Author: Doug Cornelius

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

General Solicitation and Placement Agent Agreements

D.H. Hill Securities got hit with a FINRA penalty for violating the private placement offering rules. FINRA concluded that D.H. Hill did not have a pre-existing, substantive relationships with several investors in an offering. This was a breach of the Rule 502(c)

The key point from the settlement was that the D.H. Hill began participating in the private placement offerings before creating a substantive relationship with the individuals. The “pre-existing” standard was not there because D.H. Hill started selling to them without establishing the relationship.

FINRA cites two ways for a broker-dealer to create a pre-existing, substantive relationship:

  1. through a previous investment in securities offered through the broker-dealer
  2. through submission and approval of an investor qualification questionnaire

FINRA is making it clear that its easier to sell private placements to the existing client base than reaching out for new investors.

Question 256.29 makes this even clearer:

Question: What makes a relationship “pre-existing” for purposes of demonstrating the absence of a general solicitation under Rule 502(c)?

Answer: A “pre-existing” relationship is one that the issuer has formed with an offeree prior to the commencement of the securities offering or, alternatively, that was established through either a registered broker-dealer or investment adviser prior to the registered broker-dealer or investment adviser participation in the offering. See, e.g., the E.F. Hutton & Co. letter (Dec. 3, 1985). [August 6, 2015]

Of course, the big question is long between the initial contact and screening before a relationship becomes pre-existing?

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Can a Supercomputer Be a Security?

Accept at face value that Profit Connect is not a scam. That is a stretch given the purported high returns, coupled with a money back guarantee.

• 15% to 20% Fixed APR
• High-Net-Worth 30% APR
• APR is Locked-In
• 100% Money Back Guarantee

No such thing as high returns with no risk. Of course, if the returns are that good, why would the sponsor let you invest.

After going through the mumbo-jumbo on the website, I got to an interesting take on the investment structure.

“A Profit Connect Wealth Builder is not an Investment, it is a purchase of Supercomputer time (usage) and the use of an App that pays you money, for blockchain calculations delivered to a client. The blockchain client is found, managed and supported by Profit Connect. The Wealth Builder Depositor simply places a deposit for seat time and the App makes them money every month, giving you total peace of mind. All Wealth Builder APR percentages are Guaranteed and All Wealth Builders have a Lifetime Money Back Guarantee.”

They are making some claim that you are merely renting computer time. I make the logical leap that the firm is taking the position that you are not buying securities from Profit-Connect and the firm is not selling you securities. That could be true. Renting computer time to you run Bitcoin mining is probably not a security by itself.

The Securities and Exchange Commission doesn’t spend much time on this point in the complaint.

100. The investments were part of a common enterprise because both investors and Profit Connect were to make money through Profit Connect’s investments, because Profit Connect pooled all investor funds into one bank account (the Profit Connect Investor Account), and because Profit Connect used some of those funds to make payments to investors.

101. Profit Connect investors were passive investors with no involvement in Profit Connect’s investment activity.

102. Investors relied entirely on the efforts of Profit Connect, which claimed that investor money would be invested in sectors determined by Profit Connect’s proprietary “supercomputer.”

To me the Profit Connect supercomputer is like the Howey orange grove. Renting supercomputer time is analogous to renting an orange grove. But if you package that resource into someone else doing all the work with no input from you, it looks a more like a security. I can rent supercomputer time and mine bitcoins. I take the risk of valuation fluctuations, utility costs, and success rate. Profit Connect is purporting to do all that for me. I give them money, do no work, I’m not allowed to do any work, and they give me more money back. Yeah, that does sound like a security.

It seems unlikely that the Profit Connect supercomputer is a real thing. One of the firm’s principals had been previously convicted of securities fraud. The SEC alleges that the firm had no operating revenue. All of the money coming in came from “investors.” Most of the money was paid out to solicitors and to the sponsors for personal use.

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Overlooking Tax Fraud

Cases against Chief Compliance Officers catch my attention. Jack Cook is the Chief Compliance Officer of Princeton Alternative Funding. He is in the crosshairs of the Securities and Exchange Commission.

The SEC Commissioners and senior OCIE 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

Mr. Cook served initially as Princeton’s chief operating officer and chief compliance officer. He eventually became CEO. Even though Mr. Cook had no experience in Princeton’s alternative lending space.

The SEC accuses Mr. Cook, of creating and disseminating materially false statements to investors and potential investors that misrepresented the management of the Princeton. Mr. Cook also concealed the significant role that a principal, Mr. Burgess, who had recently been convicted of tax fraud, played in managing Princeton and its investment.

The case seems to fall squarely in circumstance 1. Mr. Cook was clearly involved in the wrongdoing. The liability is not coming from his role in compliance. The SEC is accusing Mr. Cook of being the person creating the misstatements, approving the misstatements and conveying the misstatements to investors and in marketing to potential investors.

Of course there were smoking gun emails about the involvement of Mr. Burgess in the management of Princeton.

Burgess instructed them to “[b]e careful with too much transparency as it will bite you in the ass.” He later added, “I am also NOT suggesting you lie, but don’t volunteer unless you are ask[ed] the direct question.” He then noted his apparent belief that “[y]ou cannot trust anyone, period, and good deeds do not go unpunished. He [the investor] will jerk you around on future investments, just to continue to get info out of you.” To underscore his concern, Burgess added, “I will bet you my left nut (and I like my nuts) that this [investor] comes after us and uses your words to get us. Don’t let that happen.”

Less than a minute after sending this email, Burgess replied to all with a single sentence stating, “Also, delete these emails please.”

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The One with TheBull

The Dark Web and bitcoin are the tools of the trade for online criminals these days. Apostolos Trovias is alleged to be one of those criminals. He operated online under the pseudonymous online avatar “TheBull”. Mr. Trovias is alleged to have engaged in a deceptive scheme to offer and sell what he called “insider trading tips” on the Dark Web, offering purchasers an unfair advantage when trading securities.

Mr. Trovias claimed that he had order-book data from a securities trading firm that was provided to him by an employee of the trading firm. This would seem to be material, nonpublic information that was supposed to be kept confidential.

If Mr. Trovias had actually acquired some or all of the tips from actual order-book data or if he had stolen the order-book data himself, then he had engaged in a fraudulent scheme to sell material, nonpublic information that he knew or was reckless in not knowing was obtained in violation of a duty of trust and confidence. That’s illegal.

If Mr. Trovias did not actually have this information, then his statements were materially false and misleading and made in furtherance of a scheme to deceive purchasers who wanted to trade on inside information. That’s also illegal.

What fascinated me about this case is that the Securities and Exchange Commission doesn’t have to prove that Mr. Trovias was actually selling or using insider information. The SEC wins either way.

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Fine Art, Money Laundering, and Influence Peddling

The Anti-Money Laundering Act of 2020 brought art dealers under the umbrella of anti-money laundering regulation. Section 6110(a) of the AML Act amends the definition of “financial institution” under the Bank Secrecy Act (BSA) to include persons “engaged in the trade of antiquities” and directs FinCEN to promulgate implementing regulations.

The value of fine art and antiquities are inherently subjective and allow for a wide range of sale prices. The good stuff also weighs significantly less than cash. A painting worth $2.5 million is easier to transport than 275 pounds of $20 bills for the equivalent value. At the freeport in Geneva, you can sell the art without even moving it or paying taxes on the gain.

Now U.S. art dealers will have to file suspicious activities reports for cash transactions.

Into this fray steps Hunter Biden, the President’s son who is looking to sell some of his paintings.

“Everyone should try pushing brushes around. And if someone wants to pay you a half-million for the results: Cash that check.”

https://www.yahoo.com/entertainment/hunter-biden-art-worth-500-110000217.html

This raises the ethical issue of buying Hunter Biden’s artwork in an attempt to influence President Biden. According to the Washington Post story, the White House is trying to craft an ethical wall around the potential purchases to keep them anonymous. It’s a bad spot to have presidential family members selling art that is highly subjective in value into a market that is under scrutiny for anti-money laundering efforts.

The best answer is to just say “no.” Wait three (or seven) years to start selling the art after President Biden is out of office. It looks terrible to be trading on his father’s name and role as president.

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How Do You Define AUM?

The Securities and Exchange Commission took a big step with private funds and setting a defined standard of Regulated Assets Under Management. There is still discretion in how different aspects are calculated. It works well for hedge funds and private equity funds. It starts breaking down as you have more alternative assets that fall outside the definition of “private fund” and “securities portfolio” that ties to the RAUM definition.

For real estate, INREV published a tool for defining Assets under Management: Assets Under Management (AUM) 2021.  

INREV interviewed a bunch of asset managers to figure out how they came up with their AUM numbers. The resulting paper summarizes the main components of AUM and options for each component. It’s not a prescriptive attempt to standardize AUM. It’s just a thought peice.

INREV came up with ten components. Each component has two to four different ways of treatment. For example, one component is the ownership of JV’s and co-investments, with these options:

  • 100% regardless of ownership
  • 100% if the asset is consolidated in the financials but ownership
  • 100% if asset mgmt services are provided for the asset, but ownership share only if not
  • % ownership share only

Of course you can argue that JVs may be treated differently than co-investments, so there could easily be more components and more options.

The INREV summary is a good way to think about it. With the ten components and each factor, that gets you to over 36,000 different ways to calculate AUM using the INREV breakdown.

Obviously, one driving factor is the “ask” accompanied by the AUM request. It means having to give a summary of what went into the AUM calculation.

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Increases to the Qualified Client Standard

There are so many buckets for classifying clients and investors under the SEC regulatory standards. Lots of focus and discussion has been targeted at the “accredited investor” standard for private placements. The “Qualified Client” standard under the Investment Advisers Act seems to attract very little attention.

Rule 205-3 under the Advisers Act exempts an investment adviser from the prohibition against charging a client performance fees when the client is a “qualified client.” The rule allows an adviser to charge performance fees for clients with a lot of money.

There are two ways to qualify as a “Qualified Client”:  

(1) “a natural person who, or a company that, immediately after entering into the contract has at least $1,000,000 under the management of the investment adviser” or

(2) “a natural person who, or a company that, the investment adviser entering into the contract (and any person acting on his behalf) reasonably believes, immediately prior to entering into the contract … has a net worth (together, in the case of a natural person, with assets held jointly with a spouse) of more than $2,000,000.

The Dodd-Frank Wall Street Reform and Consumer Protection Act amended section 205(e) of the Advisers Act to provide that every five years, the SEC has to adjust for the effects of inflation the dollar amount thresholds for a Qualified Client, rounded to the nearest multiple of $100,000. That five year mark has come around and the standards are increasing as of August 16, 2021.

Registered investment advisers entering into performance-based compensation arrangements with clients on or after Aug. 16, 2021 will have to make sure the client has assets under management of at least $1.1 million or have a net worth of at least $2.2 million.

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The One with the “Dealmaker”

It’s one thing to make a deal. It’s another to execute on the business plan agreed to in the deal you make. Matthew Skinner calls himself a deal maker. The Securities and Exchange Commission says that he didn’t execute on his deals.

Mr. Skinner was building a real estate empire, developing residential properties in southern California, an apartment building in Arizona and unidentified multifamily real estate. It looks like some of the deals went sideways. There was litigation over property rights and cost overruns. Problems happen. You tell your investors and move forward. Looks like Mr. Skinner did not.

This is real estate, so why is the Securities and Exchange Commission involved? Mr. Skinner was selling securities to fund his real estate empire. He was purported to be using the Rule 506 option for fundraising. According the the SEC, Mr. Skinner and his funds were “engaged in general solicitation for each offering, broadly targeting members of the public with whom they had no preexisting relationship.” According to the complaint, at least some of the investors were not accredited and Mr. Skinner did not take steps to determine their status as accredited investors.

The other key part of fundraising is identifying the use of proceeds. In particular, how much, if any, is going to the sponsor of the fundraising. Mr. Skinner’s fundraising documents listed certain fees to which he was entitled. However, the SEC has accused him of taking much more than was detailed in the fundraising documents.

The last thing that caught my eye was using COVID as an excuse. I think we’ll start seeing more of this in fraud cases. Mr. Skinner “falsely cited economic dislocation caused by the COVID-19 pandemic as the reason why he could not pay [his investors] and would need to defer distributions.”

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The SEC Spat Over Its Regulatory Agenda

The Securities and Exchange Commission publishes its Unified Agenda of Regulatory and Deregulatory Action List annually, setting up items that the SEC is working on or thinking about working on. Occasionally, we learn of something new. Usually, it’s a fairly boring exercise to meet the requirements under the Administrative Procedure Act.

There was one surprise for private funds on the list: Exempt Offerings

“The Division is considering recommending that the Commission seek public comment on ways to further update the Commission’s rules related to exempt offerings to more effectively promote investor protection, including updating the financial thresholds in the accredited investor definition, ensuring appropriate access to and enhancing the information available regarding Regulation D offerings, and amendments related to the integration framework for registered and exempt offerings.”

A surprise, but not really. Exempt offerings are right in the middle of the cross purposes of protecting investors and creating efficient capital markets.

The big surprise was that two of the SEC Commissioners published a criticism of the agenda. Commissioners Peirce and Roisman take issue with the agenda revisiting the recently adopted changes to the accredited investor definition. They also note the inclusion of the Proxy Rules, Resource Extraction Payments and the whistleblower rules.

“As far as we can tell, the agency has received no new information which would warrant opening up any of these rules for further changes at this time. We are disappointed that the Commission would dedicate our scarce resources to rehashing newly completed rules.”

Looks like the new SEC is off to a rock start under the Chair Gensler.

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The One with the Coffee Cup Full of Cash

Last week, the sentence of Michael Jarigese was upheld by an appellate court. Mr. Jarigese had been sentenced to 41 months of imprisonment and three years of supervised release in connection with a bribery case. 

Mr. Jarigese was the vice president of Castle Construction Corporation, and the president of its successor company, Tower Contracting LLC, when he signed three contracts with the City of Markham for public construction projects. 

Before awarding the third contract to Castle, Markham’s Mayor Webb asked Mr. Jarigese to hire his KAT Remodeling company as a subcontractor. The subcontract was to remove and haul construction debris and to level the ground at the third project. KAT Remodeling and Mayor Webb has no construction background and the invoices were bogus. 

Mr. Jarigese paid for the bogus contract with a $75,000 check.  The remaining $25,000 was paid by stopping by the Mayor’s office with some coffee cups. But instead of coffee, the cup was full of $2500 in cash.  

The jury only took two hours before convicting Mr. Jarigese and his construction company for honest services wire fraud and federal bribery. 

What was unusual about this case was that Mayor Webb was the cooperating witness for the prosecution. He had identified those contractors who had paid him bribes. He was working with prosecutors to help reduce the sentence for his conviction of wire fraud and tax fraud. Typically, it’s the contractors and other bribe payers who cooperate with the government and testify against the politicians who took the money. 

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