More On Legal & Compliancefrom The Advisor's Professional Library
- The Few and the Proud: Chief Compliance Officers CCOs make significant contributions to success of an RIA, designing and implementing compliance programs that prevent, detect and correct securities law violations. When major compliance problems occur at firms, CCOs will likely receive regulatory consequences.
- Client Communication and Miscommunication RIA policies and procedures must specify what type of communications should be retained. The safest course of action is for RIAs to retain all communicationsto clients, from clients, and about client accounts. To comply with fiduciary obligations, communications must be thorough and not mislead.
Among recent actions taken by FINRA and the SEC were the first-ever case charging executives of a publicly traded fund for overvaluing the fund’s assets; charges against two brokers for $1 million in profits gained by insider trading; a complaint against the president and owner of a Polish-born brokerage firm for targeting the Polish community in a fraudulent scheme; charges against a Chicago-based investment advisor who defrauded clients with a failing private equity fund; charges against four Indian-based brokerage firms for providing services to U.S.-based institutional investors without SEC registration; and the charging of an oil company executive for insider trading.
Undervalued Assets of Publicly Traded Fund Lead to Unusual Charges
For the first time, executives of a publicly traded fund have been charged with overvaluing assets. Three top executives of KCAP Financial Inc., a New York-based publicly traded fund being regulated as a business development company (BDC), have been charged by the SEC with overstating the fund’s assets during the financial crisis. The fund’s asset portfolio consisted primarily of corporate debt securities and investments in collateralized loan obligations (CLOs).
An SEC investigation found that KCAP Financial Inc. did not account for certain market-based activity in determining the fair value of its debt securities and certain CLOs. KCAP also failed to disclose that the fund had valued its two largest CLO investments at cost.
KCAP’s chief executive officer, Dayl Pearson, and chief investment officer, R. Jonathan Corless, had primary responsibility for calculating the fair value of KCAP’s debt securities, while KCAP’s former chief financial officer, Michael Wirth, had primary responsibility for calculating the fair value of KCAP’s CLOs. Wirth, a certified public accountant, prepared the disclosures about KCAP’s methodologies to fair value its CLOs, and Pearson reviewed those disclosures.
According to the SEC’s order instituting administrative proceedings against the fund and the three executives, KCAP did not record and report the fair value of its assets in accordance with Generally Accepted Accounting Principles (GAAP) and in particular FAS 157, which requires assets to be fair valued based on an “exit price” that reflects the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date.
The SEC’s order found that Pearson and Corless instead concluded that any trades of debt securities held by KCAP in the fourth quarter of 2008 reflected distressed transactions, and therefore KCAP determined the fair value of its debt securities based solely on an enterprise value methodology. However, this methodology did not calculate or inform KCAP investors of the FAS 157 “exit price” for that security. Wirth calculated the fair value of KCAP’s two largest CLO investments to be their cost, and did not take into account the market conditions during that period.
According to the SEC’s order, in May 2010, KCAP restated the fair values for certain debt securities and CLOs whose net asset values had been overstated by approximately 27% as of Dec. 31, 2008. Moreover, KCAP’s internal controls over financial reporting did not adequately take into account certain market inputs and other data.
“KCAP should have accounted for market conditions in the fourth quarter of 2008 in determining the fair values of its assets,” said Julie Riewe in a statement. Riewe, deputy chief of the SEC Enforcement Division’s Asset Management Unit, added, “FAS 157 is critically important in fair valuing illiquid securities, and funds must consider market information in making FAS 157 fair value determinations and comply with their disclosed valuation methodologies.”
Antonia Chion, associate director in the SEC’s Division of Enforcement, said in a statement, “When market conditions change, funds and other entities must properly take into account those changed conditions in fair valuing their assets. This is particularly important for BDCs like KCAP, whose entire business consists of the assets that it holds for investment.”
KCAP’s overvaluation and internal controls failures violated the reporting, books and records, and internal controls provisions of the federal securities laws, namely Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act, and Rules 12b-20, 13a-1, 13a-11, and 13a-13 there under. Pearson, Corless, and Wirth caused KCAP’s violations and directly violated Exchange Act Rule 13b2-1 by causing KCAP’s books and records to be falsified. Pearson and Wirth also directly violated Exchange Act Rule 13a-14 by falsely certifying the adequacy of KCAP’s internal controls.
The three executives agreed to pay financial penalties to settle the SEC’s charges. Pearson and Wirth each agreed to pay $50,000 penalties and Corless agreed to pay a $25,000 penalty. KCAP and the three executives, without admitting or denying the findings, consented to the SEC’s order requiring them to cease and desist from committing or causing any violations or any future violations of these federal securities laws.
Polish Community Targeted by Brokerage Firm’s Owner in $4 Million Fraud
FINRA announced Wednesday that it has filed a complaint against Roman Sledziejowski, president and owner of the Brooklyn, N.Y.-based brokerage firm TWS Financial LLC, charging him with defrauding three customers of more than $4 million.
Sledziejowski, a Polish-born investment manager, and his firm TWS Financial, catered to the Polish investment community in Brooklyn, and all of his victims were natives of Poland. Through a scheme carried on primarily outside the securities firm, Sledziejowski converted client funds to his personal use while providing falsified account statements to his customers.
In its complaint, FINRA alleges that between June 2009 and August 2012, as part of his scheme, Sledziejowski instructed the customers to wire funds from their bank accounts or brokerage accounts to Innovest Holdings LLC, a company wholly owned and controlled by Sledziejowski, separate from the broker-dealer, which, in turn, owned TWS.
Sledziejowski led the customers to believe that the funds were intended for various purported investment purposes, including acquiring a Polish bank and buying stock in a vodka company. In other instances, Sledziejowski wired funds directly from the customers' TWS brokerage accounts to Innovest Holdings without their knowledge or consent.
In order to mask his misconduct, Sledziejowski provided customers with falsified account statements or "account snapshots," which were fictional accounts of their holdings in their TWS brokerage accounts or the values of those accounts. Additionally, when some of his customers raised questions about the value of their brokerage accounts or sought to withdraw funds from their accounts, Sledziejowski wired funds from Innovest's bank accounts back to their bank or brokerage accounts.
To date, more than $3 million of the customers' funds remain unaccounted for. Sledziejowski has refused to comply with FINRA's request to appear for testimony to answer questions related to the misconduct in question. On Nov. 9, TWS Financial filed an application to withdraw its broker-dealer registration.
Under FINRA rules, the individuals and firms named in a complaint can file a response and request a hearing before a FINRA disciplinary panel.
Advisor Charged with Defrauding Investors via Failing Private Equity Fund
A Chicago-based investment advisor and his firm were charged by the SEC with defrauding clients and others by promising them returns that would “beat the market” for investing in a private equity fund they managed. Investors were unaware that the fund was failing; they were being used as cash cows to raise money to repay promissory notes to earlier investors.
The SEC alleges that Joseph J. Hennessy and Resources Planning Group (RPG) raised more than $1.3 million by misrepresenting the Midwest Opportunity Fund (MOF) as a viable private equity fund that could offer high returns.
According to the SEC’s complaint filed against Hennessy and RPG in federal court in Chicago, Hennessy financed MOF’s acquisition of its largest portfolio company in 2007 in part by having the fund issue $1.65 million in promissory notes, all of which he personally guaranteed.
When MOF’s portfolio companies were unable to pay management fees later that year, MOF lacked sufficient funds to repay the notes. So, from September 2007 to March 2010, Hennessy raised $1.36 million from RPG clients and other investors to make payments on the notes. Hennessy falsely told investors that MOF was viable and offered high returns. He never mentioned the fund’s poor financial condition or that their money was paying off promissory notes he had guaranteed.
The SEC further alleges that Hennessy misappropriated money from RPG clients. In November 2007, he raised $750,000 from three RPG clients purportedly to invest in MOF. But then Hennessy used that money to redeem another client’s investment in the fund. Twice in mid-2009, Hennessy forged letters of authorization from a widowed RPG client to transfer $100,000 from her account to MOF in exchange for promissory notes that have yet to be repaid.
Hennessy therefore misappropriated client funds to make payments on the notes and prop up the fund, and used at least $641,408 to make partial payments to certain note holders, substantially reducing his personal liability on the notes.
“Private equity fund investors expect their money to be invested in viable assets that will generate positive returns,” said Marshall Sprung in a statement. Sprung, deputy chief of the SEC Enforcement Division’s Asset Management Unit, continued, “Hennessy made these promises, but betrayed his clients and others by using their money to save himself from financial ruin.”
Indian Brokerage Firms Charged with Operating Without Registration
The SEC has charged four financial services firms based in India–Ambit Capital Private Limited, Edelweiss Financial Services Limited, JM Financial Institutional Securities Private Limited, and Motilal Oswal Securities Limited–for providing brokerage services to institutional investors in the U.S. without being registered with the SEC as required under the federal securities laws.
According to the SEC’s orders against the firms, despite being unregistered broker-dealers, they engaged with U.S. investors in various ways, including the sponsorship of conferences in the U.S.; sending employees to the U.S. on a regular basis to meet with investors; trading securities of India-based issuers on behalf of U.S. investors; and participating in securities offerings from India-based issuers to U.S. investors.
Scott W. Friestad, associate director of the SEC’s Division of Enforcement, said in a statement, “The broker-dealer registration provisions are critical safeguards for the integrity of our securities markets. These four firms and all other foreign broker-dealers must educate themselves on the U.S. laws and regulations when they provide services to U.S. investors.”
The four firms have agreed to pay more than $1.8 million combined to settle the SEC’s charges. In their respective settlements, the firms agreed to be censured while neither admitting nor denying the SEC’s charges. Ambit agreed to pay disgorgement and prejudgment interest totaling $30,910. Edelweiss agreed to pay $568,347. JM Financial agreed to pay $443,545. Motilal agreed to pay $821,594.
“The firms’ cooperation with the commission staff and their prompt remedial measures, including entering into Rule 15a-6 chaperoning agreements with U.S. registered broker-dealers and/or initiating registration with the Commission as a broker-dealer, were important factors in accepting the firms’ settlement offers, particularly the commission’s decision not to impose a cease-and-desist order or a penalty,” added Friestad.
The investigation into potential violations at other firms is continuing.
$1 Million in Insider Trading Profits Leads to SEC Charges Against Brokers
The SEC charged two retail brokers, Thomas Conradt and David Weishaus, who formerly worked at a Connecticut-based broker-dealer, with insider trading on nonpublic information ahead of IBM Corporation’s acquisition of SPSS Inc.
The SEC alleges that Conradt learned confidential details about the merger from his roommate, a research analyst who got the information from an attorney working on the transaction who discussed it in confidence. Conradt purchased SPSS securities and subsequently tipped Weishaus, his friend and fellow broker, who also traded.
The SEC alleges that the research analyst’s attorney friend sought moral support, reassurance, and advice when he privately told the research analyst about his new assignment at work on the SPSS acquisition by IBM. In describing the magnitude of the assignment, the lawyer disclosed material, nonpublic information about the proposed transaction, including the anticipated transaction price and the identities of the acquiring and target companies. The associate expected the research analyst to maintain this information in confidence and refrain from trading on this information or disclosing it to others.
Instead, the research analyst told Conradt, who then told Weishaus. The latter two openly discussed their illegal activity in instant messages found during the SEC’s investigation, which is continuing, and made over $1 million in illicit profits on their insider trades.
According to the SEC’s complaint filed in federal court in Manhattan, the scheme occurred in 2009. Conradt revealed in instant messages that he received the information from the research analyst and warned Weishaus that they needed to “keep this in the family.” Weishaus agreed, typing “i don’t want to go to jail.”
They went on to discuss other people who have been prosecuted for insider trading. In another series of instant messages, Conradt bragged that he was “makin(g) everyone rich” by sharing the nonpublic information. Weishaus later noted, “this is gonna be sweet.”
The SEC alleges that Conradt, Weishaus, and other downstream tippees purchased common stock and call options–typically purchased by investors when they believe the stock of the underlying securities is going up–in SPSS. Conradt, Weishaus, and other downstream tippees invested so heavily in SPSS securities that the investments accounted for 76% to 100% of their various brokerage accounts.
Ironically, Conradt and Weishaus both hold law degrees. Conradt is admitted to practice law in Maryland, and he passed the Colorado bar examination administered in February 2012.
The SEC is seeking disgorgement of ill-gotten gains with prejudgment interest and financial penalties, and a permanent injunction against the brokers. In a parallel action, the U.S. Attorney’s Office for the Southern District of New York announced criminal charges against Conradt and Weishaus, who live in Denver and Baltimore, respectively.
Oil Company Executive Charged with Insider Trading
The SEC on Wednesday announced charges against Roger Parker, the former CEO of a Denver-based oil-and-gas company at the center of an insider trading scheme that the SEC began prosecuting last month.
According to the SEC’s complaint, the insider trading occurred in advance of Delta Petroleum Corporation’s public announcement that Beverly Hills, Calif.-based private investment firm Tracinda had agreed to purchase a 35% stake in the company, which shot its stock value up by nearly 20%. The SEC initially charged insurance executive Michael Van Gilder for his illegal trading in the case, and is now additionally charging his source: Parker, Delta’s then-CEO.
According to the SEC’s amended complaint filed late Wednesday in federal court in Denver, Parker, who lives in Englewood, Colo., tipped his close friend Van Gilder and another friend on several occasions in late November and December 2007 as the Tracinda investment was developing. Based on the inside information, Van Gilder and the other friend loaded up on Delta stock and highly speculative options contracts, and Van Gilder advised his relatives, his broker, and a coworker to do the same.
The SEC alleges that the Tracinda announcement was not the only nonpublic information that Parker tipped to Van Gilder. In November 2007, Van Gilder received an email from a mutual friend of Parker’s that included a news article expressing a negative view of Delta’s future prospects.
After sending an email to his broker indicating he might want to sell the Delta securities that he owned, Van Gilder called Parker three times that evening. Parker conveyed to Van Gilder confidential details about Delta’s third quarter 2007 earnings results that were to be announced later that week.
Based on that information, Van Gilder purchased an additional 1,250 shares and responded to the e-mail from the mutual friend by writing, “I had a dialogue with a friend, of whom you know. Do not sell this stock, rather buy more ... Delta will hit their numbers at this Thursday’s announcement.” When Delta announced its earnings, it reported production and revenue numbers above the company’s previously stated guidance.
Despite his duty as CEO to protect nonpublic information, Parker repeatedly communicated with Van Gilder following meetings and other developments as the deal progressed. Parker also illegally tipped information about Delta’s quarterly earnings.
The insider trading in this case generated more than $890,000 in illicit profits. The amended complaint seeks a final judgment ordering Parker and Van Gilder to disgorge their and their tippees’ ill-gotten gains plus prejudgment interest, ordering them to pay financial penalties, and permanently enjoining them from future violations of the above provisions of the federal securities laws. The SEC also seeks to prohibit Parker from acting as an officer or director of a public company.
The SEC’s investigation is continuing.