SEC Files Its First Robocop Cherry Picking Action
When the SEC announced it financial fraud task force and a related data initiative to facilitate the identification of situations where the company “cooked the books,” many dubbed the data program “Robocop.” While the SEC may be continuing to work on that initiative, to date the agency has not created a computer to identify financial fraud. Robocop may, however, be appearing in another form. Not only does the agency use a big data approach to help sort out possible insider trading, but now it has created a program to analyze trading by investment advisers and identify wrongful conduct such as cherry picking. After test running calculations where it appeared an investment adviser had cherry picked certain option trades, a simulation designed to verify the point was run one million times. The first proceeding based the new program was filed, In the Matter of Welhouse & Associates, Inc., Adm. Proc. File No. 3-16657 (June 29, 2015).
Welhouse & Associates, Inc. is a state registered investment adviser. Respondent Mark Welhouse is its owner, principal and CCO. Custody of client accounts and assets is at a brokerage firm.
From at least February 2010, and continuing through January 2013, the firm executed trades in an S&P 500 ETF called SPY for client accounts as well as Mr. Welhouse’s personal accounts. Mr. Welhouse told the staff that he created a daily spreadsheet of the trade allocations between client accounts and his which was furnished to the brokerage firm to make the allocations. According to Mr. Welhouse, the trades were allocated on a pro rata basis before 5:00 p.m. each day.
Contrary to Mr. Welhouse’s claims, however, an analysis of all of the accounts demonstrates that in fact the allocations were not made on a pro rata basis. For trades that increased in value on the day of purchase, frequently Mr. Welhouse day-traded by selling the options on the day of purchase. A disproportionate share of the profits were then allocated to his accounts. Trades that decreased in value frequently were not sold on the day of purchase. A disproportionate share of these trades were allocated to client accounts. During this period the brokerage firm warned Mr. Welhouse several times regarding the allocations and threatened to terminate its relationship with him and his firm. Mr. Welhouse told the staff that if the allocations were disproportionate it was a mistake.
A statistical analysis of the accounts suggests that there was no mistake. During the period Mr. Welhouse allocated 496 SPY option trades to his personal accounts and 1,127 to his clients. The total cost of the trades was $7.25 million for the personal accounts and $8.46 million for the client accounts. Yet the total first-day profits for the personal accounts was $455,277 in contrast to the total first day losses for the client accounts of $427,190. Stated differently, the first day returns for the personal accounts of Mr. Welhouse was 6.28% in contrast to a -5.05% for client accounts. This compares to a return of 0.18% for all of the first day trade transactions.
The first day returns were statistically significant, according to the Order. This was verified through a simulation run, testing the possibilities. The results showed that the chance of receiving the results shown in the personal accounts was less than one in one million. The simulation was run one million times.
Finally, clients were unaware of the allocation process. Indeed, the firm’s Form ADV and related documents stated that Welhouse did not trade for its own account. The firm’s written policies and procedures stated that trades were allocated on a pro rata basis. The Order alleges violations of Exchange Act Section 10(b) and Advisers Act Sections 206(1) and 206(2). The proceeding will be set for hearing.
The SEC filed another action based on its market access rule. This time the Respondent is Goldman, Sachs & Co., a wholly owned subsidiary of The Goldman Sachs Group, Inc. In the Matter of Goldman, Sachs & Co., Adm. Proc. File No. 3-16665 (June 30, 2015).
The action centers on erroneously sending 16,000 mispriced options orders to various option exchanges in less than an hour on August 20, 2013. Respondent Goldman is a registered broker dealer and a member of FINRA. One of the client service functions performed by the firm is the provision of options liquidity to electronic trading customers. This service was done in part through the use of a matching engine that attempts to pair the firm’s indications of interest against customer orders for the particular option contract. If there was a match the paired order was sent to an exchange for execution. If there was no match the customer order was routed to an exchange. The firm’s indications of interest, called axes, were contingent in price, size and other parameters. They were not intended to go to the exchanges unless paired with a customer order. To the contrary, axes were intended to remain in the matching engine and search for customer orders to pair-off.
On August 20, 2013, as a result of a configuration error in one of the firm’s options order routers, Goldman sent thousands of $1 limit orders to options exchanges prior to the start of regular market trading. Before the market opened the firm halted the creation of orders and began canceling the erroneous ones that had been sent for execution.
Shortly after the opening a portion of the orders were executed. Specifically, about 1.5 million options contracts representing 150 million underlying shares were executed. Goldman faced a potential $500 million loss, although in the end it was about $38 million in view of cancellations or price adjustments for erroneous trades.
The error resulted from a series of failures, according to the Order, which included:
Goldman also had inadequate risk management controls and supervisory procedures relating to the prevention of orders that exceeded the firm’s pre-set capital threshold. The Order alleges Exchange Act Section 15(c)(3) and Rule 15c-3-5.
To resolve the proceeding Goldman consented to the entry of a cease and desist order based on the Section and Rule cited in the Order as well as to a censure. In addition, the firm agreed to pay a civil penalty of $7 million.
The SEC filed its first action involving a private equity fund and broken deal expenses. By the time the Commission discovered the question the firm realized it did not have a disclosure policy, retained a consultant to study the issue and adopted a policy. Nevertheless, to settle the proceeding the firm was required to pay disgorgement and a $10 million penalty. In the Matter of Kohlberg Kravis Robert & Co. L.P.¸Adm. Proc. File No. 3-16656 (June 29, 2015).
Respondent KKR is a private equity firm specializing in buyout and other transactions. For its Flagship PE Funds and other advisory clients the firm advises and sources potential investments. The firm also provides investment management and administrative services to its private equity funds for a management fee. In addition, the firm raises capital from co-investors for its private equity transactions.
KKR incurs significant investment expenses sourcing investment opportunities. The firm is reimbursed directly from portfolio companies for expenses incurred with successful transactions. For broken deal expenses it is reimbursed through fee sharing arrangements with its funds. Consistent with the applicable limited partnership agreements, and those for the Flagship 2006 Fund LPA, KKR shared a portion of its monitoring, transaction and break-up fess with the 2006 Fund. Under the fee sharing arrangement KKR received 20% of the fees and economically bore 20% of the broken deal expenses. However, the 2006 Fund’s LPA and offering materials did not include any express disclosure that KKR did not allocate broken deal expenses to its co-investors despite the fact that they participated in, and benefited from, KKR’s general sourcing transactions.
From 2006 through 2011 KKR allocated broken deal expenses by geographic region where the potential deal was sourced. Thus it allocated broken deal expenses related to potential North American investments to the 2006 Fund. Before 2011 however the firm did not allocate or attribute any of those expenses to co-investors.
In June 2011 KKR concluded that it lacked a written policy governing its broken deal expenses. Over the next few months a policy was drafted, memorializing its allocation methodology. At the same time the firm decided to make an allocation of broken deal expenses to co-investment vehicles.
In late October 2011 KKR engaged a third party consultant to review the its fund expense allocation practice. Effective January 1, 2012 the firm revised its broken deal expense allocation methodology following the consultant’s review. A new methodology was implemented which allocated part of the expenses to partner vehicles and other co-investors.
In 2013 OCIE conducted a compliance exam which included a review of expense allocations. During the examination KKR refunded its Flagship PE Funds a total of $3.26 million in certain broken deal expenses that had been allocated to them from 2009 to 2011.
Prior to the institution of the new policy KKR did not allocate any share of broken deal expenses to its co-investors, with certain exceptions. Likewise, the firm did not expressly disclose in the LPAs or related materials that it did not allocate or attribute broken deal expenses to co-investors. As a result KKR misallocated $17.4 million in broken deal expenses between its Flagship PE Funds and co-investors, thereby breaching its fiduciary duty as an investment adviser, according to the Order. The Order alleges violations of Advisers Act Sections 206(2) and 206(4)-7.
Respondent resolved the matter, consenting to the entry of a cease and desist order based on the Sections cited in the Order. In addition, they agreed to pay disgorgement of $14,165,968 (net broken deal expenses), prejudgment interest and a penalty of $10 million.
Jing Wang, a former Qualcomm Inc. Executive Vice President began by constructing a cover-up. Then he engaged in insider trading, using inside information taken from his employer. The scheme failed. Mr. Wang has been sentenced to 18 months in prison and directed to pay a $500,000 fine after pleading guilty to securities fraud based on his insider trading, money laundering tied to his efforts to evade detection and admitted to obstruction. U.S. v. Wang, 3:13-cr-03487 (C.D. Calif. Filed Sept. 20, 2013).
