Category: Conference Notes

Dodd-Frank a year on: Where is the compliance industry now?

PEI PFC Forum 2013

These are my notes from the Private Fund Compliance Forum 2013. They are live notes, so excuse the typos.

David Smolen, Chief Compliance Officer, Silver Lake
Brynn Peltz, Partner, Goodwin Procter LLP
Roman A. Bejger, Counsel and Chief Compliance Officer, Providence Equity Partners, LLC
Michael Barnes, Senior Manager, Financial Services, Ernst & Young LLP

Fund managers fell into four categories: 1. those who accepted, 2. those who are still kicking and screaming, and 3. Those who are fighting and trying to find ways to escape, and 4. Those who registered and restructured to escape registration.

The panel felt that it’s inevitable that carried interest will be taxed differently. Of curse it’s felt inevitable for a few years and nothing has been implemented. In perspective, the change in tax of carried interest is estimated to be between $1.3 billion and $1.6 billion per year.

As a result of the Volcker Rule, we are seeing more business development companies coming on line to address bank’s trading activity. Whenever the rule comes out it may have broad impact on funding and capital commitments for private funds.

There is an uncertainty about marketing rules with the changes mandated by the JOBS Act.

There is increased focus on fees as part of examinations. The SEC is trying to re-label fees, other than advisory fees, as compensation that could require broker-dealer registration. Brynn has seen this in several deficiency letters over the last few months. The SEC is asking examinees to explain why they do not have to register as a broker-dealer. Acquisition fees, disposition fees and other transaction based fees could trigger the question of broker-dealer registration. A marketing department is suspect if the employee compensation is tied to successful placement of interests in a fund.

The SEC does not seem to be using the term “presence exam” when initiating an exam. The panelists seem to think that the SEC is still robustly conducting regular exams and presence exams are not being conducted as widely as expected.

What additional responsibilities have you taken on post-registration?

  • Lobbyist registration
  • International blue sky law analysis
  • Review of secondary transfers
  • Form PF
  • Internal marketing of compliance
  • Tracking regulatory changes
  • EU’s AIFMD
  • FCPA

Is there personal liability for CCOs?

We are looking for more guidance in this area. Keep the CCO from having supervisory liability. If the CCO hands out discipline, then the CCO could be considered a supervisor and be held liable for the bad act. However, the cases imposing supervisory liability on CCO generally are at the extreme, involving fraud or other egregious acts.

Presence exams generally last a few days. Union examiners leave right at 5. Non-union may stay longer. Generally it’s 2 to 3 people, with a junior person, a mid-level manager, and a senior person who usually does not stay all day. Sometimes there will be a group of trainees. Sometimes enforcement will also come, but it may be just a learning experience and not an indication of wrongdoing. Ask for an exit interview. If it’s refused then the exam may not be over.

 

FBI and FCPA

In addition to learning about the FBI’s compliance program, understanding white collar criminals, and a visit to the FBI Academy, the FBI Corporate Compliance Officer Outreach Event included a very frank discussion of the Foreign Corrupt Practices Act. The program brought in attorneys from the Department of Justice to discuss their approach to bringing FCPA cases.

Anyone who has read the FCPA Opinion releases may be surprised to hear the practical approach spoken by the presenters. The opinion releases paint a vary minimal threshold for ordinary business entertainment expenses to not be outside the boundaries of a bribe.

The presenters started off with four types of payments that are not bribes:

  1. Facilitation payments (still suspect)
  2. reasonable and bona fide gifts and entertainment
  3. duress payments, when there is a threat of physical harm
  4. Extortion

They pointed out that the key to a bribery case is the corrupt intent. They painted a picture that the DOJ has a hard time finding proof of corrupt intent and an even harder time convincing a jury that there was corrupt intent. In my view, that leaves a lot of grey areas between the de minimis standard in the opinion releases and the much larger payments in prosecuted cases.

They pointed to the Morgan Stanley case as one where the firm’s compliance program stopped the DOJ from seeking further prosecution. As to the compliance defense and credits under the sentencing guidelines for effective compliance programs, the speakers admitted that you rarely see those in cases. However, that is because the DOJ rarely brings cases when they see an effective compliance program.

