The Monsters of Compliance – The Mummy

mummy

Ignore the warning at your peril. The archaeologists were told to be careful with the Imhotep’s mummy. He had been punished for trying to resurrect his forbidden lover. In the 1932 version, Boris Karloff’s Imhotep was mummified alive for his crime. The archaeologists had been warned not to read the Scroll of Thoth. It brought Imhotep back to life. Then the horror begins.

A firm is at peril for ignoring the warnings of the Securities and Exchange Commission. The clearest warning is when you get a deficiency letter. The SEC will sanction investment advisory firms for repeatedly ignoring problems with their compliance programs. Last week the SEC sanctioned three firms for failing to fix identified problems.

“After SEC examiners identified significant deficiencies, these firms did little or nothing to address them by the next examination. Firms must fix deficiencies identified by our examiners.” – Andrew Bowden, director of the SEC’s National Exam Program

According to the SEC’s orders against New Orleans-based Equitas Capital Advisers, the firm failed to adopt and implement written compliance policies and procedures and conduct annual compliance reviews to satisfy the Compliance Rule. Equitas made false and misleading disclosures about historical performance, compensation, and conflicts of interest, and it inadvertently yet repeatedly overbilled and underbilled its clients. Many of these violations occurred despite warnings by SEC examiners during examinations of Equitas in 2005, 2008, and 2011. The firm failed to disclose these deficiencies to potential clients in response to questions in certain due diligence questionnaires or requests for proposals.

The SEC has said many times that the first thing the examiners will do when they return is to verify that the firm has fixed the deficiencies identified in the last examination. The only surprise with the Equitas case is that it took so long to bring sanctions given the three prior visits.

The warnings are there for a reason. Comply with them or beware the consequences.

Compliance Bricks and Mortar for October 25

halloween bricks

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

White softens stance on minor securities violations by Mark Schoeff Jr. in Investment News

Securities and Exchange Commission Chairman Mary Jo White told compliance officers Tuesday that the agency will work with them to address regulatory lapses before resorting to enforcement.

“The balance is critical,” Ms. White told a meeting of the National Society of Compliance Professionals in Washington. “We’re not seeking for every minor violation to bring an enforcement action by any means. It’s not a game of gotcha at all.”

In Praise of Electronically Monitoring Employees by Andrew McAfee in Harvard Business Review

We got to observe what happened at 392 locations across five chains (all of them sit-down places like Applebee’s or Chili’s, although neither of these were part of the research) both before and after they started using Restaurant Guard, a new piece of theft-detection software from NCR. NCR supplied us with the data but did not support the research in any other way. The data covered almost two years and 39 of the 50 states.

Is There a Glass Ceiling in Corporate Crime? in Freakonomics

Our podcast “Women Are Not Men” looked at a variety of gender gaps, including the fact that the vast majority of violent crime is committed by men. A new paper by Darrell J. Steffensmeier, Jennifer Schwartz, and Michael Roche in the American Sociological Review finds that women are less likely to be involved in corporate crime as well.

The Tuck Rule, the Push Rule and Retaliation Against Whistleblowers by Tom Fox

In thinking about that play and the Patriots loss to the Jets, I considered the following: is it now the beginning of the end of the Patriots dynasty which started on an equally obscure rule and penalty, aka “The Tuck Rule”? In the play during a 2001 playoff game, Raiders’ cornerback Charles Woodson sacked Patriots’ quarterback Tom Brady, which in turn, caused a fumble that was eventually recovered by Raiders’ linebacker Greg Biekert, and would have almost certainly sealed the game. Officials reviewed the play and eventually determined that Brady’s arm was moving forward, when it was actually moving backwards, thus making it an incomplete pass. Got it?

Monsters of Compliance – Werewolf

werewolf and compliance

The pumpkins and garish Halloween decorations are out on my front lawn. With the Halloween season upon us, my mind has become stuck on movie monsters and been mixed with compliance. This is the terrible result.

The werewolf is old and widespread legend. Lycanthropes gain the ability to turn from human form into a wolf or wolf/human hybrid. Depending on the legend, there are various methods for becoming a werewolf. In The Wolfman, Claude Raines is bitten in a wolf attack. Unfortunately, that wolf was actually a werewolf and the bite passed on the curse of lycanthopy to him. But other legends have it being a hereditary trait or passed by disease. To kill a werewolf, you need silver. At least that is one of the most popular features of the legends. In The Wolfman, the werewolf is killed by silver topped cane. Later pop culture typically has a silver bullet as the fatal cure.

