Don’t Let Compliance Molehills Grow Into Enforcement Mountains
Leverage can be a good thing. But not in the context of turning a simple problem into a real headache.
At last week’s NRS conference, OCIE general counsel John Walsh warned of “compliance leverage” — inadvertently taking simple negligence and turning it into outright fraud. “What are things you can do to ramp up, to heighten the stakes, in any compliance problem?” asked Walsh, tongue-in-cheek. “If you have a compliance program and you want to make it a bigger problem or make it more exciting, there are certain things you can do.”
Here’s a list of what not to do, based on Walsh’s discussion of recent significant enforcement cases:
Don’t ignore explicit instructions. Walsh noted that the SEC’s case against Thomas Hooker, the former CCO of Strong Capital Management, has received a great deal of attention from the compliance community. But the case, said Walsh, is a “different kind of case than what people are worried about.”
In the course of conducting a compliance review, Hooker observed that Strong’s chairman was routinely trading in fund shares. “He did the right thing,” said Walsh. “he went to his boss, the in-house counsel, and said ‘Look what I found’.” The general counsel confronted the chairman about the trading, and also instructed Hooker to keep an eye on it and make sure it did not continue. However, the timing did not stop, and the firm, the chairman, and Hooker ultimately were sued by the SEC.
“I think a lot of people look at the Hooker case and say ‘Oh my gosh, could I be there as well’,” said Walsh. However, he added, the Hooker case is not about somebody who designed a procedure and afterward the procedure did not turn out to be as good as they had hoped. “This is a case where someone received explicit instructions from their then-supervisor and they failed to carry it out,” said Walsh.
His advice: “Make sure you know what you are supposed to be doing, and make sure other people at the firm know what you are supposed to be doing.” If there is any confusion about that, where people think you are fulfilling a role that you are not, speak up.
Walsh’s co-panelist, Dechert counsel Elizabeth Knoblock, agreed, noting that there were other things that Hooker could have done. Once realizing that he could not stop the chairman’s unlawful trading, said Knoblock, Hooker could have gone back to the in-house lawyer and said: “I’ve tried everything, I don’t know what else to do. I’m at a loss here . . . . He’s not listening to me, give me some other guidance or give me some other resources. Send me to outside counsel. Come talk to him with me.” But instead of following these other approaches, said Knoblock, Hooker “shut down.”
Don’t conceal problems from the SEC examiners when directly asked about them. When problems happen, “you can’t shoot [them] under the rug and expect that the dust is not going to come flying up during the inevitable examination,” said Knoblock.
In the Hooker case, she noted, SEC examiners came in to conduct a review and specifically asked about unlawful trading. Hooker “pretended that nothing bad had happened,” said Knoblock.
While noting that he was limited to the facts as presented on the four corners of the SEC’s order in the Hooker enforcement matter, Walsh noted that the order devoted a special section to describing how Hooker had failed to provide all requested information about unlawful trading to SEC staff. That, he said, is an example of “a good way to ramp up your involvement in a problem.”
Watch out for special exceptions. Walsh pointed to the order in the SEC’s market timing case against Franklin Advisers, which had some “really unusual” language: the order noted that the firm had “generally tried, in good faith, to stop market timing” and went on to note the firm’s efforts to combat timers. Nonetheless, the firm was sued.
After deciding to shut down market timing, the firm allowed some special market timing arrangements to continue, rather than going cold turkey, explained Walsh. While the firm was generally trying to do the right thing, it was “undone” by the special arrangements.
Putting a policy down in writing “is not enough,” Knoblock added. “The policy must be monitored, implemented, enforced, and periodically reviewed for effectiveness.”
Covering up an error can make things much, much worse. Case in point: the SEC’s enforcement action against Van Wagoner, where the adviser discovered it had exceeded the amount of illiquid securities that were permitted to be held in certain accounts. At that point, “it was simple negligence,” said Knoblock. “All of a sudden they were over a bucket. They could have resolved it right then, when it was simply an error.” Instead, the adviser reclassified illiquid securities as liquid, began writing down values, which were not supported, and conducted across-the-board write-downs.
Walsh noted that the firm said that the write-downs were prompted by the events of
Interestingly, Walsh said that he often thinks of trading errors as a “litmus test” for a firm’s culture of compliance. “They are something that no one asks for,” he said. “They come out of the blue. Usually, you have to deal with them quickly. Time is compressed. You don’t have time to really think.” Because of that, and because there are no bright lines, “how you deal with it in many respects reveals who you are and what kind of firm you are.”
In the recent EGM Capital case, Walsh noted, the operational people caught the firm’s inadvertent second sale relatively quickly. Nonetheless, in the short period of time, there was a loss of roughly $400,000.
“What to do?” said Walsh. Rather than absorbing the error, the firm decided that the clients’ accounts should bear the loss. It created backdated trade tickets to make the erroneous trade look intentional.
What if the firm didn’t have $400,000 of capital sitting around to repay the error? Knoblock noted that the firm could have arrange a payback schedule or waive the client’s fee until the amount was made up. “You do not pretend that the error belongs to them,” she said. “There are alternatives to engaging in fraud if you will calm down from the panic.”
Don’t give a problem the time to grow. Walsh analogized compliance problems to kitchen fires: There are times you try to fight it with baking soda, he said, “and there are times you call the fire department.”
The SEC’s recent case against William Belko, Walsh indicated, was one where the fire department should have been called. From the time Belko discovered the mismanagement of the client accounts, the losses grew and there were several rounds of false statements, he noted.
Knoblock, who was not limited to the four corners of the complaint, speculated that Belko did not call the SEC to alert them to the investment guideline problem, nor did he call clients to inform them of the way their accounts were being managed. She suggested that perhaps Belko had an obligation to “drop a dime” and call clients to notify them that their accounts were being managed in a way that was different from what was contemplated in the advisory agreements.
“If you can’t make change, maybe leaving the organization is something that you need to do,” she said. “But it may not be the only thing that you are obligated to do.”