Compliance Bits and Pieces For July 20

These are some stories that recently caught my attention:

Inside Straight: The Shoemaker’s Children by in Above the Law

I recently heard a law firm presentation describing the UK Bribery Act along the lines I just laid out. A member of the audience asked the obvious question: “If bribery of anyone — including both government and non-government employees — can result in such severe punishments, what sort of client entertainment policy should my company have? Should we allow our sales people to treat clients to $1,000 dinners once a month? $500 dinners every other month? $50 dinners twice a year? What should our policy be?”

The law firm partner puffed up his chest and explained that the only safe policy is to prohibit all client entertainment: “The limit should be zero dollars. That will keep you safe.”

“The Limit Should Be Zero Dollars” by Howard Sklar in Open Air

The number you come up with is entirely less important than the process by which you determine it. The number can’t be outrageous, but here’s the thing: the DOJ has never brought a case against a company that came up with a reasonable number, and enforced it. There are few cases where gifts play any role, none where they play a truly primary role, and absolutely none where the DOJ overruled a business decision. That’s not something the DOJ does, as a rule. They don’t take a reasoned decision and say “you made the wrong choice.” Almost all of the time, the company failed to consider the problem, or considered it but said, “who cares,” or the equivalent.

Blogger: Graft Doubled Cost Of Venezuelan Drill Rig by Richard L. Cassin in The FCPA Blog

Rental was through a Singapore-based company incorporated in Panama called Petro Marine Energy Services LTD, formed in 2008 shortly before the rental agreement was signed. Aban Offshore said it received a rental fee of $358,000 a day. However, Petroleos de Venezuela said in its annual report for 2008 that the value of the contract for the five-year period amounted to $1.3 billion, or $730,000 per day.

Is Kickstarter selling dreams? from Felix Salmon

Maybe that just makes me a tightwad, and maybe America has millions of people who are happy dropping $100 on the experience of funding some exciting new project, just for the way it makes them feel. But it seems to me that one of Kickstarter’s greatest successes is the way in which it has managed to change the way we think about cost.

The Biggest Team in the Universe is an Emerging Growth Company by  James Saksa in Securities Compliance Sentinel

Manchester United – the world’s most valuable sports team, adored by estimated 659 million fans, winner of numerous Premiership titles, FA Cups, and Championship League titles– is going public.  In America.  As an Emerging Growth Company.

Securities Enforcement Forum 2012 is a one-day conference in Washington, D.C. that brings together securities enforcement and white-collar attorneys, current and former senior SEC and DOJ officials, in-house counsel and compliance executives, and other top professionals in the field. The conference will take place on Thursday, October 18, 2012, at the historic Mayflower Hotelin downtown Washington, D.C.

Securities Enforcement Forum 2012 will kick off with a keynote address by SEC Commissioner Luis A. Aguilar, and will feature an extraordinary faculty – including former SEC Directors of Enforcement The Honorable Stanley J. Sporkin,  William R. McLucas and over a dozen other luminaries in the securities enforcement field — who will discuss the most important issues now facing attorneys and professionals who work in this area.

Securities Enforcement Forum 2012 is also specifically designed to maximize networking and discussion opportunities for attendees, with breakfast, lunch, a cocktail party, and numerous breaks scheduled throughout the day. The conference is produced by Securities Docket, the leading publication in the securities enforcement area and the producer of over 80 related webcasts.

Judge OKs Nudity at TSA Checkpoint by David Kravets in Wired.com’s Threat Level

The incident began when Brennan refused to go through the so-called “nude” scanners and instead opted for a pat-down. A TSA officer detected nitrates on his gloves after the pat down. Nitrates are used in explosives. That, Brennan said, was the last straw. He took his clothes off and proceeded through the checkpoint. He was subsequently arrested.

Real Estate Fund CCO Forum

NEW YORK

We are starting a new forum for real estate fund compliance managers in New York. The first meeting is noon on July 24 near Chelsea Market.

BOSTON

The Boston group of real estate fund compliance professionals will meet again in September after taking the summer off.

ABOUT

The groups meet to discuss the issues that are particular to real estate funds post Dodd-Frank. We have moved past the register or non register discussions. (At least most of us have.) Here are some of the topics for the agenda:

  • Who are your access persons (entire company, a smaller subset, just the managing directors/executives)?
  • Are you getting brokerage statements or just having employees attest to the securities that they do have by providing a brokerage statement or listing the required security information on a separate sheet of paper?
  • Do you use any technology to assist in the compliance duties (certificate database, security software, email archiving, social media tracking etc.)?
  • Are you using a third party consultant?  If so, what are they doing for you?
  • Who is doing your required annual training?
  • How are you keeping up with current compliance news relating to real estate?

The meetings operate under the Chatham House Rule. So that discussion can be open without concern that any position would be attributed to you personally or your firm.

If you are interested in joining either (or both) of the group you can reach me at [email protected]. I can send you more detailed information.

OFAC and Private Funds

An SEC-registered investment adviser entered into a settlement agreement with the U.S. Treasury Department’s Office of Foreign Assets Control for allegedly failing to maintain a compliance program. The problem was triggered when the adviser’s foreign affiliate caused one of its clients to invest in a Cayman Islands fund that appeared on OFAC’s list of Specially Designated Nationals. Genesis Asset Managers, LLP agreed to a $112,500 fine for an apparent violation of the Iranian Transactions Regulations (31 C.F.R. part 560) that occurred in 2007.

OFAC claimed that Genesis did not maintain an OFAC compliance program at the time the investment was made. Of course, Genesis was not required to do so.

These were the aggravating factors in this case:

  • Genesis failed to exercise a minimal degree of caution or care in the conduct that led to the apparent violation
  • Officers of Genesis were aware of the conduct giving rise to the apparent violation
  • Substantial economic benefit was conferred to Iran
  • Genesis did not have an OFAC compliance program in place at the time of the apparent violation

These were the mitigating factors:

  • Genesis has not received a penalty notice or Finding of Violation from OFAC for substantially similar violations
  • Genesis substantially cooperated with OFAC’s investigation
  • Genesis voluntarily self-disclosed the apparent violation
  • Genesis took appropriate remedial action
  • Genesis may not have fully understood its OFAC obligations under U.S. law.

I find the last one strange. Every firm needs to comply with the OFAC regulations that prohibit transactions with parties on OFAC’s list of Specially Designated Nationals. Genesis is based on Britain so maybe the firm was bit confused about the extra-territorial reach of US law across the banking and investment systems.

Advisers should adopt risk-based procedures to ensure compliance with OFAC regulations. Most advisers and fund managers are not subject to a formal regulatory requirement to adopt written AML procedures or know-your-customer programs. That does not mean that such programs are bad ideas.

An adviser that can effectively demonstrate a reasonable OFAC/AML compliance program may be able to avoid heightened scrutiny from regulators. And investors are increasingly expecting their fund managers to have AML programs in place. If a violation does occur, the existence of a formal program can help mitigate the damage. In its enforcement guidelines, OFAC has stated that it may consider the “existence, nature and adequacy of a [firm’s] risk-based OFAC compliance program” in determining whether to bring an enforcement action and the amount of any penalty imposed.

It’s fairly easy to license a system and check your investors and business partners against the OFAC list and other sanctions lists.

Sources:

This is Not Compliance

UPDATE (9/10/2019):

The CEO/CCO in question contacted me and told me her side of the story with regards to the SEC. According to her, an investor sued based on the SEC case and the charges were largely dismissed. As I point out and have now highlighted, I relied on the order to illustrate what the SEC does not like and what you should not do. At her request, I’ve edited the post and removed her name. 

Sometimes you see a careless disregard for the rules governing private funds and investment advisers. Last week, the CEO/CCO of Calhoun Asset Management, settled fraud charges with the Securities and Exchange Commission. Her problems are probably common for start-up managers.

Calhoun and the CEO/CCO entered into an Order Making Findings (.pdf) with the SEC, but neither admitted nor denied the facts. I’ll assume the statements in the Order are true for educational purposes.

Assets Under Management

In 2006, the CEO/CCO started two hedge funds: Triumph Multi-Series Fund (later renamed Calhoun Multi-Series Fund LP) and Calhoun Market Neutral Fund. CEO/CCO attracted capital to the Funds by aggressively marketing herself as an experienced hedge fund manager, despite having no experience in portfolio management.

