Author: Doug Cornelius

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Compliance Bricks and Mortar for April 26

I haven’t published one of these in a while. Here are a bunch of compliance-related stories that recently caught my attention.

In Silicon Valley, You Can Be Worth Billions and It’s Not Enough
by David Streitfeld in The New York Times

Twenty one years later, Mr. Bechtolsheim may have seized a different kind of opportunity. He got a phone call about the imminent sale of a tech company and allegedly traded on the confidential information, according to charges filed by the Securities and Exchange Commission. The profit for a few minutes of work: $415,726.

Two SEC Lawyers Resign After Agency Censured for Abuse of Power in Crypto Case
By Austin Weinstein in Bloomberg

But the asset freeze was reversed after Shelby found that the SEC may have made “materially false and misleading representations.” The judge would go on to sanction the SEC for “gross abuse of the power entrusted to it by Congress” and ordered the agency to pay some of DEBT Box’s attorney’s fees.

Biden-Harris administration announces rule to protect retirement savers’ interests by updating investment advice fiduciary definition

The Biden-Harris administration announced today that the U.S. Department of Labor has finalized its Retirement Security Rule to protect the millions of workers who are saving for retirement diligently and rely on advice from trusted professionals on how to invest their savings. This final rule will achieve this by updating the definition of an investment advice fiduciary under the Employee Retirement Income Security Act and the Internal Revenue Code.

The final rule and related amended prohibited transaction exemptions require trusted investment advice providers to give prudent, loyal, honest advice free from overcharges. These fiduciaries must adhere to high standards of care and loyalty when they recommend investments and avoid recommendations that favor the investment advice providers’ interests — financial or otherwise — at the retirement savers’ expense. Under the final rule and amended exemptions, financial institutions overseeing investment advice providers must have policies and procedures to manage conflicts of interest and ensure providers follow these guidelines.

Supreme Court Rejects Securities Lawsuit Based On “Pure Omission” From SEC Filings
By William M. Jay, Daniel Roeser, Douglas H. Flaum, Jesse Lempel
Goodwin Procter

In a narrow but potentially significant decision, the Supreme Court has held that securities-fraud plaintiffs cannot recover based on a “pure omission” from a company’s public statements under the most common legal basis for private securities lawsuits, the SEC’s Rule 10b-5(b).  The Court’s unanimous April 12 decision in Macquarie Infrastructure Corp. v. Moab Partners L.P. wipes out precedent from the Second Circuit that potentially made any omission from the “Management’s Discussion & Analysis” (MD&A) section of periodic reports filed under the federal securities laws actionable.

A Reminder that Hypothetical Performance Does Not Belong on Your Website

The Securities and Exchange Commission brought actions five investment advisory firms for violations of the Marketing Rule. The firms posted advertisements that included hypothetical performance on their websites.

The SEC points out that websites are available to the general public and not “presenting hypothetical performance relevant to the likely financial situation and investment objectives of the intended audience.” Of course, a firm’s website and the materials posted to it are going to be considered advertisements for advisory services.

As a reminder, Advisers Act Rule 206(4)-1(e)(1) defines hypothetical performance as performance results that were not actually achieved by any portfolio of the investment adviser and includes, but is not limited to:

  • Performance derived from model portfolios;
  • Performance that is backtested by the application of a strategy to data from prior time periods when the strategy was not actually used during those time periods; and
  • Targeted or projected performance returns with respect to any portfolio or to the investment advisory services with regard to securities offered in the advertisement.

One thing I found curious about four of the five actions is that those four removed the advertisements containing hypothetical performance on June 8, 2023 before being contacted by SEC staff. What happened on that date to these four?

Sources:

Who knows what evil lurks in the hearts of men? The Shadow knows!

It survived motions to dismiss, summary judgment and now has survived a jury. The Securities and Exchange enlargement of insider trading, shadow trading, stuck through the case against Matthew Panuwat.

The SEC alleged that Mr. Panuwat traded in the stock of Incyte Corporation based on highly confidential information. Incyte was in a similar business to his employer, Medication, Inc. Mr. Panaway had learned about an impending announcement of Pfizer Inc.’s acquisition Medivation, Inc. He assumed that the stock price of Incyte would rise based on the valuation Pfizer placed on Medivation for the acquisition.

There is no doubt that knowledge of the Pfizer/Medivation transaction was material non-public information. Mr. Panaway clearly could not buy stock in Medivation ahead of the announcement. He didn’t.

Mr. Panawat took an aggressive approach to the Incyte share price. He purchased out-of-the-money options and lots of them. He purchased a majority of the daily volume of those options. The total purchase price was about half of his annual salary. He had not previously invested in Incyte. It was the biggest trade he had made. I’m sure the trades raised red flags at his brokerage which were reported to the SEC.

The jury decided that

  • Mr. Panuwat had owed a duty of “trust, confidence or confidentiality” to Medivation as a result of his employment.
  • Mr. Panuwat possessed nonpublic information as a result of his employment, that was material to Incyte.
  • Mr. Panuwat purchased the Incyte options on the basis of that nonpublic information.
  • Mr. Panuwat had “acted recklessly” in purchasing the options.

How do you deal with this from a compliance perspective? Would Incyte have been on blocked list for the investment bankers involved in the transaction?

Sources:

Off-Channel Communications Enforcement Comes to Private Funds

Over the past 2.5 years the Securities and Exchange Commission has charged 60 investment advisory firms and broker-dealers with violations of the record-keeping requirements and collected penalties approaching $2 billion. Those were all broker-dealers, dual-registered investment advisers, or affiliated investment advisers. Broker-dealers have strict communications retention mandates. Investment adviser requirements are not as strict. Private fund managers are thought to be a bit more uncertain. Everyone agrees that substantive business communications need to be captured and retained.

The first fund manager to fall into the Off-Channel Communications net is Senvest Management in New York. The firm had to pay a $6.5 million fine because employees were texting business-related messages.

Senvest has policies and procedures that required business communication to be retained, has the platforms to do so, and prohibits off-channel business communication. Senvest employees did not comply with the policies and sent thousands of business-related messages through non-firm systems. Even worse, some of these off-channel communications were on platforms that automatically deleted messages after a few months.

The take away is that private funds need to step up the monitoring of Off-Channel Communications. Senvest employees sent and received “thousands of business-related messages” using off-channel communications. Some of those included “communications concerning recommendations made or proposed to be made and advice given or proposed to be given about securities.” Those seem to be core records to be retained.

The other problem is that Senvest’s compliance manual said that the firm would “retain all electronic communications that it sends and receives.” The compliance manual also provided that employees were “strictly prohibited from using non-Senvest electronic communication services for any business purpose.”

Those compliance manual provisions might be more strict than required by the Investment Advisers Act.

Senvest was also penalized because it did not check employee devices to determine if they were complying with the firm’s policies and procedures. I think we need to take that message. Sounds to me that the SEC is laying down a requirement that compliance needs to run periodic checks of personal devices.

More Reading:

The One with Baseball and Tacos

Jordan Qsar, Austin Bernard, Chase Lambert and “Finance Person” all played baseball at Pepperdine University. After graduating, Finance Person ended up working at Jack in Box in the strategic finance group. Qsar went on to play for the minor league teams of the Tampa Bay Rays and other teams. Qsar played with Grant Witherspoon in the minor leagues.

Qsar was back in San Diego during a break in the season and went drinking with Finance Employee, Bernard and Lambert. The drinks must have made Finance Employee forget the confidentiality requirements at work. He was working on the acquisition of Del Taco. He told Qsar about it.

Qsar tipped off Witherspoon, Bernard, and Lambert about the transaction. There is a big collection of texts from the baseball players about buying lots of options in Del Taco stock in the SEC complaint. Most of the options were very inexpensive because they were out of the money. Del Taco did not trade above $8.67 during the relevant period. They were buying options with a strike price of $10. The options were inexpensive because they had $0 value if the Del Taco stock price didn’t rise above $10 in a few months.

The transaction was announced with an price of $12.51 for each Del Taco share. The four made ten of thousands of dollars in illegal profits. That’s a lot of tacos.

Those purchases of lots of out of the money options would have set off alerts at the compliance departments of their brokerage accounts. Those alerts ended up in the hands of the Securities and Exchange Commission and the Department of Justice.

Lambert was not included in the criminal action against the other three. It’s not clear whether he cooperated or the DOJ thought his actions were less egregious.

Finance Employee was not named and not charged. I assume he at least heeded his job requirements of not trading in the stock of acquisition targets. As to whether he kept his job, I would think he was quickly fired.

Of course, all of these are just charges in the SEC complaint and DOJ complaint. The defendants have not had a chance to tell their side of the story and how they came to trading in Del Taco options with little money in their accounts.

Sources:

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.

Sources:

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.

Sources:

    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.”

    Sources: