Month: June 2015

SEC Loses Case Over the Word “May”

Few things make a compliance officer’s eyes roll more than the case the SEC was fighting against an adviser who used the word “may” in its Form ADV when the SEC thought it should say “will.” One of the SEC’s own administrative judges slapped down the SEC and dismissed the case.

Cash in the grass with room for your type.

According to the SEC charging order, an unnamed broker agreed to pay The Robare Group a fee for client funds invested in funds sold by that broker. 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 SEC is focused solely on a violation for failure to disclose. The SEC claimed the disclosures were not adequate because they said the Robare Group “may” receive compensation from the broker for selling the mutual funds, when it was definitely receiving payments. That’s a very thin distinction to make. Especially when the SEC stated in the complaint that it did not identify any harm to Robare Group’s clients or even that the clients were invested in those funds in a disproportionate amount.

The Robare Group used Fidelity mutual funds and much later found out that Fidelity offered a “revenue sharing arrangement” in which it would pay the firm between two and twelve basis points based on the assets under management. According to the final decision, Robare confirmed that the arrangement would not result in additional costs to its clients and would not alter the construction of its clients’ portfolios.

In the order, the judge highlights the testimony of Melissa Harke, a branch chief in the Commission’s Division of Investment Management, who testified that advisers are expected to disclose material conflicts in the Form ADV and should conversely not throw in everything just to “cover” themselves “for legal purposes.”

The judge also highlighted that the firm used an outside compliance consultant, Renaissance Regulatory Services to help with drafting the Form ADV.

No doubt, Mr. Robare and Mr. Jones paid Renaissance in hopes of avoiding the very proceeding of which they are now the subject.

There is no doubt that the revenue sharing arrangement gave rise to a potential conflict of interest. If the conflict is “material” it has to be disclosed in the Form ADV. The judge found that the conflict was material. The judge went on to find that the SEC failed to prove that Robare acted with any intent to deceive, manipulate or defraud its clients.

The SEC tried to argue that even if Robare did not have the intent to deceive, it was reckless in its failure to “fully and accurately disclose.” The judge found that

“with respect to Form ADV disclosures, advisers operate in a difficult environment that presents challenges for even experienced compliance professionals….I find that the relevant standard of care entails employing a compliance professional and following his or her advice.”

That similarly doomed the SEC’s argument that Robare was negligent. The firm and its principals did not have the expertise to properly disclose the information on Form ADV.

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Compliance Bricks and Mortar for June 5

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

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Sen. Elizabeth Warren Sharply Criticizes SEC Chairman in Letter in the Wall Street Journal

Ms. Warren took aim at several issues in Tuesday’s letter, including a long-delayed executive compensation rule mandated by the 2010 Dodd-Frank law requiring companies disclose the pay gap between chief executives and their employees. The agency proposed the rule in 2013 but has yet to complete it. Congressional Democrats and unions have long-championed the measure though it is opposed by Republicans and business groups. [more…]

 

Why The WSJ Is Wrong About SEC Rulemaking On Claw backs by in California Corporate and Securities Law

Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act requires the SEC to require the stock exchanges to prohibit the listing of securities of issuers that have not developed and implemented compensation claw-back policies.  Thus, I expect that the SEC, when it gets around to it, will be forcing the stock exchanges to change their listing standards.  The SEC won’t be directly forcing companies to claw back incentive pay. [more…]

The Impact of Newman on SEC Enforcement by Thomas O. Gorman in SEC Actions

In the wake of Newman the SEC has three apparent options: 1) Comply with Newman’s pleading requirements; 2) bring its actions as administrative proceedings; or 3) bring actions outside of the Second Circuit where the decision may not be applicable.

Wall Street and Ethics by in Corruption, Crime & Compliance

I have to confess that there is a part of me that was skeptical about a new survey released last week finding that banks and other financial institutions have not embraced a culture of integrity.  (Survey Here).   Indeed, the survey found that numerous individuals continue to operate with the idea that illegal or unethical behavior is a necessary part of succeeding in the financial markets. [more…]

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False Credentials, Fraud and Fund-Raising

With graduation season upon us we are lauding those students who have excelled in academic achievement, or at least did just enough to earn their degrees. It is all too easy for a fraudster to concoct false degrees, titles and awards to lure in unwary investors. With two recent fraud cases, the Securities and Exchange Commission issued a new Investor Alert: Beware of False or Exaggerated Credentials.

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“Do not trust someone with your investment money just because he or she claims to have impressive credentials or experience, or manages to create a ‘buzz of success.’”

The SEC Enforcement Division announced two fraud cases against investment advisers who made false claims about their experience and industry accolades.

The SEC charged Todd M. Schoenberger of Lewes, Delaware, with misrepresenting that he had a college degree from the University of Maryland.  Also for defrauding investors. He was raising a fund and also raising money for his fund management company: LandColt Capital LP.  Schoenberger told prospective investors that LandColt would repay the notes through fees earned from managing the fund. Schoenberger never actually launched the fund, never had the commitments of capital to the fund that he claimed, and never paid investors in the management company the returns he promised. The SEC made a show of him because he had been a guest commentator on financial television shows.

I found the fake degree to be the least interesting part. The double-fraud is far more interesting. He was committing fraud in raising the fund and in raising capital for the management company at the same time.

