Compliance Bits and Pieces for January 6

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

Obeying the Law is Hard by Chris MacDonald in the Business Ethics Blog

For businesses, following the law doesn’t exhaust ethical responsibilities, but it’s an awfully good start. Most of us probably think that following the law is absolute minimally-decent behaviour for business. You absolutely must follow the law, and a business certainly shouldn’t be praised for achieving that basic minimum, right? But in fact, it’s not always so easy for companies to follow the law.

ERC’s National Business Ethics Survey

45 percent of U.S. employees observed a violation of the law or ethics standards at their places of employment. Reporting of this wrongdoing was at all-time high – 65 percent – but so too was retaliation against employees who blew the whistle: more than one in five employees who reported misconduct they saw experienced some form of retaliation in return.

Ten Compliance Issues from 2011 by Tom Fox

So as part of the compliance commentariati, I submit, for your consideration, my Top Ten anti-corruption and anti-bribery issues over the past 12 months.

  1. Amendments to the FCPA?…
  2. UK Bribery Act goes live…
  3. Crystal Ball Reading…
  4. Chief Compliance Officer Upgrade…
  5. Investigating Private Equity…
  6. ….

Conflict of Interest Risk Assessments – Part One by Jeff Kaplan in the Conflict of Interest Blog

Risk assessments are increasingly seen as essential to effective C&E programs. This is true for programs generally, of course, under the 2004 amendments to the Federal Sentencing Guidelines for Organizations. Risk assessments are also contemplated for anti-corruption compliance under the Good Practices Guidance of the OECD Anti-Bribery Working Group, the UK Bribery Act compliance guidance issued by the Ministry of Justice and settlements of various FCPA cases involving both compliance failures and model compliance programs.

Fraud Flashpoints: The Perils of Fake Social Media Profiles – A Growing GRC Concern – Part 1 by Daniel W. Draz in Corporate Compliance Insights

Everyone is talking about the use of social media applications in business, in fact it’s “all the rage!” While there’s no doubt it has incredible value and potential in a variety of business applications, something that most governance, risk and compliance (GRC) professionals don’t seem to be talking about is how the technology and usage of it applies in a corporate environment, where misinformation, competitive business intelligence, industrial espionage, “false profiles” and reliance on errant information, all generate the potential for significant business risk and liability.

In Depth On The Magyar Telekom and Deutsche Telekom Enforcement Action by the FCPA Professor

Total fines and penalties were approximately $95 million ($59.6 million against Magyar Telekom via a DOJ deferred prosecution agreement, $4.4 million against Deutsche Telekom via a DOJ non-prosecution agreement, and $31.2 million against Magyar Telekom via a settled SEC civil complaint). The SEC action against former Magyar executives remains active.

Handcuffs is from VectorPortal.com

Charges Brought in Social Media Scam

The Securities and Exchange Commission charged an Illinois-based investment adviser with offering to sell fictitious securities on LinkedIn. The SEC also issued two alerts to highlight the risks investors and advisory firms face when using social media.

The SEC’s Division of Enforcement alleges that Anthony Fields of Lyons, Illinois offered more than $500 billion in fictitious securities through various social media websites. In the complaint, they cite a LinkedIn posting to promote fictitious “bank guarantees” and “medium-term notes”:

“Bank Guarantees, Cash Backed, Deutsche Bank, Credit Suisse, HSBC, JP Morgan Chase, BNP Paribas, UBS, RBS or Barclays, One (1) year and one (a) day, Fresh Cut USD 500 Billion (USD 500,000,000,000) with Rolls and
Extensions 40% or better plus 1% commission fee to be paid, to buy side and sell side consultants 50/50. First Tranche: 500M USD . . . . If you are interested you can email for particulars . . . .”

