Compliance Building

Compliance Bricks and Mortar for January 19

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

Financial Institutions Are Playing Catch-Up in AML and Sanctions Compliance by Michael Volkov

A recent survey of financial institutions conducted by Alix Partners on AML and Sanctions compliance (here) contains informative results that support some of my general concerns about ethics and compliance programs – board members do not receive adequate training and compliance officers are continuing to struggle with lack of adequate resources. [More…]

A Sense of Purpose by Larry Fink

Without a sense of purpose, no company, either public or private, can achieve its full potential. It will ultimately lose the license to operate from key stakeholders. It will succumb to short-term pressures to distribute earnings, and, in the process, sacrifice investments in employee development, innovation, and capital expenditures that are necessary for long-term growth. It will remain exposed to activist campaigns that articulate a clearer goal, even if that goal serves only the shortest and narrowest of objectives. And ultimately, that company will provide subpar returns to the investors who depend on it to finance their retirement, home purchases, or higher education.  [More…]

The New Digital Wild West: Regulating the Explosion of Initial Coin Offerings by Randolph A. Robinson, II

In order to provide the necessary context to understand this new decentralized world, this paper provides a non-technical legal audience with a foundational understanding of how public blockchains work. The paper begins with an introduction to the coming decentralized world, including an overview of both public blockchain technology as well the Ethereum platform, the primary public blockchain upon which ICOs are being deployed. [More…]


The SEC Administrative Law Judges Are Heading to the Supreme Court

The use of administrative law judges by the Securities and Exchange Commission has been strained since the jurisdiction was expanded under Dodd-Frank. There have been a series of cases challenging the ALJs under the the Appointments Clause of the Constitution. The problem was that the judges were appointed by an internal panel instead of by the President or the SEC Commissioners.

An advertising case that led to an adviser being barred is now headed to the U.S. Supreme Court. In the Lucia case, the lower court used a three prong test to determine if an ALJ is an “Officer” under the Appointments Clause:

  1. significance of the matters resolved by the government official
  2. discretion the official exercises in reaching the decision
  3. the finality of the decision

On Jan. 12th, the Supreme Court granted an appeal to hear Lucia v. SEC. This was likely based on two factors.

One was a split in the courts on whether the SEC’s administrative law judges were properly appointed. The 10th Circuit Court of Appeals came to the opposite conclusion in Bandimere v. SEC. That court used a different three part analysis to determine if an ALJ is an “inferior officer”:

(1) the position of the SEC ALJ was “established by Law,”;
(2) “the duties, salary, and means of appointment . . . are specified by statute,”.; and
(3) SEC ALJs “exercise significant discretion” in “carrying out . . . important functions,” .

The Bandimere decision rejected the argument in the Lucia case that ALJs do not have final decision-making power. They have enough power to make them an “inferior officer.”

The second was that the Department of Justice decided that the ALJ appointment process was flawed. That position dropped in the Solicitor General’s Brief on Writ of Certiorari for Lucia the argument is now to hear the case and overturn the Lucia ruling.

“[T]he government is now of the view that such ALJs are officers because they exercise ‘significant authority pursuant to the laws of the United States.’ Buckley v. Valeo, 424 U.S. 1, 126 (1976)”

In response, the SEC ratified all the ALJ appointments. This should fix the problem and erase the constitutional problem.

In the reply brief, Lucia argued that the government’s change of its position and its revised procedures did nothing for him.

“Although the government now agrees that SEC ALJs are Officers, it has afforded petitioners no redress for having subjected them to trial before an unconstitutionally constituted tribunal… On the contrary, petitioners remain subject to draconian sanctions—including a lifetime associational bar—resulting from the tainted proceedings below”

It looks like the SEC has fixed the problem with its ALJs going forward. The problem will be what to do with all of the cases that have already been decided. It seems likely that the SEC is going to agree that the ALJs were a problem. The big question is how to fix that problem for the cases that have already been adjudicated. I would guess that there are a lot of cases that going be expunged, people no longer barred and cash fines repaid.


Full Speed Ahead for the SEC

Commissioners Hester M. Peirce and Robert J. Jackson, Jr. are, According to Jay Clayton’s math the 96th and 97th Commissioners of the Securities and Exchange Commission after being sworn in last week.

It’s been two years since the SEC has been at full strength. Perhaps this means that rule-making will proceed ahead. Based on the SEC’s regulatory agenda, Chair Clayton is planning to have the commissioners focus on a much smaller set of rules in the near term.


Compliance Bricks and Mortar for January 12

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

Five Things to Think About Before a Surprise SEC Exam

by Joshua M. Newville, Robert E. Plaze, Christopher Wells and Alexandra V. Bargoot

If a team from the SEC arrives at your office and says, “We are conducting an on-site examination and would like to talk to the CCO right now,” are you prepared? A handful of registered investment advisers have faced surprise SEC exams in recent months. These exams come in two flavors: either a “for cause” exam arising from SEC staff concerns relating to a specific ongoing issue, or a standard exam that for some reason has a surprise component. [More…]

Are You Ready for Your Next Regulatory Exam?

by Patty P. Tehrani, Esq.

I know regulatory examinations can be stressful but without a defined process even more so. I’ve lived through exams managed without a process and those guided by one and not surprisingly having a process inevitably garnered better results. Below I share some practical tips to help you develop an examinations process or improve one that you already have. [More…]

Eight Compliance Events to Watch in 2018

by Matt Kelly

Without further delay, then, my annual list of compliance issues that should be worth watching in 2018. In no particular order…

SEC guidance on cybersecurity.  [More...]

“The Big Chill”: Personal Liability and the Targeting of Financial Sector Compliance Officers

by Court E. Golumbic

Prominent law enforcement and regulatory officials have referred to financial sector compliance officers, as “essential partners” in ensuring compliance with relevant laws and regulations, whose “difficult job[s]” merit “appreciat[ion] and respect.” Officials have noted the critical role these professionals play in shaping the culture of financial institutions, as well as the industry more generally. However, a series of recent enforcement actions in which financial sector compliance officers have been personally sanctioned has strained this partnership, fueling concerns among financial sector compliance officers that they are being unfairly targeted. [More…]

Court Rejects SEC Request For “Obey The Law” Injunction

in SEC Actions

[A] district court has granted summary judgment against the Commission in a Securities Act Section 5 case centered on a years long Ponzi scheme based on the statute of limitations and refused to enter an injunction, although Kokesh is not actually citedSEC v. Jones, Civil Action No. 17-11226 (D. Mass. Opinion Jan. 5, 2018).[More…]

Discretionary Management of IRAs: Prohibited Transaction Issues for RIAs

However, there is a caveat. That is, BICE only applies to non-discretionary investment advice. In other words, if the financial institution or its advisors have the responsibility or authority to make the decisions, or if they actually make the investment or transaction decisions, and there is a financial conflict of interest (that is, a prohibited transaction), BICE does not provide relief. To make matters even worse, there are very few exemptions for prohibited transactions resulting from discretionary decisions. Based on conversations with RIAs over the last few months, I have learned that many of them are not aware that, where they have financial conflicts (for example, 12b-1 fees or payments from custodians) for discretionary investment management for IRAs, there is usually not an exemption and the compensation is prohibited. [More…]

Some bitcoin foolishness:

Miami Bitcoin Conference Stops Accepting Bitcoin Due to Fees and Congestion
Next week the popular cryptocurrency event, The North American Bitcoin Conference (TNABC) will be hosted in downtown Miami at the James L Knight Center, January 18-19. However, bitcoin proponents got some unfortunate news this week as the event organizers have announced they have stopped accepting bitcoin payments for conference tickets due to network fees and congestion. [More..]

Long Island Iced Tea shares soar after changing name to Long Blockchain
A visit to the new website shows that Long Blockchain is in the “preliminary stages of evaluating specific opportunities” in the blockchain space. At this time, the company has no agreements with any blockchain entities, nor does it have assurance that an agreement will be forthcoming, the website said. [More…]

The 7-11 Compliance Conondrum

Immigration and citizenship employee compliance requirements are fairly straightforward, although awkward. You can’t usually ask whether or not a job applicant is a United States citizen before making an offer of employment. But you do need to verify the identity and employment eligibility of all employees, by completing the Employment Eligibility Verification (I-9) Form, and reviewing documents showing the employee’s identity and employment authorization. Then you need to hold onto the I-9 while the person is employed.

U.S. Immigration and Customs Enforcement agents targeted nearly 100 of 7-Eleven stores in 17 states before dawn Wednesday to deliver audit notifications of their I-9 paperwork. In the process, it made 21 arrests of employees on suspicion of being in the U.S. illegally.

But why 7-11?

A press release from 7-11 HQ pointed out:

“7-Eleven Franchisees are independent business owners and are solely responsible for their employees including deciding who to hire and verifying their eligibility to work in the United States.”

So effectively, ICE deployed hundreds of agents at almost 100 locations at what are essentially each a separate business. I would guess that each location employs a few dozen employees at the most. That seems like a huge deployment of resources for a small amount of potential targets.

I suppose this does send a message to franchisees and franchisors of all industries to make sure they follow the I-9 requirements because ICE is willing to dedicate a ludicrous amount of resources to make a statement.

ICE indicated that this sweep was a “follow-up” of a 2013 ICE action that resulted in the arrests of nine 7-Eleven franchise owners and managers in New York and Virginia on charges of employing undocumented workers. That was one of the largest criminal immigrant employment investigations ever conducted.

Meanwhile the Office Inspector General released a report the raised concerns about ICE detainee treatment and care at detention facilities and ICE’s Screening Protocol of Aliens Who May Be Known or Suspected Terrorists is Limited and Risks National Security.

It still looks a huge of amount of resources deployed against the 7-11 franchises. In contrast, ICE raided an Iowa meatpacking plant in 2008 and detained nearly 400 undocumented workers. That plant owner, Sholom Rubashkin, recently had his prison sentence commuted by President Trump.

You can look at the 7-11 raid as a follow-up to a prior action.

“Today’s actions send a strong message to U.S. businesses that hire and employ an illegal workforce: ICE will enforce the law, and if you are found to be breaking the law, you will be held accountable,” said Thomas D. Homan, ICE Deputy Director and Senior Official Performing the Duties of the Director. “Businesses that hire illegal workers are a pull factor for illegal immigration and we are working hard to remove this magnet. ICE will continue its efforts to protect jobs for American workers by eliminating unfair competitive advantages for companies that exploit illegal immigration.” –  ICE Deputy Director Thomas D. Homan

So according to ICE statement, 7-11 draws illegal immigrants into the US and those illegal workers are taking away jobs from Americans who want to work at 7-11.

For those in compliance like me, our job is not to question the wisdom of the rule, but make sure our companies are following the rule. That means running the I-9 process and keeping the paperwork to avoid an ICE raid.


Compliance Bricks and Mortar – Blizzard Edition

I’ve just come inside after digging out from yesterday’s blizzard. These are some of the compliance-related stories I’m going to read by the fire.

Is Bitcoin Really in a Bubble? in Knowledge@Wharton

[T]he cryptocurrency community is divided on whether bitcoin is a “side show or the show.” However, he believes that the “fundamental breakthrough is not necessarily bitcoin but the blockchain technology,” which is the distributed ledger that tracks these transactions. [More…]

The SEC and Securities Plaintiffs’ Bar Take Aim at Initial Coin Offerings

However, its recent investigative report addressing the initial coin offering (“ICO”) of a virtual organization (“21(a) Report”)1 marks a dramatic increase in the SEC’s focus that will have a profound impact on how this emerging market will be regulated. The report also signals an eventual uptick in enforcement activity and supplies plaintiffs’ attorneys with a new weapon for their complaints. As discussed in this article, the 21(a) Report therefore has far-reaching implications to the creation, offer, and sale of ICOs as well as the promotional and investment activities relating to them. [More…]

Global Magnitsky Sanctions Target Human Rights Abusers and Government Corruption Around the World
by David S. Cohen, Kimberly A. Parker, Jay Holtmeier, Ronald I. Meltzer, David M. Horn, Lillian Howard Potter, and Michael Romais

On December 20, 2017, President Trump issued a new Executive Order (EO) targeting corruption and human rights abuses around the world. The EO implements last year’s Global Magnitsky Human Rights Accountability Act (the Global Magnitsky Act), which authorized the president to impose sanctions against human rights abusers and those who facilitate government corruption.[1] The US Department of the Treasury’s Office of Foreign Assets Control (OFAC), which will administer the EO, also added 15 individuals and 37 entities to its Specially Designated Nationals and Blocked Persons List (SDN List).  [More…]

CCO Authority and Independence by Tom Fox

In the 2012 FCPA Guidance, under Hallmark Three of the 10 Hallmarks of an Effective Compliance Program, the focus was articulated by the title of the Hallmark, Oversight, Autonomy, and Resources. In it the 2012 FCPA Guidance focused on the whether the CCO held senior management status and had a direct reporting line to the Board; stating “In appraising a compliance program, DOJ and SEC also consider whether a company has assigned responsibility for the oversight and implementation of a company’s compliance program to one or more specific senior executives within an organization. Those individuals must have appropriate authority within the organization adequate autonomy from management, and sufficient resources to ensure that the company’s compliance program is implemented effectively. Adequate autonomy generally includes direct access to an organization’s governing authority, such as the board of directors and committees of the board of directors.”[More…]

Start Your Compliance Year Right

After a long weekend, and perhaps a vacation, compliance professionals are coming back into the office with 2018 on the calendar. It’s a clean slate. The possibilities are endless.

Where to start?

I don’t have the answer. There is so much to get done and so many challenges ahead.

No organization has has the same risks, regulatory requirements, or challenges as any other organization. It would be foolish for me to tell you where to start the year.

I can give the simple advice to start. I’m sure you have plenty of things left from 2017 that need to be completed on top of all the other things coming down the pipeline. Start doing something. Get it done and move on to the next. Repeat as necessary.

Compliance is different things to different people, to different organizations, and to different regulators.

But getting something done is always a good step.

So go get something done today.

Compliance Bricks and Mortar for December 22

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

American Law Enforcement’s Focus on Cooperation and Self-Reporting by Lee S. Richards

More recently, law enforcement officials, anxious to improve the effectiveness of their programs, have placed even greater emphasis on the need for companies to rush in to disclose problems they have discovered at the earliest possible time. For example, the Department of Justice has recently amended the United States Attorney’s Manual to create a presumption in favor of a declination in FCPA cases where a Company self-reports, but only a maximum 25 percent fine reduction if it does not self-report yet otherwise cooperates fully. U.S. Attorney’s Manual §9-47.120. [More…]

Another ICO Draws a Securities Class Action Lawsuit by Kevin LaCroix in the D&O Diary

On December 13, 2017, an investor who purchased Centra Tech tokens in the Centra ICO filed a securities class action lawsuit in the Southern District of Florida against the company, Sharma, Trapani, and two other Centra Tech officers. A copy of the complaint can be found here. The complaint alleges that the defendants violated sections 12(a)(1) and 15(a) of the Securities Act of 1933 in connection with the ICO “by offering and selling unregistered securities in direct violation of the Securities Act.” The lawsuit purports to be filed on behalf of all investors in the Centra ICO. [More…]

Quick Case of Kickbacks and COI by Matt Kelly in Radical Compliance

You get the picture. The firms had strong policies and certification requirements, and a failure happened because an employee lied. [More…]

Magnitsky Act Compliance is Straightforward, Experts Say by Samuel Rubenfeld

The U.S. Treasury Department on Wednesday released the sanctions regulations for enforcing the Magnitsky Act, which targets Russian human-rights abusers, but sanctions experts say the rules won’t require any new compliance measures. [More…]

For those of you looking for more compliance and Star Wars stories, here are all of Tom Fox’s:

More Political Contribution Problems

There is too much money in a politics. I understand the Securities and Exchange Commission’s desire to purge political contributions from the investment adviser business for state and local government money. But I’ve never been a fan of Rule 206(4)-5, the pay-to-play rule. It’s continuing to ensnare companies in ways that highlight problems with the rule and the very low limits in the rule.

One recent case is that of PNC Capital Advisors. One its employees in business development made a $1000 campaign contribution to John Kasich’s presidential campaign. Kasich was the governor of Ohio and able to appoint trustees to the Ohio state pension funds. That made Kasich an “Official” under the rule and firm had some Ohio state pension money under management.

As I had pointed out, only two out of the twenty-two the major candidates for the last presidential election were subject to the campaign contribution limit because they held state offices: John Kasich and Chris Christie. The rule obviously creates an unnecessary distortion in political campaigns. Adding Pence, the Governor of Indiana to the ticket caused another what do we do moment.

In PNC’s case, the employee had been listed by PNC as a “covered associate” and was in the process of being promoted when PNC discovered the campaign contribution. However, the employee was not responsible for the Ohio account. At no time had the employee been involved in soliciting the Ohio plans, and had never communicated with the Ohio plans. The Contributor had never solicited any other state or local Ohio government entity. The Contributor had never made presentations for, or met with, any representatives of the Ohio plans or with any other Ohio government entities, or supervised any person who met with any of the Ohio plans or other Ohio government entity. If promoted, the Contributor will neither meet with any Ohio government entities personally, nor supervise any person who solicits investment advisory services business from Ohio government entities.

The employee failed to disclose the contribution because he was focused the office Kasich was running for, President, and failed to realize that the rule applied to the current office as well. The PNC compliance group found the contribution in the process of running checks in connection with a promotion. A promotion that is now on hold and has been for 2017.

The SEC order prohibits the employee from soliciting government funds for several months. PNC was allowed to keep the two year worth of fees. $700,000 of fees was at risk for that $1000 contribution.

That was a $1000 contribution in a campaign in which Kasich raised over $19 million.

BlackRock had a similar problem with the Kasich campaign. One of its employees wrote a check for $2700 to the Kasich campaign. The employee was in the ETF division, but since he was on the global executive committee, he fell into the definition of “covered associate.”

Similar to PNC, that employee had never solicited government entities for investment advisory business that is covered under the Rule. To the extent the Contributor has personally solicited business from any government entities, it was exclusively for direct investments in RICs that are outside the scope of the Rule. He has never attended, or otherwise participated in, any meetings, discussions, or any other communications in which a solicitation of covered investment advisory business has taken place.

Blackrock’s compliance group found the donation while conducting a routine compliance review.

Here is a list of other exemptions granted. These were identified in the PNC application and BlackRock application.

  • Davidson Kempner Capital Management LLC, Investment Advisers Act Release Nos. IA-3693 (October 17, 2013) (notice) and IA-3715 (November 13, 2013) (order)
  • Ares Real Estate Management Holdings, LLC, Investment Advisers Act Release Nos. IA-3957 (October 22, 2014) (notice) and IA-3969 (November 18, 2014) ( order);
  • Crestview Advisors, LLC, Investment Advisers Act Release Nos. IA-3987 (December 19, 2014) (notice) and IA-3997 (January 14, 2015)(order);
  • T. Rowe Price Associates, Inc., and T. Rowe Price International Ltd., Investment Advisers Release Nos. IA-4046 (March 12, 2015) (notice) and IA-4508 (April 8, 2015)(order);
  • Crescent Capital Group, LP, Investment Advisers Release Nos. IA-4140 (July 14, 2015) (notice) and IA-4172 (August 14, 2015) (order);
  • Starwood Capital Group Management, LLC, Investment Advisers Act Release Nos. IA-4182 (August 26, 2015)(notice) and IA-4203 (September 22, 2015) (order);
  • Fidelity Management & Research Company and FMR Co., Inc., Investment Advisers Release Nos. IA-4220 (October 8, 2015) (notice) and IA-4254 (November 3, 2015) (order);
  • Brookfield Asset Management Private Institutional Capital Adviser US, LLC et. al., Investment Advisers Act Release Nos. IA-4337 (February 22, 2016) (notice) and IA-4355 (March 21, 2016) (order);
  • Angelo, Gordon & Co., LP, Investment Advisers Release Nos. IA-4418 (June 10, 2016)(notice) and IA-4444 (July 6, 2016) ( order);
  • Brown Advisory LLC, Investment Advisers Act Release Nos. IA-4605 (January 10, 2017) (notice) and IA-4642 (February 7, 2017) (order)

These all look technical violations with no evidence that there were weaknesses in policies or an intent to influence. The rule is just too broad, with dollar limits that are too low.


SEC’s Regulatory Agenda

A few months ago, Securities and Exchange Commission Chairman Jay Clayton stated that the SEC had been hard at work on developing its rule-making agenda for the upcoming year.

In the coming weeks and months, I expect the SEC’s near-term rulemaking objectives to be fully reflected in our upcoming Regulatory Flexibility Act Agenda. As a general matter, I believe it is important that these publicly available agendas provide the necessary transparency and accountability for agency matters. If these plans are to meet their intended purpose, they must be streamlined to inform Congress, investors, issuers and other interested parties about what the SEC actually intends – and realistically expects – to accomplish over the coming year.

The SEC released its Regulatory Flexibility Act Agenda for 2017 and grouped the agenda into two categories: Proposed Rules and Final Rules and Long Term Actions.

The “Existing Proposed & Final Rule Stages” are rule-makings the the SEC intends to address during 2017. For those rule-makings that have progressed to some extent, there is a prediction as to when a final rule might occur. The “Long-Term Actions” rule-makings are supposedly that the SEC isn’t likely to tackle in the near term.

In going though the proposed rules and final rules, I didn’t see much that would directly affect private funds.

I did see that the dreaded proposed changes to Form D and private placements is not on the agenda and was formally withdrawn in September.


The Most Massachusetts Bribe

One thing that is clear about bribery and corruption is that the payments are not always envelopes full of cash. The FCPA opinions have long pointed out that directing charitable donations to the decision-makers “pet” charity could be a bribe. As former Director of the the Division of Enforcement at the SEC, Andrew Ceresney pointed out, “bribes come in many shapes and sizes.”

That shape could include coffee. It was not just a cup of coffee, but hundreds of pounds of coffee that lead to this story.

Former Massachusetts state senator Brian A. Joyce is facing a series of charges for racketeering, mail fraud, wire fraud, honest services fraud and extortion.

Among the most Massachusetts of charges is the allegation that Joyce took official action, or pressured others to take official action, on behalf of a coffee-business franchise owner in exchange for hundreds of pounds of free coffee. The indictment and press release don’t say which “coffee and pastry fast-food business” franchise was involved, but there is only one in Massachusetts with that many locations in New England: Dunkin’ Donuts.

The indictment alleges that the franchise owner gave Joyce 504 pounds of coffee at Joyce’s request in exchange for moving favorable legislation through the Massachusetts legislature.

Not to paint Joyce as a completely bad guy, the indictment points out that Joyce allegedly gave a pound of coffee to each state senator. Unfortunately, that generosity caught the attention of an intrepid reporter which lead to a news story and an ethics investigation. Allegedly, Joyce conspired with the franchise owner to falsify invoices for legal services and state that the coffee for given in barter.

The story is reminder that bribery comes in many shapes and sizes, including small, medium and large, with cream and sugar.


Compliance Lessons from Star Wars – Man Versus Machine

With the release of Episode VIII – The Last Jedi, I’m joining Tom Fox in tying compliance and the Star Wars franchise together in some posts this week. (I saw the movie last night, but I will refrain from revealing anything other than it was terrific.) One of the central themes of the Star Wars franchise is man versus machine.

Luke turns off his targeting computer and relies on the Force during his photon torpedo run on the Death Star. Obi Wan Kenobi describes Darth Vader as more man than machine. It’s primitive Ewoks that crush the technology driven imperial forces at the Battle of Endor. It is when Vader once again finds his humanity that he lives up to the prophecy as the one that will bring balance to the Force.

The Star Wars does not say that technology is bad. How could that be with the beloved R2-D2 and C-3PO, the only characters to appear in all of the movies. In the prequels, it is the rise of robot army that leads to the deployment of the clone troopers and the beginning of the Empire.

Compliance professionals are trying to deal with its own robot uprising: robo-advisers. How to do you regulate a robot or an algorithm that goes bad? How do you create a compliance program from preventing them from going bad? (For a good book on the dangers of algorithms and big data, add Weapons of Math Destruction to your reading list.)

The Securities and Exchange Commission brought an action against AXA Rosenberg in 2011 for a failure in the computer code for its investment model. The SEC did not bring charges against the computer for the fault in the program. It brought it against the people who controlled the model. In this case, it was the fund managers who hid the problem. The computer had done what it was told and it was told to do the wrong thing.

Earlier this year, the SEC released guidance on Robo Advisers.

Robo-advisers, like all registered investment advisers, are subject to the substantive and fiduciary obligations of the Investment Advisers Act. This presents some complications and uncertainties under the Act. Robo-advisers rely on algorithms and likely offers little, if any, human interaction with their advisory clients. The SEC guidance focused on three distinct areas identified by the SEC, with suggestions on how robo-advisers may address them:

1. The substance and presentation of disclosures to clients about the robo-adviser and the investment advisory services it offers;
2. The obligation to obtain information from clients to support the robo-adviser’s duty to provide suitable advice; and
3. The adoption and implementation of effective compliance programs reasonably designed to address particular concerns relevant to providing automated advice.

Can a robo-adviser even meet the duty of care under the Investment Advisers Act? It’s clear what that duty of care is or how personalized the service needs to be. The biggest element is conflicts of interest. As with most conflicts, they can be dealt with by disclosures and robust policies and procedures.

Even with the concerns, robo-advisers are rising in assets under management. They are providing a good service at a low cost, allowing humans to oversee the process. Robots are helping humans succeed.

Compliance Lessons from Star Wars – Rebels

With the pending release of Episode VIII – The Last Jedi, I’m joining Tom Fox in tying compliance and the Star Wars franchise together in some posts this week. Star Wars is about the rise of the evil galactic empire and the rebels who fight against it. I think some Bitcoin advocates are trying to be the rebels who portray the the Federal Reserve as the evil Galactic Empire. The battle is for freedom of money.

“This is a fantastic fundamental hedge and store of value against autocratic regimes and banking infrastructure that we know is corrosive to how the world needs to work properly,” said Chamath Palihapitiya, the founder of Social Capital and an early Bitcoin investor. “You cannot have central banks infinitely printing currency.”

In response to that, I give you this picture of the Treasury Secretary showing a new sheet of money to his wife dressed in Darth Vader garb. (Add a helmet and it’s complete)

Of course the Treasury is not the Federal Reserve and this printed money is not the same as the Federal Reserve buying bonds with money pulled out of thin air. Since we have entered a post-factual world in Washington, I’m not sure we need to let facts get in the way of a great picture.

The underlying technology of Bitcoin, blockchain, is a brilliant shared ledger. It has the ability to replace some proprietary databases of transactional information. I’m less interest in Bitcoin itself. Digital currency moves control of the currency from the central banks to computer servers.  While currency can be inflated be the central banks, Bitcoin is limited to a slow creation on the servers running blockchain.

As a naysayer, I failed to see the rise of Bitcoin. If I had a bought a few bitcoins when I first looked down my nose at it, I would have made a pile of cash.

The Federal Reserve, at the heart of the Galactic Empire, has pushed Bitcoin aside. Janet Yellen, the current Chair of the Board of Governors of the Federal Reserve System on Wednesday called Bitcoin a “highly speculative asset” and “not a stable source of value”, and “it doesn’t constitute legal tender.”  In response, Bitcoin did not back down and the exchange rate stayed stable. The empire would have to find other ways to attack cryptocurrency.

The rebellion has grown from Bitcoin to other cryptocurrencies. They are launching their attacks in Initial Coin Offerings. No initial coin offerings have been registered with the Securities and Exchange Commission as the sale of securities. They are operating outside the oversight of the SEC, failing to give purchasers/investors the protections that come with SEC registration and oversight.

If you invested in an ICO, should you be worried that the offering might be targeted by the SEC? Yes, you should be worried. That ICO is Alderaan and the SEC has the Death Star. A million voices will scream out about the injustice. So much real money and false value will be destroyed.

The SEC stopped an ICO this week for Munchee. Munchee was seeking $15 million to improve an existing iPhone app for restaurant meal reviews and to create an “ecosystem” in which Munchee and others would buy and sell goods and services using the tokens. The company emphasized that investors could expect that efforts by the company would lead to an increase in value of the tokens and it would take steps to create a secondary market for the tokens.  As the SEC has said in the DAO Report of Investigation, a token can be a security based on the long-standing facts and circumstances test that includes assessing whether investors’ profits are to be derived from the managerial and entrepreneurial efforts of others. The Munchee ICO was an illegal IPO.

The Empire of regulatory oversight has many factions. This week the IRS won a case against Coinbase, one of the largest digital currency brokers. The IRS claimed that virtual currency gains have been underreported based on the disproportionate number of taxpayers reporting gains from Bitcoin compared to the number of Coinbase account holders. Coinbase has approximately 5.9 million customers and has provided $6 billion in Bitcoin exchanges. However,  the IRS has identified only 800 to 900 taxpayers in each of the years from 2013 through 2015 who reported gains or losses that the IRS believes are “likely related to bitcoin.”

The battle will rage on. Rebel cryptocurrency against the regulated dollar. Which will allow you to buy a coffee at Dunkin Donuts? and which will you use?

See Tom’s posts:

Compliance Lessons From Star Wars – Lies

With the pending release of Episode VIII – The Last Jedi, I’m joining Tom Fox in tying compliance and the Star Wars franchise together in posts this week.

I’ve always been trouble by the lie from Obi Wan Kenobi to Luke Skywalker:

“Darth Vader betrayed and murdered your father.”

It’s the little lies that lead to bigger lies and bigger problems. Some of the ponzi schemes I see start with a sponsor telling a little lie about performance results. Then the sponsor is trapped chasing those untrue returns. That leads to bigger lies and bigger problems as the deficit between actual results and fictional results grow.

We saw the little lie growing with Bernie Madoff. Decades ago he missed his returns and lied about them. At some point he just gave up and didn’t pretend to chase the returns anymore. That became to a multi-billion dollar deficit between actual results and the fictional results he told investors.

Plenty of ponzi schemes are formed as frauds from the outset as a way to separate people from their money.  They start off with outlandish returns and promises of guaranteed results. There is a subset of these frauds that had started out with good intentions but misstep into these little lies that lead to downfall.

Obi Wan’s lie to Luke sends Luke into an ill-chosen battle with Darth Vader. Luke is seeking revenge for the death of his father. Things don’t go well for Luke in a battle against one of the fiercest warriors in the galaxy.

The cynic in me might point out that the lie was not intentional. Behind-the-scenes lore of the Star Wars franchise tells us that the plot turn in Empire Strikes Back, and told further in Episodes II and III, may not have been envisaged when Star Wars was made. For the pure of heart, we can assume the Kenobi was just trying to protect Luke from the truth.

Compliance Lessons From Star Wars – Hacked

With the pending release of Episode VIII – The Last Jedi, I’m joining Tom Fox in tying compliance and the Star Wars franchise together. Starting at the beginning with Star Wars, or what is now Episode IV – A New Hope, the climax is the destruction of the Death Star.

One of the complaints about the movie is the plot hole allowing “the ultimate power in universe” to be destroyed by a a group of small fighters. As we learned in Star Wars – Rogue One, the Death Star was hacked. The developer left a back door: a small, two meter-wide thermal exhaust port which would lead straight to the station’s main reactor.  The developer leaked the plans to rebels who launched their attack.

Clearly, the Securities and Exchange Commission is very focused on cybersecurity. Particularly, since the SEC’s EDGAR database was hacked last year. In speeches, actions and warning about exam priorities, the SEC puts cycbersecurity at or near the top of the list.

The focus on cybersecurity is not just to take the steps to harden your systems to prevent the hack, but creating a response plan in case you discover you are been hacked or have been hacked. Clearly, a flaw in the defense of the Death Star was not sending out enough imperial fighters to counter the rebel attack. The defense plan never expected an attack by small ships.

The death of Grand Moff Tarkin was not taking the threat seriously.

We’ve analyzed their attack, sir,
and there is a danger. Should I have
your ship standing by?

Evacuate? In out moment of triumph?
I think you overestimate their

Tarkin underestimated the chances and disappeared from the Star Wars movies until last year’s Rogue One prequel to Episode IV. Never underestimate a cyber-attack on your firm.

As many cybersecurity experts have told me, it’s not “if” you will be subject to an attack, it’s “when” you will be subject to a cyber-attack. Don’t suffer the imperial oversight failure of Tarkin. Be vigilant for weakness.

May the Force be with you.

Although Tom decided to ignore Episodes I-III in his posts, I will advocate for using the “machete order” for viewing the movies: IV, V, II, III, VI.

The key problem is that Mr. Lucas changed the end of VI so that Anakin is now played by Hayden Christensen. You will have no idea who that person is if you have not seen II or III. Plus II and III fill in the backstory of Anakin. You will note that Episode I, the worst of the movies, is left out. That removes Jar-Jar almost completely, removes midochlorians, and removes trade disputes. In return, you get a bigger universe, a better understanding of the threat posed by the emperor, and the redemption of Anakin.



Compliance Bricks and Mortar for December 8

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

ICO Enforcement Actions Threatened, ICO Lawsuits Proliferate By Kevin LaCroix

According to the latest update on the Coinschedule website (here), there have been a total of 228 initial coin offerings so far this year through mid-October, raising a total of over $3.6 billion. At least five of this year’s ICOs have raised over $100 million. This burgeoning activity notwithstanding, ICOs are at the center of controversy. Among other things, China and South Korea have banned ICOs. The SEC has already shown its willingness to pursue enforcement actions against ICO sponsors, as discussed further here. And now a high-profile statement by one of the country’s leading securities regulation experts suggests even greater scrutiny may lie ahead. In the meantime, as discussed below, ICO and cryptocurrency-related litigation appears to be proliferating. [More…]

See also:
Bitcoin futures are coming as CFTC gives blessing by William Watts
Bitcoin Is the World’s Hottest Currency, but No One’s Using It By Georgi Kantchev, Steven Russolillo, Paul Vigna and Christopher Whittall

What Makes a Safe Asset Safe? by Thomas Eisenbach and Sebastian Infante in Liberty Street Economics

Over the last decade, the concept of “safe assets” has received increasing attention, from regulators and private market participants, as well as researchers. This attention has led to the uncovering of some important details and nuances of what makes an asset “safe” and why it matters. In this blog post, we provide a review of the different aspects of safe assets, discuss possible reasons why they may be beneficial for investors, and give concrete examples of what these assets are in practice. [More…]

Using Side Letters in Private Funds by Alexander Davie in Strictly Business

For many fund managers, especially those early in their careers, obtaining capital and new investors is the biggest challenge, and so the temptation is great to accede to side letter requests from investors that are willing make a large investment in the fund. This can be especially true when the investor is demanding the side letter just prior to closing and may have the fund managers over a proverbial barrel. There are several risks that should be kept in mind when negotiating and drawing up such agreements. [More…]

IOSCO issues report on hedge fund statistics, trends By Amy Leisinger, J.D. in Jim Hamilton’s World of Securities Regulation

The International Organization of Securities Commissions (IOSCO) has published its biannual report on the global hedge fund marketplace, key regulatory changes, and the potential systemic risks posed by the industry. IOSCO’s survey assembles information from national authorities on hedge fund activities and is designed to enable regulators to share information and observe trends regarding exposure, leverage, liquidity management, funding, and trading activities in the hedge fund industry. [More…]

REIT controllers owed fiduciary duties to public stockholders by Joanne Cursinella, J.D. in Jim Hamilton’s World of Securities Regulation

Claims that certain defendants in a convoluted REIT scheme violated their fiduciary duties to stockholders survived a motion to dismiss. The court found that the plaintiff sufficiently alleged that the defendants set up a structure whereby they profited at the expense of the stockholders, maximizing the profits at the first entity they created to the detriment of the non-controlling stockholders of another entity they created and took public (RCS Creditor Trust v. Schorsch, November 30, 2017, Glasscock, S.). [More…]

France Gets Climate Risks Disclosures from Invest Firms by Mara Lemos Stein

France added momentum to the global push for greater climate risks awareness last year by requiring disclosures from not only companies but also institutional investors and asset managers. After the first year of reporting, governance mavens are encouraged by the level of compliance.

The energy transition and green growth law implemented in 2016 requires investors to report how they are integrating environmental, social and governance, or ESG, criteria in their portfolios; on their exposure to physical risks and risks caused by the transition to a low-carbon economy; and on steps being taken to align their firm’s decarbonization strategy with national and global emissions targets.[More…]

A Focus on Valuation Sources

Private funds are often dealing hard-to-value assets. Real estate funds are overwhelmingly dealing with hard-to-value assets. For purposes of GAAP reporting those will be the Level 2 and Level 3 assets. For these assets, valuations can be manipulated if you have a wiling participant in the process.

For thinly-traded securities, like some bonds, private funds will often rely on quotes from a broker for a potential sale. For the fund manager, the source was usually a broker that was in the circle of those trading for the fund.

A potential conflict exists, with the broker hoping to get more business from the fund and the fund hoping for a higher valuation. There is not much for the broker to lose by quoting a slightly higher sales price for thinly-traded bond in a hypothetical sale. Especially if the broker knows that she or he will not be required to actually trade that bond. In return, the broker may get additional business from the fund.

The Securities and Exchange Commission has been looking at conflicts and potentially illegal practices in this area.

In May, a former broker named Frank DiNucci Jr., said under oath that he provided bogus quotes to a trader at a mortgage bond fund. DiNucci  plead guilty to conspiracy and fraud and has been cooperating with a criminal probe by New York prosecutors. The DOJ has charged at least seven bond traders since 2013 with lying to customers about prices. Now the focus has widened to also include the buy-side of the market and is staring at practices at private funds.

Level 2 and Level 3 assets are by definition hard-to-value. A fund can not prove that the value is accurate. But it can be precise, by being consistent in its valuation procedures and ensuring that the pricing indications it receives are unbiased. Accurate and precise is the best result. But following procedures and being precise is the most important.


The Russian Death Sentence

On Tuesday, the Russian Olympic Committee was suspended from participating in the Olympic Winter Games at PyeongChang in February 2018. The action was in response to “the systemic manipulation of the anti-doping rules and system in Russia, through the Disappearing Positive Methodology and during the Olympic Winter Games Sochi 2014″. These penalties for doping are without precedent in Olympics history. Plenty of athletes have been kicked out or lost their medals for doping. This is the first time an entire county was kicked out.

This all stems back to the corrupt doping testing facilities at Sochi. Thomas Bach, president of I.O.C., noted that Russia’s cheating was widespread. Even worse,  it corrupted the Olympic laboratory that handled drug testing at the Sochi Games on orders from Russia’s Olympic officials. Russia’s sports ministry formed a team that tampered with more than 100 samples to conceal evidence of athletes’ steroid use throughout the course of the Sochi Games.

This is a terrible outcome for Russian athletes and will likely have a huge negative impact on the PyeongChang Games. The Russian athletes have excelled in many of the winter competitions. Clearly, some of that was from doping. But not all. (Do you believe in miracles?)

The IOC opened the door for some Russian athletes to compete under a neutral flag as Olympic Athletes from Russia. The IOC has organized a group to extend invitation to a select group of athletes, support staff and officials to participate in this manner. As you might expect, the athletes must not have had a prior doping violation and must go through a battery of tests before the Games.

It’s not clear how big this pool of invitees will be. Yevgenia Medvedeva, a favorite to medal in figure skating favorite, said that she “can not accept” competing in PyeongChang as a neutral athlete. She pointed out that she was 14 during the Sochi Games and not a member of the national team.

This is obviously a huge blow to the Russian sports federation, but the IOC indicated that the Russian flag may be allowed to fly at the closing ceremonies, presumably as a symbolic indication that they can move past this and compete clean in future events.


Yet Another ICO Scam

With Bitcoin hitting stratospheric pricing levels, there are scams aplenty trying to cash in on tulip-mania around Bitcoin. This chart from the Wall Street Journal says it all.

Of those trying to cash in, I’m sure some actually have legitimate business purposes and are trying to find new ways to operate financial systems. But many are just scams trying to fool some people out of cash. The latest scammer is PlexCoin. The SEC filed a complaint for an emergency action to freeze the scammers assets and stop selling any more.

Dominic Lacroix, and his company, PlexCorps, were running an initial coin offering of its PlexCoin. It launched the ICO on August 6.

PlexCorps claimed that if you invested $100 USD into PlexCoin at the ICO, you would obtain 769.23 PlexCoin, with an estimated value of $1,353, a return on your investment of 1354% “in 29 days or less”. It’s unclear how they reached the value of “$1.76 per PlexCoin”.

It wasn’t clear what was behind the PlexCoin or who was behind it. That didn’t stop ten of thousands of investors from plowing $15 million into the company.

It turns out that one of the people behind PlexCorps is Dominic Lacroix. In July, the Autorité des marchés financiers (AMF), Quebec’s chief financial regulator, had issued orders prohibiting Lacroix and several associated companies from promoting “any form of investment” to investors in Quebec and operating an investment scheme from within the province, even if it was targeted solely at investors who did not live in Quebec. Lacroix had several previous problems with the Quebec financial regulators.

According to the SEC complaint, the ICO of PlexCoin was an offering of securities.

PlexCoin, like Bitcoin has limited utility. There is no argument that crypto-currencies are growing in value. The problem is that even though there is value being created, it’s not being used as a currency very much. Rightly so. It makes poor economic sense to use a rapidly rising commodity to pay for a transaction if you have alternatives.

I think it is a commodity and not a currency. Theoretically, you could pay for your groceries with gold if the store was willing to accept the gold. Like a commodity, the commodity future exchanges are going to start trading on Bitcoin futures. The CBOE starts on December 11, following by the CME on December 18. It will be interesting to see whether some short selling will put pressure on BitCoin’s rise in value.



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