Author: Doug Cornelius

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Anti-Money Laundering Rule for Investment Advisers – Take 3

We’ve been here before. FinCEN proposed anti-money laundering rules for investment advisers in 2003 and 2015. The pushback has been the Custody Rule, which requires a third-party to hold the client assets. That third-party will be doing the AML-KYC review. Those that are doing self-custody fall under existing AML rules.

Since 2015, there has been expansion in the weaponization of the dollar against persons and countries that the United States has issues with. The current hot button being Russian wealth. So, I think the rule is going to end up being promulgated this time.

It’s a lighter version of the rule that would require registered investment advisers and exempt reporting advisers to:

  • implement an AML/CFT program;
  • file certain reports, such as Suspicious Activity Reports, with FinCEN;
  • keep records such as those relating to the transmittal of funds (i.e., comply with the Recordkeeping and Travel Rule); and
  • fulfill other obligations applicable to financial institutions subject to the BSA and FinCEN’s implementing regulations.

It would not require customer identification program requirements. At this time. That requirement is specifically called out for a future joint rulemaking with the SEC.

The rule also proposes to delegate examination authority to the SEC.

The proposal has a 60-day comment period and a 12-month compliance deadline. No need to act currently. I think we’ll need to pencil it in for workplans in the second half of 2024.

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Reviewing the Accredited Investor Definition


The Securities and Exchange Commission issued a Staff Review of the “Accredited Investor” Definition at the end of 2023. The Dodd-Frank Wall Street Reform and Consumer Protection Act directs the SEC to review the accredited investor definition every four years.  The Staff previously reviewed the definition in 2015 and in 2019 (as part of the Concept Release on Harmonization of Securities Offering Exemptions).

There were several changes in 2020 to the definition of “accredited investor” as a result of the 2019 report. The SEC allowed those meeting the “knowledgeable employee” standard to meet the “qualified purchaser” standard would also be deemed an “accredited investor.” The SEC added a qualification-based standard, initially allowed holders in good standing of the Series 7, Series 65, and Series 82 licenses as accredited investors. And lastly, the SEC added the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors. There were a few other tweaks to the definition.

But the financial thresholds remained unchanged. I think that is likely to change this year. On the Fall 2023 RegFlex Agenda the SEC listed Regulation D and Form D Improvements (3235-AN04) letting us know that the SEC is thinking about “amendments to Regulation D, including updates to the accredited investor definition, and Form D to improve protections for investors.”

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SEC Proposes Updated Definition to Help Three Funds

The press release for changes to “qualifying venture capital fund” caught my attention. I didn’t recall that definition, so I took a closer look. It’s in Section 3(c)(1) of the Investment Company Act, which makes it part of the “private fund” definition.

Section 504 of the Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018 (“EGRRCPA”) amended section 3(c)(1) of the Investment Company Act by adding “qualifying venture capital funds” into the exemptions from the investment company definition. Other companies can only have 100 people. Qualifying venture capital funds can have up to 250 people. EGRRCPA created the new definition of “qualifying venture capital fund” as:

“a venture capital fund that has not more than $10,000,000 in aggregate capital contributions and uncalled committed capital.”

That seems like an really small fund and I would think that a change to the definition if it added an extra zero would be very meaningful. Then I read that the SEC was only proposing to increase the amount from $10 million to $12 million.

Why bother? The statutory definition in EGRRCPA requires this $10,000,000 threshold “be indexed for inflation once every 5 years by the SEC. Here it is five years later.

I rarely read the economic analysis of a proposed rule, but I was really interested in the impact.

Based on the Form ADV filings there are at least 23,759 venture capital funds. Of those, there are 14,822 qualifying venture capital funds. Of those, 653 have more than 100 beneficial owners.

Ultimately, the SEC estimates that there are three (3!) venture capital funds that are not currently excluded from registration under section 3(c)(1) but that could be defined as a qualifying venture capital fund if the threshold were adjusted for inflation to $12,000,000 as proposed.

I was floored to read how many small venture capital fund are out there. I was not surprised that the rule only helped a handful of funds.

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New Marketing Rule FAQ

The Division of Examinations has been taking a close look at investment adviser marketing since the Marketing Rule rule compliance deadline last fall. We’re getting dribbles of updates as a result of those exams, with the SEC just starting to point out things it hasn’t liked in exams.

The first was extracted performance from a private fund in January 2023.

“[A]n adviser may not show gross performance of one investment or a group of investments without also showing the net performance of that single investment or group of investments, respectively.”

The latest FAQ focuses on the calculation of net and gross performance.

Q: Must gross and net performance shown in an advertisement always be calculated using the same methodology and over the same time period?

Yes, is the answer. The extra point made in the answer is taking into account the use of a subscription credit facility when calculating returns. If you exclude the use of the facility in one calculation you have to exclude it in the other calculation. And vice versa.

The FAQ goes on to make another point about calculating new IRR when a fund uses a credit facility.

“[A]n adviser would violate the general prohibitions (e.g., Rule 206(4)-1(a)(1) and Rule 206(4)-1(a)(6)) if it showed only Net IRR that includes the impact of fund-level subscription facilities without including either (i) comparable performance (e.g., Net IRR without the impact of fund-level subscription facilities) or (ii) appropriate disclosures describing the impact of such subscription facilities on the net performance shown.”

The new Private Fund Quarterly Reporting Rule also requires calculation of returns with and without the use of the credit facility. (Assuming the rule is not vacated by the courts after the recent hearing.) Add in this FAQ and I see the SEC having a very negative view on private fund’s use of credit facilities.

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SEC Begrudgingly Approves Bitcoin ETP

We all saw this train coming down the tracks. Even the hacker who took over the SEC’s Twitter account announcing the approval, merely jumped the gun. The Securities and Exchange Commission, by a 3-2 vote, authorized a dozen spot Bitcoin exchange traded products.

Gary Gensler’s SEC has been trying stem the tide and prevent crypto from becoming more legitimate by denying any form of SEC authorization. Last year’s loss in the Grayscale’s court case was the break that could not be plugged. In the original Grayscale Order, the SEC determined that the proposal had not established that the CME bitcoin futures market was a market of significant size related to spot bitcoin, or that the “other means” asserted were sufficient to satisfy the statutory standard. The U.S. Court of Appeals for the D.C. Circuit held that the SEC failed to adequately explain its reasoning. The court vacated the Grayscale Order and remanded the matter to the SEC. “Because we don’t like it” is not a sufficient reason.

That didn’t stop Chair Gensler from slapping crypto.

“While we approved the listing and trading of certain spot bitcoin ETP shares today, we did not approve or endorse bitcoin. Investors should remain cautious about the myriad risks associated with bitcoin and products whose value is tied to crypto.”

He points out that “the vast majority of crypto assets are investment contracts and thus subject to the federal securities laws.”

Commissioner Peirce countered:

“[O]ur actions here have muddied people’s understanding of what the SEC’s role is. Congress did not authorize us to tell people whether a particular investment is right for them, but we have abused administrative procedures to withhold investments that we do not like from the public.”

The SEC has allowed crypto to take step towards more credibility, liquidity and lower costs.

Personally, I don’t see ordinary people using crypto. They just trade it. I appreciate the blockchain infrastructure and potential innovation to move money cheaply. Criminals love it. It’s an easy way to move money around anonymously.

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Is a Cow a Security?

If the investment is a “security”, you have to comply with the Securities and Exchange Commission regulations. The seminal case is Howey, where a sponsor was selling interests in an orange grove in Florida. The sponsor was not just selling the small land parcels with orange trees on them, but also his management, harvesting and sale of the oranges. It’s more like buying shares in Tropicana, so the investment scheme was considered an “investment contract” that fell within the definition of a security.

The SEC just filed a case against Agridime. The company allowed you to make money raising cattle. Seems like an interesting idea, support farmers and make money. Maybe you even get some meat from your own cow as part of the profit? (Not sure if that was a feature.) Of course, raising cattle takes a lot of work so why not have Agrdime do the work for you.

Investors never get delivery of the cattle and investors relied on Agridime to do all the work. That sounds a lot like the orange groves in Howey. If so, that makes the cattle contract a security and triggers the many securities regulations.

One of those regulations is that you can’t engage in the general solicitation of investors. Agridime advertised its cattle contracts on its own public website and on Facebook. Those are clear violations of the securities laws.

Agridime offered a guaranteed 15-20% yearly profits. “We know it sounds too good to be true.”  

Yes, it was too good to be true according to the SEC. In the SEC complaint, the SEC alleges that the business was not profitable enough to pay those “guaranteed” returns. Agridime started using new investor money to pay returns to existing investors, instead of using the money on new cattle. It became a Ponzi scheme.

Before the SEC stepped in, North Dakota and Arizona had brought cases against Agridime to stop selling unregistered securities in their states. At least in Arizona, Agridime is taking the position that is a “registered and bonded livestock broker and marketing agency” under jurisdiction of the United States Department of Agriculture.

Now I’m scratching my head and wondering if the USDA has jurisdiction on cattle capital. Sure enough there are some regulations around custodial accounts and the payment of funds under the Packers and Stockyards Act of 1921.

I’m grabbing a bucket of popcorn to see how this one turns out.

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The SEC Grapples with Artificial Intelligence

The Securities and Exchange Commission looks to have opened at least two fronts in the adoption of artificial intelligence in financial services. The Division of Examinations has apparently started a sweep, sending out information requests on AI-related topics. SEC Chair Gary Gensler has expressed skepticism about the technology.

The first issue is a marketing-related issue for firms. Chair Gensler was reported to have made speech last week that warned against “AI Washing.” As there have been cases against firms purporting to based investment decisions using ESG factor, but not actually doing so (greenwashing). Chair Gensler warned about firms marketing themselves as AI enable, but not actually using AI.

You can’t oversell your AI capabilities.

The other issue is watching the risks with actually using AI for investment decision. As an example, there is concern that there is only a few underlying AI platforms, a whole lot of investment decisions could go rampaging in the wrong direction together, off a cliff. We’ve seen isolated cases of this at firms with trading algorithms that stop working. They unplug. If you’ve got a robot, you’ve got to make sure you can shut down the robot if (when?) the robot goes bad.

Earlier this year, the SEC released a proposed rule on Conflicts of Interest Associated With the Use of Predictive Data Analytics by Broker-Dealers and Investment Advisers that calls for investment advisers and broker dealers to:

“Eliminate, or neutralize the effect of, certain conflicts of interest associated with broker-dealers’ or investment advisers’ interactions with investors through these firms’ use of technologies that optimize for, predict, guide, forecast, or direct investment-related behaviors or outcomes.” – Release Nos. 34-97990 / IA-6353

It reads like a rule that is very skeptical of AI. It’s so broad and meandering that I’m not sure where it will end up. The intent is clear. Don’t let your AI do bad things.

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SEC Updates its RegFlex Agenda Fall 2023

The Securities and Exchange Commission published its twice-annual rule list agenda for the Fall 2023.

Back in June, four items caught my attention: Private Fund Reform, Cybersecurity, Outsourcing, and Safeguarding. Only one made it to publication. Unless you’ve been on vacation for a few months, you know the Private Fund Reforms became effective last month.

Cybersecurity (3235-AN08) has been pushed back to the Spring of 2024. It proposed mandatory cyber breach reporting and cybersecurity policies and procedures. The breach reporting was proposed as 48 hours. In my view that is way to short.

Outsourcing (3235-AN18) had been pushed back to Spring 2024 and it remains there. That rule had some fuzzy requirements about appropriateness of outsourcing and a requirement to conduct due diligence on service providers. I know the Division of Examinations has been compiling information as part of their exams.

Safeguarding (3235-AM32) has been pushed back to the Spring 2024. This replacement of the Custody Rule went too far in requiring custodians for more than just cash and securities.

What else caught my attention?

Regulation D and Form D Improvements (3235-AN04) is letting us know that the SEC is thinking about “amendments to Regulation D, including updates to the accredited investor definition, and Form D to improve protections for investors.” Nothing proposed, just a thought.

Predictive Data Analytics (3235-AN14) is an interesting swing in this current era of Artificial Intelligence mania and fear. I’m not sure the SEC is taking the right approach on this. On the other hand, one research report showed that the AI GPT-4 will insider trade knowing its against company policy and then lie about. (The Robots will Insider Trade). The SEC has a final action set for Spring 2024.

I missed the proposed rule amending the internet investment adviser rule in August. (I was on my bike for the Pan-Mass Challenge) It would amend Rule 203A-2(e) and narrow the exemption. Examinations are finding some abuse of the exemption.

“We are blessed with the largest, most sophisticated, and most innovative capital markets in the world. But we cannot take this for granted. Even a gold medalist must keep training.” – Chair Gary Gensler’s Statement

What proposed rules are catching your attention?

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Shadow Insider Trading Theory Lives On Again

A summary judgment motion in the shadow insider trading case was denied.

The Securities and Exchange Commission brought charges against Matthew Panuwat a business development executive at Medivation. Panuwat had learned from Medivation’s CEO that the company expected to be acquired by a major pharmaceutical company, Pfizer, within a few days, at a premium to the then-market price.  Panuwat did not trade in Medivation securities.  Rather, within minutes of hearing the news, Panuwat purchased out-of-the-money call options in Incyte Corporation, another oncology-focused biopharmaceutical company that he believed would increase in value when the Medivation acquisition was announced.

If Panuwat traded in Medivation’s stock or Pfizer’s stock, that clearly would have been insider trading.

But he didn’t trade in the stock in play. He traded in Incyte, a completely unrelated company that happened to be in the same industry and about the same size as Medivation. He bet that there would be increased interest in this space and the merger price of Medivation would float the value of similar companies.

The Securities and Exchange Commission thinks this should be considered insider trading and brought charges against Mr. Panuwat for his 2016 trade.

Mr. Panuwat brought a motion for summary judgement hoping to dismiss the charges based on the facts. The judge said there were genuine disputes of material fact concerning

The judge had previously ruled at the earlier motion to dismiss phase that information may be material to more than one company and that information does not need to come from the issuer of the security to be material. The SEC charges survived this facial attack on shadow insider trading.

  1. whether Mr. Panuwat received nonpublic information,
  2. whether that information was material to Incyte,
  3. whether Mr. Panuwat breached his duty to Medivation by using its confidential
    information to personally benefit himself, and
  4. whether Mr. Panuwat acted with scienter.

As for materiality:

“Changes in stock price after previously unknown information is disclosed to the market is “strong evidence” of how reasonable investors understand the significance of that information. … The SEC has shown that Incyte’s stock increased by 7.7% after the market learned that Pfizer acquired Medivation. See Oppo. Ex. P. Panuwat responds that Incyte’s stock prices had changed “by at least 7.7% in one day over 400 times during the time Incyte has been a publicly traded company.” … Again, it is possible that the stock price increase was unrelated to the Medivation sale. But a jury could reasonably find that it was further indication of the two companies’ connection in the market, and therefore probative of materiality. There is at least a material dispute whether the information Panuwat received in the Hung Email was material to Incyte.”

The judge found that Mr. Panuwat potential breached at least one of his three separate duties to not use this confidential information. The first was the Medivation insider trader policy that covered “securities of another publicly traded company”. Mr. Panuwat argues that Incyte was not one of the enumerated relationships in the policy. Second, Mr. Panuwat signed Medivation’s confidentiality agreement and the SEC argued that it created a duty with the Incyte information. Third, the SEC argues that there is a common law duty for an employee with regards to company information. The judge ruled that it was up to the jury to rule on potential breach.

The case is far from over. The question is whether Mr. Panuwat wants to continue fighting and has the financial resources to keep fighting the SEC charges.

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Insider Trading to Make your Ex-Girlfriend Hate You, Lose your Job, and Go to Jail

Seth Markin stumbled across a sure thing for investing his money. Pandion Therapeutics was going to be acquired by Merck & Co. He knew the acquisition price per share was going to be over twice what the shares were currently trading. He made $82,000 in trading profits in February 2021.

In June 2021 he got a phone call from his ex-girlfriend. (I have to assume it was a very angry phone call.) Mr. Markin’s name had shown up on an inquiry from by the Financial Industry Regulatory Authority. His ex-girlfriend was a lawyer working on the Pandion-Merck transaction. FINRA had asked her whether she knew any of the names on a list of people who bought Pandion stock leading up to the transaction announcement.

She, FINRA, the SEC, and the DOJ all assume that Mr. Markin had come across the transaction information while they were dating. He lied to her and told her that he had not traded in Pandion stock. (I don’t think they got back together.)

At this time, Mr. Markin was training as a new agent at the FBI Academy. He was interviewed the FBI agents about the Pandion trading, and Mr. Markin lied to them. (I don’t think he kept the job at the FBI.)

Clearly the FBI didn’t believe him. He was arrested in July 2022. Earlier this week he plead guilty to securities fraud based on that insider trading. Now He’s facing jail time.

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