More On Legal & Compliancefrom The Advisor's Professional Library
- The Need for Thorough and Effective Policies and Procedures Whethere an advisor is SEC or state-registered, RIAs must revise their policies and procedures to address significant compliance problems occurring during the year, changes in business arrangements, and regulatory developments.
- RIAs and Customer Identification Just as RIAs owe a duty to diligently protect their clients privacy and guard against theft, firms also play a vital role in customer identification. Although RIAs are not subject to an anti-money laundering rule, securities regulators expect advisors to address these issues in their policies and procedures.
The Department of Labor (DOL) and the Securities and Exchange Commission (SEC) took action recently on a number of cases that included embezzlement and breach of fiduciary duty, illegal tips on M&As, failure to protect confidential information and fraud.
Trustees of 401(k) Plan Sentenced for Embezzlement
The DOL announced that following a plea agreement entered in the U.S. District Court for the Eastern District of Kentucky, William H. Kiser and Mary Sue Kiser, trustees of the Irotas Manufacturing Co. Inc. 401(k) Plan, have been sentenced to 15 months in prison and 3 years of supervised release for embezzling funds from the plan. The Kisers also have been ordered to pay restitution.
An investigation by the Employee Benefits Security Administration (EBSA) Cincinnati regional office had shown that the Kisers, who owned Irotas Manufacturing Co. Inc. in Shelbyville, Ky.., embezzled a total of $487,138.08 from the now-defunct company’s 401(k) plan for their own use between June 17 and Aug. 14, of 2008.
“This sentencing underscores the Department of Labor’s resolve to aggressively pursue those who steal from employee benefit plans,” said L. Joe Rivers, EBSA’s regional director in Cincinnati. “We will continue our commitment to investigating thefts from employee benefit plans under our Contributory Plans Criminal Project, which targets those individuals who threaten the retirement and health benefits of American workers.”
DOL Sues over ESOP Losses, Charges Overvaluation
The DOL has filed a lawsuit against GreatBanc Trust Co., based in Lisle, Ill., and Sierra Aluminum Co., of Riverside, Calif., in the U.S. District Court for the Central District of California, based on an investigation by EBSA.
In the suit, the DOL alleges that GreatBanc violated the Employee Retirement Income Security Act (ERISA) by breaching its fiduciary duties to the Sierra Aluminum Employee Stock Ownership Plan when it allowed the plan to pay more than fair market value for employer stock in June 2006. The suit names Sierra Aluminum, the ESOP’s sponsor, as a defendant for entering into an indemnification agreement with GreatBanc that violates ERISA.
According to the suit, GreatBanc failed to adequately inquire into an appraiser’s report presenting unrealistic and aggressively optimistic projections of Sierra Aluminum’s future earnings and profitability. It also allegedly failed to investigate the credibility of the assumptions, factual bases and adjustments to financial statements that the appraiser relied on in preparing its report.
The suit also alleges that GreatBanc asked the appraiser to revise its valuation opinion in order to reconcile the ESOP’s higher purchase price with the lower fair market value of the company stock.
In addition, the suit alleges that Sierra Aluminum’s indemnification agreement with GreatBanc violated ERISA to the extent that it would permit Sierra Aluminum to pay GreatBanc’s losses, costs, expenses and damages unless and until a court enters an unappealable judgment that GreatBanc did not violate ERISA. The complaint seeks to restore losses plus interest to the plan and to enjoin Sierra Aluminum from indemnifying GreatBanc.
Investment Bank Analyst Charged by SEC with Illegal Tipping
The SEC announced that it has charged a former analyst, Jauyo “Jason” Lee, at a Boston-based investment bank with illegally tipping a close friend with confidential information about clients involved in impending mergers and acquisitions that brought in more than $600,000 in profits.
The complaint, filed in U.S. District Court for the Northern District of California, alleges that Lee, who worked in the San Francisco office of Leerink Swann LLC, was first privy to information about Leerink’s client Syneron Medical, which was negotiating an acquisition of Candela Corp. in 2009. He later learned that Leerink’s client Somanetics Corp. was in the process of being acquired by Covidien in 2010.
Lee collected nonpublic details about each of the deals from unsuspecting coworkers involved with those clients and by reviewing various internal documents about the transactions. He then communicated repeatedly with his longtime college friend, Victor Chen of Sunnyvale, Calif., via dozens of phone calls and text messages. Some of the calls took place from Lee’s office telephone at Leerink.
Chen traded heavily on that information, making more than $600,000 in illicit profits—a 237% return on his initial investment. Bank records reveal a pattern of large cash withdrawals by Lee, followed by large cash deposits by Chen, who then used the money for the insider trading.
The SEC alleges that in the days prior to each deal’s public announcement, Chen, who had never before bought securities in these companies, made sizeable purchases of stock and call options in Candela and these acquisition targets—suddenly spending a significant portion of his available cash to buy them.
Chen proceeded to sell most of his Candela and Somanetics holdings once public announcements were made about the transactions. Because Chen made some of his trades in his sister Jennifer Chen’s account, the SEC’s complaint also names her as a relief defendant for the purposes of recovering the illegal profits in her account. The SEC is seeking disgorgement of ill-gotten gains with prejudgment interest, financial penalties and permanent injunctions against Lee and Chen.
Subramanian Krishnan, the former chief financial officer of a Minnetonka, Minn.-based manufacturer of computer networking devices, was charged by the SEC for secretly diverting company funds to cover unauthorized personal expenses and other employees’ entertainment expenses that lacked any legitimate business purpose.
The SEC alleges that Krishnan, the former CFO of Digi International, evaded the company’s internal controls that he created in order to approve employees’ falsified travel and entertainment expense reports over a five-year period. He also manipulated internal controls to review and approve his own expense reports that included unauthorized hotel and entertainment expenses.
According to the SEC’s complaint filed in U.S. District Court for the District of Minnesota, Krishnan’s scheme began as early as March 2005 and continued until May 2010, when he resigned.
Digi’s internal controls required the CFO’s expense reports to be approved by the CEO. In order to circumvent this internal control, Krishnan, who lives in Plymouth, Minn., arranged for the Hong Kong office to submit his expenses as belonging to other employees. This way, Krishnan had the final authorization to approve the expenses and reimburse the Hong Kong office directly, rather than needing CEO approval.
The SEC alleges that as the scheme went undetected, Krishnan submitted or approved large numbers of fraudulent expense reports for purported work and travel expenses. Krishnan knew the expenditures violated Digi’s travel and entertainment policies because he personally drafted and approved these internal policies. Despite this, Krishnan signed each of Digi’s annual and quarterly reports over a five-year period and, as part of those filings, certified that Digi’s internal controls were effective. He also signed 20 management representation letters to auditors that falsely asserted he had no knowledge of fraud involving management having a significant role in internal controls over financial reporting.
The SEC’s complaint alleges that Krishnan violated the antifraud, issuer reporting, internal controls, books and records, filing certification and lying to auditors provisions of the federal securities laws. Krishnan has consented to the entry of an injunction from future violations of those provisions, with disgorgement, prejudgment interest, financial penalties as well as the duration of the officer-and-director bar to be determined by stipulation of the parties or motion of the SEC at a later date.
Dark Pool Operator Charged on Failing to Protect Confidential Information
Boston-based dark pool operator eBX LLC has been charged by the SEC with failing to protect the confidential trading information of its subscribers and failing to disclose to all subscribers that it allowed an outside firm to use their confidential trading information.
According to the SEC’s order instituting a settled administrative proceeding, eBX operates the alternative trading system LeveL ATS, which it calls a “dark pool” trading program. Dark pools do not display quotations to the public, meaning that investors who subscribe to a dark pool have access to potential trade opportunities that other investors using public markets do not.
eBX inaccurately informed its subscribers that their flow of orders to buy or sell securities would be kept confidential and not shared outside of LeveL, and instead allowed an outside technology firm to use information about LeveL subscribers’ unexecuted orders for its own business purposes.
The outside firm’s separate order routing business therefore received an information advantage over other LeveL subscribers, because it was able to use its knowledge of their orders to make routing decisions for its own customers’ orders and increase its execution rate. eBX had insufficient safeguards and procedures to protect subscribers’ confidential trading information.
According to the SEC’s order, eBX and the outside firm it hired to run LeveL signed a subscription agreement in February of 2008, after which the outside firm’s separate order routing business began to use certain LeveL subscribers’ confidential trading data. In November 2008, eBX signed a new agreement with the outside firm that allowed its order routing business to remember and use all LeveL subscribers’ unexecuted order information.
As a result of the agreements, the outside firm’s order routing business began to fill far more of its orders than other LeveL users did. Its order router also knew how other eBX subscribers’ orders in LeveL were priced and could use that information to determine whether to route orders to LeveL or another venue based on where it knew it might get a better price for its own customers’ orders.
eBX agreed to pay an $800,000 penalty to settle the charges. In addition, eBX was censured and ordered to cease and desist from committing or causing further violations of certain provisions of the federal securities laws regulating alternative trading systems.
The SEC said that it has obtained an emergency court order to freeze the assets of a South Florida man, Joseph Hilton, who has been charged with fraudulently offering investments in oil drilling projects.
It is not the first time Hilton has been the target of an SEC enforcement action, although at that time he was known as Joseph Yurkin. He changed his name after a final judgment for fraud in a previous SEC enforcement action against him for securities offerings he made through another company he worked for, Homeland Communications Corp.
The SEC’s complaint, unsealed in federal court in West Palm Beach, Fla., alleges that Hilton made numerous misrepresentations to investors while selling limited partnership units in two oil drilling projects earlier this year through his firm, Pacific Northwestern Energy.
After falsely telling potential investors that Pacific acquired its wells from Exxon Mobil Corp., and overstating Pacific’s experience in the oil and gas industry and the historical accomplishments of its drillers, Hilton raised approximately $789,000 from investors.
The SEC’s action froze the assets of Hilton, Pacific, and the two limited partnerships: Rock Castle Drilling Fund and Rock Castle Drilling Fund II. Hilton’s securities offerings were not registered with the SEC as required under the federal securities laws. The SEC is seeking disgorgement of ill-gotten gains plus prejudgment interest, financial penalties and permanent injunctions against Hilton and his entities. The court has appointed David Mandel, an attorney with the law firm Mandel & Mandel in Miami, as a receiver over Pacific, Rock Castle and Rock Castle II.
The SEC’s complaint also includes allegations against Hilton, Pacific, and another company controlled by Hilton called New Horizon Publishing. Through Pacific and New Horizon, Hilton additionally sold $2.5 million worth of investments in oil drilling projects sponsored by United States Energy Corp. while deceiving investors about his identity, the anticipated returns on the investments, the amount of oil being produced by U.S. Energy’s wells, and the existence of natural gas wells. Hilton also operated a boiler room of sales representatives paid on a commission basis.