(Click on image to see Jeremy Kroll interviewed by Pimm Fox on Bloomberg’s Taking Stock—starts at 8:56)
On Friday May 4, 2012 activist investor Dan Loeb accused current Yahoo CEO Scott Thompson of falsifying his resume. Thompson claimed to have received a degree in Accounting and Computer Science from an academic institution that Loeb says did not grant degrees in Computer Science at the time. Here’s The New York Times’s Dealbook blog quoting from Loeb’s letter:
“We inquired whether Mr. Thompson had taken a large number of computer science courses, perhaps allowing him to justify to himself that he had ‘earned’ such a degree,” Mr. Loeb wrote of his conversation with Stonehill, a Catholic school outside Boston. “Instead, we learned that during Mr. Thompson’s tenure at Stonehill only one such course was even offered – Intro to Computer Science. Presumably, Mr. Thompson took that course.”
A Yahoo spokesman chalked the discrepancy up to “inadvertent error”.
A falsified and embellished resume or credentials is an issue that arises in many situations. The problem should not be ignored when considering any new hire or investment due diligence. The first question one has to ask is what type of due diligence did Yahoo conduct on their own CEO candidate before hiring him that this was missed?
As Loeb discovered, any routine check would verify the schools attended and the degrees earned. A truly independent due diligence, one outside the four corners of a typical public records and reference checks, should be the first order of business when evaluating a potential senior-level hire. Your company should know exactly who you’re hiring and what they have really accomplished. This isn’t simply a matter of avoiding embarrassment.
Candidates embellish or lie about achievements for many reasons. Some want to explain away a gap in employment. Others will want to establish greater “expertise.” Errors may be nefarious or simply “inadvertant errors.”
Significant “mistakes” on a potential new hire’s resume raises the potential for more serious transgressions. The due diligence process allows a company to evaluate the candidate both on his merits but also for the potential ethical and leadership questions.
As we are seeing with Yahoo, a mistake such as this can be magnified causing harm to the companies reputation and stock price that is disproportionate to the error. The company’s Board of Directors and senior management who failed to identify the discrepancy before making a significant hire can be drawn into the distraction and see their reputations suffer as well.
Mr. Loeb has called for an independent investigation into the credentials of both the CEO and a sitting Board member. Had a thorough and independent vetting of Scott Thompson taken place, Yahoo could have saved the company an unwanted headache and publicity nightmare down the road. Risks come in all forms in today’s market, and none more so than the risk that goes unidentified, unevaluated and unmitigated.
Loeb Accuses Yahoo Officials of Resume Padding (Dealbook/New York Times)
There’s no doubt that the government’s nonprosecution agreement with Diamondback Capital Management demonstrates the value of a hedge fund’s willingness to pursue a “first-to-know” strategy. Despite having two employees indicted in the Dell insider trading ring, Diamondback was able to keep it’s doors open by disgorging profits, paying a penalty and admitting some wrongdoing. That’s a far cry better than being run out of business:
Here’s Dealbook with the details of the settlement:
Under the terms of its agreements with the Securities and Exchange Commission and the federal government, Diamondback will forfeit $6 million in ill-gotten gains and pay a civil penalty of $3 million.
In a departure from the S.E.C.’s historical practices, Diamondback’s pact with the S.E.C. does not include language that the fund “neither admits nor denies” any wrongdoing in the case.
How did Diamondback do it? They proved to the government that they had done their own investigation, knew the scope of the problem remained with the two indicted employees and were willing to cooperate.
“We believe that the proposed settlement appropriately sanctions the misconduct while giving due credit to Diamondback for its substantial assistance in the government’s investigation and the pending actions against former employees and their co-defendants,” George Canellos, the head of the S.E.C.’s New York office, said in a statement.
The stakes around insider trading are about to get even higher as the government moves toward much longer prison sentences for insider trading. If these new rules go into effect, there will be even more incentive for lower-level defendants to cooperate with the government by providing information or, even, participating in investigations.
Section 1079A(a)(1)(A) of the Dodd-Frank Act requires the United States Sentencing Commission to review its guidelines for securities fraud offenses “in order to reflect the intent of Congress that penalties for the offenses under the guidelines and policy statements appropriately account for the potential and actual harm to the public and the financial markets from the offenses.” That is another way of telling the sentencing commission to bump up the recommended sentences for crimes like insider trading.
