A Compilation of Enforcement and Non-Enforcement Actions

28 March 2011 Publication
Author(s): Peter D. Fetzer Terry D. Nelson

Legal News: Investment Management Update

Non-Enforcement Matters

SEC Provides Insight in Choosing Who to Examine

Senior SEC officials recently outlined the agency’s criteria used when it selects registered investment advisers (RIAs) for examination.

The SEC initiated its “risk-based” approach in 2010 to determine which firms to examine and which parts of a firm’s business it will want to more closely scrutinize during the examination. Factors that may dictate which firms to examine include tips, complaints, and referrals from other governmental agencies received by the SEC. In addition, the selections are often made by the risk areas identified by the SEC through a review of the firm’s Form ADV, results of previous examinations of the firm, information from third parties, business activities of affiliates, amount of assets under management, private fund advisory activities, disciplinary history, and the time that has elapsed since the last examination was conducted.

If your firm has never been the subject of an SEC examination or it has been several years since the SEC’s last visit, you should expect to be notified by the SEC in the near future. Generally, the SEC sends a written notice to the RIA stating that it will arrive at the RIA’s principal place of business on a certain date and, in order to facilitate the examination, will request a list of information to be provided to the staff prior to the examination. The pre-examination review of such required information, according to the staff, is intended to make their actual onsite time more efficient and focused.

Once the firm is selected and requested pre-examination information from the firm has been reviewed by the examiners, the SEC staff conducts the onsite examination, which can take anywhere from several days to several weeks. Generally, the examination team will consist of at least two examiners, but often includes five or more. While at the firm, the examiners target certain areas such as conflicts of interest, valuation of complex investment instruments, private funds, allocation of trades (especially where the RIA manages side-by-side incentive fee and non-incentive fee clients), advertising and performance presentations, and custody of assets issues.

As part of the examination process, the staff will especially review the firm’s supervisory and control focus. As part of that review, the staff will look for signs as to whether senior management and the board of directors are setting the appropriate compliance tone within the firm from top to bottom. John Walsh, Chief Counsel of the SEC’s Office of Compliance Inspections and Examinations, recently stated that RIAs, while gearing up for the inevitable SEC examination, should ensure employees understand their obligations; have an effective compliance program with a chief compliance officer who possesses the authority to implement and enforce the compliance program; engage senior management and the board of directors in compliance matters; and conduct, at least annually, compliance risk assessments, and effect changes in the compliance program where the risk assessment indicates weaknesses.

Apparently, the SEC has geared up its risk analysis and surveillance personnel so that its examination program can target the high-risk firms and areas of concern. In addition, the SEC has organized working groups specialized in certain areas such as new and structured products, valuation, and fixed income securities. The SEC has looked to employ persons for its examination program who have specific industry experience in the areas targeted by SEC for examination.

SEC Proposes Removal of Credit Ratings From Investment Company Act Rules

The SEC has proposed rule amendments to remove references to credit ratings in certain rules and forms under the Investment Company Act. The amendments are driven by the Dodd-Frank Wall Street Reform and Consumer Protection Act requirement that such credit-rating references be replaced with other standards. In the words of the SEC, the “focus of these efforts is to eliminate over-reliance on credit ratings by both regulators and investors, and encourage an independent assessment of creditworthiness.”

The proposed amendments would require mutual fund board of directors to evaluate the creditworthiness of certain securities, resulting in the need for boards to look closely at their policies and procedures for evaluating creditworthiness.

Proposed Changes Affecting Money Market Funds
Under the SEC’s proposal, a rating would no longer be a required element in determining which securities are permissible investments for a money market fund. A security would instead be an eligible investment for a money market fund if the fund’s board (or its delegate) determines that the security presents minimal credit risks. This determination must be based on factors pertaining to credit quality and the issuer’s ability to meet its short-term financial obligations.

An eligible security would be a first-tier security (regardless of the ratings it has received from any credit rating agency) if the fund’s board (or its delegate) determines that the issuer (or in the case of a security subject to a guarantee, the guarantor) has the highest capacity to meet its short-term financial obligations, meaning that it has an exceptionally strong ability to repay its short-term debt obligations and the lowest expectation of default. The credit risk associated with a second-tier security, which would continue to be limited to three percent of total fund assets, would differ from that associated with first-tier securities only to a small degree.

The proposed amendments also would require an investment adviser to a money market fund to exercise reasonable diligence in keeping abreast of new information about a portfolio security that the adviser believes to be credible. In the event the adviser becomes aware of any credit information about a portfolio security or an issuer of a portfolio security that suggests that the security is no longer a first-tier security or a second-tier security, as the case may be, the board (or its delegate) would have to reassess promptly whether the portfolio security continues to present minimal credit risks.

Proposed Changes Affecting Repurchase Agreements
The SEC’s proposal also would remove references to credit ratings with respect to securities collateralizing repurchase agreements. Currently, funds seeking to meet certain diversification requirements under the Investment Company Act are permitted to “look through” to the value and liquidity of the securities that collateralize a repurchase agreement rather than looking to the creditworthiness of the counterparty to the agreement if, among other things, the collateral securities have received the highest credit rating (or are unrated securities of comparable quality), or are government securities. Under the proposed rule amendments, the board (or its delegate) would be required to determine that non-governmental collateral securities are issued by an issuer that has the highest capacity to meet its financial obligations and are highly liquid.

Other Proposed Changes
The SEC’s proposed rule amendments also would remove credit ratings in two other areas:

  • Certain business and industrial development company (BIDCO) investments. Specifically, BIDCOs are limited to purchasing debt securities issued by investment companies and private funds that are rated “investment grade” by at least one credit rating agency. Under the proposed amendments, instead of limiting BIDCOs to purchasing debt securities issued by investment companies and private funds that are rated “investment grade,” a BIDCO’s board (or its delegate) would be required to determine that the debt security is (1) subject to no greater than moderate credit risk and (2) sufficiently liquid that the security can be sold at or near its carrying value within a reasonably short period of time.
  • Shareholder reports. Investment companies are required to include in their shareholder reports a table, chart, or graph depicting portfolio holdings by reasonably identifiable categories (i.e., type of security, industry sector, geographic region, credit quality, or maturity). If credit quality is used to present portfolio holdings, credit quality must be depicted using the credit ratings assigned by a credit rating agency. The proposed amendments would eliminate the required use of credit ratings by funds that choose to use credit quality categorizations in the required table, chart, or graph of portfolio holdings.

More on Pay-to-Play

In recent editions to our Legal News: Investment Management Update, we summarized the new SEC pay-to-play rule (Rule 206(4)-5 or the Rule), which required compliance (starting on March 14, 2011) by registered and exempt investment advisers under the Investment Advisers Act of 1940.

Our investment adviser clients and other counsel to investment management firms are telling us that most advisers are imposing a $150 cross-the-board limit for political contributions made by employees and their spouses. The basic reasoning behind this broad approach appears to be the concern over monitoring of employee contributions and keeping track of who is a “covered associate,” as defined under the Rule. While this approach may make sense for a particular firm, it does not eliminate the need for the firm to have a policy in place to ensure that employees stay within the $150 limitation. Firms should either require preclearance of all employee political contributions or, at the minimum, require each employee to reaffirm on an annual basis that they have read and understand the firm policy and that they have not violated the $150 contribution limit. The firm also may want to include within its policy the ability by a designated person at the firm to waive the $150 contribution limit for certain employees if it would serve the firm’s interests and still be within the Rule’s provisions.

The investment advisory firm also should remind employees that most states have limitations on individual campaign contributions that may be more limiting than the firm’s policy limitations.

Enforcement Matters

SEC Charges Individuals and Firms in Connection With International Hedge Fund Fraud

As still another example where the SEC has stepped-up its investigation and enforcement activities in connection with fraudulent activities involving hedge funds, the SEC recently filed charges in U.S. District Court (SEC v. Ficeto C.D. Cal., No. 2:11-CV-01637-6HK-RZ, 2/24/2011) in connection with an alleged international share manipulation scheme against a hedge fund trader, two firms, and two associated securities professionals. The scheme allegedly generated more than $63 million in illegal profits for the defendants.

According to the SEC’s complaint, from 2005 – 2007, Florian Homm (Spain), Todd Ficeto (Malibu, California), and Colin Heatherington (Canada), through an affiliated broker-dealer, purchased shares of microcap companies in reverse mergers, manipulated the share prices through a variety of devices, and then sold the shares at deflated prices to various offshore hedge funds controlled by Mr. Homm. The scheme, according to the complaint, allowed the hedge funds to overstate their performance and the funds’ values by more than $440 million, and the defendants collected more than $63 million in profits through stock sales, commissions, and sales credits.

The SEC charged the defendants with anti-fraud violations and is seeking permanent injunctive relief, disgorgement, interest, and monetary penalties. In a related matter, the SEC filed cease-and-desist actions against Tony Ahn, primary trader for Hunter World Markets, Inc., the involved broker-dealer, and Elizabeth Pagliarini, Hunter World Markets' Chief Compliance Officer, over their roles in the scheme. Mr. Ahn was accused by the SEC of executing the trades that manipulated the stock prices, and Ms. Pagliarini was accused by the SEC for failing to supervise Mr. Ahn’s activities and further aiding and abetting the broker-dealer’s violations. Mr. Ahn and Ms. Pagliarini have settled the charges with the SEC, with Mr. Ahn agreeing to a five-year industry bar and to a $40,000 penalty. Ms. Pagliarini agreed to be suspended for one year from a broker-dealer supervisory capacity and a $20,000 penalty.

Alleged Ponzi Scheme Results in Guilty Plea and Filing of Revised Charges

Francisco Illarramendi, principal of Connecticut-based investment advisory firm MK Capital Management, LLC, recently pled guilty in U.S. District Court to securities fraud and other charges relating to his role in defrauding investors and creditors of various hedge funds he managed at the firm (U.S. v. Illarramendi, D. Conn., Cr. No. 3:11-CV-0078, 1/14/2011). In connection with this matter, the U.S. Justice Department announced that two others — Juan Carlos Guillen Zerpa and Juan Carlos Horna Napotitano — have been charged in connection with their roles in the scheme.

In a related development, the SEC announced that it had filed an amended civil complaint against Mr. Illarramendi and his firm alleging that they misappropriated at least $53 million in investor funds.

In the criminal case, Mr. Illarramendi pled guilty to two counts of wire fraud, one count of securities fraud, one count of investment advisory fraud, and one count of conspiracy to obstruct justice.

In its report on the matter, the Justice Department stated that the scheme started in 2006 when a hedge fund being managed by Mr. Illarramendi lost millions of dollars. Instead of reporting the losses to the fund’s investors, Mr. Illarramendi intentionally concealed those losses by engaging in a scheme to deceive both the investors and creditors of the fund. As a result, this fund and other hedge funds managed by Mr. Illarramendi have liabilities that far exceed the value of their assets. In connection with the SEC’s investigation, the SEC alleges that Mr. Illarramendi, assisted by Mr. Guillen and Mr. Horna, sought to mislead the SEC by giving the SEC a verification letter that one of the hedge funds had at least $275 million in credits as a result of outstanding loans to various entities. Mr. Illarramendi, according to the SEC, has admitted that the verification letter was false as the fund had no such outstanding loans, and that he had agreed to pay Mr. Guillen and Mr. Horna more than $3 million for preparing the letter and creating false support for the $275 million in loans.

By pleading guilty, Mr. Illarramendi admitted that he and others obstructed the SEC’s investigation by fraudulently attempting to substantiate a fictitious listing of assets. He faces up to 70 years in prison, fines, restitution and forfeiture of assets. The SEC also is seeking permanent injunction, disgorgement of ill-gotten gains, interest, and civil penalties from the other defendants.

Hedge Fund Manager Charged With Misappropriating Assets

The SEC has charged hedge fund manager Lawrence Goldfarb with diverting for himself and his related entities approximately $12 million of investment proceeds that belonged to the investors in a hedge fund he managed.

According to the SEC’s complaint, filed in federal district court (SEC v. Lawrence R. Goldfarb, et al., CV-11-0938-DMR, 3-1-2011, filed in U.S. Dist. Ct. for Northern District of California) Mr. Goldfarb and his company, Baystar Capital Management LLC, diverted the $12 million to other entities he controlled and commingled investor funds in a bank account he used to pay his personal expenses. According to the SEC, Mr. Goldfarb was able to carry out the fraud because the investment for the hedge fund was made in a “side pocket.” A side pocket is generally used by a hedge fund manager to isolate an investment from the other assets of the hedge fund due to the illiquid nature of the investment. Although the side investment was profitable, Mr. Goldfarb diverted the proceeds for his related entities’ uses rather than applying those proceeds to the fund and its investors. Mr. Goldfarb has agreed to pay more than $14 million to settle the SEC’s charges.

According to the SEC, Mr. Goldfarb managed to conceal the fraud for several years by providing written statements to the fund’s investors showing that no gains had been realized in the side pocket investment although that was clearly erroneous. According to the SEC, Mr. Goldfarb also acted to hide the true results of the side pocket investment from the fund’s administrator.

In addition to the payment of the $14 million, Mr. Goldfarb agreed to a permanent injunction, payment of $130,000 in penalties, and being barred from association with an investment adviser for five years.

Legal News is part of our ongoing commitment to providing legal insight to our clients and colleagues. If you have any questions about or would like to discuss these topics further, please contact your Foley attorney or any of the following individuals:

Terry D. Nelson
Madison, Wisconsin

Peter D. Fetzer
Milwaukee, Wisconsin