My Visit with the FBI

You would expect a visit with the FBI to be terrifying. When they come with their badges out and windbreakers on, you are in trouble. The FBI headquarters is easy spot, sitting right on Pennsylvania Avenue in Washington, D.C. Even once you get past the security guards and metal detectors in the front lobby, visitors have to pass through two more security checkpoints. Fortunately, my visit did not involve handcuffs.

The Federal Bureau of Investigation partnered with the Society of Corporate Compliance and Ethics to host the FBI Corporate Compliance Officer Outreach Event. I was fortunate enough to attend.

Patrick W. Kelley, Chief Compliance Officer, Office of Integrity and Compliance of the Federal Bureau of Investigation, was the host. That was the first unexpected piece information. The FBI has a Chief Compliance Officer and a formal compliance program. The second unexpected piece of information was that the FBI’s compliance program faces many of the same issues as any company’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. It is issued to an organization, typically a telecom or ISP, to turn over various record and data. NSLs can only request non-content information, such as transactional records, phone numbers dialed or email addresses mailed to and from. Section 505 of the USA PATRIOT Act greatly expanded the use of the NSLs. 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.

The FBI Director Robert S. Mueller, III did not like the abuse and tasked Mr. Kelley with creating a compliance program to identify and prevent abuse. To their credit, they also expanded the compliance program to cover 49 other areas of risk.

I’ll be posting more stories from this event over the next few days.

Compliance Bits and Pieces for August 10

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

Anti-Money Laundering For the Non-Banking Entity by Tom Fox

While many companies which operate under anti-bribery laws such as the UK Bribery Act or anti-corruption laws such as the US Foreign Corrupt Practices Act (FCPA), have compliance programs in place to review business relationships, I have found that one of the areas which most non-banking companies do not sufficiently focus on is anti-money laundering (AML).

Fracking, conflicts of interest and adverse inferences by Jeff Kaplan in the Conflicts of Interest Blog

Take the example of “fracking,” an area of considerable complexity, and my own attempts – as a citizen who wants to be reasonably informed – to understand it.   Initially, I was skeptical about the wisdom of the fracking but the more I read the more it seemed, on balance, like a good idea (assuming strong environmental safety measures are put in place and that the embrace of fracking does not diminish the development and deployment of renewable energy sources).

Cheating in Online Courses by Dan Areily

A recent article in The Chronicle of Higher Education suggests that students cheat more in online than in face-to-face classes. The article tells the story of Bob Smith (not his real name, obviously) who was a student in an online science course.  Bob logged in once a week for half an hour in order to take a quiz. He didn’t read a word of his textbook, didn’t participate in discussions, and still got an A. Bob pulled this off, he explained, with the help of a collaborative cheating effort. Interestingly, Bob is enrolled at a public university in the U.S., and claims to work diligently in all his other (classroom) courses. He doesn’t cheat in those courses, he explains, but with a busy work and school schedule, the easy A is too tempting to pass up.

When A Business Relationship Goes Bad by Kathleen Edmond in Best Buy Ethics

Companies like Best Buy often talk about key vendor relationships and business affiliations. The reality is, of course, that companies don’t have relationships – people do. Business relationships generally come down to a person at Company A working with a counterpart at Company B to achieve some set of shared goals. In order for that relationship to be healthy and profitable for both parties, there must always be an atmosphere of trust, mutual respect and independence.

 For this reason, Best Buy maintains a strict Gifts, Business Courtesies and Vendor Relationships policy that is designed to protect Best Buy and vendor alike from the sort of temptations that can arise when relationships go bad. The vast majority of the time these relationships are healthy, respectful and profitable for both parties. Every now and then, however, bad judgment leads someone to cross the line and abuse a relationship for personal gain.

Vanderbilt: The First Tycoon

There were the rich, the super rich, and Cornelius Vanderbilt. T.J. Stiles takes you through the life of the Commodore in The First Tycoon: The Epic Life of Cornelius Vanderbilt.

Sons are notoriously prone to exaggerate the importance of their fathers, as are biographers with their subjects…

Vanderbilt founded a dynasty. The First Tycoon starts with one of the final challenges to that dynasty. The Commodore had left the vast majority of his estate to one of his children. The rest were challenging his will. He wanted his business empire to continue through his children, without it being severed and control lost.

Cornelius “Commodore” Vanderbilt was born in relatively humble family on Staten Island during George Washington’s presidency.  He started in his father’s footsteps as a boatman. He latched onto the power of steam and assembled a huge fleet of steamships. After conquering the water, he assembled a railroad empire. We see Vanderbilt’s role in transportation revolutions, battling the physical growth of the nation with better and faster means of transportation. Along the way he helped shape the growth of the modern corporation

T. J. Stiles argues that Vanderbilt did more than perhaps any other individual to create the current economic world. His steamships and railroad lines took vast amounts of capital, requiring more than one individual to fund the growth and expansion.

Compliance professionals and securities law aficionados may be fascinated by the growth of the corporate entity. At the time they offered less liability protection than we would expect today.

The history of Vanderbilt is also full of stock manipulation and anti-trust issues. Transportation companies routinely gathered together to set rates and limit competition. When competition did break out, it was a vicious battle between the rivals. Sometimes the battle was waged in the stock market with the players trying to corner securities and punish the wealth of their rivals.

The book does a remarkable job of  balancing the epics tales with a fast-moving narrative.

Compliance Bits and Pieces for August 3

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

Four Signs Your Awesome Investment May Actually Be A Ponzi Scheme by Theo Francis in NPR’s Planet Money

[I]t turns out that the Ponzi industry is much broader and deeper than even the biggest blowups suggest. That’s one lesson of a slim new book, The Ponzi Scheme Puzzle: A History and Analysis of Con Artists and Victims, from Boston University Law Professor Tamar Frankel.

Should dentists and lawyers be rotated, like auditors? by Jeff Kaplan in the Conflict of Interest Blog

As a general matter, the professional relationships that expert service providers (e.g., doctors, lawyers, accountants) have with those they serve carry the potential for conflicts of interest, at least, where the provider’s advice can impact how she is paid. Of course, we rely on providers’ professional standards of conduct to mitigate those conflicts. Beyond this, we tend to think that having a good personal relationship with an expert provider will serve as a useful “inner control,” and steel the provider against the potential for COIs inherent in the very economic nature of the relationship.

Too bad that it apparently doesn’t work.

When Your Investment Target Has Drug Cartel Ties by Nick Elliott in WSJ.com’s Private Equity Beat

The firm had done some due diligence and found the businessman had a strong record going back eight years. Springer’s firm formed the same impression, but Springer said he was suspicious that there was no information before that time, so he asked the firm for more time to dig deeper.

Knight Capital Says Trading Glitch Cost It $440 Million by Nathaniel Popper in NYTimes.com’s DealBook

$10 million a minute.

That’s about how much the trading problem that set off turmoil on the stock market on Wednesday morning is already costing the trading firm. The Knight Capital Group announced on Thursday that it lost $440 million when it sold all the stocks it accidentally bought Wednesday morning because a computer glitch. The losses are threatening the stability of the firm….

Loss Swamps Trading Firm in the Wall Street Journal

Knight officials blamed software installed earlier this week for causing the brokerage firm to enter millions of faulty trades in less than an hour on Wednesday morning. The orders roiled trading in almost 150 stocks and left Knight holding losing positions in many shares at the end of Wednesday’s trading session.

Knight Capital trading debacle shows Wall Street frailties by Andrew Tangel and Jim Puzzanghera in the Los Angeles Times

The high-speed trading arms race being waged on Wall Street has finally claimed its first major casualty.

