Author: Doug Cornelius

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

The One with the New Commuter Rail Station

Todd Hitt wanted to be big-time, but his lies have landed him in handcuffs. He claimed that the firm he founded, Kiddar Capital, had over $1.4 billion in assets under management, offices in Falls Church, Houston, Palm Springs, and London, and was put $6 million of the firm’s money into developing a Herndon, Virginia building adjacent to a future stop on the Silver Line of the D.C. Metro.

According to a complaint by the Securities and Exchange Commission and the Department of Justice, none of that was true.

Mr. Hitt solicited investors into the real estate deal, with Kiddar putting in $6 million, investors putting in $6 million and the rest of the capital from a $24 million bank loan. Mr. Hitt was good at the fundraising because he raised almost $10 million, some of that coming after the offering closed. The capital needs of the project were reduced by seller credits, requiring less than $9 million in equity after the bank loan. The complaints allege that Hitt transferred the extra cash for personal use or other projects and never put any of Kiddar’s own capital into the commuter rail station project.

The SEC is involved so this must mean securities fraud. It’s clearly a real estate transaction. One question is whether Kiddar Capital was selling interests in the real estate that could be considered securities.

According to the SEC complaint, the offering memorandum stated that it was “a private offering exempt from the registration requirements of the Securities Act of 1933.” The SEC also pleads that “investors relied entirely on, and expected profits solely from, the efforts of Defendants to manage their investments” in Class A membership interests in the real estate purchaser. That’s the brief description of the Howey test.

How did Mr. Hitt get caught?

According to the criminal action, two employees of Kiddar Capital contacted the FBI about Hitt, alleging that he was stealing investor funds or commingling investor funds. Each thought things were strange and had trouble tying together financial claims.

One of those whistleblowers tried to tried to reconcile the representation that Kiddar Capital had $1.4 billion in assets. That employee only came up with $27 million. The other employee tried to find the other Kiddar Capital offices and couldn’t.

For me, the key thing was the statement that Mr. Hitt was spending lavishly, but had liquidity trouble. The example in the criminal complaint is that Mr. Hitt employed a personal driver, but had trouble funding payroll at times. A sure way to lose employees is to not pay them.

It’s easier to be whistleblower and risk losing your job when your not getting paid anyhow.

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Weekend Reading: 2020 Commission Report on North Korean Nuclear Attacks Against the United States

Jeffrey Lewis’s first novel is speculative fiction with a terrifying title: 2020 Commission Report on North Korean Nuclear Attacks Against the United States. It’s attempting to give us hindsight about the future. Obviously, from the title, things go wrong. Very wrong.

Mr. Lewis is expert on the North Korean nuclear weapons program. He is the Director of the East Asia Nonproliferation Program at the James Martin Center for Nonproliferation Studies at the Middlebury Institute of International Studies at Monterey. His team has played an important role in revealing the extent of the North Korean nuclear program. He also puts together a suprisingly interesting and enjoyable (if slightly terrifying) podcast, the Arms Control Wonk, on disarmament, arms control and nonproliferation.

Mr. Lewis is well aware of North Korea’s arsenal and mindset of its crazy leader.

For the MAGA inclined, you will not like the portrayal of President Trump. He is not the cause of the attacks. His off-cuff statements are easily misunderstood by a paranoid regime. That leads North Korea to escalate through misunderstanding the actions and statements from the Trump administration.

Mr. Lewis shows us that many of steps that lead to his fictional war have been in place well before President Trump and his unorthodox approach.  The US has stationed bombers in Guam for over a decade and they practice sorties to the Korean peninsula on a regular basis. The “denuclearisation of the Korean peninsula” called for at the recent US North Korea summit was, in the view of North Korea, an agreement for the US to disarm.

US intelligence assessments have assumed that Kim Jong-un is a rational actor, and would never take the suicidal step to start a nuclear war. Mr. Lewis thinks that is wrong. His view is that faced with the threat of regime change, North Korea may see a nuclear strike as his best hope of survival. Even if it’s not, what is there to lose.

The 2020 Commission Report is an incredibly well written book and a page-turner. You know from the title what’s going to happen, but you can’t help watch the dominoes fall.

