SEC Sanctions Audit Firm, Partner Tied to Custody Rule

Custody Rule cases are rapidly becoming a staple of SEC enforcement. Rule 206(4)-2 requires registered investment advisers with custody of client funds or securities to implement certain controls to protect those assets. Prior to its amendment, effective in March 2010, the Rule required advisers with custody to have a reasonable basis for believing that a qualified custodian or the adviser sent quarterly account statements to each client for which custody was maintained and obtain an annual surprise exam by an independent public accountant to verify all client assets. The March 2012 amendment to the Rule added certain exceptions for an adviser of a pooled investment vehicle from the basic provisions if certain requirements were met. Those included an annual audit of the pool by a PCAOB registered and inspected independent public accountant. The audited financial statements must be delivered to investors within certain time limits. The agency has been bringing an increasing number of these cases, in many instances arising out of examinations by OCIE.

One of those actions is In the Matter of Santos, Postal & Company, P.C., Admin. Proc. File No. 3-17238 (April 29, 2016). Respondents in the action are the PCAOB registered audit firm Santos, Postal and Joseph A. Scolaro, a C.P.A. who owned 25% of the firm. He served as the engagement partner for SFX Financial Advisory Management Enterprises, Inc., an SEC registered investment adviser during the period. The audit firm primarily provides accounting, tax and audit services to individuals and private entities. SFX Financial is subject to a Commission cease and desist order based on violations of Advisers Act Sections 206(1), 206(2) and 206(4) for failing to supervise Brian J. Ourand, formerly an employee of the firm who was terminated for misappropriating client funds. See SFX Financial Advisory Enterprises, Inc., Advisers Act Rel. No. 4116 (June 15, 2015); Brian J. Ourand, Advisers Act Rel. No. 4115 (June 15, 2015).

SFX specialized in providing advisory and financial management services to high net-worth individuals. Clients received investment advisory and bill-paying services. The adviser had authority to withdraw funds and deposit client assets in brokerage and bank accounts. The firm thus had custody of client assets within the meaning of the custody rule.

Santos, Postal began providing auditing services to SFX in 2004. From 2006 through 2011 Mr. Ourand misappropriated funds from client accounts. During the period he wrote unauthorized checks from client bank accounts payable to “cash” or himself. He also wired unauthorized amounts to himself for personal use.

From 2010 to 2011 Santos, Postal completed three reports for SFX that were filed with the SEC on Forms ADV-E. In 2010 the audit firm filed an initial report which was later amended. Those reports specified that the examination was made in accord with the standards established by the AICPA and delineated certain tests that were preformed which provided a reasonable basis for the firm’s opinion.

The 2010 report contained a material misstatement, according to the Order. It represented that the audit firm had confirmed with SFX’s clients contributions to, and withdrawals from their accounts. In fact the audit firm had not.

In planning the engagement Mr. Scolar, who served as engagement partner, failed to consider fraud risk factors related to false reporting or the misappropriation of assets despite the fact that the authority of the adviser with respect to the disposition of client assets and the bill paying service presented significant risks. Mr. Scolaro failed to identify any specific attestation risks regarding the firm’s compliance with the custody rule. He also failed to understand the adviser’s internal controls and the lack of segregation of duties or to identify Mr. Ourand as a person with authority over client funds. He also used inadequate sampling procedures regarding account balances when clients failed to return confirmations.

Prior to filing the 2011 report with the Commission, the audit firm and Mr. Scolar learned of the misappropriations by Mr. Ourand. Nevertheless, the audit firm issued a report which is substantially similar to the one issued the prior year. The deficiencies in the 2010 procedures persisted. Indeed, despite a requirement that significant matters such as the misappropriation by Mr. Ourand be documented and the subject of consultations, no consultations were documented. In view of the misappropriation, all client funds were not maintained with a qualified custodian as of May 31, 2011 as required by the custody Rule.

The Order alleges a violation of Advisers Act Section 207. It also finds that the firm and Mr. Scolaro engaged in improper professional conduct. To resolve the matter each Respondent consented to the entry of a cease and desist order based on the Section cited in the Order. The firm and Mr. Scolaro were each denied the privilege of appearing and practicing before the Commission with he right to apply for reinstatement after, respectively, one year and five years. The firm was also ordered to pay disgorgement of $25,800 and prejudgment interest. Mr. Scolaro was directed to pay a penalty of $15,000.

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This Week In Securities Litigation (Week ending April 29, 2016)

The SEC requested comment on the development of a consolidated audit trail this week, a concept long discussed. The audit trail would enable regulators to track trading activity in the U.S. markets. Enforcement initiated proceedings which included two centered on the creation of a public company as a vehicle for manipulation, another focused on a failure to supervise and a financial action focused on false books and records.

SEC

Comment: The SEC is seeking comment on a proposed national market system plan to create a single, comprehensive database that would enable regulators to efficiently track all trading activity in the U.S. equity and options market – a so-called consolidate audit trail (here).

SEC Enforcement – Filed and Settled Actions

Statistics: During this period the SEC filed 2 civil injunctive actions and 2 administrative proceedings, excluding 12j and tag-along proceedings.

False registration: SEC v. Zwebner, Civil Action No. 16 CV 1013 (S.D. Cal. Filed April 26, 2016). Asher Zwebner, a citizen of Israel and the U.K., created a shell company later sold to a group which manipulated its shares (see case below), through a series of misrepresentations. The misrepresentations began in June 2010 when Crown Dynamics Corporation was incorporated in Delaware, supposedly by Amir Rehavi who in fact was a Zwebner nominee. They continued through the filing of an S-1 Registration statement. Although Mr. Zwebner controlled the entire process – even having the comments sent to him under another identity – his name never appeared. In September 2011 the registration statement became effect – Crown could and then did conduct an IPO. The IPO was a sham. Defendant Zwebner and his sons arranged for local friends to serve as supposed purchasers – that is, shills. A shareholder list of 40 IPO subscribers was created. The transfer agent issued the shares. Most of those on the IPO list never knew about the issuance of the shares. Control and the shares remained with the Defendant. Trading was also initiated through a series of false statements in the Form 211, required by FINRA for trading on the OTCBB. Yet FINRA authorized trading. Finally, the firm was sold to stock promoter Christopher Larson. The complaint alleges violations of each subsection of Securities Act Section 17(a) and Exchange Act Section 10(b). The case is pending. See Lit. Rel. No. 23526 (April 26, 2016).

Manipulation: SEC v. Zouvas, Civil Action No. 3:16-cv-998 (S.D. Cal. Filed April 25, 2016). This action centers on the manipulation of the share of Crown (background discussed above). Named as defendants are Luke Zouvas, and attorney; Cameron Robb, a business associate of defendant Larson; Christopher Larson, a CPA; James Schiprett, a nominee for defendant Larson; and Robert Jorgenson, also a nominee for defendant Larson. Although Mr. Larson acquired control of Crown, his name never appeared in any filings made with the SEC. Crown’s shares were transferred to nominees for Mr. Larson, including defendants Schiprett and Jorgenson. A call center was paid $400,000 by Mr. Larson to promote the shares and create the appearance of market interest. As the share price became inflated defendant Larson’s nominees dumped their shares. Most of the proceeds, which totaled at least $850,000, were wired to nominee accounts controlled by defendant Larson. The complaint alleges violations of Securities Act Sections 17(a)(1) and (3) and Exchange Act Section 10(b). The case is pending.

Investment fund fraud: SEC v. Bliss, Civil Action No. 2:15-cv-00098 (D. Utah). In this previously filed action Roger Bliss operated a multimillion investment fraud scheme over a seven year period beginning in 2008. Unlike many investment schemes which claim to be based on proprietary trading techniques or which supposedly invest in exotic instruments, Mr. Bliss only invested in only one stock – Apple. Mr. Bliss claimed that he day-traded exclusively in Apple stock. He never had a losing day, according to his sales pitch. He also told potential investors that he had more than $300 million in assets under management. About $260 million was supposedly his capital. Returns were guaranteed – at least 100% and up to as much as 300%. Investors flocked in. In fact Mr. Bliss had lots of losing days. His brokerage records for the period January 2012 through the end of 2015 showed that he had losses of over $3.2 million. The scheme ended with Mr. Bliss pleading guilty to state securities fraud charges. He was ordered to pay over $20 million in restitution. He also pleaded guilty to charges of perjury and obstruction of justice for lying to the court in connection with a freeze order secured by the SEC in its case against him. He resolved the SEC’s action. There he consented to a judgment entered by the court which permanently enjoined him from future violations of the registration and antifraud provisions of the federal securities laws. In addition, the order directs that he pay almost $11 million in disgorgement which will be deemed satisfied at the conclusion of a court-appointed receivership. See Lit. Rel. No. 23524 (April 22, 2016).

Failure to supervise: In the Matter of James T. Budden, Adm. Proc. File No. 3-17234 (April 27, 2016) names as Respondents James Budden, the former President and co-owner of registered investment adviser Professional Investment Management, Inc., and Alexander Budden, also a co-owner of the firm and its former vice president and secretary. The firm provides third-party administration services and investment advisory services to about fifteen retirement plans. Douglas Cowgill, a former employee of the firm, and later an owner, concealed a shortfall at the firm of over $700,000 by sending false statements to clients. He resolved a Commission fraud action against him based on those facts. This action alleged failure to supervise, violations of the custody rule and a failure to have adequate supervisory provisions. The Order alleges violations of Advisers Act Sections 206(4). Each Respondent settled, consenting to the entry of a cease and desist order based on the Section cited in the Order. Each Respondent is barred from the securities business with a right to apply for reinstatement after three years for J. Budden and two for A. Budden. In addition, J. Budden will pay a penalty of $125,000 while A. Budden will pay $75,000.

Audit failure: In the Matter of David S. Hall, P.C., Adm. Proc. File No. 3-17228 (April 26, 2016) is a proceeding which names as Respondents: the audit firm, David Hall, the owner of the audit firm who later became CFO of DynaResources, Inc., whose external auditor was his firm; Michelle Helterbran Cochran, a CPO with the audit firm; and Susan Cisneros, an auditor with the firm. Respondents failed to conduct at least 16 audits and 35 quarterly reviews in accord with PCAOB standards. Specifically, they repeatedly failed to prepare adequate documentation; to conduct an engagement quality review; and participated in several engagements where they were not independent. The Order alleges violations of Rule 2-02(b)(1) of Regulation S-X, Exchange Act Section 13(a) and Rule 102(e) of the Rules of Practice. The matter will be set for hearing.

Books, records and controls: In the Matter of Cabela’s Incorporated, Adm. Proc. File No. 3-17227 (April 26, 2016). Respondent Cabela is a specialty retailer; Respondent Ralph Castner, CPA is the firm’s CFO. In January 2012 Cabela’s entered into a new intercompany agreement with its wholly-owned bank subsidiary, World’s Foremost Bank. The agreemet increased the amount the bank paid Cabela each quarter for the use of the company’s intellectual property and trademarks and for the cost of bank promotions relating to the Visa credit card that the bank issued. Contrary to GAAP, and its filings, Cabela failed to eliminate the intercompany promotions fee in preparing results on a quarterly and annual basis. This resulted in an understatement of merchandise costs and a corresponding understatement of financial services revenue on the firm’s consolidated income statement. That increased the profitability of the company and was referenced by the company in earnings releases and by analysts. The Order alleges violations of Exchange Act Section 13(a), 13(b)(2)(A) and 13(b)(2)(B). The firm resolved the proceeding, consenting to the entry of a cease and desist order based on the Sections cited in the Order. The firm also agreed to pay a civil penalty of $1 million.

FINRA

Report: The regulator has issued its first cross-market report cards covering spoofing and layering. The reports went to member firms and provide a summary of the identified market activity along with trends in such trading. The reports are intended to be a preventive compliance measure that will parallel the regulator’s surveillance (here).

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