Knight Capital Group, a brokerage that handles nearly 11% of all stock trading in U.S. companies, is in danger of collapsing after a software glitch triggered millions of unintended orders. The New Jersey firm lost $440 million in less than an hour — nearly four times the company’s profit last year.

Badminton Falls Down

Bazuki Muhammad/Reuters

Few in the United States watch Olympic badminton. Fewer still are likely to watch after the ridiculous play in preliminary games. (Maybe a few will try to watch, just as a few slow down to watch the results of a car accident on the side of the road.) Four of the best teams in the world were kicked out of the Olympics for intentionally trying to lose matches and gain a competitive advantage. Clearly the competition was poorly structured if there was an incentive to lose.

This year the Olympics switched to a round-robin tournament, replacing the one-and-done format, so teams compete in three round-robin games before seeding them in medal brackets. There are four pools of four teams. The top two teams in each pool qualify for the quarterfinals and the bottom two spend the rest of the competition in the Olympic village.

China’s Wang Xiaoli and Yu Yang won their first two matches and secured a spot in quarterfinal. Their final match against a South Korean team would determine first and second place in Pool A.

The first complication came when the other Chinese team, Qing Tian and Yunlei Zhao, lost to Denmark in an big upset. That placed the Chinese team on the same side of the bracket as the winner of Pool A. If both Chinese teams won their quarterfinal matches, they’d meet in the semifinals and only one would make it to the finals. At best that’s gold and bronze, not gold and silver.

To avoid this situation, the Wang and Yu tanked their game. The South Koreans did not want to meet the other Chinese team so they tanked also. At one point the four players traded 6 service errors in a row. Five went directly into the net. The one that made it over made in way over and went long off the back line. That’s much more like how I play in the backyard.

After the Chinese tried to throw their match, the South Korean team of Ha Jung-eun and Kim Min-jung faced the Indonesian team of Meiliana Jauhari and Greysia Pollii in Pool C. Both teams adopted a similar losing strategy to avoid having to face the fearsome Wang and Yu. (Watch the video and you can see that they were not trying.)

A well designed tournament should eliminate strategic losses. Getting a higher seed should convey a benefit, generally it means you play someone who isn’t as good. Pool play to determine seeding means more games and allows a margin of error for a team. Clearly the Olympics missed something.

The NBA tried to eliminate an incentive to lose by implementing a draft lottery instead of merely giving the highest draft pick to the team with the worst record. The NFL gives an incentive to win by giving the teams with the best record a week off before the playoffs. That still leaves some lackluster games at the end of the season when teams pull their starters.

Strategic losing does not appear to be a new strategy in badminton. Statistics show that more than 20 percent of matches is either not finished or not played when the Chinese play against their own compatriots. They met each other 99 times on the circuit in 2011, and 20 matches were either not played at all or played partially before one of the opponents retired. This shows that 20.20% of matches between Chinese shutters were not completed in 2011. But only 0.74% of matches were uncompleted between China and other nations.

What does this have to do with compliance? Look at your internal structures and incentives. Are any designed to allow an incentive to fail. Do any give incentive for one business unit to cause another to fail?

Sources:

 

Don’t Trade Stock in Your Friend’s Company, Illegally

Ladislav “Larry” Schvacho purchased approximately 72,000 shares of Comsys IT Partners, Inc. stock between November 9, 2009 and February 1, 2010. On February 2, 2010, Manpower, Inc. and Comsys publicly announced a merger, resulting in a 31% percent increase in the share price of Comsys from its prior day’s close. As a result of his trading in Comsys stock, Schvacho obtained profits of  over $500,000.

The SEC thinks Schvacho made those trades because he was a friend of the CEO of Comsys and was illegally trading on inside information. At this time, Schvacho is contesting the charges so the allegations may or may not be true. I’m assuming they are true to see if we can learn some lessons from this case.

Schvacho and Larry Enterline worked at several companies together starting in the 1970s, including an investment fund. They also developed a close personal relationship and Enterline named Schvacho as executor of his estate. Enterline was the CEO of Comsys.

According to the SEC complaint Enterline was not cautious in speaking about the company’s business when Schvacho was around. Enterline spoke on the phone to other Comsys executives about the merger in the presence of Schvacho. The SEC also alleges Schvacho had access to merger-related documents during a vacation with Enterline.

The transactions smell like insider trading. The easiest problem for the SEC will proving that Schvacho knew about the confidential merger information. From the statements in the complaint it sounds like Enterline has provided the SEC with some specific information about what was said in the presence of Schvacho.

The tough battle for the SEC will be proving that Schvacho had a duty to keep the information confidential and not trade in the stock. Schvacho himself was not an insider. He was merely the friend of an insider. The SEC contends that “Enterline reasonably expected that Schvacho would refrain from disclosing or otherwise misusing the confidential information.” The SEC will have to show that Schvacho violated a fiduciary duty to Enterline based on their long friendship. That duty is part of the law of insider trading cases under 10b-5.

Even if the SEC cannot show insider trading, the SEC also accused Schvacho of violating Rule 14e-3, which prohibits insider trading on information about a tender offer. Unlike insider trading, Rule 14e-3 does not require proving a breach of a fiduciary duty, The SEC will merely need to prove that the person knew the information was confidential. This was just luck for the SEC in this case. The Comsys transaction happened by a tender offer instead of the more traditional merger or reverse merger.

Sources:

Will They Contest the Freeze?

It looks like the SEC has stopped a big insider trading scheme. At least for the moment. But can the SEC find the evidence to prove its suspicions about Well Advantage? I doubt it.

The case involves trading in shares in advance of the announced $15 billion acquisition of a Canadian oil producer, Nexen, by the state-owned Chinese oil company, China National Offshore Oil Corporation, or CNOOC. On Monday, July 23, 2012 CNOOC offered to acquire Nexen for $27.50 per share, a 60% premium over the Friday closing price. Three series of trades had lots of red flags, generating profits in excess of $13 million. The SEC obtained a freeze on those accounts, preventing the owners from getting their suspicious gains.

One series of trades involved accounts at Citigroup and UBS held by Well Advantage. Well Advantage purchased 831,033 shares of Nexen at a cost of about $14.3 million. The buys were made just two trading days prior to the announcement. Well Advantage had not traded in Nexen shares since at least January 2012. The Citigroup account had been dormant for six months. On the Thursday following the Monday deal announcement, a sell order was placed to liquidate the Nexen position in the account for a gain of $7.2 million. (That’s a nice piece of change for a week’s work.)

Another account was at Phillips Securities in Singapore. From July 12,2012 through July 20, 2012, the Phillip Account purchased 597,990 shares of Nexen stock for approximately $10 million. Prior to the July 2012 purchases, the Phillip Account had engaged in only negligible trading of Nexen stock since August 2010. By the end of trading on July 24, 2012, the account had sold 582,990 of its shares realizing profits of approximately $5.1 million.

The third account was at Citibank. That account only purchased 78,220 shares on July 17, realizing a profit of $721,000 when they were sold on July 23.

The SEC’s problem will be proving that the trades were made based on inside information. So far, the only link is in the first series of trades, Well Advantage’s beneficial owner, Zhang Zhi Rong, is a controlling shareholder of Rongsheng, a company that, according to its own public statements, maintains a close business relationship with CNOOC. The SEC will still need to find the smoking gun that proves Well had inside information. Given that the accounts likely involve foreign nationals it will be hard for the SEC to prove its case.

Of course the SEC may be hoping that it does not need to prove its case. The defendants will have to get relief from the asset freeze. That means allowing the SEC access to their communications and files to look for the smoking gun.

Sources:

Is Decimalization Good or Bad?

Although commentators have been viewing the Jumpstart Our Business Startups Act as a rollback of 2010’s Dodd-Frank financial reform, it’s been showing itself as much more of an attack on the earlier Sarbanes-Oxley Act. The latest attack is a required report on a possible rollback of decimalization. A decade ago, the SEC and the exchanges moved to have the price of securities quoted in pennies to deliver cost-savings to investors. The JOBS Act offers up the possibility of increasing the tick size for the new class of “Emerging Growth Companies.” The first step was a Report to Congress on Decimalization (.pdf) as required by Section 106 of the JOBS Act.

The report finds many benefits to investors.

Bessembinder finds that the average quoted bid-ask spreads for all companies declined from pre- to post-decimalization in both NYSE and NASDAQ stocks. His study results showed that large capitalization stocks’ equally-weighted quoted spreads on the NYSE declined from 11 cents to 6 cents and on the NASDAQ from 10 cents to 4 cents. Middle capitalization stocks’ equally-weighted quoted spreads on the NYSE declined from 16 cents to 10 cents and on the NASDAQ from 17 cents to 13 cents. In comparison, small capitalization stocks’ equally-weighted quoted spreads declined from approximately 23 cents to 18 cents on the NYSE, and from 26 cents to 23 cents on the NASDAQ. He found that the corresponding decline, as a percentage of trading price for small capitalization stocks, is from 1.75% to 1.16% on the NYSE and from 1.84% to 1.58% on the NASDAQ.

That’s a cost savings to investors and a profit loss to market makers. However Section 106 of the JOBS Act asks “whether there is sufficient economic incentive to support trading operations” in small and middle capitalization companies after decimalization. Both the IPO Task Force Report and a Grant Thornton paper argue that because brokerage analysts have to depend on revenue from trading commissions, they have an incentive to cover only high volume stocks. The concern is that smaller capitalization stocks do not have the trading volume to offer enough profitability for analyst coverage.

Though regulatory decimalization in the market lowered the minimum allowable tick size to $0.01, it did not mandate that market participants quote narrower spreads. Rather, the quoting of narrower spreads appears to have been a result of continued market forces.

That leaves the SEC staff recommending that the Commission not proceed with a rulemaking to increase tick size. Hopefully that will be the end of this for the foreseeable future. This section of the JOBS Act was a blatant grab by Wall Street to regulate for increased profitability.

Sources:

  • Report to Congress on Decimalization (.pdf) (As Required by Section 106) July 20, 2012
  • Bessembinder, Hendrik, 2003, Trade execution costs and market quality after decimalization, Journal of Financial and Quantitative Analysis 38(4), 747-777.

Veni… Vidi… Wiggins!

Wiggins and Cavendish stuck together all day. Photo: Casey B. Gibson

I would guess that most of you reading this story do not share my love of the Tour de France. (Except Tom Fox.) The race can be a confusing mix of skinny guys, tarted up with sponsors like a NASCAR racer, with hard to pronounce names, following tactics unusual outside of cycling. But I since I became a fan a decade ago, I continue to be enthralled by drama and athletic heroism on display.

This year, Bradley Wiggins and his Team Sky dominated the race in a way that has not been seen for several years. In a act of selfless teamwork, the yellow jersey was the second to last lead out man for his sprinter Mark Cavendish as he wheeled across the finish line on the Champs-Élysées in Paris.

George Hincapie led the peloton into Paris Sunday, a celebration of  the American’s 17th Tour de France — the most ever, by any rider — and his last. He completed 16 of the 17  Tours.  (Just for perspective of the 198 riders that stared the race, 47 dropped out or crashed out of the race.) The big American was part of nine Tour de France wins: seven with Lance Armstrong; one with Alberto Contador; and the final with Cadel Evans, in 2011.

The race was not without its incidents. A spectator threw tacks in the road a top a mountain pass causing dozens of flat tires. An owner let his enormous dog off his leash causing a high speed crash. Frank Schleck was kicked out of the Tour for a possible doping violation.