The government isn’t suggesting a gradual increase in sentences. What’s on the table is an outright doubling of sentences that would make the unprecedented 11 years given to Galleon’s Raj Rajnaratnam seem lax. Anthony Chiasson won’t face those new sentencing guidelines, if he’s convicted:
The Dodd-Frank Act requires most hedge funds to register with the Securities and Exchange Commission as investment advisers. That means any insider trading involving employees at firms like Level Global or the Galleon Group, the hedge fund Mr. Rajaratnam founded, will be subject to the proposed four-point increase.
If Mr. Chiasson were convicted of insider trading, the recommended sentence under the current sentencing guidelines would be 121 to 135 months, assuming no other enhancements applied. The amendments would increase that to 235 to 293 months, nearly twice as long. The potentially higher recommended punishment would only apply to insider trading that occurs after the amendment goes into effect, which would be later this year at the earliest if approved by the sentencing commission. The new guidelines would not apply to Mr. Chiasson’s case because the alleged insider trading occurred in 2008.
Greater Penalties for Insider Trading (Dealbook)
Beyond Compliance: Building a First-to-Know Defense Against International Bribery and Corruption Risks
by Jason N. Golub
The best way for a corporation or investment fund to inoculate itself against the risks created by increased enforcement of the United States’s Foreign Corrupt Practices Act and the advent of the United Kingdom’s new Bribery Act is to perform a rigorous audit.
Our experience is that control programs must go beyond compliance. They must deal effectively with large corruption and small, gain the support of employees and focus on identification of the highest risk individuals and entities. Who makes potentially corruptive decisions? How are they documented and monitored? What constitutes effective monitoring?
In many instances, violations of bribery laws occur because entities fail to properly train officers and employees to understand and appreciate the nature of relationships in the context of the FCPA and UK Bribery Act. While all employees must be trained and educated, training will be only be effective if the culture of compliance is set from the top.
In the event that a company learns of a potential FCPA or UK Bribery Act issue, it must act promptly and efficiently to minimize the impact on its business and investors. The company should obtain assistance on a range of issues including developing adequate policies and procedures, assessing books and records and training employees. In addition senior officials should understand how to conduct an internal investigation and what remedial actions to take if a violation is identified.
Overall, bribery and corruption risk must be integrated into all parts of an organization’s culture in order to be effective. With an increasingly aggressive set of regulators focusing on bribery it behooves any company to be the “first to know” when bribery becomes an issue, and thereby stay ahead of any potential risk issues.
K2 Global can help organizations combat bribery. Our efforts can broadly address the following areas:
- Teach staff research and reporting skills on why and how corrupt forces may operate in areas you do business
- Evaluate and draft procedures relating to due diligence and hiring of intermediaries that are best in class
- Help build and maintain effective relationships with intermediaries
- Help comply with all laws and regulations
- Surpass the minimum “adequate procedure” required by the UK Bribery Act with best practices
- Investigate actual transactions and potential situations
- Conduct due diligence on potential business partners, acquisitions and intermediaries
- Incorporate training that is practical and applicable to real situations rather than legalistic
- Mentor compliance staff and provide ongoing support and guidance
- Draft Operations Manual for bribery accounting policies, oversight, procedures and response
“The Justice Department has been vigorously enforcing the Foreign Corrupt Practices Act and achieving strong results,” Associate Attorney General Lanny A. Breuer said in a speech earlier this month in Washington, DC. “We are in the middle of our fourth FCPA trial of the year – more than in any prior year in the history of the Act. And just two weeks ago, we secured the longest prison sentence – 15 years – ever imposed in an FCPA case.”
Breuer’s enthusiasm is echoed in statistics from 2010, a year that saw Justice bringing 46 new criminal cases and the SEC filing 26 actions of its own. All together, enforcement case rose 85% from 2009 to 2010—and investigations touched companies of all shapes and sizes from little-known firms to mainstays like Blackstone and Citigroup.
Rooting out bribery as a business practice around the world is no longer an American obsession. With the addition this July of the UK’s very stringent Bribery Act, there is a whole new level of risk for investments made in either direction. Sovereign Wealth Funds that have made investments in the United States are facing new levels of scrutiny—including having foreign employees considered government officials. And there are now greater risks for US firms that want to make investments abroad.
We’ve been writing a lot lately about the importance of personal and professional networks in insider trading investigations. This piece in the New York Times deals with the increasing scrutiny leveled at expert networks (in this case, Primary Global Research) and the potential risks they post to the unwary.
A hedge fund client, frustrated by the increased compliance demands around assessing his insider trading risk, recently turned to me and said: “It’s not like my traders and PMs are going to write an email saying, ‘let’s insider trade this stock’ or ‘hey, I got some inside information we should trade on!’” My initial thought: stranger things have happened.
But the point was a fair one. While it’s true that the history of insider trading cases is littered with head-scratching emails and incriminating statements, current-day portfolio managers, traders and analysts are quite cognizant of how their trades are monitored. They know the keywords to avoid in emails, they know what not to discuss on their work phones, and what type of trades will raise the eyebrows of their internal compliance department and securities regulators.
A case in point: The second week of the Raj Rajaratnam trial highlighted just how far individuals will go to cover their own insider trading tracks. The government provided evidence that Mr. Rajaratnam instructed colleagues on how to create a fraudulent email trail in order to make it appear as if they had done their due diligence on a stock and invested on fundamentals rather than insider information. He suggested drafting emails in which they discussed “how cheap” the stock was in order to create a smokescreen. Subsequently, he also suggested that a co-conspirator trading on inside information place a flurry of trades in a short period of time (i.e. buy 10,000 shares, sell 5000 a couple days later) in order to make it more difficult for regulators to detect insider trading.
With this sort of activity on the public record, the question for a compliance-minded mutual fund or hedge fund becomes: where does this leave an institution that wants to increase internal transparency, identify potential insider trading and network risks, and stay out of the regulators’ crosshairs? What proactive solutions are available to avoid the fate of the Level Globals of the world?
In reality, there is no simple answer. One should start with the idea that the SEC has begun thinking outside the box in evaluating data and deciding where to bring insider trading investigations. Gone are the days when internal staff can simply examine outlier trades and send document requests on that basis alone. The SEC uses wire taps and other sophisticated technologies; they identify the overlap of suspicious trades with social and professional relationships; they look closely at both internal and external data sources to track down potential insider trading.
We’ve seen that banks, hedge funds and mutual funds have been slower to understand the SEC’s current approach and slower still to embrace potential outside the box testing and evaluation of traders, trade risks, and relationships. Still, adopting such practices would allow them to see these issues through the SEC’s lens and mitigate potential problems.
Traditional methods of regulatory due diligence and internal compliance focusing on trade issues do not embrace proactive testing, evaluation of outlier trades, or the understanding that technology and relationship networks have changed the nature and scope of risks faced by financial organizations.
The Galleon case is a particularly egregious example of insider trading, but the industry should learn from it and understand its ramifications and not dismiss it as an outlier. Financial organizations are already familiar with the environment created by the Galleon case: investors redeem their money at the slightest hint of a regulatory issue; regulators fire off document requests at the slightest provocation; investigators use the press as a weapon.
By the time an insider trading risk leads to a public investigation, it’s already too late for a fund to survive. Sustainable and successful companies in this environment cannot, therefore, be merely reactive. Instead, the goal must be an honest, proactive approach to identifying and mitigating potential risks associated with trades, traders and relationships. By taking a proactive approach, financial institutions show investors and regulators they are serious about risk mitigation and a culture of compliance.
Funds need to put themselves in a better position with skittish investors and demonstrate a proactive posture. An enthusiasm for testing and risk analysis goes a long way toward easing concerns when a regulatory inquiry is initially opened. The development of a culture that prevents regulatory violations and resulting inquiries can be a complex and multi-layered. It’s an ambitious goal, but one that’s attainable for financial organizations willing to take a critical look at themselves, their potential trade issues, and their risk from a difference perspective.
In my last post, I pointed out that many buyers make corporate acquisitions without sufficient due diligence, and discussed how we at K2 begin to look into acquisition targets’ financial stability on behalf of our clients. In this post, I’ll look a little more into the next steps: examining a company’s legal liabilities and internal oversight.
Looking into a company’s existing and potential legal liabilities is essential. Let’s say your company is looking to purchase a promising software company for $15 million. You are unaware that due to unpaid vendors, disgruntled investors and a handful of employment law suits, there exists an additional existing liability of $2.5 million. This doesn’t take into account the potential future liability that is often hidden from an acquiring company due to the acquired company’s mismanagement.
Many companies have gone bankrupt expending valuable resources on endless litigation. While the company you’re acquiring may seem innovative on its face, it won’t seem as attractive with the specter of years of litigation hanging overhead. (Or, as a recent client once put it, the “deal has hair on it”.)
Any due diligence process must identify not only obvious legal concerns, but also unearth the potential issues that may not be as apparent to an acquiring company. For example:
- Have the State and Federal court dockets been reviewed for cases against the company, or individual members of senior management?
- Has the in-house counsel been interviewed concerning existing and potential legal issues the company faces?
- Have there been disgruntled past employees, consultants or vendors? Were these issues appropriately dealt with?
- Have investors voiced complaints? Were the complaints addressed?
Any or all of these issues could easily go unexamined, leading to long-term financial and legal headaches for the acquiring company.
A thorough due diligence should also examine the acquired entity’s controls, including accounting, supervisory, financial and legal policies and procedures. Data, customer information and technology controls are also worth examining. Well-designed procedures will detect material weaknesses in business or legal issues affecting the company, and responsible companies will update these policies in writing regularly, with the CEO, CFO and/or the Board of Directors overseeing enforcement.
In our experience, we find that weaknesses in controls are often warning signs of larger issues. A control weakness can indicate opportunities for fraud, accounting irregularities, irresponsible corporate spending and generally questionable acts. Irrespective of the control in question, a lack of controls may raise questions about continuing with the existing management team once the acquisition is complete.
The due diligence process should evaluate what current management says about legal and control issues while keeping in mind former President Reagan’s adage – “trust but verify.” Reliance on what you’re told by management is insufficient in avoiding potential issues and will set the acquiring company up for future problems. What do past employees have to say about current management policies and procedures? What do former business partners say about the financial stability or accounting of the company? Friends, colleagues, enemies, the IRS, and court papers all have a story to tell and it is our belief that many of these stories can uncover important truths about a company.
In order to assess the true strengths and weaknesses of a potential acquisition, it is necessary to drill deeper before closing any deal. Making certain you have the right answers, and not just the easy answers, should be an essential part of your due diligence process and will ultimately save you and your investors time, headache and expense.
Under the doctrine of caveat emptor (“let the buyer beware”), the buyer cannot recover compensation from a seller for defects on a property that renders the property unfit for ordinary purposes. The only exception is if the seller actively conceals latent defects or otherwise makes material misrepresentations amounting to fraud. K2 Global is seeing more and more of these exceptions in today’s corporate world– acquisitions where buyers, once taking ownership of a new property, entity, or business, suddenly find out that they’ve purchased more (or less) than they’d bargained for.
But what are the steps a company or an individual should consider when performing due diligence surrounding a potential acquisition? The first thing to consider is performing a thorough investigation and due diligence before acquiring a business. While this seems fairly obvious, we have seen companies wait until the money is spent and the acquisition is complete before realizing there are issues they weren’t aware of.
Our approach to due diligence is to take a step beyond the routine due diligence, which will uncover the obvious “warts” of a company, and perform a deep dig that will ensure that your investors, Board of Directors and management of your company will be acquiring assets and not surprises. Our due diligence model requires an acquiring company to understand that asking questions of the existing management is not enough. Sure, they will provide the answers you expect but are they the right answers? Are they the complete story?
A thorough due diligence must poke, prod and above all else challenge what management says concerning the major issues affecting the acquired company. It requires examination of the issues uncovered from various perspectives, which is why our due diligence teams are comprised of experienced investigators from a variety of fields (from securities lawyers to forensic accountants to business intelligence professionals). As for the issues themselves, we believe a thorough due diligence, whether performed before an acquisition or before sinking additional funds into a venture, should evaluate several key aspects of the company including financial, legal, controls, technology and reputational risk:
Let’s start with financial. In order to thoroughly review a company’s financial stability, it’s essential to address the following questions:
- Are the accounting records up-to-date?
- Have there been concerns raised by internal or external auditors concerning weaknesses in the financials?
- What do the accounting policies and procedures look like and how long have they been in place?
- Have they been consistently enforced by senior management and applied to all employees?
Sufficient accounting policies support the achievement of the company’s objectives and operational effectiveness.
Conversely, accounting issues raise the possibility that there are not adequate controls in place to reliably identify material misstatements in the company financials. This can further undermine the Board of Directors and senior management’s ability to enforce and supervise issues affecting the company’s financial stability. Any or all of these issues can lead to a lack of transparency concerning the state of the financials as well as material misrepresentations to investors.
Due diligence is a layered and complex process, so there’s more to talk about. In my next post, I’ll explore how we approach an acquisition target’s legal liabilities and controls.