Author: Doug Cornelius

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

The One With the Fake Gatekeepers

If you’re going to commit financial fraud, you need to figure out a way not only to deceive your “investors” but also the gatekeepers involved in the process. Your auditor is going to ask questions and not issue financial statements if there is fraud. Your prime broker and custodian are going to ask questions. Hedonova found a way around this.

Lie about them. Say you are using Northern Trust as your custodian. Say you are using Deloitte as your auditor. But don’t actually engage them. At least that’s what the SEC claims in its complaint.

The pitch for investors is interesting. Be a part of group ownership of alternative investments: art, startups, wine, music royalties, real estate, agriculture holdings, litigation finance, etc. A fund full of alternative assets. Hedonova claims to be a “mutual fund.”

This sounds rife with problems to me. Valuations are challenging and sourcing opportunities is hard. Finding and retaining personnel is hard. Each of these alternative classes require their own expertise.

The SEC began poking around and found most of its claims about its gatekeepers were not true and had not been engaged by Hedonova.

The SEC has uncovered millions of dollars sent to Hedonova. It has not been able to identify it purchased much, if any, assets. The firm principals are oversees and, according to the SEC, are not cooperating.

As for the Hedonova website, it’s a buffet of items to stare at under the lens of the Marketing Rule. I might use it for my compliance class in the fall.

Hedonova also has used a bunch of fin-fluencers. I found a bunch of junky stories on blogs and social media platforms spewing out the virtues of Hedonova. (I’m not going to bother linking to them.)

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Supreme Court Limits SEC Internal Tribunals

“When the SEC seeks civil penalties against a defendant for securities fraud, the Seventh Amendment entitles the defendant to a jury trial.”

SEC v. Jarkesy

The case presented three issues:

(1) Whether statutory provisions that empower the Securities and Exchange Commission to initiate and adjudicate administrative enforcement proceedings seeking civil penalties violate the Seventh Amendment.
(2) Whether statutory provisions that authorize the SEC to choose to enforce the securities laws through an agency adjudication instead of filing a district court action violate the nondelegation doctrine.
(3) Whether Congress violated Article II by granting for-cause removal protection to administrative law judges in agencies whose heads enjoy for-cause removal protection.

The Supreme Court ruled on the first item and didn’t address the other two. Fights for another day.

Dodd-Frank granted the Securities and Exchange Commission broader rights to use its internal administrative law tribunals for non-registered parties. [Section 929P(a)]. Of course with the addition of private fund managers by Dodd-Frank, the world of non-registered parties got smaller.

Mr. Jarkesy and his Patriot28 fund were investigated by the SEC for inflating the fund values and lying about its service providers prior to Dodd-Frank. It decided to charge them using the in-house tribunal by using its new authority under Dodd-Frank. Mr. Jarksey lost the decision in 2014 and has been fighting ever since.

The Supreme Court decision looks at the Public Rights Exception to Article III jurisdiction. This exception allows some matters to go through administrative law proceedings and don’t require Article III proceedings. The Supreme Court essentially determines that civil penalties are designed to punish and deter and not compensate. Therefore, a case seeking civil penalties can’t go through the in-house tribunal.

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Quishing Attacks

This is a new term to me.

Quishing:

a business email compromise (BEC) attack that uses QR codes in embedded PDF documents to redirect victims to phishing URLs.

 There is a Phishing-as-a-Service (PhaaS) platform called ONNX Store, which apparently has a user-friendly interface to enable the orchestration of phishing attacks. Good to know there are services making it easy to launch cyber attacks.

This new approach uses QR codes embedded in PDF documents to direct victims to the bad URL. I think we are all getting better at spotting bad links and avoiding them. QR codes input the URL without you getting a good look at it. At interesting vulnerability. Plus you are likely using a mobile device to scan the QR code and redirect to the website. Most mobile devices are personal don’t have the robust enterprise protections of the office device.

This new Quishing Attack takes you to a face Microsoft 365 login page and has some hacks to get around two-factor authentication.

The Quishing attacks were first targeted at financial institutions. This must have included broker-dealers because FINRA published an alert.

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The One With Performance an Acre Apart from Reality

Reviewing the actions filed against other fund managers by the Securities and Exchange Commission helps me see what the SEC thinks are bad actions. When I started reading the case against Twenty Acre Capital I was hoping to gain some insight into the Marketing Rule.

