Category: Compliance Programs

Compliance Officer Banned in the United Kingdom

As a compliance officer, I often find that many lessons come from enforcement actions. Those actions imposed on compliance officers are especially instructive. The latest to catch my attention comes from the United Kingdom.

The Financial Services Authority levied a £14,000 fine and banned a compliance officer from performing any significant influence function in regulated financial services. The circumstances arose from an employee’s attempt to conceal losses after the collapse of Lehman Brothers in 2008.

Dr Sandradee Joseph was Compliance Officer at Dynamic Decisions Capital Management (DDCM), a hedge fund management company based in London. One of DDCM’s funds suffered catastrophic losses during the fall of 2008, losing 85% of its assets under management. A fund employee, rather than report the losses, decided to enter into a complicated bond transaction to create false profits. Essentially, the employee was buying bond units at a steep discount, but reporting a much greater value when calculating the fund’s NAV. The fund had lost $255 million, but the employee booked a $268 million gain on the bond transaction. A bond that the fund had only paid $5 million.

Three problems arose that the FSA thinks were instances of the compliance officer not doing her job.

The first was that the fund’s prime broker terminated its agreement with the fund because of the bond transaction. Any trade that causes the prime broker to leave should be a big red flag.

The second was an unhappy investor. The investor had put $48 million into the fund. The bond happened to violate some of its investment restrictions: maturity greater than 12 months, issued by an unlisted entity, no option to convert equity, and greater than 3% of the fund’s NAV. Violations of an investor’s investment guidelines should be a big red flag for a compliance officer.

The third problem was another unhappy investor. The bond transaction also violated this investor’s permitted investments limitation. A second big red flag that the compliance officer failed to remedy. This investor dug a bit deeper and felt that the bond may have been fraudulent.

The compliance officer tried a few defenses that sound weak to me. They sounded weak to the FSA as well.

  • The compliance officer’s role was a reporting function and it was up to individual employee to ensure compliance.
  • The compliance officer was not the fund’s lawyer and she could take a back seat on legal matters.
  • The compliance officer felt enough advisers were looking at the issue.
  • The compliance officer did not understand the bond and was relying on external lawyers to review it. (However, she never instructed a  law firm to to carry out due diligence on the bond.)
  • The compliance officer believed the bond was legitimate. (Even though she disclosed that she didn’t understand it.)

The FSA lays out the lesson learned: “In her role, if [the compliance officer] became aware of concerns that the firm was not complying with its regulatory obligations, she should have taken steps to ensure that these concerns were investigated, to verify if the concerns appeared to be legitimate, and if so to take appropriate action.”

As a compliance officer, I initially found the punishment to be on the harsh side especially since it seems to single out the compliance officer. Then I dug a little deeper and saw that criminal investigations were started by the SFO and the investors filed suit against DDCM.

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Outsourcing Compliance and the CCO

One of the requirements of registration as a registered investment adviser is the appointment of a Chief Compliance Officer and the establishment of a formal compliance program. The SEC stated that a firm need not hire a new person to be the CCO. However, there will be a substantial time commitment.

You can spread some of the compliance work to multiple people in the firm, though the CCO will ultimately be responsible for oversight. Another option is to send some of the work outside the firm that would outsource some or most of the compliance functions.

Insider trading monitoring is one of the candidates for outsourcing. There is a lot of data and a lot of paperwork to track. Even for a private equity firm that does not regularly trade in public securities, there is plenty to keep a person occupied during the week. For a private equity firm, some trade tracking software will go a long way to help the CCO (and the employees) deal with the invasive and tedious requirement to track employee trading.

The SEC rules also require an annual review and update of the compliance policies and procedures. This too is a likely area for outsourcing. A third party can provide additional insight to the firm as to what your peer firms are doing and what issues the regulators are focusing on.

Some New Financial Legislation is Moving Along

Four bills made their way through the Capital Markets and Government Sponsored Enterprises Subcommittee of the House Financial Services Committee.

The Private Company Flexibility and Growth Act, introduced by Rep. David Schweikert, raises the shareholder threshold for mandatory registration with the SEC from 500 to 1,000 shareholders. I’m surprised it’s not called the Google/Facebook Act. The 500 shareholder limit is most famous for forcing Google to go public and is close to forcing Facebook to do the same.

The Access to Capital for Job Creators Act removes the regulatory ban that prohibit general solicitation and advertising in private placements. There were two amendments to the bill during the mark-up session. Maxine Waters (D-CA) included and amendment that the revised SEC rules allowing a general solicitation under Regulation D must require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors using methods determined by the SEC. Scott Garrett (R-NJ) included an amendment that Section 4(2) of the Securities Act be revised to add the language: “whether or not such transactions involve general solicitation or general advertising.”

The Entrepreneur Access to Capital Act permits “crowdfunding” to finance new businesses by allowing companies to accept and pool donations up to $5 million without registering with the SEC. It would limit individual investments to the lesser of $10,000 or 10% of an investor’s annual income. An amendment requiring a notice filing with the SEC was rejected as was an amendment that would have barred felons from being involved.

The Small Company Job Growth and Regulatory Relief Act would expand the exemptions available to small companies from the Section 404(b) auditor attestation reporting requirements to small and mid-size companies with a market capitalization of less than $500 million. The exemption is currently at the $75 million cap set by the Dodd-Frank Act. During the mark-up, the House panel amended the bill to lower the market float from $500 million to $350 million.

Will these go anywhere? The votes seemed to very partisan with Republicans voting yes and Democrats voting no. That does not bode well for moving up the chain through the house, through the Senate and on to the President’s desk.  However, President Obama has already indicated an interest in the crowdfunding idea.

These are not the grand, sweeping changes of Dodd-Frank. These are small tweaks to the regulations on the capital markets.

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2011 LexisNexis Corporate and Securities Law Blog Nominees

For the second year, LexisNexis is seeking your input in choosing the top blogs for their Corporate and Securities Law Community.

(Warning, this post post contains blatant self-promotion.)

Looking at the list of candidates, I see many blogs that I read regularly. But there are several on the list that I had not heard of before and need to take a look at. If you are looking for a list of business law blogs to read, the list of nominees is a great place to start.

I think many more than 25 of the nominated blogs are much better than mine, whether its on quality, popularity, or some other factors. I doubt I will make it into the top 25 so I will sit back and take the consolation prize: the honor of being nominated. (Although, I thought the same last year, but still managed to squeak into the top 25.)

Lexis Nexis invites you to comment on the announcement post:

Top 25 Business Law Blogs 2010 – Corporate & Securities Law Community

To comment, you have to register. Registration is free and supposedly does not result in sales contacts. The comment period for nominations ends on October 25, 2011. They don’t say how they will end up selecting the top 25 out of the nominees, other than it’s based on their review and your comments.

As I said last year I’m also not sure how the Lexis-Nexis Communities fits in with the Martindale Hubbell Connected platform. There seems to be whole lot of substantive information in Communities that is missing in Connected. They should still get these two sites together.

Vote for the business law blogs you feel are the best or at least look through the list to add some new sites to your reading list. Go ahead and include Compliance Building.

NOMINEES FOR THE LEXISNEXIS CORPORATE & SECURITIES LAW
TOP 25 BLOGS FOR 2011

Alston & Bird’s “M&A Blog”
by Alston & Bird’s Corporate Transactions and Securities Practice

Alston & Bird’s Securities Lit. Blog
By Alston & Bird’s Securities Litigation Group

BD Law Blog
By Joel Beck

Boardmember.com

The Business Law Blog (Dryanlaw)
by Daniel J. Ryan

Business Law Post
By Arina Shulga

Business Law Prof Blog
By Multiple Authors

California Corporate & Securities Law
By Keith Bishop

Commercial Law Blog
By by Jennifer S. Martin, L. Ali Khan, Jason J. Kilborn, Robyn Meadows, Marie T. Reilly, Marc L. Roark, Keith A Rowley, Steven Semeraro, Anthony Schutz and Jim Chen discussing a variety of Commercial Law related topics.

Compliance Building
by Doug Cornelius

Conference Board Governance Blog
Editor, Gary Larkin

The Conglomerate
By Seven Law Professors blog about business, law, economics and society, including Gordon Smith, BYU Law School, Christine Hurt, Univ. of Illinois College of Law, Vic Fleischer, Univ. of Colorado Law School, Fred Tung, Emory Law School, Lisa Fairfax, George Washington Univ. Law School, David Zaring, Wharton School Legal Studies and Business Ethics Department, and Usha Rodrigues, University

Connecticut Employment Law Blog
by Daniel A. Schwartz of Pullman & Conley, LLC b

Consumer Law & Policy
Coordinators, Deepak Gupta and Jeff Sovern

Contracts Prof Blog
By Jeremy Telman

CorpGov.net
By James McRitchie

Corporate & Securities Law Blog
By Sheppard Mullin

Corporate Compliance Insights

TheCorporateCounsel.net
By Broc Romanek and Dave Lynn

Corporate Finance Law Blog
By Davis Wright Tremaine

Corporate Law and Governance
By Robert Goddard, a U.K. based Senior Lecturer at Aston Law, part of Aston Business School

