One of the key focuses of the Commission’s enforcement program has been retail investors and offering frauds. Frequently it is those investors who rush to purchase shares in the latest fad area only to find out that the investment is not really an investment but a fraud. In many instances those cases have involved coin offerings laced with buzz words such as blockchain. In one recent case the Commission was able to assist with the recovery of at least part of the lost funds. SEC v. Eyal, Civil Action No. 1:19-cv-11325 (S.D.N.Y. Filed Dec. 11, 2019).

Named as defendants were Eran Eyal, a dual citizen of South Africa and Israel residing in Brooklyn, and his firm, Uniteddata, Inc, d/b/a “Shopin.” Over a period of about eight months, beginning in August 2017, Defendants raised about $42.5 million in digital assets. Shopin supposedly planned to create a universal shopper profile that would track customer shopping histories at online retailers that would recommend purchases. The offering, conducted in typical two stage ICO fashion using a pre-sale and a sale, was based on a series of misrepresentations. Those included claims that two successful tests of Shopin’s approach had been conducted, a claim that the firm had on-going partnerships with well-known retailers, a representation that a prominent Silicon Valley blockchain entrepreneur advised the firm and a suggestion that a successful online company had invested in the firm. Shopin never created a functional platform. The proceeds from the offering were diverted to the personal use of Mr. Eyal. The complaint alleged violations of Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Section 10(b).

The Commission settled with Eran Eyal. He consented to the entry of a permanent injunction based on the Sections cited in the complaint. The settlement, entered by the District Court, also contained an offer and a director bar and a conduct-based injunction tied to digital assets. In addition, the Court’s order requires him to pay disgorgement of $422,100 in ill-gotten gains and $34,940 in prejudgment interest. Those amounts are deemed satisfied by the payment of 3,105.78 Ether tokens pursuant to Mr. Eyal’s prior plea agreement in a parallel New York state criminal action. The claim as to Shopin was dismissed. See Lit. Rel. No. 24842 (June 23, 2020).

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A Risk Alert was published by the the Office of Inspections and Examinations or OCIE, alerting Investment Advisers of managed private funds to key issues that have arisen in prior examinations. The Alert highlights a series of deficiencies, some of which have resulted in enforcement actions. Risk Alert, Office of Inspections and Examinations (June 23, 2020)(here).

The list of deficiencies identified in the Alert is divided into three sections: 1) Conflicts of interest; 2) Fees and expenses; and 3) MNPI/Code of Ethics.

Conflicts: The largest section of the Alert deals with conflicts of interest. The failure to properly disclose conflicts of interest is a violation of Section 206 of the Advisers Act as well as the pertinent Rules such as 206(4)-8. The conflicts identified include:

Allocations of investments: Certain private fund advisers did not provide adequate disclosure regarding allocations of investments among clients, including flagship funds and others that invested alongside the largest funds. Similarly, limited investment opportunities were preferentially allocated in certain instances; in others, advisers made allocations at different prices or in apparently inequitable amounts among clients.

Multiple clients/same portfolio company: In these situations, advisers caused clients to invest at different levels of a capital structure such as one client owning debt while another owned equity in a single portfolio company without adequate disclosure.

Financial relationships between investors or clients and the adviser: In select instances there was inadequate disclosure of the economic relationships involving the adviser and clients. Some clients could be, for example, seed investors while others may have provided credit facilities or similar arrangements with the adviser.

Preferential liquidity rights: In some instances, advisers entered into side letters with select investors that were given preferential treatment. In other instances, certain funds had preferential rights that were operated, for example, alongside the flagship fund without adequate disclosure.

Adviser interests: Advisers at times had interests in investments recommended to clients where there was inadequate disclosure of that fact.

Co-investments: There was inadequate disclosure of conflicts related to investments made by co-investment vehicles and other co-investors.

Service providers: There was inadequate disclosure regarding service providers and, in some instances, related incentives. For example, there was inadequate disclosure regarding arrangements among portfolio provides, private fund clients and service agreements with entities controlled by the adviser and/or its affiliates or others tied to the adviser. In some instances, private fund advisers did not have procedures to ensure that they properly implemented disclosure requirements.

Restructuring: When funds are restructured advisers did not adequately disclose the transaction and the opportunities available to all of the investors. For example, if a fund is sold there may be opportunities for the investors that are not properly disclosed to all or that are only available to certain investors in the absence of adequate disclosure of that fact.

Cross-transactions. When these types of transactions arise, advisers failed in certain instances, to adequately disclose them to all investors.

Fees and expenses: The exams revealed issues regarding the inadequate disclosure of fees and expenses.

Allocation: In a number of instances advisers incorrectly and/or inadequately allocated various fees and expenses. In some instances, the charges were not permitted and/or contrary to the agreements.

Operating partners: Some advisers failed to make full disclosure regarding those who were not employees but provided services to the private fund or portfolio companies and the related charges.

Valuation: Valuation can be a key issue. In some instances, advisers did not follow GAAP in valuing assets and/or their disclosed procedures.

Monitoring: Fund advisers at times had difficulties with the receipt of fees from portfolio companies such as monitoring fees, board fees and others which resulted in a failure to properly allocate them, account for them, apply appropriate offsets and similar matters.

MNPI/Code of Ethics

Advisers are required to establish policies and procedures with regard to material non-public information under Section 204A of the Advisers Act and to establish a Code of Ethics under Rule 205A-1. Nevertheless, OCIE observed certain deficiencies:

Section 204A: Advisers failed to establish, maintain and enforce written policies and procedures that properly addressed the risks such as employees interacting with public companies, those that may be created because of office space or those created by their employees who periodically had access to MNPI.

Code of ethics: Advisers also at times failed to establish, maintain and enforce the provisions of their code with respect to MNPI such as enforcing the terms of a restricted list, provisions regarding gifts and entertainment and sections governing the reporting of personal securities transactions.

While not every item cited above, many have been the basis of, or included in, an enforcement action. Each was identified as a deficiency. Viewed in this context, the list should be carefully reviewed by advisers not just when an inspection is scheduled but periodically to ensure adherence to proper practices.

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