Category: SEC News

Watching the Watch Dogs

According to a story by Jean Eaglesham in the Wall Street Journal, at least two employees working for SEC’s Inspector General have filed complaints alleging that he and his senior staff retaliated against them for calling out misconduct within the inspector general’s office.

The allegations center on potential time and attendance fraud by a supervisor in the inspector general’s office and a junior subordinate. The whistleblowers said the two employees regularly disappeared together for several hours during workdays and engaged in inappropriate conduct in the office. The office’s own investigation of the complaints found insufficient evidence to conclude the two employees had an inappropriate relationship, but noted that “the supervisor created the appearance” of such a relationship. The SEC Office of Inspector General referred the complaints to a federal prosecutor, who declined to pursue the case

It was a case of the process being wrong.

The whistleblowers’ concerns focus on how Carl Hoecker, the SEC inspector general, handled their complaints.  The whistleblowers allege that the internal investigation wasn’t sufficiently independent to be fair. They also claim that they suffered retaliation for voicing their concerns.

Federal agencies have inspectors general to oversee the agencies and to encourage whistleblowing. They are supposed to be a model for private firms.

The internal probe was led by two senior officials in the office. But one of those was a senior investigator who hired and supervised the two employees at the center of the complaints. Of course there is an inherent conflict. If the employees were misbehaving, the supervisor would look bad for not having dealt with the problem.

Now the Office of Special Counsel is involved. That office is yet another federal agency whose primary mission is to safeguard the mer​it system by protecting federal employees and applicants from prohibited personnel practices, especially reprisal for whistleblowing.

I’m not sure there is much here for the underlying case. A supervisor may have been canoodling with one of his co-workers. You stop that prevent all the likely harm and drama that comes along with that. But the lesson for compliance is to make sure the process looks transparent and that the whistleblower understands what is going on . Now the whistleblower problem is bigger than the original problem.

Sources:

SEC’s Retail Strategy Task Force

One of the complaints voiced by private equity firms when put under the scrutiny of the Securities and Exchange Commission was that their fund investors were sophisticated and adept when making their investment choices so there were fewer problems. Some of the actions coming out of fund review has proven that thesis may not be entirely true.

The argument was that retail investors were less sophisticated and more likely to be subject to fraud. The SEC has decided to dedicate resources to specifically focus on retail investors with the launch of the Retail Strategy Task Force.

Last month, the SEC announced that “The Retail Strategy Task Force will develop proactive, targeted initiatives to identify misconduct impacting retail investors.”

We have gotten a bit more color on the Task Force.
The issues we see in this space are extensive and often involve widespread incidents of misconduct, such as charging inadequately disclosed fees, and recommending and trading in wholly unsuitable strategies and products. Some more specific examples of some of the problems we are continuing to see:

  • Steering customers to mutual fund share classes with higher fees, when lower-fee share classes of the same fund are available.
  • Abuses in wrap-fee accounts, including failing to disclose the additional costs of “trading away” or trading through unaffiliated brokers, and purchasing alternative products that generate additional fees.
  • Investors buying and holding highly volatile products products like inverse exchange-traded funds (ETFs) for long-term investment.
  • Sale of structured products to retail investors and failing to fully and clearly disclose fees, mark-ups, and other factors that can negatively impact returns.
  • Churning and excessive trading that generate large commissions at the expense of the investor.

The Task Force will combine examination, enforcement and public education teams to better protect investors.

This does not mean that the SEC is ignoring private funds. Stephanie Avakian, Co-Director, Division of Enforcement stated:

“Finally, I want to address one question that we have received a lot since announcing our retail focus; that is, whether our enhanced retail focus means that we are allocating fewer resources to financial fraud or policing Wall Street. The answer to that question is simple: No, we are not. The premise that there is trade-off between “Wall Street” and “Main Street” enforcement is a false one.”

Sources:

The One With the Pilfering Partner

Expenses charged by private equity managers to their portfolio companies and their funds has been on the SEC’s radar since Dodd-Frank. Apollo Management was one of those caught with improper fee calculations last year. One item mentioned was the inappropriate expenses charged to the funds by one of its partners. We got more detail on that issue when the SEC brought charges against Mohammed Ali Rashid, a former senior partner at Apollo Management.

From at least January 2010 to June 2013, Mr. Rashid allegedly misappropriated $290,000 from the Apollo funds my charging personal expenses to the funds and their portfolio companies. The SEC states that there more than one thousand personal items and services charged to the funds.

Apparently, it first started in 2010 when Apollo discovered the personal charges and made Mr. Rashid repay those costs. But that did not stop him. Apollo found more instances and ended his employment in February 2014.

According to the complaint, he took steps to conceal the charges. He identified a personal salon trip as a business lunch in one instance. It was his administrative assistant that turned him in the first time. She found problems with the expense reimbursement forms for a restaurant she could not find. She ran the problems up the management chain.

