August 2014 – Page 2 – Compliance Building

Compliance Bricks and Mortar for August 8

brick walls

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

Lawyers as SEC Enforcement Targets, What a Fund Manager Needs to Know by Jay B. Gould in the Investment Fund Law Blog

In a move that should place securities lawyers and their clients on notice, Commissioner Kara Stein of the Securities and Exchange Commission (“SEC”) recently indicated that lawyers may become targets of SEC enforcement actions when a registrant has been poorly advised by its attorney and the result of that advice ends up harming investors or violating regulatory standards. The SEC has the ability to sanction, fine and bar attorneys and accountants from practicing before the SEC pursuant to SEC Rules of Practice 102(e). As a practical matter, a bar pursuant to Rule102(e) precludes an attorney or an accountant from representing a regulated entity, such as an investment adviser or broker dealer, in any further dealings with the SEC or otherwise.

White & Case discusses DC Circuit’s CFIUS Ruling by Richard J. Burke, Cristina Brayton-Lewis, Tanya Hanna and Ziad Haider in the CLS BLue Sky Blog

The DC Circuit’s ruling constitutes an important albeit narrow victory for foreign investors who have sought greater transparency in the CFIUS review process. While the ruling grants certain due process protections to investors, the CFIUS legal regime remains intact, and the due process to be accorded will still need to be balanced against other interests.

Not Securities Fraud By Reason of Insanity

insanity

Some investment fraud schemes sound crazy, but leave just a enough truthful-sounding bits to catch people. But Thomas Lawler’s scheme sounds completely bonkers. He established the Freedom Foundation to offer investors the chance to erase their debts and collect lucrative profits through the purchase of “administrative remedies”.

Never heard of profit-making “administrative remedies”? Lawler can sell you the secret.

Lawler investigated the banking system and discovered the startling “truth.” At birth, we each have an account established in our name. When you borrow from the bank, you are actually borrowing your own money that resides in your account. For a mere $1000, Lawler will prepare notices to the creditors, using the Uniform Commercial Code, international admiralty law, and papal decree to cancel the debt.

At least that is according to the SEC’s complaint. I checked out the Freedom Club USA website to find more information. The website is a big collection of crazy.

Here is a snippet:

The Vatican created a world trust using the birth certificate to capture the value of each individual’s future productive energy. Each state, province and country in the fiat monetary system, contributes their people’s value to this world trust identified by the SS, SIN or EIN numbers (for example) maintained in the Vatican registry. Corporations worldwide (individuals became corporate fictions through their birth certificate) are connected to the Vatican through law (Vatican to Crown to BAR to laws to judge to people) and through money (Vatican birth accounts value to IMF to Treasury (Federal Reserve) to banks to people (loans) to judges (administration) and sheriffs (confiscation)

The website includes ramblings about a lost 13th amendment to the Constitution, the illegality of the 1040, the Cosmic Time Plan, and an audio recording from the Prime Creator.

In sorting through the crazy, it’s hard to tell if it’s a securities fraud issue. It’s certainly a fraud. Anyone giving money to this kind of full-blown crazy is throwing their cash away. It sounds like Lawler may be selling a service and not an investment. There is too much crazy on the website for me to discern what Lawler is actually selling.

You can look to the Howey four-part definition of an investment contract. There is certainly an investment of money and the reliance on others. There is a reasonable expectation of profits. Cancelling debt is income, so the SEC can probably get over that hurdle.

But I’m not sure there is a “common enterprise.” Lawler’s scheme seems more like fraudulent credit reduction scheme than a securities investment.

Sources:

Image of Insanity by Albert Einstein by Marla Elvin
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Another Real Estate Ponzi Scheme From 2008

compliance building

The 2008 financial crisis caused many real estate investment funds to run into trouble. Some fund managers stepped over the line hoping to wait out the turmoil and recover. The Securities and Exchange Commission finalized charges against a fund manager who hoped to divert funds to stay liquid during the turmoil.

According to the SEC’s complaint, the Walter Ng, his son Kelly Ng, and Bruce Horwitz promoted Mortgage Fund 08 during the 2008 financial crisis as a new opportunity to invest in conservatively underwritten commercial real estate loans. But the Ngs and their advisory firm, The Mortgage Fund LLC, immediately began transferring money raised by MF08 to an older fund that had run into trouble. Their R.E. Loans fund was in trouble exactly because of the 2008 financial crisis.

R.E. Loans was a high-risk debt fund, charging high interest to real estate projects and developers who could not obtain traditional financing. From 2002 through 2006 the fund appeared to be successful. The Ngs raised hundreds of millions of dollars from investors and distributed hundreds of millions back to investors. But the fund ran into cash flow difficulties in 2007. It was the harbinger of the upcoming financial crisis.

From December 2007 to March 2008, the Ngs transferred almost $39 million from MF08 to R.E. Loans. I’m an optimist so I assume that the Ng were hoping some short-term affiliate loans would be enough to get R.E. Loans through the financial crisis. But delinquencies continued to rise from 15% in March 2008 to 74% by June 2008.

The Ngs lied to their investors and doubled down on the earlier fund.

The NGs were also subject to criminal investigation and charges. Kelly is serving 18 months while his elderly father is merely on probation. The charges were light because it took too long to discover and investigate the fraud. The statute of limitations limited government action.

As we have passed the five year mark for the 2008 financial crisis the frauds that happened during the time will not be prosecuted.

Sources:

The SEC is Late to a Real Estate Fraud

Company Theft

The Securities and Exchange Commission charged M. “Shi” Shailendra with making false representations to investors, misappropriating money, and acting as an unregistered broker. Shailendra was selling interests in his Interstate North 5 Acres fund known as Shi Six. He was purportedly using the money to acquire distressed real estate. Instead, he was pocketing most of the capital.

Shailendra had plans to create a massive real estate empire built with capital from the Indian community. His plans got derailed by the 2008 financial crisis and his own misdeeds.

According to news reports, the unraveling of his misdeeds has been happening for several years. Shi Investments One sued the Shailendra Group back in early 2011 for the diversion of investor funds to personal accounts and other self-dealing.

It’s good that the SEC caught him, but it seems that his investors had already grabbed him. Among the SEC’s penalties, Shailendra was ordered to disgorge over $2 million in ill-gotten gains and penalties. But the SEC waived that amount based on his inability to pay.

The fund is handed over to investors to try and regain whatever capital may remain. From the accusation in the complaint it sounds like most of the investors’ capital went to Shailendra for personal use or to fund affiliate transactions.

At a minimum, Shailendra is permanently barred from association with any broker-dealer, investment adviser or other firm under the jurisdiction of the SEC. However, lots of real estate investment operates outside that jurisdiction.

Sources:

Weekend Reading: Flash Boys

I admit to being a Michael Lewis fanboy. I consider him one of the best business writers. He has a knack for using characters as a lens to explain an issue.

The issue in Flash Boys is high frequency trading. Or high speed trading. Or electronic trading. It’s a bit of a confusing mix. Uncharacteristically, Lewis seems to stumble a bit around what the problem is. I think that is in part because the problem is complicated in a technical, legal and financial directions. Many of the people involved don’t fully understand it. Those that do fully understand it don’t want to explain it. They are too busy making money exploiting the issue.

Based on the speed you receive information, you can trade on that information and make money if you find out faster and trade faster than others. That has been true since markets existed.

For stock exchanges, the days of floor pits and individuals yelling buy and sell orders are long gone. It all happens in server stacked on top of each other with an algorithm matching buy orders and sell orders. There are multiple exchanges where trades can take place. That’s good for competition and innovation.

But those exchanges are located in different places. Not necessarily far apart, but milliseconds or microseconds apart. Just far enough that watching trades happen in one exchange can give a strong indication about what will happen in another exchange a bit further away. High speed traders exploit that information and make money. Lots of money if they are fast enough.

Lewis explores the issue in great detail and provides a good understanding. He uses Brad Katsuyama, a trader at the Royal Bank of Canada, as the focal point of his story.

The most disappointing part of the book is that it ends without resolution. The problems with high speed trading are still in the system and its hurting investors not involved in high speed trading.

Compliance Bricks and Mortar for August 1

bricks and mortar

These are some of the other stories that recently caught my attention.

Tips for finding the dirt during due diligence on funds, managers by Liz Skinner in Investment News

Advisers who can describe an exhaustive process of researching the people and firms they recommend their clients invest with stand to gain the trust and confidence of those clients. Regulators, too, like to see a robust approach to due diligence. A hardy due diligence program, though, requires more than an Internet search for problems.

Document-Comparison Etiquette by Ken Adams in Adams on Contract Drafting

When you eventually revise MCSD to its third edition, could you consider adding an appendix that talks about redlining protocol? Here’s what routinely happens to me: I send the other side a draft marked using Microsoft Word’s “track changes” feature. Using that feature, they accept some of my changes, reject others, and make changes of their own that are tracked using the “track changes” feature.

The Franchise Tax Board’s Doing Business Legal Ruling – Ex Nihilo, Aliquid Fit by Keith Paul Bishop in California Corporate & Securities Law

Gotcha! Under Legal Ruling 2014-01, the venture capital fund’s attribute of “doing business” in California is attributed to its members under general principles of partnership law. Therefore, you are doing business in California and must file a tax return and pay taxes and fees.

Dark Pool Class Action Securities Suit Filed Against Barclays by Kevin LaCroix in the D&O Diary

On June 25, 2014, New York Attorney General Eric T. Schneiderman announced (here) that his office had initiated a lawsuit in the New York (New York County) Supreme Court against Barclays and a related Barclays entity, in which the Attorney General alleged that Barclays had “dramatically increased the market share of its dark pool through a series of false statements to its clients and investors about how, and for whose benefit, Barclays operated the dark pool.” In his complaint, a copy of which can be found here, the Attorney General alleges that contrary to reassurances the bank provided its clients that it had created special safeguards to protect them from “predatory” high-frequency traders, the bank instead operated its dark pool “to favor high-frequency traders.” The complaint, which alleges violation of New York’s Martin Act, accuses Barclays of engaging in a pattern of “fraud and deceit.”

Image of Bricks and Mortar is by Lee Netherton
CC BY SA