Financial Choice Act Passes the House

While the political lens was focused on the James Comey testimony, the House of Representatives passed the Financial Choice Act. The bill is big change to many of the Dodd-Frank. For private funds, the most interesting section is: TITLE IV—Unleashing Opportunities For Small Businesses, Innovators, And Job Creators By Facilitating Capital Formation.

The Financial Choice Act does some interesting things and overreaches in many other ways. I personally think Dodd-Frank missed the mark. But it was in response to the financial crisis. There was a lot of political will to pass something to hold Wall Street accountable for the financial crisis.

I don’t think there is the political will to de-regulate financial institutions, which means there is not a good political pitch for this bill. The main theme has been to provide relief to Main Street. Smaller banks are having a harder time dealing with the banking regulations. The bigger banks, with their bigger operations and bigger balance sheets, are better able to deal with the complexity and costs.

Most think the bill is dead in the Senate. Perhaps some part of it will get passed, but it will look little like the bill passed by the House.

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Compliance Bricks and Mortar: Post-Comey Edition

Politics aside, one of the key items I saw in the Comey testimony yesterday was the effect of perception on interactions between a boss and his employees. Mr. Comey said he did “take as a direction” the president’s words to mean he should drop the investigation. That may or may not have been the intention of President Trump. Mr. Comey likened the statement to one made by King Henry II, referring to the archbishop of Canterbury, Thomas Becket, “Will no one rid me of this meddlesome priest?” That resulted in the murder of Thomas Becket.

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

DLA Piper’s 2017 Compliance & Risk Report: Compliance Grows Up

Chief Compliance Officers (CCOs) are less worried than they were a year ago about personal liability – likely a result of program improvements and increased independence and prominence of the compliance function, according to a new survey released by DLA Piper.

But DLA Piper’s 2017 Compliance & Risk Report still found that 67 percent of CCOs are at least somewhat concerned, and see significant areas for improvement – including in regard to compliance’s relationship with boards of directors. This year’s survey was expanded to query directors, who noted a higher level of concern than their CCO counterparts. [More…]

How to Improve Corporate Compliance with the Law by Vincent DiLorenzo in the CLS Blue Sky Blog

Regulatory philosophy in the U.S. and U.K. long reflected an assumption of corporate commitment to law-abiding behavior. Mainstream corporations were viewed as embracing an ethical obligation to comply with legal mandates. The result was a light-touch approach to enforcement policy—a policy relying on agreements to cease violations and not emphasizing the imposition of civil penalties. When law-abiding behavior was absent and a breach of legal standards was substantial, recurrent, or systemic, then financial penalties were imposed. More recently, regulatory philosophy has been modified to embrace the view that corporate actors are rational decision makers, choosing to comply, evade, or violate legal obligations based on cost-benefit evaluations. This regulatory philosophy reflects a neoclassical economic view, which assumes that corporate actors will comply with legal requirements if all potential costs of noncompliance exceed their benefits. In this scenario it is assumed that corporate actors assess risk based on a full appreciation of all the short-term and long-term consequences of their actions. The related assumption is that corporate decisions are linear, so that increasing the size of fines, for example, will have a direct and proportional impact on future decisions concerning legal compliance. This is both a reductionist and a linear view of human decision-making. The 2008 financial crisis has revealed flaws in both of these viewpoints. [More…]

The Limits of Gatekeeper Liability by Andrew F. Tuch in the HLS Forum on Corporate Governance and Financial Regulation

In The Limits of Gatekeeper Liability, I assess an original and provocative strategy intended to address many of the challenges facing gatekeeper liability. Proposed by Professor Stavros Gadinis and Mr. Colby Mangels in their paper Collaborative Gatekeepers, the strategy is inspired by rules that have proven effective in anti-money laundering regulation. [1] In my response, I examine some of the often overlooked subtleties involved in both justifying gatekeeper liability regimes for controlling corporate wrongdoing and in calibrating the deterrent force of these regimes. [More..]

SEC Names Stephanie Avakian and Steven Peikin as Co-Directors of Enforcement

Ms. Avakian was named Acting Director of the SEC’s Division of Enforcement in December 2016 after serving as Deputy Director of the Division since June 2014. Before being named Deputy Director, Ms. Avakian was a partner at Wilmer Cutler Pickering Hale and Dorr LLP, where she served as a vice chair of the firm’s securities practice and represented financial institutions, public companies, boards, and individuals in a broad range of investigations and other matters before the SEC and other agencies. . . .

