Category: Compliance Programs

Warren Back in Washington

The last time Washington saw Elizabeth Warren, she was thrown out of town for her strong advocacy of the Consumer Financial Protection Bureau. The Dodd–Frank Wall Street Reform and Consumer Protection Act established the CFPB. Warren is credited with creating the CFPB, tirelesslessy lobbying for its inclusion in Dodd-Frank, and worked on implementation of the bureau as a Special Assistant to the President in anticipation of taking over as director. However, Warren was seen as overly aggressive in pursuing regulations, and was not nominated for the position.

Last night, she grabbed a Massachusetts Senate seat away from Scott Brown and will be returning to Washington as a US Senator.

The next test will be her Senate assignment. Will Senate leaders dare to give her a seat on the Senate Banking Committee? Will she be the one grilling the head of the Consumer Financial Protection Bureau?

Sources:

Sandy and Disaster Preparedness

Disaster recovery is an important, though not explicitly mandatory, component of compliance program. The Securities and Exchange Commission alludes to this in the release for the compliance rule. It’s also a key part of personal plan. I’m learning that first hand.

My family is spending its third day without power. Fun and exciting at first, it has become troublesome. A shower by candlelight is much less romantic when doing so to get ready for work. Fortunately, it’s warm in Boston so the lack of heat is not a problem.

There are many worse off than me and we escaped unscathed, other than the little wire connecting our house to the world. My hearts go out to those battling much worse damage.

Aberrational Performance Inquiry of Nabs Another Private Fund Manager

The SEC has once again claimed that its Aberrational Performance Inquiry has identified another miscreant. Once again, I’m skeptical that the SEC is actually using “proprietary risk analytics” to identify hedge funds with suspicious returns.

The SEC alleges that Yorkville Advisors overstated the value of the assets in its funds to improve marketability and increase fees. According to the SEC complaint, the failure was two-pronged: one of misstatements and a second failure to follow the funds’ own policies and procedures on valuation. Yorkville denies the charges. Yorkville claims to have maintained “robust control procedures” to ensure that assets were valued properly, including having two former SEC enforcement lawyers as members of Yorkville’s valuation committee.

The lesson from the complaint is to follow your own policies and procedures when it comes to valuation and don’t hide information from your auditors.

According to the SEC press release, this is the seventh case arising from the “SEC’s Aberrational Performance Inquiry, an initiative by the Enforcement Division’s Asset Management Unit that uses proprietary risk analytics to identify hedge funds with suspicious returns.” I have seen four other cases, but I’m not sure I can identify the other two cases.

Robert Khuzami, the Director of the Division of Enforcement for the SEC revealed an investigative initiative concerning hedge funds during Congressional testimony in March, 2011.  The Aberrational Performance Inquiry program is now focusing on hedge funds that outperform “market indexes by 3% and [are] doing it on a steady basis.”  Khuzami referred to such performance as “aberrational,” and stated that Enforcement is “canvassing all hedge funds” for such “aberrational performance.

Yorkville disclosed that the SEC started looking at it in August, 2009. That’s almost two years before the Aberrational Performance Inquiry program was announced and only six months after Khuzami joined the SEC. That timing leaves me skeptical that the Aberrational Performance Inquiry program discovered the issues with Yorkville. In addition, Yorkville made investments in equities and debt so there is not a good index to benchmark the funds’ performance to determine if it is “aberrational.”

I have no doubt that the SEC is looking closer at the performance of private funds to see if the performance numbers make sense given the markets and a fund’s investment strategy. That is a direct result of the aberrations in Madoff’s performance.  And I have no doubt that there is group in the SEC looking at performance and worked on the Yorkville case.

And I have no doubt that the SEC is taking a closer at private equity funds and hedge funds. At a minimum, the SEC has a window into these fund now that fund managers have registered with the SEC.

Sources:

Why Have a Compliance Program?

I’m working on presentation for a continuing education program and decided to step back and look at the basics. I went all the way back to “why?”

You Are Required

Sometimes the answer is easy. You have to have a compliance program. Your company is in a heavily regulated industry that explicitly requires a formal compliance program. Or your industry is subject to big regulatory overhead and implicitly requires a formal compliance program.

For an example, see the SEC’s Investment Advisers Act Rule 206(4)-7. This rule explicitly requires a firm to appoint a chief compliance officer, implement a program, and it review it annually.

Defense – Federal Sentencing Guidelines

Another reason to have a compliance program is to reduce the repercussions of federal prosecution for illegal behavior. Under the Federal Sentencing Guidelines, a convicted organization is eligible for a reduced sentence if it had an effective compliance and ethics program in place at the time of the offense.  The Guidelines spell out several features that a compliance program must have for the organization to receive this credit.

