Financial Illiteracy Found in Study of Financial Literacy

“Understanding the needs of investors is critical to carrying out the Commission’s investor protection mission,” said SEC Chairman Mary L. Schapiro. Section 917 of Dodd-Frank required the SEC to study the existing level of financial literacy among retail investors. The study was recently released and paints an ugly picture.

Here’s a key quote:

These studies have consistently found that American investors do not understand the most basic financial concepts, such as the time value of money, compound interest and inflation. Investors also lack essential knowledge about more sophisticated concepts, such as the meaning of stocks and bonds; the role of interest rates in the pricing of securities; the function of the stock market; and the value of portfolio diversification…

Perhaps a few decades ago this was less of a problem when big unions were at their most powerful position and big businesses were offering pensions to retirees. With the rapid decline in pensions in favor of 401(k)s and other defined contribution plans, more and more people are responsible for their own investment decisions. It seems they do not have the skills or literacy to do so.

What to do? Neal Lipschutz suggests:

Here’s a modest suggestion: make passing a course in the basics of personal finance a requirement for a high school diploma. You can teach about credit cards, checking accounts, mutual funds and the like. You might even throw in how to vet an investment adviser.

I expect this problem will soon get worse. Private funds will soon be able to start advertising. That means investors that meet the minimal standard of accredited investor will be barraged with opportunities to invest in the once secretive world of hedge funds. That advertising will be limited by the false, misleading or deceptive standard of investment advisers, not by the more strict standards for mutual funds under the Investment Company Act.

I suspect, as does Felix Salmon, that it will not be the excellent funds that advertise. It will be the those that want the flash of the media spotlight.

Private funds will not be held to a uniformity standard allowing potential investors to better compare fund to fund. They’ve gotten accustomed to the relative uniformity with the highly regulated mutual fund products.

It was very obvious that the SEC was not happy with the JOBS Act and is washing its hands of the problems by doing exactly what Congress demanded, and nothing more. At some point there will be a backlash and some additional legislation to deal with the problems that will inevitable arise. Good firms, doing the right thing will likely be subject to further oppressive regulation because of the unrestrained actions of a few bad actors.

Being an accredited investor just means that you have money, not that you understand how to invest your money. I suspect many more will start making bad investments as they hear the siren song of hedge funds.

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506(c) and General Solicitation and Advertising in Securities Offerings

Section 201(a)(1) of the Jumpstart Our Business Startups Act (the “JOBS Act”) directs the Securities and Exchange Commission to amend Rule 506 of Regulation D. Congress wants to permit general solicitation or general advertising in offerings made under Rule 506, provided that all purchasers of the securities are accredited investors. With one caveat: the issuer must take reasonable steps to verify that purchasers of the securities are accredited investors. After some delays, the SEC has finally published a proposed rule to implement the Congressional mandate.

After waiting all summer for a proposed rule, the SEC decided to finally take action during my vacation. And on the day I promised to take my kids to Story Land. My review of the rule and commentary would have to wait until my kids had their fill of Cinderella and the Bamboo Chutes.

Thanks to William Carleton’s live blog and a review of speeches, I could see that the five commissioners were not in full agreement about the rule or the procedure for adopting the rule. Commissioner Gallagher was in favor of the proposed rules, but wanted it to be an interim final rule. Commissioner Aguilar thought the proposed rules did not go far enough in protecting investors. In the end, that may not mean much.

As expected, the removal of the general solicitation and public offering prohibitions, comes with a few caveats.

Does Not Remove Ban

I found it interesting that the SEC chose to create a new regulatory scheme, rather than merely eliminate the ban. The proposed rule includes a new Rule 506(c) that permits general solicitation and advertising provided all investors are accredited and the issuer takes reasonable steps to verify that they are accredited. 506(b) stays in place allowing an issuer to have up to 35 sophisticated, but non-accredited investors, provided there is not general solicitation or advertising, but does not have to take reasonable steps to verify the investors’ status.

“Take reasonable steps to verify”

The SEC did not do what many feared would be the worst result under the JOBS Act. The proposed rule does not impose any specific requirement to verify that an investor meets the standard of an accredited investor. “Whether the steps taken are “reasonable” would be an objective determination, based on the particular facts and circumstances of each transaction.”

To some extent that seems okay. In the private equity fund model we have a particular concern that a potential investor will be able meet a capital call. It should just mean having to document the diligence process.

However, the SEC did strike one common aspect of fundraising practice.

[W]e do not believe that an issuer would have taken reasonable steps to verify accredited investor status if it required only that a person check a box in a questionnaire or sign a form, absent other information about the purchaser indicating accredited investor status.

Offering documents will need to be changed.

A Non-Accredited Investor Sneaks In

The language of the JOBS Act made some, including me, nervous that if a non-accredited investor could sneak into an offering and blow up the exemption. A person of limited means really wanted to be an investor, lied on the questionnaire, but passed through the reasonable steps taken by the issuer to verify status. Fortunately, the SEC took that position that the issuer would not lose the ability to rely on the Rule 506(c) exemption, so long as the issuer took reasonable steps to verify that the purchaser was an accredited investor and had a reasonable belief that such purchaser was an accredited investor.

Changes to Form D

In addition, to the new 506(c) the SEC is proposing to amend Form D. The notice filing with the SEC would have a check box to indicate whether an offering is being conducted pursuant to the proposed Rule 506(c) that would permit general solicitation.

Blessing for Private Funds

Private funds typically rely on the Rule 506 safe harbor to raise funds without having to register under the Securities Act. Private funds were also restricted under Section 3(c)(1) and Section 3(c)(7) of the Investment Company Act from making a public offering of securities. Historically, the SEC has considered rule 506 transactions to be non-public offerings. But would the SEC change that position given its hostility towards the JOBS Act?

Thankfully, the answer is no.

We believe the effect of Section 201(b) is to permit privately offered funds to make a general solicitation under amended Rule 506 without losing either of the exclusions under the Investment Company Act.

Comments

Now there is 30 comment period. I’m just guessing, but I’d be surprised to see changes to the proposed rule. I think the benefit of the comment period will be to add some additional commentary around the “reasonable steps to verify” standard.

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FBI and FCPA

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

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

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

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

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

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

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

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Marathon Times, Lies, and Paul Ryan

I generally stay away from politics when it comes to any stories about compliance and ethics. Politicians spend too much time spinning the facts and bending the truth. When it comes to policy, the facts rarely tell a black and white story about whether the policy worked, so I can forgive most of the spin. But sometimes the facts are clear and you have to wonder what is going through a person’s mind when they tell a blatant lie.

In an interview with Hugh Hewitt, vice presidential candidate Paul Ryan claimed that he had run a marathon in under three hours.  An impressive time. Unfortunately, that claim was revealed to be untrue. It actually took him more than four hours to finish Duluth’s Grandma’s Marathon.

I ran one marathon. It was ten years ago, but I still remember what my finishing time was. My wife remembers what my finishing time was, because my months of training were so arduous and time-consuming.  Anyone who has run a marathon knows there is a huge difference between running a 3 hour marathon and a 4 hour marathon. A sub-three hour marathon means that you are an elite runner. A four hour marathon means that you are a fit, but still recreational, runner. You spill a great deal of blood, sweat, and tears training for a marathon. Your mileage splits and likely finishing times are burned into your mind during the months of training that lead up to the race itself.

Here’s the transcript of what Ryan said to Hewitt:

H. H.: Are you still running?
P. R.: Yeah, I hurt a disc in my back, so I don’t run marathons anymore. I just run ten miles or [less].
H. H.: But you did run marathons at some point?
P. R.: Yeah, but I can’t do it anymore, because my back is just not that great.
H. H.: I’ve just gotta ask, what’s your personal best?
P. R.: Under three, high twos. I had a two hour and fifty-something.
H. H.: Holy smokes. All right, now you go down to Miami University…
P. R.: I was fast when I was younger, yeah.

Unlike policy outcomes, a race finishing time is a very straight-forward fact. One that cannot be subject to spin, just subject to excuses about why you ended up slower than expected or faster than expected. (I developed an injury while training for the marathon. Competing in a 24 hour adventure race during the marathon training re-injured my legs. Excuses, excuses…. but my finishing time is still my finishing time.)

I ask any of you who have run a marathon whether you remember your finishing time? Of course you do. Could Ryan have misspoken? Perhaps. Here’s what Ryan had to say in response:

“The race was more than 20 years ago, but my brother Tobin—who ran Boston last year—reminds me that he is the owner of the fastest marathon in the family and has never himself ran a sub-three. If I were to do any rounding, it would certainly be to four hours, not three. He gave me a good ribbing over this at dinner tonight.”

It was not a conventional news outlet but, rather, Runner’s World who looked into his claim and found it lacking. Maybe Ryan was looking to win the marathon runner demographic by throwing out an impressive finishing time. I suspect that he has lost the votes of most marathon runners. You can make excuses, but you can’t lie about your finishing time.

Any marathon runner will tell you the difference between a four-hour marathon and a sub-three hour marathon is enormous. For a non-runner it may seem easy to confuse or inconsequential. (I suspect political affiliation will also affect one’s view of this story.) Ryan is a self-proclaimed fitness nut. It should be nearly heartbreaking to be a minute over four hours rather than a minute under four hours. It’s only two minutes, but it’s the difference between having your time start with a “3” instead of a “4”. Starting with a “2” is only a distant dream at that point.

That two minute difference pits him against the last Republican vice presidential candidate.  Sarah Palin has run a marathon in 3:59.

That difference between a 3 and 4  has to be even more troubling when your brother runs marathons and has a better time than you. As his response pointed out, Ryan’s brother will not let him forget that he has the best marathon time in the family and it starts with a “3”, not a “2”.

One of my ongoing areas of interest is what makes an otherwise respectable business person turn into a white collar criminal. During my recent trip to FBI Headquarters,  Supervisory Special Agent Susan Kossler pointed out that two of the traits that distinguish a regular person from a white collar criminal is pathological dishonesty and little regret for misstatements. You look back at a Madoff or Stanford and wonder what led them from being legitimate, successful businessmen to start believing in their own lies and deception and become fraudsters. Even today neither expresses much remorse for their fraud.

People ask marathon runners about their finishing times. Look back at how easily Ryan responded to Hewitt’s question about his finishing time. Ryan, the fitness nut, must have been asked that question many times and responded many times  (dozens? hundreds? of times). When did he stop responding with “four hours” and start  saying “almost four hours”? Or “three and a half hours”? And then “a two hour and fifty-something”? When did one marathon turn into the plural “marathons”?

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Compliance Bits and Pieces for August 24

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

The FCPA Compliance Strategic Plan – Some Lessons for the Astros by Tom Fox

I pondered over Stephen’s thought on the subject of a strategic plan recently when I heard the Houston Astros General Manager say that he was not sure what plan he has to make the Astros a winning if not relevant, team again. Basically he said it was a 1, 3 or 5 year plan, or perhaps something else, he just wasn’t sure. With those words of encouragement in mind it would appear that the Astros plan is the following: (1) Year One: Lose to a new set of teams as the Astros will move from the National League to the America League; (2) Year 3: Continue to lose; (3) Year 5: Be all you can be. How is that for a strategic plan?

Compliance and the Legal Department: A Counterpoint in 3 Geeks and a Law Blog by Susan Hackett

My point is that many law departments choose to in-source compliance rather than out-source it. In-house counsel are hired and paid to intimately learn and live with the client in order to help “keep the milk in the glass”; outside lawyers are often retained to help clean up what’s spilt. If you only see spilt milk, you don’t know much milk is kept in the glass, or how many glasses there are that never tipped over at all. When Toby suggests that GCs would be better served if they were asking for more money for compliance-related activities and that they don’t because they are risk averse, I’d respond quite simply that Toby may not be aware of the extreme focus and resource corporate clients do expend on compliance. What they spend on compliance is spent on in-house staff, and not usually spent on firms or e-discovery vendors. E-discovery systems are not preventive legal systems – they’re remedial, except for the small benefit that some regulate what can be posted or stored (it doesn’t stop the inappropriate activity behind the document or email).

The Key to Compliance: The Trenches by Michael Volkov in Corruption, Crime & Compliance

Ask anyone in the FCPA paparazzi and they will tell you exactly what you need to do to make sure you have an effective anti-corruption compliance program. There are as many answers as there are compliance professionals.

I can assure you that every compliance professional has forgotten the missing link – not Curly Q Link, but the essential aspect of every compliance program. The crux of it all – the raison de’ tere — all boils down to this – think of the interactions which occur between your company and foreign government officials, and try and calculate or imagine in your mind every one of those interactions. Each of them presents opportunities for improper payments, a motive and an opportunity to engage in bribery. The incentive is there, and your job is to stop it – you cannot police every interaction, every meeting, every dinner, and every opportunity for improper behavior.

Money Market Fund Reforms Hit Roadblock by Joe Mont in Compliance Week‘s The Filing Cabinet

Overruled by three of her commissioners, Securities and Exchange Commission Chair Mary Schapiro has been rebuffed in her two-and-half-year effort to reform money market funds.

In a statement issued at 9:20 p.m. on Wednesday night, Schapiro made public that the majority had squashed proposals she has championed to impose structural reforms on the $2.4 trillion domestic marketplace (only Commissioner Elisse Walter broke rank to offer support). These efforts, she said, were needed to “reduce the susceptibility to runs, protect retail investors and lessen the need for future taxpayer bailouts.”A pending vote on the matter has been cancelled.

A Visit to the FBI Academy

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

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

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

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What Will the SEC Do About Advertising and Solicitation?

UPDATE: The SEC will wait a week. A new meeting has been scheduled for August 29.

At today’s meeting the Securities and Exchange Commission is set to consider a rule on lifting its longstanding ban on general solicitation and advertising for privately-issued securities.

Item 3: The Commission will consider rules to eliminate the prohibition against general solicitation and general advertising in securities offerings conducted pursuant to Rule 506 of Regulation D under the Securities Act and Rule 144A under the Securities Act, as mandated by Section 201(a) of the Jumpstart Our Business Startups Act

Personally, I would welcome better information about what the SEC considers a general solicitation or general advertisement in connection with the private placement of securities. I don’t think lifting the ban is necessarily a good idea. The appearance of an ad for a private security has been a prominent red flag for an offering. Either it’s a fraud or the company is ignoring the advice of its legal counsel.

The bigger concern is what the SEC will do about verifying that the potential investor meets the accredited investor standard. Currently, most fund manager use a certification filled out by the investor. In addition to meeting the accredited investor standard, the questionnaire will typically include many other items of disclosure.

This process has worked well for decades. Hopefully the SEC won’t mess it up.

If you are wondering what changes the SEC could make, McGuire Woods put together an excellent Preview of New SEC Provisions Permitting Advertised Private Placements. The report tries to summarize the numerous comments submitted to the SEC.

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FBI and Understanding White Collar Criminals

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

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

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

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

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

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

The FBI’s Compliance Program

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

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

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

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

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

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

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

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

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

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

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Compliance Bits and Pieces – Standard Chartered Edition

The British bank Standard Chartered found itself in trouble for dealing with Iranian customers in violations of US sanctions. Here are some stories that covered the news.

Best. Quote. Ever. From Howard Sklar’s Open Air Blog

Preparing for This Week in FCPA today, I came across this quote in the New York State Department of Financial Services’ Order against Standard Chartered:

You fucking Americans. Who are you to tell us, the rest of the world, that we’re not going to deal with Iranians.

Bank Deal Rankles Regulators by Liz Rappaport, Devid Enrich and Victoria McGrane in the Wall Street Journal

Standard Chartered PLC’s money-laundering clash with a once-obscure New York regulator is shaking up efforts by financial overseers to rein in giant banks around the globe.

The New York Department of Financial Services notified the U.K. regulator for Standard Chartered just 90 minutes before announcing allegations last week against the U.K. bank, said people familiar with the matter.

British regulators said the lack of advance notice from New York regulator Benjamin M. Lawsky breached protocol.

Officials at the U.K. Financial Services Authority complained afterward to the New York regulator, which oversees Standard Chartered’s U.S. unit, that the sudden move could have damaged the stability of the bank and that the lack of advance notice breached long-standing protocol among bank regulators, these people said.

Standard Chartered Faces Suit From Victims of 1983 Beirut Bombing by David Benoit in WSJ.com’s Corruption Currents

The suit, filed Wednesday in Manhattan federal court, alleges the recently revealed claims that Standard Chartered helped Iran hide 60,000 financial transactions from U.S. regulators also kept assets hidden from the victims. The plaintiff group was awarded $2.66 billion in damages from Iran by a 2007 ruling from federal court in Washington D.C. that found Iran liable in the bombing.

Hush money in the Economist’s Schumpeter

It could have been disastrous. Standard Chartered was facing a hearing before New York state’s Department of Financial Services (DFS) on August 15th that would have certainly aired embarrassing information. Instead it will be expensive. The bank has acceded to a fast settlement of the charges that it had illicitly processed $250 billion in transactions with Iran, paying $340m in civil penalties and agreeing to various other provisions.

Lawsky Reveals Details Of Standard Chartered Bank Settlement by Steven Meyerowitz in the Financial Fraud Law blog

Benjamin M. Lawsky, New York Superintendent of Financial Services, has just announced that the New York State Department of Financial Services (“DFS”) and Standard Chartered Bank (“Bank”) have reached an agreement to settle the matters raised in the DFS Order dated August 6, 2012.

Significantly, Lawsky (pictured) said that, “[t]he parties have agreed that the conduct at issue involved transactions of at least $250 billion.”

This is signficant because in its initial public response, the Bank had indicated that it expected that the total transactions amounted to no more than $14 million. This concession alone is a huge win for Lawsky and the DFS.