Compliance Building

The One With The CCO Illegally Selling Securities

Enforcement cases against a Chief Compliance Officer always catch my attention. The latest to catch my eye is against A.G. Morgan Financial Advisors, LLC (“AGM”) of Massapequa, New York, AGM’s owner Vincent J. Camarda, and AGM’s former Chief Compliance Officer James McArthur.

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

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

AGM, Mr. Camarda and Mr. McArthur got involved with an unregistered securities offering with a lending company called Complete Business Solutions Group, that was doing business as Par Funding. The company was making short term loans to small businesses that were supposed to be secured by receivables. Par Funding was raising capital by selling unregistered securities in the form of promissory notes. Nothing illegal as long as the firm and its agents are following the the private placement rules.

According to the SEC compliant, Mr. McArthur was actively involved in the selling of the Par Funding securities to the AGM clients. This would put the nature of the SEC CCO action into the exception 1: affirmatively involved in the misconduct. (And still its CCO.)

In this case I’m not sure why Mr. McArthur is identified in the complaint as “its former Chief Compliance Officer”. There is no mention of him acting in a compliance role in the complaint. According to the firm’s website and the firm’s Form ADV filing, Mr. McArthur is also the firm’s president.

As for the alleged wrongdoing, AGM was also a client of Par Funding. The firm owed par as much as $750,000 at times and some which was personally guaranteed by Mr. Camarda. The Securities and Exchange Commission accuses AGM of telling investors that it was a safe investment, while failing to disclose that his company AGM was in debt to Par Funding and that Mr. Camarda was a guarantor on that debt to Par Funding. The SEC claims that existence of the debt was a material conflict that should have been disclosed to the AGM investors and failing to disclose the existence of the debt was a breach of fiduciary duty under the Investment Advisers Act. AGM was apparently paying down its debt to Par Funding by selling the promissory notes.

The SEC also claims that the sale of promissory notes did not fit any exemption from registration. It’s a little light on that claim. It at least three instances, the complaint notes that the respective investor had completed an “Accredited Investor Questionnaire.” It does reference a television commercial for the investment, so that could be a general advertisement in violation of the private placement rules.

Of course, the main problem was that the Par Funding investments were duds. Par Funding ended up in receivership. It’s under investigation for illegally selling securities. From news reports, Par Funding engaged in some shading lending practices, poor underwriting and had some shady characters under its employ. Investors lost money.

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The One With the Gambling Edge

Buying and selling securities is often equated with gambling. (The differences are that you can hold your securities and keep winning without making any bets.) Gamblers and investors are always looking for an edge to increase their odds of success. When it comes to investing, that edge can be the misuse of insider information.

The headline of SEC Charges Former Employee of Online Gambling Company with Insider Trading jumped out at me. Finally, the intersection of gambling and investing in an enforcement case.

It turns out to be a fairly standard insider trading case. David Roda worked at Penn Interactive Ventures, a subsidiary of Penn National Gaming, as a programmer for its online sportsbook application. He heard from a co-worker that Penn was working on an acquisition. Mr. Roda got himself added to the acquisition team and found out about the target.

According to the SEC complaint, Mr. Roda quickly acquired some call options on the target. Penn sent a message warning employees not violate the insider trading policy. That apparently spooked Mr. Roda so he sold those options. Or maybe it didn’t spook him, because he then bought more options on the target.

As you might expect, the trades looked suspicious. They were short duration options that were “out of the money.” Since the options were just above the current trading price with little time left for the price to rise, they were cheap. It would be very aggressive to buy these, unless you had a gambler’s edge. Or insider knowledge.

According to the SEC complaint, Mr. Roda’s $21,000 purchase of those options netted him over $580,000 in profits in less than two weeks. I’m sure that triggered warning lights for compliance at whatever firm he had used for the trading.

Obviously, this is just the government’s side of the case. The Department of Justice has stepped in with criminal charges as well. Mr. Roda may or may not be guilty.

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State of the Registered Investment Adviser Community

Regulatory Compliance Watch compiled information from the 14,400 advisers who filed a revised Form ADV at the end of March. RCW Exclusive: An Industry Portrait Drawn From Form ADV Data. For those of you who do not subscribe, here a few pieces of data that caught my eye.

Registered investment advisers’ assets under management increased by 19% over the year to $121 trillion. It’s not clear if that is regulatory assets under management or some other AUM number from Form ADV. Of that, $43 trillion is in investment companies and $32 trillion is in pooled investment vehicles.

The average employee per firm was 62, while the median was 8 employees. To me that indicates that there is a big range of sizes in firms, with most being very small, while there are some enormous firms. Regulatory Compliance Watch did find a firm that had accidently said it had a million employees. When contacted, the firm realized it had made a mistake and that is should only be 130. The corrected data is in the average and median numbers.

Lots of other fascinating information in the story: RCW Exclusive: An Industry Portrait Drawn From Form ADV Data. (If you have a subscription)

SEC ALJs Violate the Right to a Jury Trial

Among the many, many, many legislative actions in Dodd-Frank, one section gave the Securities and Exchange Commission broader authorization to bring enforcement actions through its internal administrative law judges instead of through federal courts. The SEC decides which cases to bring to the ALJs and which it wishes to bring in federal court. In federal court you can have a jury trial. With the SEC’s ALJs you do not get a jury trial.

If you find this problematic, the Fifth Circuit Court of Appeals agrees with you. With its coverage of Texas, Louisiana and Mississippi, this Court fired a blistering attack on the SEC in the opinion.

Congress has given the Securities and Exchange Commission substantial power to enforce the nation’s securities laws. It often acts as both prosecutor and judge, and its decisions have broad consequences for personal liberty and property. But the Constitution constrains the SEC’s powers by protecting individual rights and the prerogatives of the other branches of government. This case is about the nature and extent of those constraints in securities fraud cases in which the SEC seeks penalties.

The case was launched by the SEC in 2011 against a fund manager for overvaluing fund assets to collect more in fees. The timing of the alleged fraud and SEC litigation is such that the fund manager was not required to be registered with the SEC as an investment adviser. I can’t find a provision in the opinion that talks about whether this distinction matters.

The biggest point in the opinion is that the fund manager was deprived of its constitutional right to a jury trial by the SEC bringing the vase through the administrative law process. The Court hangs its argument on its view that a case of fraud is traditional action of “suits at common law” described in the Seventh Amendment to the Constitution which can include “suits brought under a statute as long as the suit seeks common-law-like legal remedies.” (page 7) The Court points out that fraud prosecutions were regularly brought in English courts at common law. Even though the SEC brought non-monetary remedies against the fund manager that doesn’t invalidate the right to a jury trial.

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ESG Regulation is Coming to Investment Advisers

Maybe.

The Securities and Exchange Commission is going to propose standardization of environmental, social, and governance disclosures to investors and to the SEC. The vote happens at the SEC open meeting on May 25.

MATTERS TO BE CONSIDERED:

1. The Commission will consider whether to propose amendments to the rule under the Investment Company Act that addresses investment company names that are likely to mislead investors about an investment company’s investments and risks. The amendments the Commission will consider also include enhanced prospectus disclosure requirements for terminology used in investment company names, as well as public reporting regarding compliance with the new names-related requirements.

2. The Commission also will consider whether to propose amendments to rules and reporting forms for registered investment advisers, certain advisers exempt from registration, registered investment companies, and business development companies to provide standardized environmental, social, and governance (“ESG”) disclosure to investors and the Commission.

I assume the first item is to prohibit funds calling themselves “ESG funds” or “green” funds unless they meet some specific criteria.

The second is the new ESG Rule. What is it? It’s just a proposed rule so I would be guessing.

We could look to the proposed rule of Climate-Related Disclosures for Investors for public companies. That public company proposed rule is more focused on reporting greenhouse gas emissions and disclosure of climate-related risks. I don’t think its a great model for investment advisers and investment companies. I’m intrigued to find out what the SEC is trying to do with ESG.

Of course, this is yet another addition to a very busy regulatory agenda for the SEC.

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The One with the Missing Audits

The basic premise of the Custody Rule is that registered investment advisers who have custody of
client assets must implement specific safekeeping requirements to prevent loss, misuse, or misappropriation of those assets. (Rule 206(4)-2)

For non-fund managers, there is a surprise exam requirement. For fund managers, the usual route is through audited financial statements. The Custody Rule has a strict requirement that you deliver those audited financial statements to investors within 120 days of the end of the fund’s fiscal year. The audit has to be done by independent public accountant that is registered and subject to regular inspection by the Public Company Accounting Oversight Board, and in accordance with Regulation S-X.

Audits that meet those standards are expensive and take some time to perform. Let’s face the truth, if a fund manager is having trouble getting the fund audits done on time there is likely an underlying problem.

Spruce Investment Advisors acquired the management interest in about 100 private equity funds with about $182 million in regulatory assets under management and created two funds of funds on top of them.

As you might expect with the discussion about the Custody Rule, Spruce failed to meet the requirements of the Custody Rule. The firm didn’t get the audited financial statements out on time. Easy case for the SEC to win. Send the audited financial statements out on day 121 and you’ve violated the rule.

The SEC order pokes at some allocation of expenses issues that Spruce was encountering. It looks like Spruce was paying some expenses that should have been expenses of the funds. Re-jiggering the expenses delayed the audits for the financial statements. The re-allocation was another violation with the SEC piling on that Spruce didn’t have adequate policies and procedures in place regarding the allocation of expenses.

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Compliance Bricks and Mortar for May 13

These are some compliance stories that recently caught my attention.

Coinbase earnings were bad. Worse still, the crypto exchange is now warning that bankruptcy could wipe out user funds
By Nicholas Gordon

Coinbase said in its earnings report Tuesday that it holds $256 billion in both fiat currencies and cryptocurrencies on behalf of its customers. Yet the exchange noted that in the event it ever declared bankruptcy, “the crypto assets we hold in custody on behalf of our customers could be subject to bankruptcy proceedings.” Coinbase users would become “general unsecured creditors,” meaning they have no right to claim any specific property from the exchange in proceedings. Their funds would become inaccessible.

Elon Musk’s Belated Disclosure of Twitter Stake Triggers Regulators’ Probes
By Dave Michaels

The Securities and Exchange Commission is probing Mr. Musk’s tardy submission of a public form that investors must file when they buy more than 5% of a company’s shares, the people said. The disclosure functions as an early sign to shareholders and companies that a significant investor could seek to control or influence a company.
The Tesla Inc. chief executive made his filing on April 4, at least 10 days after his stake surpassed the trigger point for disclosure. Mr. Musk hasn’t publicly explained why he didn’t file in a timely manner.

Federal Reserve Board issues enforcement action with former employee of Deutsche Bank

Romero altered the proposed annual base salary in an offer letter he received from a competing financial institution, and provided that offer letter containing the altered salary to the Bank in an effort to increase his annual base salary; …
[T]he Bank in December 2018 matched the altered salary from the competing financial institution and increased Romero’s annual base salary by approximately $28,000….

FTC Takes Action Against Lions Not Sheep and Owner for Slapping Bogus Made in USA Labels on Clothing Imported from China

Utah-based Lions Not Sheep is an apparel company that sells t-shirts, sweatshirts, jackets, and sweaters on their own website as well as through Amazon and Etsy. The company and its owner Whalen heavily marketed it through social media channels, claiming that it would “show people it’s possible to live your life as a LION, Not a sheep.” Their Made in USA claims online and on product labels included “Made in the USA,” “Made in America,” “Are your products USA Made?” “100% AMERICAN MADE,” and “BEST DAMN AMERICAN MADE GEAR ON THE PLANET.” In most cases, the products advertised using these claims consist of wholly imported shirts and hats with limited finishing work performed in the United States.

Dam, That’s Securities Fraud

The collapse of the Bumadinho Dam in Brazil in 2019 was a disaster. The structure was holding back iron ore waste before it collapsed, sending million of tons of toxic waste into the village of Córrego do Feijão. It killed 270 people. The dam was controlled by the Brazilian mining company: Vale S.A.

Clearly a massive disaster, but was it securities fraud?

The US Securities and Exchange Commission seems to think so. And the SEC is positioning the case an ESG disclosure violation.

The complaint accuses Vale of deliberately manipulating multiple dam safety audits; obtaining
numerous fraudulent stability declarations; and regularly and intentionally misleading local
governments, communities, and investors about the dam’s integrity. The SEC points to Vale’s public Sustainability Reports and other public filings that assured investors that Vale adhered to the “strictest international practices” in evaluating dam safety and that 100 percent of its dams were certified to be in stable condition.

“By allegedly manipulating those disclosures, Vale compounded the social and environmental harm caused by the Brumadinho dam’s tragic collapse and undermined investors’ ability to evaluate the risks posed by Vale’s securities.”

How is a Brazilian mining company subject to the jurisdiction of the SEC? Vale has American Depositary Shares and some debt notes registered with the SEC. That clearly moves it into SEC jurisdiction.

Why brings a securities fraud case? The complaint goes into great deal about the allegedly fraudulent acts that Vale took around the regulation and evaluation of the dam. The SEC takes the position that making public statements, especially at an investor presentation, that were false and misleading about the dam safety was misleading to investors.

The primary motivation is that the SEC’s new Climate and ESG Task Force in the Division of Enforcement is on duty.

The SEC launched the Climate and ESG Task Force within the Division of Enforcement to develop initiatives to proactively identify ESG-related misconduct consistent with increased investor reliance on climate and ESG-related disclosure and investment.

Vale said its ESG was not too bad, at least not for a mining company. But in reality its ESG was very bad, even bad for a mining company. The SEC says that is securities fraud.

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Compliance Bricks and Mortar for May 6

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

A Best Lawyers List Is Suing Another Best Lawyers List
By Jacob Gershman

[The New Jersey Supreme Court-appointed committee on attorney advertising] cautioned New Jersey attorneys against touting dubious distinctions. While lawyers in the state may promote their inclusion in lawyer directories like “Super Lawyers” or “Best Lawyers,” they may not advertise themselves as a “super lawyer” or the “best lawyer.” An attorney can still sip coffee from a “World’s Greatest Lawyer” mug like the Saul Goodman character on “Better Call Saul,” according to the advertising committee’s chairman.

SEC Nearly Doubles Size of Enforcement’s Crypto Assets and Cyber Unit

Since its creation in 2017, the unit has brought more than 80 enforcement actions related to fraudulent and unregistered crypto asset offerings and platforms, resulting in monetary relief totaling more than $2 billion. The expanded Crypto Assets and Cyber Unit will leverage the agency’s expertise to ensure investors are protected in the crypto markets….

The SEC’s New Risk Alert Warns about the Use of Alternative Data
by Andrew J. Ceresney, Avi Gesser, Julie M. Riewe, Kristin A. Snyder, Jonathan R. Tuttle, Charu A. Chandrasekhar, and Mengyi Xu

The Risk Alert should be considered along with the SEC’s September 2021 enforcement action against alternative data provider App Annie and EXAMS’ recent statement in its 2022 Priorities that it plans to scrutinize advisers’ use of alternative data in their business and investment decision-making processes. When viewed together, these actions demonstrate the agency’s increasing scrutiny of the usage of alternative data for securities trading and the potential that such data may contain MNPI. As discussed in our blog post on the case, the SEC found that alternative data provider App Annie made material misrepresentations and omissions about its policies and procedures for handling alternative data (in that case, data on companies’ mobile app usage) and failed to implement its policies and procedures involving such data.

The pandemic’s true death toll
The Economist

“How many people have died because of the covid-19 pandemic? The answer depends both on the data available, and on how you define “because”. Many people who die while infected with SARS-CoV-2 are never tested for it, and do not enter the official totals. Conversely, some people whose deaths have been attributed to covid-19 had other ailments that might have ended their lives on a similar timeframe anyway. And what about people who died of preventable causes during the pandemic, because hospitals full of covid-19 patients could not treat them? If such cases count, they must be offset by deaths that did not occur but would have in normal times, such as those caused by flu or air pollution.”
“Although the official number of deaths caused by covid-19 is now 6.2m, our single best estimate is that the actual toll is 21.3m people. We find that there is a 95% chance that the true value lies between 14.7m and 25m additional deaths.”

The One that Fools the Motley Fool

I’ve followed The Motley Fool from the early days of the internet. (Or at least my early days on the internet.) From a compliance perspective, I’ve always been fascinated with how their marketing gets passed by the compliance department. Whether you like them or not, their stock picks can move prices. The Motley Fool picks usually come out at noon on Thursday in a combination of the Fool services.

If you you could buy some of that stock before the recommendation was published, you could make a tidy profit by front-running the announcement. That is exactly what the Securities and Exchange Commission is accusing David Stone of doing illegally. They also charged one of his acolytes, John Robson, with the same front-running activity.

The classic crime of front running was the publisher of a newsletter buying the stock just before it announced a buy recommendation (or selling just before a sell recommendation).

The SEC complaint has a detailed account of the timing of the stock buys of Stone and Robson on one hand, and the recommendations of The Motley Fool on the other hand. Stone and Robson were clearly buying stocks just before the Fool recommendations came out for those stocks and sold shortly after. You look at it and clearly looks like insider trading.

The SEC also uncovered some emails between the two that make it even clearer that the Stone and Robson were front-running the Fool recommendations.

“I’m ok with sharing the weekly trades with you. I have used it so far to generate a
significant amount of money and I’m sure you will be able to as well. There is a small
possibility that what we are doing could be considered insider trading. The Motley fool
[sic] uses only public information about [sic] to make its recommendations and even the recommendations are behind a paywall so it is a stretch to call it insider trading but it
certainly behaves like it because it almost guarantees favorable price moves at a certain
time.”

The missing part is how Stone was getting the information. There is no mention in the complaint of how. I would guess that Stone had managed to hack the Motley Fool website to find the recommendations before they went live.

“Looks like tomorrow’s update is in video form which means I can’t see what is in ahead of time.”

I think the question will pivot on how the hack happened. Was the Fool just publishing pages, but not announcing and not publishing the link? In that case, maybe the information was not obtained illegally. It would just be poor security by the Fool. I doubt that is the case. It sounds more like Stone had hacked into the Fool webserver and could see the pages in development for the recommendation.

This looks a lot like the outsider trading cases that the SEC brought against traders who made a big pile of money by hacking into corporate press release websites and trading on the news before it was made public.

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