Satisfying the requirements in the Guidelines for an effective compliance and ethics program is widely viewed as an important step in (i) avoiding prosecution altogether, (ii) positioning a corporation to advocate for a non-prosecution or deferred prosecution agreement, and (iii) mitigating the fine that must be paid if a non-prosecution or deferred prosecution agreement is negotiated.

Response to Crisis

Compliance programs can originate from a crisis facing an organization. Either because of prosecution or narrowly missing prosecution, the organization decides to implement a program to prevent the problem from happening again.

For an example, see the Federal Bureau of Investigation’s Integrity and Compliance Program. According to the FBI’s Patrick Kelley, the FBI’s Chief Compliance Officer in the Office of Integrity and Compliance, the Bureau’s program was modeled after corporate compliance programs. The precipitating event was a Congressional hearing on the possible abuse of National Security Letters by the Bureau. In addition to monitoring this one risk, the compliance program has been expanded to include the top 50 risks. These risks extend beyond core operations to things such as OSHA compliance.

Whistleblowers

With the passage of the Dodd-Frank Financial Reform and Consumer Protection Act, there is a new program to reward whistleblowers. Under the new program eligible whistleblowers are entitled to an award of between 10% and 30% of the monetary sanctions collected in actions brought by the Securities and Exchange Commission and related actions brought by other regulatory and law enforcement authorities.

Expect a dramatic increase in employees coming forward to report wrongdoing within their companies. The recent award of over $100 million to a whistleblower will surely increase the awareness of whistleblower financial rewards.

Reduce Risk and Deter Bad Behavior

A compliance program may not prevent all problems from occurring. If a problem arises, a good compliance program may isolate the incident and defer further prosecution.

For an example, see the SEC’s complaint against Garth Peterson. Mr. Peterson was a Managing Director of Morgan Stanley, located in Hong Kong and running the firm’s Chinese real estate investments. Mr. Peterson was accused of violating the Foreign Corrupt Practices Act and other illegal actions.  Starting in Section 23 of the complaint, the Department of Justice details many of the steps Morgan Stanley took to comply with the Foreign Corrupt Practices Act.

The program failed to prevent Mr. Peterson’s illegal behavior, but it did convince the Department of Justice not to prosecute the firm itself.

Sources:

Federal Sentencing Guidelines Section 8b2 – Effective Compliance and Ethics Program
http://www.ussc.gov/Guidelines/2011_Guidelines/Manual_PDF/2011_Guidelines_Manual_Full.pdf

SEC’s Complaint against Garth Peterson
http://www.sec.gov/litigation/complaints/2012/comp-pr2012-78.pdf

SEC’s Office of the Whistleblower – Frequently Asked Questions
http://www.sec.gov/about/offices/owb/owb-faq.shtml

SEC’s Investment Advisers Act Rule 206(4)-7
http://www.sec.gov/rules/final/ia-2204.htm

Federal Bureau of Investigation’s Integrity and Compliance Program
http://www.justice.gov/oig/reports/2011/e1201.pdf

Compliance Bits and Pieces – Private Fund Advertising Edition

Last week’s release of the SEC’s game plan for allowing advertising for the private placement of securities will cause a big shift in what the public is able to see. As stated in the release of the proposed rule, the private market is nearly as big as the public capital markets. In 2011, $895 billion was raised through Rule 506 private placements while only a bit more, $984 billion was raised in registered offerings. This trend has been true for several years for Regulation D fund raising. Here is a round up of commentary on the proposed rule:

Proposed Rule Regarding General Solicitation and Advertising by Mary L. Schapiro in the Harvard Law School Forum on Corporate Governance and Financial Regulation

I believe that the proposed rules fulfill Congress’s clear directive that issuers be given the ability to communicate freely to attract the capital they need, while obligating them to take steps to ensure that this ability is not used to sell securities to those who are not qualified to participate in such offerings.

Increasing the Vulnerability of Investors by Luis A. Aguilar in the Harvard Law School Forum on Corporate Governance and Financial Regulation

I cannot support the proposal, because it presents a framework that is not balanced and that fails to address the acknowledged increased vulnerability of investors. In fact, there is no consideration of any of the commenters’ proposals that would have decreased investor vulnerability.

Sen. Levin Urges SEC to Enhance Investor Protections in Proposed Rules Implementing JOBS Act Ending of General Solicitation in Jim Hamilton’s World of Securities Regulation

Senator Carl Levin (D-MI), Chair of the Senate Investigations Subcommittee, urged the SEC to improve the investor protection aspects of proposed regulations implementing the elimination of the ban on general solicitation in Regulation D effected by the Jumpstart Our Business Startups (JOBS) Act. In his statement, the Senator specifically asked the SEC to require those who advertise private deals to take steps to ensure that investors have the information and expertise to make these risky investments. The Commission should also require that the content of the advertising satisfies some minimum standard, such as those that mutual funds are currently subject to. The proposed regulations do neither, said Chairman Levin, adding that they undermine investors protections, put at risk the investments of ordinary citizens, and ignore years of experience and law.

New SEC Rules Practically Require Hedge Funds To Advertise On DealbreakerBy

The day when you can advertise your hedge fund on Dealbreaker creeps ever closer, so claim your spot now because they are going fast.* The SEC has shown some justifiable skepticism about implementing the JOBS Act, and at least SEC-ster thinks that it’s been dragging its feet on the hedge fund advertising rules, but still, it has to be said, when the SEC was told to let you advertise your hedge fund, they really let you advertise your hedge fund. Soon you will be able to:

  • say whatever you want about your hedge fund, and
  • not say whatever you don’t want to say about it, as long as
  • you take reasonable steps to actually sell it only to accredited investors.

To generally solicit, or not to generally solicit? by William Carleton

A lot was at stake. I had said the rules could prove disastrous to angel investing, should the SEC specify methods of “verification” of accredited status that were too onerous for companies, or too invasive of investors’ privacy.

But disaster didn’t happen.

Hedge Fund Advertising is right around the corner… FINALLY! in HedgeCo.Net

We can now also offer hedge funds the ability to advertise their fund to our large user base. We can target different types of investors (ie: family offices, high net worth, etc.), we can target investors looking for certain styles of funds, assets under management, sharpe ratio, etc. These types of tools and others we have created specifically for hedge funds will be very powerful for firms who are looking to grow their AUM going forward. Also, as a result of owning not only HedgeCo.Net but also owning several other well trafficked hedge fund websites and having established relationships with hedge fund publications both online and offline, we have created the first Hedge Fund Advertising Network.

Badminton Falls Down

Bazuki Muhammad/Reuters

Few in the United States watch Olympic badminton. Fewer still are likely to watch after the ridiculous play in preliminary games. (Maybe a few will try to watch, just as a few slow down to watch the results of a car accident on the side of the road.) Four of the best teams in the world were kicked out of the Olympics for intentionally trying to lose matches and gain a competitive advantage. Clearly the competition was poorly structured if there was an incentive to lose.

This year the Olympics switched to a round-robin tournament, replacing the one-and-done format, so teams compete in three round-robin games before seeding them in medal brackets. There are four pools of four teams. The top two teams in each pool qualify for the quarterfinals and the bottom two spend the rest of the competition in the Olympic village.

China’s Wang Xiaoli and Yu Yang won their first two matches and secured a spot in quarterfinal. Their final match against a South Korean team would determine first and second place in Pool A.

The first complication came when the other Chinese team, Qing Tian and Yunlei Zhao, lost to Denmark in an big upset. That placed the Chinese team on the same side of the bracket as the winner of Pool A. If both Chinese teams won their quarterfinal matches, they’d meet in the semifinals and only one would make it to the finals. At best that’s gold and bronze, not gold and silver.

To avoid this situation, the Wang and Yu tanked their game. The South Koreans did not want to meet the other Chinese team so they tanked also. At one point the four players traded 6 service errors in a row. Five went directly into the net. The one that made it over made in way over and went long off the back line. That’s much more like how I play in the backyard.

After the Chinese tried to throw their match, the South Korean team of Ha Jung-eun and Kim Min-jung faced the Indonesian team of Meiliana Jauhari and Greysia Pollii in Pool C. Both teams adopted a similar losing strategy to avoid having to face the fearsome Wang and Yu. (Watch the video and you can see that they were not trying.)

A well designed tournament should eliminate strategic losses. Getting a higher seed should convey a benefit, generally it means you play someone who isn’t as good. Pool play to determine seeding means more games and allows a margin of error for a team. Clearly the Olympics missed something.

The NBA tried to eliminate an incentive to lose by implementing a draft lottery instead of merely giving the highest draft pick to the team with the worst record. The NFL gives an incentive to win by giving the teams with the best record a week off before the playoffs. That still leaves some lackluster games at the end of the season when teams pull their starters.

Strategic losing does not appear to be a new strategy in badminton. Statistics show that more than 20 percent of matches is either not finished or not played when the Chinese play against their own compatriots. They met each other 99 times on the circuit in 2011, and 20 matches were either not played at all or played partially before one of the opponents retired. This shows that 20.20% of matches between Chinese shutters were not completed in 2011. But only 0.74% of matches were uncompleted between China and other nations.

What does this have to do with compliance? Look at your internal structures and incentives. Are any designed to allow an incentive to fail. Do any give incentive for one business unit to cause another to fail?

Sources:

 

Is Decimalization Good or Bad?

Although commentators have been viewing the Jumpstart Our Business Startups Act as a rollback of 2010’s Dodd-Frank financial reform, it’s been showing itself as much more of an attack on the earlier Sarbanes-Oxley Act. The latest attack is a required report on a possible rollback of decimalization. A decade ago, the SEC and the exchanges moved to have the price of securities quoted in pennies to deliver cost-savings to investors. The JOBS Act offers up the possibility of increasing the tick size for the new class of “Emerging Growth Companies.” The first step was a Report to Congress on Decimalization (.pdf) as required by Section 106 of the JOBS Act.

The report finds many benefits to investors.

Bessembinder finds that the average quoted bid-ask spreads for all companies declined from pre- to post-decimalization in both NYSE and NASDAQ stocks. His study results showed that large capitalization stocks’ equally-weighted quoted spreads on the NYSE declined from 11 cents to 6 cents and on the NASDAQ from 10 cents to 4 cents. Middle capitalization stocks’ equally-weighted quoted spreads on the NYSE declined from 16 cents to 10 cents and on the NASDAQ from 17 cents to 13 cents. In comparison, small capitalization stocks’ equally-weighted quoted spreads declined from approximately 23 cents to 18 cents on the NYSE, and from 26 cents to 23 cents on the NASDAQ. He found that the corresponding decline, as a percentage of trading price for small capitalization stocks, is from 1.75% to 1.16% on the NYSE and from 1.84% to 1.58% on the NASDAQ.

That’s a cost savings to investors and a profit loss to market makers. However Section 106 of the JOBS Act asks “whether there is sufficient economic incentive to support trading operations” in small and middle capitalization companies after decimalization. Both the IPO Task Force Report and a Grant Thornton paper argue that because brokerage analysts have to depend on revenue from trading commissions, they have an incentive to cover only high volume stocks. The concern is that smaller capitalization stocks do not have the trading volume to offer enough profitability for analyst coverage.

Though regulatory decimalization in the market lowered the minimum allowable tick size to $0.01, it did not mandate that market participants quote narrower spreads. Rather, the quoting of narrower spreads appears to have been a result of continued market forces.

That leaves the SEC staff recommending that the Commission not proceed with a rulemaking to increase tick size. Hopefully that will be the end of this for the foreseeable future. This section of the JOBS Act was a blatant grab by Wall Street to regulate for increased profitability.

Sources:

  • Report to Congress on Decimalization (.pdf) (As Required by Section 106) July 20, 2012
  • Bessembinder, Hendrik, 2003, Trade execution costs and market quality after decimalization, Journal of Financial and Quantitative Analysis 38(4), 747-777.

Veni… Vidi… Wiggins!

Wiggins and Cavendish stuck together all day. Photo: Casey B. Gibson

I would guess that most of you reading this story do not share my love of the Tour de France. (Except Tom Fox.) The race can be a confusing mix of skinny guys, tarted up with sponsors like a NASCAR racer, with hard to pronounce names, following tactics unusual outside of cycling. But I since I became a fan a decade ago, I continue to be enthralled by drama and athletic heroism on display.

This year, Bradley Wiggins and his Team Sky dominated the race in a way that has not been seen for several years. In a act of selfless teamwork, the yellow jersey was the second to last lead out man for his sprinter Mark Cavendish as he wheeled across the finish line on the Champs-Élysées in Paris.

George Hincapie led the peloton into Paris Sunday, a celebration of  the American’s 17th Tour de France — the most ever, by any rider — and his last. He completed 16 of the 17  Tours.  (Just for perspective of the 198 riders that stared the race, 47 dropped out or crashed out of the race.) The big American was part of nine Tour de France wins: seven with Lance Armstrong; one with Alberto Contador; and the final with Cadel Evans, in 2011.

The race was not without its incidents. A spectator threw tacks in the road a top a mountain pass causing dozens of flat tires. An owner let his enormous dog off his leash causing a high speed crash. Frank Schleck was kicked out of the Tour for a possible doping violation.

