Author: Doug Cornelius

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The One with the Failure to Disclose Fees

The private fund industry is plagued with bad actors who don’t disclose fees and affiliate relationships. That has directly lead to the new reporting rule issued by the SEC for private fund advisers. The latest firm to get caught is the Prime Group, based in Saratoga Springs, New York. Prime’s business is investing in self-storage properties.

Prime is not registered with the Securities and Exchange Commission as an investment adviser. The new private fund reforms will only be partially applicable. Prime has at least two investment funds according to the SEC order. I assume they fall outside the definition of a “Private Fund” because Prime is relying on the c(5) exemption or claiming that the fund doesn’t invest in securities.

Prime also has an affiliate real estate brokerage firm owned by Prime’s CEO. Prime had employees and independent contractors that sourced acquisitions. When a fund bought one of these sourced acquisitions, it paid a brokerage fee to the affiliate. This arrangement is, of course, very usual and legal. According to the SEC Order, the majority of Fund II’s transactions paid a brokerage fee to the affiliate.

What Prime did wrong was sell interests in the fund without disclosing the payment of brokerage fees to the affiliate. There was some disclosure, but not enough. From the Fund II Limited Partnership Agreement:

“The General Partner may, from time to time, engage any person to render services to the Fund on such terms and for such compensation as the General Partner may determine, including attorneys, investment consultants, brokers, independent auditors and printers. Person so engaged may be Affiliates of the General Partner or employees of Related Persons.”

The SEC stated that “from time to time” failed to reflect that most of the transactions involved payment of the brokerage fee. This sounds a bit like the SEC’s attack on the use of “may” in disclosures.

The PPM for Fund II disclosed other affiliate fees, a 1% acquisition fee charged on all transactions and 5% property management fee paid to an affiliate, but failed to disclose the brokerage fee. It obviously would have been better practice to disclose the fee. It is common to pay a brokerage fee on transactions, although it usually paid by the seller, not the buyer. In my opinion if this is all the disclosures, it is potentially misleading.

The SEC dug further into Prime’s own DDQ and specific DDQs from some investors:

“Do you use the service of a broker to source deals?”
“Prime has not and does not use a broker; all sourcing is done internally.

“[Disclose]any fees, including consulting fees, paid to any affiliated group or person.”
“NA.”

Any other fees?
“Individual deal team members, unaffiliated with Prime Group Holdings or the fund manager, receive a brokerage fee of 1% to 3% of net purchase price.”

Unfortunately, Prime took a perfectly usual and legal fee and got itself in trouble by not disclosing it.

The twist, at least for a compliance geek, is that the SEC charge was not under the Investment Advisers Act. It was under Section 17(a)(2) of the Securities Act.

(a) It shall be unlawful for any person in the offer or sale of any securities … directly or indirectly—

(2) to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading.”

Since Prime was not registered as an investment adviser and the fund was not a private fund, there is a strong argument that there was no investment advice about securities and therefore the activity falls outside the scope of the anti-fraud provisions of the Investment Advisers Act. But the interests in Prime’s funds are securities, so the Securities Act does apply to the sale of those interests. So the SEC relied on the anti-fraud provisions of the Securities Act.

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Abusing Hypothetical Performance Under the New Marketing Rule

“These charges mark the first violation of the SEC’s amended marketing rule” according to the SEC press release.

Really, when use marketing collateral that your strategy has a 2700% return, you are going to catch the attention of the regulators. Titan Global Capital Management USA LLC, a New York-based FinTech investment adviser, used this hypothetical performance in its advertisements. Plus this was for a crypto strategy, so it’s even more suspect. I assume this lead the Securities and Exchange Commission to take a closer look at Titan Global and find a host of other problems.

The SEC Order provides great insight into what the SEC thinks about compliance with the Marketing Rule as a registered investment adviser. There has been a great deal of mumbling in the compliance world about the lack of guidance from the SEC on how to comply with the general provisions. The SEC annulled decades of guidance on how to be complaint with advertising. The one substantive FAQ about net performance for a single investment in a fund didn’t come out until four months after the compliance deadline.

So how did Titan Global achieve this 2700% return? They took their strategy and ran it for three weeks against price changes, with no actual money invested. During those three weeks, the strategy yielded a 21% return. Titan Global extrapolated that being able to achieve that return for a whole year and came up with a 2700% annualized return.

Titan Global is registered with the SEC as an investment adviser and put a marketing policy in place in June 2021 to comply with the Marketing Rule. There is no question about jurisdiction or applicability of the rule.

A list of the errors cited by the SEC:

  1. Titan Global failed to adopt and implement any policies or procedures reasonably designed to ensure that the hypothetical performance metrics included in its advertisements complied with the Marketing Rule.
  2. The hypothetical performance results were materially misleading. (Advisers Act section 2026(2)
  3. Titan Global failed to present material criteria used and assumptions made in calculating its hypothetical performance projection, including sufficient information to appreciate the significant risks and limitations associated with this hypothetical performance projection.
  4. Titan Global’s target audience was retail investors which requires heightened disclosure.
  5. Titan Global did not disclose in the advertisements that the 2,700 percent annualized return was based on a purely hypothetical account in which no actual trading had occurred.
  6. Titan Global failed to disclose that the annualized return had been extrapolated from a period of only three weeks.
  7. Titan Global failed to disclose Titan’s views as to the likelihood that this three week performance could continue for an entire year.
  8. Titan Global did not disclose whether the hypothetical projection was net of fees and expenses.
  9. Titan Global did provided information about the assumptions it used to calculate the hypothetical annualized return, and risks, as clearly and prominently as the highlighted 2,700 percent annualized return.
  10. The disclosures failed to disclose the significant risks associated with the strategy.

The SEC sums this all up by saying Titan Global’s “advertisement did not present the hypothetical projected performance in a fair and balanced way, or in a way that was not materially misleading.”

I don’t think there is much argument with that summary. This is not a marginal case. I think this advertising would have been found to be misleading under the old Advertising Rule. This part of the SEC Order just uses some of the new language in the Marketing Rule to frame the violation.

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Kirschner Update: Leveraged Loans are Not Securities

The Second Circuit put the leveraged loan market at ease and ruled that those notes are not securities. The Court had asked the Securities and Exchange Commission to offer its opinion on whether they were securities and the SEC declined to do so.

The Second Circuit followed the four factors of the Reeves “family resemblance” test.

1) “[T]he motivations that would prompt a reasonable seller and buyer to enter into” the transaction;
2) “[T]he plan of distribution of the instrument”;
3) “[T]he reasonable expectations of the investing public”; and
4) “[W]hether some factor such as the existence of another regulatory scheme significantly reduces the risk of the instrument, thereby rendering application of the Securities Acts unnecessary.”

The court found that the company and the note purchasers had different motivations. The company was entering into a commercial transaction. The note purchasers may have been motivated for investment.

Even though there ended up being lots of note purchasers, the distribution was controlled and not made available to the general public.

The court found that the note purchasers should have expected the notes to be treated as loans and not investments in the company.

Finally, the court found that there was some regulatory guidance and the loans were secured by a perfected interest in the company’s assets.

The court found that the notes had a family resemblance to loans issued by banks for commercial purposes. Therefore they are not securities.

The result of the decision is that the note purchasers can’t bring fraud claims under the state securities laws, which would have given them an additional remedy. In end, it was a lot of worrying, with no change in the law. It does stand as a reminder to focus on structuring loan transactions and documents to make sure you hit the points of the Reeves test.

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The Private Fund Rule Is Coming

The Securities and Exchange Commission has set the agenda for its August 23 meeting.

ITEM 2: Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews

OFFICE: Division of Investment Management

STAFF: William A. Birdthistle, Sarah G. ten Siethoff, Melissa Harke, Marc Mehrespand, Tom Strumpf, Robert Holowka, Shane Cox, Neema Nassiri

The Commission will consider whether to adopt rules and amendments under the Investment Advisers Act of 1940 (“Advisers Act”) for private fund advisers and whether to adopt amendments to the compliance rule under the Advisers Act.

It would be really unusual for the rule to not be adopted if its on the agenda. The question is “what will be in the final rule?”

The proposed rule in second quarter of 2022 had proposals that could be very problematic:

  • Limitations on indemnification for private fund advisers
  • Limitations on clawbacks for taxes
  • Limitations on different treatment for different investors
  • Standards for fee and expense disclosure
  • Not allowing existing contractual arrangement to continue if they differ from the rule requirements

The proposed rule was a kitchen sink of items with no unifying theme, other than to try to make private funds more like mutual funds without the liquidity. The rule could have a profound impact on the private fund industry.

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ABA Amends Rule on Client Due Diligence

The American Bar Association House of Delegates adopted a resolution that strengthens a lawyer’s obligation to decide before accepting or maintaining representation whether a client seeks to use the lawyer’s services to further a crime or fraud. This is part of an effort to alleviate concerns about the use of lawyers to facilitate money laundering and other financial crimes.

Kevin Shepherd, the ABA’s Treasurer, said that the U.S. Treasury Department had informed him that a failure to pass the resolution would cause the agency to take immediate regulatory action and to lobby for legislation imposing additional obligations on lawyers.

A few months ago Robert Wise, a New York lawyer, plead guilty to criminal charges stemming from payments he made for Russian oligarch Viktor Vekselberg, to maintain six properties in New York and Florida owned by the Russian billionaire in violation of sanctions.

The resolution adds a new inquiry requirement for lawyers under the ABA Model Rule of Professional Conduct:

(a) A lawyer shall inquire into and assess the facts and circumstances of each representation to determine whether the lawyer may accept or continue the representation. Except as stated in paragraph (c), a lawyer shall not represent a client or, where representation has commenced, shall withdraw from the representation of a client if:

…. (4) the client or prospective client seeks to use or persists in using the lawyer’s services to commit or further a crime or fraud, despite the lawyer’s discussion pursuant to Rules 1.2(d) and 1.4(a)(5) regarding the limitations on the lawyer assisting with the proposed conduct.

The commentary is very direct

[1] Paragraph (a) imposes an obligation on a lawyer to inquire into and assess the facts and circumstances of the representation before accepting it. The obligation imposed by Paragraph (a) continues throughout the representation. A change in the facts and circumstances relating to the representation may trigger a lawyer’s need to make further inquiry and assessment. For example, a client traditionally uses a lawyer to acquire local real estate through the use of domestic limited liability companies, with financing from a local bank. The same client then asks the lawyer to create a multi-tier corporate structure, formed in another state to acquire property in a third jurisdiction, and requests to route the transaction’s funding through the lawyer’s trust account. Another example is when, during the course of a representation, a new party is named or a new entity becomes involved.

We’ve seen the actions FinCEN have taken against title insurance companies under the Real Estate Geographical Targeting Orders.

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Charging the Gatekeeper

The SEC charged EIA All Weather Alpha Fund and its investment adviser, Andrew Middlebrooks, for fraud last year. The SEC alleged that Middlebrooks misrepresented the Fund’s performance in order to retain current investors and to induce new investors. The Adviser directed the creation of and approved an inflated NAV for the Fund with false and misleading performance results. The Fund provided investors with statements showing positive returns in the investors’ accounts and purported Fund gains from trading. In reality, the purported gains reflected in the investor statements were false. The Fund had actually lost money.

Normally, you would have expected a fund auditor to pick up on the problem. One of the claims against Middlebrooks and the Fund is that they falsely claimed the Fund had an auditor.

In the past, the SEC has shown its willingness to go after gatekeepers who missed obvious red flags in a fraud, in addition to the fraudster. The obvious target in this case would have been the auditor. The SEC claimed that Middlebrooks fabricated the financial statements and an audit report.

The SEC turned to the fund administrator for culpability. To be honest, I was a bit surprised to hear that there was a fund administrator. Based on the SEC order, it looks like the fund administrator failed to catch the red flags.

The agreement between the Fund and Theorem Fund Services required the fund to appoint an independent auditor to conduct an audit of the fund. At the onboarding in early January 2018, Theorem relied on a representation of the Fund. At year end of 2018, Theorem found out that no auditor had been engaged. That started the process of Theorem ending its services. By then, the damage had been done.

Over the course of 2018 Theorem was responsible for calculating the Fund’s NAV monthly. Theorem did what it was supposed to do and used the trading statements to calculate the NAV. The big failure happened in March 2018 when the fund lost $342,000. Rather than record the loss on the Fund, Middlebrooks decided to treat the loss as a “receivable” from the fund manager. The result would be no reduction of the Fund’s NAV. This treatment of losses as a receivable continued through 2018 and Theorem published investor statements that didn’t show the losses.

As a result of this “weird treatment,” the Fund’s performance for July 2018 since inception was positive 148.39%. The true result was a negative 63.9%.

Obviously the treatment of the loss as a receivable is “weird.” I suppose its possible that a fund could structure a loan from the manager to the fund to cover losses. That would need to be disclosed in the financial statements and creates a whole set of conflicts and compliance issues. Blackstone offered a guaranteed return to an investor in BREIT earlier this year.

Here, there was no disclosure. There was actually no receivable. There was no provision in the fund documents to allow a loan and no note or documentation to evidence the loan resulting in the receivable. Theorem just accepted that the Fund’s word that it was legally liable to reimburse the losses. (They were not.)

In January 2019, the fund switched trading platforms. Theorem at that time required disclosure of the receivable and a plan for its repayment to investors. The Fund did not do so and Theorem terminated the arrangement.

Theorem still provided investor statements with the bogus receivable until the termination was effective 30 days later.

The question I have is “who turned in the Fund and Middlebrooks?” It could have been Theorem. But the charging documents make no mention of Theorem’s cooperation. I think it’s more likely to have been a disgruntled investor.

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Are Syndicated Loans Securities?

Notes are securities and loans are not securities. Simple enough. Except, our financial system doesn’t operate in such a black and white manner. Syndicated loans kind of fall in the middle.

Your traditional loan is a single lender who holds and controls the debt. Notes and bonds get issued into a more fungible format to more than one investor, with control centralized with a trustee or loan administrator. There are lots of different structures on the notes and bond side of the spectrum.

Syndicated loans involve a group of lenders. Typically it’s a smaller group of lenders and they have some amount of control, collectively, over the administration of the loan.

There a fight in the Second Circuit in Kirschner v. JP Morgan Chase Bank on whether a particular syndicated loan issuance was a security. There is enough uncertainty that the court asked the Securities and Exchange Commission to offer its opinion. A few days ago, the SEC declined to do so.

While we are used to a discussion of the Howey test when talking about securities, it’s important to note that it is focused on the definition of an “investment contract.” There is a whole other line of cases on the “loan” versus “note” definition lead by the Reves v. Ernst & Young case which established the “family resemblance test.”

The analysis is whether the note in question is like any of these notes that are not securities:

  1. the note delivered in consumer financing,
  2. the note secured by a mortgage on a home,
  3. the short term note secured by a lien on a small business or some of its assets,
  4. the note evidencing a ‘character’ loan to a bank customer,
  5. short-term notes secured by an assignment of accounts receivable, or
  6. a note which simply formalizes an open-account debt incurred in the ordinary course of business (particularly if, as in the case of the customer of a broker, it is collateralized [… and]
  7. notes evidencing loans by commercial banks for current operations.

In determining whether the note in question has a family resemblance to one of the seven, there are four factors to consider:

  1. The motivation of seller and buyer – If the seller’s motivation is to raise money for his/her business and the buyer’s motivation is to earn profits, then the note is likely a security.  Even if the note is not necessarily characteristic of a security, if the investor reasonably expected that they were buying a security, and would be protected by the accompanying securities laws, then its more likely to be a security.
  2. The plan of distribution of the note – If the note instrument is being offered and sold to a broad segment or the general public for investment purposes, it is a security.
  3. The reasonable expectations of the investing public – If the investors think that the securities laws and their anti-fraud provisions apply to the note, then it’s more likely to be a security.
  4. Alternative regulatory regime – Is there another regulatory scheme, like banking regulation, that applies to the note, then its less likely to be a security.

The case as hand involves a $1.775 billion syndicated loan to Millennium Laboratories. As you might expect, Millennium defaulted. The loan participants are suing the loan syndicator to try get some additional recovery. The district court ruled that the syndicated loan interests were not securities and the loan participants appealed to the Second Circuit.

As mentioned above, the Second Circuit is mulling over the appeal and asked the SEC to opine on the treatment of this loan syndication. The SEC’s failure to say that the syndicated loan interests are not securities has created a bit of a panic in the syndicate loan markets.

We’ll keep an eye out for this decision.

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The One with the Girlfriend’s Laptop

The Securities and Exchange Commission actually uses the term “romantic partner”, not girlfriend in this complaint. I guess the SEC doesn’t want to impose labels on the relationship. Based on this case, I assume the relationship is over. The COVID pandemic was hard on a lot of relationships with couples isolated at home. Stealing information from your “romantic partner” seems likely to end the relationship.

That’s just what Steven Teixeira did. While working at home during the pandemic, Teixeira would access her laptop while she was out of the room or outside their Queens apartment.

She was an executive assistant at an investment bank. She was responsible for scheduling meetings of the investment bank’s valuation and fairness committees concerning potential transactions involving the investment bank’s clients. She had access to material nonpublic information relating to dozens of the investment bank’s transactions.

Teixeira had a friend who knew a guy who was a stock trader, Jordan Meadow. The three met and Teixeira offered up his access to the information to Meadow. The three plotted an insider trading scheme, with Meadow offering to buy Teixeira and the third friend Rolex watches. Teixeira and Meadows began trading on the flow of transaction information that Teixeira was snooping from his romantic partner’s laptop.

Their aggressive trading caught the attention of the regulators and Meadow’s compliance department. The scheme came to an end in January 2023 when the romantic partner returned to working in the office rather than from home.

Teixeira pled guilty in a cooperation agreement. The DOJ and SEC are pursuing more serious charges against Meadow.

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Ripple is Sometimes a Security (?)

The big challenge with crypto is how it fits into regulatory schemes that were drafted almost a century a go. Add in the politically driven split between the regulation of commodities by the CFTC and the regulation of securities by the SEC and you get a mess. Slap in the variable structures used by crypto issuers when selling crypto tokens and you get a tangled mess.

This challenge just got messier with the recent decision in the case of the Securities and Exchange Commission v Ripple Labs.

The definition of a “security” includes an “investment contract.” The meaning behind that term was established in the 1946 case of the SEC v. W.J. Howey. The decision created a three prong test:

(1) invests his money (2) in a common enterprise and (3) is led to expect profits solely from the efforts of the promoter or a third party.

Bitcoin largely falls outside the definition. You don’t expect a dividend on Bitcoin. You’re investing for the rise in price alone. There is no meaningful company behind it trying to find a way to make a profit. Bitcoin is more like a commodity.

Some will argue a currency. But currencies are used as a store of value to buy things. I don’t think Bitcoin is being used to buy many legal goods.

Ripple Labs comes along and sells the XRP token to generate cash to build out the Ripple platforms, some of which will use the XRP token. The facts are a bit murky about whether the XRP coin holders would get some of the profit from the Ripple platforms.

The court looked first at the past sales of XRP tokens directly to institutional buyers and decisively finds that the XRP tokens are securities. “When the value of XRP rose, all Institutional Buyers profited in proportion to their XRP holdings.” (page 18)

For some weird reason, the court then finds that indirect sales and sales on exchanges are not investment contracts. Since they were blind bid/ask transactions, the buyers didn’t know if the money was going to Ripple or to a secondary seller.

So institutional buyers get more protection than retail buyers under the court’s reasoning. That seems to be the opposite approach of the protective regulatory approach of the SEC.

That also seems weird in the reality of exchanges for “securities.” An investment would be a security if it’s bought directly from the issuer and possibly not a security if it’s purchased from a secondary seller.

Under the court’s decision, crypto is looking very good. Sales of “investment contracts” to institutional investors can rely on the private placement regime. Sales to retail investors through an exchange would not be an investment contract.

Weird result. The product’s status as a security is dependent on how it’s sold. Doesn’t sound right to me. I assume the SEC will appeal this result. I think this will just be a temporary win for Crypto.

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The One with Insider Trading, Pharma and the Police Chief

Joseph Dupont was a senior executive at Alexion Pharmaceuticals and reserve officer with the Dighton police force. (Dighton’s most notable attraction is Dighton Rock, covered in petroglyphs.) Dupont worked on Alexion’s acquisition of Portola Pharmaceuticals.

Dupont knew he couldn’t trade in the stock of Portola with all of the inside information he had. But that apparently didn’t stop him from leaking the information to his buddy, Shawn Cronin, who was a sergeant on the Dighton police force. (He has since become Chief.) Cronin then told two other mutual buddies, Stanley Kaplan and Jarett Mendoza. Kaplan then told a colleague, Paul Feldman, who spread the information even further.

The SEC Complaint and US Attorney Indictment have some compelling facts. Dupont had Alexion meeting to hammer out the details of the acquisition on April 8. That night Dupont had a long conversation with Cronin. Cronin texted Kaplan that night:

“Good evening, sir. If you need something to take your mind off of the everyday battle, remember that stock I told you about? Good time to buy.”

Cronin then opened a new brokerage account and placed an order to buy shares in Portola. Kaplan did the same. They continued to buy more shares in the following weeks.

The criminal indictment has a bunch of incriminating messages among the defendants:

“I need more inside information.”
“Knowing of a buyout or an news beforehand is gol[d].”
“Let’s hope our golden goose will continue laying golden eggs!”

When the acquisition was announced the stock price of Portola jumped 130%.

All of this suspicious trading caught the attention of the regulators after the merger and launched an inquiry. Alexion was forced to ask its employees whether they knew any of the names on the list of suspicious traders. Cronin lied and said he didn’t know any, even though Cronin, Kaplan and Mendoza were on the list.

The gains they made:

  • Cronin – $72,000
  • Mendoza – $39,000
  • Kaplan – $472,000
  • Feldman – $1.73 million (He put the most money in)

All are facing disgorgement of the gains, civil penalties and significant jail time. Mendoza has already plead guilty.

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