Author: Doug Cornelius

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FinCEN Sets Foundation for Real Estate Anti-Money Laundering Regulations

The Financial Crimes Enforcement Network (FinCEN) has gotten more active in fighting money laundering. While the last administration mostly focused on putting parties on the sanctions list, the current administration is looking to expand regulatory requirements. One of the several initiative recently launched is targeted at real estate.

On December 8, FinCEN announced an Advance Notice of Proposed Rulemaking on real estate transactions. It’s an advanced notice so there is no text to parse, just areas for discussion. The focus is on recordkeeping and reporting requirements on for people participating in transactions involving non-financed purchases of real estate.

Unlike the Geographic Targeted Orders, this new rulemaking could include commercial real estate. FinCEN recently renewed the Geographic Targeted Orders for all-cash purchases of real estate in Boston; Chicago; Dallas-Fort Worth; Honolulu; Las Vegas; Los Angeles; Miami; New York City; San Antonio; San Diego; San Francisco; and Seattle.

FinCEN is looking for comment on the potential scope of regulations. It has identified a few areas specifically:

  1. Scope of recordkeeping and reporting
  2. Who should be subject to the requirements
  3. Which types of real estate purchases should be covered
  4. Geographic scope of such a requirement,
  5. Appropriate reporting dollar-value threshold.

FinCEN is also looking for general comments on the risk of money laundering and other illicit financial activities in the real estate market and the extent to which any reporting requirements would address that risk. In footnote 76, FinCEN lists a bunch of prosecuted cases in which real estate was a vehicle for money laundering:

  • United States v. Real Property Located in Potomac, Maryland, Commonly Known as 9908 Bentcross Drive, Potomac, MD 20854, Case No. 20-cv-02071, Doc. 1 (D. Md. Jul. 15, 2020) (purchase of property in Potomac, MD)
  • United States v. Raul Torres, Case No. 1:19CR390, Doc. 30 (N.D. Ohio Mar. 30, 2020) (purchase of multiple properties in Cleveland, OH); United States v. Bradley, No. 3:15-cr-00037- 2, 2019 U.S. Dist. LEXIS 141157 (M.D. Tenn. Aug. 20, 2019) (purchase of multiple properties in Wayne County, MI);
  • United States v. Coffman, 859 F. Supp. 2d 871 (E.D. Ky. 2012) (purchases of properties in Kentucky and South Carolina);
  • United States v. Paul Manafort, Case 1:18-cr-00083-TSE, Doc. 14 (E.D. Va. Feb. 26, 2018) (purchase of a property in Virginia);
  • United States v. Miller, 295 F. Supp. 3d 690 (E.D. Va. 2018) (purchase of properties in Virginia and Delaware);
  • Atty. Griev. Comm’n of Md. v. Blair, 188 A.3d 1009 (MD Ct. App. 2018) (purchase of properties in Washington, DC and Maryland);
  • United States v. Patrick Ifediba, et al., Case No. 2:18-cr-00103-RDP-JEO, Doc. 1 (N.D. Ala. Mar. 29, 2018) (purchase of multiple properties in Alabama);
  • United States v. Delgado, 653 F.3d 729 (8th Cir. 2011) (purchase of multiple properties in Kansas City, MO),
  • United States v. Fernandez, 559 F.3d 303 (5th Cir. 2009) (purchase of multiple properties in El Paso, TX);
  • United States v. 10.10 Acres Located on Squires Rd., 386 F. Supp. 2d 613 (M.D.N.C. 2005) (purchase of two properties in North Carolina);
  • State v. Harris, 861 A.2d 165 (Super. Ct. App. Div. 2004) (purchase of multiple properties in a non-GTO-covered jurisdiction in New Jersey);
  • see also Lakshmi Kumar & Kaisa de Bel, “Acres of Money Laundering: Why U.S. Real Estate is a Kleptocrat’s Dream,” Global Financial Integrity, p. 29 (Aug. 2021) (highlighting money laundering cases outside of jurisdictions covered by the Real Estate GTOs)

Comments on the proposed rulemaking must be received on or before February 7, 2022.

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FINRA Extends Parking Period from Two Years to Five Years

Registered Representatives with a broker-dealer presently have two years from their date of leaving a firm to re-register with another firm. Otherwise their qualifications, and especially their passed examinations, would lapse. Reps would sometimes try to “park” their registration at a firm to avoid having to re-take examinations. Nobody wants to re-take those exams.

FINRA just allowed for a five year gap between firms, as long as the rep takes continuing education. Effective as of March 2022, FINRA amended Rules 1210 and 1240 to create a new Maintaining Qualifications Program (MQP). That gives a rep five years to find that new firm or to explore a new opportunity before losing qualification and having to re-take exams. During those five years, the rep will have to take a new set of continuing education requirements each year during the gap between firms.

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SEC Chairman Gensler Talks About Private Funds

Last week, Securities and Exchange Commission Chair Gary Gensler, made a speech at the Institutional Limited Partners Association Summit. The topic? (You can guess by the title.) Private Funds. In particular, potential new regulatory requirements around private fund.

I think it’s time we take stock of the rapid growth and changes in this field, as well as that decade of learning, and bring more sunshine and competition to the private funds space.

Fees and expenses – These are always at the top of the list when talking about private funds. The industry had a long history of not being completely transparent about fees. His spin is that competition and transparency about fees should lower costs, which would raise the returns for limited partner investors, who are pensions and endowments, ultimately helping workers prepare for retirement and families pay for their college educations.

Side letters – Chair Gensler is concerned that side letters may create “uneven playing field” by giving some investors preferred liquidity terms or disclosures or different fees. I’m less concerned about fees. That’s a point of bargaining. Bigger investors get fee breaks. That’s true for mutual funds as well as private funds. The difference is that private funds can give bigger breaks to attract key investors, which reduces their costs. If its public, the fund can just stick to its schedule. Preferred liquidity can be more of a problem.

Performance metrics – Chair Gensler is concerned with the transparency of performance metrics for private funds. It is hard to compare apples-to-apples with private funds because many do things differently. The new Marketing Rule requires private fund managers (at least those that are registered investment advisers) to provide net returns in performance metrics.  That would seem to provide a pretty good method to compare fund returns and to compare against other benchmarks.

Fiduciary duties and conflicts of interest – Chair Gensler expressed concerns about the modification and reduction of fiduciary duties by general partners. Of course, that only applies to fund managers that are not registered investment advisers. Once you’re registered, you’re subject to the fiduciary requirements of the Investment Advisers Act. As for conflicts, Chair Gensler raises the possibility of the SEC prohibiting certain conflicts and practices. No more information on what those conflicts or practices may be for private funds.

Form PF – Chair Gensler is looking to revise the Form PF filing information. “I think we ought to consider whether more granular or timelier information would be useful in these circumstances.”

It sounds like there is some future rulemaking in the works that will directly affect private funds,

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The Division of Examinations Is Not Happy with your Fee Calculation

The SEC’s Division of Examination ran a sweep of exams focused on advisory fees, predominantly those charged to retail clients. Not bothering with any clever names, it was simply the Advisory Fees Initiative. The Division placed 130 examination into the Initiative. The results are in a recent Risk Alert: Division of Examinations Observations: Investment Advisers’ Fee Calculations. The sweep focused on three areas:

  1. Accuracy of the fees charged
  2. Accuracy and adequacy of disclosures around fees
  3. Effectiveness of the compliance program and firms’ books and records

There is no bigger conflict with the investment adviser’s fiduciary duty than fees. An investment adviser is literally taking money from it’s client and placing the money in the adviser’s hands.

To summarize the findings in the Risk Alert:

Mistakes were made.

The bad news: exams found lots of different ways that firms messed up billing and taking fees from clients. The good news: there were no novel findings.

I guess the second one isn’t really good news. Firms have been making these same mistakes for years. The Division points back to the 2018 Risk Alert that covers all of these same problems.

The additional emphasis in the 2021 risk alert is on disclosure. The exams identified

Form ADV Part 2 brochures and/or other disclosures, including disclosure that: (1) did not reflect current fees charged or whether fees were negotiable; (2) did not accurately describe how fees would be calculated or billed; and (3) was inconsistent across advisory documents, such as stating the maximum fee in an advisory agreement that exceeded the fees disclosed in the adviser’s brochure

The risk alert does emphasize that firms must have written policies and procedures addressing fee billing and the monitoring of fee calculations.

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Withdrawal of Advertising Rule Guidance

On December 22, 2020, the Securities and Exchange Commission adopted the new Marketing Rule (amended Rule 206(4)-1) under the Investment Advisers Act that will replace both the current advertising and cash solicitation rules and will govern investment adviser marketing. Since it’s a complete re-write of investment adviser marketing, most, if not all, of the staff guidance, no-action letters and other publications are likely inapplicable. The SEC said it would be evaluating them and withdrawing them as appropriate.

The Division of Investment Management has made that announcement: Division of Investment Management Staff Statement Regarding Withdrawal and Modification of Staff Letters Related to Rulemaking on Investment Adviser Marketing (PDF)

The big ones are in there. Clover Capital Management, DALBAR, and Franklin Management. The staff also withdrew the 2014 Guidance on the Testimonial Rule and Social Media. There are over 200 items withdrawn.

What leaves me scratching my head is whether any of the past guidance was not withdrawn. Is there something still sticking around? It will take a bunch of research to figure that out. The IM Information update says that “certain” staff statements around the old advertising rule are being withdrawn. Not “all” statements. It might have been useful for the SEC to point out any guidance that was not withdrawn.

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Pre-existing, Substantive Relationship

Rule 506(b) of Regulation D provides a safe harbor for issuers to engage in private placements. Private placements undertaken pursuant to Rule 506(b) are limited by Rule 502(c) of Regulation D, which imposes as a condition on offers and sales under Rule 506(b)that “… neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising…”

The SEC Staff has issued various interpretive letters that have tried to clarify the regulation. One of those was the statement that a general solicitation is not present when there is a “pre-existing, substantive relationship” between an issuer, or its [agent], and the offerees.

The SEC has published some Q and A’s on the topic. 256.31 says “substantive” means you have sufficient information to determine the offeree is an accredited or sophisticated investor. Blast emails to unknown investors would not be substantive.

As to the “pre-existing” prong, question 256.30 says there is no minimum waiting period, but there is a waiting period. The Lamp Technologies No Action letter in 1997 said that 30 days is sufficiently long to be pre-existing. (See Footnote 6). So somewhere between 0 days and 30 days is pre-existing enough, as long as you know the potential investor is accredited, to send information on offering.

There is also the question of what amounts to an offering. If it’s at the early stages of a fund, before its formed, perhaps there is no actual security sell. It’s hypothetical information about an upcoming offering.

This all circles back to the IR people asking whether they can leave a copy of the pitchbook for a fund at the initial meeting with an investor. I think the answer is generally “no”, unless you can show that there is a pre-existing substantive relationship with the investor. An initial meeting is generally the 0-day period, unless there has been a series of discussions prior to that initial meeting.

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Twitter Pump and Dump

It should be obvious that some random twitteratti handing out investment advice is going to be a shady character. Right? There are lots of them. I’m not sure any get dragged before the Securities and Exchange Commission on charges.

@AlexDelarge6553 made thousands of tweets encouraging his numerous followers to buy stocks. No surprise that the man behind @AlexDelarge6553 held a bunch of those stocks he encouraged his followers to buy. The SEC named Steven M. Gallagher as the man behind the twitter handle. He bought a bunch of the stock, encouraged his followers to but the stock. The price went up and @AlexDelarge6553 sold out of positions as the price rose.

Classic pump and dump scheme or scalping scheme. Of course the stocks involved were penny stocks at tiny prices and tiny volumes. That made it easier to manipulate the stock price.

Kudos for the SEC for bringing the case. Bigger kudos to @AlexDelarge6553’s broker who tried to shut him down and, I assume, alerted the SEC to the problem.

“Despite repeated, written warnings from his brokerage firm (“Broker A”) that he appeared to be engaged in manipulative trading in violation of securities laws and regulations, Gallagher continued to engage in manipulative trading and scalping. On September 9, 2021, Broker A informed Gallagher that it was closing his trading account effective October 9, 2021, and that it would immediately prevent him from making new stock purchases, restrict his account to just liquidating transactions, and not allow him to open a new account in the future.”

Of course, since he was still allowed to liquidate his holdings, he could keep flogging his followers to buy as he sold out of his positions.

The fun part for the SEC is they have the transaction data from @AlexDelarge6553’s broker and his public tweets. It’s really easy to match the timing of the tweets to the timing of the transactions.

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ENABLERS Act

With the release of the Pandora Papers, there is a renewed focus on the illicit movement of money and filling the holes in anti-money laundering rules. “The Washington Post and other news organizations exposed the involvement of political leaders, examined the growth of the industry within the United States and demonstrated how secrecy shields assets from governments, creditors and those abused or exploited by the wealthy and powerful.”

A bipartisan group of lawmakers introduced legislation that would require investment advisers, trust companies, lawyers, art dealers and others to investigate foreign clients seeking to move money and assets into the American financial system. The group got creative with the name of the bill: “Establishing New Authorities for Businesses Laundering and Enabling Risks to Security Act“. Which <surprise> acronyms into the ENABLERS Act.

The ENABLERS ACT would add new groups to the requirements of the Bank Secrecy Act and require rulemaking to implement the requirements. The new groups:

  1. “person engaged in the business of providing investment advice for compensation”
  2. Dealers in art, antiques, or collectibles
  3. Lawyers
  4. Trust companies
  5. Public accountants
  6. Public relations in such a manner as to provide another person anonymity
  7. Third-party payment services

The first category is the most important to me. Investment advisers have been lobbying to stay outside of the Bank Secrecy Act because of the custodian requirements. The client accounts are held at financial institutions that are subject to the Bank Secrecy Act. The success of that argument has been diminishing over the years.

Art dealers are a big one. There is already regulations moving into place to deal with that industry. It’s notorious as a way to move value around illicitly.

Lawyers are tough because of attorney-client privilege. I’m not sure how public accountants fit into the picture.

I wonder what PR firms did to anger the people who wrote this bill.

Of course it’s only a bill. A lot of things will have to happen to get this into law. Congress is not exactly a well-functioning organization right now.

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The SEC Continues its Attack on the Word “May”

I’ve been critical before of the Securities and Exchange Commission’s Attack on May. Personally, I’ve always viewed “may” as a permissive position when it comes to disclosure. The SEC thinks its completely inadequate.

The SEC view is that if an investment adviser always takes the fee or usually take the fee, “may” is inadequate. How often is “usually” when it comes to “may”? Sixty percent of the time is bad, according to a recent SEC complaint against TCFG Wealth Management and the firm’s CEO/President/COO.

According to the complaint, TCFG imposed a fee markup on rates charged by the firm’s clearing broker. Those fees, and the markup, would be passed on to the TCFG clients when the firm made trades on their behalf. The individual advisers at the firm could chose not to pass the markup through to their clients. In which case the markup was still imposed. The individual investment adviser employee would pay the markup instead of the client.

According to the complaint, 60% of the transactions passed through the fee markup to the firm clients. That was 10,000 transactions and $300,000 in revenue to the firm.

The TCFG form ADV Firm Brochures stated that TCFG “may” receive portions of the fees charged to accounts of TCFG
clients. It further stated that these additional fees TCFG received were “charged” by Clearing Broker, not TCFG, and were for things like wire fees, postage fees, clearing fees and ticket charges, which TCFG said it used to help pay for administrative support for its various entities.

Obviously, the second half was false when disclosing what the fee was used for. The SEC took issue with the statement that the clearing broker charged the fees, when it was TCFG that charged the fee. Plenty of messiness in this arrangement to draw the wrath of the SEC. We haven’t heard the TCFG side of the story.

It’s clear that the SEC has drawn a line in the sand over “may” when disclosing fees. If your firm charges the fee more than half the time, “may” is not the right word to use.

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CCO Liable in Cherry Picking Scheme

According to SEC’s complaint against Strong Investment Management and its owner, Joseph Bronson, for more than four years, Bronson traded securities in Strong’s omnibus account but delayed allocating the securities to specific client accounts until he had observed the securities’ performance over the course of the day. This allowed Bronson to harvest substantial profits at his clients’ expense by “cherry picking” the trades. He would disproportionately allocate profitable trades to himself and unprofitable trades to Strong’s clients.

Of course, there is an additional charge of Strong and Bronson misrepresenting their trading and allocation practices in the firm’s Form ADV filings. The forms stated that all trades would be allocated in accordance with pre-trade allocation statements and that the firm did not favor any account, including those of the firm’s personnel. That does make me wonder if you could get away with cherry picking by stating that you could do so in Form ADV. But let’s not go down that path.

Bronson’s brother and the former chief compliance officer of Strong, John Engebretson, was also charged with failing to perform his compliance responsibilities and ignoring numerous “red flags” raised during the course of the fraudulent scheme. As a result, Engebretson was charged along with Bronson and Strong with violating the compliance requirements of the federal securities laws. Engebretson agreed to settle the charges against him. As part of the settlement, Engebretson agreed to be enjoined, pay a civil monetary penalty in the amount of $15,000, and to be barred from association with any broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization.

The SEC complaint alleges that as the chief compliance officer, John Engebretson aided and abetted the company’s violations by “carrying out his compliance responsibilities in an extremely reckless manner.”

The SEC Commissioners and senior Division of Examination staff have usually stated three circumstances that lead to CCO liability:

  1. when the CCO is affirmatively involved in misconduct;
  2. when the CCO engages in efforts to obstruct or mislead the Commission; or
  3. when the CCO exhibits “a wholesale failure to carry out his or her responsibilities”

I wish this standard was carried over to the Division of Enforcement. Instead, the enforcement attorneys state this

“Engebretson also aided and abetted [Strong]’s failure to implement compliance policies and procedures in several ways”

It doesn’t say that the CCO was affirmatively involved in misconduct. It doesn’t say that there was a “wholesale failure.” Please just stick with the standard. Say that “Engebretson exhibited a wholesale failure to carry out his or her responsibilities” in the complaint. Is that so hard? We can infer that the failure was wholesale. Later in the complaint, it uses “wholly abdicated his responsibilities.” So close.

Final judgement came out against Strong and Bronson recently and made me realize I never caught this story in 2018.

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