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News February 14, 2005 Issue

Rogue Compliance Officer Leaves Advisory Firm Embroiled in Host of Woes

Recall the case of Susana Longo, the rogue compliance officer who allegedly defrauded her firm’s clients of over $5 million by forging checks and account documents? Last we heard, her house and other possessions had been sold and the $2.1 million proceeds placed in receivership.

There’s more to the story. Her former employer, a small Atlanta-based advisory firm by the name of Applied Financial Group, has been entangled in a legal dispute with its former custodian, Charles Schwab & Co.

At issue: who, exactly, should have caught Longo’s hand in the cookie jar?

While the proceeding is being held in abeyance pending finalization of a settlement, the allegations made by the adviser against its custodian, and vice versa, paint a cautionary tale worth heeding by all advisers. In particular, the allegations illustrate the importance of an adviser’s internal controls not only as a regulatory matter, but also as a key component in private litigation and the ability of an adviser to draw on its E&O insurance.

"The SEC is only one aspect of any problem," explained Dechert partner Mel Schwarz. Private litigation, he noted, can create "even larger monetary exposure than the SEC would cause." (Schwarz was speaking as a general matter and without familiarity with the case or the specific parties involved).

The adviser, along with its affiliated plan administrator, Applied Financial Concepts (AFC) and one of AFG’s defrauded clients, initiated the NASD arbitration proceeding against Schwab in September 2004. Based on a description of the proceeding in a court filing submitted by Lloyd’s of London (more on that below), it appears that the adviser asserted that Schwab was negligent in its custodial duties because it continued to honor an advisory client’s checks for months after the client passed away. The adviser alleged that at least some Schwab personnel knew that the client was deceased. The adviser also claimed that Schwab negligently honored "non-customary withdrawals" from the advisory firm’s pension plan accounts and made transfers between unrelated pension plan accounts custodied at Schwab. That, said the adviser, exceeded Schwab’s authority as custodian.

Schwab turned around and asserted that the adviser was the negligent party. In a counter-claim filed October 18, Schwab said that the adviser and its affiliated plan administrator "have presented no explanation for how their own employee could, over the course of four years, take more than $5 million out of the accounts of four clients, without any detection by AFG, AFC, or their principals." Schwab claimed that the firm gave Longo "complete license" in all aspects of the business. The former compliance officer, they said, "was left to supervise herself."

Moreover, Schwab faulted the adviser’s internal controls and apparent failure to test the reconciliation of its account platform against the Schwab statements. "The failure of AFG and AFC to provide adequate supervision and internal controls, or even to review their own internal records, is inexplicable," said the custodian. Schwab noted that the adviser, on its Form ADV, asserted that account review was a continuous process. However, said Schwab, "it appears that AFG and AFC had no procedures in place to compare Schwab’s official statements to AFG’s own reports to its clients."

Schwab asked AFG and AFC to indemnify, defend, and reimburse Schwab for its costs in defending claims brought against it by the adviser’s pension plans.

A few days after Schwab filed its counter-claim, AFC asked Lloyd’s of London, which underwrote its E&O policy, to indemnify it against Schwab’s claims (according to one source familiar with the case, AFG’s E&O policy, underwritten by AIG, was more "tightly-worded" than the Lloyd’s policy and precluded coverage). Coverage under the E&O policy was necessary, since the firm’s fidelity bond would not cover the amount of loss.

Then, on November 5, Baker Audio (one of the allegedly defrauded clients) filed its own lawsuit against the adviser (see IM Insight, January 31, 2005 for more details on the Baker Audio suit).

At that point, allegations were flying and fingers were pointing. The various parties in the case — AFG, AFC, Schwab, and the four defrauded clients — took a collective deep breath. On November 9, they sat down at the table with a mediator and hammered out a settlement agreement pursuant to which some parties would pay others, and (to put it in plain English) everyone would agree to put the matter behind them.

But there was one problem: the settlement agreement was conditioned on Lloyd’s coughing up $2 million under AFC’s E&O policy. And when the parties sat down on November 9, Lloyd’s wasn’t at the table.

Why not?

Lloyd’s explained itself in a lawsuit filed against the adviser and others on December 9. The insurer alleged that AFC’s E&O policy was not intended to cover losses arising from employee theft or other fidelity matters. Among other things, Lloyd’s pointed to a provision in the E&O policy that excluded coverage of any claims arising out of "any commingling or other use of client funds." Longo, claimed the insurer, commingled client funds and converted them to another use (her own). Lloyd’s also pointed to an exclusion in the policy for acts arising out of securities law violations. Lloyd’s noted that the SEC "is conducting an investigation into this matter" and that one of the firm’s advisory clients (Baker Audio) alleged that the firm violated provisions of the federal securities laws. Of course, neither the advisory firm nor its affiliated plan administrator have been charged by the SEC with any wrongdoing.

Lloyd’s asked the state court to declare that it didn’t have to pay the $2 million out of the E&O policy.

At that point, everybody ganged up and collectively sued Lloyd’s in federal court.

In a suit filed January 19, AFG, AFC, Schwab, the four defrauded advisory clients, and other insurance carriers claimed that Lloyd’s filed the state suit to win "tactical advantage," and asked the court to make Lloyd’s pay the $2 million under the policy. d