Compliance Bricks and Mortar for September 8

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

Three Equifax Managers Sold Stock Before Cyber Hack Was Revealed by Anders Melin

Three Equifax Inc. senior executives sold shares worth almost $1.8 million in the days after the company discovered a security breach that may have compromised information on about 143 million U.S. consumers. The credit-reporting service said late Thursday in a statement that it discovered the intrusion on July 29. Regulatory filings show that three days later, Chief Financial Officer John Gamble sold shares worth $946,374 and Joseph Loughran, president of U.S. information solutions, exercised options to dispose of stock worth $584,099. Rodolfo Ploder, president of workforce solutions, sold $250,458 of stock on Aug. 2. None of the filings lists the transactions as being part of 10b5-1 pre-scheduled trading plans. [More…]

Why the Supreme Court May Review the S.E.C.’s In-House Judges by Peter Henning in DealBook

The S.E.C. asked for en banc review of that decision, but the appeals court denied the request in May. In response, the agency issued an ordersuspending all administrative cases in which a decision could be reviewed in the 10th Circuit, which covers Colorado, Kansas, New Mexico, Oklahoma, Utah and Wyoming.

That kind of inconsistency in the law demands the Supreme Court resolve the split in how the appeals courts assess whether the S.E.C.’s administrative judges were appointed properly. [More…]

Robert Jackson of New York to be a Member of the Securities and Exchange Commission for the remainder of a 5-year term expiring June 5, 2019.

Mr. Jackson is a Professor at Columbia Law School and Director of its Program on Corporate Law and Policy. Mr. Jackson’s academic work focuses on corporate governance and the use of advanced data science techniques to improve transparency in securities markets. His career has spanned the public and private sectors. Mr. Jackson served as a senior advisor at the Department of the Treasury during the financial crisis, assisting Kenneth Feinberg in his work as Special Master for TARP Executive Compensation, and previously worked as a lawyer in private practice. Mr. Jackson holds two bachelor’s degrees from the University of Pennsylvania, an M.B.A. in Finance from the Wharton School of Business, a master’s degree from Harvard’s Kennedy School of Government, and a law degree from Harvard Law School. Born in the Bronx, New York, Mr. Jackson currently lives in New York City. [WhiteHouse.gov]

Let’s Not Get Too Excited with FINRA’s Proposal on Re-Taking Exams by Ernest Badway

Most brokers despise the fact that they need to re-take their examinations if they are not employed with a broker-dealer for 2 years or if they are not associated with a member firm.   Now, FINRA comes to the rescue with a new proposal to permit registered representatives to avoid re-taking their exams for up to 7 years so long as they fulfill continuing education requirements.  See http://www.finra.org/sites/default/files/rule_filing_file/SR-FINRA-2017-007.pdf. [More…]

Whistleblower Hotlines: Still a Vital Tool by Matt Kelly in Ethics & Compliance Matters

Recently the chief compliance officer of a global company asked me: does a company need a telephone-based whistleblower hotline anymore? In our all-technology, all-the-time world, could a company phase out telephone hotlines in favor of a web-only reporting system?

The answer to that question requires a bit of finesse. The short answer is yes: in the purest, technical interpretation of corporate governance law and SEC rules, a company isn’t required to provide a telephone hotline as one reporting option. But you would need bulletproof arguments demonstrating why your organization no longer needs a telephone hotline, and never will in the future.  [More…]

 

Can Concert Tickets Be Securities?

WFAN morning show co-host Craig Carton was arrested for scamming investors out of $5.6 million. His ploy was a fraudulent ticket resale business. He promised the ability to deliver face-value tickets to concerts by Katy Perry, Justin Bieber, Metallica and Barbra Streisand. According to the Securities and Exchange Commission, he used the investors’ money to repay gambling debts.

The case has attracted attention because of the high-profile of Mr. Carton. It attracted my attention because I was curious if it was a securities law violation.

Mr. Carton has not responded to the SEC charges and is also subject to parallel criminal charges. I looked at the SEC complaint to see how it handled the threshold question of whether securities were involved, accepting the charges as true for educational purposes.

Using the Howey test to determine if there is an investment contract, we look at the four factors:

  1. an investment of money,
  2. a common enterprise,
  3. a reasonable expectation of profits, and
  4. a reliance on the entrepreneurial or managerial efforts of others.

As usual, 1 and 4 are the easy prongs. Investors gave Mr. Carton money with promises of getting more back. The SEC cites a presentation with a per deal average of 2.2X and 187% IRR.

The investors were just putting up money and relying on Mr. Carton to execute on the acquisition and resale of tickets. That should leave the fourth prong satisfied.

The complaint points to two separate schemes, one with an individual and a second with a hedge fund.

According to the SEC’s complaint, the scheme with the individual investor involved only that individual investor and not a pooling of money. There is a split among the courts about the “common enterprise” prong of the test. Some courts look toward a pooling of money. Some are just satisfied if the success of the investor depends on the promoter’s expertise. The complaint is in the Second Circuit which places a heavy reliance on a pooling of money to meet the common enterprise prong.

As to the individual investor, there may be some grounds to argue that it was not a securities transaction and therefore outside the scope of the SEC. That would still leave Mr. Carton with the criminal charges of wire fraud, etc.

As to the hedge fund scheme, the investment document was, at least in name, structured as a loan. The operative document was a Revolving Loan Agreement. There is little to discern in the complaint about whether it was a loan in name only and a was really a “security” that would give the SEC jurisdiction. If it’s a loan, that may be outside the definition of “security” and we never get to “investment contract” test in Howey. Again, the scheme would still subject Mr. Carton to criminal charges of wire fraud and bank fraud.

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Follow Up on the Osunkwo CCO Liability

I was quite bothered by the Osunkwo CCO liability case that, on its face, sanctioned a CCO for misstating a firm’s assets under management. A few years ago, the SEC had expressed an unwillingness to prosecute CCOs, except in three extreme circumstances:

  1. Participating in the wrongdoing
  2. Hindering the SEC examination or investigation
  3. Wholesale failure

None of those were indicated in the administrative order against Mr. Osunkwo.

I had gone through the SEC filings to see if I could find something that more devious that make me feel less uneasy about this sanction against a CCO for errors on the Form ADV.

In the Diamond CCO liability case earlier this year, that CCO was also sanctioned for mistakes on a Form ADV filing. Ms. Diamond had stated that the private fund was subject to annual GAAP audits by a third party auditor to comply with the custody rule. In fact, the fund was not and was a fraud. Investors lost money because the CCO did not do her job.

I thought the SEC did a poor job in the administrative order by not lining up the pieces to state that there was a wholesale failure and investors lost money because of that failure. But at least the fraud was mentioned in that order.

There was no indication of fraud in the Osunkwo administrative order. There is a mention that Aegis Capital and Circle One are no longer registered as investment advisers.

indicted for stealing investor money that was supposed to be used to fund the acquisition and consolidation of small to mid-sized RIAs. Those principals, John Lakian and Diane Lamm are accused of diverting some of that money for personal uses.

I have not had time to pull together all of charges, but it looks like the SEC is placing liability on Osunkwo for indirect losses. I have not found any documents that accuse anyone of pilfering money from the investment adviser clients at the firms that Osunkwo was CCO. Instead, it’s the losses from the investors in the RIA holding company that lead to the CCO liability.

I assume that the holding company was valuing an acquired RIA at $X per AUM. By overstating the AUM in the RIA, Osunkwo was allowing the holding company to overstate the value of its holdings. Investors and and lenders to the holding company sustained losses indirectly because of the Form ADV overstatement of AUM.

I don’t like this expansion of CCO duties and expansion of CCO liability. It’s stretching the obligations of the CCO to not only protect the clients of an investment adviser, but the investors in the owner of the investment adviser.

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Back to Compliance

After two weeks out of the office, I’m back to compliance. It’s not that compliance stops if it’s embedded in firm culture and operations. It also means that the work does not stop while you’re out of the office.

I enjoyed two weeks in the midwest and mountains. It included a trip to Yellowstone. I have this picture of a charging bison as proof.

Post-Labor Day means the official end of summer. Employees are back from summer vacations and kids are back in school. Meeting minutes need to be compiled, reports need to be completed, training needs to start up again.

It’s good to take time off to recharge and refocus on the tasks as hand.

But the tasks pile up while you’re on vacation. Tasks are piled up on my desk. I assume that at least a few of you are also dealing with a big pile of work to be done.

Compliance Bricks and Mortar – Harvey Edition

My thoughts go out to readers of Compliance Building in Texas who live in the path of Hurricane/Tropical Storm Harvey. I hope you were able to stay on high ground. It looks like this will be the first natural disaster of the Trump administration.

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

How the SEC Neglects to Enforce Control Person Liability by Marc I. Steinberg and Forrest Colby Roberts in the CLS Blue Sky Blog

Scholars and politicians alike have spoken and written at great length about the importance of gatekeepers in our current corporate governance system. However, relatively little has been done to discipline  gatekeepers who seem to have lost the keys to the gate.  Meanwhile, the country’s primary securities regulator, the Securities and Exchange Commission, refuses to employ one of its most powerful tools to keep gatekeepers in check.  Our recent article, Laxity at the Gates:  The SEC’s Neglect to Enforce Control Person Liability, examines the SEC’s reluctance to bring claims against corporate insiders under Section 20(a) of the Securities Exchange Act, known as the control person provision. [More…]

Audit Report Choice Looms for SEC by Matt Kelly in Radical Compliance

If Clayton wants to cast his lot with the critics who say the PCAOB’s demands upon audit firms (and by extension, upon the companies they audit) are out of control, repudiating its new audit report standard would send that message loud and clear. Or Clayton could toe the historical line, and approve that which the PCAOB has recommended. Or he could finesse some third way, approving the standard while adding caveats and clauses a-plenty to keep all constituencies at least quiet, if not content. [More…]

Improving the SEC’s Enforcement Program: A Ten-Point Blueprint for Reform by Bradley J. Bondi

The SEC should prioritize seeking out and penalizing those individuals, such as Bernie Madoff and Allen Stanford, who commit intentional wrongdoing through schemes designed to defraud investors. The “broken windows” approach, promoted by then-SEC Chair Mary Jo White, disproportionately emphasizes small and sometimes unintentional securities law violations in the hope that doing so will deter more significant violations. But a practical consequence of this is the disproportionate expenditure of the SEC’s limited resources on small and unintentional violations, often against well-intentioned executives and chief compliance officers for negligence-based violations or honest mistakes. As a result, more significant and intentional violations, such as Ponzi schemes, boiler rooms, and bucket shops, may go undetected, unpunished, and undeterred. [More…]

FinCEN expands beneficial owner reporting rules for real estate by Richard L. Cassin in the FCPA Blog

The Treasury Department’s Financial Crimes Enforcement Network added Honolulu Tuesday to a reporting program for real estate deals involving cash transactions. FinCEN also extended reporting requirements for six other metropolitan areas under a data collection program that started in March 2016. The new Geographic Targeting Order (pdf) runs through March 20, 2018.

[More…]

In a Boon to Prosecutors, Insider Trading Ruling Is Reshaped by Peter J. Henning in DealBook

Another problem is that the Second Circuit decision also upheld Mr. Martoma’s conviction on the ground that the payments Dr. Gilman received from SAC through the expert networking firm meant there was a quid pro quo relationship. Although he was not paid for the actual information provided to Mr. Martoma about the negative drug trial results, the majority opinion concluded there was enough evidence for the jury to a find a tangible benefit that would have met the requirement of the Newman case even before it was rejected in Salman. [More…]

More Changes to Insider Trading Law

With the ground-shaking decision in Newman, insider trading law became a bit murky. Cases have been filling in the gaps left in its wake. The Mathew appellate Martoma decision helped fill in some more.

From a compliance perspective, this is all chasing butterflies and tilting at windmills. It was clear that Mr. Martoma was involved in insider trading. It was just a question of whether it was illegal. He knew the information he was getting was not supposed to be disclosed to the public. He should not have pushed for its disclosure and he should not have traded on it. At least not according to any self-respecting compliance professional at a trading firm.

But I’m sure enforcement professionals are very interested to see if they can find a way to keep their insider trading clients from going to jail.