Twenty Acre is a registered investment adviser and advises a private fund. Twenty Acre presented performance returns, as one does, in the marketing materials for the fund. The Marketing Rule applies. [Advisers Act Rule 206(4)-1 Release No. IA-5653 (Dec. 22, 2020) (effective May 4, 2021)]

The Marketing Rule prohibits and adviser from publishing an advertisement that would

“(1) Include any untrue statement of a material fact, or omit to state a material fact necessary in order to make the statement made, in the light of the circumstances under which it was made, not misleading; … or Include or exclude performance results, or present performance time periods, in a manner that is not fair and balanced.”

See Advisers Act Rule 206(4)-1(a)

Twenty Acre published “performance returns that were experienced by a single limited partner that had invested in the Fund at inception and was eligible for all Fund investments.” That sounded like this might be an insightful look at performance advertising. This one investor’s performance differed from the Fund’s overall performance because some IPO investments the Fund had made were credited to the investor’s capital account in greater proportion than other investors’ capital accounts. The investors that didn’t get the IPO investments were restricted by FINRA Rules 5130 and 5131.

Twenty Acre didn’t note that the performance presented was just for the one investor and not the fund as a whole. Of course, that seems like a mistake. But an enforcement action seemed like a lot for failing to footnote.

Then I read the difference and spit coffee all over my computer screen. The one investor achieved a 44.8% net performance in 2021. [Fantastic return!] Comparatively, the fund as a whole achieved a -5.7% return. [That is not fantastic.]

Okay, so that was more than not including a footnote. That’s a $100,000 fine.

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Private Funds Rule is Vacated

We consider a challenge to the Final Rule by petitioners National Association of Private Fund Managers, Alternative Investment Management Association, Ltd., American Investment Council, Loan Syndications and Trading Association, Managed Funds Association, and the National Venture Capital Association collectively “Private Fund Managers”). For the following reasons, we VACATE the Final Rule.

The central focus is thus on whether the Dodd-Frank Act expanded the Commission’s rulemaking authority to cover private fund advisers and investors under section 211(h) of the Advisers Act, see Part III.B.1., and whether section 206(4) authorizes the Commission to adopt the Final Rule, see Part III.B.2. We hold neither section grants the Commission such authority

page 17

The Court found that the language in Section 211(h) applies to retail customers and therefore the SEC exceeded its authority. It looks at Section 913 of Dodd-Frank and points out that it applies to the defined term “retail customers.” Section 211(h) was enacted under Section 913. Therefore, rules under 211(h) should only be for the protection of retail investors. Private fund investors are not “retail customers.”

As for enacting the Private Fund Rules under the anti-fraud provisions of Section 206, the Fifth Circuit found the SEC conflated “lack of disclosure” with fraud or deception.

The Fifth Circuit found the remedy to be vacating the entire Private Funds Rule.

I assume the SEC will appeal the decision to the Supreme Court. The reasoning of the Fifth Circuit is strong enough that it risks invalidated other SEC rules if left standing. I’m hoping that the SEC will formally announce the delay of the compliance deadlines under the Private Fund Rules. It looks like it is pencils down on these new requirements.

23-60471_Documents-SEC-Private-FUnds-CaseDownload

Goodbye Salt Lake City


“The Securities and Exchange Commission today announced that it will close its Salt Lake Regional Office (SLRO) later this year, reducing its regional footprint from 11 regional offices to 10.”

The SEC’s Salt Lake City office has always stood out for covering such a small area. According to the press release, it has been the SEC’s smallest regional office. It has not housed examination teams for many years.

The One with the Self-Reporting, Spying Spouse

We’ve seen a few cases of trading on material, non-public information sprouting from spouses working at home. We just got another one, with a twist.

Most recently, we had the case of a BP manager having her spouse spy on the merger activity she was working on for her company. That husband is tied up with criminal charges and a divorce. [The One with the Divorce]

In today’s case, Ms. Perez de Madrid checked out her husband’s computer screen while he was out of the room. He was a lawyer for an international, research-focused biopharmaceuticals private company in connection with its acquisition of global, commercial-stage biopharmaceutical company with ADS shares listed on NASDAQ. She promptly bought shares in the acquisition target. A few weeks later the value of the shares doubled when the acquisition was announced.

What to do with a $300 thousand windfall? Rather than go on a secret spending spree she told her husband. Since he was a lawyer, I assume he immediately knew there was a problem. He knew she could face jail time.

They kept the money in the account and reported the illegal activity to the Securities and Exchange Commission. Clearly, the SEC likes problems to be self-reported. The penalty was only disgorgement of the gains and a small interest payment. No jail time. No penalty.

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The One with the Bad Films

Film production is risky. There is need for capital to make the films and there are investors who want to say they helped fund a film. Christopher Conover had clients and investors who wanted to make those investments.

Mr. Conover disclosed that he “receives fees related to Mr. Conover’s role as an Executive Producer for film and television productions” and “a conflict of interest exists to the extent Hudson has an incentive to recommend investments in films and television productions for which Mr. Conover serves as Executive Producer.”

For two years, Hudson failed to disclose the producer compensation in its Form ADV. When it did update the disclosure is failed to disclose that the compensation was based solely on the amounts of money loaned to the Production Company for these films. The SEC felt the disclosure was inadequate.

The real problem is that the investments went bad. Mr. Conover made the mistake of allowing one investor to redeem and take money out while preventing other investors from doing so. According to the fund documents, partners who wanted to redeem their interest had to give at least 90 days’ notice and were capped at a withdrawal of 50% on a quarterly basis. Hudson and Mr. Conover deviated from their practice of satisfying limited partner redemptions on a pro rata basis when it lacked liquidity and redeemed a single investor in full ahead of other simultaneously submitted redemption requests from other investors. That special treatment was a violation of Mr. Conover’s fiduciary duty in the eyes of the SEC.

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Compliance Bricks and Mortar for May 17

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

The Board Member’s Oversight of AI Risk – Moving from Middle to Modern English

By Sean Dowd, Rich Kando, and Chris Crovatto, AlixPartners LLP
Harvard Law School Forum on Corporate Governance

Risk assessments take on many forms, but there are three critical components of a risk assessment that, when consistently applied, help to compartmentalize a company’s often highly complex risk environment and measure progress. A risk assessment requires (1) the identification of the inherent risks present within a company’s operations, in this case a company’s GenAI program and its use case, (2) the effectiveness of a company’s existing safeguards in addressing those inherent risks, and (3) the remaining residual risks after the application of those safeguards.

PCAOB Adopts New Quality Control and Auditor Responsibility Standards

by David Lynn
The Corporate Counsel .net

On Monday, the PCAOB adopted two new standards. First, the PCAOB adopted a new audit quality control standard, replacing the existing AICPA standard that pre-dated the creation of the PCAOB. The new standard requires all PCAOB registered firms to identify their specific risks and design a quality control system that includes policies and procedures to address those risks. 

How Bank Regulation and Supervision Can Weaken Financial Stability

By Hamid Mehran and Chester Spatt
The CLS Blue Sky Blog

We argue that bank regulation and supervision interfere with pricing risk by creating opacity. Given that market disclosures enhance the efforts of supervisors, and vice versa, more disclosure could enhance financial stability (see Spatt, 2010)[1]. In addition, we believe that disclosure would provide information on the competence and performance of regulators and supervisors (reducing adverse selection about regulators) and increase their incentives (reducing moral hazard). This would make capital markets more effective in addressing future banking problems and reducing reliance on bank regulators who have arguably failed the public. We question the value of withholding vast amounts of banks’ privileged information and argue that, although this unique regulatory practice has a long history, it is not ethical in the context of fair treatment of investors in public entities. Indeed, firms are required under the securities laws to disclose material nonpublic information, at least when they raise capital.

CFPB Survives Another Attack

Consumer Financial Protection Bureau v. Community Financial Services Association of America, Limited __ US ___ (2023)

The Bureau’s funding statute satisfies the requirements of the Appropriations Clause. The statute authorizes the Bureau to draw public funds from a particular source—“the combined earnings of the Federal Reserve System”— in an amount not exceeding an inflationadjusted cap. 12 U. S. C. §§5497(a)(1), (2)(A)–(B). And, it specifies the objects for which the Bureau can use those funds—to “pay the expenses of the Bureau in carrying out its duties and responsibilities.” §5497(c)(1). The Bureau’s funding mechanism also fits comfortably within the historical appropriations practice described above. P. 15– 16.

Investment Adviser Statistics

The Securities and Exchange Commission published its 2024 report on Form ADV data for investment advisers.

The number of advisers and total assets have increased dramatically.

From 2012 when Dodd-Frank implemented a change requiring fund managers to register the number of registered investment advisers and Exempt Reporting advisers has increased by 60% from 13,222 to 21,203. The Regulatory assets under management has increased 138% from $55 trillion to $128.8 trillion.

The number of private funds has tripled from 33 thousand to over 100 thousand, with gross assets also tripling from $9 trillion to $27 trillion.

For real estate funds, there 658 registered advisers with over $1.1 trillion in gross assets for the 5,215 real estate funds. Those are increases from 371 advisers, $0.3 trillion in gross assets in 1,827 funds in 2012.

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