Author: Doug Cornelius

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

Are Liquor Licenses Securities?

San Diego-based ANI Development LLC, its principal, Gina Champion-Cain, raised hundreds of millions of dollars from investors to make short-term, high-interest loans to parties seeking to acquire California alcohol licenses. The SEC alleges, the investment opportunities were shams and diverted directed significant amounts of investor funds to other uses.

Under California state law, liquor license applicants are required to escrow an amount equal to the license purchase price while their application remains pending with the State. Cain told investors that this regulatory requirement presented an investment opportunity.

She directed investors to deposit their money into specified escrow accounts maintained by ANI Development, and represented to them that their funds were being loaned to liquor license applicants at a high interest rate. That escrow agent allowed Cain to move the money around instead of keeping it safe in escrow.

Were those loans securities? If not, then its not securities fraud. The SEC addressed this is issue in the complaint using the Howey test.

60. As directed by defendants, investors’ funds were pooled in a common escrow account, which defendants claimed was being used to fund the transfer of California state liquor licenses.
61. Whether investors would profit from their investment was dependent on the success of defendants’ represented liquor license funding program.
62. Cain and ANI Development’s efforts in identifying liquor license escrow participants who were appropriate for investment, executing the loans to those entities, and collecting the purported interest payments from those participants, were critical to the enterprise’s success, as investors were not allowed to play an active role in managing ANI Development’s investment decisions under the claimed liquor license funding program.

Sounds like it passes the test because Cain pooled money into the escrow accounts instead of keeping them separate.

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Pair of Ponzis with Real Estate

Real estate related fraud cases with the Securities and Exchange Commission catch my attention. Two real estate-ish cases popped up in a flurry of cases filed before Labor Day weekend. One was for timber and the other for mobile home parks.

Timber operates in a gray area between real estate and extraction. Clearly, the land has value for capital and the trees have value as product. Of course you have to own the land or have the right to harvest the trees.

In the case of Madison Timber Properties, LLC, the SEC claims that the company and its principals didn’t own the land or have the harvesting rights. In other instances, the SEC claims the company would pledge the same tracts to more than one investor. Instead of using the money to acquire land or harvesting rights, the company diverted investor capital for other uses.

Last week, the SEC brought charges against Terry Wayne Kelly and his company for selling the notes that funded Madison Timber. At the base level, Kelly and his firm were not registered as broker-dealers. The Madison Timber notes were not registered nor did the sales properly use an exemption from registration.

Further, the SEC charged that Kelly was aware of the red flags at Madison Timber. At a meeting with unnamed financial institutions, Kelly and Madison were confronted about the business practices at Madison. The SEC charged that Kelly is civilly liable for negligently and recklessly selling the securities.

In a separate action, the SEC accused Tytus Harkins and the Hartman Wright Group with defrauding investors in connection with mobile home parks. They misrepresented the

Unlike Madison, Hartman Wright owned the real estate. But according to the SEC, Madison overstated the purchase price for the mobile home parks.

In both cases, the firms used some of the cash provided by later investors to redeem or make payments to earlier investors. That gives each scheme the label of a Ponzi scheme.

The question that I’m left with is how the firms expect to exit from these schemes. There would not be enough cash to pay off investors at the end of the day. Eventually the scheme would unravel.

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Form SHL: Report by U.S. Funds on Foreign Ownership

Hopefully, if this form filing is applicable to your firm, you’ve already sent it in. It’s due on August 30. The penalty for failing to submit the form is a civil penalty of not less than $2,500 and not more than $25,000.

The form is required if your firm was the recipient of a mailing of the form or if you have more than $100 million in foreign investors in your fund.

The filing is part of a mandatory survey conducted under the authority of the International Investment and Trade in Services Survey Act (22 U.S.C. 3101) and Executive Order 11961 of January 19, 1977. The Act specifies that the authority to secure current information on international investment, including (but not limited to) such information as may be necessary for computing and analyzing the balance of payments accounts and the international investment position of the United States.

This report collects information on securities issued by U.S.-residents that are owned by foreign residents, including U.S. equities (including shares in funds), U.S. short-term debt securities (including selected money market instruments), U.S. long-term debt securities, and U.S. asset-backed debt securities.

