Author: Doug Cornelius

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

Compliance Bricks and Mortar for December 22

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

American Law Enforcement’s Focus on Cooperation and Self-Reporting by Lee S. Richards

More recently, law enforcement officials, anxious to improve the effectiveness of their programs, have placed even greater emphasis on the need for companies to rush in to disclose problems they have discovered at the earliest possible time. For example, the Department of Justice has recently amended the United States Attorney’s Manual to create a presumption in favor of a declination in FCPA cases where a Company self-reports, but only a maximum 25 percent fine reduction if it does not self-report yet otherwise cooperates fully. U.S. Attorney’s Manual §9-47.120. [More…]

Another ICO Draws a Securities Class Action Lawsuit by Kevin LaCroix in the D&O Diary

On December 13, 2017, an investor who purchased Centra Tech tokens in the Centra ICO filed a securities class action lawsuit in the Southern District of Florida against the company, Sharma, Trapani, and two other Centra Tech officers. A copy of the complaint can be found here. The complaint alleges that the defendants violated sections 12(a)(1) and 15(a) of the Securities Act of 1933 in connection with the ICO “by offering and selling unregistered securities in direct violation of the Securities Act.” The lawsuit purports to be filed on behalf of all investors in the Centra ICO. [More…]

Quick Case of Kickbacks and COI by Matt Kelly in Radical Compliance

You get the picture. The firms had strong policies and certification requirements, and a failure happened because an employee lied. [More…]

Magnitsky Act Compliance is Straightforward, Experts Say by Samuel Rubenfeld

The U.S. Treasury Department on Wednesday released the sanctions regulations for enforcing the Magnitsky Act, which targets Russian human-rights abusers, but sanctions experts say the rules won’t require any new compliance measures. [More…]

For those of you looking for more compliance and Star Wars stories, here are all of Tom Fox’s:

More Political Contribution Problems

There is too much money in a politics. I understand the Securities and Exchange Commission’s desire to purge political contributions from the investment adviser business for state and local government money. But I’ve never been a fan of Rule 206(4)-5, the pay-to-play rule. It’s continuing to ensnare companies in ways that highlight problems with the rule and the very low limits in the rule.

One recent case is that of PNC Capital Advisors. One its employees in business development made a $1000 campaign contribution to John Kasich’s presidential campaign. Kasich was the governor of Ohio and able to appoint trustees to the Ohio state pension funds. That made Kasich an “Official” under the rule and firm had some Ohio state pension money under management.

As I had pointed out, only two out of the twenty-two the major candidates for the last presidential election were subject to the campaign contribution limit because they held state offices: John Kasich and Chris Christie. The rule obviously creates an unnecessary distortion in political campaigns. Adding Pence, the Governor of Indiana to the ticket caused another what do we do moment.

In PNC’s case, the employee had been listed by PNC as a “covered associate” and was in the process of being promoted when PNC discovered the campaign contribution. However, the employee was not responsible for the Ohio account. At no time had the employee been involved in soliciting the Ohio plans, and had never communicated with the Ohio plans. The Contributor had never solicited any other state or local Ohio government entity. The Contributor had never made presentations for, or met with, any representatives of the Ohio plans or with any other Ohio government entities, or supervised any person who met with any of the Ohio plans or other Ohio government entity. If promoted, the Contributor will neither meet with any Ohio government entities personally, nor supervise any person who solicits investment advisory services business from Ohio government entities.

The employee failed to disclose the contribution because he was focused the office Kasich was running for, President, and failed to realize that the rule applied to the current office as well. The PNC compliance group found the contribution in the process of running checks in connection with a promotion. A promotion that is now on hold and has been for 2017.

The SEC order prohibits the employee from soliciting government funds for several months. PNC was allowed to keep the two year worth of fees. $700,000 of fees was at risk for that $1000 contribution.

That was a $1000 contribution in a campaign in which Kasich raised over $19 million.