Real Estate Fund CCO Forum

NEW YORK

We are starting a new forum for real estate fund compliance managers in New York. The first meeting is noon on July 24 near Chelsea Market.

BOSTON

The Boston group of real estate fund compliance professionals will meet again in September after taking the summer off.

ABOUT

The groups meet to discuss the issues that are particular to real estate funds post Dodd-Frank. We have moved past the register or non register discussions. (At least most of us have.) Here are some of the topics for the agenda:

  • Who are your access persons (entire company, a smaller subset, just the managing directors/executives)?
  • Are you getting brokerage statements or just having employees attest to the securities that they do have by providing a brokerage statement or listing the required security information on a separate sheet of paper?
  • Do you use any technology to assist in the compliance duties (certificate database, security software, email archiving, social media tracking etc.)?
  • Are you using a third party consultant?  If so, what are they doing for you?
  • Who is doing your required annual training?
  • How are you keeping up with current compliance news relating to real estate?

The meetings operate under the Chatham House Rule. So that discussion can be open without concern that any position would be attributed to you personally or your firm.

If you are interested in joining either (or both) of the group you can reach me at [email protected]. I can send you more detailed information.

This is Not Compliance

UPDATE (9/10/2019):

The CEO/CCO in question contacted me and told me her side of the story with regards to the SEC. According to her, an investor sued based on the SEC case and the charges were largely dismissed. As I point out and have now highlighted, I relied on the order to illustrate what the SEC does not like and what you should not do. At her request, I’ve edited the post and removed her name. 

Sometimes you see a careless disregard for the rules governing private funds and investment advisers. Last week, the CEO/CCO of Calhoun Asset Management, settled fraud charges with the Securities and Exchange Commission. Her problems are probably common for start-up managers.

Calhoun and the CEO/CCO entered into an Order Making Findings (.pdf) with the SEC, but neither admitted nor denied the facts. I’ll assume the statements in the Order are true for educational purposes.

Assets Under Management

In 2006, the CEO/CCO started two hedge funds: Triumph Multi-Series Fund (later renamed Calhoun Multi-Series Fund LP) and Calhoun Market Neutral Fund. CEO/CCO attracted capital to the Funds by aggressively marketing herself as an experienced hedge fund manager, despite having no experience in portfolio management.

In filling out a due diligence questionnaire for a potential investors, CEO/CCO state that the firm grew from $27 million in assets under management in 1999 to $200 million. However, the firm never had more than $3 million in assets under management.

I understand the desire of fund managers to puff up the AUM number. After all, that dollar amount often stands for measure of success. However, the calculation of AUM needs to be documented and defensible. Lies can easily be detected and puffery will raise red flags.

Performance

The fund marketing materials refer to a 10-year track record with 11+% average annual returns. The CEO/CCO failed to maintain the documentation supporting this track record. CEO/CCO only maintained records dating back to 2007. In a PowerPoint presentation, CEO/CCO included a full-page chart of monthly and annual performance returns from 1999 through 2009. The legend at the bottom of the page states that “[t]hese returns represent our flagship fund, Calhoun Fund SPC, Ltd.” Calhoun Fund SPC, Ltd. However, the fund did not commence operations until January 1, 2007.

The SEC rules are very clear that any statements in marketing materials about performance must be well documented. Calhoun’s overstatement should be easily detected with a little due diligence by a prospective investor.

Due Diligence

Calhoun promoted its due diligence capabilities in its marketing materials. This included regular monitoring, performance reviews, and on-site visits. “We take every precaution necessary to complete thorough due diligence and research on every manager we recommend” (emphasis in original).

The truth was that Calhoun’s actual due diligence was virtually nonexistent. CEO/CCO did not even perform the due diligence herself. Instead, she outsourced the due diligence to a third party, and that third party did little actual diligence.

Form ADV

Of course, lying to the SEC will really get you. On the Forms ADV she filed with the SEC, CEO/CCO repeatedly misrepresented  assets under management.

CEO/CCO first registered Calhoun as an investment adviser on August 31, 2007. On Calhoun’s Form ADV, CEO/CCO stated that Calhoun had $30 million in assets under management. In reality Calhoun had less than $6 million under management. On February 18, 2009, CEO/CCO filed an amendment to the ADV showing $79.8 million in assets under management. In reality, Calhoun had approximately $7 million under management.

Lessons?

Lying is bad. Unlike a fisherman’s tale about the one that got away, fund managers are expected to document their tales in detail.

CEO/CCO has to pay a $50,000 fine and is barred from the securities industry for five years.

Sources: