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News February 2, 2015 Issue

Ponzi Scheme Charges Against Adviser Make the Case for Effective Monitoring

No chief compliance officer wants to discover a Ponzi scheme in his own backyard. The best preventative against one is frequent and vigilant monitoring of trades.

CCOs may want to take a second look at their current and past trades following the SEC’s January 15 filing of a complaint in U.S. District Court for the Southern District of Florida. The complaint alleged that an unregistered Florida adviser, its manager and three related funds misled more than 50 investors and used most of the $17 million raised from them to make Ponzi-like payments back to them. The firm’s manager, according to the agency, "treated the funds as his personal piggy bank, tapping them to buy a $1.75 million home, luxury automobiles, and jewelry, and to cover his daily living expenses."

The federal judge on January 16 issued a temporary restraining order and placed an asset freeze against the firm, Elm Tree Advisors, manager Frederic Elm, and the three funds to prevent further firm activity.

"Elm misled investors about how he and his funds would use the money and about how much he charged them in fees," said SEC Miami Regional Office director Eric Bustillo.

Monitoring and more monitoring

It is not clear whether a CCO raised a warning in the Elm case, as the word "compliance" is not mentioned in the complaint. Whatever the case, advisers of all sizes should take precautions to ensure there are no secret Ponzi schemes going on under their noses.

"’Follow the money’ can be a guiding principle for a lot of what you do as a compliance officer," said

Mayer Brown attorney Adam Kanter. "If you see a lot of money coming in and then a few days later the same money is going out to other people, that’s probably something that needs to be looked into."

"The CCO should be an integral member of the team standing on the firm’s control deck," said

Eaton & Van Winkle partner Paul Lieberman, ensuring that, among other things:

  • Investors are suitable for the investments planned;
  • Trading orders are being properly executed and the paperwork is properly completed;
  • Trading is carefully monitored to ensure that fund fees, both management and performance, conform with disclosures made in the offering document; and
  • Bank statements and checks written and deposited by the fund are valid and accounted for.

Controls should be placed on the ability to move money, said Kanter. "Require multiple sign-offs if the wires or checks are for more than a certain amount."

In addition, before a fund becomes operational, there should be a preparatory meeting involving the CCO, the principals involved and legal counsel, to discuss all factors pertaining to the fund. Those factors include investment strategy, whether the fund accepted suitable investors, and whether the firm’s administrative infrastructure can handle the back office, trade processing, and the receipt and deposit of client and investor funds (not only trade settlements and expense/fee payments, but investor subscriptions and redemptions both into and out of the fund), among other things, Lieberman said.

"Everyone should be concerned with the accuracy and completeness of disclosures in the private placement memorandum and aware of what is going on in the fund trading and finances, including the fees charged," he said.

Funding the funds

The firm began raising money from investors no later than in November 2013, according to the SEC’s complaint, with investors making their investments in at least two different ways, the agency said.

The first way, used by most of the investors, involved purchasing limited partnership interests under a subscription agreement and then returning the signed agreements to Elm by mail or email.

"The private placement memoranda represented the money was being invested in, among other things, ‘equity stock and option strategies,’ and ‘privately-held, high-growth, emerging Internet and mobile companies,’" the agency said, "and further provided that Elm and [the firm] would take a 2 percent annual management fee plus 20 percent of any profits the [funds] earned."

The second way involved investing in one of the funds through promissory notes that provided that principal investment plus interest would be repaid, depending on each situation, from one to five years. Like the subscription agreements, the promissory notes were returned to Elm by mail or email.

Bad investments … and returns to investors

It’s not that Elm did not invest some of the money. In fact, the agency said, he invested approximately $7.1 million in net transfers to a

TD Ameritrade account in the name of one of the funds. Unfortunately, "at no point during the relevant time period, however, did investments in any of the funds return a profit." From January 2014 to the end of November 2014, that account lost approximately $3.9 million in stock trading, according to the complaint.

"To date, Elm has withdrawn at least $5.2 million of investor funds from the account to make payments to investors," the SEC said. Since the Elm Tree funds did not return a profit, these repayments were simply the return of investor principal in Ponzi-like fashion."

Disclosure issues

Statements in both the private placement memoranda and the promissory notes were "false and misleading," the agency said. While it was true that some investor money was invested, the "vast majority" was allegedly used to repay other investors and to fund Elm’s personal expenses and those of his wife, according to the complaint.

Contrary to their representations, Elm and the firm took "significantly more" than a 2 percent management fee, the SEC alleged. "Based upon the amount of investor proceeds invested in the Elm Tree funds, the stated management fee would have been approximately $184,000 to $381,000," it said, adding that there would have been no profit sharing with Elm or the firm, since the funds did not make any profits. "Elm, however, withdrew and misappropriated at least $2 million, … paying everyday expenses such as utility bills, gas, lawn care, pet and baby items and medical bills."

Some of the larger bills, according to the complaint, included $732,000 to pay for a $1.75 million home, $300,000 for luxury cars, more than $130,000 for jewelry, and $55,000 to a local religious organization.

Elm and Elm Tree Advisors also provided false valuation statements to investors, the SEC said, such as one statement for the period ended November 28, 2014 saying that one fund was worth more than $125 million. The truth, according to the agency, was that none of the funds earned a profit during the relevant time period, "and thus could not have been valued anywhere near what the valuation statement reported. Rather, the funds lost $3.9 million in trading, and Elm returned additional money to other investors or misappropriated it himself. … Records show that the TD Ameritrade brokerage account in which Elm traded had only approximately $3.2 million as of the end of November 2014."


The SEC charged Elm and Elm Tree Advisors with 10 counts of fraud, including violating Sections 17(a)(1), 17(a)(2) and 17(a)(3) of the Securities Act for engaging in fraud; Section 10(b) of the Exchange Act and its Rules 10b-5(a), (b) and (c), also for engaging in fraud; Sections 206(1) and 206(2) of the Advisers Act, which prohibit fraud; Section 206(4) of the Advisers Act and its Rule 206(4)-8(a)(1) for making untrue statements of material fact; and Section 206(4) of the Advisers Act and its Rule 206(4)-8(a)(2) for engaging in fraud. An attorney representing Elm and Elm Tree Advisors did not respond to either an email or a message left with his office.