Looking at the Direction of the New Securities and Exchange Commission

With Chairman Jay Clayton in place, the Securities and Exchange Commission is now controlled by Republican appointees. Former Chair White came from a litigation and prosecutor background. Chair Clayton comes from a deal-making and capital formation background. I think we can guess the direction of the SEC for the next few years.

Beyond the guessing, Chair Clayton gave a speech to the Economic Club of New York that offers some insight. He outlined eight principles that will guide his chairmanship:

  1. The SEC’s mission is our touchstone.
  2. Our analysis starts and ends with the long-term interests of the Main Street investor.
  3. The SEC’s historic approach to regulation is sound.
  4. Regulatory actions drive change, and change can have lasting effects.
  5. As markets evolve, so must the SEC.
  6. Effective rulemaking does not end with rule adoption.
  7. The costs of a rule now often include the cost of demonstrating compliance.
  8. Coordination is key.

Obviously, number 7 caught my attention.

“It is incumbent on the Commission to write rules so that those subject to them can ascertain how to comply and — now more than ever — how to demonstrate that compliance.  Vaguely worded rules can too easily lead to subpar compliance solutions or an overinvestment in control systems.  We must recognize practical costs that are sure to arise.”

He also pointed out the costs of compliance in number five on the evolution of the SEC:

As the SEC evolves alongside the markets, however, we must remember that implementing regulatory change has costs.  Companies spend significant resources building systems of compliance, hiring personnel to operate those systems, seeking legal advice concerning the design and effectiveness of those systems, and adapting the systems as regulations change.  Shareholders and customers bear these costs, which is something that should not be taken lightly, lest we lose our credibility as regulators.

The SEC uses cost-benefit analysis in its rule-making process. I expect we will see an emphasis on the compliance costs in those analyses.

I like the emphasis on “bright-line” rules in number 7. Fuzzy rules makes it hard to implement rules and hard to prove compliance with the rules, leaving you open to second-guessing by regulators.

The other news is that it is rumored that President Trump will nominate former Senate Republican aide and current Senior Research Fellow at the Mercatus Center, Hester Peirce, to fill one of the empty seats at the Securities and Exchange Commission. From her recent publications, it seems that she may have some big ideas for change at the SEC.

That leaves one empty seat that is supposed to go to a Democratic appointee. I would bet that this seat stays empty for a long time.

Sources:

The One With The Incriminating Internet Searches

The case against Fei Yan was a fairly straight-forward insider trading case involving leaky M&A transactions. In this case, the leaks came from a junior corporate associate working on the transactions. We can only guess that she told her husband, Mr. Yan, about her day at work and revealed too much information.

While Mr. Yan was working as a postdoctoral associate at the Massachusetts Institute of Technology’s electronics research lab. He apparently had enough free to time to trade stocks and advance into options. He did so in an account in his mother’s name, using leaked information from his wife. At least that is what the SEC and DOJ are going to try to prove.

Mr. Yan started trading in Mattress Firm just forty-five days before the announcement of its acquisition by Steinhoff International. His gifted trading netted him almost $10,000.

The next transaction was the acquisition of Stillwater Mining by Sibanye Gold. With Mr. Yan’s now advanced trading skills, he moved to the higher leverage of options. He acquired a slate of call options within 30 days of the transaction’s announcement. With the additional leverage, he generated a profit of over $100,000.

The case ended up with criminal charges as well. I was curious about what escalated it to make it worthy of criminal prosecution.

The SEC complaint noted two Google searches:

“how sec detect unusual trade”
“insider trading with international account”

And further notes the Mr. Yan reviewed several items in the search results, including “Want to Commit Insider Trading? Here’s How Not to Do It.”

That article noted the 2013 Badin Rungruangnavarat insider trading case where his trading was most of the trading activity in the options and futures involved. It also involved a lot more money.

Mr. Badin made $3.2 million which makes him a much juicier target for prosecution. Mr. Yan’s $120,000 in profits are going to cost him a much larger amount in legal fees to defend the civil case and the criminal case to keep him out of jail. According to reports, he used a court-appointed attorney at the bail hearing. If convicted, he could face up to 25 years in prison and as much as $5 million in fines for the security fraud charges, and 20 years in prison and up to a $250,000 fine for the wire fraud charge.

I assume the Google searches made the federal prosecutors see that Mr. Yan had criminal intent, clearly knowing what he was doing was illegal and taking steps to hide the trading activity.

Given the small amounts, how did he get caught? I would guess the brokerage compliance team noted the suspicious activity and reported it to the SEC.

