You Can’t Hide Your Insider Trading in Your Spouse’s Account

insider trading

Steven M. Dombrowski was the former director of internal audit at Allscripts Healthcare Solutions. Through his position he learned that the company’s first quarter 2012 financial results were much worse than expected. Despite restrictions, he decided to profit from his company’s misfortune.

He clearly knew that he couldn’t trade in the stock, so he decided to hide the trades in his wife’s account. Dombrowski began his insider trading by selling short 1,000 shares of Allscripts stock, and purchasing 50 Allscripts May $15 put option contracts. He kept buying more put options as he learned more and more about the upcoming earnings announcement. Of course, the stock price fell and the trading paid off. Dombrowski’s insider trading resulted in $286,211.55 in illegal profit.

How did he get caught? The complaint leaves out the details. But I noticed that the Options Regulatory Surveillance Authority played a role in the investigation. The options trading looked suspicious. I would guess that there are not that many options in Allscripts stock being traded. Dombrowski’s trades were probably outside of the norm for the stock and happened around the earnings release. That should easily raise the red flag for a stock like Allscripts that does not have a deep pool of liquidity.

Hiding the trading activity in his wife’s account was not going to work once regulators focused on the trades. That’s an easy one.

References:

How Not to Use Twitter as a Fund Manager

Navigator Money Management

The Securities and Exchange Commission charged Mark A. Grimaldi and his firm, Navigator Money Management, with making false claims through Twitter, newsletters, and other communications about the success of their investment advice and a mutual fund they manage. Grimaldi and Navigator were using social media and widely disseminated newsletters to cherry-pick information and make misleading claims about their success in an effort to attract more business.

The Investment Advisers Act’s main thrust is to not be fraudulent, deceptive or misleading. When it comes to the restrictions on advertising, the rules can get complicated.

Grimaldi co-founded The Money Navigator and it had more than 60,000 subscribers by the end of 2011. He used it in part to promote the performance of his various investment financial advise platforms. He stretched the truth and the SEC caught him.

Based on the order, the SEC came in for a exam and poured through the publication looking for advertising rule violations and found some.

Mark Grimaldi manages Sector Rotation (NAVFX),” which “was ranked number 1 out of 375 World Allocation funds tracked by Morningstar. Sector Rotation produced an average annual return of 10.25% from August 31, 2002, to October 31, 2011, vs. 5.47% for the S&P 500 Index, according to Morningstar.”

The ranked #1 and nearly doubling the S&P index must stand out as problematic. The #1 ranking was from October 2010 to October 2011. It was ranked lower before that time frame. I read the copy as saying it was #1 from 2002 to 2011.

It’s tough to claim a 10.25% return from 2002 to 2009 when the fund did not exist prior to December 2009. The return is based on a hypothetical return published in The Money Navigator, not actually put to work. Plus, Grimaldi did not work at The Money Navigator until 2004.

That kind of stretching the truth is even more problematic when you edit the statements down to the 140 characters used in Twitter:

the April issue of the Money Navigator will give you an inside look of how I doubled the S&P500 the last 10 years w/o using low cost funds”

“[m]y cap app model has DOUBLED the S&P 500 the last 10 years.”

You can add on two more failure. If you state a specific recommendation you need to disclose all of the recommendations within the past year. When showing past performance you need disclaimer that it should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list under Rule 206(4)-1(a)(2)

You should read the order as way to test your knowledge of the advertising rules. I bet that Mr. Grimaldi also understands them better now.

 

References:

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.

References:

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

Weekend Book Review: A Giant Cow-Tipping by Savages

giant cow tipping by savages

The 1908s was the start of the M&A boom, glorified on the big screen by Wall Street. John Weir Close looks back at those days in A Giant Cow-Tipping by Savages.

The author is a lawyer and a journalist. He founded the M&A Journal and was an editor at The American Lawyer. His book seems to wrap more context, color and gossip around his old stories on M&A deals. The book reads like a collection of stories and lacks a coherent narrative.

You may guess from the title that Mr. Close may have warm feelings for M&A nostalgia, but has no love for the players. He dwells on their flaws. For many of the key players, those flaws were deep.

Many of the deals were deeply flawed. Bidders were fueled by fee-seeking advisers, cheap debt, and hubris. Many of the deals highlighted in the book lead to poor or disastrous results for the companies involved. The reality is that many of the mergers did not necessarily prove beneficial. The resulting company was laden with too much debt or managers who didn’t understand the business.

The book starts by painting the corporate raiders as savages who brought down the managerial elite. CEOs and boards were sitting in comfortable seats and never feared that someone would come along and try to takeover their companies. Companies were then viewed for the break up values and the savages could rip it into pieces to create more value.

The book’s title comes from a statement by Ted Turner during the AOL acquisition of Time-Warner. He didn’t understand how a publisher, trying to sell magazines for a few dollars an edition, could combine with a company trying to give that content away for free. Turner was proved right as the AOL Time Warner merger is one of the worst business combinations of all time and cost Turner a fortune.

Since the book is really collection of stories, it is uneven. Some stories and some players are more interesting than others. Mr. Close is better at eliciting an interesting story in some chapters, but not others. At many times, the lawyer side takes over and dwells on uninteresting minutiae.

If you loved the merger stories of the 1980s you’ll like the book. Otherwise it may not be a good addition for your to-read stack.

Disclosure: The publisher sent me a copy of the book to review.

Compliance Bricks and Mortar for January 31

bricks curvy

These are some of the compliance-related stories that recently caught my attention.

Five Golden Rules of What Works – The Internal Marketing of Compliance by Tom Fox

I am attending the ACI Foreign Corrupt Practices Act (FCPA) Boot Camp in Houston. … One of the presentations was on how to tell your compliance story. It presented several interesting aspects of how to not only communicate your internal compliance story but how to also market compliance within your organization. Céline Gearson, Chief Ethics and Compliance Officer at Cameron International, had an interesting perspective on how she internally markets her compliance function. She termed these as “The Five Golden Rules of What Works”.

1. Socialize, Socialize, Socialize
2. Communicate metrics and near misses
3. Create engagement and excitement
4. Become a marketing guru and IT expert
5. Embed your initiatives into business processes

Did Dennis Rodman violate the FCPA? By Richard L. Cassin in the FCPA Blog

Among the more than $10,000 in gifts Dennis Rodman delivered to North Korea dictator Kim Jong Un in Pyongyang this month were “hundreds of dollars’ worth of Irish Jameson whiskey, European crystal, an Italian suit, a fur coat, and an English Mulberry handbag for Kim’s wife, Ri Sol-ju,” the Daily Beast said Friday. The U.S. government is now investigating whether Rodman violated the law against importing luxury goods into North Korea.

Keep emergency plans updated, or face disastrous consequences from regulators in Investment News

Financial advisory firms need to think seriously about disaster planning and should be conducting annual tests of their preparedness plans if they want to stay out of hot water with regulators. Each year, registered investment advisers need to document the testing of their continuity plan, as well as any updates to these plans, Les Abromovitz, a senior consultant at National Compliance Services Inc., said at a pre-conference session at TD Ameritrade Institutional’s national conference in Orlando on Wednesday.

SEC’s turf threatened, Commissioner Michael Piwowar says by Dina ElBoghdady in the Washington Post

In one of his first public speeches since joining the SEC in August, Republican Commissioner Michael Piwowar said that the Financial Stability Oversight Council is “reaching into the SEC’s realm” and posing “an existential threat” to the agency and other regulators. The council, also known as the FSOC, was charged by Congress with heading off risks to the financial system. It consists of regulators from the Federal Reserve, the Federal Deposit Insurance Corp. and others — including the SEC. Each of the top regulators on the council has a voting member, and for the SEC, that’s been the commission’s chairman.

Clifford Chance Adopts Continuous Improvement Program by Ron Friedmann in Prism Legal

This week Clifford Chance, one of the largest law firms in the world, published a white paper called Applying Continuous Improvement to high-end legal services.  I view it as a potential turning point in BigLaw. A few other law firms, especially Seyfarth Shaw with SeyfarthLean, have promoted process improvement, a sibling of continuous improvement.  But Clifford Chance is a Magic Circle with much bigger throw weight than most firms.

Facebook debunks Princeton study in Flowing Data

Researchers at Princeton released a study that said that Facebook was on the way out, based primarily on Google search data. Naturally, Facebook didn’t appreciate it much and followed up with their own “study” that debunks the Princeton analysis, blasted with a healthy dose of sarcasm. They also showed that Princeton is on their way to zero-enrollment.

SEC Compliance Outreach Program National Seminar

SEC Seal 2

The SEC’s Office of Compliance Inspections and Examinations (OCIE), Division of Investment Management, and the Asset Management Unit of the Division of Enforcement jointly sponsor the compliance outreach program. On January 30, 2014, there was a national meeting.

These are my notes.

Welcoming Remarks from Chair Mary Jo White

Investors and the SEC relies on compliance officers. OCIE has only 450 dedicated who have to look over 11,000 registered investment advisers. The top goal is getting firms to express a dedication to compliance throughout the organization. She highlighted the exam priorities for 2014.

Introductory Remarks

Speakers:

  • Drew Bowden, Director, Office of Compliance Inspections and Examinations
  • Norm Champ, Director, Division of Investment Management
  • Andrew Ceresney, Director, Division of Enforcement

Andrew started off as the person you don’t want to meet. If your talking to enforcement, you are being accused of doing something seriously wrong. One focus is firms with past problems. The first thing examiners will do is look at the deficiencies from an exam and see if the firm has fixed those noted problems. Custody is a critical rule because its focus is on the safety of client assets.

He highlighted a case his group brought under Rule 38a-1(c) of the 1940 Investment Company Act. That rule makes it unlawful to mislead or obstruct a firm’s CCO in the performance of his or her duties. Andrew also highlighted the Convergex case for failing to highlight markups and markdowns.

Norm highlighted the guidance and updates issued by the SEC. The initiative came out of failed no-action letters. The SEC would deny the relief, but that denial was rarely public. He highlighted the guidance update on misleading fund names and the guidance on the custody rule for private stock certificates.

He also highlighted some facts on the new public private-placement rules under 506(c). He is not seeing a lot of use of the new regime.

The SEC’s goals are to be transparent. The vast majority of investment advisers are trying operated in a proper and ethical way. The panel clearly highlighted custody as an item subject to close scrutiny.

Panel I: Program Priorities

Speakers:

  • Jane Jarcho, National Associate Director, National Exam Program
  • David Grim, Deputy Director, Division of Investment Management
  • Julie Riewe, Co-Chief, Division of Enforcement, Asset Management Unit

Julie highlighted the aberrational performance inquiry initiative. The mismatched performance usually lead to to a large cache of other misdeeds at the adviser. On the private fund side of things, the SEC is looking at conflicts of interest, allocations of opportunities, mis-allocations of expenses.  She highlighted multiple funds investing in the same opportunity. (Are you using the second investment to prop up the first?)

David focused on the floating NAV for money market funds (I hate that idea.) and other mutual fund reporting issues.  He expects a new rule-making proposal on target date funds.

Jane talked about the selection of priorities and the priorities for the upcoming year and rest of the panel joined in.

  1. Wrap fee program
  2. JOBS Act
  3. Cybersecurity
  4. IA-BD harmonization

Examiners are looking at certain aspects of wrap fee programs. It starts with a suitability policy and procedure. Do you have one and is it being followed?

There is a clear focus on the issues that will arise from lifting the ban on general solicitation. He acknowledged the murkiness caused by releasing the proposed rules for investor protection on the same day as the adoption. This will be a big priority for 2014.

Question & Answer Session (Advisers with $1 Billion or Less in Regulatory AUM)

25% of the registered advisers have more than $1 billion under management’ 62% have less than $500 million and 12% are between $1 billion and $500 million.

Panel II: Private Fund Adviser Topics

Speakers:
  • Ashish Ward, Exam Manager, National Exam Program, Los Angeles Regional Office
  • Alpa Patel, Senior Counsel, Division of Investment Management
  • Igor Rozenblit, Specialist, Division of Enforcement, Asset Management Unit
  • James Capezzuto, General Counsel & Chief Compliance Officer, Cornerstone Capital Management LLC
  • Barbara Burns, Chief Compliance Officer, AEA Investors SBF LLC
Key focus areas in presence exams: (1) investment conflicts of interest, which includes allocation of opportunities and fees, (2) Marketing, in particular performance marketing, (3) valuation and (4) custody. The SEC has conducted about 250 exams and found numerous issues in these areas.
Fees need to be disclosed, including fees charged to portfolio companies and expenses charged for back-office operations. Are you generating additional revenue for the management company while reducing cash to the funds.
The panel pointed out Rule 206(4)-8 that looks through the fund to investors in the fund for fraudulent, deceptive or manipulative acts.

Panel III: Registered Investment Company

This was not relevant to me, so I skipped this session.

Panel IV: Valuation Issues

Speakers:
  • Matthew O’Toole, Senior Special Counsel, National Exam Program, San Francisco Regional Office
  • Leo Chan, Senior Specialized Examiner, National Exam Program, San Francisco Regional Office
  • Sarah ten Siethoff, Senior Special Counsel, Division of Investment Management
  • Jaime Eichen, Chief Accountant, Division of Investment Management
  • Jeffrey Blockinger, Chief Legal Officer & Chief Compliance Officer, Och-Ziff Capital Management Group
The big theme is that there is no one-size-fits-all approach for valuation. There was discussion about whether the SEC would offer some guidance on valuation expectation. That sounded unlikely.
Mutual funds and BDC are required to use GAAP financing. Advisers are not as limited. However, a panelist pointed out that for private funds to comply with the custody rule, it must have GAAP financials.

Panel V: Chief Compliance Officer Obligations

Speakers:
  • Mark Dowdell, Assistant Director, National Exam Program, Philadelphia Regional Office
  • Janet Grossnickle, Assistant Director, Division of Investment Management
  • Marshall Sprung, Co-Chief,Division of Enforcement, Asset Management Unit
  • Chris Marzullo, General Counsel & Chief Compliance Officer, Brandywine Global Investment
  • Management LLC
  • Judy Werner, Executive Director, National Society of Compliance Professionals
I missed this session.

Closing Remarks

by Drew Bowden, Director, National Exam Program
I missed this session.

Materials

NEAT and MIDAS: The SEC’s New Tools

univac

“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.

References:

Due Diligence for Alternative Investments

sec-seal

The Securities and Exchange Commission published a new risk alert on investment advisers and alternative investments. It’s a rambling piece that spends most its time laying out the OCIE’s observations on due diligence practices. To the extent there is any focus, it’s focus is on the perspective of advisers to pension funds and managers of funds of private funds.

I skipped over the industry practices to the compliance section in Section II. The SEC highlights some deficiencies that caught my attention.

The first is the inclusion of due diligence policies and procedures as part of the annual review. This struck me as a bit odd. It didn’t strike me that diligence procedures are necessarily part of ensuing compliance with securities laws.

That odd bit comes back into the picture in the disclosure issues. The OCIE staff found that advisers were making statements about their disclosure practices, but then operating in a different manner. This goes back to the Hennessee Group case where a fund manager touted its expansive diligence process, but failed to conduct the diligence. Hennessee ended up investing in Sam Israel’s Bayou Fund. Hennessee’s touted diligence practices, if they had followed them, should have spotted Bayou as a fraud and not invested.

The last tidbit on compliance was allowing adviser’s employees to invest along side the client. However, some advisers were allowing employees to have preferential treatment on liquidity and fees.

From that perspective, the industry practices in Section I make more sense. OCIE is painting a picture of best practices on diligence procedures for investing in alternative investments. This is what OCIE is going to be looking for from pension fund advisers and fund of fund managers.

References:

Fees and Conflicts

adoption money

I sat down with a few people last week to discuss various fee structures with fund managers and investment advisers. One fee was raised as potentially problematic. “I’m not sure if this fee is a conflict.”

My thought is that every fee is an inherent conflict. You are taking money from the fund investor or client and putting it into the hands of the fund manager / adviser.

The first step of the fee analysis is whether it is disclosed. One of the primary commands of the Investment Advisers Act is disclosure. You must make your clients and investors aware of the fees you charge. Compliance must make sure that the fee information is clearly disclosed in accordance with the regulations and SEC actions.

The second step is the analysis of whether the fee could cause a distortion in behavior that could cause the fund manager / adviser to act in a different way because of the fee income.

If the fund charges an acquisition fee, then the fund may be more likely to make acquisitions because it gets extra income when it does so.

Even the asset based management fee that most people think keeps the fund manager and investor most aligned can cause distortions. In June 2012, the SEC announced its pursuit of zombie funds. It was concerned that fund managers are keeping portfolios together merely to collect the management fee instead creating realizations to return capital to investors.

Fees are always a conflict. You must disclose them and understand the distortions so you can keep your fund’s interest aligned with the investor’s interest.

Compliance Bricks and Mortar for January 24

bricks ancient compliance

It’s been a busy week with guests in the house. I haven’t been able to publish any stories, but these are a few that caught my eye.

Finders Are Not Always Keepers! in the Word of Wisdom Blog from Latham & Watkins Capital Markets Group

Let’s start with the basics. Section 15(a) of the Exchange Act requires that persons engaged in “broker” or “dealer” activity must register with the SEC unless an exemption is available. In general, a “broker” is any person “engaged in the business of effecting transactions in securities for the account of others” and a “dealer” is any person “engaged in the business of buying and selling securities for such person’s own account.” Based on no-action guidance from the SEC Staff, activities that may be deemed (alone or in combination) to confer “broker” status include: …

Where are the Jobs in the Jobs Act? An Examination of the Uneasy Connection between Securities Disclosure and Job Creation by Ian K. Peck on SSRN:

The JOBS Act, passed in April 2012, is designed to produce American jobs through removing various regulatory barriers for small companies to access investor capital. As the regulations continue to be implemented, commentators have dissected the various ways in which the JOBS Act attempts to achieve this goal. One of the methods involves making the IPO process initially less burdensome, through scaling back financial and corporate governance disclosures. Crowdfunding, which will eventually permit companies to raise investor capital through an online “funding portal”, has garnered both deep criticism from regulators and praise from small business owners. Yet little attention has been paid to the notion that the very reason for disclosure reform is job creation. This matters because job creation has not historically played a direct role in the reform of securities disclosure statutes and regulations. This Article analyzes what role, if any, job creation should occupy in the reform of securities disclosure laws. After establishing the normative baseline for disclosure theory and reform, this Article highlights various unintended consequences of using job creation as a justification for reform and proposes a framework for understanding job creation-based disclosure reforms going forward.
(Pointed by Securities Law Prof Blog)

Odds Raised Slightly SEC Will Knock on Your Door This Year in fi360 Blog

In past years OCIE has typically focused on higher risk RIAs – those with custody or the larger complexes that pose more risk to the markets. The vast majority of adviser firms registered with the Commission, however, have 10 or fewer non-clerical employees. Over the next two years, OCIE plans to inspect 1,000 of these rarely or never-inspected RIA firms. In recent years, the SEC has inspected roughly 9 percent of all firms annually.

The fault lies not in our agencies, but in our Congresses by William Carleton

There’s nothing the SEC can do to make non-accredited crowdfunding under Title III of the JOBS Act cost-efficient. The essential problem is that Congress wrote a mini-registration law, rather than authorizing the agency to craft a crowdfunding exemption.

Image is from Vault of Roman Bath in Bath – England by Heinz-Josef Lücking
CC BY SA