The Corporate Library Blog–GMI
Published by GMI

Corporate Tool
By Josh King

Credit Slips
By Multiple Authors

David Tate’s Blog

DealLawyers.com Blog
By Broc Romanek

Delaware Corporate and Commercial Litigation Blog
By Francis G. X. Pileggi

The D&O Diary
Published by Kevin M. LaCroix

The Emerging Business Advocate
By Seaton M. Daly III

FCPA Compliance and Ethics Blog
by Thomas Fox

FCPA Professor
By Mike Koehler

Fraud Bytes
By Mark Zimbleman and Aaron Zimbleman

Harvard Corporate Governance Blog
By Harvard Law School Program on Corporate Governance

Hedged.biz
By Brian Goh, Burnham Banks, Mark Martyrossian, Mark Fleming

Hedge Fund Law Blog
by Bart Mallon

Indiana Commercial Foreclosure Law
By John Waller

Indian Corporate Law Blog
By Multiple Authors

nHouseBlog
Albish Publishing

Investor Relations Musings
by John Palizza

The Investment Fund Law Blog
by Pillsbury Winthrop Shaw Pittman

Jim Hamilton’s World of Securities Regulation

LFNP Blog
By Arthur Ryman

M&A Law Prof Blog
By Brian JM Quinn, Boston College Law School Professor

Marks on Governance
by Norman Marks

Marler Blog
By Bill Marler

Metropolitan Corporate Counsel
Publisher, Martha Driver

Nancy Rapoport’s BlogSpot
By Nancy Rapoport

NC Business Litigation Blog
By Mack Sperling of Brooks Pierce LLP

New York Business Law
Frederic R. Abramson

New York Business Litigation and Employment Attorneys Blog
By David S. Rich

No Funny Lawyers
By Jim Thomas

Northwest Litigation Blog
By Ater Wynne LLP

Perkins Coie’s MergerViewpoints
Publisher, Scott B. Joachim

PLI Securities Law Practice Center
By Kara O’ Brien

ProfessorBainbridge.com
by Stephen M. Bainbridge

Race to the Bottom (Corp Governance Blog)
a faculty and student collaborative blog published By J. Robert Brown, Jr.

retheauditors.com
By Francine McKenna

Reverse Merger Blog
By David Feldman

Robert A. G. Monks’ Blog
by Robert Monks

SEC Actions
By Thomas O. Gorman of Porter Wright

SEC Tea Party
By Robert Fusfeld

Securities Law Prof Blog
By Barbara Black

SEC Whistleblower Program
By Nick Fasulo

Small Business Trends
By Anita Campbell

Startup Company Lawyer
By Yoichiro Taku

Strictly Business
by Alexander Davie

10Q Detective
By David Phillips

The 10b-5 Daily
By Lyle Roberts

Truth on the Market
By Geoffrey Manne and Multiple Authors

UCC Food Ind. Law, Food Liability Law Blog
By Richard Goldfarb, Stoel Rives LLP

Uniform Commercial Code Litigation
By Robinson & Robinson LLP

USA Inbound Deals
by Bill Newman

US PIRG
By Ed Mierzwinski

The Venture Alley
Editors Trent Dykes, Asher Bearman of DLA Piper

Virginia Business Litigation Lawyer
By Lee Berlik

What About Clients
By Dan Hull

Workplace Prof Blog
By Richard Bales & Multiple Authors

WSJ Deal Journal

Crowdfunding

It’s hard to raise capital. The regulatory restrictions imposed by securities laws make it harder to do so. As any bright-eyed entrepreneur with a dream project will tell you, the lawyers and the securities laws make it very expensive and time consuming to raise capital for a small project.

The central goal of the Securities and Exchange Commission is to facilitate companies’ access to capital while at the same time protecting investors. More often than not, the securities laws and regulations are put in place due to some prior malfeasance. Limitations on the sale of securities are in place because there were (and still are) lots of shady characters trying to make a quick buck by de-frauding investors.

The Obama administration and the Congress think the regulatory burdens need to be removed to encourage small business capital formation. I’m going to guess that they are fans of Kickstarter, a website that allows entrepreneurs and artists to raise capital for their projects. (I’m also a fan and have contributed to some projects.)