The standard includes foreign ownership of private funds. Often foreign investors use blockers of domestic subsidiaries to invest. The form’s instructions indicate that you can use the standard of whether the investor gave you a W-8 instead of a W-9 to determine that the investors is “foreign.”

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Blame It On the Junior Compliance Associate

“The compliance associate had no trading experience and no formal training to conduct the review required by the rule, such as training related to the analysis of financial statements and other information.”

Rule 15c2-11 of the Exchange Act requires broker-dealers to obtain, review and maintain information about the issuer before initiating or resuming the publication or submission of a quotation for an OTC and non-exchange listed security. The broker-dealer must have a reasonable basis for believing that the information it has obtained is accurate and reliable. FINRA Rule 6432 requires a broker-dealer to demonstrate compliance with Rule 15c2-11 by filing the Form 211, reviewed and signed by a principal of the firm.

Canaccord Genuity LLC had written policies and procedures that said the right things about complying with those rules.

In practice, it failed to follow its written policies and procedures and violated the rules, according to the SEC order.

Canaccord put one of its compliance associates in charge of the process and have the associate the responsibility to obtain and review the information required by Rule 15c2- 11. The associate fill out the Form 211s and placed the electronic signature of the designated principal on the filings. The Rule 15c2-11 files were stuck in a compliance filing cabinet and could not be independently accessed by the traders or the firm’s designated principal without requesting them from the compliance department.

Of course, this case caught my attention because the headlines implicated compliance as part of the problem. The SEC order did not impose a separate penalty on the compliance associate. The associate, as you read in the opening paragraph, was not qualified to conduct the review.

The unanswered question is whether the compliance associate knew the policy and knew that he or she was violating the policy?

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Compliance Bricks and Mortar for August 16

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

Woodstock 50th and Succession Planning in Compliance
by Tom Fox
FCPA Compliance & Ethics

The Woodstock music festival informs today’s topic of succession planning from the compliance perspective and is another area where compliance can play a key role. A.G. Lafley and Noel M. Tichy, in a 2011 Harvard Business Review (HBR)article,“The Art and Science of Finding the Right CEO”, discussed the issue of succession planning at Procter & Gamble (P&G). Many of the concepts and issues that Lafley discusses within the context of succession planning in general are applicable to the concern of compliance within this area.

http://fcpacompliancereport.com/2019/08/woodstock-50th-succession-planning-compliance/

Do Fiduciary Duties Matter?
By A. Joseph Warburton
The CLS Blue Sky Blog

I analyze fiduciary duties in a unique setting – the British mutual fund industry – where trusts and corporations exist within the same industry.  Prior to 1997, all British mutual funds had to be organized legally as trusts, and fund managers were subjected to a strict (trust) fiduciary standard.  In 1997, this regulatory restriction was changed.  Funds were permitted to organize as either trusts or corporations, and fund managers were subjected to the applicable fiduciary standard.  (In contrast, the U.S. applies a uniform fiduciary standard under the Investment Company Act of 1940 regardless of the fund’s organizational form).  Hence, the British fund industry offers a unique laboratory for empirical study of fiduciary standards.

http://clsbluesky.law.columbia.edu/2019/08/13/do-fiduciary-duties-matter/

Other Lessons in Verwaltung Case
By Matt Kelly
Radical Compliance

Don’t get me wrong; I’m all for any enforcement action that underlines the importance of heeding a compliance officer’s advice. But the misconduct in question happened 10 years ago, in a foreign country with a deep culture of bank secrecy. One can’t be too surprised that Verwaltung executives behaved the way they did at that time. 

That, to my thinking, is the better point to ponder here. Verwaltung is about the maturity of a corporate compliance function. Compliance officers can use the facts here to diagram an immature compliance function, and gain a better understanding of how mature your own organization’s approach to compliance truly is. 

http://www.radicalcompliance.com/2019/08/12/other-lessons-verwaltung-case/

SEC Stops Recidivist’s Fraud Before Investors Are Harmed

On August 13, 2019, the Securities and Exchange Commission (“SEC”) charged Antonio M. Bravata, of Ferndale, Michigan, a recidivist securities law violator and convicted felon, with securities fraud conducted while serving a sentence for an earlier investment fraud. Bravata was previously charged by the SEC, and later by criminal authorities, for his participation in a $50 million securities fraud conducted through BBC Equities, LLC. In 2013, Bravata was found guilty in a jury trial, sentenced to 5 years of incarceration, and ordered to pay restitution. In the SEC case, Bravata was found liable for securities fraud, enjoined from future violations, and ordered to pay disgorgement and penalties. [my emphasis]

https://www.sec.gov/litigation/litreleases/2019/lr24559.htm

SEC Targets a Venture Capital Fund Manager

Frost Management Company was what seems like a typical venture capital fund complex that had raised five private funds and invested the capital in a portfolio of start-up companies.  The SEC says it found undisclosed affiliate payments and brought a suit against Frost.

