Author: Doug Cornelius

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

The One With the Lack of Write-Downs

I think many frauds start with a failure to recognize mistakes. Yes, it’s hard to tell your investors that you lost some of their money. It makes it harder to attract new investors and additional investments. It gets really hard to do that when you go to jail.

Martin Silver was the co-founder, managing partner, and chief operating officer of the International Advisory Group LLC. The firm was an investment adviser that specialized in trade finance lending—risky loans to small- and medium-sized companies in emerging markets. The firm also sponsored three private funds to invest in the trade finance loans.

One of the funds had assets of about $300 million. The firm learned that a South American coffee producer had defaulted on a $30 million loan. Fearing that existing investors would flee the fund and that ongoing fundraising efforts would suffer if the loss were disclosed, Silver decided to conceal the loss by incorrectly valuing the loan on the fund’s books. Later, he replaced the defaulted the loan with fake loans to prop up the value of the fund after auditor inquiries.

Then, a second loan in the fund’s portfolio defaulted. Silver continued his actions of not writing down the value of the loan and eventually replacing it with fake loans.

Eventually, faced with liquidity demands for redemptions, Silver formed the second and third funds to buy the fake loans from the initial fund. Eventually, the schemes collapsed and charges were brought.

Of course the scheme collapsed. You can never find the out-sized returns to make up for the big loss.

Mr. Silver pled guilty to one count of conspiracy to commit investment adviser fraud, securities fraud, and wire fraud, which carries a maximum sentence of five years in prison; one count of securities fraud, which carries a maximum sentence of 20 years in prison, and one count of wire fraud, which carries a maximum sentence of 20 years in prison.

Sources:

Compliance Bricks and Mortar for April 23

These are some of the compliance-related stories that recently caught my attention.

Alex Oh Named SEC Director of Enforcement

Washington D.C., April 22, 2021 — The Securities and Exchange Commission today announced that Alex Oh has been appointed Director of the Division of Enforcement. Oh was most recently a partner at Paul, Weiss, Rifkind, Wharton & Garrison LLP and co-chair of the law firm’s Anti-Corruption & FCPA Practice Group. She was previously an Assistant U.S. Attorney in the Criminal Division of the U.S. Attorney’s Office for the Southern District of New York, where she was a member of the Securities & Commodities Fraud Task Force and the Major Crimes Unit.

Wirecard employees removed millions in cash using shopping bags
Olaf Storbeck
Financial Times

The practice started as early as 2012, and six-digit amounts of banknotes were often moved in Aldi and Lidl plastic bags, former employees told the police. The total amount, the current whereabouts of the cash and the purpose of removing it from the building are unclear. Wirecard, whose main business was processing payments for merchants, owned its own bank but did not have branches. As demand for cash grew over time, Wirecard Bank bought a safe which was located in the group’s headquarters in a Munich suburb.

https://www.ft.com/content/31a8ed93-f602-47f0-9120-4b4f152ec7bc

Former Goldman Analyst Barred by Finra for Insider Trading
Bloomberg Law

Maguire bought shares in two companies through undisclosed accounts after seeing internal emails that showed the analyst covering the stocks was raising his ratings from “neutral” to “buy,” according to a Tuesday statement from the Financial Industry Regulatory Authority. Maguire made the purchases in April and June 2020, after the upgrades were approved internally but before research reports announcing the changes were published.

https://news.bloomberglaw.com/securities-law/ex-goldman-research-analyst-barred-by-finra-for-insider-trading

Petitioner asks SEC to clarify when NFTs are securities, recommends NFT rulemaking
John Filar Atwood
Jim Hamilton’s World of Securities Regulation

Like initial coin offerings (ICOs) before them, non-fungible tokens (NFTs) have grown in popularity very quickly, and Arkonis Capital believes it is now time for the SEC to step in and provide guidance on whether NFTs are securities. In a rulemaking petition, Arkonis said that a concept release on how to regulate NFTs is a meaningful first step in providing guidance, but that it would only prove beneficial if it is followed by an SEC rulemaking on the regulation of NFTs.

https://jimhamiltonblog.blogspot.com/2021/04/petitioner-asks-sec-to-clarify-when.html

The Flu Vanished During Covid. What Will Its Return Look Like? 
Keith Collins
New York Times

Withdrawal of No Action Letters

In connection with Securities and Exchange Commission’s new Marketing Rule, I’m expecting the SEC to withdraw a bunch of the no-action letters that address advertising by registered investment advisers. For example, the Clover no-action letter doesn’t seem to fit with the new Marketing Rule and will likely have to be withdrawn to avoid confusion.

The release for the Marketing Rule stated so.

Additionally, pursuant to the staff’s review, the staff will be withdrawing the staff’s remaining no-action letters and other staff guidance, or portions thereof, as of the compliance date of the final rules. [832]

https://www.federalregister.gov/d/2020-28868/p-1389

That footnote 832 said: “A list of the letters to be withdrawn will be available on the Commission’s website.“

That website now exists: https://www.sec.gov/divisions/investment/im-modified-withdrawn-staff-statements

Or maybe it already existed and I never noticed that page on the SEC’s website before before. It looks new to me and the vast majority of the withdrawal dates are from the past year and moving forward.

However, there are no withdrawal notices for investment adviser marketing yet. I assume there will be a bigger announcement when it happens.

Sources:

Compliance Bricks and Mortar for April 16

These are some of the compliance-related stories that recently caught my attention.

U.S. Senate votes 53-45 to confirm Gary Gensler as Biden’s SEC chief
Katanga Johnson
Reuters

“Gary Gensler has the perfect mix of market expertise, regulatory experience and commitment to the public interest to be an outstanding SEC Chairman,” said Barbara Roper, chief investor advocate at Washington-based Consumer Federation of America.

https://www.reuters.com/business/finance/us-senate-votes-53-45-confirm-gary-gensler-bidens-sec-chief-2021-04-14/

Is Your Compliance Program Consumed by Process Rather Than Outcomes?
Duncan Milne
SCCE’s The Compliance & Ethics Blog

This approach significantly reduces the impact of the compliance program – senior management and the wider business can then view the compliance function as one of form over substance and a purely administrative cost center – something they are required to have rather than something they actually need. Or worse still, something that actually impedes business performance rather than enhancing it. It can be demotivating to compliance teams, generating endless content that nobody ends up reading, with any valuable insights getting lost in the trees.

https://complianceandethics.org/is-your-compliance-program-consumed-by-process-rather-than-outcomes/

SEC Accuses Actor of $690 Million Fraud Based on Fake Netflix Deal
Matt Robinson
Bloomberg

Zachary Horwitz never made it big on the Sunset Strip — there was the uncredited part in Brad Pitt’s “Fury” and a host of roles in low-budget thrillers and horror flicks. But federal charges suggest he had acting talent, duping several financial firms out of hundreds of millions of dollars and enabling him to live the Hollywood dream after all.

https://www.bloomberg.com/news/articles/2021-04-07/actor-s-690-million-fraud-based-on-fake-netflix-deal-sec-says

Division of Examinations issues ESG Risk Alert
Rodney F. Tonkovic, J.D.
Jim Hamilton’s World of Securities Regulation

The SEC’s Division of Examinations has issued a risk alert highlighting its recent observations from exams of firms offering ESG products and services. The alert gives the Division’s observations of deficiencies and internal control weaknesses derived from examinations of ESG investing by advisers and funds.

https://jimhamiltonblog.blogspot.com/2021/04/division-of-examinations-issues-esg.html

Individuals as Qualified Purchasers

To pull the pieces together, private funds are exempt from the Investment Company Act under Section 3(c)(1) or Section 3(c)(7). Under (1) the fund is limited to 100 investors. Under (7), there is no limit on the number of investors, but the investors have to be “Qualified Purchasers.”

The definition of “qualified purchaser” in Section 2(51)(A) includes individuals as

(i) any natural person … who owns not less than $5,000,000 in investments, as defined by the Commission;

Which leads us to seeking out the definition of “investments” for purposes of the “qualified purchaser” definition. That was published by a SEC rule-making in 1997 and can be found in Section 270.2a51-1(b).

The first issue to tackle is marriage or spousal equivalent.

The rule provides that, in determining whether a natural person is a qualified purchaser, the person may include in the amount of his or her investments any investments held jointly with the person’s spouse (“Joint Investments”). Thus, a person who owns $3 million of investments individually and $2 million of Joint Investments would be a qualified purchaser. The spouse also would be a qualified purchaser if he or she owned, individually, an additional $3 million of investments.

A married couple investing jointly can include their joint assets. If only one spouse is investing, that spouse can use the assets in his or her own name and the joint assets to reach $5 million.

For individuals there are six items that can be considered investments.

  1. Securities, as defined in section 2(a)(1) of the Securities Act of 1933. Excluded are securities in a company controlled by the person, unless that company is (i) an investment company or one of the exclusions from the definition, (ii) a company with publicly traded securities, or (iii) showing at least $50 million in shareholders’ equity on its financial statements.
  2. Real estate held for investment purposes. That excludes your principal residence, your vacation home and the office you work in.
  3. Commodity interests held for investment purposes. That means you have to be primarily in the business of trading commodity interests.
  4. Physical commodities held for investment purposes. That means you have to be in business of trading commodities. Your Babe Ruth baseball card is not going to count unless your business is trading baseball cards.
  5. Financial contracts held for investment purposes that fall outside the definition of securities.
  6. Cash and cash equivalents held for investment purposes. That’s going to exclude your checking account, but you can probably include your savings account.

Add that stuff together if its in the person’s name or held jointly. If it adds up to $5 million. That person is a “qualified purchaser.” You just have to have a reasonable belief that the person is a qualified purchaser.

Sources:

Suspicious Activity Reporting

The Securities and Exchange Commission’s Division of Examinations released a Risk Alert on Compliance Issues Related to Suspicious Activity Monitoring and Reporting at Broker-Dealers. While it spent most of the publication laying out the vague requirements of reporting suspicious activity, it took a sharp turn and listed six types of activities that the SEC would consider suspicious activity that should be reported.

  1. Large deposits of low-priced securities, followed by the near-immediate liquidations of those securities and then wiring out the proceeds.
  2. Patterns of trading activity common to several customers including, but not limited to, the sales of large quantities of low-priced securities of multiple issuers by the customers.
  3. Trading in thinly traded, low-priced securities that resulted in sudden spikes in price or that represented most, if not all, of the securities’ daily trading volumes.
  4. Trading in the stock of issuers that were shell companies or had been subject to trading suspensions or whose affiliates, officers, or other insiders had a history of securities law violations.
  5. Questionable background of customers such as the fact that they were the subject of criminal, civil, or regulatory actions relating to, among other things, securities law violations.
  6. Trading in the stock of issuers for which over-the-counter stock quotation systems had published warnings because the issuers had ceased to comply with their SEC financial reporting obligations or for which the firms relied on a “freely tradeable” legal opinion that was inconsistent with publicly available information.

I found this to be a great reference list.

Sources:

SPAC, SMACK, SHAQ?

SPACs are the current tulips of the markets. Everyone wants a piece of one. Celebrities are joining the rush. As noted in the title, Shaq has one. Actually Shaq is on his second SPAC.

Almost 250 SPAC IPOs were completed in 2020, raising total gross proceeds of approximately $75 billion That was about half of the number of IPOs and half of the capital raised in IPOs.

There are lots or reasons for companies to become liquid and raise capital through a SPAC. There is certainty in pricing. Private company founders and their backers don’t have to spend months worried about how much capital will be raised in an IPO. They negotiate the capital raise with the SPAC executives.

The downside is that the private company may not have been through the compliance wringer to make sure it’s ready for the rigors of being a public company.

The SEC is catching up and has released a series of statements and policy notices about SPACs. The Division of Corporate Finance pointed out that these newly crafted public companies have to focus on their books and records and their financial controls. The public SPACs have to meet these standards. But since they are just sitting on a pile of cash, their controls can be very simple. It’s really the controls of the acquired company that will be in operation.

A public statement by the SEC’s Chief Accountant also pointed to the financial controls, governance, and audit controls that creates faith in the public markets.

One item that the SEC has started to focus on is the treatment of the warrants involved in the SPAC combination. The reason that sponsors are jumping on the SPAC bandwagon is the promote granted to the SPAC organizers in the form of warrants.

