Category: Corporate Governance

Blockchain for Corporate Records

Jamie Dimon, chief executive of JPMorgan Chase & Co, speaking at a bank investor conference said Bitcoin “is a fraud” and will blow up. Further, that if any JPMorgan traders were trading the crypto-currency, “I would fire them in a second, for two reasons: It is against our rules and they are stupid, and both are dangerous.”

I’ve said it before. I don’t find Bitcoin to be a currency and it’s utility is suspect. But like Tesla stock and Dutch tulip bulbs, people will trade on the item if there is a dollar to be made. I don’t think it’s a fraud. There is value.

The interesting part of Bitcoin is the underlying blockchain technology that traces who holds all of the bitcoins in circulation. Imagine if Bank of America, JP Morgan, US Bank, Wells Fargo and all of the other banks used one ledger to track the movement of cash and each of them had a copy to prevent fraud. That’s blockchain, a distributed ledger.

Blockchain has uses outside of the tracking of money. It can be used to track almost anything.

Delaware and Nevada passed laws this summer allowing Blockchain to be used to track corporate records. It sounds innovative, but I’m skeptical.

The grand theme of Blockchain is trust. Since many people have copies of the distributed ledger, you prevent fraud. Because everyone has direct access information, you cut out intermediaries who would intervene to charge a transaction fee.

Most corporate records don’t fall into that category. There is a single instance and that is all that is needed.

The exception is stock ownership. I see some utility there to track ownership of a firm’s shares. For it to work, all of the shareholders and the firm would need to have the Blockchain ledger. For a small firm, it’s probably overkill. For a large company there may be some economies of scale.

I’m not sure how it works for a public company. Trading in public companies is fraught with issues. The markets do more than just transfer ownership. Their main role is pricing the shares. Blockchain could be used for the record-keeping but not does not lend itself well to the pricing.

For Bitcoin, Blockchain does a great job of tracks who holds the currency. The pricing comes from converting bitcoins into dollars which is outside of Blockchain and done by intermediaries who charge a fee. I assume the same would true if company moved the trading of public company shares onto blockchain.

The other problem is whether one Blockchain instance could address the shares at multiple firms or would there need to be separate instances of Blockchain. That also has some scaling issue.

I think there are tremendous uses for Blockchain to share value and information across firms and eliminate transaction costs. In these early days, it sounds more like people with a hammer thinking everything looks like a nail.

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Cybersecurity: a growing risk imperative #CFOandCOO

I’m attending the PERE CFOs & CCOs Forum. These are my notes from the session.

PERE

On a scale of 1 to 5 the attendees created a classic bell curve on how confident we felt about our cybersecurity programs, with most choosing “3.”

The panel labeled social engineering as the upcoming threat. There were several stories of fake invoices coming from outside the firm, spoofed to look like it was coming from within the firm. The other example was malware injected into the it system by a junior person opening a malware file sent through email.

Cybersecurity should be part of the regular compliance training. Focus spoofing and phishing prevention training on those who can move funds or authorize funds to move.

Cybersecurity is now a common item on SEC exams. Be ready to answer questions.

Hackers tend to be opportunistic. They need to see a weakness or they are more likely to move on to another target. The scary problem is when our firm is specifically targeted.

The panelists seem to have some strict rules on the use of personal email. The challenge is that younger workers are used to collaborative tools and easier access to information.

For mobile devices, the standard is to be able wipe the phone remotely in case it is lost to keep information secure. Make sure everyone knows to quickly report a lost phone.

Cybersecurity is part of fundraising. It is a very common item on investors’ due diligence questionnaires. Although probing beyond the questions tends to be limited.

Cyberinsurance is becoming more common. The coverage is expanding. It covers losses. It does not necessarily cover all of the incident response.

Do As I Say, Not As I Do

As financial firms are the recipients of more and more reporting obligations from government regulators, I find it amusing to note when the lawmakers fail in their own reporting obligations. The Wall Street Journal is reporting that Senator Bob Corker failed to disclose millions of dollars in his financial reports.

senator bob corker

The senator is the third-ranking Republican on the Senate Banking Committee, which oversees the real-estate and financial-services sectors. This is the committee that oversees the Securities and Exchange Commission and is, at least in part, the architect of the reporting obligations of fund managers and investment advisers.

“I am extremely disappointed in the filing errors that were made in earlier financial disclosure reports,” Mr. Corker said in a statement to the Wall Street Journal.

I don’t think the SEC would be as receptive to that statement when made during an examination.

Or for blaming the accountants for using the wrong method.

I’m not accusing the Senator for any wrongdoing. He relies on his team of advisers to follow the rules imposed on him.

Of course the same can be said for many investment advisers. Do As I Say, Not As I Do

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The New Rule 506(d) and Bad Actors

baD BOYS

At its latest meeting, the Securities and Exchange Commission approve the rule that lifted the ban on general solicitation and advertising for certain private placements. The SEC also adopted the new rule that disqualifies felons and other bad actors from participating in certain securities offerings. The first rule was mandated by the JOBS Act. The “bad actor” rule was mandated by Dodd-Frank.

The bad actor rule makes private placements a bit harder and will require private funds and companies to do more homework in connection with the fundraising. That’s because an issuer cannot rely on the Rule 506 exemption if the issuer or any other person covered by the rule had a “bad actor disqualification.”

I think the starting point is who is covered by the rule. The rule applies to

  • The issuer, including its predecessors and affiliates
  • Directors, executive officers, general partners, and managing members of the issuer
  • Any other officer participating in the offering
  • Anyone who holds 20% or more of the outstanding voting equity securities
  • Investment managers and principals of pooled investment funds
  • Any general partner or managing member, director, executive officer or other officer participating in the offering of a fund sponsor
  • Solicitors paid to sell the securities investors as well as the general partners, directors, officers, managing members or other officer participating in the offering

For fund managers registered with the SEC the employees affected are a narrower group than those in Item 11 on Form ADV. That part of the Form ADV disclosure applies to all employees, other than employees performing only clerical, administrative, support or similar functions. Plus the Form ADV includes all of the officers, partners, directors, and certain affiliates.

The big difference is the 20% threshold for ownership in the company. For startups, that would likely pull some angel investors into the “actor” category.

It’s not clear what to do if the 20% investor is an entity. The rule does not seem to cover that circumstance. I suppose that if Bernie Madoff set up Scumbag Bernie Investor LLC to invest in the fund that would be a mere facade to hide his ownership. If the entity has multiple owners and officers it seems that a single “bad actor” inside the investor should not taint the whole entity.

The other fuzzy item is “officers participating in the offering.” The SEC had declined to merely use job title as the defining line. That would have included everyone who had the title of vice president.

Participation in an offering would have to be more than transitory or incidental involvement, and could include activities such as participation or involvement in due diligence activities, involvement in the preparation of disclosure documents, and communication with the issuer, prospective investors or other offering participants.

I’m not sure how I feel about that guidance. A lot of people end up reviewing the Private Placement Memorandum.

Of those relevant actors to determine if they were bad, they need to have been involved in a “disqualifying event” which includes:

  • Criminal convictions in connection with financial fraud.
  • Subject to an order of judgement that limits involvement in the securities industry.
  • Subject to an order of judgement that limits involvement in the banking industry
  • Subject to an order of judgement from the CFTC.
  • Subject to a US Postal Service false representation order.

The actual list is much more convoluted, long, and unwieldy. That means putting together a questionnaire will be difficult. For private fund adviser, it does not match up squarely with the Form ADV disclosures and is not as clearly written as the Form ADV disclosures.

The default would be to put together a questionnaire and just use the text of Rule 505(d). I’m not sure it’s comprehensible by a non-lawyer. Actually, I’m not sure it’s easily comprehensible by a lawyer. I just added it to my questionnaire for Form ADV, making it extend to four pages.

The next question is how much diligence you need to conduct to determine if one of your “actors” is a “bad actor”? The rule requires the issuer to exercise “reasonable care.” Which in “light of the circumstances, the issuer made a factual inquiry into whether a disqualification exists.”

That’s the kind of fuzziness that keeps a compliance officer up at night.

Fortunately, the SEC offers some color to the “reasonable care” in the release.

For example, we anticipate that issuers will have an in-depth knowledge of their own executive officers and other officers participating in securities offerings gained through the hiring process and in the course of the employment relationship, and in such circumstances, further steps may not be required in connection with a particular offering.

So the questionnaire approach should work for employees, unless you have some suspicion that an employee has been up to no good.

What about for investors?

Factual inquiry by means of questionnaires or certifications, perhaps accompanied by contractual representations, covenants and undertakings, may be sufficient in some circumstances, particularly if there is no information or other indicators suggesting bad actor involvement.

That’s enough to let me fall asleep at night. Maybe I’ll need just a little bourbon to take the edge off.

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How Wall Street Killed Financial Reform

I’m sure you heard in the news that JP Morgan lost $2 billion in a trades using complex derivatives tied to corporate bond defaults. But didn’t we fix this two years ago when Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act? It seems like JP Morgan’s mistakes should be the first test of Dodd-Frank. The law fails. It’s just lucky that JP Morgan’s trade was stopped before it destroyed the bank.

By coincidence, Matt Taibbi wrote a piece in Rolling Stone about the failings of Dodd-Frank: How Wall Street Killed Financial Reform. I generally find Mr. Taibbi’s take on finance to be a bit over the top, with more hyperbole in a world that lacks the subtle shades of compromise. This article is no different. But he also gets lots of the right points. Dodd-Frank will not result in financial reform.

Taibbi makes five key points.

1. Strangle it in the Womb

Financial reform started off with some great ideas. But they were watered down as the law progressed through the legislative process. For example, Mr. Volker’s simple concept of banning proprietary trading got twisted and poked, allowing broad exemptions. The Consumer Financial Protection Bureau went from being an independent watchdog to an office under the budgetary constraints of the Federal Reserve System.

2. Litigation

The federal regulators will need to contend with courtroom challenges to their regulations, with industry arguing that they go beyond the scope of the legislation or failed to adequately run a cost-benefit analysis of the regulation.

3. If You Can’t Win, Stall

Many sections of the law are experiencing “unforeseen delays.” Taibbi blames Wall Street lobbyists. I blame the law itself. Dodd-Frank deferred much of the implementation to the regulators, meaning they would need to craft new complex regulations and definitions of key terms that are mere sketched out in the law itself. This overloaded the ability of the regulators to produce new regulations. They are tasked with a ten-fold increase in the rule-making agenda. That means the regulators need more staff and the time to get them up to speed. But Congress largely failed to provide the financial support.

4. Bully the Regulators

When Congress is frustrated with a regulator, they just cut funding. Rather than increase the SEC’s budget to allow for the resources to create and implement the new regulations, Republican congressmen tried to cut the Commission’s budget.

5. Pass a Gazillion Loopholes

Congress is moving bills forward to further undercut Dodd-Frank. We saw that with the Rapid passage of the Jumpstart Our Business Startups Act. (I would argue that it undercuts Sarbanes-Oxley, not Dodd-Frank.) As the balance of power in Congress shifts, parts of financial reform become less viable. I think the true test will come a year from now, after the Presidential election. A Romney win and some Republican congressional wins will likely lead to a rapid erosion of Dodd-Frank.

The one point that Taibbi only alludes to is that Congress does not understand the financial markets or the securities laws. I watched some of the Congressional testimony on the JOBS Act. Only a handful of the member of Congress had any idea what was really in the law. Dodd-Frank is even worse. It was a massive law. I would place a wager that no more than 10 members of Congress actually read the whole law before voting on it. Even fewer understood the implications.

 

A Conversation with Paul Volcker

In a night out that only a compliance geek would love, I spent Monday night listening to Malcolm Salter talk with Paul Volcker, former Chairman of the Federal Reserve. Harvard University’s Edmond J. Safra Center for Ethics and the Center’s director, Lawrence Lessig, hosted the event in the Ames Courtroom at Harvard Law School. The topic, as you might expect, was Implementing Financial Reform

It was clear that Mr. Volcker is a supporter of traditional commercial banking. He stated that they are essential to commerce. Their core functions of taking deposits, making loans, and operating the payment system are essential and need to be protected. There is a price for that protection: government oversight and restrictions.

The 2008 crisis came from non-banks. Hedge funds and investment banks touted their efficiency, lack of regulatory oversight, brilliant managers, and best financial engineers. In 1998 they invented Credit Default Swaps. They blew themselves up.

There were $60 trillion of CDS instruments insuring $6 trillion of loans. Today there are $700 trillion of the greater category of derivatives.  That is an order of magnitude larger that the world’s GDP.

Mr. Volker was quick to point out that proprietary trading was not the cause of the 2008 crisis, it was the origination of many, many bad home loans to people who could not repay them. However, proprietary trading did play a role.

Mr. Salter pulled out a thick binder contained the proposed Volcker Rule. (I did the same thing at the PEI CFO Forum.) But Mr. Volcker found that disingenuous. The rule itself is only about 35 pages and the rest of the binder contained the commentary and thousands of questions posed by regulators.

Mr. Volcker compared the current rule on proprietary trading to a rule on Truth in Lending that he implemented while he was Chairman of the Federal Reserve. The initial draft from his staff was 170 pages, he sent it back with a requirement that it be no more than 100 pages. He wanted it simpler and they delivered. To his surprise, most of the industry comments were to have more details in the rule.

It became apparent to me that Mr. Volcker was advocate of a principle-based oversight rather than a rules-based oversight. The more rules there are, the more gamesmanship that the industry will engage in. He pointed to the example of Barclays and Deutsche Bank re-shaping their US subsidiaries so they would no longer be classified as bank holding companies. He thinks it will be relatively easy for regulators to spot proprietary trading by focusing on volume an volatility.

Switching topics, Mr. Volcker pointed out that the standards for bank capital requirements were another part of the 2008 crisis. Under the regulatory capital requirements, banks were not required to set much capital aside for mortgages and sovereign debt.  There is some backlash in the Volcker rule because it allows proprietary trading in US government securities, but not in non-US sovereign debt. That has been the case for many years, going back to Glass-Steagall. The problem is drawing the line between which sovereign debt is safe and which is not.

Mr. Volcker does not think that the proposed rule is on a deathwatch. Rule-making is inherently complex and this is a complex area. To add to the complexity, several government agencies are involved in the rule. He also pointed out that much more lobbying and money is involved in the rule-making process than when he was Chairman of the Fed. You want industry responses to rules. The difficult part is when that response is coupled with a campaign contribution to Congress.

Circling back to the ethics aspect (the event was sponsored by the Center for Ethics), Mr. Volcker pointed out that proprietary trading causes an inherent conflict of interest with your customers. The trader is no longer acting as a broker, pulling a buyer and seller together. The proprietary trading bank is buying and selling for its inventory.

Proprietary trading creates a conflict in the compensation structure. Traders get paid on short-term gains, often before the trade’s economic effect is fully realized. That outsized and short-term compensation becomes a siren song for bankers looking for fatter wallets, causing them to take bigger risks. (Like, say originating sub-prime loans and reselling them.)

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The Case for Professional Boards

If you want to improve governance at a corporation, do you need professional directors? Did SOX merely add a layer of legal obligations of board, and do little to improve the quality of those serving as directors?

Robert C. Pozen makes the case in The Case for Professional Boards in the December issue of the Harvard Business Review.

Pozen starts by limiting the size of the board to seven people: the CEO plus six independent directors. He points to research that groups of this size are optimal for decision-making. Bigger groups can result in “social loafing”, relying on others to take the lead and ceding decision-making. Six also gives you enough people to populate the three key committees: nominating, compensation and audit.

The greatest need in a board is expertise. Pozen expects an accounting expert to head the audit committee. He also allows for one generalist to provide a broad perspective on the company’s strategy. But the rest should be experts in the company’s main line of business. That is not easy. Independent experts are most likely working for company’s competitors. He expects that most professional directors would be retired executives in the company’s industry. That would also lead to the elimination of mandatory retirement ages for directors.

Pozen makes a strong case. “To improve corporate oversight we need not more legal procedures but a culture of governance in which directors commit to the role as their primary occupation.” It’s just very radical strategy for companies who have grown and gathered their directors organically.

Facebook, Capital and Liquidity

There have been many stories written about the Goldman Sachs investment in Facebook. On one hand, there is the chatter about the investment placing the valuation at $50 billion. On the other, there hand there is the talk about how this affects a possible IPO by Facebook.

There are two main reasons for an public offering of stock: liquidity and capital.

If you need capital, a public offering of common stock is merely one of many ways to raise capital. The benefit of this option is that the capital does not need to be repaid. A bank loan, a bond offering, venture capital or private capital will generally need to be repaid at some point. Each source of capital has a price and repayment terms that you need to align with the company’s needs and business plan.

It sounds like Facebook has ready access to capital in many forms. So an initial public offering may not be the best or the cheapest source of capital.

The liquidity of public stock is useful for rewarding employees and cashing out earlier sources of capital. Employee stock is great, but in a private company is very illiquid. It does you very little good to be a millionaire on paper if you can’t access the wealth. Early round investors, like venture capital funds, want to be cashed out at some point. They need to return capital to their investors. It sounds like some of the private trading of Facebook stock is being done by employees and early investors.

The third reason for a public offering stock was the reason faced by Google. Once you have more than 499 investors, you need to start making reports public. So you may as well get the benefits of liquidity in the stock.

The cash from a public offering does not need to repaid, but there are costs to the capital. That means complying with Sarbanes-Oxley. The CEO and CFO has potential criminal liability for false reporting. The board of directors will now need to include independent directors. The company will be subject to shareholder lawsuits. There are lots of costs.

To me it sounds like Facebook and Goldman have come up with an ingenious solution to the address the capital needs for Facebook and to avoid a public offering of stock. I assume the Goldman investment and its new fund will be used to provide some capital for expansion and growth. I also suspect that some of it will be used to cash out early investors, purchase employee stock, and repurchase stock that has been privately traded. Gobbling up the stock would be an opportunity to keep the number of investors well below the 499 trigger point. Early investors may take their money and run.

Assuming Goldman can provide $2 billion and charge its investors a 4% fee for investing, they have already made $80 million on their $450 million investment.

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New York Stock Exchange and Corporate Governance

Last week, the NYSE Euronext released the final report of the NYSE–sponsored Commission on Corporate Governance. The report identified 10 core governance principles. They cover the scope of the board’s authority, management’s responsibility for governance and the relationship between shareholders’ trading activities, voting decisions and governance.

The Commission on Corporate Governance was established in the fall of 2009 to examine core governance principles that could be widely supported by issuers, investors, directors, experts, and other market participants. These stakeholders have different viewpoints on governance issues, but the NYSE hoped they could find a consensus.

They started with the 10 core principles:

  1. The Board’s fundamental objective should be to build long-term sustainable growth in shareholder value for the corporation;
  2. Successful corporate governance depends upon successful management of the company, as management has the primary responsibility for creating a culture of performance with integrity and ethical behavior;
  3. Good corporate governance should be integrated with the company’s business strategy and not viewed as simply a compliance obligation;
  4. Shareholders have a responsibility and long-term economic interest to vote their shares in a reasoned and responsible manner, and should engage in a dialogue with companies thoughtful manner;
  5. While legislation and agency rule-making are important to establish the basic tenets of corporate governance, corporate governance issues are generally best solved through collaboration and market-based reforms;
  6. A critical component of good governance is transparency, as well governed companies should ensure that they have appropriate disclosure policies and practices and investors should also be held to appropriate levels of transparency, including disclosure of derivative or other security ownership on a timely basis;
  7. The Commission supports the NYSE’s listing requirements generally providing for a majority of independent directors, but also believes that companies can have additional non-independent directors so that there is an appropriate range and mix of expertise, diversity and knowledge on the board;
  8. The Commission recognizes the influence that proxy advisory firms have on the markets, and believes that it is important that such firms be held to appropriate standards of transparency and accountability;
  9. The SEC should work with exchanges to ease the burden of proxy voting while encouraging greater participation by individual investors in the proxy voting process;
  10. The SEC and/or the NYSE should periodically assess the impact of major governance reforms to determine if these reforms are achieving their goals, and in light of the many reforms adopted over the last decade the SEC should consider the expanded use of “pilot” programs, including the use of “sunset provisions” to help identify any implementation problems before a program is fully rolled out.

In Section IV of the report, they dive deeper into the roles of the board of directors, company management, and shareholders, recognizing the interdependence and inter-relatedness of the three groups. I found this to be the most interesting section. They lay out rights, responsibilities and expectations.

In the end, they do not end up advocating for change:

“Finally, it is important to note that as the Commission reviewed these issues, it did so in the context of the reality that, notwithstanding certain governance failures over the last decade, the current governance system generally works well. The Commission believes that failures of corporate governance were not the sole reason for the financial crisis of 2008, and more broadly believes that most of the thousands of public companies in this country are well governed, with hard-working and ethical boards and shareholders who are involved in the companies. This does not mean that the system is perfect, but it does mean that before further fundamental change is sought, all parties considering such change should recognize the strengths of the current system and the benefits it provides to investors and the economy.”

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The Most Influential People in Corporate Governance

The National Association of Corporate Directors (NACD) publishes the Directorship 100. They surveyed 15,000 public company directors and executives to form the final 100 honorees.

I was interested to see how they broke them into groups:

  1. Regulators and Rule Makers
  2. Directors
  3. CEOs
  4. Governance Policy Makers
  5. Attorneys
  6. Investors
  7. Auditors
  8. Recruiters
  9. Compensators
  10. D&O Insurers, Governance Advisors
  11. Corporate Governance Officers, Corporate Secretaries & General Counsel
  12. Professors
  13. Strategists
  14. Media

I found it interesting that “attorneys” list was as big as the list of “directors.” It’s clear from the list that there are lots of stakeholders affecting the boardroom’s activity.

All members of the Directorship 100, regardless of how they arrived here, have power and influence. Some of it is new, some of it is long-standing. Our modest job is to reveal those who exert the kind of influence that will permit the continued, if sometimes shaky, path that our system of capitalism is on, and the importance of corporate governance as a critical guidepost along the route

They also included the 2010 Corporate Governance Hall of Fame.

I also wanted to say congratulations to Douglas K. Chia of Johnson & Johnson for making the list. He even managed to get his picture into the pdf version of the publication (page 44).

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