SEC Rule 504 allows a public offering to investors (including non-accredited investors) for securities offerings of up to $1 million. There is no limit on the type of investors, so they need not be accredited investors.  There are no prescribed disclosures and no limitations on resales of the securities. The Rule generally does not allow companies to solicit or advertise their securities to the public.(Of course, the antifraud and other civil liability provisions of the federal securities laws are still applicable.)

However, these offerings are subject to state “blue sky” regulation. That means having to jump through the patchwork of state securities laws, depending where your target investors are located.

How does Kickstarter get around this? It doesn’t. Capital for Kickstarter projects cannot be for securities or lending. As a patron, you do not get your capital returned. Often, you’ll get the end product that the artist or entrepreneur was hoping to produce. (My son is patiently waiting for our pack of trebuchettes to arrive.)

Generally, the term “crowdfunding” is used to describe a form of capital raising whereby people pool money, generally as small individual contributions, to support a specific goal. Since the capital raising did not provide an opportunity for profit participation, initial crowdfunding efforts did not raise issues under the federal securities laws.

The Entrepreneur Access to Capital Act would create a new exemption for small companies, allowing them to raise up to $5 million. The limitation would be that investments are limited to the lesser of $10,000 or 10% of the investor’s annual income.

President Obama cheered for crowdfunding as part of the American Jobs Act unveiling. I failed to find and proposed legislative changes in his proposed bill.

I’m for fueling entrepreneurial growth in this country. I’m concerned that the changes could lead to an onslaught of fraud. I think Kickstarter works well because you are funding the effort. You are not seeing dollars signs.

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Was Full Tilt Poker a Ponzi Scheme?

The United States Government forced online poker sites to the fringes of the financial system. The U.S. government has long argued that online poker gambling is illegal under the Wire Act, a 1961 law that explicitly prohibits sports betting conducted over electronic communication. In 2006, Congress made it illegal for financial institutions to process funds for online gambling.

It should be no surprise that an online poker site would run into legal problems. The complaint against Full TItle Poker caught my eye because

“By March 31, 2011, Full Tilt Poker owed approximately $390 million to players around the world, including approximately $150 million to United States players. However, the company had only approximately $60 million in its bank accounts.”

Many Ponzi schemes started off as legitimate enterprises. When funding shortfalls or an unexpected loss hits, the managers try to hide the bad news. This creates a spiraling downfall leading from poor management to criminal behavior. In this case, Full Tilt was having trouble moving the cash around the financial system to collect wagers from players and make payments to the winners. It sounds like Full Tilt was funding winnings without withdrawing initial bets from the player accounts.

But was it a Ponzi scheme? While there is no official definition of a Ponzi scheme, these are what I think are the elements:

(1) A promise of financial reward.

(2) Current contributions to the scheme are not invested, but are spent to make good on returns promised to earlier contributors.

(3) The manager of the scheme maintains his ability to pay the returns only by getting other contributors.

(4) The contributors think the manager is investing their contributions to make the return (not necessarily in a fully legal way).

(5) If future contributors do not arrive in sufficient numbers, the Ponzi scheme will have too little money to pay current returns/redemption.

Full Tilt was not an investment scheme. Sure you can argue about whether poker success is based on skill or luck, with luck being a key element of gambling. (I think it’s a combination of both.) But it’s not an investment and you are not buying a security. The contributors did not think the manager was doing anything with the money other than keeping it safe. They were winning or losing based on the hands the contributors played.

It does seem that current winnings were being paid from new contributions. According to the complaint, the mangers were taking more cash out than the business could support. The company had a funding shortfall because it was having trouble moving the wagers and winnings through the financial system.

You would hope that a leading federal prosecutor would know the difference between different types of fraud. Full Tilt was not a Ponzi scheme. As good as you may be at poker, your wagers are not investments.

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Miscommunication

Are you speaking the same language as the rest of your firm?

Do they understand your questions?

Do they understand your answers?

Miscommunication is at the root of many problems. Many compliance policies are written by lawyers, for lawyers. That may work fine once there is an investigation or a problem. But they do little to prevent the problem. Outside of compliance and legal, the rest of the firm can’t grasp the language used.

One of the goals of compliance should be translate complex legal requirements into easy to understand rules.

There are only 10 types of people in the world: Those who understand binary, and those who don’t.

Comic is from xkcd 1 to 10.

The Slow Rulemaking on Swaps and Derivatives

One of the strange splits in US financial regulation is that many swap and derivatives are regulated by the Commodities Futures Trading Commission instead of the Securities and Exchange Commission. I think of the CFTC, I think of Trading Places and with the SEC I think of Wall Street.

The Commodity Futures Trading Commission has delayed its rollout of regulations under the Dodd-Frank Wall Street Reform and Protection Act has been pushed back until at least early 2012. This delay is the second time the CFTC has put the brakes on its new rules that will govern the over-the-counter derivatives market. In my view, taking longer to get the rules right is better than pushing through bad rules just to meet some arbitrary deadline. The question will be whether the CFTC will succeed in creating rules that will make the derivatives market one that is more transparent and easier to oversee for lines of trouble.

As for trouble, take a look at Greek bonds as an example. The Credit Default Swaps cost a record $5.8 million upfront and $100,000 annually to insure $10 million of Greece’s debt for five years using credit-default swaps. That means the market is saying it’s about a 58% chance that Greece will default in the next five years. But how extensive is that exposure in the US? How many people are on the hook for payouts if Greece defaults?

If your firm uses derivatives or swaps for dealing with debt risks or foreign exchange risks, you should pay attention to the CFTC rulemaking. They are likely to change the process and the cost of dealing with these risks.

Gary Gensler, Chairman of the CFTC, says that “until the CFTC completes its rule-writing process and implements and enforces these new rules, the public remains unprotected. That’s why the CFTC is working so hard to ensure that swaps-market reforms promote more open and transparent markets, lower costs for companies and their customers, and protect taxpayers.”

Earthquakes, Hurricanes, and Disaster Recovery

Monday’s East Coast earthquake was far from a disaster. I just thought I had too much coffee, until I heard others in the hallway say “Do you feel that?” Then I realized the shaking was not just because I was over-caffeinated.

Even though significant earthquakes are rare on the East Coast, hurricanes are not. Irene, the first big hurricane of the season is also approaching the East Coast.

Perhaps these are some good reminders to blow the dust off your disaster recovery plan. As a registered investment adviser, you need to have a plan. Each of the thousands (hundreds?) of private fund managers getting ready to register as investment advisers with the Securities and Exchange Commission will need a plan.

It’s easy to miss the requirement for having a business continuity plan. It’s in Rule 206(4)-7. Oh, you don’t see anything about business continuity in the rule? It’s not in the rule, it’s in the Release for Rule 206(4)-7:

We believe that an adviser’s fiduciary obligation to its clients includes the obligation to take steps to protect the clients’ interests from being placed at risk as a result of the adviser’s inability to provide advisory services after, for example, a natural disaster or, in the case of some smaller firms, the death of the owner or key personnel. The clients of an adviser that is engaged in the active management of their assets would ordinarily be placed at risk if the adviser ceased operations. [SEC Release No. IA-2204]

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Image of 20111 VA Earthquake is by Frank Paynter

Massachusetts and Expert Network Services

At least one of the hedge funds being investigated for its use of expert networks in based in Massachusetts. In an unusual instance of the state regulators acting before Securities and Exchange Commission, the Massachusetts securities regulators are proposing a new regulation to address the use of expert network services. They are proposing a new section under 950 CMR 12.205(9)(c)(16) to the existing list of dishonest and unethical practices:

16. a. To retain consulting services, for compensation that is provided either directly to the consultant or indirectly through a Matching or Expert Network Service, unless the adviser obtains a written certification, signed by the consultant that:

(i) describes all confidentiality restrictions that the consultant has, or reasonably expects to have, regarding Confidential Information; and

(ii) affirmatively states that the consultant will not provide any Confidential Information to the adviser.

b. Notwithstanding section (a) an investment adviser who comes into possession of material Confidential Information through a consultation is precluded from trading any relevant security until such time as the Confidential Information is made public.

c. Definitions. For purposes of this section:

(i) “Confidential Information” means any non-public information, which one is bound by a confidentiality agreement or fiduciary (or similar) duty not to disclose.

(ii) “Matching or Expert Network Service” means a firm that for compensation matches consultants with investment advisers.

As alleged in In the Matter of Risk Reward Capital Management Corp., RRC Management LLC, RRC BioFund LP, and James Silverman, Docket No. E-2010-057, some investment advisers have paid expert networks and consultants to access confidential information about publicly traded companies.

Massachusetts wants additional measures to ensure that confidential information is not being accessed and traded upon. The proposed regulations do not alter an investment advisers’ existing duty not to trade on insider information. The goal is to provide investment advisers with greater clarity as to what is impermissible conduct when paying consultants for information.

In the end, it seems like it is just a record-keeping exercise to me.

You can review comments or submit a comment on the proposed regulation.  There is a proposed effective date of December 1, 2011.

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