Sources:

On Pan-Mass Challenge weekend, August 4 – 6, I will saddle up to ride with 6,200 other cyclists to raise money for life-saving cancer research and treatment at Dana-Farber Cancer Institute. 100% of your donation will go to cancer research and treatment at Dana-Farber Cancer Institute through its Jimmy Fund. I have made a personal commitment to raise $8000.00. I hope you can you will support my fundraising effort. Please give generously with one of the following links:

Thank you,
Doug

Donate $1,000
Donate $500
Donate $250
Donate $100
Donate $50
Donate $25
Donate any amount

 

Compliance Bricks and Mortar for July 14

When this post gets published, I will have hopefully finished a 130 mile training ride across Massachusetts in preparation for the Pan Mass Challenge. I’m leaving my house in the middle of the night to be in Becket, MA by noon for parents’ weekend at my son’s summer camp. There is still time to support my Pan-Mass Challenge ride to fight cancer. 100% of your donation goes to the Dana Farber Cancer Institute.

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

Tone at Top Gone Wrong: The Christie Example by Matt Kelly in Radical Compliance

Nothing says “America!” these days like righteous indignation at a fellow American doing something we don’t like. So as we return from our Fourth of July holiday, let’s all give thanks to one American who cultivates that spirit and gives chief compliance officers a great example to cite next time you’re talking with the CEO about tone at the top.

Chris Christie, governor of New Jersey and beachgoer extraordinaire, thank you. Compliance officers owe you a debt of gratitude for your shameless, ridiculous, preposterous tone at the top. [More..]

Justice Department ethics watchdog quits because Trump made her feel like a hypocrite by Francine McKenna in Marketwatch

Hui Chen, the first-ever compliance counsel to the U.S. Department of Justice criminal division’s fraud section, is mad as hell and has decided she is not going to take it any more.

Chen announced via LinkedIn last week that she was leaving her role consulting to the department’s prosecutors on cases involving corporate ethics and compliance crimes. In her post entitled “Mission Matters,” Chen said that she felt like a hypocrite as she sat with companies accused of ethics and compliance violations. [More…]

Shkreli’s Ex-Compliance Officer Says He Quit Over Dodgy Deals by Patricia Hurtado in Bloomberg

Jackson Su worked for Shkreli from January 2012 until December of that year and told a jury at Shkreli’s fraud trial in Brooklyn, New York, that he got so fed up watching his boss execute questionable and unethical transactions that he quit and complained to the U.S. Securities and Exchange Commission. [More…]

Conflicts and Capital Allocation by Benjamin Edwards in the CLS Blue Sky Blog

In the aggregate, retail investors allocate tremendous amounts of capital and often turn to financial advisers to help them pick the best investment opportunities. In a recently published article, I describe how financial adviser conflicts of interest now distort overall capital allocation by driving capital to investment opportunities that reward financial advisers—altering the flow of capital. [More…]

Team Kinetic Karma with its Pedal Partner, Maya, and her family:

Email Smoking Guns

Martin Lomasney created a famous saying on the importance of discretion:

“Never write if you can speak; never speak if you can nod; never nod if you can wink.”

At the time of Lomasney, it was not email or Twitter, but telegrams that were the principal method of electronic communication.

In the case of President Trump and his son, it’s email and Twitter that are causing them problems. Donald Trump Jr. gave us all an unexpected lesson on the subject by releasing what appear to be incriminating emails on Twitter. Those emails are about his meeting with a Russian operative who was offering him dirt on Hillary Clinton.

The Trump campaign has been denying collusion with Russia during the campaign. These emails clearly show that the campaign was at least tried to collude with Russia.

 “if it’s what you say I love it”

According to Junior, there was no substance to the meeting and no actual collusion. But now the burden is back on the Trump campaign to show that there was no substance, after this documented willingness to do so. Junior’s emails are the first concrete evidence that the Trump campaign was aware of Russian government effort to help elect Donald Trump. On July 24, Junior  appeared on CNN to decry the Clinton campaign’s claims that the Russians were helping Trump as “disgusting” and “phony.”

I’m not saying there was or was not a crime.

There clearly was a lack of discretion and a failure to follow Mr. Lomasney’s sage advice.

The proper response should have been “Let me check with the legal team and I’ll call you back.”

Sources:

ILPA Guidance on Subscription Lines of Credit

The Institutional Limited Partners Association (ILPA) released guidance regarding the use of subscription lines of credit facilities by private equity funds. ILPA outlines the risks and potential impact on limited partners.

As with most potential conflicts, ILPA recommends better disclosure and greater clarity for their use.

Subscription lines of credit are a great tool for a fund. It allows a quick draw on capital and gives the fund manager to give limited partners a better plan for when capital will be called.

