GM Shows That Lying Can Be Worse Than The Problem

GM and compliance

General Motors had a problem with its cars and didn’t fix it. Then the company apparently tried to cover up the mistake and lied about the mistake. As a result, GM lost the story and ended up with a headline of GM Lied and People Died.

The problem seems to come from a mistake made by an engineer in designing the ignition switch design. He approved the design even though it failed to meet GM’s standard on torque requirements. The result is that the key could inadvertently move out of position, affecting power brakes, power steering and air bags.

That engineer authorized a switch redesign after problems surfaced. However, he did not assign a new part number, making it impossible to track any changes to the part. As the defect became apparent, GM compounded the engineer’s problem by failing to fix the problem.

So far 13 deaths and 32 crashes have been linked to the defect. GM has repaired more than 113,000 cars out of a total 2.6 million worldwide under the switch recall.

Because of the lies and cover-up, GM loses the ability to tell a more nuanced story about the defect.

Car and Driver tested the effects of the key defect and the results do make it sound like the car turns into a death trap. For brakes, with a full failure, the effort to stop the car increased from 51 pounds to 220 pounds. That’s a big push but achievable by most people. The magazine’s tests resulted in 3 more feet of stopping distance.  That increase is after a complete shutdown. The brakes will still have some boost after the engine shuts off.

Steering effort increases from a range of 3.3 pounds to 8.0 pounds up to 15.1 pounds to 29.2 pounds.  That increase in manageable for most people.

For years, people were driving cars without power steering and power brakes. Of course, the sudden loss of power can lead to panic and increase the risk of an accident. As it likely did in the 32 linked crashes.

The airbags deployment is also a more nuanced position. The airbags can deploy when the key is not in the “on” position. Cars are loaded with sensors that trigger the decision to deploy the airbags. A misfired airbag can be dangerous. So in many models, the airbags do not deploy when a person is out of position in the vehicle. This is particularly true when a passenger is not restrained by a seatbelt.

At least seven of the thirteen victims were not wearing their seatbelts. That increases the chances that the airbags would not deploy, even if the key was in the “On” position.

At least four of the drivers were under the influence of drugs or alcohol at the time of the accidents. That will decrease their ability to properly react to the defective shutdown after the key moves.

But GM lost the ability to control the narrative. The company manufactured a vehicle with a known defect and then failed to fixed the defect after it was discovered. The dominant narrative that the cars turned into uncontrollable deathtraps doesn’t hold up. But GM is stuck addressing its internal problems with the media and regulators.

The lies made the problem many times worse for the company.

References:

Compliance Bricks and Mortar for June 6

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

The key to hedge-fund riches: your retirement dollars by Timothy Spangler in The Guardian

First, there is the misconception that “there are no restrictions on what they can invest in.” This is true. They can invest the same way Sir Richard Branson or your Aunt Edna can invest, if they had the money and the expertise. They are not given a special pass to avoid all of modern Wall Street regulation that applies to ever trader out there. But, since retail investors are excluded, hedge funds don’t have to submit to any of the “bubble wrap” restrictions that the SEC puts on mutual funds and other products meant for retail investors.

SEC, Bitcoin and Unregistered Offerings by Thomas O. Gorman in SEC Actions

Bitcoin has been a much discussed item recently. The virtual currency is a digital representation of value that is traded and can serve as a medium of exchange. There are websites that use it. At one time there was a stock exchange called the Global Bitcoin Stock Exchange which apparently listed shares valued in the medium but is now out of business. And, there are trading platforms that use bitcoin such as the MPEx based in Romania.

Now the Commission has brought an administrative proceeding involving two offerings of unregistered securities valued in bitcoin.

The SEC’s (New) Admissions Policy: Questions and Consequences by Nancy Adams in Securities Litigation & Compliance Matters

Nearly a year has passed since the SEC announced that it would require admissions of wrongdoing as a condition of settling SEC charges in certain cases. Perhaps it can no longer be called a “new” policy. But lawyers are still wrestling with questions about the policy and its consequences – both intended and unintended. How broadly does the new policy apply? How and when should the question of its application be addressed in a case?

FATCA: What it is, and why it may apply to your business by Stephanie Quiñones in The Securities Edge

The Foreign Account Tax Compliance Act (“FATCA”) is a US law designed to counter offshore tax avoidance by US persons. Controversial because of its wide-ranging breadth and application to non-US financial institutions, in the most general sense, FATCA imposes a 30% withholding tax on payments of US source income made to foreign financial institutions (“FFIs”) unless they enter into an agreement with the US Internal Revenue Service (“IRS”) and disclose information about their US account holders.