Mr. Wang traded on inside information obtained from his employer in three instances. First, on March 1, 2010, after the close of the market, Qualcomm announced an increase in its dividend and a stock repurchase plan. Earlier, in February Mr. Wang became aware of these plans. On the morning of March 1, he attended a company board meeting where the plan was discussed. Later that day he instructed his friend and broker Gary Yin, a registered representative at Merrill Lynch, to use all of the funds in an account he controlled to purchase Qualcomm shares. Mr. Yin also purchased shares. After the announcement the share price increased and both men sold the securities at a profit.
Second, on January 5, 2011 Qualcomm announced the acquisition of Atheros Communications, Inc. Prior to the announcement Mr. Wang learned about the deal through the course of his duties. He also attended a board meeting where it was discussed. He purchased shares of Atheros as did Mr. Yin. After the announcement the share price increased and both men sold their shares at a profit.
Third, on January 26, 2011 Qualcomm announced increased guidance. During the prior month Mr. Wang became aware that the firm was considering announcing increased guidance. That information was confirmed at a December 6, 2010 board meeting Mr. Wang attended. The day before the announcement he telephoned Mr. Yin and instructed him to purchase company shares. After the announcement the share price increased. Mr. Wang sold all of his shares at a profit.
The cover-up traces to 2006 before the insider trading. In that time period Messrs. Wang and Yin created off-shore entities and set-up accounts. The ownership of the accounts was designed to make it appear that they belonged to others. The money laundering charge was based on the efforts of Mr. Wang to transfer over $525,000 from one of the offshore accounts that included about $250,000 from the insider trading to another nominee brokerage account in the British Virgin Islands. As part of the plea agreement Mr. Wang also admitted to fabricating evidence and a false cover story in conjunction with his brother Bing Wang and Mr. Yin. See also SEC v. Wang, Civil Action No. 3:13-cv-02270 (S.D. Cal. Filed Sept. 23, 2013)(Mr. Yin pleaded guilty to conspiring with Jing Wang and Bing Wang to obstruct justice and launder money).
The SEC brought another custody rule action this week – against the outside auditors alleging that one examination was insufficient and the others incomplete thereby causing the client to violate the surprise audit requirement of the rule. failing the surprise audit requirement. The agency also brought another suspicious trading action, alleging the required elements on “information and belief. A third action claimed that two firms involved in the EB-5 program acted as unregistered brokers. In addition, the Commission brought two cases centered on claims of selling unregistered securities and another tied to compliance failures.
Remarks: Chair Mary Jo White delivered remarks titled “Building Meaningful Communication and Engagement with Shareholders” to the Society of Corporate Secretaries and Governance Professionals 69th National Conference, Chicago, Illinois (June 25, 2015). Her remarks focused on preliminary voting results and unelected directors (here).
Remarks: Commissioner Luis Aguilar delivered remarks titled “A Threefold Cord – Working Together to Meet the Pervasive Challenge of Cyber-Crime” to the SINET Innovation Summit, New York, New York (June 25, 2015). He reviewed the issues relating to cyber-crime, the current regulations and guidance from the agency and possible future legislation and SEC efforts in the area (here).
Remarks: Commissioner Daniel Gallagher delivered remarks titled “Activism, Short-Term, and the SEC” at the 21st Annual Stanford Directors’ College (June 23, 2015). In his remarks the Commissioner addressed the SEC role regarding activism, shareholder proposals, proxy firms and the future (here).
SEC Enforcement – Filed and Settled Actions
Statistics: During this period the SEC filed 3 civil injunctive cases and 4 administrative actions, excluding 12j and tag-along proceedings.
Custody rule: In the Matter of Michael S. Wilson, CPA, Adm. Proc. File No. 3-16652 (June 25, 2015) names as Respondents Mr. Wilson, a 50% shareholder in audit firm Cotterman-Wilson CPAs, Inc., also named in the proceeding. Professional Investment Management, Inc., a registered investment adviser with custody of client assets retained Cotterman-Wilson to conduct the surprise audits required by the custody rule. The firm conducted the required audits from 1999 to 2008. In 2009 it did work but its opinion lacked a reasonable basis and the firm failed to file Form ADV-E as required. In 2010 and 2011 Respondents failed to complete the exams and did not timely withdraw or file the required form. This caused Professional Investment to violate the Rule. The Order alleges violations of Advisers Act Section 206(d). To resolve the matter both the firm and Mr. Wilson consented to the entry of a cease and desist order based on the Section cited in the Order. In addition, Mr. Wilson was denied the privilege of appearing and practicing before the Commission and ordered to pay a $50,000 penalty. The firm was also denied the privilege of appearing and practicing before the Commission but with the right to apply for re-entry after three years. The firm was ordered to pay disgorgement of $10,868 along with prejudgment interest.
Suspicious trading: SEC v. Luo, (S.D.N.Y. Filed June 23, 2014) is a “suspicious” trading case. The action centers on the buy-out announcement for Qihoo 360 Technology Co, Ltd, by its Chairman and CEO and a consortium of other affiliates, announced on June 17, 2015. Defendant Hijian Luo is a resident of Guangzhou, China. He is the CEO of 4399 Co., Ltd., an online game company that provides single, multiplayer and children’s games along with animation through the internet. Qihoo 360 is a Cayman Islands entity with its principal executive offices in Beijing, China. The firm, which conducts business through a number of subsidiaries and affiliates, is a leading internet company in China. The firm listed its ADSs on the NYSE in March 2011. The next month it conducted an IPO and trades under the symbol QIHU. Mr. Luo opened an account with the San Francisco office of Credit Suisse Securities (USA) LLC on March 6, 2015. The account was not funded until May 18, 2015 when Mr. Luo wired in $720,000. The next day he purchased 2,250 QIHU out of the money call options at a total price of $711,778.
The options purchased by Mr. Luo became in the money as of June 11 when the stock traded at a high of $67 and closed at $65.95. Mr. Luo did not sell. Following the buy-out announcement, which was for all of the outstanding shares and the ADSs, the share price of the company rose to $66.05 at the close on June 16, 2015. The next day the share price increased again, closing at $70.15. All of Mr. Luo’s options were sold following the deal announcement. This resulted in a realized profit of about $1,019,537. On June 22 Mr. Luo transmitted wire instructions for the transfer of $600,000 to a bank in Singapore. The key insider trading and tipping elements were alleged on “information and belief.” The complaint alleges violations of Exchange Act Section 10(b). The Commission obtained a freeze order. The case is pending.
Unregistered broker: In the Matter of Ireeco, LLC, Adm. Proc. File No. 3-16647 (June 23, 2015). Respondents in the proceeding are Ireeco, LLC and Irecco Limited. LLC is a Florida limited liability company, while Limited in a Hong Kong entity. Between January 2010 and May 2012 LLC solicited foreign investors who wished to invest in the EB-5 program which provides a path to a permanent green card in return for job creating investments. Here those investments were made through regional centers – an entity involved with the promotion of economic growth approved by the USCIS to administer projects. Applicants through a center are only required to invest $500,000 rather than $1 million. The firm earned fees under the “referral partner agreements” it had with regional centers for brining in customers. The fee was paid once a conditional green card was approved by USCIS. The fee was a commission based on a fixed portion of the administrative fee the investor paid to the center, on average about $35,000 per investor. From January 2010 to present Respondents were paid fees for actively soliciting 158 foreign investors. The applicants invested about $79 million in the regional centers. The Order alleges violations of Exchange Act Section 15(a)(1). To partially resolve the proceeding Respondents consented to the entry of a cease and desist order based on Exchange Act Section 15(a). They also agreed to a censure. A hearing will be conducted to determine if it is appropriate to order disgorgement and/or civil penalties.
Unregistered securities: SEC v. Mulholland (E.D.N.Y. Filed June 23, 2015) is an action against Gregg Mulholland, a recidivist who is past due on a $5.3 million judgment owed to the Commission for selling unregistered securities. This complaint alleges that Mr. Mulholland sold at least 83 million unregistered shares of Vision Plasma through nine offshore international business corporations in 2012. There was no registration statement in effect. The complaint alleges violations of Securities Act Sections 5(a) and 5(c). The case is pending. A parallel criminal action has been filed. See Lit. Rel. No. 23293 (June 25, 2015).
Compliance: In the Matter of Pekin Singer Strauss Asset Management Inc., Adm. Proc. File No 3-16646 (June 23, 2015). Named as Respondents are the firm, a registered investment adviser and Ronald Strauss, until recently the president of the firm, and William Pekin and Joshua Stauss, both portfolio managers for Appleseed Fund. The Order alleges that in 2009 and 2010 the firm was unable to timely complete annual compliance program reviews and to implement and enforce provisions of its policies and procedures and code of ethics. In addition, from 2011 through early 2014 Respondents kept or placed a number of clients in the investor share class of Appleseed who were eligible for less expensive shares. The additional fee of 25 basis points went to the firm. The Order alleges violations of Advisers Act Sections 206(2), 204A, 206(4) and 207. Respondents resolved the claims with each Respondent consenting to the entry of a cease and desist order. The firm’s order is based on Advisers Act Sections 204A, 206(2), 206(4) and 207; the order as to Mr. Strauss is based on the same Sections except 206(2); and as to Messrs. Pekin and Strauss, it is based on Sections 206(2) and 207. In addition, the firm and Messrs. Pekin and Strauss were censured. The firm will pay a penalty of $150,000 while each of the individuals will pay $45,000.
Investment fund fraud: SEC v. Williamson, Civil Action No. 1:15-cv-22080 (S.D. Fla.) is a previously filed action against investment adviser Phil Williamson. Using Sterling Investment Fund, which purportedly invested in mortgages and property, Mr. Williamson solicited largely public sector retirees to invest in what was actually a Ponzi scheme. Mr. Williamson settled with the Commission and the Court entered a final judgment permanently enjoining him from future violations of Advisers Act Sections 206(1), (2) and (4) and directing the payment of disgorgement in the amount of $748,050. A parallel criminal case is pending. See Lit. Rel. No. 23291 (June 23, 2015).
Unregistered securities: In the Matter of Ironridge Global Partners, LLC, Adm. Proc. File No. 3-16649 (June 23, 2015) is a proceeding which names as Respondents Ironridge and Ironridge Global IV, Ltd. which was, until recently a wholly owned subsidiary of Ironridge Global Partners. Beginning in 2011, and continuing through early 2014, the two firms implemented a business model in which microcap issuers were solicited for a liabilities for equity financing program. Under the so-called LIFE program, Respondents acquired claims against microcap issuers which were then resolved through with unregistered shares under a state court order. Utilizing Securities Act Section 3(a)(10) , which exempts from registration shares acquired in a court approved exchange for bona fide outstanding claims, Respondents received and sold about 5.5 billon shares of stock, realizing about $22 million. The Order alleges violations of Exchange Act Section 15(a). The case will be set for hearing.
Investment fund fraud: SEC v. Capital Cove Bancorp LLC, Civil Action No. SACV 15 00980 (C.D. Cal. Filed June 18, 2015) is an action which names as defendants Capital Cove, formerly a registered investment adviser, and Christopher Lee, the firm’s owner. The defendants are alleged to have raised about $1.9 million from 15 U.S. investors over a two year period. Most of the money was misappropriated. To effectuate their schemes defendants formed two investment funds, soliciting investors with false claims that the funds invested in real estate. One of the investors they solicited was an undercover FBI agent. They also sold membership interests in a fund. The complaint alleges violations of Securities Act Sections 5(a), 5(c) and 17(a), Exchange Act Section 10(b) and Advisers Act Sections 207 and 203A. The case is pending. See Lit. Rel. No. 23292 (June 24, 2015).
Disclosure: The Australian Securities and Investment Commission announced civil penalty proceedings against Padbury Mining Limited and two of its directors. The proceeding is based on the firm’s failure to comply with its continuous disclosure obligations based on an April 11 2014 announcement that $6 billion in funding had been secured to develop the Oakejee port and rail project. The announcement followed execution of an agreement with Superkite Pty Ltd. and Super Holdings Pty Ltd regarding funding. The funding agreement was terminated by the parties. The firm failed to disclose that the agreement was subject to significant conditions precedent which had not been met.
Outsized trades continue to draw SEC scrutiny and enforcement actions – even where the agency does not have the evidence to fully plead a claim. Despite the difficulties of these so-called “suspicious” trading cases, in many instances the Commission is able to develop the evidence to support its allegations. In the meantime the trading profits are typically held in a frozen account.
SEC v. Luo, (S.D.N.Y. Filed June 23, 2014) is a “suspicious” trading case. The action centers on the buy-out announcement for Qihoo 360 Technology Co, Ltd, by its Chairman and CEO and a consortium of other affiliates, announced on June 17, 2015. Defendant Hijian Luo is a resident of Guangzhou, China. He is the CEO of 4399 Co., Ltd., an online game company that provides single, multiplayer and children’s games along with animation through the internet.
Qihoo 360 is a Cayman Islands entity with its principal executive offices in Beijing, China. The firm, which conducts business through a number of subsidiaries and affiliates, is a leading internet company in China. The firm listed its ADSs on the NYSE in March 2011. The next month it conducted an IPO and trades under the symbol QIHU.
Mr. Luo opened an account with the San Francisco office of Credit Suisse Securities (USA) LLC on March 6, 2015. The account was not funded until May 18, 2015 when Mr. Luo wired in $720,000. The next day he purchased 2,250 QIHU out of the money call options at a total price of $711,778. The strike prices ranged from $60.50 to $65.00. The options were short term.
The options purchased by Mr. Luo became in the money as of June 11 when the stock traded at a high of $67 and closed at $65.95. Mr. Luo did not sell.
Following the buy-out announcement, which was for all of the outstanding shares and the ADSs, the share price of the company rose to $66.05 at the close on June 16, 2015. The next day the share price increased again, closing at $70.15.
All of Mr. Luo’s options were sold following the deal announcement. This resulted in a realized profit of about $1,019,537. On June 22 Mr. Luo transmitted wire instructions for the transfer of $600,000 to a bank in Singapore.
The complaint alleges, on “information and believe,” that at the time Mr. Luo purchased the call options he was in possession of material non-public information regarding the proposed transaction. The inside information was “tipped by such person with the expectation of receiving a benefit, such person did in fact receive a benefit, and Defendant knew of such benefit,” also alleged on information and belief.
The complaint alleges violations of Exchange Act Section 10(b). The Commission obtained a freeze order. The case is pending.
The EB-5 program was designed to create a path to becoming a permanent residence in the U.S. for certain immigrants while facilitating job creation in the United States. Initiated in 1990, the program gives a foreign applicant a path to permanent residency following an investment of $1 million, or $500,000 in a targeted employment area. The investment must be in a USCIS approved U.S. commercial enterprise, defined as any for-profit activity formed for the ongoing conduct of lawful business. The applicant obtains a conditional green card following the investment. It is good for two years. If the investment creates or preserves at least 10 full time jobs during the two year period the applicant may obtain a permanent green card.
While the program has been successful at spurring investment in the U.S. and giving applicants an opportunity to obtain a permanent green card, there have been difficulties. In the past the SEC has brought fraud actions based on the investment program. Now the Commission has brought its first action charging individuals with acting as unregistered brokers in connection with the EB-5 program. In the Matter of Ireeco, LLC, Adm. Proc. File No. 3-16647 (June 23, 2015).
Respondents in the proceeding are Ireeco, LLC and Ireco Limited. LLC is a Florida limited liability company, while Limited in a Hong Kong entity. Both were founded by Stephen Parnell and Andrew Bartlett. Between January 2010 and May 2012 LLC solicited foreign investors who wished to invest in the program through regional centers – an entity involved with the promotion of economic growth approved by the USCIS to administer projects. Applicants through a center are only required to invest $500,000.
LLC solicited potential investors through a website which claimed the firm had extensive experience in the area and could guide applicants to the correct center for them. In 2012 Messrs. Parnell and Bartlett formed Limited. It became a managing member of LLC. Eventually LLC became the contracting party. Solicitation continued through the website.
Applicants who contacted Respondents were eventually guided to a regional center. The firm earned fees under the “referral partner agreements” it had with regional centers for brining in customers. The fee was paid once a conditional green card was approved by USCIS. The fee was a commission based on a fixed portion of the administrative fee the investor paid to the center, on average about $35,000 per investor.
From January 2010 to present Respondents were paid fees for actively soliciting 158 foreign investors. The applicants invested about $79 million in the regional centers. The Order alleges violations of Exchange Act Section 15(a)(1).
To partially resolve the proceeding Respondents consented to the entry of a cease and desist order based on Exchange Act Section 15(a). They also agreed to a censure. A hearing will be conducted to determine if it is appropriate to order disgorgement and/or civil penalties.
IAP Worldwide Services Inc., a Virginia based facilities management firm, entered into a non-prosecution agreement with the Department of Justice and agreed to pay a $7.1 million penalty to resolve FCPA charges. A vice president of the firm pleaded guilty to one count of conspiracy to violate the FCPA. He is scheduled to be sentenced in September 2015.
The decision to enter into a non-prosecution agreement was based not just on the cooperation of the company but “a variety of factors,” according to the DOJ. The agreement requires the company to continue cooperating, conduct a review of its existing internal controls, policies and procedures and make any necessary modifications to ensure compliance in the future. Under the terms of the agreement the firm will report periodically to the Department of Justice regarding remediation and implementation of its compliance program and internal controls and policies and procedures.
The underlying conduct centers on the efforts of IAP to secure a contract for the Kuwait Security Program, initiated by the Kuwait Ministry of Interior. The project, initiated in 2004, was designed to provide nationwide surveillance capabilities for several government agencies, generally through the use of closed-circuit television. Phase I focused on planning. Phase II was the instillation period. The second phase was generally considered to be the more lucrative portion of the project.
To ensure that it would obtain Phase II, IAP sought to obtain the first part of the project. This would permit it to design favorable standards. Firm vice president James Rama and others were successful in securing Phase I and eventually the second phase. To secure Phase I in 2005 Mr. Rama and others set up shell company Ramaco. IAP and Mr. Rama then agreed with others that half of the Phase I contract, valued at $4 million, would be channeled through the shell company to a consultant. Some or all of the money was to be used to pay bribes to government officials. Eventually, about $1,783, 688 was channeled through an IAP account to Ramaco used for that purpose. IAP was successful in securing Phase II.
SEC Commissioner Daniel Gallagher published a statement explaining his dissent in two recent enforcement actions in which the Chief Compliance Officer of an investment adviser was charged, noting that the trend in such actions is toward strict liability. “Statement on Recent SEC Settlements Charging Chief Compliance Officers with Violations of Investment Advisers Act Rule 206(4)-7 (here“>here). The Commissioner called for guidance for COO’s who are critical gatekeepers. This is not the first time the Commissioner has spoken out on behalf of COOs (here).
The two enforcement actions which prompted the dissent are In the Matter of Blackrock Advisers, LLC, Adm. Proc. File No. 3-16501 (April 20, 2015)(here) and In the Matter of SFX Financial Advisory Management Enterprises, Inc., Adm. Proc. File No. 3-16590 (June 15, 2015)(here). In each the Commission charged the firm’s COO with violations of Advisers Act Rule 206(4)-7. The former centered, in part, on the question of whether the firm had adequate policies and procedures to monitor the outside activities of employees and disclose conflicts to fund boards and advisory clients. The latter focused on weather the firm’s policies and procedures were sufficient to detect a multi-year fraud. Each CCO settled.
Rule 206(4)-7 is at the center of the Commissioner’s concerns. The rule is “not a model of clarity,” according to Commissioner Gallagher. It provides, in part, that the adviser is required to adopt “and implement written policies and procedures reasonably designed . . .” to prevent violations of the Act. On its face the rule addresses the adviser – it requires the firm to designate a CCO. While the adviser is responsible for implementation, the SEC interprets Rule 206(4)-7 as if it is directed to CCOs.
The rule also offers “no guidance as to the distinction between the role of CCOs and management in carrying out the compliance function,” the Commissioner noted. The SEC has offered none in the years since the enactment of the rule except through enforcement actions which at times have “unfairly contorted the rule to treat the compliance function as a new business line, with compliance officers assuming the role of business heads.”
Enforcement actions are not the way to resolve the uncertainty surrounding the rule, according to Commissioner Gallagher. Rather, the Commission should consider the message sent to the compliance community of resolving the ambiguity inherent in the rule through enforcement actions. Those actions have a “psychological impact, and in many cases [cause] reputational damage . . . [from] months or years of testimony, the Wells process, and settlement negotiations . . . [that can be] as chilling as the scarlet letter of an enforcement violation” he stated.
Yet CCO are critical gatekeepers, necessary to effectively implement compliance programs. They are “all we have. They are not only the first line of defense, they are the only line of defense,” Commissioner Gallagher argued. Viewed in this context, it is imperative that the Commission “take a hard look” at the rule and consider if amendments or at least agency or staff guidance is necessary.