Category: Compliance Programs

Backtesting Performance Failure

f squared

One area of performance advertising that the Securities and Exchange Commission has given great scrutiny, but not banned, is using backtested performance. Since, backtesting only shows theoretical past trades, it does not involve market risk. That means it’s inherently suspect. You can just keep fine-tuning the model to maximize results, with no ability to carry that forward to maximize returns going forward.

The SEC delivered a Christmas enforcement present to F-Squared Investments and its co-founder Howard Present for failures with back-tested performance.

There were two failures. One was that F-Squared failed to disclose that the past performance advertised was based on back-tested performance and not actual trading. Second, the past performance was incorrectly calculated. In reading the settlement documents for the case it looks like the problem originated with the data sources for the F-Squared AlphaSector index. It relied on a third-party data provider to generate the trading models.

F-Squared advertised that $100,000 invested on April 1, 2001 would have been worth $235,000 on August 24, 2008.

There were two problems with that statement. F-Squared was not in existence until 2006 and did not use this trading model until 2008. F-Squared failed to disclose that the performance was based on backtested performance.

The second problem was that the calculation was incorrect. In compiling the past performance the data provider was off by a week on each trade. That actual performance would only have been $138,000 if the past performance was calculated correctly. (Merely taking the broad bet by investing in S&P 500 ETFs would have resulted in $128,000.)

According to the complaint, Mr. Present tried to get better back up for the past performance methodology. That arose again during a 2012 mock audit. When he sought the information again, he discovered that the data model was created by a 20 year old former intern who would have only been 14 in 2001. It was at that time that Mr. Present discovered the dating problem with the past performance.

The SEC has not come out and said the backtested performance is not allowed by investment advisers and fund managers. It has addressed the issue in at least four other enforcement cases. In the F-Squared case, the SEC did not say that the backtesting was by itself was fraudulent, deceptive or manipulative. It was the incorrect calculations and disclosure failure that was fraudulent, deceptive or manipulative.

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Stealing From Investors Through Fraudulent Expenses

sec-seal

The Securities and Exchange Commission charged a hedge fund manager, his investment advisory firm, and an employee with stealing from investors in two hedge funds. The theft was carried out by charging more than $1 million for fraudulent research expenses and fees.

According to the SEC complaint, Steven R. Markusen, the owner of Archer Advisors LLC, and an employee, Jay C. Cope, diverted investor’s money from the funds for fake research expenses. They have not settled with the SEC so I only have the government’s side of the case.

The SEC accused Markusen of charging fund investors twice for the same fake research expenses. First, he billed the funds directly for Cope to conduct “research” for the funds. Second, they diverted soft dollars from the hedge funds to Cope for the same “research”, claiming Cope was an independent consultant. The soft dollars were supposed to be used to buy third-party investment research that benefited the funds.

According to the complaint, Markusen was using the expense reimbursements to pay Cope’s salary. The fund documents required employees to be paid by the fund manager. Archer was trying to disguise the salary as research payable by the fund.

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SEC Issues Second Exemptive Relief from Pay-to-Play

compliance politics and money

It’s been about a year since the Securities and Exchange Commission granted its first exemptive order Rule 206(4)-5 when an adviser accidentally violated the pay-to-play rule. The SEC has now issued its second relief order. Ares Real Estate Management Holdings filed for exemptive relief after a senior partner wrote a $1,100 check to Colorado Governor John Hickenlooper’s campaign.

The Colorado governor appoints members to the Board of Trustees for Colorado’s pension system. That system was investor in one of Ares’ older funds.

Ares had compliance policies and procedures that require pre-approval of all political contributions. The employee thought the limitation didn’t apply in this situation because the adviser was not seeking new investments from the Colorado public pension fund.

The Colorado system had not made a new investment in an Ares fund since 2007. That’s six years before the contribution was made and three years before Hickenlooper was elected governor.

Since it’s a closed-end private fund, the investor has no right to redeem and is locked in for the fund’s duration.

After finding the problem, Ares put the fees into escrow pending an outcome of the exemptive order. Ares also walled that employee off from the Colorado investment to avoid tainting the relationship.

A big pile of cash was at stake for Ares. Over $1 million in fees could be generated over the two year ban.

