Pre-existing, Substantive Relationship

Rule 506(b) of Regulation D provides a safe harbor for issuers to engage in private placements. Private placements undertaken pursuant to Rule 506(b) are limited by Rule 502(c) of Regulation D, which imposes as a condition on offers and sales under Rule 506(b)that “… neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising…”

The SEC Staff has issued various interpretive letters that have tried to clarify the regulation. One of those was the statement that a general solicitation is not present when there is a “pre-existing, substantive relationship” between an issuer, or its [agent], and the offerees.

The SEC has published some Q and A’s on the topic. 256.31 says “substantive” means you have sufficient information to determine the offeree is an accredited or sophisticated investor. Blast emails to unknown investors would not be substantive.

As to the “pre-existing” prong, question 256.30 says there is no minimum waiting period, but there is a waiting period. The Lamp Technologies No Action letter in 1997 said that 30 days is sufficiently long to be pre-existing. (See Footnote 6). So somewhere between 0 days and 30 days is pre-existing enough, as long as you know the potential investor is accredited, to send information on offering.

There is also the question of what amounts to an offering. If it’s at the early stages of a fund, before its formed, perhaps there is no actual security sell. It’s hypothetical information about an upcoming offering.

This all circles back to the IR people asking whether they can leave a copy of the pitchbook for a fund at the initial meeting with an investor. I think the answer is generally “no”, unless you can show that there is a pre-existing substantive relationship with the investor. An initial meeting is generally the 0-day period, unless there has been a series of discussions prior to that initial meeting.

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Twitter Pump and Dump

It should be obvious that some random twitteratti handing out investment advice is going to be a shady character. Right? There are lots of them. I’m not sure any get dragged before the Securities and Exchange Commission on charges.

@AlexDelarge6553 made thousands of tweets encouraging his numerous followers to buy stocks. No surprise that the man behind @AlexDelarge6553 held a bunch of those stocks he encouraged his followers to buy. The SEC named Steven M. Gallagher as the man behind the twitter handle. He bought a bunch of the stock, encouraged his followers to but the stock. The price went up and @AlexDelarge6553 sold out of positions as the price rose.

Classic pump and dump scheme or scalping scheme. Of course the stocks involved were penny stocks at tiny prices and tiny volumes. That made it easier to manipulate the stock price.

Kudos for the SEC for bringing the case. Bigger kudos to @AlexDelarge6553’s broker who tried to shut him down and, I assume, alerted the SEC to the problem.

“Despite repeated, written warnings from his brokerage firm (“Broker A”) that he appeared to be engaged in manipulative trading in violation of securities laws and regulations, Gallagher continued to engage in manipulative trading and scalping. On September 9, 2021, Broker A informed Gallagher that it was closing his trading account effective October 9, 2021, and that it would immediately prevent him from making new stock purchases, restrict his account to just liquidating transactions, and not allow him to open a new account in the future.”

Of course, since he was still allowed to liquidate his holdings, he could keep flogging his followers to buy as he sold out of his positions.

The fun part for the SEC is they have the transaction data from @AlexDelarge6553’s broker and his public tweets. It’s really easy to match the timing of the tweets to the timing of the transactions.

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ENABLERS Act

With the release of the Pandora Papers, there is a renewed focus on the illicit movement of money and filling the holes in anti-money laundering rules. “The Washington Post and other news organizations exposed the involvement of political leaders, examined the growth of the industry within the United States and demonstrated how secrecy shields assets from governments, creditors and those abused or exploited by the wealthy and powerful.”

A bipartisan group of lawmakers introduced legislation that would require investment advisers, trust companies, lawyers, art dealers and others to investigate foreign clients seeking to move money and assets into the American financial system. The group got creative with the name of the bill: “Establishing New Authorities for Businesses Laundering and Enabling Risks to Security Act“. Which <surprise> acronyms into the ENABLERS Act.

The ENABLERS ACT would add new groups to the requirements of the Bank Secrecy Act and require rulemaking to implement the requirements. The new groups:

  1. “person engaged in the business of providing investment advice for compensation”
  2. Dealers in art, antiques, or collectibles
  3. Lawyers
  4. Trust companies
  5. Public accountants
  6. Public relations in such a manner as to provide another person anonymity
  7. Third-party payment services

The first category is the most important to me. Investment advisers have been lobbying to stay outside of the Bank Secrecy Act because of the custodian requirements. The client accounts are held at financial institutions that are subject to the Bank Secrecy Act. The success of that argument has been diminishing over the years.

Art dealers are a big one. There is already regulations moving into place to deal with that industry. It’s notorious as a way to move value around illicitly.

Lawyers are tough because of attorney-client privilege. I’m not sure how public accountants fit into the picture.

I wonder what PR firms did to anger the people who wrote this bill.

Of course it’s only a bill. A lot of things will have to happen to get this into law. Congress is not exactly a well-functioning organization right now.

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The SEC Continues its Attack on the Word “May”

I’ve been critical before of the Securities and Exchange Commission’s Attack on May. Personally, I’ve always viewed “may” as a permissive position when it comes to disclosure. The SEC thinks its completely inadequate.

The SEC view is that if an investment adviser always takes the fee or usually take the fee, “may” is inadequate. How often is “usually” when it comes to “may”? Sixty percent of the time is bad, according to a recent SEC complaint against TCFG Wealth Management and the firm’s CEO/President/COO.

According to the complaint, TCFG imposed a fee markup on rates charged by the firm’s clearing broker. Those fees, and the markup, would be passed on to the TCFG clients when the firm made trades on their behalf. The individual advisers at the firm could chose not to pass the markup through to their clients. In which case the markup was still imposed. The individual investment adviser employee would pay the markup instead of the client.

According to the complaint, 60% of the transactions passed through the fee markup to the firm clients. That was 10,000 transactions and $300,000 in revenue to the firm.

The TCFG form ADV Firm Brochures stated that TCFG “may” receive portions of the fees charged to accounts of TCFG
clients. It further stated that these additional fees TCFG received were “charged” by Clearing Broker, not TCFG, and were for things like wire fees, postage fees, clearing fees and ticket charges, which TCFG said it used to help pay for administrative support for its various entities.

Obviously, the second half was false when disclosing what the fee was used for. The SEC took issue with the statement that the clearing broker charged the fees, when it was TCFG that charged the fee. Plenty of messiness in this arrangement to draw the wrath of the SEC. We haven’t heard the TCFG side of the story.

It’s clear that the SEC has drawn a line in the sand over “may” when disclosing fees. If your firm charges the fee more than half the time, “may” is not the right word to use.

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CCO Liable in Cherry Picking Scheme

According to SEC’s complaint against Strong Investment Management and its owner, Joseph Bronson, for more than four years, Bronson traded securities in Strong’s omnibus account but delayed allocating the securities to specific client accounts until he had observed the securities’ performance over the course of the day. This allowed Bronson to harvest substantial profits at his clients’ expense by “cherry picking” the trades. He would disproportionately allocate profitable trades to himself and unprofitable trades to Strong’s clients.

Of course, there is an additional charge of Strong and Bronson misrepresenting their trading and allocation practices in the firm’s Form ADV filings. The forms stated that all trades would be allocated in accordance with pre-trade allocation statements and that the firm did not favor any account, including those of the firm’s personnel. That does make me wonder if you could get away with cherry picking by stating that you could do so in Form ADV. But let’s not go down that path.

Bronson’s brother and the former chief compliance officer of Strong, John Engebretson, was also charged with failing to perform his compliance responsibilities and ignoring numerous “red flags” raised during the course of the fraudulent scheme. As a result, Engebretson was charged along with Bronson and Strong with violating the compliance requirements of the federal securities laws. Engebretson agreed to settle the charges against him. As part of the settlement, Engebretson agreed to be enjoined, pay a civil monetary penalty in the amount of $15,000, and to be barred from association with any broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization.

The SEC complaint alleges that as the chief compliance officer, John Engebretson aided and abetted the company’s violations by “carrying out his compliance responsibilities in an extremely reckless manner.”

The SEC Commissioners and senior Division of Examination staff have usually stated three circumstances that lead to CCO liability:

  1. when the CCO is affirmatively involved in misconduct;
  2. when the CCO engages in efforts to obstruct or mislead the Commission; or
  3. when the CCO exhibits “a wholesale failure to carry out his or her responsibilities”

I wish this standard was carried over to the Division of Enforcement. Instead, the enforcement attorneys state this

“Engebretson also aided and abetted [Strong]’s failure to implement compliance policies and procedures in several ways”

It doesn’t say that the CCO was affirmatively involved in misconduct. It doesn’t say that there was a “wholesale failure.” Please just stick with the standard. Say that “Engebretson exhibited a wholesale failure to carry out his or her responsibilities” in the complaint. Is that so hard? We can infer that the failure was wholesale. Later in the complaint, it uses “wholly abdicated his responsibilities.” So close.

