Author: Doug Cornelius

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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.

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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:

Compliance Bricks and Mortar – Post Halloween Edition

These are some of the compliance-related stories that I read recently while getting ready for Halloween.

It’s the Great Pumpkin: Lessons in Process Validation Through Monitoring
by Tom Fox
FCPA Compliance & Ethics

The compliance lesson from Linus’ adventure; it is process validation. Unlike Santa Claus, who we have been repeatedly told “Yes, Virginia there is a Santa Claus”; there has been no process validation for the Great Pumpkin. Linus faints when he thinks he sees the Great Pumpkin rising from his pumpkin patch; unfortunately it is only Snoopy. In the compliance world, process validation comes through oversight. Two of the seven compliance elements in the 1992 US Sentencing Guidelines call for companies to monitor, audit and respond quickly to allegations of misconduct. 

http://fcpacompliancereport.com/2019/10/its-the-great-pumpkin-lessons-in-process-validation-through-monitoring/

Enforcement Co-Director Peikin touts self-reporting, creative remedies at Securities Docket conference
by Amanda Maine, J.D.
Jim Hamilton’s World of Securities Regulation

Regarding self-reporting in general, former SEC Enforcement Director William McLucas, now at Wilmer Hale, said that the lack of guidance about self-reporting from the SEC can result in tough discussions with clients because there are no guarantees for self-reporting in contrast to the detailed guidelines from the Department of Justice. George S. Canellos, formerly of the SEC’s Enforcement Division and currently at Milbank, agreed, stating that without formal guidelines for cooperation credit, the SEC is “all over the map.”

https://jimhamiltonblog.blogspot.com/2019/10/enforcement-co-director-peikin-touts.html

Compliance Job Interview Questions and Answers
by Corporate Compliance Insights

At CCI, we know what questions reveal a candidate’s qualifications, and we know what answers a hiring authority is looking for. If you’re hiring a compliance officer, you need to ask these questions.  If you’re interviewing for a compliance position, you need to be prepared to answer them.

https://www.corporatecomplianceinsights.com/compliance-job-interview-questions-and-answers/

Corporate Oversight and Disobedience
by Elizabeth Pollman

Over a decade has passed since landmark Delaware corporate law decisions on oversight responsibility, and only a small handful of cases have survived a motion to dismiss. Scholars have puzzled over what it means to have the potential for corporate accountability lodged within the duty of good faith, but almost never brought to fruition in terms of trial liability. …

Under current Delaware case law, courts have allowed Caremark claims to proceed where evidence exists to infer that the board utterly failed to implement a compliance monitoring system or that the directors engaged in disobedience by knowingly managing legal risk or flouting, violating, or ignoring the law.

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3474337

Is the SEC up to its $84-trillion RIA challenge?
by Tobias Salinger
Financial Planning

Agency officials have said as much: The SEC’s latest annual performance review cites the notable rise in the share of RIAs receiving exams but also two missed goals around enforcement. This month, the agency’s inspector general took it to task over those findings.
The average time it takes the SEC to start an enforcement action after opening an investigation is two years and one month. Only 49% of the time was the agency able to file cases within two years of starting its investigation. The figures came nowhere near the SEC’s own targets.

https://www.financial-planning.com/news/sec-enforcement-cases-of-rias-take-two-years-ig-says

CCO Indicted for Obstruction of Justice

I don’t like compliance officers being dragged into enforcement actions. If they are involved in the wrongdoing or are just a wholesale failure at compliance, I understand the desire for regulators to take aim at a CCO. The charges against Michael Cohn as a CCO are extremely bad.

Mr. Cohn was the managing director and chief compliance officer at GPB Capital Holdings. Just prior to joining GPB he was compliance examiner at the Securities and Exchange Commission.

Mr. Cohn was charged with obstruction of justice and unauthorized access of a government computer for accessing information about an investigation into GPB. While talking with GPB for the CCP job , Mr. Cohn told GPB that he had inside information about the SEC’s investigation into the firm, according to an indictment filed in the U.S. District Court for the Eastern District of New York.

According to the Department of Justice press release, Mr. Cohn accessed information on SEC servers relating to an Enforcement Division investigation into GPB.  During discussions with GPB personnel about obtaining a job there, Cohn advised them that he had inside information about the SEC’s investigation, and on several occasions he disclosed information to members of GPB’s senior management about that investigation. 

Yeah, that’s bad.

Of course, Mr. Cohn is merely charged with crimes and has not an opportunity to defend himself from the charges.

But the indictment should serve as a warning not to engage in this type of bad behavior.

Sources:

Reg BI and Form CRS Checklist

FINRA released some needed guidance to help firms comply with the new broker investment advice standards and disclosure requirements of Regulation Best Interest and the new client disclosure document Form CRS.

The checklist is available on the FINRA website:
https://www.finra.org/sites/default/files/2019-10/reg-bi-checklist.pdf .

If you have responsibility for broker-dealer compliance the checklist looks like a great tool.

Boards Must Rigourously Exercise Their Oversight Function

“[T]o satisfy their duty of loyalty, directors must make a good faith effort to implement an oversight system and then monitor it.”

Marchand v. Barnhill, 212 A.3d 805 (Del. 2019)

Clovis Oncology’s stock dropped sharply in 2015 when it disclosed poor clinical trial results for Rociletinib a promising experimental drug for the treatment of lung cancer. That meant the FDA was unlikely to approve Rociletinib to enter the market. Shareholder lawsuits ensued. The claim was that board breached its fiduciary duties by disregarding red flags that reports of the drug’s performance in clinical trials were inflated.

Delaware’s Caremark line of cases impose a responsibility on corporate boards to have a compliance program, but with a great deal of discretion to design it for the corporation’s context, industry, and resources. However, that compliance obligation is heightened when the corporation operates in an area of mission-critical regulatory compliance risk.

In the recent decision of In re Clovis Oncology, Inc. Derivative Litigation, the court highlighted the two components required of corporate compliance. First, you have to have an oversight system in place. Second, you have to monitor the oversight system. In area of mission-critical regulatory compliance, board oversight responsibility is heightened.

If you fail to do either, the corporation risks fiduciary litigation when bad news comes out.

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