Compliance Bricks and Mortar for October 5

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

The Knowledge Transfer Equation by V. Mary Abraham

But how do we transfer knowledge effectively? The answer Davenport & Prusak offer may not be exactly what you were looking for:

“The short answer, and the best one, is: hire smart people and let them talk to one another.” [More…]

Regulatory Changes and the Cost of Capital for Banks by Anna Kovner, Peter Van Tassel, and Brandon Zborowski in Liberty Street Economics

Measuring the cost of capital requires a model because expected (as opposed to realized) stock returns are not observed empirically. In this blog post, we use the Capital Asset Pricing Model (CAPM) to estimate the cost of capital. The CAPM provides a benchmark estimate of expected stock returns from an equilibrium model that is often used by market participants. Our staff report provides additional cost of capital estimates from related multifactor models.  [More…]

How the S.E.C. Is Trying to Push Traditional Corporate Governance Upon Tesla by Peter J. Henning in DealBook

The S.E.C. may be doing the dirty work for Tesla’s directors by getting Mr. Musk to move the company toward a more traditional management structure so that he is not the focal point of its operations. Whether or not it succeeds, it will be worth watching. [More…]

N.Y. Appellate Court: Coverage Precluded for Disgorgement “Penalty” by Kevin LaCroix in the D&O Diary

In the latest development in nearly decade-long legal battle, a New York intermediate appellate court has held in light of the U.S. Supreme Court’s 2017 decision in Kokesh v. SEC that amounts Bear Stearns paid under an SEC disgorgement order represent a “penalty” for which coverage is precluded under the bank’s insurance policy. This ruling, which overturned a trial court order holding that the disgorgement amount was covered, represents a substantial reversal of fortune for the claimants in this long-running and high-profile insurance coverage dispute. While further proceedings in the case seem likely, the ruling nevertheless represents a setback for policyholders seeking to establish insurance coverage for disgorgement amounts. The intermediate appellate court’s September 20, 2018 opinion can be found here. [More…]

The Long and Short of It: Do Public and Private Firms Invest Differently? (.pdf) by Naomi Feldman, Laura Kawano, Elena Patel, Nirupama Rao, Michael Stevens, and Jesse Edgerton

Using data from U.S. corporate tax returns, which provide a sample representative of the universe of U.S. corporations, we investigate the differential investment propensities of public and private firms. Re-weighting the data to generate observationally comparable sets of public and private firms, we find robust evidence that public firms invest more overall, particularly in R&D. Exploiting within-firm variation in public status, we find that firms dedicate more of their investment to R&D following IPO, and reduce these investments upon going private. Our findings suggest that public stock markets facilitate greater investment, on average, particularly in risky, uncollateralized investments [More…]

Och-Ziff Case Teaches Another Costly Lesson About Hiding Bad News by Sue Reisinger in Corporate Counsel

Och-Ziff Capital Management Group, one of the world’s largest hedge funds, agreed Tuesday to pay nearly $29 million to settle a class action suit accusing the company of not disclosing a material fact—an African bribery investigation carried out by federal prosecutors from 2014 to 2016. [More…]

 

All You Wanted to Know About SEC Remedies

Steven Peikin, Co-Director of the SEC’s Division of Enforcement gave an encyclopedic description of the Remedies and Relief in SEC Enforcement Actions at PLI’s White Collar Crime symposium. The speech was meant to address the effectiveness of enforcement actions. He wanted to point out that the number of enforcement actions or the total amount of penalties are not good metrics for assessing the work of the enforcement division.

The speech looked at all of the remedies available and how they address the mission of the Securities and Exchange Commission.

Undertakings – Specifically target and attempt to address specific risks

He gave the example of Tesla and Elon Musk. The undertaking to control Musk’s corporate communication was to address the “the potential harm to investors caused by Musk’s communication practices and a lack of sufficient oversight and control of those communications.”

Bars and Suspensions – serve a critical prophylactic function

They preserve the integrity of the markets and protect investors by limiting the activity of known bad actors by removing them from the industry or preventing them from serving as officers or directors at public companies.

Penalties – serve as a deterrent

“Penalties are one of the primary enforcement tools we have to incentivize regulated entities to remain in compliance with the rules that protect investors.”

Disgorgement – Even where a defendant “cooperates and agrees to meaningful undertakings, it should not be entitled to keep its ill-gotten gains, which we are often in a position to restore to harmed investors.”

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If Your Clients Are Going to Lose Money Anyway, Why Not Just Steal It?

Say you run a trading platform and lots of your traders lose money. Why not just take their money for yourself instead of them losing it to the market?

For one, that’s stealing.

But apparently that didn’t stop Jeffrey Goldman, Naris Chamroonrat, Christopher Eikenberry, Ran Armon, Adam Plummer, and Yaniv Avnon from doing just that.  They set up Nonko Trading as a purported offshore proprietary trading firm. It was organized to cater to U.S.-based day-traders, but evading the U.S. Broker-Dealer registration and regulatory requirements.

The Nonko group interviewed traders first. They targeted traders that appeared inexperienced or unsophisticated. Instead of providing these traders with access to a live securities trading platform, the Nonko team provided them with training accounts that merely trading.  When these traders sent funds to Nonko to place securities trade orders, the orders were never actually sent to the markets. Instead, the Nonko team simply pocketed the traders’ money.

Their theory is that the traders won’t notice that you stole their money if they were going to lose it anyway. If you’ve see The Producers you know how this works. Your targets won’t know you’ve stolen you money if the targets thought they lost it.

If a trader stated to make money, they moved that trader from the simulation on the TRZ platform to the live NTRD version of the platform.

The Nonko crew apparently left a trail of messages pointing out their misdeeds”

the current frame work [sic] now with TRZ is that we interview the
traders first and make sure they are complete newbs before putting
them on TRZ, while at the same time, we have a close watch to see
which account is starting to make money, at any point in time they
start to show signs of profitablity [sic] we quickly switch them
over to a NTRD account (live)
with this new platform, we will use the same process but as we
expect to have smaller deposits and more new accounts, we will
have to figuire [sic] a more stricter way to flag “game” accounts,
we havent [sic] gotten that far yet

The Nonko Group lured day traders by offering high margin limits (20:1) and small commissions. They also put together written TRZ Guidelines on which traders should be selected for the fraudulent TRZ platform.

During the initial phases of the training accounts scheme, Goldman commented to Chamroonrat on Skype: “trz group down 3k…every trader down. How come part of me feels good and part of me feels bad?!?!??”

You feel bad, because you’re stealing their money.

In The Producers, the scheme goes awry when the production makes money. For Nanko, it went wrong when a newbie trader on the TRZ version called the underlying provider for technical help. The help desk was confused that the trader thought his simulation was real. Once the provider saw the problem it emailed all of the TRZ traders telling them it was just a simulation.

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When Your Model Doesn’t Work

Don’t sell it if it doesn’t work right.

That’s an easy lesson learned by Aegon USA, its CIO and Director of New Initiatives. Unfortunately, they were a subadvisor to Transamerica, who had to pay the biggest fine out of the bunch.

Transamerica offered, sold and managed quantitative-model-based mutual funds, variable life insurance investment portfolios, variable annuity investment portfolios and separately managed accounts, which were marketed as “managed using a proprietary quant model” and promised that these quantitative techniques were “emotionless,” “model driven” and “model-supported” and provided descriptions of how the quantitative models were to have operated.

Unfortunately, the models didn’t work as intended and Transamerica didn’t look at them close enough to confirm that the models worked and didn’t disclose the risks with the models.

Aegon had developed the models in 2010. The person who developed the model was an analyst who recently earned his MBA, had no experience in portfolio management, had no formal training in financial modeling, and no training in developing quantitative models for use in managing investment strategies. Aegon and Transamerica named a senior manager as the portfolio manager even though the analyst was the sole architect of the model. That analyst was so significant to the product that internal audit attribute “key person risk” to him.

To its credit, internal audit found that Aegon did not have a process in place to validate its models or conduct peer reviews. Unfortunately, this was after Aegon had launched ten versions of the product. A high level peer review found glaring errors. Those were fixed, but the models were not subject to formal validation until 2013.

During the summer of 2013, Aegon determined that its allocation models contained material errors. For example, Aegon found that the model contained “numerous errors in logic, methodology, and basic math” and concluded that these errors rendered it to “not be fit for purpose.”

In the end, they were pushing a product that didn’t work the way they said it would and oversold the experience behind the product.

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Elon Musk and the SEC Move Fast

On August 7, 2018, Elon Musk, the CEO of Tesla, tweeted to his 22 million Twitter followers that he could take Tesla private at $420 per share. There turned out to be little to no truth behind that public announcement. Regardless, Tesla’s stock price rose 6% on increased volume.

It took only a month and half for the SEC to bring its case against him. The SEC announced the filing of an enforcement action against Musk because:

Musk’s false and misleading public statements and omissions caused significant confusion and disruption in the market for Tesla’s stock and resulting harm to investors.

The SEC’s complaint alleges that Musk hadn’t discussed specific deal terms with any potential financing partners. He did have some discussions, but none about price.

“Taking care to provide truthful and accurate information is among a CEO’s most critical obligations.” – Stephanie Avakian, Co-Director of the SEC’s Enforcement Division.

It seems clear that Musk screwed up. It’s not clear that he did so for his own financial gain. If he had sold a bunch of stock right after the Tweet, it’s likely the Department of Justice would be involved and bringing criminal charges. The SEC complaint does ask for disgorgement and civil penalties. Elon has cash, so he can find the likely penalty in his couch cushions.

But the big claim for relief is to bar Musk from “acting as an officer or director of any issuer that has a class of securities registered pursuant to Section 12 of the Exchange Act or that is required to file reports pursuant to Section 15(d) of the Exchange Act.” That means no more CEO of Tesla.

There are few CEOs who are more closely identified with their companies that Musk and Tesla. We had Gates and Microsoft, and Jobs and Apple. I suppose Buffett and Berkshire-Hathaway are there.

I don’t know much about Tesla and don’t know if there is a bench of talent to fill in. The market doesn’t think so. The stock went down sharply after the charges were filed. It dropped 13% losing over $7 billion in shareholder value.

Just as quickly, Musk decided to settle with the SEC rather spend his time distracted by a lengthy battle. After all, there was no allegation of profit-making or conspiracy to manipulate. It was just a stupid off-the-cuff statement.  Rumor has it that Musk was close to settling last week, but pulled out and decided to fight. The market’s reaction over the weekend must have made him reconsider.

The SEC settled for Musk relinquishing his Chairman role, but he can stay on as CEO. The Chairman must be independent and the board must add two additional independent directors. That seems like some better corporate governance.

The SEC required a new committee of independent directors to put in place a additional controls and procedures to oversee Musk’s communications. On November 5, 2013, Tesla filed a Form 8-K disclosing that Musk’s Twitter account would be used to disseminate material information about the company.

To sum things up, the SEC imposed better governance on Tesla and pulled Musk’s Twitter privileges. That’s a good thing. The CEO should not have unfettered communication privileges with the public. You need accuracy and truth in corporate communication. Musk’s Twitter account was labeled as official corporate communication.

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Weekend Reading: Bad Blood

Add Bad Blood to the top of your to-read list.

Bad Blood tells the terrible story of Theranos and its founder, Elizabeth Holmes. She took the Silicon Valley habit of vaporware and “fake it ’til you make it” to medical devices. The Theranos machines were unreliable, if they worked at all. Bad software will mess with a company’s data. Bad medical devices could kill people.

To be a bit sympathetic to Ms. Holmes, it wasn’t all about the money. I’m sure she enjoyed the public admiration and accolades. The book doesn’t have her talking about rolling in piles of cash. Ms. Holmes was passionate about her vision of a revolution in health care to save lives and improve health outcomes. She was motivating the Theranos employees to go along with the bad acts to achieve the revolution.

She believed the entrenched blood testing laboratories, Quest Diagnostics and LabCorp, were out to stop her and stop the revolution. Doubts about the viability of Theranos’s products were perceived by Holmes as sabotage by the entrenched blood testing companies.

At some point she embraced the limelight and began believing her vision was working. Facts just got in the way. Success at the company was more likely if you told Ms. Holmes what she wanted to hear.

The company failed at corporate governance. Ms. Holmes had nearly all of the voting rights. There was no check on her power. The powerless board was full of statesman, not professional investors, corporate managers or medical experts. A Board of Directors with Henry Kissinger, former Secretary of State George Shultz, William Perry (former Secretary of Defense), , Sam Nunn (former U.S. Senator), and  James Mattis (General, USMC) is impressive. But they brought no expertise or guidance for a medical device start up.

Compliance Bricks and Mortar for September 28

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

Today’s compliance is more than due diligence and red flags by Alison Taylor in the FCPA Blog

Every year for the past decade, BSR has surveyed sustainability leaders at our global member companies on the State of Sustainable Business, in a collaboration with Globescan. To mark our 10th year and reflect the shifting global agenda, we have updated the list of corporate sustainability priorities we track: ethics/ integrity and diversity/ inclusion just appeared on our list for the first time. [More…]

Getting Seriously Public About Non-Compliant Expenses by Kristy Grant-Hart

Most fraud and anti-bribery enforcement actions which involve gifts and hospitality include lavish elements. Reports of managers stealing from the company to take luxury trips, buy themselves luxury gifts, or throw themselves lavish parties is the stuff of many articles and court cases. But the trend in companies is turning toward the punishment of smaller indiscretions, and the compliance profession should celebrate this shift. [More…]

How Tech Informs Compliance by Tom Fox

I asked [Thomas Sehested, co-founder and Chief Executive Officer of GAN Integrity Inc.] what a compliance professional might consider to focusing on initially from a tech standpoint. Interestingly, he noted that even with the wide range of company sizes and industry foci, “you want to look at what you do on a day to day basis and automate that so that you, as a compliance professional, can focus on what you’re good at and that’s making the strategic decisions about how your company should handle compliance. It should not be about chasing people down and making sure that they filled out their questionnaires and trainings.” [More…]

SEC Cybersecurity Requirements for Registered Investment Advisors (RIAs) By Pat Cleary

The post goes into excruciating detail as to what you need in order to roll out a fairly decent cybersecurity program that attempts to meet all SEC cybersecurity requirements. I do not recommend sitting down and reading this in one sitting. Take every section like a chapter and cross-reference it with your existing cybersecurity policy. If you don’t have a policy yet, go ahead and build out a cybersecurity manual, one section at a time, using this post and the NIST Framework as a guide. (If you are in a hurry, you can read this post first.) [More…]

Giving Cops The Finger Is Protected Speech, Says Another Federal Court by Tim Cushing

Another federal court has given its official approval of flipping the bird to cops. This isn’t to say it’s a wise idea, just a Constitutional one. Extending the middle finger is protected speech.  [More…]

Lower the Wealth Standard for Investing in Private Placements

With the reduction in the number of public companies and larger companies staying private, the Securities and Exchange Commission is once again talking about loosening the “accredited investor” standard.

Much of the concern about private placements is about risk. They seem to be universally labeled as the most risky of investments. The accredited investor definition is categorized as the class of individuals who do not need the ’33 Act protections in order to be able to make an informed investment decision and protect their own interests. They get past the red velvet rope and into the VIP room to buy securities through a private placement. That VIP room is full of fraudsters and high rollers. You get to decide who is who.

It’s not that the ’33 Act protections remove risk. There are plenty of people who have lost money in the stock markets. Prices can fluctuate wildly, fraud exists, the markets get manipulated and we are all being fleeced by high-speed traders.

It’s too easy to label private placements as risky. They cover a broad swath of investments with different levels of risk. Public companies may raise capital through a private placement because its quicker, easier and less expensive than through a public offering. Hedge funds are sold through private placements, but they can be anywhere on the risk spectrum. Of course there are start-ups and crowdfunded firms that are the most risky of investments. This would be true if the capital were raised through a public offering or a private offering.

The risk is incredibly varied for private placements. So labeling them as risky investments is an incorrect categorization.

In my view, it’s not the risk of loss that is the main problem with private placements.

The biggest risk is the loss of liquidity.

Whether the investment ends up being a bad one or a wildly successful one, the investor will have limited ability to access that gain or loss and limited ability to time the realization of that gain or loss.

With an investment in the public markets, the investor can sell at any time. With that investment in Pets.com, you have the chance to sell your stock and get some money back before it goes bankrupt.

The same is would not be true for Pets.com as a private company, like with one of today’s unicorns.  With a private placement, the investor will have a limited ability to sell.

The net worth prong of the accredited investor definition is key because it shows that the individual has other resources and is not reliant on the private placement. Excluding the primary residence was a good change for the definition. Someone who is house rich and cash poor is less likely to be able to deal with the liquidity problem.

Excluding retirement accounts is exactly the wrong thing to do with the net worth requirement. That money is already relatively illiquid. An investor can access it, but is subject to penalty. Retirement money is long term money that will not be subject to liquidity demands and can be invested over the long term.

The current income test is a useful measure of liquidity demands of an investor. A higher income indicates that the investor is more likely to be able to absorb the loss in liquidity from a private placement.

Another recommendation is that private placement investments be limited to a portion of income or net worth. That is better aligned with the liquidity risk. However, it would impossible to verify and incredibly intrusive to implement.

That comes back to the compliance aspect. The more complicated the method for determining whether an investor is an accredited investor that harder it is for a company to use private placements or to open them to individuals. Removing the primary residence from the net worth definition was a good idea to address the liquidity risk, but it makes the confirmation more difficult.

The failure to ensure that all investors in a private placement are accredited investors can lead to very bad results. Complicating the definition will lead to a reduction in the usefulness of this fundraising regime.

In his statement a few weeks ago, Chairman Clayton broadened his thoughts on private placement to not just the accredited investor standard, but the entire private placement regime. He lumped them all together in the “exempt offering framework.” He calls it an “elaborate patchwork.” I agree that a broad restructuring of non-public security sales should be implemented that makes it clear how companies can raise capital with a clear framework for protection and disclosure of risks to investors.

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