Massachusetts, Illinois surveying RIAs about cybersecurity by Minda Smiley in Investment News

“Many of the RIAs are smaller and we want to get their input to see what exactly they feel they have and what they might need,” said William Galvin, secretary of the Commonwealth of Massachusetts. “We want to see what kind of protections are in place and if additional protections are needed, we want to prescribe what they should be.”

Do You Want Your Lawyer To Be Horatius Or Atticus Finch? by Keith Paul Bishop in California Corporate & Securities Law

Lawyers should be treated differently from accountants because their roles and professional obligations are fundamentally different. Simply put, lawyers are not gatekeepers. To foist the role of gatekeeper on private attorneys undermines the critical role that lawyers play in our polity as advocates for their clients and checks on the government. The former Soviet Union had lawyers, but they all worked for the government. By labeling lawyers as gatekeepers and threatening enforcement, the government is in effect saying “you work for us”.

Judge Rakoff Reversed by Second Circuit on SEC-Citi case, Still Sort of Wins by David Smyth in Cady Bar the Door

And yet, it turns out Judge Rakoff was wrong the whole time.  By essentially insisting on admissions to the facts alleged in the SEC’s complaint, Rakoff exceeded his authority as a district judge.  According to the Second Circuit today, here is what a court evaluating a proposed SEC consent decree for fairness and reasonableness should assess: (1) the basic legality of the decree, (2) whether the terms of the decree, including its enforcement mechanism, are clear; (3) whether the consent decree reflects a resolution of the actual claims in the complaint; and (4) whether the consent decree is tainted by improper collusion or corruption of some kind.  Of course, a district court may need to make additional inquiry to ensure the decree is fair and reasonable.  Indeed, it shouldn’t be a “rubber stamp.”  But the primary focus should be on ensuring the decree is procedurally proper and take care not to infringe on the SEC’s discretionary authority to settle on a particular set of terms.

Spot the Fraudster

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One of the challenges that consumers face when dealing with a financial adviser is what it means to be a “financial adviser.” The terms financial planner, wealth consultant, stockbroker, investment adviser, financial consultant, and others get thrown around, leaving you how that person gets paid for helping you with your money. A fraudster may sling around those terms and get paid by taking your money instead of investing it.

What to do when someone claims his firm is “an accredited investment and consulting firm specializing in wealth creation and preservation”? I know to run to FINRA’s BrokerCheck and the SEC’s Investment Adviser Search for diligence. In this case, you find red flags.

The Securities and Exchange Commission alleges that Scott Valente and his firm The ELIV Group LLC fraudulently raised more than $8.8 million from 80 clients by falsely claiming they achieve consistent and outsized positive returns coupled with misrepresentations about the safety of the investments. Valente and the firm are challenging the accusation, so we only have the SEC’s view of the case.

The other view is the FINRA history. Broker Check can be controversial because brokers have a hard time fighting back against customer accusations. There is one brightline in BrokerCheck and Valente has it on his report. Valente is barred from association with any FINRA member. He was kicked out of the brokerage industry.

Apparently, he decided to switch over to “wealth creation and preservation”, instead of merely selling securities, and formed ELIV Group.

According to the ELIV website, it invests 40% of the assets into “initial public offerings.” But it then goes on to say to that “We are able to buy privately held companies before they go public at very low prices.” Well that does not sound like an IPO. That sounds live private equity or venture capital investing to me. But maybe I’m just being overly technical.

The second method is E-mini S&P 500 Futures. That’s a risky investment that requires constant trading, unlike the bread and butter S&P index funds and ETFs.

ELIV’s third method is options. Again, another volatile trading strategy.

The fourth strategy is currency trading, using seven currencies.

That’s a lot of trading and a lot of different areas of expertise. The website claims a five year average annual return of 34.5%. That’s a great result, especially considering that the firm has been around for less than five years.

Perhaps Mr. Valente can pull it off. However, the SEC says that Valente generated losses and stole money from his investors (? … clients?… victims?). The SEC claims that Mr. Valente withdrew over $2 million to pay his personal expenses, far in excess of the 1% management he was entitled to.

According to the SEC complaint at least some of the ELIV clients were Mr. Valente’s clients while he was a broker. There is the problem for consumers. How are they supposed to conduct diligence on a financial adviser when the securities laws, licensing requirements, and disclosure information sites are fractured into so many parts?

References:

Secure Borders

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What do compliance and border security have in common? More than you might initially think. Try reading Sylvia Longmire’s Border Insecurity. Some of the issues with border security will resonate with compliance professionals. (Hopefully, you don’t have to deal with illegal immigration, human trafficking, terrorism and drug smuggling as the compliance issues at your company.)

One common problem is how you define success.

If there is a rise in the number of successful drug stops. Two things could be happening. You may have your rate of catching traffickers. Instead of finding 50% of the drug crossings, you are now finding 75%. Or there has been an increase in drug crossings and your success rate has stayed the same. It’s almost impossible to know.

The same is true with compliance. If there is a rise in the number of calls to the hotline, is it because more people are reporting, or because there are more incidents? It’s hard to measure success when the goal is prevention.

If the border were completely secure, there would be no apprehensions beyond the border and there would be 100% success in preventing illegal drugs from crossing border. Of course the border cannot be completely secure. Even if the entire length was securely double fenced, illegal crossing could go under the fences through tunnels, or over the fences with aircraft or catapults. (Yes, they really catapult drug packages over the fence.) Bad guys could move through legal crossings and possibly avoid detection. The World Trade Center terrorists came border checkpoints and not through clandestine crossings

Compliance can’t prevent bad things from happening. It can discourage the activity and it can try to detect the activity. Bad people will do bad things and try to get around the controls that prevent them.

There is ethics sprinkled in the book. Few doubt that the prevention of drug smuggling and criminals from crossing the border are very important elements of border security. Economic immigrants are a more nuanced discussion and Longmire does a great job discussing both sides. There is the humanitarian side and the economic side. Longmire’s approach is that it is a distraction. The limited border defense resources should be focused on the very bad things: drugs, criminals, and terrorists.

I found this book to be much better than Longmire’s first book Cartel. That book read like a collection of blog posts pasted together into a book. I received both books from the publisher with the expectation of a review.

Making Compliance Easier

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At PEI ‘s Private Fund Compliance Forum, one attendee asked how to make compliance easier. That caught the room by surprise. If compliance was easy, we would likely would not be at the Forum.

But it did get me thinking about ways to make compliance easier.

First, compliance is hard because the laws we comply with are complicated. Lots of the blame for difficulty can be pinned on Congress, the state legislatures and the regulators. The more complex the law, the harder the compliance.

The most obvious way to make compliance easier is to set simple rules. That may make it easier to comply, but more difficult for the organization.

Take political contributions as an example. For me, there is the SEC rule that limits investment adviser contributions. Layer on the state level requirement and you end up with a complicated list of what you can do and cannot do.

To make compliance easy, just ban all political contributions. Of course you run into the problem with the jurisdictions that prohibit a prohibition on political contributions. You also run into the problem of employees wanting to make political contributions. Your easy approach to compliance just got more complicated.

Or take the example of bribery and corruption. Your compliance policy could just ban all gifts and entertainment. But that leads to the awkward position of not even being able to buy a business prospect a cup of coffee as you are discussing an opportunity.

To make compliance easier, the organization and employees will need to sacrifice opportunities. The world is too competitive to sacrifice large swaths of opportunities that pose little or no risk to the organization.

That does not mean that compliance has to be hard in all areas of the business. You need to look at the risks and opportunities. Find the areas where you can make simple rules that don’t limit low-risk opportunities. Unfortunately, there are not that many.

Go back to my first point. The lawmakers and regulators keep making more and more rules. It’s rare to see a roll-back. As the laws grow, compliance requirements grow.

 

Compliance Bricks and Mortar for May 30

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

Cybersecurity Crackdown in ThinkAdvisor

Think that your firm is too small or that your cyberdefenses are too strong to worry about digital attacks on your firm’s—and your clients’—data? The SEC and FINRA don’t think so. A reading of the regulators’ official announcements and the insights of those who know how they operate suggest that advisors run the risk not only of compromised data but of major fines as the regulators gear up to make examples of firms for cybersecurity shortcomings.

Lawyers as SEC Enforcement Targets, What a Fund Manager Needs to Know by Jay B. Gould in Pillsbury’s Investment Fund Law Blog

In a move that should place securities lawyers and their clients on notice, Commissioner Kara Stein of the Securities and Exchange Commission (“SEC”) recently indicated that lawyers may become targets of SEC enforcement actions when a registrant has been poorly advised by its attorney and the result of that advice ends up harming investors or violating regulatory standards.  The SEC has the ability to sanction, fine and bar attorneys and accountants from practicing before the SEC pursuant to SEC Rules of Practice 102(e).  As a practical matter, a bar pursuant to Rule102(e) precludes an attorney or an accountant from representing a regulated entity, such as an investment adviser or broker dealer, in any further dealings with the SEC or otherwise.

SEC judge bans money manager for misleading Morningstar, investors by Trevor Hunnicutt in InvestmentNews

The administrative law judge found that Max E. Zavanelli — a portfolio manager who has compared his success at investing to the legendary Fidelity Investments manager Peter Lynch — misrepresented and omitted important data in newspaper advertisements, its own newsletters and reports for Morningstar.

Godzilla versus Collateralized Debt Obligations by Erik Gerding in the Conglomerate

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Private Equity at Work

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Eileen Appelbaum and Rosemary Batt tried to take an academic look at private equity firms and published their results in Private Equity at Work: When Wall Street Manages Main Street. The authors paint the world in black and white. They present the book as a question of whether private equity firms are (1) financial innovators that save failing businesses or (2) financial predators that bankrupt otherwise healthy companies and destroy jobs?

You can guess the answer from the first two paragraphs. The authors spend eight lines on the successful Aidells Sausage Company investment and 19 lines on the disastrous Mervyn’s Department Store investment.

The authors largely treat private equity firms as parasites and propose far-reaching and ill-thought out ideas to curb them. They reach their conclusions from a misunderstanding of private equity, poor comparisons, and a lack of data.

The authors chose to use the corporate-raiding barbarians of the 1980s leveraged buyouts as the origin of private equity instead of Bain Capital’s genesis of management consulting.

The authors routinely use public companies as a benchmark. They fail to note that public companies are merely a small fraction of the operating companies in the United States. It’s hard to get data on private companies, of course, because they are private.

In my mind comparing the bankruptcy rate of private equity-owned companies to the rate of public companies is not a true comparison of failure. I accept the premise that public companies typically carry less debt as a percentage of their capital structure. But I don’t accept the premise that the public company standard is true for non-public companies, whether they are operator owned or private equity-owned.

The authors get trapped in the idea that private equity is all about taking public companies private using high levels of debt. The LBO sector is only one part of the private equity world.

I was particularly annoyed at the authors for their failure to correctly describe the regulatory framework and background for private equity firms. Private equity firms were not subjected to SEC regulation by Dodd-Frank. The SEC always had the power to enforce the anti-fraud provisions of the various securities laws. Dodd-Frank removed a commonly-used exemption from registration as investment advisers. That old exemption was based the number of clients (i.e. funds) the firm managed, not size.

When it comes to performance, the authors have some good data, but much of it is admittedly flawed data on performance. Those flaws don’t keep them from reaching their conclusions. They note that a large chunk of private equity firms do not beat the S&P 500 or similar public company benchmark. They state that many investors would have been better off investing in an ETF. They fail to note that the same is true for mutual funds. The majority of which fail to exceed their respective benchmarks.

The authors also label private equity as focused on short-term shareholder value. They seem to forget that public companies are even more focused on short-term issues. A public company’s value is determined with every trade and the value swings up and down with the stock ticker wrapping around the tote board.

Eventually, the authors sprinkle in some positive stories of private equity. But the book is largely a hatchet job on private equity.

Eileen Appelbaum is Senior Economist at the Center for Economic and Policy Research. Rosemary Batt is the Alice Hanson Cook Professor of Women and Work at the ILR School, Cornell University.

A publicist sent me a copy to review. There were many times while reading the book that I wished he had saved the postage.

Fees, Expenses and the S.E.C.

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Andrew Bowden threw a grenade at the private fund industry three weeks ago when he spoke at PEI’s Private Fund Compliance Forum. He said that the SEC found violations of law or material weaknesses in over 50% of the exams they had conducted of private equity funds when it came to fees and expenses.

Mr. Bowden pointed to two particular types of fees and expenses: monitoring fees and operating partners. Although both of these are customary in private equity deal and disclosed in PPMs and financial statements, the SEC does not like them. He lumped them together with fraudulent expenses in the Camelot case.

Two recent news stories are carrying on Bowden’s view of private equity.

Last week, the Wall Street Journal ran a story on how KKR failed to credit certain fees back to investors because the unit was not an affiliate:  KKR Error Raises Question: What Cash Should Go to Investors? KKR is required to share with investors in its largest buyout fund 80% of any “consulting fees” collected by any KKR “affiliate.” The unit in question was owned by KKR’s management and not considered an affiliate. The article specifically tied back to Mr. Bowden’s speech.

On Sunday, Gretchen Morgenson penned an article in the New York Times about monitoring fees: The Deal’s Done. But Not the Fees. The article highlighted $30 million in monitoring fees paid to Goldman Sachs, Kohlberg Kravis Roberts and TPG Capital for their oversight of Biomet. The unpaid fees under the 10-year monitoring contract became due on the sale to Zimmer Holdings. This article also specifically mentions Mr. Bowden’s speech.

In my view, it’s not that the fees are illegal or “fraudulent, manipulative or deceptive” under Section 206. It’s a matter of disclosure to investors and internal procedure. Investors deserve a right to know the fees they are paying, either directly through the fees by the fund, or indirectly by the fees paid by the portfolio company to the fund manager. Perhaps in some fund documents the fees can be laid out in more detail. Fund managers should have internal procedures for how fees are implemented and checked to make sure they comply with the fund documents.

Personally, I think Mr. Bowden is lumping a lot of customary fees and expenses into his 50% bucket. I’m offended that he is including the case of fraud, like the Camelot case, in with instances of fees that the SEC merely does not like.

References:

Weekend Reading: The Sea & Civilization

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Lincoln Paine wants to change your view of the world. He wants you to focus on the blue parts of the map that cover over 70% of the world’s surface. In his book, The Sea and Civilization, he makes that case that mankind’s technological and social adaptation to the water has been a driving force in human history, whether it was to wage war, or for migration or commerce.

Perhaps Jared Diamond’s great book Guns, Germs and Steel should have been Guns, Germs, Steel and Boats. Paine makes the case by telling the tales of recorded history through the lens of the seas.

At times he succeeds. At other times, the book comes across as a rote recital of history. There were several places in the book where I wanted more insight. Paine is incredibly thorough, hitting most of the major events affected by sea travel. I wish there was more depth instead of breadth.

Compliance Bricks and Mortar for May 23

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

SEC Enforcement Director: What Empowered Compliance Looks Like by Jaclyn Jaeger in Compliance Week

“Companies that have done well in avoiding significant regulatory issues typically have prioritized legal and compliance issues and developed a strong culture of compliance across their business lines,” said Ceresney. “I’ve found you can predict a lot about the likelihood of an enforcement action by asking a few simple questions about the role of the company’s legal and compliance requirements:

  • Are legal and compliance personnel included in critical meetings?
  • Are their views sought and followed?
  • Do legal and compliance officers report to the CEO, and have significant visibility to the board?
  • Are legal and compliance departments viewed as important partners in the business, and not simply as support functions, or a cost center?

SEC officials seek clarity on compliance officers’ liability by Sarah N. Lynch

At separate conferences, Securities and Exchange Commission members Kara Stein and Daniel Gallagher called for the agency to provide more clarity, noting many officers fear they will become the subject of an enforcement action.

Financial Literacy by Alex Tabarrok in Marginal Revolution

Only about a third of Americans answer all three questions correctly (and that figure is inflated somewhat due to guessing). The Germans and Swiss do significantly better (~50% all 3 correct) on very similar questions but many other countries do much worse. In New Zealand only 24% answer all 3 questions correctly and in Russia it’s less than 5%.

Second Circuit Reverses SEC Market Timing Verdict by Thomas O. Gorman in SEC Actions

The Second Circuit reversed a jury verdict in favor of the SEC in a market timing case, concluding that there was no evidence to support it. Specifically, the Court found that the “SEC ultimately succumbs to its strategic choice at trial to pursue a theory of scienter or nothing. Its entire jury presentation was premised on the idea that [Defendant] O’Meally violated Section 17(a) through intentional conduct. The SEC’s summation relied solely on intent and recklessness; theories rejected by the jury. And as to negligence, the SEC never introduced testimony or any other evidence on the appropriate standard of care against which a jury could measure O’Meally’s conduct.” This was “fatal” to its case. SEC v. O’Meally, No.. 13-213 (2nd Cir. Decided May 19, 2014).

What Kills You and Your Investments by Barry Ritholtz in Bloomberg View

You don’t understand risk.

I don’t mean you, in your professional capacity. I mean you, the human being whose brain is desperately trying to keep you alive. An endless procession of mortal threats are trying to end your particular genomic variation, forcing your brain to respond first and think later.
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Let’s look at some of the world’s top predators as an example of risk in the modern world.

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Image is from GatesNotes: The Deadliest Animal in the World