Author: Doug Cornelius

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Social Media Pump and Dump is Not Illegal (?)

Pump and Dump schemes brought the fiduciary standard to light. In SEC v Capital Gains Research Bureau the US Supreme Court said a pump and dump scheme by an investment adviser violated its fiduciary duty.

More recently, the SEC published an investor alert about Social Media and Investment Fraud. There is a lot of different frauds in there, but one is

Fraudsters may use social media to conduct schemes including: 

Pump and dump schemes – pumping up the share price of a company’s stock by making false and misleading statements to create a buying frenzy, and then selling shares at the pumped up price. 

A little over a year ago, the US Attorney is the Southern District of Texas thought they had seen a fraudulent social media pump and dump and brought charges against eight social media finance influencers. Edward Constantinescu aka Constantin 38, of Montgomery; Perry “PJ” Matlock, 38, of The Woodlands; John Rybarczyk, 32, of Spring; Dan Knight, 23, of Houston; along with Gary Deel, 28, and Tom Cooperman, 34, both of Beverly Hills, California; Stefan Hrvatin, 35, of Miami, Florida; and Mitchell Hennessey, 23, of Hoboken, New Jersey were accused of “pumping” the prices of securities by posting false and misleading information, and concealing their intent to later “dump” their securities after the prices rose. It was lucrative. The US attorney claimed the eight had illegally made more than $114 million.

Last week a federal judge in Texas said this wasn’t illegal and dismissed the criminal charges against the eight. Matt Levine thinks it’s a “weird opinion.” I agree.

I think what the order is trying to get at is that the eight had no obligations to the companies it was pumping, no obligations to their follower on social media, and since they were nota regulated entity, had no obligation to the financial markets.

Assuming this holds up to appeal, if there is one, pump and dump by influencers is not illegal, as long as as they are outside the finance industry. Or hired by the finance industry.

An alternative take on social media influencers is the action by FINRA against M1 Finance for social media posts made by influencers on the firm’s behalf that were not fair or balanced, or contained exaggerated, unwarranted, promissory or misleading claims.

M1 Finance paid social media influencers to post content promoting the firm, and instructed the influencers to include a unique hyperlink to the firm’s website that potential new customers could use to open and fund an M1 Finance brokerage account. …

FINRA found that M1 violated FINRA Rule Rule 2210 (Communications with the Public) and Rule 2010 (Standards of Commercial Honor and Principles of Trade). In addition, M1 Finance did not review or approve the content in its influencers’ posts prior to use or retain those communications. M1 Finance also failed to have a reasonable system, including written procedures, for supervising the communications that the firm’s influencers made on its behalf. These were in violation of FINRA Rules 2210, 2010, 3110 (Supervision) and  4511 (General Requirements-Books and Records).

The firm got in trouble, but the social media influencers seem outside the reach of FINRA.

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SEC’s “Gag Rule” Survives Another Challenge

As part of the Wells Report in 1972, the Securities and Exchange Commission adopted its no-admit/no-deny policy. The SEC, in agreeing to settle a case, relinquishes the opportunity to present the case in court. The defendant relinquishes the right to defend the case in court, in the press, and in the eyes of the public.

The New Civil Liberties Alliance as part of its many attacks against administrative law has challenged the policy. It started in 2018 with a petition to amend the rule. Six years later, the SEC denied the petition on January 30, 2024.

The NCLA also took its legal attack to court, supporting an appeal by Christopher Novinger to get out from under this part of his settlement with the SEC. The Fifth Circuit denied his appeal this week on procedural ground. The decision is based deep on federal civil procedure and does not really get to the substance of the appeal. But the procedural hurdles may not allow an appeal.

The SEC complaint charged that Mr. Novinger fraudulently offered and sold life settlement interests by knowingly (or with severe recklessness):

  1. misrepresenting the purported safety and security of the investment;
  2. making false and misleading representations to prospective investors about his business experience ;
  3. failing to disclose to investors the sanctions imposed, and adverse actions taken, against them by multiple regulatory agencies;
  4. creating and using phony, meaningless titles for himself that were not actual, recognized designations in the financial industry – such as “licensed financial consultant,” “licensed financial strategist,” and “licensed consultant” – to create a false air of legitimacy; and
  5. providing investors with a net worth calculator that improperly inflated investors’ assets.

Mr. Novinger settled the case in 2016 and as part of the settlement was barred from association with an broker, dealer, investment adviser and was barred from participating in any penny stock offering. Of course, he agreed to not deny the charges against him.

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SEC Brings AI Washing Cases

Back in December, Chair Gensler gave a speech to an AI Summit and warned about companies overstating their use artificial intelligence tools. From there, you can see the SEC approaching the concerns as part of fundraising fraud and marketing fraud. Chair Gensler probably knew that the Securities and Exchange Commission was actively working on two enforcement cases that got announced this week.

  • “the first investment adviser to convert personal data into a renewable source of investable capital”
  • “uses machine learning to analyze the collective data shared by its members to make intelligent investment decisions”
  • “turns your data into an unfair investing advantage”
  • “put[s] collective data to work to make our artificial intelligence smarter so it can predict which companies and trends are about to make it big and invest in them before everyone else”
  • “expert AI driven forecasts”
  • “first regulated AI financial advisor”
  • “the models are outperforming IMF forecasts by 34%, and the platform keeps improving”

These are quotes from the marketing materials for Delphia (USA) Inc. or Global Predictions Inc.

Section (a)(2) of the Marketing Rule says that an advertisement may not:

(2) Include a material statement of fact that the adviser does not have a reasonable basis for believing it will be able to substantiate upon demand by the Commission;

When asked by SEC examiners to substantiate those claims.

They could not. These appear to be the first cases by the SEC against investment advisers for AI-washing. And two of the few cases under the Marketing Rule.

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    Private Funds Are Bigger Than Commercial Banks

    The annual Securities and Exchange Commission request for funding from Congress is not generally very interesting. For fiscal year 2025 its seeking $2.6 billion to support over 5,000 full-time equivalents. Some of the stats are interesting. This one caught my eye:

    Looking at the private funds area, in the last five years, the number of funds has increased 54 percent to approximately 56,000. The assets managed by private fund managers, now at $26 trillion in gross assets, surpasses the size of the entire U.S. commercial banking sector of approximately $23 trillion.

    Page 4

    Those 5,000 FTE cover a lot of firms:

    We oversee approximately 40,000 entities—including more than 13,000 registered funds, more than 15,400 investment advisers, more than 3,400 broker-dealers, 24 national securities exchanges, 103 alternative trading systems, 10 credit rating agencies, 33 self-regulatory organizations, and six active registered clearing agencies, among other external entities. In addition, the SEC oversees the Public Company Accounting Oversight Board (PCAOB), the Financial Industry Regulatory Authority (FINRA), the Municipal Securities Rulemaking Board (MSRB), the Securities Investor Protection Corporation (SIPC), and the Financial Accounting Standards Board (FASB).

    As for examinations of registered investment advisers, the SEC reached 2,362 this past year, expect to reach 2,282 this year and hopes to reach 2,324 in the following year. (See page 22) That’s assuming it gets the budget requested.

    Sources:

    The SEC Still Hates the Word “May”

    Disclosure of conflicts is a cornerstone is a cornerstone of the regulation of investment adviser. 3D/L Capital Management clearly came up short.

    3D/L entered into an arrangement with an ETF manager that would provide a revenue share to 3D/L they labeled an “onboarding fee.” The SEC complaint points out that the onboarding fee creates a conflict, by incentivizing 3D/L to allocate client money to those ETF funds. 3D/L failed to disclose the onboarding fee for two years.

    Then 3D/L revised its Form ADV Part 2. The SEC was not happy with the wording of the disclosure.

    The ETF Manager had paid an “onboarding fee to make ETFs available for inclusion in 3D/L’s composite portfolios.” While this disclosure exposed the existence of the fee, it further stated that “[t]his [p]rogram may create a potential conflict of interest.”

    (My emphasis)

    The SEC stated that this was inadequate because there was an actual conflict of interest.

    The SEC seemed happier when 3D/L revised its Form ADV to “onboarding fee . . . results in a conflict of interest.”

    Lawyers love the word “may”. (speaking as one) The SEC does not like the word “may.”

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    Corporate Transparency Act Hits a Snag

    On March 1, the US District Court in Northern Alabama ruled that the “Corporate Transparency Act is unconstitutional because it exceeds the Constitution’s limits on Congress’ power.” It’s not clear what effect this ruling is going to have on other parties and other jurisdictions.

    Congress passed the 2021 National Defense Authorization Act which included a bill called the Corporate Transparency Act (“CTA”). The CTA requires most entities incorporated under State law to disclose personal stakeholder information to the Treasury Department’s criminal enforcement arm.

    There are two dozen exemptions, mostly for entities that are otherwise regulated. Many private fund managers have been trying to figure out how the exemptions apply. There is still some uncertainty on these exemptions. For example, registered investment advisers are exempt and private funds listed on Form ADV are exempt. Subsidiaries can be exempt, but FinCEN Seems to want to keep that exemption very narrow.

    L. 6. Does a subsidiary whose ownership interests are partially controlled by an exempt entity qualify for the subsidiary exemption?

    No. If an exempt entity controls some but not all of the ownership interests of the subsidiary, the subsidiary does not qualify. To qualify, a subsidiary’s ownership interests must be fully, 100 percent owned or controlled by an exempt entity.

    A subsidiary whose ownership interests are controlled or wholly owned, directly or indirectly, by certain exempt entities is exempt from the BOI reporting requirements. In this context, control of ownership interests means that the exempt entity entirely controls all of the ownership interests in the reporting company, in the same way that an exempt entity must wholly own all of a subsidiary’s ownership interests for the exemption to apply.

    [Issued January 12, 2024] https://www.fincen.gov/boi-faqs#L_6

    Back to the case…

    The Government argued that it has three sources of constitutional authority for enactment of the CTA. First, the Government argues that Congress has the power to enact the CTA under its foreign affairs powers. The CTA comes from the government’s interest in curbing foreign money laundering and other bad foreign money influences. The second sources is the Commerce Clause authority. Because many entities engage in activities that qualify as or affect “commerce,” the act of corporate formation itself is enough to invoke Congress’ Commerce Clause powers. Third, the Government argued that the CTA is a necessary and proper exercise of Congress’ taxing power, because one purpose of the FinCEN database created by the CTA is to assist in efficient tax administration.

    The Court didn’t agree with any of these three arguments.

    So now what?

    Unless you are Isaac Winkles or the National Small Business Association, the court’s ruling does not apply to you. I suppose if you are in Alabama, you could argue that it might cover you. For the rest of us, who have created a new non-exempt entity in 2024, I think we still have to make that filing it 90 days.

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    Revisiting Managed Accounts

    SEC IA Rule 204A-1 requires all of an investment adviser’s access persons to report, and compliance to review, their personal securities transactions and holdings periodically. Section (3)(I) has an exception for

    (3) Exceptions from reporting requirements. Your code of ethics need not require an access person to submit:
    (i) Any report with respect to securities held in accounts over which the access person had no direct or indirect influence or control;

    Way back in 2015 the Division of Investment Management released Guidance 2015-03 about what it means for an access person to have no direct or indirect influence or control over the account for purposes of relying on the reporting exception.

    There are three themes that fail the exception:

    • suggesting purchases or sales of investments to the trustee or third-party discretionary manager;
    • directing purchases or sales of investments; or
    • consulting with the trustee or third-party discretionary manager as to the particular allocation of investments to be made in the account.

    Effectively, the SEC asks compliance to do some diligence on the account and the person running the account to make sure the access person is blocked from making investment decisions.

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    The One with the Divorce

    We’ve seen many insider trading cases involving friends, spouses, domestic partners, and dates. We can guess what the end result would be. I think the Tyler Loudon case is the first one that has taken us all the way to the end.

    Tyler and Mrs. Loudon lived in Houston. Mrs. Loudon worked as a mergers and acquisitions manager at BP p.l.c., the big energy company. As many couples did during the pandemic, they worked in home offices and in relatively close proximity to each other. Mrs. Loudon was working on BP’s acquisition of TravelCenters of America.

    Apparently, Mrs. Loudon shared some of the acquisition information with Tyler. Of course, she expected that he would not do something stupid with the information.

    He did. He did do something stupid.

    Tyler bought shares in TravelCenters. That alone of course is illegal. Then he took the stupidity to a higher level. He sold all of his other positions in his brokerage account and Roth IRA and put all of that money into purchasing TravelCenters shares. I’m sure that was flagged by his brokerage firm as suspicious activity.

    FINRA opened an investigation. Tyler confessed to his wife. Mrs. Loudon told her BP supervisor about he husband’s trading. BP fired Mrs. Loudon. Mrs. Loudon moved out of the marital home and filed for divorce.

    We generally assume that a violation of spousal secrets to do stupid insider trading is going to lead to relationship issues. This is the first SEC complaint I remember that has take us all the way to the end of the marriage.

    Besides divorce, Tyler is also facing up to five years in prison and a $250,000 fine with the Department of Justice and possible more in SEC fines. Of course, Tyler also had to forfeit all of the trading profits.

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    The One With Buzz

    If you can grab the trading symbol “BUZZ” you should be able to make some money with it. Right? A company that owns beehives? or sells honey? or sells honey products? Or social buzz? VanEck Associates wanted to ride the social media wave and created an ETF that would

    “Track the performance of the 75 large cap U.S. stocks which exhibit the highest degree of positive investor sentiment and bullish perception based on content aggregated from online sources including social media, news articles, blog posts and other alternative datasets.”

    The investment thesis is that “Investor sentiment has proven to be an important factor in stock performance”. Sure. Why not. The tracker is the BUZZ NextGen AI US Sentiment Leaders Index. That index targets the most mentioned stocks online, determines whether the mention is positive or negative and then takes the 75 large cap stocks that have the most positives.

    The initial proposal was that VanEck would license the BUZZ index for the ETF in exchange for 20% of the management fee it earned from the ETF. Then the BUZZ index provider decided to partner with an “Influencer” who would promote the ETF.

    The “Influencer” goes unnamed in the SEC complaint, but it was fairly easy to find out that it was Dave Portnoy, the founder of BarStool Sports and “bro-influencer-in-chief.”

    Before the launch of the ETF, a new agreement was struck with Mr. Portnoy getting a sliding scale of the ETF fees depending on how big the ETF grew in AUM. It would go up to 60% if the ETF reached $1.25 billion in AUM in 18 months.

    All of that seems fine, as long as its disclosed. That is where VanEck came up short according to the SEC order. VanEck didn’t fully disclose the terms of the license agreement with the Buzz index to the ETF board. Van Eck didn’t tell the ETF board about Mr. Portnoy involvement or the details about the planned fee structure of the fund.

    Under the Investment Company Act, the adviser needs to provide the board information about the advisory contract, including the following (see Form N-1A, Item 27(d)(6)(i))

    • “the extent to which economies of scale would be realized as the [f]und grows,”
    • “whether fee levels reflect these economies of scale for the benefit of [f]und investors.”
    • “the costs of the services to be provided and profits to be realized by the investment adviser and its affiliates from the relationship with the [f]und.”

    Under the Investment Advisers Act, VanEck was tagged with a failure to have adequate policies and procedures about furnishing the ETF board with accurate information reasonably necessary for the ETF board to evaluate the terms of the advisory contract, as well as material information related to a proposed ETF launch.

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