Category: CCO Liability

A Continuing Look as CCO Liability in the Stanford Ponzi Scheme

Eight years ago,  Stanford Financial Group collapsed and was labeled a Ponzi scheme. The Securities and Exchange Commission is continuing to seek penalties for those involved. One of those is Bernerd Young, who served as the Chief Compliance Officer at Stanford Group Company, the Texas-based registered investment adviser and broker dealer that promoted the Stanford CDs to US investors.

The SEC claims that Young approved Stanford’s false and misleading disclosures despite red flags about the products. An SEC Administrative Law Judge found that Young was

“at least negligent in allowing the use of marketing material that promised depositor security on the basis of facts about SIB’s portfolio that could not be verified and on the basis of a discussion of insurance that [he] knew had no relevance to depositor security but that might confuse a potential investor into thinking that it did.”

Young did not challenge most of the relevant facts about the underlying fraud at Stanford. He just disputes his liability by claiming that he reasonably carried out his compliance and due diligence responsibilities in good-faith reliance on Stanford officials, outside professionals, and regulators.

The ALJ found him subject to liability and barred Young from the industry, ordered almost $600 thousand in disgorgement and a civil penalty of $260,000. The disgorgement was for about half of his salary since half of Stanford’s income was fraudulent.

The Commission upheld the holding of the ALJ.

Young is appealing the decision to the US Circuit of Appeals for the DC Circuit. Mr. Young’s challenge is an attack on the ALJ proceeding in line with Lucia and Bandimere.

I also noted in the SEC order that Mr. Young had challenged the proceedings based on the statute of limitations. Although I don’t think it gets him in the clear, yesterday’s Kokesh puts a hard cap on the disgorgement to five years and opens the possibility of limiting the disgorgement remedy even more. In this case, Young’s salary is being disgorged based on some abstract ratio of fraud to legitimate activity at Stanford. I think it would interesting to see how this disgorgement held up to court scrutiny.

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CCO Liability for False Statements on Form ADV

Susan Diamond was Chief Compliance Officer of Saddle River Advisors. Now, Ms. Diamond is out of pocket for a $15,000 penalty and is subject to a nine-month suspension from being associated with any investment adviser or other financial services firms. After the suspension, she will be prohibited from acting in the securities industry in certain managerial and compliance capacities.

What did she do?

Diamond, on behalf of Saddle River, prepared, signed, and filed Forms ADV that contained untrue statements.

On its face, the order imposes liability for nothing other than answering questions on Form ADV incorrectly.

In Section 7.B.(1)(B) under the heading, “Service Providers” and the subheading “Auditors.”

Are the private fund’s financial statements subject to an annual audit?    Yes
Are the financial statements prepared in accordance with U.S. GAAP?  Yes
Name of Auditing Firm    SRA Funds’ Tax Preparer
Are the private fund’s audited financial statements distributed to the private fund’s investors?   Yes

None of these responses were true. Saddle River’s financial statements were not audited, prepared in accordance with U.S. GAAP, or distributed to investors. The firm identified as SRA’s “auditing firm” had prepared only tax returns and Forms K-1 for the Saddle River Funds and was never engaged by Saddle River to perform an audit.

BOOM! Diamond’s career is over.

All CCOs now need to be worried that getting a question wrong on the Form ADV will end their careers.

This is a very bad order.

The SEC does not lay out any facts in the order that shows Diamond knew the statements were incorrect. The order merely states that Diamond was in a position to answer the questions because she had signatory power on the fund accounts and made accounting entries in the general ledger.

On its face, the SEC is imposing liability on a CCO solely related to the compliance operations of a CCO. Filing the Form ADV is a core responsibility of the CCO.

The order is a terrible statement by the SEC.

It’s not that Saddle River was free of problems. It’s accused of stealing over $5 million from investors, preying on investors with a claim that it was investing their money in pre-IPO tech companies.

However, in the order against her, the SEC failed to state that Diamond was involved in any of that wrongdoing at Saddle River.

I am not surprised to see CCO liability when the CCO is involved in the wrongdoing. I am surprised to see a CCO facing liability merely on the facts stated in the order against Diamond.

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A New Level of Compliance Officer Concern: Getting Arrested

Oliver Schmidt is the former top emissions compliance manager for Volkswagen in the United States. The FBI arrested him on Saturday as part of the Volkswagen emissions scandal. He was denied bail, pending a court appearance later this week.

Perhaps, the case is not one of a compliance officer missing a problem, but a compliance officer actively engaged in the wrongdoing. The charges are for conspiracy to :

  1. Defraud the US by impeding the EPA’s function of approving certificates of conformity for vehicles
  2. Commit wire fraud
  3. Violate the Clean Air Act

In this case, it looks like Schmidt was involved in the wrong-doing and the cover-up according to the criminal complaint.