For me, the current status of the law is that the Newman decision said the government needed to prove the tipper gained a tangible reward, or “personal benefit,” for providing insider information. The 2016 Supreme Court ruling in Salman v. U.S., said proving a tipper and trader were relatives was enough to meet the “personal benefit” standard.

In the Martoma case, the Second Circuit describes the the “misappropriation theory” of insider trading:

“that a person . . . violates § 10(b) and Rule 10b‐5[] when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information.” Id. at 652. It is thus the breach of a fiduciary duty or other “duty of loyalty and confidentiality” that is a necessary predicate to insider trading liability.

It then goes on to the seminal insider trading case of Dirks v. S.E.C., 463 U.S. 646 (1983)

the Supreme Court held that a “tippee”—someone who is not a corporate insider but who nevertheless receives material nonpublic information from a corporate insider, or “tipper,” and then trades on the information—can also be held liable under § 10(b) and Rule 10b‐5 but “only when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and the tippee knows or should know that there has been a breach.” Id. at 660.2 “[T]he test” for whether there has been a breach of a fiduciary duty or other duty of loyalty and confidentiality “is whether the [tipper] personally will benefit, directly or indirectly, from his disclosure” to the tippee. Dirks, 463 U.S. at 662.

It goes on to cite its own United States v. Newman, 773 F.3d 438 (2d Cir. 2014)

To the extent Dirks suggests that a personal benefit may be inferred from a personal relationship between the tipper and tippee, where the tippee’s trades ‘resemble trading by the insider himself followed by a gift of the profits to the recipient,’ we hold that such an inference is impermissible in the absence of proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.

The Second Circuit comes out with this standard:

Thus, we hold that an insider or tipper personally benefits from a disclosure of inside information whenever the information was disclosed “with the expectation that [the recipient] would trade on it,” … and the disclosure “resemble[s] trading by the insider followed by a gift of the profits to the recipient,” … whether or not there was a “meaningfully close personal relationship” between the tipper and tippee.

For my simplistic compliance perspective, this means that if the tippee pays money or gives something valuable to the tipper in exchange for money, the tippee risks going to jail.

Martoma gave his tipper money through an expert network agency. As a result, his conviction stands.

I think this leaves golf buddies possibly able to trade on insider knowledge, unless they are relatives or betting on the results.

I should point out that there was a blistering dissent in the case and I’m not sure if Mr. Martoma still has enough cash to appeal to the Supreme Court. We may see more in the Martoma case.

I’m sure that you will be reading many more nuanced discussions about this case and its implications from those much more versed in insider trading than me. But, I think this case does little to change the compliance view on insider trading.

If you want more information on the Martoma case or the SAC Capital attack, read Black Edge. It’s well worth the time if you have any interest in the area.

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The One with The Fake Ron Stenson

Some of the things that catches my attention with frauds and Ponzi schemes are the steps that the fraudsters will take to cover up the fraud and how they think they will escape from the fraud unscathed. The recent charges against Jeremy Drake caught my attention because of the steps he took.

The Securities and Exchange Commission has filed the charges, but Mr. Drake has not yet had a chance to refute them. I’m just using the allegations as a way to help me (and maybe you) better understand how frauds evolve.

According to the complaint, Mr. Drake worked as a registered investment adviser representative. He managed to convince a professional athlete and his wife to become his clients. (I poked around, but couldn’t find out who.) The relationship started off with a standard 1% fee.

In 2012 Mr. Drake told them they were entitled to a VIP discount on the fee. I assume (1) his clients pressed him on fees, (2) his firm did not agree to the discount, and (3) Drake lied to keep them as clients. He fed them some gobbledygook about how they were getting credits in their account from the brokerage. I can only assume that he thought he could eventually convince his firm to give the discount.

But there was no discount. The client met with Mr. Drake a year later and he once again spewed out the discounted rate. He documented the fraud by sending fake account statements stating that the clients had paid “net” rates of 0.177% and 0.15%, resulting in “net” fees of $44,994 and $34,737. They had in fact paid a 1.0% rate in both accounts, resulting in actual fees paid of $280,349 and $231,889.

At this point, you may expect that the firm could have spotted Mr. Drake’s fraud. The rep is sending the account statements instead of them coming from the custodian.

A year later, the same discussion over fees happened again and more fake documents were sent. The client’s wife first language was not English, so perhaps Mr. Drake thought he could use the language barrier to keep the fraud going. The client’s wife’s assistant was the translator.

In 2016 with a new assistant and a new accountant, the client pressed Drake again. Drake continued with the lies and fake documents. The fraud was not holding together and they pressed Drake on the fee discount. To bolster the fraud, Drake created a false persona named “Ron Stenson” whom he held out as an employee of “Charles Schwab Advisor Services” who could help explain the fee credit. He pressed a colleague into the role of Ron Stenson to answer phone call inquiries.

At this point Mr. Drake realized he couldn’t keep the fraud going. The accounts were short almost a million dollars in the fees the firm was taking compared to what he was telling the clients. I scratch my head wondering how Mr. Drake was going to get out of this. I have to assume that he hoped the firm was going to grant the discount at some point.

Should Mr. Drake’s firm caught some of this activity through email monitoring? Maybe. I’m skeptical of the effectiveness of email monitoring. It’s full of false positives, causing compliance to stare at a lot of stuff instead of spending time looking at other areas.

Theoretically, Mr. Drake’s clients should have been getting account statements directly from the  third-party custodian. That should have shown actual fees deducted and the actual positions held by the client. That is one of the key pillars of the custody rule. The client should be able to verify an advisor’s work by getting the account statement directly from the custodian or getting statements that have been vetted through a third-party auditor.

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CCO Sanctioned for Incorrect Form ADV Filings

According to the Securities and Exchange Commission, David I. Osunkwo failed as a CCO for incorrectly stating the amount of AUM and the number of clients for two affiliated investment advisers. Mr. Osunkwo relied on estimates provided to him by the Chief Investment Officer. For that, he was fined $30,000 and suspended for a year from certain jobs related the investment adviser and securities industry. Unfortunately, this is another instance of the SEC publishing a case that increases the potential liability for CCOs.

Osunkwo served in 2010 and 2011 as the chief compliance officer at Aegis Capital LLC and Circle One Wealth Management LLC. The firms had outsourced CCO duties to a third-party provider called Strategic Consulting Advisors LLC, where Osunkwo was a principal. As part of the outsourcing, Osunkwo was designated CCO of both firms. Osunkwo was tasked with preparing a consolidated 2010 year-end Form ADV for Circle One that would reflect its merger with Aegis under the same parent company, Capital L Group LLC.

According to the SEC, Osunkwo reviewed information of Aegis Capital’s and Circle One’s investment management business and client accounts including 2009 year’s ADV. For 2010 AUM and account information, Osunkwo relied on estimates provided to him by the CIO.

The SEC said the CIO sent Osunkwo an email that stated:

David – . . . I believe AUM was as follows on 12/31 Funds: $36,800,000 Schwab/Fidelity: $96,092,701 (1,179 accounts) (not sure how many customers) Circle One: probably higher than $50m, but hopefully [another employee] told you a number today Total is in the $182.89m range . . . .

I assume that Osunkwo could not show that he relied on anything other than this email.

The problem is that the actual combined AUM of Aegis Capital and Circle One was only $62,862,270.28. The Form ADV overstated the AUM by 190%  The Form ADV also overstated the total client accounts by at least 1,000 accounts, which was off by 340%.

The SEC does not lay out any facts in the order that shows Osunkwo knew the statements were incorrect. On its face, the SEC is imposing liability on a CCO solely related to the compliance operations of a CCO, with no evidence of fraud.

The SEC did not point out that any investors were harmed. This is in contrast to the Diamond CCO liability case where her firm was involved in fraud and her actions effectively covered up that fraud.

The parallel case against Aegis Capital and Circle One Wealth is all about recordkeeping and filing violations. There is no indication of harm to the clients.

At one point the SEC had expressed an unwillingness to prosecute CCOs except in three extreme circumstances:

  1. Participating in the wrongdoing
  2. Hindering the SEC examination or investigation
  3. Wholesale failure

In the case against Mr. Osunkwo, I don’t see any of these three circumstances. Nor does the SEC state or imply that any of these circumstances had occurred. Nor is there any allegation of fraud or harm to clients.

On the face of the order, Mr. Osunkwo relied on the CIO for information included on the Form ADV and as a result he was sanctioned. That leaves all CCOs having to wonder how far they must go to verify information on Form ADV filings. This case tells me that I can’t rely on information from senior firm employees when preparing a Form ADV. Add in the Diamond case, I have to be concerned about what information the SEC thinks I should have known when filling out the Form ADV.

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Eclipse Watching

In case you unaware, the sun is being blotting out by the moon across all of the United States today. I happen to have traveled to my in-laws who live right in the path of totality.

I think this astronomical phenomenon is far more interesting than any compliance story I could read or write about.

My one compliance tip is to not look directly at the sun, except during the brief total phase of a solar eclipse if you are in the path of totality.

The only safe way to look directly at the uneclipsed or partially eclipsed sun is through special-purpose solar filters or eclipse glasses. These eclipse glasses or handheld solar viewers should be labeled as being compliant with the ISO 12312-2 international safety standard.

Compliance Bricks and Mortar for August 18

Sorry for the lack of posts this week. I was attending and speaking at the Boston Investment Adviser Compliance Symposium. I needed to earn some continuing education credits for the my IACCP designation.

While I was sitting it conferences, here are some of the compliance-related stories that caught my attention.

Accredited Investors vs. Qualified Clients vs. Qualified Purchasers: Understanding Investor Qualifications by Alexander Davie in Strictly Business

The three most common types of investors referenced in these laws and the regulations adopted by the Securities and Exchange Commission (SEC) are 1) accredited investors, 2) qualified clients, and 3) qualified purchasers. While the terms may sound familiar, there are crucial distinctions between each category that have a significant impact on issues like whether a fund qualifies for the private placement exemption, whether a fund’s manager will be entitled to receive performance-based compensation, and whether the fund will be required to register as an investment company. [More…]

Dentist, Claiming Tip Was a Rumor, Wins Insider Trading Case by T. Gorman in SEC Actions

The defense claimed that Mr. Roberts relied on his research but not a rumor of a transaction he received from his brother-in-law, according to a report by Law 360 (Aug. 15, 2017). While Mr. Roberts chose not to testify, his version of the trading transactions was put in evidence by the FBI to whom he had given statements.

Mr. Robert’s claim about rumors regarding the transaction appears to draw support from the other insider trading cases that swirled around the Shaw transaction. For example, SEC v. Trahan, Civil Action No. 17-cv-731 (W.D. LA. Filed June 6, 2017), is another action based on the deal. It named as defendants Michael Trahan, the owner of engineering consulting company Petra Consultants, Inc. Mr. Trahan was a consultant to Shaw. During his engagement, and before the July 30, 2012 announcement date, an employee of the firm told him about the merger. Mr. Trahan purchased 5,600 shares of Shaw common stock which he sold after the deal announcement for a profit of $69,735.00. The complaint alleged violations of Exchange Act Section 10(b). To resolve the case Mr. Trahan consented to the entry of a permanent injunction prohibiting future violations of Section 10(b). In addition, he agreed to pay disgorgement of $69,735.00, prejudgment interest and a penalty equal to his trading profits.

[More…]

Selfie Time: What Could Go Wrong? by By Margaret Scavotto, Director of Compliance Services at Management Performance Associates

A nurse aide, lab tech, medical assistant – or any other healthcare employee  – is new on the job. They are excited about their new position and decide to take a selfie to memorialize the occasion, then send it off to Facebook, Instagram, Twitter and Snapchat, with the click of a button, in under 20 seconds. What could go wrong? [More…]

Federal Spoofing Conviction by Lewis J. Liman, Jonathan S. Kolodner and Matthew Solomon in the CLS Blue Sky Blog

Coscia was the first trader to be convicted under the anti-spoofing provision of the Commodity Exchange Act (“CEA”), 7 U.S.C. § 6c(a)(5).  The Seventh Circuit’s decision upholding Coscia’s conviction marks the first time a federal appellate court has provided guidance on the scope of the anti-spoofing prohibition, and the Circuit’s comprehensive rejection of Coscia’s constitutional challenge fortifies the government’s ability to conduct additional investigations and prosecutions in an environment of increasingly aggressive regulation of the listed futures and derivatives markets. [More…]