More On Legal & Compliancefrom The Advisor's Professional Library
- 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.
- Agency and Principal Transactions In passing Section 206(3) of the Investment Advisers Act, Congress recognized that principal and agency transactions can be harmful to clients. Such transactions create the opportunity for RIAs to engage in self-dealing.
Among recent enforcement actions taken by the SEC were charges against cosmetics company Revlon for misleading shareholders during a going-private transaction; a settlement with eight former directors of Morgan Keegan funds for failing to properly oversee asset valuations; charges against two executives at a medical insurance company for a Ponzi scheme; and charges against a penny stock promoter for illegally boosting the price of the stock to stimulate sales.
Eight Former Morgan Keegan Fund Directors Settle in Valuation Failure
Eight former directors of five Regions Morgan Keegan open- and closed-end funds that were heavily invested in securities backed by subprime mortgages have settled with the SEC on charges that they failed to properly oversee asset valuation in the funds. In some cases, portfolio managers were allowed to arbitrarily value the assets.
J. Kenneth Alderman of Birmingham, Ala.; Jack Blair of Germantown, Tenn.; Albert Johnson of Hoover, Ala.; James Stillman McFadden of Germantown; Allen Morgan Jr. of Memphis; W. Randall Pittman of Birmingham; Mary Stone of Birmingham; and Archie Willis III of Memphis were originally charged in December after the SEC found that they delegated their responsibility to ensure a fair valuation to a valuation committee, and provided inadequate guidance on how fair valuation determinations should be made.
The eight made no effort to determine how valuations were reached by the committee, despite the fact that the assets in question constituted substantial percentages of the funds, in most cases more than 60%. The funds involved were the RMK High Income Fund, RMK Multi-Sector High Income Fund, RMK Strategic Income Fund, RMK Advantage Income Fund, and Morgan Keegan Select Fund.
The valuation committee, for its part, didn’t use reasonable procedures to value the assets, and often allowed the portfolio manager to arbitrarily determine values. That meant that the funds overstated the values of the assets just before the crash of the housing market in 2007. Morgan Keegan and other firms were previously charged by the SEC and other agencies, and the firms agreed to settle the charges for $200 million.
The directors neither admitted nor denied the charges, but agreed to the entry of the settled SEC order.
Penny Stock Promoter Busted in FBI Sting
Penny stock promoter David Bahr of Rancho Santa Fe, Calif., was charged by the SEC for fraudulently arranging the purchase of $2.5 million worth of shares in the penny stock company iTrackr Systems in an attempt to fake legitimate market interest and lure other investors to purchase the stock.
Bahr artificially increased the trading price and volume of iTrackr Systems stock when he conspired with a purported businessman with access to a network of corrupt brokers. The plan was to keep the price of the stock high enough for him to promote it later and drive it even higher. He also arranged for distribution of promotional material that overstated the likelihood of iTrackr’s success and future profits.
However, the supposed businessman Bahr was dealing with was actually an undercover FBI agent. In November, Bahr connected with the agent, who, he was told, represented a group of registered representatives who had trading discretion over certain client accounts.
In exchange for a 30% kickback, these brokers could arrange to purchase iTrackr stock through their customers’ accounts and hold the shares for up to a year in order to avoid sales that might decrease iTrackr’s stock price.
Bahr agreed to pay the kickback, signing on for the purchase of 10 million iTrackr shares at an average of $0.25 per share for a total of $2.5 million, and also agreed not to disclose the kickback to any iTrackr investors. Then, during a test run of their arrangement, Bahr paid a $3,000 kickback in exchange for the initial purchase of $14,000 worth of iTrackr shares.
The SEC ordered a suspension of trading on iTrackr shares; its investigation is continuing. The U.S. Attorney’s Office for the Southern District of California has filed criminal charges against Bahr.
Revlon Charged with Misleading Shareholders on Going-Private Transaction
The SEC announced that it has charged the cosmetics company Revlon with federal securities law violations for misleading investors during a transaction to go private.
Without admitting or denying the SEC’s findings, Revlon agreed to settle the charges and pay a penalty of $850,000.
The agency’s investigation found that the company ring-fenced from its independent board members information on a voluntary exchange offer to satisfy a significant debt to its controlling shareholder, MacAndrews and Forbes (M&F). In 2009, M&F asked Revlon to offer minority shareholders the option to exchange their common stock shares on a one-for-one basis for preferred shares with certain financial characteristics. Revlon would then provide those exchanged common shares to M&F to pay down its debt.
When Revlon’s 401(k) trustee said that the transaction could only be done with 401(k) stockholders if a third-party advisor judged that the preferred shares were at least equal to the fair market value of the common shares, the deal was threatened—since the third-party advisor found the preferred shares were worth less.
So Revlon took a number of actions to ensure that both the trustee’s insistence that the preferred shares be at least equal to common stock FMV and its determination that the shares were not in fact equal did not reach shareholders involved in the transaction. As a result, shareholders were presented with materially misleading information regarding the proposed transaction, and the board was prevented from considering whether the stock value was adequate during its deliberation on whether to approve the transaction.
Dallas Medical Insurance Company Execs Charged in Ponzi Scheme
Duncan MacDonald and Gloria Solomon, two executives at a Dallas-based medical insurance company, were charged by the SEC with operating a $10 million Ponzi scheme that victimized at least 80 investors.
The two solicited investments for Global Corporate Alliance (GCA) by promoting it as a proven business with a strong track record of generating revenue from the sale of limited-benefit medical insurance. Actually, however, GCA was a startup with zero operating history and only marginally more revenue.
When it was obvious that the search for a single investor to fund the venture was fruitless, MacDonald instead looked for smaller fish to finance the company. He pitched it to both investors and brokers as a going concern with more than 100,000 premium-paying members, and went so far as to claim that a Chinese hedge fund had bought a portion of GCA’s revenue stream from paying members. There was no real revenue stream, nor was there a Chinese hedge fund.
MacDonald and Solomon concocted both monthly enrollment numbers and a “Monthly Overage Disbursement Statement” that purported to show monthly member enrollments and cancellations. It was formatted to look like the report from a database, but it was actually a manually populated Excel spreadsheet that Solomon updated.
These phony documents were used to entice prospective investors and also to make payouts to those who had already signed on out of the funds from later investors. Of course, eventually the well ran dry; MacDonald and Solomon each took around $1 million of the $10 million in investor funds they’d acquired, and spent the remaining investor funds on various business-related expenses until GCA’s accounts were left with a negative balance.
Then they concocted a chain of excuses for the lack of additional payments to investors, while MacDonald tried to find a fresh crop of victims. He failed again.
The SEC seeks various relief for investors including disgorgement of ill-gotten gains with prejudgment interest, financial penalties and permanent injunctions. The U.S. Attorney’s Office for the Northern District of Texas has filed criminal charges against MacDonald and Solomon.
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