Author: Doug Cornelius

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

Affiliate Funds Shuffling Funds

George Heckler, of Charleston, South Carolina, operated a decade-long fraud through three private hedge funds, Cassatt Short Term Trading Fund LP (Cassatt), CV Special Opportunity Fund LP (CV Special), and Conestoga Holdings LP (Conestoga). This fraud caught my attention because my brother and mom both live in South Carolina.

Heckler’s initial fund was Conestoga, which was formed in 1998. Unfortunately, the fund had a big investment in an illiquid investment and that investment went south, resulting in millions of dollars in losses.

Rather than admit to the problem, Heckler raised new cash to pay off Conestoga investors looking to exit. He raised the additional funds, in part, to repay the Conestoga investors. He convinced a fund administrator to help him with the fraud. He used the Cassat and CV Special capital raises to pay off investors in Conestoga. He falsely stated in those fund financial statements that the funds were properly invested.

Although Heckler has not agreed to the SEC charges, he did plead guilty to the criminal charges brought by the Department of Justice.

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SEC’s ESG Task Force


The Securities and Exchange Commission announced the creation of a Climate and ESG Task Force in the Division of Enforcement. The Division of Corporate Finance announced an enhanced focus on climate-related disclosures in public filings. The Division of Examinations announced a focus on climate-related risks as part its 2021 examination priorities. Sounds like all of the SEC has turned to ESG and climate issues over the last two weeks.

Or not.

Commissioner Hester M. Peirce and Commissioner Elad L. Roisman issued a joint public statement calling into question these climate/ESG initiatives.

“What does this ‘enhanced focus’ on climate-related matters mean?  The short answer is: it’s not yet clear.  Do these announcements represent a change from current Commission practices or a continuation of the status quo with a new public relations twist?  Time will tell.”

As the two commissioners point out, the Commission has not voted on any new standards or expectations relating to climate-related disclosure. They also point (as I did) although there is a big headline for climate issues in the press release for the 2021 examination priorities, there is little mention of it in the actual publication. As for the Enforcement Task Force, its clear these two commissioners are not on board.

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Investment Adviser Marketing Rule Finally Published

After sitting in limbo for three months, the Securities and Exchange Commission finally published the Investment Adviser Marketing Rule in the Federal Register on March 5, 2021. That makes the effective date May 4, 2021 and the compliance date 18 months after that (October November 4, 2022).

So far I’ve not heard any information on why the extended delay. There were rumors of changes to the rule under the new Chair of the SEC. There were rumors of combing the publication with the rescission of some of the 50 years worth of no-action letters and other guidance. The rumors were apparently not true.

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Risk Alert on Digital Asset Securities

The Securities and Exchange Commission’s Division of Examination has been visiting firms that have been involved in digital assets. The Division published a Risk Alert that you should read if your firm has digital assets in client accounts.

Right off the bat, the risk alert hedges on its definition of “digital assets” to say that it a particular digital asset may or may not be a security. I believe the SEC’s current position is that BitCoin is not a security. Everything else it potentially a security.

There is the usual expected requirements for investment advisers and fund managers: books and records, disclosure and custody.

Custody continues to be one of the most difficult aspects of putting digital assets in client accounts. Have fun trying to meet the custody rule requirements. Even if you do, the security around digital asset keys should keep you up at night. That’s true for Bitcoin as well, even though its not a security.

One highlight was due diligence and evaluation of the risks involved in digital assets. You really need to vet these investments like you would any other investment recommendation. I like this example of required diligence:

“that the adviser understands the digital asset, wallets, or any other devices or software used to interact with the relevant digital asset network or application, and the relevant liquidity and volatility of the digital asset)”

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Division of Examination 2021 Examination Priorities

The Securities and Exchange Commission’s Division of Examinations has published its 2021 examination priorities.

The big headline is a greater focus on climate-related risks as part of information security and operational resiliency.

“Building on the efforts noted above concerning our business continuity plan outreach related to the pandemic, the Division will shift its focus to whether such plans, particularly those of systemically important registrants, account for the growing physical and other relevant risks associated with climate change. The scope of these examinations will be similar to the post-Hurricane Sandy work of the Division and other regulators, with a heightened focus on the maturation and improvements to these plans over the intervening years. As climate-related events become more frequent and more intense, we will review whether systemically important registrants are considering effective practices to help improve responses to large-scale events.”

The other big focus looks like it will be Regulation BI and Fiduciary Duty compliance.

“The Division will focus on compliance with Regulation Best Interest, Form CRS, and whether registered investment advisers have fulfilled their fiduciary duties of care and loyalty. The Division will examine whether firms are appropriately mitigating conflicts of interest and, where necessary, providing disclosure of conflicts that is sufficient to enable informed consent by retail investors.” 

The new addition to the priorities is looking at LIBOR.

