Author: Doug Cornelius

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

CCO Liability for Wholesale Failure

A few years ago, the SEC had expressed an unwillingness to prosecute CCOs, except in three extreme circumstances:

  1. Participating in the wrongdoing
  2. Hindering the SEC examination or investigation
  3. Wholesale failure

Some of the past actions imposing CCO liability have left me uncertain that these are the correct standards.

A COO liability case that I missed does a better job of showing a case of “Wholesale failure.”

Anthony LaPeruta was the CCO of Southwind Associates of NJ Inc. (d/b/a Villafranco Wealth Management). From the facts laid out in the enforcement order, he did a bad job as CCO. Bad enough to be considered “wholesale failure” leading to a bar from acting in a supervisory or compliance capacity at any SEC registered entity.

Southwind was subject to OCIE exams in 2003, 2006 and 2013. It was the last one that lead to the enforcement action.

Southwind had hired a consultant in 2011 to review the compliance program. Based on that review, the firm published a new compliance manual. The consulatant reported 59 action items that the firm had to fix. Southwind failed to timely implement the majority of the consultant’s action items.

Custody can be tough at the margins. Southwind’s failure was not at the margins. The firm failed to have the required surprise exam for the accounts that Southwind had custody. For the pooled investment vehicles that Southwind managed, the firm failed to distribute audited financial statement to comply with the Custody Rule. When it finally did, it chose an independent accountant that was not subject to regular inspection by the PCAOB and, therefore, was not qualified to perform audits for purposes of Rule 206(4)-2(b)(4).

Southwind failed to preserve required electronic communication. One attempt was to have its IT specialist send all sent and received client communication to a Gmail account. Even if this could have worked, the firm lost access to the account when the IT specialist left the firm. Some other information was on hard drives that ended up damaged.

Southwind failed to implement privacy safeguards to comply with Regulation S-P. Sending all that email to Gmail was considered putting the information at risk.

La Peruta never engaged in any annual review of Southwind’s written policies and procedures as required by the Compliance Rule.

All of these rules violations were identified by the compliance consultant and Southwind failed to fix the problems. LaPeruta as the CCO was the one who was responsible for these problems and failing to fix them.

I would agree that this was a “wholesale failure.” The SEC failed to use this language instead it said: “LaPeruta willfully aided and abetted and caused Southwind’s violations of Sections 204(a) and 206(4) of the Advisers Act and Rules 204-2(a)(7), 206(4)-2, and 206(4)-7 thereunder and Rule 30(a) of Regulation S-P, 17 C.F.R. § 248.30(a).”

I guess that means “willfully aiding and abetting and causing” a rules violation is a wholesale failure.

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Weekend Reading: Lake Success

Lake Success  will challenge you with an unlikable protagonist. Barry Cohen is an obscenely rich hedge fund manager who decides to leave his wife and autistic son to take a bus ride to reconnect with his college girlfriend. His travelling companion is a suitcase full of expensive watches.

My favorite passage from the book:

“Is it true that your chief compliance officer had no relevant experience in the financial industry? That his sole educational credential was a bachelor’s in Russian studies from Middlebury College? That you met him at a party thrown by your friend Joseph Moses Goldblatt at the Flashdancers Gentlemen’s Club?

Lake Success  uses Barry’s travels, failings and occasional successes to paint a portrait of America wrapped up in the Trump election.

I loved Gary Shteyngart’s writing. You should add Lake Success  to your To-Read List.

Compliance Bricks and Mortar for September 21

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

SEC Enforcement & Venue: A Question of Fairness by T. Gorman  in SECActions

ow is the time for the Commission to step-up and be a leader in the effort to instill a new fairness in the administrative enforcement process. That begins with a recognition that not every case can effectively be adjudicated in an administrative forum. Some cases, for example, may require extensive discovery by those charged; some cases may need the rigors of the rules of evidence; and some cases may be fact intensive, requiring a jury to hear the case. Others may require securities expertise from the trier of fact of the type possessed by ALJs. One size does not fit all. [More…]

Lawmakers urge SEC to retool Reg BI by Anne Sherry, J.D. in Jim Hamilton’s World of Securities Regulation

The ranking members of four House and Senate committees are leading a call for the SEC to revise Regulation Best Interest, asserting that the proposed rule does not quite satisfy the agency’s Congressional mandate and that it falls short of protecting investors. In the letter to SEC Chairman Jay Clayton, the lawmakers urge the SEC to amend the proposal before it is finalized, even if it means re-proposing the rulemaking. [More…]

Did Deregulation End the “Quiet Period” of Low-Risk Banking? by Paul G. Mahoney in the CLS Blue Sky Blog

But I remain convinced that I’m right on the big picture: It’s a Wonderful Life-style banking (taking demand deposits paying 0 percent and savings deposits paying 2.5 percent, making mortgage loans paying 5.5 percent, pocketing the difference and going home at 3:00) existed because it was a wonderful economy. It was inevitable that banking would become different, and riskier, once that environment changed. The details might have come out differently, but change and additional risk were unavoidable. [More…]

Cycling, Courtesy and the Compliance Profession by Tom Fox in FCPA Compliance & Ethics

Once upon a time I had a burgeoning cycling career. That ended when I was taken out by a Hummer on a training ride (Final score Hummer 1 – Tom 0). However, I still cycle regularly and enjoy watching the Tour de France and hearing about Doug Corneilus’s annual PanMass ride. I also still enjoy the occasional non-drug related cycling story. When you couple the above with a story from one of my favorite sportswriters, Jason Gay from the Wall Street Journal, you can see my interest when Gay’s piece yesterday was entitled “She Just Rode 184 MPH on a Bicycle. Really.” In my cycling career it was possible for me to reach up to 40 mph on flat ground and higher going down hills, although by that time I was usually too mortified to look at my odometer to see the speed I had achieved. Yet here was Denise Mueller-Korenek, a 47-year-old,who broke the all-time land speed record for bicycles, literally hitting 184 mph. [More…]

 

The One About Blackfish

The Securities and Exchange Commission brought an action against SeaWorld Entertainment Inc. and its former CEO. They agreed to pay more than $5 million to settle fraud charges for misleading investors about the impact the documentary film Blackfish had on the company’s reputation and business. SeaWorld’s former vice president of communications also agreed to settle a fraud charge for his role in misleading SeaWorld’s investors.

The Blackfish movie sharply criticized SeaWorld’s treatment of its featured attraction: orcas. These huge, smart marine mammals were the main attraction at SeaWorld and central to the SeaWorld’s marketing.

I went to the San Diego SeaWorld a decade ago because whales were one of my son’s favorite subjects. The orca show was his favorite part of the trip. (Other than the two-foot long dolphin plushie I was lured into buying at my son’s insistence.)

The problem is that SeaWorld ignored the effects of Blackfish in its shareholder reporting.

The movie caused significant media attention on orcas in captivity as the film became widely distributed in 2013. The SEC’s complaint alleges that from approximately December 2013 through August 2014, SeaWorld and former CEO James Atchison made untrue and misleading statements or omissions in SEC filings, earnings releases and calls, and other statements to the press regarding Blackfish’s impact on the company’s reputation and business.

On Aug. 13, 2014, SeaWorld finally acknowledged in shareholder communication that its declining attendance was partially caused by negative publicity, and SeaWorld’s stock price fell by 33%. The SEC charges that SeaWorld should have said something sooner.

“This case underscores the need for a company to provide investors with timely and accurate information that has an adverse impact on its business. SeaWorld described its reputation as one of its ‘most important assets,’ but it failed to evaluate and disclose the adverse impact Blackfish had on its business in a timely manner.” – Steven Peikin, Co-Director of the SEC Enforcement Division.

In August 2013, SeaWorld noticed a drop in attendance. SeaWorld denied there was a link between the movie and the drop in attendance.

In September 2013, SeaWorld conducted a reputation study and found that its reputation had fallen by 12.8% from the proper year. That study also showed that those who were aware of the Blackfish movie had 32% less favorable opinions. Things got worse and worse.

It seems clear that SeaWorld took too long to disclose the Blackfish effect. What’s missing is when SeaWorld should have stated the connection.

One piece of the complaint that rubs me the wrong way is the SEC’s continued war on the use of “may.”

SeaWorld filed an S-1 in March 2014. It said:

Our brands and our reputation are among our most important assets. Our
ability to attract and retain customers depends, in part, upon the external
perceptions of the Company, the quality of our theme parks and services and our
corporate and management integrity. . . . An accident or an injury at any of our
theme parks . . . that receives media attention, is the topic of a book, film,
documentary or is otherwise the subject of public discussions, may harm our
brands or reputation, cause a loss of consumer confidence in the Company,
reduce attendance at our theme parks and negatively impact our results of
operations.

The SEC complaint says: By couching the reputation and business impacts as hypothetical events that “may” occur, SeaWorld made untrue or misleading statements. I’m not sure that “will” is the right word to use there. But the SEC points out that SeaWorld knew that the movie was having a negative impact and should have clarified that “may.”

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Dangers of Buying Out Limited Partners

VSS Fund Management had a fund that was getting old. VS&A Communication Partners III was in its seventeenth year and still had two portfolio companies. Several limited partners wanted a liquidity option that would get them out of the fund.

Providing that liquidity option got the firm in trouble.

In accordance with the LP Agreement for the fund, VSS prepared to make a distribution in kind to the LPs. Lots of LPs hate getting distributions in-kind.

One of the firm’s principals, Jeffrey Stevenson, must have liked those two portfolio companies because he offered to buy the LP interests from LPs who preferred cash over the distribution. The LPs knew it was Stevenson and that he was a principal of the fund manager.

In both instances, the value was based on the latest year-end NAV. VSS sent a letter to LPs in April with both options.

By the time the elections were coming in, VSS was getting some preliminary first quarter financial information from the portfolio companies.

In Mid-May, VSS decided to change course, it was going to keep the fund going for those investors that wanted to stay in and the rest could take the Stevenson cash offer. That offer was still based on the year-end NAV. The information to the investors did not provide any of the preliminary financial information. More than 80% of the LPS accepted the cash offer.

Anytime the fund manager is buying out a limited partner, the transaction is fraught with peril. There is an inherent information asymmetry. The fund manager knows a lot more about the current fund valuation and the likelihood of future returns.

VSS’s and Stevenson’s failure to include this [preliminary first quarter financial] information in connection with the May 2015 Offer represented a material omission that caused statements in the May 15, 2015 letter to be misleading.

Section 206(3) of the Investment Advisers Act makes it unlawful for any investment adviser, directly or indirectly “acting as principal for his own account, knowingly to sell any security to or purchase any security from a client, …without disclosing to such client in writing before the completion of such transaction the capacity in which he is acting and obtaining the consent of the client to such transaction.”

VSS didn’t violate that provision. The SEC found that VSS violated section 206(4) for failing to state a material fact, making the May letter misleading.

The problem is that VSS was the arbiter of the NAV. The ownership in the portfolio companies is illiquid and hard to value. There is always going to be a concern that the fund manager is going to lowball the price to get the better deal.

According to one story, that preliminary information was incomplete and turned out to be incorrect.

VSS should have made some disclosure about the first quarter results. A principal transaction like this is a tough transaction and almost no level of disclosure is enough.

I think the action is tough on VSS. It gave its partners the option to stay in the fund with the uncertainty of what the results may be. The rest chose the liquidity option. They preferred cash in the hand now, instead of the uncertainty of future returns.

The SEC chose to ignore this and focus on somewhat incomplete disclosure.

ILPA is taking a look at issue and is working on guidance.

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SEC Reminds Us that Guidance Is Not Binding

The Trump Administration’s attack on regulations just made a sweep through the financial industry. The Securities and Exchange Commission, The Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, National Credit Union Administration, and Office of the Comptroller of the Currency all clarified that staff guidance is not a regulation.

SEC Chairman Clayton made it clear that the SEC’s “longstanding position is that all staff statements are nonbinding and create no enforceable legal rights or obligations of the Commission or other parties.” He makes it clear that to have the power of law, there needs to be a published rulemaking in the Federal Register, and adoption of a final rule which considers public comments on the proposal to be in accordance with the Administrative Procedure Act.

I think this cuts both ways. Some guidance creates an additional regulatory burden. But sometimes it clarifies the application of a rule to lessen the regulatory burden.

The banking regulators will focus on making sure that bank examiners will not criticize a supervised financial institution for a “violation” of supervisory guidance. That is clearly falling on the case of regulation by guidance. It does not address the opposite position where a party is complying with the guidance, but the regulators still bring an action.

The SEC enforcement tends to throw everything they don’t like under the vagaries of Section 206 as a fraudulent, deceptive or manipulative act. Take a look at tomorrow’s story for one of those.

I generally think of SEC guidance for investment advisers as a mixed bag. For me, it mostly helps reduce the regulatory burden. It certainly helps craft my thoughts about how to comply with the formal regulations, particularly where the regulation is unclear on a the particular application.

Certainly, there is grumbling about regulation by examination. I’m not sure if this statement from he Chairman will reach to that.

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Compliance Bricks and Mortar – Florence Edition

To all of you in the path of Hurricane Florence, I wish you the best in your battle against the winds and rain. If you need something to read, these are some of the compliance-related stories that recently caught my attention

Why Compliance Programs Fail—and How to Fix Them by Hui Chen and Eugene Soltes in the Harvard Business Review

The ubiquity of corporate misconduct is especially surprising given the staggering amount firms spend on compliance efforts—the training programs, hotlines, and other systems designed to prevent and detect violations of laws, regulations, and company policies. The average multinational spends several million dollars a year on compliance, while in highly regulated industries—like financial services and defense—the costs can be in the tens or even hundreds of millions. Still, all these assessments deeply underestimate the true costs of compliance, because training and other compliance activities consume thousands of valuable employee hours every year. [More…]

When You Anonymously Report on Trump by Matt Kelly in Radical Compliance

Like millions of other Americans, I read that anonymous opinion column in the New York Timeslast week, apparently written by some senior official in the Trump Administration quietly aghast at the nuttiness of President Trump — and I thought, “Wow, that guy is a cowardly jackass.”

….

How would a compliance officer handle an anonymous report like that?

After all, that’s the closest approximation to what this missive is. An employee is raising alarms about executive misconduct, and doing so anonymously. Compliance officers field reports like that all the time. So what layers could we peel back and examine here, to appreciate how our own whistleblower reporting systems might work better? [More…]

A Retrospective on the Demise of Long-Term Capital Management by Paul L. Lee

LTCM was the largest hedge fund operating in the United States and its brush with death provided a preview of some of the forces that would contribute to the near collapse of the U.S. financial system in September 2008. In August and September 1998, as in September 2008, market fears were all consuming. Secretary of the Treasury Robert Rubin was quoted at the time as saying that “the world is now experiencing its worst financial crisis in 50 years,” and Chairman of the Federal Reserve Board Alan Greenspan said that “he had never seen anything in his lifetime that compared to the terror of August 1998.” Ironically, the success of the U.S. authorities in minimizing the effects of the near collapse of LTCM and the effects of other market disruptions in the 1990s may have lulled the markets and the authorities themselves into a false sense of confidence in their ability to manage future crises.[More…]

How CEOs Reinvented the Dating Game Scandal in Stock Options by Edmund L. Andrews

In Dating Game 2.0, however, many top executives appear to be reaping the same kinds of windfalls with a new variant on the original scam. Instead of manipulating the dates of option grants to match a dip in the stock price, companies appear to be manipulating the stock price itself so that it’s low on the predetermined option date and higher right afterward. [More…]

 

Yes, A Cryptocurrency Can Be a Security

Earlier this week, a federal judge denied a claim that a cryptocurrency is not a security under the federal securities law. The judge didn’t say that it was a security. Instead, he ruled that a reasonable jury could conclude that the cryptocurrency is a security.

This ruling comes from the SEC enforcement action against RECoin, the first cryptocurrency backed by real estate. It wasn’t really. RECoin never hired a broker, lawyer, or developer to acquire the real estate investments advertised in the offering of RECOin.

Maksim Zaslavskiy, the principal behind RECoin, is not strongly arguing that there was not a problem with RECoin. At this point he’s arguing that it’s not a securities problem and the SEC should leave him alone.

The ruling is not surprising. The Securities and Exchange Commission has been saying for months in public announcements and enforcement actions that ICO tokens can be securities. (although the SEC did say that Bitcoin and Ether are no longer securities.)

This one federal court judge has agreed with the SEC on this, so one point to the SEC.

The judge jumped right into the Howey test and the definition of an “investment contract.” That is a “contract, transaction, or scheme whereby a person [1] invests his money [2] in a common enterprise and [3] is led to expect profits solely from the efforts of the promoter or third party.”

As for the first prong, Zaslavskiy argued that the parties did not invest money in RECoin. They merely transferred from one medium of currency to another. The judge notes that money does not necessarily mean cash, any exchange of value is enough.

In the second prong, giving out tokens instead of stock or bonds does not make it any less a common enterprise. The tokens were supposed to be pooled to invest in real estate.

The marketing materials serve up the third prong. They pitched the RECoin as an attractive investment opportunity which grows in value. There was no element of control given to the token holders.

Zaslavskiy argues that RECoin should be considered a currency, which falls outside the definition of a security.

“He also overlooks the fact that simply labeling an investment opportunity as “virtual currency” or “cryptocurrency” does not transform an investment contract—a security—into a currency.”

The judge found no basis behind the argument, because no real estate, coins, tokens or currency of any sort ever existed in the enterprise.

It’s slowly coming, but people will start going to jail for these fraudulent coin offerings.

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Browns Don’t Lose, But a Player Does

For the first time in 13 years, the Cleveland Brown did not lose on their NFL opening weekend. Being the Browns, they didn’t win either. They had to compete without the help of Mychal Kendricks. The now former linebacker was cut by the Browns after charges of insider trading.

The $1.2 million in insider trading profits cost Kendricks $3.5 million from his Browns contract. Plus he faces a significant civil penalty from the SEC, Plus, the US Attorney’s Office in Philadelphia decided to bring criminal charges which could result in jail time.

Why did Kendricks do this? In the complaint, the SEC published a text message from Kendricks to Damilare Sonoiki.

I’m at a messed up place as far as my money is concerned I have enough money to live and to support myself but not enough money to avoid taxes … I don’t have enough money to buy a business and get the tax breaks I need.

How did they do this? Sonoiki worked at investment bank. It’s unnamed in the complaint, but based on the transactions it looks like it was Goldman Sachs. Sonoiki met Kendricks at a party. Sonoiki got information on M&A deals from work and passed them on to Kendricks. Kendricks gave him football tickets and cash in exchange for the inside information.

How did they get caught? Kendricks opened a trading account, but tried to have Sonoiki make the trades directly.  The firm flagged the account for having a mismatched IP address. Then the trades were just options with big short-term gains. I’m sure the brokerage account flagged the account and alerted the SEC.

It’s a very brazen case of insider trading. The only question is why it took so long to get caught.

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