One piece of evidence was that Mr. Schmidt produced a slidedeck regarding the emissions problem. In a meeting with the California Air Resources Board he identified two outcomes: 1- positive, then VW gets approval for 2016 model cars; 2-no explanation for the emission problem=indictment. I’m guessing, he may not have realized that indictment would be aimed at him.

Schmidt was a manager in charge of the Environmental and Engineering Office which is the group in VW that is responsible for communicating and coordinating with regulators. That sounds like a compliance role, but not in the way that most compliance professionals think of the role.

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The State of CCO Enforcement Actions

I was at the IA Watch conference titled “Coping with Regulatory Change” and several presenters from the Securities and Exchange Commission in different panels took a fair amount of time saying that the SEC is not targeting CCOs for enforcement actions. This was in light of several SEC actions against compliance officers in the last few years.

failure

The SEC party line is that it will defer to the good-faith determinations of the CCOs. Of course, CCOs are not granted immunity from enforcement actions. The SEC has put for the three categories for when CCOs are subject to actions by the SEC.

1.  Participating in the wrongdoing

The first area of liability is when the compliance officer is participating in the wrongdoing. This is an obvious area of liability. Compliance title is not an absolute shield.

There was the Yue Han case in last few weeks where a compliance associate at Goldman Sachs was accused of trading on inside information on pending deals. He found the inside information while conducting email surveillance in his compliance role.

2. Hindering the SEC examination or investigation

The second area is not doing the bad acts, but effectively helping to cover them up.Lying to the SEC or submitting knowingly false documents is known area liability.

The example is the Wells Fargo case. Judy Wolf was a compliance professional at the firm. When an SEC investigation in insider trading came to light, Ms. Wolf went back and altered the documents around her own review of the particular trades.

Even though this was an enforcement action, the SEC administrative law judge dismissed the action this last August.

3. Wholesale failure

The third are of liability is when there is a “wholesale failure” by the compliance officer.  This level of failure seems to be a high standard, but the recent SEC actions makes me wonder how high that standard is. It doesn’t seem to be as such a high bar as you might think.

Shortly after the conference a new action was released that included separate charges against the CCO. The Sands Brothers case involved repeated violations of the custody rule. After SEC deficiency letters and a prior enforcement action, the firm continued to fail to deliver audited financial statements as required by the custody rule. Surely a failure.

“Wholesale failure”? Sure. I would not want to defend the CCO by saying it was not a wholesale failure. Sadly, the order did not use this term.

The SEC has been inconsistent with its interpretation of the “wholesale failure” of the CCO. In the BlackRock case, the CCO was blamed for inadequate policies and procedures.

The SEC’s order found that BlackRock and its then-chief compliance officer Bartholomew A. Battista caused the funds’ failure to report a “material compliance matter”.  Rice failed to report violations of BlackRock’s private investment policy to the boards of directors.  BlackRock additionally failed to adopt and implement policies and procedures for outside activities of employees, and Battista caused this failure.  Battista agreed to pay a $60,000 penalty to settle the charges against him.

In SFX, the SEC charged the CCO for failed to supervise the president of the firm who stole $670,000, for violation of the custody rule, and for making a false statement in a Form ADV filing.  The CCO negligently failed to conduct reviews of cash flows in client accounts, which was required by the firm’s compliance policies, and did not perform an annual compliance review.  Mason also was responsible for a misstatement in SFX’s Form ADV that client accounts were reviewed several times each week.

Another was a technical interpretation case. In the Delaney case, the CCO was charged because the firm was failing to meet the requirements of 204T related to stock loans and execution of close-outs. The charges were for failing to give proper guidance on the rule, implementation of technology to comply with the Rule. The SEC position was that Delaney was that he knew the firm was violating the rule and did not take steps to stop it.

The SEC has said that CCOs are not targets. However, actions speak louder than words.

When a Compliance Officer Breaks Bad

There has been considerable discussion in the compliance community around the Securities and Exchange Commission bringing charges against compliance officers. There are three areas that the SEC feels it is justified in bringing charges: (1) when the compliance officer is involved in the wrongdoing; (2) when the compliance officer impedes the examination or investigation; and (3) when the compliance officer is in wholesale failure. The latest SEC charges against a compliance officer fall into the first area.

Breaking Bad long

Yue Han was an associate in the compliance department of Goldman Sachs. That gave him access to the emails of the investment bankers to look for potential misconduct. The SEC claims that Mr. Han broke bad and used the information he gathered from those emails to spot upcoming M&A activity for his own personal gain.

Mr. Han has not settled the charges so this story is based only the SEC’s allegations. He left the country and may not dispute the charges. The SEC has gotten an asset freeze, so he will have to fight the claim if he wants the cash back.

The SEC claims that its case stems from its Market Abuse Unit’s Analysis and Detection Center, which uses data analysis tools to detect suspicious patterns. The SEC claims that its enhanced detection capabilities enabled SEC enforcement staff to spot Han’s unusual trading activity in two different accounts.

Four companies are at the center of the SEC’s case: Yodle, Zulily, Rentrak, and KLA.  In each case, he bought out-of-the-money options cheaply just before an acquisition was announced and recognized a big gain after an acquisition was announced. Goldman Sachs was an adviser in each of the deals.

In one of the Han trading accounts, the broker-dealer barred him from acquiring further trading in the account. I assume the firm noticed the suspicious trading.

The complaint leaves out whether or not Mr. Han cleared his trades with Goldman. I would assume not since the firms would have been on the blocked list.

I would guess that Mr. Han is not going to dispute the charges and try to re-gain his trading profits.

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SEC Brings Charges Against CCO for Custody Failure

Last week at the Coping With Regulatory Failure conference, representatives from Securities and Exchange Commission repeated the SEC’s line that the SEC is not after compliance officers. But yet another case of CCO liability came out and this one kicks the CCO out of the industry and levels a $60,000 fine.

Failure stamp over white background. High detail in high resolution.

The SEC panelists repeated the line that the SEC only goes after CCOs in three circumstances:

  1. The CCO participated in the fraud
  2. The CCO hinders the exam or investigation
  3. Wholesale failure of the CCO

It’s the “wholesale failure” standard that has left many CCOs wondering if the SEC understands that term.

With a new enforcement action ruling out that pins liability on the CCO I thought it was worth a look to see if it meets the SEC standard.

The SEC announced charges against Sands Brothers Asset Management last year. The charge itself was a fairly technical violation of the Custody Rule. Sands Brothers managed private funds. According to the SEC’s order instituting an administrative proceeding, Sands Brothers was at least 40 days late in distributing audited financial statements to investors in 10 private funds for fiscal year 2010. The next year, audited financial statements for those same funds were delivered anywhere from six months to eight months late. The same materials for fiscal year 2012 were distributed to investors approximately three months late.

That’s not good. But it is a bit technical.

The really bad part is the SEC has been after the firm to fix this problem for years. Sands Brothers and its co-founders first landed in trouble in 1999. The exam noted a deficiency for custody rule procedures. The firm thought it did not have custody, but as a manager of a private fund, it does have custody.

Sands Brothers landed in trouble again 2010 when the firm was the subject of an enforcement action for custody rule violations. The firm failed to submit an adequate audit and did not timely distribute audited financial statements.

“There is no place for recidivism in the securities markets… so now they [the Firm] face more severe consequences,” said Andrew M. Calamari, Director of the SEC’s New York Regional Office.

So it’s hard to have any sympathy for the firm for the Custody Rule violations.

But what about the CCO? These are the factors that apparently caused the CCO to be a “wholesale failure.”

  • The CCO knew or was reckless in not knowing about, and substantially assisted,
    SBAM’s violations of the custody rule. (The CCO had executed the notarized offer of settlement to enter into the 2010 Order on behalf of Sands Brothers.)
  • The compliance manual tasked the CCO with “ensur[ing] compliance with the restrictions and requirements of Rule 206(4)-2 adopted under the Advisers Act.”
  • Kelly engaged the auditors for full audits (but not surprise examinations)
  • The CCO signed representation letters to, and was a principal contact for, the auditors.
  • The CCO knew that the audited financial statements were not being distributed on time.
  • The CCO implemented no policies or procedures to ensure compliance with the custody rule – even after the 2010 Order and after Sands Brothers continued to miss its custody rule deadline year after year.
  • The CCO simply reminded people of the custody rule deadline without taking any more substantial action.
  • The CCO did not make any attempt to notify the staff of the Commission of any difficulties Sands Brothers was encountering in meeting the custody rule deadlines.

It’s hard to have much sympathy for the CCO in this situation. The Principals of the firm were also subject to bar and monetary fines, so the CCO was not singled out.

The ALJ decision had blamed the CCO for being “reckless” for not doing more to prevent the custody violations. The Settlement Order with the COO also said that he “knew or was reckless in not knowing about” the custody violations.

If we go by the SEC’s earlier standard, then the SEC is equating “reckless” with “wholesale failure.” It would have been much better for the SEC to use the standard is has been espousing: “wholseale failure”; rather than using the “reckless” standard in the order.

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Failure is from Graphic Leftovers under license