Compliance Bricks and Mortar for June 21

compliance bricks and mortar

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

SEC Buys Itself a Headache by David Smyth in Cady Bar the Door

If you’re reading this, you’re surely aware of the several-years-old-now fight between the SEC and some federal judges regarding the SEC’s policy of settling cases while allowing defendants to neither admit nor deny the claims against them.  Very briefly, the SEC contends that its policy allows it to settle cases against companies that would otherwise take on vast liability in follow-on private litigation if it were forced to admit bad conduct that hurt shareholders.  Otherwise, the SEC says, the litigation burden would be almost overwhelming.

Recent FCPA Enforcement Actions Show Increased Scrutiny on Financial Services Sector (.pdf) by Ruti Smithline and Jarod G. Taylor of Morrison & Foerster

Last week, the U.S. Department of Justice (DOJ) announced the indictment of a managing partner of U.S. broker-dealer Direct Access Partners (DAP) for violations of the Foreign Corrupt Practices Act (FCPA), the Travel Act, and money laundering statutes. This indictment follows on the heels of last month’s indictment of two other DAP employees for the same alleged conduct, as well as the foreign official who received the bribes at issue.

The investigation into DAP was prompted by information discovered during a routine, periodic examination by the U.S. Securities and Exchange Commission’s (SEC’s) New York office broker-dealer examination staff. The discovery of the alleged conduct without the involvement of any whistleblower, self-reporting, or regulator tasked directly with FCPA enforcement should serve as a wake-up call for the need for anticorruption compliance by regulated companies.

Justice Department Fought to Conceal NSA’s Role in Terror Case From Defense Lawyers by Keven Poulsen in Wired.com’s Threat Level

When a senior FBI official told Congress the role the NSA’s secret surveillance apparatus played in a San Diego terror financing case today, nobody was more surprised to hear it than the defense attorney who fought a long and futile court battle to get exactly the same information while defending the case in court.

If You Pay More, Do You Actually Get More? by Keith Paul Bishop in California Corporate & Securities Law

The typical private fund is organized as a limited partnership or limited liability company that is managed by a general partner or manager.  The fund manager is usually compensated in three ways – an annual management fee (often 2%), a carried interest (often 20%), and an investment in the fund (often 1%).  In a recently presented paper, Professors David T. Robinson and Berk A. Sensoy tackled the question of whether private fund managers actually earn their keep.

Given the limited rights of limited partners and members and asymmetrical access to information, one might expect that these professors would conclude that fund managers who charge more, actually under perform.  Based on an analysis of 837 buyout and venture capital private equity funds from 1984-2010 to, the two scholars reach the opposite conclusion:

 

Curvy bricks by Orange Steeler
CC BY

Trouble on Top of Trouble

detroit

MayfieldGentry Realty Advisors mastered the one-two by disclosing to a client that the firm stole their funds on the evening before they were brought up on charges for a pay-to-play violation.

In May, 2012, the Securities and Exchange Commission charged former Detroit mayor Kwame M. Kilpatrick, former city treasurer Jeffrey W. Beasley, and MayfieldGentry in a secret exchange of gifts to peddle influence over the city funds’ investment process. The SEC alleges that Kilpatrick and Beasley, who were trustees to the pension funds, received $125,000 worth of private jet travel and other perks paid for by MayfieldGentry. That would currently be a violation of SEC Rule 206(4)-5.

As long as the firm was going down, MayfieldGentry decided to also disclose that the firm had stolen $3.1 million. The SEC brought new charges against the firm for that theft.

In reading the complaint, assuming the facts are true, it looks like MayfieldGentry was as best sloppy and lazy. The firm had an agreement to buy two shopping centers for $7.4 million and obtained a bank loan for $4.3 million of the price. That left the firm needing $3.1 million of equity, but only had $200,000 of cash. The easy answer was to have its client, the Police and Fire Retirement System of the City of Detroit, fund the equity.

The problem is that MayfieldGentry didn’t bother to get approval from the pension fund. Even worse, it purchased the property in a subsidiary wholly-owned by MayfieldGentry. The firm didn’t transfer ownership of the subsidiary to the pension fund.

Apparently, the plan was to have another investor purchase the property and transfer the cash back to the pension fund’s account. Bad timing trapped the firm. The acquisition happened in March 2008. Then the financial markets imploded and the value of the shopping centers collapsed.

Since the case involved real estate, perhaps the SEC lacks jurisdiction? No, MayfieldGentry was registered with the SEC as an investment adviser.

Maybe the case was an instance of an adviser making a mistake, then failing to remedy the problem. Would the pension fund have agreed to investment? We don’t know. I assume the answer was “no”, otherwise the firm would have transferred the properties to the pension fund.

Sources:

Same Sex Marriage and Accredited Investors

Compliance, the SEC and the Supreme Court

The US Supreme Court is likely to come out shortly with its ruling on same sex marriages. The ruling may have an impact on fundraising for private funds and other private placements.

One of the standards for private placements of securities is that the investors generally need to meet the definition of “accredited investors.” For individuals that means a (1) net worth, excluding the primary residence, of $1 million, or (2) annual income in excess of $200,000 in each of the two most recent years or joint income with a spouse in excess of $300,000.

That word “spouse” is the one being addressed by the Supreme Court.  Section 3 of the Defense of Marriage Act (DOMA) states that in determining the meaning of “any ruling, regulation, or interpretation of the various administrative bureaus and agencies of the United States,…the word ‘spouse’ refers only to a person of the opposite sex who is a husband or a wife.” (1 U.S.C. § 7 (1997)

William Carleton picked up on the wrinkle in Rule 506 that same-sex marriages were not treated equally for purposes of the accredited investor standard.

Here in my home state of Massachusetts, “spouse” is not limited to a man and a woman. In the landmark Goodridge decision that made same-sex marriage legal, the Massachusetts Supreme Judicial Court went through a laundry list of legal rights that couples enjoy once they are married. Those were rights not available not available to same-sex couples.

You can add the accredited investor standard to that big pile of legal rights.

The accredited investor concept was included in Regulation D “based on the presumption that accredited investors can fend for themselves without the protections afforded by registration.” I’m not sure how gender plays a role in determining the financial ability of a couple. But currently it does.

What happens if the Supreme Court strikes down the DOMA restriction? I assume the SEC will not do anything and let the term “spouse” sit in the definition. They have enough political landmines to deal with, I don’t see the SEC jumping out with a rulemaking embrace of same-sex marriage when it still has not yet removed the ban on general advertising or issued rules on crowdfunding.

That will leave it up to the issuers, the fund managers, the start-up companies, and their lawyers to wrestle with the definition of “spouse.” I expect a few intrepid offerings will get an extra investor or two. I expect many conservative issuers will wait for more guidance from the SEC.

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Regulation of Investment Advisers

sec-seal

The Securities and Exchange Commission recently published a compendium describing the regulation of investment advisers: Regulation of Investment Advisers. It’s not light reading, but the 59-pages provide a helpful overview of investment adviser regulation.

It comes from the Staff of the Investment Adviser Regulation Office in the Division of Investment Management. So it carries a bit different take than the Office of Compliance and Inspections, whose examiners will show up your doorstep. OCIE focuses a bit more on the nuts and bolts, while this compendium is more like the architectural drawings for compliance.

One interesting aspect of the compendium is the document file: rplaze-042012.pdf

I assume that it means it was one of the last actions of long-time SEC staffer Robert Plaze. Mr. Plaze retired as the Deputy Director of the Division of Investment Management at the end of August, 2012. It looks like he did not quite hang up his white hat and worked on this compendium. I’m glad he did.

Compliance Bricks and Mortar for June 14

bricks 15

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

Investor Alert—Don’t Trade on Pump-And-Dump Stock Emails

FINRA and the SEC’s Office of Investor Education and Advocacy are issuing this Investor Alert to warn investors to be on the lookout for email spam promoting “pump-and-dump” stock scams.

SEC Compliance Program Annual Reviews: A Guide for Newly Registered Advisers by Nathan J. Greene, Jesse P. Kanach of Shearman & Sterling

Many newly registered investment advisers will need to complete their first annual compliance review this year. This article describes SEC requirements regarding annual reviews of compliance programs and, in particular, covers who should conduct the review, planning and documenting the review, reporting review findings and responding to problematic conduct identified by the review.

SEC’s Cohen Predicts Major Whistleblower Awards Soon in Corporate Crime Reporter

In its three years of existence, the Securities and Exchange Commission’s (SEC) whistleblower program has produced only one $50,000 payout. But within the next couple of months, it will produce “incredibly impactful cases” with “some extremely significant whistleblower awards.” That’s the take of Stephen Cohen, Associate Director of the SEC’s Division of Enforcement.

