Category: SEC News

Fighting Against the SEC’s Administrative Hearings

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Prior to the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Securities and Exchange Commission’s authority to impose penalties in a case brought as an administrative proceeding was restricted to regulated entities. The SEC could not impose a significant civil penalty in an administrative proceeding. That limited administrative proceedings to cease-and-desist proceedings against broker-dealers, investment advisers, and mutual funds. The alternative to the administrative brought before an SEC administrative law judge was a lawsuit brought in federal court.

Dodd-Frank changed that with its Section 929P. The SEC may now impose a civil penalty in an administrative proceeding against any person or company.

Administrative proceedings have many built-in advantages for the SEC: limited discovery, no right to a jury trial, an inherently biased administrative law judge, and a biased appeal to the SEC commissioners. The SEC has the “home court” advantage. According to a Wall Street Journal story, in the 12 months through September, the SEC won all six contested administrative hearings where verdicts were issued, but only 11 out of 18 federal-court trials.

There is an upside to the administrative proceeding. Some defendants will see it as a quicker or less costly proceeding.

One defendant thinks otherwise and has filed suit against the SEC in defense of an upcoming administrative proceeding. Joseph Stillwell runs an investment fund that is under investigation by the SEC. He received a Wells Notice and is expecting his case to end up as administrative proceeding after settlement talks have stalled.

A second defendant in a separate case also challenged an administrative proceeding. Jordan Peixoto was accused by the SEC of insider trading, but the SEC decided to use its new administrative proceeding alternative to federal court. Unlike Stillwell, Peixoto was not subject to SEC registration. The only other time the SEC has acted in this manner was with Rajat Gupta.

There is a constitutional question raised by each case. Each raises concerns about due process and presidential appointment powers. Since the SEC is an independent agency, the SEC commissioners can only be removed for good cause. The administrative judges also have tenure and can only be removed for cause. Prior federal cases have only permitted one level of tenure, not the two levels for the SEC administrative judges.

There is an ethical question. The administrative judges are appointed by the SEC and any appeal of the judges decision is appealed to the SEC commissioners. Since it takes a vote of the SEC commissioners to proceed with an enforcement action, those commissioners are hearing the appeal of the case they authorized to proceed in the first place. The judges are not held to any code of conduct or code of ethics. In the Peixoto complaint, the proceeding is called a “star chamber” where the accused is defenseless.

He also pulled up a statement by the SEC’s general counsel that called into question the adequacy of the administrative process for insider trading cases.

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Failing to Disclose Fees

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The Securities and Exchange Commission has been focused on fees charged by investment advisers and fund managers. The latest target is Robare Group Ltd. based in Houston. The SEC alleges that the firm was receiving a fee from certain investments made for its clients but failed to properly disclose that it was receiving the fee.

According to the SEC order, an unnamed broker agreed to pay the Robare Group a fee for client funds invested in funds sold by the broker. There is nothing inherently wrong with that arrangement. However, it should be disclosed to clients. The concern is that the adviser would direct clients to invest in those funds because it is good for the adviser, not necessarily because it is good for the client.

One interesting thing about the alleged violation is that the SEC is not stating any harm to Robare Group’s clients or even that the clients were invested in the fund for a disproportionate amount. The SEC is focused solely on a violation for failure to disclose. The disclosures were not adequate because they said the Robare Group “may” receive compensation from the broker for selling the mutual funds, when it was definitely receiving payments, the SEC said. In my opinion, that’s a very thin distinction to make.

The interesting thing about the press release for the alleged violation is the statement that the SEC’s asset management unit has enforcement initiative focused on undisclosed compensation arrangements between investment advisers and brokers. This is sounds like a similar effort focused on undisclosed compensation to private equity fund managers from portfolio companies.

 

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SEC’s Municipal Advisor Exam Initiative

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The Securities and Exchange Commission announced a new examination initiative directed at newly regulated municipal advisors. The examinations are designed to establish a “presence” with the newly regulated municipal advisors.

We’ve seen this blueprint before. It looks a lot like the presence exam initiative for newly registered private fund managers and the never before examined initiative for unexamined advisers. The SEC is trying to knock on as many doors as they can.

The SEC is working with the Municipal Securities Rulemaking Board (MSRB) and the Financial Industry Regulatory Authority (FINRA) to facilitate a coordinated approach to oversight of municipal advisors. SEC’s OCIE will examine municipal advisors for compliance with applicable SEC rules and applicable final MSRB rules once the MSRB rules are approved by the SEC and become effective.

Section 975 of Dodd-Frank added a new requirement that “municipal advisers” register with the SEC. Municipal Advisor is defined in 15 U.S.C. 78o-4(e)(4)(E)(4) as:

(A) means a person (who is not a municipal entity or an employee of a municipal entity) that—

(i) provides advice to or on behalf of a municipal entity or obligated person with respect to municipal financial products or the issuance of municipal securities, including advice with respect to the structure, timing, terms, and other similar matters concerning such financial products or issues; or

(ii) undertakes a solicitation of a municipal entity;

(B) includes financial advisors, guaranteed investment contract brokers, third-party marketers, placement agents, solicitors, finders, and swap advisors, if such persons are described in any of clauses (i) through (iii) 5 of subparagraph (A); and

(C) does not include a broker, dealer, or municipal securities dealer serving as an underwriter (as defined in section 77b(a)(11) of this title), any investment adviser registered under the Investment Advisers Act of 1940 [15 U.S.C. 80b–1 et seq.], or persons associated with such investment advisers who are providing investment advice, any commodity trading advisor registered under the Commodity Exchange Act [7 U.S.C. 1 et seq.] or persons associated with a commodity trading advisor who are providing advice related to swaps, attorneys offering legal advice or providing services that are of a traditional legal nature, or engineers providing engineering advice;

Starting later this year, OCIE in coordination with FINRA and the MSRB will hold a Compliance Outreach Program for newly regulated municipal advisors where they will learn more about the examination process and their obligations under the Dodd-Frank Wall Street Reform and Consumer Protection Act and related rules.

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The SEC Shows Some Respect for the Working Woman

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The Securities and Exchange Commission decided to emphasize that working wives can be a source of material non-public information. The SEC press release highlighted insider trading cases brought against husbands who engaged in insider trading after learning confidential information from their wives.

The first case was against Tyrone Hawk. His wife worked at Oracle. Mr. Hawk overheard Mrs. Hawk talking about Oracle’s acquisition of Acme Packet. He decided to make a quick buck and bought shares in Acme Packet. His trade netted him $150,000 after the stock went up 23% on the takeover news.

The second case was against Ching Hwa Chen. His wife worked at Informatica. He overheard news from Mrs. Chen that the company was not going to make its quarterly earnings target. He decided to profit on the bad news by taking a short position on the stock. He made a quick $140,000 in profit.

To emphasize the point, the press release highlighted three older cases of husbands engaging in insider trading after misappropriating information from their spouses: James Balchan, M. Jason Hanold, and William A. Marovitz.

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Do U.S. Regulators Listen to the Public?

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Regulators get piles of comment letters on proposed rules. But do the comments have an affect? Three math and finance professors tried analyzed the text of comments and regulations to find and answer.

Andrei A. Kirilenko, Shawn Mankad, and George Michailidis created a regulatory analytical tool called RegRank. The three researchers pointed RegRank at the CFTC and the 104 proposed rules the commission issued between January 2010 and September 2013. Those proposed rules resulted in 60,000 comment letters and 67 final rules.

The researchers used RegRank to rate a particular proposed rule, final rule and comments as pro-regulation or anti-regulation.  Then they use the tool to characterize how the CFTC rules evolved.

The data indicates that the regulators adjust the rules based on comments.

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There is a general pattern of a proposed rule becoming more in line with the calculated sentiment of the comment letters when it becomes a final rule.

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Are SEC Employees Profiting from Enforcement Actions?

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Emory University accounting professor Shivaram Rajgopal points an accusatory finger at Securities and Exchange Commission employees and proclaims a pattern of selling stocks of companies subject to enforcement actions. His study finds “significant abnormal returns of (i) about 4% per year for all securities in general; and (ii) about 8.5% in U.S. common stocks in particular. The abnormal returns stem not from the buys but from the sale of stock ahead of a decline in stock prices.”

Rajgopal throws the big rock:

Most of these returns stem from the timely sale of these stocks, suggesting that a regulator’s employees are most likely to know about sanctions against companies before the market as a whole.

The study is based on reported securities trades by 3,500 SEC employees during late 2009, and for all of 2010 and 2011. However, the data is severely constrained. Rajgopal merely had a list of transactions and no ability to compute the profits or losses. There is also no data on holdings. The study only looks at what was bought and sold. Rajgopal constructs a synthetic hedge model in an attempt to model the trading.

I’m going to assume his analysis is correct and that SEC employees were more likely to sell in companies that become subject to SEC enforcement actions. Rajgopal claims this is illegal trading before public announcements. I think it’s just SEC employees over-emphasizing SEC actions as a reason to sell the stock.

One fault in Rajgopal’s accusation is how limited the news about an enforcement action may be. The SEC is a huge organization. But even if the news of an enforcement action is leaky, only a small percentage of the 3,500 employees would have that information and be able to make the illegal trade. That small number would not be as statistically significant as Rajgopal finds in his study.

The only meaningful part of the report is its focus in Table 3 of 87 trades of the 7,200 employee trades studied. Those 87 trades are in Bank of America, General Electric, Citi, Johnson & Johnson, JP Morgan, and General Electric in the period prior to the announcement of enforcement actions.

The trades highlight the need for preclearance. An organization may have material non-public information. But the information is only seen by a subset of employees. Clearly, you can track document and email traffic to prove that someone knew that information. That’s what the SEC does in its insider trading investigations. The tough part is defending from an accusation of having the knowledge.

It’s hard to prove that you didn’t know something.

The SEC is stuck with an accusation and little way of proving that those 87 trades were not made on material non-public information. Clearly, the information existed within the SEC. Perhaps the SEC can find a smoking gun that proves that some of those 87 were made by employees who knew about the enforcement action. I would guess that majority were made without that knowledge and no way to prove that they lacked the knowledge.

The SEC should have a pre-clearance requirement or a planned sell window so that the SEC and its employees can avoid the taint of accusations like Rajgopal’s accusation. That’s why public companies have 10b-5 plans and registered investment advisers have pre-clearance requirements.

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Private Fund Theft Through Diligence Payments

camelot and compliance

The Securities and Exchange Commission charged Lawrence E. Penn III and his firm Camelot Acquisitions Secondary Opportunities Management, a private equity manager, with stealing $9 million from investors in their private equity fund. He is accused of siphoning off $9.3 million through sham due diligence payments.

The SEC claims that Penn used a shell company to funnel due diligence expense payments from the private equity funds. That money was then transferred to Penn and Camelot. Penn and Camelot are merely charged so we can only see the issue through the SEC’s eyes. Since it was a private equity fund, the story caught my eye.

Camelot’s audit firm could not obtain satisfactory evidence that certain due diligence payments were legitimate. The fund only paid millions in due diligence expenses to a firm called Ssecurion. But no other firm for due diligence.That;s strange for a firm to be using a single diligence provider given the many areas of diligence required for private equity investments.

Another red flag should have been the cost. I think $9 million is a big expense item for a fund with about $175 million AUM.

The audit firm kept poking and Camelot produced generic looking materials that could be found on the internet. None were branded or had any indication that they came from Ssecurion. The audit firm was worried and didn’t have any credible evidence that the costs were legitimate.

The audit firm reported the matter to the Securities and Exchange Commission.  The SEC’s Office of Compliance and Inspections and Examinations initiated a for-cause exam. Camelot failed to produce requested books and records and Penn failed to show up for several meetings. As a result, OCIE could not complete the examination and handed the case over to enforcement.

Camelot’s Form ADV Part 2 states Deloitte and Touche terminated the audit relationship during the summer of 2013. Deloitte disowns prior financial statements and did not prepare a report for 2012.

It sounds like a great job by Deloitte reporting the problem. Except it took the firm a few years and a few audits to uncover the problem. Alleged problem. Penn and Camelot have not responded to the charges.

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Gustave Doré’s illustration of Lord Alfred Tennyson’s “Idylls of the King”, 1868

NEAT and MIDAS: The SEC’s New Tools

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“This is not your father’s SEC – or your mother’s or even your older brother or sister’s.”

Securities and Exchange Commission Chair Mary Jo White is proud of two new technology tools the Commission is rolling out. She spoke about the new tools at the 41st Annual Securities Regulation Institute.

The first is NEAT, the National Exam Analytics Tool. This new tool is designed to analyze trading data, looking for potential insider trading by comparing trades against significant corporate events. That will be fun. But then the SEC needs to find the connection between the suspicious activity and now connection with an obligation to hold material non-public information confidential. That’s the hard part.

NEAT will also be able to find signs of front running, improper allocations, and other misdeeds by investment advisers. Chair White told the tale of running NEAT against an adviser’s 17 million transactions. Sounds scary. Mostly because of the headache it will be trying to match a trade blotter against the format required by NEAT to input the data.

MIDAS, the Market Information Data Analytics System, collects one billion records of trading data, time-stamped to the microsecond, every day. MIDAS is focused on market stability. It should help the SEC monitor and understand mini-flash crashes, reconstruct market events, and to develop a better understanding of long-term trends.

Both of these tools will create a tremendous amount of data. But that’s just the first step. It’s about understanding the data and finding the signal through the noise.

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SEC’s First Deferred Prosecution Agreement With an Individual

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The Securities and Exchange Administration announced that it entered into its first deferred prosecution agreement with an individual. What’s remarkable is that this is first time the SEC has done so.

Back in early 2010, the SEC announced that it had launched a new enforcement cooperation initiative. The SEC did a big (for the SEC) marketing campaign to announce initiative. The SEC even went so far as to allow me and a few other bloggers to chat with then SEC Enforcement Director Robert Khuzami. The SEC set out how it will evaluate whether, how much, and in what manner to credit cooperation, to serve as an incentive to report violations and cooperate fully and promptly in enforcement cases.

It’s been almost three years and the SEC has finally found a bad guy willing to cooperate. Scott Herckis served as administrator for Connecticut-based Heppelwhite Fund LP. The fund was run by Berton M. Hochfeld. The SEC filed an emergency enforcement action against Hochfeld in November 2012 for misappropriating more than $1.5 million from the fund and overstating its performance to investors. The SEC’s action halted the fraud.

Herckis started as the Heppelwhite fund administrator in 2010. Hochfeld asked for transfers from the fund’s account to Hochfeld’s account. Eventually those transfers ended up getting very large and Herckis realized the fund’s NAV was overstated. He resigned and contacted the SEC.

“We’re committed to rewarding proactive cooperation that helps us protect investors, however the most useful cooperators often aren’t innocent bystanders,” said Scott W. Friestad, an associate director in the SEC’s Division of Enforcement. “To balance these competing considerations, the DPA holds Herckis accountable for his misconduct but gives him significant credit for reporting the fraud and providing full cooperation without any assurances of leniency.”

Herckis cannot serve as a fund administrator or otherwise provide any services to any hedge fund for a period of five years, and he also cannot associate with any broker, dealer, investment adviser, or registered investment company.  The Deferred Prosecution Agreement requires Herckis to disgorge approximately $50,000 in fees he received for serving as the fund administrator.

I suppose that’s not a bad result for Herckis. It’s hard to assess his culpability in the fraud. Herckis looks more like a whistleblower. However, it appears that he continued to cooperate with Hochfeld’s fraud long after he realized it was wrong. The fraud would not have happened without Herckis allowing the transfers.

It’s good to see that the SEC is using its shiny new tools. The SEC announced its first Deferred Prosecution Agreement against a company back in May 2011.

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SEC Brings its First Charges Against a Municipal Issuer

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Nine Washington cities and counties in the Wenatchee Valley region thought it would be a good idea to join forces to build a regional events center and ice hockey arena. They formed the Greater Wenatchee Regional Events Center Public Facilities District and authorized the District to issue bonds to fund the construction of the Town Toyota Center. In 2011 the District defaulted on $41.77 million in bonds anticipation notes.

According to the SEC order, the problem began at the start when the developer/operator, the district, and its consultants had trouble arranging financing. That was in part because earlier projections raised questions about the Center’s economic viability. Unexpected building costs led to overruns and a redesign to a smaller facility. Even though the developer was experiencing weak ticket sales and seeing other troubling signs about future revenue, it revised its projections upward.

The District issued Bond Anticipation Notes to raise capital in the fall of 2008 to purchase the Center from the developer. Those notes are short term and issued in anticipation of a future issuance of long term bonds to pay them off in three years at maturity. The District had to use those notes because the bond market was shut down by the financial crisis of 2008.

In 2011, the Center’s revenues were worse than its pessimistic obligations and was operating at a significant loss. That means the Center did not have the cash flow to support the issuance of long term bonds and was unable to pay the notes at maturity in 2011.

The big problem was a disclosure in the offering document for the notes that the financial projections and assumptions had not been reviewed by a third party. In fact, they had been reviewed and the independent consultant raised concerns.

“This municipal issuer is paying an appropriate price for withholding negative information from its primary offering document and giving investors a false picture of the future performance of the project.” – Andrew Ceresney, co-director of the SEC’s Division of Enforcement

Whether it’s a municipal issuer or a private fund, full and honest disclosure is important so an investor has all the material facts to make his or her investment decision. “The SEC is happy to go against sloppy, negligent conduct if need be.”

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