An SEC investigation found that Michael G. Thomas of Oil City, Penn, claimed that he was named a “Top 25 Rising Business Star” by Fortune Magazine. He used that false badge in general solicitation for his private fund.  No such distinction actually exists at Fortune Magazine. As you might expect, Thomas also greatly exaggerated his own past investment performance and inflated the fund’s projected performance.  He claimed to have turned $600 in to $6 million, when he actually started with more than $600 and turned it into less.

I think the older Hicks case is a better example of false credentials. The SEC alleges that Hicks falsely represented in the offering memorandum for his Locust Offshore Management hedge fund that he had undergraduate and graduate degrees at Harvard University and that the fund’s quantitative strategies were based on mathematical models that Hicks developed while at Harvard earning those degrees. However, that is far form the truth. Hicks only attended Harvard for three semesters, was twice required to withdraw for failing to perform academically, and never graduated. Hicks only took one mathematics course during his time at Harvard, receiving a D- for a grade.

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Senator Warren Versus SEC Chair White

Senator Elizabeth Warren sent a sharp letter to Mary Jo White, Chair of the Securities and Exchange Commission.

“You have now been SEC Chair for over two years, and to date, your leadership of the Commission has been extremely disappointing.”

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Senator Warren raises four major issues:

  1. The SEC’s failure to finalize the rules for disclosure of the ratio of CEO pay to the median worker.
  2. The SEC’s failure to curb the use of waivers for companies found to be in violation of securities law.
  3. The SEC has settled the vast majority of cases without requiring the companies to admit guilt.
  4. Chair White’s inability to participate in numerous cases because of her prior employment and her husband’s ongoing employment.

Personally, I believe that Senator Warren and Chair White are both well-meaning individuals who are both trying to protect the American consumer and the American financial markets. Senator Warren is one of my Senators and I voted for her.

I think the CEO pay rule is a useless exercise that will take a great deal of resources at public companies. The actual calculations will be full of assumptions and inconsistencies. The end result will do nothing to curb CEO pay inflation, protect consumers, or bolster the capital markets.

According to competing stories, in a private meeting between White and Warren, White promised the final CEO Pay Ratio Rule would be enacted in 2015. However, the SEC released a rulemaking schedule to the Office of Management and Budget that stated the CEO Pay Ratio rule would not be done until April 2016. I’m not sure the statements are inconsistent. There may be a misunderstanding between when the rule is “finalized” and when it becomes “effective.” I suspect the goal is to get the rule enacted in 2015 but not have it be effective for annual filings until the 10Ks for 2016.

The waiver granting has gotten out of hand. I know many feel that it merely reinforces “too big to fail.” The SEC is liberally granting the waivers to the big firms that allows them to continue operating. However, the true test will be when a smaller firm gets into the same trouble. Will the SEC kill the smaller firm by not granting the same waiver?

Senator Warren cites the statistic that between June 2013 and September 2014, the SEC made 520 settlements but only required admission of guilt in 19 cases. But before White’s tenure, the SEC had never required a guilty admission, according to an SEC official. It’s still a strange legal limbo to settle, but not admit guilt.  The problem, of course, is the impact on private litigation such as shareholder lawsuits.

According to Warren’s letter, Chair White had to recuse herself at least four dozen times. Her personal restrictions have expired now that it has been two years since she left her law firm and her clients. Senator Warren raises an interesting point about Chair White’s husband. She sets up a theory that defendants may try to hire his firm to force her to recuse herself from the case.

These are all valid concerns. The letter is clearly setting the stage for the upcoming nominations for the two open slots on the SEC.

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Compliance Failures and the TSA

I was not at all surprised when it was revealed that the Transportation Security Administration had a 95% failure rate during a recent series of tests. I’m sure the TSA screeners found a much higher percentage of water bottles and laptops left in their cases.

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An internal investigation of TSA security checkpoints at the nation’s busiest airports, conducted by Homeland Security “Red Teams” posing as passengers, found that agents failed to detect mock explosives in 67 of 70 test cases, according to ABC News. In one test, an undercover agent was stopped after setting off a metal detector, but TSA screeners failed to detect a fake explosive device that was taped to his back during a follow-on pat down.

This is an ongoing problem. A report of a red team getting a test device past TSA security at Newark Airport appeared in 2013.

It’s not that the TSA fails to find dangerous items in luggage. The latest TSA post highlights the 45 firearms discovered in carry-on bags last week.

The problem is one of false positives. The testing of passengers is so out of line with the risks presented that there is a far greater incident of false-positives than problems prevented. It is only human nature to become numb to the false-positive warnings. The fable of “the boy who cried wolf” has been around for centuries.

Screeners will inevitably be drawn to water bottles and laptops instead of actual weapons. That is what they see most often, so that is the problem they will most focus on. I’m sure that thousands of water bottles are confiscated for every dangerous item that passes through airport security.

When we talk about compliance programs, we talk about a risk-based approach. Concentrate your efforts and limited resources on the biggest and most-likely risks to prevent them. Even with the bloated budget of the TSA, its resources are still limited. The technology is often less-than capable. It’s staff is likely under-trained and under-prepared for many possible risks.

When the technology and staff are presented with actual threats, instead of the much more common false-positives, they mostly failed. They failed to spot the real threat because they are distracted by the far more numerous false-positives.

The TSA failure is an example of the results when failing to take risk-based approach to compliance.

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