If DOMA is overturned, will the discrimination in the accredited investor definition go away? by William Carleton

To address the problem of the insidious discrimination in the accredited investor definition, either the term “spouse” will need to be removed, or a constructive definition arrived at.

I’m not sure which solution is better.

I am sure, however, that there will be broad consensus in the angel investing community that the sexual orientation discrimination in the SEC rule is repugnant.

To learn more about this issue, go to http:\\startupequality.com.

The Leaky Merger and Insider Trading

chattem

On December 21, 2009, Sanofi-Aventis, a French pharmaceutical company, announced a tender offer for Chattem, a Tennessee-based distributor of over-the-counter pharmaceutical products, at the price of $93.50 per share. Shares of Chattem closed 32.60% higher than the prior trading day’s close of $69.98 and volume increased more than 3,000% to 10.3 million shares. This may be one of the leakiest M&A transactions. So far the SEC has brought 8 insider trading cases that came from this transaction. The latest case is against Andrew W. Jacobs and his brother Leslie J. Jacobs II.

Andrew met with his brother-in-law who was the vice-president of marketing for Chattem. The brother-in-law leaked the news that Chattem was going to be acquired in the near future. He was apparently looking for career advice since the transaction was likely to affect his employment. Andrew had been through a similar experience when his company was acquired by a European company.

Even though the brother-in-law required Andrew to keep the conversation confidential, the SEC alleges that Andrew leaked the information to Leslie. He saw the opportunity and purchased 2,000 shares of Chattem and made a tidy profit of almost $50,000.

That’s not going to cover his legal bills.

The SEC charged Leslie with insider trading and Andrew for tipping the material non-public information. The brother to brother connection is a lot easier to prove than the Facebook friends sources of inside information the SEC used in the Badin Rungruangnavarat insider trading case.

Chattem was a leaky company when it came to information about the transaction.

Most of the insider trading cases are sourced to one conversation. A Chattem board member told his accountant, Thomas D. Melvin about the transaction. Melvin tipped a bunch of friends who traded on Chattem stock. Melvin, his friends, neighbors and brokers have all been charged with insider trading.

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Action in Congress

act of congress

Robert Kaiser was granted rare access to the action behind the scenes of the creation of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Act of Congress is an enjoyable study of the enactment of that law, used as tool to explore how Congress works, and largely how it it doesn’t work.

Kaiser was already an associate editor and senior correspondent with the Washington Post and had just finished a book on lobbying and money in Washington. He proposed to Congressman Frank that Kaiser become the historian of the congressional response to the Great Crash of 2008. Frank was planning a big legislative changes to the financial services industry and the new president shared this goal. Senator Chris Dodd and Representative Barney Frank let Kaiser talk on the record with staff.

Act of Congress lives by the famous remark “Laws are like sausages, it is better not to see them being made.” The book’s goal is to be both entertaining and educational as it sneaks behind the curtain to watch the sausage production.

“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.”

Kaiser lets the stupidity of some Congress make it to the pages. He lets their public statements stand for themselves, although he tosses the phrase “intellectual lightweight” at a few. I sense he had a lot of personal perspective some of the congressmen that did not make it to the pages.

I found the book to be well-written and interesting. I suspect the interesting part may be governed more by my interest in the Dodd-Frank Act. It’s an enormous piece of legislation with profound impact on the financial services industry. In places it is poorly written and in others it’s full of exemptive holes. This books will enlighten you to some of the compromises that were made to get the law enacted.

I suspect those who have that interest may be limited. If you have made it this far, perhaps you share that interest. In which case you should add Act of Congress to your reading list.

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Red Flags for Insider Trading

compliance and red flags

Badin Rungruangnavarat was very lucky. He invested a bunch of cash from May 21 to May 28. When the market closed on May 29 he had unrealized gains of over $3 million and had achieved a return in excess of 3000%. Now he is unlucky because the Securities and Exchange Commission froze his investment gain and labeled it the illegal fruits of insider trading.

Badin had put all of his money into derivatives based on the stock price of Smithfield Foods, Inc. On May 29, there was a public announcement that Shanghui International Holdings had agreed to acquire Smithfield. As you might expect, Shangui paid a premium on the traded stock price.

So maybe Badin wasn’t lucky. Maybe he had some material non-public information and was illegally trading on that information.

Badin opened the account at Interactive Brokers on May 10. Badin deposited $920,000 and only traded in Smithfield derivatives. All of the call options he purchased were out of the money. He purchased 80% of Smithfield’s options for the month of May. Through those derivatives, he controlled roughly 25% of the average daily volume of Smithfield’s stock.

The facts stink of insider trading. What’s missing is the inside information.

The SEC turned to Facebook to identify the source of insider information. (It looks like the SEC does not ban access to Facebook.) In the complaint, the SEC states that Badin has a Facebook friend who is an associate director at the investment bank that advised another bidder for Smithfield. That may not be the source, but at least it something for the SEC to grab a hold of in hopes of making its case.

This is at least the third time that Interactive Brokers has flagged an account for insider trading. See Zhongpin and Potash. The firm’s compliance surveillance seems to working for these egregious cases.

Sources:

Red flags by Rutger van Waveren CC BY ND

Compliance Bricks and Mortar for June 7

compliance bricks and mortar

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

Madoff: Don’t let Wall Street scam you, like I did By Sital S. Patel in MarketWatch

After all those years of racing to remain a step ahead of the authorities, Madoff has a few ideas about how the market can be made more fair for retail investors. Among them: The Securities and Exchange Commission should be beefed up, hedge funds need to be registered and brokerages should have independent custodians.

The Separation of Investments and Management by John Morley in the CLS Blue Sky BLog

Every type of enterprise that we commonly think of as an investment fund—including hedge funds, private equity funds, venture capital funds, mutual funds and closed-end funds—adopts a pattern of organization that I call the “separation of investments and management.” These enterprises place their securities, currency and other investment assets and liabilities into one entity (a “fund”) with one set of owners, and their managers, workers, office space and other operational assets and liabilities into a different entity (a “management company” or “adviser”) with a different set of owners. Investment enterprises also radically limit fund investors’ control. A typical hedge fund, for example, cannot fire and replace its management company or its employees—not even by unanimous vote of the fund’s board and equity holders.

National Financial Capability Study from the FINRA Investor Education Foundation

The 2012 National Financial Capability Study (NFCS) presents new survey findings that underscore the need to ensure all Americans have access to the education, resources and tools they need to manage their money with confidence. This second iteration of the study builds on the findings and benchmarks established in 2009 and adds to the growing conversation about how individuals can best manage and make decisions about their financial resources.

Sen. Warren Asks SEC for Any Research on Benefits of ‘No Admission’ Settlements by Bruce Carton in Compliance Week

At the hearing, new SEC Chair Elisse Walter began to testify about how the SEC “look[s] at the distinction between what we could get if we go to trial, and what we could get if we don’t,” but she was shut down by Sen. Warren who apparently did not want to get sidetracked. In a letter (via World of Securities Regulation) dated May 14, 2013, however, Sen. Warren asked White, as well as the heads of the Federal Reserve and the DOJ, to provide more information on this point. Reiterating her concern that a regulator that is unwilling to actually take large financial institutions to trial has far less leverage in settlement negotiations, Warren asked White, Ben Bernanke and Eric Holder to answer the following question:

Have you conducted any internal research or analysis on trade-offs to the public between settling an enforcement action without admission of guilt and going forward with litigation as necessary to obtain such admission and, if so, can you provide that analysis to my office?

Codes of Conduct: what are they good for? by Catherine Choe in FCPA Compliance and Ethics Blog

I had an interesting and frustrating conversation with a relative about the work that I do, which includes working with companies on refreshing their Codes of Business Conduct. Despite working at a large, publicly traded, multinational corporation, I had to describe the Code twice before he recalled having certified reading the one at his company. It got me thinking about why we have Codes and whether they’re doing an adequate job serving their purposes.

When a CCO becomes a Whistleblower (It Usually Ends in Tears) by Donna Boehme in the Whistleblowers Protection Blog

This story is about Paul Moore, the former chief risk and compliance officer for HBOS, fired in 2004 for his warnings to the bank’s C-Suite and Board of its excessive risk taking culture. Paul says the release of the Parliamentary report, plainly called “An Accident Waiting to Happen,” was like the “parting of the Red Sea” for him. Paul is Exhibit A for why former federal prosecutor Michael Volkov called the CCOs the “Person of the Year” in 2011 and has described this difficult role as the “unsung hero” of the corporate landscape