Real Estate or the Lottery

Viktor Gjonaj thought he had figured out a way to make money. He was a commercial real estate broker and convinced members of his Albanian-American community in Detroit that he had lucrative real estate investment opportunities. He raised over $26 million.

Gjonaj had a promising plan. It involved lottery tickets instead of real estate. Gjonaj diverted his investors’ cash to playing the Michigan Lottery Daily 3 and Daily 4 games.

Maybe he had system that worked. He apparently won millions from the lottery. Unfortunately, it appears that he spent millions more buying the tickets. According to the complaints filed by the Securities and Exchange Commission and the US Attorney, Gjonaj was betting $1 million per week on the lottery using the money that was supposed to be put towards real estate investments.

His scheme unraveled. It appears that most of the investor money is gone. He is subject to lawsuits by his investors, an action by the Securities and Exchange Commission, and criminal charges from the US Attorney.

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Performance Advertising and the Funds That Weren’t There

Eric Malley decided that buying buy hundreds of luxury Manhattan residences on the cheap and leasing them to corporate tenants would be a great way to make money. He would let others in on his plan as investors. He created MG Capital Management Residential Fund III and raised $23 million from about 60 investors. It seemed successful enough that he launched a follow up Fund IV that raised $35 million.

You may be asking yourself: What about Fund I and Fund II?

The marketing materials for Fund III and Fund IV described very successful predecessor funds. In the Fund III PPM the outcome was described as

Fund I:
(1) raised $350 million of investor capital;
(2) earned a gross return on investment (ROI) of 38.99% and a net ROI of 30.81% during its six-year investment term from 2007 through 2013;
(3) outperformed the S&P 500 Index by 4.5-to-1; and
(4) sold its 74-property portfolio to two buyers for $750 million

and

Fund II:
(1) raised $55 million of investor capital in only 30 days; and
(2) achieved an average gross ROI of 38.06%,
cumulative unrealized gains on equity of 154.55%, and
a gross investment multiple of 2.55x.

In the complaint filed by the Securities and Exchange Commission, there is no evidence that these funds existed. Nor is there any evidence that MG controlled the $1.8 billion portfolio of real estate supposedly owned by the funds.

As for the Fund III and Fund IV, well, they did not perform well. According to the SEC complaint, Fund IV “earned $1.6 million in rent and incurred operating expenses of $8.3 million, resulting in net operating losses of approximately $6.7 million” and “$4.7 million in unrealized losses on portfolio investments, bringing Fund IV’s total net loss to approximately $11.4 million.”

As you might expect, MG is accused of illegally siphoning money from the funds. The SEC claims that (1) MG retained cash rebates from the sellers of the properties purchased by the funds and (2) charged the fund for unearned brokerage fees.

MG Capital and its principal Eric C. Malley are subject to civil charges by the SEC, criminal charges by the Department of Justice, and civil suits by investors. We haven’t heard their side of the story. Take the information above as a clear statement of what you should not do.

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Division of Examination

Goodbye Office of Compliance Inspections and Examinations.
Hello Division of Examination.

The Securities and Exchange Commission decided that OCIE, with 23% of the SEC employees, is probably more than an office and elevated it to the level of “Division” by naming it the Division of of Examinations. That puts it on equal name status with Corporate Finance, Investment Management, Trading and Markets, Economic and Risk Analysis and Enforcement.

I’m not sure I ever felt that OCIE was somehow less important because it was an “Office” and not a “Division.” Names do matter and its good to see that the examination staff can now carry around a more prestigious division name.

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Corporate Transparency Act

I’m not sure what Anti-Money Laundering has to do with the United States military, but Congress included big changes to anti-money laundering law in the National Defense Authorization Act for 2021. After a veto by President Trump and an override by Congress, NDAA has become the law, including Section 6401-6403, the Corporate Transparency Act.

It’s really easy to create a corporation, limited liability company or limited partnership in the United States. There are many, many legal, reasonable and important reasons to be able to do so. From the law enforcement and government sanctions parties, they see the company structure merely as an impediment to their ability to push bad guys out of the US banking system. The government side won and it may have a dramatic impact on the creation and reporting of companies.

The Corporate Transparency Act will require companies to submit a report of their beneficial interest to the U.S. Department of the Treasury’s Financial Crimes and Enforcement Center. For new companies, this information has to be submitted at the time of formation. Existing companies will have to submit this information within two years. All companies will have to update the information for a change of ownership within one year after the change.

The reporting requirement will not apply to all companies, just to any company that fits into the definition of “Reporting Company.” That definition has a lengthy list of companies that are exceptions and fall outside the scope of the Reporting Company definition. Of the twenty-four exceptions, there are some obvious types: public companies, banks, and broker-dealers.

I really wanted to focus on the possible impact on me and private fund managers.

Section 6403 of the NDAA adds a new section 5336 to Title 31 of the US Code. I focused on this exception in 31 USC 5336(a)(11) from the definition of “Reporting Company”:

‘‘(xi) an investment adviser—
(I) described in section 203(l) of the Investment Advisers Act of 1940 (15 U.S.C. 80b–3(l)); and
(II) that has filed Item 10, Schedule A, and Schedule B of Part 1A of Form ADV, or any successor thereto, with the Securities and Exchange Commission;

So registered investment advisors that report their ownership on Form ADV are not Reporting Companies and don’t have to report ownership. Obviously, they are already reporting ownership.

There is an exception for pooled investment vehicles operated or advised by investment advisers:

‘‘(xviii) any pooled investment vehicle that is operated or advised by a person described in clause (iii), (iv), (vii), (x), or (xi)

Although the definition of “pooled investment vehicle” is very specific:

(A) any investment company, as defined in section 3(a) of the Investment Company Act of 1940 (15 U.S.C. 80a–3(a)); or
(B) any company that—
(i) would be an investment company under that section but for the exclusion provided from that definition by paragraph (1) or (7) of section 3(c) of that Act (15 U.S.C. 80a–3(c));
and
(ii) is identified by its legal name by the applicable investment adviser in its Form ADV (or successor form) filed with the Securities and Exchange Commission.

Later, there is a broader exception:

‘‘(xxii) any corporation, limited liability company, or other similar entity of which the ownership interests are owned or controlled, directly or indirectly, by 1 or more entities described in clause (i), (ii), (iii), (iv), (v), (vii), (viii), (ix), (x), (xi), (xii), (xiii), (xiv), (xv), (xvi), (xvii) (xix), or (xxi);

Companies owned or controlled, directly or indirectly, by a registered investment adviser also fall outside the definition of “reporting company.”

This would seem to be good for private fund managers. The funds and fund subsidiaries seem to fall outside the definition of Reporting Company.

There is still a long path until we get to the point of having to do this reporting. FinCEN will have to establish the regulatory framework and the database to hold this information. It’s not clear how the reporting requirement will specifically interact with the various state secretaries of state who are responsible for company formation.

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Doubling Down on Disgorgement

Back in 2017, the Supreme Court in Kokesh v. Securities and Exchange Commission pointed out that the disgorgement claims made by the Securities and Exchange Commission are penalties and therefore subject to the five-year statute of limitations. The Kokesh decision left some question about whether the SEC could pursue disgorgement at all. The Supreme Court did not mean to kill it and earlier this year upheld the SEC’s disgorgement power in Liu v. Securities and Exchange Commission.

Congress managed to tuck some some goodies in the National Defense Authorization Act. Sure, that went through gyrations after President Trump vetoed it because it didn’t have some things he wanted in it. On Jan. 1, Congress overrode President Trump’s veto of the defense spending bill.

Section 6501 of the NDAA specifically authorizes disgorgement and allows for a 10 year period in some instances.

SEC. 6501. INVESTIGATIONS AND PROSECUTION OF OFFENSES FOR VIOLATIONS OF THE SECURITIES LAWS.
(a) In General.–Section 21(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78u(d)) is amended–

(3) by adding at the end the following:

(7) Disgorgement.–In any action or proceeding brought by the Commission under any provision of the securities laws, the Commission may seek, and any Federal court may order, disgorgement.

(8) Limitations periods.–
(A) Disgorgement.–The Commission may bring a claim for disgorgement under paragraph (7)–
(i) not later than 5 years after the latest date of the violation that gives rise to the action or proceeding in which the Commission seeks the claim occurs; or
(ii) not later than 10 years after the latest date of the violation that gives rise to the action or proceeding in which the Commission seeks the claim if the violation involves conduct that violates–
(I) section 10(b);
(II) section 17(a)(1) of the Securities Act of 1933 (15 U.S.C. 77q(a)(1));
(III) section 206(1) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-6(1)); or
(IV) any other provision of the securities laws for which scienter must be established.

The 10-year period is only for scienter-based claims. The SEC will have to allege intentional fraud.

What’s not clear in the statutory change is whether the Liu limiting principles will still apply to disgorgement claims. The Supreme Court laid out three limitation on disgorgement claims:

  • Disgorged funds should be returned to the victims.
  • Joint and several liability theory may not apply;
  • Should be limited to “net” profits, allowing deduction of legitimate business expenses

I’ll leave figuring out whether they still apply to the legal scholars and, inevitably, future court cases.

In addition to the disgorgement extension, there is a new anti-money laundering scheme as part of the NDAA. More to come on that.

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Massachusetts Fires an Arrow at Robinhood

The Secretary of the Commonwealth filed its first enforcement action under the Massachusetts Fiduciary Rule. Robinhood and its gamification of investing are in its bullseye.

The Massachusetts Securities Division adopted amendments to 950 Mass. Code Regs. 12.200 earlier this year as they relate to the standard of conduct applicable to broker-dealers and agents. The amendments apply a fiduciary conduct standard to broker-dealers and agents when dealing with their customers. The Division said it would begin enforcing the amended regulations on September 1, 2020.

“Each broker-dealer shall observe high standards of commercial honor
and just and equitable principles of trade in the conduct of its business.”
– 950 CMR 12.204(1)(a)

According to the data, Robinhood has almost a half million customers in Massachusetts. Approximately 68% of the Massachusetts customers approved for options trading on Robinhood have no or limited investment experience. One advertisement states:

“I’m a broke college student and investments might help my future tremendously.”

The administrative complaint shoots at Robinhood claiming its infrastructure is inadequate. The outages and disruptions in the platform earlier this year are the indicators. The crux of this prong of the complaint is that Robinhood is continuing to recruit new customers without properly improving its infrastructure. The complaint states 70 outages over the course of 2020.

The second prong of the complaint takes that position that Robinhood’s supply of lists of most popular stocks is an encouragement to purchase the security without consideration of the customer’s suitability.

The third prong is Robinhood’s permission and encouragement for customers to trade. The complaint uses the example of one customer that clicked the investment experience button when creating the account. That customer made 12,748 trades this year. An average of 92 trades a day.

A fourth prong is that Robinhood failed to properly screen customers before allowing them to trade options. Robinhood failed to follow its own policies and procedures.

Wrapping it up, the complaint says that each of these four prongs is a violation of the Massachusetts Fiduciary Standard applicable to broker-dealers.

All of this is just the regulators side of the case. A Robinhood spokeswoman said before the complaint was filed that the company has and will continue to work closely with all regulators.

“Robinhood has opened up financial markets for a new generation of people who were previously excluded.”
“We are committed to operating with integrity, transparency, and in compliance with all applicable laws and regulations.”

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Vaccine Tracker

From xkcd: https://xkcd.com/2398/

Meanwhile on Wednesday, the Securities and Exchange Commission is scheduled to vote on a new advertising rule for registered investment advisers. From the Sunshine Act notice for the meeting;

2. The Commission will consider whether to adopt amendments under the Investment Advisers Act of 1940 to update rules that govern investment adviser marketing to accommodate the continual evolution and interplay of technology and advice, while preserving investor protections. The Commission will also consider whether to adopt amendments to Form ADV to provide the Commission with additional information about advisers’ marketing practices, and corresponding amendments to the books and records rule under the Advisers Act.

The SEC Says Your Algorithm Is Not Good Enough

BlueCrest Capital was wildly successful as a hedge fund for many years. Its principals were wealthy enough that they could start a new fund with their own money and dedicate traders to running that new proprietary fund. That’s okay, even if the trading strategies between the new proprietary fund the existing hedge fund overlap. Compliance can manage the overlap. BlueCrest would need to properly disclose the conflict to investors.

The Securities and Exchange Commission said that BlueCrest failed to properly disclose. The parties agreed to a $170 million settlement.

The SEC order finds that BlueCrest made inadequate and misleading disclosures concerning existence of the proprietary fund, the movement of traders from the hedge fund to the proprietary fund, the use of the algorithm in hedge fund, and associated conflicts of interest.  According to the order, BlueCrest transferred a majority of its highest-performing traders from the hedge fund to the proprietary fund, and assigned many of its most promising newly hired traders to the proprietary fund.

What caught my attention in the order was that BlueCrest failed to disclose that it reallocated the transferred traders’ capital allocations in the hedge fund to a semi-systematic trading system, which was essentially a replication algorithm that tracked certain trading activity of a subset of BlueCrest’s live traders.

As you might expect, the algorithm underperformed the live traders. Why else would there be a SEC case? If the algorithm was better, the SEC would not have bothered. Actually, I bet BlueCrest would have used the algorithm on the proprietary fund if was outperforming the live traders.

According to the order, the hedge fund algorithm basically made the same trades as the live traders in the proprietary fund, but did so the following day. The algorithm trades ended up being less profitable, resulted in more volatility and had more risk in its portfolio.

There is nothing wrong with this practice as long as it’s disclosed. The SEC order highlights some diligence questionnaires which the SEC found misleading in BlueCrest’s description of its trading strategies and use of algorithms.

The SEC thinks there is a big difference between live traders and algorithms and the use of algorithms needs to be disclosed.

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Compliance Outreach and OCIE Observations

The SEC’s Office of Compliance Inspections and Examination launched a lot info last week. It livestreamed a National Investment Adviser/Investment Company Compliance Outreach and published a Risk Alert on notable compliance issues identified by OCIE related to Rule 206(4)-7.

Peter Driscoll, Director of OCIE, started off the program highlighting three words that should be applicable to your firm’s CCO: Empowered, Seniority, and Authority. He wants firms to think of compliance and the CCO as an essential component to running and advisory business and not just a box to be checked. CCOs should be routinely included in strategy discussions and brought into decision-making early-on for their meaningful input.

Then he mentioned that OCIE was publishing a risk alert right then on compliance programs.

Mr. Driscoll moved the Outreach program to a panel with Dalia Blass from Investment Management and Marc Berger from Enforcement. In discussing private funds, they highlighted the usual hot spots:

  • Valuation
  • Undisclosed conflicts
  • custody rule
  • allocation of expenses

In discussing upcoming regulatory changes, Ms. Blass mentioned the proposed Advertising Rule changes. Sounds like it’s still in process. No mention of a timeline. She also mentioned that there may be some upcoming regulatory changes around valuation and custody.

The second panel was on resiliency, information security and business continuity. This is even more important with so many firms and their employees working remotely.

The second panel focused on undisclosed conflicts. One panelist expressed grave concern over the use of the word “may” when describing conflicts. If there is an actual conflict, “may” is not the right word to use. If a firm always takes a fee, “may” is not the right word to use.

The panelists raised the issue of disclosing PPP loans. It was noted that taking a PPP loan was an indication of financial distress that likely should be disclosed to clients.

Turning to the new risk alert, the focus is the structure of compliance programs. It starts right off with a failure to have adequate compliance resources to support a robust compliance program. That includes having a CCO who devotes adequate time to compliance and is knowledgeable about the Advisers Act. One special note was for firms that had grown in size or complexity, but had not increased their compliance resources accordingly.

The Risk Alert emphasizes the importance of the annual review and documenting the annual review. As it’s coming up to year-end, it’s a good check list as you may be starting to work on your annual review.

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