Videogame Failure and Securities Fraud

As a Red Sox fan, Curt Schilling is an iconic player to me, leading the team to break the curse of the Bambino. I don’t think that leads to him being a successful entrepreneur or video game developer. Nonetheless, he invested a great deal of his own wealth and raised a big pile of capital to create 38 Studios and start production of a massive multi-player video game. Despite his greatness as a pitcher, he was not able to close the deal and publish the game. The company folded and laid off its employees.

Now the Securities and Exchange Commission has brought charges of securities fraud in connection with the raising of capital.

schilling sock

Rhode Island was looking to bring jobs to the state and lured 38 Studios to relocate to the Ocean State. The Rhode Island Economic Development Corporation agreed to issue bonds and raise $50 million of capital for 38 Studios through a $75 million offering. The remaining $25 million was for offering expenses and a reserve fund.

The EDC hired Wells Fargo as the placement agent to sell the bonds. However, Wells Fargo had already been hired by 38 Studios to raise capital. According to the SEC complaint, the bond offering documents should have disclosed more about Wells Fargo’s role and how much it was getting paid.

The other problem was that the bond offering was not enough money to finish production of the video-game.  The original projection was for the full $75 million to go to 38 Studios. By only getting $50 million, it had a capital shortfall. It would run out of money by the end of 2011. According to the SEC complaint, the offering documents should have disclosed this shortfall and did not.

38 Studios managed to last longer than projected. It did not default on the bond payments until the Spring of 2012. Then it filed for bankruptcy in June 2012.

The SEC does not spell it out, but clearly the myth of Curt Schilling was the selling point for the deal. Wells Fargo’s ability to sell the bonds was based on the myth of Curt Schilling.

The ability of 38 Studios to successfully produce a videogame was a myth. The job creation behind the bond offering was myth. According to the SEC suit and various other lawsuits it looks like a lot of people thought they could make money from the myth of Curt Schilling.

The first tenet of our securities laws is disclosure. Making money from the myth is not inherently illegal. Failing to disclose is.

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Phishing for Losses

You’re security is only as secure as your employees. I was struck by this when I received an email from the head of my firm wanted to discuss a wire. I was being subject to a phishing attack.

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I think we all see this often. Personally, I always find it curious when a bank sends me an email with a a warning about my account. I’m not worried since I don’t have an account at that bank. Of course that also leads to me ignoring emails from my own bank.

I pay a bit more attention when the CEO sends me an email.

Email business scams may caused more than $2 billion in losses over the last two years.

It’s not just advisers or fund managers that need to worry. At least one publicly listed company has suffered a loss from this scam. The company had to admit in it’s quarterly report that $46.7 million had gone missing.

As good as a firm’s systems may be to deter external threats and hackers, it’s the social engineering attacks at a firm that are becoming more successful.

Convincing an employee to authorize a wire takes less technical skill than hacking into a firm’s network. It all starts with a simple email.

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Whistleblower Revealed

Several weeks ago the Securities and Exchange Commission handed out a big whistleblower award to an industry expert who lacked the first person knowledge of wrongdoing. That whistleblower has been revealed.

Close-up Of Metal Sport Whistle On American Flag

The SEC itself has a strict rule on disclosing the identity of whistleblowers. Eric Hunsader said the Securities and Exchange Commission is sending him a $750,000 whistleblower award according to Francine McKenna of Marketwatch.

The SEC fined the New York Stock Exchange and its parent NYSE Euronext in 2012 for violating Regulation NMS. The NYSE sent data through two of its proprietary feeds before sending that data to the consolidated feeds, according to the SEC.

Hunsader said his firm, Nanex, originally discovered the issue on the day of the flash crash, May 6, 2010: Analysis of the “Flash Crash”.

With high-frequency trading small delays in quotes can lead to dramatic changes in trading. The NYSE data feed was delayed because of the diversion, resulting in the quotes being time-stamped improperly. This inaccuracy in data lead to a flood of short-selling causing prices to drop dramatically.

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Compliance Bricks and Mortar for February 26

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

brick drain

 

Protecting the Compliance Officer: A Balanced Approach by Michael W. Peregrine in Corporate Counsel

From a governance perspective, it matters not that these chief compliance officer (CCO) enforcement actions appear to be narrowly focused in particular industry sectors. Rather, what matters is the potential these actions may have to more broadly destabilize the role and function of the compliance officer. The job is hard enough as it is. Should compliance officers feel (fairly or unfairly) that they are exposed to regulatory sanction for simply errors of omission or commission, the job will become even more challenging. Interest in compliance positions–especially in heavily regulated industries–may decline. Companies will be frustrated in their attempt to maintain effective compliance programs if they are unable to attract and maintain qualified, experienced compliance officers.
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Expanding personal liability for chief compliance officers by Brett Ingerman, Michael D. Hynes, Brian H. Benjet, Christian Michael Van Buskirk of DLA Piper

The imposition of personal liability on chief compliance officers is part of the regulators’ broader interest in compliance failures at the highest levels of financial institutions. Last Thursday, the Financial Industry Regulatory Authority (FINRA) sent letters to a dozen financial firms, inquiring about the methods by which the firms establish and maintain a culture of compliance. In addition to requesting general information on the firms’ practices, FINRA specifically requested information on how the firms established a “tone from the top.” FINRA characterized the request letters as an attempt to better understand how culture affects compliance, but the focus on the “tone from the top” suggests FINRA perceives or is at least particularly concerned about deficiencies among the highest ranking executives of financial firms. [More…]

 

Outsourced Compliance Officer Trend Renews Standards Debate by Stephen Dockery is WSJ.com’s Risk & Compliance Journal

It was also eventually cited by the SEC in a detailed risk alert in November on the “growing trend” of outsourcing chief compliance officers. The deep dive by the commission mentioned cases of strong compliance work by outsourced officers, but it also said some practices by off-site CCOs were cause for concern, where outsourced CCOs’ attention was lacking, or implementation of their suggestions never occurred.  [More…]

Compliance Careers Might Get Interesting, Part II by Matt Kelly in Radical Compliance

There we were, me and a small group of compliance professionals, talking shop about where good compliance officers come from these days. One person, a recruiter for asset management firms, told the tale of how she recently placed a chief compliance officer at a hedge fund in the Midwest. This CCO was “a dream candidate,” the recruiter said: accomplished scholar, top-ranked law school, work at two major law firms, a stint in investment banking, some time on the regulatory side, “and just a friendly person people would want to talk to.” [More…]

Rob Cohen Discusses SEC’s Analysis and Detection Center by David Smyth in Cady Bar the Door

Enter the Analysis and Detection Center.  I have a friend whose job requires him to think about insider trading for, oh, probably more than half of every day.  When the SEC filed its first case referring to the Analysis and Detection Center, he emailed me asking something like, “There is one?”  We both wondered what it was.  So did Bruce Carton.  It turns out the SEC is using it, whatever it is, to generate its own insider trading cases, without relying on FINRA or CBOE or any ol’ whistleblower. [More…]

Dodd Frank and Industry Consolidation

Enhancing regulations is meant to protect consumers. The side effect is often to protect the large incumbent firms and make it more difficult for smaller firms to thrive. This theory is proving true under Dodd-Frank.

Dodd-Frank-Act

A study by Marshall Lux and Robert Greene on community banks found that since Dodd-Frank community banks have lost market share, especially small community banks.

The top 5 largest banks also lost market share.

Community banks have also suffered a significant decline in assets while the large banks have grown. Again the five biggest banks also suffered a smaller decline in assets.

However, the five biggest banks had an increase in commercial banking, while the other banks suffered declines and the community banks suffered declines.

For private equity firms, the data is unclear.

Marc Wyatt looked at the size of the funds being marketed and noted a decrease in size. He concluded that the cost of SEC registration and regulation is not stifling the formation of smaller managers. Perhaps he missed this comment from Prequin:

The stumbling block, however, has been the number of managers able to hold a final close, with this being at the lowest level since 2010. It is evident that the private equity fundraising market is still in a state of bifurcation. The largest, brand-name managers are receiving the majority of investor commitments, with smaller managers – particularly first-time funds – finding it difficult to raise capital.

This would seem to support my opening statement. Regulation is generally better for incumbent firms. Bigger firms can absorb the regulatory overhead, with the hurdle being bigger for smaller and start-up firms.

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Excessive Travel as a Bribe Under the FCPA

The recent PTC Case caught my attention for a few reasons. First, the company is based near my house and I biked past it’s headquarters this past weekend. Second, the actions stated in the headline were not good, but seemed to be at the extreme of what I thought would be considered bribery.

ptc

According to the SEC’s press release, an SEC investigation found that two Chinese subsidiaries of PTC Inc. provided non-business related travel and other improper payments to various Chinese government officials in an effort to win business. From 2006 to 2011, two PTC China-based subsidiaries provided improper travel, gifts, and entertainment totaling nearly $1.5 million to Chinese government officials who were employed by state-owned entities that were PTC customers.

The travel was sightseeing trip in the US in connection with visiting the corporate headquarters in Massachusetts.

That does not sound so bad. Not great. But not a $28 million fine bad.

There is obviously the red flag of PTC selling to a China-based company. Most would start with the assumption that the company is state owned and therefore the employees could be considered government officials. If they are government officials you have to be worried about the FCPA.

The SEC order states that the employees are government officials and does not spend any time addressing this.

Were the trips meant to generate business for PTC? The SEC order only mentions a small connection, stating that the officials who went on the trips were “often” signatories on the purchase agreements.

It’s a settlement order and not a pleading, so we have to just agree that the individuals were government officials and that the things given to them were meant to influence their purchasing decision.

I’ve said it before and I stand behind the statement:

“If your are trying to figure out whether a company is a private company or an “instrumentality” of a foreign government under the Foreign Corrupt Practices Act you are already in trouble.”

At first blush this PTC case caused me to question the statement.

Combining business activities with some pleasure activities is a common practice. The presence of government officials should not change this practice. The concern is whether the pleasure activities are excessive compared to the business activities.

The SEC and the DOJ have made it clear that bribery is not limited to cash in an envelope. Excessive gifts and travel can be considered an illicit bribe.

That was the case here.

The officials would visit the PTC office in Massachusetts for one day and then spend ten days touring the sights of New York City, Los Angeles, the Grand Canyon and Honolulu. That’s a ten to one ratio of business to pleasure.

That does sound excessive.

It sounded excessive to PTC who had a policy prohibiting excessive gifts and entertainment. PTC’s policy required pre-clearance for expenses over $500 with documentation of the business purpose.

The costs of the overseas travel were hidden in the contracts. The funds budgeted for the overseas travel were disguised as expenses related to success fees or subcontracting payments for business partners. The cover-up made the trips more illicit. If the employees involved thought the trips were legitimate there would have been no reason to hide them.

I do have a problem with the SEC order including “tours of MIT, Harvard, and Faneuil Hall” in the list of what the SEC considers excessive leisure activities. Showing prospective business partners the area, amenities and source of corporate talent should be a legitimate leisure activity connected with the business. PTC is headquartered in a suburban office park. The Charles River is lovely in that area, but it’s legitimate to show the Greater Boston.

The rest of the activities sound excessive to me. Excessive enough, that I would not expect to pay those expenses for a business partner, whether it was a private individual or a government official.

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Can Money Buy An Election?

When Jeb Bush dropped out of the Presidential race this weekend, my first thought was about all that money. Running for elected office costs too much money and all that money is seen a corrupting influence. One of the most controversial rulings was Citizens United that broadened the rights of corporations and unions when comes to political spending. This 2016 Presidential race is the first big test of the Super PAC.

Politician: Holding Out a Stack of Money

The Super PAC has lost. Or at least, they are not assuring victory.

Before I continue, I’ll let you know that I don’t like any of the current major candidates running for President. My political views don’t fit neatly into either party. (I’m liberal on social issues and conservative on economic issues.)

Jeb Bush had a huge war chest for his campaign between his own campaign and the Super PAC that had lined up behind him. He also had the Bush campaign infrastructure in place.

Hilary Clinton had  a huge war chest for her campaign, with a sweep of donations and a giant Super PAC behind her. She had the Clinton political machine in place behind her.

A year ago it seemed very likely that we would see Bush versus Clinton for President.

After three votes, it seems that money does not buy an election. Bush has dropped out after three dismal results. Clinton is in a tough fight with a Socialist Senator from the tiny state of Vermont.

Perhaps I see a bit more faith in democracy and hope that money alone will not buy an election. There is still too much money in politics.  Whether or not it has an actual corrupting influence, it certainly has the appearance of a corrupting influence.

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Compliance Bricks and Mortar for February 19

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

brick drain

Private Equity’s Unintended Dark Side by Alexander Ljungqvist, Lars Persson and Joacim Tåg in the CLS Blue Sky Law Blog

But what about more long term consequences of buyouts? In a recent paper, we explore whether private equity could, inadvertently, impose a major externality on the economy, by undermining the hard-won consensus in support of shareholder capitalism that has emerged in Anglo-Saxon economies over the past 100 years: in return for participating in the gains from corporate activity, shareholder-voters lend their support to business-friendly policies.
[More…]

The Ethics and Compliance Officer’s Many-Colored Hat by Jason L. Lunday in Compliance & Ethics Professional

Below are thirteen key disciplines that have influenced the Ethics and Compliance field and are important competences for an ECO to have or acquire through others to effectively manage an ethics and compliance program. [More…]

Mark Cuban Challenges the Referee: the Constitutionality of SEC In-House Courts by , and in Orrick’s Securities Litigation, Investigations and Enforcement

After the repeated challenges to the SEC’s in-house courts as previously reported, Mark Cuban joined the debate by filing an amicus curiae brief in support of petitioners Raymond J. Lucia Companies, Inc. and Raymond J. Lucia (collectively “Lucia”) in Lucia v. SEC.  Cuban, describing himself as a “first-hand witness to and victim of SEC overreach” in a 2013 insider trading case brought against him in an SEC court, argued that the D.C. Circuit should grant the petitioners’ appeal because SEC in-house judges are unconstitutionally appointed. [More…]

Toward More Effective SEC and DOJ Remedies by T. Gorman in SEC Actions

The thesis for the Judge Bean approach is simple and straight forward: “If a corporation has violated the law, individuals within the corporation must also have violated the law,” according to the report. Unstated is the thesis that jail for a few executives will cure what ails the world of Wall Street and big corporations as will being forced to make admissions. While these points seem intuitive their premise is at best doubtful. While admissions may satisfy a craving for retribution, the reason such a requirement will change the behavior of a large corporate entity is unclear. [More…]

Ex-Brokers Go on Trial in Test of Revised Insider Law by Patricia Hurtado in Bloomberg Business

Two former stockbrokers accused of insider trading by the U.S. Securities and Exchange Commission don’t deny making hundreds of thousands of dollars on a tip about a billion-dollar deal. They just deny they broke the law. Insider trading laws are in flux following a 2014 federal appeals court ruling in New York that, in part, says prosecutors must show a source of a leak got some kind of a concrete benefit. The trial of Daryl Payton and Benjamin Durant tests the new requirement in a civil proceeding in New York for the first time.[More…]

Volkov Law Group Partners with Charlotte School of Law to Create New Center for Compliance and Ethics

I am very happy to announce the public launch of the Center for Compliance and Ethics at the Charlotte School of Law in Charlotte, NC. The Center will be hosting many exciting events including:

  • A lunch and learn on February 24th about our compliance certificate program.
  • A webinar on March 10th where professors in the compliance certificate program speak about careers in compliance.
  • A webinar later in March on the Foreign Corrupt Practices Act, taught by leading compliance expert Mike Volkov.
  • A Symposium on compliance and ethics in June at Charlotte School of Law’s campus that will provide both a forum for discussion and will produce a white paper on important compliance issues.

 

If You Recommend It, You Have to Mean It

The Securities and Exchange Commission charged an investment bank’s research analyst with publishing a rating on a stock that was inconsistent with his own view. Charles P. Grom gave a public “buy” recommendation to the retailer Big Lots, but privately expressed his concerns about the company.

“We just had them in town so it’s not kosher to downgrade on the heels of something like that,” he said on an internal conference call, according to the S.E.C.

Stock Market Launch

Regulation Analyst Certification (Reg AC) came out of the Dot Com bubble burst. Investment banks were handing out favorable public analyst recommendations to their clients, but providing conflicting advice to their institutional clients. Sarbanes-Oxley required the SEC to adopt a rule addressing analyst conflicts.

The most famous case under Reg AC was Henry Blodget. In 2003, the former Merrill Lynch tech stock analyst paid $4 million in fines and disgorgement and was permanently barred from the industry. (Mr. Blodget neither admitted nor denied wrongdoing as part of the settlement.) Ten investment banks paid $1.4 billion in fines for publishing analyst recommendations that conflicts.

It’s been quiet under Reg AC for a decade. I assume banks took steps to correct the conflicts.

I also assume that they enforced the “Fight Club Rule.” The First Rule and Second Rule being that you do not talk about Fight Club.  Analyst should not speak about any conflicting advice.

Mr. Grom broke the rule and revealed that investment banks may not have taken Regulation AC to heart.

On March 2, 2012, Mr. Grom published a “Buy” rating on Big Lots.

On March 28, Mr. Grom and the bank hosted Big Lots executives and spent most of the day with them.

Over the course of the day Mr. Grom told a trader to sell 25,000 shares from the bank’s proprietary account.

Over the course of the same day Mr. Grom spoke with four of the bank’s top priority “Global Research Service Level 1” hedge funds. Each of those funds then sold all of their positions in Big Lots.

Then on March 29. Mr. Grom issued a research report on Big Lots entitled “Not All Is Good In Buckeye Land,” in which he reiterated his BUY rating.

On that same day he said on  a conference call with the bank’s research and sales personnel: “We just had them in town so it’s not kosher to downgrade on the heels of something like that.”

Then on April 24 he revealed that he had violated Reg AC on a call with the bank’s research and sales personnel

“[F]ortunately we told many clients a few weeks back to sell the stock.. . . I think the writing was on the wall [that] we were getting concerned about it, but I was trying to maintain, you know, my relationship with them. So, that’s why we didn’t downgrade it a couple of weeks back.”

Oops.

The question that comes to mind: how did Grom get caught? Perhaps it was internal compliance who reviewed the internal call. That would be a double face palm event for violating Fight Club Rule 1 and Rule 2. Maybe it was SEC or FINRA examiners reviewing a recording of those conference calls.  It’s an easy win for them.

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506(c) Enforcement Actions

Although I had a lot of hope that the changing of private placement advertising restrictions by the Securities and Exchange Commission would remove potential foot-faults from the fundraising process, the end result proved challenging. Now it appears that the SEC is on the brink of challenging firms that took at advantage of the loosened restrictions.

private placement

Given the enormous restrictions on being a company with publicly listed securities, private placements have been a vibrant form of raising capital. Although deemed more “risky”, to me that is a poor label without a further discussion of risk. The risk is liquidity, not risk of loss. A huge portion of the private placement market is by firms that provide no more risk than a publicly listed company. There is also capital being raised by start-ups and riskier companies. The common factor is not the risk of loss. The common factor is the investor’s limited ability to sell the security. If the investor needs liquidity, the investor will have limited options.

The main concern of the SEC in passing Rule 506(c) was be the increase in fraud. So far, we have not seen the enforcement actions to back up that fear.

However, the use of advertising under 506(c) for a private placement has been limited. From 2013, when 506(c) became effective, through 2015, there were $2,800 billion in offerings under 506(b) and only $71 billion in offerings for 506(c).

It seems like enforcement proceedings are in process for some firms that abused Rule 506(c). SEC Chair Mary Jo White stated that the SEC has some open investigations. Over the next few months perhaps those become public.

The failure of Rule 506(c) is that it was coupled with a proposed rulemaking that would dramatically change the landscape of private placements. We have not heard anything more on that rulemaking. It’s specter still haunts Rule 506(c) offerings.

I think Rule 506(c) is more than what most fund managers wanted for changes in advertising. Fund managers wanted some safe harbors for advertising to avoid foot-faults. Fund managers want to able to participate in league tables, talk to the press and talk at conferences without the fear that an inadvertent slip of the tongue would wreck havoc on a fundraising. I encountered no fund managers who were interested in media campaigns as part of a fundraising.

It looks like we may get more insight into the SEC’s view of Rule 506(c) when the enforcement actions are announced.

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