Category: Compliance Programs

Massachusetts Proposes New Regulations Related to Investment Adviser Representative Registration

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On March 15, 2013, the Massachusetts Securities Division started the process to amend the  regulations for investment adviser representative (“IAR”).

The proposal would require an IAR applicant to submit to a review of the Massachusetts Criminal Offender Record Information (CORI) of the applicant.

The Division believes that it is in the public interest and for the protection of investors to conduct criminal background checks of those individuals seeking IAR registration in order to ensure that the applicant is not subject to a statutory disqualification and has truthfully and accurately disclosed any criminal background required on Form U-4. The Registrations, Inspections, Compliance and Examinations (“RICE”) Section of the Division has recently been granted access to utilize the Massachusetts “iCORI system,” an electronic criminal history database, in order to conduct these reviews.

However, the CRD system for submitting Form ADV is not able to accept the required CORI acknowledgement. So Massachusetts registered investment advisers will have to send the form directly to the state regulators.

Also, Massachusetts is cleaning up its regulations as to Form ADV to comply with the SEC’s 2010 changes to the form. The proposed language is based upon the NASAA model brochure rule. Along with that ate a bunch of other small changes that clean up the Massachusetts investment adviser regulations.

The Request for Comment and the Proposed Regulations are available on the Division’s website at http://www.sec.state.ma.us/sct/sctidx.htm.

The comment period will end on Wednesday, May 15, 2013.  A public hearing on these proposed changes will be held at 10:00 a.m. on Wednesday, May 15 at One Ashburton Place, 17th Floor, Boston, MA 02108.

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No Extra Time for the SEC

Compliance, the SEC and the Supreme Court

The United States Supreme Court adopted a strict interpretation of the five-year period in which the Securities and Exchange Commission may seek to impose a civil penalty on a registered investment adviser. In Gabelli v. SEC the Supreme Court ruled that when the government acts in an enforcement capacity seeking civil penalties, it cannot benefit from the more lenient “discovery rule” standard available to private plaintiffs. That means the SEC needs to bring the case within five years of the fraud, not five years after the fraud is discovered.

In 2008, the SEC brought a civil enforcement action against Bruce Alpert and Marc Gabelli under the anti-fraud provisions of the Investment Advisors Act. The SEC sought civil monetary penalties based on market timing that it claimed had taken place from 1999 to 2002. Mutual fund manager Marc Gabelli and a colleague, Bruce Alpert, permitted the market timing, allowing select investors to buy shares at favorable prices to take advantage of pricing disparities in the securities held by mutual funds. As a result, the preferred investor reaped significant profits and ordinary investors suffered large losses.

The relevant statute of limitations 28 U.S.C. § 2462 states:

“Except as otherwise provided by Act of Congress, an action… for the enforcement of any civil fine, penalty or forfeiture… shall not be entertained unless commenced within five years from the date when the claim first accrued.”

Gabelli argued that the clock started running when the fraud happened, not when the SEC discovered the fraud. If Gabelli wins the argument, then the SEC took too long to bring the case.

The SEC argued for the benefit of the discovery rule, which had been used in Merck & Co. v. Reynolds, the private securities fraud class-action suit . “[S]omething different was needed in the case of fraud, where a defendant’s deceptive conduct may prevent a plaintiff from even knowing that he or she has been defrauded.”

The SEC did not agree with the SEC’s argument.

“[W]e have never applied the discovery rule in this context, where the plaintiff is not a defrauded victim seeking recompense, but is instead the Government bring ing an enforcement action for civil penalties. Despite the discovery rule’s centuries-old roots, the Government cites no lower court case before 2008 employing a fraud-based discovery rule in a Government enforcement action for civil penalties.”

The SEC looked to a 1918 case where the the government was entitled to the benefit of the discovery rule, Exploration Co. v. United States, 247 U. S. 435 (1918). However, in that case the government was the victim of the fraud. The government was not bringing an enforcement action for penalties.

The ruling points to the examination power of the SEC and its resources to root our fraud. The Supreme Court also found that proving the date of discovery would be difficult in a federal agency as big as the SEC.

The ruling is clearly a black eye for the SEC.

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Image of James Earle Fraser’s statue The Authority of Law, which sits on the west side of the United States Supreme Court building, on the south side of the main entrance stairs is by Matt Wade.
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Investment Adviser Certified Compliance Professional

IACCP Certification

Just tooting my own horn today. I finally fulfilled the requirement to become an Investment Adviser Certified Compliance Professional®.

With the SEC’s registration requirement for private fund managers, I took a closer look at what the SEC requires for compliance professionals.  Rule 206(4)-7 imposes no particular requirements on a chief compliance officer. The SEC release for the rule provides a bit a more context on the professional background requirements:

“An adviser’s chief compliance officer should be competent and knowledgeable regarding the Advisers Act…”

I  looked at several compliance programs but decided the Investment Adviser Certified Compliance Professional Program co-sponsored by the Investment Adviser Association and National Regulatory Services would be the best choice.

I assume this certification and designation would give me the right to say I am “competent and knowledgeable regarding the Advisers Act.”

The program is a lot of work: 20 courses and a test. The test was hard. I did not feel confident that I had passing marks when I handed it in. But apparently I did.

This was my lineup of courses, all of which were well run:

  • Introduction to the Advisers Act
  • Books and Records Requirements for Investment Advisers
  • Insider Trading, Contracts and Form ADV Deilvery Req.
  • Understanding Fiduciary Duties, Sweep of Anti-Fraud Prov
  • Custody, Pay to Play, Solicitors and Proxy Voting Anti-Fraud Rules
  • Compliance Programs Rules
  • IA Codes of Ethics
  • Prof. Ethics: Ethical Decision-Making for Compliance
  • Form ADV Part 1- Annual Updating Amendment and More
  • Form ADV Part 2: Identifying and Disclosing Conflicts-
  • Critical Skills for High Performance Compliance Profes
  • Investment Adviser Performance and Advertising
  • Investment Adviser Regulatory Update
  • Anti-Money Laundering Risk Management and Monitoring
  • Safely Embracing the Power of Social Media
  • Defensible Due Diligence for Investment Advisers and Hedge Funds
  • A Tailored Compliance Testing Program for IAs
  • SEC Examinations for Investment Advisers
  • Trading Practices, Portfolio Compliance and Related Enforcement Cases
  • RIA Year-End Compliance Check-Up

More on the Investment Adviser Certified Compliance Professional Program.

Do You Fit In?

do you fit in

Sometimes you have to feel like compliance does not fit into the overall strategy of the business.

It’s not that a business should operate out of compliance. It’s just that compliance can feel like a misaligned part of the business. The vast majority of employees want to operate within the normal boundaries of the law and good business practice.

Sometime compliance programs come from fear rather than planning. The focus of the program may be misaligned based on that fear and ignore more important risks.

Regulatory requirements may require you to focus on issues that are meaningless risks to the company. You may be stacking up paperwork in your office as a defensive wall in case the regulators suddenly knock on your door. You meet the four corners of the regulatory requirements, but miss the more important risks

You may ask for certifications that leave employees scratching their heads as to the relevance of the answers.

The sometimes elusive goal is to have compliance integrated into the structure of the firm.

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View of house between two casinos – Town of Atlantic City, North end of Absecon Island, South of Absecon Channel, Atlantic City, Atlantic County, NJ by Jack E. Boucher from the Historic American Buildings Survey/Historic American Engineering Record/Historic American Landscapes Survey Collection at the Library of Congress

Have You Disclosed Your Derivatives Positions?

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The Securities and Exchange Commission filed charges against a fund manager and its subadviser for their extensive use of derivatives. From April 2007 through October 2008, the Fiduciary/Claymore Dynamic Equity Fund engaged in derivative strategies to supplement the Fund’s primary investment strategy. But the Fund failed to include adequate disclosure about the risks to the Fund arising from the Fund’s use of derivatives, either in its annual report or in an amended Fund registration statement.

The Fund’s primary investment strategy was to invest in equities and write call options on a substantial portion of those equities. This covered call strategy trades upside potential in the equities held in the portfolio for current income from option premiums received.

Things changed in April 2007 when the Fund supplemented its income and returns by writing out-of-money S&P 500 put options. The Fund collected a premium from the purchaser of the option, and in exchange agreed to compensate the purchaser for any declines in the S&P 500 beyond the strike price of the option. Between April 2007 and August 2008, the Fund collected $9.6 million in premiums from written put options. For the six months ending May 31, 2008, written put options  added approximately 2.1% to the Fund’s return.

Then the financial markets collapsed in October 2008. The Fund lost  $45,396,878, or 45% of the Fund’s NAV in its undisclosed derivates strategy.

The Fund was a registered investment company so some of the violations stem from the failure to make proper disclosures under the Investment Company Act. The SEC also found violations under the anti-fraud provisions of the Investment Advisers Act, Section 206(4) and Rule 206(4)-8. Those provisions prohibit the making of any untrue statement of a material fact or the omission of a material fact necessary to make statements made not misleading, or to otherwise engage in any act, practice, or course of business that is fraudulent, deceptive, or manipulative with respect to any investor or prospective investor in a pooled investment vehicle.

If derivatives are substantial part of a fund’s portfolio, it sounds like the SEC expects you to disclose that fact to investors.

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How Effective is Your Gate?

tight security

Does your compliance program sometime feel like this gate? A tool working alone is not necessarily effective. It may be a great tool, but still not be effective.

If it’s easy to get around then it’s not effective. Do you even know if people are going around? Is it even possible to know if they are going around?

Sometimes you have a great tool, but the tool does not work for your organization.

Image from There I Fixed It.

Compliance Bricks and Mortar for January 11

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

On the lighter side there has been a bit attention focused on a presidential appointment. Jack Lew, President Obama’s reported pick to replace outgoing Treasury secretary Tim Geithner, has drawn some unusual scrutiny because of his signature. Jack Lew’s Terrible Signature May Grace Dollar Bills Now by Kevin Roose

A lesser-known but extremely pertinent fact about Lew is that he has the world’s worst signature. And pretty soon, that signature could be on every single one of your dollar bills.

If Lew is confirmed as Treasury secretary, his signature will occupy the lower-right-hand spot on U.S. paper currency. And that signature, which was widely mocked when it surfaced on a September 2011 memorandum, is legitimately crazy.

Fu Manchu and the Wal-Mart FCPA Investigation Water Torture by Tom Fox

I thought of Fu Manchu and his infamous drip, drip, drip water torture when I read the latest news about the ongoing Wal-Mart Foreign Corrupt Practices Act (FCPA) investigation. Yesterday, I read three articles about the most recent revelations in Wal-Mart’s ongoing PR nightmare. Renee Dudley, reporting in Bloomberg, in an article entitled “Wal-Mart CEO Knew of Mexico Bribery, Congressmen Say”, wrote that “Democratic Representatives Henry Waxman of California and Elijah Cummings of Maryland said today in a statement that documents obtained by their staffs show that Duke and senior Wal-Mart officials were informed about allegations of corruption regarding a store in Teotihuacan.”

Year In Review Roundups by the FCPA Professor

Viewing FCPA enforcement in the aggregate is of course also useful and informative and this post begins by aggregating the previous DOJ and SEC FCPA enforcement facts and figures from 2012. After providing various aggregate facts and figures, this post concludes with a roundup of other year in reviews.

‘They Owe It to Me’: FBI Identifies Top Email Phrases Used by Fraudsters by Bruce Carton in Compliance Week

According to research conducted by Ernst & Young in collaboration with the FBI, these phrases are among the top terms used by employees in emails discussing fraud. E&Y has developed software that companies can use to monitor employees’ emails for these phrases and approximately 3,000 other words and phrases that are commonly used in emails by people committing fraud.

Getting Comfortable With an Uncertain World by Matt Kelly in Compliance Week

If you’re going to read one book at the start of this year to improve your understanding of the world and the compliance professional’s role in it, read The Signal and the Noise by Nate Silver. It’s been on the best seller list since its debut last September, and I finally opened a copy the other day. Before I finished even Chapter 1, I could see why the book has been so popular, and why it can be so useful for those of us who make a living in the corporate compliance world.

Suspicious Activity Reports and Private Funds

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Over the years, the Financial Crimes Enforcement Network (FinCEN) has required banks, brokers, and other financial entities to officially report suspicious activities of its customers. Investment advisers and private fund managers have managed to sty outside the requirements. In large part, that’s because a fund’s custodial accounts are already subject to the self-policing. since the account is with a broker subject to the FinCEN requirements.

But changes are coming. James H. Freis, Jr., Director of the FinCEN, let us know that his agency is working on anti-money laundering requirements for investment advisers. At a November 15, 2011 speech at the American Bankers Association/American Bar Association’s Money Laundering Enforcement Conference he raised the issue and mentioned that a new rule is in the works.

Reuters is reporting that a proposed rule is likely to come out in the first half of 2013. The rule would likely address anti-money laundering concerns. Although that may be an issue for some types of funds, it’s not a concern for most private funds. Once you limit redemption rights, you make the investment very unpalatable for drug kingpins and other bad guys trying to hide their money. They are not typically patient investors looking for long term returns.

Hedge funds were thrown into the bucket of “shadow banking” and private equity firms were labeled as “vulture funds” during Romney’s presidential campaign. It looks like the federal government will continue to pile regulatory requirements on private fund managers for the foreseeable future.

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Do You Have Skin in the Game?

skin in the game

If you tell investors that you have skin in the game, you need to have skin in the game. For the second time this year, the SEC has brought an enforcement action against a private fund for falsely informing investors that the Managers had skin in the game. Most investors want a manager’s executives to invest in the fund right alongside investors.

Don’t say it, if you don’t do it.

The most recent enforcement action was brought against Aladdin Capital Management, Aladdin Capital and a former executive, Joseph Schlim. All parties consented to the administrative orders, but neither admit nor deny the charges.

“[w]hy is an investor better off just investing in Aladdin sponsored CLOs and CDOs?” Aladdin answered by emphasizing that the “most powerful response I can give to your question is that Aladdin co-invests alongside MAST investors in every program. Putting meaningful ‘skin in the game’ as we do means our financial interests are aligned with those of our MAST investors.”

An inherent conflict in the transactions is that Aladdin was collecting a placement fee for much of the equity going into the deal. By reserving 10% for itself, it was losing 10% of its potential commission. Presumably, they could have taken that commission as equity in the deal instead of cash. But the product was packed with sub-prime mortgages and garbage debt.

Back in May, the SEC brought a similar administrative proceeding against Quantek Asset Management LLC for misleading investors about whether its executives had personally invested in its fund.

The two cases show that the SEC is will not tolerate misrepresentations in this area:

“If you sell an investment with the pitch that you are co-investing and have ‘skin in the game,’ then you better actually have ‘skin in the game…. Such a representation by an investment adviser or broker-dealer is an important consideration to investors in complex products.” Robert Khuzami, Director of the SEC’s Enforcement Division

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