It is great that the SEC granted the relief. But the case is an example of the problem with the Rule 206(4)-5. It is too broad. The contribution amounts were relatively small and had no connection to the investment.

Money in politics is a problem. It’s noble that the SEC has taken a stance. However, it’s contrary to the current law that political contributions are considered free speech. the SEC is taking a big club to the problem.

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Cheating Your Way to Marathon Victory

rosie ruiz

Tabitha Manning ran the Chickamauga Battlefield Marathon setting a personal best record time of 2:54:21. But it looks like she pulled a Rosie Ruiz.

For those of you not familiar with the history of the Boston Marathon, Rosie Ruiz was declared the winner of the 1980 Boston Marathon with a time of 2:31:56. At that time, it was one of the fastest female marathon runs. Currently, the female elite runners leave before the men. In 1980, women were back in the pack and harder to track.

Ms. Ruiz raised some red flags during her post-win interviews. She didn’t seem as fatigued or covered in sweat as the other competitors. A few people came forward and stated that they saw Ms. Ruiz burst from the crowd on Commonwealth Avenue in the last mile of the marathon. Race officials took away her olive wreath crown and title.

As a result of Ms. Ruiz’s hijinks marathons began using RFID chips to track a runner’s progress on the course. That makes it easier to see if a competitor has jumped on the train to reach the finish instead of running.

That chip marks when you cross the start line and the finish line. For most races it will mark your time at other places along the course.

Going back to Ms. Manning, she seems to have exploited the Chickamauga Battlefield Marathon’s use of only a mid-race split in addition to the start and finish. In looking at the course, it runs two laps around the battlefield park. But there is a road right down the middle.

The chip show Ms. Manning running a 2:54 marathon, but 2:06:51 for the first half and 47:30 for the second half.

That’s a big burst of speed.

Or a quick car ride.

Race officials could also check Ms. Manning’s previous running times and see that the first half time was closer to her previous races.

Ms. Manning was disqualified and Lillian Gilmer was crowned the winner.

When people wonder how design a control, that marathon chip is an excellent example. It marks your progress around the course to make sure that you are not taking shortcuts. The Chickamauga Battlefield Marathon organizers went cheap on the controls. As a result there was only one place (maybe two places) where the chip was scanned. That allowed Ms. Manning to use a shortcut.

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Compliance Bricks and Mortar for October 24

bricks 40

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

SEC Charges Athena Capital in First HFT Case in the Corporate Crime Reporter

The Securities and Exchange Commission (SEC) has sanctioned a New York City-based high frequency trading firm for placing a large number of aggressive, rapid-fire trades in the final two seconds of almost every trading day during a six-month period to manipulate the closing prices of thousands of NASDAQ-listed stocks.

Why High-Frequency Trading Is So Hard to Regulate by Peter J. Henning in DealBook

The challenge in pursuing charges against these firms is that they are taking advantage of changes in the technology underpinning the markets to profit from quick trades, which is not illegal. But regulators can find it difficult to draw the line between acceptable trading strategies and manipulation because of the complexity of the strategies.

SEC Breaks Down FY 2014 Enforcement Results, Highlights by Bruce Carton in Compliance Week

Late last week, the SEC issued a press release summarizing its enforcement results for the agency’s fiscal year 2014, which ended September 30, 2014. The SEC emphasized that it filed a record 755 enforcement actions in FY 2014, and that these cases “included a number of first-ever cases, including actions involving the market access rule, the ‘pay-to-play’ rule for investment advisers, an emergency action to halt a municipal bond offering, and an action for whistleblower retaliation.”

Association for Corporate Growth’s Compliance & Regulatory Survey

association of corporate growth

The Association for Corporate Growth released a report identifying the top compliance and regulatory concerns impacting small and midsize private equity firms. The results are unsurprising, but reinforce concerns.

The top five regulatory issues were found to be:

  • SEC Examinations (75%)
  • Investment Adviser Act Compliance (66%)
  • Valuation Issues (58%)
  • General Solicitation rules (54%)
  • Legislation (tax reform, carried interest) (50%)
  • Allocation of Fees and Expenses (50%)

The Investment Adviser Act compliance item included custody, recordkeeping and reporting. I’m not sure if that includes marketing limitations.

I was surprised that political contributions and the pay-to-play regulations only gathered 24.6%. That’s the one that keeps me up at night.

I was not surprised that SEC examination was the top vote-getter. An exam is a pain in the neck and there can only be bad things from it. No investor is going to make a decision because the firm had a positive exam. But you may lose a potential investor if you have a bad exam.

ACG also probed deeper on SEC examinations. Of the 158 votes for that concern, 57 had been examined. Many of the firms who indicated they were examined in 2012 and early 2013 indicated that their examiners were not familiar with the private equity business model. Those firms examined in 2014 generally indicated that their examination was conducted efficiently, and/or they comment that the examiners appeared familiar with private equity. Only one person commented that the examiners were more combative than necessary.

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Don’t Forge Documents You Give to SEC Investigators

failure

You’re bound to make a mistake. Don’t make the mistake even worse by faking a document you submit to the Securities and Exchange Commission in order to cover your original mistake.

Back in 2012, the SEC brought charges against Waldyr Da Silva Prado Neto, a citizen of Brazil who was working for Wells Fargo in Miami. He was accused of illegally trading in the stock of Burger King after he learned of an impending private equity transaction.

Wells Fargo admitted to compliance weaknesses and paid a $5 million fine in connection with that supervision failure. In connection with that failure’s administrative order, the SEC expressed its displeasure with a delay in production of the documents and the state of the documents.

When the documents were produced, the firm failed to produce an accurate record of the review as it existed at the time of the staff’s request. Instead, the firm produced a document that had been altered by an employee after the Commission staff issued its follow up request. When questions arose surrounding the altered document, Wells Fargo Advisors placed the employee on administrative leave and eventually terminated this employee.
That failure probably resulted in the SEC enforcement action and a bigger fine for Wells Fargo.
The other shoe dropped. The SEC brought charges against Judy K. Wolf, the ex-Wells Fargo employee, for faking the document.
The SEC alleges that Wolf was responsible for reviewing  Waldyr Da Silva Prado Neto trading records in 2010 in connection with the Burger King trades. She reviewed the trading records and closed her review with no findings. The SEC alleges that Wolf altered her review report in 2012 after the insider trading charges were filed. She made it look like her review was more thorough than it actually was.
The Order notes some of the red flags according to the Wells Fargo “look back” policy:
  • Prado and his customers represented the top four positions in Burger King securities firm-wide;
  • Prado and his customers bought Burger King securities within 10 days before the acquisition announcement, including on the same days;
  • The profits by Prado and his customers each exceeded the $5,000 threshold specified in the look back review procedures;

What did her in was an additional note in the log:

“09/02/10 opened 24% higher@ $23.35 vs. previous close of $18.86. Rumors of acquisition by a
private equity group had been circulating for several weeks prior to the announcement. The
stock price was up 15% on 9/1/12, the day prior to the announcement.” (My emphasis)

Wolf made a typo on the announcement date. According to the order, she argued that it was merely a contemporaneous type, but admitted in later testimony that she had made that additional log note after the SEC investigation. Wells Fargo was able to produce earlier copies of the log that did not have those two sentences.

Wolf tried covering her mistake, but it blew up into a bigger problem. Wells Fargo fired her and the SEC brought charges against her personally.

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Weekend Reading: Issues Related to State Voter Identification Laws

voter id

The claim by advocates of voter identification laws is that the requirement is put in place to prevent voter fraud. The question is whether it is too burdensome to mandate a state-issued photo ID. The underlying subtext is that Republican controlled state legislatures are putting the voter ID laws in place because it will disproportionately affect likely Democratic voters.

The non-partisan Government Accountability Office studied the effect of photo ID laws and produced a report: Issues Related to State Voter Identification Laws (.pdf).

As part of its study, the GAO reviewed some existing studies. Five of these 10 studies found that ID requirements had no statistically significant effect on turnout; 4 studies found a decreases in turnout; and 1 found an increase in turnout that were statistically significant.

The GAO decided to run its own review of data and tried to find ways to compare the effect of voter turnout, controlling for issuing like hotly contested elections. The GAO used Kansas and Tennessee and benchmarked them to several other states that had not passed voter identification laws.

