Gary DeWaal's Bridging the Week: January 6 - 10 and 13, 2014 (Those Darn Red Flags, CFTC FCM Relief, Steve Jobs)

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Published Date : January 13, 2014

Missed "red flags" again have raised regulators' ire and contributed to criminal charges being filed against two entities. The problem is that many "red flags" are not as obvious as regulators may think until they are viewed in isolation, often only after a problem already has occurred. Regrettably, "red flags" often are buried among countless reports and electronic communications dispersed widely within a firm (perhaps in multiple geographical locations and in different legal entities), and their significance may not be obvious until pieced together. However, in light of the common theme citing missed "red flags" in so many regulators' enforcement actions worldwide, firms must improve the way "red flags" are identified in real time particularly when they emerge in different hierarchal pillars within one office, let alone in different geographical locations and different legal entities.

These new missed "red flags" enforcement actions and the following additional matters are covered on this week's "Gary DeWaal's Bridging the Week:"

• JP Morgan criminally charged and settles related to its handling of Bernard Madoff accounts; OCC and FINCEN civil charges also settled (includes Compliance Weeds);
• US CFTC grants certain operational relief to FCMs related to their handling of customer funds under its new enhanced customer protection rules;
• US SEC publicizes 2014 examination highlights;
• Another week, another firm (Alcoa Inc.) is fined for illegal payments to foreign government officials;
• ICE Futures seeks CFTC authority for more summary fines; ICE Clear Europe seeks permission to accept more collateral types to satisfy clearing members' margin;
• US CFTC extends comment period on proposed aggregation policy for position limits; and
• US NFA waxes poetic in welcoming New Year (cites TS Eliot).

In addition, in this week's section, "Totally Irrelevant (But Is It?)," Walter Isaacson's 2011 biography of Steve Jobs is belatedly reviewed, along with my reflection on how some business principles of Apple, Inc. might be applied to the financial services industry.

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JP Morgan Criminally Charged and Settles Related to Its Handling of Bernard Madoff Accounts; OCC and FINCEN Civil Charges Also Settled

Last week, criminal charges and a parallel civil forfeiture action were filed against JP Morgan Chase Bank related to its provision of banking services to Bernard Madoff Investment Services (BLM) from 1986 through 2008.  Simultaneously, JP Morgan agreed to resolve these matters by making a non-tax deductible payment of US $1.7 Billion to Madoff victims, and to other terms (including to "continue its ongoing effort to implement and maintain an effective [Bank Secrecy Act/Anti-Money Laundering] compliance program"). In return, the US Attorney's Office in New York City agreed (1) to defer prosecution of the Firm for two years related to this matter after which, if the Bank continues to comply with all terms, (2) to endeavor to dismiss all charges.

Concurrent with this action, the Office of the Controller of the Currency and the Financial Crimes Enforcement Network also announced settlements with the Bank related to its handling of BLM's accounts. As part of these settlements, the Bank agreed to pay fines of US $350 Million to OCC and US $461 Million to FINCEN, the latter fine which is satisfied by JP Morgan's  forfeiture payment related to its criminal charges.

According to court documents prepared by the US Attorney's Office, Madoff operated "the largest known Ponzi scheme in history" from the early 1970's through his arrest during December 2008.  The Ponzi scheme "was conducted almost exclusively through a demand deposit account and other linked cash and brokerage accounts" maintained at JP Morgan during this time.

Although, at various times since the early 1990's various JP Morgan employees worldwide observed suspicious conduct involving BLM, the Firm never filed a report regarding its suspicions with US regulators, says the Court documents. The Firm did file such a report with UK regulators, however.

Among other suspicious activities during 2008, an analyst on the Bank's London-based Equity Exotics Desk wrote an email, describing the Bank's,

"…inability to validate Madoff's trading activity or even custody of assets; questioned Madoff's ‘odd choice' of a small, unknown accounting firm; and reported that [the Bank] ‘seem[ed] to be relying on Madoff's integrity' with little to verify that such reliance was well-placed'."

In its report to the United Kingdom's Serious Organized Crime Agency in the same year, the Bank wrote that,

‘'the investment performance achieved by [the Madoff Securities] funds … is so consistently and significantly ahead of its peers year-on-year, even in the prevailing market conditions, as to appear too good to be true – meaning that it probably is."

The Court documents also indicated that on two occasions – one each in 2007 and 2008, the Bank's automated AML compliance system generated alerts regarding potential suspicious activity regarding BLM. However,

"[i]n both cases, prior to closing the alerts, the investigators attempted to review the [Know Your Customer] file for Madoff Securities but, upon receiving error messages to the effect that no file was available, did not conduct further investigation into the business of Madoff Securities beyond a review of the company's website."

In its action, FINCEN claimed that the Bank ignored numerous "red flags" that BLM might be engaging in a potential fraud, including that,

• BLM's investment returns were "so consistently and significantly ahead of its peers, even in prevailing market conditions, as to appear too good to be true;"
• BLM's "trading techniques and investment activity lacked expected transparency;"
• BLM used a "very small, unknown auditor that was not registered with the American Institute of Certified Public Accountants or peer-rated;" and
• BLM or BLM feeder funds repeatedly declined to give full information to the Bank in response to its due diligence reviews.

Compliance Weeds:

The problem is that many potential red flags don't attract attention until after a problem has occurred for three reasons:

1. the staff reviewing them real time or shortly after the fact may not be sufficiently seasoned to recognize their significance or motivated to elevate the content to a superior;
2. in isolation, an individual red flag may not be so glaring, but only stands out boldly in conjunction with other red flags received across an organization. Unfortunately firms (especially global firms) are not necessarily organized to ensure that all diverse red flags are captured, assimilated and reviewed systematically; and
3. even in isolation, an individual red flag may not stick out among a multitude of electronic communications or other data.

As a result it is incumbent upon firms to enhance their collection, assimilation and systematic review of possible "red flags" in order to identify potential problems as close to real time as possible, or at least promptly afterwards. Three straight forward measures that firms may wish to consider to improve the handling of "red flags:"

1. enhance staff training regarding "red flags" and suspicious conduct (including to mandate training at least annually), and the need to act on adverse information promptly;
2. develop or create a data base program that allows capture of all potential adverse information about any customer, client, counterparty, vendor, or employee (collectively, "subject"), and require all personnel systematically to make entries relevant to a subject that fall within their job performance. Among information that likely should be included are (a) regulatory requests; (b) litigation; (c) adverse public information; (d) adverse credit information; (e) complaints or (f) heard or observed suspicious behavior related to a subject. Care must be taken in collecting and sharing this information (particularly across legal entities and geographies) to ensure respect for laws related to privacy and reporting of suspicious activity, and other relevant provisions. (For smaller firms, this data base can be in the form of a simple Excel Spreadsheet maintained by one department where all information is called into by other department personnel.) Ensure that one department or person (depending on firm size) is required to review this data base regularly for single or multiple entries that, in aggregate, suggest possible wrongful conduct, and that there is an appropriate escalation process for "red flags;" and
3. restrict the use of electronic communication for internal purposes, and impose strict rules regarding the number of cc's and bcc's on any email. Do not permit "reply all" as a default setting. Reducing the amount of email increases the probability that important matters are reviewed and thoughtfully considered.

US CFTC Grants Certain Operational Relief to FCMs Related to Their Handling of Customer Funds Under Its New Enhanced Customer Protection Rules:

Friday evening, in time for the January 13 effective date for certain new enhanced customer protection rules approved by the US Commodity Futures Trading Commission last October 2013 (see: http://www.garydewaalandassociates.com/?p=1286), the Commission's Division of Swap Dealer and Intermediary Oversight granted future commission merchants (1) temporary relief in connection with certain matters related to their receipt of customer funds in a single payment to one customer funds account type, as well as (2) permanent relief regarding certain matters related to their handling of customer funds in so-called "Part 30" non-US depositories.

Under new CFTC rules, FCMs are prohibited from commingling customer funds that are required to be maintained in each of the separate protected customer funds' type accounts – Section 4d(a)(2) Funds Accounts (for US domestic futures and options), Part 30 Secured Funds Accounts (for non-US futures and options), and Cleared Swaps Funds Accounts (for cleared swap transactions). However, this requirement does not prohibit a customer from satisfying its margin calls related to different activities by making a single payment to its Section 4d(a)(2) Funds Account, provided the FCM simultaneously records a book entry for relevant amount(s) to the customer's Part 30 Secured Funds and/or Cleared Swaps Funds Account. Recognizing technological limitations as pointed out by the Futures Industry Association, DSDIO granted no action relief through April 14, 2014, to FCMs that accept a single payment for all of a customer's margin obligations for different activities (whether in the Section 4d(a)(2) Funds Account or other Customer Funds type account) without recording the simultaneous book entry(ies). This relief is conditioned on the FCM maintaining sufficient funds to meet the liquidating equities of all the FCM's customers in each account type at all times.

DSDIO also granted permanent relief to FCMs under limited circumstances in connection with the prohibition that they may not maintain deposited in non-US authorized depositories more than 120% of funds required by non-US boards of trade or foreign brokers in connection with customers non-US trading activity. Because of operational issues related to the handling of non-US funds and calculating funding obligations across time zones, DSDIO said it would recommend that no action be taken against FCMs that exceed the 120% requirement provided (1) the relevant non-US depositories are authorized to handle Part 30.7 Customer Funds; (2) the FCM performs its calculation by noon each day of required 30.7 Funds held abroad that exceed the 120% limit as of close of business the prior day, and on the same day, the FCM initiates processes to transfer such excess amount to US authorized depositories; and (3) US authorized depositories receive such excess funds within two business days of the initiating action.

And briefly:

• US SEC Publicizes 2014 Examination Highlights: Last week it was FINRA (see article re: FINRA 2014 Examination Highlights: http://www.garydewaalandassociates.com/?p=1719), and this week the US Securities and Exchange Commission publicized its examination highlights for 2014 for each of the type of entities it oversees. For all entities, the SEC will, among other matters, (1) seek to identify and prevent fraudulent or unethical behavior; (2) assess how firms identify and mitigate conflicts of interest and various risks of their business (i.e., legal, compliance, financial and operational); (3) examine the governance and supervision of information technology systems (including operational capability and information security, as well as the ability to deal with unexpected malfunctions and system outages); (4) consider unique issues with dually registered broker-dealers and investment advisers (e.g., the influence of dual registrants regarding the type of account a customer may open); and (5) ensure compliance with new laws and regulations. For Broker Dealers, the SEC will also seek to assess firms' market access controls; internal controls generally; customer protection and capital rules' compliance; and AML compliance, among other matters. For Investment Advisors and Companies, the SEC, among other topics, will be reviewing the safety of assets and custody; conflicts of interest; and the accuracy and completeness of claims regarding investment objectives and performance.


• Another Week, Another Firm (Alcoa Inc.) Is Fined for Corrupt Payments to Foreign Government Officials: Aluminum producer Alcoa Inc. settled both criminal charges by the US Department of Justice and civil charges by the US SEC last week related to certain of its subsidiaries' alleged payment of bribes from 1989 to 2009 to Bahrain government officials to retain business. Apparently one of Alcoa's subsidiaries retained a consultant to help it negotiate long-term contracts with government officials. The relevant manager described the consultant as "well versed in the normal ways of Middle East business," and an individual who "will keep the various stakeholders…happy." Another internal memorandum stated that "[t]he methodology of business in the Middle East is a complex web of interactions that are necessarily difficult to understand to disguise the payment of commissions" Both the USDOJ and SEC considered these and other matters "red flags" that the company failed adequately to address. The SEC additionally claimed that Alcoa did not conduct adequate due diligence to assess the legitimacy of using a middleman in the first place. The subsidiaries are alleged to have made over US $110 Million in illegal payments during the relevant time. As part of its settlement, Alcoa will pay a criminal fine of US $209 Million and disgorge US $175 Million. In agreeing to this Settlement the SEC noted that Alcoa made a voluntary disclosure of certain of these matters to both the USDOJ and it in February 2008, and has undertaken extensive remedial action to enhance its anti-corruption policies and procedures.
   
• ICE Futures Seeks CFTC Authority for More Summary Fines; ICE Clear Europe Seeks Permission to Accept More Collateral Types to Satisfy Clearing Members' Margin: ICE futures filed with the CFTC on January 10 proposed amendments to its disciplinary rules to enable it (through its Vice President of Market Regulation) to authorize summary fines of up to US $10,000 for certain infractions related to (1) block trades, including failure to meet applicable minimum quantity requirements or for a participant not to meet eligible contract participant requirements, and (2) failing timely to produce documents and other records requested by authorized Exchange personnel or committees. These rule amendments are scheduled to be effective on January 28, 2014. Separately, ICE Clear Europe proposed to permit its clearing members to post Japanese Government bonds, German development Bank (KfW) bonds, and European Investment Bank notes as additional types of cover to satisfy margin requirements.


• US CFTC Extends Comment Period on Proposed Aggregation Policy for Position Limits: The CFTC extended to February 10 its comment period for its proposed amendment to its rules related to the aggregation of accounts to determine compliance with position limit requirements. The original deadline was January 14 (for more, see: http://www.garydewaalandassociates.com/?p=1347.)


• US NFA Waxes Poetic in Welcoming New Year (Cites TS Eliot): In an unusual new year's message for the financial services industry, the US National Futures Association quoted poetry by TS Eliot (from Four Quartets: ""For last year's words belong to last year's language/And next year's words await another voice") in summarizing its principle 2012- 2013 achievements. Among other things, NFA cited it enhancement of rules and processes following the collapses of MF Global and Peregrine Financial Group. According to NFA, it has now not only implemented the recommendations of Berkeley Research Group which it retained following the collapse of PFG, including enhancing its risk management and examination process, it has established an Office of Professional Development to oversee the training and professional development of NFA staff. The NFA also cited its implementation of a number of new rules to enhance customer protection, and its ongoing development of a compliance program for swap dealers. In conclusion the NFA wrote,

"[t]he events of the past two years have been shocking, traumatic and almost overwhelming ... almost. The failures of MF Global and PFG have eroded trust in both the marketplace and regulators. But as hurtful as these lessons have been, they have helped us to improve over the last two years and we have become a much stronger, more effective regulator. We are painfully aware of Warren Buffet's admonition, ‘It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you'll do things differently'."

And finally:

Totally Irrelevant (But Is It?): Because I do not like to read books in hard cover or electronic format, I only recently read Walter Isaacson's 2011 biography of Steve Jobs, after it was released in paperback during late 2013. Frankly, if you have not read this book by now, do so. Not only does Isaacson's account provide entertaining insight into the psychology and behavior of the legendary Steve Jobs, as well as the birth and evolution of what became known as Apple, Inc. (and Pixar, Inc. too), it provides some very practical tips on running a successful business—which even can be applied to businesses in the financial services industry. Among the tips that jumped out at me were:

