Author: Doug Cornelius

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Compliance Bricks and Mortar for November 22

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

Death Knell for Regulatory Guidance Hits Most Federal Agencies…
Broc Romanek
TheCorporateCounsel.net

We’ve been covering the Administration’s gradual squeeze on regulatory guidance for some time (here’s our latest from April). As noted in this DLA Piper memo, President Trump signed two ‘Executive Orders’ recently that limit the practice of “regulation by guidance.” Here’s the “improved agency guidance” order that requires each agency to post its guidance documents on an indexed, searchable website after the OMB has issued implementing guidance about how to accomplish that (here’s a comprehensive Davis Polk memo on this order).

https://www.thecorporatecounsel.net/blog/2019/11/death-knell-for-regulatory-guidance-hits-most-federal-agencies.html

How co-working magnifies compliance perils
Richard L. Cassin
The FCPA Blog

Here’s the problem. Some people here lack, um, situational awareness. They forget (or don’t care?) that when they talk to colleagues in the common areas — at the big open work tables, in the community lunchroom, around the water cooler — other people might be listening in. When they yell into their phones while walking the halls, or put their calls on speaker, it all reaches the ears of outsiders. When they hold meetings in the conference rooms scattered throughout the workspace, the walls aren’t nearly thick enough to keep all the sound inside.

https://fcpablog.com/2019/11/14/how-co-working-magnifies-compliance-perils/

Sexual Harassment Prevention Lessons from the Television’s “Survivor”
by Daniel Schwartz
Connecticut Employment Law Blog

Why?  Here are a few things that stood out to me from an employment perspective:
First, a female player (Kellee) complained to a producer that another male player (Dan) was a little too “touchy” and made her feel uncomfortable. To be sure, there was plenty of video evidence to back her up.   The male player was given a “warning” and play continued.  But here’s the thing: The female player never knew that a warning was issued and Dan worked with others to get Kellee voted out of the game immediately thereafter.  Not telling the complainant what was going on with her complaint is just one of the ways the producers seem to have mishandled things.

https://www.ctemploymentlawblog.com/2019/11/articles/sexual-harassment-prevention-lessons-from-the-televisions-survivor/

2019 Was Big for the SEC. 2020 Will Be Huge.
By John Manganaro
PlanAdviser.com

Given its broad authority, the SEC is normally engaged in a wide range of rulemaking and regulatory activities in any given year—and that has certainly been the case in 2019. For plan advisers, three or four of the SEC’s ongoing regulatory activities should take precedence while planning for compliance in 2020. These are the Regulation Best Interest (Reg BI) package, the new advertising rules for advisers and brokers, and the revised approach to rules and requirements related to proxy voting and the use of proxy advisers.

https://www.planadviser.com/2019-big-sec-2020-will-huge/

SEC Enforcers Continue to Focus on Undisclosed Fees
by Joshua M. Newville & Brian Hooven

In a series of enforcement cases over the past few months, the SEC has continued to bring actions focused on undisclosed fees charged to clients. Many of these cases have charged firms with fraud and other violations based on fees that were not adequately disclosed. While some attention has focused on retail wealth managers, institutional advisers to private funds have attracted scrutiny for undisclosed fees, leading to the following enforcement actions:

https://www.lexblog.com/2019/11/12/sec-enforcers-continue-to-focus-on-undisclosed-fees/

Paul Weiss Discusses Delaware Decisions Showing Renewed Focus on Board Oversight

Breach of the duty of oversight claims against Delaware directors are known as “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.”[1]  The plaintiff must successfully argue that the directors either “utterly failed to implement any reporting or information system or controls” or “having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention.”[2]  These “Caremark claims”—named after the Court of Chancery’s seminal decision in this area, In re Caremark International Inc. Derivative Litigation—require well-pled allegations of bad faith (i.e., that “the directors knew that they were not discharging their fiduciary obligations,” a standard of wrongdoing “qualitatively different from, and more culpable than . . . gross negligence”) to survive dismissal.[3]  As a result of these high pleading standards, Caremark claims have historically had limited success.

http://clsbluesky.law.columbia.edu/2019/11/20/paul-weiss-discusses-delaware-decisions-showing-renewed-focus-on-board-oversight/

Thoughts on Compliance Career Risk
by Matt Kelly
Radical Compliance

Career success is always about demonstrating how you add value to an organization larger than yourself. In our case, it’s about refashioning what you do away from executing a task (testing controls, bargaining with regulators, training employees, writing policies) toward providing a resource executive management needs: a greater awareness of the company’s overall risk posture, so that managers can make better decisions. 

http://www.radicalcompliance.com/2019/11/21/thoughts-on-compliance-career-risk/

CCO Barred for Lying on Form ADV

Gregory M. Prusa was the Chief Compliance Officer of the Salus, LP, a hedge fund. Among other problems, Mr. Prusa made false or misleading statements in the Form ADV filing for Salus. Now he is barred from the securities industry.

