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News October 19, 2015 Issue

Non-Compliance with Firm’s Own Policy Contributes to Failure-to-Supervise Charges

Don’t let your firm become the subject of an SEC investigation because this lesson was forgotten: An unmet requirement in your compliance manual, even if not required by a law or SEC rule, may still lead to a citation or enforcement action.

James Goodland, owner and former chief compliance officer of Minnesota-based Securus Wealth Management, and his firm on September 30 settled with the SEC after being charged with failing to reasonably supervise an investment advisory representative. Among the supervision failures attributed to Goodland in the administrative order was that he did not comply with his own firm’s written policies and procedures for email monitoring.

That alleged failure contributed to clients investing more than $1 million as part of what the agency said was a "manipulative scheme" by the IAR from January 2010 through July 2013 to support the market price of the common stock of a start-up company.

Goodland, when contacted, said that "while I can’t comment on my thoughts of the SEC allegations, what I can comment on is that Securus has had no customer complaints as a result of this or any other matter."

Email reviews

Goodland’s practice, according to the SEC, was to randomly select and review approximately 50 client emails about seven or eight times each year – a total many adviser compliance departments might find more than adequate. Securus’ policies and procedures, however, required monthly email monitoring. Goodland also did not review specific emails that the firm flagged for his review, and those emails he did review did not focus on any particular issues, and he failed to document his reviews, the agency said.

"Even after Goodland received notifications in January and February 2013 that Securus had outstanding emails that had not been reviewed in the email system, Goodland did not personally review the emails and instead delegated the review to another employee who reported to Goodland and was not a supervisor," the SEC said.

In addition to charging improper email reviews, the SEC alleged that Goodland failed to catch other red flags concerning the IAR’s conduct and failed to monitor his trading in client accounts. The SEC also found that Securus lacked compliance procedures to identify and address conflicts of interest.

"The SEC’s ‘inadequate email review’ allegations seem to be predicated on both the supervisor’s deviation from the firm’s own policy," said DLA Piper senior counsel Patrick Hunnius, "as well as the firm’s compliance system’s ability to identify un-reviewed emails, but not being able to tell, after the emails were eventually reviewed, whether those reviews were conducted by a supervisor or a non-supervisor."

"The allegations in this case read like a ‘greatest hits’ album of missteps that the SEC has been highlighting in various cases over the last couple of years," said Mayer Brown attorney Adam Kanter. "It’s got everything from marking the close, to ignoring red flags, to conflicts of interest, to failure to abide by your own compliance policies and procedures. Any of these things individually could already spell trouble for an adviser, and having them all stacked up on top of each other likely contributed to the industry bar that was meted out as punishment."

The underlying accusation

The IAR, the subject of a separate settlement with the SEC, allegedly took improper actions to support the market price of the common stock of Maryland-based Gatekeeper USA, a start-up business with no revenue that sought to market and sell a container security monitoring device, a prototype that the SEC said had never been sold to anyone, for cargo in the shipping industry. The company’s stock was thinly traded on the over-the-counter grey market, the agency said.

The IAR caused his clients to invest more than $1 million in shares of Gatekeeper stock during the period in question, according to the agency. "This trading was unusual for Securus, whose primary business involved investing in mutual funds on behalf of its clients," the SEC said, adding that approximately 98 percent of the firm’s clients, most of whom were individuals, invested in mutual funds.

The IAR also failed to disclose "significant conflicts of interest" to his clients that arose from his personal ownership of Gatekeeper shares, as well as from his own involvement with the company, the administrative order said.

From January 2010 through July 2013, Gatekeeper sought $10 million to $20 million in financing from investment banks to develop, manufacture and sell its device, but was not able to raise the money, the SEC said. During this period, according to the administrative order, the IAR did the following:

  • Frequently used his Securus email account and telephone to communicate with Gatekeeper’s vice president of finance about the status of the financing efforts. He "learned that substantial anticipated Gatekeeper financing was dependent upon sustaining a sufficient market price for Gatekeeper stock," the SEC said.
  • Frequently "marked the close" and executed the last transaction in Gatekeeper stock on the days that he traded. When an employee "marks the close," he or she places orders at or near the close of market trading in an effort to affect a security’s closing price. Trades in which the IAR was involved were the last trades reported to the market on 197 days, or 85 percent, of the 233 days they were traded, according to the administrative order. "On at least 50 days, the trades of [the IAR’s] clients marked the close within the last 15 minutes of the trading day."
  • Prevented sales of Gatekeeper shares that might have placed downward pressure on the market price. The IAR, according to the SEC, "determined the sources of selling pressure by tracking who held the public float in a spreadsheet he created from transfer agent records and by communicating with shareholders by phone and email. [He] repeatedly asked clients and other shareholders to not sell any Gatekeeper stock."
  • Placed simultaneous Gatekeeper buy orders from clients to offset the same or a greater amount of shares sold by clients who he was unable to prevent from selling. The IAR did this to prevent a decline in the Gatekeeper market price, the SEC said.
  • Often transmitted positive information about the status of Gatekeeper’s financing to a non-client investor (Investor A), and caused that investor to purchase Gatekeeper shares during particular time periods. "Investor A paid approximately $188,000 for 56,000 shares of Gatekeeper during this period," the agency alleged.
  • Sent numerous emails from his email account at Securus to Gatekeeper’s vice president of finance. In those emails, according to the SEC, the IAR described how his trading in his clients’ accounts, together with the trading of Investor A, increased the reported closing price of Gatekeeper. "[He] also discussed his efforts to prevent clients from selling Gatekeeper stock, and his practice of placing simultaneous client buy orders with client sales orders in these emails," the agency said.
  • Made material misrepresentations to clients about the market for Gatekeeper stock. As an example, the SEC noted that in a January 2011 letter mailed to clients, the IAR sought to explain to clients why Gatekeeper’s stock price had fallen to $1 after it had been approximately $3 for months. He "stated that Gatekeeper stock traded in low volumes on the pink sheets (though it actually traded on the riskier grey market), that the over-the-counter market was a ‘target’ for ‘stock manipulators’ and that ‘in spite of orders to buy and sell at the market,’ a naked short seller ‘bypassed the normal order flow and forced an artificial close.’"
  • Failed to disclose his personal conflicts of interest. The IAR did not disclose his personal holdings of Gatekeeper stock to clients until August 2010, the agency said. He "also failed to disclose to his clients that he had loaned approximately $141,000 to Gatekeeper’s officers and the developer of the … device, that he paid at least $57,000 towards Gatekeeper’s expenses and insurance premiums, and that he had edited and provided content for Gatekeeper communications with shareholders."

The IAR’s clients’ trading in Gatekeeper stock comprised at least 38 percent of Gatekeeper stock market volume and at least 42 percent of that volume when trading by Investor A was included, according to the SEC. The clients and Investor A paid a median of 35 cents per share higher than the immediately preceding price for Gatekeeper stock by other traders, the agency said, noting that at times, clients "paid up to 100 percent more for their shares" than immediately preceding traders did. "

Emails and red flags

While the Securus email system flagged some emails between the IAR and Gatekeeper’s vice president of finance in regard to Gatekeeper’s financing efforts, it did not flag emails in which the IAR discussed his "manipulative trading" of Gatekeeper stock in client accounts, the SEC said. But, the agency noted, "Had Goodland timely and properly reviewed the flagged Gatekeeper emails, he likely would have recognized [the IAR’s]  ongoing communications with a corporate officer about financing efforts as additional red flags and implemented additional oversight. If Goodland had conducted a heightened review of [the IAR’s] other emails concerning Gatekeeper, he likely would have detected [the IAR’s] manipulative tactics and prevented further violations."

That said, the SEC did not present any evidence in its administrative order to support these suppositions.

Other red flags that the agency said Goodland failed to follow up on included:

  • IAR personal trading in Gatekeeper and client trading outside of typical strategies. The IAR told Goodland during regularly scheduled biweekly meetings that he personally owned Gatekeeper shares and was "building positions" in Gatekeeper stock with clients on a discretionary basis. "Goodland knew that Gatekeeper was a grey market stock and that [the IAR’s] purchases of Gatekeeper stock were outside of Securus’ normal investment strategies for clients," the SEC said.
  • Communication with Gatekeeper. The IAR provided Goodland with updates on the Gatekeeper financing efforts. "Goodland was aware that [the IAR] obtained this information from Gatekeeper’s vice president of finance," the agency said.

Violations and penalties

Securus and Goodland were charged with violating Sections 203(f) and 203(e)(6) of the Advisers Act, both of which provide for the imposition of sanctions against an adviser that failed to reasonably supervise another person who commits a violation. Securus was also charged with violating, and Goodland with aiding and abetting, as well as causing the firm’s violation, of Section 206(4) and its Rule 206(4)-7, the Compliance Program Rule, for failing to adopt and implement reasonable written compliance policies and procedures. Goodland was barred from the securities industry and ordered to pay a civil money penalty of $30,000.

The IAR was charged with violating Section 10(b) of the Exchange Act and its Rule 10b-5, which prohibit fraud, as well as aiding and abetting, and for causing Securus’ violations of Sections 206(1) and (2), which also prohibit fraud. He was barred from the securities industry, as well as from working for any adviser or investment company, required to pay disgorgement and interest of $69,000, and a civil money penalty of $75,000.