Category: SEC News

The One with Bookrunning in Exchange for Not Removing a Platform

Merrill Lynch has lots of relationships and is trying to manage an advisory business, a brokerage business and an investment banking business. It got into trouble for letting the last two interfere with the normal operations of its advisory business.

In general during the time of the SEC action, a material change in any product on Merrill’s advisory platforms, such as replacing the product’s portfolio manager, results in Merrill’s Due Diligence team conducting an in-depth review of the product. If they give it a thumbs down, the analysts put together a termination recommendation. It eventually ends up with Merrill’s Governance Committee for the ultimate decision. The Governance Committee had apparently always approved termination recommendations.

In 2012 one of the products in platform managed by a U.S. subsidiary of a foreign multinational bank announced a change in portfolio manager. It was a big change. The product was run by a single portfolio manager with accounts having a minimum of $100,000 invested in portfolios of 20-25 bonds specifically selected by the portfolio manager. The new manager was a team that had been responsible for institutional accounts with a minimum of $100 million invested in diversified portfolios of approximately 150 bonds.

That was a big change and had no track record for the new investing style. It seems like an easy termination and due diligence recommended the termination.

The problem is that a Merrill employee contacted the platform before the Governance Committee vote. The employee was trying to get in front of the operational issues from inevitable termination.

But that proactive communication gave the platform time to lobby Merrill management for a reconsideration. Apparently, that also included discussion of a possible active bookrunner role in a registered offering associated with the platform. Senior management apparently intervened in the termination process.

The most unusual part was the person who ran the agenda for Merrill’s Governance Committee got an email from a platform employee telling the Merrill person that the item was going to removed from the agenda.

The Due Diligence Employee received this email on the morning of January 16 and forwarded the email to another Merrill executive, stating, “Here is a first. An external manager telling an internal product staffer what can go on an internal governance agenda” to which the recipient responded, “[A]stonishing.”

The Governance Committee did not vote on the termination and instead diligence went back for more review.

Merrill ended up with non-active bookrunner rule in the offering, getting a smaller allocation.

Ultimately, the product stayed on hold for a year. The performance was satisfactory. It performed as well and in some instances better than the products that would have replaced it.

Investors were not harmed, but Merrill had a breakdown in procedure. It’s decision-making was clearly in conflict. The SEC came down hard, forcing Merrill to disgorge the fees it earned on the platform over the year and pay an equivalent fine.

Sources:

Quarterly Reporting or Semi-Annual Reporting

According to a tweet from President Trump, he asked the Securities and Exchange Commission to study the possibility of moving from quarterly to semi-annual reporting for public companies.

In speaking with some of the world’s top business leaders I asked what it is that would make business (jobs) even better in the U.S. “Stop quarterly reporting & go to a six month system,” said one. That would allow greater flexibility & save money. I have asked the SEC to study!

— Donald J. Trump (@realDonaldTrump) August 17, 2018

From a compliance perspective, the issue is more about quarterly guidance, than quarterly reporting.

The broader argument is about short-term focus on reported numbers than the long term focus of the company. I’m not sure that would work out that way or change things. There are many people smarter than me that have written detailed research papers on the topic. They don’t seem to have reached a conclusion.

According to a story in Wall Street Journal, the impetus of Trump’s tweet was a meeting with outgoing PepsiCo CEO Indra Nooyi. During a dinner with the President, he asked “What can we do to make it even better?” According to the Wall Street Journal: “she said, ‘Two-time-a-year reporting, not quarterly.’”

Will companies switch if you make the regulatory change?

Probably not.

The European Union made this change in 2014. Less than 10% of UK companies switched from quarterly to semi-annual.

Institutional investors report their results quarterly and expect their underlying investments to report quarterly. Companies would need to convince shareholders to accept less frequent reporting.

The other aspect is contractual obligations for quarterly reporting. Most companies have a obligations to their lenders for quarterly reporting. That would not go away just because of the regulatory change.

Then there is the question of whether President Trump’s tweet amounts to an official action by the White House. We seem to have a mixed message form some sources as to whether its an official order or not.

Sources:

Stop the Fraud with a PAUSE

A new program from the Securities and Exchange Commission will always (hopefully) catch my attention. I paused for a minute when I saw a press release for the SEC’s update of PAUSE, the “List of Firms Using Inaccurate Information to Solicit Investors.” That sounded interesting. The list even had a catchy acronym. PAUSE stands for Public Alert: Unregistered Soliciting Entities.

For me, interesting turned into a groan, like hearing a bad pun.

Bad acronym aside, I applaud any program that makes investors more aware of bad people trying to take their money away.

The PAUSE list comes from consumer complaints about firms claiming to be registered with the SEC, but are not. Feel free to browse through the list. I found dead links on the first few I tried to check out.

In addition to the PAUSE list, there is also Impersonators of Genuine Firms. This is a list of entities that use a name that is the same as, or similar to, the name of a US registered securities firm, notwithstanding the fact that the soliciting persons are not affiliated with a US registered securities firm. The SEC provides some detail to distinguish the fake firms from the registered firms.

My favorite additional list was the one of Fictitious Regulators. This is a list of entities that claim an endorsement, approval or other support by a governmental agency or international organization that does not exist or does not really lend support to the entity or the investments it is offering. Most of the websites for these scam agencies are dead.

Going back to the original press release, it used the word “update.” That meant PAUSE was not new. It was first created in 2007. (Release Nos. 34-56534 ; IA-2658 ; File No. S7-24-07)

In light of the challenges associated with taking enforcement action against such operations, the Commission believes that it is useful to devise a complementary approach that serves to empower prospective investors. The goal of the PAUSE Program is to provide prospective investors with relevant information about unregistered soliciting entities before they invest.

I don’t remember hearing much about PAUSE in the last 11 years.

 

Not Understanding the Meaning of “supervised release”

Howard M. Appel is a bad guy who has been convicted of securities fraud multiple times. This time it was for actions in 2010 through 2013. He secretly acquiring large blocks of stock in three publicly traded companies and then manipulated the market for those shares with co-conspirators. It was classic pump and dump schemes.

He assembled a team of associates to hold shares on his behalf. He created liquidity by conducting matched trades, increasing the volume of trades but with no economic effect. Then the associates would start raising the trading price through their trading activity. Meanwhile, Appel would convince 3rd parties to buy the stock with the story of its rising price. Then he would have his associates sell the stock for a big profit. As he walked away, the stock price would crash.

What caught my attention in this case was Appel’s criminal history. He was in jail from June 2008 to June 2010 for conspiracy and money laundering in connection with a previous pump an dump scheme. He was on supervised release from June 2010 until June 2013.

He was running the new pump and dump schemes while under supervised release.

Clearly, more supervision was need.

Sources:

The One With Cross-Fund Transactions

United Development Funding and its investment platforms have been under attack for a few years. It looks it has finally come to grips with its mistakes. UDF is closing out investigations into its funding of real estate investments from multiple investment platforms.

The attacks started in 2015 when Kyle Bass, who runs Dallas-based hedge fund Hayman Capital Management LP, bet against UDF IV shares and publicly raised questions about UDF. Bass called the company a billion-dollar house of cards and a Ponzi Scheme, using newly raised capital to pay off old investors. Bass detailed projects that were funded for more than a decade without any noticeable development, projects without impairments being recorded and loans being paid off without an obvious cash flow.

Bass noticed the October 2014 that the UDF III partnership, a non-traded, publicly registered REIT announced that it had formed a special committee comprised of independent advisors to evaluate potential strategic alternatives.

Then in February 2016, the FBI raided the offices of UDF. There were internal investigations, a threatened delisting by NASDAQ and an SEC investigation. The SEC just announced settlement of its case.

So what happened?

UDF III had loans to developments were stalled and the developers lacked capital re-pay the loans. UDF IV fund loaned money to developers who had also borrowed money from UDF III. Rather than using those funds for development projects that were underwritten by UDF IV, UDF directed the developers to use the loaned money to pay down their older loans from UDF III. Even worse, in some instances, the developer never received the borrowed funds at all, and UDF simply transferred the money between funds so that UDF III could make the distributions to its investors.

This is an example of the dangers posed by transactions between investment platforms. It looks like a Ponzi scheme. The additional problem was the lack of disclosure, the failure to right down the UDF III loans and UDF IV’s improper treatment of its capital deployment.

The investigations do not point to fraud in that UDF or its executives were pocketing the cash improperly. Certainly the fundraising for UDF IV would have been less successful if investors knew the capital was in part being used to fund investments by UDF III.

What UDF did with funding would not have been a problem if it has disclosed the information. Instead UDF hid the problem by not fully disclosing the inter-platform transactions and not writing down the value of the UDF III investments.

Sources:

Continuing Lucia

After last week’s Supreme Court decision in Lucia v. Securities and Exchange Commission, it’s clear that administrative law judges of the US Securities and Exchange Commission are not mere federal employees but qualify as “Officers of the United States” under the Appointments Clause of the US Constitution. That means they need be appointed by the president, courts of law, or heads of departments, in this case the SEC Commissioners.

It’s also clear that Mr. Lucia’s victory is hollow. The remedy in the decision was that Mr. Lucia was entitled to a new hearing by new administrative law judge who had been properly appointed. In December the SEC Commissioners ratified the appointment of the ALJs. That was done in anticipation of this decision. I assume that is enough to meet the requirements of the Appointments Clause. I expect that may also be challenged by Mr. Lucia if he case starts over.

There is still lots of uncertainty after the Lucia decision. Enough uncertainty that the SEC has halted all administrative proceedings for 30 days.

The Lucia decision required that the case be heard before a new ALJ. At a minimum,  the SEC is going to do a lot of shuffling of cases from ALJ to another for any case started before December. It may also decide to shift the cases over to federal courts. According to one estimate there are 100+ cases involved.

One big unanswered question is whether the SEC ALJ proceedings are the proper venue. Dodd-Frank expanded the use of administrative proceedings. Under Chair White, the SEC increased its use of administrative proceedings instead of federal court. Under Chair Clayton, the SEC seems to be increasing using federal courts instead of the administrative proceedings. This was one of the points raised in Justice Breyer’s concurring opinion in Lucia.

I expect we will hear some news from the SEC during this 30-day halt on how they are going to proceed with ALJs.

Sources:

The SEC’s Administrative Law Judges are “Officers of the United States”

The Supreme Court issued its decision in Lucia v. Securities and Exchange Commission.  The problem is that the administrative law judges were appointed by an internal panel instead of by the President or the SEC Commissioners. The Appointments Clause of the Constitution is there to make sure that those who wield power are subject to “political force and the will of the people.” The President appoints “Officers” who are those who exercise “significant authority pursuant to the laws of the United States.”

Radio personality Raymond J. Lucia, Sr. got in trouble with the SEC by claiming that his “Buckets of Money” strategy had been successfully backtested when in fact it had not been. Lucia was a registered investment advisor, but the SEC barred him for his transgressions. He appealed.

The Supreme Court re-affirmed a three prong test to determine if an official is an “Officer” under the Appointments Clause:

  1. Holds a continuing office established by law
  2. Exercises significant discretion when carrying out the functions of that office
  3. Issues decisions with finality

The majority opinion found all three of these to be true with the SEC’s ALJs.

The concurring opinion of Justices Thomas and Gorsuch though that the determination of an “officer” merely has to answer the first prong, proposing a much broader definition of an “officer.” The dissent by Justices Sotomayor and Ginsburg felt the finality part of the third prong was not true for the SEC’s ALJs because the SEC can overrule the decision.

What is the impact of the decision?

For Mr. Lucia, it means he is entitled to a new hearing with a different ALJ. The Supreme Court explicitly stated that Mr. Lucia is entitled to a new hearing with a different ALJ who is properly appointed.

I believe all of the SEC’s ALJs are now properly appointed directly by the SEC. In December, the SEC changed its process in anticipation of this decision. The Solicitor General had decided to agree with the argument of Mr. Lucia that the ALJs are “officers.”

The unanswered question is what happens to those cases decided by ALJs. I suppose there could be many others with adverse findings who are going to ask for new hearings with a different ALJ.

Sources:

SALI – the SEC’s Search Action Lookup – Individuals

The Securities and Exchange Commission launched a new tool to help with investor protection: The SEC Action Lookup for Individuals – or SALI. (Is it pronounced “sally”?)

SALI is a database of individuals who (1) have been parties to past SEC enforcement actions and against whom federal courts have entered judgments or (2) the SEC has issued orders.

I would guess this is the SEC’s response to BrokerCheck as it has been trying to level the playing field between brokers and investment advisers. While BrokerCheck could tell you the disciplinary history of a broker, there was not an authoritative source for investment advisers. Of course, there are sources. The Form ADV Part 2 has a disciplinary section. That’s subject to self-reporting and reliant on distribution by the adviser. Less scrupulous advisers may not hand them out.

There is also the larger field of unregistered individuals who have been subject to SEC enforcement actions. SALI will provide a searchable spot for that type of investor review. At least for the data entered which currently only goes back to 2014.

“One of the SEC’s most important tasks is to arm our investors with the tools necessary to identify potential fraudsters. An important risk factor is whether the person you are dealing with has a disciplinary history with the SEC or other regulators,” said SEC Chairman Jay Clayton. “SALI provides Main Street investors with an additional tool they can use to protect themselves from being victims of fraud and other misconduct.”

Does it work?

First, I went and entered my name. No results, as expected. Then I went to SALI and entered “Preston“. It pulled up Caleb Preston and Charles Preston and their mortgage loan fund fraud. It includes links to the complaints, press release and judgment.

Great.

I went to SALI and entered “Cohen”. I was surprised not to see Steve Cohen. After all he was subject to a disciplinary action in 2016. His punishment lapsed at the end of 2017. I tried again with “Tilton”. No results. She won her case. That was true for Cohen. His punishment merely lapsed.

I’m not sure that is the right result for Cohen.  It’s probably the right result for Tilton.

According to the details:

“Your results will not include individuals whose cases are currently pending at the trial court or those against whom no judgment or order has been issued.”

That is true for Tilton. It’s not true or unclear for Cohen.

Regardless of its flaws, it’s great to see a new tool from the SEC. One that I’m sure will get better as the SEC adds more to the search history and clarifies what gets expunged.

Sources:

 

The New Standards for Investment Advisers and Broker-Dealers

One of the challenges that consumers face when dealing with a financial adviser is what it means to be a “financial adviser.” The terms financial planner, wealth consultant, stockbroker, investment adviser, financial consultant, and others get thrown around, leaving you how that person gets paid for helping you with your money.

The Securities and Exchange Commission is trying to help consumers with a trio of proposals.

On the Broker-Dealer side, the SEC is proposing Regulation Best Interest. This would create a new standard of conduct for broker-dealers and their representatives when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer. The proposed standard of conduct is to

  • act in the best interest of the retail customer
  • at the time a recommendation is made
  • without placing the financial or other interest of the broker-dealer or natural person who is an associated person making the recommendation ahead of the interest of the retail customer

This new standard would be satisfied if:

  1. broker-dealer, before or at the time of the recommendation reasonably discloses to the retail customer, in writing, the material facts relating to the scope and terms of the relationship, and all material conflicts of interest associated with the recommendation;
  2. broker-dealer, in making the recommendation, exercises reasonable diligence, care, skill, and prudence; the broker-dealer establishes, maintains, and enforces written policies and procedures reasonably designed to identify and at a minimum disclose, or eliminate, all material conflicts of interest that are associated with such recommendations;
    and
  3. broker-dealer establishes, maintains, and enforces written policies and procedures reasonably designed to identify and disclose and mitigate, or eliminate, material conflicts of interest arising from financial incentives associated with such recommendations.

For item 1, there would be a new Form CRS. Broker-dealers would provide this to their clients.

For registered investment advisers, there would be a new Part 3 to Form ADV that would be Form CRS.

There is a lot in this package. SEC Chairman Clayton summarized them:

We propose to fill these gaps through (1) mandating clear disclosures — specifically, addressing how BDs and IAs identify themselves to investors and requiring them to provide investors with a standardized disclosure document of no more than four pages in length, highlighting among other things the principal services offered, legal standards of conduct that apply, fees the customer will pay, and certain conflicts of interest that exist, (2) raising the standard of conduct applicable to BDs to make it clear, among other things, that they cannot put their interests ahead of the interests of their retail customers, and (3) reaffirming, and in some cases clarifying, our views on the standard of conduct applicable to investment advisers.

There will be lots of commentary on these proposed regulations from all sides. One of those critics is SEC Commissioner Kara M. Stein:

 I am concerned that this rule will not only confuse retail investors, but also broker-dealers. In particular, the lack of a definition of best interest, the use of similar terms to mean different things, the use of different terms to mean the same things, and the possibility that the SEC and FINRA interpret the same language in their suitability standards differently. All of these concerns would make it difficult for the industry to discern a clear compliance path. Any resulting confusion may well result in higher compliance costs for broker-dealers, which will likely be passed onto the investor. What’s more, the lack of a clear standard is not likely to give investors more confidence in the broker-dealer business model.

There is over 1000 pages in these proposals. I’ll share more thoughts on them this week.

Sources:

Compliance Outreach Program National Seminar 2018

I didn’t manage to get down to Washington DC to be there in person, but I’ve been watching the webcast of the Compliance Outreach Program National Seminar 2018 For Investment Adviser and Investment Company Senior Officers this morning.

This is the agenda and my notes so far.

Introductory Remarks from SEC Directors
Speakers:

  • Dalia Blass, Director, Division of Investment Management
  • Peter Driscoll, Director, Office of Compliance Inspections and Examinations (National Exam Program)
  • Stephanie Avakian, Co-Director, Division of Enforcement

Good policy starts with good information. To get the information you need to interact with others. The SEC wants to engage with compliance professionals to get better information to be able to make better policies.

They wanted to avoid CCO liability, but it was one of the most asked question.

One category are cases where the CCO was actively involved in the malfeasance or engaged in misleading regulators. This is the biggest category.

The second is where the CCO had a clear responsibility to implement a procedure and failed to.

There is a new alert coming out later today on fees and expenses. (Here it is:  Most Frequent Advisory Fee and Expense Compliance Issues Identified in Examinations of Investment Advisers (PDF))

Insights from SEC Leadership Regarding Program Priorities
Speakers:

  • Paul Cellupica, Deputy Director, Division of Investment Management
  • C. Dabney O’Riordan, Co-Chief, Division of Enforcement, Asset Management Unit, Los Angeles Regional Office
  • Kristin Snyder, Co-National Associate Director, National Exam Program, San Francisco Regional Office

Update on certain National Exam Initiatives
Fiscal year 2018 priorities
Update on certain fiscal year 2017 priorities

A sunshine act notice went out for a meeting on April 18. There is a continuing effort to avoid investor confusion between the different type of financial firms. The subject matters of the Open Meeting will be the Commission’s consideration of:

  • whether to propose new and amended rules and forms to require registered investment advisers and registered broker-dealers to provide a brief relationship summary to retail investors.
  • whether to propose a rule to establish a standard of conduct for broker-dealers and natural persons who are associated persons of a broker-dealer when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer.
  • whether to propose a Commission interpretation of the standard of conduct for investment advisers.

The SEC will focus on ETFs. All of them are operating on exemptive orders. It makes sense to standarize the platforms instead of ad hoc rulings.

The Volker Rule is still alive and the SEC is going to keep working on it. But it sounds like the SEC wants to simplify it and remove some of the compliance burdens. Given the number of agencies involved, the SEC is just one player.

Fair Act is being considered regarding reports on various companies and wants to extend it to investment companies.

The SEC is considering a revamp of the marketing rules for investment advisers. There will be a particular focus on the anti-testimonial rule and its interaction with social media.

The share class initiative is continuing for enforcement. There was an emphasis to fix the problem before the SEC finds out if this has been an issue at your firm.

For exams, there is a focus on retail investors and in particular those saving for retirement. This includes a focus on how firms deal with older clients. The ReTIRE Initiative is still going strong. (They took great stride to point out that private fund investors are often retail investors.)

Exams are still focused on visiting firms that have never been examined. They are continuing the new registrant program.

The SEC has been learning how to use Form PF. It has been helping the SEC to inform its rule-making efforts. The experience with Form PF led to the separately-managed accounts questions on Form ADV.

Question & Answer Session 1
Speakers:

  • Ahmed Abdul-Jaleel, Assistant Regional Director, National Exam Program, Chicago Regional Office (Moderator)
  • Brian Blaha, Staff Accountant, National Exam Program, Denver Regional Office
  • Sara Cortes, Assistant Director, Division of Investment Management, Investment Adviser Regulation Office
  • Louis Gracia, Deputy Associate Regional Director, National Exam Program, Chicago Regional Office
  • Barbara Gunn, Assistant Director, Division of Enforcement, Asset Management Unit, Fort Worth Regional Office
  • Michael Spratt, Assistant Director, Division of Investment Management, Disclosure Review Office

When you get a document request list, ask questions if you are unsure what it’s asking for. If it’s going to take longer to produce the documents, let them know.

As for thoughts on the private equity fund exams and enforcement cases, does the SEC think the industry has changed? Yes. Limited partners are more informed. It’s not just fund managers, but gatekeepers who have failed to do their job of being a check on fund managers.

There was a fair amount of the liquidity rule. But since it does not apply to private funds, I’ve not been paying much attention to it or the questions about it.

One question was on anti-money laundering. It’s not the SEC who would be issuing the rules. It’s up to FinCEN. The SEC merely provides technical support.

Fees and Expenses Impacting Retail Investors
Speakers:

  • Louis Gracia, Deputy Associate Regional Director, National Exam Program, Chicago Regional Office (Moderator)
  • Adam Aderton, Assistant Director, Division of Enforcement, Asset Management Unit
  • Jennifer Porter, Branch Chief, Division of Investment Management, Investment Adviser Regulation Office
  • Nicole Tremblay, Senior Vice President and Chief Compliance Officer, Weston Financial

Lots of this panel’s material is in the new National Exam Program Risk Alert that came out today: Most Frequent Advisory Fee and Expense Compliance Issues Identified in Examinations of Investment Advisers.

One panelist pointed out that “fees are negotiable” is generally not a good fee disclosure. Advisers should have a fee schedule.  If you let one client negotiated fees, you should state that lower fees can be negotiated.

The Sessions continue this afternoon, but I had to step away.