by T. GormanPosted on Posted in SECActions

A Risk Alert regarding its National Exam Program was issued by the SEC’s Office of Compliance Inspections and Examinations or OCIE. Drawing from its prior exam experience, OCIE identified five key areas of risk for investment advisers. Each point is highlighted by examples which should facilitate exam preparation and compliance for investment advisers.

Area 1 — Compliance Rule: Under this rule an adviser is prohibited from giving investment advice to a client unless certain requirements are met. Specifically, the adviser must: a) adopt and implement written compliance procedures; b) review those procedures at least annually for effectiveness; and c) designate a COO charged with administering the policies and procedures.

Examples of failures to properly comply with this rule include: Having policies and procedures which are not tailored to the adviser’s business; not performing – or not adequately performing – the annual review; failing to follow the adviser’s policies and procedures; and having an out of date compliance manual.

Area 2 – Regulatory Filings: Advisers are required to file certain regulatory filings which include Form ADV (filed annually), Form PF for advisers to one or more private funds with assets of over $150 million; and Form D, required to be filed no later than 15 days after the first sale of securities in the offering of a private fund.

Examples of failures include: Inaccurate disclosures; untimely amendments to Form ADV; incorrect and/or untimely filing of Form PF; and incorrect and/or untimely filing of Form D.

Area 3 – Custody Rule: Advisers who have custody of client cash or securities or the authority to obtain possession of them must comply with the rule. The rule has a series of requirements keyed to the protection of client assets.

Examples of failures include: A failure to recognize that the adviser has custody which can, for example, occur when the adviser has online access to client accounts; and obtaining a surprise exam (one of the options for complying with the rule) that does not meet the requirements of the rule because it is not a surprise since it is conducted on the same date each year.

Area 4 – Code of Ethics: Advisers are required to have a Code of Ethics – disclosed in Form ADV Part 2A — that has three key elements: a) establishes standard business conduct for supervised persons; b) requires access persons to periodically report personal securities transactions and holdings to a designated person; and c) requires that access persons obtain the adviser’s pre-approval before investing in an IPO or private placement.

Examples of failures include: A failure to identify access persons; the required elements are not included in the code; access persons do not report holdings in a timely manner; and a failure to disclose the Code as required.

Area 5 – Books and Records Rule: Advisers are required to keep and maintain certain books and records with include typical accounting and other business records.

Examples of failure include: A failure to maintain all of the required records; records that are either not updated or are inaccurate; and inconsistent records.

Since failures in these areas can, at a minimum, result in remedial action or, in certain instances, a referral to the Division of Enforcement for appropriate action, advisers should carefully review these points to ensure compliance.

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by T. GormanPosted on Posted in SECActions

The Commission dropped an action against two senior executives of Thornburg Mortgage, Inc. rather than retry the market crisis era case. In the initial trial a jury found in favor of the two executives on a number of counts but deadlocked on charges of fraud and lying to the auditors. SEC v. Goldstone, Case No. 12-257 (D.N.M. Filed March 13, 2012).

Thornburg Mortgage was the second largest independent mortgage company in the country. The SEC claimed that shortly before the filing of the firm’s 2007 Form 10-K on February 28, 2008 the institution was suffering from a liquidity crisis. The cash for the long term lender came from the short term capital markets through repurchase or repo agreements. Those agreements required Thornburg to make margin calls if the value of the securities collateralizing them fell below certain thresholds. The company had paid about $2 billion in margin calls and liquidated about $22 billion in mortgage backed securities.

As the mortgage company prepared to file its 2007 10-K, its financial condition continued to deteriorate. The adjustable rate mortgage or ARM securities it held dropped in value, although the firm did not take a write down. By late February 2008 the company could not meet the more than $300 million in margin calls it had recently received. At the same time, paying late meant that Thornburg would violate its agreements with at least three lenders. If the firm was declared in default its financial condition would sink further. That default would trigger the cross-default clauses with other lenders which would lead to the seizure of the ARM securities that were the collateral for the loans. Disclosure of these facts would undermine plans to raise additional cash. Disclosure would also result in questions by the auditors about the valuation of its ARM securities which could lead to a $400 million write-off.

The auditors were not told about the violation of the lending agreements or that that Thornburg sold some of its ARM securities to make margin calls. Just hours before filing the Form 10-K the company made the final payment on its margin calls. The Form 10-K was approved and certified by defendants Goldstone and Simmons. The filing represented that Thornburg had successfully met its margin calls without being required to sell assets. It also stated that the firm had the ability to hold its ARM securities until they recovered their market value.

Within two hours of filing the Form 10-K the company received more margin calls. Thornburg did not have the capital to meet the calls. Two business days after the filing the mortgage company filed a Form 8-K acknowledging this fact and stating that it had received a notice of default. Five days later, on March 7, 2008, Thornburg filed a second Form 8-K announcing that it would restate its days old Form 10-K. When that restatement was filed on March 11 it reflected a loss of $428 million from the write down of its ARM securities. It also reported a loss in the fourth quarter, erasing the previously claimed gain for the period, and acknowledged that the company might not continue as a going concern. Eventually Thornburg filed for bankruptcy. The complaint alleged violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A, 13(b)(2)(B) and 13(b)(5) as well as control person liability under section 20(a). The retrial was scheduled to begin on February 21, 2017.

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