Compliance Bricks and Mortar for May 19

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

Cybersecurity: Ransomware Alert from SEC’s OCIE

Starting on May 12, 2017, a widespread ransomware attack, known as WannaCry, WCry, or Wanna Decryptor, rapidly affected numerous organizations across over one hundred countries. Initial reports indicate that the hacker or hacking group behind the attack is gaining access to enterprise servers either through Microsoft Remote Desktop Protocol (RDP) compromise or the exploitation of a critical Windows Server Message Block version 1 vulnerability. Some networks have also been affected through phishing emails and malicious websites. [More…]

Personal Liability for Compliance Officer in MoneyGram Settlement: Powerful Motivator or Chilling Deterrent? by Erin Schrantz, Anouck Giovanola, and Justin Spiegel

On May 4, 2017, the U.S. Attorney’s Office for the Southern District of New York (“SDNY”) and the Financial Crimes Enforcement Network (“FinCEN”) announced the settlement of civil claims brought under the Bank Secrecy Act (“BSA”) against the former Chief Compliance Officer of MoneyGram International, Inc. (“MoneyGram”), Thomas Haider, stemming from MoneyGram’s failure to implement and maintain an effective anti-money laundering (“AML”) program or to timely file suspicious activity reports (“SARs”).[1]  The settlement represented the resolution of the first-ever suit filed by the federal government against an individual compliance officer in the finance industry,[2] and is likely to add fuel to increasing anxiety regarding the Department of Justice’s (“DOJ”) willingness to hold corporate executives liable for compliance failings.[More…]

McConnell Is Pessimistic Congress Will Overhaul Dodd-Frank by Elizabeth Dexheimer in Bloomberg

Senate Majority Leader Mitch McConnell said he’s pessimistic Congress will overhaul the Dodd-Frank Act because he doubts Republicans can secure enough Democratic votes to make major changes to the sweeping legislation that tightened oversight of banks after the financial crisis.

“I’d love to do something about Dodd-Frank, particularly with regard to community banks but that would require Democratic involvement,” Kentucky’s McConnell told Bloomberg News in an interview Tuesday. “I’m not optimistic.” [More…]

Household Borrowing in Historical Perspective by Andrew Haughwout, Donghoon Lee, Joelle Scally, and Wilbert van der Klaauw in Liberty Street Economics

Today, the New York Fed’s Center for Microeconomic Data released its Quarterly Report on Household Debt and Credit for the first quarter of 2017. The report shows a rise in household debt balances in the quarter of $149 billion, the eleventh consecutive quarterly increase since the long period of deleveraging following the Great Recession. As of March 31, 2017, household debt balances stood at $12.73 trillion, surpassing the previous 2008 peak and hitting a level 14 percent above the trough seen in the second quarter of 2013. With this report’s release, we’re adding two new charts which show both early and severe delinquency trends by loan product type. The report and the analyses presented here are based on the New York Fed’s Consumer Credit Panel (CCP), which is sourced from Equifax credit report data. [More…]

The Case for Federal Preemption of State Blue Sky Laws by Rutheford B. Campbell, Jr.in The CLS Blue Sky Blog

The pernicious effect of state registration rules is easily and vividly demonstrated. For example, a business that announces its offering by posting the offering information on its website or advertising its offer in a widely distributed publication would likely be subject to the separate and individual registration requirements of each of the 50 states. In each state, therefore, the issuer would be required either to file a registration statement with the state or qualify for one of the state’s exemptions from its registration requirements. [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 SEC Reaching Back Far In The Past With Its Powers of Disgorgement

We have become used to the Securities and Exchange Commission extracting disgorgement of ill-gotten gains from those violating the securities laws. However, the enabling laws do not explicitly grant the SEC the right to disgorgement. We seem to accept that power, but how far back can the SEC go to grab cash from defendants?

In the SEC’s case against Charles Kokesh, 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. Some of that ill-gotten cash was overcharging to pay expenses of the investment advisory firm, but some went into his pocket and that of his stable of polo ponies. 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.

The briefs and arguments are a delight for legal scholars. The parties are battling over legal history and dictionary definitions to determine what Congress meant in 1839 when it passed that five year limit and used the word “forfeiture.”

The arguments are compounded by the creation of the SEC’s power of disgorgement, not by Congressional action, but by case law. The SEC only legitimized disgorgement in 1970 in the case of  SEC v. Texas Gulf Sulphur Co., 312 F. Supp. 77 (S.D.N.Y. 1970).

