Category: Compliance Programs

The One Where You Really Want to Be 94% ESG

Before the current backlash in the political environment, many investors were very focused on making investment that took into account positive environmental, social, and governance factors. Invesco wanted to meet the needs of its investors by saying that it had “over 94% of AUM currently integrating ESG.”

That’s a great goal. If it was true.

It wasn’t.

A third of Invesco’s AUM was management of the QQQ Trust ETF that tracks the 100 largest non-financial companies traded on the Nasdaq exchange. As a passive index, it’s not taking ESG into account. Invesco could have excluded that amount from its calculation and only include actively managed. But it didn’t.

Invesco stated that its ESG-integrated investment strategies had a “minimal but systematic” level of ESG integration. Invesco could have defined what that meant when it did its internal surveys to determine compliance. But it didn’t.

The result is a $17.5 million fine.

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The One Without its Biblical Strategy

Inspire Investing advertises its ETF as “biblically responsible investing.” The obvious problem is how you define what is biblical. If it were so easy to define would we would not have so many sects and theologies of Christianity and Judaism.

Inspire came up with its own methodology for excluding companies. A company is automatically given a negative score for having any “exposure” to fourteen categories. Alcohol is on the list, but weapons are not. Other factors are used to develop a positive score.

Inspire touts a scientific approach in its marketing. It looks like Inspire was not able to prove that it was actually using this approach.

10. For example, certain companies were excluded from Inspire’s investment universe for donating to certain advocacy organizations or sponsoring certain events that Inspire considered to be Prohibited Activities. At the same time, multiple companies held within the Inspire ETF portfolios donated to organizations or sponsored events that were the same or similar.

I suppose these Inspire ETFs would be prohibited investments by some of the 35 states that prohibit ESG investing. The Inspire ETFs take into account factors other than pecuniary factors, which is prohibited by many of those anti-ESG laws. Its “positive score” factors are typical of ESG funds.

The Inspire BIBL ETF also consistently underperforms the market.

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Cut Those Pennies in Half

I’m old enough to remember when stock prices were quoted in eights. They had been marked that way for 200 years on the New York stock exchange. Then they were shifted to decimals. That pushed the bid-ask spread for many stocks to $.01. Now that penny limit is being cut in half.

The Securities and Exchange Commission just enacted changes to Rule 612 which will reduce the tick size to $.005.

Now we have to figure out what systems and spreadsheets will break because trading is happening in half-pennies.

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The One with the Model Portfolio on the Website

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

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

It’s okay to use hypothetical performance in your marketing materials, IF (that’s a big if) the adviser adopts and implements policies and procedures reasonably designed to ensure that the performance is relevant to the likely financial situation and investment objectives of the intended audience of the advertisement. (See section (d)(6)(i) of the Marketing Rule)

In the release, the SEC states

We believe that advisers generally would not be able to include hypothetical performance in advertisements directed to a mass audience or intended for general circulation. In that case, because the advertisement would be available to mass audiences, an adviser generally could not form any expectations about their financial situation or investment objectives. (See page 220)

Earlier this spring the SEC brought enforcement actions against five firms for publishing hypothetical performance on their websites. The SEC just found another firm who published returns from model portfolios on its website. See IA Release 6646.

It’s become very clear that model portfolio returns do not belong on a firm’s website.

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The One With the Fake Gatekeepers

If you’re going to commit financial fraud, you need to figure out a way not only to deceive your “investors” but also the gatekeepers involved in the process. Your auditor is going to ask questions and not issue financial statements if there is fraud. Your prime broker and custodian are going to ask questions. Hedonova found a way around this.

Lie about them. Say you are using Northern Trust as your custodian. Say you are using Deloitte as your auditor. But don’t actually engage them. At least that’s what the SEC claims in its complaint.

The pitch for investors is interesting. Be a part of group ownership of alternative investments: art, startups, wine, music royalties, real estate, agriculture holdings, litigation finance, etc. A fund full of alternative assets. Hedonova claims to be a “mutual fund.”

This sounds rife with problems to me. Valuations are challenging and sourcing opportunities is hard. Finding and retaining personnel is hard. Each of these alternative classes require their own expertise.

The SEC began poking around and found most of its claims about its gatekeepers were not true and had not been engaged by Hedonova.

The SEC has uncovered millions of dollars sent to Hedonova. It has not been able to identify it purchased much, if any, assets. The firm principals are oversees and, according to the SEC, are not cooperating.

As for the Hedonova website, it’s a buffet of items to stare at under the lens of the Marketing Rule. I might use it for my compliance class in the fall.

Hedonova also has used a bunch of fin-fluencers. I found a bunch of junky stories on blogs and social media platforms spewing out the virtues of Hedonova. (I’m not going to bother linking to them.)

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The SEC Still Hates the Word “May”

Disclosure of conflicts is a cornerstone is a cornerstone of the regulation of investment adviser. 3D/L Capital Management clearly came up short.

3D/L entered into an arrangement with an ETF manager that would provide a revenue share to 3D/L they labeled an “onboarding fee.” The SEC complaint points out that the onboarding fee creates a conflict, by incentivizing 3D/L to allocate client money to those ETF funds. 3D/L failed to disclose the onboarding fee for two years.

Then 3D/L revised its Form ADV Part 2. The SEC was not happy with the wording of the disclosure.

The ETF Manager had paid an “onboarding fee to make ETFs available for inclusion in 3D/L’s composite portfolios.” While this disclosure exposed the existence of the fee, it further stated that “[t]his [p]rogram may create a potential conflict of interest.”

(My emphasis)

The SEC stated that this was inadequate because there was an actual conflict of interest.

The SEC seemed happier when 3D/L revised its Form ADV to “onboarding fee . . . results in a conflict of interest.”

Lawyers love the word “may”. (speaking as one) The SEC does not like the word “may.”

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Reviewing the Accredited Investor Definition


The Securities and Exchange Commission issued a Staff Review of the “Accredited Investor” Definition at the end of 2023. The Dodd-Frank Wall Street Reform and Consumer Protection Act directs the SEC to review the accredited investor definition every four years.  The Staff previously reviewed the definition in 2015 and in 2019 (as part of the Concept Release on Harmonization of Securities Offering Exemptions).

There were several changes in 2020 to the definition of “accredited investor” as a result of the 2019 report. The SEC allowed those meeting the “knowledgeable employee” standard to meet the “qualified purchaser” standard would also be deemed an “accredited investor.” The SEC added a qualification-based standard, initially allowed holders in good standing of the Series 7, Series 65, and Series 82 licenses as accredited investors. And lastly, the SEC added the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors. There were a few other tweaks to the definition.

But the financial thresholds remained unchanged. I think that is likely to change this year. On the Fall 2023 RegFlex Agenda the SEC listed Regulation D and Form D Improvements (3235-AN04) 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.”

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SEC Begrudgingly Approves Bitcoin ETP

We all saw this train coming down the tracks. Even the hacker who took over the SEC’s Twitter account announcing the approval, merely jumped the gun. The Securities and Exchange Commission, by a 3-2 vote, authorized a dozen spot Bitcoin exchange traded products.

Gary Gensler’s SEC has been trying stem the tide and prevent crypto from becoming more legitimate by denying any form of SEC authorization. Last year’s loss in the Grayscale’s court case was the break that could not be plugged. In the original Grayscale Order, the SEC determined that the proposal had not established that the CME bitcoin futures market was a market of significant size related to spot bitcoin, or that the “other means” asserted were sufficient to satisfy the statutory standard. The U.S. Court of Appeals for the D.C. Circuit held that the SEC failed to adequately explain its reasoning. The court vacated the Grayscale Order and remanded the matter to the SEC. “Because we don’t like it” is not a sufficient reason.

That didn’t stop Chair Gensler from slapping crypto.

“While we approved the listing and trading of certain spot bitcoin ETP shares today, we did not approve or endorse bitcoin. Investors should remain cautious about the myriad risks associated with bitcoin and products whose value is tied to crypto.”

He points out that “the vast majority of crypto assets are investment contracts and thus subject to the federal securities laws.”

Commissioner Peirce countered:

“[O]ur actions here have muddied people’s understanding of what the SEC’s role is. Congress did not authorize us to tell people whether a particular investment is right for them, but we have abused administrative procedures to withhold investments that we do not like from the public.”

The SEC has allowed crypto to take step towards more credibility, liquidity and lower costs.

Personally, I don’t see ordinary people using crypto. They just trade it. I appreciate the blockchain infrastructure and potential innovation to move money cheaply. Criminals love it. It’s an easy way to move money around anonymously.

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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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The One With the Gambling Edge

Buying and selling securities is often equated with gambling. (The differences are that you can hold your securities and keep winning without making any bets.) Gamblers and investors are always looking for an edge to increase their odds of success. When it comes to investing, that edge can be the misuse of insider information.

The headline of SEC Charges Former Employee of Online Gambling Company with Insider Trading jumped out at me. Finally, the intersection of gambling and investing in an enforcement case.

It turns out to be a fairly standard insider trading case. David Roda worked at Penn Interactive Ventures, a subsidiary of Penn National Gaming, as a programmer for its online sportsbook application. He heard from a co-worker that Penn was working on an acquisition. Mr. Roda got himself added to the acquisition team and found out about the target.

According to the SEC complaint, Mr. Roda quickly acquired some call options on the target. Penn sent a message warning employees not violate the insider trading policy. That apparently spooked Mr. Roda so he sold those options. Or maybe it didn’t spook him, because he then bought more options on the target.

As you might expect, the trades looked suspicious. They were short duration options that were “out of the money.” Since the options were just above the current trading price with little time left for the price to rise, they were cheap. It would be very aggressive to buy these, unless you had a gambler’s edge. Or insider knowledge.

According to the SEC complaint, Mr. Roda’s $21,000 purchase of those options netted him over $580,000 in profits in less than two weeks. I’m sure that triggered warning lights for compliance at whatever firm he had used for the trading.

Obviously, this is just the government’s side of the case. The Department of Justice has stepped in with criminal charges as well. Mr. Roda may or may not be guilty.

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