The last piece of news was to be on the lookout for some substantial guidance on the FCPA. The guidance is not coming out  as a response to the Chamber of Commerce or other critics of the FCPA. It’s a response to the OECD’s review of the US corruption laws in 2010. The Phase III report recommended consolidation and summarization of available information on the application of the FCPA. This guidance will be that consolidation. To meet the deadline of the OECD report, we should expect the guidance to come out in October.

Materials:

A Visit to the FBI Academy

As part of my visit to the FBI Headquarters for the FBI Corporate Compliance Officer Outreach Event, we took a trip to Quantico to visit the FBI Academy. The Academy shares space with the Marine Corps base and is therefore behind heavy security. Even with all of that security, there are buildings at the Academy under even more security. Needless to say, we did not get to visit those buildings.

This part of the trip was more about FBI programs, than about compliance. The exception was a viewing of the FBI’s ethics video. This was an impressive production with field agents placing the ethical standards in the context of actual case issues. Change the discussion from law enforcement and the ethics video would be an example of a great corporate ethics video, putting a code of conduct in the context of real situations.

The FBI Academy facilities have an overall 1970s feel to them. This makes sense, since the facilities were built in the 1970s.  We didn’t get change to enter Hogan’s Alley, a mock city used for tactical training. However, we did hear lots of gun fire. The first barrage sounded like a dozen or so trainees opening fire at once. A few minutes later an enormous barrage echoed across the compound, sounding like the ill-fated San Diego fireworks. Clearly, the trainees had switched to automatic weapons.

Materials:

FBI and Understanding White Collar Criminals

As part of my visit to the FBI Headquarters for the FBI Corporate Compliance Officer Outreach Event, Supervisory Special Agent Susan Kossler discussed her work in the Behavior Analysis division of the FBI.  The Silence of the Lambs and  “Criminal Minds” have glamorized the work of FBI profilers, making them seem like real life versions of Sherlock Holmes who always get their man.

Of course, reality is much more complex. And according to SSA Kossler, much less glamorous.

In applying the analysis to financial crimes, the research unfortunately shows that many of the traits that are indicative of a white collar criminal are also the traits most companies seek in their top executives.

The other complexity is the division in criminal behavior between the leaders and the followers. Take the case of Bernie Madoff. Clearly, he was the leader of the crime. Others convicted, under indictment, or under investigation were mostly followers. They believed in their leader and followed him into the dark cave of blatant fraud. Their motivations and behavioral traits are likely much different than those of Mr. Madoff.

SSA Kossler provided an extensive bibliography if you are interested in further study.

Sources:

Bibliography: (Bold indicates the article is available online.)

The FBI’s Compliance Program

As I mentioned last week, I had a chance to meet with the Federal Bureau of Investigation and learn about their compliance program and some aspects of other FBI programs.

Patrick W. Kelley gave a very thoughtful overview of the FBI’s compliance program. Like many compliance programs, it was born from a crisis. The FBI was accused of abusing the use of National Security Letters. An NSL is a demand letter, which differs from a subpoena.  An internal FBI audit found that they violated the NSL rules more than 1000 times in an audit of 10% of its national investigations between 2002 and 2007.

Mr. Kelley was tasked with creating a compliance program to identify and prevent abuse. He looked around at other government agencies, but decided that the private sector was a better model for his program. As a result, the program sounds more like a corporate compliance program and not merely a government bureaucracy.

That means, there is a strong emphasis on management buy-in, the tone at the top and risk reduction methodology. To show the tone at the top, FBI Director Robert S. Mueller, III took time out of his day to speak with the group and talk about the importance of the compliance program.

The Office of Integrity and Compliance reports to the Deputy Director and has a council of senior leaders to help oversee and guide the program. The leaders come from across the Bureau giving a wide swath of exposure to the operational risks they confront.

As with any compliance program, training is a challenge. As global organization, the FBI has tens of thousands of employees spread out across hundreds of offices across the United States and the foreign jurisdictions. Training is at a premium because it can’t be an operational impediment. You would hate to think the FBI missed an opportunity to prevent a major incident from occurring because the agent was sitting in a compliance training program.

On the other hand, I felt the FBI took compliance and operational limitations under the law and the constitution very seriously.

