Compliance Bricks and Mortar for March 10

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

SEC Reduces Whistleblower Bounty Based On Culpability And Delayed Reporting by Harris Mufson, Steven J. Pearlman and Amy Blackwood in Proskauer Whistleblower Defense

On February 28, 2017, in an Order almost entirely devoid of detail, the SEC announced that a whistleblower will receive 20% of any monetary sanctions collected in an enforcement action commenced as a result of the whistleblower’s tip. The SEC is giving this “reduced” award while acknowledging that the whistleblower (1) was “culpable” in the securities violation at issue, and (2) unreasonably delayed reporting the company’s wrongdoing to the agency. [More…]

Beware of “Virus-Infected” Emails Purportedly From the SEC!!! in TheCorproateCounsel.net

Whoa! Last week, a member received an email claiming to be from EDGAR/SEC that had an attachment for revised 10-K filing instructions. She forwarded the email to her IT department – & it turned out the attachment was a “very nasty piece of malware” that could have infected the entire company. It was a phished email that came from a SEC email address ([email protected]) with a subject line of “Important changes to Form 10-K and Instructions.”

So beware! This is quite a tailored type of malicious email for an in-house lawyer to be receiving! Yesterday, the SEC posted a notice about this phishing scam.

You get what you ask for by Jack Vinson in Knowledge Jolt with Jack

This topic is familiar in many management circles: If you look for something, you will likely find it. If people know you are monitoring or looking for something, they will make an effort to supply that thing. And on the other side, if you don’t ask for that thing / report / result, you won’t get it. [More…]

SEC Enforcement Arm Braces for Cutbacks

The SEC’s enforcement arm is bracing for budget cutbacks that may result in fewer enforcement cases, Bloomberg writes.

Already, the department has halted non-essential travel and the hiring of outside contractors who help in-house lawyers with cases, sources tell the publication. [More…]

Terrorism Financing Via Bitcoin May be Exaggerated by MARA LEMOS STEIN

Law enforcement and regulators best take a measured approach in tackling the potential increase in the use of virtual currencies to finance terrorist activities, as there is still scant evidence the nascent technology will become a preferred method of cash transfer and other means of funding remain readily available and hard to track, said a U.K. intelligence think-tank. [More…]

Inadvertently Obtaining Custody

The concept behind the custody rule is simple. The adviser needs to hold client assets safely and needs a third -party to verify that the adviser is actually holding the assets. But as it’s been put in place, the Custody Rule is complicated. At times the SEC has needed to provide guidance, and then provide further guidance  to the guidance.

In fairness, part of the problem is that there are so many different business models employed by registered investment advisers that it is hard to have things work for all of them.

The latest guidance under the Custody Rule has to do with some of the arrangements in place between advisers and their custodians. It turns out that some standard custody agreements grant advisers broader access to client funds and securities than the advisers’ agreements with their clients.

The SEC’s Division of Investment Management issued a Guidance Update discussing situations when an investment adviser may inadvertently have “custody” of client assets pursuant to Rule 206(4)-2 under the Advisers Act of 1940.

The Guidance warns advisers to look for custody agreements that permit an adviser to instruct the custodian to disburse or transfer assets. That creates “custody” even if the adviser does not actually give those instructions or the advisory agreement with the client does not permit the adviser to do so.

The fix? The Guidance says to send a letter to the custodian that limits the adviser’s authority and to have the client and custodian provide written consent to acknowledge the arrangement.

The way I read that is to fix the custody agreement.

Staying on the custody theme, the SEC staff issued a no-action letter to the Investment Adviser Association on the use of a standing letter of authorization with a client to transfer assets to a designated third party.

The SEC takes the position that a SLOA grants access to the client’s assets. The transfer instructions come from the client, but the adviser is involved so that invokes custody.

To fix that custody problem, the SEC lays out seven steps that need to be implemented and requires a n update to Form ADV Item 9 next year.

One theme is that the SEC is indicating a willingness to provide relief under the Custody Rule when an adviser has taken steps to mitigate the mitigate potential harms to its clients by these Custody Rule foot-faults.

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The Fearless Girl

The sculpture, titled “The Fearless Girl,” was made by Kristen Visbal and photographed by Federica Valabrega.

State Street Global Advisors conspired in the middle of the night to drop a statue in Bowling Green Park of a girl facing off against the famous Wall Street Charging Bull. It’s part of a campaign by SSGA to emphasize that companies with women in top positions perform better financially.

SSGA manages nearly $2.5 trillion for institutional investors, predominantly in index funds. It has the power to exert enormous influence if it chooses to do so.

“State Street Global Advisors is issuing new gender diversity guidance to the more than 3,500 companies we invest in across three major regions (US, UK and Australia), designed to increase the number of women on corporate boards. As one of the largest investment managers in the world and a significant shareholder we believe that board diversity enhances board quality and effectiveness as it brings together directors with different skills, backgrounds and expertise.”

SSGA is bringing the hammer:

“In the event that companies fail to take  action to increase the number of women on their boards, despite our best efforts to actively engage with them, we will use our proxy voting power to effect change — voting against the Chair of the board’s nominating and/or governance committee if necessary.”

One compliance concern is SSGA’s role as an investment adviser, and therefore a fiduciary. SEC rules give advisers great latitude to set its own proxy voting policy. See Rule 206(4)-6. I would assume from the press release that SSGA has implemented a new written proxy voting policy. I expect that we will see a new description of the policy in the Form ADV filing later this month.

SSGA pulled together research to show that having more women on boards is a better financial choice for companies. MSCI ESG Research’s research shows that companies in the MSCI World Index with strong female leadership generated a Return on Equity of 10.1% per year versus 7.4% for those without (as of September 9, 2015, measured on an equal-weighted basis)

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The SEC Is Using Satellites To Hunt For Fraudsters

I did not find the headline to be remarkable: SEC Charges Mexico-Based Homebuilder in $3.3 Billion Accounting Fraud. The subtitle caught my attention:

SEC Uses Satellite Imagery to Crack Case

We learned from the Rajaratnam insider trading case that the SEC was using wire taps and informants as part of its securities fraud investigations. The SEC is clearly stepping up a notch by using satellites to hunt for fraudsters.

The Securities and Exchange Commission caught Mexico-based homebuilding company Desarrolladora Homex S.A.B. de C.V. in a lie and forced it to admit that it had reported fake sales of more than 100,000 homes during a three-year period. From at least 2010 through 2013 Homex improperly recognized billions of dollars of revenue by systematically and fraudulently reporting revenue from the sale of tens of thousands of homes annually that it had neither built nor sold.

This all comes to late for investors in Homex. Its securities were, until April 2014, dually listed on the New York Stock Exchange and the Mexican Stock Exchange. In 2013 Homex had begun defaulting on its debt obligations and repeatedly failed timely to file quarterly and annual reports with the SEC. In April 2014, Homex filed for the Mexican equivalent of bankruptcy reorganization.

Homex’s Real Estate Project 877 (named “Benevento” and located in the Mexican state of Guanajuato) is illustrates the fraud. Homex’s senior management identified Benevento to the SEC as one of the Company’s top ten real estate development projects by revenue. Homex provided Benevento’s project plan (identifying the location, block and lot number of each planned housing unit), and details (by block, lot number, sale price and sale date) of the Benevento sales that Homex had included in its financial statements. These documents stated that all of Benevento’s planned units had been built and sold, and that Homex had recognized and reported that revenue by December 31, 2011.

However the SEC pulled up satellite images taken in March 2012 that reveal that hundreds of those very same Benevento units remained unbuilt.

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Compliance Bricks and Mortar for March 3

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

Detecting Managed Earnings With CEO Profiles by Tri Nguyen, Chau Duong and Sunitha Narendran in the CLS Blue Sky Blog

We offer the PSCORE, a composite grouping of individual characteristics linked with a higher likelihood of earnings management by prior research. We identified nine individual variables or signals from existing research to develop the PSCORE. These signals or variables can be sorted into four categories: financial expertise, personal reputation, internal power, and age. We used finance-related working experience and qualifications as the signals for financial expertise. The length and performance of a CEO’s tenure as well as how often the media mentioned the CEO were used as signals for personal reputation. The signals for internal power included information about other significant positions a CEO held in a company (e.g. chairman, founder). Age was captured from curricula vitae in the public domain disclosing the actual age and distance from retirement of a CEO. [More…]

SEC Opinions Underused by Enforcement Targets, Official Says by Rob Tricchinelli in Bloomberg BNA

Parties accused of wrongdoing by the SEC don’t take full advantage of the commission’s opinions in guiding their defense, a top agency enforcement official said Feb. 24.

As it handles enforcement cases, the Securities and Exchange Commission often issues legal opinions, which cover many areas of securities laws that federal-court cases don’t reach as frequently.

“It’s really a missed opportunity to not be aware of what they are,” Joseph K. Brenner, chief counsel in the SEC’s Enforcement Division, said at a panel during the Practising Law Institute’s “SEC Speaks” event in Washington. [More…]

Will Blockchain Transform Compliance? by Tom Fox in the FCPA Compliance Report

This is made even more powerful in the area of financial reporting. Typically, a search is “horizontal (across the web) and vertical (within particular websites). What you find can be out-of-date or inaccurate in other ways. On a blockchain, though, there’s a third dimension: sequence. In addition to being able to obtain a historical picture of the company since it was incorporated, you can see what has occurred in the last few minutes.” The authors correctly note, “The opportunity to search a company’s complete record of value will have profound implications for transparency as it brings to light off-book transactions and hidden accounts. People responsible for records and reports will be able to create filters that allow stakeholders to find what they are searching for at the press of a button. Companies will be able to create transaction ticker tapes and dashboards, some for internal use”. This would be extremely helpful in the difficult vetting of third parties around financial information. [More…]

And the Oscar for Control Failures Goes to… by Matt Kelly in Radical Compliance

If a company has multiple versions of a report floating around (which, in abstract terms, is what happened here), that tells me to look more at the risk assessment and control activities. Someone handing an announcer the wrong envelope is not a far-fetched risk to imagine; when you include the sky-high reputation consequences for PwC, it seems like a singularly easy risk to identify and anticipate. (COSO Principle 7: “Identify and analyze risks.”)[More…]

The SEC Is Serious About Protecting Seniors

It was a real estate fraud action that caught my eye, but the victims that kept me reading. The Securities and Exchange Commission filed charges against Paul Garcia and his fund management company, Caliber Capital, for defrauding investors.

Since it was a real estate fraud, it caught my eye. But I didn’t have to dive into the murky waters of what is a security and what isn’t a security. Garcia is alleged to be selling interests in a fund and then not using the money as he said he would. I don’t see any argument that passive interests in an investment fund could be anything other than securities.

Mr. Garcia enticed investors to invest in a golf course purchase and shuffled money to keep things going. Things did not go well and Caliber Partnership filed for bankruptcy in January 2016. The lender foreclosed and the investors are likely left with no assets from the partnership. Even with the underlying asset being real estate, it does not change the nature of the interests.

What caught my eye in the case was the SEC inclusion of one investor in particular in the press release and the complaint:

“The investors included an eighty two-year-old who invested $250,000 in Caliber.”

This may be a common tactic for the SEC to gain sympathy for the investors and to paint the alleged fraudster as being particularly sinister.

I went back to the SEC’s 2017 priorities. One of the priorities for examinations is senior investors and the issues around them. I expect we may see more SEC press releases mentioning the little old lady from Pasadena who got bilking by a fraudster.

If your investors include that little old lady from Pasadena, the SEC is going to use that fact.

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Changes to the Accredited Investor Standard?

The Securities and Exchange Commission has three mandates: (1) protect investors, (2) maintain fair, orderly, and efficient markets, and (3) facilitate capital formation. Regulation of private securities transaction through the accredited investor standard falls squarely in the conflict between these mandates.

The general statement about why certain investors can invest in securities subject to less regulatory oversight is that they are able to handle the risk. The standard for handling risk is the accredited investor standard and it’s based on tests of income or net worth. In theory, if you had a certain amount of money you could handle the risk.

The existing thresholds for an accredited investor were created in the 1980s. The big change was Dodd-Frank that excluded primary residence from the net worth calculation. The income and net worth test are not pegged to inflation and therefore have become more inclusionary over the past decades.

Last week, Acting Chairman Michael S. Piwowar quoted William Graham Sumner’s Forgotten Man in adding his view of securities regulation. He gave his view on accredit investors:

“Distinguishing investors who can fend for themselves from those who cannot is a line-drawing exercise fraught with peril. The Commission did just that in 1982 when it adopted Regulation D, dividing the world of private offering investors into two categories: those persons accorded the privileged status of “accredited investor” and those who are not.”

Here he steps into a fallacy. Or at least what I believe is a fallacy. He tags private placements as “high-risk, high-return securities available only to the Davos jet-set.”

First, the tests for accredited investor are not so high that you need to be in the Davos Jet-set.

Second, private placements are not all high-risk, high-return investments.

Perhaps the SEC is suffering from a lack of data on private placements. Private placements are investments that the issuer can sell to a smaller group of investors without having to go through the cost of a public offering.

Congressional mandates, SEC regulation, and shareholder lawsuits have made being a public company less attractive. There are additional costs and risks with allowing your securities to trade publicly. Until a few weeks ago, a public company had to worry about [the resource extraction rule conflict materials in its supply chain] and how to calculate the pay ratio between the CEO and its workers.

The risk for private placements is really not the loss of capital. It’s loss of liquidity.

Private placements have limited opportunities for investors to achieve liquidity. That generally means a long hold period. If the investor needs cash, the investor will have to look for other holdings to sell to get that liquidity. Private placements do not have a market for resale, so the investor needs to find a willing buyer in secondary sale process or wait for the liquidity event, if one ever comes.

Using income and net worth tests make sense because of the liquidity risk associated with private placements. The accredited investor will more likely have the income or capital to address the liquidity.

Within the world of private placements there are very risk investments and low risk investments when looking at an investors likely return of capital.

For example look at hedge funds, they may be more or less risky than a mutual fund depending on the investing style. As an investor, you have limited opportunities to receive back your investment and any returns. Most hedge limits have significant notice periods for redemption and often limited redemption to a few times each year for investors to get their hands on cash.

There seems to be a lot of focus on the high-risk early stage investing associate with private placements. Those are only good investments if you can make lots of them. You see something like 5% of startups making money and rest essentially going to zero. Assuming those odds, you need to make 20 investments. The accredited investor standard ends up being low if you just focus on those risky investments and ignore the more plentiful lower risk investments.

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Compliance Failure at the Oscars

PwC had a public failure last night, in the worst possible way, during the Oscars telecast. After running nearly 45 minutes over schedule, the final remaining award was for best picture. Warren Beatty and Faye Dunaway were on stage with a red envelope. The duo was presenting the best picture award in celebration of the 50th anniversary of Bonnie and Clyde. 

Mr. Beatty looked confused, perhaps trying to be funny. He passed the envelope to Ms. Dunaway who quickly looked at the movie title on the card and blurted out “La La Land”. She failed to note the mistake that had confused Mr. Beatty.

As Beatty explained onstage:

“I opened the envelope and it said, “Emma Stone, ‘La La Land.’ That’s why I took such a long look at Faye and at you ― I wasn’t trying to be funny.”

The producers and cast of La La Land took the stage and began giving speeches. They managed to get through their speeches before a stage hand jumped into the fray and started looking at envelopes.

PwC has handled the balloting process at the Academy Awards for over 80 years. The failure came in the last step in the process: handing the correct envelope to the correct presenter for the correct award.

It seems clear that Mr. Beatty had the wrong envelope. He realized he had the wrong message inside the envelope. Re-watching the video, he looks into the envelope a second time realizing the card says Emma Stone for LaLa Land. He turned to Ms. Dunaway apparently looking for help, but she plunged ahead.

He didn’t know where to turn to when he had a problem.

PwC failed to monitor delivery of the envelope and failed to put a stop before things went too far. I’m sure critics of audit firms will be able to draw many parallels.

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Can a California Note Be A Security?

Debt instruments can be securities. Section 3(a)(10) of the Securities Exchange Act of 1934 explicitly includes “notes” in the definition of a security, but does not include loans. Federal law uses some variation of the factors stated in S.E.C. v. Howey Co., 328 U.S. 293 (1946) n analyzing whether an instrument is an “investment contract” and therefore a security.

California also has a “risk capital test” to test whether an investment is a security.  That test came out of Silver Hills Country Club v. Sobieski, 55 Cal.2d 811 (1961).

The risk capital test, articulated by the California Supreme Court in Silver Hills Country Club v. Sobieski (1961) 55 Cal.2d 811, 815 describes:

  1. an attempt by an issuer to raise funds for a business venture or enterprise;
  2. an indiscriminate offering to the public at large where the persons solicited are selected at random;
  3. a passive position on the part of the investor; and
  4. the conduct of the enterprise by the issuer with other people’s money.

The test reflects the court’s assessment that the term “security” is defined broadly in order “to protect the public against spurious schemes, however ingeniously devised, to attract risk capital.” (Id. at p. 814.)

The instrument in question in the Black  case was a note that provided:

“(a) In the event the real property located at 177 and 200 North Edgewood Lane, Eagle, Idaho is sold by Borrower, the amount of interest shall be based on the percentage of profits minus expenses Borrower receives from the sale; or “(b) In the event Borrower develops said real property, Lender shall receive two (2) lots based on the tentative map to be selected by Lender. “(c) In the event that neither (a) or (b) take place before one year from the making of this note, the principal together with interest at the rate of ten percent (10%) shall become due and payable at the election of Lender.”

Mr. Black was arguing that the note failed the risk capital test because it was a heavily negotiated agreement and not one that was intended to offered to the public at large. It failed the second prong of the risk capital test.

According to California’s Sixth Appellate District in People v. Black (page 12):

“It is generally accepted that both the risk capital and federal tests may be applied, either separately or together; a transaction is a security if it satisfies either test.”

Black’s argument that it was not a security under Silver Hills failed to find traction. But the court still found that the note was not a security under the Howey test.

The California court found that repayment of the note was not wholly dependent on the efforts of Mr. Black. There was other collateral that may have allowed for some repayment of the note.

Surprisingly, the court comes back to include the nature of the transaction being individually negotiated and not being intended for wide distribution as factor in reaching its conclusion. Although the court rejected Mr. Black’s argument that the Silver Hills risk capital test is muted mooted by the federal Howey test, it seems to still include it in reaching its conclusion.

Perhaps, the court and Mr. Black should have looked at the formula used by the United States Supreme Court in Reves v. Ernst & Young (.pdf). That decision limits the Howey four part analysis of securities to “investment contracts”. Instead, it creates a new framework to determining if a note is a “note” under section 3(a)(10), and therefore a security. This is the Family Resemblance test.

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Can Compliance Be Cool?

John Glenn passed away at the end of 2016. He was a Senator, an astronaut, and distinguished pilot in the World War II and the Korean War. The picture below struck me as one of ultimate cool.

Astronaut John Glenn Relaxing on Deck

Mr. Glenn had just finished orbiting the Earth on February 20, 1962. Doing so in a tin can with less computing than your smart phone. He was the first American to orbit the Earth, the third American in space, and just the fifth human in space. Chunks of his Friendship 7 had been turned to flaming debris, flying past his window on the descent back to the surface, being sacrificed to keep his heat shield in place.

There he is in the picture above, Chuck’s on his feet, aviators, keeping the sun from his eyes and his collar popped, looking like nothing could bother him.

Post Dodd-Frank, compliance became cool. … Okay, maybe not cool, but better embraced. Organizations needed help to navigate the byzantine regulatory frameworks to ensure their organizations were in compliance with the thick rules coming rapid-fire from Washington. Compliance could prevent missteps and protecting their organizations from being turned into flaming debris by regulators and prosecutors.

The Trump Administration looks to be rolling back regulations and whatever “cool” compliance may have gathered could be smashed on the rocks of de-regulation. We still don’t know how far the administration and Congress may go in de-regulation.

The gains of the compliance profession are likely to erode and will never be as cool as John Glenn looks in that picture.

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