The Kokesh case was argued in front of the Supreme Court last month, so we should be looking ahead to decision shortly that may have a profound impact on SEC enforcement actions.

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I’m Once Again Asking You For Your Hard-Earned Money

Compliance Building is a free resource I publish for me, and share with you, to help the compliance profession.

Now I need some of your hard-earned money. I should point out that the money is not for me; It’s for charity. Help me fight cancer, by raising money for the Dana Farber Cancer Institute.

I’m riding the Pan Mass Challenge in 2017 and hope you will consider supporting me this year. [Click here to make a donation]

Your money will go to help kids like Maya. She is my PMC team’s pedal partner this year. 

In January, Maya turned five years old. A month later, doctors found a large mass on one of her kidneys. Maya has Clear Cell Sarcoma, a very rare renal cancer. Maya went through surgery to remove the mass and has completed six days of radiation.  The next step is seven months of chemotherapy to beat her cancer. Maya’s mom reported that Maya is taking her treatments in stride as only a five year old who loves unicorns can. They are seeing to positive results!

I ride the Pan-Mass Challenge because I believe the money it raises makes a difference in the fight against cancer. It’s making a difference for Maya.

If you’ve read this far, you are either a very dedicated reader of Compliance Building or have also been touched by cancer. Unfortunately, most people have been touched by this terrible disease.

Last year, I lost my best friend to cancer. Jeff was diagnosed with cancer just before Thanksgiving 2015. This terrible disease killed him just two months later. Jeff and I grew up with Dave. After Dave’s mom died of cancer, Dave formed Team Kinetic Karma and I first rode my first Pan-Mass Challenge.

I came back to ride again when Dave was diagnosed with cancer. He fought back and won. The Dana-Farber Cancer Institute helped him beat back the disease.

Then my dad was diagnosed with cancer. He fought back and won. The Dana-Farber Cancer Institute helped him beat back the disease. But his sister, brother, and mother (my aunt, uncle and Nana) did not win and lost their battles with cancer.

We are hoping that Maya will win her battle. Your donations will help.

100% of your donation to my PMC ride will go the Dana-Farber Cancer Institute. The Pan- Mass Challenge is the biggest source of income for Dana-Farber.

Compliance Building readers have been very generous. So many of you have donated in the past and helped me to achieve my fundraising goal. (Many you have already donated this year and I apologize for this additional request.)

If everyone who reads Compliance Building donated a few dollars I would exceed my fundraising goals. If you think Compliance Building worth $1 a week. Then, please contribute $50…(Or More)

The Pan Mass Challenge ride is 192 miles over two days from Sturbridge to Provincetown. If I hit my fundraising goal, I will add another 100 miles on a third day of riding from the New York border over the Berkshires to Sturbridge.

Donations can be made by clicking on any of the links below, or sending a check to my mailing address:

Doug Cornelius
15 Lockwood Rd
West Newton MA 02465

Click here to make $25 donation

Click here to make a $50 donation

Click here to make a $100 donation

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Click here to make a $500 donation

Click here to make a $1,000 donation

Click here to make a donation of any other amount

The One With The Pilfering Lawyer and The Document Management System

The SEC and the DOJ broght charges against Walter C. Little and his neighbor Andrew M. Berke for illegal insider trading. This particular case caught my attention because Mr. Little was a law firm partner and he found the information by searching through his law firm’s document management system.

According to the complaints, Mr. Little obtained material, nonpublic, confidential information about seven issuers and 11 corporate announcements through his access rights on law firm’s internal computer network. However, Mr. Little did not work for those clients or on those transactions.

Mr. Little and Mr. Berke have not settle the claims. Mr. Little is going to have an uphill battle because the law firm disclosed the data about Mr. Little accessing the confidential documents.

In one case, the law firm was serving as legal counsel to Pentair on a possible merger with ERICO Global in a transaction that the firm called Project Lionel.

The damning timeline:

  1. On August 4, The document management system shows Mr. Little accessing documents titled “Pentair – Commitment Letter” and “Lionel Goldman Sachs Engagement Letter”.
  2. On August 5, Mr. Little and Mr. Berke exchange text messages and phone calls.
  3. On August 6, Mr. Berke starts buying call option on Pentair stock.
  4. On August 11, Mr. Litte accessing a document entitle “Project Lionel – Form 8-K(Execution of Merger Agreement)”
  5. On August 11 and over the next few days, Mr. Little buys Pentair call options.
  6. On August 17, Pentair issues a press statement announcing the merger.

A partner at a big law firm knows that accessing merger information about firm clients is wrong and trading on that information is illegal. The trading would be flagged as suspicious by the brokerage firm and sent the information to FINRA. If there was enough suspicious activity around the merger, FINRA would send a query to the law firms involved. The law firm would see the partner’s name and turn over all of the relevant information.

The only question I have is how well did Mr. Little disguise his trading. Since the trading happened over the course of a year with several different clients, I assume he did a good job of hiding the trading. I would guess that it was the last deal with Hanger, Inc. that caught the regulators attention. Once in their sights, the regulators were able to trace back to Mr. Little’s trading on other law firm clients.

Mr. Berke seems to have a more defensible position. The prosecutors will need to prove the information was passed to him and that the trading was not just a coincidence. Then, it’s into the post-Newman world of whether he needed to know the information was supposed to be confidential or whether the relationship between the two needed some level of significance.

Then there is the law firm leaving documents unprotected. This is common. It’s tough to balance the sharing needs of a sprawling team against the information security impositions in the document management system.

At a minimum it’s an embarrassment to the law firm. I would assume the law firm has changed its document security settings, defaulting to limited rights, instead of defaulting to a public setting. I’m sure there is plenty of complaining because it makes it hard to work collaboratively when document security gets in the way.

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We Have Seen The Enemy And It Is US

There was a massive cyberattack over the weekend that has afflicted 200,000 computers in more than 150 countries. The malware locks users out of their computers and threatens to destroy data if a ransom is not paid. It turns out that the the malicious software used in the cyberattack was originally been developed by the National Security Agency. It was then stolen by a hacking group known as the Shadow Brokers and converted into the ransom malware, WannaCrypt.

There was concern that there might be a second wave spread this morning as people return to work. So far that is not the case.

It turns out that WannaCrypt was especially effective in China. Probably because there is a lot more pirated versions of the Microsoft software on Chinese computers. Microsoft released a patch in March.

The scary news is that the US government is stockpiling malware. As pointed out in Countdown to Zero Day there is no US or international norms on the use of computer malware as weapons. We have the US government funding weaponized computer malware that can be released into the wild causing wanton destruction. We like to think that malware is being used to protect the US, but this is an example of the dangers of creating this malware.

Like any weapon, we should be concerned that it can’t fall into the wrong hands. In the case of WannaCrypt, it was stolen and put to evil use.

Thankfully a benevolent hacker found the weakness in WannaCrypt. There was a kill switch. If not, it could have done much more damage.

The malware attack was a good example of the need to keep software up to date.

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The Jay Clayton Era at the SEC Has Begun

Jay Clayton was sworn in last week as the new Chairman of the Securities and Exchange Commission. That makes him the first permanent head of a financial regulator during the Trump administration.

Yesterday, Chairman Clayton gave his first public speech by making the opening remarks at the SEC Advisory Committee on Small and Emerging Companies.

Facilitating capital formation is one of the central tenets of the SEC’s mission and it is a focus that this committee and I share. One of my priorities is for the Commission to focus on facilitating capital-raising opportunities for all companies, including, and importantly, small- and medium-sized businesses. Doing so will not only help those companies, but it also will provide expanded opportunities for investors, help our economy grow, facilitate innovation, and further job creation.

Nothing dramatic. We expected Chairman Clayton to have more of a focus on capital formation than enforcement actions. He comes from a capital formation background. Former Chair White came from a prosecutorial background.

It’s not too early to look to the rest of the Commission. There are still two vacancies. The candidates put worth by President Obama are back working at their old jobs. I think there is little expectation that they will end up in those vacant seats.

Commissioner Stein’s term expires next month. That will give President Trump three seats to fill.

The law is that no more three commissioners may belong to the same political party (Section 4 of the Exchange Act). Chairman Clayton and Commissioner Piwowar are both Republicans. Would it surprise anyone if President Trump nominated another Republican to fill the vacant seat of Commissioner Stein and leave the other two seats vacant?

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Comey and Compliance

The firing of FBI Director has set off a firestorm. Obviously, there is a great deal of partisan tilt to the action. I wanted to focus on the lesson we can see from a compliance perspective. It is an example of the need for independence of compliance and investigations.

President Trump fired someone who was investigating him or his circle of supporters for violations. The Attorney General recused himself from probe into Russia and President Trump because he was potentially involved. But the Attorney General recommended firing the person leading the probe into Russia and President Trump.

Perhaps, Director Comey was issuing subpoenas and continuing an investigation that would have been adverse to President Trump. That would be a problem, a cover-up.

Perhaps, President Trump legitimately thought Director Comey was unfit for his job. It would not be the first time a President has fired the FBI Director. President (Bill) Clinton fired  FBI Director William Sessions for serious ethical lapses.

The problem is that it looks like a cover-up. Without independence, the motives for firing or disciplining an employee for investigating his boss is always going to look suspicious. If it looks like a cover-up, many people are going to assume there is a cover-up.

It’s better to structure a compliance program so that it has some independence operationally. For a firm with a board of directors, the compliance program should have a way to report to the board of directors. Compliance officers should have alternative reporting structures in case they have to investigate a boss.

For an private fund adviser, there should be mechanisms for the CCO to report to a compliance committee instead of a single individual.

What you want to avoid is having to investigate your boss. That is an irreconcilable conflict. People are always going to question the end result. People are especially going to question why the investigator was fired in the middle of an investigation.

 

Real Estate Fund Information from the SEC

The Securities and Exchange Commission has been acquiring troves of data about private funds through the Form PF filing requirement. Some, including myself, have been skeptical that the SEC will figure out what to do with the data as a tool to protect investors. But, the SEC has been able to compile statistics and published a suite of new data and analyses of private fund statistics and trends. The SEC released the third quarter private fund statistics.

The number of real estate funds reporting on Form PF has increased.
The number of real estate funds reporting on Form PF has increased.

period 2014Q4 2015Q1 2015Q2 2015Q3 2015Q4 2016Q1 2016Q2 2016Q3
Funds 1,802 1,800 1,801 1,806 2,056 2,093 2,091 2,108
Advisers 262 263 264 265 288 290 288 290
Net NAV ($billions) 280 280 281 319 323 323 323 323

The rise from 1802 to 2108 in advisers is a big increase. There is only a small rise of 52 from the end of 2015 to the end of the third quarter in 2016. It’s the larger multi-platform Form PF filers who file quarterly.

Pure real estate fund advisers are only filing quarterly. Given that, I didn’t expect to see much change intra-year, and that held true.

There is a wealth of information in the SEC’s report. I’m still looking for some trends.
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Weekend Reading: Bourbon Empire

I went on Spring vacation to Kentucky with Mrs. Doug and the compliance nuggets. There was a lot of bourbon and horses. For vacation reading, I dug into my ever-growing tower of books to read and brought along Bourbon Empire by Reid Mitenbuler to read. It seemed appropriate.

Reid Mitenbuler portrays bourbon as a balance of Jefferson and Hamilton’s ideas, still being argued today in politics. On one side is the small agrarian culture championed by Jefferson, in opposition to the capitalist growth of Hamilton. Bourbon is Jefferson on the outside, with Hamilton on the inside.

In Kentucky, bourbon finds that its color. History collides with myth, filling in the recorded gaps with burnt oak.

I found the origins of “proof” to be a fascinating relic of taxation. Ever since President Washington imposed the whiskey tax, distillers have tried to work around taxes for profit. Tax collectors would measure the strength of the whiskey by mixing it with gunpowder and setting it on fire. If the flame sputtered, the alcohol content was low and if it flared up it, there was too much alcohol. A steady flame proved that the alcohol content was proper. This proof came at about 50% alcohol. So if the whiskey was 100% proved, it was was about 50% alcohol.

There was little government oversight of what could be put in the bourbon bottle or put on the label. The biggest first step of regulation was the 1897 Bottled-in-Bond Act that required the whiskey be made a single distillery by a one distiller, aged for at least four years, unadulterated and bottled at exactly 100 proof. The bottle’s label had to identify the distillery where the whiskey was distilled and bottled. If it met those standards, the whiskey would have the right to bear the green stamp of approval featuring the image of John G. Carlisle, a Kentucky congressman.

Whiskey, like all alcohol, was scrubbed out of existence by Prohibition. Okay, so that is clearly an overstatement. It went from local farmers and big distillers, to the underground criminal element. One interesting loophole of prohibition was an exception for medicinal whiskey. (Medicine has come a long way in the last few decades.) If you are going to dispense medicine, you need pharmacies. Walgreens grew from 20 stores in Chicago to over 525 stores during the era of prohibition. Mr. Mitenburger points to The Great Gatsby in which Daisy describes the mysterious bootlegging Mr. Gatsby as having “owned some drugstores, a lot of drugstores.”

Bourbon and Kentucky are linked. My tourguide at the Woodford Reserve distillery point to Kentucky limestone, with its removal of iron from the water, as the key to Kentucky bourbon. Whatever may be the truth or the myth or marketing, 95% of the world’s bourbon is made in Kentucky.

With the fall of Prohibition, government regulation of alcohol increased. That was especially true in labeling and identification of what was inside the bottle. To earn the “straight” identification, the whiskey needs to be aged in brand-new charred oak barrels for at least two years.

It was the rise of Maker’s Mark in the 1980s that turned bourbon towards its “craft” status, embracing quality over mass-production in its marketing. It was the embracing of the Kentucky mystery and Jeffersonian small-batch aesthetics that define most bourbon today. Behind the scenes, a handful of distilleries make the vast majority of bourbon and pour different variations into long line of product labels.

I enjoy a good bourbon and I enjoyed Bourbon Empire.

Compliance Bricks and Mortar for May 5

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

House Panel Approves Plan to Undo Parts of Dodd-Frank Financial Law by Rachel Witkowski

The House Financial Services Committee launched a Republican-supported rollback of Obama-era financial regulations, voting 34-26 along party lines Thursday for a plan to undo significant parts of the 2010 Dodd-Frank law.

The committee vote sent the Financial Choice Act to the full House, where it likely will be approved in the coming weeks. [More…]

SEC Staff Reports On “Real Estate Funds”, But What Exactly Are They? by Keith Paul Bishop

The SEC gathers the data from Form PFs.  You are required to file a Form PF if, among other things, you manage a “private fund”.  The Form PF does require disclosures from “real estate funds” and it defines these as “any private fund that is not a hedge fund, that does not provide investors with redemption rights in the ordinary course and that invests primarily in real estate and real estate related assets.”  A “private fund” is defined as “Any issuer that would be an investment company as defined in section 3 of the Investment Company Act of 1940 but for section 3(c)(1) or 3(c)(7) of that Act.”  Notably missing from the definition of “private fund” is a fund that relies on the exclusion in section 3(c)(5) of the ICA but not either section 3(c)(1) or 3(c)(7).   [More…]

SEC Probes Solar Companies Over Disclosure of Customer Cancellations by Kirsten Grind

The Securities and Exchange Commission is examining whether San Francisco-based Sunrun Inc. RUN -0.63% and Elon Musk’s San Mateo, Calif.-based SolarCity Corp. have adequately disclosed how many customers have canceled contracts after signing up for a home solar-energy system, the person said. Investors use that cancellation metric as one way to gauge the companies’ health. Companies typically give customers a few days after signing a contract, or even up until the time of installation, to back out of a deal. [More…]

Trump Pick for SEC Chairman Assembling Top Agency Staff by Dave Michaels

Mr. Clayton has considered at least two well-known defense attorneys for enforcement director, typically the SEC’s highest-profile staff position. The lawyers include Steven Peikin, a former prosecutor who works with Mr. Clayton at Sullivan & Cromwell LLP. Mr. Peikin represented Goldman Sachs Group Inc. in its dealings with prosecutors and SEC lawyers over claims a former member of its board, Rajat Gupta, had leaked inside information to a hedge-fund manager. . . .Another candidate for the top enforcement job is Matthew Martens, a partner at Wilmer Cutler Pickering Hale and Dorr LLP, who was the SEC’s top trial attorney from 2010 to 2013. [More…]

In S.E.C.’s Streamlined Court, Penalty Exerts a Lasting Grip by Gretchen Morgensen

A money manager settled his case with the S.E.C. thinking he could go back to work in a year. Nearly five years later, he is still waiting.

Mr. Wanger, who now calls himself the $2,200 Man on a website he has created, said his experience with the S.E.C.’s in-house court system did not feel like he was in America. “I’ve spent the last seven years fighting for the right to defend myself in a real court in front of a real judge,” he said. “Constitutional rights have no meaning unless you’re willing to extend them to people you don’t necessarily like. [More..]