Tag: Attack on May

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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“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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The One That “May” Pay Commissions

EquiAlt is in the business of snapping up distressed properties in Florida. That takes capital and it raised it through a series of funds through debt offerings. That seems like mismatched cash flow to me. You have to make interest payments on investments in real estate that are not generating cash flow. The SEC took an even more skeptical view and accused the firm of being a Ponzi Scheme and defrauding investors.

“The SEC’s filings present an inaccurate picture of Mr. Rybicki’s business dealings,” Washington D.C. attorney Stephen L. Cohen said in an email to the Tampa Bay Times. “We look forward to addressing these matters with the court.”

Since it was a real estate company it caught my attention, a found a few items that were worth exploring.

As with most alleged frauds, the SEC lists a bunch of luxury items by the alleged fraudsters. The EquiAlt’s principals apparently bought Ferraris, Porsches and a Rolls Royce. Plus expensive watches and private jet charters.

Lesson: Just assume that if the SEC shows up at your office and sees a Rolls Royce or a Ferrari out front, the SEC is going to be immediately suspicious.

The SEC got hung up on the use of “may” is the private placement documents. EquiAlt was is accused of using in-house employees and unlicensed external sales agents to to raise investor money. According to the SEC, they were ALWAYS paid commissions. The SEC is taking the position that the fundraising documents should not have said that the funds MAY pay commissions.

I hate that the SEC raises this issue. But it does.

Lesson: If you always pay some kind of fee, especially to an affiliate, make sure you use a more forceful term than “may.” Or I suppose you could find a time to forego the payment so that “may” is more accurate.

The last thing that caught my attention was a claim that the fund raising documents falsely stated that a certain individual was EquiAlt’s Chief Financial Officer when that person did not do so.

Lesson: Always make sure you get your firm’s personnel right in the fund-raising documents.

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“May” May Not Be Adequate Disclosure

I’m sure you heard that Facebook is paying a $5 billion fine for privacy violations to the Federal Trade Commission. You may not have heard that the Securities and Exchange Commission decided to pile on and fine Facebook another $100 million for disclosure failures.

As Matt Levine of Bloomberg says “Everything is securities fraud.”

[T]he Risk Factor disclosures in its Form 10-Q filed on October 30, 2014, Facebook cautioned that “Improper access to or disclosure of user information, or violation of our terms of service or policies, could harm our reputation and adversely affect our business.” In the same Form 10-Q, the company advised that if developers “fail to comply with our terms and policies . . . our users’ data may be improperly accessed or disclosed.” This, the company acknowledged, “could have a material and adverse effect on our business, reputation, or financial results.”

My emphasis and the emphasis of the SEC in its press release

The problem was that Facebook knew that the users’ data had in fact been improperly accessed and disclosed. The SEC is taking the position that this phrasing of a risk creates a false impression that it is merely hypothetical and not actually happening.

The SEC had this fight over “may” in the Robare case. That ended up being a bad strategy for that case. If you remember, Robare’s disclosure was that it may be earning other fees, when it was always earning those fees. One court overturned the SEC. But it had a long history after the case and the SEC ended up winning anyhow.

In the Facebook case, the company made press releases that were incorrect or misleading because they failed to disclose the Cambridge Analytica problem.

The SEC tops this off by pointing out that the Facebook stock price fell from $185 to $159 after the Cambridge Analytica problem was disclosed to the public. That reinforces that the problem was material and should have been disclosed.

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Another CCO Liability Case and the SEC Complains about “May” Instead of “Will”

The SEC’s complaint against Temenos Advisory, Inc. and George L. Taylor paints a very bad picture for the firm and its Chief Compliance Officer. In this case, the CCO is also the CEO, founder and majority owner of Temenos.

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

The Temenos case falls clearly in category 1. The CCO participated in the alleged wrongdoing. I’m not going to lose any sleep over this case.

And the picture painted by the SEC is one of blatant wrongdoing. Taylor concealed from clients that he and the firm were pocketing high commissions from the sales of the investment recommendations. Taylor is also accused of misleading clients about the risks and prospects of the investments. To top things off, the SEC alleges that Temenos grossly overbilled some of their advisory clients using an inflated value for the investment.

It’s not wrong for advisers to take commissions from the sale of products. But it needs to be disclosed to clients. In the complaint, the SEC once again expresses its displeasure of an adviser saying it “may” receive a commission from the sale of a product. The SEC claims that Temenos should have told its clients that it was routinely receiving fees for investments in the private placement offerings and that the fees were many times larger than the advisory fees the clients were paying for advice.

I thought this “may” versus “will” was killed with the Robare case. The ruling stayed away from the distinction between “may” and “will” by pointing out that the disclosure was inadequate to explain the fee sharing arrangement and how it could influence Robare to recommend one fund over another.

According to the complaint, Temenos did disclose the commission scheme in some instances, but not others, and in some cases understated the commission.

Of course, if you are going to get paid a commission, you need to be registered as a broker-dealer. Temenos was not. According to the complaint, Temenos was not conducting the basic level of diligence required by broker-dealers when selling private investment products.

Temenos also had a valuation problem. The firm carried the private placement interests at the cost of the original investment and never adjusted the value up or down. Of course, a firm can do that if it’s disclosed to investors and it’s part of its policies and procedures. The SEC states that the Temenos policy was to value a hard-to-price or illiquid securities at $0.

According to SEC complaint Temenos went ever further down the fraud curve and used values based on overstated cost. In one instance, the statement said the client had made a $200,000 investment when she had only made a $100,000 investment.

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“May” or “Will” is Less Important Than Completeness

The Robare case popped to my attention last year because the Securities and Exchange Commission was focused on the use of the word “may” instead of “will” as adequate disclose of a fee arrangement. My eyes rolled at such distinction. The administrative law judge felt the same way and dismissed the case. Now the Commission has heard the appeal of the case and found the adviser at fault.

Cash in the grass.

According to the SEC charging order, The Robare Group would receive a fee for client funds invested in certain mutual funds. Of course, there is nothing inherently wrong with that arrangement as long as it is disclosed to clients. Obviously, the concern is that the adviser would direct clients to invest in those funds because it is good for the adviser, not necessarily because it is good for the client.

The original decision seemed centered around the SEC raising a fuss that Robare said in the Form ADV that is “may receive compensation from some mutual funds”. The SEC thought it should say “will” to highlight the conflict. The ALJ was not moved by this argument.

He also found that Robare was not negligent because it had engaged a compliance consultant to help with the disclosures. Surely this was a boon to compliance consultants.

The Commissioners overturned the ALJ. The ruling stayed away from the distinction between “may” and “will” by pointing out that the disclosure was inadequate to explain the fee sharing arrangement and how it may influence Robare to recommend one fund over another.

The disclosure mentioned individuals getting sales commissions. That was not accurate. Robare was paid based on the assets in certain funds.

The disclosure did not let clients know which funds generated the extra fee. A client would not be able to cast a skeptical eye on the arrangement of his or her portfolio. The case notes that there was no evidence that Robare’s clients were dispoportionally invested in funds that paid an extra fee to Robare.

The SEC seems moved that Fidelity reviewed the Robare Form ADV and did not find adequate disclosure and made the firm redo it.

In a blow to compliance consultants, the Commission did not allow Robare to escape a charge of negligence merely because it used a compliance consultant.

The ALJ found that Robare was not negligent in part because Robare relied on “experience and competent compliance consultants” to help ensure that it met the disclosure requirements. The Commission acknowledged that there is defense available at times for reliance on defense counsel. But there is not necessarily such a defense available for reliance on compliance consultants. Even if there were such a defense, the Commission felt than Robare did not demonstrate that the firm had met the equivalent standards.

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