Compliance Program Fails and other Lessons Learned from Recent SEC and FINRA Cases for December 2018

by Hardin Compliance Consulting LLC
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Case regarding Thaddeus J. North, CCO, appeal from FINRA Disciplinary Action:  In an “uncomfortably timed release,” this opinion regarding Thaddeus J. North, former Chief Compliance Officer for FINRA member Southridge Investment Group LLC (“Southridge”) was posted on the SEC website the night before SEC Commissioner Hester M. Peirce’s speech to the National Society of Compliance Professionals.  Although she agreed with former Commissioner Dan Gallagher’s position that the SEC should be careful when bringing cases against compliance personnel and not impose “strict liability for CCOs under Rule 206(4)-7,” she was forced to provide some explanation for the Commission’s decision against North.

In this case, the SEC upheld a FINRA disciplinary action against Mr. North, CCO for a small broker-dealer, for his failure to (i) establish a system for the review of electronic communication and (ii) review such correspondence as required under the firm’s policies and procedures, and (iii) to report to FINRA his firm’s relationship with a statutorily disqualified person. The sanctions imposed included a two-month suspension from all principal and supervisory capacities and a total of $40,000 in fines.  FINRA found that North reviewed email infrequently, and failed to review any instant messages or chats archived from Bloomberg for 26 months, which accounted for about 80% of the firm’s electronic communications.  He was also made aware of a service agreement between a registered representative’s outside business and an individual who had been statutorily disqualified and failed to investigate it further.

North made some egregious errors in this case which all CCOs should keep in mind.  First, he was responsible for reviewing the firm’s supervisory procedures, which he did in 2010.  Unfortunately, he left in the following bracketed boilerplate language, ‘“[a]n appropriate random sampling (ENTER PERCENTAGE OR OTHER DEFINABLE SAMPLE SIZE) of all copies of email will be reviewed.”   Leaving in boilerplate language is a huge tip-off to regulators that the reviewer is not doing a thorough job.  Make sure your compliance manual reflects your actual practices and replace any bracketed boilerplate language.

Second, he testified that “all email review is boring” at a hearing as his justification for failing to review Bloomberg instant messages.  Admittedly, this statement has the ring of truth, but it is not a valid excuse for ignoring electronic communications.  In upholding FINRA’s sanctions, the SEC stated that North’s failure to review the firm’s Bloomberg message or chats, which made up 85% of the firm’s electronic communications, “is sufficient to sustain FINRA’s findings.”  Mr. North’s cavalier attitude in front of the regulators cost him dearly.

FINRA and the SEC were also unmoved by North’s claim that he didn’t understand the email retention system and consequently failed to review the separate repositories containing Bloomberg communications. The Commission found this failure underscored the “extent to which he acted unreasonably.”   CCOs should make it a priority to understand the systems used to support the compliance program.

Finally, North should have paid more attention to the financial information requested by FINRA in its investigation of Southridge in 2010.  If he had done so, he might have discovered the fact that one of the firm’s registered representatives had entered into an agreement with a statutorily disqualified person and could have taken steps to remedy the situation.  The SEC noted that North had prior knowledge regarding the relationship between the registered representative and the disqualified individual.  This red flag, combined with FINRA’s interest in a somewhat fishy service arrangement of the registered representative’s outside business, should have caused North to investigate the situation further.  CCOs should closely review information requested by regulators and undertake an internal review.  It appears that the SEC and FINRA punished North for his inaction.   Contributed by Contributed by Jaqueline Hummel, Partner and Managing Director

CEO Hit with SEC Fine for Failing to Support Compliance Program:  This has to be one of my favorite cases because of the astounding facts.  An investment adviser, Pennant Management, Inc. (“Pennant”) and its CEO, Mark Elste (“Elste”) let clients down in many ways, including failing to perform initial due diligence and ongoing monitoring for investments it recommended to its clients and ignoring CCO warnings and requests for compliance resources.  The most fascinating aspect of this case for me was the fact that a portfolio manager (!) willingly accepted the role of interim CCO, on the condition that he could hire outside counsel and compliance consultants as needed.  Not only that, but the portfolio manager educated himself about his compliance responsibilities and reviewed the firm’s compliance policies and procedures.  He even went further by telling (in writing!)  Elste that the compliance program was deficient.  The CCO’s responsibilities were expanded over the next two years, although Elste continuously denied requests for additional compliance resources. It wasn’t until mid-2014 that Pennant finally hired another full-time compliance analyst and engaged an outside compliance consultant to conduct a gap analysis of the firm’s compliance program.

Ultimately the SEC ended up fining Elste $45,000 for violations of Section 206(4) of the Advisers Act and Rule 206(4)-7 (the Compliance Program Rule).  The firm was fined an additional $400,000 for making misrepresentations to clients and its failures concerning the compliance program.  The firm withdrew from SEC registration in 2015.    Contributed by Jaqueline Hummel, Partner and Managing Director

SEC Issues What May be the First of Many Enforcement Actions Regarding Unregistered Exchanges Trading Digital Assets:  Zachary Cobern, founder of EtherDelta will pay $388,000 in disgorgement, penalties and pre-judgment interest to the SEC for causing EtherDelta to violate Section 5 of the Exchange Act of 1934 (the “Exchange Act”).  EtherDelta is an online trading platform that allows investors to buy and sell digital tokens in the secondary market.  Under Section 5 of the Exchange Act, any trading system that meets the criteria of an “exchange” set forth under the Exchange Act Rule 3b-16(a) must register as an exchange or operate under an exemption (e.g., a registered Alternative Trading System).  Because EtherDelta provided multiple investors with website access to its order book, containing official listings of tokens available for trade, and buyers and sellers utilized a “smart contract” to agree to and execute the trades, it was deemed to be a national securities exchange requiring registration.  EtherDelta operated the exchange without registration or exemption for a period of 15 months.

Digital assets are new to the broker-dealer world, its regulators and investors.  The regulators are taking a deep dive to determine how the securities laws apply to these new digital products that seem to be developing overnight, all in the name of investor protection.  The compliance and legal departments are key components in a firm’s development of new products and services.  A firm must understand exactly what it is offering to investors to determine what securities laws govern the offering and execution of the product. FINRA provides guidance regarding due diligence on new products in Notice to Members 05-26 and Regulatory Notice 12-03Contributed by Rochelle Truzzi, Senior Compliance Consultant

 Terminator 2: Judgment Day – same make, same model, new mission!  In this case, the Commodity and Futures Commission (“CFTC”) terminated Algointeractive, Inc. for fraud, misappropriation and misrepresentation.  The U.S. District Court for the Southern District of New York ordered a default judgment against Algointeractive, Kevin P. Whylie, and Matthew James Zecchini and ordered them to pay $1 million in civil penalties and $240,550 in restitution to pool participants.  The charges brought by the CFTC included fraudulent solicitation and misappropriation.  Of the $300,000 that was raised for Algointeractive, only $55,000 was actually invested on behalf of the pool participants, but never in futures contracts.

This particular fraud was propagated by two college dropouts who, in their due diligence questionnaires to investors, lied about their backgrounds, education, experience, track record and AUM.  The assets raised were never placed in a segregated pooled account but rather misappropriated into multiple accounts for the firm and, in most cases, were spent on personal expenses including transportation, meals and entertainment. To perpetuate their 2 ½ year fraud, they created false account statements for the participants and expense charts. Furthermore, the firm did not register as a Commodity Pool Operator (“CPO”) or an Associated Person (“AP”) with the National Futures Association (“NFA”).

The lesson learned from this case is that due diligence matters, whether you are reviewing or writing materials for your firm or reviewing due diligence materials of another firm.  Independently verify backgrounds and experience of principals, review regulators’ websites for public information about the firm in question, perform Google searches, and review account statements in detail.  Investors should also be wary of small firms that do not use independent compliance consultants or experts.  Having one person act as CEO, President, and Chairman of the Board should also raise a red flag.  Balancing all those roles, as Zecchini was, makes it almost impossible to place the client’s interests first, even for those with the best intentions.  In this case, the fraud was not sophisticated; it was based on lies on top of lies that should have been easily identified with a little verification.  You always have the option to play the Terminator and say “Hasta la vista, baby.”  Contributed by Heather Augustine, Senior Compliance Consultant

Worth Reading: 

Costumes, Candy and Compliance:  Check out Hester M. Peirce’s speech to the National Society of Compliance Professionals.   In addition to demonstrating she has a sense of humor, Ms. Peirce discussed her views on when CCOs should be held liable for failures of a compliance program.

SEC Asks Investors What They Think about the Client Relationship Summary Form:  You can read the 122-page report from the RAND Corporation, or check out this helpful summary from Melanie Waddell.

Fund Shareholders Have to Receive Reports. They Don’t Have to Pay So Much for Them:  With the SEC’s new Rule 30e-3 on the horizon (see Optional Internet Availability of Investment Company Shareholder Reports discussed above), the ICI surveyed mutual fund disclosure distribution costs and concluded that the heavy influence and high prices of a single vendor could jeopardize the potential savings associated with the Rule.  The article plainly explains the convoluted pricing currently used by intermediaries and summarizes the ICI’s proposal to right the system going forward.

How Institutional Investors Are Changing the Cryptocurrency Market:  There is a shift underway – institutional investors have steered clear of the cryptocurrency markets, but traditional financial institutions are now seeking diversification with crypto assets.  As a result, this article asserts that new crypto-investment products are under development, large volume crypto purchases have the potential to act as an anchor preventing market imbalance, and security for crypto-trading will likely improve.

U.K. Tackles Cryptoasset Regulation, Releasing Task Force Report That May Guide Other Countries:  Faegre Baker Daniels concisely summarizes the newly published Final Report by the U.K. Cryptoassets Task Force.  The Task Force report provides a good analysis of the key concepts of cryptoassets, distributed ledger technology, risks, and potential benefits, and how those fit within the current regulatory framework.

SEC issues Investor Bulletin Explaining Variable Annuities:  This SEC bulletin is aimed at main-street investors, covering the basics of variable annuities, their potential risks, optional features, and related fees and expenses.  They also issued one on Variable Life Insurance that provides a general overview of that product and associated risks, benefits, and costs.

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