Author: Doug Cornelius

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

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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The One with Fund Custody Footfault

ECM had investment advisory clients and managed two private funds in which some of its advisory clients invested. Based on the SEC order it looks like ECM tripped over the complexities of the Custody Rule in managing the investments.

An investment adviser has custody of client assets if it holds, directly or indirectly, client funds or securities, or if it has the ability to obtain possession of those funds or securities. Under the custody rule, an investment adviser who has custody has four main obligations:

  1. ensure that a qualified custodian maintains the clients assets;
  2. notify the client in writing of accounts opened by the adviser on the client’s behalf,
  3. have a reasonable basis for believing that the qualified custodian sends account statements at least quarterly to clients, and
  4. ensure that client funds and securities are verified by actual examination each year by an independent public accountant in a surprise exam.

A private fund can comply with obligations 2, 3, and 4 by having the fund audited annually and sending the audited financial statements to the fund investors with 120 days of the fiscal year of the private fund.

You don’t have to comply with custody requirement of 1 for “privately offered securities.” Those are private placements that are uncertificated and can’t be transferred without consent of the issuer. Think limited partnerships and private funds.

One problem was with what the order called “paper memberships” in the private fund. I was a bit confused by what was going on. I think the problem was that ECM was holding on to the limited partnership agreements signed by its clients who invested in the private funds.

The privately offered securities exception is only for obligation 1 of custody. You still have to comply with obligation 4 of custody and have a surprise examination.

Of course that is if you have custody. I think the problem is solved by having the partnership agreements send to the clients so you don’t have custody.

It looks like ECM also failed to have the private funds audited.

Of course this may all change when (or if) the SEC enacts the proposed Safeguarding Rule.

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The One with the Fake WeWork Bid

The Securities and Exchange Commission brought charges against Jonathan Larmore, his real estate investment company ArciTerra and its affiliate Cole Capital, based in Phoenix. According to the charges, Mr. Larmore was siphoning million of dollars from his investors in the ArciTerra funds to pay for his lavish lifestyle.

The SEC discovered this fraud because Mr. Larmore made a bid to purchase WeWork on the Friday before WeWork filed for bankruptcy. It was an attempt at stock manipulation.

Mr. Larmore had purchased call options for over 7 million shares in the days prior, with strike prices between $2 and $5 that were scheduled to expire at 4:00 on Friday November 3. The stock was then trading around $1. Those call options would be worth $0 if the share price of WeWork did not rise about the strike prices on Friday.

On the morning of November 3, Mr. Larmore sent Schedule TO to the SEC indicating that he intended to make a tender offer for WeWork at a price of $9. He also tried to publish a press release through the business wire service that morning.

“We have consulted with God, legal, financial and other advisors to assist us with this transaction. We stand ready to proceed timely.”

Larmore was not ready to proceed timely. He and Cole Capital did not have the financial resources to acquire the shares. Nor did they have any prospects for securing capital to proceed.

Larmore also did not know how to release a press release on the wire service. It had been rejected for formatting issues and other irregularities. It wasn’t fixed and released until 5:12 pm on November 3. That was after the public markets had closed and after his call options had expired.

He botched his stock manipulation and opened himself to further SEC inquiry which highlighted his other misdeeds.

It’s not clear how much of the SEC’s case outside of the stock manipulation is coming from its own inquiries. There are several lawsuits and accusations of fraud against Mr. Larmore and his real estate company. Mrs. Larmore noted in an April filing in her divorce from Mr. Larmore that “there appears to be some sort of SEC investigation in process, potentially against the entities or Jon.”

More Reading:

Corporate Transparency Act Deadline Extended

It’s coming down to crunch time on the Corporate Transparency Act. Passed as part of the National Defense Authorization Act for 202, it requires companies to submit a report of their beneficial ownership and control to the U.S. Department of the Treasury’s Financial Crimes and Enforcement Center. For new companies, this information has to be submitted at the time of formation. Existing companies will have to submit this information during 2024.

Originally, at the time of formation meant within 30 days. FinCEN just announced that it will be extended for 90 days during 2024.

I understand why FinCEN is looking for reporting on entities formed in the US. As numbered Swiss bank accounts and offshore Cayman Island trusts are falling into line with prudential KYC-ALM laws, it’s the United States that makes it really easy to create a company and not disclose ownership or control.

I don’t think FinCEN is ready to make it easy to disclose the information required by the Corporate Transparency Act. I’ve heard there are concerns about whether the new database can handle the crush of information. I’ve worked with a few vendors trying to help with solutions for filing but haven’t had the ability to access a prototype of the FinCEN database.

It’s great that the initial deadline has been extended from 30 days to 90 days. Good luck to those brave souls who are going to be the first to file after January 1, 2024.

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2024 SEC Exam Priorities

In a surprisingly early announcement, the Securities and Exchange Commission’s Division of Examinations has released its 2024 examination priorities just two weeks into the start of its fiscal year. I’m used to seeing this released months into the fiscal year.

“Since the publication of our fiscal year 2023 priorities approximately eight months ago, we have advanced our mission as reflected in this year’s priorities, which provide both continuity and change to reflect a fluid and evolving economic and regulatory landscape. Given the shorter interval in between the publication of our priorities, several initiatives and focus areas from last year remain as fiscal year 2024 priorities.”

I’m focused on the private funds section.

  1. The portfolio management risks present when there is exposure to recent market volatility and higher interest rates. This may include private funds experiencing poor performance, significant withdrawals and valuation issues and private funds with more leverage and illiquid assets.
  2. Adherence to contractual requirements regarding limited partnership advisory committees or similar structures (e.g., advisory boards), including adhering to any contractual notification and consent processes.
  3. Accurate calculation and allocation of private fund fees and expenses (both fund-level and investment-level), including valuation of illiquid assets, calculation of post commitment period management fees, adequacy of disclosures, and potential offsetting of such fees and expenses.
  4. Due diligence practices for consistency with policies, procedures, and disclosures, particularly with respect to private equity and venture capital fund assessments of prospective portfolio companies.
  5. Conflicts, controls, and disclosures regarding private funds managed side-by-side with registered investment companies and use of affiliated service providers.
  6. Compliance with Advisers Act requirements regarding custody, including accurate Form ADV reporting, timely completion of private fund audits by a qualified auditor and the distribution of private fund audited financial statements.
  7. Policies and procedures for reporting on Form PF, including upon the occurrence of certain reporting events.

Of these seven, only #3: fee calculation and #6: custody) carry over from last year.

I’m curious about Form PF. Exam staff typically have, in the past, had limited access to Form PF data.

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No More Accelerated Monitoring Fees

In the proposed Private Fund Reform Rules, the Securities and Exchange Commission had contemplated a ban on charging a portfolio investment for monitoring, servicing, consulting, or other fees in respect of any services the investment adviser does not, or does not reasonably expect to, provide to the portfolio investment. This was an attack on a practice of some private equity firms to enter into a long term agreement with a portfolio company to enter into long term contracts, then have unexpired terms paid at exit.

That ban was dropped as an explicit rule from the reforms package. Instead the SEC made it an implicit rule.

The SEC stated on page 250:

“We believe that charging a client fees for unperformed services (including indirectly by charging fees to a portfolio investment held by the fund) where the adviser does not, or does not reasonably expect to, provide such services is inconsistent with an adviser’s fiduciary duty.”

The SEC also points out that it has brought actions in the past under Section 206(2) against private fund managers for improperly charging monitoring, servicing, consulting, or other fees, which may accelerate upon the occurrence of certain events, to a portfolio investment.

It did so again this week with charges against American Infrastructure Funds because it accelerated a portfolio company monitoring fee without timely disclosure to clients or investors. The SEC’s order also finds that American Infrastructure Funds violated its duty of care by failing to consider whether the fee acceleration was in its clients’ best interest.

I’m not sure why the SEC pulled back and didn’t make the accelerated fee ban explicit. The whole purpose of the series of 206(4) rules is to allow the SEC to “define, and prescribe means reasonably designed to prevent, such acts, practices, and courses of business as are fraudulent, deceptive, or manipulative.” Instead, the SEC is relying on regulation by enforcement under the fiduciary standard.

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