Whistleblower Retaliation

A year ago, the Securities and Exchange Commission charged Paradigm Capital Management with engaging in prohibited transactions and then retaliating against the head trader who reported the trading activity to the SEC. It was the first time the SEC filed a case under its new authority to bring anti-retaliation enforcement actions. Now it has handed part of the penalty to the whistleblower.

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The underlying problem, according to the SEC’s order, was that the firm’s principal conducted transactions between Paradigm and a broker-dealer that she also owned while trading on behalf of a hedge fund client. Principal transactions pose conflicts between the interests of the adviser and the client. Under an SEC rule advisers are required to disclose that they are participating on both sides of the trade and must obtain the client’s consent.

It’s tricky to effectuate consent for a hedge fund. Most hedge funds are privately-owned so there is no board of directors to act on behalf of the fund. The head trader and the SEC thought that the hedge fund’s conflict process was ineffective. Paradigm made the mistake of mistreating the head trader, turning the actions into retaliation against the whistleblower. Paradigm settled the case for $2 million.

In turn, the SEC granted the whistleblower the maximum award of 30% of the settlement.

The whistleblower first submitted the case to the SEC in March 2012 and disclosed that he or she had done so to Paradigm in July 2012, suffering a month of mistreatment before resigning. It took two years before the SEC settled the case with Paradigm and another year for the whistleblower to receive the award.

That’s a long time for the wheels of justice to turn for the whistleblower.

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Compliance Bricks and Mortar for June 12

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

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Jamie Dimon Says He’s Unsure If Elizabeth Warren Understands Global Banking System by Kim Chipman for Bloomberg

[W]hen asked about his biggest worries, Dimon expressed concern that the U.S. may eventually be hurt by ideological decisions being made in Washington. [More…]

Legal Ethics for Compliance Lawyers By Jeffrey Kaplan From Compliance & Ethics Professional, a publication for SCCE members

I do not think that there is any great tension between the two. Of course, a company’s lawyers have to abide by somewhat different rules with respect to reporting suspected violations than do employees generally, because the lawyer’s knowledge of possible wrongdoing may be subject to the attorney-client privilege. But this is as it should be, since jeopardizing the privilege would make it less likely that a company would seek legal advice on C&E matters, thereby weakening C&E programs.[More…]

Warning: Keeping Compliance Simple by Michael Volkov in Corruption, Crime & Compliance

CCOs have to avoid something that comes with influence and authority – making compliance programs too complex. Why do I worry about this?

Compliance depends on simplicity and accessibility. It does not depend on self-actualizing theories and designs of wordy compliance concepts. Take one example – (and I apologize to advocates of this) the so-called “three-lines of defense” (“TLOD”) or other compliance program acronyms and theories.[More…]

How biased are you about bribery (or anything else)? Watch the first video. Then read the post and find out. by Etai Biran in thebriberyact.com

Being aware of our biased behavior during the information selection stage has significant implications on the rest of the decision making process. Selecting the right information to form a decision will have great impact on the decision’s outcome. Using the wrong information to evaluate a situation will have a “domino effect” on the rest of the decision making process and will eventually lead to bad judgment and bad decisions. If the information selection process is biased it may well be that the final decision turns out to be a bad one because it was based on wrongful information all along.[more…]

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Fort Jackson; Brick Wall is by Jodi Green
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Cyber Insurance: A Pragmatic Approach to a Growing Necessity

Cybersecurity has become an increasing focus of financial regulators. Insurance companies are stepping up to help deal with the risk of cyber attacks.  Bruce Carton’s CyberSecurity Docket hosted a great webinar on cyber insurance. These are some of the highlights.

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John Reed Stark is President of John Reed Stark Consulting LLC, a data breach incident response and digital compliance firm. 

David R. Fontaine is Executive Vice President, Chief Legal & Administrative Officer and Corporate Secretary of Altegrity, a privately held company that among other entities owns Kroll’s data breach response services. 

The industry has accumulated the actuarial data needed to underwrite the damages and likelihood of a cyberattack. But the market is still very new and evolving. There is no standard policy language.

One focus is what will be covered by the insurance. There are three areas of losses:

  1. liability (lawsuits from customers for the breach)
  2. breach response cost (notifying customers of the breach)
  3. government fines/penalties.

You also need to focus on what triggers the coverage: a lost laptop, internet intrusion, data sourced from the company.

The coverage will be based on some detailed reps and warranties. You need to make sure they are right and you understand them.

Here is an incident response workflow:

  1. Preserve. Assmble the team, unhook the infected machines
  2. Digital Forensic Analysis: figure out what happened to the machine
  3. Logging analysis: figure out how the machine was accessed
  4. Malware reverse engineering.
  5. Surveillance
  6. Remediation efforts
  7. Exfiltration analysis. Figure out what was taken.
  8. State regulatory analysis. There are 47 different regulatory schemes.
  9. Federal regulatory analysis. Everyone thinks they have jurisdiction.
  10. PCI Compliance, if credit card data was involved
  11. Law enforcement liaison.
  12. Customer notifications

It’s clear that every company is at risk for a cyber attack. If bad guys want to attack, you can’t stop them. Insurance may be able address some of the risk and damages.

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The SEC Suffers a Setback In Its Use of In-House Judges

Prior to the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Securities and Exchange Commission’s authority to impose penalties in a case brought as an administrative proceeding was restricted to regulated entities. Dodd-Frank changed that with its Section 929P. The SEC may now impose a civil penalty in an administrative proceeding against any person or company. That means the SEC could use its in-house courts for insider trading cases. The SEC suffered its first major setback in that strategy.

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The SEC charged Charles L. Hill with the illegal use of material non-public information in the purchase of Radiant stock. The SEC alleged that Hill was tipped off by Radiant’s COO that the company was about to be acquired by NCR Corporation. Hill bought over 100,000 shares of Radiant and turned a profit of $744,000 in a month.

Hill is a real estate developer and is not a registered with SEC. The SEC chose to use an administrative proceeding instead of federal district court to bring the charges.

Hill fought back.

Hill filed for Temporary Restraining Order against the SEC, seeking to declare the administrative proceeding unconstitutional and to stop the SEC proceedings.

The judge found that the administrative proceeding does not provide meaningful judicial review. The SEC tried to deal with this challenge in the proceeding, but even the administrative judge admitted that the constitutional challenge was outside the SEC’s expertise.

The judge did not agree with Mr. Hill’s non-delegation claim. The SEC was free to chose the forum because Congress properly delegated that choice.

The judge also did not agree with Mr. Hill’s claim that the administrative proceeding wrongfully took away his Seventh Amendment right to a jury trial. Past interpretations of the Seventh Amendment have carved out the position that the jury is not the exclusive fact-finding mechanism for civil cases.

Mr. Hill did succeed in arguing that the administrative proceeding was a violation of the Appointments Clause of Article II of the Constitution.

Under that Clause, the President has principal officers who he or she selects, and are then confirmed by the Senate. There are inferior officers who may be appointed by the President, the heads of departments or the judiciary. The judge agreed that the SEC’s administrative judges are inferior officers.

As inferior officers, the administrative judges must be appointed by the five commissioners of the SEC. The SEC hired the judge in Mr. Hill’s case through its office of in-house judges.

The ruling is a setback for the SEC, but it seems it could be easily fixed. The SEC commissioners could directly make the appointments. That would likely cure the Appointment Clause violation.

The judge did not get to the two levels of tenure argument that might violate the Removals Clause of Article II. That issue is still out there and may be another roadblock to the SEC’s use of administrative judges for contested insider trading cases.

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SEC Loses Case Over the Word “May”

Few things make a compliance officer’s eyes roll more than the case the SEC was fighting against an adviser who used the word “may” in its Form ADV when the SEC thought it should say “will.” One of the SEC’s own administrative judges slapped down the SEC and dismissed the case.

Cash in the grass with room for your type.

According to the SEC charging order, an unnamed broker agreed to pay The Robare Group a fee for client funds invested in funds sold by that broker. Of course, there is nothing inherently wrong with that arrangement as long as it is disclosed to clients. Obviously, the concern is that the adviser would direct clients to invest in those funds because it is good for the adviser, not necessarily because it is good for the client.

The SEC is focused solely on a violation for failure to disclose. The SEC claimed the disclosures were not adequate because they said the Robare Group “may” receive compensation from the broker for selling the mutual funds, when it was definitely receiving payments. That’s a very thin distinction to make. Especially when the SEC stated in the complaint that it did not identify any harm to Robare Group’s clients or even that the clients were invested in those funds in a disproportionate amount.

The Robare Group used Fidelity mutual funds and much later found out that Fidelity offered a “revenue sharing arrangement” in which it would pay the firm between two and twelve basis points based on the assets under management. According to the final decision, Robare confirmed that the arrangement would not result in additional costs to its clients and would not alter the construction of its clients’ portfolios.

In the order, the judge highlights the testimony of Melissa Harke, a branch chief in the Commission’s Division of Investment Management, who testified that advisers are expected to disclose material conflicts in the Form ADV and should conversely not throw in everything just to “cover” themselves “for legal purposes.”

The judge also highlighted that the firm used an outside compliance consultant, Renaissance Regulatory Services to help with drafting the Form ADV.

No doubt, Mr. Robare and Mr. Jones paid Renaissance in hopes of avoiding the very proceeding of which they are now the subject.

There is no doubt that the revenue sharing arrangement gave rise to a potential conflict of interest. If the conflict is “material” it has to be disclosed in the Form ADV. The judge found that the conflict was material. The judge went on to find that the SEC failed to prove that Robare acted with any intent to deceive, manipulate or defraud its clients.

The SEC tried to argue that even if Robare did not have the intent to deceive, it was reckless in its failure to “fully and accurately disclose.” The judge found that

“with respect to Form ADV disclosures, advisers operate in a difficult environment that presents challenges for even experienced compliance professionals….I find that the relevant standard of care entails employing a compliance professional and following his or her advice.”

That similarly doomed the SEC’s argument that Robare was negligent. The firm and its principals did not have the expertise to properly disclose the information on Form ADV.

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Compliance Bricks and Mortar for June 5

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

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Sen. Elizabeth Warren Sharply Criticizes SEC Chairman in Letter in the Wall Street Journal

Ms. Warren took aim at several issues in Tuesday’s letter, including a long-delayed executive compensation rule mandated by the 2010 Dodd-Frank law requiring companies disclose the pay gap between chief executives and their employees. The agency proposed the rule in 2013 but has yet to complete it. Congressional Democrats and unions have long-championed the measure though it is opposed by Republicans and business groups. [more…]

 

Why The WSJ Is Wrong About SEC Rulemaking On Claw backs by in California Corporate and Securities Law

Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act requires the SEC to require the stock exchanges to prohibit the listing of securities of issuers that have not developed and implemented compensation claw-back policies.  Thus, I expect that the SEC, when it gets around to it, will be forcing the stock exchanges to change their listing standards.  The SEC won’t be directly forcing companies to claw back incentive pay. [more…]

The Impact of Newman on SEC Enforcement by Thomas O. Gorman in SEC Actions

In the wake of Newman the SEC has three apparent options: 1) Comply with Newman’s pleading requirements; 2) bring its actions as administrative proceedings; or 3) bring actions outside of the Second Circuit where the decision may not be applicable.

Wall Street and Ethics by in Corruption, Crime & Compliance

I have to confess that there is a part of me that was skeptical about a new survey released last week finding that banks and other financial institutions have not embraced a culture of integrity.  (Survey Here).   Indeed, the survey found that numerous individuals continue to operate with the idea that illegal or unethical behavior is a necessary part of succeeding in the financial markets. [more…]

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False Credentials, Fraud and Fund-Raising

With graduation season upon us we are lauding those students who have excelled in academic achievement, or at least did just enough to earn their degrees. It is all too easy for a fraudster to concoct false degrees, titles and awards to lure in unwary investors. With two recent fraud cases, the Securities and Exchange Commission issued a new Investor Alert: Beware of False or Exaggerated Credentials.

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“Do not trust someone with your investment money just because he or she claims to have impressive credentials or experience, or manages to create a ‘buzz of success.’”

The SEC Enforcement Division announced two fraud cases against investment advisers who made false claims about their experience and industry accolades.

The SEC charged Todd M. Schoenberger of Lewes, Delaware, with misrepresenting that he had a college degree from the University of Maryland.  Also for defrauding investors. He was raising a fund and also raising money for his fund management company: LandColt Capital LP.  Schoenberger told prospective investors that LandColt would repay the notes through fees earned from managing the fund. Schoenberger never actually launched the fund, never had the commitments of capital to the fund that he claimed, and never paid investors in the management company the returns he promised. The SEC made a show of him because he had been a guest commentator on financial television shows.

I found the fake degree to be the least interesting part. The double-fraud is far more interesting. He was committing fraud in raising the fund and in raising capital for the management company at the same time.

An SEC investigation found that Michael G. Thomas of Oil City, Penn, claimed that he was named a “Top 25 Rising Business Star” by Fortune Magazine. He used that false badge in general solicitation for his private fund.  No such distinction actually exists at Fortune Magazine. As you might expect, Thomas also greatly exaggerated his own past investment performance and inflated the fund’s projected performance.  He claimed to have turned $600 in to $6 million, when he actually started with more than $600 and turned it into less.

I think the older Hicks case is a better example of false credentials. The SEC alleges that Hicks falsely represented in the offering memorandum for his Locust Offshore Management hedge fund that he had undergraduate and graduate degrees at Harvard University and that the fund’s quantitative strategies were based on mathematical models that Hicks developed while at Harvard earning those degrees. However, that is far form the truth. Hicks only attended Harvard for three semesters, was twice required to withdraw for failing to perform academically, and never graduated. Hicks only took one mathematics course during his time at Harvard, receiving a D- for a grade.

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Senator Warren Versus SEC Chair White

Senator Elizabeth Warren sent a sharp letter to Mary Jo White, Chair of the Securities and Exchange Commission.

“You have now been SEC Chair for over two years, and to date, your leadership of the Commission has been extremely disappointing.”

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Senator Warren raises four major issues:

  1. The SEC’s failure to finalize the rules for disclosure of the ratio of CEO pay to the median worker.
  2. The SEC’s failure to curb the use of waivers for companies found to be in violation of securities law.
  3. The SEC has settled the vast majority of cases without requiring the companies to admit guilt.
  4. Chair White’s inability to participate in numerous cases because of her prior employment and her husband’s ongoing employment.

Personally, I believe that Senator Warren and Chair White are both well-meaning individuals who are both trying to protect the American consumer and the American financial markets. Senator Warren is one of my Senators and I voted for her.

I think the CEO pay rule is a useless exercise that will take a great deal of resources at public companies. The actual calculations will be full of assumptions and inconsistencies. The end result will do nothing to curb CEO pay inflation, protect consumers, or bolster the capital markets.

According to competing stories, in a private meeting between White and Warren, White promised the final CEO Pay Ratio Rule would be enacted in 2015. However, the SEC released a rulemaking schedule to the Office of Management and Budget that stated the CEO Pay Ratio rule would not be done until April 2016. I’m not sure the statements are inconsistent. There may be a misunderstanding between when the rule is “finalized” and when it becomes “effective.” I suspect the goal is to get the rule enacted in 2015 but not have it be effective for annual filings until the 10Ks for 2016.

The waiver granting has gotten out of hand. I know many feel that it merely reinforces “too big to fail.” The SEC is liberally granting the waivers to the big firms that allows them to continue operating. However, the true test will be when a smaller firm gets into the same trouble. Will the SEC kill the smaller firm by not granting the same waiver?

Senator Warren cites the statistic that between June 2013 and September 2014, the SEC made 520 settlements but only required admission of guilt in 19 cases. But before White’s tenure, the SEC had never required a guilty admission, according to an SEC official. It’s still a strange legal limbo to settle, but not admit guilt.  The problem, of course, is the impact on private litigation such as shareholder lawsuits.

According to Warren’s letter, Chair White had to recuse herself at least four dozen times. Her personal restrictions have expired now that it has been two years since she left her law firm and her clients. Senator Warren raises an interesting point about Chair White’s husband. She sets up a theory that defendants may try to hire his firm to force her to recuse herself from the case.

These are all valid concerns. The letter is clearly setting the stage for the upcoming nominations for the two open slots on the SEC.

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Compliance Failures and the TSA

I was not at all surprised when it was revealed that the Transportation Security Administration had a 95% failure rate during a recent series of tests. I’m sure the TSA screeners found a much higher percentage of water bottles and laptops left in their cases.

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An internal investigation of TSA security checkpoints at the nation’s busiest airports, conducted by Homeland Security “Red Teams” posing as passengers, found that agents failed to detect mock explosives in 67 of 70 test cases, according to ABC News. In one test, an undercover agent was stopped after setting off a metal detector, but TSA screeners failed to detect a fake explosive device that was taped to his back during a follow-on pat down.

This is an ongoing problem. A report of a red team getting a test device past TSA security at Newark Airport appeared in 2013.

It’s not that the TSA fails to find dangerous items in luggage. The latest TSA post highlights the 45 firearms discovered in carry-on bags last week.

The problem is one of false positives. The testing of passengers is so out of line with the risks presented that there is a far greater incident of false-positives than problems prevented. It is only human nature to become numb to the false-positive warnings. The fable of “the boy who cried wolf” has been around for centuries.

Screeners will inevitably be drawn to water bottles and laptops instead of actual weapons. That is what they see most often, so that is the problem they will most focus on. I’m sure that thousands of water bottles are confiscated for every dangerous item that passes through airport security.

When we talk about compliance programs, we talk about a risk-based approach. Concentrate your efforts and limited resources on the biggest and most-likely risks to prevent them. Even with the bloated budget of the TSA, its resources are still limited. The technology is often less-than capable. It’s staff is likely under-trained and under-prepared for many possible risks.

When the technology and staff are presented with actual threats, instead of the much more common false-positives, they mostly failed. They failed to spot the real threat because they are distracted by the far more numerous false-positives.

The TSA failure is an example of the results when failing to take risk-based approach to compliance.

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Compliance Bricks and Mortar for May 29

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

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Whistleblowers Find SEC Rewards Slow and Scarce by Jean Eaglesham and Rachel Louise Ensign in the Wall Street Journal

An SEC spokeswoman declined to say how much money has been collected for any of the 658 enforcement actions the agency’s website lists as being potentially eligible for awards. She also declined to say how many, if any, of the pending award claims relate to cases in which no bounty is available, even if the claim is approved. [More…]

Law School Moral Hazard and Flawed Public Policy by Steven J. Harper in the CLS Blue Sky Blog

Law schools have become poster children for market dysfunction. As the Great Recession decimated the demand for new lawyers, a functioning market would have led most schools to reduce enrollments. Instead, the overall number of admitted students increased to more than 60,000 in 2010 – up ten percent from 2008. Three years later, the result was the largest-ever graduating class of JDs: 46,776 in 2013. Nine months after law school, only about half of them had found full-time long-term (“FTLT”) JD-required jobs.[More…]

SEC Broadens Constitutional Inquiry into Its Own Administrative Judges in Timbervest Case in Securities Diary

On May 27, 2015, the SEC agreed to expand its own consideration of constitutionality challenges to its administrative law adjudicative process.  It issued an order asking for further briefing on whether the appointment of its administrative law judges conforms to the Constitution’s Appointments Clause.  The order, which was issued in the administrative proceeding In the Matter of Timbervest LLC et al., File No. 3-15519, is laid out below. [More…]

How FIFA’s Structure Lends Itself To Corruption by in FiveThirtyEight

FIFA has 209 member-nations, and each one’s soccer association is equally powerful in the sport’s governing body. Every member, from China (population: 1.36 billion) to tiny Montserrat (population: 5,215), gets one vote in the FIFA Congress. That means each one gets to cast a vote in the FIFA presidential election scheduled for this Friday in Zurich. And each one — from Brazil (five men’s World Cup wins, one of the world’s best women’s teams) to, well, let’s stick to Montserrat (men’s team never ranked higher than No. 165, women’s team unranked) — will get equal say in choosing hosts of future World Cups. [More…]

Bricked is by Henk Sijgers
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