The SEC pulled out a laundry list of violations. Fields was not registered as a broker-dealer nor listed as an associated person a registered broker-dealer at the time of the postings. He later set up an unfunded investment adviser and unfunded broker-dealer. Fields provided false and misleading information concerning assets under management, clients, and operational history to the public through its website and in SEC filings. Fields also failed to maintain required books and records, did not implement adequate compliance policies and procedures, and held himself out to be a broker-dealer while he was not registered with the SEC.

The question I have is did someone turn in Fields? Or is the SEC searching social media sites looking for suspicious securities postings?

In the new investor alert, the SEC offers tips to help avoid fraud online. (.pdf)

If you see a new post on your wall, a tweet mentioning you, a direct message, an e-mail, or any other unsolicited – meaning you didn’t ask for it and don’t know the sender – communication regarding a so-called investment opportunity, you should exercise extreme caution. An unsolicited sales pitch may be part of a fraudulent investment scheme.

The SEC points out the three big red flags:

  1. It sounds too good to be true
  2. A promise of guaranteed returns
  3. Pressure to buy right now

In addition to the investor-facing alert, the SEC also issued a risk alert aimed at a registered investment adviser’s use of social media. It once again points out that while the social media platforms may be new, the securities laws are not. You can only use the shiny new tools in compliance with the existing regulatory regime.

“While many RIAs are eager to leverage social media to market and communicate with existing clients, and to promote general visibility, RIAs should ensure that they are in compliance with all of the regulatory requirements and be aware of the risks associated with using various forms of social media. The staff hopes that sharing observations from its recent review of RIAs’ use of social media as well as its suggestions regarding factors that firms may wish to consider is helpful to firms in strengthening their compliance and risk management programs.”

Sources:

When Red Flags Are Not Enough

Purchase out of the money call options set to expire in two weeks, do not have any activity on that stock before, exclusively use options when you have rarely traded options in the account before, purchase those options just before the announcement of the company’s acquisition, and then quickly try to move the money off-shore.

Those red flags were enough for the Director of Compliance Operations at Interactive Brokers to put a hold on the account of Luis Martin Caro Sanchez. After reviewing the trades, the information was forwarded to the Securities and Exchange Commission for investigation. It reeked of insider trading, so the SEC obtained an immediate freeze on the account and charged Sanchez with insider trading.

Sanchez had bought several hundred of the risky Potash call options on August 12 and 13, 2010. A week later, the acquisition was announced causing a dramatic rise in the price of Potash stock. Sanchez managed to reap nearly $500,000 in profits at a handsome 1046% return. The actions seemed to be so blatant that I labeled it the perfect way to get caught insider trading. Of course one of the key elements of insider trading is having access to inside information.

Suspicious trades alone are not enough. In order for the SEC to win an insider trading case against a company outsider, the SEC must prove that an outsider made his trades based on material nonpublic information given to him by an insider. The SEC failed to find a connection.

Sanchez claimed he made became interested in Potash based on a technical signal “when he observed a crossover signal in the exponential moving average for the price of Potash stock.” He made the buy after

“there was a consolidation of the impulse of the cross of mediums, average, and that consolidation is known as pull-back, and consists of a slight drop in the price after a push for a higher price. And there was a hole that was filled – a gap that was produced during the increase – the previous increase.”

In fairness to Sanchez, he is from Spain and the interview was conducted without a certified, neutral translator. But to me, his explanation is just a bunch of mumbo-jumbo spewing out to make the SEC think he is a trading expert.

As much as the SEC tried, they could not link Sanchez to an insider. They could not even link him to his co-defendant, Juan Jose Fernandez Garcia. Both Garcia and Sanchez lived in Madrid and both made suspicious trades on Potash stock using accounts at Interactive Brokers. That was the only connection.

Garcia also happened to work at Banco Santander, who was an adviser to BHP in connection with its purchase of Potash. Garcia quickly settled with the SEC and forfeited his $576,032.00 in trading profits.

Sanchez was willing to fight for his windfall and challenged the SEC to prove he had inside knowledge. The SEC failed and Sanchez gets to keep his cash.

