The SEC Sues Investment Advisory Firm in Connection with Alleged Failure to Disclose Revenue Sharing and Other Financial Conflicts, as Well as Converting Clients to Wrap Accounts Without Considering Whether it is in Clients’ Best Interests

In recent years, the SEC has been conducting a nationwide and industry-wide “sweep” of investment advisory firms, pursuant to which it has opened investigations and brought enforcement actions against a multitude of investment advisory firms related to their disclosures and practices concerning revenue sharing and other alleged financial conflicts.1  We have previously blogged about litigated disclosure cases2 and given the fact that litigated decisions are the true test of enforcement theories, compared to settlements that may pose untested legal theories regarding potential violations, contested proceedings should be followed closely.

In one of the most recent of these actions, on March 1, 2022, the SEC filed an action against Cambridge Investment Research Advisors, Inc. (“CIRA”), a registered investment adviser.3  The SEC alleges CIRA failed to adequately disclose conflicts of interest and failed to seek best execution in connection with its receipt of revenue sharing from client investments in no-transaction fee mutual funds (“NTF mutual funds”) and money market sweep funds (“sweep funds”), its conversion of client accounts to wrap account programs, and its investment adviser representatives’ receipt of compensation of forgivable loans in exchange for meeting certain investment criteria.  These undisclosed investment practices, the complaint alleges, also allowed CIRA to avoid paying millions of dollars in transaction fees.  In addition, according to the complaint, CIRA converted hundreds of accounts to its more expensive wrap account program without adequate disclosure and without analyzing whether doing so was in its clients’ best interests.  The complaint further alleges that CIRA failed to disclose that its investment adviser representatives received compensation in the form of forgivable loans in exchange for meeting certain criteria such as maintaining certain asset levels and tenure with CIRA.

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Cryptocurrency Exchange Founders Plead Guilty to Bank Secrecy Act Violations

On February 24, 2022, two of three founders of an off-shore cryptocurrency derivatives exchange, the Bitcoin Mercantile Exchange or “BitMEX,” pled guilty to violating the Bank Secrecy Act (BSA) by failing to maintain an anti-money laundering program.  Pursuant to their respective plea agreements, defendants Arthur Hayes and Benjamin Delo each agreed to pay a $10 million criminal fine and face up to five years in prison.  The defendants’ guilty pleas were entered approximately one month before they were scheduled to stand trial in the United States District Court for the Southern District of New York.

Hayes and Delo – along with two other BitMEX executives – were indicted in October 2020 for evading U.S. anti-money laundering rules.  A Department of Justice (DOJ) press release announcing the charges detailed that BitMEX was required to register with the Commodity Futures Trading Commission (CFTC) and to establish an adequate anti-money laundering program because it solicited and serviced U.S. traders.  Despite these obligations, BitMEX had only nominal programs in place to combat money laundering which, according to DOJ, were “toothless or easily overridden to serve BitMEX’s bottom line goal of obtaining revenue through the U.S. market without regard to U.S. regulation.”

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BlockFi to Pay $100 Million Over Crypto Lending Platform

On February 14, 2022, the SEC announced charges against BlockFi Lending LLC – a New Jersey-based cryptocurrency lending platform – for failing to register its crypto lending product and violating the Investment Company Act of 1940.  BlockFi agreed to a settlement in which it will pay a $50 million penalty, cease unregistered offers and sales of its lending product, and attempt to bring its business in compliance with the Investment Company Act within sixty (60) days.  Additionally, BlockFi agreed to pay $50 million in fines to 32 states to settle similar charges.

