The Commission’s focus on retail investors, reflected not just in enforcement trends but also in the OCIE inspection program, is spawning interesting trends. One is the rise in enforcement actions involving investment adviser. That trend traces to before the current retail investor focus, but has been accelerated by it. The other is in offering fraud actions. The common denominator here is the victims – retail investors.

This week two enforcement actions have been brought focused on offering frauds. One – ARO Equity — involved a barred securities law recidivist. The other – Blakstad — centers on what turned out to be essentially a Ponzi scheme conducted by a man who is a corporate officer of a number of microcap issuers and is facing criminal and civil insider trading charges brought by the U.S. Attorney’s Office and the Commission.

ARO Equity: Thomas Renison is a state licensed insurance agent who was barred from the securities business by the state of Maine and from association with an investment adviser by the Commission. ARO Equity, LLC is a private investment firm that is located in the home of Timothy Allcott, a long unemployed former manager of a billiards hall and motel. Each is named as a defendant in SEC v. ARO Equity, LLC, Civil Action No. 1:20-cv-10027 (D. Mass. Filed Jan. 8, 2020).

The action centers on an offering that took place over a three-year period beginning in mid-July 2015. Over $6 million was raised from about 15 investors, largely senior citizens. Investors were solicited to purchase promissory notes in ARO Equity. The notes had a term of three to five years and paid interest of 8% to 12% annually.

Messrs. Renison and Allcott told investors the returns on the notes were superior to those available from other retirement products. Key to these claims were repeated representations regarding the safety of the investments.

Unfortunately, the notes were anything but a safe investment, according to the Commission’s complaint. While investor capital was used to fund several small businesses, none had made a profit. Two other business that obtained about $3.3 million in loans were also unprofitable. One was later sold at a loss of about $1.3 million.

Nevertheless, Mr. Renison was paid a finders fee of $580,000. Mr. Allcott was paid a salary of about $225,000. Portions of the investor capital was paid to the sons of Mr. Renison. Little was left to repay investors. The Commissions complaint alleges violations of Securities Act Section 17(a), Exchange Act Sections 10(b) and 15(a) and Advisers Act Sections 206(1) and 206(2). The case is pending. See Lit. Rel. No. 24710 (Jan. 8, 2020).

Blakstad: Donald Blakstad, is a defendant along with two of his controlled entities in SEC v. Blakstad, Civil Action No. 20-CV-163 (S.D.N.Y. Filed Jan. 8, 20120). Mr. Blakstad owns, controls and holds executive officer positions in Midcontinental Petroleum, Inc., a purported oil firm, and Defendants ESI, supposedly a firm engaged in the crypto mining business, and Xact Holdings Corporation, a holding company formed to acquire another entity. In July 2019 he was charged by the DOJ and the Commission with insider trading.

Over a four-year period, beginning in mid- 2015, Mr. Blakstad raised funds through Midcontinental, ESI and Xact. Overall about $3.5 million was obtained from 14 or more investors.

Mr. Blakstad used a variety of representations to convince investors to purchase the securities of the firms. With respect to Midcontinental, investors were told that their funds would be used begin operations and for other costs related to the oil, gas and alternative energy exploration business. Those would include the acquisition of land leases and other equipment necessary for energy exploration. For ESI investors were told that their funds would be used to purchase equipment and pay start-up costs to initiate cryptocurrency mining operations. For Xact investors were told that their money would be used to purchase a Canadian firm and lease facilities in Huston, Texas.

The representations made by Mr. Blakstad as to each company were false. Rather than use the funds as represented, he used the investor capital has his “own personal piggybank” in the words of the complaint. He also used part of the funds to pay an individual used to solicit investors. The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). The case is pending. See Lit. Rel. No. 24711 (Jan. 8, 2020).

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The exam priorities of the SEC’s Office of Inspections and Compliance or OCIE, announced on January 7, 2020, are a key priority for every investment advisor and investment company. Those priorities are key not just for those who may be facing an exam this year but also for the industry. The priorities typically center on a combination of emerging issues, key risk areas for the firm, traditional areas of concern not just to the agency but the industry and current SEC priorities.

The areas identified this year are no different — they build on the past while tying those points to current Commission priorities. Those identified in the press release (here) and the glossy booklet published by the Office titled 2020 Examination Priorities, Office of Compliance Inspections and Examinations (here), are: Retail investors; market infrastructure; information security; focus areas for advisers, ICs, broker-dealers and muni advisors; AML; fintech; and FINRA and MSRB. When evaluating these points, it is however critical that they be considered in the context of the overall OCIE program.

Promoting compliance

The focus of OCIE is compliance. The exam process, and the areas selected for examination, tie directly to this goal. Exams will thus be driven the factors identified in the Exam Priorities but not delimited by them. Other factors tied to past and emerging risks as seen by the Office and the agency, and informed by new rule initiatives, may impact the exam.

OCIE also uses analytics, as does the entire agency, to identify key areas on which to focus. Those analytics are anchored in the four key pillars of the program: “promoting compliance, preventing fraud, identifying and monitoring risk, and informing policy. The risk-based approach, both in selecting registrants and examination candidates and in scoping risk areas to examine, provides OCIE with greater flexibility to cover emerging and exigent risks to investors and the marketplace as they arise,” according to the 2020 Exam Priorities.

Critical to the exam process is a review of the compliance programs of the advisory. The traditional focus is whether the policies and procedures are reasonably designed, implemented and maintained. This includes account selection, portfolio management, custody, best execution, fees and valuation.

The program results also fosters compliance. Last year the Office verified over 3.1 million investor accounts totaling over $1.5 billion. When appropriate OCIE also encourages registrants to make customer and clients whole. In addition, it issued over 2,000 deficiency notices in the last fiscal year and made over 150 referrals to the Division of Enforcement involving a range of issues.

Key exam areas for advisors

Retail investors: Retail investors are a key area of focus not just for OCIE but also the Commission. Chairman Clayton, for example, has repeatedly discussed the importance of the retail investor, and in particular, seniors.

Here, the inspections will continue to asses whether the advisory, as a fiduciary, is fulfilling its duties of care and loyalty, particularly where potential conflicts are present. As the 2020 Exam Priorities makes clear, this “will include assessing . . . whether RIAs provide advice in the best interests of their clients and eliminate, or at lease expose through full and fair disclosure, all conflicts of interest which might incline an RIA, consciously or unconsciously, to render advice which is not disinterested.” It is critical that the advisor faithfully fulfil its duties and obligations to the client.

The exams will also focus on key disclosure issues tied to the advisor’s duties and asses the recommendations and advice furnished to clients. Seniors and recommendations and advice provided to “entities and individuals targeting retirement communities . . [and] teacher and military personnel . . .” will be a focus. One example of issues in this area is certain securities products that pose elevated risks for the investors and investment advice involving such products.

Fees and compensation are also critical here since conflicts may be presented in a number of forms. For example, sharing arrangements that involve the advisor and an entity can present conflicts. Issues can also arise with mutual funds as in the share class selection cases, and with ETFs, municipal and other fixed income securities and microcap securities.

Information security: This is a critical security and risk area for virtually any enterprise. OCIE will focus on questions centered on the systems at the firm and risks presented by vendors and third parties. With respect to the enterprise, the exam will focus on six key points: 1) governance and risk management; 2) access controls; 3) data loss prevention; 4) vendor management; 5) training; and 6) incident response and resiliency. Key for the enterprise is the proper configuration of network storage, information security and retail trading security.

Issues regarding third-party and vendor risk management will also be assessed. Those include question regarding oversight, cloud-based storage, controls surrounding online access and mobile application assess to customer accounts. In addition, safeguards surrounding the proper disposal of retired hardware will be considered.

RIAs and ICs: For complex programs, OCIE typically assesses compliance in one or more core areas keyed to the appropriateness of account selection, portfolio management practices and custody issues. The Office will continue to prioritize exams of firms that are dually registered or are affiliated with broker dealers.

Additional areas will include investments in mutual funds and ETFs. In this regard the examinations “will assess industry practices and regulatory compliance in various areas which include . . . (1) RIAs that use third-party administrators to sponsor the mutual funds they advise or are affiliated with; (2) mutual funds or ETFs that have not previously been examined; and (3) RIAs to private funds that also manage a registered investment company with a similar investment strategy.” The Office will also review RIAs to private funds to assess risk compliance and controls.

AML programs: The Bank Secrecy Act requires that financial institutions, which includes broker-dealers and investment companies to establish anti-money laundering programs. The programs must include policies and procedures reasonably designed to identify customers and beneficial owners of legal entities, perform customer due diligence in accord with the Customer Due Diligence rule, monitor suspicious activity and were appropriate file SARs.

Conclusion

OCIE also conducts inspections in other areas. Those include market infrastructure for clearing agencies and national securities exchanges, transfer agents, FINRA and the MSRB. The priorities of the program are designed to assess certain risks in each of these areas as well as information gathering, all of which facilitates coordination with other regulators and agencies.

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