Two features of the werewolf made we think of compliance.

The first is finding the cause. When it comes to investment fraud or corporate crime, it’s rare that the bad guy (and it usually is a guy) starts off bad. At some point, something goes wrong and the guy steps over the line to be the bad guy. When Claude Raines is bitten, he doesn’t know that the bite was the turning point. But it was, and it lead him down a dark path that eventually leads to his own death.

Enron started out as a legitimate company before it embraced widespread accounting fraud. I believe Bernie Madoff started out as legitimate investment manager before he crossed the line and turned his business into a Ponzi scheme. In reading the story of Sam Israel, you can point to the event that turned him from a struggling investment manager into a fraudster. To make the numbers for his annual report he used an accounting trick to rebate back his brokerage fees to improve the fund’s return. That lie was the bite of the werewolf.

Once bitten, the ordinary man becomes evil. For a compliance professional, the key is to recognize the bite and to recognize when someone has been bitten.

The second feature of the werewolf that makes me think of compliance is the cure.

The “silver bullet” is a straightforward solution with extreme effectiveness. Unfortunately for the werewolf, the silver bullet is death. That’s a bit extreme for compliance professionals. Unfortunately, it’s rare to find a silver bullet when it compliance issues, whether it’s preventing a problem or trying to remedy the problem. If prevention were so straightforward, there likely would not be a compliance profession.

One of the goals of a compliance professional is to prevent someone from shooting your company with a silver bullet because it has turned into a werewolf.

The Monsters of Compliance – Frankenstein’s Monster

Frankenstein and compliance

The pumpkins and garish Halloween decorations are out on my front lawn. With the Halloween season upon us, my mind has become stuck on movie monsters and been mixed with compliance. This is the terrible result.

Victor Frankenstein builds a creature in his laboratory with a mixture of surgery, chemistry, and alchemy. His creation horrifies Dr. Frankenstein and he disavows the experiment. The abandoned monster wanders through the wilderness searching for kindness and acceptance, unaware of his own identity.

I expect we will see this metaphor in the crowdfunding rules expected to be released today. The rules will likely be a mess of cobbled together parts. That’s because the Doctor designed the framework that way. In this case, the Doctor is Congress.

The SEC will be stuck wandering the wilderness being chased by pitchfork-wielding entrepreneurs who wanted a simple platform for getting equity funding from the masses. The problem was not of the monster’s creation, but of its master’s doing. Congress created an unworkable framework and the SEC is stuck with its design, trying to get its pieces to work together.

In many ways, the ills of the Securities and Exchange Commission can be blamed on its master. Congress limits its budget. The SEC is not self-funded like the Federal Reserve, the bank regulators, or FINRA. As Robert Kaiser points out in his book, Act of Congress:

“Of the 535 members of the House and Senate, those who have a sophisticated understanding of the financial markets and their regulation could probably fit on the twenty-five man roster of a Major League Baseball team.”

The SEC must heed the mandates of Congress and the cobbled together pieces of legislation that make up our securities laws.

UPDATE:

The proposed rules were published shortly after the post was published. Although I have not read it, the release proposal is 585 pages long. The text of the regulations is 50 pages long and includes several additional pages of proposed forms. That makes it a big monster.

The Monsters of Compliance – Zombies

CDC_zombie

I finally grabbed some pumpkins and put some garish Halloween decorations on my front lawn. My mind has become stuck on movie monsters and been mixed with compliance. This is the terrible result.

What happens when the dead won’t die? The zombie apocalypse.

Zombies in pop culture can be traced back to George Romero’s The Night of the Living Dead and the sequel, Dawn of the Dead. Romero was able to make statements about race and consumerism in the context of the dead rising. (I’ll avoid the argument over whether zombies should be able to run, or merely shuffle.)

In compliance culture, the current zombies are private equity funds that won’t die. Most private equity funds are set up with a definitive end date so the investors can be sure to get their capital (or whatever remains of it) by some date in the future. Otherwise, the investment is very illiquid.

“We’re looking at zombielike funds that potentially have stale valuations.”  “The investigation into zombie funds is an important effort being driven across the country.” – In a 2012 interview of Bruce Karpati, former co-head of the SEC’s asset-management enforcement unit

Instead of achieving realizations and returning capital, the SEC is looking at a small number of funds that may be sitting on investments merely to earn investment fees. The fund should be dead but it won’t die.

It’s more likely that the fund manager can’t make the shot to the head to kill the last investments. Some of the bottom of the barrel investments may have a limited market or their business plans are taking longer to implement. Many fund managers are sympathetic to that after the economic disruption of 2008.

The danger is looking like a zombie when the shotgun wielding white hat comes into view. If you have that unhealthy pallor and look like you’ll scream “brains”, you may end up being dead instead of undead.

The Monsters of Compliance – Gremlins

gremlins-movie-image

I finally grabbed some pumpkins and put some garish Halloween decorations on my front lawn. My mind has become stuck on movie monsters and been mixed with compliance. This is the terrible result.

Mogwai, the gremlin was sold subject to three rules:

  1. Never expose it to sunlight.
  2. Never get it wet.
  3. Never, ever feed it after midnight.

Billy, the young owner, violates the first rule when he accidentally spills a glass of water on Mogwai. The result is five new gremlins, each more mischievous than Mogwai. This was the start of trouble.

Billy learned the rule about water in a vacuum, not knowing the results. Perhaps if he knew that spilling water on Mogwai would create such trouble he would have been more careful. Perhaps he would not have kept a glass of water on his nightstand next to Mogwai.

I think there is an obvious compliance lesson there. Rules can’t be promulgated without some explanation about the consequences of violating the rule. You need to let your people know that there is a good reason for having the rule and the bad things that can be prevented by following the rule.

Billy breaks the third rule when he is tricked. The mischievous gremlins bit through the power cord of his clock, tricking him into believing that their request for food was coming well before midnight. Billy knew he was not supposed to feed the gremlins after midnight and tried to comply with the rule. After seeing the result of breaking the second rule he knew strange things could happen by breaking the rules.  He did not know how bad it could be. The cute fuzzy gremlins metamorphosed into terrible scary monsters.

Billy had a control failure. If he knew the result of breaking the rule, he probably would have put a stronger control in place to prevent breaking the rule. If he knew that double checking the time could save his town from destruction, I bet he would have put more effort into confirming the time before feeding the gremlins.

The first rule ends up saving Billy and his town. He had learned his lesson when accidentally exposing Mogwai to a glimpse of sunlight. It hurt the creature. He ended up using that rule to his advantage and killed the leader of the gremlins with sunlight. He knew the consequences of breaking that first rule.

In the end, Billy was not worthy of Mogwai because he was unable to follow the rules. He was subject to sanctions when the Mogwai was taken away. There are consequences for breaking the rules in horror movies.

 

Compliance Bricks and Mortar for October 18

bricks 11

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

Wrapping Up My Five-Year Experiment by Kathleen Edmond

Of course, this blog is near and dear to my heart and is among the loose-ends I want to tie up before I go. Over the past five years, I have covered dozens of issues on every relevant topic I could get my hands on. It has been a gratifying experience and I intend to relaunch KathleenEdmond.com at some point in the future. However, I will do so from an independent perspective, not as a representative of Best Buy Co., Inc.

In the Crosshairs by Erik Kolb in PERE

With the private funds industry now effectively supervised, US regulators look to be setting their sights on separate accounts. Is their concern really warranted?

The government shutdown in SEC filings in Footnoted

It’s now been two weeks since the government shutdown began. While the number of companies mentioning the crisis in Washington in their routine filings to the SEC can’t quite be described as a thundering roar, we did count about 15 companies that have had something to say about the mess in Washington DC in their filings over the past two weeks.

Social media hot topic at SCCE conference by Aarti Maharaj in Corporate Secretary

One of the hotly debated topics at this year’s annual Society of Corporate Compliance and Ethics (SCCE) Conference was the role social media should play in supporting the compliance and ethics officer. It is now six months since the SEC officially deemed social media a suitable outlet for companies to disseminate material information to investors. But in this new post Dodd-Frank era, compliance officers and corporate governance professionals are still skeptical about the legal obligations and risks associated with using this relatively new medium.

Ethics, Compliance and School Drop-Off Etiquette by Tom Fox

When one parent begins to feel that his or her time is more “Valuable” than another’s that is where the problems begin. Hmmm… let’s see if we can paint this dilemma in a business context. Perhaps there is an industry or global standard designed to ensure workplace safety, clean production of milk powder or even provide a level playing field for conducting global business and winning sales contracts. Once one parent or Company feels that they are above the rest, we start down a slippery slope.

Best Execution Failure

Exécution_de_Marie_Antoinette_le_16_octobre_1793

Best execution refers to the obligation of an investment adviser to ensure that the prices its orders receive reflect the optimal mix of price improvement, speed and likelihood of execution. The concern is whether the investment adviser is getting some other compensation that influences the decision to use one broker over another. This concern should be heightened when there is an affiliate involved.

In meeting the “best execution” obligation, an adviser must execute securities transactions for clients in such a manner that the clients’ total cost or proceeds in each transaction is the most favorable under the circumstances. In assessing whether this standard is met, an adviser should consider the full range and quality of a broker’s services when placing brokerage, including, among other things, execution capability, commission rate, financial responsibility, responsiveness to the adviser, and the value of any research services provided. That’s a fairly fuzzy standard.

One of the landmark decisions in this area was an administrative proceeding against Mark Bailey & Co.(.pdf). Many of the clients were referred by a third party brokerage firm. The clients would tell the firm to keep using the referral brokerage firm for their transactions. The claim was that the firm violated Section 206(2) of the Advisers Act because the firm failed to negotiate lower brokerage commissions. The SEC also took the position that the firm should have been batching transactions to lower brokerage costs and receive a volume discount. The conflict came from perception that the firm was willing to pay the higher commission to the broker in exchange for continuing referrals from the broker.

A recent case highlighted the conflict when an investment adviser is also affiliated with a fund platform. The SEC brought a case against Manarin Investment Counsel Ltd. and Roland R. Manarin claiming they violated their obligation for “best execution” by selecting higher cost mutual fund shares for the three fund clients even though cheaper shares in the same funds were available. The three funds were advised by Manarin and an affiliate of Manarin served as the broker for investments by the funds.

The SEC claims that Manarin consistently purchased Class A shares with higher fees paid to the affiliated broker instead of institutional shares that would have a lower fee structure.  In effect, this case highlights the need to look at the various classes of mutual fund shares available as part of best execution, not merely the brokerage cost involved. In this case, the conflict was heightened because the higher fees were going to an affiliate of the adviser.

Sources:

Image is Marie Antoinette’s execution in 1793 at the Place de la Révolution

Out of the Office: Bermuda Edition

map of bermuda and compliance

Compliance Building is on assignment to Bermuda this week. Downtown Hamilton is full of post office box company headquarters, rental corporate directors, and offshore transactions. However, I’m heading out into the middle of the Atlantic Ocean for rest and relaxation, not compliance research.

A new post will appear after I finish dusting the pink sand off.

Asset Management and Financial Stability

Asset management report cover

The US Office of Financial Research recently released a report raising concerns that the largest asset managers could pose a threat to financial stability. That puts firms like BlackRock, Deutsche Asset & Wealth Management, Prudential Financial, AXA Investment Managers, MetLife, Invesco and UBS Global Asset Management in the cross-hairs of being considered “systemically important.”

The Financial Stability Oversight Council decided to study the activities of asset management firms to better inform its analysis of whether to consider such firms for enhanced prudential standards and supervision under Section 113 of the Dodd-Frank Act. Section 113 gives the FSOC the power to designate a non-bank firm as a “systemically important financial institution”. Being considered “systemically important” means heightened supervision by the US Federal Reserve and also makes the firm subject to risk-based capital requirements and leverage rules.

The FSOC asked the Office of Financial Research to step in and collect data. The Dodd-Frank Wall Street Reform and Consumer Protection Act established the Office of Financial Research within the Treasury Department to improve the quality of financial data available to policymakers and to facilitate more robust and sophisticated analysis of the financial system.

This report is the first step to seeing greater regulatory control of large asset managers. According to the Report, the U.S. asset management industry oversees the allocation of approximately $53 trillion in financial assets.

The Report asserts that separate accounts managed by large asset managers are less transparent than those of mutual funds, banks, and private funds because the activities are not publicly reported.

The Report identifies four key factors that make the industry vulnerable to shocks:

(1) “reaching for yield” and herding behaviors;
(2) redemption risk in collective investment vehicles;
(3) leverage, which can amplify asset price movements and increase the potential for fire sales; and
(4) firms as sources of risk;

To me, (1) and (3) seem to miss the point of separate accounts. Pension plans and institutional investors usually choose a separate accounts strategy to have greater control over their investments. The active involvement of the separate account holder acts as a control against the asset manager reaching for yield or using excessive leverage.

Of course, the findings in the Report do not mean that the big asset managers are imminently subject to additional regulatory oversight. There is a lengthy process for designated a firm as “systemically important.” However, this report could lead to adverse regulation that might adversely impact the separate account business of large asset managers, including those with real estate investment management platforms.

References: