The Massachusetts Securities Division instituted administrative proceedings against an unregistered fund manager for unlawfully charging a performance fee in addition to misleading investors. The MSD asserts that the respondent unlawfully “householded” an elderly client’s assets with a nephew with power of attorney in order to meet net worth thresholds required to charge a performance fee. Massachusetts law prohibits charging performance fees in violation of Rule 205-3 of the Advisers Act, which limits performance fees. In addition to other sanctions, the MSD seeks to prohibit the respondent from registering as an exempt reporting adviser.
OUR TAKE: Expect more cases like this where the state regulators take the enforcement lead. This is a rare case specifically alleging violations of the performance fee rule. Also, securities lawyers and compli-pros should take notice that (i) the Massachusetts statute makes it unlawful to violate an SEC rule that would otherwise apply only to SEC-registered advisers and (ii) the MSD seeks to prohibit federal exempt reporting adviser registration as a remedy.
The SEC charged two lawyers with securities fraud for providing legal opinions and other assistance to fraudulent blank check company schemes. One of the lawyers also faces criminal charges brought by the U.S. Attorney’s Office. The lawyers are accused of issuing due authorization and Rule 144 opinions, prerequisites to the public offering and sale of the shell companies, as well as other substantial assistance including moving assets through their lawyer trust accounts. The Director of the SEC’s Miami Regional Office warned that “Lawyers are critical gatekeepers when it comes to protecting the integrity of our capital markets.”
OUR TAKE: Lawyers and other securities markets gatekeepers cannot plead ignorance when red flags indicate that they knew or should have known about their clients’ wrongdoing. Firms must conduct significant due diligence both before accepting a client and during representation. It is also noteworthy that the SEC charged the lawyers with securities fraud and not just aiding/abetting.
The North American Securities Administrators Association (NASAA), the organization of state securities regulators, reported that state securities regulators imposed $914 Million in restitution, fines and penalties in 2016, as compared to $766 Million in the prior year. In its Enforcement Report, NASAA also reported significant increases in criminal penalties including incarceration and probation. The number of investigations and administrative actions also increased especially against investment advisers, which, according to NASAA, may be due to “heightened state interest in individuals and firms who have transitioned from broker-dealer registration to investment adviser registration in recent years.” NASAA also reported significant information sharing with federal regulators.
OUR TAKE: Over the last several years, the state securities regulators have expanded examinations and enforcement along with the SEC and FINRA, making it much more difficult for any adviser or broker-dealer to avoid regulatory scrutiny. It’s worth noting that many state securities regulators have criminal enforcement authority.
The SEC accused the operations manager of a state registered investment adviser of aiding and abetting her boss’s fraud by impersonating clients to gain online account access. The SEC maintains that the operations manager, under the direction and the supervision of the firm’s principal, telephoned a broker and impersonated a client to create on-line access to client funds that the principal ultimately misappropriated as part of a broader scheme involving almost $400,000 in client funds. The principal, also a defendant in the enforcement action, has left the United States. The SEC charges that the operations manager “knew or recklessly disregarded” that her boss’s conduct “was improper and knowingly rendered…substantial assistance.”
OUR TAKE: Don’t help your boss commit securities fraud. There is no “dutiful assistant” or “just following orders” defense whether or not the SEC can show you personally benefitted. In this case, the trusty assistant was left holding the liability bag when her boss fled the country.
An investment adviser was indicted in part for making a false declaration in a court proceeding by lying to the SEC during a sworn deposition. The deposition occurred during an enforcement case that alleges that the adviser defrauded retirees by lying about account balances, falsifying documents, and creating false wires. According to the SEC, the adviser lied in a deposition about providing false documents to investors.
OUR TAKE: Once a formal enforcement proceeding commences, any misstatements under oath can lead to criminal proceedings for perjury or lying to a regulator. It’s always wise to ensure that the lawyer defending the enforcement action has sensitivity to the possible criminal prosecution implications. An enforcement action may results in fines and industry bars, but criminal proceedings could result in jail time.
The full SEC dismissed an enforcement case against a self-directed IRA custodian because it had no fiduciary or other obligation to investigate the merits of underlying investments. The custodian held assets that ultimately turned out to be Ponzi schemes, but the SEC opined that the custodian, which was not registered as an investment adviser or broker-dealer, had no implied duty to conduct due diligence in the absence of actual knowledge of red flags suggesting misconduct. The SEC cited the custodian’s low per account fees and its client agreements which specifically disclaimed any fiduciary obligation. The SEC determined that the firm acted as a reasonably prudent passive self-directed IRA custodian, as determined by governing state law. The SEC dismissed the appeal of the Enforcement Division from a similar finding by the Administrative Law Judge.
OUR TAKE: The full SEC came to the right decision on the law given the Enforcement Division’s dubious legal theory that could encompass almost any third party actor in any way connected to a fraudulent transaction. (See https://cipperman.com/2015/06/17/sec-takes-action-against-ira-custodian/.) Unfortunately, it took the respondent more than 2 years to clear its name. Third party service providers would be better off conducting due diligence and avoiding any SEC entanglements altogether.
The SEC fined and censured a public company for failing to register as an investment company because over 80% of its assets consisted in non-controlling interests in other OTC companies. The respondent changed business direction in 2014 and began purchasing OTC and private interests in marijuana related businesses, which came to represent more than 80% of its assets. In 2015, the company could not respond to SEC requests about investment company registration, which is required when investment securities exceed 40% of total assets. As a public company, the respondent could not rely on private offering exemptions (3(c)(1) or 3(c)(7)). As part of the settlement, the company agreed to register or pay a $5000 penalty for each month that the company failed to register.
OUR TAKE: Operating companies engaged in passive investing, which often occurs in emerging industries, must be aware of becoming an inadvertent investment company. Once total investment securities exceed about one-quarter of total assets, it’s time to consult a 1940 Act lawyer.
A valuation firm was censured and fined and its principal was fined and barred for misleading its investment firm client about how it valued European options. The valuation firm represented that it valued the options using independent data and Black-Scholes modeling. The SEC charges that the firm merely used the estimated valuations provided by the client and then applied formulaic ranges. The SEC asserts that the valuation firm acted as an unregistered investment adviser because it “provided advice…about the value of securities…in exchange for compensation.” Following therefrom, the SEC charged violations of Section 206(2) of the Advisers Act, which prohibits investment advisers form engaging in any fraudulent activity.
OUR TAKE: The SEC uses a tortured reading of the definition of “investment adviser” to hold accountable a third party valuation agent responsible for mis-pricing a fund. All service providers should beware that the SEC will seek to assert its authority through broad use of the securities laws.