Category: Compliance Programs

Dam, That’s Securities Fraud

The collapse of the Bumadinho Dam in Brazil in 2019 was a disaster. The structure was holding back iron ore waste before it collapsed, sending million of tons of toxic waste into the village of Córrego do Feijão. It killed 270 people. The dam was controlled by the Brazilian mining company: Vale S.A.

Clearly a massive disaster, but was it securities fraud?

The US Securities and Exchange Commission seems to think so. And the SEC is positioning the case an ESG disclosure violation.

The complaint accuses Vale of deliberately manipulating multiple dam safety audits; obtaining
numerous fraudulent stability declarations; and regularly and intentionally misleading local
governments, communities, and investors about the dam’s integrity. The SEC points to Vale’s public Sustainability Reports and other public filings that assured investors that Vale adhered to the “strictest international practices” in evaluating dam safety and that 100 percent of its dams were certified to be in stable condition.

“By allegedly manipulating those disclosures, Vale compounded the social and environmental harm caused by the Brumadinho dam’s tragic collapse and undermined investors’ ability to evaluate the risks posed by Vale’s securities.”

How is a Brazilian mining company subject to the jurisdiction of the SEC? Vale has American Depositary Shares and some debt notes registered with the SEC. That clearly moves it into SEC jurisdiction.

Why brings a securities fraud case? The complaint goes into great deal about the allegedly fraudulent acts that Vale took around the regulation and evaluation of the dam. The SEC takes the position that making public statements, especially at an investor presentation, that were false and misleading about the dam safety was misleading to investors.

The primary motivation is that the SEC’s new Climate and ESG Task Force in the Division of Enforcement is on duty.

The SEC launched the Climate and ESG Task Force within the Division of Enforcement to develop initiatives to proactively identify ESG-related misconduct consistent with increased investor reliance on climate and ESG-related disclosure and investment.

Vale said its ESG was not too bad, at least not for a mining company. But in reality its ESG was very bad, even bad for a mining company. The SEC says that is securities fraud.

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Fund Fee Calculation Error

Calculating fund fees during the commitment period is usually easy for most private equity funds. Take the committed capital and multiply it by the applicable fee percentage. After the commitment period, the calculation often gets more complicated. Most funds have some reduction to actual capital deployed with deductions for write-downs and partial realizations.

Global Infrastructure Management got the calculation wrong for its funds. Part of the problem was an inconsistency between the funds’ PPMs and the funds’ partnership agreement in how to treat partial realizations. The PPMs stated the post-commitment management fee would be based on the capital contributions relating to the retained portion of investments. The partnership agreements said the fee would be calculated based on each limited partner’s capital contribution that was used to acquire an investment, and thus a partial disposition of the investment would not reduce management fees.

Global followed the partnership agreement and didn’t reduce the fee for partial dispositions. Unfortunately, Global employees appeared to have also told some investors that it would reduce and others that it wouldn’t.

It seems clear that the SEC view is that inconsistency works against the fund manager. The SEC made Global rebate fees back to investors based on the partial realization language in the PPMs. Fund managers need to prove that they are entitled to the fees and are may be cut short by inconsistent language.

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The SEC Has Observed Your Private Funds and the SEC Is Not Happy

On January 27, the SEC’s Division of Examinations published a Risk Alert on the EXAMS staff Observations from Examinations of Private Fund Advisers. The Risk Alert is labeled as a follow up to the 2020 Observations from Examinations of Investment Advisers Managing Private Funds and the 2017 The Five Most Frequent Compliance Topics.

The EXAMS staff breaks their problematic observations into four broad categories:

  1. failure to act consistently with disclosures;
  2. use of misleading disclosures regarding performance and marketing;
  3. due diligence failures relating to investments or service providers; and
  4. use of potentially misleading “hedge clauses

Disclosures

The staff found fund managers not getting consent from their LPACs when required by the fund documents. That seems like a poor choice by those fund managers.

Fund managers were not getting the management fee calculations right during the post-commitment period. Sure, commitment period is easy, just the percentage against the commitment. Post-commitment you typically have to deal with equity invested calculations, impairments and partial sales.

Some funds were diverting from their designated strategy. I see this issue pop up during long term funds. The world ends up in a different place than when the fund originated. You still need to stay within the guard rails.

Marketing Performance

Fund managers like to think they are a unique flower and benchmarks don’t apply to them and their performance needs to be shown in a special way. (That is true.) The problem is stepping over the line and showing it in a misleading way. The Risk Alert points out failures in calculations by using the wrong dates, cherry picking, omitting information on leverage, and not including fees. This is a continuing problem with private funds. It’s been raised by the SEC many times and the SEC is raising the issue again. I don’t think the new Marketing Rule went into enough detail on what the SEC wants.

Due Diligence

“A reasonable belief that investment advice is in the best interest of a client also requires that an adviser conduct a reasonable investigation into the investment that is sufficient to ensure that the adviser is not basing its advice on materially inaccurate or incomplete information.”

Hedge Clauses

The EXAMS staff observed private fund advisers that had included hedge clauses in fund documents that waive or limit the Advisers Act fiduciary duty except for certain exceptions, such as a non-appealable judicial finding of gross negligence, willful misconduct, or fraud. That could violate Section 206(1) and section 206(2) of the Advisers Act. You can’t contract away your fiduciary obligations.

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The SEC Continues its Attack on the Word “May”

I’ve been critical before of the Securities and Exchange Commission’s Attack on May. Personally, I’ve always viewed “may” as a permissive position when it comes to disclosure. The SEC thinks its completely inadequate.

The SEC view is that if an investment adviser always takes the fee or usually take the fee, “may” is inadequate. How often is “usually” when it comes to “may”? Sixty percent of the time is bad, according to a recent SEC complaint against TCFG Wealth Management and the firm’s CEO/President/COO.

According to the complaint, TCFG imposed a fee markup on rates charged by the firm’s clearing broker. Those fees, and the markup, would be passed on to the TCFG clients when the firm made trades on their behalf. The individual advisers at the firm could chose not to pass the markup through to their clients. In which case the markup was still imposed. The individual investment adviser employee would pay the markup instead of the client.

According to the complaint, 60% of the transactions passed through the fee markup to the firm clients. That was 10,000 transactions and $300,000 in revenue to the firm.

The TCFG form ADV Firm Brochures stated that TCFG “may” receive portions of the fees charged to accounts of TCFG
clients. It further stated that these additional fees TCFG received were “charged” by Clearing Broker, not TCFG, and were for things like wire fees, postage fees, clearing fees and ticket charges, which TCFG said it used to help pay for administrative support for its various entities.

Obviously, the second half was false when disclosing what the fee was used for. The SEC took issue with the statement that the clearing broker charged the fees, when it was TCFG that charged the fee. Plenty of messiness in this arrangement to draw the wrath of the SEC. We haven’t heard the TCFG side of the story.

It’s clear that the SEC has drawn a line in the sand over “may” when disclosing fees. If your firm charges the fee more than half the time, “may” is not the right word to use.

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“May” Can Be a Failure to Disclose

I’ve complained about the Securities and Exchange Commission focusing on the use of the word “may” in disclosures. I’ve typically expected “may” to offer some optionality for the adviser. The SEC has found it inadequate in several instances. We can agree to disagree.

I just came across a case in which I agree that the use of “may” was clearly inadequate in the disclosure.

Diastole Wealth set up a private fund to help its clients pool investments so that they can indirectly invest in things they would not otherwise be able to invest in individually, like private funds. Diastole is run by Elizabeth Eden. Her son had worked at Diastole. He also owned a piece of the firm.

The son left to set up software companies to make tools to help small investment advisers. Several of Diastole’s client invested in the software companies. A potential problem? Yes. Although Diastole and Eden were aware of these investments they did not select or recommend these investments to the clients and did not receive advisory fees related to these investments. No problem.

The problem comes in 2017 when Eden had the Diastole fund invest in the software companies. To me that seems like a conflict that would need to disclosed. Diastole eventually realized this as well and send a “Disclosure and Conflicts of Interest Waiver” to the fund investors. The Disclosure stated that the firm “may” recommend investments in the son’s software companies. In this case, the investments had already occurred. That’s a problem.

I agree in this case that “may” is misused. If you agree with me that “may” provides optionality, this is not a case of optionality. The investments has already occurred. The Disclosure should have been clear that the investments had already happened. If Diastole wanted to have the option to make future investments, then “may” would be appropriate. It does not work at all when the conflict has already happened.

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SoFi, when the “Fi” stands for “fine”

SoFi Wealth, the robo-adviser ran into trouble when it substituted third-party ETFs with SoFi-sponsored ETFs in its platform.

According to the SEC order, SoFi Wealth failed to provide its clients with full and fair disclosure of its conflicts of interest relating to the transactions, including that it:

  1. SoFi had a preference for placing clients into SoFi’s newly-created proprietary ETFs rather than third-party ETFs, and SoFi’s economic interest in these proprietary ETFs presented a conflict of interest for SoFi Wealth,
  2. SoFi was investing client assets in these proprietary ETFs to help market the SoFi brand as having a broader array of services and products than previously offered, and
  3. SoFi intended to use client assets to capitalize the new SoFi ETFs with significant investment on their second day of trading, making the ETFs more liquid and favorable to the market.

It’s not that an adviser can’t us its own funds or ETFs in client portfolios. It just needs to properly disclose the conflict. SoFi did not.

SoFi’s compliance group probably should have read the J.P. Morgan case from 2015. Morgan got in trouble for having a preference for investing client assets in proprietary funds and not disclosing the conflict.

The complaint once again has the SEC quibbling over the use of the word “may.” The disclosure said that SoFi would select a mix of ETFs “that represent the broad asset allocation determined by these strategies, which may include ETFs for which SoFi is the sponsor.” The SEC issue was that the SoFi investment committee had already approved the replacement of third-party ETFs with SoFi ETFs. I hate that the SEC quibbles over the use of “may.” I don’t see how the word “may” really changes anything in the disclosure.

The big problem was that SoFi replaced the ETFs in client accounts. That means it sold the old choice and had the client buy the new one. No big deal in IRAs. But it is a big deal in taxable accounts. It triggered over $1.3 million in taxable gains for the clients and offered no material benefit to the client.

All the benefit ran to SoFi whose ETFs were now bigger and more liquid.

SoFi had sweetened the pot by waiving the expense fees of the ETF. Again good for the ETF holders, but it would take some time to make up for the taxable gain.

Some compliance lessons. Be careful using the word “may” in disclosures. Don’t replace third-party choices with proprietary choices in taxable accounts unless you also disclose the tax issue.

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SPAC, SMACK, SHAQ?

SPACs are the current tulips of the markets. Everyone wants a piece of one. Celebrities are joining the rush. As noted in the title, Shaq has one. Actually Shaq is on his second SPAC.

Almost 250 SPAC IPOs were completed in 2020, raising total gross proceeds of approximately $75 billion That was about half of the number of IPOs and half of the capital raised in IPOs.

There are lots or reasons for companies to become liquid and raise capital through a SPAC. There is certainty in pricing. Private company founders and their backers don’t have to spend months worried about how much capital will be raised in an IPO. They negotiate the capital raise with the SPAC executives.

The downside is that the private company may not have been through the compliance wringer to make sure it’s ready for the rigors of being a public company.

The SEC is catching up and has released a series of statements and policy notices about SPACs. The Division of Corporate Finance pointed out that these newly crafted public companies have to focus on their books and records and their financial controls. The public SPACs have to meet these standards. But since they are just sitting on a pile of cash, their controls can be very simple. It’s really the controls of the acquired company that will be in operation.

A public statement by the SEC’s Chief Accountant also pointed to the financial controls, governance, and audit controls that creates faith in the public markets.

One item that the SEC has started to focus on is the treatment of the warrants involved in the SPAC combination. The reason that sponsors are jumping on the SPAC bandwagon is the promote granted to the SPAC organizers in the form of warrants.

The Securities and Exchange Commission last week began privately telling accountants that warrants, which are issued to early investors in the deals, might not be considered equity instruments, according to people familiar with the matter.

It’s the special sauce that has helped lubricate the SPAC engine. It’s not a bubble in valuation. It’s a bubble in method.

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Massachusetts Fires an Arrow at Robinhood

The Secretary of the Commonwealth filed its first enforcement action under the Massachusetts Fiduciary Rule. Robinhood and its gamification of investing are in its bullseye.

The Massachusetts Securities Division adopted amendments to 950 Mass. Code Regs. 12.200 earlier this year as they relate to the standard of conduct applicable to broker-dealers and agents. The amendments apply a fiduciary conduct standard to broker-dealers and agents when dealing with their customers. The Division said it would begin enforcing the amended regulations on September 1, 2020.

“Each broker-dealer shall observe high standards of commercial honor
and just and equitable principles of trade in the conduct of its business.”
– 950 CMR 12.204(1)(a)

According to the data, Robinhood has almost a half million customers in Massachusetts. Approximately 68% of the Massachusetts customers approved for options trading on Robinhood have no or limited investment experience. One advertisement states:

“I’m a broke college student and investments might help my future tremendously.”

The administrative complaint shoots at Robinhood claiming its infrastructure is inadequate. The outages and disruptions in the platform earlier this year are the indicators. The crux of this prong of the complaint is that Robinhood is continuing to recruit new customers without properly improving its infrastructure. The complaint states 70 outages over the course of 2020.

The second prong of the complaint takes that position that Robinhood’s supply of lists of most popular stocks is an encouragement to purchase the security without consideration of the customer’s suitability.

The third prong is Robinhood’s permission and encouragement for customers to trade. The complaint uses the example of one customer that clicked the investment experience button when creating the account. That customer made 12,748 trades this year. An average of 92 trades a day.

A fourth prong is that Robinhood failed to properly screen customers before allowing them to trade options. Robinhood failed to follow its own policies and procedures.

Wrapping it up, the complaint says that each of these four prongs is a violation of the Massachusetts Fiduciary Standard applicable to broker-dealers.

All of this is just the regulators side of the case. A Robinhood spokeswoman said before the complaint was filed that the company has and will continue to work closely with all regulators.

“Robinhood has opened up financial markets for a new generation of people who were previously excluded.”
“We are committed to operating with integrity, transparency, and in compliance with all applicable laws and regulations.”

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Compliance Outreach and OCIE Observations

The SEC’s Office of Compliance Inspections and Examination launched a lot info last week. It livestreamed a National Investment Adviser/Investment Company Compliance Outreach and published a Risk Alert on notable compliance issues identified by OCIE related to Rule 206(4)-7.

Peter Driscoll, Director of OCIE, started off the program highlighting three words that should be applicable to your firm’s CCO: Empowered, Seniority, and Authority. He wants firms to think of compliance and the CCO as an essential component to running and advisory business and not just a box to be checked. CCOs should be routinely included in strategy discussions and brought into decision-making early-on for their meaningful input.

Then he mentioned that OCIE was publishing a risk alert right then on compliance programs.

Mr. Driscoll moved the Outreach program to a panel with Dalia Blass from Investment Management and Marc Berger from Enforcement. In discussing private funds, they highlighted the usual hot spots:

  • Valuation
  • Undisclosed conflicts
  • custody rule
  • allocation of expenses

In discussing upcoming regulatory changes, Ms. Blass mentioned the proposed Advertising Rule changes. Sounds like it’s still in process. No mention of a timeline. She also mentioned that there may be some upcoming regulatory changes around valuation and custody.

The second panel was on resiliency, information security and business continuity. This is even more important with so many firms and their employees working remotely.

The second panel focused on undisclosed conflicts. One panelist expressed grave concern over the use of the word “may” when describing conflicts. If there is an actual conflict, “may” is not the right word to use. If a firm always takes a fee, “may” is not the right word to use.

The panelists raised the issue of disclosing PPP loans. It was noted that taking a PPP loan was an indication of financial distress that likely should be disclosed to clients.

Turning to the new risk alert, the focus is the structure of compliance programs. It starts right off with a failure to have adequate compliance resources to support a robust compliance program. That includes having a CCO who devotes adequate time to compliance and is knowledgeable about the Advisers Act. One special note was for firms that had grown in size or complexity, but had not increased their compliance resources accordingly.

The Risk Alert emphasizes the importance of the annual review and documenting the annual review. As it’s coming up to year-end, it’s a good check list as you may be starting to work on your annual review.

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Exchange-Traded Products Initiative

The Securities and Exchange Commission announced a new initiative focused on complex products: The Exchange-Traded Products Initiative. It’s led by the Division of Enforcement’s Complex Financial Instruments Unit. It was developed by Armita Cohen and data analytics specialists Daniel Koster and Jonathan Vogan and has been coordinated by Ms. Cohen.

The first inkling of this initiative was the Morgan Wilshire case in late September. That firm was selling inverse ETFs to its clients. The firm’s representatives were not knowledgeable about the products. The inverse ETF tries to create the opposite returns of an index over a short period of time, typically one day. If held longer, the product stop achieving the originally targeted results.

Like with the earlier case, the five cases announced as part of the Exchange-Traded Products Initiative were complex products but had the patina of simplicity because they were exchange-traded. The products were designed be held in the short-term for limited use.

Instead, the firms were marketing to a broader set of clients and not getting them back out of the product in the short-term. Of course, this means that customers lost money.

The compliance failure was the firms failing to determine if the product was suitable for the client, a lack of training on the product and a lack of appropriate review of the transactions.

Some of this will be increasingly problematic under the new Reg BI standards instead of the older standards for broker-dealers.

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