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In a move that should place securities lawyers and their clients on notice, Commissioner Kara Stein of the Securities and Exchange Commission (“SEC”) recently indicated that lawyers may become targets of SEC enforcement actions when a registrant has been poorly advised by its attorney and the result of that advice ends up harming investors or violating regulatory standards.  The SEC has the ability to sanction, fine and bar attorneys and accountants from practicing before the SEC pursuant to SEC Rules of Practice 102(e).  As a practical matter, a bar pursuant to Rule102(e) precludes an attorney or an accountant from representing a regulated entity, such as an investment adviser or broker dealer, in any further dealings with the SEC or otherwise.

Several years ago, before he retired, I asked Gene Gohlke, then the acting head of the SEC’s Office of Compliance, Inspections and Examinations, why it was that the SEC brought Rule 102(e) proceedings against accountants, but rarely against attorneys.  “Lawyers are different,” was the answer I received.  And that has been the approach  of the SEC for quite some time, only bringing proceedings to bar attorneys in the most obvious and egregious cases.  My question to Mr. Gohlke was prompted by what I saw as questionable legal advice from certain “boutique” law firms that were providing not just aggressive advice, but simply incorrect advice.  You may recall that before the relatively recent Mayer Brown no-action letter, hedge fund managers were being advised that they could hire third party marketers that were not registered as broker dealers through “solicitation agreements” pursuant to Rule 206(4)-3 under the Investment Advisers Act of 1940.  This position, which was advocated by every former real estate or anti-trust  lawyer turned hedge fund lawyer, was flatly wrong, but generally embraced by fund managers.  When the SEC finally caught on that some fund managers were hiring unregistered broker dealers, Bob Plaze, then associate director of the Division of Investment Management of the SEC, somewhat famously quipped that if fund managers had been interpreting the Dana letter to allow such activity, they had been interpreting it wrong.

Additionally, in his recent speech, David Blass put fund managers on notice that they have been misinterpreting the scope of the “issuer’s exemption,” Rule 3a4-1 under the Securities Exchange Act of 1934.  Fund managers are now on notice that they need to either hire third party brokers, or pay their internal employees based on something other than the amount of capital raised on behalf of the fund.  This also grew out of a misunderstanding of that rule by the aggressive and misinformed section of the securities bar.  There are many other examples, such as relying on the issuer’s exemption” when the fund is organized as a unit trust, rather than a partnership or exempted company (don’t do it), misinterpretation of what constitutes permissible use of soft dollars within the safe harbor Section 28(e), operation of the custody rule, execution of short sales, and many more.  When the SEC finds deficiencies in a fund management organization, it is typically the fund manager that suffers the consequences, not the attorney that advised the fund management company.

But with the SEC now identifying attorneys as key “gatekeepers,” all of that could change.  Commissioner Stein is “troubled greatly” by enforcement cases where the lawyers that gave advice on the transaction and prepared and reviewed disclosures that were relied upon by investors are not held accountable.  The Commissioner identified that when lawyers do provide bad advice, or effectively serve to assist fraud, their involvement is used as a shield against liability, both for themselves and for others.  The problem has been surfaced by the SEC, now we will see how and against whom enforcement action is taken in order to make an example for the industry.

What does this mean for fund managers?  First, fund managers need to recognize that “forum shopping” is dangerous.  You can always find a lawyer somewhere that is complacent, desperate, or unethical enough to tell the fund manager whatever they want to hear.  This is a short term folly and can only lead to a bad result in the longer term.  Second, the market has changed substantially since the heady days of 2002-2007.  It is no longer just the overworked and understaffed regulators with which fund managers need to concern themselves.  Investor sophistication in the due diligence area has increased substantially and now endowments, family offices and ultra-high net worth investors want to understand that the fund manager has made good decisions with respect to their service providers and has not opted for a low-end option that the fund manager can dominate and control.  Particularly for start-up fund managers that have essentially one shot at executing on a successful offering, the choice of an administrator that has no FATCA solution, or a lawyer that is unknown or not respected, can kill the offering before it ever gets started.  As attorneys, we recognize that competition in the asset management business is fierce and raising assets has rarely been more difficult; however, this is a business that is built on trust and confidence.  Fund managers need to demonstrate with every decision they make; they are motivated by the best interests of their investing clients.

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On May 16, 2014, a federal court in Florida entered an Order finding in favor of the Commodity Futures Trading Commission (CFTC) following a trial against four Hunter Wise related companies and their owners on charges that they had fraudulently misrepresented the nature of precious metals transactions that resulted in millions of dollars in customer losses.

Hunter Wise was found to have orchestrated a multi-level marketing scheme in which so-called retail dealers served a sales function for Hunter Wise, soliciting customer accounts. The dealers advertised and claimed that they sold physical metals, including gold, silver, platinum, palladium, and copper, to retail customers on a financed basis and forwarded customer funds to Hunter Wise, whose identity was not disclosed to the customers.  Using deceptive marketing materials provided to them by Hunter Wise, the dealers claimed to arrange loans for the purchase of physical metals and advised customers that their physical metals would be stored in a secure depository.  Customers were then charged “exorbitant interest” on the purported loans and storage fees for the metal they thought they had purchased.  In fact, neither Hunter Wise nor any of the dealers purchased any physical metals, arranged actual loans for their customers to purchase physical metals, or stored physical metals for any customers participating in their retail commodity transactions.  Over 90 percent of the retail customers lost money.

Hunter Wise Commodities, LLC, Hunter Wise Services, LLC, Hunter Wise Credit, LLC, and Hunter Wise Trading, LLC and the individuals running the companies, have been ordered to pay, jointly and severally, $52.6 million in restitution to the defrauded customers and to pay a civil monetary penalty, jointly and severally, of $55.4 million, the maximum provided by law.  The CFTC charged Hunter Wise, its principals, and other related parties in December 2012.  The Court found that the principals of Hunter Wise knowingly defrauded more than 3,200 retail customers for more than 16 months, between July 2011 and February 2013, and engaged in fraudulent conduct that was “repeated, callous and blatant.”

In considering the appropriate penalties, the Court noted that the fraudulent scheme was “egregious and recurrent” and “calculated to deceive retail customers.” The Court held that the likelihood of future violations was “strong” given that Hunter Wise principals did not acknowledge any wrongdoing.  Further, the “systematic and pervasive nature” of the fraud necessitated full restitution for all customers who lost money between July 16, 2011 and February 25, 2013.

This case follows a CFTC “Precious Metals Fraud Advisory” alert issued in January of 2012 in which the CFTC indicated that it was aware of an increase in the number of companies offering customers the opportunity to buy or invest in precious metals.  The CFTC’s Consumer Fraud Advisory specifically warned that frequently companies do not purchase any physical metals for the customer, but instead simply keep the customer’s funds.  The Consumer Fraud Advisory further cautioned consumers that leveraged commodity transactions are unlawful unless executed on a regulated exchange.

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The Commodity Futures Trading Commission (“CFTC”) staff recently issued guidance to registered CPOs regarding the delegation of commodity pool operator (“CPO”) functions from persons that might otherwise be subject to CPO registration.  For non-natural persons delegating CPO functions to a registered CPO, the relief from registration is conditioned on the CPO that is delegating its authority (the “Delegating CPO”) controlling, being controlled by, or being under common control with, the registered CPO (the “Designated CPO”).  The new staff letter removed the previous requirement that “unaffiliated directors” of the commodity pool that would be considered CPOs agree to be jointly and severally liable with the registered CPO for violations of the Commodity Exchange Act or the CFTC‘s regulations by the registered CPO.  This new no-action relief is not self-executing.  Each Delegating CPO must apply to the CFTC in order to take advantage of this new CFTC staff position.

In order to coordinate filing obligations for the CFTC and the Securities and Exchange Commission (SEC), many CPOs, which may also be registered investment advisers, seek to delegate their obligations to affiliated commodity trading advisors or registered CPOs.  Information provided in Form PF may be used to fulfill portions of the filing requirements for Form CPO-PQR under CFTC regulations, if the same entity is filing both reports.  However, previous CFTC guidance on this point was ambiguous at best. The new staff letter is meant to provide clear and consistent guidance for when CPO delegation will be permitted, but will not adversely affect no-action relief that was previously granted under the former CFTC position.

The new staff letter sets forth specific criteria for the approval of CPO delegations. The criteria in the new CFTC letter for obtaining CFTC delegation approval are as follows:

  • The Delegating CPO must have delegated to the Designated CPO all of its investment management authority with respect to the commodity pool pursuant to a legally binding document.
  • The Delegating CPO must not participate in the solicitation of participants for the commodity pool or manage any property of the commodity pool.
  • The Designated CPO must be registered as a CPO with the CFTC.
  • The Delegating CPO must not be subject to a statutory disqualification.
  • There must be a business purpose for the Designated CPO being a separate entity from the Delegating CPO other than solely to avoid the Delegating CPO registering with the CFTC.
  • The books and records of the Delegating CPO with respect to the commodity pool must be maintained by the Designated CPO in accordance with CFTC Regulation 1.31.
  • If the Delegating CPO and the Designated CPO are each a non-natural person, then one must control, be controlled by, or be under common control with the other.
  • Delegating CPOs that are (i) non-natural persons or (ii) board members other than “unaffiliated board members” must execute a legally binding document with the Designated CPO in which each party undertakes to be jointly and severally liable for any violation of the Commodity Exchange Act or the CFTC’s regulations by the other party in connection with the operation of the commodity pool.
  • “Unaffiliated board members” that are Delegating CPOs must be subject to liability as a Board member in accordance with the laws under which the commodity pool is established.

The new staff letter itself includes a form of no-action request that a Delegating CPO would file with the CFTC, including identifying information about the Delegating CPO and the Designated CPO, and certifications by the Designated CPO and Delegating CPO regarding satisfaction of the criteria set forth in the new staff letter. Unfortunately, the no-action letter request must be submitted pursuant to the process set forth in CFTC Regulation 140.99 in paper form instead of by e-mail.

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As we have previously reported, the Securities and Exchange Commission (“SEC”) has taken a significantly heightened interest in whether people who engage in certain promotional activities on behalf of issuers of securities should be subject to regulation as a broker dealer.  The David Blass speech of April 5, 2013 put hedge fund general partners on notice that certain sales practices undertaken by hedge fund personnel may require registration as a broker dealer.  The SEC has recently followed up this guidance with enforcement action.

On May 15, 2014, the SEC  charged a Tiburon, California based securities salesman for selling millions of dollars in oil-and-gas investments without being registered with the SEC as a broker-dealer or associated with a registered broker-dealer.  The defendant, Behrooz Sarafraz, agreed to settle the SEC charges by paying disgorgement of his commissions, prejudgment interest, and a penalty for a total of more than $22 million.

According to the SEC’s complaint filed in federal court in San Francisco, Sarafraz acted as the primary salesman on behalf of TVC Opus I Drilling Program LP and Tri-Valley Corporation, which were based in Bakersfield, California.   From February 2002 to April 2010, these companies raised more than $140 million for their oil-and-gas drilling venture.  While Sarafraz was raising money for these entities, he was not associated with any broker-dealer registered with the SEC.  The SEC also alleged that Sarafraz worked full-time locating investors for the Opus and Tri-Valley oil-and-gas ventures.  He described the investment program to investors and recommended they purchase Opus partnership interests or securities of Tri-Valley and its affiliated entities.  In return, Sarafraz received commissions that ranged from seven to 17 percent of the sales proceeds that he and members of a sales network generated.  The SEC alleges that Opus and Tri-Valley paid Sarafraz approximately $18.3 million in sales commissions.  He paid approximately $1.9 million to others as referral fees and kept the remaining $16.4 million for himself.

For the two companies for which Sarafraz raised money, this could be just the beginning of the process.  If investors have lost money or would otherwise seek to unwind these transactions, it is possible that the investors could sue the companies and Sarafrax for rescission.  Typically, in a rescission recovery case, the plaintiffs who purchased through the unregistered broker can receive the higher of the current market price of the price that they originally paid for the securities.  Hedge funds and other private companies that use solicitors should take note.

The SEC also charged New York-based Rafferty Capital Markets with illegally facilitating trades for another firm that was not registered as a broker-dealer as required under the federal securities laws.  According to the SEC’s order instituting settled administrative proceedings, Rafferty agreed to serve as the broker-dealer of record in name only for approximately 100 trades in asset-backed securities that were actually introduced by the unregistered firm.  While Rafferty held the necessary licenses and processed the trades, it was the unregistered firm that managed the business.  Five of the firm’s employees became registered representatives with Rafferty but they performed their work in the offices of the unregistered firm, which retained sole authority over their trading decisions and determined their compensation.  Rafferty had no involvement in the trading or compensation decisions while the registered representatives executed the trades through Rafferty’s systems on behalf of the unregistered firm.  Based on the agreement, Rafferty kept 15 percent of the compensation generated by these trades and sent the remaining balance to the unregistered firm.

The SEC’s order found that Rafferty willfully violated Federal securities laws and also willfully aided and abetted and caused the unregistered broker-dealer’s violation of the registration provisions of the Securities Exchange Act.  Rafferty consented to a cease-and-desist order that censures the firm and requires the disgorgement of $637,615 as well as payment of $82,011 in prejudgment interest and a $130,000 penalty.  This case should serve as a cautionary tale for hedge fund and other private fund managers that seek to hire sales people who construct sham arrangements with a broker dealer in order to appear to be in compliance with the broker dealer registration provisions.  Expect more of these types of action from the SEC in the near future.