Final judgement came out against Strong and Bronson recently and made me realize I never caught this story in 2018.

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A Drop Box is not Good Custody

Redwood Wealth got into trouble with the Securities and Exchange Commission for missing the custody compliance issues related to an investment program.

Redwood Wealth had some of its advisory clients invest in an affiliated mortgage company. Obviously, there are some disclosure items. Presumably, Redwood Wealth took take of that adequately.

The investment was structured as loans, with promissory notes documenting the loan from the advisory clients to the mortgage company. I’m going to guess that Redwood was not used to dealing with securities that are paper securities. Speaking from experience, it’s a pain in the neck to deal with these.

The question is how you deal with the custody issue. In this case Redwood Wealth has physical possession of the notes and therefore has custody of the securities. An investment adviser is not supposed to have custody like this. It looks like Redwood Wealth placed copies of the notes in an online dropbox. That doesn’t cut it for the Custody Rule.

The other problem is that the notes were not showing up on the clients’ account statements. Again, I would guess that Redwood was not used to dealing with securities that are paper securities. That also placed the notes outside the ability of CCO to review or evaluate whether it was a proper investment for the advisory client.

The SEC is not accusing Redwood of losing client money. Just the opposite. The SEC explicitly states that no Redwood client lost money. However, the SEC still brought an enforcement action and levied a $50,000 fine against Redwood and required it to hire an independent compliance consultant.

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The Non-Compliant Compliance Officer

You hate to see a peer break bad.

The Securities and Exchange Commission charged Jose Luis Casero Sanchez, a former Senior Compliance Analyst who worked in the Warsaw, Poland office of an international investment bank, with insider trading involving at least 45 corporate events with the investment bank’s clients. 

Ugh. He’s giving compliance a bad name.

For an investment bank, a role of compliance is to maintain a list of restricted companies for trading because of material non-public information. It should be held tightly and lovingly. Not used to profit.

The SEC didn’t want to drag the investment bank into the litigation press releases and complaint. The press identified it as Goldman Sachs, who confirmed.

Mr. Sanchez was a Spanish national, worked in Poland and did his illegal trading in US-based brokerage accounts. The accounts were in the name of his parents. He had accounts at Schwab, Interactive Brokers and Tastyworks. I have to admit that I hadn’t heard of Tastyworks before. Apparently if I make 750 referrals to the firm I get a Tesla. (anyone? anyone?)

This is a clear case of insider trading under US law. It’s clear that Goldman had the policies in place prohibiting this kind of behavior. The kind of behavior that Mr. Sanchez was supposed to prevent or stop.

The SEC got IP logs for access to the accounts. Those logs are not always that exact. But in this case they were traced back to Poland. It doesn’t need to be more exact than that to show that Mr. Sanchez was running the accounts, not his parents.

In his first account at Interactive Brokers, the compliance people at Interactive Brokers clearly saw stuff they didn’t like. Mr. Sanchez was trading options and doing really well. I assume they flagged the account, reported it and shut it down.

Undeterred and unafraid, Mr. Sanchez moved on to Schwab and Tastyworks. He continued his options trading. I’ll assume he was taking aggressive positions. For some reason he went back to Interactive Brokers and opened a new account in his mother’s name this time. He churned through companies on the Goldman Grey List of companies being advised.

The last trade mentioned in the complaint was at Interactive Brokers in May 2021. Who wants to bet that the compliance people at Interactive Brokers flagged this account and brought it to the attention of the SEC? I’m willing to bet good money that they did the heavy lifting for the SEC of identifying bad behavior. That’s what good compliance people are supposed to do.

I’m sure the SEC did a great job of then tying the companies involved in the account’s trades back to Goldman. They got the IP addresses from the broker showing that Poland was involved. Goldman looked at the last name on the account and the employees in Poland. (How many Spaniards work at Goldman in Poland?)

Boom!

Then they checked Mr. Sanchez’s browser history and noticed Schwab and and Tastyworks (did I earn that Tesla yet?).

Boom! Boom!

They got you Mr. White.

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Compliance Bricks and Mortar for September 17

Back blogging on a regular basis for the week. Hoping to keep it up. These are some other compliance-related stories that recently caught my attention.

The Scammer Threat to Your Hotline
By Ted Banks
SCCE’s The Compliance & Ethics Blog

Several of the companies that originally received the fake report have now received a message from one Ofir Gefen, who purports to be a Ph.D. candidate at the National University of Singapore. The messages were, according to Gefen’s email, part of a study to test response times of public companies based on whether the hotline call related to conduct that might benefit the company (e.g., bribery) or the language in the report.  Gefen said “Once the claim was made, we’ve only recorded your initial response and did not pursue the matter any further. Thereby interfering with your day-to-day business as little as possible.” He admitted that this study involved a deception, and that there were no real people involved. He tracked response times, and then said (to reassure the companies that received the message) that all identifiable information would be scrubbed, and then the data would be uploaded to Amazon Mechanical Turk (MTurk), which I had never heard of before.

https://complianceandethics.org/the-scammer-threat-to-your-hotline-updated/

Update on Jailed Compliance Officer
By Matt Kelly
Radical Compliance

We have an update on Samuel Bickett, the corporate compliance officer jailed in Hong Kong on trumped-up charges that he assaulted a police officer. He is currently appealing his 18-week prison sentence, and spending the rest of his time helping other inmates he met during an early stint in Hong Kong’s maximum-security prison.

Bickett, you might recall, was sentenced in July on charges that he assaulted a plainclothes police officer in December 2019 while walking through a Hong Kong subway station. One problem with that case, however: the police officer was beating a teen-aged boy participating in pro-democracy protests, and never identified himself as a police officer despite others repeatedly asking whether he was.

https://www.radicalcompliance.com/2021/09/14/update-on-jailed-compliance-officer/

The Economics of Crypto Funds
By Paul P. Momtaz
The CLS Blue Sky Blog

The most striking finding is that crypto funds underperform the market, no matter the benchmark (equally-, value-, and liquidity-weighted crypto market benchmarks). For example, relative to the equally-weighted market benchmark, crypto funds underperform by 21 percent per year. This means that investors are on average better off if they invest in either Bitcoin, Ether, or both.The result is striking because crypto funds underperform the market even before fees. Considering that most of the funds charge investors substantial fees (a performance fee of 20 percent on the profits and a management fee of 2 percent on the assets under management are typical), the underperformance is even more pronounced.

https://clsbluesky.law.columbia.edu/2021/09/15/the-economics-of-crypto-funds/

Del. Court Substantially Denies Boeing Duty of Oversight Claim Dismissal Motion
By Kevin LaCroix
The D&O Diary

Of particular interest is Vice Chancellor Zurn’s conclusion that the plaintiffs had sufficiently alleged scienter — that is, not only that the directors acted inconsistently with their fiduciary duties, but they also “knew of their shortcomings.” Zurn noted that in Marchand the Delaware Supreme Court inferred scienter from the numerous oversight shortcomings alleged; Zurn said that “those allegations support an inference of scienter [in this case] as well.” Zurn added further that no inference is needed in this case, in light of the board’s own words showing that “directors knew the Board should have had structures in place to receive and consider safety information.” Zurn quoted from emails sent after the Ethiopian Air crash, in which the need for Board reporting on safety issues; she also referred to numerous public statements in which the Board was “crowing” about “taking specific actions to monitor safety that it did not actually perform.” These statements “evidence that at the least [the company’s new CEO and board chair] knew what the Company should have been doing all along.”

https://www.dandodiary.com/2021/09/articles/shareholders-derivative-litigation/del-court-substantially-denies-boeing-duty-of-oversight-claim-dismissal-motion/

Must A Corporation Have A Physical Location?
By Keith Paul Bishop
California Corporate & Securities Law

When it comes to corporations, California rejects the possibility of a corporation without a “there”.    All California corporations and foreign corporations registering to transact intrastate business in California must annually file a Statement of Information (Form SI-550).  Item 3a of the Statement requires disclosure of the corporation’s “complete street address, city, state and zip code of the corporation’s principal executive office”.  Lest there be any doubt, the Secretary of State’s instructions state that the address must be a “physical address” and prohibit a P.O. Box address or an “in care of” address.  

https://www.calcorporatelaw.com/must-a-corporation-have-a-physical-location

Former employer of ‘Roaring Kitty,’ who pumped up GameStop, fined for lack of oversight.
by Matt Phillips
The New York Times

The insurer MassMutual will pay a $4 million fine to Massachusetts securities regulators as part of a settlement involving the conduct of Keith Gill, a former employee and online trader known as “Roaring Kitty” whose relentless cheerleading for shares of GameStop was at the heart of the meme stock mania earlier this year.

https://www.nytimes.com/2021/09/16/business/roaring-kitty-gamestop-massmutual-settlement.html

“May” Can Be a Failure to Disclose

I’ve complained about the Securities and Exchange Commission focusing on the use of the word “may” in disclosures. I’ve typically expected “may” to offer some optionality for the adviser. The SEC has found it inadequate in several instances. We can agree to disagree.

I just came across a case in which I agree that the use of “may” was clearly inadequate in the disclosure.

Diastole Wealth set up a private fund to help its clients pool investments so that they can indirectly invest in things they would not otherwise be able to invest in individually, like private funds. Diastole is run by Elizabeth Eden. Her son had worked at Diastole. He also owned a piece of the firm.

The son left to set up software companies to make tools to help small investment advisers. Several of Diastole’s client invested in the software companies. A potential problem? Yes. Although Diastole and Eden were aware of these investments they did not select or recommend these investments to the clients and did not receive advisory fees related to these investments. No problem.

The problem comes in 2017 when Eden had the Diastole fund invest in the software companies. To me that seems like a conflict that would need to disclosed. Diastole eventually realized this as well and send a “Disclosure and Conflicts of Interest Waiver” to the fund investors. The Disclosure stated that the firm “may” recommend investments in the son’s software companies. In this case, the investments had already occurred. That’s a problem.

I agree in this case that “may” is misused. If you agree with me that “may” provides optionality, this is not a case of optionality. The investments has already occurred. The Disclosure should have been clear that the investments had already happened. If Diastole wanted to have the option to make future investments, then “may” would be appropriate. It does not work at all when the conflict has already happened.

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Shadow Insider Trading

Matthew Panuwat was a business development executive at Medivation, an oncology-focused biopharmaceutical company. Panuwat learned from Medivation’s CEO that the company expected to be acquired by a major pharmaceutical company, Pfizer, within a few days, at a premium to the then-market price.  Panuwat did not trade in Medivation securities.  Rather, within minutes of hearing the news, Panuwat purchased out-of-the-money call options in Incyte Corporation, another oncology-focused biopharmaceutical company that he believed would increase in value when the Medivation acquisition was announced.

If Panuwat traded in Medivation’s stock or Pfizer’s stock, that clearly would have been insider trading.

But he didn’t trade in the stock in play. He traded in Incyte, a completely unrelated company that happened to be in the same industry and about the same size as Medivation. He bet that there would be increased interest in this space and the merger price of Medivation would float the value of similar companies.

Should this be insider trading?

The Securities and Exchange Commission thinks so. It brought charges against Mr. Panuwat for this 2016 trade. I’m sure your noticing the big time gap. The SEC filed just before the expiration of the statute of limitations.

The SEC seems to be hanging its charges on Medivation’s insider trading policy:

“Because of your access to this information, you may be in a position to profit financially by buying or selling or in some other way dealing in the Company’s securities…or the securities of another publicly traded company, including all significant collaborators, customers, partners, suppliers, or competitors of the Company.”

A company’s definition of insider trading shouldn’t be the standard for a government action. Should it?

The SEC states:

Panuwat’s undisclosed, self-serving use of Medivation’s information to purchase securities, in breach of his duty of trust and confidence, defrauded Medivation and undermined the integrity of, and investor confidence in, the securities markets.

Panuwat did make an aggressive trade. He purchased 578 out-of-the-money call options with less than a month left to expiration. The options had strikes from $80 to $85 when Incyte’s stock was trading at $76. I’m sure that triggered some compliance review at his brokerage and probably got red flagged for further review.

The SEC is claiming that Panuwat used confidential information he acquired from his employer. That seems right. The question is how far should that dome of limiting action should spread. The SEC seems to think it should be a big dome. It should reach out to peer/competitor companies.

Given how long this has been sitting around, there must be some hand wringing at the SEC. The complaint is bit short on facts given that there has been five years to gather information.

In compliance, how do you deal with this potential expansion of the insider trading limits? It sounds like insider trading polices and monitoring would have to include peers of the company. Of course, this all assumes this case comes out in favor of the SEC.

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