Bad Boys The SEC is Coming For You: Supervision Initiative

The SEC’s Office of Compliance Inspections and Examinations’ 2016 Examination Priorities included a focus on individuals with a history of disciplinary events. That priority has been put into action. The SEC issued a new Risk Alert on upcoming examination.

OCIE is undertaking an initiative to examine the supervision practices and compliance programs of registered investment advisers that employ individuals with a history of disciplinary events in the financial services sector. OCIE is calling the new initiative: the “Supervision Initiative.”

Okay so the name is a bit ambiguous. I suppose I may be the only one that it is looking for more interesting names:

  • Downed Hawks
  • Bad Boys
  • Operation Tiger Pit

The Supervision Initiative likely means that firms with bad boys and women are more likely to be subject to examination.

The Supervision Initiative examinations will assess such advisers’ business and compliance practices related to the firms’ supervision of higher-risk individuals in four areas:

Compliance Program “An important component of the examinations is to evaluate whether the advisers foster robust compliance cultures and tone at the top. The tone at the top is critical to setting the ethical environment of the organization and preventing misconduct.”

Disclosures. “Examiners will likely review registered advisers’ practices regarding their disclosures of regulatory, disciplinary, or other actions with a focus on assessing the accuracy, adequacy, and effectiveness of such disclosures.”

Conflicts of Interest. “Particular attention will be given to conflicts that may exist with respect to financial arrangements (e.g. unique products, services, or discounts) initiated by supervised persons with disciplinary events.”

Marketing “Examiners will review a registered adviser’s advertisements including pitch-books, website postings, and public statements to identify any conflicts of interests or risks associated with supervised persons with a history of disciplinary events.”

I would guess that the SEC is looking for firms to have taken extra steps to ensure that those who have transgressed in the past are in better supervision and in a firm that stresses good behavior.

As the SEC insists in disclosures past performance is not indicative of future results. But I think the SEC believes that those who have violated the rules in the past are likely to do so again.

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Compliance Bricks and Mortar for September 16

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

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Wells Fargo CEO Defends Bank Culture, Lays Blame With Bad Employees by Emily Glazer and Christina Rexrode in the Wall Street Journal

He later said through a spokeswoman that when the bank falls short “I feel accountable and our leadership team feels accountable—and we want all our stakeholders to know that.”

Rather, Mr. Stumpf said that some employees didn’t honor the bank’s culture. “I wish it would be zero, but if they’re not going to do the thing that we ask them to do—put customers first, honor our vision and values—I don’t want them here,” he said. “I really don’t.” [More…]

Worst Bar Exam Results Ever? Only ONE Person From This Law School Passed The Bar Exam by Staci Zaretsky in Above the Law

Indiana Tech School of Law threw open its doors in 2013, amid cries that Indiana had no need for another law schoolduring a time when jobs for law school graduates were few and far between. The administration had hoped to enroll 100 students, but only 30 students signed up to attend, and just 27 enrolled. After three years of hard work, by the time Indiana Tech’s inaugural class was set to graduate this past May, 20 students earned a degree from the state’s fifth law school. [More…]

Was This “Whiz Kid” An Investment Adviser? by Keith Paul Bishop in California Corporate & Securities Law

Earlier this week, the Securities and Exchange Commission announced that a self-styled “stock trading whiz kid” and his Los Angeles, California company have agreed to pay $1.5 million to settle a complaintfor violations of Rule 10b-5.  There is an odd disconnect between the SEC’s press release and its complaint.  The press release is headlined “stock newsletter fraud” and repeatedly refers to the defendant’s “newsletter company”.  In fact, the SEC never uses the word “newsletter” in the complaint.  Rather, the SEC alleges that the defendant and his company defrauded subscribers and potential subscribers to an on-line “chat room”, and two stock picking “alert services”. [More…]

Social and Behavioral Sciences Team 2016 Annual Report from the Executive Office of the President (the Nudge Report)

On September 15, 2015, President Obama issued Executive Order 13707, “Using Behavioral Science Insights to Better Serve the American People.” The Order directs Federal Government agencies to apply behavioral science insights—research insights about how people make decisions and act on them—to the design of their policies and programs. The Order also charges the Social and Behavioral Sciences Team (SBST), a cross-agency group of applied behavioral scientists, program officials, and policymakers, with providing policy guidance and advice to Federal agencies in pursuit of this directive

[More…]

The Free-Time Paradox in America by Derek Thompson in The Atlantic

Here is the conundrum: Writers and economists from half a century ago and longer anticipated that the future would buy more leisure time for wealthy workers in America. Instead, it just bought them more work. Meanwhile, overall leisure has increased, but it’s the less-skilled poor who are soaking up all the free time, even though they would have the most to gain from working. Why? [More…]

Trustee Charged As A Failed Gatekeeper

When a fraud is uncovered, the Securities and Exchange Commission not only wants to get the fraudsters, it also wants to get those who should have stopped the fraud: the gatekeepers. Recently, the SEC has brought charges against a fund administrator and fund auditors. The latest is a case against

Château de Crécy-la-Chapelle: Gate

The Securities and Exchange Commission announced that a subsidiary of Oklahoma-based BOK Financial Corporation agreed to pay more than $1.6 million to settle charges that it concealed numerous problems and red flags from investors in municipal bond offerings to purchase and renovate senior living facilities. According to the SEC’s order, BOK Financial failed in its gatekeeper role as indenture trustee and dissemination agent for the bond offerings.

In a case brought last year, the SEC filed charges against Christopher F. Brogdon for dozens of municipal bond and private placement offerings in which investors supposedly earn interest from revenues generated by the nursing home, assisted living facility, or other retirement community project supported by their investment. But Brogdon secretly commingled investor funds instead of using the money to finance the project described to investors in the disclosure documents for each offering and diverted investor money to other business ventures and personal expenses.

According to the SEC’s order, BOK Financial, and a former senior vice president at the bank, Marrien Neilson, became aware of numerous red flags:

  • Brogdon was withdrawing money from bond offering’s reserve funds and failing to replenish them.
  • He had failed to file annual financial statements for the bond offerings.
  • The nursing home facilities serving as collateral for one of the bond offerings had been closed for years.

But Neilson allegedly warned others that disclosing red flags could impair future business and fees from Brogdon, upset bondholders, and cause regulatory issues for bond underwriters. So Neilson and BOK Financial decided not to inform bondholders as required.

BOK Financial settled the charges. Neilson is challenging the charges, so we only have the SEC’s side of the story.

Neilson was the primary recipient of bonus compensation awarded on the basis of the fees paid to BOKF for the Brogdon Bond Offerings. She also received bonus compensation for other bond offerings that financed the sale of Brogdon-owned nursing homes and assisted living facilities to third parties. The SEC charged that she knew or recklessly disregarded that Brogdon was supposed to make disclosures to the bondholders about the red flags.

In the SEC Order, there are numerous emails showing Neilson in a poor light:

“In a March 1, 2010 email to one of Brogdon’s assistants regarding late debt service payments for an offering, Neilson states that the late payment put her “in an extremely awkward position” because “the Reserve Fund has previously been used and not replenished and I did not call a default.” In the same email, Neilson states that “[b]ondholders are going to want to know why we don’t used [sic] the Reserve Fund.” Neilson also states that “we need to disclose the other Reserve funds if they are not replenished,” asking Brogdon’s assistant “if you want a list of them and how much?”

I assume Brogdon was trying to keep his enterprise afloat and Neilson was helping him kick the can down the road. Perhaps a little more debt can buy a little more time to get cash flow positive. That didn’t happen and the debt facilities finally went into default and bankruptcy.

The gatekeeper should have stopped the fraud. Instead, it helped with a dozen more offerings expanding the scope of the fraud.

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Château de Crécy-la-Chapelle: Gate by Baishiya 白石崖
CC BY SA

See the Changes to Form ADV

With all the regulatory changes to Form ADV coming out, I found it tough to figure out what the changes look like on the form. The Securities and Exchange Commission published a helpful redline that highlights the changes.

The SEC is not willing to stand behind the redline, noting:

This document illustrates most of the revisions to Form ADV related to adopted rule release IA-4509. This document should not be considered a complete and comprehensive list of changes to Form ADV.

I think many will find the “separately managed account” portion to be confusing. The first being the use of this term which sounds much like the term, separate account, used in the insurance industry to invest. The borrowing and derivatives reporting will be time-intensive.

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Political Party Contributions and the SEC’s Pay-to-Play Rule

I was looking through an issue under Rule 206(4)-5. The Securities and Exchange Commission limits the ability of investment advisers and fund managers to contribute to certain politicians that can influence investment decisions for state pension funds. Under Rule 206(4)-5, you can contribute up to $150 to any candidate or up to $350 if you can vote for the candidate. I was looking at how that rule applies to political parties.

Section (a)(2) makes it unlawful for an investment adviser or any of its covered associates

(ii) To coordinate, or to solicit any person or political action committee to make, any:
…

(B) Payment to a political party of a state or locality where the investment
adviser is providing or seeking to provide investment advisory services to a government
entity.

So it’s not unlawful to make a contribution to the party, but it’s unlawful to solicit others to make a contribution to the party.

Just to confirm the SEC responses seems to agree with this reading of the rule.

Question V.3. Contributions to Others.

Q: If an adviser subject to the pay to play rule, or one of the adviser’s covered associates, makes a contribution to a political party, PAC or other committee or organization, but not to an official, could the adviser still be subject to a two-year time out under rule 206(4)-5(a)(1)?

A: A contribution to a political party, PAC or other committee or organization would not trigger a two-year time out under rule 206(4)-5(a)(1), unless it is a means to do indirectly what the rule prohibits if done directly (for example, the contribution is earmarked or known to be provided for the benefit of a particular political official) (see footnote 154 of the Adopting Release).

We note, however, that the pay to play rule prohibits advisers and their covered associates from coordinating or soliciting any person (including a non-natural person) or PAC to make any payment to a political party of a state or locality where the investment adviser is providing or seeking to provide investment advisory services to a government entity (see rule 206(4)-5(a)(2)(ii)). (Posted March 22, 2011).

A covered associate at an investment adviser could attend a state political party fundraiser, but not host one.

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California’s Private Fund Disclosure Bill

California’s soon to be enacted new law, AB 2833, requires every California public investment fund to require its alternative investment vehicle fund managers to make disclosures regarding fees and expenses.

welcome-to-california

AB 2833 mandates that that every California public investment fund (that includes CalSTRS and CalPERS) must make the following disclosures at least annually:

  • The fees and expenses the fund pays directly to the alternative investment vehicle, the fund manager or related parties.
  • The fund’s pro rata share of fees and expenses that are paid from the alternative investment vehicle to the fund manager or related parties. In lieu of having the alternative investment vehicle provide this information, the fund may calculate it using information contractually required to be provided by the alternative investment vehicle.
  • The fund’s pro rata share of carried interest distributed to the fund manager or related parties.
  • The fund’s pro rata share of aggregate fees and expenses paid by all of the portfolio companies held within the alternative investment vehicle to the fund manager or related parties.
  • Any additional information already required to be disclosed under the Public Records Act in regards to alternative investments.

The law defines “alternative investment” as “an investment in a private equity fund, venture fund, hedge fund, or absolute return fund.” That leaves me wondering if the term is intended to include real estate funds.

 The bill applies to new contracts that the public investment fund enters into on or after January 1, 2017, and to all existing contracts pursuant to which the public investment fund makes a new capital commitment on or after January 1, 2017.

Sources:

State Line 2-welcome-to-california
CC BY
Phillip Capper from Wellington, New Zealand

Compliance Bricks and Mortar for September 9

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

bricks curvy

Whistle-Blowing Insiders: ‘Game Changer’ for the S.E.C. by Peter Henning in DealB%k

Since the program’s creation in 2011, the S.E.C. has received more than 14,000 tips, including almost 4,000 last year. That number falls well short of the original estimate of 30,000 submissions each year, but quality is far more important than quantity. Not surprisingly, agency officials heap praise on the program. Mary Jo White, the S.E.C. chairwoman, called it “a game changer for the agency,” while the director of the enforcement division, Andrew J. Ceresney, said that whistle-blowers “had a transformative impact.” [More…]

Tribute to Star Trek and Anti-Corruption Programs by Tom Fox in FCPA Compliance & Ethics

The Original Series, now termed Star Trek – The Original Series (TOS), largely worked because of the interplay of the show’s three main characters, Captain Kirk, Mr. Spock and Dr. McCoy as representations of the Greek terms ethos, pathos and logos.

…

All of this dovetails into compliance as well. The three basic tenets of a best practices compliance program are to prevent, detect and remedy. [More…]

Is this the first shot in the SEC’s war against social media? by Joshua Horn in Securities Compliance Sentinel

The SEC can also use this information on an ongoing basis to assess what firms are putting out there on social media. The industry has to assume that the SEC will be doing more with this information than just tucking it away for examination purposes.Core Values

This new rule should incentivize you to review your social media policy, assuming that you have one. If you do not have one, you need to have one prepared. [More…]

Is This The SEC Or The Lotto? by Keith Paul Bishop in California Corporate & Securities Law

The SEC’s total payout is impressive, but the number of payees is extremely small. According to the SEC, awards were paid to only 33 persons. Moreover, 77.6% of the payout, or $83 million, went to just 4 whistleblowers. From inception through fiscal 2015, the SEC received a total of 14,116 whistleblower tips and made payments to 22 persons. Based on these numbers, the probability of receiving an award is 0.00155. In comparison, the California Lottery posts the odds of winning $10 on its $1 “Set For Life” Scratchers game at 0.00962, or more than 6 times better. [More…]

Joe Murphy to courts and regulators: Stop undermining compliance by Joe Murphy in the FCPA Blog

But there is a nasty little secret behind this conclusion. The legal system, which is supposed to help prevent business crime, actually undermines company compliance efforts. Instead of providing substantial incentives and recognizing the value of our work, there are strong undercurrents that undermine our efforts. [More…]

 

Is The SEC “Kicking and Mutilating The Corpse”?

I have a written a few stories on the SEC’s case against Louis Schooler and his firm, Western Financial Planning Corp. The Securities and Exchange Commission brought charges against them for a real estate investment scheme. Schooler was selling general partnership interests that owned real estate using what looked like inflated valuations.

hylas

By default general partnership interests are not securities, but the judge found that a general partnership could be an investment contract (and therefore a security) if one of three factors is present.

(1) the general partnership agreement leaves so little in the hands of the partners that the arrangement in fact distributes power as would a limited partnership;

(2) the partners are so inexperienced and unknowledgeable in the general partnership business affairs that they are incapable of intelligently exercising their partnership powers; or

(3) the partners are so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that they cannot replace the manager of the enterprise or otherwise exercise meaningful partnership or venture powers.

Schooler has continued to fight the decision, but has been hit with having to pay $150 million in disgorgement.

The SEC took an additional approach and sought to bar Schooler from the securities industry. That raised my eyebrow because Schooler does not think he is in the securities industry. He is claiming to be selling real estate interests. I’m not sure how much the bar would work. It’s a bit of a circular argument.

It does not seem to matter because Schooler decided to take some time off and go sailing in the South Pacific on his Hylas 42 sailboat: Entertainer. I’m sure that the many people who lost money in Schooler’s investment scheme have some bad thoughts of that image of him sailing alone in the tropical breeze.

Those investors are likely believing in karma now. Schooler did not appear for the ruling. He has gone missing in the South Pacific.

That did not stop the SEC from finalizing the industry bar. It also lead to his lawyer’s charge that the SEC’s Enforcement Division “is acting out of pure vengeance and spite, akin to not only killing a person, but kicking and mutilating the corpse.”

The SEC’s response:

“[T]here has been a report that Schooler’s yacht ran aground on a reef in or around Tahiti, no remains were recovered, and no death certificate has been issued. At present the U.S. State Department considers Schooler to be missing rather than dead.

I’m sure that there are many, like me, wondering if this is straight out of a movie. Did Schooler set up an elaborate scenario to fake his own death? Latitude 38 says some circumstances of the shipwreck are suspicious.

Neither scenario does anything to help those who lost money by investing with Schooler.

Sources:

 

 

Weapons of Math Destruction

With big data, comes formulas to parse through the data trying to make sense of it. Those algorithms can help make sense of the data and help filter through the noise to find trends. But those algorithms can also be easily misused and have harmful, if unintended consequences. Cathy O’Neil explores these problems in Weapons of Math Destruction.

weapons of math destruction

Ms. O’Neil is a former academic, hedge fund quant, and data scientist for startups. At the hedge fund she was looking at ways to make money by predicting financial trends. As a data scientist she was looking to predict people’s purchases and browsing habits to monetize those habits. Those are good algorithms where the people using them understand them and update the algorithms as they see problems and can check to see if they are working properly by verifying outcomes.

Many data driven outcomes fail. Those are the focus of Weapons of Math Destruction.

I’m a big fan of the Slate Money podcast with Cathy O’Neil, Felix Salmon, and Jordan Weissmann. When the publisher offered me a review copy of Ms. O’Neil’s book, I jumped at the chance.

It’s a short book and even though the title makes it sound like it’s full of math, it’s not. It’s more about social policy. She points to the danger of decision makers blindingly following algorithmic output that they do not understand.

Take the US News and World Report listing of best colleges. This is preeminent guide for high school students trying to figure out which college to attend. The rankings do not look at actual student outcomes. The publisher does not look at happiness, learning or improvements. It looks at proxies for the outcomes like SAT scores, alumni contributions, and graduation percentages. Colleges started making decisions to improve their rankings in the algorithm by improving those measured proxies. As anyone writing checks for their college bound children, affordability is not one of the measured proxies.

As you might expect there are big chunks of the book dedicated to failings in the financial sector by relying on poorly designed algorithms. The biggest problems often being false assumptions plugged into the data running through the algorithm.

With the election season upon us, the chapter on political algorithms is fascinating. The data scientists of commerce were brought into political campaigns. They are able to micro-target potential voters sending different messages to different groups highlighting the positions that would make the candidate more favorable to that segment of the population. Civic engagement and the political process is increasingly being algorithm driven.

Since our world is increasingly being driven by big data, it’s important to understand what is happening behind the decision-making. Weapons of Math Destruction is an excellent tool to help you understand data driven decision-making.

Compliance Bricks and Mortar for September 2

These are some of the compliance-related stories that recently caught my attention. Maybe you need something to read over Labor Day Weekend?

pavement-1265179_1280

Conflicted Feelings About Conflict Minerals by Matt Kelly in Radical Compliance

Don’t die of shock, but a new government report finds that compliance with the Conflict Minerals Rule is still sputtering.

That’s the overall conclusion of the latest Government Accountability Office review of conflict minerals compliance, which is pretty much the same conclusion as last year’s GAO report. Companies are marginally better at determining where their conflict minerals come from. They are not any better at determining whether their conflict minerals somehow fund African warlords.  [More…]

Companies Lack Active-Shooter Plans by Ben Dipietro in the WSJ’s Risk & Compliance Journal

A survey of about 900 organizations found while 69% of respondents listed an active-shooter situation as one of the biggest threats to workplace safety, 39% said their organization doesn’t have a communications plan in place to deal with such an incident. Even at those organizations that do have a plan, 79% said their organization isn’t fully prepared. The survey from critical communications services provider Everbridge Inc. highlights the risks companies face as they try to protect employees and others from potentially deadly office attacks, said Imad Mouline, Everbridge’s chief technology officer. [More…]

Why You May Want To Reconsider Promising Confidentiality To Whistleblowers by Keith Paul Bishop in California Corporate & Securities Law

The scope of the promise may be unclear.  Often, the promise of confidentiality is as succinct as “All reports and disclosures you make under this Code of Ethics will remain confidential unless required to be disclosed by applicable law.”  The company may believe that it is agreeing not to disclose the reporting person as the source of the disclosure.  The reporting person may take the position that the company has agreed not to disclose either the fact of the report or its substance, particularly when either may serve to identify the whistleblower. Misunderstandings about what was and was not promised may lead to litigation [More…]

Ethics for ethicists? A Code of Ethics and Compliance Professionals by Joe Murphy in the Compliance and Ethics Blog

As children we learn the story of the cobbler’s children. The person who makes the shoes for the village is the one whose children lack shoes. It is an ironic picture—those whose job is to provide a product in fact do without the product themselves. And yet, in the compliance and ethics field, where we spend our days telling corporate clients how to act legally and ethically, and we routinely push them to adopt and apply codes of conduct, do we follow this advice ourselves? [More…]

The Hedge Fund Trader Who Beat the Feds by William D. Cohan in Fortune

Hedge fund manager Todd Newman’s successful career was upended when he was prosecuted for insider trading. After his conviction was thrown out on appeal, the case became a landmark in Wall Street regulation. An inside look at what it’s like to be stalked by the feds—and not back down.[More…]