Undeterred by the scolding, he continued using the corporate account as a personal charge card. He claimed to purchase items identified as gifts to portfolio company executives. Gifts they never received. He charged a personal vacation to the fund, claiming it was a business trip.

His assistant turned him in again when he falsified a clothing purchased. He had pre-approval from compliance to spend $3500 on ties to some of the portfolio company executives. When his assistant called the store for a receipt, it turned out to be a charge for Rashid’s father’s suit. Apollo slapped him on the wrist again and made him re-pay these inappropriate charges.

The firm took what seems to have been the appropriate steps and ran a full forensic review of Mr. Rahid’s expense account. As a result of the review, Apollo placed him on unpaid leave. Mr Rashid self-identified $220,000 in improper charges. The review came up with an additional $60,000. All of which he re-paid as Apollo showed him the door.

According to the SEC complaint against the firm, Apollo had self-reported the problem to the SEC.  That did not stop the SEC from including this problem in the larger order related to improper fee charges to the funds last year.

Sources:

Home Court Advantage

One of the arguments made by Lynn Tilton in her battle against the administrative law judges of the Securities and Exchange Commission was the inherent unfairness of that judicial system compared to the federal courts. She failed in her battle against the system, but won on the merits.

From October 2010 through May 2015, 90 percent of cases that the SEC brought before ALJs were decided in favor of the SEC. In federal court, the SEC only has an 84 percent success rate. [Cite].

The SEC changed its rules in 2016 to give more discovery to defendants in administrative proceedings. So that discrepancy may be out of date.

As a compliance professional, my job is to keep me and my firm far away from having to appear in an administrative proceeding. So, I have no expertise on the differences between the two judicial systems and why one is more fair than the other.

I got hung up on why have two separate systems at all?

On one side is the administrative remedies for those registered with the SEC. That made sense to revoke licenses and stop securities fraud. Quick actions would protect investors and hopefully provide a quick resolution for a registrant unjustly accused.

The SEC’s powers have grown over the years, particularly with Dodd-Frank. The SEC has been slow to provide some of the federal court protections to civil litigants to those who stood before an SEC tribunal.

The SEC administrative judges provide subject-matter expertise that may lead to better results than with a federal district court.

The SEC’s Division of Enforcement provided a framework for its approach on forum selection. On the basis of that framework, cases with novel or difficult issues are steered to the federal courts. That may account for the different rates of success between ALJs and federal courts.

It’s probably time for the SEC to once again review the procedures in administrative law proceedings to reduce or remove the claim that the ALJ system provides home court advantage.

Sources:

The Triumph of Lynn Tilton

Lynn Tilton and her firm, Patriarch Partners, are known for their high-risk, high-return investments in distressed companies. The Securities and Exchange Commission brought a case against her and the firm claiming that they were using improper valuations, failing to mark down assets when the investment became more distressed. Ms. Tilton chose to fight the charges and had to on the SEC’s home turf. The SEC chose to bring the case as an action in its administrative court’s instead of federal district court.

She fought a two-prong attack. The first was challenging the SEC’s use of an administrative court. The US Supreme Court September denied hearing the appeal of Lynn Tilton in her case arguing that the appointment of administrative law judges was Unconstitutional under the Appointments Clause.

That lead her back to fight her case in front the ALJ. Tilton won her case last week. Administrative Law Judge Carol Fox Foelak dismissed the SEC’s case. The judge concluded that the SEC failed to prove Tilton deceived the highly sophisticated institutional investors in her funds about the finances of the troubled companies in her underlying portfolio.

“I feel truly grateful to Judge Foelak,” Tilton said. “But it doesn’t change my opinion that cases like these belong in federal court. I absolutely feel my rights were compromised.”

According to Reuters, Tilton lawyer Randy Mastro of Gibson Dunn said he filed dozens of motions to obtain discovery that defense lawyers would have been entitled to see under the Federal Rules of Civil Procedure. Most were denied. Nor could Gibson Dunn lawyers depose SEC witnesses. (The SEC changed its rules in 2016 to give more discovery to defendants in administrative proceedings, but the new rules didn’t apply to discovery in Tilton’s case.) At trial, defense lawyers had to cross-examine SEC witnesses without prior knowledge of what they might say.

This is not quite the final say in the matter. Judge Foelak’s initial decision can be overturned by the SEC commissioners. That is part of what currently saves the ALJs under the Appointments Clause. It ultimately comes done to what the Presidentially-appointed SEC Commissioners decide.

Sources:

Looking at the Direction of the New Securities and Exchange Commission

With Chairman Jay Clayton in place, the Securities and Exchange Commission is now controlled by Republican appointees. Former Chair White came from a litigation and prosecutor background. Chair Clayton comes from a deal-making and capital formation background. I think we can guess the direction of the SEC for the next few years.

Beyond the guessing, Chair Clayton gave a speech to the Economic Club of New York that offers some insight. He outlined eight principles that will guide his chairmanship:

  1. The SEC’s mission is our touchstone.
  2. Our analysis starts and ends with the long-term interests of the Main Street investor.
  3. The SEC’s historic approach to regulation is sound.
  4. Regulatory actions drive change, and change can have lasting effects.
  5. As markets evolve, so must the SEC.
  6. Effective rulemaking does not end with rule adoption.
  7. The costs of a rule now often include the cost of demonstrating compliance.
  8. Coordination is key.

Obviously, number 7 caught my attention.

“It is incumbent on the Commission to write rules so that those subject to them can ascertain how to comply and — now more than ever — how to demonstrate that compliance.  Vaguely worded rules can too easily lead to subpar compliance solutions or an overinvestment in control systems.  We must recognize practical costs that are sure to arise.”

He also pointed out the costs of compliance in number five on the evolution of the SEC:

As the SEC evolves alongside the markets, however, we must remember that implementing regulatory change has costs.  Companies spend significant resources building systems of compliance, hiring personnel to operate those systems, seeking legal advice concerning the design and effectiveness of those systems, and adapting the systems as regulations change.  Shareholders and customers bear these costs, which is something that should not be taken lightly, lest we lose our credibility as regulators.

The SEC uses cost-benefit analysis in its rule-making process. I expect we will see an emphasis on the compliance costs in those analyses.

I like the emphasis on “bright-line” rules in number 7. Fuzzy rules makes it hard to implement rules and hard to prove compliance with the rules, leaving you open to second-guessing by regulators.

The other news is that it is rumored that President Trump will nominate former Senate Republican aide and current Senior Research Fellow at the Mercatus Center, Hester Peirce, to fill one of the empty seats at the Securities and Exchange Commission. From her recent publications, it seems that she may have some big ideas for change at the SEC.

That leaves one empty seat that is supposed to go to a Democratic appointee. I would bet that this seat stays empty for a long time.

Sources:

SEC Releases New Form ADV Frequently Asked Questions

Earlier this month, the Securities and Exchange Commission released 23 new frequently asked questions (“FAQs”) on Form ADV to provide guidance on recent amendments to Form ADV. Those amendments become effective in October.

These new FAQs include guidance on (i) the umbrella registration approach that many private fund sponsors use to register multiple affiliates and (ii) the reporting of significant new information concerning separately managed accounts (not separate accounts).

There are four new FAQs on social media accounts. They are a bit weird. An adviser does not need to report a social media account if a third party controls the account content. So if you have a third party controlling your firm social media account under the firm name, it does not show up. On the other side, the firm does not have to report an employee’s account when the firm controls the account content.

There is an interesting FAQ on the differences between a private fund and a pooled investment vehicle in Item 5D. “[P]ooled investment vehicles include, but are not limited to, private funds.”

“Additionally, the staff believes for purposes of Item 5.D there are some facts and circumstances in which it may be appropriate for an adviser to treat a single-investor fund (also known as a “fund of one”) as a pooled investment vehicle. For example, an adviser could reasonably treat a single-investor fund as a pooled investment vehicle where the fund seeks to raise capital from multiple investors but has only a single, initial investor for a period of time, or where all but one of the investors in the fund have redeemed their interests. However, an adviser generally should not consider a single-investor fund to be a pooled investment vehicle if that entity in fact operates as a means for the adviser to provide individualized investment advice directly to the investor in the fund.”

As for distributing audited financial statements to meet the custody rule, the new FAQ in 7b makes it clear that

You may answer “Yes” if you will distribute the audited financial statements as required, but have not yet done so at the time of filing the Form ADV.

The SEC revised its FAQ on Item 1.O and points out question that many people trip over in Item 1.O. The question is whether the adviser has over $1 billion in assets. It’s not whether the adviser as more than $1 billion in AUM. “Non-proprietary assets, such as client assets under management, should be excluded when responding to Item 1.O, regardless of whether they appear on an investment adviser’s balance sheet.”

Sources:

Supreme Court Limits One of the SEC’s Remedies

The Securities and Exchange Commission has essentially been claiming that its remedy of disgorgement is not subject to a statute of limitations. To the SEC, disgorgement is not punitive but remedial in that it lessens the effects of a violation by restoring the status quo.

Charles Kokesh decided to fight back against this position. In the SEC’s case against him, the SEC wants to go back ten years. Between 1995 and 2006, Kokesh pilfered $34.9 million from the business-development companies for which his firm was acting as investment adviser. The SEC brought charges in 2009. The court ordered disgorgement of all of the pilfered funds.

Mr. Kokesh argues that 28 U.S.C. §2462 limits the disgorgement to five years by stating that “an action, suit or proceeding for the enforcement of any civil fine, penalty, or forfeiture, pecuniary or otherwise, shall not be entertained unless commenced within five years from the date when the claim first accrued”. If the five-year limit is imposed, Mr. Korkesh’s penalty would be reduced to $5 million.

Yesterday, the Supreme Court agreed with Mr. Kokesh and set a limit on the SEC’s powers.

Disgorgement, as it is applied in SEC enforcement proceedings, operates as a penalty under §2462. Accordingly, any claim for disgorgement in an SEC enforcement action must be commenced within five years of the date the claim accrued.

In addition to limiting the period susceptible to disgorgement, the Supreme Court indicated that a facial attack on the disgorgement remedy in footnote 3:

Nothing in this opinion should be interpreted as an opinion on whether courts possess authority to order disgorgement in SEC enforcement proceedings or on whether courts have properly applied disgorgement principles in this context The sole question presented in this case is whether disgorgement, as applied in SEC enforcement actions, is subject to §2462’s limitations period.

The Supreme Court noted that the SEC specifically has the powers of injunction and civil penalties. Perhaps the disgorgement could be tested. In the decision, the Supreme Court noted that the “SEC disgorgement sometimes exceeds the profits gained as a result of the violation” and, ” as demonstrated by this case, SEC disgorgement sometimes is ordered without consideration of a defendant’s expenses that reduced the amount of illegal profit.”

Sources:

The SEC Reaching Back Far In The Past With Its Powers of Disgorgement

We have become used to the Securities and Exchange Commission extracting disgorgement of ill-gotten gains from those violating the securities laws. However, the enabling laws do not explicitly grant the SEC the right to disgorgement. We seem to accept that power, but how far back can the SEC go to grab cash from defendants?

In the SEC’s case against Charles Kokesh, the SEC wants to go back ten years. Between 1995 and 2006, Kokesh pilfered $34.9 million from the business-development companies for which his firm was acting as investment adviser. Some of that ill-gotten cash was overcharging to pay expenses of the investment advisory firm, but some went into his pocket and that of his stable of polo ponies. The SEC brought charges in 2009. The court ordered disgorgement of all of the pilfered funds.

Mr. Kokesh argues that 28 U.S.C. §2462 limits the disgorgement to five years by stating that “an action, suit or proceeding for the enforcement of any civil fine, penalty, or forfeiture, pecuniary or otherwise, shall not be entertained unless commenced within five years from the date when the claim first accrued”.

If the five-year limit is imposed, Mr. Korkesh’s penalty would be reduced to $5 million.

The briefs and arguments are a delight for legal scholars. The parties are battling over legal history and dictionary definitions to determine what Congress meant in 1839 when it passed that five year limit and used the word “forfeiture.”

The arguments are compounded by the creation of the SEC’s power of disgorgement, not by Congressional action, but by case law. The SEC only legitimized disgorgement in 1970 in the case of  SEC v. Texas Gulf Sulphur Co., 312 F. Supp. 77 (S.D.N.Y. 1970).

The Kokesh case was argued in front of the Supreme Court last month, so we should be looking ahead to decision shortly that may have a profound impact on SEC enforcement actions.

Sources:

The Jay Clayton Era at the SEC Has Begun

Jay Clayton was sworn in last week as the new Chairman of the Securities and Exchange Commission. That makes him the first permanent head of a financial regulator during the Trump administration.

Yesterday, Chairman Clayton gave his first public speech by making the opening remarks at the SEC Advisory Committee on Small and Emerging Companies.

Facilitating capital formation is one of the central tenets of the SEC’s mission and it is a focus that this committee and I share. One of my priorities is for the Commission to focus on facilitating capital-raising opportunities for all companies, including, and importantly, small- and medium-sized businesses. Doing so will not only help those companies, but it also will provide expanded opportunities for investors, help our economy grow, facilitate innovation, and further job creation.

Nothing dramatic. We expected Chairman Clayton to have more of a focus on capital formation than enforcement actions. He comes from a capital formation background. Former Chair White came from a prosecutorial background.

It’s not too early to look to the rest of the Commission. There are still two vacancies. The candidates put worth by President Obama are back working at their old jobs. I think there is little expectation that they will end up in those vacant seats.

Commissioner Stein’s term expires next month. That will give President Trump three seats to fill.

The law is that no more three commissioners may belong to the same political party (Section 4 of the Exchange Act). Chairman Clayton and Commissioner Piwowar are both Republicans. Would it surprise anyone if President Trump nominated another Republican to fill the vacant seat of Commissioner Stein and leave the other two seats vacant?

Sources: