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Thomas O. Gorman,
Dorsey and Whitney LLP
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    SEC Files Prime Bank Fraud and Offering Fraud Actions as Administrative Proceedings

    January 26, 2015

    The trend of selecting administrative proceedings rather than Federal court by the SEC appears to be continuing. Since last September, for example, the SEC has filed at least seven insider trading cases as administrative proceeds. Previously, the agency typically brought insider trading cases as civil injunctive actions. While the Commission has acknowledged the trend, it ascribes no particular significance to it. At the same time it is spawning increasing numbers of suit trying to halt it.

    Despite those suits the trend seems to be continuing and broadening. At the end of last week the SEC filed two more administrative proceeding. This time the actions focused on prime bank fraud and an offering fraud. Frequently these types of actions have been brought as civil injunctive actions, although not always.

    In the Matter of Spectrum Concepts, LLC, Adm. Proc. File No. 3-16356 (Jan. 23, 2015) is a prime bank fraud action which names as Respondents Spectrum, a vehicle used in the transactions; Donald Worswick, the president and owner of Spectrum; Michael Grosso, previously a nutritionist and fitness trainer; and Michael Brown who claimed to be an attorney but in fact was not.

    The scheme was orchestrated by Mr. Worswick and Spectrum with assistance from Messrs. Grosso and Brown. Over several months in 2012 the Respondents sold about $465,000 of investments in a “Private Joint Venture Credit Enhancement Agreement” to at least five elderly investors. Investors were told their funds would be invested in a variety of items including private funding projects used to set up a credit facility and a trade slot that would be blocked for the benefit of a trade platform. A number of investors were promised the full return of their capital in addition to returns on their investment. Those returns supposedly ranged from 900% in 20 days to as much as over 4,600% annually.

    The investments were fictitious, according to the Order. While some investors were able to obtain a refund after changing their mind, others had their funds misappropriated. The Order alleges violations of Securities Act Sections 5(a) and (c) and 17(a) and Exchange Act Section 10(b). The proceeding will be set for hearing.

    In the Matter of David B. Havanich, Jr., Adm. Proc. File No. 3-16354 (Jan 23, 2014) is an offering fraud action. The scheme was allegedly conducted by Respondents: David Hananich, the co-founder and president of Diversified Energy Group, Inc. and the president and director of St. Vincent de Paul Children’s Foundation, Inc., a non-operating non-profit corporation; Carmine DeLLaSala, a co-founder and director of Diversified; and Matthew Welch, an officer of Diversified. They were assisted by Hampton Scurlock, RTAG Inc., a registered investment adviser owned by Mr. Welch, Jose Carrio, Dennis Karaski, Carrio, Karasik & Associates LLP and Michael Salovay.

    About $17.4 million was raised from 440 investors over a six year period beginning in 2006. Investors were told that Diversified invested in fractional interests in oil and gas production properties and commodities trading. A portion of investor funds were also used to purchase interests in oil and gas wells, cattle, a device to increase gas mileage and real estate.

    Misrepresentations were made to investors. Those included misstatements regarding Diversified’s financial performance, its use of industry experts and technologies and the affiliation of certain officers with St. Vincent’s charity which did not operate.

    The interests sold were not registered. The agents retained beginning in 2009 to sell Diversified bonds were not registered. Those agents were paid 5% to 10% of the investor proceeds. Despite receiving an email and other correspondence from Diversified’s outside counsel detailing the limits on the firm’s use of unregistered agents, sales by agents continued. Collectively those agents earned about $985,000.

    USAO Wants Newman Insider Trading Case Reheard

    January 25, 2015

    The Second Circuit’s decision in U.S. v. Newman, Nos. 13-1837-cr. 13-1917-cr (2nd Cir. Dec. 10, 2014) continues to be the key focus in insider trading cases. There the Court held that remote tippees must not only know that the information was transmitted in breach of a duty under the classic theory of insider trading but also that the tipper received a personal benefit that was in the nature of a quid pro quo. The Court reversed and dismissed the convictions of two hedge fund executives because the jury instructions failed to inform the jury that the tippees had to know about the personal benefit and, in any event, the evidence on the point was insufficient (here). As the week drew to a close another judge in Manhattan vacated the guilty pleas of four individuals who were down stream tippees in the IBM take-over case based on Newman. U.S. v Conradt, No. 12 Cr. 887 (S.D.N.Y.). In opposing that motion the Government argued that the personal benefit test only applied to insider trading based on the classic theory, not the misappropriation theory (here).

    The Petition

    Now the Government has requested rehearing in the Newman case and rehearing en banc. Petition of the United States of America For Rehearing and Rehearing En Banc in U.S. v. Newman, No. 13-1837, 13-1917 (2nd Cir. Filed January 23, 2015). In its petition the Government argues two key points: First, that the panel decision redefines “personal benefit” in a manner which is contrary to Dirks v. SEC, 436 U.S. 646 (1983). Second, that in applying this “new and incorrect definition of personal benefit . . . the panel erroneously ordered dismissal of the charges . . .” Although the Government asserts in the Petition that the jury instructions were correct despite the fact that they did not require that the defendants know the tipper received a personal benefit, the point was not raised — “a requirement the Government argued against, but does not challenge herein . . .” as the Petition states.

    Initially, the Petition argues that Newman constricts the definition of the personal benefit test in a manner which is directly contrary to Dirks. Under that decision the insider violates the duty owed to his or her company in “a way that violates the federal securities laws when he discloses inside corporate information for an improper purpose – that is, for a personal benefit rather than a corporate purpose,” the Government noted. The personal benefit under Dirks may be “direct or indirect” and can take a variety of forms. While there may be a quid pro quo, there may also be an intention to benefit a particular individual. The critical point is that “’[t]he tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient,’” the Government argued, quoting Dirks.

    In this case the panel took a very different approach, the Government claims. It took the gift language from Dirks and added an “unprecedented limitation that effectively upended Dirks: ‘To the extent Dirks suggests that a personal benefit may be inferred from a personal relationship between the tipper and tippee,’ the Panel held, ‘such an inference is permissible in the absence of proof of a meaningfully close relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.” This is “flatly inconsistent” with Dirks, according to the Government. Under the Supreme Court’s decision a gift is enough. Here the Panel not only “nullified part of the Dirks personal benefit test – apparently eliminating Dirks’s express recognition that an improper but uncompensated gift of information by an insider suffices – but, citing no authority, replaced it with a set of novel, confounding criteria for the type of ‘exchange’ that will now be required . . .”

    Second, the evidence “under a proper ‘personal benefit’ instruction (such as the one suggested by the parties and given by the District Court), the evidence amply supported the jury’s conclusion that the Dell and NVIDIA insiders disclosed secret corporate information for personal benefit” the Government contends. At the same time the defendants “knew or consciously avoided knowing that the insider-tippers acted for a personal benefit.” Accordingly, once it was determined that the jury instructions were erroneous, the Panel should have vacated the convictions and remanded for retrial.

    Finally, the Government contends that the new definition of “personal benefit” threatens the integrity of the securities markets. Indeed, the “Panel’s ambiguous and diluted notion of when an insider ‘personally benefits’ from disclosure of inside information not only conflicts with Supreme Court precedent, but also invites selective leaking of valuable information to favored friends and associates of well-placed corporate insiders.” This will undermine confidence in the securities markets.

    Comment

    The Government’s argument is based almost exclusively on Dirks, although it does cited decisions from other circuits. Notably absent from the cases cited by the Government is the Second Circuit’s decision in SEC v. Obus, No. 10-4749 (2nd Cir. Sept. 6, 2012). There the Court not only applied the Dirks personal benefit test but held that the tippee must know of the breach of duty and the personal benefit. Yet the Government successfully argued in the District Court that the jury need not find that the tippee knew of the personal benefit. Accordingly, this point was omitted from the jury instructions. As a result the Newman Court held that the jury instructions were erroneous because they did not follow Dirks and Obus.

    Now, however, the Government seeks shelter under Dirks. There is no doubt that the Supreme Court crafted the personal benefit test for the same reasons as the Panel in Newman returned to it. The Dirks Court sought to draw a bright line between prohibited insider trading and other disclosures of corporate information. The Newman panel recognized this point in resurrecting the a test which had become a largely perfunctory test. By restoring the personal benefit test to the bright line it was intended to be, the Court returned to the true meaning of Dirks.

    Finally, the Government’s reliance on policy points regarding the difficulty of proof under the Panel decision is more than inappropriate. It serves to highlight the convoluted morass that insider trading law has become where elements are added, subtracted, defined and redefined in the courts rather than in Congress with criminal liability, years in prison, or at a minimum, in an SEC case, order barring the person from his or her profession for life, hang in the balance – all because the Government overreached in the beginning.

    This Week In Securities Litigation (Week ending January 23, 2015)

    January 22, 2015

    The SEC named ratings giant Standard & Poor’s in three actions this week and one of its senior executives in another. The firm settled all three actions, admitting to a series of facts but not violations of the law in one action. The proceeding involving the executive will be set for hearing.

    The Commission also filed a settled FCPA action against an executive stemming from a bribery scheme in Qatar. The company entered into a deferred prosecution agreement which was based on the fact that it self-reported and cooperated.

    Finally, the agency brought a series of actions involving insider trading, acting as an unregistered broker, failing to have adequate investment adviser policies and procedures and conflicts.

    CFTC

    Remarks: Chairman Timothy G. Massad delivered remarks before the Asian Financial Forum, Hong Kong (Jan. 10, 2015). His remarks focused on growth in the markets in the region (here).

    SEC Enforcement – Filed and Settled Actions

    Statistics: During this period the SEC filed 2 civil injunctive action and 8 administrative proceedings, excluding 12j and tag-along-actions.

    Insider trading: SEC v. Huang, Civil Action No. 15-cv-269 (E.D. Pa. Filed Jan. 22, 2015) is an action against Bonan Huang and Nan Huang, both employees of a large credit card company. The two defendants conducted thousands of searches in the non-public data basis of its employer for millions of customers at numerous largely retail corporations. Through the searches they were able to view and analyze aggregated sales data for the companies they searched. That information was used to trade in advance of earnings announcements for the companies. The complaint alleges violations of Exchange Act Section 10(b). The action is pending. See Lit. Rel. No. 23179 (Jan. 22, 2015).

    Misappropriation: SEC v. MayfieldGentry Realty Advisors, LLC, Civil Action No. 13-cv-12520 (E.D. Mich.) is a previously filed action against, among others, the adviser and Marsha Bass, the COO and part owner of the adviser, and Chauncey Mayfield, the founder and president of the adviser. The complaint alleged that Mr. Mayfield took about $3.1 million from the Police and Fire Retirement System of the City of Detroit and invested it in real estate without authorization. Ms. Bass settled with the Commission and the Court entered a final judgment of permanent injunction against her based on Advisers Act Sections 206(1) and 206(2). In addition, she will pay a civil penalty of $35,000. See Lit. Rel. No. 23176 (Jan. 22, 2015).

    Unregistered broker: In the Matter of Spring Hill Capital Markets, LLC, Adm. Proc. File No. 3-16353 (Jan. 22, 2015) is a proceeding which names as Respondents Capital Markets, Spring Hill Capital Partners, LLC, Spring Hill Capital Holdings, LLC and Kevin White. Capital Holdings is a holding company that owns Capital Partners, Capital Markets and Spring Hill Management Company, LLC. Capital Markets is a registered broker dealer. Capital Partners is majority owned by Mr. White through Capital Holdings. Mr. White founded the entity defendants and is a registered representative. At the direction of Mr. White, Capital Partners entered into an agreement with an unaffiliated broker dealer under which it would trade fixed income securities. The five employees of the firm were registered representatives but the firm never registered. From May 2009 through early 2010 Partners introduced about 100 trades in asset backed securities yielding over $4 million in compensation. Under the agreement Partners retained 85% of this as compensation. In March 2010 Mr. White also had a trader withhold a trade ticket from the unaffiliated broker to conceal the fact that Spring Hill did not have a customer for the transaction. This caused the books of the broker to be inaccurate. The Order alleges violations of Exchange Act Sections 15(a), 15(c)(3) and 17(a) and the related Rules. The action will be set for hearing.

    Policies and procedures: In the Matter of Du Pasquier & Co., Inc., Adm. Proc. File No. 3-16350 (Jan. 21, 2015). The firm was a registered investment adviser and broker-dealer. The firm ceased operation as of July 31, 2014 and transferred its accounts and customers to Aegis Capital Corporation. Prior to that the firm, which at one point had about $48 million in assets under management, at various times beginning in 2007 failed to adopt policies and procedure to prevent violations of the Adviser Act, failed to conduct best execution reviews and did not adequately review the marketing materials The firm also failed to annually review the adequacy of its compliance policies and their effectiveness. The firm did not correct certain misstatements in its Form ADV or deliver Form ADV Part 2A and Part 2B to various clients. The Order alleges violations of Advisers Act Sections 204, 204A, 206(4) and 207. To resolve the matter the firm consented to the entry of a cease and desist order based on the Sections cited in the Order. It will also pay a civil penalty of $50,000.

    Misappropriation: SEC v. Wwebnet, Inc., Civil Action No. 12-cv-6581(S.D.N.Y.) is a previously filed action against the video software company and Robert Kelly. The complaint alleged that between 2005 and 2008 the defendants made a number of misrepresentations to investors which permitted Mr. Kelly to funnel at least $2.1 million of investor funds to himself. The court entered a final judgment against Mr. Kelly, enjoining him from future violations of Securities Act Section 17(a) and Exchange Act Section 10(b). He is also required to pay disgorgement of $2,111,660 and prejudgment interest which is deemed paid by the forfeiture order in the parallel criminal case in which Mr. Kelly pleaded guilty to securities and wire fraud charges. He was sentenced to serve 27 months in prison and pay restitution. See Lit. Rel. No. 23177 (Jan. 22, 3015).

    Disclosure: In the Matter of Standard & Poor’s Ratings Services, Adm. Proc. File No. 3-16348 (Jan. 21, 2015)(S&P I): In the Matter of Standard & Poor’s Ratings Services, Adm. Proc. File No. 3-16346 (Jan. 21, 2015)(S&P II); In the Matter o f Standard & Poor’s Ratings Services, Adm. Proc. File No. 3-16348 (Jan. 21, 2015)(S&P III); In the Matter of Barbara Duka, Adm. Proc. File No. 3-16349 (Jan. 21, 2015). The actions tie to the disclosures and statements made regarding the methodology for rating conduit/fusion Commercial Mortgage Backed Securities or CF CMBS – those comprised of geographically diversified pools of at least 20 mortgage loans made to unrelated borrowers. In 2010 and 2011 fees for rating CF CMBS were paid by the issuers. S&P sometimes competed for rating assignments for these transactions. Business in this segment of the market for S&P had declined since the market crisis. The firm would spend about two months analyzing the loans and properties after which final feedback was provide to the issuer concerning recommended ratings for levels of the capital structure proposed by the issuer. The feedback included summary data concerning the Debt Service Coverage Ration or DSCR, a key metric using in rating the transactions as well as others which reflected the stress placed on the loans. When the issuer announced the transaction S&P would publicly disseminate Presale reports with a preliminary recommendation and the rationale. Investors would them make their investment decision.

    In 2009 S&P published certain criteria used in evaluating these transactions. The next year that was modified and incorporated into a model used to evaluate the transactions. Subsequently, S&P published a commentary on a CF CMBS transaction which it did not rate but in which the firm discussed the methodology. In 2010 the CMBS Analytical Group of S&P decided to alter its model for analyzing these transactions. The new approach generally resulted in making the transaction more attractive. The modified approach was used in 2011 to rate six CF CMBS transactions. When investors questioned certain aspects of the ratings for some transactions, S&P’s senior management reviewed the ratings and discovered the use of blended constants. The ratings were withdrawn for two transactions. Later the other transactions were reviewed and a press release issued stating that the ratings were consistent with S&Ps rating definitions. Investors were not told about the change in methodology. S&P had internal controls designed to ensure that the ratings assigned used approved criteria. Those controls were deficient. S&P I alleges violations of Exchange Act Section 17(a)(1), which prohibits fraudulent conduct, Section 15(E)(c)(3), regarding internal controls and certain record keeping rules.

    To resolve S&P I, the firm admitted the facts in Annex A which basically outline those on which the Order is based. The firm also entered into certain undertakings which included an agreement to refrain from making preliminary or final ratings for any new issue U. S. conduit/fusion CMBS transaction for twelve moths and to adopt, implement and maintain polices and procedures and internal controls that address recommendations and issues identified in a specified letter and to submit a report on those new policies and procedures. In addition, the firm consented to the entry of a cease and desist order based on the Sections and Rules cited in the Order and to a censure. S&P will pay $6.2 million in disgorgement, prejudgment interest and a civil penalty of $35 million.

    S&P II centers on the publication in 2012 of an article describing an internal study regarding CMBS Criteria. Specifically, the article depicted what it called an average commercial mortgage loan pool losses of about 20% under Great Depression levels of economic stress. The article was based on significant assumptions that were not disclosed. The firm also failed to accurately describe certain aspects of its 2012 CMBS Criteria used to determine credit ratings on 25 CF CMBS between October 2012 and 2014. The Order alleges violations of Exchange Act Section 17(a)(1) and Rule 17g-2(a)(6) which requires NRSROs to make and retain books and records which are complete and that document the established procedures and methodologies used to determine ratings. S&P resolved the proceeding by agreeing to certain undertakings and consenting to the entry of a cease and desist order based on the Section and Rule cited in the Order. In addition, the firm agreed to pay a civil penalty of $15 million.

    S&P III is based on the failure of the firm to maintain and enforce internal controls regarding changes made to an assumption used in evaluating certain RMBS. S&P self reported this issue to the SEC and took voluntary steps to remediate the issue. The Order alleges violations of Exchange Act Section 15E(c)(3)(A) regarding internal controls and the related rules. The firm resolved the proceeding by consenting to certain undertakings which include developing measures to enhance its written polices and procedures and internal control structure. The firm also agreed to the entry of a cease and desist order based on the Section and Rules cited in the Order and to a censure. The firm will pay a penalty of $1 million.

    The Barara Duka proceeding alleges that she was responsible for the actions of the analytical group within S&P that analyzed and assigned ratings to new issues of CMBS. It alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b) and certain related rules. The proceeding will be set for hearing.

    Conflicts: In the Matter of Consulting Services Group, LLC, Adm. Proc. File No 3-16345 (Jan, 16, 2015) names as a Respondent the once registered investment adviser. The firm was controlled by Edgar Lee Giovannetti until 2011. Consulting Services terminated its registration with the SEC in 2013. The adviser’s business included providing consulting services to public pension funds and recommending third-party investment advisers to actively managed public pension accounts. The firm either failed to disclose or incorrectly characterized in its ADV Part II a $50,000 personal loan between Mr. Giovannetti, its then CEO, and an investment adviser the firm recommended to certain of its public pension and other clients. The Order alleges violations of Advisers Act Sections 206(2) and 207. To resolve the matter the firm consented to the entry of a cease and desist order based on the Sections cited in the Order. It also agreed to pay a civil penalty of $150,000.

    Investment fund fraud: SEC v. Elm, Civil Action No. 15-cv-60082 (S.D. Fla. Filed Jan. 15, 2015) is an action against Frederick Elm, Elm Tree Investment Advisors, LLC, an unregistered investment adviser, and three funds. Beginning November 2013 the defendants raised about $17 million from over 50 investors. While the funds were to be invested, in fact much of the investor money was diverted by Mr. Elm to his personal use. Investors were furnished with falsely inflated account statements. The complaint alleges violations of Securities Act Section 17(a), Exchange Act Section 10(b) and Advisers Act Sections 206(1), 206(2) and 206(4). The Court granted the Commission’s request for a TRO. The case is pending. See Lit. Rel. No. 23175 (Jan. 21, 2015).

    FCPA

    In the Matter of Walid Hatoum, Adm. Proc. File No. 3-16352 (Jan. 22, 2015). Mr. Hatoum was employed by PBS&J International, Inc., a wholly owned subsidiary of PBSJ Corporation, in February of 2009 and quickly promoted to President of the international subsidiary. The parent is an employee owned engineering and construction firm based in Florida. In 2009 the International subsidiary won two contracts for construction work, one in Qatar and the other for work in Morocco. Both were competitively solicited and approved by the Quatari Diar Real Estate Investment Company, a state owned enterprise. To secure the contracts, Mr. Hatoum offered bribes to the then Director of International Projects at Qatari Diar. That official provided Mr. Hatoum advance information that permitted the firm to win the contracts. For the first project the bribes were channeled through Local Partner, a firm in which Foreign Official had an interest. After the award an agency fee was to be paid to Local Partner where a checking account was opened that could be accessed by the wife of Foreign Official, For the second contract a so-called agency fee was imbedded in the agreement. The scheme unraveled when the general counsel of the company launched an internal investigation. The company self-reported. Prior to that time the Order states that had the firm conducted appropriate due diligence about Local Partner and followed up on red flags it would have been discovered the violations earlier. The contracts were terminated, although the firm made a substantial profit on a bridge agreement for work it did on one until project until a replacement could be securied. The Order alleges violations of Exchange Act Section 30A, 13(b)(2)(A), 13(b)(2)(B) and 13(b)5. Mr. Hatoum resolved the action, consenting to the entry of a cease and desist order based on the Sections cited in the Order. He also agreed to pay a civil penalty of $50,000.

    The company entered into a two year deferred prosecution agreement. Under the terms of the agreement the company will implement a series of undertakings which include enhanced FCPA procedures. The firm will also pay disgorgement of $2,892, 504, prejudgment interest and pay a civil penalty of $375,000.

    Criminal cases

    Insider trading: U.S. v. Lucarelli (S.D.N.Y.) is a previously filed action in which Michael Lucarelli, formerly an executive with investor relations firm Lippert/Heilshorn & Associates, used client information to insider trade. This week Mr. Lucarelli was sentenced to serve 30 months in prison and directed to forfeit $955,521.62, the amount of his trading profits.

    Hong Kong

    Improper payments: The Securities and Futures Commission announced that following a trial three directors of First China Financial Network Holding Ltd. were ordered to repay RMB 18,692,000 to the company. The directors were Wang Wenming, Lee Yiu Sun and Richard Yin Wingneng. While the payment was supposedly made in connection with an acquisition, the SFC established at trial that there was no such obligation. The court also concluded that an indemnification resolution for the officers by the company for their legal expenses in defending this action was inappropriate. The court will consider if additional remedies are appropriate.

    MOU: The SFC and the European Securities and Markets Authority entered into an MOU on cooperation arrangements in connection with the Hong Kong established central counterparties which have applied for recognition by ESMA. This fulfills a precondition under European Market Infrastructure Regulation for ESMA to recognize these CCPs as eligible to provide services to clearing members or trading venues in the European Union.

    UK

    Investment fund fraud: A Serious Frauds Office investigation resulted in the conviction after a jury trial of Uif Magnus Michael Peterson who was the founding director of Weavering Capital (UK). Over a six year period investors put about $780 million into the fund which was supposed to be low risk and liquid. In fact Mr. Peterson inflated the value of the fund using a series of interest rate swaps with an off-shore fund he controlled while paying himself well. When the market crisis hit and investors requested their money the fund collapsed.

    Standard & Poor’s Resolves Three SEC Actions, Makes Admissions

    January 21, 2015

    Standard & Poor’s Ratings Services was named as a Respondent in three settled administrative proceedings by the SEC. Each is tied to the Rating Services’ role in the conduit/fusion Commercial Mortgage Backed Securities market after the market crisis. In resolving one action S&P admitted certain facts attached as Annex. The firm did not admit to violating the federal securities laws. In the Matter of Standard & Poor’s Ratings Services, Adm. Proc. File No. 3-16348 (Jan. 21, 2015)(S&P I). S&P did not make any admissions in resolving two related proceedings. In the Matter of Standard & Poor’s Ratings Services, Adm. Proc. File No. 3-16346 (Jan. 21, 2015)(S&P II); In the Matter of Standard & Poor’s Ratings Services, Adm. Proc. File No. 3-16348 (Jan. 21, 2015)(S&P III). A fourth proceeding named as a Respondent Barbara Duka, a managing director of S&P, responsible for new issue ratings of Commercial Mortgage Backed Securities or CMBS. In the Matter of Barbara Duka, Adm. Proc. File No. 3-16349 (Jan. 21, 2015). This proceeding was not settled.

    The actions tie to the disclosures and statements made regarding the methodology for rating conduit/fusion Commercial Mortgage Backed Securities or CF CMBS – those comprised of geographically diversified pools of at least 20 mortgage loans made to unrelated borrowers. In 2010 and 2011 fees for rating CF CMBS were paid by the issuers. S&P sometimes competed for rating assignments for these transactions. The firm would spend about two months analyzing the loans and properties after which final feedback was provide to the issuer concerning recommended ratings for levels of the capital structure proposed by the issuer. The feedback included summary data concerning the Debt Service Coverage Ration or DSCR, a key metric using in rating the transactions as well as others which reflected the stress placed on the loans.

    When the issuer announced the transaction S&P would publicly disseminate Presale reports with a preliminary recommendation and the rationale. Investors would them make their investment decision.

    In 2009 S&P published what was called the Criteria Article. It told market participants how key calculations were made by the firm. The Criteria Article in part contained loan constants for an “archetypical Pool” of loans called Table 1. S&P concluded that it would use Table 1 loan constants to calculate DSCR.

    The next year the firm decided to use the “higher of” the actual constants or Table 1 to determine debt service payments. This methodology was incorporated into the model that was used to analyze CF CMBS transactions. Subsequently, S&P published a commentary on a CF CMBS transaction which it did not rate but in which the firm stated that it used the Table 1 loan constants to calculate DSCRs in the analysis of CF CMBS transactions. Several months later the S&P published a Presale for a CF CMBS transaction in which it stated the higher of the actual loan constants or Table 1 loan constants were used to calculate DSCRs.

    In 2010, after its CF CMBS business declined, the CMBS Analytical Group of S&P decided to change the assumption embodied in its model for analyzing these transactions. Under the new method the “higher of” approach was dropped in favor of using an average of the “higher of” the actual loan constant or Table 1 and the actual loan constant. This approach generally resulted in making the transaction more attractive.

    The modified approach was used in 2011 to rate six CF CMBS transactions. When investors questioned certain aspects of the ratings for some transactions, S&P’s senior management reviewed the ratings and discovered the use of blended constants. The ratings were withdrawn for two transactions. Later the other transactions were reviewed and a press release issued stating that the ratings were consistent with S&Ps rating definitions. Investors were not told about the change in methodology.

    S&P had internal controls designed to ensure that the ratings assigned used approved criteria. Those controls were deficient. S&P I alleges violations of Exchange Act Section 17(a)(1), which prohibits fraudulent conduct, Section 15(E)(c)(3), regarding internal controls and certain record keeping rules.

    To resolve S&P I, the firm admitted the facts in Annex A which basically outline those on which the Order is based. The firm also entered into certain undertakings which included an agreement to refrain from making preliminary or final ratings for any new issue U. S. conduit/fusion CMBS transaction for twelve moths and to adopt, implement and maintain polices and procedures and internal controls that address recommendations and issues identified in a specified letter and to submit a report on those new policies and procedures. In addition, the firm consented to the entry of a cease and desist order based on the Sections and Rules cited in the Order and to a censure. S&P will pay $6.2 million in disgorgement, prejudgment interest and a civil penalty of $35 million.

    S&P II centers on the publication in 2012 of an article describing an internal study regarding CMBS Criteria. Specifically, the article depicted what it called an average commercial mortgage loan pool losses of about 20% under Great Depression levels of economic stress. The article was based on significant assumptions that were not disclosed. The firm also failed to accurately describe certain aspects of its 2012 CMBS Criteria used to determine credit ratings on 25 CF CMBS between October 2012 and 2014. The Order alleges violations of Exchange Act Section 17(a)(1) and Rule 17g-2(a)(6) which requires NRSROs to make and retain books and records which are complete and that document the established procedures and methodologies used to determine ratings. S&P resolved the proceeding by agreeing to certain undertakings and consenting to the entry of a cease and desist order based on the Section and Rule cited in the Order. In addition, the firm agreed to pay a civil penalty of $15 million.

    S&P III is based on the failure of the firm to maintain and enforce internal controls regarding changes made to an assumption used in evaluating certain RMBS. S&P self reported this issue to the SEC and took voluntary steps to remediate the issue. The Order alleges violations of Exchange Act Section 15E(c)(3)(A) regarding internal controls and the related rules. The firm resolved the proceeding by consenting to certain undertakings which include developing measures to enhance its written polices and procedures and internal control structure. The firm also agreed to the entry of a cease and desist order based on the Section and Rules cited in the Order and to a censure. The firm will pay a penalty of $1 million.

    The Barara Duka proceeding alleges that she was responsible for the actions of the analytical group within S&P that analyzed and assigned ratings to new issues of CMBS. It alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b) and certain related rules. The proceeding will be set for hearing.

    Personal Benefit Test Does Not Apply To Misappropriation Theory of Insider Trading — USAO

    January 20, 2015

    In U.S. v. Newman, Nos. 13-1837-cr, 13-1917, 2014 WL 6911278 (2nd Cir. Decided Dec. 10, 2014) the Second Circuit handed prosecutors perhaps the only defeat they have suffered in recent years in an insider trading cases. After noting that not a single criminal prosecution of tippees as remote as third and fourth tier tippees Todd Newman and Anthony Chiassons could be found, the Court reversed and dismissed their convictions. The predicate was the long established, but all but disappeared, personal benefit test of Dirks v. S.E.C., 463 U.S. 636 (1983).

    Following Dirks, and distinguishing earlier Second Circuit cases which might appear to the contrary, the Court held that the elements of tippee liability are: “(1) the corporate insider was entrusted with a fiduciary duty; (2) the corporate insider breached his duty by (a) disclosing confidential information to a tippee (b) in exchange for a personal benefit; (3) the tippee knew of the tipper’s breach, that is, he knew the information was confidential and divulged for personal benefit; and (4) the tippee still used that information to trade . . .” That personal benefit, while broadly defined, must be more than “the mere fact of a friendship, particularly of a casual or social nature.” Rather, it is defined to include pecuniary gain and also reputational benefit that will translate into future earnings. This will require “evidence of a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the latter.”

    There is no doubt that Newman may have a significant impact not just on criminal insider trading actions but also those of the SEC. The Manhattan U.S. Attorney’s Office, unaccustomed to losing insider trading cases, now claims, however, that Newman is limited to actions based on the classic theory of insider trading cases. Under this approach insider trading cases based on the misappropriation theory adopted in U.S. v. O’Hagan, 521 U.S. 642 (1997) would not be impacted by Newman.

    The Government’s theory is being advanced in actions centered on the acquisition by IBM of SPSS, Inc., announced in July 2009. The Government’s Memorandum of Law In Support of The Sufficiency of the Defendants’ Guilty Pleas, dated Jan. 12, 2015, filed in U.S. v. Durant, Case No. 1:12-cr-00887 (S.D.N.Y.). Prior to that announcement Daryl Payton, Benjamin Durant, David Weishaus and Thomas Conradt were all stockbrokers employed in the Manhattan office of a Connecticut based securities trading firm. The information they obtained about the deal and used to trade traced to an attorney working on the acquisition. Collectively the defendants made over $1 million from trading in advance of the deal. Four of the five defendants pleaded guilty while one is awaiting trial. In pleading guilty each admitted to trading in SPSS securities based on inside information, stated that he understood the information traced to a breach of duty and that his actions were done knowingly and were wrong or illegal.

    On a motion to vacate the guilty pleas based on Newman, the Government now argues that the Second Circuit’s decision is not applicable to misappropriation cases. This contention is based on what the Government claims is a distinction in the type of duty on which the classic and misappropriation theories of insider trading are based.

    The classic theory of insider trading is based on “a relationship of trust and confidence between an insider and shareholders that gives rise to a duty to disclose or to abstain because of the necessity of preventing a corporate insider from taking unfair advantage of uninformed shareholders.” (internal quotations and citations omitted). Accordingly, Dirks requires that in order for an insider to have improperly disclosed the information he must do so based on a breach of that duty and for personal benefit. Under this approach the question of whether the insider obtained a benefit is part of the duty analysis, not because a benefit in and of itself is required. Rather, the benefit “evidences the improper motive necessary to give rise to liability for insider trading . . .” under the classic theory, according to the Government.

    This contrasts with the duty on which the misappropriation theory is based. O’Hagan, which crafted the misappropriation theory, drew the duty from the Restatement (Second) of Agency. Under agency principles a “fiduciary breaches the duty not to misappropriate a principal’s confidential information whenever the fiduciary disclosed that information in competition with or to the injury of the principal.” (internal quotations omitted). This is because the fiduciary “has a duty not to use the information acquired for any purpose likely to cause the principal harm or to interfere with his or her business. This duty is distinct from that on which the classic theory is based since it is grounded in the protection of property rights in information and potential harm to the principal rather than self-dealing. Accordingly, the duty on which the misappropriation theory is based does not require proof of a personal benefit. This is consistent with decisions such as U.S. v Libera, 989 F. 2d 596 (2nd Cir. 1993) which held that the misappropriation theory protects property rights and SEC v. Materia, 745 F. 2d 197 (2nd Cir. 1984) which is similar, the Government argues.

    The difficulty with this theory is not just Newman but also the Second Circuit’s decision in S.E.C. v. Obus, 693 F. 3d 276 (2nd Cir. 2012). The former specifically states that “the elements of tipping liability are the same, regardless of whether the tipper’s duty arises under the classic or the misappropriation theory.” Newman, 2014 WL 6911278, *4. Obus, which unlike Newman was based on the misappropriation theory, held that the elements of tippee liability include the personal benefit test, citing Obus. The statement in Newman is not controlling, according to the Government because “[i]t would be incorrect to read more into this one sentence than it can logically bear . . . it is also surely dicta . . .

    Obus lists a personal benefit as part of the elements of tippee liability. The Government, however, drew a distinction as to remote tippees: “Obus also makes plain that a downstream tippee need not know of any benefit to the tipper in order to have knowledge of the tippe’s breach . . . tippee liability is established if a tippee ‘knew . . that confidential information was initially obtained and transmitted improperly (and thus through deception), and if the tippee intentionally . . . traded while in knowing possession of that information.” The distinct duties on which the classic and misappropriation theories are based dictates a difference in tippee liability, according to the Government. The motions to vacate are pending.

    Tipper in Serial Insider Trading Ring Indicted

    January 19, 2015

    Criminal insider trading charges were filed against the former managing clerk of Simpson Thacher & Bartlett, Steven Metro. U.S. v. Metro (D. N.J. Jan. 15, 2015). Mr. Metro was indicted by a grand jury on one count of conspiracy to commit securities fraud, one count of securities fraud and one count of tender offer fraud.

    The charges against Mr. Metro trace to 2009 when he began using his position to acquire information on pending deals regarding Simpson clients. As a managing clerk Mr. Metro did not typically work on deals. Rather, he researched the firm data base for information on pending acquisitions and tender- offers.

    Mr. Metro furnished the information to his friend and former law school classmate Frank Tamayo. Typically he furnished Mr. Tamayo the information at a personal meeting held in a bar or coffee shop near their respective places of employment in mid-town Manhattan. During the meeting Mr. Tamayo would be furnished information about the deal and the name or ticker symbol of the company whose securities should be purchased. Mr. Tamayo typically recorded the name on a small piece of paper.

    The actual trades were placed by Vladimir Eydelman, a stock broker in Colts Neck, New Jersey. He would meet with Mr. Tamayo to acquire the information. Typically the meeting would be held near the large clock in New York City’s Grand Central Terminal. Mr. Tamayo would show the broker the slip of paper with the name of the company or ticker system for the securities to be purchased. The slip of paper would then be destroyed. According to the charging papers, Mr. Eydelman knew the source of the information. The broker would place trades for himself, family members, friends, clients and Mr. Tamayo. The shares would usually be sold shortly after the deal announcement.

    Over the course of the scheme, information on thirteen deals was obtained by the clerk and eventually transmitted to Mr. Eydelman. About $5.6 million was made in trading profits. The broker continually reinvested about $7, 000 from the initial deal for Mr. Metro which he held. That sum grew to about $168,000. Messrs. Eydelman and Metro were previously named in complaints filed by the U.S. Attorney’s Office for New Jersey and the SEC. U.S. v. Eydelman (D.N.J. Filed March 19, 2014); SEC v. Eydelman, Civil Action No. 3-14-cv-01742 (D.N.J. Filed March 19, 2014). See Lit. Rel. No. 22948 (March 19, 2014). Mr. Tamayo was not named in those papers. The middleman was then identified as a confidential witness. The actions are pending.

    In Remembrance…

    January 18, 2015

    in remembrance of martin luther king jr

    This Week In Securities Litigation (The week ending January 16, 2015)

    January 15, 2015

    The Commission brought cases related to HFT this week, but not against those traders. One action involved the operations of one of the largest dark pools. A second involved two exchanges. Each action involved specific types of orders which gave advantages to select groups of traders who were familiar with the trading systems and specifications of but not all market participants. The SEC also brought actions centered on market manipulation, conflicts and the misappropriation of assets.

    SEC

    Remarks: Commissioner Daniel M. Gallagher addressed the Women in Housing & Finance Public Policy Luncheon, delivering remarks titled Can the U.S. Be an International Financial Center? Washington, D.C. (Jan. 13, 2014). His remarks focused on the impact of regulation on the position of the U.S. capital markets in the world (here)

    Rules: The Commission adopted rules to increase the transparency in the security-based swap market (here).

    Exam program: The SEC announced the 2015 examination priorities (here).

    Market committee: The Commission announced the members of its New Equity Market Structure Advisory Committee (here).

    SEC Enforcement – Filed and Settled Actions

    Statistics: During this period the SEC filed 2 civil injunctive action and 7 administrative proceedings, excluding 12j and tag-along-actions.

    Dark pools/disclosure: In the Matter of UBS Securities LLC, Adm. Proc. File No. 3-16338 (Jan. 15, 2015) is a proceeding focused on the operation of UBS owned UBS ATS, an alternative trading system known as a dark pool. Between 2008 and 2011 the ATS executed hundreds of millions of sub-penny orders in violation of Reg. NMS, Rule 612. Many of the orders were the product of two order types which permitted the subscriber to gain priority in execution. This was not disclosed by the ATS. The pool, which is one of the largest, also did not disclose the fact that subscribers could prevent their order flow from executing in the venue against certain orders, largely those of market makers and high frequency traders. The feature was available only for those who used the UBS trading algorithms. There was no internal policy requiring the disclosure of the feature or the new order types to all subscribers. The Order alleges violations of Securities Act Section 17(a)(2), Exchange Act Section 17(a) and a series of rules along with Regulation ATS and Rule 612 of Regulation NMS. UBS resolve the proceeding, consenting to the entry of an order based on the Sections and Rules cited and to a censure. The firm also agreed to pay disgorgement of $2,240,702.50, prejudgment interest and a penalty of $12 million.

    Microcap fraud: In the Matter of John Briner, Esq., Adm. Proc. File No. 3-16339 (Jan. 15, 2015) is a proceeding naming as Respondents Mr. Briner and Diane Balmy, both attorneys; two audit firms, De Joya Griffith, LLC and M&K CPAs, PLLC, and seven CPAs affiliated with the firms – Arthur De Joya, Jason Griffith, Chris Whetman, Philip Zhang, Matt Manis, Jon Ridenour and Ben Ortego. The action is an out-growth of stop order proceeding brought last year by the Commission relating to twenty sham offerings for mining companies. The scheme was orchestrated by barred attorney, John Briner, who recruited figureheads Stuart Carnie, Charles Irizarry, and Wayne Middleton to pose as the heads of the entities. Messrs. Carnie, Irizarry and Middleton settled in separate proceedings as noted below. Each of the offerings was alleged to be a sham. The audit firms and their auditors claimed to have audited the financial statements of the firms when in fact they did not. The Order alleges violations of Securities Act Section 17(a) by the attorneys and unprofessional conduct by the audit firms and auditors. The proceeding will be set for hearing. See also In the Matter of Wayne Middleton, Adm. Proc. File No. 3-16342 (Jan. 15, 2015); In the Matter of Charles Irizarry, Adm. Proc. File No. 3-16341 (Jan. 15, 2015); and In the Matter of Stuart Cranie, Adm. Proc. File No. 3-16340 (Jan. 15, 2015). These actions center on claims that the named Respondent served as a figurehead for the corporations at the behest of Mr. Briner. Each alleged violations of Securities Act Section 17(a). In each the Respondent settled, consenting to the entry of a cease and desist order and agreed to pay disgorgement, prejudgment interest and a penalty. Each Respondent also agreed to the entry of an order barring him from serving as an officer or director and from participating in any penny stock offering. Mr. Middleton will pay disgorgement of $4,000, prejudgment interest and a penalty of $8,000; Mr. Irizarry will pay disgorgement of $6,000, prejudgment interest and a penalty of $12,000; and Mr. Carnie will pay disgorgement of $6,000, prejudgment interest and a penalty of $12,000.

    Manipulation: SEC v. Milrud, Civil Action No. 2:15-cv-00237 (D. N.J. Filed Jan. 13, 2015) and U.S. v. Milrud, Mag. No. 15-7001 (D.N.J. Jan. 13, 2015) are actions for market manipulation against Aleksandr Milrud, a Canadian citizen resident in Ontario and Florida. The scheme began in 2013 when Mr. Milrud recruited groups of online traders based primarily in China and Korea. He used these traders to engage in a spoofing scheme. The scheme centered on placing trades in a “dirty” account which were canceled when the price started to move as a result of increased interest in the stock from the orders. The price movement was then captured by placing trades on the other side through a separate “clean” account. The scheme came to light when Mr. Milrud demonstrated it to a broker he was recruiting. A broker is now a confidential witness. The SEC’s complaint alleges violations of: Securities Act Section 17(a) and (c); Exchange Act Section 10(b) and Rule 10b-5(a) and (c); Exchange Act Section 9(a)(2); and control person liability under Exchange Act Section 20(b) along with joint and several liability under Section 20(a). The cases are pending.

    Order types: In the Matter of Edga Exchange, Inc., Adm. Proc. File No. 3-16332 (Jan. 12, 2015). Respondents Edga Exchange, Inc. and Edgx Exchange, Inc. are currently registered with the Commission as national securities exchanges under Section 6(a) of the Exchange Act. The exchanges were acquired by BATS Global Markets in 2013 as part of the acquisition of Direct Edge. Prior to their 2009 application to become exchanges, Edga and Edgx were ECNs. ECNs and exchanges offer different categories of order types, including those which are displayed and not displayed or hidden. The access rule, Rule 610 of Regulation NMS, requires that exchanges establish rules requiring members to avoid displaying quotations that lock or cross any protected quotation in a NMS stock. A crossed market exists when a protected bid price exceeds the protected offer price. A locked market exists when a protected bid price is identical to a protected offer price. Under the access rule the Direct Edge ECNs developed an order handling procedure known as price sliding for non-routable orders – those that had to be executed in that venue – that would otherwise lock or cross a protected quotation, a National Best Bid or Offer. After the rules were developed the exchanges crafted alternatives to the price sliding functionality. When certain high speed traders requested a modification, the exchanges created it. Additional changes were made. The modifications were disclosed to all traders. They also were not reflected in rules approved by the Commission. The Order alleges violations of Exchange Act Sections 19(b) and (g). To resolve the action each Respondent consented to the entry of a cease and desist order based on the Sections cited in the Order, to the entry of a censure and to jointly and severally pay a $14 million penalty.

    Misappropriation: SEC v. Thibeault, Civil Action No 1:15-cv-10050 (D. Mass. Filed Jan. 9, 2015). The action names as defendants: Daniel Thibeault, President, primary owner and CEO of defendant Graduate Leverage, LLC; Graduate Leverage, founded by Mr. Thibeault in 2003, operates multiple investment and financial businesses; GL Capital Partners LLC is a registered investment adviser primarily owned by Graduate Leverage; GL Investment Services, LLC is a registered investment adviser whose sole member is Graduate Leverage; and Taft Financial Services, LLC which is “nominally” run by Eric Kratzer but on “information and belief” is controlled by Mr. Thibeault. The GL Beyond Income Fund was created by Mr. Thibeault in 2012. He served as the portfolio manager or co-manager. It is a closed end management company which purchases consumer loans. The Fund’s daily valuation report for December 8, 2014 lists about $35.65 million in consumer loans. It also claims to hold about $385,000 in U.S. equities and $6.55 million in promissory notes issued from the Fund to an entity named LAOH Capital LLC. The fund listed its total assets as of December 8, 2014 as $423.585 million. In early 2013, Mr. Thibeault initiated a scheme to use the Fund’s money to support his faltering financial advisory business. Fictitious loans were created with the proceedings being transferred to Taft Financial which then forwarded the funds to Graduate Leverage. An inspection by the Commission staff determined that a significant number of promissory notes were missing and there were flaws in others. Following the inspection the FBI executed a search warrant at the offices of the defendants. The complaint alleges violations of Exchange Act Section 10(b), Securities Act Section 17(a) and Advisers Act Sections 206(1) and (2). Requests for freeze orders and other relief are pending. See Lit. Rel. No. 23171 (Jan. 9, 2015).

    Conflicts: In the Matter of Shelton Financial Group, Inc., Adm. Proc. File No. 3-16334 (Jan. 13, 2015) names as Respondents the registered investment adviser and its founder, Jeffrey Shelton. The Order alleges that the firm had an arrangement with a broker under which it was paid for all client assets that were invested in certain mutual funds. The broker, in return, obtained certain custodial support services. Initially the arrangement was not disclosed. Later it was partially disclosed. While eventually the conflicts were disclosed the initial failure violated Advisers Act Sections 206(2) and 207 as well as 206(4), according to the Order. To resolve the matter the defendants consented to the entry of a cease and desist order based on the Sections cited in the Order and to a censure. In addition, the Respondents will, on a joint and several basis, pay disgorgement of $99,114,19, prejudgment interest and a penalty of $70,000.

    Criminal cases

    Investment fund fraud: U.S. v Duffy, Case No. 1:09-cr-00709 (S.D.N.Y.) is an action in which the former chief compliance officer of WG Trading Company, LP, Deborah Duffy was sentenced to time served in prison for conspiracy, securities fraud and money laundering. Ms. Duffy maintained the books and records for WG Trading, a fraudulent commodities trading and investment advisory scheme conducted by Stephen Walsh and Paul Greenwood from 1996 through early 2009. The scheme raised billions of dollars, much of which was misappropriated. Ms. Duffy previously pleaded guilty. She cooperated with the government which is reflected in her sentence.

    FINRA

    Fraud/suitability: A hearing panel expelled John Carris Investments, LLC and barred CEO George Carris from the securities industry for recklessly selling shares of stock and promissory notes issued by the firm’s parent based on misleading and incomplete statements. Andrey Tkatchenko, a registered representative, was suspended for two years and fined $10,000 for recommending the stock and notes without a reasonable basis. The firm and Mr. Carris were also expelled and barred for manipulating the share price of Fibrocell stock. Head trader Jason Barter was suspended for 18 months and fined $5,000 in connection with those transactions. The panel also found a series of other violations including operating without sufficient capital, inaccurate books and records, failing to remit payroll taxes, failing to implement the AML system and not enforcing supervisory systems.

    Fair trade: A FINRA hearing panel determined that John Thomas Financial and its chairman, Tommy Belesis, violated principles of fair trade in connection with the sale of a block of American West Resources, Inc. stock. Specifically, while the firm sold a block of stock as the price spiked, customers were unable to sell their shares. The panel also found that Mr. Belesis and CCO Joseph Casstellano intimidated registered representatives. Mr. Belesis, in addition, lied to the regulator. Fraud and other charges were dismissed. Mr. Belesis and the firm were suspended for two years and jointly and severally fined $100,000. Mr. Castellano was suspended for one year and fined $50,000. The panel also found that the firm failed to keep required records and rejected as not credible testimony by Mr. Belesis that he was unfamiliar with the record keeping requirements.

    Hong Kong

    Concealed losses: The Securities and Futures Commission barred Jagjit Singh Dhillon, formerly of Credit Suisse Securities (Hong Kong), for life for concealing certain trading loses in two trading books for which he was responsible The losses, suffered in May 2012, caused the firm to have to make negative adjustments of U.S. $4 million to the cumulative monthly profit and loss figures for its trading book and recalculate the risk exposure recorded in its risk management systems.

    SEC and FINRA Exam Priorities

    January 14, 2015

    The SEC and FINRA announced the priorities for their examination programs from 2015 this week. The SEC priorities build in several respects on those from the prior year. They are divided into four areas which, to some extent, overlap: 1) retail investors; 2) market wide risks; 3) data analytics; and 4) other areas.

    Retail investors: In view of recent trends in the industry, including the fact registrants are developing and offering to retail investors a variety of new products and service and the fact that investors are increasingly dependent on their investments for retirement, the program will focus on four key areas that tend to center on retirement accounts:

    • Fee arrangements: In view of trends among financial professionals to service retail investors as investment advisers, the program will focus on recommendations regarding account types and if they are in the best interest of clients, including the fees charged and the risks.
    • Sales practices: This area will focus on the sales approach used regarding the movement of retirement assets from employer plans to individual accounts, including the fees charged and the risks.
    • Suitability: The staff will focus on recommendations and determinations to invest retirement assets into complex or structured products and higher yield securities including due diligence conducted, disclosures made and the suitability of recommendations.
    • Branch offices: In this area the staff will focus on supervision issues and use its analytics (see below) to assess deviations from compliance practices.

    Market-wide risks: In this area the program will focus on structural risks and trends that can impact multiple firms or an entire industry. Areas of focus include:

    • Large firms: In conjunction with Trading and Markets the program will focus on the largest broker-dealers and asset managers to assess risk at individual firms and across industries.
    • Clearing agencies: All agencies assessed as systemically important will be examined using a risk based approach.
    • Cybersecurity: Building on an initiative started last year, the program will focus on compliance and controls.
    • Execution: The program will focus on potential conflicts involving payments or credits for order-flow and the duty of best execution.

    Data analytics: Enhanced analytics will be used to assess the potential to engage in fraudulent and/or other potentially illegal activity including:

    • Recidivists: This involves the identifications of those with a record of misconduct.
    • Microcap fraud: The focus here is to identify brokers and transfer agents that may be involved with microcap fraud such as market manipulations. Enforcement also has a microcap fraud task force which focuses on these areas.
    • Excessive trading: The focus here is on clearing and introducing brokers to identify excessive trading. This complements the retail issues listed above.
    • AML: This will focus on clearing and introducing brokers that have not filed SARs or have filed reports which are incomplete and brokers who permit deposits of cash or direct access to the markets.

    Other areas: Other priorities for the Division include municipal advisers, proxy services, never before examined investment companies, fees and expenses in private equity and transfer agents.

    FINRA: The regulator plans to focus on the sale and supervision of interest rate sensitive and complex products, transactions centered on wealth events for investors and cybersecurity, including platforms that interact with the markets. In addition, FINRA identified five broad areas of focus:

    • The alignment of firm and customer interests;
    • Standards of ethical behavior;
    • The development of strong management and supervisory systems;
    • The development and marketing of novel products and services; and
    • The management of conflicts of interest.

    SEC-USAO File Actions On “Old Fashioned” Spoofing Scheme

    January 13, 2015

    Spoofing or layering is typically associated these days with computers and high speed trading. It is a form of market manipulation in which the trader places a series of fictitious orders on one side of the market to draw interest from would-be investors who believe they are real, legitimate orders. As the price moves the manipulator cancels the orders while capturing the price movement by entering orders on the other side.

    Aleksandr Milrud is charged with doing it the old fashioned way. Eschewing high speed trades and crafted computer programs, Mr. Milrud supposedly engaged in spoofing by having people not programs and machines enter the trades. Using his own compliance system to avoid detection, the scheme yielded over $1 million per month. His mistake? He demonstrated the scheme to a broker who is now a cooperating witness for the government – caught the low tech, old fashioned way. SEC v. Milrud, Civil Action No. 2:15-cv-00237 (D. N.J. Filed Jan. 13, 2015); U.S. v. Milrud, Mag. No. 15-7001 (D.N.J. Jan. 13, 2015). Both cases are pending.

    Mr. Milrud, a Canadian citizen resident in Ontario and Florida, began his scheme in 2013. He recruited groups of online traders based primarily in China and Korea. The traders were given access to trading accounts and technology. Each trader had a “dirty work” account and one for “clean” trades. The accounts were held at different clearing firms to mask the coordination between them.

    In the dirty work account each trader placed multiple non-bona fide “buy” or “sell” orders to create the upward or downward pressure on the price of the security. As market participants were drawn in by the orders, the price would start to move in the planned direction. Once the price moved as planned the trader would reverse course, cancel the trades in the dirty account and placing trades through the clean account in the opposite direction. Those trades captured the price movement generated by the dirty account trades. To facilitate the transactions Mr. Milrud had a game maker create a special key for the computers for the transactions.

    To minimize the possibility of detection, Mr. Milrud instructed traders to use small quantities of relatively high-volume securities, to manipulate a wide variety of stocks and to only move the price a few cents. He also plugged into the system and monitored the trading in both the dirty and clean accounts.

    Mr. Milrud met with an off-shore broker that had an office in New Jersey as part of the scheme. He illustrated his approach by showing the broker how the trading was conducted. A series of detailed schedules listing the trades is attached to the SEC’s complaint. Not mentioned in the SEC’s complaint, but in the papers for the criminal case, is the fact that a former broker is now a cooperating witness for the government.

    The SEC’s complaint alleges violations of: Securities Act Section 17(a) and (c); Exchange Act Section 10(b) and Rule 10b-5(a) and (c); Exchange Act Section 9(a)(2); and control person liability under Exchange Act Section 20(b) along with joint and several liability under Section 20(a).