Friday, August 31, 2012

SEC Litigation Releases: Weekly Review

SEC Charges Brokers for Defrauding Brazilian Public Pension Funds in Markup Scheme,  August 29, 2012, (Litigation Release No. 22462).

According to the complaint (opens to PDF), Fabrizio Neves conducted a markup scheme while working at LatAm Investments LLC. The complaint alleges that from 2006 to 2009 Neves, with the assistance of Jose Luna, overcharged customers around $36 million "by using hidden markup fees on structured note transactions." Neves allegedly made millions in inflated sales commissions and Luna allegedly "received hundreds of thousands of dollars in inflated salary and commissions from LatAm and tens of thousands of dollars in additional compensation from a company that Neves controlled." The SEC seeks disgorgement, financial penalties, and enjoinment from future violations of the Securities Act and the Exchange Act. Luna has agreed to pay over $1.16 million in disgorgement and prejudgment interest, as well as a penalty amount to be determined.

Securities and Exchange Commission v. Wwebnet, Inc. and Robert L. Kelly,  August 29, 2012, (Litigation Release No. 22461).

According to the complaint (opens to PDF), from 2005 to 2008 video software company, Wwebnet, along with its chief executive officer, Robert L. Kelly, made material misrepresentations and omissions to investors in Wwebnet. The pair allegedly failed to disclose the "existence of a related-party transaction, which enabled Kelly to funnel at least $2.1 million of investor funds to himself," misrepresented "that Wwebnet had been generating revenue pursuant to contracts with entertainment companies when Wwebnet had never generated any such revenue," and misrepresented Kelly's compensation by failing to disclose Wwebnet's monthly $9,000 rental payments  for Kelly's luxury apartment in Manhattan. The SEC seeks permanent enjoinment from future violations of the Securities Act and the Exchange Act, as well as civil penalties, disgorgement, prejudgment interest, a penny stock bar, and an officer and director bar against Kelly.

SEC Charges Former Sky Bell Hedge Fund Manager with Making Misrepresentations in Selling and Recommending His Hedge Funds,  August 27, 2012, (Litigation Release No. 22460).

According to the complaint (opens to PDF), from 2005 to 2007 Gary R. Marks "negligently misrepresented the level of correlation and diversification among certain Sky Bell Hedge Funds." These funds, which Marks managed through Sky Bell Asset Management, Inc., included "the Agile Sky Alliance Fund that was co-managed with the Agile Group, PipeLine Investors, Night Watch Partners, and Sky Bell Offshore Partners." Additionally, the complaint claims that Marks "made unsuitable investment recommendations to certain advisory clients" urging them to invest mainly in Sky Bell Hedge Funds, failed to "disclose that PipeLine Investors invested significantly in a purported subadviser's fund," and "provided misleading information to certain investors about the liquidity problems at the Agile Sky Alliance Fund." Marks consented to a proposed Final Judgment enjoining him from future violations of the Advisers Act and Securities Act, as well as an order to pay over $420,000 in disgorgement and prejudgment interest. 

Convicted Ponzi Scheme Operator Jeffrey L. Mowen Ordered to Pay Over $18,000,000 in SEC Action,  August 27, 2012, (Litigation Release No. 22459).

On August 27, 2012, the US District Court for the District of Utah entered a final judgment against Jeffrey L. Mowen ordering him to pay over $18 million in disgorgement, prejudgment interest and penalties for allegedly operating a Ponzi scheme that raised over $40 million from over 150 investors. The scheme involved raising funds through Thomas Fry, who in turn then raised funds through other defendants, "Fry's promoters, via the unregistered offer and sale of high-yield promissory notes." On May 4, 2011, Mowen pled guilty to wire fraud in a related case, United States of America v. Mowen, and is serving a ten year prison sentence. On June 15, 2012, a final judgment ordering disgorgement and penalties was entered against Fry and several of his promoters. 

SEC Charges Eric Martin, Former Vice President of Investor Relations of Carter's Inc., with Insider Trading,  August 24, 2012, (Litigation Release No. 22458).

On August 23, 2012, the SEC filed a civil injunctive action against Eric Martin for allegedly trading shares of Carter's Inc. during blackout periods "while in possession of material, nonpublic information regarding the company's financial results" that he learned while serving as Carter's Director and, later, Vice President of Investor Relations. From at least 2007 to 2009, Martin "realized profits and avoided losses in excess of $170,000" through the illegal trading. The SEC seeks a permanent injunction, disgorgement with prejudgment interest and civil monetary penalties against Martin, as well as disgorgement with prejudgment interest from his wife, Robin Martin, who was named as a relief defendant.

Wednesday, August 29, 2012

The JOBS Act and Private Placements [UPDATE]

By Tim Husson, PhD

Both the New York Times and the Wall Street Journal are reporting that the SEC has proposed removing the restriction on general solicitation of hedge funds and other private placement investments as required by the JOBS Act of 2012. Last week we blogged about the implications of this action, and at that time there was concern that the SEC would impose further restrictions that would dampen the effects of the law. It now appears that the SEC will not impose any additional regulations.

The types of investments covered by this action still can only be sold to wealthy (or 'accredited') investors. Some had hoped that the SEC would clarify rules related to how this restriction will be enforced, since the provision only requires that such investments take "reasonable steps" to prevent selling to unaccredited investors.  The current proposal does not suggest any universal validation procedures but directs issuers "to consider the facts and circumstances of the transaction."

A fact sheet related to the proposal is available here, and the SEC offers a dedicated website for news related to the JOBS Act.

Monday, August 27, 2012

ETFs in Mutual Funds: a Raw Deal?

By Tim Husson, PhD

Ian Salisbury at SmartMoney raises an interesting point:
The whole point of actively run funds, their proponents say, is that a living, breathing fund manager has a better chance of sussing out great investment opportunities than an exchange-traded fund, which just blindly tracks an index. Indeed, that's one of the reasons actively managed funds have higher fees than ETFs -- to pay for all that expert guidance. 
So it might come as a shock to some investors that the top holdings of several major stock mutual funds are actually ETFs.
One of the reasons why ETFs have become so popular in recent years is their lower costs relative to many mutual funds.  But ETFs do have fees, so a mutual fund holding an ETF would be effectively layering additional fees on whatever amount of their portfolio invested in ETFs.  This would be similar to fund-of-fund hedge funds, which accrue fees on both the fund itself and each of its fund holdings.  SmartMoney has covered this issue before, and note that "if a mutual fund holds a big stake in an ETF, an investor can just buy the same ETF...and sell the fund."

Cory Banks at IndexUniverse takes a different angle by arguing that sometimes mutual fund managers need a place to temporarily park cash, and therefore need quick access to low-cost index tracking investments such as ETFs.  Therefore it might not always be the case that ETFs in a mutual fund are always a bad deal:
Mutual funds have to equitize cash, either from inflows or dividends, or just because they sell something and don't see anything in the market they want to buy. They used to buy futures, where margins could climb sky high; now they use ETFs. It allows them to get quick, cheap exposure to the market. 
You put the money to work in an index product, and then when you get a better idea, you buy some stocks and sell off that index position. It's the best way to handle "cash management." 
And here’s the dirty secret: everyone does it. In fact, you’ll notice it frequently happens around the last day of the quarter, depending on what inflows, outflows and dividends different mutual funds receive.
Banks does concede that a mutual fund that holds only ETFs would be "a pretty blatant rip-off."  We would agree that such a fund would likely be rip-off especially if the holdings of that fund remain relatively constant over time.  In such a case, it would almost always be cheaper for the investor to simply replicate the portfolio of the mutual fund using the underlying ETFs themselves.

Friday, August 24, 2012

SEC Litigation Releases: Week in Review

SEC Charges New York-Based Firm and Owner in Penny Stock Scheme,  August 23, 2012, (Litigation Release No. 22457).

Edward Bronson and his company, E-Lionheart Associates LLC (which also conducts business under the name Fairhills Capital Inc.), have been charged by the SEC with conducting a penny stock scheme in which they allegedly reaped over $10 million in illegal profits. The alleged scheme involved buying shares at deep discounts from over 100 penny stock companies and then selling them without filing registration statements. Bronson and E-Lionheart claimed to have exemption from registration through state law exemptions, however these state laws are not applicable to these transactions. In effect, investors in these shares were not provided with information that a registration statement would have provided. The SEC has charged E-Lionheart and Bronson with violating sections of the Securities Act and seeks disgorgement, penalties and penny stock bars. The SEC has also named Fairhills Capital Inc. as a relief defendant.


SEC Files Enforcement Action to Halt $600 Million Pyramid and Ponzi Scheme
North Carolina Company Solicited Investors Over Internet,  August 22, 2012, (Litigation Release No. 22456).

According to the complaint (opens to PDF), Paul R. Burks and Rex Venture Group LLC conducted a combined Ponzi and Pyramid scheme via ZeekRewards.com. Burks and his company raised over $600 million through more than one million Internet customers from the website. ZeekRewards, which began in January 2011, was a purported "affiliate advertising division" for companion website, Zeekler.com and offered various ways for customers to earn money.  Two of these ways--the "Retail Profit Pool" and the "Matrix"--involved purchasing unregistered securities in the form of investment contracts. The company purportedly used net profits for customer payouts. However, the SEC alleges that the "'net profits' paid to investors were comprised of funds received from new investors." Burks and Rex Venture Group LLC have agreed to "permanent injunctions against future violations of the registration and antifraud provisions." Additionally, Burks has agreed to "relinquish his interest in the company and its assets" as well as pay a $4 million civil penalty. The SEC has also frozen approximately $225 million in ZeekRewards' assets.

SEC Charges Former Array BioPharma Manager for Insider Trading,  August 21, 2012, (Litigation Release No. 22455).

According to the complaint (opens to PDF), James L. Lieberman used nonpublic information he learned as Array BioPharma Inc.'s manager of environmental health and safety to illegally trade Array stock. Only minutes after learning that a licensing transaction between Novartis and Array was imminent, Lieberman bought Array common stock for both himself and his sister. Lieberman gained over $70,000 in illegal profit. Lieberman has consented to a final judgment enjoining him from violations of the Exchange Act, and has agreed to pay over $147,000 in disgorgement, prejudgment interest, and penalties.

SEC v. Ricardo Bonilla Rojas and Shadai Yire, Inc.,  August 21, 2012, (Litigation Release No. 22454).

According to the complaint (opens to PDF), Ricardo Bonilla Rojas and his firm, Shadai Yire, raised at least $7 million between August 2005 and February 2009 from mainly evangelical Christian groups and factory workers. According to the SEC, Rojas falsely assured these inexperienced investors he would invest their money in commodities and "that their principal contributions were '100% guaranteed'" with promised returns of up to 50 percent. In reality, Rojas used their funds to repay earlier investors as well as pay himself $700,000. Rojas and Shadai Yire, both unregistered to offer securities, went as far as to create phony account statements to assure investors of their investments' growth. The SEC charges Rojas and Shadai Yire with violations of both the Securities Act and Exchange Act, and seeks disgorgement, penalties, and enjoinment from future violations.

SEC Charges College Football Hall of Fame Coach in $80 Million Ponzi Scheme,  August 17, 2012, (Litigation Release No. 22453).

According to the complaint (opens to PDF), James M. Donnan, III and Gregory L. Crabtree raised $80 million by selling unregistered securities in GLC Limited to investors from at least August 2007 to mid-October 2010. Many investors were contacts Donnan had established as a sports commentator and former college football coach. GLC allegedly was "in the wholesale liquidation business and earn[ed] substantial profits by buying leftover merchandise...and reselling those discontinued, damaged, or returned products to discount retailers." However, the SEC claims only $12 million of the investors' funds were used to purchase leftover merchandise. The remaining funds were used to pay "returns" to earlier investors and stolen for personal use by Donnan, Crabtree, and Donnan's children: Jeffrey Tood Donnan, Tammy L. Donnan and son-in-law, Gregory K. Johnson. The SEC charges Donnan and Crabtree with violating sections of the Securities Act and Exchange Act and "seeks permanent injunctions, disgorgement with prejudgment interest, and the assessment of civil penalties against them." The SEC also names Donnan's children as relief defendants and seeks disgorgement of investor funds that they received. 

SEC Sues New York Penny Stock Distributor,  August 17, 2012, (Litigation Release No. 22452).

According to the complaint (opens to PDF), Jossef (Yossef) Kahlon and TJ Management Group, LLC "abused and misused a federal securities law to buy hundreds of millions of shares of stock at steep discounts and to quickly resell all the shares to the public at market rates." They generated at least $7.7 million in profits and allegedly deprived investors of important business information for various issuers. The SEC has sued Kahlon and TJ Management Group, LLC, and seeks permanent injunctions, civil penalties, penny stock bars, and disgorgement.

New Charges in Insider Trading Case Include Former CEO and Professional Baseball Player,  August 17, 2012, (Litigation Release No. 22451).

Last year, the SEC brought charges against Doug DeCinces, former professional baseball player, as well as three others--Joseph J. Donohue, Fred Scott Jackson, and Roger A. Wittenbach--for insider trading involving the acquisition of Advanced Medical Optics Inc. by Abbot Laboratories Inc. They made more than $1.7 million in the trading and agreed to pay over $3.3 million to settle the charges. Now, the SEC has charged the alleged source of these tips, James V. Mazzo, who was the Chairman and CEO of Advanced Medical Optics. According to the complaint (opens to PDF), over $2.4 million in profits resulted from Mazzo's illegal tipping. After Decinces, who was a close friend and neighbor of Mazzo, received the tips, he passed the information along to former Baltimore Orioles teammate Eddie Murray and his friend David L. Parker. Murray and Parker have also been charged by the SEC for their alleged illegal trading. Murray has consented to a final order enjoining him from violating the Exchange Act, and has agreed to pay over $358,000 in disgorgement, prejudgment interest, and penalties.

Thursday, August 23, 2012

State Securities Administrators Issue List of Top Ten Investment Scams

By Paul Meyer, MA

The North American Securities Administrators Association (NASAA) has just published its annual list of the most prevalent scams.   Among the usual suspects (oil and gas drilling programs, real estate fraud, precious metals) is a warning about “inappropriate advice or practices from investment advisers.”  Bernie Madoff was a registered investment adviser (RIA).  His fraud has drawn significant scrutiny to an industry not accustomed to the attention.

The registered investment advisory business is not well understood, even by its clients.  Unlike broker-dealers, registered investment advisers are not governed by a dedicated self-regulatory organization like FINRA.  Rather, the U.S. Securities and Exchange Commission, Division of Investment Management, directly regulates all federally registered RIAs.  The significant increase in the number of RIAs over the past several years has severely strained the SEC’s regulatory resources.

RIAs are fiduciaries to their clients.  They must put their clients’ interests first, mitigate conflicts of interest, disclose all material facts, and make only suitable investment recommendations.

Customers of registered investment advisers regularly engage our firm to help them determine whether their RIA has met its fiduciary obligations.  Too often, we discover that the RIA abused the trust of our client by providing self-interested investment advice or otherwise abusing undisclosed conflicts of interest.  Designation as a Registered Investment Adviser is very easy to acquire and does not automatically endow its holder with a special degree of knowledge or ethical conduct.

Wednesday, August 22, 2012

The JOBS Act and Private Placements

By Tim Husson, PhD

The Jumpstart Our Business Startups (JOBS) Act (PDF) that was enacted this past April was ostensibly designed to increase investment opportunities by relaxing certain regulatory requirements on small businesses.  There are several excellent reviews of the provisions of the JOBS Act, which not surprisingly is a lengthy and impenetrable document, and there has been considerable debate between proponents, who argue that increased investment opportunities can help support new business ventures and create jobs, and critics, who worry that the reduced regulatory requirements may remove important investor protections.

The Wall Street Journal's Andrew Ackerman has called attention to one provision of the Act (section 201(a)) which repeals a ban on certain advertising for what are known as private placement investments.  Private placements are usually equity interests in small companies or business ventures, and are loosely regulated by the SEC because their shares are not publicly traded or available to investors through brokers.  Private placements can only be sold to wealthy ('accredited') investors, and until the JOBS Act, could not be 'generally solicited', meaning advertised publicly, according to section 230.502(c) of Title 17 of the Code of Federal Regulations.

The reason the ban on solicitations existed was because of the highly speculative nature of many private placement investments.  For example, many private placements are oil and gas exploration projects that have limited probability of success.  Other private placements are special purpose vehicles for highly complex derivatives transactions.  Because private placements have effectively no regulatory requirements, their disclosures to investors can be insufficient, incomplete, or even misleading.  Perhaps the most well known private placement investments are hedge funds, who may stand to benefit from being able to more widely solicit new investors.

At SLCG, we have seen numerous instances of misrepresented or unsuitable private placement investments, including hedge funds.  As the JOBS Act will soon allow these firms to advertise publicly, we hope investors and their investment advisors realize that private placements are risky and speculative, and should only be considered with caution and proper due diligence.  We feel that general solicitation of private placements is similar in many respects to advertising for prescription drugs--just because a particular drug has a flashy ad does not make it appropriate for all patients.  Likewise, just because a private placement has an attractive marketing pitch does not make it appropriate for all investors.

Tuesday, August 21, 2012

SEC Investor Bulletin on ETFs

By Tim Husson, PhD

The SEC recently released an Investor Bulletin on ETFs (PDF) which provides background information about ETFs in general and defines several terms which may be confusing to investors. ETFs can be complex and risky investments, as they allow nearly anyone to purchase portfolios which would typically only be suitable for sophisticated investors or traders.

Some commentators were not satisfied with the Bulletin, particularly its lack of new guidelines related to leveraged and inverse products. Paul Baiocchi at IndexUniverse says of the Bulletin, "too bad it was about five years too late," highlighting that FINRA and the SEC released a very similar report almost three years ago.
Well, this toothless bulletin does little to address the concerns facing any of the remaining unknowing investors who may still have access to these funds through their discount brokerage.   
Without creating real ETF “gates” as my colleague Dave Nadig made the case for back in March, the SEC is just spinning its wheels, and seemingly covering its tracks without offering any new insight on the problem.

If the SEC were serious about preventing the types of losses experienced back in 2008 which rightfully opened up the discussion of tighter regulations on inverse and leveraged funds nearly half a decade ago, it would have outlined real solutions, and not just regurgitated FINRA’s three-year-old warnings.
We've talked a lot on this blog about the risks of leveraged and inverse ETFs, and have several ongoing research projects on the subject. We agree that the SEC's Bulletin does not fully address the apparent misunderstanding that many investors have related to how these ETFs rebalance their exposure. In addition, the Bulletin does not address the risks of ETNs, which bear certain resemblances to ETFs but are in fact structured very differently, nor does it address certain commodities ETFs which also have unique and easily misunderstood features.

However, the SEC's Bulletin will likely be an informative reference for ETF investors in general. The Bulletin at least clearly states that there are issues related to leveraged and inverse ETFs that investors should be aware of, and gives a variety of useful background material that is relevant for nearly all ETF products. We agree that new guidelines would likely go a long way in preventing further investor harm, but having a resource such as the Bulletin that covers the basics of ETF investing can also be useful.

Monday, August 20, 2012

FINRA Targets Conflicts of Interest

By Paul Meyer, MA

FINRA has announced its intention to conduct a targeted examination (or sweep) of its members’ practices relating to the identification and management of conflicts of interest. The importance of this effort cannot be overstated. Conflicts of interest in the securities industry are particularly troublesome because customers usually do not stand in an arm’s-length, caveat emptor relationship to their broker. Instead, most customers trust and rely upon their broker’s superior knowledge and skill, assuming that their adviser is acting in their best interests and unaware of the myriad opportunities for conflicts of interest to work against them. The industry’s pervasive conflicts of interest present the broker with opportunities to betray that trust that can be irresistible.

Conflicts of interest come in many forms. For example:
  • The broker earns a commission only when recommending a transaction.
  • The broker recommends his firm’s own products rather than potentially better or less expensive products that accomplish the same objective.
  • The broker is paid more to sell a proprietary product.
  • The broker recommends a security because his firm has an investment banking relationship with the company.
  • The broker-dealer is a counter-party in a client transaction.
  • The broker-dealer trades ahead of (front runs) a known pending customer order.
  • The broker recommends margin borrowing because his firm earns money on the interest spread.
FINRA’s rules of ethical conduct preclude broker-dealers from taking unfair advantage of conflicts of interest, yet they remain a frequent source of harm to customers. FINRA’s sweep should result in strong additional measures to curb this abuse.

Friday, August 17, 2012

SEC Litigation Releases: Week in Review

SEC Charges Oracle Corporation with FCPA Violations Related to Secret Side Funds in India,  August 16, 2012, (Litigation Release No. 22450).

According to the complaint (opens to PDF), the Indian subsidiary of Oracle Corporation, Oracle India Private Limited, "structured transactions with India's government...in a way that enabled Oracle India's distributors to hold approximately $2.2 million of the proceeds in unauthorized side funds." Oracle India's alleged misconduct occurred from 2005 to 2007, when the company would often use the side funds to pay unauthorized and "storefront-only" vendors. These side funds then created the risk for illicit activity including bribery or embezzlement. The SEC charged Oracle Corporation with violating the Foreign Corrupt Practices Act and various sections of the Exchange Act. Oracle has agreed to a judgment enjoining it from violating the Exchange Act and will pay a $2 million civil penalty. The settlement accounts for Oracle's voluntary disclosure of its subsidiary's conduct and measures taken to enhance its FCPA compliance program, including firing the employees involved in the scheme.

SEC Halts Denver-Based Ponzi Scheme,  August 15, 2012, (Litigation Release No. 22449).

The SEC announced fraud charges and an asset freeze against Bridge Premium Finance LLC, Michael J. Turnock, and William P. Sullivan, II, "for allegedly perpetrating a Ponzi scheme." Bridge Premium raised at least $15.7 million in investors' funds which purportedly "would be used to make loans to small businesses to pay their up-front, annual commercial insurance premiums." Bridge Premium enticed investors with promises of annual returns of 12 percent and guarantees that their funds were "100% Protected." However, according to the SEC, Bridge Premium paid investor returns with funds from other investors since at least 2002. Furthermore, Bridge Premium's offering was not registered with the SEC. The SEC has charged Bridge Premium with violating sections of the Securities Act and the Exchange Act. Under the Exchange act, "Turnock is liable as a control person...for Bridge Premium's violations." Additionally, the SEC alleges that Sullivan violated various sections of the Securities Act and Exchange Act. The Court issued a "Temporary Restraining Order, Asset Freeze, Other Equitable Relief, and Order Setting Preliminary Injunction Hearing...on August 14, 2012." Bridge Premium's, Turnock's, and Sullivan's assets have all been frozen by the Court's order.

SEC Charges Petro-Suisse Ltd. and Mark Gasarch with Offering Fraud,  August 14, 2012, (Litigation Release No. 22448).

According to the complaint (opens to PDF), from 2003 to 2006 Petro-Suisse Ltd. along with its Director, Mark Gasarch, Treasurer, and legal counsel offered fraud through the medium of 21 private placements memorandums. These PPMs purported that Petro-Suisse or an affiliate would "cause each of the 21 partnerships to enter into written agreements to finance the drilling of oil wells in Trinidad." These partnerships would then "receive contractual rights to receive returns measured by the net revenues of the wells drilled." However, the partnerships never entered into any such written agreements, rendering these PPMs materially false and misleading. Petro-Suisse and Gasarch consented to Final Judgments enjoining them from violating sections of the Exchange Act and have agreed to pay over $8 million jointly and severally in disgorgement. Additionally, Gasarch has agreed to pay a $130,000 civil penalty.

SEC Charges Home and Construction Loan Companies and Their Principal with Offering Fraud,  August 14, 2012, (Litigation Release No. 22447).

The SEC filed a civil injunction against Ivan Wade Brown and his wholly-owned and solely-controlled companies: Highland Residential, LLC and Avanti Capital Partners, LLC. According to the complaint (opens to PDF), beginning in 2004 Ivan Wade Brown raised over $27 million dollars in investor funds through the "fraudulent and unregistered sale of promissory notes in Highland and Avanti." He initially sold these promissory notes for Highland in 2004, but he formed Avanti when the Utah Division of Securities started investigating his and Highland's conduct in 2007 . Brown claimed the funds would be used to make secured bridge loans under little-to-no risk circumstances. Instead, he allegedly used these funds for personal use, to make Ponzi payments, to invest in unidentified properties, and to invest in other suspected frauds. The SEC has charged Brown, Highland, and Avanti with violating sections of the Securities Act and Exchange Act.  

Court Enters Final Judgment Against Alero Odell Mack, Jr.,  August 14, 2012, (Litigation Release No. 22446).

On August 7, 2012, the Court entered a Final Judgment against Alero Odell Mack, Jr. regarding a SEC complaint that Mack along with Steven Enrico Lopez, Sr. and various entities under Mack's control raised around $4 million in investor funds through fraudulent investment schemes. The Final Judgement enjoins Mack from violating sections of the Securities Act, Exchange Act and the Investment Advisers Act of 1940. Additionally, Mack has been ordered to pay over $1 million in disgorgement, prejudgment interest and penalties. 

SEC Charges Six Individuals in $6 Million "Shell-Factory" Scheme,  August 14, 2012, (Litigation Release No. 22445).

According to the complaint (opens to PDF), from 2006 to 2011 Thomas D. Coldicutt, Jr., Elizabeth L. Coldicutt, Robert C. Weaver, Jr., Christopher C. Greenwood, Linda S. Farrell, and Susana Gomez "engaged in an elaborate scheme to create and sell at least 15 public shell companies." They reaped almost $6 million in ill-gotten gains from the scheme. Allegedly, husband-and-wife duo, Thomas and Elizabeth Coldicutt, "installed nominee officers and directors in corporations they secretly controlled." The corporate nominees, including Farrell, Weaver, Greenwood, and Gomez, were then directed and assisted by the Coldicutts to submit "materially false and misleading registration statements and reports to the SEC." The SEC contends that "these companies' SEC filings failed to disclose that the Coldicutts controlled and funded the companies." Furthermore, the SEC alleges that the Coldicutts "obtained nominees to purchase stock in the companies" and then provided the nominees with "all or most of the funds to purchase the stock." The shell companies were supposedly formed to pursue mining activities, when in fact these companies never conducted nor ever intended to conduct any real mining activities. Farrell, Weaver, Greenwood, and Gomez all "act[ed] as corporate nominees, recruit[ed] other nominees to hold stock in the shells, and sign[ed] materially false and misleading SEC filings." Additionally Weaver, Greenwood, and Farrell each "formed, registered, marketed, and ultimately sold at least one shell." 


Thursday, August 16, 2012

New Suitability Rules Now in Effect

By Paul Meyer, MA

FINRA was created in 2007 through a combination of the former NASD with the regulatory functions of the NYSE. Since then, FINRA has been attempting to consolidate each entity’s old rules into a single manual. Although progress has been slow, recently new suitability rules took effect. This much-needed update (parts of the old rule date back to 1938) brings the suitability rule a little closer to the realities of business in a modern, full-service securities firm; but it is still a far cry from the uniform fiduciary standard -- the value of which there is near universal agreement.

The new rule essentially incorporates the ethical principals of the old rule and adds two new, but related, concepts: quantitative suitability and portfolio strategy. Quantitative suitability refers to the amount of a security held in relation to the entire portfolio. A suitable strategy, therefore, must incorporate the basic principles of diversification and asset allocation.

The new suitability rules are a codification of investment management principles that have been the proper standard of care for many years. Ultimately the industry must adopt the fiduciary standard.

Tuesday, August 14, 2012

Overreliance on Credit Ratings Results in Large Losses for Municipalities

By Tim Dulaney, PhD

Earlier this week, the SEC charged Wells Fargo's brokerage firm with selling complex securities to institutional investors such as municipalities and non-profits.  The Institutional Brokerage and Sales Division, between January 2007 and August 2007, made recommendations to institutional clients to purchase asset-backed commercial paper "issued by limited purpose companies called structured investment vehicles (SIVs) and SIV-Lites backed largely by mortgage-backed securities and CDOs."  Already this order (PDF) is receiving substantial attention in the press and in the blogosphere.

Of course, this is not the first time a municipality has been put through the ringer by entering into a deal they didn't understand. What makes this case perhaps particularly insidious is that the registered representatives didn't even perform their due diligence before, or have reasonable basis for, suggesting the investments.  According to the release:
Wells Fargo and its registered representatives did not review the private placement memoranda (PPMs) for the investments and the extensive risk disclosures in those documents. Instead, they relied almost exclusively on the credit ratings of these products despite various warnings against such over-reliance in the PPM and elsewhere. Wells Fargo also failed to establish any procedures to ensure that its personnel adequately reviewed and understood the nature and risks of these commercial paper programs.
Clearly basing any affirmative investment recommendation almost solely on a single number or rating is reckless and irresponsible.  A deeper analysis of proposed investment is required by both the investor and the broker advocating for a particular investment.

This time, Wells Fargo skated away without losing their shirt -- fined less than 0.05% of their profit for last year.  Hopefully the SEC is able to garner more significant penalties in the future as they pursue the those that use complex instruments to reap large profits from unknowing investors.

Monday, August 13, 2012

Poor Incentives and Predatory Lending in Municipal Finance

By Tim Husson, PhD and Olivia Wang, PhD

Last year, Poway Unified School District had a problem.  A decade earlier, it had started a program to modernize its aging schools.  In 2008, voters had approved additional funding for the project under the condition that the school board could not raise taxes further.  Unfortunately, by 2011, the project needed an additional $105 million to complete.  But because they could not raise taxes, they could not issue the kind of tax-backed bonds (called general obligation bonds) that usually fund large municipal expenditures.

The District's solution was to borrow the $105 million through a capital appreciation bond.  Under the terms of the bond, the District would defer interest payments for 20 years (ostensibly avoiding any need for tax increases), and pay the remaining amount over the next 20.  While this approach did indeed solve their immediate funding needs, it saddled future school boards with over $877 million in interest payments.  Needless to say, many are outraged.

This deal highlights an endemic problem in municipal finance.  Many school boards, county officials, city governments, and other community leaders are under intense budgetary pressure, and often have an incentive to fund current projects by placing massive liabilities on future generations.  In addition, many of these local officials are not sophisticated enough to recognize predatory lending practices or unsound investment strategies.

At SLCG, we have seen numerous instances of excessively risky or expensive financing options sold to community leaders across the country.  Powey Unified is not the only school district to have incurred such massive liabilities--in fact, it may not be the only school district in San Diego to have done so.  Unfortunately, municipal authorities often have insufficient expertise to manage the large budgets for which they are responsible.

Friday, August 10, 2012

SEC Litigation Releases: Week in Review

SEC Charges Participants in $5 Million Boiler Room Scheme,  August 10, 2012, (Litigation Release No. 22444).

The SEC charged Edward M. Laborio, Jonathan Fraiman, Matthew K. Lazar, and seven entities controlled by Laborio for their alleged roles in a boiler scheme that ran from December 2006 to August 2009. The seven entities include Envit Capital Group, Inc., Envit Capital, LLC, Envit Capital Holdings, Inc., Envit Capital Private Wealth Management, LLC, Envit Capital Multi Strategy Mixed Investment Fund I LP, Aetius Group PLC, and Aetius Group LLC. The scheme "used high-pressure sales tactics to raise up to $5.7 million from approximately 150 investors through the fraudulent sale of five unregistered securities offerings." Laborio and Fraiman "made multiple misrepresentations and misleading statements to investors" including "scripts with sales pitches containing fabricated information." Allegedly, Laborio used investor funds to pay personal expenses including gambling losses. Lazar allegedly raised $585,000 from investors through one scheme alone. The SEC seeks permanent injunctions, disgorgement and other penalties.

Former Chief Financial Officer of Soyo Group Ordered to Pay $15,600,000 Penalty for Securities Fraud,  August 10, 2012, (Litigation Release No. 22443).

The SEC ordered Nancy Shao Wen Chu, former Chief Financial Officer of Soyo Group, Inc., to pay $15.6 million "in penalties for committing securities fraud." Additionally, Eric Jon Strasser was ordered to pay $260,000 in penalties. Allegedly, between January 2007 and November 2008, Chu and another defendant booked "over $47 million in fraudulent sales revenues" through Soyo and reported such revenue on the company's SEC filings. This scheme almost doubled Soyo's net revenues for 2007, causing a dramatic increase in Soyo's share price.  The Court has ordered a penalty of $130,000 against Chu "for each of the 120 fictitious transactions [... ] and against Strasser for each of the two fraudulent SEC filings."   

SEC Charges Former Public Company CEO with Fraud,  August 10, 2012, (Litigation Release No. 22442).

According to the complaint (opens to PDF), Ronald D. Brooks allegedly "committed securities fraud while serving as CEO and chairman of Standard Oil Company USA, Inc." In Standard Oil's initial disclosure statement Brooks represented that he had no prior criminal convictions when in reality Brooks "has three prior felony convictions," two of which are for securities violations. The complaint charges Brooks with violating the Exchange Act, and the SEC "seeks a permanent injunction, a civil monetary penalty, an officer-and-director bar, and a penny-stock bar."
  
Former Deloitte Partner Pleads Guilty to Insider Trading,  August 9, 2012, (Litigation Release No. 22441)

On August 8, 2012, Thomas P. Flanagan, former Deloitte and Touch LLP partner, pled guilty "to one count of criminal securities fraud for engaging in insider trading." Flanagan, certified accountant and employee of Deloitte for 38 years, along with his son, Patrick T. Flanagan, used  nonpublic information from 2005 to 2008 to trade illegally. Combined, the father and son generated over $485,000 in illegal profits. Additionally, between 2003 and 2008 Thomas P. Flanagan was found by the SEC to have violated the SEC's auditor independence rules on 71 occasions. Thomas P. Flanagan has consented to pay penalties totaling over $1 million and  Patrick T. Flanagan consented to pay penalties totaling nearly $125,000.

Securities and Exchange Commision v. Heart Tronics, Inc., et al.,  August 8, 2012, (Litigation Release No. 22440)

On August 8, 2012, Martin B. Carter and Ryan A. Rauch agreed to settle charges "brought against them in SEC v. Heart Tronics, Inc., et al." Allegedly, Heart Tronics "announced millions of dollars in fraudulent sales orders for its heart monitoring device between 2006 and 2008." Carter, who fabricated numerous documents to support these claims, also shipped products to a friend to produce the illusion that the company delivered its product to a "bona fide customer." While encouraging investors to buy Heart Tronics stock, Rauch allegedly failed to inform them that he was being paid in exchange for Heart Tronics' promotion. Carter agreed to a judgment enjoining him from violating sections of the Securities Act and Exchange Act and a permanent penny stock bar. Rauch consented to a judgment that permanently enjoins him from violating sections of the Securities Act and imposes a three-year penny stock bar. Additionally, Rauch has agreed to pay over $37,000 in disgorgement, prejudgment interest, and civil penalties.

The SEC filed a civil enforcement action on December 20,2011 alleging that Heart Tronics, Inc. (formerly Signalife, Inc. and Recom Managed Systems, Inc.) along with "several individuals associated with the Company, engaged in a wide-ranging series of frauds." Mitchell J. Stein, the fraud schemes' mastermind, led "a campaign of public misinformation to drive up the price of Heart Tronics' stock." He then sold his and his wife's stock for a profit of more than $5.8 million. A grand jury indicted Stein on December 13, 2011 on 14 criminal counts. The SEC's "civil action against the remaining defendants, including Stein, Heart Tronics' co-CEOs Willie Gault and Rowland Perkins, and former stock broker Mark Nevdahl, is stayed until the conclustion of the criminal case against Stein."

SEC Obtains Bar Against Former Executive from Serving as an Officer or Director of a Public Company Due to Illegal Insider Trading,  August 8, 2012, (Litigation Release No. 22439)

On July 30, 2012, R. Brooke Dunn, former executive at Shuffle Master, Inc., was barred from serving as an officer or director of a public company for five years due to alleged insider trading in Shuffle Master stock and options. The SEC filed a complaint against Dunn along with Nicholas P. Howey on November 19, 2009. According to the complaint, on February 26, 2007 Dunn provided Howey with nonpublic information. Previously, Dunn and Howey settled the SEC's lawsuit "by agreeing to pay a civil penalty in the amount of $181,594 each." Additionally, Howey agreed to pay over $211,000 in disgorgement and prejudgment interest.

SEC Files Settled FCPA Charges Against Pfizer Inc. and Wyeth LLC,  August 8, 2012, (Litigation Release No. 22438)

On August 8, 2012, the SEC filed a settled enforcement action against Pfizer Inc. "for violating the Foreign Corrupt Practices Act." Allegedly, "employees and agents of Pfizer's subsidiaries in Bulgaria, China, Croatia, Czech Republic, Italy, Kazakhstan, Russia, and Serbia" bribed foreign officials "to obtain regluatory and formulary approvals, sales, and increasesd prescriptions for the company's pharmaceutical products." According to the complaint, if a doctor agreed to use Pfizer products, the doctor's institution then received a percentage of the value purchased in "the form of cash, international travel, or free products." A separate action was filed against Wyeth LLC--a pharmaceutical company acquired by Pfizer a few years ago--for FCPA violations as well. Allegedly, "subsidiaries marketing Wyeth nutritional products...bribed government doctors to recommend their products to patients." The complaint alleges that Pfizer's misconduct started as early as 2001, and Wyeth's misconduct started at least as early as 2005. In October 2004, Pfizer "made an initial voluntary disclosure of misconduct by its subsidiaries to the SEC...and fully cooperated with SEC investigators." Pfizer also allegedly undertook "a comprehensive worldwide review of its compliance program." Pfizer has consented to pay over $26.3 million in disgorgement and prejudgment interest. Wyeth has agreed to pay over $18.8 million in disgorgement and prejudgment interest. Pfizer is also "required to report to the SEC on the status of its remediation and  implementation of compliance measures over a two-year period." 

SEC Charges Real Estate Investment Company and Its Principals with Offering Fraud,  August 7, 2012, (Litigation Release No. 22437)

According to the July 6, 2012 complaint (opens to PDF),  The Companies (TC), LLC and its principals, Kristoffer A. Krohn, Stephen R. Earl, and former officer, Michael K. Krohn, "initiated four unregistered offerings of securities from January 2009 to June 2011" to raise money for real estate purchases. The Companies, or its subsidiary, Alpha Real Estate Holdings, L.P., purchased distressed real estate for investment. Kris Krohn, Earl, and Mike Krohn provided "content for and approval of the private placement memoranda...used to solicit investors." The PPMs "contained material misrepresentations and omissions related to, among other things, the value of properties to be purchases or that were owned by the Companies or Alpha LP." In total, the four offerings raised nearly $12 million from almost 170 investors. Each defendant has consented to a judgment permanently enjoining him from violating sections of the Securities Act. Additionally, The Companies agreed "to inform all investors in writing of the final judgment, provide audited financial statements, and offer return of consideration for investors who choose to return their securities to The Companies." Kris Krohn, Mike Krohn, and Earl have each also agreed to pay a $75,000 penalty each.

SEC Freezes an Additional $6 Million in Nexen Insider Trading Case,  August 6, 2012, (Litigation Release No. 22436)

According to the complaint (opens to PDF), the SEC obtained an emergency court order to freeze over $6 million "in assets of additional unknown traders who made approximately $2.3 million in illegal profits" through insider trading regarding Nexen Inc.'s acquistion by CNOOC Ltd. This court order follows an initial complaint filed by the SEC on July 27,2012. The assets frozen in this court order bring "the total value of assets frozen in this case to more than $44 million." The SEC seeks an order that will require the traders to pay disgorgement with interest and financial penalties, and permanently bar them from future violations of the Securities Act and the Exchange Act. 

Final Judgments Entered Against Former Executives of Massachusetts Company,  August 6, 2012, (Litigation Release No. 22435)

Final judgments were entered on July 23 and 24, 2012 against Inofin executives, Kevin Mann, Sr. and Michael J. Cuomo, for their alleged involvement in illegally raising at least $110 million "through the sale of unregistered notes." According to the SEC's complaint, Melissa George, another Inofin executive, was also involved with Cuomo and Mann in materially misrepresenting the Company's use of investor funds and the Company's financial performance. Sales agents, David Affeldt and Thomas K. Keough, have also been charged in allegedly promoting the offering and sale of the unregistered securities. Additionally, Nancy Keough, Thomas Keough's wife, is named "as a relief defendant for the purposes of recovering proceeds she received as a result of the violations." Cuomo and Mann have been ordered to pay nearly $2 million and over $1 million, respectively, in penalties. Action against Inofin, George, Affeldt and the Keoughs is pending.

SEC Charges Massachusetts Resident with Insider Trading in Art Technology, Inc.,  August 3, 2012, (Litigation Release No. 22434)

According to the complaint (opens to PDF), Joseph McVicker used information he gained from a close friend at a social event to engage in insider trading in shares of Art Technology Group, Inc. McVicker earned over $44,000 in illegal profits in November 2010. McVicker will pay over $88,000 in disgorgement, prejudgment interest, and civil penalties.

SEC Charges Bristol-Myers Squibb Executive with Insider Trading in Stock Options of Potential Acquisition Targets,  August 3, 2012, (Litigation Release No. 22433)

According to the complaint (opens to PDF), Bristol-Myers' treasury department executive, Robert D. Ramnarine, used confidential information regarding companies being targeted for potential acquisitions to engage in illegal trading. Ramnarine, who made more than $300,000 in illegal profits, "conducted Internet research from his Bristol computer to determine whether he could be detected by regulators." Some of the phrases he searched included "can stock option be traced to purchaser" and "illegal insider trading options trace," viewing articles including "Ways to Avoid Insider Trading." He allegedly "conducted his insider trading schemes from August 2010 to July 2012" to trade in stock options of Pharmasset Inc., Amylin Pharmaceuticals Inc., and ZymoGenetics Inc.

Thursday, August 9, 2012

Many ETF Issuers Consolidating Offerings

By Tim Dulaney, PhD and Tim Husson, PhD

As inflows to ETFs have exploded over the past few years, many issuers expanded their lineup of funds to take advantage of the increased investor interest.  Some have tried to compete with established funds by creating funds with very similar exposure, while others have offered highly specific investment strategies in an attempt to capture a niche market.

In general the ETF market has exhibited a 'winner take all' pattern whereby the oldest and largest funds attract by far the most investor interest.  The smaller, newer funds may be heavily marketed by their issuers, but could bear substantially more liquidity risk, and may be more likely to be shuttered if inflows fail to materialize.

In recent days, many issuers have begun to cull their less popular ETF offerings. Yesterday we reported that Direxion is closing several of its leveraged and inverse leveraged ETFs that have failed to attract significant investor attention. IndexUniverse noted earlier this week that Scottrade is planning on liquidating their entire offering of ETFs (15 in total) and closing up their ETF unit (FocusShares).   In addition, Russell is conducting a strategic review on their US ETF business which will likely shrink the size of their ETF unit.

Investors in shuddered funds may not be able to redeem their shares at full value.  Typically, when ETFs close they liquidate their holdings over a period of time and then distribute the proceeds, net of closing costs, to shareholders.  During that liquidation period, the share value of the fund may not track its underlying index, and the liquidation may yield less proceeds than the net asset value reported before the liquidation began.

These closings highlight the fact that investors in smaller ETFs face liquidity risk if their ETF's shares do not attract an active market.  If an issuer stops supporting the market for an ETF through market making activities (or closes the fund completely), then investors may find that they cannot buy or sell shares at prices that correspond to the underlying investment objectives of the fund.

So while issuers aggressively market their newest offerings as they attempt to gain market share, investors should be aware that smaller funds carry additional risks and may require active monitoring to prevent unexpected liquidation.

Wednesday, August 8, 2012

Direxion to Close Several Leveraged ETFs

By Tim Dulaney, PhD

Direxion Shares ETF Trust announced last week that -- upon recommendation of the trust's advisor Rafferty Asset Management, LLC -- nine daily leveraged and inverse Exchange Traded Funds will be liquidated and shares will no longer be open for purchase as of early next month.  From the announcement,
Due to the Funds' inability to attract sufficient investment assets, Rafferty believes they cannot continue to conduct their business and operations in an economically efficient manner. As a result, the Board concluded that liquidating and shuttering the Funds would be in the best interests of the Funds and their shareholders.
The nine leveraged and inverse leveraged ETFs that will be closing in the coming weeks are unfortunately some of the most clever ETF tickers out there.  Here's the list of soon-to-be-history funds:
  1. Direxion Daily Agribusiness Bull 3X Shares (COWL): 
    • Assets Under Management (8/1/2012): $2.41MM 
    • Average Daily Trading Volume (5/1/2012 - 8/1/2012): 4,347
    • Daily Leverage: 300%
  2. Direxion Daily Agribusiness Bear 3X Shares (COWS) : 
    • Assets Under Management (8/1/2012): $1.14MM
    • Average Daily Trading Volume (5/1/2012 - 8/1/2012): 1,115
    • Daily Leverage: -300%
  3. Direxion Daily Basic Materials Bear 3X Shares (MATS):  
    • Assets Under Management (8/1/2012): $1.30MM
    • Average Daily Trading Volume (5/1/2012 - 8/1/2012): 4,739
    • Daily Leverage: -300%
  4. Direxion Daily BRIC Bull 3X Shares (BRIL): 
    • Assets Under Management (8/1/2012): $5.00MM
    • Average Daily Trading Volume (5/1/2012 - 8/1/2012): 1,115
    • Daily Leverage: 300%
  5. Direxion Daily BRIC Bear 3X Shares (BRIS):  
    • Assets Under Management (8/1/2012): $2.69MM
    • Average Daily Trading Volume (5/1/2012 - 8/1/2012): 6,009
    • Daily Leverage: -300%
  6. Direxion Daily Healthcare Bear 3X Shares (SICK): 
    • Assets Under Management (8/1/2012): $2.10MM
    • Average Daily Trading Volume (5/1/2012 - 8/1/2012): 799
    • Daily Leverage: -300%
  7. Direxion Daily India Bear 3X Shares (INDZ): 
    • Assets Under Management (8/1/2012): $4.28MM
    • Average Daily Trading Volume (5/1/2012 - 8/1/2012): 12,633
    • Daily Leverage: -300%
  8. Direxion Daily Latin America Bear 3X Shares (LHB): 
    • Assets Under Management (8/1/2012): $4.18MM
    • Average Daily Trading Volume (5/1/2012 - 8/1/2012): 28,478
    • Daily Leverage: -300%
  9. Direxion Daily Retail Bear 3X Shares (RETS): 
    • Assets Under Management (8/1/2012): $2.71MM
    • Average Daily Trading Volume (5/1/2012 - 8/1/2012): 19,347
    • Daily Leverage: -300%
Direxion currently offers 49 leveraged or inverse leveraged ETFs with total assets of just over $6 billion (as of 8/1/2012).  These nine leveraged and inverse leveraged ETFs represent approximately 0.5% of the total assets under management as of 8/1/2012.  Direxion has chosen to continue offering, at least for now, MATL (the 3x bull analog of MATS) and RETL (the 3x bull analog of RETS) even though both of these funds had less than $5MM in assets (as of 8/1/2012) and an average trading volume of less than 6,000 shares over the past three months.

It is possible that, following regulatory actions (including, for example, FINRA sanctioning sellers of LETFs), the solicited purchases of LETF shares by retail customers has finally waned.  On the other hand, perhaps these funds were just the victims of a glut of inventory and choices investors currently face when choosing an LETF.  

Monday, August 6, 2012

Mutual Fund and ETF Issuers Competing on Fees

By Tim Husson, PhD

In March, we posted a graph of the returns and fees of the 25 largest funds by net assets and called attention to the striking difference in fees between funds offered by the Vanguard Group and those offered by American Funds.  While both had very similar 5-year annualized total returns, the Vanguard funds had significantly lower fees.

Today the Wall Street Journal ran an article about how Vanguard's funds have attracted net inflows of $452 billion from January 2008 to June 2012, while American Funds' have seen net outflows of $200 billion over the same period.  The author, Tom Lauricella, attributes the difference to a change in investors' strategies:
For many financial advisers, especially those at the big brokerage houses, gone are the days of claiming to "add value" for clients by finding market-beating fund managers. Instead, the firms are emphasizing smart shifts among different types of holdings. 
And they are gravitating to what was once unthinkable: getting exposure to desired segments through lower-cost index-based portfolios, often through ETFs.
The article goes on to describe how American Funds remains reluctant to offer lower-cost ETFs in place of its usual mutual fund investments because of their increased transparency, which "would tip off the market to the firm's trading."  But in a market environment when actively managed funds frequently underperform passive index funds, the difference in fees alone could be what is moving investors towards the lower-cost Vanguard funds, as many of the article's commenters have pointed out.

Friday, August 3, 2012

SEC Litigation Releases: Week in Review

SEC Settles Litigation with Former Veritas Software Corporation Chief Financial Officer,  August 2, 2012, (Litigation Release No. 22432).

On July 20, 2012, a final judgment was entered against Kenneth E. Lonchar in the case SEC v. Mark Leslie, Kenneth E. Lonchar, Paul A. Sallaberry, Michael M. Cully, and Douglas S. Newton. Lonchar, the former Chief Financial Officer of Veritas Software Corporation, had been charged with inflating Veritas' reported revenues "by approximately $20 million in connection with a software sale to America Online, Inc." Also, Lonchar was charged with using improper accounting practices to "'smooth' artificially Veritas' financial results." Lonchar has agreed to pay $400,000 in disgorgement, prejudgment interest, and penalties. He has also been suspended from appearing or practicing before the Commission as an accountant, but can request reinstatement in five years.

Shane A. Mullholand and Dissemination Services LLC Enjoined and Barred from Penny Stock Offerings,  August 2, 2012, (Litigation Release No. 22431).

 On July 30, 2012, the court enjoined Shane A. Mullholand and Dissemination Services LLC from violating sections of the Securities Act of 1933 and the Securities Exchange Act of 1934. Mullholand and Dissemination have also been ordered to pay over $4.8 million in disgorgement and prejudgment interest and $240,000 in civil penalties. Mullholand and Dissemination were charged with "acting as underwriters engaged in a scheme to evade the securities registration requirements" because they offered and sold securities for six companies "when no registration statements were filed or in effect to provide information to public investors." 
 
SEC Charges Multiple Individuals and Entities in the U.S. for Widespread Misconduct in Connection with Chinese Reverse Merger Company,  July 30, 2012, (Litigation Release No. 22430).

In an investigation into China Yingxia International, Inc., the SEC has filed complaints against various entities and individuals. According to the complaint against Peter Siris et al. (opens to PDF), Peter Siris along with his associated entities, Guerrilla Capital Management, LLC and Hua Mei 21st Century, LLC were involved in "insider trading, trading in violation of Rule 105 of Regulation M, fraudulent representations in a securities purchase agreement, misstatements to investors in pooled investment vehicles, acting as an unregistered securities broker, and unregistered sales of securities." Siris, "a well-known fund manager and active investor in Chinese companies," invested $1.5 million in China Yingxia through tow New York-based hedge funds he managed. Siris, along with his consulting firm, Hua Mei, acted as advisers to China Yingxia. Hua Mei allegedly received cash and shares which "were improperly sold without any registration statement in effect." Additionally, in February and March 2009, Siris sold over 1.1 million shares based on non-public information regarding China Yingxia's Ceo's illegal activity. Siris not only allegedly made more than $172,000 in ill-gotten gains, but he also "omitted material information and made material misrepresentations to investors in his funds concerning his role with China Yingxia." Siris allegedly engaged in insider trading, selling short the securities of two Chinese companies. Further, Siris claimed "in one securities purchase agreement that he had not traded the issuer's securities," when in fact he had "sold short the issuer's stock."Siris gained almost $289,000 from this illegal activity. Siris and his entities have agreed to pay over $660,000 in disgorgement and prejudgment interest and Siris agreed to pay a civial penalty of about $464,000. Siris, Guerrilla Capital, and Hua Mei have been enjoined from violating provistions of the Securities Act, Exchange Act, and Advisers Act. 

In the complaint against Alan Sheinwald et al. (opens to PDF) Ren Hu, former chief financial officer of China Yingxia, was charged by the SEC for "fraudulent representations in Sarbanes-Oxley certifications, lying to auditors, failure to implement internal accounting controls, and aiding and abetting China Yingxia's failure to implement internal controls." Alan Sheinwald, along with his investor relations firm, Alliance Advisors, LLC, was charged with acting as unregistered securities brokers. Other individuals connected to China Yingxia have been charged as well. Peter Dong Zhou has been charged with "insider trading, unregistered sales of securities, and aiding and abetting unregistered broker activity." Steve Mazur has been charged with acting as an unregistered securities broker. Finally, James Fuld, Jr. has been charged for unregistered sales of securities. Cease-and-desist orders have been issued against Zhou and Mazur, as well as a cease-and-desist order against Fuld. Zhou has agreed to pay over $73,000 in disgorgement, prejudgment interest and penalties. Zhou has also agreed to a "collateral bar, penny stock bar, and investment company bar, with the right to apply for reentry after three years." Mazur has agreed to pay over $177,000 in disgorgement, prejudgment interest, and penalties. Mazur has agreed to "a collateral bar, penny stock bar, and investment company bar, with right to apply for reentry after two years." Fuld has agreed to pay over $216,000 in disgorgement and prejudgment interest. 


SEC Charges Ohio Oil and Gas Concern with Offering Fraud,  July 30, 2012, (Litigation Release No. 22429).

According to the complaint (opens to PDF), Michael A. Bodanza, former chief financial officer and founding member of Preferred Holdings Co., LLC, was involved with the unregistered offering and sale of securities. Preferred Financial Holdings Co., LLC was formed in 2006 to "engage in oil and gas exploration, drilling, and leasing through operating subsidiaries." From June 2007 to August 2010, Bodanza and Preferred Holdings allegedly raised almost $6.8 million from investors through the "unregistered sale of Preferred Holdings promissory notes." Bodanza allegedly failed to disclose to investors the financial problems that Preferred Holdings experienced from 2007 through 2010. During this time frame, the company experienced combined net losses of more than $6 million. Bodanza also allegedly failed to tell investors crucial information including: Preferred Holdings "removed one of its founding members and its chief operating officer," suing him for causing the company to incur damages between $3 million and $4 million; the only operating drilling rig held by the company's subsidiary "suffered an irreparable breakdown in August 2008"; the company was involved with an insurance dispute to recover $1 million as a result of this breakdown; the company's drilling subsidiary "incurred $260,000 in drilling expenses above its original cost estimates"; and the company's subsidiary failed to acquire property in Tennessee that would have been used to drill and sell gas. Bodanza agreed to judgment permanently enjoining him from violating sections of the Securities Act and the Exchange Act and an order to pay "disgorgement of $359,656 and prejudgment interest of $50,551." However, based on Bodanza's financial condition, all but $154,000 of the disgorgement and prejudgment interest have been waived. Preferred Holdings has agreed to a judgment permanently enjoining it from violating sections of the Securities Act and Exchange Act, and has agreed to pay over $4.7 million in disgorgement and prejudgment interest, "jointly and severally with the Relief Defendants." Preferred Holdings subsidiaries, Preferred Drilling Co., LLC, Preferred Financial Investment Co., LLC, Preferred Financial Leasing Co., LLC, and Preferred Well Management Co., LLC have been charged as Relief Defendants "based on their receipt or benefit from the funds raised through the unregistered, fraudulent offering." Each of the Relief Defendants has agreed to pay over $4.7 million in disgorgement and prejudgment interest, "jointly and severally with Preferred Holdings."


SEC Freezes Assets of Insider Traders in Nexen Acquisition,  July 30, 2012, (Litigation Release No. 22428).

On July 27, 2012, the SEC obtained an emergency court order to freeze the assets of the Hong Kong-based firm, Well Advantage Limited, and other unknown traders using trading accounts in Hong Kong and Singapore "to reap more than $13 million in illegal profits by trading in advance of this week's public announcement that China-based CNOOC Ltd. agreed to acquire Canada-based Nexen Inc." Zhang Zhi Rong controls Well Advantage as well as "another company that has a 'strategic cooperation agreement' with CNOOC." The SEC's emergency order came within 24 hours after Well Advantage placed an order to liquidate its entire position in Nexen. Well Advantage purchased more than 830,000 shares in Nexen on July 19, whose stock rose nearly 52 percent on July 23 after the announcement of its acquisition went public. Well Advantage and the unknown traders made over $13 million in illegal profit. The frozen assets of the traders are valued at more than $38 million.

Securities and Exchange Commission v. Emanuel L. Sarris, Sr. and Sarris Financial Group, Inc.,  July 30, 2012, (Litigation Release No. 22427).

The SEC has charged Emanuel L. Sarris, Sr. and his firm, Sarris Financial Group, Inc. with facilitating a Ponzi scheme where over 70 individuals invested $30 million in private funds which were "purportedly traded in foreign currencies, called 'Kenzie Funds.'" In actuality, these funds "were a massive Ponzi scheme that defrauded at least 400 investors out of more than $105 million."  Sarris and Sarris Financial allegedly failed to disclose to investors that they were hired by one of the companies that managed the Kenzie Funds to induce investments. When selling these funds, Sarris and Sarris Financial allegedly made false claims about the funds' "safety, performance, and legitimacy" and even "proposed that the Kenzie entities use existing or new investor money to pay redemptions to departing investors."

Securities and Exchange Commission v. LocatePlus Holdings Corporation, Jon Latorella and James Fields,  July 30, 2012, (Litigation Release No. 22426).

LocatePlus Holdings Corporation, a company that sold on-line access to public record databases for investigative searches, has agreed to settle charges that "it engaged in securities fraud from 2005 through 2007 by misleading investors about its funding and revenue." On October 14, 2010, the SEC filed a civil enforcement action against LocatePlus "alleging that [it] violated the anti-fraud and books and records provisions of the federal securities laws." Jon Latorella, former LocatePlus chief executive officer, and James Fields, former LocatePlus chief financial officer, were both charged with conspiracy to commit securities fraud "for their roles in a scheme to fraudulently inflate revenue at LocatePlus." On June 14, 2012, Latorella was sentenced to 60 months' imprisonment. The criminal case is still pending against Fields. LocatePlus has agreed to an order barring the trade of its securities in the public market. The proposed judgment against LocatePlus, "which is subject to court approval, will not impose monetary relief against LocatePlus in light of its bankruptcy and financial condition."


Judgments Entered Against Defendants for Disturbing Unregistered Shares of Universal Express Inc.,  July 27, 2012, (Litigation Release No. 22425).

On July 26, 2012 an amended judgment was entered against Michael J. Xirinachs and Emerald Asset Advisors LLC, enjoining them from future violations of provisions of the Securities Act and ordered them to jointly and severally pay over $7.6 million in disgorgement, prejudgment interest, and civil penalties. Xirinachs has been ordered separately to pay over $2.5 million in disgorgement, prejudgment interest, and civil penalties. Xirinachs and Emerald Asset have also been barred from "participating in penny stock offerings for three years, but [are] allowed to purchase penny stocks during that period." Xirinachs and Emerald Asset were engaged in "unregistered distribution of billions of shares of Universal Express Inc. (USXP) between February 2006 and June 2007."



Wednesday, August 1, 2012

ETFs are Finding Their Way into 401(k) Plans

By Carmen Taveras, PhD

In a recent blog post we discussed how mutual fund fees can drastically reduce funds available for retirement (see here). We cited a paper from the Center for Retirement Research that studied a typical 401(k) plan’s investment costs, which including advertising fees, administration fees, asset management fees, and trading costs total 1-2% of assets annually (see here). The paper proposed boosting the returns of 401(k) plans by investing in passively managed and lower cost ETFs instead of actively managed and higher cost mutual funds. In another of our blog posts we commented on an S&P performance report that found that most actively managed mutual funds exhibit lower returns than their analogous passive benchmark indices (see here). Nevertheless, most 401(k) savings plans consist of a set of mutual funds and do not allow investing in ETFs. This reality may soon change.

SEC exemptions have made it possible for mutual fund companies to invest in ETFs. Historically, the Investment Company Act of 1940 limited mutual funds and other investment companies from:

(i) Acquiring more than 3% of the total outstanding voting stock of another investment company (or ETF);
(ii) Investing more than 5% of their assets in a single investment company; and
(iii) Investing more than 10% of their assets in other investment companies (see Section 12(d)(1)(A)).

Recently, many ETFs have received SEC exemptions allowing other investment companies (including mutual funds) to invest in them above the 3%, 5%, and 10% limitations. JPMorgan SmartRetirement Blend Funds are a new family of funds that invests both in other JPMorgan mutual funds and in ETFs that have received the SEC exemption (see prospectus). The advantage of this new type of fund is that their investment in passively managed ETFs may reduce the costs of 401(k)s without compromising returns.

So far the average 401(k) investor cannot typically trade directly into an ETF. In a Bloomberg interview, Neil Plein, vice president of Invest n Retire LLC, posits that technological reasons may be the biggest issue preventing 401(k) plans to invest directly in ETFs. He states that the 401(k) systems “were designed for mutual funds with end-of-day pricing […] When you have an ETF, you have an investment vehicle that trades intra-day, not end-of-day” (see full interview). Another often heard critique of 401(k) plans offering ETFs directly is that the ability to trade intraday may result in higher trading costs for investors chasing performance.

Even though most investors cannot invest in ETFs directly through their 401(k) plans, they may soon be able to invest in mutual funds that invest in ETFs. The JPMorgan Funds may lead the way to more 401(k) assets shifting from traditional mutual funds to ETFs.