BlackRock had a similar problem with the Kasich campaign. One of its employees wrote a check for $2700 to the Kasich campaign. The employee was in the ETF division, but since he was on the global executive committee, he fell into the definition of “covered associate.”

Similar to PNC, that employee had never solicited government entities for investment advisory business that is covered under the Rule. To the extent the Contributor has personally solicited business from any government entities, it was exclusively for direct investments in RICs that are outside the scope of the Rule. He has never attended, or otherwise participated in, any meetings, discussions, or any other communications in which a solicitation of covered investment advisory business has taken place.

Blackrock’s compliance group found the donation while conducting a routine compliance review.

Here is a list of other exemptions granted. These were identified in the PNC application and BlackRock application.

  • Davidson Kempner Capital Management LLC, Investment Advisers Act Release Nos. IA-3693 (October 17, 2013) (notice) and IA-3715 (November 13, 2013) (order)
  • Ares Real Estate Management Holdings, LLC, Investment Advisers Act Release Nos. IA-3957 (October 22, 2014) (notice) and IA-3969 (November 18, 2014) ( order);
  • Crestview Advisors, LLC, Investment Advisers Act Release Nos. IA-3987 (December 19, 2014) (notice) and IA-3997 (January 14, 2015)(order);
  • T. Rowe Price Associates, Inc., and T. Rowe Price International Ltd., Investment Advisers Release Nos. IA-4046 (March 12, 2015) (notice) and IA-4508 (April 8, 2015)(order);
  • Crescent Capital Group, LP, Investment Advisers Release Nos. IA-4140 (July 14, 2015) (notice) and IA-4172 (August 14, 2015) (order);
  • Starwood Capital Group Management, LLC, Investment Advisers Act Release Nos. IA-4182 (August 26, 2015)(notice) and IA-4203 (September 22, 2015) (order);
  • Fidelity Management & Research Company and FMR Co., Inc., Investment Advisers Release Nos. IA-4220 (October 8, 2015) (notice) and IA-4254 (November 3, 2015) (order);
  • Brookfield Asset Management Private Institutional Capital Adviser US, LLC et. al., Investment Advisers Act Release Nos. IA-4337 (February 22, 2016) (notice) and IA-4355 (March 21, 2016) (order);
  • Angelo, Gordon & Co., LP, Investment Advisers Release Nos. IA-4418 (June 10, 2016)(notice) and IA-4444 (July 6, 2016) ( order);
  • Brown Advisory LLC, Investment Advisers Act Release Nos. IA-4605 (January 10, 2017) (notice) and IA-4642 (February 7, 2017) (order)

These all look technical violations with no evidence that there were weaknesses in policies or an intent to influence. The rule is just too broad, with dollar limits that are too low.

Sources:

SEC’s Regulatory Agenda

A few months ago, Securities and Exchange Commission Chairman Jay Clayton stated that the SEC had been hard at work on developing its rule-making agenda for the upcoming year.

In the coming weeks and months, I expect the SEC’s near-term rulemaking objectives to be fully reflected in our upcoming Regulatory Flexibility Act Agenda. As a general matter, I believe it is important that these publicly available agendas provide the necessary transparency and accountability for agency matters. If these plans are to meet their intended purpose, they must be streamlined to inform Congress, investors, issuers and other interested parties about what the SEC actually intends – and realistically expects – to accomplish over the coming year.

The SEC released its Regulatory Flexibility Act Agenda for 2017 and grouped the agenda into two categories: Proposed Rules and Final Rules and Long Term Actions.

The “Existing Proposed & Final Rule Stages” are rule-makings the the SEC intends to address during 2017. For those rule-makings that have progressed to some extent, there is a prediction as to when a final rule might occur. The “Long-Term Actions” rule-makings are supposedly that the SEC isn’t likely to tackle in the near term.

In going though the proposed rules and final rules, I didn’t see much that would directly affect private funds.

I did see that the dreaded proposed changes to Form D and private placements is not on the agenda and was formally withdrawn in September.

Sources:

The Most Massachusetts Bribe

One thing that is clear about bribery and corruption is that the payments are not always envelopes full of cash. The FCPA opinions have long pointed out that directing charitable donations to the decision-makers “pet” charity could be a bribe. As former Director of the the Division of Enforcement at the SEC, Andrew Ceresney pointed out, “bribes come in many shapes and sizes.”

That shape could include coffee. It was not just a cup of coffee, but hundreds of pounds of coffee that lead to this story.

Former Massachusetts state senator Brian A. Joyce is facing a series of charges for racketeering, mail fraud, wire fraud, honest services fraud and extortion.

Among the most Massachusetts of charges is the allegation that Joyce took official action, or pressured others to take official action, on behalf of a coffee-business franchise owner in exchange for hundreds of pounds of free coffee. The indictment and press release don’t say which “coffee and pastry fast-food business” franchise was involved, but there is only one in Massachusetts with that many locations in New England: Dunkin’ Donuts.

The indictment alleges that the franchise owner gave Joyce 504 pounds of coffee at Joyce’s request in exchange for moving favorable legislation through the Massachusetts legislature.

Not to paint Joyce as a completely bad guy, the indictment points out that Joyce allegedly gave a pound of coffee to each state senator. Unfortunately, that generosity caught the attention of an intrepid reporter which lead to a news story and an ethics investigation. Allegedly, Joyce conspired with the franchise owner to falsify invoices for legal services and state that the coffee for given in barter.

The story is reminder that bribery comes in many shapes and sizes, including small, medium and large, with cream and sugar.

Sources:

Compliance Lessons from Star Wars – Man Versus Machine

With the release of Episode VIII – The Last Jedi, I’m joining Tom Fox in tying compliance and the Star Wars franchise together in some posts this week. (I saw the movie last night, but I will refrain from revealing anything other than it was terrific.) One of the central themes of the Star Wars franchise is man versus machine.

Luke turns off his targeting computer and relies on the Force during his photon torpedo run on the Death Star. Obi Wan Kenobi describes Darth Vader as more man than machine. It’s primitive Ewoks that crush the technology driven imperial forces at the Battle of Endor. It is when Vader once again finds his humanity that he lives up to the prophecy as the one that will bring balance to the Force.

The Star Wars does not say that technology is bad. How could that be with the beloved R2-D2 and C-3PO, the only characters to appear in all of the movies. In the prequels, it is the rise of robot army that leads to the deployment of the clone troopers and the beginning of the Empire.

Compliance professionals are trying to deal with its own robot uprising: robo-advisers. How to do you regulate a robot or an algorithm that goes bad? How do you create a compliance program from preventing them from going bad? (For a good book on the dangers of algorithms and big data, add Weapons of Math Destruction to your reading list.)

The Securities and Exchange Commission brought an action against AXA Rosenberg in 2011 for a failure in the computer code for its investment model. The SEC did not bring charges against the computer for the fault in the program. It brought it against the people who controlled the model. In this case, it was the fund managers who hid the problem. The computer had done what it was told and it was told to do the wrong thing.

Earlier this year, the SEC released guidance on Robo Advisers.

Robo-advisers, like all registered investment advisers, are subject to the substantive and fiduciary obligations of the Investment Advisers Act. This presents some complications and uncertainties under the Act. Robo-advisers rely on algorithms and likely offers little, if any, human interaction with their advisory clients. The SEC guidance focused on three distinct areas identified by the SEC, with suggestions on how robo-advisers may address them:

1. The substance and presentation of disclosures to clients about the robo-adviser and the investment advisory services it offers;
2. The obligation to obtain information from clients to support the robo-adviser’s duty to provide suitable advice; and
3. The adoption and implementation of effective compliance programs reasonably designed to address particular concerns relevant to providing automated advice.

Can a robo-adviser even meet the duty of care under the Investment Advisers Act? It’s clear what that duty of care is or how personalized the service needs to be. The biggest element is conflicts of interest. As with most conflicts, they can be dealt with by disclosures and robust policies and procedures.

Even with the concerns, robo-advisers are rising in assets under management. They are providing a good service at a low cost, allowing humans to oversee the process. Robots are helping humans succeed.

Compliance Lessons from Star Wars – Rebels

With the pending release of Episode VIII – The Last Jedi, I’m joining Tom Fox in tying compliance and the Star Wars franchise together in some posts this week. Star Wars is about the rise of the evil galactic empire and the rebels who fight against it. I think some Bitcoin advocates are trying to be the rebels who portray the the Federal Reserve as the evil Galactic Empire. The battle is for freedom of money.

“This is a fantastic fundamental hedge and store of value against autocratic regimes and banking infrastructure that we know is corrosive to how the world needs to work properly,” said Chamath Palihapitiya, the founder of Social Capital and an early Bitcoin investor. “You cannot have central banks infinitely printing currency.”

In response to that, I give you this picture of the Treasury Secretary showing a new sheet of money to his wife dressed in Darth Vader garb. (Add a helmet and it’s complete)

Of course the Treasury is not the Federal Reserve and this printed money is not the same as the Federal Reserve buying bonds with money pulled out of thin air. Since we have entered a post-factual world in Washington, I’m not sure we need to let facts get in the way of a great picture.

The underlying technology of Bitcoin, blockchain, is a brilliant shared ledger. It has the ability to replace some proprietary databases of transactional information. I’m less interest in Bitcoin itself. Digital currency moves control of the currency from the central banks to computer servers.  While currency can be inflated be the central banks, Bitcoin is limited to a slow creation on the servers running blockchain.

As a naysayer, I failed to see the rise of Bitcoin. If I had a bought a few bitcoins when I first looked down my nose at it, I would have made a pile of cash.

The Federal Reserve, at the heart of the Galactic Empire, has pushed Bitcoin aside. Janet Yellen, the current Chair of the Board of Governors of the Federal Reserve System on Wednesday called Bitcoin a “highly speculative asset” and “not a stable source of value”, and “it doesn’t constitute legal tender.”  In response, Bitcoin did not back down and the exchange rate stayed stable. The empire would have to find other ways to attack cryptocurrency.

The rebellion has grown from Bitcoin to other cryptocurrencies. They are launching their attacks in Initial Coin Offerings. No initial coin offerings have been registered with the Securities and Exchange Commission as the sale of securities. They are operating outside the oversight of the SEC, failing to give purchasers/investors the protections that come with SEC registration and oversight.

If you invested in an ICO, should you be worried that the offering might be targeted by the SEC? Yes, you should be worried. That ICO is Alderaan and the SEC has the Death Star. A million voices will scream out about the injustice. So much real money and false value will be destroyed.

The SEC stopped an ICO this week for Munchee. Munchee was seeking $15 million to improve an existing iPhone app for restaurant meal reviews and to create an “ecosystem” in which Munchee and others would buy and sell goods and services using the tokens. The company emphasized that investors could expect that efforts by the company would lead to an increase in value of the tokens and it would take steps to create a secondary market for the tokens.  As the SEC has said in the DAO Report of Investigation, a token can be a security based on the long-standing facts and circumstances test that includes assessing whether investors’ profits are to be derived from the managerial and entrepreneurial efforts of others. The Munchee ICO was an illegal IPO.

The Empire of regulatory oversight has many factions. This week the IRS won a case against Coinbase, one of the largest digital currency brokers. The IRS claimed that virtual currency gains have been underreported based on the disproportionate number of taxpayers reporting gains from Bitcoin compared to the number of Coinbase account holders. Coinbase has approximately 5.9 million customers and has provided $6 billion in Bitcoin exchanges. However,  the IRS has identified only 800 to 900 taxpayers in each of the years from 2013 through 2015 who reported gains or losses that the IRS believes are “likely related to bitcoin.”

The battle will rage on. Rebel cryptocurrency against the regulated dollar. Which will allow you to buy a coffee at Dunkin Donuts? and which will you use?

See Tom’s posts:

Compliance Lessons From Star Wars – Lies

With the pending release of Episode VIII – The Last Jedi, I’m joining Tom Fox in tying compliance and the Star Wars franchise together in posts this week.

I’ve always been trouble by the lie from Obi Wan Kenobi to Luke Skywalker:

“Darth Vader betrayed and murdered your father.”

It’s the little lies that lead to bigger lies and bigger problems. Some of the ponzi schemes I see start with a sponsor telling a little lie about performance results. Then the sponsor is trapped chasing those untrue returns. That leads to bigger lies and bigger problems as the deficit between actual results and fictional results grow.

We saw the little lie growing with Bernie Madoff. Decades ago he missed his returns and lied about them. At some point he just gave up and didn’t pretend to chase the returns anymore. That became to a multi-billion dollar deficit between actual results and the fictional results he told investors.

Plenty of ponzi schemes are formed as frauds from the outset as a way to separate people from their money.  They start off with outlandish returns and promises of guaranteed results. There is a subset of these frauds that had started out with good intentions but misstep into these little lies that lead to downfall.

Obi Wan’s lie to Luke sends Luke into an ill-chosen battle with Darth Vader. Luke is seeking revenge for the death of his father. Things don’t go well for Luke in a battle against one of the fiercest warriors in the galaxy.

The cynic in me might point out that the lie was not intentional. Behind-the-scenes lore of the Star Wars franchise tells us that the plot turn in Empire Strikes Back, and told further in Episodes II and III, may not have been envisaged when Star Wars was made. For the pure of heart, we can assume the Kenobi was just trying to protect Luke from the truth.

Compliance Lessons From Star Wars – Hacked

With the pending release of Episode VIII – The Last Jedi, I’m joining Tom Fox in tying compliance and the Star Wars franchise together. Starting at the beginning with Star Wars, or what is now Episode IV – A New Hope, the climax is the destruction of the Death Star.

One of the complaints about the movie is the plot hole allowing “the ultimate power in universe” to be destroyed by a a group of small fighters. As we learned in Star Wars – Rogue One, the Death Star was hacked. The developer left a back door: a small, two meter-wide thermal exhaust port which would lead straight to the station’s main reactor.  The developer leaked the plans to rebels who launched their attack.

Clearly, the Securities and Exchange Commission is very focused on cybersecurity. Particularly, since the SEC’s EDGAR database was hacked last year. In speeches, actions and warning about exam priorities, the SEC puts cycbersecurity at or near the top of the list.

The focus on cybersecurity is not just to take the steps to harden your systems to prevent the hack, but creating a response plan in case you discover you are been hacked or have been hacked. Clearly, a flaw in the defense of the Death Star was not sending out enough imperial fighters to counter the rebel attack. The defense plan never expected an attack by small ships.

The death of Grand Moff Tarkin was not taking the threat seriously.

OFFICER
 We’ve analyzed their attack, sir,
and there is a danger. Should I have
your ship standing by?

TARKIN
 Evacuate? In out moment of triumph?
I think you overestimate their
chances!

Tarkin underestimated the chances and disappeared from the Star Wars movies until last year’s Rogue One prequel to Episode IV. Never underestimate a cyber-attack on your firm.

As many cybersecurity experts have told me, it’s not “if” you will be subject to an attack, it’s “when” you will be subject to a cyber-attack. Don’t suffer the imperial oversight failure of Tarkin. Be vigilant for weakness.

May the Force be with you.

Although Tom decided to ignore Episodes I-III in his posts, I will advocate for using the “machete order” for viewing the movies: IV, V, II, III, VI.