The GAO comes to the conclusion that voter turnout is reduced by 2-3 percent.

voter turnout effect

GAO found that turnout was reduced by larger amounts by age. Those between the ages of 18 and 23 than among registrants between the ages of 44 and 53 were less likely to vote. The turnout effect was 7.1% larger.

For those who had been registered less than 1 year the reduction was 5.2% greater than among registrants who had been registered 20 years or more.

For African-American registrants the reduction was 3.7% greater than among White, Asian-American, and Hispanic registrants.

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Other reports on the effects of Voter ID Requirements:

Compliance Bricks and Mortar for October 10

Arvika, Sweden. Gamla posten, brick wall

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

Yet Another Study Debunks ‘Revolving Door’ Worries by Bruce Carton in Compliance Week

Although I have followed the revolving door issue closely for many years, I have never seen any actual evidence that the “SEC lawyers will go easy on firms to get a future job” theory is, in fact, true. Not only is it contradicted by my own personal experience as an SEC attorney (as I discussed here back in 2009), but it is, more importantly, contradicted by no fewer than three academic studies completed in the past two years.

Whistleblowers Fight Over SEC Award by   in Dodd-Frank.com

In a case filed in the United States District Court for the Northern District of Illinois, Eastern Division, the plaintiff claims three persons collaborated to develop evidence for a whistleblower claim. The three allegedly planned to make the whistleblower submission in the name of a jointly owned entity. After reading Rule 21F-2, which states only natural persons, and not entities, may be whistleblowers, the three allegedly changed their plans and determined that the defendant would submit the claim and the three would share in the proceeds. The SEC ultimately awarded the defendant $14.7 million. The defendant allegedly reneged on the promise to share the award. The defendant allegedly settled with one of the other two, and the third commenced the action.

If the Word ‘How’ Is Trademarked, Does This Headline Need a ™? by Jonathan Mahler in the New York Times

The other thing that distinguishes this case from a typical trademark dispute is that it is thick with irony: One company is accusing another of stealing its platform for ethical behavior.

The Empire of Edge: How a doctor, a trader, and the billionaire Steven A. Cohen got entangled in a vast financial scandal by Patrick Radden Keefe in the New Yorker

The business model at S.A.C., though, was based not on instinct but on the aggressive accumulation of information and analysis. In fact, as federal agents pursued multiple overlapping investigations into insider trading at hedge funds, it began to appear that the culture at S.A.C. not only tolerated but encouraged the use of inside information. In the recent trial of Michael Steinberg, one of Cohen’s longtime portfolio managers, a witness named Jon Horvath, who had worked as a research analyst at S.A.C., recalled Steinberg telling him, “I can day-trade these stocks and make money by myself. I don’t need your help to do that. What I need you to do is go out and get me edgy, proprietary information.” Horvath took this to mean illegal, nonpublic information—and he felt that he’d be fired if he didn’t get it.

Lawsuit on SEC’s Political Contribution Rule Hits Some Snags

USDC for DC Meade_and_Prettyman_Courthouse

The New York Republican State Committee and the Tennessee Republican Party brought suit against the Securities and Exchange Commission challenging its political contributions rule for investment advisers, . The complaint seeks an injunction against the enforcement of the rule’s political contribution restrictions on contributions to federal candidates.

The US District Court for the District of Columbia dismissed the case. But not all is lost in Mudville. The decision hinged on whether the District Court or the Court of Appeals should have jurisdiction over the case.

The District Court found that the political contributions rule is an “order” for purposes of the Investment Advisers Act. That means the proper venue is the Court of Appeals. That means that the New York Republican State Committee and the Tennessee Republican Party merely have to refile the case in the Court of Appeals.

However, the District Court raised the issue of standing that may come to haunt the New York Republican State Committee and the Tennessee Republican Party. As political organizations, they are not directly affected by the rule. It’s really the candidates and the regulated advisers who are hurt by the rule. The party organizations failed to allege any specific facts that show a decline in contributions because of the political contributions rule.

The party organizations did point to State Senator Lee Zeldin, a candidate for the U.S. House of Representatives as an individual who was harmed by the rule.

I thought this would be a tough case to win on the merits. It may never get to the merits because of the jurisdiction and standing issues.

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