Frost was an “exempt reporting adviser” with a filing from 2017. It apparently failed to file to renew the filing.

Before jumping into the charges, the first item to note is that the anti-fraud provisions of the Investment Advisers Act apply to all advisers. It doesn’t matter if you’re registered, unregistered, or exempt reporting. Those undisclosed fees will get you in troubled regardless of the firm’s registration status.

Frost caused its portfolio companies to pay incubator fees and, in some instances, monitoring fees that were not properly disclosed to investors. The SEC claims that those fees impacted the performance of the portfolio companies. That poorer performance affected the investors in the Frost venture capital funds and therefore was fraudulent, deceptive or manipulative.

The SEC seems to be hedging its argument by also claiming that the fees charged were”excessive.” In some of the five funds there appears to be some instance of disclosure. The actual process for determining the fees did not match the disclosure.

Mr. Frost apparently lost an investor arbitration case at the end of 2018 and wound down its incubator.

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Compliance Officer Barred for Audit Failures

Regulatory actions against compliance officers catch my attention. I don’t think compliance should be the target unless compliance engaged in the wrongdoing. I saw the action against Joseph Storms, identified as a “compliance associate” and dove in.

Mr. Storms entered the securities industry as a compliance intern in 2005 with FINRA member firm Raymond James & Associates, Inc. I’m not sure what happened during the next ten years, but he is identified as being a compliance associate and was registered with Raymond James as a general securities representative and general securities principal from November 19, 2015 to March 24, 2017.

He was terminated and Raymond James filed the Form U5 in April 2017 reporting that it had discharged Storms for “improperly editing internal branch audit documents.” It took two years, but FINRA filed a complaint in January 2019.

During his time as a compliance associate, Storms’s primary responsibility was to audit branch offices and to perform any follow-up work that resulted from the audits. He would sent out online questionnaires and follow-up with the person depending on the answers.

An example given in the decision is an undisclosed outside business activity. If the response was yes, Storms had to find out more and make sure the firm approved it.

Apparently, that was too much work for Mr. Storms. He would dump the questionnaire responses into a spreadsheet and change the data. He changed 524 questions from 145 registered representatives for 60 branch audits. Instantly, he was caught up on his work.

Apparently his supervisor was not so easily fooled and questioned Mr. Storms about the altered data. I assume that lead to termination.

FINRA followed up with a possible disciplinary action. Apparently it was also too much work for him to respond to FINRA.

This all paints Mr. Storms in a bad light. He failed to even bother defending himself. I’m not sure there is a good defense.

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Compliance Bricks and Mortar for August 9

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

Board Members Should Take Note — Delaware Supreme Court Issues Important Decision on Caremark Compliance Standard
by Michael Volkov
Corruption, Crime & Compliance

The Delaware Supreme Court returned to this issue in a recent case – Marchand v. Barnhill et al, HERE, a case involving Blue Bell Creameries  and a listeria outbreak.  The facts, while compelling, involve a serious health and safety issue but nonetheless has significant implications for overall ethics and compliance functions. 
In 2015, Blue Bell, a large ice cream manufacturer, experienced a listeria outbreak, which caused the death of three individuals.  Blue Bell had to recall its products and shut down production.  Shortly after that, Blue Bell suffered a “liquidity crisis,” and the company was forced to secure financing that caused a fall in its stock price.  A stockholder brought a derivative suit alleging that the directors breached their fiduciary duty of loyalty under Caremark.  The trial court granted defendants’ motion to dismiss finding that plaintiffs did not plead any facts to support the claim that the board “utterly failed to adopt or implement any reporting and compliance systems.”

https://blog.volkovlaw.com/2019/08/board-members-should-take-note-delaware-supreme-court-issues-important-decision-on-caremark-compliance-standard/

Diversified Portfolios Do Not Reduce Competition
by Barbara Novick, BlackRock, Inc.
Harvard Law School Forum on Corporate Governance and Financial Regulation

Theories about the incentives of company executives due to common owners fail to consider the metrics by which the performance of executives is measured and the composition of pay packages, which is primarily in company stock. For example, according to their 2018 annual proxy filing, American Airlines’ CEO has had 100% of his direct compensation paid in the form of equity since 2015. Further, airline executives’ performance is measured by metrics such as pre-tax income, margin improvement, and stock price—all measures driven by own-company performance. 

https://corpgov.law.harvard.edu/2019/08/07/diversified-portfolios-do-not-reduce-competition/

Corzine Hedge Fund Firm Granted SEC Registration With Limits
by Limes Weiss
Bloomberg

The SEC order includes “trading parameters” that bar JDC-JSC from engaging in proprietary trading and require it to have a “reasonable basis” to expect that, under normal conditions, each of its funds could be “orderly liquidated” within five trading days. That could restrict Corzine to trading in only the most liquid of markets, such as those for currencies and large-cap stocks, said David Tawil, co-founder of Maglan Capital, a New York-based hedge fund.

https://www.bloomberg.com/news/articles/2019-08-06/corzine-s-hedge-fund-firm-granted-sec-registration-with-limits?

Final Volcker Rule Regulation Eases Hedge Fund and Private Equity Fund Restrictions
by Deborah J. Enea and Elizabeth R. Glowacki

The final rule also eased the Volcker Rule’s restrictions on affiliations between investment advisers and hedge funds or private equity funds. Investment advisers can have the same name or a variation of the same name as the hedge funds and private equity funds that they sponsor and in which they invest, subject to the following conditions: …

https://www.pepperlaw.com/publications/final-volcker-rule-regulation-eases-hedge-fund-and-private-equity-fund-restrictions-2019-08-01/

Chief compliance officer liability and the opioid epidemic
by Jaclyn Jaeger
Compliance Week

In a period of three months, two chief compliance officers have been charged for their individual roles in the opioid epidemic—a clear indication the Department of Justice continues to expand the scope of prosecutions to those who fail in their compliance responsibilities.

https://www.complianceweek.com/regulatory-enforcement/chief-compliance-officer-liability-and-the-opioid-epidemic/27512.article#.XUhsorrCtdg.twitter

Revenue Sharing Disclosure Problems

The SEC charged Commonwealth Equity Services, LLC (d/b/a Commonwealth Financial Network), a registered investment adviser and broker-dealer, with failing to disclose material conflicts of interest related to revenue sharing Commonwealth received for certain client investments. According to the SEC’s complaint, Commonwealth had a revenue sharing agreement with its clearing broker for trades in their accounts. Under the agreement, Commonwealth received a portion of the money that certain mutual fund companies paid to the clearing broker to be able to sell their funds through the clearing broker’s programs, if Commonwealth invested its clients’ assets in certain share classes of those funds.

Commonwealth has not agreed to settle the SEC’s charges. At this point we just have the SEC’s side of the case. I thought it would be useful to look at the charges to see what bothered the SEC.

The SEC’s complaint alleges that Commonwealth negligently breached its fiduciary duty to its clients because Commonwealth failed to tell its clients that there were (i) mutual fund share class investments that were less expensive to clients than some of the mutual fund share class investments that resulted in revenue sharing payments to Commonwealth, (ii) mutual fund investments that did not result in any revenue sharing payments to Commonwealth, and (iii) revenue sharing payments to Commonwealth under the clearing broker’s “transaction fee” program.

There is no inherent problem with revenue sharing as long as it properly disclosed. Using different share classes are okay as long as there disclosure and the reason for choosing the different classes. What savings you get from lower cost shares may be eaten up my more brokerage and custody costs.

The SEC alleges that Commonwealth’s advisory clients invested without a full understanding of the firm’s compensation motives and incentives. The complaint also alleges that Commonwealth violated Section 206(4) and rule 206(4)-7 because it failed to adopt and implement policies and procedures reasonably designed to ensure that Commonwealth identified and disclosed these conflicts of interest.

Here is the disclosure that the SEC didn’t like:

Additionally, NFS offers an NTF [no transaction fee] program composed of noload mutual funds. Participating mutual fund sponsors pay a fee to NFS to participate in this program, and a portion of this fee is shared with Commonwealth. None of these additional payments is paid to any advisors who sell these funds. NTF mutual funds maybe purchased within an investment advisory account at no charge to the client. Clients, however, should be aware that funds available through the NTF program may contain higher internal expenses than mutual funds that do not participate in the NTF program and could present a potential conflict of interest because Commonwealth may have an incentive to recommend those products or make investment decisions regarding investments that provide such compensation to Commonwealth.

The SEC didn’t like it because it used the world “may” indicating a potential instead of an actual conflict. I wish the SEC would get away from its hatred of “may” in disclosures.

Secondly, the SEC felt that the disclosure failed to point out that there were instances when lower fee funds were available but Commonwealth had an incentive to put investor into higher fee funds and would get revenue sharing.

The disclosures evolved and the arrangements got more complicated. The case will drag on. It’s far from a slam-dunk for the SEC. There does some seem to ways that Commonwealth’s disclosure could have been clearer.

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Compliance Bricks and Mortar – Pan Mass Challenge 2019 Edition

If you’re reading this on Friday morning, I’ll be on my bike riding from New York border to Sturbridge for the unofficial Day Zero ride of the Pan Mass Challenge. The official start is Saturday morning, when I’ll ride from Sturbridge to Bourne, and then from Bourne to Provincetown on Sunday. That will be almost 300 miles of bike riding, surrounded by thousands of other riders raising money to fight cancer.

Thanks to so many of you who read Compliance Building for your generous donations and kind words. I have my donor list and those kind words printed and tucked into the back pocket of my jersey. I’ll keep them with me over the three days of cycling I have to complete this weekend.

If you have not contributed, there is still plenty of time to make a donation to fight cancer. I love seeing donation messages pop up while I’m riding. Donate here: http://pmc.org/egifts/DC0176

As for compliance-related matters, here are some of the stories that recently caught my attention.

Let’s Ride, Walmart’s Compliance Chief (and Cyclist) Urges Company Employees
by Sue Reisinger 
Law.com

Daniel Trujillo, Walmart Inc.’s executive vice president and global chief ethics and compliance officer, is a triathlete who can often be seen riding his bike to work. Now Walmart is using Trujillo’s love for the sport by having him lead its new bike-to-work program.
…
He recently blogged about the program, noting that only a small group of employees, including several in-house counsel, now bike to the office in Bentonville, in northwest Arkansas. The company already supports a popular “bike-to-work Fridays” concept, and the goal of the new program is to have 10% of the home office workforce riding bikes to work by 2023.

https://www.law.com/corpcounsel/2019/07/30/lets-ride-walmarts-compliance-chief-and-cyclist-urges-company-employees/?slreturn=20190701073035

When Sanctions and Cybersecurity Collide
By Matt Kelly
Radical Compliance

Compliance professionals talk constantly these days about cybersecurity, third-party risk, and sanctions compliance. Now we have an example from the news that is one headache-inducing brew of all three — and also, I fear, a harbinger of compliance and risk challenges to come. 
The company in question is Hikvision, a Chinese maker of security cameras. Last year Congress passed the National Defense Authorization Act, which bans the use of Hikvision cameras by U.S. government agencies, for fear that the Chinese government might hack into the cameras to spy on American interests. 

http://www.radicalcompliance.com/2019/07/31/when-sanctions-cybersecurity-collide/

Disclosure and Notification Considerations When Managing a Crisis
by Cleary Gottlieb Steen & Hamilton LLP
NYU Law’s Compliance & Enforcement blog 

One of the first things a company should consider in a crisis is whether disclosure to authorities is mandatory.  Mandatory disclosure obligations vary widely across legal regimes and may be imposed by Congress, government regulators, self-regulatory bodies, or even stock exchanges.  For example, regulated entities may face immediate disclosure obligations to report violations of financial laws to FINRA (Rule 4530) or annual disclosure obligations to report misconduct to the CFTC in the entity’s chief compliance officer report (although earlier disclosure of a crisis may be advisable).  Often the relevant laws, rules, and regulations do not specify what information must be disclosed, injecting substantial discretion into what is otherwise a mandatory obligation.

https://wp.nyu.edu/compliance_enforcement/2019/07/31/disclosure-and-notification-considerations-when-managing-a-crisis/