The key problem is that Mr. Lucas changed the end of VI so that Anakin is now played by Hayden Christensen. You will have no idea who that person is if you have not seen II or III. Plus II and III fill in the backstory of Anakin. You will note that Episode I, the worst of the movies, is left out. That removes Jar-Jar almost completely, removes midochlorians, and removes trade disputes. In return, you get a bigger universe, a better understanding of the threat posed by the emperor, and the redemption of Anakin.

 

 

Compliance Bricks and Mortar for December 8

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

ICO Enforcement Actions Threatened, ICO Lawsuits Proliferate By Kevin LaCroix

According to the latest update on the Coinschedule website (here), there have been a total of 228 initial coin offerings so far this year through mid-October, raising a total of over $3.6 billion. At least five of this year’s ICOs have raised over $100 million. This burgeoning activity notwithstanding, ICOs are at the center of controversy. Among other things, China and South Korea have banned ICOs. The SEC has already shown its willingness to pursue enforcement actions against ICO sponsors, as discussed further here. And now a high-profile statement by one of the country’s leading securities regulation experts suggests even greater scrutiny may lie ahead. In the meantime, as discussed below, ICO and cryptocurrency-related litigation appears to be proliferating. [More…]

See also:
Bitcoin futures are coming as CFTC gives blessing by William Watts
Bitcoin Is the World’s Hottest Currency, but No One’s Using It By Georgi Kantchev, Steven Russolillo, Paul Vigna and Christopher Whittall

What Makes a Safe Asset Safe? by Thomas Eisenbach and Sebastian Infante in Liberty Street Economics

Over the last decade, the concept of “safe assets” has received increasing attention, from regulators and private market participants, as well as researchers. This attention has led to the uncovering of some important details and nuances of what makes an asset “safe” and why it matters. In this blog post, we provide a review of the different aspects of safe assets, discuss possible reasons why they may be beneficial for investors, and give concrete examples of what these assets are in practice. [More…]

Using Side Letters in Private Funds by Alexander Davie in Strictly Business

For many fund managers, especially those early in their careers, obtaining capital and new investors is the biggest challenge, and so the temptation is great to accede to side letter requests from investors that are willing make a large investment in the fund. This can be especially true when the investor is demanding the side letter just prior to closing and may have the fund managers over a proverbial barrel. There are several risks that should be kept in mind when negotiating and drawing up such agreements. [More…]

IOSCO issues report on hedge fund statistics, trends By Amy Leisinger, J.D. in Jim Hamilton’s World of Securities Regulation

The International Organization of Securities Commissions (IOSCO) has published its biannual report on the global hedge fund marketplace, key regulatory changes, and the potential systemic risks posed by the industry. IOSCO’s survey assembles information from national authorities on hedge fund activities and is designed to enable regulators to share information and observe trends regarding exposure, leverage, liquidity management, funding, and trading activities in the hedge fund industry. [More…]

REIT controllers owed fiduciary duties to public stockholders by Joanne Cursinella, J.D. in Jim Hamilton’s World of Securities Regulation

Claims that certain defendants in a convoluted REIT scheme violated their fiduciary duties to stockholders survived a motion to dismiss. The court found that the plaintiff sufficiently alleged that the defendants set up a structure whereby they profited at the expense of the stockholders, maximizing the profits at the first entity they created to the detriment of the non-controlling stockholders of another entity they created and took public (RCS Creditor Trust v. Schorsch, November 30, 2017, Glasscock, S.). [More…]

France Gets Climate Risks Disclosures from Invest Firms by Mara Lemos Stein

France added momentum to the global push for greater climate risks awareness last year by requiring disclosures from not only companies but also institutional investors and asset managers. After the first year of reporting, governance mavens are encouraged by the level of compliance.

The energy transition and green growth law implemented in 2016 requires investors to report how they are integrating environmental, social and governance, or ESG, criteria in their portfolios; on their exposure to physical risks and risks caused by the transition to a low-carbon economy; and on steps being taken to align their firm’s decarbonization strategy with national and global emissions targets.[More…]