SEC’s First Deferred Prosecution Agreement With an Individual

SEC Enforcement Logo

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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Compliance Bricks and Mortar for November 8

damaged-brick-wall-with-mortar

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

Happy Birthday, Federal Sentencing Guidelines for Organizations by Jeff Kaplan in Conflicts of Interest Blog

Twenty-two years ago today the Federal Sentencing Guidelines for Organizations went into effect. Although only a set of rules (i.e., not an actual statute), these Guidelines have had a revolutionary effect on how many governments around the world seek to prevent/detect business crime and what businesses do – i.e., develop and implement C&E programs – to try to stay out of trouble.

Paradise By the Dashboard Light and Compliance Tune-Ups by Tom Fox

Meatloaf’s standard Paradise by the Dashboard Light, is the lead in for today’s blog post (the ‘automotive’ focus of the song and not the ‘paradise’ focus for the less prurient among you.) I still think that one of the most significant Foreign Corrupt Practices Act (FCPA) enforcement matters over the past couple of years was the Morgan Stanley Declination to Prosecute. In this Declination the Department of Justice (DOJ) listed a variety of factors which led to its decision not to prosecute the company for the FCPA violations of its Managing Director Garth Peterson. Although all of the factors were clearly important in the DOJ’s calculus, one which has stuck with me is the 35 separate compliance reminders that Peterson received over the seven years in question. That is five reminders a year. I do not think that such a number of reminders will induce compliance fatigue.

Colonel Solicitation by William Carleton

The article says that one must have 10 years of experience in the industry, or something like that, to be invited to participate in the forum. That sounds like a group of folks who might have pre-existing relationships with one another. The entrepreneur engaged in solicitation, for sure – cold calling, really, if the article recites the story accurately – but was this solicitation of a general, public nature?

Maybe he was engaged in solicitation of a lower rank or grade. We might call it “Colonel Solicitation.”

SEC Brings its First Charges Against a Municipal Issuer

town toyota center

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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When the Numbers Don’t Add Up

compliance and a calculator

Sometimes when you look at an investment opportunity, you run through the math and see that things don’t add up. That means it might be a fraud. Take a look at the offering of Bio Profit Series V, LLC detailed in an enforcement action by the Securities and Exchange Commission.

Assuming the SEC’s complaint is true, the fund was selling 10-year notes paying 6% per year with a bonus payment of 45% of the outstanding principal at maturity. That is not an outrageous return by itself. On top of that, the managing member receives a business operations and management fee of 7.5% of the proceeds from the note sale. (See item 15 on the Form D for the offering.)

The fund is supposed to be in the business of buying and making residential loans secured by first or second deeds of trust in California. How can the fund offer that kind of return when interest rates are below 6%?

The SEC lawyers laid out the math in the complaint. Bio Profit Series V would have to generate an average annual return of 12.2% per year to pay the annual return and bonus payment. It was the fourth fund raised by Yin Nan Wang and his Velocity Investment Group, all of which had promised returns that did not add up. (Apparently, Wang skipped over Series IV.)

According to the SEC complaint, Wang was using new investor money to pay old investors. He admitted to the ponzi scheme when talking to a company that originated loans for one of the Bio Profit funds.

Although the underlying investments may be in loans that constitute real estate, the interest in the funds are securities. That gives the Securities and Exchange Commission jurisdiction. It appears that all, or at least a large portion of the investors are from overseas. That may complicate matters.

What’s missing in the story of how the SEC found out about the alleged scam. It does not appear that any investors are complaining of lost money. Perhaps it was the person who was told it was a ponzi scheme. Perhaps that person used the SEC’s relatively new Tip, Complaints and Referrals Portal to alert them to the fraud?

Weekend Book Review: Mortal Bonds

mortal bonds

Sometimes, when I’m looking for a break from reading compliance materials, I look to read a thriller. Maybe a financial thriller would be a good change of pace. A publisher offered me a review copy of the financial thriller from an award-winning author and I cracked it open.

Mortal Bonds is Michael Sear’s follow up to his award-winning debut novel: Black Fridays. That book introduced Jason Stafford, a former Wall Street executive who went down a dark path and landed in prison.

In Mortal Bonds, Stafford is investigating a financial fraud. William von Becker ran a largest investment firm, but it turned out to be a fraud. After von Becker dies in prison, his family hires Stafford to find some of the missing money. They think there is a lot of missing money and want to return it to gain leverage with the Feds. It’s a thriller, so bad things start happening.

The “bonds” in the title refer to bearer bonds. Unfortunately, for Sears when I hear bearer bonds I think of Die Hard with Hans Gruber holding the Nakatomi Plaza hostage to steal $640 million in bearer bonds in the vault. That was a great action movie, with some ridiculous plot devices, but a fun story with enjoyable characters.

That’s too high of a bar for Mortal Bonds. I didn’t read the first Jason Stafford book, so perhaps I needed some of the back story to help with the book. It was fine for a light, fluffy read, but not remarkable.

Compliance Bricks and Mortar for November 1

candy bricks

My kids and I are suffering from a candy hangover this morning after sweeping through the neighborhood trick-or-treating. I’ll try to regain my focus by reading some of these compliance-related stories that recently caught my attention.

Bold and Unrelenting Enforcement from the SEC: A Six Month Review by Terence Healy in The CLS Blue Sky Blog

Mary Jo White promised Congress she would pursue a “bold and unrelenting” enforcement program as Chairman of the Securities and Exchange Commission (“SEC”). In public remarks last week, White reiterated her desire for the Enforcement Division “to be everywhere” and to be “felt and feared” in areas beyond where its resources can reach. Now, six months into her tenure, it is time to take measure of what this new enforcement model may mean for public companies.

Red Sox Win the World Series: Character Does Matter – in Sports and Compliance by Tom Fox

The Red Sox certainly showed their character after last year’s miserable season. Seemingly disdaining the current analytical mania in professional baseball, the brought seasoned veterans, who no other teams ostensibly wanted, into the clubhouse and, much like the Phoenix, rose from last years’ ashes to claim the championship. So character does matter. It matters in baseball and I would posit it matters in business.

SEC to take ‘swipe’ at RIAs that have never been examined by Trevor Hunnicutt in Investment News

The Securities and Exchange Commission plans to make examining the estimated 4,000 advisers who have never been visited by regulators an enforcement priority next year, according to Andrew J. Bowden, director of the SEC’s Office of Compliance Inspections and Examinations. Speaking in Manhattan on Thursday, Mr. Bowden said the commission will zero in on about half of the firms that have never been examined, a group that includes those that have been registered for more than three years and are based in the United States.

Goldman, Feeling Robbed, Still Has to Pay for Accused’s Defense by Peter J. Henning in DealBook

A victim of a crime would never be expected to pay for the perpetrator’s lawyer to defend the case. But corporate law can be counterintuitive, and Goldman Sachs found itself on the wrong side of a court decision that found that the bank’s bylaws require it to advance the legal fees of a former employee who has been accused of stealing its computer code.

The image is the Kids Soap – Candy Bricks by ajsweetsoap available from Etsy.

The Monsters of Compliance – Monster Mash

monster mash and compliance

I was working in the lab late one night
When my eyes beheld an eerie sight
For my monster from his slab began to rise
And suddenly to my surprise

He did the mash
He did the monster mash
The monster mash
It was a graveyard smash
He did the mash
It caught on in a flash
He did the mash
He did the monster mash

Even if you mix all of the monsters together, you can still get a good result. The vast majority of fund managers and investment advisers have good intentions are focused on delivering the best returns they can for their investors. They may have conflicts and alternative streams of income. That doesn’t mean they are doing anything wrong. The monsters are not always scary.

You need to remember that the monsters are out there. That means you need to make good decisions. Take lessons from Hell No: the Sensible Horror Film.

  • Don’t sneak into the abandoned insane asylum with your Ouija board.
  • Don’t watch the cursed tape that kills you in five days.
  • Don’t split up.
  • Call for backup

You can deal with the monsters. Just don’t ignore them. Maybe you can even dance with them.

The Monsters of Compliance – Dracula

dracula and compliance

The pumpkins and garish Halloween decorations are out on my front lawn. With the Halloween season upon us, my mind has become stuck on movie monsters and been mixed with compliance. This is the terrible result.

Vampires have taken many forms, mixing mythologies, weaknesses and desires. There is the regal version played by Bela Lugosi, the tortured soul of Angel, the vicious version played by Christopher Lee, the superhero version of Blade, the numerology of Count von Count, and the delicious Count Chocula. (Vampires don’t sparkle.)

Dracula has remained as the most vampirish of vampires. Unlike lesser vampires, Dracula glows with a veneer of aristocratic charm. He has supernatural strength, the ability to charm you into doing something you don’t want to do, and perhaps the ability to turn into a bat. With all those strengths come many weaknesses: crosses, holy water, garlic, and daylight. He would seem easy to defeat if he were not so charming.

When trying to draw a compliance comparison, one person came to mind when I thought of the Count: Bernie Madoff. His charm was his power, leading a flock believers, while all long he sucked the life out of them. He drained their money for his own use. It was daylight that killed hill. He pulled back the curtain of secrecy and exposed his operations to the sunlight. All of the wealth and all of the power turned to dust.

Ponzi schemers are the vampires of compliance. It’s relatively easy to repel them with a few splashes of garlic flavored due diligence. But once under their charm, they drain you. The Securities and Exchange Commission can try to swoop in like Van Helsing, but by then the ponzi scheme will have already claimed some victims.

The Monsters of Compliance – Freddy Krueger

freddy kruger and compliance

The pumpkins and garish Halloween decorations are out on my front lawn. With the Halloween season upon us, my mind has become stuck on movie monsters and been mixed with compliance. This is the terrible result.

Freddy Krueger terrorizes the kids of Springwood, Ohio, attacking them when they sleep. He seeks revenge for the dark actions of their parents long ago. The first it the series, A Nightmare on Elm Street, terrified me. I had to watch it in the middle of the day so I could shake off the fear before falling asleep. (I found the rest of the series less scary.)

For fund managers and investment advisers, falling asleep and missing the problems can get you in trouble. The SEC announced sanctions against three firms for falling asleep when it comes to the custody rule.

For one firm, it was victimized by a hack of its client’s email account, but it’s internal procedures were inadequate to stop the fraud. The firm received an email purportedly from one of its clients asking to wire $290,000 to a foreign bank account. The firm complied. Unfortunately, someone had hacked into the client’s email, falsified the wire request and directed it into its criminal hands.

The weakness was that the firm did not obtain its clients’ authorizations before transferring funds to third party accounts.The SEC order also has a strange tale of pre-signed letters of authorization and copying clients’ signatures to transfer funds.

The firm also failed to conduct surprise audits for the accounts as required by the rule. Those were violations of the rule, but did not lead to the problem nor could the audits have prevented the problem.

The firm fell asleep and Freddy launched his nightmare at the firm for their past failures.

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