The Securities and Exchange Commission last week began privately telling accountants that warrants, which are issued to early investors in the deals, might not be considered equity instruments, according to people familiar with the matter.

It’s the special sauce that has helped lubricate the SPAC engine. It’s not a bubble in valuation. It’s a bubble in method.

Sources:

Form ADV FAQ Comes a Little Late

Most investment advisers filed their form ADVs last week, before the March 31 filing deadline. That didn’t stop the Securities and Exchange Commission from publishing a new FAQ about Form ADV on April 6. Hopefully you got it right.

There has been some questions about office locations that need to be disclosed on Form ADV during the pandemic. The general thought was that temporarily working from home during the pandemic didn’t need to be disclosed. Was that the right approach?

Let’s see…

Q: My firm has employees who are temporarily conducting investment advisory business from a temporary location other than their usual place of business (their homes, for example) as part of the firm’s business continuity plan due to circumstances related to coronavirus disease 2019 (COVID-19). Item 1.F of Part 1A requires information about a firm’s principal office and place of business. Section 1.F of Schedule D requires information about “each office, other than your principal office and place of business, at which you conduct investment advisory business.” Is my firm required to update either Item 1.F of Part 1A or Section 1.F of Schedule D in order to list the temporary teleworking addresses of its employees?

A: No. As long as the employees are temporarily teleworking as part of the firm’s business continuity plan due to circumstances related to coronavirus disease 2019 (COVID-19), staff would not recommend enforcement action if the firm does not update either Item 1.F of Part 1A or Section 1.F of Schedule D in order to list the temporary teleworking addresses. For purposes of this FAQ, “temporarily teleworking” includes prolonged plans to telework, provided that the firm maintains a physical office location. (Updated April 6, 2021)

Marketing Rule FAQs

The Securities and Exchange Commission finally published the new Marketing Rule for investment advisers. Based on the publication date, it becomes effective on May 4. The compliance date is November 4, 2022. A frequently asked question is whether you can slowly wade into the standards of the new rule or do you have to do a full belly-flop.

Apparently, that question has become frequent enough that the SEC published a response. The answer is the full belly-flop.

“An adviser may choose to comply with the amended marketing rule in its entirety any time starting on the effective date, May 4th, 2021. Until an adviser transitions to the amended marketing rule, the adviser would continue to comply with the previous advertising and cash solicitation rules and look to the staff’s positions under those rules. The staff believes an adviser may not cease complying with the previous advertising rule and instead comply with the amended marketing rule but still rely on the previous cash solicitation rule. “

https://www.sec.gov/investment/marketing-faq

Sources:

Bad Investments and Overcharging

Douglas Elstun failed his clients in two ways. He over charged them and he put them into inappropriate investments.  

Mr. Elstun invested some of his clients’ money in daily leveraged ETFs, which deliver multiples of short-term performance of a stock index. He also invested some clients in inverse ETFs which are designed to deliver the opposite performance of a market index in the short term. If these sound complex, you’re right. A FINRA regulatory notice said:  

“[The ETFs] are highly complex financial  instruments that are typically designed to achieve their stated objectives on a daily basis.” … “[The ETFs] are typically unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.” 

Mr. Elstun used a buy and hold strategy for his clients with these complex ETFs, resulting in millions of dollars in losses. He either didn’t understand the ETFs because he portrayed them as hedges against a market downturn, or he was making misleading statements to his clients.  

Mr. Elstun also overcharged his clients. Even though several advisory agreements stated that he was only entitled to a fee of 1%, he started charging 1.25%. The SEC charged him with falsifying revised agreements. 

In addition to wrongfully increasing the rate, Mr. Elstun also wrongfully expanded the base of assets to apply the rate. For certain clients he included equity in houses, other real estate and vehicles that the clients purchased.  

Mr. Elstun is still contesting the charges so we only have the SEC’s side to rely upon.

Making sure investment advice is appropriate for a particular client is a key compliance role. Any good compliance review should have shown that a long term hold in those ETFs was bad advice. As you might expect, Mr. Elstun was also the CCO of the firm.

Sources: