The recent issues gripping the financial world seem to revolve around one word, “transparency.”  The Madoff and Stanford scandals at their core were secretive financial manipulations engineered by a small group.  The famous acronym, CDO, which stands for Collateralized Debt Obligations, are derivatives that track the financial health of certain securities like mortgages.  CDOs were not fully known or understood by management or regulators.  These same institutions created special purpose subsidiaries to house these securities, thereby making them not particularly transparent to regulators or management.

In the end, the lack of transparency combined with the lack of understanding by the people who created and transacted these deals, caused the horrific problems that we are now encountering.  There is a strong movement to create a new regulation paradigm.  Experts have called for stricter and more comprehensive regulations, a systemic regulator, increased regulatory staff, new management and compensation processes, etc. – in short, creating a new world for financial firms.

While more and different regulations are necessary in most cases, the problems that were encountered resulted from regulators or managers not asking the right question or waiting to hear the right answer.  For instance, if the senior management of AIG questioned its risk models for the financial subsidiary in London and determined that the exposure was not hedged, the models were based on the housing market continuing to increase in value, they might have adjusted the exposure.  Moreover, if a regulator fully understood the relationship between the Madoff’s Broker Dealer and the Investment Advisor, he or she might have asked for additional documents that could have brought the ponzi sheme to light years earlier.

In my view, the key to transparency is for management to be required to disclose its practices and have those attestations and disclosures available in an accessible form for both senior compliance management and regulators to view.  Information silos where scribbled notes and incomplete forms become key documents are consistent with the lack of transparency.  Management must utilize systems that allow for unfettered, ecumenical, mandated review.  A compliance person should not have to directly ask a manager to complete a form; managers must be compelled by the firms policies and the requirements of the system to complete the disclosures.  If the form is not completed or is incomplete, it will be fully transparent to management and regulators.  With this in hand, these constituencies will be able to ask the type of questions that can help to prevent issues before they occur.

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In today’s regulatory environment, firms are challenged to comply with supervisory guidelines for employee personal trade monitoring, affirmations & disclosure processes, gifts and entertainment tracking, and case management.   Typically, the low cost solution is to manage manual processes or use legacy applications which require manual intervention.

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The incidence of sanctioned brokerage firms and their employees seems to have accelerated as the market has turned down. In January, per Howard Haykin, Editor and Publisher of Compliance Insights, a daily online newsletter for compliance professionals, “7 employees were sanctioned for engaging in outside business activity – for compensation or not – without having provided written notice to his/her member firm; 6 Employees for failing to (adequately) supervise; 5 employees for engaging in private securities transactions, for compensation, without prior written notice to, or prior written approval from, his/her member firm.”

According to Tim Pedregon, a former Finra examiner, the alleged fraudulent activities that took place between Bernard Madoff’s Investment Advisor – registered in 2005 — and the Broker Dealer fell into the pot of problematic activities noted above; these transactions between the two regulated entities required outside business disclosures for review by the broker dealer compliance officers and available for review by Finra. Since, according to Finra, transacting business with the registered investment advisor was “a securities transaction outside the regular course or scope of an associated person’s employment with a member,” the Finra regulated broker dealer was required to identify its investment advisor as an outside business enterprise. Thus Pedregon asked, “Pursuant to FINRA Rule 3040, I am wondering if the Chief Compliance Officer monitored the private securities transactions in accordance with the rule? “

In short, the Compliance department’s role to supervise identified a short-coming in the Madoff firm that should have been elevated by compliance and noted by Finra. While compliance staff, or in fact the CCO, can be concerned about confronting senior executives at firms, technology can fill the gap; technology is not deferential and is omnipresent. With an automated system of entering private securities transactions, personal trades, outside business activities, etc, firm members must only be reminded, not convinced or cajoled. The presence of an automated system combined with adequate reminders, make this process non-personal and effectively diffuses any confrontational issues for compliance.

Larry Goldfarb Compliance Issues, Compliance Technology Solutions broker dealer, compliance software, Compliance Technology Solutions, compliance11, employee personal trading, financial institutions, finra 3050, regulatory compliance

The advantage of computer technology is that it is dispassionate; it doesn’t discriminate as to who provides the input and given its logic and the identical circumstances, it should provide the same answer time and time again.

The sad tale of David Aufhauser, the former General Counsel to the US Treasury Department and the General Counsel of UBS Investment Bank drives home the fact of the impartiality of computers. He was on the train from Stamford, CT to his home in Washington, D.C. when he received an email from the Chief Risk Officer noting a pending issue with the liquidity of the Auction Rate Note Market. He immediately called his broker and sold out of his position.

Andrew Cuomo, The Attorney General of NY State got wind of this transaction and concluded his investigation by fining Mr. Aufhauser $6.0MM (his 2007 bonus), $0.5MM to disgorge the sale, and banned him from the securities industry for 2 years — all this for a quick call to his broker. If Mr. Aufhauser was in the habit of pre-clearing all of his trades, and UBS had a requirement that all employees had to use the system, Mr. Aufhauser would not be subject to his current circumstance. The problem here is that senior officials are used to cutting corners. Since the group assigned to vet trading activity worked for Mr. Aufhauser (the compliance department) he was not used to being subject to typical employee procedures; this is also true for the most senior executives.

Essentially, the problem with a manual vetting process is that it is open to human factors. This is even the more surprising because UBS has a personal trading pre-clearance system. Unfortunately, it did not apply to all securities and all employees. I believe the lesson here is while systematic processes are not relevant for all issues (see value at risk), it makes sense for processes where protecting reputations is paramount.

Larry Goldfarb Compliance Issues broker dealer, compliance software, Compliance Technology Solutions, compliance11, employee personal trading, financial institutions, finra 3050, regulatory compliance