• bigger is not necessarily better; it's all about return on investment. Offering a few very good products is better than many average ones. (Application: very few firms can afford to be everything to everybody. Identify a firm's strength and build upon it.);
• be bold in thinking what a customer might want; be simple in design and be mindful not only of the aspects of a product a client sees (the external portion), but what's inside too. Be mindful of details. (Application: Consider always a firm's offering from a client's perspective – what makes the offering more efficient for it. Ensure the efficient offering is backed by systems that are robust and as simply designed as possible to minimize breakdowns.);
• redefine product offerings constantly (Application: original new offerings generate new revenue. Using generic solutions may in the short term save money, but will not necessarily create new revenues long term.); and
• innovation does not occur through electronic communication. Companies must encourage face-to-face communication, especially among different organizational pillars. The design of office space can encourage this communication. (Application: discourage all internal electronic communications except as absolutely necessary. Ensure that different parts of organizations constantly share critical information.)

That being said, Isaacson's biography points out how miserably Steve Jobs often treated perceived adversaries as well as colleagues and employees, let alone some of his own family members and friends. This is a dark side of Steve Jobs that certainly detracts from his legend and this behavior is inexcusable. There are also extensive references to Steve Job's dietary and philosophic idiosyncrasies.

Isaacson's biography also does not delve into labor conditions at Apple's foreign suppliers, or some of the other well-publicized regulatory issues for which Apple has been criticized (e.g., handling of e-Books, corporate tax minimization).

However, Steve Jobs was a genius at anticipating what customers wanted (even when customers themselves were not aware), and this insight, coupled with his instinctive management skills (other than regarding employee relations), is what made Apple ultimately so innovative and financially successful. Again, this is a crisply written book that is well worth reading; it's much better than the movie!

For further information, see:

Alcoa Inc. FCPA Violations:
SEC Order:
http://www.sec.gov/litigation/admin/2014/34-71261.pdf
US Department of Justice Press Release:
http://www.justice.gov/opa/pr/2014/January/14-crm-019.html
CFTC Extension of Comment Period regarding Aggregation:
http://www.cftc.gov/PressRoom/PressReleases/pr6821-14
CFTC FCM Relief Regarding Handling of Customer Funds:
Single payment for Margin Relief:
http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/14-02.pdf
Relief regarding 120% Requirement for non-US Depositories of 30.7 Funds:
http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/14-03.pdf
ICE Clear Amendment to Acceptable Collateral for Margin Proposal:
https://www.theice.com/publicdocs/regulatory_filings/ICEU_CFTC_010713.pdf
ICE Futures Proposed Rule Amendments to Permit Summary Fines for Certain Block Trade and Record Production Offenses:
https://www.theice.com/publicdocs/regulatory_filings/14-2_Amendments_to_Rule_21.02.pdf
JP Morgan Regulator Matters Related to Bernard Madoff:
Court Documents Related to Criminal Charges:
http://www.justice.gov/usao/nys/pressreleases/January14/JPMCDPASupportingDocs/JPMC%20DPA%20Packet%20(Fully%20Executed%20w%20Exhibits).pdf
FINCEN Settlement:
http://www.fincen.gov/news_room/ea/files/JPMorgan_ASSESSMENT_01072014.pdf
OCC Settlement:
http://www.occ.gov/topics/laws-regulations/enforcement-actions/bank-enforcement-actions/civil-money-penalties/ea-2014-001.pdf
SEC 2014 Examination Priorities:
http://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2014.pdf

The information contained in this article is not legal advice. For legal advice, please consult with your attorney. The information in this article is derived from sources believed to be reliable as of January 11, 2014, but no representation or warranty is made regarding the accuracy of any statement. To ensure compliance with requirements imposed by U.S. Treasury Regulations, Gary DeWaal and Associates LLC informs you that any U.S. tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Gary DeWaal and Associates may represent one or more entities mentioned in this article.

Recent Commentaries

• Bridging the Week has moved.
• Bridging the Week by Gary DeWaal: September 1 to 5 and 8, 2014 (Banks Are the Big News; MF Global; Investment Advisor Conflicts; ISDAfix)
• Between Bridges by Gary DeWaal: CME Group Issues New Rule Regarding Disruptive Trading Practices

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