When Compliance and Legal Functions Collide by Matt Kelly in Compliance Week‘s Big Picture

The general counsel is still the boss. Yes, I know, the revised U.S. Sentencing Guidelines say companies should have an independent compliance function, with a chief compliance officer who answers to the CEO or (ideally) the board. Well, that’s not happening yet. Fourteen of our 20 attendees said they report into the legal function; only two reported directly to the audit committee.

SEC Expects Massive Staff Increase Needed to Implement FinReg in Compliance Avenue

SEC Chairman Mary Schapiro, during her Testimony Concerning Oversight of the U.S. Securities and Exchange Commission: Evaluating Present Reforms and Future Challenges, which she gave before the United States House of Representatives Committee on Financial Services Subcommittee on Capital Markets, Insurance and Government-Sponsored Enterprises, stated that the Commission expects to hire approximately 800 new positions during the course of the implementation.

Criminal Provisions in the Dodd-Frank Dodd-Frank Wall Street Reform & Consumer Protection Act by NACDL’s White Collar Crime Section

On the front page of today’s Wall Street Journal is story about one of the fallouts from Goldman Sachs’ recent problems with the SEC: George Carlin Never Would’ve Cut It at the New Goldman Sachs.

One of the most sensational bits of Goldman Sachs fiasco was an email from a Goldman executive “[B]oy that, timberwolf was one $h!#ty deal.” Apparently, Goldman thinks the solution is to ban profanity in electronic messages.

Of course, everyone needs to pay closer attention to what is written down in email. They are often reviewed and taken out of context during litigation. Saying it was “$h!#ty deal” is more sensational than saying it was a “bad deal.”

Monitoring language in email has been part of financial service compliance for years. The SEC requires that compliance monitor for improper activity and advice. It will be easy enough to have the monitoring program also search for George Carlin’s “Seven Words You Can Never Say on Television” and their variants.

The big problem will be false positives once you start getting into the variants. That means frontline employees and deal flow will be get emails bounced back or blocked. Inevitably, compliance will get the blame for messing up a deal.

The other problem is enforcement. The first line of enforcement will probably be to block messages from being sent with profanity in them. That works as long as you can eliminate false positives. The alternative is to notify compliance when a message has profanity. Compliance can then keep track of the number of messages and report back to management for discipline.

“Employee A had 354 message with “$h!#ty”, 1,567 with F@(k, and 456 with this word which I don’t know but sounds dirty.”

Sounds like a $h!#ty policy and $h!#ty role for the compliance department.

• More likely to get sanctioned.
• Reduction of $30.3 million in penalties when you initiate your own investigation.
• Reduction of $609,000 in company penalties for each week earlier the statement is announced the public.
• Reduction of $112,000 in personal penalties for each week earlier the statement is announced the public.

We in the compliance field have often heard from federal regulators that cooperation will get you benefits. Although when asked how much, it’s merely a “trust us” reply. Back in the beginning of 2010, the SEC launched a new enforcement cooperation initiative. The SEC’s 2001 Seaboard Report lists several criteria that SEC staff evaluate before making enforcement decisions, including whether ―the company cooperated completely with the appropriate regulatory and law enforcement bodies‖ and whether ―the company promptly, completely, and effectively disclosed the existence of the misconduct to the public [and] to regulators

I figured some academic would spend the time to sit down and see how much benefit really accrues when you cooperate. Rebecca Files of the University of Texas at Dallas did just that.

Dr. Files dove into a set of the 2443 press releases announcing an earnings restatements compiled by the General Accounting Office (GAO 2003, 2006a,b) during the 1997-2005 time period. She ended up culling the list down to 1,249 for a variety of reasons. Of those, 127 received a formal sanction by the SEC.

Individuals were sanctioned in 115 of the 127 cases, paying an average of $3.9 million in fines. Companies were sanctioned in 109 of the cases with an average fine of $35.5 million.

When the company had independently investigated their restatements, they paid an average of $30.3 million less in penalties than those that did not.

Dr. Files concludes that the end result is mixed. “[C]ompany-initiated investigations significantly increase the likelihood of an SEC enforcement action, but decrease firm-level penalties associated with a sanction. … Regarding forthright disclosures, I find somewhat mixed results. Headline disclosure of a restatement increases the likelihood of an SEC sanction, suggesting that SEC staff is influenced by the visibility of press release disclosures when choosing its enforcement targets. However, individuals pay significantly smaller fines when the restatement is disclosed prominently in a press release or on a Form 8-K or amended filing. Placing restatement information in a Form 8-K or amended filing also significantly reduces the likelihood of an SEC sanction, but only in the post-2001 period. Consistent with the Seaboard Report, timely disclosure of a restatement reduces the likelihood of being sanctioned and results in lower individual and firm penalties.”

Sources:

• SEC Enforcement: Does Forthright Disclosure and Cooperation Really Matter? by Rebecca Files on SSRN
• “Seaboard Report” A/K/A In In the Matter of Gisela de Leon-Meredith (Securities Exchange Act Release No. 44969, October 23, 2001)
• The Impact of Cooperation by Thomas O. Gorman in SEC Actions
• SEC’s New Enforcement Cooperation Initiative – prior post

It turns out that failing to adhere to your investment guidelines can not only get you sued by your investor, it can get you sent to jail.

Mark D. Lay ran a hedge fund whose sole investor was the Ohio Bureau of Worker’s Compensation. The fund agreement had a non-binding 150% leverage guideline. Lay apparently relied on the non-binding nature of it and had 2/3 of the trades in excess of 150 leverage and over 20% of those trades involved leverage over 1000%. Lay ended up losing $214 million of the $225 million invested by the Bureau.

Apparently Lay not only greatly exceeded the leverage guidelines, he also lied about his excess.

Lay was convicted investment advisory fraud, conspiracy to commit mail and wire fraud, and two counts of mail fraud. Those convictions earned him a 12-year sentence at the Federal Correctional Institution in Fort Dix, N.J. and an order to repay nearly $213 million from the loss and forfeit $590,526 of the $1.7 million in fees the bureau paid.

Lay lawyers tried get him out of the investment advisory fraud by claiming that the Bureau was not a client. They argued that the Bureau was merely an investor in the fund and that Lay advised the fund. It was this handling of deeming an investor in the fund as the “client” that caught my attention.

Lay’s legal team used the Goldstein v. SEC case to argue that the SEC is precluded form treating fund investors as clients. The Sixth Circuit Court of Appeals did agree with that argument. The found that the SEC could not treat all investors in a fund as clients, but they could treat some as clients under the Investment Advisers Act.

In this case, the Bureau was already a client under a different investment management agreement. So a client relationship was already established. Also, the Bureau was the only investor in the fund. This is an atypical fund relationship.

The case points out that investors in a fund may still be clients of the fund manager under the Investment Advisers Act.

Sources:

• Sixth Circuit Opinion in US v Mark D. Lay (July 14, 2010)
• Sixth Circuit Upholds Convictions of Hedge Fund Manger by Thomas O. Gorman in SEC Actions
• Key figure in Workers’ Comp fraud loses appeal by Mark Niquette for the Columbus Dispatch

A continuing quirk of the Foreign Corrupt Practices Act is the ability to ask the Department of Justice whether a particular set of facts would be a violation of the Act. Given all of the recent FCPA activity I expected there to be an uptick in Opinion Procedure Releases under the FCPA. So far that does not seem to be the case. There was one release in 2009 and only the second for 2010 has recently been issued.

Maybe the bribery situations being faced by corporate America are straightforward and don’t need interpretation (or unwanted attention) from the Department of Justice.

The Opinion Requestor runs a micro-finance operation in a country in Eurasia. (I’m not sure why they used this identification.) They are trying to convert from a non-profit model to a commercial operation. The government of the unnamed Eurasian country is insisting that the requestor make a significant grant to local micro-finance institution. The regulating agency has provided a short list of six local MFIs in the Eurasian country. Either cough of the cash to get it localized or it can’t get its operating permits.

Of the six local micro-finance institutions, they found three “as generally unqualified to receive the grant funds and put them to effective use.” They then conducted further diligence on the remaining three and ruled out two more: one for conflict of interest concerns, the other after the discovery of a previously undisclosed ownership change in the entity.

That left them with one choice, so they dove deeper in their diligence. They discovered that one of the board members of the local micro-finance institution was also a government official.

The requestor laid out a series of controls is would put in place to protect the investment in the local micro-finance institution from corrupt influence and prevent money from flowing to board members.

There is some interesting discussion about what charitable institutions need to look at and controls needed to avoid FCPA violations. The DOJ also refers to three prior releases that have dealt with charitable-type grants or donations:

1. FCPA Opinion Release 95-01 (Jan. 11, 1995)
2. FCPA Opinion Release 97-02 (Nov. 5, 1997)
3. FCPA Opinion Release 06-01 (Oct. 16, 2006)

The situation in the release is unique but you can use the controls and discussion in the release to help with your own FCPA compliance program.

Sources:

• FCPA Opinion Procedure Release 10-02
• Microfinance Meets The FCPA in the FCPA Blog
• Opinion Release 10-02 and Charitable Donations under the FCPA by Tom Fox

Courtesy of Saturday Morning Breakfast Cereal.

More:

• The Myth of Sisyphus and Camus

From 2010 Blank Park Zoo in Des Moines Iowa

The encounter was unexpected, but there was no significant loss or gain.

Here are some recent stories that I found interesting:

Dodd-Frank Forum: What would Brandeis think? by Mike Guttentag in The Conglomerate

Louis Brandeis famously coined the metaphor (“sunlight is the best policeman”) that provided the philosophy underpinning the first federal securities acts (disclosure, disclosure, and more disclosure). I thought it might be fun to run a thought experiment: what would the intellectual father of federal securities regulation think of the Dodd-Frank Act?

The FCPA’s Top Ten in the FCPA Blog

Here are the top ten FCPA settlements of all time. If our math is right, the financial penalties (criminal fines, civil disgorgement, and prejudgment interest) add up to $2.8 billion, with almost 50% of that coming from the top two settlements.

The Men Who Ended Goldman’s War by Louise Story for the New York Times

LAST Wednesday at around 3 p.m., the Securities and Exchange Commission and Goldman Sachs settled an epic, seismic battle — one waged over whether the storied investment bank defrauded investors in a transaction that regulators said Goldman had built to self-destruct.

SEC Expects Massive Staff Increase Needed to Implement FinReg in Compliance Avenue

Yesterday, SEC Chairman Mary Schapiro, during her Testimony Concerning Oversight of the U.S. Securities and Exchange Commission: Evaluating Present Reforms and Future Challenges, which she gave before the United States House of Representatives Committee on Financial Services Subcommittee on Capital Markets, Insurance and Government-Sponsored Enterprises, stated that the Commission expects to hire approximately 800 new positions during the course of the implementation.

Image of Louis Brandeis is from the United States Library of Congress’s Prints and Photographs Division under the digital ID cph.3a31794.

The SEC is trying to improve Form ADV. I wonder if it takes into account the new registration standards under the Dodd-Frank Act or whether they will need to make another to recognize the new law.

From the SEC press Release SEC Approves Disclosure Form Changes to Provide Investors Greater Information About Their Investment Advisers:

Under the new rules, advisers will have to provide new and prospective clients with narrative brochures that are organized in a consistent, uniform manner and that include plain English disclosures of the adviser’s business practices, fees, conflicts of interest, and disciplinary information. Advisory firms also must provide “brochure supplements” to clients containing information about the employees who will provide the advisory services to that client.

The Amendments

• Improved Format and Updating Requirements. Advisers are required to prepare a narrative, plain English, brochure, presented in a consistent, uniform manner that will make it easier for clients to compare different advisers’ disclosures. The clear and concise narrative descriptions provided in the brochure will improve the ability of clients and prospective clients to evaluate advisers and to understand conflicts of interest that the firms and their personnel face, the effects of those conflicts on the firms’ services, and the steps the adviser takes to address the conflicts.

  Advisers must deliver the brochure to a client before or at the time the adviser enters into an advisory contract with the client. In addition, advisers must provide each client an annual summary of material changes to the brochure and either deliver a complete updated brochure or offer to provide the client with the updated brochure.

• Expanded Content. The new brochure addresses those topics the Commission believes are most relevant to clients, including:
  • Advisory business — An investment adviser must describe its advisory business, including the types of advisory services offered, state whether it holds itself out as specializing in a particular type of advisory service, and disclose the amount of client assets that it manages.
  • Fees and compensation — An investment adviser must describe how it is compensated for its advisory services, provide a fee schedule, and disclose whether fees are negotiable. The investment adviser must also describe the types of other fees or expenses, such as brokerage fees, custody fees, and fund expenses that clients may pay in connection with the services provided.
  • Performance-based fees and side-by-side management — An investment adviser that accepts performance-based fees, or that supervises an individual who accepts such fees, is required to disclose this fact. If the investment adviser also manages accounts that are not charged a performance fee, the adviser must explain the conflicts of interest that arise from the simultaneous management of these accounts and must describe how it addresses those conflicts.
  • Methods of analysis, investment strategies, and risk of loss — An investment adviser must describe its methods of analysis and investment strategies and explain that investing in securities involves risk of loss which clients should be prepared to bear. Investment advisers who use a particular method of analysis or strategy or who recommend a particular type of security are required to explain the material risks involved and discuss the risks in detail if those risks are unusual.
  • Disciplinary information — An investment adviser is required to disclose in its brochure material facts about any legal or disciplinary event that is material to a client’s evaluation of the advisory business or to the integrity of its management personnel. An investment adviser must deliver promptly to clients updated information when there is new disclosure of a disciplinary event or a material change to an existing disciplinary event.
  • Code of ethics, participation or interest in client transactions, and personal trading — An investment adviser is required to describe briefly its code of ethics and state that a copy is available upon request. The adviser must also disclose whether it or an affiliate recommends to clients, or buys or sells for client accounts, securities in which the adviser or an affiliate has a material financial interest and, if so, the conflicts of interest associated with that practice. The adviser also must disclose whether it or an affiliate invests (or is allowed to invest) in the same securities that it recommends to clients or in related securities, such as options or other derivatives, and must explain the conflicts involved and how it addresses those conflicts. In addition, an investment adviser that trades in the recommended securities at or around the same time as the client has to explain the specific conflicts inherent in that practice and how it addresses them.
  • Brokerage practices — An investment adviser is required to describe the factors considered in selecting or recommending broker-dealers for client transactions and determining the reasonableness of brokers’ compensation. Investment advisers also must disclose soft dollar practices (research or other products or services, other than execution, provided by brokers or a third party to the investment adviser in connection with client transactions); client referrals (using client brokerage to compensate brokers for client referrals); directed brokerage (asking or permitting clients to send trades to a specific broker for execution); and trade aggregation (bundling trades to obtain volume discounts on execution costs). Investment advisers must explain how they address the various conflicts of interest associated with these practices.
• Supplements. An adviser is required to deliver “brochure supplements” to new and prospective clients providing them with information about the specific individuals who will provide services to the clients. The supplement will contain brief résumé-like disclosure about the educational background, business experience, other business activities, and disciplinary history of the individual, so that the client can assess the person’s background and qualifications. It will also include contact information for the person’s supervisor in case the client has a concern about the person.
• Internet Availability. Advisers are required to electronically file brochures, which will be publicly available on the SEC’s website.

The SEC expects that most investment advisers will begin distributing and publicly posting new brochures in the first quarter of 2011.

“The fact is, the financial industry is central to our nation’s ability to grow, prosper, compete, and innovate. There are a lot of banks that understand and fulfill this vital role, and a lot of bankers who want to do right by their customers. Well, this reform will help foster innovation, not hamper it. It is designed to make sure that everyone follows the same set of rules, so that firms compete on price and quality, not tricks and traps. It demands accountability and responsibility from everyone. It provides certainty to everybody from bankers to farmers to business owners. And unless your business model depends on cutting corners or bilking your customers, you have nothing to fear from this reform.” – excerpt from the president’s speech

The President was joined on the stage by two non-politicians:

Andrew Giordano is a retired Vietnam veteran from Locust Point, Maryland who the President met last year when he participated in a roundtable to discuss the outdated rules regulating the financial sector. Mr. Giordano was saddled with hundreds of dollars in overdraft fees on his veteran’s account because his bank had automatically enrolled him in “overdraft” protection that he never asked for. The new Consumer Protection Bureau will enforce new rules on overdraft programs to make sure that consumers like Mr. Giordano get a real choice and are not unknowingly charged unnecessary fees.

Robin Fox is a 7th grade science teacher from Rome, Georgia who sent an letter to the President in early August because her credit card company retroactively increased the rate on her existing credit card balance from 10.90% to 17.90%, even though she paid her account on time. The increase has been a burden on her family at an already difficult time, after her husband’s landscaping business dried up due to the financial crisis. The new Consumer Protection Bureau will enforce the Credit CARD Act of 2009, which bans arbitrary rate hikes on existing balances and other unfair practices by credit card companies.

The politicians on the stage:

• Vice President Biden
• Secretary Timothy Geithner
• Chairman Chris Dodd, D-CT
• Chairman Barney Frank, D-MA
• Speaker Nancy Pelosi, D-CA
• Senator Harry Reid, D-NV
• Senator Blanche Lincoln, D-AR
• Representative Collin Peterson, D-MN
• Representative Steny Hoyer, D-MD
• Representative Paul Kanjorski, D-PA
• Representative Maxine Waters, D-CA
• Representative Mel Watt, D-NC
• Representative Luis Gutierrez, D-IL
• Representative Gregory Meeks, D-NY
• Representative Dennis Moore, D-KS
• Senator Tim Johnson, D-SD
• Senator Jack Reed, D-RI

I assume everyone got pens.

Sources:

• President Obama’s prepared remarks a the bill signing
• Background on the signing ceremony
• Image is from AFP