But according to ILPA, some fund managers are starting to use the lines of credit to hold off calling capital for longer and longer periods of time.

ILPA is also concerned that disparate of use of lines of credit among different fund managers makes it hard to compare returns from one manager to another.

Some of the recommendations that caught my attention:

  1. Use the date the credit facility is drawn for calculating the waterfall instead of the capital call.
  2. Disclosure of the impact of the facility on IRR.
  3. Limit the outstanding balance to less than 25% of uncalled capital.
  4. Limit the borrowing to 180 days outstanding.

It would seem to me that if a fund agrees to the time limit for the outstanding balance, then the other 3 items are reduced. The facility is then much more about allowing the fund manager to have better speed of execution instead of a tool to manipulate returns.

Sources:

 

Compliance Bricks and Mortar for June 30

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

SEC’s Clayton Vows to Do More Exams with Less Funding in AdvisorHub

SEC Chairman Jay Clayton testified to Congress on Tuesday morning that the agency will increase its examinations of investment advisers by 20% in the current fiscal year and nudge the numbers up a further 5% in fiscal 2018, despite requesting a slightly lower budget than in the current year. [More…]

My Retirement – Search for Successor by Roy Snell

I am retiring in March of 2020. At the outset, I would like to thank you for the opportunity to serve as CEO of this organization for the past 16 years. It has been a tremendous privilege to lead this organization and work with thousands of talented professionals.

In order to facilitate a smooth transition, we have a succession planning committee assisting in the process of finding a new CEO for SCCE and HCCA. [More…]

THE CCO AS A FUTURIST by Tom Fox in FCPA Compliance & Ethics

The Compliance Week 2017 Annual Conference opened this year with a Futurist, Dr. Brian David Johnson, who talked to the assembled group about where the compliance profession might be heading down the road. I thought about Dr. Johnson’s talk when I read an article in the most recent issue of the MIT Sloan Management Review by Amy Webb, entitled “The Flare and Focus of Successful Futurists”. One of the things that struck me was her opening line which reads, “Futurists are skilled at listening to and interpreting signals, which are harbingers of what’s to come. They look for early patterns — pre-trends, if you will — as the scattered points on the fringe converge and begin moving toward the mainstream.”[More…]

Supreme Court to Review Whether Dodd-Frank Anti-Retaliation Provisions Protect Internal Whistleblowers by Kevin LaCroix in The D&O Diary

[Y]ou might well have overlooked the fact that on Monday the Court also agreed to take up the question of whether or not the Dodd-Frank Act’s anti-retaliation provisions apply to and protect individuals who did not make a whistleblower report to the SEC. The lower courts have struggled with the question of whether or not the anti-retaliation protections extend to individuals who file internal reports within their own companies. A split on the issue has developed and now the U.S. Supreme Court will have the opportunity to address the question in the case of Digital Realty Trust v. Somers. The Court’s June 26, 2017 order granting Digital Realty Trust’s petition for a writ of certiorari can be found here. [More…]

Columbia professor Jackson leads field for SEC job by Sarah N. Lynch and Svea Herbst-Bayliss in Reuters

Columbia University law professor Robert Jackson is a leading contender for one of the two commissioner vacancies on the U.S. Securities and Exchange Commission, according to people familiar with the matter.If ultimately nominated by U.S. President Donald Trump and confirmed by the Senate, Jackson would fill a vacant spot reserved for a Democrat on the five-member panel. [More…]

If you enjoy Compliance Building, please join many of my other readers and donate to support my Pan-Mass Challenge bike ride to fight cancer. (Thank you to those who have already donated.) I’m pedaling from the New York border to Provincetown on August 4-6. 100% of your donation goes to the fight against cancer. You can read more and donate here: http://profile.pmc.org/DC0176

SEC Releases New Form ADV Frequently Asked Questions

Earlier this month, the Securities and Exchange Commission released 23 new frequently asked questions (“FAQs”) on Form ADV to provide guidance on recent amendments to Form ADV. Those amendments become effective in October.

These new FAQs include guidance on (i) the umbrella registration approach that many private fund sponsors use to register multiple affiliates and (ii) the reporting of significant new information concerning separately managed accounts (not separate accounts).

There are four new FAQs on social media accounts. They are a bit weird. An adviser does not need to report a social media account if a third party controls the account content. So if you have a third party controlling your firm social media account under the firm name, it does not show up. On the other side, the firm does not have to report an employee’s account when the firm controls the account content.

There is an interesting FAQ on the differences between a private fund and a pooled investment vehicle in Item 5D. “[P]ooled investment vehicles include, but are not limited to, private funds.”

“Additionally, the staff believes for purposes of Item 5.D there are some facts and circumstances in which it may be appropriate for an adviser to treat a single-investor fund (also known as a “fund of one”) as a pooled investment vehicle. For example, an adviser could reasonably treat a single-investor fund as a pooled investment vehicle where the fund seeks to raise capital from multiple investors but has only a single, initial investor for a period of time, or where all but one of the investors in the fund have redeemed their interests. However, an adviser generally should not consider a single-investor fund to be a pooled investment vehicle if that entity in fact operates as a means for the adviser to provide individualized investment advice directly to the investor in the fund.”

As for distributing audited financial statements to meet the custody rule, the new FAQ in 7b makes it clear that

You may answer “Yes” if you will distribute the audited financial statements as required, but have not yet done so at the time of filing the Form ADV.

The SEC revised its FAQ on Item 1.O and points out question that many people trip over in Item 1.O. The question is whether the adviser has over $1 billion in assets. It’s not whether the adviser as more than $1 billion in AUM. “Non-proprietary assets, such as client assets under management, should be excluded when responding to Item 1.O, regardless of whether they appear on an investment adviser’s balance sheet.”

Sources:

Compliance Bricks and Mortar for June 16

I want to clarify my Pay-to-Play and Yard Signs post from earlier this week. I think an early draft of the post was sent through the email system that was incorrect. A senior SEC official clearly stated that yard signs are not limited by the Pay-to-Play Rule and that the speaker who made the statement was 100% incorrect. (After the speaker’s statement I thought I could turn my compliance forensic testing into bike rides past all of my employees’s house to check for political signs. Oh well, back to the office.)

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

SEC identifies adviser cyber security flaws by Jason Wallace in Reuters

In the wake of the recent WannaCry ransomware attack, the Securities and Exchange Commission’s exam team is warning investment advisers that many are failing to perform steps critical to fighting cyber security attacks.

In specific, a relatively high percentage of advisers examined are failing to conduct continuous cyber-risk assessments, nor are they performing penetration or venerability tests. The shortcomings were far higher among investment advisers than among broker-dealers, and concerns raised by the WannaCry attack were particularly relevant to smaller firms. [More…]

SEC DERA, We Love You! by Matt Kelly in Radical Compliance

DERA joined on March 20. As of this morning, the Division had posted 193 tweets. I haven’t done a thorough analysis of the humor-to-boring ratio, but I can safely say that DERA is far more witty than the general SEC News feed, and light years beyond the Enforcement Division’s feed, which is a total snoozer.

We also love the wry self-awareness that DERA has about economists. They get a bum rap as nerds even in the corporate compliance field—and really, who are we to throw stones here?—but DERA knows how to bring it. [More…]

New ACC Survey Finds ‘Dramatic’ Gender Pay Gap for In-House Counsel by Sue Reisinger in Corporate Counsel

A new report from the Association of Corporate Counsel draws “a dramatic picture of gender pay disparity” for women in-house lawyers, while it shows their male colleagues may be sitting in denial.

The “Global Perspectives: ACC In-House Trends Report,” released Tuesday, indicates that a higher percentage of women than men occupy lower-level categories when it comes to in-house salaries. [More…]

The Never Ending Story: Money Laundering by Monica Ramirez Chimal in SCCE’s Compliance & Ethics Blog

Did you know that one of the sources to finance terrorism and trigger for money laundering is counterfeit goods? Due to the actions of law enforcement, the criminal is making money laundering more complex; they are looking for those countries, industries, companies and persons which can help them to launder lots of money at a low cost in a very quick time. [More…]

How Principles of Good Governance Can Improve Oversight of Financial Regulatory Institutions by Hadar Jabotinsky and Mathias Siems in the CLS Blue Sky Blog

Financial regulatory institutions are at the center of intense debates over how to supervise financial firms and markets. They are also the focus of an important and growing body of literature that is mainly concerned with the question, “Who should regulate the regulators.” Financial regulatory institutions are usually audited as part of the review of a particular country by international organizations such as the International Monetary Fund, the World Bank, or the OECD. In practice, this means that the structure of financial regulatory institutions and the conduct of financial regulators are not regularly and consistently monitored.

In our recent paper, we argue that the debate should include not just who should regulate the regulators, but also how they should be regulated. We examine how the principles of corporate governance address conflicts of interests between shareholders and other stakeholders in corporations, and apply those principles, with necessary adjustments, to financial regulatory institutions. We believe that this would solve many of the problems with monitoring financial regulatory institutions and holding them accountable.  [More…]

Raising the Corporate Veil in Kleptocracy Initiative

For actors looking to take advantage of the U.S.’s transformation into a global offshore haven, there are few tools more popular than limited liability companies (LLCs). From states like Nevada and Wyoming to high-rises in Miami and New York, LLCs have become one of the most prominent features of the U.S.’s shell company industry. And due to the U.S.’s lack of a beneficial ownership registry, actors both foreign and domestic continue to use LLCs to mask their identity – and their wealth.[More…]

What all urban planners should be asked: would you let your child cycle here? by Klaus Bondam

Connie Hedegaard, former Danish EU commissioner for climate action, puts it this way: “One might say that Europe faces a choice. Do we want to pursue an American-style approach where kids depend on their parents to take them to school for many years? Or do we want a Nordic-style approach in which mobility considerations are integrated into urban planning, and where the necessary infrastructure is provided so kids can bike to school by themselves? I know which I prefer.” [More…]

It would have been my friend Jeff’s birthday this week, except cancer killed him. This week I’m matching PMC donations. If you enjoy Compliance Building, please join many of my other readers and donate to support my Pan-Mass Challenge bike ride to fight cancer. (Thank you to those who have already donated.) I’m pedaling from the New York border to Provincetown on August 4-6. 100% of your donation goes to the fight against cancer. You can read more and donate here: http://profile.pmc.org/DC0176

Yard Signs and Pay to Play

I was fortunate to be able to attend the Securities and Exchange Commission’s CCO Outreach in Boston yesterday. I’ll post more later, but today I wanted focus on one topic that one panel discussed: the pay to play rule.

The CCO Outreach stated that they were not trying to play “gotcha” as part of the exam process. Personally, I find the pay to play rule to be one of the biggest “gotchas” in the Investment Adviser Act’s regulatory environment.

It was clear that the panelists were very focused on political contributions as part of the exam process. They slowly turned the screws.

They wanted firms to have policies and procedures around campaign contributions. Of course.

They wanted compliance to be verifying contribution disclosures against the records of campaign contributions. This is easier said than done. They noted the ease of using OpenSecrets.org. They were going off tracks. OpenSecrets has very little state information and is focused largely on federal money on federal campaigns. It is not federal candidates that are subject to the rule. The only time a federal candidate is implicated by the pay to play rule is when a state elected official is running for a federal office. Those instances are a gotcha cases. It’s the state and local campaigns that are directly in the cross-hairs of pay-to-play rule. State and local camapign contribution records vary widely from state to state.

Then a panelist said you need apply the prohibition across the whole firm. That’s a broader statement than required by the rule. The rule applies the limitation to “Covered Associates”, not all employees of an investment adviser. Perhaps the panelist misspoke. Or maybe it was a further indication that the panel had gone off the tracks.

Then, the big bang. Several of us in the audience were shocked when a panelist said yard signs were covered by the pay-to-play rule. The panelist stuck to this after some push back. Perhaps the panelist misspoke and was trying to indicate that fundraising for a Official is subject to the pay-to-play rule. Or maybe it was a further indication that the panel had gone off the tracks.

We met with the some senior SEC officials after the panel, who stated very clearly that the rule does NOT interfere with the Constitutional right to plant a political sign in your yard. [So the panelist misspoke? But now there is the specter of an examiner looking at yard signs. Are signs over a certain size covered?]

I understand the corrupting influence of money in politics. I recognize that several political officials have been convicted or accused of demanding political contributions in exchange for an assignment to invest government money.

[Begin the airing of grievances.]

But the SEC’s pay-to-play rule does little to stop that and is overreaching.

Bribing political officials is already illegal. The pay-to-play rule removes the need to prove the illicit intent and makes it a violation merely for making a contribution.

The contribution limits are absurdly low. Candidates raise tens of millions of dollars to run for governor. A contribution of $150 or $350 is meaningless. The SEC should raise the limit.

I still question the pay-to-play rule’s ability to protect investors. The decision to make the investment may be tainted, but the investment itself is not necessarily harmful to the financial returns for the pension plan. The plan is not getting the best investment choice because of an illicit bribe. What politician is going risk violating the bribery law for taking a $1000 campaign contribution to influence government pension money?

The pay-to-play rule is written overly broad and implicates failed candidates and PACs that may or may not have anything to do with state pension money. An investment adviser was trapped by the pay-to-play rule for an employee giving a $500 donation for a failed candidate for governor. That’s even though the state pension plan had already made the commitment to the private fund.

My impression from the panel is that the examiners are using the rule as a “gotcha” to trap investment advisers in foot faults that do nothing to harm or put the investing public at risk.

Sources: