Compliance Building

Compliance Bricks and Mortar for June 17

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

Power plants are no longer America’s biggest climate problem. Transportation is. by Brad Plumer in Vox

Here’s an important energy milestone: For the first time since 1979, America’s cars, trucks, and airplanes emit more carbon dioxide than its power plants do. … But power plants are only about one-third of America’s CO2 emissions. Transportation, another third (and now the biggest source), remains much tougher to address. In fact, since 2013, transport emissions have been creeping upward again. [More…]

You won’t believe what gets an email flagged at Goldman: CNBC has the list by Eamon Javers

CNBC has obtained a document detailing more than 180 phrases flagged for scrutiny by the monitoring system. The document was produced in 2008, and the firm has updated its search terminology since then. But the list gives a rare peek inside a large bank’s real-time compliance surveillance operation, and reveals details of how that process works that even veteran Wall Street executives may not know. [More…]

The Orlando Tragedy and the Compliance Profession by Michael Scher in the FCPA Blog

The vigil in Florida’s state capital is one of many around the world. It’s in an old church. LGBT folks and families surround me. Police are here but I still feel threatened, checking the exits just in case. Is this the way LGBT kids feel; why they go to Pulse to feel normal, have fun, not be another target after so many? It’s crazy. They shouldn’t have to live this way. Slaves from near-by plantations made the bricks and built this church long ago. America can do better. – See more at: http://www.fcpablog.com/blog/2016/6/15/mike-scher-the-orlando-tragedy-and-the-compliance-profession.html#sthash.9kYaG9mA.dpuf [More…]

SEC Morgan Stanley Cybersecurity Enforcement Action: Key Takeaways by John Reed Stark

There are a slew of important takeaways from the SEC action, especially that cybersecurity failures can, and will, happen to any financial firm. And in this instance, after recognizing its cybersecurity failures, Morgan Stanley did just about everything right. Even better than right – Morgan Stanley actually excelled in its response. [More…]

Whistleblowers: No Reasonable Belief of Violation, No Protection by T. Gorman in SEC Actions

A recent decision by the eighth circuit court of appeals now adds to the debate over who can qualify as a whistleblower. Beacon v. Oracle America, Inc., No. 15-1729 (8th Cir. Decided June 6, 2016). There the court concluded that one must “establish that a reasonable person in his [the whistleblower’s] position, with the same training and experience, would have believed . . .” that the conduct complained of violated the federal securities laws to be engaged in protected activity. [More…]

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Last weekend I rode in the B2VT. It was a grueling bike ride over 130 miles from the historic battlefields of Lexington to the Okemo Mountain in Vermont. I decided to ride because of my friend Jeff. He enjoyed big challenges and I loved taking on big challenges with him.

Jeff was diagnosed with cancer just before Thanksgiving. This terrible disease killed him just after the New Year. I’m riding the Pan-Mass Challenge raising money to fight cancer. I would appreciate your support. [Donate Here] Jeff’s birthday would have been this week. As a gift to my lost friend, I’m matching any donations I receive this week until I reach my fundraising goal.

Jeff would have loved the B2VT ride, especially once it took a turn for the worse. At mile 80, the already cool day turned cold in the mountains of New Hampshire and Vermont. Then cold rain came down in buckets and only occasionally relented to drizzle.

It reminded of the time Jeff and I competed in the Boston 24 Hour Adventure Race. In the middle of the night while trying to navigate to the waypoints in Blue Hills, it started raining. He quoted the line from Caddyshack: “I’d keep playing. I don’t think the heavy stuff’s gonna come down for quite awhile.” So we kept going and pushing on to the finish.

Back to this weekend, many riders in the B2VT were cursing the rain. Me too. It felt more like October than June. Riders were hurting. Some were starting to experience hypothermia. I pedaled on. If Jeff was still alive and along side me I know what he would have said: “I’d keep playing. I don’t think the heavy stuff’s gonna come down for quite awhile.” So I kept playing.

It’s what Jeff would have wanted.

I can’t think of a better way to remember him than to to ride for him and raise money to fight what killed him. Maybe we can help save the next person.

[Donate Here]

Compliance Lawyers and Legal Education

I had an interesting discussion on the possible role of law schools in helping train law students for jobs in the compliance field. Compliance does not require a law degree, but there seems to be a demand for compliance professionals with legal degrees in the mid and higher levels, particularly in highly regulated industries.

legal education law school

Part of the discussion was about compliance as a distinct discipline. There seemed to be little disagreement about. There were differing viewpoints about the nature of discipline and the profession. That seems normal because there are differing requirements depending on the field and the role within a particular organization.

Can law students be taught compliance? The answer, in part, depends on an approach to teaching the law.

When I was a law student, the basic approach was case law. We studied appellate case decisions. These were instances where something went wrong, someone was angry enough to bring a case, fought it out in court and then appealed the decision. To me, that seems the opposite of compliance. That teaches you how to deal with a situation and argue the positions after the bad thing happened. Compliance is about preventing the bad thing from happening.

Several people mentioned that they had gotten letters to supplement their compliance credentials. I got my IACCP^®. Others mentioned CCEP and other credentialed designations.

There is a demand for something beyond or different than a legal degree to grow a compliance professional. There is a potential role there for law schools. I know that Seton Hall has certification programs in compliance for healthcare.

I also note that several law school are involved with the Compliance Certification Board Accrediting Program:

Charlotte School of Law, Charlotte, NC

Cleveland Marshall College of Law, Cleveland, OH

Cumberland School of Law – Samford University, Birmingham, AL

DePaul University College of Law, Chicago, IL

George Washington University, Washington DC

Mitchell Hamline School of Law, St. Paul, MN

Widener University Delaware Law School, Wilmington, DE

I would guess that more law schools are looking at compliance as way to add value to the legal education. The classic role of placing graduating law students into the big law firms is a shrinking market. I heard that one law school has gone from placing 70% of its graduates into the biggest law firms to only 30%, while at the same time shrinking class size and maintaining its rankings.

UC Irvine Law School
By Mathieu Marquer
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Investment Fraud and Online Dating

Most good financial advisers will tell you that referrals are their best source of business. The same is true for fraudsters. Affinity fraud is just using a network to funnel new “investors” into a fraud. The Boston office of the Securities and Exchange Commission brought charges against an alleged fraudster using an unusual network.

The SEC alleges that Thomas J. Connerton told investors that his company, Safety Technologies LLC, was developing a material to make surgical gloves better resistant to cuts or punctures. He claimed that several major glove manufacturers wanted the technology and Safety Technologies was on the brink of imminent deals that would result in large payouts for investors in his company. But no deals have ever been anywhere close to materializing.

Instead, the SEC alleges that Connerton has been emptied the company’s bank accounts for his own expenses. Those expenses include a $20,000 for an engagement ring for his latest online date.

She is also an investor.

Of the 50+ investors in the company, six are women Connerton met through online dating. There are 14 others who are family or friends of those women. A third of his “investors” and half of the money are tied to Connerton’s online dating activities.

And you thought your ex had problems.

Sources:

Weekend Reading: The Fever of 1721

We are all familiar with the Founding Fathers and the events that lead to the American Revolution. Stephen Coss points to events in 1721 as the seeds of that revolution two generations later in his new book: The Fever of 1721.

The Boston of 1721 was already full of conflicts between American colonists and the British crown that would lead to the revolution 50 years later. The royal governor, Samuel Shute, quickly came into conflict with Massachusetts legislature. The crown appointed the governor, but the local legislature was in charge of his compensation. The legislators voted to pay the new governor no salary. This lead to the Massachusetts colony’s government being paralyzed by dissent. The Abenaki Indians were become actively hostile as the colony continued to grow and settle further and further into New England and the natives’ lands. War was increasingly likely. The financial markets were a mess with a crippling currency shortage. The English financial markets were suffering from the bursting of the “South Sea Bubble”.

In April 1721, the Seahorse, a British navy frigate, sailed into Boston harbor after hunting pirates. But it carried a deadly cargo: smallpox. In the 17th and 18th century, towns like Boston were struck by a smallpox epidemic ever decade or so. The Seahorse was supposed to dock at Spectacle Island to prevent infection. But the quarantine procedures failed. One fourth of Boston’s population contracted smallpox, and almost 10% of the population died.

A local clergyman heard the tale of one of his family’s African slaves about the West African method of inserting pus from a smallpox victim into an uninfected person. The recipient would gain immunity while usually suffering only a mild form of the disease. The clergyman began advocating for this treatment.

However, the clergyman was Cotton Mather, one of the main players in the Salem witch trials. He had to overcome the public’s suspicion of him and the overt racism of relying on an African method as a legitimate medical procedure.

The local papers were involved in the controversy about this medical procedure. Perhaps the biggest flamethrower of publishing in Boston was James Franklin, publisher of the New-England Courant, and his younger brother/apprentice, Benjamin Franklin. The Courant was trying to operate as an independent newspaper, published without government license. It criticized the vaccination procedure as well as Boston’s government and influential citizens. The Franklin brothers thought the medical procedure would just further spread the disease and unnecessarily kill the patients.

The Fever of 1721 pulls together these tales of medical innovation, freedom of the press, government strife, and economic crisis. I had not heard of this portion of Boston’s history and found the stories to be fascinating.

I’m a sucker for books on Boston history and took a copy from the publisher in exchange for a review.

Compliance Bricks and Mortar for June 10

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

Pigeon at Castelvecchio Verona

U.S. Offers Rare Account of Why It Didn’t Pursue Bribery Charges by Samuel Rubenfeld in WSJ.com’s Risk & Compliance Journal

As the Securities and Exchange Commission announced it reached non-prosecution agreements in two unrelated foreign-bribery cases, the U.S. Justice Department took the rare step of releasing letters sent to the companies explaining why it decided to close the cases without filing charges.

The companies — Cambridge, Mass.-based internet-services provider Akamai Technologies and Providence, R.I.-based home-security and thermostat systems-maker Nortek — both agreed to forfeit ill-gotten gains connected to bribes paid to Chinese officials by foreign subsidiaries, the SEC said. Both companies self-reported the misconduct and they cooperated extensively with SEC probes, the SEC said. [More…]

The Panama Papers and Shell Games, Part I by TOm FOx in the FCPA Compliance & Ethics Report

All of this is not simply about performing adequate due diligence so that you will know with whom you are doing business. Internal corporate investigators need to be aware of how shell corporations are set up to help detect fraud in their own organizations. In his piece Hubbs cited to a Department of Justice (DOJ) Press Release from then Deputy Assistant Attorney General Bruce Swartz around the resolution of the Hewlett-Packard (HP) FCPA resolution for the following, “Hewlett-Packard subsidiaries created a slush fund for bribe payments, set up an intricate web of shell companies and bank accounts to launder money, employed two sets of books to track bribe recipients, and used anonymous e-mail accounts and prepaid mobile telephones to arrange covert meetings to hand over bags of cash.” [More…]

The First Form 1-Ks Are Filed! by Broc Romanek in TheCorporateCounsel.net

Hat tip to Bjorn Hall of Fundrise for letting me know that the Fundrise Real Estate Investment Trust, LLC (which they lovingly call the “Income eREIT”) filed the first-ever “Annual Report on Form 1-K” back in late April. Under Rule 257(b)(1) of Regulation A, Form 1-K is the annual report now required to be filed by Tier 2 companies that conducted their offerings under Regulation A+. The form is due within 120 calendar days of fiscal year covered by the report. Only Tier 2 companies are required to file a Form 1-K, one of trade-offs for not having to register with the states. Since Fundrise made their filing back in late April, there have been four other Form 1-Ks filed. [More…]

Prostitutes, vacations and cash: The Navy officials ‘Fat Leonard’ took down by Craig Whitlock and Kevin Uhrmacher in The Washington Post

Leonard Glenn Francis, a Malaysian defense contractor, has pleaded guilty to bribing “scores” of Navy officials with cash bribes, prostitutes and other gifts – such as hotel stays, airfare and electronics – so they would feed him classified or inside information, which he used to defraud the Navy. The slowly unfolding investigation has exposed a staggering degree of corruption within the Navy. [More…]

If you enjoy Compliance Building, please support my Pan-Mass Challenge ride to fight cancer. You can read more and donate here: https://www2.pmc.org/egifts/DC0176

Pigeon at Castelvecchio, Verona by Andy Hay
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Charging Fund Investors For In-House Legal Staff

In house lawyers fall into two sections of typical fund documents. On one had, fund documents usually state that the fund pays for legal expenses. Another section states that the general partner is responsible for employee expenses.

Can you charge in-house legal staff as a fund expense?

It depends.

This was mentioned by Marc Wyatt, Deputy Director – Office of Compliance Inspections and Examination, US Securities and Exchange Commission, at PEI’s Private Fund Compliance Forum 2015.

It’s not that a fund manager is prohibited from charging its fund clients for in-house legal counsel. As with any fee or expense, it needs to be properly disclosed and properly documented.

I have heard that at least one real estate private fund manager has received a deficiency letter after an examination because of the way it treated legal expenses. The fund manager charged internal legal staff compensation and expenses to the fund.

The SEC relied on the provisions in the fund documents stating that overhead, including compensation of personnel, is to be paid by the general partner / fund manager.

The general partner / fund manager pointed to other language that stated it could charge the funds for legal expenses.

I think the SEC thinks that in the case of a tie, the fund investors should win.

If you charge in house legal fees to fund investors, there are some steps a fund manager should take:

Disclose it on Form ADV.
Disclose it in the financial statements for the funds. To be in accordance with GAAP, related party transactions must be included in the notes to the financial statements.
Maintain timesheets and other documents to support the time or work of in-house legal staff.
Maintain written policies and procedures to address when the expenses should be paid by the fund and when they should be paid by the fund manager.

It may not actually be costing the fund any more for in-house versus outside cost. In fact, it may actually be cheaper. But it is extra revenue to the fund manager. The SEC has indicated that it cares about that difference.

Fraud, But Is It Securities Fraud?

Although the Securities and Exchange Commission gets blamed for not bringing enough fraud claims, it’s jurisdiction is limited to securities fraud. When I see a real estate case filed by the SEC I pay attention. The case against Richard W. Davis, Jr. brought the “What is a Security?” questions out.

mountains

The SEC alleges that Richard W. Davis Jr. breached his fiduciary duty and had conflicts of interest using investor money to enter into transactions with entities he beneficially owned or controlled. The SEC further alleges that Davis made false or misleading statements to investors before and after they made their investments, failed to inform investors of their losses, commingled funds and took more management fees than was allowed.

Davis sold interests in two funds and he marketed them as investing in “hard assets” like real estate and mineral rights. I will assume those interests are securities. Mr. Davis would have needed to comply with the private placement requirements. According to the complaint, he did not do so.

The complaint labels the funds as “pooled investment vehicles” within the meaning of Rule 206(4)-8(b) of the Advisers Act, 17 C.F.R. § 275.206(4)- 8(b):

(b) Definition. For purposes of this section “pooled investment vehicle” means any investment company as defined in section 3(a) of the Investment Company Act of 1940 (15 U.S.C. 80a-3(a)) or any company that would be an investment company under section 3(a) of that Act but for the exclusion provided from that definition by either section 3(c)(1) or section 3(c)(7) of that Act (15 U.S.C. 80a-3(c)(1) or (7))

To be an “investment company”, the pooled fund would need to invest in securities. A pooled fund that invests mostly and directly in real estate would fall outside the definition of an investment company.

The complaint is short on the details other than the bad acts alleged by the SEC. The issue is not contested since Mr. Davis agreed to settlement.

Sources:

Mountains National Bison Range Montana
By Jaix Chaix
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Compliance Bricks and Mortar for June 3

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

bricks

How the Feds Pulled Off the Biggest Insider-Trading Investigation in U.S. History by Patricia Hurtado & Michael Keller in Bloomberg

For more than seven years, the U.S. government has relentlessly prosecuted Wall Street traders who used inside information to rake in hundreds of millions of dollars in profits.

Federal prosecutors in New York have racked up 91 convictions and collected almost $2 billion in fines. In the latest action on May 19, the government looked beyond Wall Street, accusing a legendary Las Vegas gambler of profiting from insider tips.

Here’s a by-the-numbers look at what happens when the Feds get serious about insider trading. [More…]

The Most Powerful Man in Banking by Ryan Tracy and Emily Glazer in the Wall Street Journal

The most important person in the banking business isn’t a banker.

To most Wall Street executives, that title goes to Federal Reserve governor Daniel Tarullo, a brusque, white-haired former law professor who has come to personify Washington’s postcrisis influence over how banks do business.

Mr. Tarullo heads the Fed’s Committee on Bank Supervision. On paper—and in practice for most of the previous decades—the post isn’t a hugely powerful one. But the 63-year-old took office at the Fed in 2009 at a moment of broad public support for a more aggressive tack and has pressed that advantage ever since. [More…]

The Wall Street Golden Boy Who Allegedly Fleeced His Friends and Family by William D. Cohan in Vanity Fair

Groomed at Groton, Princeton, and Harvard Law, financial expert Andrew Caspersen had the trust of everyone around him. So why, as prosecutors allege, would he start a fraudulent investment that targeted his Wall Street buddies and even his own mother? William D. Cohan delves into the case and the two tragedies—the death of Caspersen’s fiancé on 9/11 and his father’s suicide—that could provide an answer. [More…]

Want to Work in Compliance – Learn How to Read a Balance Sheet by Tom Fox in the FCPA Compliance & Ethics Report

One of the most interesting tag lines I heard at Compliance Week 2016 was the following, if you want to work in my compliance department; you need to learn how to read a balance sheet. I thought that single line encapsulated the change in the compliance function over the past few years more than any other. Why, because it speaks to the change of compliance from being centered in the legal department, run by lawyers as a rules based program, to fully understanding that compliance is a business process that needs to centered in its own discipline. For if you cannot read a balance sheet you cannot bring a positive value to a business unit. [More…]

If you enjoy Compliance Building, please support my Pan-Mass Challenge ride to fight cancer. You can read more and donate here: https://www2.pmc.org/egifts/DC0176

Doug with Team Kinetic Karma, stopping at the Scituate Lighthouse, on our Memorial Day Weekend Training Ride

Private Equity Fund Managers and Broker Dealer Registration

The Securities and Exchange Commission has been poking around fees earned by private equity firms and found many to its distaste. One item the SEC has highlighted in the past was fees for acting as a broker dealer. I’ve been waiting to see if the SEC’s distaste would be enough to bring an enforcement action. The SEC has brought that case.

Blackstreet Capital Management paid itself transaction based compensation in connection with acquisition and disposition of portfolio companies. The fund documents permitted this fee.

Blackstreet purchased and sold securities on behalf of its private equity fund and earned a transaction based fee for those services. Those services included soliciting deals, identifying buyers or sellers, negotiating and structuring transactions, arranging financing, and executing the transactions. Those transactions would have largely been securities that Blackstreet was buying and selling for its private equity fund.

The problem is that those services look a lot like the services of a broker dealer. By collecting transaction based compensation, it seems to fall right into the definition of broker dealer.

“The rules are clear: before a firm provides brokerage services and receives compensation in return, it must be properly registered within the regulatory framework that protects investors and informs our markets,” said Andrew J. Ceresney, Director of the SEC Enforcement Division. “Blackstreet clearly acted as a broker without fulfilling its registration obligations.”

The charge is not for improperly charging fund investors. The fee was disclosed in the fund documents and presumably Blackstreet was charging an appropriate fee. The SEC charge is merely because Blackstreet was not registered as a broker dealer.

There are other issues disclosed in the order, so its not clear if the SEC would bring an enforcement action solely because of this issue. It is clear that the SEC is sending a signal.

Sources:

Delaying Losses To Earn Current Fees

Fee structure is a guiding force for how fund managers operate and a keystone for compliance professionals. A compliance professional needs to focus on ways that a fee structure could cause the fund manager to act to the detriment of fund investors. The Securities and Exchange Commission just charged a fund manager for using distorted timing to generate more fees.

Cash in the grass.

According the SEC complaint, Hope Advisors and its principal owner, Karen Bruton, distorted the trading patterns of its hedge fund it managed to maximize fees to the detriment of fund investors. Hope Advisors and Ms. Bruton are challenging the charges so I’m looking at the complaint as an example of problematic behavior and not that they actually did these things.

Hope was entitled to an incentive fee of 20% of any realized gains during the previous month. But first the fund needed to make up for any realized losses. Unrealized gains and unrealized losses were not used in calculating the incentive fee.

The PPM for the fund discloses that the incentive fee may be paid even though the fund is experiencing unrealized losses.

According to the SEC, Hope was causing the fund to realize gains currently by deferring current unrealized losses through options. The fund would sell call options in the current month, earning a fee, and buy an equivalent set of options that expired in the next month. The SEC claims that there was no economic substance to the trades because there was little chance to make or lose money regardless of the market’s direction.

The fund would keep kicking the unrealized losses into the next month, while still taking fees. The fund had an NAV of $136 million, with unrealized losses of $57 million.

According to the statements in the complaint, it seems that Hope was acting to the detriment of fund investors. However, this behavior and risk is disclosed in the PPM.

Is disclosure enough for this circumstance?

I think trades that have no economic benefit (or risk) to the fund investors but are done merely to increase a fund managers compensation are suspect. Compliance professionals should look closely to see if the trade is merely done to benefit the fund manager.

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