“The Division will continue to engage with registrants through examinations to assess their understanding of any exposure to LIBOR, their preparations for the expected discontinuation of LIBOR and the transition to an alternative reference rate, in connection with registrants’ own financial matters and those of their clients and customers.”

The rest looks like perennial items that a carry-over from the 2020 Examination Priorities.

Private funds are still on the list. The Division will always been focused on the disclosure of fees and conflicts for private fund managers. The Division detailed some very specific types of funds that are in its crosshairs.

One is private funds that invest in structured products, such as collateralized loan obligations and mortgage backed securities. The Division wants to see if these funds have higher risk of non-performing loans and loans with higher default risk. Fund mangers need to be sure that the default risk is being disclosed to investors. Sounds like the Division is going to be very focused on those disclosures.

The Division highlighted four other private fund specific items:

  1. preferential treatment of certain investors by advisers to private funds that have experienced issues with liquidity, including imposing gates or suspensions on fund withdrawals;
  2. portfolio valuations and the resulting impact on management fees;
  3. adequacy of disclosure and compliance with any regulatory requirements of cross trades, principal investments, or distressed sales;
  4. conflicts around liquidity, such as adviser led fund restructurings, including stapled secondary transactions where new investors purchase the interests of existing investors while also agreeing to invest in a new fund.

That last one looks very specific. I suspect the SEC has found some fund restructurings that it doesn’t like. Those may be more prevalent as a result of the pandemic.

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The New Advertising Rule for Private Funds and Investment Advisers Is Still Sitting

As an early Christmas present, the Securities and Exchange Commission approved a new marketing rule on December 22, 2020. This was after a vote on the rule was suddenly canceled at an open meeting the week prior.

Now we are two months after approval of the rule, but it hasn’t yet been published in the Federal Register. So it’s not effective yet and the long runway for compliance has not been laid out.

What’s going on?

The Biden administration imposed a regulatory freeze. It’s not legally binding on Securities and Exchange Commission. Perhaps the SEC is embracing the freeze even though its not required.

In connection with the new Marketing Rule the SEC stated that it was reviewing the 60 years of guidance and no-action letters that have governing marketing under the old advertising rule. Perhaps the erasure of that guidance will be part of the final publication.

Otherwise, the SEC is giving us time to re-read the new Marketing Rule and thinking about the roadmap.

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A Shot of Tequila and Pilfered Investor Funds

Joseph Cimino wanted to make a great tequila and needed capital to make it happen. He raised almost $1 million and got 6 Degree tequila into production. Unfortunately, he apparently lied to his investors in raising the capital and then stole almost half of that capital.

Cimino created a 40-page booklet providing sales and expense forecasts and describing 6 Degree’s product and business plan. This booklet reported 2015 sales of approximately $260,000 and a net profit of approximately $40,000. But 6 Degree did not launch its operations until the spring of 2016, so those numbers were entirely fictitious.

In another example, Cimino gave a potential investor a financial update showing sales of over 800 cases in Puerto Rico, when the truth was less than 200 cases in sales. Puerto Rico was one of the few places 6 Degree was sold. In another report, Cimino falsely represented in an investor report and quarterly profit and loss statement that the company’s year-to-date sales totaled 3,410 cases, when its actual sales totaled only 350 cases.  

When he wasn’t lying to his investors and potential investors about the company’s results, he was allegedly stealing money from the company. He transferred approximately $472,000 from the company to his personal accounts. 

Mr. Cimino is currently subject to civil and criminal charges by the Securities and Exchange Commission and Department of Justice. According to the statement of the FBI agent in the criminal complaint, Mr. Cimino admitted to at least some of the false claims. He does not admit to illegally taking the cash.

I assume that Mr. Cimino was initially just puffing the success of the company in order to entice investors. The classic, “fake it, ’til you make it.” The problem is that doing so in connection with raising capital, “faking it” is securities fraud. If you publish numbers in a fundraising document, you need to be able to substantiate that number. Moving the decimal point over is going to get you in trouble.

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Another Fake COVID Test Fraud

COVID vaccinations are continuing to roll out and we can hope to see an end to the pandemic. Regulators are continuing to roll out cases against people and companies that tried to illegally profit from the pandemic.

The latest case is against Arrayit Corporation, a life sciences company in Sunnyvale, California. Although a public company, the Securities and Exchange Commission had put a halt to the trading in its shares on public markets in 2015 because the company had failed to file annual reports with audited financial statements. The company failed to respond to auditors requests for information. That moved its share trading to the OTC pink sheets. 

The CEO of Arrayit, Rene Schena, and her brother Mark Schena, President of Arrayit, began telling investors that the reports were coming out and the company had some new revenue sources. 

In March of 2020 Arrayit began making statements to investors.

“Dear [investor], Confirming that we have a SARS-Cov-2 test and that the test is pending emergency approval.”

At that point Arrayit had no reagents needed for a test. Also, Arrayit had not actually applied for Emergency Use Authorization. 

Arrayit took it a step further and told investors that it had received more than 50,000 requests for its finger stick blood test. This was not true. As a result of the untrue or misleading statements Arrayit’s stock price traded up 50% and its volume increased 100%.

The SEC charged Arrayit, Rene Schena, and Mark Schena with fraud. Arrayit and Rene Schena have settled with the SEC. She will pay a $50,000 fine and is barred from acting as an officer or director. Mark Schena’s case is still pending. 

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Increased SEC Enforcement?

The annual number of enforcement actions by the Securities and Exchange Commission decreased each year during the Trump administration. Starting at the high of 1,063 in 2016 and dropping to 827 in 2019, according to a tabulation in the Wall Street Journal. Now there is a new President and new Acting Chair of the Securities and Exchange Commission. Are enforcement actions going to increase?

Acting Chair Allison Herren Lee broadened the delegation of authority to senior officers in the Division of Enforcement. Under former Chair Clayton during the Trump administration, only the two co-heads of the Enforcement Division could approve the issuance of a Formal Order of Investigation. Now a broader group of officials in the Enforcement Division can do so.

Will this result in more enforcement actions? My guess would be “no.” I think the number of enforcement actions is correlated more to the size of the enforcement staff. It was reduced by about 8% during the Trump administration. Enforcement staff can only handle so many cases per person.

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Is Your Real Estate Fund Invested in Real Estate?

One of the challenges with real estate funds is staying within the various requirements of a real estate fund at the beginning of its life and at the end of its life. At start-up, the fund may be sitting on substantial non-real estate while it is starting to invest. Similarly at the end of its life, a fund may be sitting on substantial non-real estate while its real estate investments have been sold off. Then the fund has to run through the muddy area of whether any of its non-real estate holdings are “securities”. That analysis is key when addressing the definitions and exemptions under the Investment Company Act.

Landwin Partners Fund I ran into this problem and got hit with an action from the Securities and Exchange Commission. The action was against the fund manager and the principal of the fund manager.

The fund manager, like all of us, noticed that the fund’s cash holdings were producing little to no interest. The fund’s bank/financial company offered some short-term bank notes to earn some interest. That spread to bonds, preferred stock and common stock that were unrelated to real estate.

According to the SEC order, $2.4 million of the fund’s $20 million of capital was in these non-controlling, non-real estate interests. The first problem was that the fund’s offering documents didn’t authorize investments in anything other than real estate. That put beyond its organizational powers.

The second problem was that the high ownership level of true securities implicated the Investment Company Act. Section 3(a)(1)(C) of the Investment Company Act defines an “Investment Company” as

“engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 per centum of the value of such issuer’s total assets (exclusive of Government securities and cash items) on an unconsolidated basis”

The Securities and Exchange Commission lumped the fund’s holdings in real estate-related limited partnership interests and mortgage loans together with the publicly traded securities to take the position that the fund had exceeded that 40% threshold in the definition of an “Investment Company.”

I was surprised to see real estate partnership interests and mortgage loans being included in the definition of “security” for the purposes of the definition of an “Investment Company.” The fund had over 300 investors so it could not use the 3(c)1 exemption which imposes a 100 investor cap. I would assume that the investor base did not qualify the fund for exemption under 3(c)7 which requires the investor base to be “Qualified Purchasers.”

That would leave the fund looking to use the 3(c)5 exemption for investments in real estate. I assume the SEC took the position that the investments were securities and not the type of investments that qualify for the 3(c)5 exemption.

The SEC order didn’t go into details about the failure of the fund to meet those exemptions. It merely states that the fund failed to meet any exemption.

Similarly, the SEC order didn’t provide any information on why the real estate limited partnership interests or mortgage loans should be considered “securities.”

Mortgage loans as securities? Maybe. Sure, bonds and participating interests are more likely to be considered securities. If the fund was the lender, I didn’t think the loan would be considered a security. The order doesn’t tell us anything about the nature of the mortgage loans that made them securities. I would think that a mortgage loan would be considered an asset that qualified under the 3(c)5 exemption as “…(C) purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.”

Similarly, real estate limited partnership interests could be considered a security. It should depend how much control the limited partner has over the partnership. I believe that having major decision rights and some control over management moves the interest out of the definition of a security. As with mortgage loans, I would think that real estate-related limited partnership interests would be considered an asset that qualified under the 3(c)5 exemption as “…(C) purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.”

Real estate fund managers who are not registered as investment advisers should be concerned about this case. It sounds like the SEC is possibly taking an aggressive approach on what is a security and the availability of the 3(c)5 exemption for real estate fund managers.

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