Sources:

Red Flags is Rutger van Waveren

The Great Depression versus the Great Recession

One of the signposts at the beginning of 2012 is that the U.S. economy seems to be recovering. The troubles in the Euro-zone are still creating great uncertainty and people are still cautious. But manufacturing outputs are continuing to increase. I see “help wanted” signs starting to appear in business doors. (Feel free to disagree with this conclusion.)

One sign of trouble is that the unemployment rate is still very high. There are 6.6 million fewer jobs in the United States than there were four years ago. Some 23 million Americans who would like to work full-time cannot get a job.

Those of you following the macro-economic responses to 2008s Great Recession know that Ben Bernanke was a student of the 1930s Great Depression. One of the lessons he took away was that the Federal Reserve’s tightening of the money supply as a response to the economic conditions  helped cause the Great Depression. Bernanke took the opposite response at the beginning of the Great Recession and opened the monetary spigots wide open as a response to the woes of the financial sector in 2008.

Bernanke saved the banking system, but the economy is still stubbornly not creating new jobs.

The failure to create jobs is unlike any other post-WWII recession. Look at the percentage of job losses in this chart.  It’s not just a dramatic loss in jobs. There seems to be structural loss in jobs that the economy is not creating. You can see it in the numbers of the long-term unemployed.

It looks like something has changed in our economy.

Joseph E. Stiglitz, a man much smarter than me, has made some comparisons between the Greet Recession and the Great Depression in the December issue of Vanity Fair: The Book of Jobs. His theory is that the dramatic upheavals in the economy are a result of dramatic changes in the workforce.

Just before the Great Depression more than 1/5th of all Americans worked on farms. By comparison,today only 2% of Americans produce our food, plus a surplus to ship to other countries and to burn as fuel in our cars. Accelerating productivity before the Great Depression created a surplus of farm products, which lead to lower prices, which lead to a decline in farm incomes. Farmers had borrowed heavily to sustain production and were faced with the inability to pay back the banks. This swept the financial sector into the “vortex of declining farm income.” The 1930s America was moving from an agricultural economy to a manufacturing economy.

The parallel to 2008 is that the US economy has realized a tremendous increase in productivity in manufacturing. Contrary to popular opinion, American still has a robust manufacturing base. American manufacturing output has doubled since 1975.

We just don’t make as much of the same stuff as we did in 1975. Labor intensive products are made cheaper overseas. You won’t see the Made in the USA label very often on clothing, toys, and consumer electronics. It takes one third fewer people to manufacture twice as much stuff in America. Bruce Greenwald and Judd Kahn theorize that although the loss of jobs to overseas providers is significant, it’s the increase in productivity that caused most off the job losses in the manufacturing sector.

Andrew McAfee and Erik Brynjolfsson point out that the human workforce has to compete against the automated workforce of computers and machines. If a computer can do your job, then your job may be in danger. This is becoming increasing true in white collar jobs and not just manufacturing.

Stiglitz theory is that the cheap debt and rising home prices of the last decade allowed us to disguise the loss in jobs an income that came from the loss in manufacturing jobs. As a county, we were using our homes as piggy banks creating artificial demand. In 2008, the curtain was pulled back to reveal the true weaknesses in parts of the economy.

Perhaps it’s time to compare the abandoned farms of the 1930s to the abandoned homes of today’s Detroit.

What does this mean for compliance?

I’m not sure. Certainly, it will mean more changes. I expect we will continue to see changes in regulations and business practices as the government and industry grapple with the changes in the economy. We can already see in today’s Iowa caucus that the Republican presidential candidates most discussed topic is jobs. Politicians will continue to pin the blame on fat-cat bankers for quite a while. They make an easy target.

Sources:

Happy New Year

Boston Public Garden: New Year's Eve by Michael Krigsman

New Year’s Eve is a time to reflect on the past and look forward to the future. You may also add an excessive amount of alcohol, an expensive dinner in a crowded restaurant, or a long wait for Chinese food delivery.

I’m sure there is a compliance story in there somewhere, but I’m just going to enjoy taking some time off during the long weekend. Enjoy the end of your year and the start of the next.

Handy Decision Trees to Help with your Bribes

Thinking about making a payment or giving “anything of value” as part of a business meeting and wondering if you could be prosecuted for it under the Foreign Corrupt Practices Act or the Travel Act? Just reach into your briefcase and pull out a handy-dandy decision tree to help you through this difficult process.

T. Markus Funk put together a decision tree to help walk you through the FCPA and Travel Act’s Anti-bribery provisions (.pdf).

Comment Period Extended for Volcker Rule

The Securities and Exchange Commission and federal banking regulators have extended the comment period on the Volcker Rule proposed regulations from January 13, 2012 to February 13, 2012. In Release No. 34-66057, the regulators noted that the extension of the comment period is appropriate “due to the complexity of the issues involved and to facilitate coordination of the rulemaking among the responsible agencies as provided in section 619 of the Dodd-Frank Act.” The proposed rule was released in October. The Volcker Rule is scheduled to go into effect July 21, 2012.

The extension’s Release cites comment letters from the Center for Capital Markets Competitiveness of the U.S. Chamber of Commerce (November 17, 2011); American Bankers Association et al. (November 30, 2011); and Representative Neugebauer (R-TX) (December 20, 2011). The ABA letter points out the 1400 questions asked in the proposed regulations.

The Dodd-Frank Act put the Volcker Rule in place to restrict the ability of bank and non-bank financial companies to engage in proprietary trading and to limit their ability to have interests in, or relationships with, a hedge fund or private equity fund.  The concept is simple, but difficult in execution. All banks and financial institutions engage in some form of proprietary trading to hedge the risks in their loan portfolios. Add in the extensive use of securitizations. Sprinkle in the decision by the remaining Wall Street firms to become bank holding companies after the 2008 crisis to get part of the bailout. Whip it all up with the difficulties in defining a non-bank financial company.

Feel free to add handfuls of industry lobbying to the mix, depending on your level of cynicism.  For example, Representative Schweikert is asking the regulators to exclude venture capital investing under Section (d)(1)(J)

Sources:

The New Accredited Investor Standard

After thinking about it for almost year, the Securities and Exchange Commission has finalized the new definition of “accredited investor.” On January 25, 2011, the SEC proposed amendments to the accredited investor standards in the rules under the Securities Act of 1933 to implement the requirements of Section 413(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Section 413(a) of the Dodd-Frank Act required the SEC to adjust the accredited investor net worth standard that applies to natural persons individually, or jointly with their spouse, to “more than $1,000,000 . . . excluding the value of the primary residence.” Previously, this standard required a minimum net worth of more than $1,000,000, but permitted the primary residence to be included in calculating net worth. Under Section 413(a), the change to remove the value of the primary residence from the net worth calculation became effective upon enactment of the Dodd-Frank Act. This rule merely clarifies a few points.

Section 415 of Dodd-Frank requires the Comptroller General of the United States to conduct a “Study and Report on Accredited Investors” examining “the appropriate criteria for determining the financial thresholds or other criteria needed to qualify for accredited investor status and eligibility to invest in private funds.” The SEC lets us know that they may take a more thorough revision of the accredited investor standard after that report comes out in July 2013.

Under the rule, owning a home can only decrease your net worth. To the extent your mortgage debt is less than the fair market value of your house, you can’t include that equity in calculating net worth. To the extent your mortgage is in excess of the value of your house, the amount underwater is counted against net worth.

Just to really screw up things, the SEC requires certain mortgage refinancings to be counted against net worth. If the borrowing occurs in the 60 days preceding the purchase of securities in the exempt offering and is not in connection with the acquisition of the primary residence, the new increase in debt secured by the primary residence must be treated as a liability in the net worth calculation. This is intended to prevent manipulation of the net worth standard, by eliminating the ability of individuals to artificially inflate net worth under the new definition by borrowing against home equity shortly before participating in an exempt securities offering.

This new 60 day rule will be a pain in the neck. On the other hand, I saw some shady operators touting the ability to leverage up your home to get you over the threshold into accredited investor land. That scheme would seem to be targeted right at the vulnerable class of “house-poor”. Apparently state securities regulators were also concerned about advising investors to use equity in their home to purchase securities.

One of the other comments was that mortgage debt in excess of the home value should not count when the loan is non-recourse or the lender is prohibited by state law from collecting a shortfall after foreclosure. The SEC dismissed that idea as being too complicated and requiring a detailed legal analysis. They also counter with some data from a 2007 Federal Reserve Board Survey that suggests that the number of households nationwide that qualify as accredited investors is not affected by whether the net worth calculation includes or excludes the underwater portion of debt secured by the primary residence.

The rule ends up amending:

  • Rule 144(a)(3)(viii),
  • Rule 155(a),
  • Rule 215, and
  • Rule 501(a)(5) and 501(e)(1)(i) of Regulation D
  • Rule 500(a)(1)
  • Form D under the Securities Act;
  • Rule 17j-1(a)(8) under the Investment Company Act of 1940and
  • Rule 204A-1(e)(7) under the Investment Advisers Act of 1940

The rule is adopted with only a limited grandfather provision. The old accredited investor net worth test will apply to purchases of securities in accordance with a right to purchase such securities, only if

  1. the right was held by a person on July 20, 2010 (the day before the enactment of  Dodd-Frank)
  2. the person qualified as an accredited investor on the basis of net worth at the time the right was acquired and
  3. the person held securities of the same issuer, other than the right, on July 20, 2010.

Otherwise, the new rule goes into effect 60 days after it’s published in the Federal Register. That will the rule will be effective by the end of February 2012.

Sources:

Happy Holidays

W.A. Rogers Editorial cartoon from 1902 published in Harper’s Weekly

Uncle Sam standing smiling at Christmas tree laden with warships, telephones, an automobile, a fat man labeled “The Trusts,” and skyscrapers; with bags of money at its base.

(The things that make Uncle Sam happy have not changed much over the last 100 years.)

Compliance Bits and Pieces for December 23

Here are some recent compliance-related stories that caught my attention.

The Saga of MF Global – Don’t Shoot the Messenger, Fire the Chief Compliance Officer by Tom Fox

Both the DOJ minimum best practices and the amendment to the US Sentencing Guidelines, giving the CCO direct access to a company’s Board of Directors, would seem to provide the profile that would mandate that a Board wants to know the reason why a CCO (or Chief Risk Officer) would suddenly resign, particularly after he “repeated clashed” with a CEO over compliance issues. The universal corporate blanket “resigned to pursue other opportunities” is a white-wash that a Board should look beyond, if indeed that reason was given to the MF Board. The bottom line is that when a CCO leaves, particularly if it was due to a clash with the CEO, the Board had better take a close look into the reasons as it may be that the CEO wants to take risks which could put the company at grave risk.

The SEC Issues Disclosure Guidance on RELPs and REITs by Vanessa Schoenthaler in 100 F Street

The Securities and Exchange Commission’s Office of Investor Education and Advocacy published an Investor Bulletin on real estate investment trusts (REITs) and, at the same time, the Division of Corporation Finance issued informal disclosure guidance detailing the comments it most frequently raises when reviewing sales materials submitted by real estate limited partnerships (RELP) and REITs pursuant to Securities Act Industry Guide 5.

Legal bloggers are eligible for free passes to attend the LegalTech conference in New York, Jan. 30 to Feb. 1, 2012. This is a full-access pass, covering all programs and the exhibit hall. There is also a Blogger’s Breakfast on Tuesday, Jan. 31, at 9 a.m. in the Petit Triannon room at the New York Hilton. To reserve your free pass, send an email to Carl Seering at [email protected]. Be sure to include your name, company or firm, address, email and phone number.