Does it Matter Where the Signature Is?

Just about every compliance certification has the employee sign at the bottom. We have been signing letters and contracts at the end for millenia.

But maybe there is a way to increase ethical performance by moving that signature to the top.

Lisa L. Shu, Nina Mazar, Francesca Gino, Dan Ariely, and Max H. Bazerman recently published a paper that found differences in compliance/ethical performance depending on whether the participant signed first or at the end.

In one experiment, the subjects took a test and scored it themselves. They would be paid based on their performance and reimbursed for their expenses incurred in attending the test. After self-scoring the test they went into another room to self report their income on a tax form. There were three forms:

  • One with a certification at the beginning that all information is true
  • A second with the same certification, but at the end
  • A third with no certification

The test and reporting was set up to be very easy to cheat, with a simple and immediate cash reward for cheating. You should not be surprised that cheating was rampant.

With the third form, with no certification, cheating occurred 64% of the time. With the certification at the bottom, the cheating actually rose to 79%. The winner, with the certification at the beginning, only had a 37% cheat rate.

Moving the certification to the beginning had a dramatic, positive effect on reducing cheating.

The paper includes several other similar experiments with the same results. A slightly different test involved word puzzles. Those that signed an honesty pledge before engaging in the cheating experiment ended up solving more of the ethics-related words than the others.

The authors theorize that the certification at the top pre-sets the person to start thinking more ethically. If they don’t hit the certification until the end, they have already supplied the information with whatever ethical slant they may have.

I’m going to re-think how I design my certification. At the top will be a certification that all of the information is true and correct, before they start filling in the information.

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Compliance Lessons from Weinergate

In a tearful statement to the media, Rep. Anthony Weiner admitted he posted a lewd picture of his anatomy to Twitter. Not only that, he says he’s engaged in “inappropriate” online communications with at least six other women.

It was just a few days ago that I revisited the Fabulous Fab Rule:

Don’t write emails so provocative that they wind up reproduced on the front page of the Wall Street Journal.

That rule is focused on email which for many companies is archived for years. That means it could end up in litigation or an enforcement action. The rule is really applicable to any type of publishing.

The internet has turned us all into publishers, or at least given us the ability to be publishers. Traditional publishers have layers of review before information, stories, and pictures get published. On the internet, the only layer of review is your common sense. That’s all that stands between you and that send button.

Weinergate is just another example of failed common sense. He never should have hit that send button.

I have not found anything new in the scandal. I don’t think you need a new policy prohibiting people from sending pictures of themselves in their underwear. (I suppose there is an exception if you are in the adult entertainment industry.) Common sense should take care of that.

I suppose its useful to compare this to Eliot Spitzer. He had his own sex scandal, but it required a government investigation. Weiner merely shot himself by sending out a public message.

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Image of Meet Congressman Weiner is by David Boyle
CC BY 2.0

Lessons from Wunderlich

I don’t take pleasure from others’ failings, but I do try to learn lessons. The recent settlement between Wunderlich Securities and the Securities and Exchange Commission is full of lessons to be learned.

  • overcharged advisory clients for commissions and other transactional fees in violation of Section 206(2) of the Advisers Act
  • failed to satisfy the disclosure and consent requirements of Section 206(3) of the Advisers Act when WSI engaged in principal trades with advisory clients;
  • failed to adopt, implement and review written policies and procedures as required by Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder; and
  • failed to establish, maintain, and enforce a written code of ethics as required by Section 204A of the Advisers Act and Rule 204A-1 thereunder.

It seems some of the failings, at least according to the order was that Wunderlich hired a CCO with a background in Broker-dealer compliance, but at the same time, the firm moved from a broker-dealer model to an investment adviser model. That left the CCO in a new regulatory scheme.

Under Section 206(3) of the Advisers Act, an investment adviser must disclose to its clients in writing before the completion of each transaction that it acts as a principal. Wunderlich failed to follow this rule in over 3,00 instances according to the order. The issue is that the investment adviser can both collect a fee and realize a difference between its cost of the security and the price it’s sold to the the client. That difference in price is a conflict that needs to be managed. Wunderlich even hired a consultant to to review their operations who highlighted the principal trading problem. That still did not lead to a correction.

Wunderlich failed to have written compliance policies or a written code of ethics. That leads to the follow up failure of an annual review of the written compliance policies and procedures. Its hard to update something that is not in place. Wunderlich was using its broker-dealer manual and failed to update it to meet the requirements under the Investment Advisers Act. Once again, this failure was highlighted in a consultant’s report and the firm failed to fix the problem.

A long true lesson in compliance is when a problem is highlighted, you need to fix it. The spotlight is on the problem.

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Compliance Bits and Pieces for June 3

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

Launching Into Unethical Behavior: Lessons from the Challenger Disaster by Ann E. Tenbrunsel and Max H. Bazerman in Freakonomics

On the night before the Challenger was set to launch, a group of NASA engineers and managers met with the shuttle contracting firm Morton Thiokol to discuss the safety of launching the shuttle given the low temperatures that were forecasted for the day of the launch. The engineers at Morton Thiokol noted problems with O-rings in 7 of the past 24 shuttle launches and noted a connection between low temperatures and O-ring problems. Based on this data, they recommended to their superiors and to NASA personnel that the shuttle should not be launched.

The Big Lesson From Compliance Week 2011 by Matt Kelly in Compliance Week

This year I can boil that lesson down to one telling insight, that sprang to mind thanks to two particular moments that happened during the conference: the superb keynote address given by U.S. Attorney Preet Bharara on Tuesday morning, and an outburst later that day from our first-ever Compliance Week protester.

“Profound personal integrity, repeatedly demonstrated and openly valued, is absolutely critical … The best-conceived compliance programs and practices and policies in the world will be too weak to stave off scandal if the core principles are not internalized, if there is not from the top a daily drumbeat for integrity.”

Hedge Fund Industry Asks for Global Regulatory Coordination as EU Implements Alternative Investment Fund Directive in Jim Hamilton’s World of Securities Regulation

During 2013 to 2015 there will be a passport for sales of EU alternative investment funds to investors within the EU. For US and other non-EU funds and managers, national private placement regimes will continue to operate. However, noted ESMA Chair Steven Maijoor, for these regimes to be used, appropriate co-operation arrangements will have to be put in place between the EU regulator concerned and the authority of the third country.

A Trader, an F.B.I. Witness, and Then a Suicide by Peter Lattman and William K. Rashbaum in the New York Times’ Dealbook

But the federal authorities’ techniques have rarely been seen on Wall Street before.

Late last year, F.B.I. agents conducted three simultaneous raids of large hedge funds. Two of those funds have since closed. And for the first time in an insider trading inquiry, the government has been using wiretaps — a method typically reserved for drug crimes and organized crime cases — to record the telephone conversations of Wall Street traders.

Be Careful Playing with Your New Things – Homeownership:

From XKCD

Paying a Bribe? There’s an App for that

Can you crowdsource the fight against corruption? An international team coming from Estonia, Lithuania, Finland and Iran thinks you might. They created a smartphone app that allows people to anonymously report incidences of bribery and later see the data visualized on an interactive map.

Bribespot is an app that allows you to see how much corruption is going on around. Using your smartphone (or a website) you can report locations where bribes are requested/paid, indicate the size of a bribe and area of government affected by it.

At the moment you can use Bribespot on Android, but they have not finished the iPhone app. There is no mention of a blackberry app.

In poking around the data, I found three reports in the United States.

  • Made to pay $100 (~75 euro) to get a fake ID back from a bouncer at Fat Tuesday
  • 35 EUR To cut the line at Pianos
  • 70 EUR for 3 guys to cut the line at Southside

Those are not exactly riveting incidents.

On the other hand, there are many reports coming in from Lithuania and Romania in Bribespot’s Check-in Stream.

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Revisiting the Fabulous Fab

Last summer, Fabrice Tourre didn’t turn around fast enough to see the bus coming at him. Goldman Sachs had given him a big push and put him in the front and center of their big bet on a crash in the residential mortgage securities market.

Tourre ended up as the Fabulous Fab after giving himself that nickname in a series of colorful emails. In one he wrote, “The whole building is about to collapse anytime now,” according to the complaint. “Only potential survivor, the fabulous Fab.”

I still use Tourre as part of my records management policy and education.

The Fabulous Fab Rule: Don’t write emails so provocative that they wind up reproduced on the front page of the Wall Street Journal.

What has happened to Tourre and his colleagues at Goldman Sachs?

Goldman settled the matter for $550 million, with $250 million going to investors and $300 million going to the SEC.

Louise Story and Gretchen Morgenson of the New York Times took another look at the Goldman mortgage desk and the prosecutions against it: S.E.C. Case Stands Out Because It Stands Alone.

According to the article, the SEC looked at Jonathan M. Egol who worked closely with the Fabulous Fab. “But Mr. Egol, now a managing director at the bank, was not named in the case, in part because he was more discreet in his e-mails than Mr. Tourre was, so there was less evidence against him, according to a person with knowledge of the S.E.C.’s case.” That just seems to reinforce the Fabulous Fab Rule.

Also, the story points out that Torre’s trading desk was using a shared email account or listserv to share the messages with the larger group.

The story about the Fabulous Fab Rule gets worse. The New York Times obtained additional information from a lost laptop.

[The information was] provided to The New York Times by Nancy Cohen, an artist and filmmaker in New York also known as Nancy Koan, who says she found the materials in a laptop she had been given by a friend in 2006.  The friend told her he had happened upon the laptop discarded in a garbage area in a downtown apartment building. E-mail messages for Mr. Tourre continued streaming into the device, but Ms. Cohen said she had ignored them until she heard Mr. Tourre’s name in news reports about the S.E.C. case.  She then provided the material to The Times.

That just makes the nightmare worse. An employee is sending out provocative emails, they are going to mass distribution list, and an unsecured laptop is getting the messages.

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Felons and Fund Managers

Most private funds rely on a Rule 506 exemption under Regulation D to sell their limited partnership interests to investors. A new SEC rule amending Rule 506 should catch the eye of private fund compliance officers. The concept it fairly straight-forward: felons should not be allowed to take advantage of the private offering exemptions.

Dodd-Frank

Section 926 of Dodd-Frank requires the SEC to adopt rules disqualifying an offering from reliance on Rule 506 of Regulation D when certain felons or other “bad actors” are involved in the offering. Rule 506 is the most widely claimed exemption under Regulation D. For the 12 month period ended September 30, 2010 the Commission received 17,292 initial filings for offerings under Regulation D, of those 16,027 claimed a Rule 506 exemption.

What types of felonies?

The  proposal is not for all felonies, just those related to the securities industry. So you could be a convicted Under the proposed rule, a “disqualifying event” would include:

  • Criminal convictions in connection with the purchase or sale of a security, making of a false filing with the SEC or arising out of the conduct of certain types of financial intermediaries. The criminal conviction would have to have occurred within 10 years of the proposed sale of securities (or five years, in the case of the issuer and its predecessors and affiliated issuers).
  • Court injunctions and restraining orders in connection with the purchase or sale of a security, making of a false filing with the SEC or arising out of the conduct of certain types of financial intermediaries. The injunction or restraining order would have to have occurred within five years of the proposed sale of securities.
  • Final orders from state securities, insurance, banking, savings association or credit union regulators, federal banking agencies or the National Credit Union Administration that bar the issuer from:
    • associating with a regulated entity.
    • Engaging in the business of securities, insurance or banking.
    • Engaging in savings association or credit union activities.
  • Or orders that are based on fraudulent, manipulative or deceptive conduct and are issued within 10 years before the proposed sale of securities.
  • Certain Commission disciplinary orders relating to brokers, dealers, municipal securities dealers, investment companies and investment advisers and their associated persons, which would be disqualifying for as long as the order is in effect;
  • Suspension or expulsion from membership in a “self-regulatory organization” or from association with an SRO member, which would be disqualifying for the period of suspension or expulsion;
  • Commission stop orders and orders suspending the Regulation A exemption issued within five years before the proposed sale of securities; and
  • U.S. Postal Service false representation orders issued within five years before the proposed sale of securities.

Who is covered?

The proposed rule would cover

  • the issuer (i.e. the fund)
  • its predecessors and affiliated issuers
  • Directors, officers, general partners and managing members of the issuer.
  • 10 percent beneficial owners and promoters of the issuer (i.e. the fund manager).
  • Persons compensated for soliciting investors
  • the general partners, directors, officers and managing members of any compensated solicitor (i.e. employees of your placement agents).

The rule is bit fuzzy on how this would apply to fund manager, since it is not legally the issuer. Under the investment advisers registration you already need to disclose criminal activity. That disclosure is broader than what is proposed under the new rule. This is just disclosure, not a bar from use of the offering exemption.

Reasonable Care Exception

The proposed rule would provide an exception from disqualification when the issuer can show it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed.

Paragraph (c)(1) of this section shall not apply:

(i) Upon a showing of good cause and without prejudice to any other action by the Commission, if the Commission determines that it is not necessary under the circumstances that an exemption be denied; or

(ii) If the issuer establishes that it did not know, and in the exercise of reasonable care could not have known, that a disqualification existed under paragraph (c)(1) of this section.

Instruction to paragraph (c)(2)(ii). An issuer will not be able to establish that it has exercised reasonable care unless it has made factual inquiry into whether any disqualifications exist. The nature and scope of the requisite inquiry will vary based on the circumstances of the issuer and the other offering participants.

Here is where compliance steps in. The rule has no explicit record-keeping, reporting or disclosure requirements. But if you want make sure you can take advantage of the “reasonable care exception” you will need to keep records.  It looks like we will need a new form for employees to fill out asking for a disclosure of events under the rule. It also looks like you will need to run criminal background checks on your principals and key employees.

In the release the SEC said: “The steps required would vary with the circumstances, but we anticipate may include such steps as making appropriate inquiry of covered persons and reviewing information on publicly available databases.”

Comments

This is still a proposed rule, but time is short. Under Dodd-Frank, the disqualification rules need to be in place by July 21, 2011. There is time to Submit Comments.

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Compliance Bits and Pieces for May 27

Here are some compliance-related stories that recently caught my eye:

Gold is Not an Investment by Carl Richards in the NY TImes.com’s Bucks

Gold is not an investment. It’s a speculation. Investments are made by evaluating underlying value. Speculative bets are made by looking at the price of something and simply hoping the price goes up. Investing is about value; gambling is about price. Gold has no real underlying value. I know there is a market for it. I know it is real, just like real estate was real in 2007.

Historical Echoes: Communication before the Blog… in the Liberty Street Economics blog of the Federal Reserve Bank of New York

Over the years, the Federal Reserve System has used many methods to communicate about the role it plays in support of stable prices, full employment, and financial stability. Current communication tools include the new press conferences by the Chairman, speeches by Bank presidents, public websites, economic education programs, local outreach efforts, publications, and blogs like this one.

Ninety years ago, however, the options were more limited. The Fed was still new and the nation’s economy was plagued by a growing number of bank failures. The five posters below (from the mid-1920s), with their images of strength and stability, were part of a larger series designed for display at member banks. They were likely intended to inform the public about the Federal Reserve System and foster confidence in its member banks.

Hedge Funds and Advertising: “No advertising” rules more confusing than ever by Judy Gross in Hedge Rows

In the category of “Laws that Haven’t Caught Up with the 21st Century”, the internet aspects of the rules that prohibit hedge fund advisers from “advertising” may come in first place. The SEC rules only allow hedge funds to be offered on a “private placement” basis. This means no general solicitations are allowed. While this is understandable in regard to some venues (think giant billboard in Times Square), when it comes to the internet, these rules may leave you scratching your head.

Failing to Clarify: The Courts Try to Define “Foreign Official” in FCPA Cases by Michael Volkov in the FCPA Compliance and Ethics Blog

In three separate cases, Lindsey Manufacturing, O’Shea and Carson, defendants filed motions to dismiss challenging the DOJ’s interpretation of “foreign official” under the FCPA. Two of these cases have now been resolved and the Justice Department’s position has been upheld. While doing so, the courts have launched separate fact-specific tests to “guide” actors in resolving how the law applies to state-owned enterprises.

The SEC Proposes Rules for Disqualification of Felons and Other Bad Actors from Rule 506 Offerings in 100 F Street

Section 926 requires the adoption of rules disqualifying an offering from reliance on Rule 506 of Regulation D when certain felons or other “bad actors” are involved in the offering. Rule 506 is by far the most widely claimed exemption under Regulation D. For the 12 month period ended September 30, 2010 the Commission received 17,292 initial filings for offerings under Regulation D, of those 16,027 claimed a Rule 506 exemption.

The New SEC Whistleblower Rule

In a blow to the efforts of internal compliance, the SEC will let corporate whistle-blowers collect a percentage of penalties when they report financial wrongdoing, even when they bypass companies’ internal complaint systems.

“For an agency with limited resources like the SEC, it is critical to be able to leverage the resources of people who may have first-hand information about violations of the securities laws,” said SEC Chairman Mary L. Schapiro. “While the SEC has a history of receiving a high volume of tips and complaints, the quality of the tips we have received has been better since Dodd-Frank became law. We expect this trend to continue, and these final rules map out simplified and transparent procedures for whistleblowers to provide us critical information.”

The small life ring the SEC threw to internal compliance is that the amount of the amount will be affected by how the person dealt with internal compliance. The amount of the award can be increased if the person reported the problem through internal compliance procedures and decreased if the person interfered with internal compliance or reporting systems.

A May 4 opinion from Judge Leonard Sand held that Dodd-Frank says a person has to report wrongdoing to the SEC — or be able to seek protection under other laws — before receiving legal sanctuary.

The final rule won’t provide protections to those who don’t report to the SEC, reinforcing the court’s interpretation.

While there is lots of discussion around provision providing the incentive to go to the SEC, there is also a question of the anti-retaliation protections. In the recent Egan v. TradingScreen case, a court found that the employee needs to go to the SEC get the statutory anti-retaliation protection.

For private companies, the Egan case also emphasized the point that the whistleblower provisions of Section 806 only apply to public companies subject to the Exchange Act. The employee alleged that Trading Screen was planning to public and should be subject. That didn’t work. He tried to another tactic that since it was a SEC registered broker-dealer it should be subject. The judge didn’t accept that argument either.

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Image: Qiqi Green Whistle 8-16-09 3 by Steven Depolo
CC BY 2.0

Learning Lessons From Gaffken & Barriger

I read through an occasional SEC complaint looking for lessons to be learned. Those involving real estate funds particularly catch my eye. I found the complaint against Lloyd V. Barriger (.pdf) and his management of his Gaffken & Barriger Fund to be full of lessons.

I don’t have any independent facts and am accepting the complaint at face value. Barringer has not settled with the SEC so I’m sure he has a different view of the events and disagrees with some of the statements. In large part it looks like he was trying to make it through the collapse of the housing market and the liquidity crunch of 2007 & 2008 by stretching his funds and his investments. Ultimately, his fund could not hold out any longer and collapsed.

“In the midst of the credit crisis, Barriger chose to lie about the solvency and liquidity of his fund rather than admit the somber truth of a collapsing business,” said George Canellos, Director of the SEC’s New York Regional Office. “He continued to solicit new investor funds based on the same misrepresentations up until the day before the fund collapsed.”

Gaffken & Barriger started off by investing in microcap securities. Then it, like many investors, was lured by the outsized returns of the real estate in 1998. Effective August 1,2005, the Fund’s stated purpose was “investing, holding, and trading in real estate, real estate loans, real estate securities, other securities and other financial instruments and rights thereto[.]” According to the PPM, the Fund’s primary strategy was “hard money lending”making high interest short-term bridge loans to real estate developers.

As you might guess with hindsight, the fund started experiencing higher delinquencies in 2005 and started experiencing losses. I would guess that he started stretching the truth hoping his investments would bounce back, only be trapped into bigger lies as the losses grew instead of decreasing.

I found it interesting that the SEC focused on the preferred returns to the limited partners in the fund. This is a practice that is common in many real estate funds. Investors often get a preferred return and the sponsor gets an over-sized portion of the profit above that return. I think the SEC got caught up in the tax allocations of the fund and took it as a bad fact. I’m not sure that warranted.

Another lesson to take away is that Dodd-Frank will not do anything to prevent this type of fraud. Given the size of Gaffken & Barriger it would not be SEC registered, but would be state registered. The SEC would still be able to investigate, but would not be the examiner.

That is a common theme I have noticed in SEC complaints against investment advisers and fund managers. They are mostly below the $100 million threshold for SEC registration. These troublemakers will need to be caught by state examiners. The SEC may be able to come riding in on its white horse to round up the bad guys, but will not be in a position to make an early intervention to prevent the fraud.

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