Author: Doug Cornelius

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

SEC Enforcement Annual Results and Looking Forward

The Securities and Exchange Commission’s Enforcement Division just issued a report highlighting its priorities for the coming year a look back at enforcement actions that took place during the past year.

The Enforcement Division’s Co-Directors Stephanie Avakian and Steven Peikin stated stated five core principles that will guide their enforcement decision-making:

  1. focus on the Main Street investor;
  2. focus on individual accountability;
  3. keep pace with technological change;
  4. impose sanctions that most effectively further enforcement goals; and
  5. constantly assess the allocation of resources.

Principles 1 and 3 are being addressed with the SEC’s new Retail Strategy Task Force and Cyber Unit.

Principle 2 is an indication that the SEC will continue to focus on the individual wrongdoers at an organization and not just the organization itself. Corporate fines just hurt shareholders, while cases against individuals may do more to deter wrongdoing.

Principles 4 and 5 are just common sense. Which is a good thing to demonstrate in Washington these days.

The annual report notes that the SEC brought 754 enforcement actions which consisted of 446 standalone actions and returned a record $1.07 billion to harmed investors.

I don’t like seeing a touting of enforcement actions and money collected. I would hate to see the SEC driven towards quotas, which do not necessarily indicate a better protection of investors. (See principle 4 above.) Take a look at the Wells Fargo case to see how a numbers driven organization got in trouble. (See Why Sales Quotas Ruined Wells Fargo by Matt Levine.)

So it was great to see this note in the report:

While such statistics provide some kind of measurement, they provide a limited picture of the quality, nature, and effectiveness of our efforts. For example, returning $100,000 to several dozen defrauded investors has little impact on our overall statistics, but can be lifechanging for those investors. And, of course, violations that are prevented or deterred are never reflected in statistics. We also note that some cases take many years from initiation to resolution. Note that in 2017, $1.07 billion was distributed to harmed investors while $140 million was distributed in 2016, but much of the effort that resulted in the 2017 numbers occurred in prior years.

The trouble with the goal of enforcement is the same trouble that compliance has. How do you measure your effectiveness? Your goal is to have less wrong-doing. If you are finding less wrong-doing, you can’t be sure if it is because there is less wrong-doing and you are being effective. Or, you are finding less wrong-doing because you are doing a worse job of spotting it and being less effective.

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The Pot of Gold at the End of the Rainbow

With all of the SEC enforcement actions, it takes something related to my area or a quirk to catch my attention. The fraud that caught my attention this morning was a hedge fund manager claiming he no longer needed income and instead wanted to help friends and charitable causes. He told investors that his 20% of the trading profits would fund his wife’s charitable organization for abused women and children, The End of the Rainbow Foundation in Colorado.

Running a hedge fund for charity sounds nice. I’m not sure I’ve heard that happening. It didn’t in this case. Michael Anderson, the hedge fund manger, talked 18 investors into giving him $5.3 million to “invest.”

He didn’t.

He suffered $600,000 in trading losses, used some of the investor money to redeem investors based on falsified returns, and pilfered at least $2.3 million.

The SEC got wind of the problems in early 2017 and launched an investigation and hoped to shut down the fraud.

Whatever thread Mr. Anderson had been hanging on to justify his fraud snapped. He was found dead in his garage with his ATV running and filled with carbon monoxide. According to the SEC complaint, a few weeks before his death, Mr. Anderson hired an attorney to help him draft a sworn confession, admitting to defrauding Rainbow Partners’ investors, fabricating their account statements, making Ponzi payments, and misappropriating investors’ funds. The confession also stated that he controlled all aspects of Rainbow Partners’ business and was wholly responsible for the transactions. This was an attempt to isolate his wife from the fraud.

According to another action, Mr. Anderson was also involved with another investment firm, BigHorn Wealth. It also sounded sketchy, with a promotion that it went to cash at then end of each day. That strategy makes it easy to hide trading account balances from investors. It turns out that BigHorn had taked a big position in an exchange-traded gold fund and had lost $2.4 million in that fund.

There was also $1 million wired to purchase bars of gold around the time of his confession. That 53 pounds of gold has not been recovered.

It sounds like Mr. Anderson had a tangled web of investment firms and control, some of which sustained losses, and he raised funds to redeem investors to keep his facade of success in place. He tried to save his wife from the fraud.

Perhaps he stashed those gold bars for her at the end of the rainbow.

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Watching the Watch Dogs

According to a story by Jean Eaglesham in the Wall Street Journal, at least two employees working for SEC’s Inspector General have filed complaints alleging that he and his senior staff retaliated against them for calling out misconduct within the inspector general’s office.

The allegations center on potential time and attendance fraud by a supervisor in the inspector general’s office and a junior subordinate. The whistleblowers said the two employees regularly disappeared together for several hours during workdays and engaged in inappropriate conduct in the office. The office’s own investigation of the complaints found insufficient evidence to conclude the two employees had an inappropriate relationship, but noted that “the supervisor created the appearance” of such a relationship. The SEC Office of Inspector General referred the complaints to a federal prosecutor, who declined to pursue the case

It was a case of the process being wrong.

The whistleblowers’ concerns focus on how Carl Hoecker, the SEC inspector general, handled their complaints.  The whistleblowers allege that the internal investigation wasn’t sufficiently independent to be fair. They also claim that they suffered retaliation for voicing their concerns.

Federal agencies have inspectors general to oversee the agencies and to encourage whistleblowing. They are supposed to be a model for private firms.

The internal probe was led by two senior officials in the office. But one of those was a senior investigator who hired and supervised the two employees at the center of the complaints. Of course there is an inherent conflict. If the employees were misbehaving, the supervisor would look bad for not having dealt with the problem.

Now the Office of Special Counsel is involved. That office is yet another federal agency whose primary mission is to safeguard the mer​it system by protecting federal employees and applicants from prohibited personnel practices, especially reprisal for whistleblowing.

I’m not sure there is much here for the underlying case. A supervisor may have been canoodling with one of his co-workers. You stop that prevent all the likely harm and drama that comes along with that. But the lesson for compliance is to make sure the process looks transparent and that the whistleblower understands what is going on . Now the whistleblower problem is bigger than the original problem.

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Compliance Bricks & Mortar for November 10

These are some of the compliance-related stories in my reading list.

Your General Counsel is Your CECO? Really? by Joseph E. Murphy

There continues to be controversy about whether a company’s general counsel should also be the CECO, especially at large companies. Putting aside the question of whether this is a good idea, however, I want to pose a different question for companies that claim their GC is also the CECO: Could you prove it? [More…]

Governance and Transparency at the Commission and in Our Markets by SEC Chairman Jay Clayton

The next near-term agenda, which will be published as part of the federal government’s Unified Agenda in coming months, will be shorter than in the recent past. This change is rooted in a commitment to increase transparency and accountability. Some may question the prioritization reflected in the near-term agenda. They have a right to do so, and we welcome constructive comments. We should endeavor to be transparent to Congress, investors, issuers, and other interested parties about what rules we intend to pursue and have a reasonable expectation of completing over the coming year. And then, we must set forth to do it. [More…]

SEC Warns Investors About Paid-to-Click Scams

The Securities and Exchange Commission is warning investors to beware online “paid-to-click” scams that promise an easy payday by merely purchasing a membership or an advertising product up front and then clicking on a certain number of online ads each day. The SEC’s investor alert explains that these online advertising programs may have little to no revenues besides membership fees or sales of “ad packs” and may be nothing more than a Ponzi scheme. [More…]

California SB 396: New Law Requires Anti-Harassment Training to Cover Gender Identity and Sexual Orientation

The new law applies to organizations with 50 or more employees, and amends the existing sexual harassment training for managers and supervisors, as required by the California Department of Fair Employment and Housing (DFEH). SB 396 also requires employers to display a poster developed by the DFEH on transgender rights in the workplace. The existing California laws covering sexual harassment training are California AB 1825 and California AB 2053.  [More…]

DOJ Penalty Policy Under Review by Matt Kelly in Radical Compliance

The Justice Department is reconsidering how it imposes monetary penalties for corporate misconduct, so that parallel investigations happening with other regulators don’t pile on the pain unnecessarily, the deputy attorney general said Wednesday.

Deputy AG Rod Rosenstein made those remarks during a wide-ranging speech in New York. He also said he hopes to avoid putting policy changes into a “Rosenstein Memo,” and still stressed the importance of companies cooperating with the Justice Department when misconduct is under scrutiny. [More…]

Compliance Building has been quiet this week. It’s for sad reasons. One of my dogs died earlier this week.

Guinness was 200 pounds of joy and enthusiasm, who rarely realized that he was so enormous. We knew when we rescued him, that it would be a roller-coaster to integrate him into our family. But it was a joyous few years.

Great Danes are not known for having long life spans. But his was cut short unexpectedly after developing some heart troubles. I miss his giant head, his table destroying tail and his enormous personality.

Analysis of a 3(c)5 Fund

Dodd-Frank created a new legal definition for a “private fund” as pooled investment vehicles that are excluded from the definition of “investment company” under the Investment Company Act of 1940 by section 3(c)(1) or 3(c)(7) of that Act.

Under 3(c)(1), the main limitations are that you have one hundred or fewer holders of beneficial interest in the fund and that you do not propose to sell them in a public offering. Under 3(c)(7) you can go beyond the 100 owners, but they need to be “qualified purchasers.” That means they need to have a bigger wallet.

Real estate funds managers have used these standards because they are bright-line tests. It also skirts around the issue of whether the fund is investing in “securities” and “what is a security”. The SEC has taken a broad view on what could considered a security.

Real estate fund managers have also looked at 3(c)5 and wondered if they can rely it as an exclusion under the Investment Company Act:

(5) Any person who is not engaged in the business of issuing redeemable securities, face-amount certificates of the installment type or periodic payment plan certificates, and who
is primarily engaged in one or more of the following businesses:
… (C) purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.

The SEC issued a new no-action letter to Redwood Trust that takes a deep look at some features of this exclusion. Although the credit risk transfer certificates at issue in the letter are not widely applicable to real estate fund managers, the discussion around the exclusion is useful:

We have taken the position that the exclusion in Section 3(c)(5)(C) may be available to an issuer if: at least 55% of its assets consist of “mortgages and other liens on and interests in real estate” (called “qualifying interests”) and the remaining 45% of its assets consist primarily of “real estate-type interests;” at least 80% of its total assets consist of qualifying interests and real estate-type interests; and no more than 20% of its total assets consist of assets that have no relationship to real estate (these factors together, the “Asset Composition Test”).[3]

We generally have taken the position that qualifying interests are assets that represent an actual interest in real estate or are loans or liens fully secured by real estate [4]

We generally also have taken the position that an asset is not a qualifying interest for purposes of Section 3(c)(5)(C) if it is an interest in the nature of a security in another issuer engaged in the real estate business.[5]

We have, however, indicated that certain mortgage-related instruments that may not be treated as qualifying interests may be treated as real estate-type interests.[6]

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Compliance Bricks and Mortar for November 3

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

Yes! Compliance Goes Hollywood! by Matt Kelly in Radical Compliance

Compliance officers, rejoice! The fame and recognition so long denied to you may finally be at hand! The FX network has commissioned the pilot for a new TV series STARRING A COMPLIANCE OFFICER!!! It will be a comedy, of course. Is there any other way to look at this profession? [More…]

U.S. SEC wrongly collected $14.9 billion from defendants: lawsuit by Nate Raymond

The U.S. Securities and Exchange Commission has been hit with a class action lawsuit seeking to recover $14.9 billion that lawyers for an investment firm’s liquidating trustee say should not have been collected given a recent U.S. Supreme Court ruling. The lawsuit was filed in federal court in Boston on Thursday by the liquidating trustee for F-Squared Investment Management LLC, who contends the firm paid the securities regulator $30 million that the SEC was not actually authorized to collect.[More…]

Admitting Wrongdoing to the SEC: An Empirical Study of Admissions in SEC Settlements by Verity Winship and Jennifer K. Robbennolt

What is the connection between what the SEC actually does and what it says it will do? In 2013, the SEC unveiled a new policy requiring some enforcement targets to admit wrongdoing when they settled with the agency. In An Empirical Study of Admissions in SEC Settlements, we analyze settlements from before and after the introduction of this policy to determine how the SEC’s practice lines up with its new approach to admissions. We find an uptick of admissions following the policy announcement, with the highest number in FY2016.  Using an inclusive definition of admissions, we identify fewer than one hundred settlements containing admissions that were announced during the seven years of our study (FY2011-FY2017). [More…]

The Promise and Perils of Crowdfunding by John Armour and Luca Enriques

In our article, The Promise and Perils of Crowdfunding: Between Corporate Finance and Consumer Contracts, we sketch a road map for the regulation of crowdfunding for start-ups. We begin by considering the use of crowdfunding and the characteristics of typical crowdfunding contracts. One such contract—the “reward” model, which rewards funders with units of product—offers firms and funders the promise of reducing uncertainty by generating new information about consumer demand. By using the reward model, founders capture synergies between their product and capital markets. Rather than raise capital and aggregate information about likely success as a by-product (through the price mechanism), they tap the product market, thus directly testing demand, and raise capital as a by-product. [More…]

The One with the Deceptive Investment Description

Augustine Capital Management did many things wrong while managing its Augustine Fund. One highlight or the misdeeds is using fund assets to make conflicting transactions without notifying investors.

The fund charged the salaries of two principals, Thomas F. Duszynski and John T. Porter, as fund operating expenses. According to the fund documents, the management fee was supposed to compensate Augustine for its  “overhead and expenses in managing the Partnership.” The manager could charge  “operating expenses” to the Fund, a term defined by the PPM to include communication costs, brokerage commissions, legal, accounting, and auditing fees. The fund documents did state that the Fund would pay salaries, healthcare, or rent for the manager. But they made the Fund pay for it anyhow.

It’s not that a manager is not allowed to charge those expenses to the fund. It just has to be disclosed to investors so they know what they are paying for.

In the same light, you need to disclose your investments to the fund investors. Augustine chose to hide a related-party transaction. Augustine had made an investment in FT Investing. However, Duszynski and Porter held an interest in FT. Then they bought out the Fund’s investment in FT at a loss. After the sale, they had the Fund make $600,000 in loans to FT, with no documentation. Duszynski and Porter’s original ownership in FT had been funded by a loan from the Fund.

Nothing in the Fund documents allowed personal loans to the management company or its employees/owners. The Fund had no board of advisors or other mechanism to approve of the related-party transactions. They failed to accurately describe the transactions to Fund investors.

Augustine Fund formerly held an investment in FT Investing, LLC. This investment was liquidated in December 2013. When the original investment was made, the Fund also made an interest-bearing loan to one of its co-investors in FT Investing. This loan is on track to be fully repaid on its maturity date in December 2014.

This description was misleading because it did not reflect the conflict with the loan: that the loan was made to Duszynski, a principal of the fund manager. Additionally, it misrepresented the loan’s repayment status, because Duszynski had not begun repaying the loan.

“Reasonable investors would have considered it important both that the Fund’s monies were used to make a substantial personal loan to a director of the general partner without the investors’ consent, and that the director defaulted on the loan.”

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SEC’s Retail Strategy Task Force

One of the complaints voiced by private equity firms when put under the scrutiny of the Securities and Exchange Commission was that their fund investors were sophisticated and adept when making their investment choices so there were fewer problems. Some of the actions coming out of fund review has proven that thesis may not be entirely true.

The argument was that retail investors were less sophisticated and more likely to be subject to fraud. The SEC has decided to dedicate resources to specifically focus on retail investors with the launch of the Retail Strategy Task Force.

Last month, the SEC announced that “The Retail Strategy Task Force will develop proactive, targeted initiatives to identify misconduct impacting retail investors.”

We have gotten a bit more color on the Task Force.
The issues we see in this space are extensive and often involve widespread incidents of misconduct, such as charging inadequately disclosed fees, and recommending and trading in wholly unsuitable strategies and products. Some more specific examples of some of the problems we are continuing to see:

  • Steering customers to mutual fund share classes with higher fees, when lower-fee share classes of the same fund are available.
  • Abuses in wrap-fee accounts, including failing to disclose the additional costs of “trading away” or trading through unaffiliated brokers, and purchasing alternative products that generate additional fees.
  • Investors buying and holding highly volatile products products like inverse exchange-traded funds (ETFs) for long-term investment.
  • Sale of structured products to retail investors and failing to fully and clearly disclose fees, mark-ups, and other factors that can negatively impact returns.
  • Churning and excessive trading that generate large commissions at the expense of the investor.

The Task Force will combine examination, enforcement and public education teams to better protect investors.

This does not mean that the SEC is ignoring private funds. Stephanie Avakian, Co-Director, Division of Enforcement stated:

“Finally, I want to address one question that we have received a lot since announcing our retail focus; that is, whether our enhanced retail focus means that we are allocating fewer resources to financial fraud or policing Wall Street. The answer to that question is simple: No, we are not. The premise that there is trade-off between “Wall Street” and “Main Street” enforcement is a false one.”

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Compliance Bricks and Mortar for October 27

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

SEC Names Peter B. Driscoll as Director of the Office of Compliance Inspections and Examinations

Mr. Driscoll was named as OCIE’s first Chief Risk and Strategy Officer in March 2016 after previously serving as OCIE’s Managing Executive from February 2013 through February 2016. He first joined the Commission as a summer legal intern in the Chicago Regional Office in 2000. He rejoined the SEC in 2001 as a staff attorney in the Division of Enforcement and was later a Branch Chief and Assistant Regional Director in OCIE’s Investment Adviser and Investment Company examination program. [More…]

It’s Nasdaq now; no longer NASDAQ.

  • References to “NASDAQ” will be changed to “Nasdaq”
  •  References to “The NASDAQ Stock Market LLC” or “NASDAQ Stock Market LLC” will be changed to “The Nasdaq Stock Market LLC”

President Trump Signs Bill Directing SEC to Expand Safe Harbor for Certain Investment Fund Research Reports

The amended Rule will expand the safe harbor for research reports that are not deemed to be “offers” for purposes of Section 5 of the 1933 Act, or prohibited activities for purposes of Rule 101 of Regulation M, to include the publication or distribution of research reports relating to “covered investment funds.” Covered investment funds include exchange-traded funds (ETFs), exchange-traded managed funds (ETMFs) and publicly traded commodity pools that invest primarily in commodities, currencies, or derivative instruments that reference commodities or currencies. [More…]

Congress Is Doing A Huge Favor For BofA While No One Else Watches by Zach Carter and Ben Walsh

House and Senate committees will consider an obscure bill called the “Fair Access to Investment Research Act” on Thursday. It will not be a major media event. The bill, which will likely sail through Congress, will not cause a new financial crisis, bar millions from accessing health insurance or undermine any foreign policy alliances. But it will help one company — Bank of America — make money by avoiding lawsuits. [More…]

Senate votes to repeal CFPB arbitration rule in win for financial institutions by Ian McKendry

The rule, which was released in July, would have prevented banks, credit unions and other lenders from requiring customers use the arbitration process to resolve disputes, stopping them from filing class-action lawsuits. To overturn it, Senate Republicans used an obscure legislative process called the Congressional Review Act which allows lawmakers to overturn a recently finalized rule by a majority vote. Even then, however, the vote was close.[more…]

Congress Makes It Harder to Sue the Financial Industry by Andrew Ackerman and Yuka Hayashi

The 51-50 vote handed the financial industry its most significant legislative victory since President Donald Trump took office and was a rebuke of Consumer Financial Protection Bureau Director Richard Cordray, who pressed ahead with his agenda in defiance of Republicans. [More…]

SEC Announces Measures to Facilitate Cross-Border Implementation of the European Union’s MiFID II’s Research Provisions

The no-action relief provides a path for market participants to comply with the research requirements of MiFID II in a manner that is consistent with the U.S. federal securities laws. More specifically, and subject to various terms and conditions: (1) broker-dealers, on a temporary basis, may receive research payments from money managers in hard dollars or from advisory clients’ research payment accounts; (2) money managers may continue to aggregate orders for mutual funds and other clients; and (3) money managers may continue to rely on an existing safe harbor when paying broker-dealers for research and brokerage. [More…]

The 10 Most Popular M&A Project Names of 2016

There is nothing more obvious and trite than using Phoenix for your restructuring or bankruptcy project, though I’m sure all of those companies will undoubtedly ‘rise from the ashes,’ thanks to the magic of their advisory team. Everyone must realize there are plenty more deal names in the sea. Let’s try and break the pattern of using the same colors, birds, rare stones and mythic beasts. You can use our M&A project name generator to help you. [More…]

Admissions in SEC Enforcement Cases: The Revolution that Wasn’t By David Rosenfeld

Four years on, it’s safe to say that the critics’ worst fears have failed to materialize. The SEC’s enforcement program remains robust, and the agency continues to report record enforcement numbers. But the success of the admissions policy is open to question for several reasons. First, the SEC has actually obtained admissions in only a very small number of cases. Consistent with what the SEC stated at the outset – that admissions would only be required in egregious cases and no-admit/no-deny would otherwise continue to be the norm – the policy of requiring admissions has been used sparingly. There are various metrics for assessing the admissions ratio, but even under the most generous measures, since inception of the policy, admissions have been obtained in settlements with well under 3 percent of the individuals and entities charged over that period, and by other measures the figure drops to well under 2 percent. Most SEC cases continue to settle (rather than go to trial), and the overwhelming majority of those cases are still settled on a no-admit/no-deny basis. [More…]

The One With the Pilfering Partner

Expenses charged by private equity managers to their portfolio companies and their funds has been on the SEC’s radar since Dodd-Frank. Apollo Management was one of those caught with improper fee calculations last year. One item mentioned was the inappropriate expenses charged to the funds by one of its partners. We got more detail on that issue when the SEC brought charges against Mohammed Ali Rashid, a former senior partner at Apollo Management.

From at least January 2010 to June 2013, Mr. Rashid allegedly misappropriated $290,000 from the Apollo funds my charging personal expenses to the funds and their portfolio companies. The SEC states that there more than one thousand personal items and services charged to the funds.

Apparently, it first started in 2010 when Apollo discovered the personal charges and made Mr. Rashid repay those costs. But that did not stop him. Apollo found more instances and ended his employment in February 2014.

According to the complaint, he took steps to conceal the charges. He identified a personal salon trip as a business lunch in one instance. It was his administrative assistant that turned him in the first time. She found problems with the expense reimbursement forms for a restaurant she could not find. She ran the problems up the management chain.

Undeterred by the scolding, he continued using the corporate account as a personal charge card. He claimed to purchase items identified as gifts to portfolio company executives. Gifts they never received. He charged a personal vacation to the fund, claiming it was a business trip.

His assistant turned him in again when he falsified a clothing purchased. He had pre-approval from compliance to spend $3500 on ties to some of the portfolio company executives. When his assistant called the store for a receipt, it turned out to be a charge for Rashid’s father’s suit. Apollo slapped him on the wrist again and made him re-pay these inappropriate charges.

The firm took what seems to have been the appropriate steps and ran a full forensic review of Mr. Rahid’s expense account. As a result of the review, Apollo placed him on unpaid leave. Mr Rashid self-identified $220,000 in improper charges. The review came up with an additional $60,000. All of which he re-paid as Apollo showed him the door.

According to the SEC complaint against the firm, Apollo had self-reported the problem to the SEC.  That did not stop the SEC from including this problem in the larger order related to improper fee charges to the funds last year.

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