The general rule is the the CCO should only be subject to an action if he or she was involved in the wrongdoing, impeded the investigation or completely failed in the compliance program.

Mr. Prusa was also the CEO of Salus and its general partner S.A.I.C., Limited. Two hats can lead to trouble. The problem here was fundraising.

Mr. Prusa and is partner Brandon E. Copeland launched Salus in October 2107 and filed a Form ADV in November 2017. The filing indicated $20 million in RAUM and reasonable expectation to reach the higher RAUM required with filing with the SEC within 120 days.

In April 2018 and January 2019, Salus filed Form ADVs stating that it was a “large advisory firm” with $178 million in RAUM. Some of filings indicated that in addition to the Salus fund the firm also had high net worth individual clients that had a mix of bonds and equities. All of the Form ADV filings stated the auditor, custodian and prime broker for the hedge fund.

None of that information in the Form ADV was true. Salus never had any RAUM or reasonable expectation of having sufficient RAUM. It never had any individual clients. The fund never had any of those key relationships.

Unsurprisingly, the lies carried over to the Confidential Offering Memorandum for the hedge fund. The fund never received any capital commitments, so it never had any investments and never an auditor, custodian or prime broker.

It does have a website. https://www.salushedgefund.com/

The facts lay out Mr. Prusa being involved in the wrongdoing. So it seems appropriate to bring an action against him.

Sources:

CCO Is Barred and Faces Jail Time for Overbilling

The Securities and Exchange Commission charged Cameron G. High of Yellowstone Partners, LLP, of Idaho Falls, for fraudulently overbilling the firm’s clients and charging fees for work not performed. That amount to a total of over $11 million in excess charges from more than 100 of the firm’s clients. Mr. High faces up to 20 years in prison for wire fraud in connection with the overbilling.

The primary bad actor in the case is David Hansen, the former CEO of Yellowstone Partners. He is also on fraud charges and facing jail time.

It’s the CCO charges that caught my attention. High also held a 5% interest in Yellowstone and was a registered investment adviser representative.

According to the SEC complaint, it was Hansen who masterminded and ordered the overbilling. It was a combination of double charging and adding extra charges to the bills.

Certainly, a CCO should be subject to charges if he or she was involved in the wrongdoing. According to the complaint, and I infer from the criminla charges, Mr. High was involved in the wrongdoing.

Mr. High knew the overbilling was improper, but still followed the orders of Mr. Hansen. Hr. High also lied to clients when the overbilling was discovered and blamed it on the custodian. There was a clear pattern of bad behavior and culpability.

Sources:

SEC 2019 Enforcement Report

The Securities and Enforcement Commission’s Division of Enforcement release its 2019 Annual Report highlighting the 862 actions and $4.3 billion in disgorgement and penalties.

The report emphasized actions against individuals. Excluding the Share Class Initiative cases, 69% of the standalone cases were against individuals. This is in line with cases filed during the past few years. Included in this individual accountability is the suspension or barring of nearly 600 people from the securities industry.

Actions against investment advisers and investment companies in FY 2019 nearly doubled from the year before. That sounds ominous. But this increase includes 95 settlements that resulted from self-reports in the SEC’s Share Class Selection Disclosure initiative. Removing those cases, removes the over-allocation of cases to advisers.

For FY2019, the Division had __ ares of focus:

  1. Retail investor protection, the most vulnerable to bad actors in the industry.
  2. Cyber-related misconduct – hacking and ICO failures
  3. Unlawful trading – new SEC tech to spot problems.

The Report highlights some of the Division’s difficulties.

The Kokesh case made it clear that the SEC’s power to impose penalties and disgorgement is subject to a five-year statute of limitations. The Report estimates that this has resulted in the SEC foregoing over $1 billion in disgorgement.

The SEC had been subject to a two-year hiring freeze, which was lifted in the Spring of 2019. The freeze is effectively a reduction in size because personnel leaving for retirements and departures can not be filed.

Sources:

Compliance Bricks and Mortar for November 15

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

The SEC Cancels Another Open Meeting: What Gives?
Broc Romanek
TheCorporateCounsel.net

The SEC has cancelled tomorrow’s open Commission meeting about proposing changes to its whistleblower office. I think this is the third cancelled open meeting in as many months. Does it matter? Not really. Is it worth blogging about? Probably not. Did I blog about it anyway? Yes.
Here’s a few thoughts:

https://www.thecorporatecounsel.net/blog/2019/10/the-sec-cancels-another-open-meeting-what-gives.html

Broken Windows: Remarks before the 51st Annual Institute on Securities Regulation
by Commissioner Hester M. Peirce

How can we make our enforcement program even better than it is? Over the past nearly two years, I have thought a lot about this question as I read the enforcement recommendations sent to my office and talk with our enforcement staff. The SEC’s enforcement program effectively serves American investors and the capital markets that underpin the broader economy. There is, however, always room for improvement. Therefore, in my remaining time with you this morning, I will suggest several avenues for improvement. Some of these themes are familiar, but they are ones that merit being raised with you. I welcome feedback on these suggestions from this room full of seasoned lawyers.

https://www.sec.gov/news/speech/peirce-broken-windows-51st-annual-institute-securities-regulation

The 10 Most Significant Changes in the Proposed Adviser Advertising Rule
Cipperman Compliance Services

The 10 Most Significant Changes in the Proposed Adviser Advertising Rule
1. Expanded Definition of “Advertisement”. The proposed rule applies to “any communication, disseminated by any means.”  This definition includes all digital and social media communications.

…

https://cipperman.com/2019/11/08/the-friday-list-the-10-most-significant-changes-in-the-proposed-adviser-advertising-rule/

Study: Second-Hand Reports More Reliable
by Matt Kelly
Radical Compliance

Some news that’s both useful to corporate compliance officers and totally relevant to our political drama in Washington: fresh research shows that whistleblower reports based on second-hand information tend to be more reliable than those from first-hand reporters. 
Moreover, second-hand reports are more likely to be about accounting or business integrity issues; and the more second-hand reports a company gets, the fewer lawsuits and smaller regulatory settlements it’s likely to pay out in future years. 

http://www.radicalcompliance.com/2019/11/01/study-second-hand-reports-more-reliable/

Is a Ranch a Security?

Thomas M. Maney had a 1000-acre parcel of undeveloped, vacant, desert land in Kern County, California. He decided to find other interested in owning part of it and helping with the development decisions. He split it into 4000 undivided, fractional ownership interests. So far, that’s just a time-share and not a security.

Then Silver Saddle required buyers to contribute $500 of additional funds for each quarter share into a pooled fund for further development of the property. According to the complaint filed by the State of California Department of Business Oversight:

“Investors were told that the capital contributions of $500.00, $1,000.00 or $2,000.00 made to the Capital Improvement Fund would appreciate in value and that the investors would later use the funds to develop the 1,020 acres of undeveloped land into viable commercial and industrial properties.”

That sounds less like a real estate purchase and more like a pooled fund of capital with the purpose of generating a return.

As for control, purchasers could vote on how to spend the money in the Capital Improvement Fund. But only full-unit holders could vote. Half-share and quarter-share owners could not vote. Plus, the ranch’s board of directors made all of the management decisions. The board was controlled Mr. Maney. The owners were effectively relying on others to manage the money.

Pooled funds, relying on the work of others to earn a return puts it into the definition of “investment contract” and therefore a security.

Of course, there were other problems with the sales of interests at Silver Saddle. The DBO accused Maney of diverting funds for personal use, using high-pressure sales tactics, promising a lack of risk and high returns, and failing to disclose a past history of unlawful real estate sales.

Sources:

When Is a Note Not A Security?

I had to scratch my head for a moment when reading the case against Jan Atlas. The SEC accused the lawyer of issuing legal opinions in which he falsified or omitted important facts in connection with an unregistered, fraudulent offering.

“At the time he drafted the May 17 opinion letter, Atlas knew that certain facts stated in the letter on which he was basing his opinion were false, and that he was omitting from the letter other facts inconsistent with his opinion. For example, the letter based its conclusions in large part on statements that 1 Global was offering and selling nine-month notes, and only to sophisticated investors. “

“Nine-months”? What did that have to with the analysis?

Clearly, I have spent too much time looking at the Howey test and less with the statutes.

Promissory notes are presumptively considered to be securities and are listed as securities under the Securities Act § 2(a)(1). However, Section 3(a)(3) has a specially exemption for certain notes:

Any note, draft, bill of exchange, or banker’s acceptance which arises out of a current transaction or the proceeds of which have been or are to be used for current transactions, and which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited

There is that “nine months” reference. I don’t remember running into this exemption before.

In the case of Mr. Atlas, the SEC accused him of knowing that the notes subject to his opinion has an automatic renewal option. That would remove them from that exemption.

Sources:

Compliance Bricks and Mortar for November 8

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

The 2020 U.S. Election is Here: How is Your Firm Monitoring Political Contributions and Government Relationships?
by Elaine Vincent
ACA Compliance

While the SEC certainly has plenty of responsibilities on its plate, based on precedent it is likely that the regulator will step up enforcement and investigation of potential play-to-play situations in an election year. And even if your firm makes it through the election cycle without a knock on the door from the SEC, this doesn’t mean you’re in the clear. The SEC will be on the lookout for violations during lookback periods after 2020.

https://www.acacompliancegroup.com/blog/2020-us-election-here-how-your-firm-monitoring-political-contributions-and-government

The Basis for ISS’ Lawsuit Against the SEC
by Steven Friedman, Institutional Shareholder Services, Inc

If allowed to stand, the August interpretation and guidance would effectively treat the advice proxy advisers provide to their clients in the same way that the SEC regulates proxy solicitations (meaning the communications, most typically made by the boards and management of public companies, advocating that shareholders vote to support the position favored by the person doing the solicitation).  In contrast, proxy advice is a specialized form of investment advice rendered at the direction, and in the best interest, of our institutional investor clients. As such, proxy advice is the antithesis of a “solicitation” under the securities laws.

https://corpgov.law.harvard.edu/2019/11/05/the-basis-for-iss-lawsuit-against-the-sec/

Kokesh Redux: SCOTUS to Hear Challenge to SEC Disgorgement Authority
by John Jenkins
The CorporateCounsel.net

Whether the SEC actually has the ability to seek disgorgement is an issue that the Kokesh Court specifically raised in footnote 3 of Justice Sotomayor’s opinion:
“Nothing in this opinion should be interpreted as an opinion on whether courts possess authority to order disgorgement in SEC enforcement proceedings or on whether courts have properly applied disgorgement principles in this context. The sole question presented in this case is whether disgorgement, as applied in SEC enforcement actions, is subject to § 2462’s limitations period. “

https://www.thecorporatecounsel.net/blog/2019/11/kokesh-redux-scotus-to-hear-challenge-to-sec-disgorgement-authority.html

Majority of bitcoin trading is a hoax, new study finds
by Kate Rooney

The analysis showed that “substantially all of the volume” reported on 71 out of the 81 exchanges was wash trading, a term that describes a person simultaneously selling and buying the same stock, or bitcoin in this case, to create the appearance of activity in the market. In other words, it’s not real.

https://www.cnbc.com/2019/03/22/majority-of-bitcoin-trading-is-a-hoax-new-study-finds.html

SEC Division of Enforcement Publishes Annual Report for Fiscal Year 2019

In fiscal year 2019, the SEC brought a diverse mix of 862 enforcement actions, including 526 standalone actions. These actions addressed a broad range of significant issues, including issuer disclosure/accounting violations; auditor misconduct; investment advisory issues; securities offerings; market manipulation; insider trading; and broker-dealer misconduct. Through these actions, the SEC obtained judgments and orders totaling more than $4.3 billion in disgorgement and penalties. Importantly, the SEC also returned roughly $1.2 billion to harmed investors as a result of enforcement actions.

SEC Proposes to Modernize the Advertising Rules for Investment Advisers

I had my coffee ready and headphones on to listen to Tuesday morning’s Securities and Exchange Commission open meeting for Item 3: “Investment Adviser Advertisements; Compensation for Solicitations.” After cancelling a appointment to watch it, I discovered that Item 3 had been taken off the meeting agenda. The SEC voted on Monday to propose amendments to modernize the rules under the Investment Advisers Act addressing investment adviser advertisements and payments to solicitors.

