Sunday, August 31, 2014
William Byrnes' comments:
On January 25, Kathryn Keneally, assistant attorney general of the Justice Department’s Tax Division, served as the keynote speaker for the American Bar Association Section of Taxation 2014 Midyear Meeting. to provide agency updates – including on the Switzerland banks non-prosecution agreement program that expired December 31.
David Voreacos of Bloomberg News reported that Kathryn Keneally, in her keynote remarks, stated that 106 Swiss banks (of approximately 300 total) filed the requisite letter of intent to join the Program for Non-Prosecution Agreements or Non-Target Letters (the “Program“) by the December 31, 2013 deadline. Renown attorney Jack Townsend reported on his blog on December 31st a list of 47 Swiss banks that had publicly announced the intention to submit the letter of intent, as well as each bank’s category for entry: six announced seeking category 4 status, eight for category 3, thirty-three for category 2. 106 is a large jump from the mid-December report by the international service of the Swiss Broadcasting Corporation (“SwissInfo”) that only a few had filed for non prosecution with the DOJ’s program (e.g. Migros Bank, Bank COOP, Valiant, Berner Kantonalbank and Vontobel). 
SwissInfo reported that Migros Bank selected Program Category 2 because “370 of its 825,000 clients, mostly Swiss citizens residing temporarily in the US or clients with dual nationality”, met the criteria of US taxpayer. Valiant told SwissInfo that “an internal review showed it had never actively sought US clients or visited Americans to drum up business. The bank said less than 0.1% of its clients were American.” The DOJ reported that in July 2013, Liechtensteinische Landesbank AG, a bank based in Vaduz, Liechtenstein, entered into a non-prosecution agreement and agreed to pay more than $23.8 million stemming from its offshore banking activities, and turned over more than 200 account files of U.S. taxpayers who held undeclared accounts at the bank.
William R. Davis and Lee A. Sheppard of Tax Analysts’ Worldwide Tax Daily reported that “one private practitioner estimated that some 350 banks holding 40,000 accounts have not come in.” (see “ABA Meeting: Keneally Reports Success With Swiss Bank Program”, Jan. 28, 2014, 2014 WTD 18-3.)
Two court orders entered in November 2013 in a New York federal court will further aid the offshore compliance investigations by authorizing the IRS to serve what are known as “John Doe” summonses on five banks to obtain information about possible tax fraud by individuals whose identities are unknown. The John Doe summonses direct the five banks to produce records identifying U.S. taxpayers holding interests in undisclosed accounts at Zurcher Kantonalbank (ZKB) and its affiliates in Switzerland and at The Bank of N.T. Butterfield & Son Limited (Butterfield) and its affiliates in Switzerland, the Bahamas, Barbados, Cayman Islands, Guernsey, Hong Kong, Malta and the United Kingdom. The summonses also direct the five banks to produce information identifying foreign banks that used ZKB’s and Butterfield’s correspondent accounts at the five banks to service U.S. clients.
Swiss banks Wegelin ceased operations because of the DOJ investigation and its consequent guilty plea. Bank Frey followed suit because of the DOJ investigation and costs of future compliance with FATCA (its former head of private banking was indicted, and an > attorney in the same indictment pled guilty to conspiracy to commit tax fraud <). Frey bank, in a November 28, 2013 statement, defended itself: “In October, the former Bank Frey & Co. AG decided to cease its banking activities and to terminate all of its client relationships. Beforehand, the Bank verified the tax compliance of all its US clients, and an external auditor confirmed so. In addition, the Bank examined all of its other clients to determine whether they had any link to the US. Again, an external auditor checked and confirmed these findings. As a result, it was determined that Bank Frey did not have any clients with potential US tax issues.”
What is the Program for Non-Prosecution Agreements or Non-Target Letters for Swiss Banks?
The Tax Division of the Department of Justice > released a statement on December 12 < strongly encouraging Swiss banks wanting to seek non-prosecution agreements to resolve past cross-border criminal tax violations to submit letters of intent by a Dec. 31, 2013 deadline required by the Program for Non-Prosecution Agreements or Non-Target Letters (the “Program“). The Program was announced on Aug. 29, 2013, in a > joint statement < signed by Deputy Attorney General James M. Cole and Ambassador Manuel Sager of Switzerland (> See the Swiss government’s explanation of the Program < ). Switzerland’s Financial Market Supervisory Authority (FINMA) has issued a deadline of Monday, December 16, 2013 for a bank to inform it with its intention to apply for the DOJ’s Program.
The DOJ statement described the framework of the Program for Non-Prosecution Agreements: every Swiss bank not currently under formal criminal investigation concerning offshore activities will be able to provide the cooperation necessary to resolve potential criminal matters with the DOJ. Currently, the department is actively investigating the Swiss-based activities of 14 banks. Those banks, referred to as Category 1 banks in the Program, are expressly excluded from the Program. Category 1 Banks against which the DoJ has initiated a criminal investigation as of 29 August 2013 (date of program publication).
On November 5, 2013 the Tax Division of the DOJ had released > comments about the Program for Non-Prosecution Agreements or Non-Target Letters for Swiss Banks < .
Swiss banks that have committed violations of U.S. tax laws and wished to cooperate and receive a non-prosecution agreement under the Program, known as Category 2 banks, had until Dec. 31, 2013 to submit a letter of intent to join the program, and the category sought.
To be eligible for a non-prosecution agreement, Category 2 banks must meet several requirements, which include agreeing to pay penalties based on the amount held in undeclared U.S. accounts, fully disclosing their cross-border activities, and providing detailed information on an account-by-account basis for accounts in which U.S. taxpayers have a direct or indirect interest. Providing detailed information regarding other banks that transferred funds into secret accounts or that accepted funds when secret accounts were closed is also a stipulation for eligibility. The Swiss Federal Department of Finance has released a > model order and guidance note < that will allow Swiss banks to cooperate with the DOJ and fulfill the requirements of the Program.
The DOJ’s November comments responded to such issues as: (a) Bank-specific issues and issues concerning individuals, (b) Choosing which category among 2, 3, or 4, (c) Qualifications of independent examiner (attorney or accountant), (d) Content of independent examiner report, (e) Information required under the Program – no aggregate account data, (f) Penalty calculation – permitted reductions, (g) Category 4 banks – retroactive application of FATCA Annex II, paragraph II.A.1, and (h) Civil penalties.
Regarding which category to file under, the DOJ replied: “Each eligible Swiss bank should carefully analyze whether it is a category 2, 3 or 4 bank. While it may appear more desirable for a bank to attempt to position itself as a category 3 or 4 bank to receive a non-target letter, no non-target letter will be issued to any bank as to which the Department has information of criminal culpability. If the Department learns of criminal conduct by the bank after a non-target letter has been issued, the bank is not protected from prosecution for that conduct. If the bank has hidden or misrepresented its activities to obtain a non-target letter, it is exposed to increased criminal liability.”
Category 2 Banks against which the DoJ has not initiated a criminal investigation but have reasons to believe that that they have violated US tax law in their dealings with clients are subject to fines of on a flat-rate basis. Set scale of fine rates (%) applied to the untaxed US assets of the bank in question:
- Existing accounts on 01.08.2008: 20%
– New accounts opened between 01.08.2008 and 28.02.2009: 30%
– New accounts after 28.02.2009: 50%
Category 2 banks must delivery of information on cross-border business with US clients, name and function of the employees and third parties concerned, anonymised data on terminated client relationships including statistics as to where the accounts re-domiciled.
Category 3 banks have no reason to believe that they have violated US tax law in their dealings with clients and that can have this demonstrated by an independent third party. A category 3 bank must provide to the IRS the data on its total US assets under management and confirmation of an effective compliance programme in force.
Category 4 banks are a local business in accordance with the FATCA definition.
Regarding the requirement of the independence of the qualified attorney or accountant examiner, the DOJ stated that the examiner “is not an advocate, agent, or attorney for the bank, nor is he or she an advocate or agent for the government. He or she must provide a neutral, dispassionate analysis of the bank’s activities. Communications with the independent examiner should not be considered confidential or protected by any privilege or immunity.” The attorney / accountant’s report must be substantive, detailed, and address the requirements set out in the DOJ’s non-prosecution Program. The DOJ stated that “Banks are required to cooperate fully and “come clean” to obtain the protection that is offered under the Program.”
In the ‘bottom line’ words of the DOJ: “Each eligible Swiss bank should carefully weigh the benefits of coming forward, and the risks of not taking this opportunity to be fully forthcoming. A bank that has engaged in or facilitated U.S. tax-related or monetary transaction crimes has a unique opportunity to resolve its criminal liability under the Program. Those that have criminal exposure but fail to come forward or participate but are not fully forthcoming do so at considerable risk.”
 See Mathew Allen, US tax deal could prove deadly for small banks, SwissInfo, December 10, 2013, available at http://www.swissinfo.ch/eng/politics/US_tax_deal_could_prove_deadly_for_small_banks.html?cid=37506872
 See Supermarket banks sign up to US tax probe, SwissInfo, December 11, 2013, available at http://www.swissinfo.ch/eng/business/Supermarket_banks_sign_up_to_US_tax_probe.html?cid=37516028 (accessed December 12, 2013).
Saturday, August 30, 2014
CAMPBELL R. HARVEY, Duke University - Fuqua School of Business, National Bureau of Economic Research (NBER)
I will address eight common claims about bitcoin: 1. Physical bitcoins exist; 2. The founder of bitcoin is a person called Satoshi Nakamoto; 3. Bitcoin is mainly used for criminal activity; 4. A lack of security plagues bitcoin; 5. Mining is a waste of energy; 6. Bitcoin too small today to be an important economic force; 7. Bitcoin is currently too volatile to be viable; 8. Bitcoin is just another currency.
For additional details beyond "Bitcoin Myths and Facts," I have another paper/slidedeck called "Cryptofinance" that goes deeper into the mechanics of cryptocurrencies. It is available at http://ssrn.com/abstract=2438299.
Wenxia Ge , University of Manitoba - Asper School of Business; Jeong-Bon Kim V, City University of Hong Kong; TieMei Li, University of Ottawa - School of Management; Yutao Li, University of Lethbridge
We examine the effects of the extent of a multinational firm’s operations in offshore financial centers (OFCs) on the price and non-price terms of bank loan contracting. Using a cross-country sample of firms with at least one subsidiary in an OFC, we find that intensive offshore operations are associated with unfavorable loan terms, such as higher loan spreads, smaller loan amounts, a higher probability of a loan being secured by collateral, and more prevalent use of restrictive covenants in a loan contract. We also find that such associations are more pronounced for more opaque firms and for firms that are headquartered in countries or jurisdictions with weaker legal or regulatory enforcement. Our findings indicate that banks and other private lenders view offshore operations as a credit risk-increasing factor when lending to multinational firms that have subsidiaries in OFCs.
Friday, August 29, 2014
The inaugural Global Secrurity Dash for FDS Conference was held in Soel Korea on August 25. As Korea begins to develop a financial fraud detection policy, the conference brought together members of the government and private sector. It is a little amazing that this type of financial regulation is just at the incubator stage in Korea, but it seems a welcom step forward.
From the Korea IT Times, "Some 150 financial security specialists and prominent figures from central government agencies such as the Ministry of Science, ICT and Future Planning, the Financial Security Agency were also in attendance. Also at the event were leading figures from educational and corporate bodies, such as Korea University’s Graduate School of Information Security, major Korean banks, other financial enterprises and other security specialists.
The conference provided a much-needed platform for the discussion of governmental policy and developments involving information security. Participants were able to express their thoughts and offer insight into a way to develop an effective Fraud Detection System (FDS)."
According to a Treasury press release and ThinkAdvisor, "The Treasury Department’s Financial Crimes Enforcement Network (FinCEN), recently issued proposed rules under the Bank Secrecy Act to clarify and strengthen customer due diligence requirements — including anti-money laundering rules — for banks, brokers or dealers in securities, mutual funds, and futures commission merchants as well as introducing brokers in commodities."
"FinCEN’s proposed amendments to the Bank Secrecy Act for broker-dealers, banks and mutual funds would add a new requirement that these entities 'know and verify the identities of the real people (also known as beneficial owners) who own, control, and profit from the companies they service.'
Comments on that proposal are due Oct. 3."
"The proposed new regulation would require, when an account is opened, that banks and other financial institutions identify and verify the identity of the “real people behind the businesses who are their customers,” Cohen said. “While this may sound rather technical, it nonetheless is a critically important step forward in the fight against dirty money.”
Treasury says that the proposal will not only increase the ability of financial institutions, law enforcement and the intelligence community to identify the assets and accounts of terrorist organizations, money launderers, drug kingpins and other national security threats, but also facilitate reporting and investigations in support of tax compliance, and advance national commitments made to foreign counterparts in connection with the provisions of the Foreign Account Tax Compliance Act (FATCA)."
"As Fisher explains, in defining what constitutes a “beneficial owner,” each of the above mentioned financial institutions would have to identify:
- Each individual who owns 25% or more of the equity interests in the juridical entity that is the customer of the covered financial institution; and
- One individual who exercises significant managerial control over that customer
'If no individual owns 25% or more of the equity interests, the covered financial institution may identify a beneficial owner under the second prong only,' Fisher says. 'The same individual (or more than one) may be identified under both prongs.'"
It was reported by the El Paso Times, that "At about 6 a.m. [on August 26], more than 50 FBI agents and evidence collection specialists began serving search warrants at the Anamarc campuses in Santa Teresa and 3210 Dyer in Central El Paso, and the owners' home in the 4000 block of Little Lane in the Upper Valley."
"FBI agents possibly looking at fraud allegations Wednesday morning raided two campuses of Anamarc College, which closed abruptly this summer, and the home of the owners of the college."
"Before closing, Anamarc had previously told students that the school was moving up its summer vacation several days. The move came after the school was notified by the U.S. Department of Education that it would be placed on a special "cash monitoring" status that meant it would received federal financial aid money on a reimbursement basis, instead of at the beginning of a semester. The department took that action after the college failed to provide a required letter of credit, according to a letter providing notice of the decision."
Large financial institutions, including BOA, UBS, GE, JP Morgan Chase, and Wells Fargo, conspired to divide up the muni bond market among themselves to drive up their profits by paying below the market price that would have been established via a competitive bidding process. The government's antitrust investigation has resulted in numerous convictions and $743 million in settlements.
BOA and its employee Brian Scott Zwerner agreed plea deals very early in the process - BOA before the investigation began. Reuters reports that Brian Zweller did not receive jail time, and a small fine of $10,000, though he agreed to pay Bank of America $890,000.
SEC Admin Proceeding August 26, 2014 (of Brian Scott Zwerner)
Bloomberg reported "In a $65.2 million bond issue for the Beacon Tradeport Community development district in Florida handled by Bank of America, the bank recommended the broker who was handling the investment bids. Bank of America told the broker what it planned on bidding, allowing the broker to advise other banks where they shouldn’t bid, the SEC said. Bank of America paid the broker a $50,000 kickback for steering the bids by disguising it as a fee in another deal."
The history of who did what, when, and what happened to them... (National Association of Bond Lawyers)
excerpted from the FBI Release... Brian Scott Zwerner ... engaged in a conspiracy to falsify bank records related to the marketing profits for a type of contract, known as an investment agreement, and other municipal finance contracts, including derivative contracts. Public entities throughout the United States, such as state, county and local governments and agencies, invested the proceeds of bonds issued in these contracts.
According to the court document, the Charlotte, N.C.-based bank that employed Zwerner was a provider of investment agreements and other municipal finance contracts to public entities. Public entities seek to invest money from a variety of sources, primarily the proceeds of municipal bonds that they issued, to raise money for, among other things, public projects.
Public entities typically hire a broker to conduct a competitive bidding process for the award of the investment agreements. Competitive bidding for these agreements is the subject of regulations issued by the Department of the Treasury and is related to the tax-exempt status of the bonds .
The department said in the court document that Zwerner was the manager of the Municipal Derivatives Trading Desk at the bank. According to the court document, Zwerner engaged in the conspiracy from at least as early as January 1999 until approximately May 2002. Among other objectives, Zwerner and co-conspirators falsified bank records related to marketing profits so that the bank could pay kickbacks to brokers, including Rubin/Chambers, Dunhill Insurance Services Inc., also known as CDR Financial Products, a Beverly Hills, Calif.-based financial products and services firm. Specifically, Zwerner understated the marketing profits on trade tickets for certain investment agreements or other municipal finance contracts so that money could be held back and accumulated in an off-the-books account in order to pay the kickbacks. According to the court document, trade tickets are reports that record the essential terms of investment agreements.
The department said that the kickbacks were in exchange for brokers, including CDR, manipulating the competitive bidding process so that the bank would be the winning bidder for certain investment agreements and other municipal finance contracts.
This is the ninth guilty plea to arise from an ongoing investigation into the municipal bonds industry.
Three former employees of CDR have pleaded guilty to bid-rigging and fraud conspiracies in relation to the ongoing investigation. Five other individuals have pleaded guilty to charges related to the ongoing investigation. In October 2009, CDR, two of its employees and one former employee were charged for participating in bid-rigging and fraud conspiracies and related crimes. The CDR trial is scheduled to begin on Jan. 9, 2012. In addition, six other former executives at financial service companies or financial institutions have been indicted as a result of this investigation and are awaiting trial.
Thursday, August 28, 2014
For the past four years, the Work Group for Distance Learning in Legal Education has met to discuss and develop recommended & best practices. The Work Group is a collaboration effort thrice annually since 2011 consisting of volunteer faculty or administration members from at least fifty ABA member law schools, legal education stakeholders such as the publishers, and various technology providers. See http://www.law.harvard.edu/programs/plp/pages/distance_learning_working_group.php
Our next event of short “state of industry” presentations, pedagogical, administrative, and policy discussions, before finalizing for publication our recommendations and best practices is:
September 18 – 20 (Thursday afternoon through Saturday lunch) in St. Paul, graciously hosted by William Mitchell - https://www.eventbrite.com/e/working-group-for-distance-learning-in-legal-education-fall-2014-meeting-registration-12051364957
Only 18 spaces remain! We hold an annual AALS breakfast and the Spring meeting will be hosted by Hastings in San Francisco. After that, the group will merge itself into CALI for an annual meeting on maintaining the recommendations and best practices (and a mid year AALS breakfast).
SEC News Release
The Securities and Exchange Commission adopted revisions to rules governing the disclosure, reporting, and offering process for asset-backed securities (ABS) to enhance transparency, better protect investors, and facilitate capital formation in the securitization market.
The new rules, among other things, require loan-level disclosure for certain assets, such as residential and commercial mortgages and automobile loans. The rules also provide more time for investors to review and consider a securitization offering, revise the eligibility criteria for using an expedited offering process known as “shelf offerings,” and make important revisions to reporting requirements.
ABS are created by buying and bundling loans, such as residential and commercial mortgage loans, and auto loans and leases, and creating securities backed by those assets for sale to investors. A bundle of loans is often divided into separate securities with varying levels of risk and returns. Payments made by the borrowers on the underlying loans are passed on to investors in the ABS.
Asset-backed securities are created by buying and bundling loans – such as residential mortgage loans, commercial mortgage loans or auto loans and leases – and creating securities backed by those assets that are then sold to investors.
Often a bundle of loans is divided into separate securities with different levels of risk and returns. Payments on the loans are distributed to the holders of the lower-risk, lower-interest securities first, and then to the holders of the higher-risk securities. Most public offerings of ABS are conducted through expedited SEC procedures known as “shelf offerings.”
During the financial crisis, ABS holders suffered significant losses and areas of the securitization market–particularly the non-governmental mortgage-backed securities market–have been relatively dormant ever since. The crisis revealed that many investors were not fully aware of the risk in the underlying mortgages within the pools of securitized assets and unduly relied on credit ratings assigned by rating agencies, and in many cases rating agencies failed to accurately evaluate and rate the securitization structures. Additionally, the crisis brought to light a lack of transparency in the securitized pools, a lack of oversight by senior management of the issuers, insufficient enforcement mechanisms related to representations and warranties made in the underlying contracts, and inadequate time for investors to make informed investment decisions.
In April 2010, the SEC proposed rules to revise the offering process, disclosure and reporting requirements for ABS. Subsequent to that proposal, the Dodd-Frank Act was signed into law and addressed some of the same ABS concerns. In light of the Dodd-Frank Act and comments received from the public in response to the 2010 proposal, the SEC re-proposed some of the April 2010 proposals in July 2011. In February 2014, the Commission re-opened the comment period on the proposals to permit interested persons to comment on an approach for the dissemination of loan-level data. The proposals sought to address the concerns highlighted by the financial crisis by, among other things, requiring additional disclosure, including the filing of tagged computer-readable, standardized loan-level information; revising the ABS shelf-eligibility criteria by replacing the investment grade ratings requirement with alternative criteria; and making other revisions to the offering and reporting requirements for ABS.
The Final Rules:
Requiring Certain Asset Classes to Provide Asset-Level Information in a Standardized, Tagged Data Format
To provide increased transparency about the underlying assets of a securitization and to implement Section 942(b) of the Dodd-Frank Act, the final rules require issuers to provide standardized asset-level information for ABS backed by residential mortgages, commercial mortgages, auto loans, auto leases, and debt securities (including resecuritizations). The rules require that the asset-level information be provided in a standardized, tagged data format called eXtensible Mark-up Language (XML), which allows investors to more easily analyze the data. The rules also standardize the disclosure of the information by defining each data point and delineating the scope of the information required. Although specific data requirements vary by asset class, the new asset-level disclosures generally will include information about:
- Credit quality of obligors.
- Collateral related to each asset.
- Cash flows related to a particular asset, such as the terms, expected payment amounts, and whether and how payment terms change over time.
Asset-level information will be required in the offering prospectus and in ongoing reports. Providing investors with access to standardized, comprehensive asset-level information that offers a more complete picture of the composition and characteristics of the pool assets and their performance allows investors to better understand, analyze and track the performance of ABS. The Commission continues to consider the best approach for requiring information about underlying assets for the remaining asset classes covered by the 2010 proposal.
Providing Investors With More Time to Consider Transaction-Specific Information
The final rules require ABS issuers using a shelf registration statement to file a preliminary prospectus containing transaction-specific information at least three business days in advance of the first sale of securities in the offering. This requirement gives investors additional time to analyze the specific structure, assets, and contractual rights for an ABS transaction.
Removing Investment Grade Ratings for ABS Shelf Eligibility
The final rules revise the eligibility criteria for shelf offerings of ABS. The new proposed transaction requirements for ABS shelf eligibility replace the prior investment grade requirement and require:
- The chief executive officer of the depositor to provide a certification at the time of each offering from a shelf registration statement about the disclosure contained in the prospectus and the structure of the securitization.
- A provision in the transaction agreement for the review of the assets for compliance with the representations and warranties upon the occurrence of certain trigger events.
- A dispute resolution provision in the underlying transaction documents.
- Disclosure of investors’ requests to communicate with other investors.
The final rules also require other changes to the procedures and forms related to shelf offerings, including:
- Permitting a pay-as-you-go registration fee alternative, allowing ABS issuers to pay registration fees at the time of filing the preliminary prospectus, as opposed to paying all registration fees upfront at the time of filing the registration statement.
- Creating new Forms SF-1 and SF-3 for ABS issuers to replace current Forms S-1 and S-3 in order to distinguish ABS filers from corporate filers and tailor requirements for ABS offerings.
- Revising the current practice of providing a base prospectus and prospectus supplement for ABS issuers and instead requiring that a single prospectus be filed for each takedown (however, it is permissible to highlight material changes from the preliminary prospectus in a separate supplement to the preliminary prospectus 48 hours prior to first sale).
Amendments to Prospectus Disclosure Requirements
The Commission approved amendments to the prospectus disclosure requirements for ABS, which include:
- Expanded disclosure about transaction parties, including disclosure about a sponsor’s retained economic interest in an ABS transaction and financial information about parties obligated to repurchase assets.
- A description of the provisions in the transaction agreements about modification of the terms of the underlying assets.
- Filing of the transaction documents by the date of the final prospectus, which is a clarification of the current rules.
Revisions to Regulation AB
The Commission also approved other revisions to Regulation AB, including:
- Standardization of certain static pool disclosure.
- Revisions to the Regulation AB definition of an “asset-backed security.”
- Specifying, in addition to the asset-level requirements, the disclosure that must be provided on an aggregate basis relating to the type and amount of assets that do not meet the underwriting criteria that is described in the prospectus.
- Several changes to Forms 10-D, 10-K, and 8-K, including requiring explanatory disclosure in the Form 10-K about identified material instances of noncompliance with existing Regulation AB servicing criteria.
For a brief of the below, see SEC Tightens Rules on Credit Rating Agencies, Asset-Backed Securities by Melanie Waddell of ThinkAdvisor (Washington Bureau Chief of Investment Advisor Magazine).
SEC Press Release: The Securities and Exchange Commission Wednesday, August 27 adopted new requirements for credit rating agencies to enhance governance, protect against conflicts of interest, and increase transparency to improve the quality of credit ratings and increase credit rating agency accountability. The new rules and amendments, which implement 14 rulemaking requirements under the Dodd-Frank Wall Street Reform and Consumer Protection Act, apply to credit rating agencies registered with the Commission as nationally recognized statistical rating organizations (NRSROs).
The new requirements for NRSROs address internal controls, conflicts of interest, disclosure of credit rating performance statistics, procedures to protect the integrity and transparency of rating methodologies, disclosures to promote the transparency of credit ratings, and standards for training, experience, and competence of credit analysts. The requirements provide for an annual certification by the CEO as to the effectiveness of internal controls and additional certifications to accompany credit ratings attesting that the rating was not influenced by other business activities.
The Commission also adopted requirements for issuers, underwriters, and third-party due diligence services to promote the transparency of the findings and conclusions of third-party due diligence regarding asset-backed securities.
Highlights of the Amendments and New Rules
Factors an NRSRO must consider when establishing, maintaining, enforcing, and documenting an Internal Control Structure
The Dodd-Frank Act amended the Exchange Act to require an NRSRO to establish, maintain, enforce, and document an effective internal control structure governing the implementation of and adherence to policies, procedures, and methodologies for determining credit ratings, taking into consideration such factors as the Commission may prescribe, by rule.
The rule amendments require an NRSRO to consider certain identified factors. In particular, with respect to establishing an internal control structure, the NRSRO must consider:
- Controls reasonably designed to ensure that a newly developed methodology or proposed update to an in-use methodology for determining credit ratings is subject to an appropriate review process (for example, by persons who are independent from the persons that developed the methodology or methodology update) and to management approval prior to the new or updated methodology being employed by the NRSRO to determine credit ratings.
- Controls reasonably designed to ensure that a newly developed methodology or update to an in-use methodology for determining credit ratings is disclosed to the public for consultation prior to the new or updated methodology being employed by the NRSRO to determine credit ratings, that the NRSRO makes comments received as part of the consultation publicly available, and that the NRSRO considers the comments before implementing the methodology.
- Controls reasonably designed to ensure that in-use methodologies for determining credit ratings are periodically reviewed (for example, by persons who are independent from the persons who developed and/or use the methodology) in order to analyze whether the methodology should be updated.
- Controls reasonably designed to ensure that market participants have an opportunity to provide comment on whether in-use methodologies for determining credit ratings should be updated, that the NRSRO makes any such comments received publicly available, and that the NRSRO considers the comments.
- Controls reasonably designed to ensure that newly developed or updated quantitative models proposed to be incorporated into a credit rating methodology are evaluated and validated prior to being put into use.
- Controls reasonably designed to ensure that quantitative models incorporated into in-use credit rating methodologies are periodically reviewed and back-tested.
- Controls reasonably designed to ensure that an NRSRO engages in analysis before commencing the rating of a class of obligors, securities, or money market instruments the NRSRO has not previously rated to determine whether the NRSRO has sufficient competency, access to necessary information, and resources to rate the type of obligor, security, or money market instrument.
- Controls reasonably designed to ensure that an NRSRO engages in analysis before commencing the rating of an “exotic” or “bespoke” type of obligor, security, or money market instrument to review the feasibility of determining a credit rating.
- Controls reasonably designed to ensure that measures (for example, statistics) are used to evaluate the performance of credit ratings as part of the review of in-use methodologies for determining credit ratings to analyze whether the methodologies should be updated or the work of the analysts employing the methodologies should be reviewed.
- Controls reasonably designed to ensure that, with respect to determining credit ratings, the work and conclusions of the lead credit analyst developing an initial credit rating or conducting surveillance on an existing credit rating is reviewed by other analysts, supervisors, or senior managers before a rating action is formally taken (for example, having the work reviewed through a rating committee process).
- Controls reasonably designed to ensure that a credit analyst documents the steps taken in developing an initial credit rating or conducting surveillance on an existing credit rating with sufficient detail to permit an after-the-fact review or internal audit of the rating file to analyze whether the analyst adhered to the NRSRO’s procedures and methodologies for determining credit ratings.
- Controls reasonably designed to ensure that the NRSRO conducts periodic reviews or internal audits of rating files to analyze whether analysts adhere to the NRSRO’s procedures and methodologies for determining credit ratings.
With respect to maintaining the internal control structure, the NRSRO must consider:
- Controls reasonably designed to ensure that the NRSRO conducts periodic reviews of whether it has devoted sufficient resources to implement and operate the documented internal control structure as designed.
- Controls reasonably designed to ensure that the NRSRO conducts periodic reviews or ongoing monitoring to evaluate the effectiveness of the internal control structure and whether it should be updated.
- Controls reasonably designed to ensure that any identified deficiencies in the internal control structure are assessed and addressed on a timely basis.
When enforcing the internal control structure, the NRSRO must consider:
- Controls designed to ensure that additional training is provided or discipline taken with respect to employees who fail to adhere to requirements imposed by the internal control structure.
- Controls designed to ensure that a process is in place for employees to report failures to adhere to the internal control structure.
Report on the Effectiveness of the NRSRO’s Internal Control Structure
The Dodd-Frank Act also amended the Exchange Act to provide that the Commission shall prescribe rules requiring an NRSRO to annually submit to the Commission an internal controls report that contains information on management’s responsibilities relating to the internal control structure, the effectiveness of the internal control structure, and an attestation of the CEO or equivalent on the report.
The rule amendments require an NRSRO to file an annual report with the Commission regarding the NRSRO’s internal control structure that contains a:
- Description of the responsibility of management in establishing and maintaining an effective internal control structure.
- Description of each material weakness in the internal control structure identified during the fiscal year, if any, and a description, if applicable, of how each identified material weakness was addressed.
- Statement as to whether the internal control structure was effective as of the end of the fiscal year.
The amendments also provide that management is not permitted to conclude that the internal control structure of the NRSRO was effective as of the end of the fiscal year if there were one or more material weaknesses in the internal control structure as of the end of the fiscal year. The amendments further prescribe when a material weakness exists for purposes of this reporting requirement.
NRSRO Conflicts Relating to Sales and Marketing Activities
The Dodd-Frank Act amended the Exchange Act to provide that the Commission shall issue rules to prevent an NRSRO’s sales and marketing considerations from influencing the production of credit ratings. It also specifies that the Commission shall provide for exceptions for small NRSROs and for the suspension or revocation of an NRSRO’s registration for violating a rule addressing conflicts of interest.
The rule amendments:
- Prohibit an NRSRO from issuing or maintaining a credit rating where a person within the NRSRO who participates in determining or monitoring the credit rating, or developing or approving procedures or methodologies used for determining the credit rating, including qualitative and quantitative models also: participates in sales or marketing of a product or service of the NRSRO or a product or service of an affiliate of the NRSRO; or is influenced by sales or marketing considerations.
- Provide that upon written application by an NRSRO, the Commission may exempt the NRSRO, either unconditionally or on specified terms and conditions, from the sales and marketing prohibition if the Commission finds that due to the small size of the NRSRO it is not appropriate to require the separation within the NRSRO of the production of credit ratings from sales and marketing activities and such exemption is in the public interest.
- Establish an alternative rule-based finding that can be used by the Commission in a proceeding under section 15E(d)(1) of the Exchange Act to suspend or revoke the registration of an NRSRO (namely, if the Commission finds, in lieu of a finding specified under sections 15E(d)(1)(A), (B), (C), (D), (E), or (F) of the Exchange Act, that the NRSRO has violated a rule addressing conflicts of interest and that the violation affected a credit rating).
NRSRO Look-Back Reviews
The Dodd-Frank Act amended the Exchange Act to require an NRSRO to have policies and procedures for conducting a “look-back” review to determine whether the prospect of future employment by an issuer or underwriter influenced a credit analyst in determining a credit rating, and, if such influence is discovered, to revise the credit rating in accordance with rules the Commission shall prescribe.
New Rule 17g-8 requires that the NRSRO’s look-back review procedures must address instances in which a review determines that a conflict of interest influenced a credit rating by including, at a minimum, procedures that are reasonably designed to ensure that the NRSRO will:
- Promptly determine whether the current credit rating must be revised so that it no longer is influenced by a conflict of interest and is solely a product of the documented procedures and methodologies the NRSRO uses to determine credit ratings.
- Promptly publish, based on the determination of whether the current credit rating must be revised, a revised credit rating or an affirmation of the credit rating and with either publication include disclosures about the existence and impact of the conflict of interest.
- If the credit rating is not revised or affirmed within 15 calendar days of the date of the discovery that the credit rating was influenced by a conflict of interest, publish a rating action placing the credit rating on watch or review and include with the publication an explanation that the reason for the action is the discovery that the credit rating was influenced by a conflict of interest.
Public Disclosure of NRSRO Credit Rating Performance Statistics
The Dodd-Frank Act amended the Exchange Act to provide that the Commission, by rule, shall require NRSROs to publicly disclose information about their initial credit ratings and subsequent changes to the credit ratings to allow users of credit ratings to evaluate the accuracy and compare the performance of credit ratings across NRSROs.
Before the SEC’s rule amendments approved today, NRSROs were required to disclose the percent of credit ratings in each class for which they are registered that over a one-year, three-year, and 10-year period were downgraded or upgraded (transition rates) or classified as a default (default rates).
The rule amendments enhance the disclosures of transition and default rates by, among other things:
- Standardizing the methodologies used by NRSROs in computing their transition and default rates.
- Requiring transition and default rates for various subclasses of structured finance products (e.g., residential mortgage-backed securities and commercial mortgage-backed securities).
- Standardizing the presentation of the transition and default rates in an easy to understand table.
Public Disclosure of NRSRO Credit Rating Histories
Before the SEC’s rule amendments, NRSROs were required to disclose in an XBRL format histories of their credit ratings (e.g., the initial credit rating and all subsequent modifications to the credit rating (such as upgrades and downgrades) and the dates of such actions). The goal of the proposed amendments is to allow users of credit ratings to compare how different NRSROs rated an individual obligor, security, or money market instrument and how and when those ratings were changed over time. The disclosure of rating histories also is designed to provide “raw data” that can be used by third parties to generate independent performance statistics such as transition and default rates. The amendments increase the amount of information that must be disclosed by expanding the scope of the credit ratings that must be included in the histories and by adding additional data elements that must be disclosed in the rating history for a particular credit rating.
NRSRO Credit Rating Methodologies
The Dodd-Frank Act amended the Exchange Act to provide that the Commission shall prescribe rules with respect to the procedures and methodologies, including qualitative and quantitative data and models, used by NRSROs to determine credit ratings that require each NRSRO to ensure that certain objectives are met.
Paragraph (a) of new Rule 17g-8 requires an NRSRO to have policies and procedures reasonably designed to ensure that:
- The procedures and methodologies the NRSRO uses to determine credit ratings are approved by its board of directors or a body performing a function similar to that of a board of directors.
- The procedures and methodologies the NRSRO uses to determine credit ratings are developed and modified in accordance with the policies and procedures of the NRSRO.
- Material changes to the procedures and methodologies the NRSRO uses to determine credit ratings are:
- Applied consistently to all current and future credit ratings to which the changed procedures or methodologies apply.
- To the extent that the changes are to surveillance or monitoring procedures and methodologies, applied to current credit ratings to which the changed procedures or methodologies apply within a reasonable period of time, taking into consideration the number of credit ratings impacted, the complexity of the procedures and methodologies used to determine the credit ratings, and the type of obligor, security, or money market instrument being rated.
- The NRSRO promptly publishes on an easily accessible portion of its corporate Internet website:
- Notice of the existence of a significant error identified in a procedure or methodology the NRSRO uses to determine credit ratings that may result in a change to current credit ratings.
- The NRSRO discloses the version of a credit rating procedure or methodology used with respect to a particular credit rating.
Form and Certifications to Accompany Credit Ratings
The Dodd-Frank Act amended the Exchange Act to provide that the Commission shall require, by rule, NRSROs to disclose with the publication of a credit rating a form containing certain qualitative and quantitative information about the credit rating. It also requires an NRSRO at the time it produces a credit rating to disclose any certifications from providers of third-party due diligence services with respect to ABS.
The SEC’s rule amendments require an NRSRO to publish two items when taking certain rating actions: a form containing the quantitative and qualitative information about the credit rating specified in the statute; and any certification of a provider of third-party due diligence services received by the NRSRO that relates to the credit rating. Under the new amendments, “rating action” includes preliminary credit ratings, initial credit ratings, upgrades and downgrades of credit ratings, and affirmations and withdrawals of credit ratings if they are the result of a review using the NRSRO’s procedures and methodologies for determining credit ratings.
The information that must be disclosed in the form includes:
- The version of the procedure or methodology used to determine the credit rating.
- The main assumptions and principles used in constructing the procedures and methodologies used to determine the credit rating.
- The potential limitations of the credit rating, including the types of risks excluded from the credit rating that the NRSRO does not comment on, including, as applicable, liquidity, market, and other risks.
- Information on the uncertainty of the credit rating, including information on the reliability, accuracy, and quality of the data relied on in determining the credit rating and a statement relating to the extent to which data essential to the determination of the credit rating were reliable or limited.
- A description of the types of data about any obligor, issuer, security, or money market instrument that were relied upon for the purpose of determining the credit rating.
- A statement containing an overall assessment of the quality of information available and considered in determining the credit rating for the obligor, security, or money market instrument, in relation to the quality of information available to the NRSRO in rating similar obligors, securities, or money market instruments.
- Information relating to conflicts of interest, including whether the NRSRO was paid to determine the credit rating by the obligor being rated or the issuer, underwriter, depositor, or sponsor of the security or money market instrument being rated, or by another person.
- An explanation or measure of the potential volatility of the credit rating.
- Information on the content of the credit rating, including, if applicable, the historical performance of the credit rating and the expected probability of default and the expected loss in the event of default.
- Information on the sensitivity of the credit rating to assumptions made by the NRSRO.
- If the credit rating is assigned to an ABS, information on the representations, warranties, and enforcement mechanisms available to investors.
Issuer/Underwriter Disclosure of ABS Third-Party Due Diligence Report
The Dodd-Frank Act amended the Exchange Act to require the issuer or underwriter of an ABS to make publicly available the findings and conclusions of any third-party due diligence report obtained by the issuer or underwriter. New Rule 15Ga-2 requires an issuer or underwriter of an ABS that is to be rated by an NRSRO to furnish Form ABS–15G on the EDGAR system containing the findings and conclusions of any third-party due diligence report obtained by the issuer or underwriter. The rule applies to both registered and unregistered offerings of ABS.
Certification of ABS Third-Party Due Diligence Provider
The Dodd-Frank Act amended the Exchange Act to require a provider of third-party due diligence services for ABS to provide a written certification to any NRSRO that produces a credit rating to which the services relate and provides that the Commission shall establish the format and content of the written certification. New Rule 17g-10 requires third-party due diligence providers to use new Form ABS Due Diligence-15E to make the written certification to be provided to the NRSRO. The form elicits information about the due diligence including a description of the work performed, a summary of the findings and conclusions of the third party, and the identification of any relevant NRSRO due diligence criteria that the third party intended to meet in performing the due diligence. The amendments require the NRSRO to disclose a certification (if it receives the certification) with each rating action to which the certification relates.
NRSRO Standards of Training, Experience, and Competence
The Dodd-Frank Act provides that the Commission shall issue rules reasonably designed to ensure that NRSRO credit analysts meet standards of training, experience, and competence necessary to produce accurate ratings for the categories of issuers whose securities the person rates and are tested for knowledge of the credit rating process.
New Rule 17g-9 requires an NRSRO to:
- Establish, maintain, enforce, and document standards of training, experience, and competence for the individuals it employs to participate in the determination of credit ratings that are reasonably designed to achieve the objective that the NRSRO produces accurate credit ratings in the classes of credit ratings for which the NRSRO is registered.
- Consider the following when establishing the standards:
A requirement for periodic testing of the individuals employed by the NRSRO to participate in the determination of credit ratings on their knowledge of the procedures and methodologies used by the NRSRO to determine credit ratings in the classes and subclasses of credit ratings for which the individual participates in determining credit ratings.
A requirement that at least one individual with an appropriate level of experience in performing credit analysis, but not less than three years, participates in the determination of a credit rating.
Universal NRSRO Rating Symbols
The Dodd-Frank Act provides that the Commission shall by rule require each NRSRO to establish, maintain, and enforce written policies and procedures with respect to the use of rating symbols. Paragraph (b) of new Rule 17g-8 requires an NRSRO to have policies and procedures that are reasonably designed to:
- Assess the probability that an issuer of a security or money market instrument will default, fail to make timely payments, or otherwise not make payments to investors in accordance with the terms of the security or money market instrument.
- Clearly define each symbol, number, or score in the rating scale used by the NRSRO to denote a credit rating category and notches within a category for each class of credit ratings for which the NRSRO is registered (including subclasses within each class) and to include such definitions in the performance measurement statistics that must be disclosed in Form NRSRO (the NRSRO registration form, which must be up-to-date and publicly disclosed).
- Apply any symbol, number, or score in a manner that is consistent for all types of obligors, securities, and money market instruments for which the symbol, number, or score is used.
Wednesday, August 27, 2014
- We’ve covered a lot of ground, yet a long journey lies ahead…
Everyone will now have read Chapter 1 which forms the basis of this lecture series and is available for download at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2457671
I think it appropriate to begin this week with a quote by Senator Russell Long (of Louisiana) who was Chairman of the Finance Committee in 1969. Senator Long, speaking of the Tax Reform Act of 1969 stated: “when the Finance Committee began public hearings on the Tax Reform Act of 1969 I referred to the bill as ‘368 pages of bewildering complexity.’ It is now 585 pages . . . . It takes complicated amendments to end complicated devices.”
Since the original 10 pages of the March 18, 2010 enactment of the Foreign Account Tax Compliance Act, which was as a Pay As You Go revenue raiser for the Hiring Incentives to Restore Employment Act, FATCA has consumed nearly 2,000 pages of regulations, corrections, notices, international agreement models and as of yesterday, 101 international agreements.
To cite some of the important regulatory milestones that will bring us current to July 10, after the HIRE Act was enacted in 2010, the 365 page Draft Regulations were released on Feb 8, 2012, but as Senator Long said “It takes complicated amendments to end complicated devices” the Final Regs released January 28, 2013 came in around 543 pages.
Over the next year, Notices and Corrections added up to another hundred pages, followed by the 565 page Coordinating Regs released Feb 20 of this year. On top of these, add the FFI agreement that was released Dec 26, 2013 but updated just 2 weeks ago on June 24.
This past March and April we saw the release of the new W-8s, Form 8966, Form 1042-S, and finally on June 25 the instructions for the BEN-E. Last, but not least, the IRS, much to its credit, managed to release the new QI agreement before the July 1 expiration of all the former QI agreements.
Last month withholding agents began the chapter 4 withholding of 30% on withholdable payments, such as interest earned on bank deposits, made to payees in 143 countries and their dependencies that do not have one of the 101 IGAs with the US as of today.
While the blog airwaves and commentators have in general been critical of the complexity of FATCA, sophisticated tax compliance officers from the financial industry are actually complementing the US Treasury for having listened to our stakeholder comments and concerns. The complexity within the FATCA regulations, in general, results from drafting exceptions and exemptions, for institutions and entities, from various diligence, reporting, and withholding obligations.
- Trust but Verify…
The United States is a self-reporting and assessment system whereby each year 150 million taxpayers fill in their 1040 with their worldwide income. It is reasonably estimated by various government sources that 10 million of these taxpayers have reporting obligations regarding either their foreign income and / or their foreign accounts. Unfortunately, less than 10% of Americans with international income or asset exposure are compliant with at least filing the dreaded, but very simple, FBAR form that requires reporting of signatory authority over accounts if the collective balance exceeds $10,000. Only approximately 800,000 FBARs were filed for 2012 for that group of potentially 10 million American taxpayers. With so little FBAR reporting, it’s no wonder that Congress and the IRS suspect that hundreds of billions of American’s foreign income goes unreported on the 1040 each year. Absent alternative information forms, the IRS does not have a scalable method to verify 1040 and select for audit the returns of potential tax evaders.
In the infamous words of Ronald Reagan, “Trust but Verify”, the US tax system is not just based upon self-reporting. The United States Congress has deputized financial institutions, and some businesses, to be information collectors, and verification auditors. We know this information collection as forms 1099, W8, W9, and the 1042-S. And we know the verification standards, such as by example “actual knowledge” and, requirements for “due diligence”.
- Bureau of Information Retrieval …
Each year, tens of millions of these forms are transmitted to the IRS with information about US and foreign taxpayers. Allow me briefly to introduce some salient metrics that have been collected by my research colleague, Haydon Perryman, who is Director of Compliance Solutions of Strevus”.
- We know that when QI was introduced only 20% of W8s were fit for purpose. We also know that 13 years after QI’s inception that only 35% of W8s are fit for purpose.
- We also know form interviews with large financial institutions that on average after a financial institution solicits a pre-existing customer for a new W8 it takes between 5 and 7 months for that W8 to be submitted, valid or otherwise.
When we apply these metrics to the customer base for whom we must reach out, - obtaining W8s or W9s (or their equivalent substitutes under an IGA), - validate those withholding certificates – and then we repeat this process in the 65% of the cases where the W8 submission was ‘invalid’, we can rapidly appreciate the size and scale of the challenge.
Moreover, the IRS estimates that 400,000 – 600,000 FFIs will register on its FATCA portal this portal, although my industry colleagues put the true figure around one million. Now imagine every FFI registrant approaching its customers and counter-parties for withholding certificates and other documentation. Industry estimates that there will be 900 million withholding certificates requiring validation for FATCA purposes.
- Analysis of GIIN Registrations
The July 1st GIIN list of financial institutions registrations is instructive in that it is indicative of certain compliance patterns that have emerged. Again, my colleague Haydon Perryman and myself have undertaken hours of in-depth research of the June and now the July GIIN registrations lists.
87,933 financial institutions and their branches registered from the 250 countries and their dependencies recognized by the IRS for FATCA purposes. Note that not ALL countries and dependencies are recognized by the IRS, such as Kosovo. And some jurisdictions, which are not recognized by the State Department, such as the State of Palestine, are recognized by the IRS.
Of the total 87,000 registered FFIs, 83,000 representing almost 95% are based in the 101 countries and jurisdictions that as of yesterday have an IGA. 48,000 FFIs registered from Model I IGA jurisdictions whereas approximately 15,000 of the FFIs registered as Model 2 reporting FFIs and branches. Note that these 15,000 Model 2 FFI registrations are impacted by the FFI Agreement changes of June 24, 2014. Most of the 4,000 FFIs from the remaining 143 countries and jurisdictions on the GIIN list registered probably either as Participating FFIs or branches.
While the exact number is unknown, based on the July GIIN list, industry and foreign government feedback, it is reasonable to estimate that half a million firms, funds, and other entities, such as trusts, will need to register. In its FATCA FAQs, the IRS has said that “At this time, the full FFI list is expected to be less than 500,000 records.”, thus implying that it would be close to half a million registrations. Therefore we can reasonably infer that less than 20% of the global FFIs are currently registered for FATCA. Moreover, all these non-registered FFIs in the 143 countries without an IGA must be treated as non-participating and withheld upon for FATCA by withholding agents.
Unfortunately, the compliance story is even worse when we consider how many of the 87,000 FFIs are members of an expanded affiliated group. 3,700 of the FFIs registered are parents of “expanded affiliated group” (“EAG”) that have registered the affiliated group members, which includes entities related by 50% and more ownership. What this slide and our data informs us is that while the large global institutions from the G5 have registered, the vast majority of smaller FFIs have not. Interestingly, Cayman Islands leads with 813 EAG parents, followed very far behind by the UK.
Of the 250 countries and jurisdictions with FFI registrations, almost 20% of the total registered FFIs are from the Cayman Islands firms, representing 14,207 registrations. Our research of the Cayman registrations shows a significant number of investment funds among that total.
The United Kingdom almost 7,000 FFIs are less than 10% of the 75,000 UK FFIs requiring registration as estimated by the United Kingdom Revenue. Note that the 75,000 figure was reduced from the UK government’s initial estimate of 300,000 after it reassessed self-certifying FFIs that are not required to registered, based upon the USA-UK IGA. The UK list is dominated by fund management firms and their various funds, private equity and the plethora of feeder funds investment trusts and quite a few trusts.
NAFTA has thus far been a large disappointment for Treasury with only 2,500 FFIs registered from Canada and 410 from Mexico. However, Canada and the US already automatically exchange information about bank interest, and the US-Canada IGA removed the registration of trusts as FFIs, so it is expected that Canadian FFIs will have registered and be in full compliance by the end of the year.
Brazil leads the BRIC countries with 2,362 FFI registered, followed by Russia at 729, India at 321 and the world’s 2nd largest economy China only has 213.
The European countries and financial centers have mixed registration results. France (2,422), Germany (2,894), Netherlands (2,280) and Ireland (2,007), Switzerland (4,279), Luxembourg (4,061), Austria (2,978), Guernsey (2,395), Jersey (1,618), Isle of Man (312), Lichtenstein (239), and Gibraltar (96).
Caribbean - BVI (2,373), Bahamas (6,146), Panama (484), Bermuda (1,579).
FATCA is the most important development for a globalized model of international exchange of tax information that will be made on an automatic basis. But its complexity and the high related costs of FATCA have been the source of important frictions and pressures at the highest level between the stakeholders concerned: the U.S. Treasury, the governments of all other countries, and the financial industry.
To briefly mention two frictions of local law that conflict with the FATCA regulations: firstly, many countries’ national data protection laws do not allow the transmittal of customer information without customer authorization, which is fundamental for FATCA to work, and secondly, some civil law countries do not allow a financial institution to unilaterally terminate certain customer relationships, which is required for recalcitrant account holders.
As a result of these difficulties, the U.S. Treasury issued the “Joint Statement from the United States, France, Germany, Italy, Spain and the United Kingdom regarding the intergovernmental approach to improving international tax compliance and implementing FATCA” known as the “G5 Joint Statement”. The Treasury issued this G5 Joint Statement on the same day of the release of the proposed FATCA regulations, February 8, 2012.
The G5 Joint Statement acknowledged the challenging character of implementation of certain FATCA regulations and resulted in the release on July 6, 2012 “Model Intergovernmental Agreement to Improve Tax Compliance and Implement FATCA”, referred to as an “IGA” model agreement, and specifically as “Model 1”. Basically, the model agreement allows FFIs in each of the jurisdictions to report U.S.-owned account information directly to their local tax authorities, using local reporting forms and systems, rather than the IRS, which in turn will automatically share that information with the IRS.
- Intergovernmental Agreements
This Model 1 IGA allows FFIs of those countries to be considered “deemed compliant”, will avoid the 30 percent withholding and, significant in addressing a substantial industry concern, will not be required to impose “passthru withholding” on non-U.S. source payments they make to other FFIs.
This first model has two versions: reciprocal and non-reciprocal. The reciprocal version includes a policy commitment from the U.S. to pursue regulations and support legislation permitting the U.S. to pass information relating to U.S. accounts held by residents of FATCA partners to other FATCA partners. The U.K. was the first country to sign a reciprocal Model 1 FATCA agreement on September 12, 2012. Mexico signed one shortly later on November 19, 2012 but the USA and Mexico reissued it on April 4, 2014 to take into account the regulatory and IGA modifications, and implementation extensions granted other countries.
The second model, known as Model 2, was originally released on November 15 of 2012 but has since been updated, most recently re-released June 6 of this year. This second model provides a framework whereby FFIs register with the IRS and either are exempted from FATCA or agree to share FATCA required information directly with the IRS. In turn, these FFIs are to be treated by withholding agents as complying with FATCA and will not be subject to 30 percent FATCA withholding on payments to them. In addition, these FFIs would not be required to impose “pass-thru withholding” on payments they make to other domestic registered or exempt FFIs or FFIs in jurisdictions that have entered into an IGA with the U.S.
The most important IGA advantage relevant for today is that a GIIN not required until Jan 1, 2015. Other advantages include Reporting of Tax Information to the Home Country Revenue instead of IRS, Replacement of “Substantial U.S. Owner” with the standard of “Controlling Persons”, which is an FATF anti money laundering standard, No Closing of and withholding upon Recalcitrant accounts and that Retirement Accounts are Deemed Compliant FFIs or are Exempt beneficial owners. And finally, most Favored Nation Clause that allows IGA partner countries to Cherry Pick from any advantages granted to another partner or through an amendment to the regulations, such as the 6 month extension granted to treat entity accounts as preexisting ones thus not subject to the stricter FATCA documentation standards.
TIEAs and information exchange articles of the double tax agreements are still relevant because Model 2 countries, by example, must agree to provide additional FATCA information to the IRS about recalcitrant accounts, based on tax information request by the normal channels, that the US IRS may mop up such information that has not been passed in the first instance directly by a financial institution.
- Common Reporting Standards
On February 13 of this year the OECD released the Standard for Automatic Exchange of Financial Account Information Common Reporting Standard, known by the two acronyms of CRS and GATCA for Globalized FATCA.
The CRS calls on jurisdictions to obtain information from their financial institutions and automatically exchange that information with other jurisdictions on an annual basis. It sets out the financial account information to be exchanged, the financial institutions that need to report, the different types of accounts and taxpayers covered, as well as common due diligence procedures to be followed by financial institutions.
Part I of the OECD report gives an overview of the standard whereas part II contains the text of the Model Competent Authority Agreement (CAA) and the Common Reporting and Due Diligence Standards (CRS) that together form the “standard”.
As of last week, 66 countries and major financial centers committed to early implementation of this automatic exchange of information between their jurisdictions. These early adopters includes all 34 OECD member countries, as well as countries such as the BRIC nations, Argentina, Colombia, Costa Rica, Indonesia, Latvia, Lithuania, Malaysia, Saudi Arabia, Singapore and South Africa. Thus, more than half the 121 Global Forum members have committed to early adoption of GATCA, with the remaining group expected to join by the end of the year after the publication of the detailed Commentary.
The OECD stated that it will deliver a detailed Commentary on GATCA, as well as technical solutions to implement the actual information exchanges, during the G20 finance ministers meeting in September 2014.
What are the main differences between the OECD’s CRS and the US’ FATCA?
The CRS consists of a fully reciprocal automatic exchange system but the US specificities have been removed. For instance, the CRS is based on residence and unlike FATCA does not refer to citizenship. Terms, concepts and approaches have been standardized allowing countries to use the system without having to negotiate individual IGAs.
Unlike FATCA the CRS does not provide for thresholds for pre-existing individual accounts, and it includes a residential address test derived from the EU tax savings directive. The CRS also provides for a simplified indicia search for such preexisting accounts. Finally, it has special rules dealing with certain investment entities where they are based in jurisdictions that do not participate in the automatic exchange under the standard.
The CRS is similar to FATCA in its broad application across three dimensions:
- The financial information to be reported with respect to reportable accounts includes all types of investment income (including interest, dividends, income from certain insurance contracts and other similar types of income) but also account balances and sales proceeds from financial assets.
- The financial institutions that are required to report under the CRS do not only include banks and custodians but also other financial institutions such as brokers, certain collective investment vehicles and certain insurance companies.
- Reportable accounts include accounts held by individuals and entities, which includes trusts and foundations, and the standard includes a requirement to look through passive entities to report on the individuals that ultimately control these entities.
UK Son Of FATCA
(a) income from employment
(b) director's fees
(c) life insurance products
(e) ownership of and income from immovable property
Clients in the 170 countries and their dependencies that the US does not have a tax treaty already suffer chapter 3 withholding. So what is it in for them to comply with FATCA?
Because Chapter 3 has important exemptions to its withholding, such as portfolio interest and interest on bank accounts that chapter 4 does not. FATCA’s 30% will hurt the most when it applies to the gross proceeds of a bond, that is, including its return of the underlying debt, because so much of the world’s financial system depends on US debt such as treasuries as the safe reserve.
- and now the W8-BEN
That brings us to the forms wherein we will start the discussion about the W-8BEN.
The Form W-8BEN has been split into two forms. The new 2014 Form W-8BEN is for use solely by foreign individuals, whereas the new Form W-8BEN-E is for use by entities for 2014 (revision date 2014) to provide US withholding agents.
Foreign individuals, such as non-resident aliens – that is NRAs, must use Form W-8BEN to document their foreign status and also to claim any applicable treaty benefits for chapter 3 purposes. A NRA (nonresident alien individual) is any individual who is not a citizen or resident alien of the United States.
The NRA should enter the country of nationality on line 2 of the form. If the NRA is a dual national, enter the country where the NRA is both a national and a resident at the time of completing the W-8BEN. If the NRA is not a resident in any country of nationality, then the NRA should type in the country where most recently resident.
However, if the individual is a dual national and one nationality is the United States, then the individual is NOT an NRA. The US national is always a US taxpayer. A US taxpayer must file a W-9 even if holding nationality in another jurisdiction.
Moreover, a foreign person who has a “green card” and not had it revoked or voluntarily turned it in, or a foreign person who meets the “substantial presence test” for the calendar year is a resident alien, that is, a US taxpayer. Resident aliens must also submit a W-9.
However, an alien who is a bona fide resident of one of the five US territories, being Puerto Rico, Guam, the Commonwealth of the Northern Mariana Islands, the U.S. Virgin Islands, or American Samoa, is considered an NRA, and thus should fill out a W-8BEN, not the W-9.
The NRA must give the Form W-8BEN to the withholding agent if the NRA is the beneficial owner of an amount subject to withholding, -- or if the NRA is an account holder of an FFI -- then to the FFI to document his/her status as a nonresident alien. Also, an NRA receiving payments from a payment settlement entity for credit card transactions and other third-party network transactions, such as paypal, must provide a Form W-8BEN. Finally, to avoid backup withholding by a broker of securities, an NRA will need to provide a W-8BEN.
Important to note - a sole member of a "disregarded" entity is considered the beneficial owner of income received by the disregarded entity, and thus the sole member must provide a W-8BEN. The sole member should inform the withholding agent if the account is in the name of a disregarded entity. The sole member includes his or her own name in line 1, but must include the name and account number of the disregarded entity on line 7 where it states “reference number”. However, if the disregarded entity is claiming treaty benefits as a hybrid entity, it must instead complete Form W-8BEN-E.
If the income or account is jointly owned by more than one person, the income or account can only be treated as owned by a foreign person if Forms W-8BEN or W-8BEN-E are provided by EVERY owner of the account. If the withholding agent or financial institution receives a Form W-9 from any of the joint owners, then the payment must be treated as made to a U.S. person and the account treated as a U.S. account.
In general the W-8BEN will remain valid until December 31st of the 3rd year after the date of the signature unless there is a change of circumstances. There are exceptions to the validity period that our last two speakers will bring up.
If any information on the Form W-8BEN becomes incorrect because of a change in circumstances, then the NRA must provide within 30 days of the change of circumstances the withholding agent, payer, or FFI with a new W-8BEN. By example, if an NRA has a change of address to an address in the United States, then this change is a change in circumstances that requires contacting the withholding agent or FFI within 30 days. Generally, a change of address within the same foreign country or to another foreign country is not a change in circumstances. However, if Form W-8BEN is used to claim treaty benefits of a country based on a residence in that country and the NRA changes address to outside that country, then it is a change in circumstances requiring notification within 30 days to the withholding agent or FFI.
On line 2, the NRA must enter the country of citizenship. If the NRA is a dual citizen, then the NRA must enter the country where the NRA is both A citizen and A resident at the time of completing the W-8BEN. If the NRA is not a resident in any country in which the NRA has citizenship, enter the country where the NRA was most recently a resident.
Line 3 requires the NRA’s permanent resident address in the country where the NRA claims to be a resident for purposes of that country’s income tax. If the Form W-8BEN is to be used for claiming a reduced rate of withholding under an income tax treaty, then the NRA must determine permanent residency in the manner required by that tax treaty. The NRA may not use the address of a financial institution, a post office box, or any of other type of mailing address.
If the NRA does not have a tax residence in any country, then his permanent residence is where the NRA normally resides.
If the country does not use street addresses, line 3 allows a descriptive address, such as “Manor House, Kensington Estate”.
Line 5 requires a taxpayer identification number, which is the US social security number (SSN), or if not eligible to receive a SSN which most NRA are not, then an individual taxpayer identification number (ITIN). To claim certain treaty benefits, either line 5 must be completed with an SSN or ITIN, or line 6 must include a foreign tax identification number (foreign TIN).
Individual Taxpayer Identification Numbers (ITINs) will expire if not used on a federal income tax return for five consecutive years, the Internal Revenue Service announced today. To give all interested parties time to adjust and allow the IRS to reprogram its systems, the IRS will not begin deactivating ITINs until 2016.
The new, more uniform policy applies to any ITIN, regardless of when it was issued. Only about a quarter of the 21 million ITINs issued since the program began in 1996 are being used on tax returns.
Under the new policy, an ITIN will expire for any taxpayer who fails to file a federal income tax return for five consecutive tax years. Any ITIN will remain in effect as long as a taxpayer continues to file U.S. tax returns. This includes ITINs issued after Jan. 1, 2013. These taxpayers will no longer face mandatory expiration of their ITINs and the need to reapply starting in 2018, as was the case under the old policy.
A taxpayer whose ITIN has been deactivated and needs to file a U.S. return can reapply using Form W-7. As with any ITIN application, original documents, such as passports, or copies of documents certified by the issuing agency must be submitted with the form.
Line 6 of Form W-8BEN requires a foreign tax identifying number (foreign TIN) issued by a foreign jurisdiction of residence when an NRA documents him or herself with respect to a financial account held at a U.S. office of a financial institution. However, if the foreign jurisdiction does not issue TINs or has not provided the NRA a TIN yet, then the NRA must enter a date of birth in line 8.
At this point let us turn to our client case studies...
Tuesday, August 26, 2014
Bradley Hope of the WSJ Markets will tell you how in his article: Former Foe of Speed Traders Now a Consultant -
Modern Markets Initiative, a pro-HFT trade group set up late last year, announced today it had hired a former Bank of America Corp. executive, Bill Harts, as its chief executive and signed a consulting contract with the law firm DLA Piper.
DLA Piper’s point of contact for the trade group is none other than Bart Chilton, a former regulator at the Commodity Futures Trading Commission who used to refer to high-frequency trading firms as “cheetahs.”
Watch the video highlights of Commodity Futures Trading Commissioner Bart Chilton talking about ponzi schemes
Follow up on my post last week: Shortage of Financial Advisors For Increasing Client Pool - Are the Law Students Prepared For This Career?
Jack J. Kelly of CompliancEx reports:
In 2012 HSBC was fined $1.9 billion to settle allegations that the bank enabled drug cartels and other nefarious not-nice people launder billions of dollars. Thereafter, the bank, without much choice in the matter, ramped up Compliance related spending including hiring 1,000s of new Compliance professionals. The estimated costs run to $1 Billion.
HSBC, fined $1.9 billion by U.S. authorities in 2012 to resolve allegations it enabled Latin American drug cartels to launder billions of dollars, has been beefing up its internal controls in the face of regulatory scrutiny. The London-based lender increased compliance staff to 6,000 from 1,500 over the past four years and is spending an additional annual cost of between $500 million to $1 billion, according to Flint.
Are law students preparing to be practice ready for these anti money laundering positions (that lawyers are well, if not best, suited for)? Few law students follow an anti money laundering & compliance specialization in law school, much less follow up with related externships to claim some experience to be "practice ready". Thus, these positions continue to be filled by the business school graduates.
Monday, August 25, 2014
The Federal Housing Finance Agency (FHFA), as conservator of Fannie Mae and Freddie Mac, announced it has reached a settlement with Goldman Sachs, related companies and certain named individuals. The settlement addresses claims alleging violations of federal and state securities laws in connection with private-label mortgage-backed securities (PLS) purchased by Fannie Mae and Freddie Mac between 2005 and 2007.
Under the terms of the settlement, Goldman Sachs will pay $3.15 billion in connection with releases and the purchase of securities that were the subject of statutory claims in the lawsuit FHFA v. Goldman Sachs & Co., et al., in the U.S. District Court of the Southern District of New York. Goldman Sachs will pay approximately $2.15 billion to Freddie Mac and approximately $1 billion to Fannie Mae. This settlement, worth approximately $1.2 billion, effectively makes Fannie Mae and Freddie Mac whole on their investments in the securities at issue. As part of the settlement, FHFA, Fannie Mae and Freddie Mac will release certain claims against Goldman Sachs & Co. related to the securities involved.
The settlement also resolves claims that involved a Goldman Sachs security in FHFA v. Ally Financial Inc., et al. FHFA previously settled claims against Ally Financial Inc.
This is the sixteenth settlement reached in the 18 PLS lawsuits FHFA filed in 2011. Three cases remain outstanding and FHFA is committed to satisfactory resolution of those actions.
FHFA v. Goldman Sachs & Co (main thrust excerpted below)
Between September 7, 2005 and October 29, 2007, Fannie Mae and Freddie Mac purchased from Goldman Sachs over $11.1 billion in residential mortgage-backed securities (the “GSE Certificates”) issued in connection with 40 securitizations for which Goldman served as sponsor, depositor, and/or lead underwriter.
These securities were sold pursuant to registration statements, including prospectuses and prospectus supplements that formed part of those registration statements, which contained materially false or misleading statements and omissions. Defendants falsely stated that the underlying mortgage loans and properties complied with certain underwriting guidelines and standards. These false statements and misleading omissions significantly overstated the ability of the borrowers to repay their mortgage loans and the value of the collateralized property.
1. Cross Border Banking: Reconceptualizing Bank Secrecy Ruth Plato-Shinar Netanya Academic College, Israel, July 1, 2014, Rethinking Global Finance and its Regulation (Cambridge University Press, Forthcoming)
IMF Working Paper No. 14/136 Kyunghun Kim and Srobona Mitra
Date Posted: August 25, 2014 Working Paper Series
ECB Working Paper No. 1710 Gonzalo Camba-Mendez and Dobromil Serwa
European Central Bank (ECB) and National Bank of Poland Date Posted: August 12, 2014
Working Paper Series
IMF Working Paper No. 14/120 Nicola Gennaioli , Alberto Martin and Stefano Rossi
Bocconi University - Department of Finance , Universitat Pompeu Fabra - Centre de Recerca en Economia Internacional (CREI) and Krannert School of Management Date Posted: August 01, 2014
Working Paper Series
This paper develops an open-economy DSGE model with an optimizing banking sector to assess the role of capital flows, macro-financial linkages, and macroprudential policies in emerging Asia. The key result is that macro-prudential measures can usefully complement monetary policy. Countercyclical macroprudential polices can help reduce macroeconomic volatility and enhance welfare. The results also demonstrate the importance of capital flows and financial stability for business cycle fluctuations as well as the role of supply side financial accelerator effects in the amplification and propagation of shocks.
Robert Wood, of Wood, LLP, provides a video commentary on the case at The Legal Broadcast Network. "Wood notes that, while this is a Spanish case, it is being watched by tax experts in the U.S., the U.K., and elsewhere. Increasingly, he suggests, secrecy is being viewed as 'a badge of willfulness that can mean more penalties, even jail.'"
One place is the United States. ...
One big attraction for these allegedly corrupt officials is that China has no extradition treaty with the U.S.
read this entire expose by Leslie Wayne at the International Consortium of Investigative Journalists
Close relatives of China’s top leaders have held secretive offshore companies in tax havens that helped shroud the Communist elite’s wealth, a leaked cache of documents reveals.
The confidential files include details of a real estate company co-owned by current President Xi Jinping’s brother-in-law and British Virgin Islands companies set up by former Premier Wen Jiabao’s son and also by his son-in-law.
Nearly 22,000 offshore clients with addresses in mainland China and Hong Kong appear in the files obtained by the International Consortium of Investigative Journalists.
Sunday, August 24, 2014
this week's headlines: fraud by students and professors, stock tips from AA and golfing, real life breaking bad
Saturday, August 23, 2014
Summary: Macro-prudential policies aimed at mitigating systemic financial risks have become part of the policy toolkit in many emerging markets and some advanced countries. Their effectiveness and efficacy are not well-known, however.
Using panel data regressions, we analyze how changes in balance sheets of some 2,800 banks in 48 countries over 2000–2010 respond to specific macro-prudential policies. Controlling for endogeneity, we find that measures aimed at borrowers––caps on debt-to-income and loan-to-value ratios––and at financial institutions––limits on credit growth and foreign currency lending––are effective in reducing asset growth.
Countercyclical buffers are little effective through the cycle, and some measures are even counterproductive during downswings, serving to aggravate declines, consistent with the ex-ante nature of macro-prudential tools.
|Author/Editor:||Stijn Claessens ; Swati R. Ghosh ; Roxana Mihet|
|Publication Date:||August 19, 2014|
|Electronic Access:||Free Full text
IMF Working Paper No. 14/156 authored by Nasha Ananchotikul; Longmei Zhang
Summary: In recent years, portfolio flows to emerging markets have become increasingly large and volatile. Using weekly portfolio fund flows data, the paper finds that their short-run dynamics are driven mostly by global “push” factors. To what extent do these cross-border flows and global risk aversion drive asset volatility in emerging markets? We use a Dynamic Conditional Correlation (DCC) Multivariate GARCH framework to estimate the impact of portfolio flows and the VIX index on three asset prices, namely equity returns, bond yields and exchange rates, in 17 emerging economies. The analysis shows that global risk aversion has a significant impact on the volatility of asset prices, while the magnitude of that impact correlates with country characteristics, including financial openness, the exchange rate regime, as well as macroeconomic fundamentals such as inflation and the current account balance. In line with earlier literature, portfolio flows to emerging markets are also found to affect the level of asset prices, as was the case in particular during the global financial crisis.
Friday, August 22, 2014
Former Associate Dean of MIT Sloan School and His Harvard MBA Son Agree to Plead Guilty in Hedge Fund Scam of over $140 of million
Two Boston-area hedge fund managers were charged [August 12] with conspiracy to commit securities fraud, wire fraud and obstruction of justice. In total, the Bitrans lost more than $140 million of GMB investors’ principal. If the plea agreements are accepted by the Court, the Bitrans will be sentenced to no more than five years in jail but no less than two years, as well as a period of up to three years of supervised release and more than $10 million in forfeiture.
Gabriel Bitran, 69, of Newton, a former professor and associate dean of the Massachusetts Institute of Technology ("MIT") Sloan School of Business, and his son Marco Bitran, 39, of Brookline, a Harvard Business School graduate and money manager, were charged with conspiracy to commit securities fraud, wire fraud and obstruction of justice in connection with their hedge fund businesses, GMB Capital Management and GMB Capital Partners. Both Gabriel and Marco Bitran have agreed to plead guilty to the charge.
It is alleged that from 2005 through 2011, Gabriel and Marco Bitran solicited and maintained investors in their hedge fund and investment advisory businesses with false claims that, for eight or more years, they had managed friends and family funds, delivering average annual returns between 16 and 23%, with no down years. The Bitrans falsely told investors that the money in GMB hedge funds would be invested according to a complex mathematical trading model developed by Gabriel Bitran and based upon his MIT research on optimal pricing theory. The Bitrans also routinely concealed from investors that certain of their hedge funds were simply “funds of funds,” that is, hedge funds in which values of investments are determined by the value of investments in other independently managed hedge funds, some of which were themselves broad-based funds of funds.
By means of their fraudulent representations, the Bitrans induced investors to entrust over $500 million to their businesses. From this money, the Bitrans paid themselves millions of dollars in management fees for managing the funds in which they had fraudulently induced people to invest.
In the fall of 2008, several of the Bitrans’ hedge funds had disastrous losses, resulting in investors losing 50–75% of their principal in many instances. Nonetheless, in the fall of 2008, as their funds were experiencing these losses, Gabriel and Marco Bitran redeemed approximately $12 million of their own money from these hedge funds, while deferring other investors’ requests for redemption. The Bitrans thereby extracted much of the value of their own investments while leaving other investors to suffer more losses as the funds’ values declined precipitously.
In January 2009, while investigating potential victims of the Madoff fraud, the United States Securities and Exchange Commission (“SEC”) examiners learned of the Bitrans’ performance claims and asked for supporting documentation. In response, the Bitrans allegedly made false statements to the SEC examiners and provided fabricated records purporting to support their claimed actual trading performance.
As they did so, Gabriel and Marco Bitran acknowledged to each other that they had made false statements to investors and owed them restitution. In July 2009, Gabriel Bitran emailed Marco Bitran and discussed the fact that they had misled investors:
“We have mislead [sic] a lot of people with a range of statements that were incorrect simply to increase our income. . . . A person with the experience and knowledge of the financial sector and a veteran professor of MIT should not have engaged in this type of behavior. . . . I certainly do not blame you for everything that happened; we both share responsibility. . . . With [several named individuals] and probably a few others . . . we told them a story that was not true! . . . In my view you are discarding their anger as bad losers. This is not the whole story. They are not idiots, they know that they were mislead [sic]. The penalty for this type of action is Full [sic] restitution, which obviously we cannot afford.”
Similarly, in a September 1, 2009 email, Marco Bitran acknowledged to his father that he had not acted honestly. He stated:
“We are certainly sharing equally in this dad. . . . Lots of our problems were caused by my good intentions but very poor actions when it came to true honesty.”
Still, from early 2009 through 2010, the Bitrans took steps to shield their assets by transferring them out of GMB businesses and into entities with less obvious affiliations to Gabriel and Marco Bitran. To effect some of these transfers, they used the identity of a family member without that person’s knowledge, obtaining falsely notarized signatures in that person’s name, to shield millions of dollars that they had preferentially transferred out of the GMB hedge funds.
The SEC’s investigation found that Gabriel and Marco Bitran raised millions of dollars for their hedge funds through GMB Capital Management LLC and GMB Capital Partners LLC by falsely telling investors they had a lengthy track record of success based on actual trades using real money. In truth, the Bitrans knew the track record was based on back-tested hypothetical simulations. The Bitrans also misled investors in certain hedge funds to believe they used quantitative optimal pricing models devised by Gabriel Bitran to invest in exchange-traded funds (ETFs) and other liquid securities. Instead, they merely invested the money almost entirely in other hedge funds. GMB Capital Management later provided false documents to SEC staff examining the firm’s claims in marketing materials of a successful track record.
According to the SEC’s order instituting settled administrative proceedings, Gabriel Bitran founded GMB Capital Management in 2005 for the stated purpose of managing hedge funds using quantitative models he developed based on his academic optimal pricing research to trade primarily ETFs. He and his son Marco Bitran solicited potential investors with three primary selling points:
- Very successful performance track records based on actual trades using real money from 1998 to the inception of the hedge funds.
- The firm’s use of Gabriel Bitran’s proprietary optimal pricing model to trade ETFs.
- Gabriel Bitran’s involvement as founder and portfolio manager of the funds.
The SEC’s order states that over a period of three years, the Bitrans raised more than $500 million for eight hedge funds and various managed accounts while making these misrepresentations to investors. In order to market the hedge funds, GMB Management and the Bitrans created performance track records beginning in January 1998 showing double-digit annualized return without any down years. They distributed these track records to potential investors in marketing materials, and told investors that they were based on actual trading with real money using Gabriel Bitran’s optimal pricing models. In reality, the Bitrans knew their representations were false and the track records were based on hypothetical historical investments. For two of their hedge funds, they created track records showing annualized returns of 16.2 percent and 11.7 percent with no down years, and told investors the returns were based on actual trading when in fact they were based on hypothetical historical allocations to hedge fund managers.
According to the SEC’s order, investors were misled to believe their money was being invested according to Gabriel Bitran’s unique quant strategy when in reality certain GMB hedge funds were merely investing predominantly in other hedge funds without his involvement. For example, investors in two GMB hedge funds were told that Gabriel Bitran spent 80 percent of his time managing the funds and was involved in reviewing trades in the funds on a daily basis. However, he actually had no role in the management of either fund.
Both funds experienced a series of losses at the end of 2008, and GMB eventually dissolved them. When a possible financial fraud of $3.7 billion at the Petters Group Worldwide was reported in late September 2008, the two hedge funds’ investments in a fund that was entirely invested in the Petters Group became illiquid. However, GMB did not disclose to investors that it had been impacted by the Petters fraud, instead sending investors a letter stating that “a swap instrument that the Fund entered into seeking to realize a higher return on a portion of its uninvested cash” had become illiquid because “one of the parties underlying the swap instrument is currently experiencing a credit and liquidity crisis, in conjunction with other alleged factors.” Furthermore, the two GMB funds suffered significant losses in hedge funds that had invested with Bernard Madoff. These investments in funds that ultimately invested with the Petters Group and Madoff were made contrary to what GMB investors were told.
According to the SEC’s order, during an SEC examination of GMB Capital Management, the firm produced a document that the Bitrans claimed was a real-time record of Gabriel Bitran’s trades since 1998. In fact, the document was false and created solely for the purpose of responding to the SEC staff’s request for the books and records that supported GMB’s performance claims.