A Conversation with Paul Volcker

In a night out that only a compliance geek would love, I spent Monday night listening to Malcolm Salter talk with Paul Volcker, former Chairman of the Federal Reserve. Harvard University’s Edmond J. Safra Center for Ethics and the Center’s director, Lawrence Lessig, hosted the event in the Ames Courtroom at Harvard Law School. The topic, as you might expect, was Implementing Financial Reform

It was clear that Mr. Volcker is a supporter of traditional commercial banking. He stated that they are essential to commerce. Their core functions of taking deposits, making loans, and operating the payment system are essential and need to be protected. There is a price for that protection: government oversight and restrictions.

The 2008 crisis came from non-banks. Hedge funds and investment banks touted their efficiency, lack of regulatory oversight, brilliant managers, and best financial engineers. In 1998 they invented Credit Default Swaps. They blew themselves up.

There were $60 trillion of CDS instruments insuring $6 trillion of loans. Today there are $700 trillion of the greater category of derivatives.  That is an order of magnitude larger that the world’s GDP.

Mr. Volker was quick to point out that proprietary trading was not the cause of the 2008 crisis, it was the origination of many, many bad home loans to people who could not repay them. However, proprietary trading did play a role.

Mr. Salter pulled out a thick binder contained the proposed Volcker Rule. (I did the same thing at the PEI CFO Forum.) But Mr. Volcker found that disingenuous. The rule itself is only about 35 pages and the rest of the binder contained the commentary and thousands of questions posed by regulators.

Mr. Volcker compared the current rule on proprietary trading to a rule on Truth in Lending that he implemented while he was Chairman of the Federal Reserve. The initial draft from his staff was 170 pages, he sent it back with a requirement that it be no more than 100 pages. He wanted it simpler and they delivered. To his surprise, most of the industry comments were to have more details in the rule.

It became apparent to me that Mr. Volcker was advocate of a principle-based oversight rather than a rules-based oversight. The more rules there are, the more gamesmanship that the industry will engage in. He pointed to the example of Barclays and Deutsche Bank re-shaping their US subsidiaries so they would no longer be classified as bank holding companies. He thinks it will be relatively easy for regulators to spot proprietary trading by focusing on volume an volatility.

Switching topics, Mr. Volcker pointed out that the standards for bank capital requirements were another part of the 2008 crisis. Under the regulatory capital requirements, banks were not required to set much capital aside for mortgages and sovereign debt.  There is some backlash in the Volcker rule because it allows proprietary trading in US government securities, but not in non-US sovereign debt. That has been the case for many years, going back to Glass-Steagall. The problem is drawing the line between which sovereign debt is safe and which is not.

Mr. Volcker does not think that the proposed rule is on a deathwatch. Rule-making is inherently complex and this is a complex area. To add to the complexity, several government agencies are involved in the rule. He also pointed out that much more lobbying and money is involved in the rule-making process than when he was Chairman of the Fed. You want industry responses to rules. The difficult part is when that response is coupled with a campaign contribution to Congress.

Circling back to the ethics aspect (the event was sponsored by the Center for Ethics), Mr. Volcker pointed out that proprietary trading causes an inherent conflict of interest with your customers. The trader is no longer acting as a broker, pulling a buyer and seller together. The proprietary trading bank is buying and selling for its inventory.

Proprietary trading creates a conflict in the compensation structure. Traders get paid on short-term gains, often before the trade’s economic effect is fully realized. That outsized and short-term compensation becomes a siren song for bankers looking for fatter wallets, causing them to take bigger risks. (Like, say originating sub-prime loans and reselling them.)

Additional materials:

Steps to Determine if an Investor is Accredited

Private funds will be able to advertise and solicit for investor, provided all of the investors are “accredited investors.” The will dramatically change the way capital raising for private funds operates.

The drawback is the loss of 35 non-accredited investors in the fund. That exception has been eliminated. Funds will need to wait until the Securities and Exchange Commission issues the rules under Section 201 of the JOBS Act.

Part of those rules may be a mandated approach to determine if someone is an accredited investor.

“Such rules shall require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission.”

The SEC may take the opportunity to mandate an approach to validate an investor’s financial standing. As with most regulations, it could clear up uncertainty or create a paperwork headache (or both).

Will you need a copy of an investor’s W-2? A certified financial statement? Those are reasonable requests. However it would create much more personal information that would need to be safeguarded by the fund sponsor.

There is the possibility that the mandated approach would also address the requirements to determine if an investor is “qualified client” under the Investment Advisers Act or a “qualified purchaser” under the Investment Company Act.

We will have to wait and see what comes out of 100 F Street.

Sources:

Compliance Bits and Pieces – JOBS Act Edition

The Jumpstart Our Business Startups Act is soon to be law. Here is a smattering of post that caught my attention.

In spite of what you may heave heard, the Senate just effectively killed crowdfunding by Alexander J. Davie

The replacement crowdfunding bill is significantly more complex and fraught with liability for issuers. While even the McHenry approach had some degree of complexity, the Merkley version makes it look simple and straightforward in comparison. Here are just a few examples of some of the differences that I think will sink the new crowdfunding law and prevent it from being of any practical use: ….

The “JOBS” Act and the Capital Raising Process (Crowdfunding and the Consequence of Gambling) by J. Robert Brown Jr. in The Race to the Bottom

But in fact, the crowdfunding exemption included in the JOBS Act is not limited to amounts that investors can afford to lose. The provision allows those with an income or net worth of less than $100,000 to invest up to 5% of that amount or $5000 every year. For those with a net worth or annual income above $100,000, they can invest up to 10% of that amount or up to $100,000 during any 12 month period.

The Three Audiences of the JOBS Act by William Carleton

No one can really know for sure, of course, but I would say that the changes made in the Senate to crowdfunding will make crowdfunding and angel financing mutually exclusive. It’s a bit ironic, but Title II of HR 3606 in many ways puts true crowdfunding behind the accredited investor gate, while giving non-accrediteds a new kind of limited offering registration as an alternative to the others (little used) already out there.

Chowing Down On The JOBS Act And Ralston Purina by Keith Paul Bishop in California Corporate and Securities Law blog

Anyone who has studied securities laws has undoubtedly heard of the Supreme Court’s decision in SEC v. Ralston Purina Co., 346 U.S. 119 (1953). In that case, the Supreme Court struggled with the exemption in the Securities Act of 1933 for “transactions by an issuer not involving any public offering” (now in Section 4(2) but then found in Section 4(1)). Yesterday, Congress passed the “Jumpstart Our Business Startups Act“. Assuming that President Obama signs this bill, the JOBS Act will dramatically change the longstanding limitations on private offerings.

Jobs Bill Opens Door to Hedgie Advertising by Juliet Chung in WSJ.com’s Deal Journal

Could pro golfers soon test their skills at the Paulson & Co. Open? Will legions of basketball or hockey fans one day cheer on their home team from the friendly confines of D.E. Shaw Center?

Which Hedge Fund Manager’s TV Commercial Are You Most Looking Forward To? by Matt Levine in NY Times.com’s DealBreaker

“I take back whatever mildly negative things I may have said about the JOBS Act, since apparently in addition to making it easier for small startups to rip off investors, it will also make it easier for small hedge funds to rip off investors”

The jumper cables are Coleman Cable 08565 12-Foot Heavy-Duty Booster Cables, 6-Gauge

Accredited Investors and the JOBS Act

The Jumpstart Our Business Startups Act repeals the SEC’s ban on general solicitation and advertising under Rule 506. That is the exemption from registration used by most private fund managers. Is this a good thing?

I didn’t like the ban, mostly because it was so broad. The SEC gave little guidance as to what was advertising in support of the company and what was advertisement in support of the sales of securities. I would have welcomed better guidance. Now it looks like private fund managers will be free to have late-night television ads, email campaigns, twitter accounts, and Facebook fan pages.

Section 201(a) gives the SEC 90 days to

“revise its rules issued in section 230.506 of title 17, Code of Federal Regulations, to provide that the prohibition against general solicitation or general advertising contained in section 230.502(c) of such title shall not apply to offers and sales of securities made pursuant to section 230.506, provided that all purchasers of the securities are accredited investors.”

At first, I thought the last proviso was extraneous. Rule 506 allows unlimited fundraising as long, but it’s limited to accredited investors. But that’s not right. Rule 506 allows up to 35 investors that are not accredited, as long as they are “sophisticated” – have sufficient “knowledge and experience in financial and business matters” to make them “capable of evaluating the merits and risks of the prospective investment”.

If a manager is going to advertise that it is fundraising, then it needs to ban those previously allowed 35, even if they are sophisticated. Money rules. You need $ 1 million, excluding your primary residence, or $200,000 in income, $300,000 income with your spouse. It doesn’t matter if you are sophisticated. Even though the Crowdfunding section of the JOBS Act is supposed to allow a broader range of capital sources, this part of the law cuts off access to non-accredited investors.

That means fund managers may have to cutoff  “friends and family” investors from the fund, unless they are accredited investors.

The jumper cables are Heavy-Duty Auto Jumper Cables – 20-Ft Length – Heavy 4-Gauge Copper Wire by Tooluxe

Next Steps for the JOBS Act

The Jumpstart Our Business Startups Act, as amended by the Senate, was voted on by the House of Representatives yesterday and passed 380 to 41. That makes it a very bi-partisan bill, even though all 41 “Nays” were Democrats. If I remember my Schoolhouse Rocks song correctly, it’s up to the President to sign it or veto it.

The White House has already expressed support for the concept of crowdfunding. I expect President Obama will sign it into law very soon. He may actually have signed it by the time you are reading this.

As with the big Dodd-Frank law of 2010 that increased regulatory oversight, this law that decreases the regulatory burden tasks the Securities and Exchange Commission with many tasks. There are several studies and rulemakings thrown at the SEC. (I didn’t see any budget increase to go along with these tasks.)

The one I’m most focused on is in Title II-Access to Capital for Job Creators. Section 201(a) requires the SEC to

“revise its rules issued in section 230.506 of title 17, Code of Federal Regulations, to provide that the prohibition against general solicitation or general advertising contained in section 230.502(c) of such title shall not apply to offers and sales of securities made pursuant to section 230.506, provided that all purchasers of the securities are accredited investors.”

The law gives the SEC 90 days to make the revision.  WWSECD? (What Will the SEC Do?)

The SEC could simply insert the new language into Rule 506. It’s exactly what Congress demanded. However, the SEC could provide some clarity and other restrictions around the advertising. There could be rules about record-keeping or submission of advertisements. The SEC still has its ant-fraud mandate so it could impose other requirements. Some of the SEC commissioners have already spoken out against the law. But given the short timeframe, I doubt the SEC will do anything except insert the new language.

However, the SEC does need to act before the late-night TV advertisements begin. There may be some regulatory limbo if the SEC does not enact the revision by the end of the 90 day period. Why would the SEC pick this fight with Congress? Get ready for a new wave of advertisements for unregistered securities starting this summer. But you can only buy them if you are an accredited investor.

The SEC will have to study the “tick rule” to determine if penny increments are too small for the new category of emerging companies under Title I of the JOBS Act: Reopening American Capital Markets to Emerging Growth Companies. Section106 tasks the SEC with this study. I guess Congress thinks the trading on public companies with less reporting on executive compensation, lesser financial reporting obligations, and less auditing would trade differently than companies that meet the more exacting standards of a public company. Of course this is just for small companies, with less than $1 billion in gross revenues. (When did a billion get to be so small?)  I’m sure the brokerage houses would love to see a bigger spread on the tick.

Title I also tasks the SEC with a review of Regulation S-K. Section 108 gives the SEC 180 days to study how to streamline the registration process.

Title IV-Small Company Formation expands the Regulation A exemption allowing a more streamlined approach for smaller issues. The limit is raised from $5 million to $50 million. (When did $50 million get to be so small?) The Comptroller General gets tasked with study of the state blue sky laws on Regulation A offerings.

Title V- Private Company Growth and Flexibility Act, or as I call it the let’s not make Facebook go public section. It raised the 12(g)(1)(A) standard from 500 shareholders to 2,000 or 500 who are not accredited.  Section 503 tasks the SEC with revising the definition of “held of record” and safe harbor provisions for employee compensation.  The SEC also look at its authority to enforce Rule 12g5-1 and report its recommendation back to Congress.

Title VI-Capital Expansion makes a shareholder increase for banks and bank holding companies and gives the SEC a year to issue final regulations to implement the changes.

Title VII makes the SEC tell people about the JOBS Act.

The Securities and Exchange Commission shall provide online information and conduct outreach to inform small and medium sized businesses, women owned businesses, veteran owned businesses, and minority owned businesses of the changes made by this Act.

I expect we will see a new web page or domain from the SEC on the JOBS Act.

Those are not very sexy changes and probably leave you scratching your head about why Congress would pass these changes and do so very quickly. It leaves me curious as well. Many of the SEC commissioners took that rare action of publicly stating their opposition to the law. The state regulatory association stated:

Election-year politics have blinded Congress and the White House to the unintended consequences of the JOBS Act, which while well intentioned, could do little more than open the floodgates to investment fraud.

I suppose it was election year politics. And good marketing. The bill sponsors were able to give it the acronym JOBS, even though the bill has little to do directly with jobs. The sponsors have draped small businesses with the flag of job creators and opening the floodgates of capital to them will allow them to grow and re-create the millions of jobs lost in 2008-2009.

There was also the sexy piece of the JOBS Act that I have not mentioned, Title III-CROWDFUND. It’s designed to enable aspiring entrepreneurs to access capital using the internet to gather small dollar investments from would-be investors across America. William Carleton has done a great job of covering the crowdfunding aspect of the law.

Don’t expect Kickstarter to start offering equity funding any time soon. The SEC has 270 days to enact the rules around crowfunding and regulation of funding portals.

Sources:

Is Apple a Hedge Fund?

I don’t own any Apple stock, but their announcement about what they’re planning to do with their big stockpile of cash caught my attention. Not because I’m going to rush out and buy the stock, but because of Dodd-Frank.

My analysis of when fund managers need to register with the Securities and Exchange Commission has me focused on the composition of a company’s assets. I was skeptical that Apple had those billions sitting in stacks of $100 bills in a vault at the Apple headquarters. Some of it had to be invested in securities.

Under the Investment Advisers Act you need to register if you are providing investment advice about securities. Apple is in the business of making shiny gadgets and driving tech-boys into slather over its latest product. Is that still true when the company is sitting on an enormous pile of cash and securities?

I decided to take a look at the balance sheet in Apple’s last 10-Q and broke it out into assets and securities.

 Assets Securities
Cash and Cash equivalents          9,815
Short-term marketable securities        19,846
Accounts receivable, less allowances      8,930
Inventories      1,236
Deferred tax assets      1,937
Vendor non-trade receivables      7,554
Other current assets      4,958
Long-term marketable securities        67,445
Property, plant and equipment, net      7,816
Goodwill         896
Acquired intangible assets, net      3,472
Other assets      4,281
   41,080        97,106
     138,186
70%

About 70% of Apple’s assets are in securities. That made me think of my analysis of whether you are an investment adviser. Apple could be a hedge fund. They have more in securities than they do iPhones.

Under Dodd-Frank, the definition of private fund is taken from the definition of an investment company in the Investment Company Act. Part of that definition is that the issuer

owns or proposes to acquire investment securities having a value exceeding 40 percentum of the value of such issuer’s total assets (exclusive of Government securities and cash items) on an unconsolidated basis.

Apple is above that 40% level, so I took a closer look at Apple’s breakdown of its securities:

Cash 3,956
Money market funds  3,495
Mutual funds  1,238
U.S. Treasury securities 14,685
U.S. agency securities 20,000
Non-U.S. government securities  5,251
Certificates of deposit and time deposits 3,837
Commercial paper  1,518
Corporate securities 38,914
Municipal securities  4,078
Asset-backed securities  549
Total  55,043

That $55,043 happens to represent 40% of 138,681. I would guess that Apple is very aware of that 40% threshold to be considered an investment company and is purposefully keeping its allocation among securities to not go above the 40% threshold.

Because Apple has kept itself below the 40% level you don’t need to address the second prong of the test: whether Apple “holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities.”

So, the answer is “no.” Not because Apple is technology company, but because the company is purposefully managing its portfolio of securities to stay outside the definition.

Compliance Week Annual Conference 2012

I attended Compliance Week’s annual conference in 2010 and 2009. It’s a great conference with lots of great people and great programs. But I’m not attending this year because I decided to spend by professional development budget on getting the Investment Adviser Certified Compliance Professional designation.

If you want to go to Compliance Week 2012, the conference organizers passed on a special discount offer of $350 off the regular rate, a saving of almost 20%.  I like Matt Kelly, the editor and publisher of Compliance Week, so I was willing to tart up Compliance Building with an advertisement for the conference.

The conference is specifically geared to corporate financial, legal, risk, audit, and compliance executives at public companies.  It takes place in Washington, DC June 4-6, 2012.

Confirmed keynote speakers this year are :

  • James Doty, chairman of the Public Company Accounting Oversight Board
  • Bob McDonald, CEO of Procter & Gamble
  • Judge Jed Rakoff, U.S. district judge for the Southern District of New York
  • Leslie Seidman, chairman of the Financial Accounting Standards Board
  • Sam Sommers, author of Situations Matter: Understanding How Context Transforms Your World.

To take advantage of the discount offer use code CW2012BL  and register here
http://www.complianceweek.com/compliance-weeks-6th-annual-conference-may-2011/eproduct/12/6433/

Here are some links for more information:

Compliance Bits and Pieces for March 23

Photo by Carol Highsmith, April 2007. http://hdl.loc.gov/loc.pnp/highsm.04037

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

No, You Can’t Tase Compliance by Scott Greenfield

It is undisputed that defendant did not threaten, fight with, or physically resist the officers at any time; rather, he simply refused to open his mouth to allow the officers to obtain a buccal swab. . . We cannot agree with the suppression court that, after 10 to 15 minutes of asking a suspect to comply with a court-ordered buccal swab of which the suspect had no prior knowledge, it is reasonable for the police to tase a nonviolent, handcuffed, and secured defendant in order to force the suspect into submission.

A Good Meal, A Good Time And A Good Securities Offering? by Keith Paul Bishop in California Corporate and Securities Law

A California administrative decision illustrates how a simple dinner party can get suddenly veer from a purely social gathering to arguably a public offering of securities. It seems that the party began innocently enough. When a woman moved into a rural residential community, the local women organized a dinner party to welcome the new arrival. … It turns out, however, that the new neighbor had plans to build an alcohol and drug rehabilitation facility in the community. Thus, she saw this dinner party as more than an opportunity to meet her neighbors; she saw it as an opportunity to win support for her project. In fact, she brought a copy of a prospectus for her project.

Defined Benefit Plans: Recent Developments Highlight Challenges of Hedge Fund and Private Equity Investing (.pdf) by the Government Accountability Office

In order to assess the extent to which pension plans have realized desired benefits from investing in hedge funds and private equity, and actions they may have taken in response to recent experiences, particularly given ongoing market volatility, you asked us to examine the following questions:

  • What is known about the experiences of defined benefit pension plans with investments in hedge funds and private equity, including recent lessons learned?
  • How have plan sponsors responded to lessons learned from recent experiences with such alternative investments?
  • What steps have federal agencies and other entities taken to help plan sponsors make and manage investments in such alternative assets, and what additional steps might be warranted?

On Wall St., Keeping a Tight Rein on Twitter by William Alden in DealBook

This is how Wall Street firms are tiptoeing into the fast-paced world of social media. Firms like Morgan Stanley must tightly monitor communications to ensure that they are in compliance with securities regulations. As a result, they generally block employees from using social media sites like Twitter or even checking personal e-mail accounts at work. Indeed, the banks underwriting the gigantic Facebook I.P.O. bar their employees from using the social networking site.

Lifting the Ban on General Solicitation and General Advertising

On Thursday afternoon, the US Senate passed the Jumpstart Our Business Startups Act, a bill designed to make it easier for small companies to raise capital. The centerpiece of the legislation is the crowdfunding provision. However, the Senate passed an amendment to that section of the legislation. That means the Senate version and the House version of the law are different. It’s up to the House to pass the Senate version, or meet in conference to find a compromise.

The Senate did not change Title II of the legislation. Those sections eviscerate the long-standing prohibition on general advertisement and general solicitation of investors. Amendments to Title II were proposed, but were shot down.

It seems like the House is willing pass the Senate version of the legislation and the President is willing to sign it. That means one of the biggest limitations to fundraising for private funds is likely to be erased. It will take a few months after the passage of the law for the SEC to change the regulations in Rule 506.

As early as this summer, the marketing opportunities for private funds will dramatically increase. Maybe that’s a fair trade for having to register as an investment adviser with the SEC.

Here is the text of the bill:

TITLE II—ACCESS TO CAPITAL FOR JOB CREATORS

SEC. 201. MODIFICATION OF EXEMPTION

(a) MODIFICATION OF RULES.— (1) Not later than 90 days after the date of the enactment of this Act, the Securities and Exchange Commission shall revise its rules issued in section 230.506 of title 17, Code of Federal Regulations, to provide that the prohibition against general solicitation or general advertising contained in section 230.502(c) of such title shall not apply to offers and sales of securities made pursuant to section 230.506, provided that all purchasers of the securities are accredited investors. Such rules shall require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission. Section 230.506 of title 17, Code of Federal Regulations, as revised pursuant to this section, shall continue to be treated as a regulation issued under section 4(2) of the Securities Act of 1933 (15 U.S.C. 77d(2)).

(2) Not later than 90 days after the date of enactment of this Act, the Securities and Exchange Commission shall revise subsection (d)(1) of section 230.144A of title 17, Code of Federal Regulations, to provide that securities sold under such revised exemption may be offered to persons other than qualfied institutional buyers, including by means of general solicitation or general advertising, provided that securities are sold only to persons that the seller and any person acting on behalf of the seller reasonably believe is a qualified institutional buyer.