The proposed rule would replace Rule 206(4)-1, first adopted in 1961. It will be a dramatically different approach to advertising restrictions.

Specifically, we are proposing a restructured and more tailored rule that: (i) modifies the definition of “advertisement” to be more “evergreen” in light of ever-changing technology; (ii) replaces the current four per se prohibitions with a set of principles that are reasonably designed to prevent fraudulent or misleading conduct and practices; (iii) provides certain additional restrictions and conditions on testimonials, endorsements, and third-party ratings; and (iv) includes tailored requirements for the presentation of performance results, based on an advertisement’s intended audience. The proposed rule also would require internal review and approval of most advertisements and require each adviser to report additional information regarding its advertising practices in its Form ADV.

In addition to modifying the advertising rule, the SEC is including a revision to the cash solicitation rule, Rule 206(4)-3. The premise of that rule was to male sure clients were aware that paid solicitors have a conflict of interest.

We are proposing to expand the rule to apply to the solicitation of current and prospective investors in any private fund, rather than only to “clients” (including prospective clients) of the investment adviser. Our proposal would require solicitor disclosure to investors, which alerts investors to the effect of this compensation on the solicitor’s incentive in making the referral. In addition, we are proposing changes to eliminate: (i) the requirement that solicitors provide the client with the adviser’s Form ADV brochure; and (ii) the explicit reminders of advisers’ requirements under the Act’s special rule for solicitation of government entity clients and their fiduciary and other legal obligations. Our proposal would also eliminate the requirement that an adviser obtain a signed and dated acknowledgment from the client that the client has received the solicitor’s disclosure, and instead would afford advisers the flexibility in developing their own policies and procedures to ascertain whether the solicitor has complied with the rule’s required written agreement.

There is a lot to digest in the 500 pages of the release. Since it appears the Commissioners all agreed to proposed rules, this is likely to be very close to final rule.

Sources:

The One With The Silenced Investors

In response to Dodd-Frank, the SEC adopted Rule 21F-17 in August 2011, which provides:

(a) No person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement . . . with respect to such communications.

I have mostly heard stories about violation of the rule as applied to employee severance agreements or employment agreements. You can’t prevent departing employees from being whistleblowers.

In a different approach to whistleblower protection, the Securities and Exchange Commission brought a case against a company for trying to limit the ability of its former investors from reported alleged wrongdoing to the SEC.

Mykalai Kontilai, wanted to build a website for the auction of collectibles, especially sports memorabilia. He grew that idea into plans for an affiliated social network, a physical coffee shop, and a television show. He managed to raise $23 million from 140 investors to implement his vision. Collectors Café was born.

According to the SEC complaint, Kontilai misappropriated more than $6.1 million of the money raised for personal use. He is also accused of misrepresenting the material facts about Collectors Café to those investors.

According to the SEC some of the investors alleged wrongdoing and wanted their money back. In at least two instances, Collectors Café and Kontilai attempted to resolve investor allegations of wrongdoing by conditioning the return of investor money on confidentiality clauses prohibiting the investors from communicating with law enforcement, including the SEC, about the alleged securities law violations.

In a stock purchase agreement to buy back the stock, there was this provision:

[Investors] … further warrant and affirm that. . . they will not, directly or indirectly, individually, collectively or otherwise, contact any third-party, including, but not limited to governmental or administrative agencies or enforcement bodies, for the purpose of commencing or otherwise prompting investigation or other action relative to [Collectors Café] or the subject matter herein.

In a settlement agreement with other investors, there was this provision:

“The Shareholders, for themselves and their counsel and advisors, confirm that they are not aware of, and have not had to date, and will not initiate on a going forward basis, any communications with any regulatory agencies such as the United States Securities and Exchange Commission or any other Federal, State, or Local governmental agency concerning the matters related to this Agreement.”

Collectors Café and Kontilai even went a step further and attempted to enforce the illegal confidentiality clause by filing a lawsuit claiming that the victims breached the confidentiality provision by communicating with SEC staff about possible securities law violations.

The SEC action is mostly filled with the alleged fraud at Collectors Café. This came after the SEC contacted the investors trying to find information about their complaint.

The two provisions contain the opposite of what should be in a settlement agreement. We know you can’t stop employees from acting as whistleblowers in severance agreements. It’s also clear that you can’t stop investors from talking to the SEC about securities fraud.

Sources: