Lessons Learned from Recent SEC and FINRA Cases - June 2018

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Inflated Valuations Stay in the SEC’s Cross Hairs:   The SEC brought a complaint against Premium Point Investments LP (“Premium Point”), Anilesh Ahuja aka Neil Ahuja, Amin Majidi and Jeremy Shor, for a scheme to pump up their funds’ poor performance by using a “friendly” broker to provide inflated mortgage-backed security quotes.  In turn, the firm promised to direct trades to the broker.  The defendants also used an imputed mid-point valuation that was not based on the individual security, but on a broad sector of securities price ranges, which resulted in further inflating the bond prices. The SEC alleges that the scheme ran from September 2015 through March 2016, when performance of the firm’s funds began to deteriorate.  The result of the inflated valuations allowed the firm to charge higher management and performance fees.  The curious thing about this case is that Premium Point disclosed the imputed price procedures in their Valuation Policy, however when a big institutional client said it would not invest with the firm because of this policy, Premium Point removed the procedure from the policy but continued the practice.

It’s a little surprising that the institutional client invested with them after calling them out. The old saying “trust but verify” is especially critical in these situations. In April 2016, the auditor for Premium Point’s funds became concerned about the overvalued securities and pressured Premium Point to restate the funds’ net asset value (NAV) from 2015 on.  In one case a fund was overvalued by $40 million dollars. Ultimately, Premium Point was unable to obtain audited financials and did not obtain annual surprise audits.  Not surprisingly, Premium Point was hit with a laundry list of fraud charges and aiding and abetting violations of the Investment Advisers Act.  Contributed by Heather D. Augustine, Senior Compliance Consultant

Firm Blows Up after Junior Trader Blows Whistle on Valuation Process;  It sounds like the basis for a John Grisham novel.  A junior trader at a hedge fund is asked to get fake quotes from friendly brokers to help the firm pump up the value of its portfolios. He participates in the scheme for a while, but either gets cold feet or decides he can make more as a whistleblower than as junior trader.  So, he contacts the SEC and, in exchange for immunity, agrees to work as a confidential informant for the FBI.  

This is the true story of Visium Asset Management, LP (“Visium”).  Unfortunately for Visium, the initial investigation strayed far afield, and led to revelations that not only were portfolio managers at Visium inflating the price of securities, they were also trading on inside information.  The fallout from this nefarious activity included an SEC enforcement action against three of the hedge fund managers and their source of inside information, the SEC filing charges against another inside tipster, an SEC settlement with Visium’s CFO on charges that he failed to adequately supervise the misbehaving portfolio managers. Not only that, but Visium agreed to pay more than $4.7 million plus interest in illegal profits and an additional $4.7 million in penalties.  And for the piece de resistance, the Firm went out of business.  Perhaps most tragically, one of the portfolio managers, Sanjay Valvani, committed suicide shortly after his indictment.

Lessons learned from this case:  First, portfolio managers should treat junior traders with respect, especially if you count on them to participate in illegal activity.  Second, the SEC views information gathered from government sources the same way as inside information about corporations.  In this case, the portfolio managers used former government officials to obtain confidential information from friends and former colleagues in government agencies.  The information was then parlayed into various market bets, reaping Visium and its hedge funds substantial gains. Contributed by Jaqueline M. Hummel, Partner and Managing Director

FINRA Charges Recidivists with Bigger Fines:  On May 8th, Fifth Third Securities, Inc. (“Fifth Third”) submitted a Letter of Acceptance, Waiver and Consent (“AWC”) to FINRA, in which the firm was fined $4 million and required to pay approximately $2 million in restitution.  FINRA noted in the AWC that in determining the fine for Fifth Third, it specifically considered the firm’s recidivist activities, its failure to comply with a prior regulatory action, the harm to the customers resulting from the Firm’s violations, and the extent and duration of the activities.  Fifth Third has a history of issues resulting from inadequate sales and supervisory procedures related to variable annuities.  FINRA found that the firm failed to comply with the terms of a 2009 AWC (which resulted from significant deficiencies in its VA business), made material misstatements and omissions of material facts in connection with variable annuity exchanges, failed to have a reasonable basis to recommend or approve the exchanges, and failed to reasonably supervise the exchanges.   My recommendation is to add the following to your To-Do List:  (1) review your policies and procedures regarding the sale and supervision of variable annuities; and (2) review to ensure your firm has implemented the corrections necessary to comply with prior regulatory findings.  Failing to fix deficiencies cited in prior exams can result in more zeroes being added to the amount of your fine.   Contributed by A. Rochelle Truzzi, Senior Compliance Consultant

Worth Reading:

Private Fund Advisor Wins -- Mostly -- in Battle with SEC:  Check out this summary of a private firm’s fight with the SEC on valuation by Doug Cornelius.

6 big questions about the SEC advice rule:  Greg Iacurci of InvestmentNews discusses some of the more confusing aspects to the new “Best Interest” standard.

Companies use ‘nudges’ to promote ethical behavior: Learn more about how some companies are offering subtle reminders to their employees to think about ethics when making business decisions.

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