Gary DeWaal and Associates LL

Gary DeWaal's Bridging the Week: January 20 to 24, and 27, 2014 (Accounting Firms under Attack; Enhanced CTA/CPO Customer Protection Necessary?)

Bridging the Week My View

Published Date: January 27, 2014

Accounting firms received the brunt of a US regulator's attention this past week when one major US accounting firm was challenged for not being "independent," while China-based affiliates of four top US accounting firms were barred by an administrative law judge for the regulator from auditing China-based companies listed on US exchanges for six months for not complying with requests for documents. The firms had alleged that complying would cause them to violate China laws, including privacy rules.

As a result, all the following matters are covered on this week's Gary DeWaal's Bridging the Week:

KPMG agrees to pay more than US $8.2 million to settle US SEC claim of independence violation; SEC issues guidance regarding impact of audit firm loan of employees to audit clients;
China-based affiliates of four top US accounting firms barred by SEC ALJ from performing audits of China-based firms listed on US exchanges for six months;
US NFA seeks comments on possible new CPO/CTA capital requirements and customer protection measures (includes My View);
SEC settles with former Oppenheimer fund manager related to false valuations;
US CFTC deems certified another Made Available to Trade determination involving certain interest rate swaps; creates an interdivisional group related to swaps recordkeeping and reporting;
Recovery and resolution receives attention from two sources: The US FRB for certain large US Bank Holding Companies, and ICE Clear Europe for itself;
European Court of Justice upholds the authority of the EU to empower ESMA to regulate short sales contrary to UK view; and
UK FCA settles with Standard Bank PLC related to lapses in AML program regarding PEPs.

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Article Version:

KPMG Agrees to Pay More Than US $8.2 Million to Settle SEC Claim of Independence Violation; SEC Issues Guidance Regarding Impact of Audit Firm Loan of Employees to Audit Clients

The US Securities and Exchange Commission alleged that KPMG violated its rules related to auditor independence by providing non-audit services to affiliates of three public companies it was auditing from 2007 through the end of 2011. The services included bookkeeping, payroll and expert services. Some KPMG personnel also owned stock in one of the relevant public companies, and an affiliate of another.

In connection with one affiliate, KPMG also hired a retired former senior employee, and then loaned the individual back to the entity to perform the same tasks he had done as an employee (i.e., "acting as a manager, employee and advocate for the affiliate").

KPMG agreed to pay in excess of US $ 8.2 Million to settle this matter.

Simultaneously with announcing this settlement, the SEC issued a separate report advising audit firms that they may not lend staff to audit clients in a manner that makes such employees tantamount to being company employees.

According the SEC, "no one factor is determinative" to assess whether a loaned employee acts as an employee of an audit client -- which is prohibited. However, certain characteristics do not assist the determination:

"For example, the fact that professionals loaned to an audit client may be junior- level in skill, experience or title, or are performing only ministerial tasks, does not exempt that individual from the prohibitions against acting as an employee of an audit client. Similarly, the fact that loaned staff were not directly paid by the audit client also does not exclude the relationship from the prohibition."

For the SEC, the provision of certain non-audit services to an audit client impairs the auditor's independence. Therefore, auditors that provide non-audit services in a way that compromises independence "…should expect to be held accountable."

Affiliates of Four Top US Accounting Firms Banned from Performing Audits of China-based Firms Listed on US Exchanges for Six Months

An SEC Administrative Law Judge banned the China-based affiliates of four top US-based accounting firms from performing audits of US-listed Chinese companies for six months for their failure to produce certain work papers to SEC staff in connection with investigations into such companies. The SEC was reviewing such companies for possible accounting fraud and served requests for documents on the respondents at various times between March 11, 2011 and April 26, 2012.

The four firms that were barred from appearing or practicing before the SEC for six months were Ernst & Young Hua Ming LLP, KPMG Huazhen, Deloitte Touche Tohmatsu Certified Public Accountants, Ltd., and PricewaterhouseCoopers Zhong Tian CPAs Limited. A fifth accounting firm, BDO China Dahua CPA Co., Ltd., was named in the relevant SEC action but solely was censured.

The accounting firms had failed to produce the requested documents for fear of violating Chinese laws and procedures related to producing documents to overseas regulators, including privacy requirements. In China, each of the accounting firms is licensed by the China Securities Regulatory Commission, and most by the Ministry of Finance too.

In 2011, each of the respondents had attended a meeting with MOF and CSRC officials where they "explicitly" were told "…that Chinese accounting firms must abide by Chinese laws and they cannot provide work papers and related documents to overseas regulators directly [and] ...that legal penalties would be imposed on firms that provide work papers without authorization." This position was confirmed by the regulators on subsequent occasions.

The respondents defended not only against the SEC's substantive allegations, but argued that the proposed ban against them performing auditing services in China would cause investor losses, US delisting by China-based companies and a loss of market capitalization. The ALJ rejected these arguments, claiming that there were "adequate substitute auditors" who had "all conducted audit work, including audit reports, and produced audit work papers without raising any issues…"

Respondents have 21 days to request a review by the Commission. The Initial Decision issued by the SEC ALJ will not become final until the Commission issues an Order of Finality.

And briefly:

US NFA Seeks Comments on Possible New CPO/CTA Capital Requirements and Customer Protection Measures: Last week, the US National Futures Association announced that it is seeking comment regarding a possible new requirement that registered commodity trading advisors and commodity pool operators maintain a minimum amount of capital, much like futures commission merchants and non-guaranteed introducing brokers currently are required. Currently CPOs and CTAs are not subject to any capital requirement. In addition, the NFA seeks advice on a number of other possible new customer protection measures involving CPOs, including whether: (1) an independent third party should be required to review and authorize a CPO's disbursement of any pool funds; (2) a CPO should have an independent third party prepare or verify account statements regarding a pool's value periodically throughout the year; and (3) an independent third party should be required to prepare or verify a pool's performance results. The NFA also seeks views regarding (1) how might pool assets independently be verified in a manner similar to how FCM customer balances at their depositories are now compared daily by NFA or the Chicago Mercantile Exchange with FCM reports to identify discrepancies, and (2) how to handle inactive CPO and CTA members. Comments are due by April 15, 2014, although curiously, the NFA is seeking comments pro-actively from CPOs and CTAs only. (For more details, see an article on the NFA comment request initially published on this website on January 23: http://www.garydewaalandassociates.com/?p=1879.)

My View: Although in recently years the failures of MF Global and Peregrine Financial Group grabbed the big headlines, the problem of fraud at some less reputable CPOs and CTAs has been far more pervasive and re-occurring. Accordingly, in my view, the NFA deserves a lot of credit for raising the issues addressed in its comment request. That being said, there are no easy answers to the NFA's questions, particularly regarding tracking customer funds invested by CPOs, because of their dispersed nature and wide investment mandates, especially within fund of funds. However customers placing money with CPOs or to be managed by CTAs deserve to be protected as much as customers of future commission merchants or introducing brokers. Whether the answers will include some or all of the NFA proposed ideas, entirely different ideas, or that no new measures are warranted at all, is surely worthy of a robust discussion. Just keep in mind: bad guys tarnish the reputation of an entire industry, and if there is a sufficiently large blow up, it won't be NFA but Congress that tries to impose a solution!

SEC Settles with Former Oppenheimer Fund Manager Related to False Valuations of Fund: The same week that the NFA solicited comments regarding ideas for the better protection of managed funds' customers in the futures industry, the SEC settled with a former portfolio manager of Oppenheimer & Co., related to false statements he made to investors about the valuation of a fund of funds, Oppenheimer Global Resource Private Equity Fund I, LP for which he was responsible. Specially, the manager, Brian Williamson, agreed to be barred from the securities industry for at least two years and to pay a fine of US $100,000. The SEC had alleged, among other things, that Williamson (1) from September 2009 through mid-October 2009, sent or had others send marketing materials to prospective investors that disclosed an internal rate of return for the Fund without taking into effect fees and expenses; and (2) from October 2009 through June 2010, misrepresented the value of the Fund's largest investment as derived from the underlying managers' calculated value, when in fact, he valued it himself. Oppenheimer & Co., agreed to pay US $2.8 Million to settle related charges in March 2013.
CFTC Deems Certified Another Made Available to Trade Determination involving Certain Interest Rate Swaps; Creates an Interdivisional Group related to Swaps Recordkeeping and Reporting: There were no earth shattering developments at the US Commodity Futures Trading Commission last week, but there were some important matters notwithstanding. First, the CFTC's Division of Market Oversight deemed additional interest rate swaps self certified (i.e, Made Available to Trade) by trueEx LLC, a Swap Execution Facility. This means such swaps are mandated to begin trading on or subject to the rules of a designated contract market or SEF as of February 21, 2014, whether on trueEx or another qualified execution facility. Two weeks ago, the CFTC deemed certified certain interest rate swaps proposed by Javelin SEF, LLC. These swaps must begin trading on or subject to the rules of a DCM or SEF as of February 15, 2014. Second, the CFTC created an interdivisional staff working group to review certain swaps transaction data recordkeeping and reporting requirements. Under the direction of the Division of Market Oversight, the group is required most immediately to publish by March 15, 2014, for public comment questions related to compliance with applicable reporting rules and consistency by market participants regarding regulatory reporting, Third, a US Court entered a consent order against CTI Group, LLC, Cooper Trading and two principals related to their involvement in fraudulently soliciting clients to purchase a trading system to trade E-mini Standard and Poors 500 Stock Index contracts from at least August 2009 through May 2012. Under the Agreement, CTI Group and Cooper Trading will pay US $10 Million as sanctions and US $10.175 million in disgorgement, while the two individuals will combined pay US $5.5 Million as sanctions and over US $3.4 Million in disgorgement. And finally, the Technology Advisory Committee scheduled for January 13, 2014, but cancelled because of impending weather, was rescheduled for February 10. Swap data reporting, the CFTC's Concept Release on Automated Trading, and Made Available to Trade determinations are all scheduled to be discussed at this meeting.
Recovery and Resolution Receives Attention from Two Sources: The FRB for Certain Large Domestic Bank Holding Companies, and ICE Clear Europe for Itself: The US Board of Governors of the Federal Reserve System last week issued its "Heightened Supervisory Expectations" for eight domestic bank holding companies, in an effort to blunt the effect of one of these very large firm's failure on the broader financial system and economy. These expectations relate to the firms' practices and procedures regarding collateral management; payment, clearing and settlement activities; liquidity and funding; management information systems; and shared and outsourced services. The eight BHCs are Bank of American Corporation; Bank of New York Mellon Corporation; Citigroup Inc.; Goldman Sachs Group; JP Morgan Chase & Co; Morgan Stanley; State Street Corporation; and Wells Fargo & Company. Separately, ICE Clear Europe submitted to the Securities and Exchange Commission for its approval proposed amendments to its rules to facilitate its recovery and orderly wind-down following a clearing member default that results in the exhaustion or potential exhaustion of its resources. ICE Clear proposes, among other things, (1) a "cooling off period" (typically 30 business days) following a clearing member default that might cause an assessment on the remaining clearing members of a capped amount; (2) a process for a clearing member to terminate its clearing membership in the ordinary course and during this cooling off period and to unwind its positions and limit its ongoing liability; (3) a process to haircut mark-to market gains to clearing members, following the default of a clearing member and the inability of the clearing house to pay all clearing members in full; and (4) new default auction procedures. These proposed rules will only apply to clearing members related to their futures and options and FX clearing positions; they will not apply in connection with CDS positions. ICE Clear filed these same rules for certification with the CFTC on January 16.
European Court of Justice Upholds the Authority of the European Union to Empower ESMA to Regulate Short Sales Contrary to UK View: Last week the European Court of Justice upheld the authority of the Council of the European Union and the European Parliament to vest certain powers on the European Securities and Markets Authority under an EU regulation that permits the adoption of measures to harmonize short sales across member states. On March 25, 2012, ESMA was empowered with "extensive advisory, notification and regulatory powers with respect to short selling." In response, in May 2012, the United Kingdom challenged this authority claiming that ESMA had been given too much discretion of a political nature that conflicted with EU principles regarding the delegation of powers. The Court rejected this argument claiming that the authority granted to ESMA related to short sales did not go beyond powers granted to the agency when it was created, and were sufficiently limited.
UK FCA Settles with Standard Bank PLC related to Lapses in AML Program regarding PEPs: The UK Financial Conduct Authority fined Standard Bank PLC UK £ 7.6 Million (US $12.5 Million) related to deficiencies in its Anti-money Laundering policies and procedures regarding corporate customers with ties to politically exposed persons. (In the UK PEPs generally are individuals who at any time within the prior year would be considered a prominent public official, or an immediate family member or close associate of such person.) This failure lasted from December 15, 2007, through July 20, 2011. During this period, Standard Bank had over 5,000 corporate customers of which 282 were linked to PEPs. However, prior to establishing business relationships with these customers, the Bank failed to carry out adequate enhanced due diligence, or conduct adequate ongoing due diligence. FCA considered the Bank's conduct particularly serious because, among other reasons, it provided loans and other services to a large number of corporate customers from jurisdictions regularly identified as posing a higher risk of money-laundering.

For more information, see:

US CFTC Matters:

CFTC v. CTI Group et al (Consent Order):
http://www.cftc.gov/ucm/groups/public/@lrenforcementactions/documents/legalpleading/enfctiorder012214.pdf
Interdivisional Group Established to Review Report and Recordkeeping Compliance:
http://www.cftc.gov/PressRoom/PressReleases/pr6837-14
trueEx IRS Made Available to Trade Mandate:
http://www.cftc.gov/PressRoom/PressReleases/pr6838-14

UK FCA: Decision Notice re: Standard Bank:
http://www.fca.org.uk/static/documents/decision-notices/standard-bank-plc.pdf
US Federal Reserve Bank: Principles and Practices for Recovery and Resolution Preparedness:
http://www.federalreserve.gov/bankinforeg/srletters/SR1401.htm
http://www.federalreserve.gov/bankinforeg/srletters/sr1401a1.pdf
ICE Clear SEC Submission Related to Recovery and Wind-down:
https://www.theice.com/publicdocs/regulatory_filings/ICEU_SEC_012314.pdf
NFA Comment Solicitation re: CPOs/CTAs:
http://www.nfa.futures.org/news/newsNotice.asp?ArticleID=4377
SEC Actions related in Auditor Independence:

In the Matter of KPMG:
http://www.sec.gov/litigation/admin/2014/34-71389.pdf
SEC Report Related to "Acting as an Employee" of an Audited Firm:
http://www.sec.gov/litigation/investreport/34-71390.pdf

SEC v. BDO China et al.:
http://www.sec.gov/alj/aljdec/2014/id553ce.pdf

SEC: In the Matter of Brian Williamson:
http://www.sec.gov/litigation/admin/2014/33-9515.pdf
UK v. Council of the European Union and the European Parliament:
http://curia.europa.eu/juris/document/document.jsf?text=&docid=140965&pageIndex=0&doclang=EN&mode=req&dir=&occ=first&part=1&cid=67078

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 25, 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.