Author: Doug Cornelius

You can find out more about Doug on the About Doug page

Insider Trading Cops

This insider trading case caught my attention because of the local setting. David Forte is an officer with the Needham Police Department. That’s the next town over from my town. I’m such a homer.

One of Forte’s brothers was the Chief Information Officer at Analog Devices. The brother discovered that Analog was going to buy Linear Technology Corporation in a transaction that would inevitably and rapidly raise the price of Linear stock. There was a phone call shortly before the merger between the brothers. Shortly after the phone call, Forte made some very aggressive trades on the stock of Linear.

What are aggressive trades?  Forte bought short-dated out-of-the-money call options on a merger target in an account that had never bought call option before or traded in that stock. I’m sure the compliance officer at Forte’s brokerage flagged the trades and reported them to the regulators as suspicious. The list of suspicious traders got shared with the companies and the shared last names were a sure giveaway.

Forte told two friends who also made aggressive trades and also got caught. All three were arrested and charged criminally for insider trading. 

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The Russian Hack of the EDGAR

A few years ago Ukranians hacked EDGAR to obtain nonpublic earnings information and used that information to trade stocks. The hackers made about $1.4 million and spread that information to associates for about $4.1 million in total profit. Now a bigger hacking plot has been discovered and it has bigger international implications.

The Securities and Exchange Commission brought fraud charges against five Russian nationals for engaging in a multi-year scheme to profit from stolen corporate earnings announcements obtained by hacking into the systems of two U.S.-based filing agent companies before the announcements were made public. These companies helped to “Edgar-ize” documents for filing in the EDGAR system. It looks like the SEC did a good job of securing its systems. This private provider did less so.

It was more lucrative. The SEC claims that the hacking group made over $80 million in profits. Maybe they made better use of the information than the Ukrainians did in their plot. Or maybe the five Russians had more capital.

The Russians hacked into the providers’ public company clients’ filings include, among other things, Forms 8-K and related exhibits, which consist of press releases containing the public companies’ earnings announcements. The Providers’ public company clients can use the platforms to create, edit, and submit their filings to the SEC through the EDGAR filing system. The weak security was at provider instead of the main database.

It looks like the hackers were not just hacking the SEC filings. Some of the five are implicated in the alleged hacking around the 2016 election.

One of them was just scooped up in Switzerland and has been extradited back to the United States for charges. Vladislav Klyushin. He had flown to Switzerland for a ski vacation at the Zermatt ski resort. It looks like US intelligence learned of the travel and had the Swiss pick up Klyushin at the airport. Russia and the US fought over extradition, with the US eventually winning and putting him on plane to face charges.

The five hackers worked at a Russian information technology firm called M-13 that specialized in penetration testing and other services. Looks like they were wearing white hats and black hats.

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The SEC Is Not Happy with Form CRS Disclosures

Before the holidays, the Securities and Exchange Commission issued a Staff Statement Regarding Form CRS Disclosures. It caught my attention because this was a weird form of letting the industry know that the SEC had concerns about practices. Then I noticed that the SEC had created a Standards of Conduct Implementation Committee and this statement was coming from the Committee. I poked around a bit to try to find who sits on the Committee, but haven’t had any luck yet.

Form CRS is the customer relationship summary required to be provided to retail clients of an investment adviser or broker-dealer. This was part of Regulation Best Interest that was adopted in June 2019 and required compliance by June 30, 2020. After a year and a half of use, the SEC is digging in deep and trying to make it work right.

The number one problem was that use of legalese and technical language in Form CRS. I’m sure most of these were written by lawyers or heavily edited by lawyers.

They Committee also found some hedging language stating that their relationship summary “does not create or modify any agreement, relationship or obligation” between the client and the firm. The rule doesn’t allow that.

One deficiency that particularly caught my eye was that some firms were using language from the proposed rule rather than the final rule. The Staff Statement highlight some particular language:

For example, many firms included the proposed conversation starters and/or proposed standard of conduct language (i.e., “We are held to a fiduciary standard that covers our entire investment advisory relationship with you.”) rather than the required language as adopted (i.e., “we have to act in your best interest and not put our interest ahead of yours”).

Regulation was a big change in disclosure for retail firms. I’m sure it is particularly hard for dually registered firms that have some of the more difficult conflicts to disclose. Everyone should expect that Form CRS will be a big focus for SEC examination for the foreseeable future.

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Happy Holidays

I hope your year is coming a happy end and that 2022 will be the best year yet. Or at least better than 2021.

Yes, this a picture of me, with a Santa hat on my bike helmet, wearing an ugly sweater, with tree lights wrapped around. me. You can see my bike in the background with a red nose and antlers mounted on it. We are posing at the famous giant Santa in Coletti-Magni Park. The only thing missing is snow. (I don’t always take myself seriously.)

The Biden Strategy on Fighting Corruption

Yesterday’s story on FinCEN planning new Real Estate Anti-Money Laundering Regulations is just part of the larger plan of the Biden administration’s plan to fight corruption. For more details check out the recently released United States Strategy on Countering Corruption.

This is full of worthy goals. The stability of the US dollar is big lure for dirty money. I have some concerns about overly weaponizing the dollar internationally for fear that some other currency will take over as the de facto currency of the world. Right now, there are no other good candidates.

As for the details on the White House plan, I focused on how it might directly affect me.

One is the return of the 2015 rulemaking to “prescribe minimum standards for antimoney laundering programs and suspicious activity reporting requirements for certain investment advisor.” This time there is a particular focus on hedge funds, trusts, private equity funds and other vehicles. In particular, it looks like there will some focus on operations of private placements.

The White House is also looking at the gatekeepers to transactions: lawyers, accountants, and registered agents. They may hit with some anti-money laundering requirements, both as recordkeepers and targets for enforcement.

As yesterday’s story on real estate pointed out that it has been a tool for laundering money, the White House strategy includes a focus on digital assets and art. Those are two areas that are believed to be exploited by illicit money.

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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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