BlockFi offered and sold to investors BlockFi Interest Accounts (“BIAs”), through which investors lent crypto assets to BlockFi and, in exchange, BlockFi promised variable monthly interest payments paid in cryptocurrency.  The SEC’s Order sets forth the Commission’s findings.  First, it concluded that the BIAs were securities because they were notes under Reeves v. Ernst & Young, 494 U.S. 56 (1990), and because they were sold as investment contracts under SEC v. W.J. Howey Co., 328 U.S. 293 (1946).  Second, the SEC found that BlockFi was engaged in an illegally unregistered securities offering.  Third, it found that BlockFi violated Sections 17(a)(2) and 17(a)(3) of the Securities Act by making materially false and misleading statements concerning its collateral practices and the risks associated with its lending activity.  Finally, the SEC determined that BlockFi was operating as an unregistered investment company.

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SEC Disgorgement Claim Challenged After Supreme Court’s Decision in Liu

The SEC’s disgorgement request in a litigated proceeding in federal district court is being challenged in the wake of the Supreme Court’s 2020 decision in Liu v. SEC, which limited how much the agency can seek in disgorgement.

In April 2015, the SEC filed a complaint in the U.S. District Court for the Northern District of Texas against two California oil-and-gas companies, Team Resources, Inc., and Fossil Energy Corporation, their common principal, and four sales associates (collectively, “Team Resources”) for allegedly operating a fraudulent oil and gas production scheme. The SEC charged that Team Resources lured investors to the oil companies by touting unreasonable oil and gas production figures and distributing misleading information regarding the companies’ operations.

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Ubiquitous Use of WhatsApp and Other Unrecorded Internal Communications Result in Substantial Penalties in Recent SEC, CFTC Actions

The SEC has, for many years, used broker-dealer and associated persons’ failure to create and maintain books and records as a basis for the imposition of serious penalties.  In recent actions, it appears to be continuing—and upping the ante on—its enforcement in this area.

Simply stated, it is increasingly imperative for broker-dealers and investment advisory businesses, among other entities, to develop and maintain policies and procedures to ensure that their records are properly created, maintained, and produced to the appropriate agency upon request—including that employees’ communications related to their business should be made only through approved channels, and approved and monitored devices, such that those communications can be maintained and preserved for production as required by federal securities laws and regulatory authorities, and in any pending or threatened litigation.

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Reg BI: What’s Going On and What May Happen Next?

Chicago partner, Jim Lundy, co-leader of the firm’s White Collar Defense and Investigations team and the firm’s SEC & Regulatory Enforcement Defense practice, provides a end of year update on Reg BI. In this blog post, Jim discusses the events that have taken place since SEC Chair Gary Gensler’s last statements on Reg BI early in 2021 including the recent speech from SEC Commissioner and former Acting Chair Allison Herren Lee and deficiency letters across the brokerage industry.

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The SEC’s Renewed Focus on Accounting Misconduct

Two recent enforcement actions by the U.S. Securities and Exchange Commission (SEC), including a recent settled action against Kraft Heinz Co. (“Kraft”), underscore the agency’s renewed and continuing focus on accounting and financial reporting misconduct.

Two weeks ago, the SEC announced its third and latest enforcement settlement through its data-driven EPS (Earnings Per Share) Initiative. The EPS Initiative, run by the SEC’s Enforcement Division, used data analytics to detect potential reporting violations. The EPS Initiative has resulted in two prior actions. On September 28, 2020, the SEC publicly disclosed the EPS Initiative with two settlements, as discussed previously in this blog here.

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SPAC Attack: The SEC Charges a SPAC for Failure to Launch

On July 13, 2021, the SEC announced charges against Stable Road Acquisition Company (“Stable Road”), its sponsor, SRC-NI, its CEO, Brian Kabot, Stable Road’s proposed merger target Momentus Inc.(“Momentus”), and Momentus’s founder and former CEO Mikhail Kokorich (“Kokorich”) for “misleading claims about Momentus’s technology and about national security risks associated with Kokorich.” All parties except Kokorich are settling with the SEC, paying total penalties of more than $8 million, amongst other remedies. The SEC’s litigation will proceed against Kokorich in the U.S. District Court for the District of Columbia. The Complaint seeks permanent injunctions, penalties, disgorgement plus prejudgment interest, and an officer-and-director bar against Kokorich.

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