Most recently, Mr. Peikin was Managing Partner of Sullivan & Cromwell’s Criminal Defense and Investigations Group. His practice focused on white-collar criminal defense, regulatory enforcement, and internal investigations. Mr. Peikin also is Adjunct Professor of Law at New York University Law School, where he teaches a class on the criminal enforcement of securities and commodities laws.

[More…]

SEC Administrative Law Judges: The Sequel by Greg Morvillo in the NYU Law’s Compliance & Enforcement

Back in February, I wrote a blog piece on the state of the law as it relates to the litigation over SEC Administrative Law Judges.  As, I’m sure you know, all good sequels recap the previous incarnation without belaboring the point so here goes:  a circuit split is brewing.  In Lucia v SEC, the D.C. Circuit held that SEC ALJs are not inferior officers and do need not be constitutionally appointed. Thereafter, the Tenth Circuit, took the exact opposite position in Bandimere v. SEC.  ALJ’s are inferior officers under Article III and if not appointed by the head of a department, are unconstitutionally presiding over cases before them.  While it is not as exciting as seeing an old Luke Skywalker at the end of Star Wars: The Force Awakens, it is, in fact, where we left off in February. [More…]

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A Continuing Look as CCO Liability in the Stanford Ponzi Scheme

Eight years ago,  Stanford Financial Group collapsed and was labeled a Ponzi scheme. The Securities and Exchange Commission is continuing to seek penalties for those involved. One of those is Bernerd Young, who served as the Chief Compliance Officer at Stanford Group Company, the Texas-based registered investment adviser and broker dealer that promoted the Stanford CDs to US investors.

The SEC claims that Young approved Stanford’s false and misleading disclosures despite red flags about the products. An SEC Administrative Law Judge found that Young was

“at least negligent in allowing the use of marketing material that promised depositor security on the basis of facts about SIB’s portfolio that could not be verified and on the basis of a discussion of insurance that [he] knew had no relevance to depositor security but that might confuse a potential investor into thinking that it did.”

Young did not challenge most of the relevant facts about the underlying fraud at Stanford. He just disputes his liability by claiming that he reasonably carried out his compliance and due diligence responsibilities in good-faith reliance on Stanford officials, outside professionals, and regulators.

The ALJ found him subject to liability and barred Young from the industry, ordered almost $600 thousand in disgorgement and a civil penalty of $260,000. The disgorgement was for about half of his salary since half of Stanford’s income was fraudulent.

The Commission upheld the holding of the ALJ.

Young is appealing the decision to the US Circuit of Appeals for the DC Circuit. Mr. Young’s challenge is an attack on the ALJ proceeding in line with Lucia and Bandimere.

I also noted in the SEC order that Mr. Young had challenged the proceedings based on the statute of limitations. Although I don’t think it gets him in the clear, yesterday’s Kokesh puts a hard cap on the disgorgement to five years and opens the possibility of limiting the disgorgement remedy even more. In this case, Young’s salary is being disgorged based on some abstract ratio of fraud to legitimate activity at Stanford. I think it would interesting to see how this disgorgement held up to court scrutiny.

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Supreme Court Limits One of the SEC’s Remedies

The Securities and Exchange Commission has essentially been claiming that its remedy of disgorgement is not subject to a statute of limitations. To the SEC, disgorgement is not punitive but remedial in that it lessens the effects of a violation by restoring the status quo.

Charles Kokesh decided to fight back against this position. In the SEC’s case against him, the SEC wants to go back ten years. Between 1995 and 2006, Kokesh pilfered $34.9 million from the business-development companies for which his firm was acting as investment adviser. The SEC brought charges in 2009. The court ordered disgorgement of all of the pilfered funds.

Mr. Kokesh argues that 28 U.S.C. §2462 limits the disgorgement to five years by stating that “an action, suit or proceeding for the enforcement of any civil fine, penalty, or forfeiture, pecuniary or otherwise, shall not be entertained unless commenced within five years from the date when the claim first accrued”. If the five-year limit is imposed, Mr. Korkesh’s penalty would be reduced to $5 million.