In addition to the compliance side of the OIC, there is also a formal ethics program. These too involve similar themes as you would see in a corporate environment:

  • Gifts (Personal Gifts, Gifts of Travel, Gifts to FBI)
  • Use of Government Property/Time
  • Conflicts of Interest
  • Financial Disclosure
  • Awards
  • Outside Employment
  • Involvement in Non-Federal entities
  • Political Activities
  • Misuse of Position
  • Endorsement and preferential treatment
  • Fundraising in the Federal Workplace

The big issue confronting the OIC is the new disclosure requirements as a result of the STOCK Act. The law was revised to requires certain executive branch employees to make financial disclosures just as Congress is required. That means some FBI employees will need to start making financial disclosures or need to make expanded financial disclosures.

Sources:

My Visit with the FBI

You would expect a visit with the FBI to be terrifying. When they come with their badges out and windbreakers on, you are in trouble. The FBI headquarters is easy spot, sitting right on Pennsylvania Avenue in Washington, D.C. Even once you get past the security guards and metal detectors in the front lobby, visitors have to pass through two more security checkpoints. Fortunately, my visit did not involve handcuffs.

The Federal Bureau of Investigation partnered with the Society of Corporate Compliance and Ethics to host the FBI Corporate Compliance Officer Outreach Event. I was fortunate enough to attend.

Patrick W. Kelley, Chief Compliance Officer, Office of Integrity and Compliance of the Federal Bureau of Investigation, was the host. That was the first unexpected piece information. The FBI has a Chief Compliance Officer and a formal compliance program. The second unexpected piece of information was that the FBI’s compliance program faces many of the same issues as any company’s compliance program.

Like many compliance programs, it was born from a crisis. The FBI was accused of abusing the use of National Security Letters. An NSL is a demand letter, which differs from a subpoena. It is issued to an organization, typically a telecom or ISP, to turn over various record and data. NSLs can only request non-content information, such as transactional records, phone numbers dialed or email addresses mailed to and from. Section 505 of the USA PATRIOT Act greatly expanded the use of the NSLs. An internal FBI audit found that they violated the NSL rules more than 1000 times in an audit of 10% of its national investigations between 2002 and 2007.

The FBI Director Robert S. Mueller, III did not like the abuse and tasked Mr. Kelley with creating a compliance program to identify and prevent abuse. To their credit, they also expanded the compliance program to cover 49 other areas of risk.

I’ll be posting more stories from this event over the next few days.

A New Era of Fundraising and Marketing

These are my notes from the a New Era of Fundraising and Marketing session at the Private Fund Compliance Forum 2012.

Panel Members:
Julia D. Corelli, Partner, Pepper Hamilton LLP
Kurt A. Krieger, Legal Director, Huntsman Gay Global Capital, LLC
Jason Ment, Partner, General Counsel & Chief Compliance Officer, StepStone Group LLC
Helane L. Morrison, General Counsel & Chief Compliance Officer, Hall Capital Partners LLC

False advertising is prohibited, regardless of whether your firm is registered. Puffery and misleading statements are prohibited. Until the JOBS Act’s new rules go into effect, a registered adviser cannot advertise or generally solicit. Facebook, twitter and bulk email is bad. You need a existing, substantive relationship before contacting someone to solicit a commitment as part of fundraising.

Testimonials are bad. You can’t have friends say great things about you in advertising. It’s not just testimonial about the investment manager, but testimonials about the portfolio companies. The panelists shared stories of SEC deficiency letters that specifically dinged managers.

Deal lists need to be based on objective criteria that does not skew the results. You can’t have a bad pattern.

You need disclosures that past performance is not an indication of future performance.

Performance numbers need to be net numbers and not gross numbers. None of the guidance is tailored to the private equity space where calculation of performance is very idiosyncratic.

The SEC has indicated that exams will be focused on performance information in marketing materials. That points right at the valuation issues behind that performance.

Political contributions are a hot button. If you are going to solicit state or local pension funds, you need to limit political contributions to certain candidates and the political parties in that state. There are also state and local lobbying rules that could apply. See California for example that makes certain internal people fall into the statutory definition of lobbyist.

Summary, all marketing materials should be approved by compliance before being set free into the wild.

The panel expressed some concern that the JOBS Act changes may not be as simple as deletion of the ban on solicitation and advertising.

When using benchmarks, it’s important to use appropriate benchmarks. You can’t be misleading. It needs to be an apple to apple comparison.

You need to be cautious when communicating with investors during a fundraising period. If it could be used to entice the limited partner to invest in the next fund, it could be considered advertising and subject to the marketing limits.

Insider Trading and Restricted Lists

These are my notes from the “Insider trading and restricted lists” session at the Private Fund Compliance Forum 2012.

Two items affect insider trading: federal securities law (10b5) and a firm’s code of ethics under the Investment Advisers Act.

The panelists do not circulate a restricted list. The SEC will ask for the restricted list and ask employees if they know where the restricted list.

Given your firm’s profile, you can tailor the restrictions to the profile. The SEC does not have specific limitations.

It is important to use the insider trading list to explain why companies end up on the restricted list.

It’s also important to get companies back off the restricted list. If you signed a Non-Disclosure Agreement you need to at least respect the term of the NDA. If you lose the auction, then wait for the deal to be announced. Review the list on a regular basis to make sure it stays up to date.

What about extending the code beyond employees? Most of the panelists extend the restrictions to any relative living in the household.

If you are using paper statements, mark on the statement that you reviewed the statement. Date and initial works. Also put a check mark next to the trades shown on the statement indicating your review.

The panel also spent a fair amount of time discussing expert networks. Paying any individual for information could make them an expert network. Keep in mind that the new STOCK Act that prohibits Congressional trading also creates a duty of confidentiality when it comes to Congressional actions and makes more legislative information gathering subject to insider trading limitations.

Policies need to be reasonable designed to prevent violations of the federal securities laws.

At a minimum you need to do what you say you will do, even if that may not be enough. Document decisions and discussions about trading decisions.

Conducting an Effective Annual Review

These are my notes from the “Conducting an effective annual review” session at the Private Fund Compliance Forum 2012.

Moderator:
Charles Lerner, Editor, The US Private Equity Fund Compliance Guide and The US Private Equity Fund Compliance Companion & Principal, Fiduciary Compliance Associates LLC
Panel Members
Nicholas Denton-Clark, Managing Director & Chief Compliance Officer, PineBridge Investments LLC
Kelly S. Hale, Compliance Officer, TA Associates
Danielle M. Perfetuo, Chief Compliance Officer & Counsel, Alcion Ventures
Robert E. Phay, Jr., Associate General Counsel & CCO, Commonfund

You are required to update the policies and procedures every year. That means date them.

One topic was whether to run the annual review throughout the year or all at once. Panelists came down on each side.

One panelist looked that the litigation releases to see what went wrong with other firms. That adds a perspective on whether the firm’s policies and procedures could address and prevent the problem. It’s a also a great tool to help educate business people on compliance problems.

Top Ten things to consider when conducting an annual review

  1. Utilize your risk assessment to determine focus areas
  2. Review new products or business lines and current market conditions
  3. Review results and issues raised in previous review
  4. Review top SEC deficiency and focus areas
  5. Ensure new rules, regulations and guidance are addressed in your policies and procedures
  6. Confirm conflicts of interests are addressed and/or mitigated
  7. Interview employees to assess program effectiveness
  8. Review your disclosure documents and other regulatory filings
  9. Test the effectiveness of and compliance with your policies
  10. Document your review

For new registrants, Charles recommended that you do the annual review in the fall. If it’s a bust, then don’t document the review. Then do another in early 2013, within a year of registration, hopefully with the problems fixed from the busted annual review.

The SEC does not require a written report, but it needs to be a written report. How else can you prove that you did the annual review unless there was a written report. They key is to show that you were thoughtful about the process.

What goes into the report? List everything that you looked at, what problems were discovered or changes that could impact the item, proposed changes, and follow up.

What do you do if the policy is not being followed? Depends on the rule. If it follows the SEC required minimum then you need more training. Otherwise, adjust the policy so there are fewer transgressions. For example, if your policy requires pre-clearance of political contributions and people are not pre-clearing. Maybe you remove the requirement of pre-clearance.

Allocation of expenses is a hot button for the SEC when it comes to private equity. That includes calculation of the fee.

What happens if a limited partner asks for a copy of the annual review? Don’t give it to them. If the LP is a public pension fund, that document would be subject to a FOIA request.

Most of the panelists used outside counsel as an intermediary for annual review and some forensic testing. That makes the attorney-client privilege as a defense to producing the report. If the SEC asks, it’s probably still a good idea to give it to them.

It’s a good idea to keep individual names out of the annual review so that the names don’t end up in a SEC deficiency letter.