In filling out a due diligence questionnaire for a potential investors, CEO/CCO state that the firm grew from $27 million in assets under management in 1999 to $200 million. However, the firm never had more than $3 million in assets under management.

I understand the desire of fund managers to puff up the AUM number. After all, that dollar amount often stands for measure of success. However, the calculation of AUM needs to be documented and defensible. Lies can easily be detected and puffery will raise red flags.

Performance

The fund marketing materials refer to a 10-year track record with 11+% average annual returns. The CEO/CCO failed to maintain the documentation supporting this track record. CEO/CCO only maintained records dating back to 2007. In a PowerPoint presentation, CEO/CCO included a full-page chart of monthly and annual performance returns from 1999 through 2009. The legend at the bottom of the page states that “[t]hese returns represent our flagship fund, Calhoun Fund SPC, Ltd.” Calhoun Fund SPC, Ltd. However, the fund did not commence operations until January 1, 2007.

The SEC rules are very clear that any statements in marketing materials about performance must be well documented. Calhoun’s overstatement should be easily detected with a little due diligence by a prospective investor.

Due Diligence

Calhoun promoted its due diligence capabilities in its marketing materials. This included regular monitoring, performance reviews, and on-site visits. “We take every precaution necessary to complete thorough due diligence and research on every manager we recommend” (emphasis in original).

The truth was that Calhoun’s actual due diligence was virtually nonexistent. CEO/CCO did not even perform the due diligence herself. Instead, she outsourced the due diligence to a third party, and that third party did little actual diligence.

Form ADV

Of course, lying to the SEC will really get you. On the Forms ADV she filed with the SEC, CEO/CCO repeatedly misrepresented  assets under management.

CEO/CCO first registered Calhoun as an investment adviser on August 31, 2007. On Calhoun’s Form ADV, CEO/CCO stated that Calhoun had $30 million in assets under management. In reality Calhoun had less than $6 million under management. On February 18, 2009, CEO/CCO filed an amendment to the ADV showing $79.8 million in assets under management. In reality, Calhoun had approximately $7 million under management.

Lessons?

Lying is bad. Unlike a fisherman’s tale about the one that got away, fund managers are expected to document their tales in detail.

CEO/CCO has to pay a $50,000 fine and is barred from the securities industry for five years.

Sources:

What Does FINRA Think About Crowdfunding?

The crowdfunding provisions in Title III of the JOBS Act provide an exemption from registration under the Securities Act of 1933 for securities offered by through crowdfunding, provided the numerous requirements are met. An intermediary that seeks to engage in crowdfunding must be registered as a broker-dealer or a funding portal. I expect many people are looking at what the regulatory requirements are going to be for this new type of entity. The JOBS Act also requires that a funding portal be a member of an applicable SRO, but limits the examination and enforcement authority of the SRO over registered funding portals to rules “written specifically for registered funding portals.”

FINRA issued Regulatory Notice 12-34 soliciting public comment on the appropriate scope of FINRA rules that should apply to member firms engaging in crowdfunding activities, either as funding portals or as brokers.

Commenters are encouraged to identify the types of requirements that should apply to registered funding portals, taking into account the relatively limited scope of activities by a registered funding portal permitted under the JOBS Act. Comments are particularly requested about possible rules concerning supervision, advertising, anti-money laundering, fraud and manipulation, and just and equitable principles of trade.

I think would-be crowdfunding portal developers are going to have a hard time dealing with the know-your-customer rules required in setting up an account.

Would established firms set up crowdfunding portals. FINRA is clearly anticipating that some of its member firms will do so. And why not? I’m sure a brokerage firm could view a crowdfunding portal as a minor league, allowing them to farm prospects for bigger alternative investments.

FINRA is already looking at potential conflicts.

FINRA also requests comment on whether engaging in crowdfunding might present special conflicts or concerns for a broker-dealer, such as might arise if a registered representative were to recommend that a customer visit the firm’s crowdfunding site.

Sources:

Compliance Bits and Pieces for July 13

These are some recent compliance-related stories that caught my eye.

How To Define Your Terms In 300 Pages by Theo Francis in NPR’s Planet Money

In Tuesday’s show, economist Luigi Zingales warned that massive, overly complicated laws and regulations go a long way toward undermining public trust in the government. They leave only lobbyists and lawyers reading the rules, in the pursuit of loopholes.

By coincidence, on Tuesday a key federal financial regulator said it had approved a collection of definitions and conditions for regulating a big chunk of the derivatives market.

It was several hundred pages long.

Lying Liars Who Believe Those Lies by Dan Ariely

What do Williams Gehris, America’s most decorated war hero, and Walter Williams, the last Civil War veteran to pass away, have in common? Both were frauds. They spun tales of military heroism, duped the public, and then – whoops – someone discovered that they hadn’t actually achieved the purported feats.

The chilling effect of accredited investor verification by William Carleton

Here’s the problem with opposing heightened verification altogether: the JOBS Act clearly contemplates that issuers must do something more to ensure that all the investors in a deal are accredited, when the deal has been broadcast publicly. So the SEC is going to have to reflect this legislative imperative in its rules. I’ve accepted that reality, and put all my eggs in the basket of hoping that it will remain possible to conduct Rule 506 offerings as before – without general solicitation and without advertising.

5 Business Ethics Must-Reads by Chris MacDonald

  1. Adam Smith The Wealth of Nations
  2. Edward Freeman Stakeholder Capitalism
  3. Joseph Heath Business Ethics Without Stakeholders
  4. John Boatright What’s Wrong—and What’s Right—with Stakeholder Management
  5. Joseph Heath Business Ethics and Moral Motivation

Why Should the Boss Listen to You: Compliance Professional as Trusted Advisor by Tom Fox

Bribes are Like a Box of Chocolates

The Securities and Exchange Commission charged medical device company Orthofix International N.V. with violating the Foreign Corrupt Practices Act. A subsidiary paid bribes, referred to as “chocolates”, to Mexican officials in order to obtain lucrative sales contracts with government hospitals. (I assume every commentator on this story will reference Forrest Gump, including me.)

The “chocolates” came in the form of cash, laptop computers, televisions, and appliances that were provided directly to Mexican government officials or indirectly through companies owned by the officials.

“Once bribery has been likened to a box of chocolates, you know a corruptive culture has permeated your business,” said Kara Novaco Brockmeyer, Chief of the SEC Enforcement Division’s Foreign Corrupt Practices Act Unit.

Orthofix consented to a final judgment ordering it to pay $4,983,644 in disgorgement and more than $242,000 in prejudgment interest. Orthofix also disclosed in an 8-K filing that it has reached an agreement with the U.S. Department of Justice to pay a $2.22 million penalty in a related action.

I found it interesting that Orthofix had a chance to discover the bribes, but missed it. The Orthofix subsidiary involved in the bribery, Promeca, hid the bribes in the promotional and training expenses budget item. That line item went over budget, leading to an inquiry from the parent company. Orthofix failed to find the true problem or put a control in place to control the budget line item.

It should come as no surprise that compliance program failed.

20. Although Orthofix disseminated some code of ethics and anti-bribery training to Promeca, the materials were only in English, and it was unlikely that Promeca employees understood them as most Promeca employees spoke minimal English.

Clearly, you need a translation of your code of ethics into other languages if you are operating abroad.

Sources:

Iran, Tuvalu, and Oil

Anyone who works with sanctions monitoring most likely hates ships. Their names are so common that the ships’ names routinely cause false positives. (My software has a button to exclude ships’ names, but I often forget to activate that feature.) Now the Iranian oil sanctions program is highlighting some issues with ships.

The tiny Pacific island nation of Tuvalu is prepared to re-flag a fleet of National Iranian Tanker Co. vessels to operate under Tuvalu’s ship registry.  From a personal perspective, it will likely mean more ship names in the databases. Fortunately, my company doesn’t deal with ships so it will only affect me when I forget to select the right option.

On a global scale, it may be an effective way to hide ownership and get cash to Iran. There is still the problem of moving the cash through the global financial system.

Rep. Howard Berman, the ranking member of the House Foreign Relations Committee wrote a letter to Willy Telavi, prime minister of Tuvalu, to cancel the registry.

It is my understanding that the Government of Tuvalu has permitted the National Iranian Tanker Company (NITC) to reflag as many as 22 vessels under the Tuvalu ship registry, allowing them to remain under NITC ownership and continuing to transport Iran’s crude oil exports. This has the effect of assisting the Iranian regime in evading U.S. and EU sanctions and generating additional revenues for its nuclear weapons program and its support for international terrorism.

It would be profoundly disappointing to me if your government has acted in contravention of the broad international coalition that is working together to use peaceful means, including economic sanctions, to change the threatening behavior of the Iranian regime.

Prior to selling its soul to Iran, Tuvalu was mostly known for its strong position on global warning. The county is small and flat. At just 26 square kilometers Tuvalu is the fourth smallest country in the world, larger only than the Vatican City at 0.44 square kilometers, Monaco at 1.98square kilometers and its neighbor Nauru at 21 square kilometers. At its highest, Tuvalu is only 4.8 meters above sea level. A dramatic rise in sea level could make the country inhabitable.

Why would such an environmentally fragile country help a rogue nation? Tuvalu has been looking for a place to re-settle its inhabitants once sea levels rise. It seems unlikely that they would choose Iran for resettlement. I would assume it comes down to cash. I suspect Iran offered a big pile of cash, with some of it going directly to select Tuvalu officials.

Sources:

Image of Iranian and Tuvalu flags courtesy of crossed flag pins.com

The Rebirth of Regulation A Offerings

The Jumpstart Our Business Startups Act requires the Securities and Exchange Commission to amend Regulation A, raising the threshold for use of that exemption from $5 million to $50 million. From the numbers I’ve seen, Regulation A was rarely used as a source of raising capital. It seemed strange that it was included in the JOBS Act. But there were many strange things in the JOBS Act.

Section 402 of the JOBS ACT required the GAO to study the impact of state securities laws on Regulation A offerings. The GAO released its study: Factors That May Affect Trends in Regulation A Offerings.

The report confirmed the lack of use of Regulation A in capital raising. The number of Regulation A offerings filed with the SEC decreased from 116 in 1997 to 19 in 2011. Similarly, the number of qualified offerings dropped from 57 in 1998 to 1 in 2011.

The big difference is that Regulation A offerings are still subject to state securities laws. In contrast, Rule 506 offerings under Regulation D are not subject to the state securities law.

To contrast, there were 15,500 initial Regulation D offerings for up to $5 million in 2010 and 2011, compared to the 8 qualified Regulation A offerings during the same period.

One aspect of a Regulation A offering compared to a Regulation D offering is that it is subject to review, comment, and qualification by the SEC. According to the GAO report 20% of Regulation A filings were abandoned during the SEC comment process.

Another aspect of Regulation A is that the securities’ sales are not limited to accredited investors. So there is a larger pool of potential investors.

On the state side of the process, all states conduct a similar disclosure review as the SEC. Apparently some states will also engage in a merit review to determine if potential investors are getting a good deal. According to the report, businesses are generally advised by legal counsel to avoid Regulation A offerings in states that have a merit review.

So where does this leave Regulation A offerings in the new world of capital formation after the JOBS Act? I would guess in the same place. The big advantage of Reg A offerings over Reg D offering is that they can be sold to non-accredited investors. That comes with a lot of cost and lost time to go through the review process. I would guess that the new crowdfunding offering would be a more attractive alternative to reaching non-accredited investors. Of course, the regulations on crowdfunding do not yet exist and the mandatory equity crowdfunding portals do not yet exist.

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Independence Day and Compliance

What better way to celebrate the independence of the United States than by taking the day off from work, grilling meat, and watching stuff blow up. I’m doing the same thing on the blog and taking a vacation.


“The Second Day of July 1776, will be the most memorable Epocha, in the History of America. I am apt to believe that it will be celebrated, by succeeding Generations, as the great anniversary Festival. It ought to be commemorated, as the Day of Deliverance by solemn Acts of Devotion to God Almighty. It ought to be solemnized with Pomp and Parade, with Shews, Games, Sports, Guns, Bells, Bonfires and Illuminations from one End of this Continent to the other from this Time forward forever more. ”

– John Adams on July 3, 1776 to his wife (via A Tradition of Celebration by the Adams Family Researched by James R. Heintze)

 
Fireworks display by Agiorgio
CC BY SA