banks, the CDD process has to be run each time a new account is opened. Each time a loan is renewed or a certificate of deposit is rolled over, the bank is establishing another banking relationship and a new account is established. Covered financial institutions are required to obtain beneficial ownership information of a legal entity that opens a new account or renews a product, even if the legal entity is an existing customer. For financial services or products established before May 11, 2018, Covered financial institutions must obtain certified beneficial ownership information of the legal entity customers of the new or renewed products.

The FAQ goes deep. It’s worth reading to think about how your firm should amend its AML procedures.

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What is Pre-Marketing?

In establishing a new investment vehicle, a sponsor needs to find a pool of interested investors. Given the varying rules around fundraising in different jurisdictions, the sponsor may chose to look for support in one place over another. The big problem is the time and cost it takes to get a proposed investment registered in a jurisdiction may not be worth that time and money if no investor from that jurisdiction ends up being interested.

This is a particular problem with private equity funds when the terms of the fund may still be fluid in the early days of the fundraising process. The terms of a private placement are more often negotiated with prospective investors than a registered offering.

The question in many jurisdictions is what constitutes activities that amounts to marketing, triggering the registration process.

In the US the activities are fairly clear. You need to only direct the discussions to accredited investors and it can’t be so broadly distributed that it could be considered general marketing or general solicitation. Generally, for a private fund sponsor’s formation efforts, the sponsor wants to keep the number or prospective investors small to get a sense that the terms are right and that there is market for the product.

The European Union had been more difficult under the AIFMD rules. As much as the EU is trying to standardize the AIFMD rules across its member countries, the requirements still vary widely from member country to member country.

Last month the EU indicated that it’s looking at defining pre-marketing under the AIFMD rules. Currently, AIFMD regulates “marketing” to investors. It does not specifically regulated “pre-marketing”. Without any specific rule to base it on, member country to member country has been setting general framework on where the line is between marketing and pre-marketing.

The new regulatory regime could be good or bad for fund sponsors. If it’s drawn too narrowly, it will keep fund sponsors away from. It will disproportionately affect smaller sponsors who are not prepared to spend the money with uncertainty of potential investors. Larger sponsors will have more time and money to comply.

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Research on Insider Trading

Just to revive any anger you have left from the 2008 financial crisis and its aftermath, a new academic paper found evidence of insider trading among corporate insiders at leading financial institutions during the Financial Crisis. That’s on top of other research that brokers leak information or front run trades.

One research paper on political connections comes from the private meetings between government officials and financial institutions during the financial crisis which eventually lead to the Troubled Asset Relief Program.

Any corporate insiders with knowledge of those discussion could have known how much money was involved and which financial institution would get it. With financial institutions staring into a pit on destruction and some being dangled a rope to safety, one could have made a good chunk of cash if you knew which company to bet on and which ones to avoid.  The government was making hundreds of billions of dollars available.

The paper examines conduct at 497 financial institutions between 2005 and 2011. The researchers focused on individuals who had previously worked in the federal government. In the two years prior to the TARP, these people’s trading gave no evidence of unusual insight. But in the nine months after the TARP was announced, they achieved particularly good results. The paper concludes that “politically connected insiders had a significant information advantage during the crisis and traded to exploit this advantage.”

The other research paper on order flow leakage uses data from 1999 to 2014 from Abel Noser, a firm used by institutional investors to track trading transaction costs. The data covered 300 brokers, but the researched focused on the 30 biggest. 80-85% of the trading volume flowed through those 30.

The researchers found evidence that large investors tended to trade more in periods ahead of important announcements. That would be hard to explain, unless they have access to inside information.

The most innocent access to information would be brokers that “spread the news” of a particular client’s desire to buy or sell large amounts of shares. That helps with market-making. A less innocent explanation is that they give this information to favored clients to boost their own business.

Of course, large institutions can be both beneficiaries and victims of this  information leakage. But in general they are net gainers to the lowly retail investor who does not have access to this information. It further leads to a conclusion that the markets are rigged and they should not participate at all.

One common theme to these papers is the use of big-data and analytics to find these trends and identify weaknesses in the systems. We have seen cases from the SEC’s Division of Economic and Risk Analysis attacking frauds. It may be useful for the SEC to focus on these systemic problems.

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  • Insider trading has been rife on Wall Street, academics conclude in The Economist
  • Political connections and the informativeness of insider trades by Alan D. Jagolinzer, Judge Business School, University of Cambridge; David F. Larcker, Graduate School of Business, Rock Center for Corporate Governance, Stanford University; Gaizka Ormazabal, IESE Business School, University of Navarra; Daniel J. Taylor, the Wharton School, University of Pennsylvania. Rock Center for Corporate Governance at Stanford University, Working Paper No. 222.
  • Brokers and order flow leakage: evidence from fire sales by Andrea Barbon, Marco Di Maggio, Francesco Franzoni, Augustin Landler. National Bureau of Economist Research, Working Paper 24089, December, 2017; and “The Relevance of Broker Networks for Information Diffusion in the Stock Market” by Marco Di Maggio, Francesco Franzoni, Amir Kermani and Carlo Summavilla. NBER Working Paper, No 23522, June, 2017

Compliance Bricks and Mortar for March 30

For those of you with that responsibility, I hope you have your Form ADV filed or ready to go. Meanwhile, here are some other compliance-related stories that recently caught my attention.

It’s Not Cricket – Ethics on the Pitch by Tom Fox in FCPA Compliance & Ethics

Is it cricket? Or isn’t it cricket? That might be a question many Americans are asking these days while the rest of the sporting world is embroiled in one of Cricket’s biggest scandals ever; which decidedly isn’t cricket. Confused yet? The scandal involves the highest levels of the Australian national Cricket team, who concocted a scheme to scruff the ball on piece of yellow tape in the pants pocket of the bowler, Cameron Bancroft. He was instructed to do so by (now former) team captain Steve Smith and (now former) vice-captain David Warner. All three have been thrown off the team. Now here is the best part, bowler Bancroft scruffed the ball on yellow tape on the pitch, not only in view of the entire playing field but all the fans in the stands. Better yet, he was caught on international television doing the deed. [More…]

Will SEC Rule Curb Corporate Political Spending Disclosure? by Mara Lemos Stein in the WSJ.com’s Risk & Compliance Journal

A provision in the latest U.S. government spending bill bars the U.S. Securities and Exchange Commission from mandating corporate disclosure of political spending but it won’t stop the trend of increased transparency around the issue, said two advocates for more transparent corporate governance. [More…]

Is the Cryptocurrency Bubble About to Burst? by Glenn Luinenburg and Jennifer Zepralka in WilmerHale Launch

We previously discussed ICOs and the Securities and Exchange Commission’s (SEC) Report of Investigation on the DAO. But there are still open questions about other types of ICOs, where it may not be squarely an investment, but instead the token has some use other than just providing a return to the holders. That’s where the SEC’s Munchee case in December gave us some more color and in our recent QuickLaunch University webinar on the future of ICOs and cryptocurrencies, we discussed this case and other developments and offer a few key takeaways if you are invested in or planning to launch an ICO: [More…]

Should compliance officers be optimists? by Jeff Kaplan in Conflict of Interest Blog

I think the case for optimism has grown – particularly in the past year. By this I mean not that things are looking better than in the recent past but that the need for an optimistic cast of mind may be at an all-time high. [More…]

 

Use of Data in Proving Fraud

The Securities and Exchange Commission’s case against Robert Magee and Valor Capital was a straight forward cherry picking case. What caught my eye was the data and statistical analysis that the SEC used to prove its charges.

Magee was doing the wrong thing by order block trades in an omnibus trading account and then allocating the trades to his personal account and client accounts at the end of the day. That procedure is ripe for compliance failure without a preset decision on who gets the trades. The concern will always be that the securities that increased during the day will be allocated to favored accounts and those that went down would be allocated to others.

The SEC ran the numbers to prove its point.

From July 2012 to January 2015, Magee’s personal accounts posted first-day profits of 0.876%. Those were 459 trades of which 376 were profitable on the first day.

Meanwhile, the client accounts posted a -2.309% return on the first day during roughly the same period. Those were 1,365 trades of which only 219 were profitable on the first day.

Of course, the disparate results could be based on good luck. The SEC ran some stats and found that the probability that disproportionate allocation of favorable trades was due to chance was less than one in 100,000 during one period and less than one in a trillion during another period.

Valor’s brokerage firm terminated its relationship because it suspected the cherry-picking. The subsequent brokerage firm did the same. The third brokerage firm did not permit the use of an omnibus account to execute trades. The Texas state securities regulator reprimanded and fined Magee in August 2016 for no pre-allocating block trades.

According to the SEC’s press release, this is the fourth action arising out of an enforcement initiative to combat cherry-picking led by the SEC’s Los Angeles Regional Office and supported by the agency’s Division of Economic and Risk Analysis.  The previous actions were against Jeremy Licht of JL Capital Management, Gary Howart of Howarth Financial, and Joseph B. Bronson of Strong Investment Management.

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Dividing Up Clients On Form ADV

For those of us working with registered investment advisers, the deadline for filing Form ADV is quickly approaching.

I’ve heard a few people struggling to classify their clients. I put together this chart to help me think about it.

 

 

With the recent changes to Form ADV, I see the SEC carving client accounts into two big buckets: Separately Managed Accounts and Pooled Investment Vehicles.

Each of those big buckets is separated into further classifications.

I found the name “separately managed accounts” to be confusing because it sounds a lot like the insurance term “separate accounts.”

I heard a lot of uncertainty on how to treat a fund of one. It could be a pooled investment vehicle. Or it could be a separately managed account. I have not heard anything to help draw the line. The best advice I’ve heard is to just be consistent. If you treat the fund of one operationally like you treat your other funds, then label it that way on the Form ADV. If you treat it operationally like you treat your separately managed accounts, then label it that way on the Form ADV.

For real estate managers, it sounds like they have some investment vehicles that are not private funds. Some of this discussion goes back to the 2012 thoughts on whether to register with the SEC or not. A straight real estate investment with a couple of investors with major action consent sounds like it falls out of the “private fund” definition. That real estate investment does not have securities, so it should fall outside the definition of an investment company. Even if it were so treated, it would be entitled to the 3(c)5 exemption. That would keep it outside the “private fund” definition.

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The One With The Fake Returns

Most frauds have some element of fake returns. I picked the case against McKinley Mortgage Co., Charles Preston, and his son, Caleb Preston because the headline in the release included: Private Real Estate Fund with Scheme to Defraud Retail Investors.” Frauds involving private real estate funds catch my attention.

McKinley bought promissory notes secured by deeds of trust or originated new loans, packaged them into investment pools and sold interests in the pools to investors.

According to the complaint, the problems started in 2012 when the sponsors started taking more in management fees and expenses than allowed under the fund documents. According to the complaint, it was an extra $700,000 in 2012 and $1.5 million in 2013. The it grew even bigger in subsequent years.

They also expanded the scope of investments. The fund documents said that up to 25% could be invested in Mexico. They exceeded that amount.

Then they increased the amount of returns from the funds to prospective investors.

Three bad things to do.

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How Compliant Should You Have to Be?

BMW issued a voluntary recall of all BMW i3 electric cars ever sold in the U.S.  and has sent a stop-sale order to its U.S. dealers for any new or used i3 vehicles. There have only been 30,000 sold. That’s not very many, but it’s all of them. The reason is a “compliance issue” with federal regulators over a failed National Highway Traffic Safety Administration crash test.

Compliance issue caught my attention in connection with its electric car. (I don’t drive a BMW and think the i3 is a weird looking car.)

“While BMW’s compliance testing showed results well below the required limits, more recent testing has shown inconsistent results. Consequently, BMW has issued a recall and is working with the agency to understand the differences in the test results.”

This is not a Volkswagen fake-testing issue. The company saw slightly different results than the government tests.

The test failures are very specific. The tests resulted in a marginally higher neck load on 5% of the population. That 5% is adult females who are around five feet tall and weigh about 110 pounds. The failure also only applies to someone sitting in the driver’s seat and not wearing a seatbelt.

Being in New England, I’m reminded that “Live Free or Die” New Hampshire is the only state that does not mandate seat belt use. In every other state there is a law requiring seat belt use.

To protect petite women who live in New Hampshire, BMW has to recall all of the i3 cars. It’s a tough penalty for getting the company’s crash results wrong.

Of course, the answer would seem to be: “Wear a seatbelt.”

That leaves me with a libertarian conundrum. Impose a regulation requiring seatbelt use? or impose a regulation requiring additional design cost so that people don’t have to wear seat belts?

Where is the best place to impose compliance?

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Compliance Bricks and Mortar for February 23

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

FINRA warns public about fake . . . FINRA
by Richard L. Cassin

The Financial Industry Regulatory Authority (FINRA) warned about con artists posing as FINRA to make phony investment pitches. Scammers are using FINRA’s name and logo in letters that say FINRA is guaranteeing investments. The letters include a fake signature from FINRA president and CEO Robert W. Cook. [More…]

When The Sport of Curling Should Make Your Hair Curl
by Adam Turteltaub

In the You Can’t Make This Up Department, reports out of Korea indicate that a Russian curler has tested positive for a banned substance.  Yup, doping in curling. Doping in sports is not so surprising these days.  Doping from a Russian athlete, not so shocking either.  But doping in curling?  Really?  Curling?  I mean, seriously?  Have you watched the sport?  I don’t deny that it’s harder than it looks, it is probably quite physical, and I know I couldn’t make the US Olympic curling team, but really? [More…]

2018 Cross-Industry Compliance Staffing and Budget Benchmarking and Guidance Survey
by the Society of Corporate Compliance and Ethics

On the following pages are a series of data tables that can be used to benchmark compliance program budgets and staffing by several factors. As you review the data, keep in mind that this data should be considered directional in nature. Different companies of the same size will likely have very different histories in terms of compliance issues and risks. [More…]

Six Do’s and Don’ts of Due Diligence Questionnaires
by Kristy Grant-Hart

Due diligence questionnaires are a critical tool for understanding third-parties. But they can quickly get out of control, putting unreasonable burdens on the answering party, and at worst, invading the privacy of individuals in wholly unnecessary ways. How do you balance the legitimate need for information with the reality that no questionnaire can fully protect the company from the possibility that the third-party will misbehave? Here are three do’s and don’ts when it comes to due diligence questionnaires. [More…]

SEC’s Jackson questions rationale for dual-class ‘forever shares’
By Mark S. Nelson, J.D.

New SEC Commissioner Robert Jackson hit the ground running in his first substantive speech as a commissioner by taking on the topic of the proliferation of companies that have adopted dual-class share structures. Jackson’s speech in San Francisco at a Silicon Valley event on M&A, antitrust, and governance issues comes at a time when initial public offerings (IPOs) have become scarcer and an abundance of private capital allows growing start-ups to remain private longer, thus giving the founders of some companies that do go public the leverage to demand share structures that may protect their jobs. For Jackson, though, the question is one of how long a company should retain a dual-class structure post-IPO rather than a debate about the merits and demerits of such structures. He said the outcome of the debate over dual-class structures may have long term implications for Main Street investors. [More…]

 

The Limit of Whistleblowers

The Supreme Court just decided a case that limits the whistleblower anti-retaliation provisions in Dodd-Frank. The Court handed down its decision in Digital Realty Trust v. Somers.

Dodd-Frank defines “whistleblower” as a person who provides “information relating to a violation of the securities laws to the Securities and Commission.” 15 U. S. C. §78u–6(a)(6). A whistleblower is then eligible for an award if original information provided leads to a successful enforcement action. Under Rule 21F, a whistleblower has to go through particular steps to be able to claim an award, but the anti-retaliation protections apply whether or not the requirements, procedures and conditions to qualify for an award are satisfied.

Mr. Somers reported suspected securities-law violations to senior management of Digital Realty Trust. He was fired. He did not alert the SEC prior to his termination. He didn’t file an administrative complaint within 180 days that is required under the Sarbanes-Oxley whistleblower protections. Nonetheless, he brought suit against the company with a claim of whistleblower retaliation.

The Supreme Court stuck with the clear definition in Dodd-Frank. A whistleblower for securities law violations must report the violation to the SEC to have protection from retaliation.

The Supreme Court pointed out that there is a different definition of whistleblower under the CFPB part of Dodd-Frank. Under 12 U.S.C. §5567(a)(1), a “covered employee” who provides information to the company, the FBI, or any other State, local, or Federal, government authority or law enforcement agency relating to a violation of a law subject to the CFPB’s jurisdiction gets whistleblower protection.

Mr. Somers argued that the limiting whistleblower definition should only apply to eligibility for awards. The Court completely disagreed with that argument and relied on the plain language of the statue. There were two concurring opinions, but they only took different approaches to whether the Court should take into consideration legislative history as part of statutory interpretation. The two concurring opinions agreed with the result, leaving Mr. Somers as a non-whistleblower. The ruling settled a split between the Ninth and Fifth Circuits, reversing the Ninth Circuit’s decision.

There is an obvious impact on compliance programs. As much as we might hope that employees who think there is a problem would tell someone internally first, there is much more incentive to go directly to the SEC.

It’s all confusing in application. A tip left with the SEC is kept anonymous, so a company would not know the identity of the whistleblower. A company could fire an employee who left a tip without knowing that the employee did so. Without a requirement that the employee also tell the company, the company is in the dark and may not even be aware of the problem.

The other piece missing in the arguments is whether there even was an actual securities law problem at Digital Realty Trust.

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