Yesterday, the Supreme Court agreed with Mr. Kokesh and set a limit on the SEC’s powers.

Disgorgement, as it is applied in SEC enforcement proceedings, operates as a penalty under §2462. Accordingly, any claim for disgorgement in an SEC enforcement action must be commenced within five years of the date the claim accrued.

In addition to limiting the period susceptible to disgorgement, the Supreme Court indicated that a facial attack on the disgorgement remedy in footnote 3:

Nothing in this opinion should be interpreted as an opinion on whether courts possess authority to order disgorgement in SEC enforcement proceedings or on whether courts have properly applied disgorgement principles in this context The sole question presented in this case is whether disgorgement, as applied in SEC enforcement actions, is subject to §2462’s limitations period.

The Supreme Court noted that the SEC specifically has the powers of injunction and civil penalties. Perhaps the disgorgement could be tested. In the decision, the Supreme Court noted that the “SEC disgorgement sometimes exceeds the profits gained as a result of the violation” and, ” as demonstrated by this case, SEC disgorgement sometimes is ordered without consideration of a defendant’s expenses that reduced the amount of illegal profit.”

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Compliance Bricks and Mortar Post-Paris Edition

President Trump announced that the United States will withdraw from the Paris Climate Agreement. The U.S. is the world’s second-largest emitter of carbon, with China in the top spot. China affirmed its commitment to meeting its targets under the Paris Climate Agreement and recently canceled construction of 100 coal-fired power plants, with plans to invest billions in massive wind and solar projects. The Paris Climate Agreement is far from perfect and may hurt the US more than the other 195 countries given its massive carbon emissions.

Compliance with the agreement would be hard. It would take big investments in energy that does not come from fossil fuel. That’s especially hard when fossil fuel is so inexpensive.

Looking at the Constitutional process, the agreement was never ratified by the Senate, as is required for a treaty. Withdrawal from the agreement is no surprise. President Trump stated he would do so during his campaign.

Climate change is real. The hope was to avoid a tragedy of the commons. There is no other deal to be made on climate change.

Now what?

From NASA’s Global Climate Change library

In other news, these are some of the compliance-related stories that recently caught my attention.

Potential Liability for PE Firms When Preferred Stock Is Redeemed by a Non-Independent Board—Hsu v. ODN by Gail Weinstein & Robert C. Schwenkel, Fried, Frank, Harris, Shriver & Jacobson LLP

The plaintiff contended that, over the two-year period prior to the exercise date of Oak Hill’s redemption right, rather than managing the Company to maximize its long-term value for the benefit of the common stockholders, the directors had operated the Company so that it would be in a position to redeem the maximum amount of Preferred Stock as quickly as possible after the redemption right was exercised.

The Delaware Court of Chancery, giving the benefit of all reasonable inferences to the plaintiff (as required at the pleading stage), declined to dismiss the plaintiff’s claims. [More…]

Ex-Obama Officials Find There’s No Place Like Their Old Law Firms by Elizabeth Olson in the New York Times

The revolving door between government and law firms is decades old, as the newest political overseers arriving in Washington recruit their own legal hands for savvy counsel to prevent — or rescue them from — misdeeds or mistakes. And, as white-collar practices at major law firms have been booming in the wake of the regulatory overhauls that followed the economy’s 2008 crisis, that swinging door typically means a big payday for most lawyers. [More…]

What are you doing about outside business disclosures by Joshua Horn in Securities Compliance Sentinel

The purpose of requiring outside business disclosures is for a firm to make sure that it and its clients know about any conflicts of interest that their brokers may have. For example, the firm would want to know if the broker had a real estate broker’s license because that business may compete with the time the broker can give to her securities investing clients. [More…]

Are Hedge Funds Worth As Much As They Say They Are? by Pierre-Axel Gide in the CLS Blue Sky Blog

I tried to determine whether hedge funds provide investors with diversification benefits and deliver risk-adjusted returns above market returns. As a market benchmark, I used the S&P 500 Index and ran multiple regression analyses of monthly index returns. Doing so resulted in various alphas and betas corresponding to different hedge fund styles (also called tilts). [More…]

Matching Business Models and Processes with Cybercrime Insurance Programs by David Bergenfeld in the D&O Diary

Time and again, insureds seek payment for cybercrime claims only to be denied by their insurers and the courts that review the subsequent lawsuits that are inevitably filed by insureds. As courts strictly interpret cybercrime policies, insureds need to ensure that their cybercrime policies provide adequate coverage for the known risks and perils of their businesses. Such coverage can only be achieved through a diligent review of business models and processes to match them with a proper insurance program. Recently, federal appellate and district courts denied insureds’ claims for cybercrime coverage where the insureds’ insurance program did not match their business models and processes. [More…]

When ‘Political Intelligence’ Meets Insider Trading by Peter Henning in the New York Times’s DealBook

A case involving insider trading charges based on government information dispensed by a “political intelligence” operative raises interesting questions about how some of the tricky rules for proving the offense will be applied when information is leaked from a federal agency rather than a corporation. [More…]

Shareholder Proposals for Climate Change

Later today, we will hear President Trump announce from the Rose Garden about whether the US will pull out of the Paris climate accord. Meanwhile, ExxonMobil shareholders have stated that they do care about climate change.

As an ExxonMobil shareholder, I see that the firm is the frequent subject of activist shareholder items. There were nine such items on the agenda for the meeting yesterday.

Preliminary results of the vote on Wednesday had 62.3 percent in favor of the climate change proposal, up from the 38 percent who voted in favor of a similar resolution last year.

“RESOLVED: Shareholders request that, beginning in 2018, ExxonMobil publish an annual assessment of the long-term portfolio impacts of technological advances and global climate change policies, at reasonable cost and omitting proprietary information. The assessment can be incorporated into existing reporting and should analyze the impacts on ExxonMobil’s oil and gas reserves and resources under a scenario in which reduction in demand results from carbon restrictions and related rules or commitments adopted by governments consistent with the globally agreed upon 2 degree target. This reporting should assess the resilience of the company’s full portfolio of reserves and resources through 2040 and beyond, and address the financial risks associated with such a scenario.

The company’s board of directors has recommended a “no” vote.

ExxonMobil recognizes the dual challenge of meeting the world’s growing energy demand to support the economic growth needed for improved living standards, while simultaneously addressing the risks posed by climate change. In this regard, we believe the risks of climate change are serious and warrant thoughtful action.

It’s thoughtful action is just different than the shareholder proposal. ExxonMobil supports the Paris accord that President Trump appears to be ready to reject. (Why hold a Rose Garden conference to say you’re not changing?) ExxonMobil has also stated that it supports a carbon tax.

The New York State Common Retirement Fund (one of my firm’s investors) was the lead proponent of the resolution. Patrick Doherty, director of corporate governance for the New York State Office of the State Comptroller, which runs the New York State Common Retirement Fund stated: “We have a very, very strong financial interest in the long-term health of the company.”

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The Positives and Negatives of A Subscription Credit Line

I came across two competing narratives on the use of subcription credit facilities for private equity funds: (1) Howard Marks of Oaktree Capital published a memo on subscription lines of credit for closed-end funds and (2) Eileen Appelbaum’s Private Equity’s Latest Con.

Unlike hedge funds, private equity funds call capital from limited partners over time as investments are made, up to the amount of their commitment. Subscription credit facilities allow a funds to use the commitments as collateral for a line of credit.

Subscription credit facilities are substantially different than margin borrowing used by hedge funds. They do not leverage the limited partner’s capital.  It acts a temporary substitute for capital, to repaid with a later call for capital from a the limited partners. A $10 million fund can’t invest more $10 million in total, but it may delay calling that capital.

To summarize Mr. Mark’s view of the positives:

  • Less frequent capital calls
  • Quicker ability to deploy capital from a loan draw
  • The use of borrowed money can reduce or even eliminate the deleterious impact on early returns of the so-called “J-curve.”

To summarize Mr. Mark’s view of the negatives:

  • Higher expenses for the fund to pay for interest and borrowing expenses
  • Lowering the hurdle can increase the GP’s probability of collecting incentive fees and cause the payment of incentive fees to the GP to begin sooner
  • Some LPs may actually want to have their capital called and earn their preferred return.
  • Complicates the selling of LP interest in a secondary transfer
  • Disclosure of LP financial information to the lender
  • Possibility of LP default

Ms. Applebaum takes the reduction of the J Curve as a negative and calls it a “sleight of hand.” The J curve is a particular quirk of private equity as it generally requires putting more capital into an investment resulting in a negative return before that new capital starts generating an appreciation for the investment.

Ms. Applebaum and Mr. Marks both agree with the negative distortion of the IRR calculation caused by delaying the capital contributions. Mr. Marks points out that the expenses affect a fund’s overall return and the total amount of IRR. Therefore it also has a effect on the fund manager’s IRR.

Mr. Marks then takes it to the next level by pointing out that IRR is not the single metric that determines a fund’s performance. Investors should also judge a fund by the amount of the capital deployed and the total amount of cash returned to investors.

Some things that funds have done to address the negatives:

  • Limit the length a time an investment can be on the line of credit before calling capital
  • Eliminating deal-by-deal incentive payments, so that overall fund performance, including the costs of the line, are taken into account
  • Reporting overall fund performance along side deal-by-deal performance

Subscription credit facilities provide fund managers with funding flexibility and liquidity, allowing quicker execution. As with any tool, you need to manage the risks.

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Compliance Bricks and Mortar – Memorial Day Edition

As we pause this weekend to remember those who have fallen while serving the armed forces, these are some of the compliance-related stories that caught my attention recently.

No Movie Could Capture the Crazy Details of Bernie Madoff’s Story by GORDON MEHLER AND LARRY H. KRANTZ in The Atlantic

Bernie Madoff is back, nearly a decade after his arrest for the largest known financial fraud in history. An HBO movie, The Wizard of Lies, starring Robert De Niro, premieres on Saturday, and Madoff, an earlier ABC miniseries starring Richard Dreyfuss, have catapulted the preeminent Ponzi schemer into the limelight again, even as lawsuits to recover his investors’ losses continue to grind on in the courts. [More…]

More Details on COSO ERM Framework by Matt Kelly

COSO is streamlining the framework’s principles, not gutting them. The draft ERM framework published last summer had five primary components, supported by 23 underlying principles. Public feedback on the draft said some of the 23 principles seemed overlapping or redundant, so could COSO consolidate them? That’s how the final framework came to 20 principles. [More…]

The Supreme Court Meets Lehman Brothers by Frank Partnoy in the CLS Blue Sky Blog

The U.S. Supreme Court will soon decide an unusual, yet important, case brought by investors in bonds issued by Lehman Brothers, the infamous investment bank that collapsed in September 2008. The case, CalPERS v. ANZ Securities, Inc., is not about whether those investors were defrauded: It is widely known that Lehman concealed its exposure to subprime mortgage loans and complex derivatives, just as it used accounting gimmicks to hide risks. The investigation after Lehman’s bankruptcy showed incontrovertibly that its investors had been wronged.

Nor is the case about whether those investors could properly recover in class action litigation alleging that Lehman and others violated the federal securities laws. Various lawsuits filed by Lehman bond investors were consolidated in federal court in New York and then settled in 2011, three years after Lehman’s bankruptcy filing. That settlement has not been challenged. But the date of that settlement – and the three-year time period – are important. [More…]

Appeals Court Questions Impact of SEC Forum Challenge in Bloomberg

If the D.C. Circuit rules in favor of the SEC, it probably won’t resolve the issue, as the circuit split would be “destined for decision by the Supreme Court, which has shown in the recent days a willingness to limit the reach of the SEC,” R. Daniel O’Connor of Ropes & Gray, Boston told Bloomberg BNA. [More…]

Former SEC Officials Say Don’t Bank on Big Regulatory Disruption by B. Colby Hamilton

Be happy about the prospect of regulatory upheaval in Washington, D.C. Don’t worry.

That was the sentiment shared by former U.S. Securities and Exchange Commission chairwoman Mary Jo White and JPMorgan Chase & Co. vice chairman Stephen Cutler—himself the former head of enforcement at the SEC—at a legal summit Wednesday.  [More…]

If you enjoy Compliance Building, please join many of my other readers and support my Pan-Mass Challenge ride to fight cancer next week. (Thank you to those who have already donated.) I’m pedaling from the New York border to Provincetown on August 5-6. 100% of your donation goes to the fight against cancer. You can read more and donate here: http://profile.pmc.org/DC0176

The One With the Fake Fitbit Steps and Fake News

The quest of any insider trader is to get a stock bet in place before a big announcement is made. Robert W. Murray thought he could just make his own announcement and sell out of his trade. The target was Fitbit.

This case caught my attention because of the yelling about “fake news” and Fitbit. I became a fan of the Fitbit products a few years ago when I wanted to lose some weight. I managed to drop 25 pounds using my Fitbit (and watching what I ate and exercising more).

Mr. Murray had no inside information, so he decided he could make some money by manufacturing his own announcement. He did some research and thought he could put a fake filing on EDGAR, the SEC filing system. According to the SEC complaint, Mr. Murray figured out how to do a fake filing by research at least two prior EDGAR manipulation cases:  the 2015 Nedko Nedev Case and the 2016 Nauman Aly case.

Mr. Murray bought some out-of-the-money call option cheap the filed a fake tender offer for Fitbit, Inc. on EDGAR. It worked. The stock price spiked by 10% on news of the tender offer. The stock came back down after Fitbit made an announcement that it had received no communications about a tender offer.

Mr. Murray had a great ROI on his call options of 351%. He did not have much money at risk. He only spent $887 on the options and realized a gain of $3,118.

Mr. Murray was able to disguise his IP address for his filing. However, he used his real email as a backup recovery email for the EDGAR account. He booked a hotel reservation using that account. There was a recovery email for the the first recovery email that tied back to Mr. Murray’s employer.

Assuming the facts in the complaints turn out to be true, Mr. Murray spent a lot of time and energy to create the fake steps and fake news for a $3200 profit. Looks like he is going to use all of that up in legal fees, and then a lot more to try to keep himself out of jail.

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The One With The Floundering Hedge Fund

I’m a local homer, so fraud cases in Massachusetts catch my attention, especially when they involve private funds. The case of the floundering hedge fund, MC2 Capital, founded by Yasuna Murakami, is the usual example of greed and failure to acknowledge one’s mistakes.

Mr. Murakami had big dreams and in the glory days of 2007 thought he could graduate from business school and start a hedge fund. According to the order from the Massachusetts Secretary of State, he had no professional experience trading securities.

He convinced a business school classmate who had been working at Bear Stearns in 2007 to join with him to form MC2 Capital. They were able to raise $3.6 million. The fund was supposed to focus primarily on small to medium cap US stocks with an emphasis on value-oriented investments. However, in reality it had no strategy and had significant holdings in extractive industries and used margin loans for its trading.

It should come as no surprise that inexperienced managers with no strategy lost a great deal of money for the fund investors. By August 2011, the fund had only $33,577.51 in net equity. MC2 lied to investors and covered up the losses. Investors got fake K-1s and account statements.

The trading losses did not deter them. They started a second fund, and then a third fund for Canadian investments.

For the Canadian investments, MC2 managed to eventually link up in 2011 with a successful Canadian asset management firm and fund manager who agreed to run the investments for 70% of the fund fees. That firm cancelled the arrangement in 2015. To make up for the loss, MC2 made up a fake firm as the replacement asset manager.

By the end of 2016, the combined worth of all three funds was less than $10,000. Yet, MC2 told one if its investors that its investment was worth over $4.5 million, with a year to date gain of 18.7%.

It should come as no surprise that some of the investor money was not just lost in trading, but ended up directly in Mr. Murakami’s pocket.

As you might expect, MC2 was using new investor money to pay redemption requests. MC2 turned into a Ponziu scheme.

The Massachusetts fraud case did not pull in the other MC2 partner, Avi Chait. The SEC action does and implicates Mr. Chait in the wrongdoing. It may be that Mr. Chait was not aware of Mr. Murakami’s wrongdoing. The SEC complaint has this quote from Mr. Chait to Mr. Murakami, “I am trying to sell a fund that I know nothing about at all.” It all became too much for him in 2016 and Mr. Chait redeemed his interest and his relatives’s interest, pocketing the fake returns.

The SEC swooped in May, after Massachusetts has already brought its action in January and fund investors had brought their suit in November.

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