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Monthly Archives: June 2014

SEC Charges Hedge Fund Advisory Firm and Others in South Florida-Based Scheme to Misuse Investor Proceeds

On June 23, 2014, the SEC announced that they had charged a West Palm Beach, Florida based hedge fund advisory firm and its founder with fraudulently shifting money from one investment to another without informing investors. The firm’s founder and another individual later pocketed some of the transferred investor proceeds to enrich themselves.

The SEC alleged that Weston Capital Asset Management LLC and its founder and president Albert Hallac illegally drained more than $17 million from a hedge fund they managed and transferred the money to a consulting and investment firm known as Swartz IP Services Group Inc. The transaction went against the hedge fund’s stated investment strategy and wasn’t disclosed to investors, who received account statements falsely portraying that their investment was performing as well or even better than before. Weston Capital’s former general counsel Keith Wellner assisted the activities.

The SEC further alleged that out of the transferred investor proceeds, Hallac, Wellner, and Hallac’s son collectively received $750,000 in payments from Swartz IP. Weston Capital and Hallac also wrongfully used $3.5 million to pay down a portion of a loan from another fund managed by the firm.

Weston Capital, Hallac, and Wellner agreed to settle the SEC’s charges along with Hallac’s son Jeffrey Hallac, who is named as a relief defendant in the SEC’s complaint for the purposes of recovering ill-gotten gains in his possession. The court will determine monetary sanctions for Weston Capital and Hallac at a later date. Wellner and Jeffrey Hallac each agreed to pay $120,000 in disgorgement.

According to the SEC’s complaint, Weston Capital managed more than a dozen unregistered hedge funds in early 2011 with combined total assets of approximately $230 million. One of the funds managed by the firm was Wimbledon Fund SPC, which was segregated into five separate classes of investment portfolios. The Class TT Segregated Portfolio was required to invest all of its investor money in a diversified multi-billion hedge fund called Tewksbury Investment Fund Ltd., that invested in short-term, low risk interest bearing accounts and U.S. Treasury Bills.

The SEC alleged that in violation of its stated investment strategy, Weston Capital and Hallac redeemed TT Portfolio’s entire investment in the Tewksbury hedge fund and transferred the money to Swartz IP. The transaction was not disclosed to investors and Weston Capital and Hallac solicited and received investments for the TT Portfolio during this time while knowing the funds would not be invested in Tewksbury. As soon as Swartz IP received the money transfers, it disbursed the funds primarily to a special purpose entity created to support and finance varying medically related business ventures.

The SEC’s complaint alleged that Weston and Hallac violated federal anti-fraud laws and rules as well as Sections 206(1), 206(2), and 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-8, and that Wellner aided and abetted these violations. Without admitting or denying the allegations, Weston Capital, Hallac, and Wellner consented to the entry of a judgment enjoining them from future violations of these provisions.

FINRA Disciplinary Action Against Dawson James Securities, Inc.

In June 2014, FINRA announced that Dawson James Securities, Inc. submitted a Letter of Acceptance, Waiver and Consent in which the firm was censured, fined $75,000, and required to revise its Written Supervisory Procedures.

Without admitting or denying the findings, the firm consented to the sanctions and to the entry of findings that the firm’s Written Supervisory Procedures failed to provide for one or more of the four minimum requirements for adequate Written Supervisory Procedures in several subject areas, including registered representatives’ disclosure of potential conflicts of interests to clients; registered representatives’ trading in the opposite direction of solicited customer transactions; sales practice concerns, including unauthorized trading, suitability, excessive trading and free-riding; concentrations of securities in clients’ accounts; sharing of profits or losses in clients’ accounts; wash sales; coordinated trading; marking the open and marking the close; cancel-rebill transactions in clients’ accounts; and the review of registered representatives’ electronic communications.

The findings also stated that the firm failed to investigate numerous red flags relating to a registered representative’s activities. The firm failed to enforce its Written Supervisory Procedures, which specified that all electronic correspondence, whether incoming or outgoing, would be reviewed on a daily basis. The firm failed to ensure that its head trader was reasonably carrying out his delegated supervisory responsibilities relating to proprietary trading, trade reporting, clock synchronization, short sale compliance, compliance with the Manning Rule, mark ups and mark downs, and compliance with inventory guidelines.

FINRA Fines Merrill Lynch $8 Million; Over $89 Million Repaid to Retirement Accounts and Charities Overcharged for Mutual Funds

On June 16, 2014, FINRA announced that it had fined Merrill Lynch, Pierce, Fenner & Smith, Inc. $8 million for failing to waive mutual fund sales charges for certain charities and retirement accounts. FINRA also ordered Merrill Lynch to pay $24.4 million in restitution to affected customers, in addition to $64.8 million the firm has already repaid to disadvantaged investors.

Mutual funds offer several classes of shares, each with different sales charges and fees. Typically, Class A shares have lower fees than Class B and C shares, but charge customers an initial sales charge. Many mutual funds waive their upfront sales charges for retirement accounts and some waive these charges for charities.

Most of the mutual funds available on Merrill Lynch’s retail platform offered such waivers to retirement plan accounts and disclosed those waivers in their prospectuses. However, at various times since at least January 2006, Merrill Lynch did not waive the sales charges for affected customers when it offered Class A shares. As a result, approximately 41,000 small business retirement plan accounts, and approximately 6,800 charities and 403(b) retirement accounts available to ministers and employees of public schools, either paid sales charges when purchasing Class A shares, or purchased other share classes that unnecessarily subjected them to higher ongoing fees and expenses. Merrill Lynch learned in 2006 that its small business retirement plan customers were overpaying, but continued to sell them more costly shares and failed to report the issue to FINRA for more than five years.

Merrill Lynch’s written supervisory procedures provided little information or guidance on mutual fund sales charge waivers. Even after the firm learned that it was not providing sales charge waivers to eligible accounts, Merrill Lynch relied on its financial advisors to waive the charges, but failed to adequately supervise the sale of these products or properly train or notify its financial advisors about lower-cost alternatives.

In concluding this settlement, Merrill Lynch neither admitted nor denied the charges, but consented to the entry of FINRA’s findings.

SEC Charges Hedge Fund Adviser With Conducting Conflicted Transactions and Retaliating Against Whistleblower

On June 16, 2014, the SEC announced that it had charged an Albany, N.Y.-based hedge fund advisory firm with engaging in prohibited principal transactions and then retaliating against the employee who reported the trading activity to the SEC. This was the first time the SEC had filed a case under its new authority to bring anti-retaliation enforcement actions. The SEC also charged the firm’s owner with causing the improper principal transactions.

Paradigm Capital Management and owner Candace King Weir agreed to pay $2.2 million to settle the charges.

According to the SEC’s order instituting a settled administrative proceeding, Weir conducted transactions between Paradigm and a broker-dealer that she also owned while trading on behalf of a hedge fund client. Such principal transactions pose conflicts between the interests of the adviser and the client, and therefore advisers are required to disclose that they are participating on both sides of the trade and must obtain the client’s consent. Paradigm failed to provide effective written disclosure to the hedge fund and did not obtain its consent as required prior to the completion of each principal transaction.

A Commission rule adopted in 2011 under the Dodd-Frank Act authorized the SEC to bring enforcement actions based on retaliation against whistleblowers who report potential securities law violations to the agency. The SEC’s order found that after Paradigm learned that the firm’s head trader had reported potential misconduct to the SEC, the firm engaged in a series of retaliatory actions that ultimately resulted in the head trader’s resignation.

According to the SEC’s order, Paradigm’s head trader reported trading activity revealing that Paradigm engaged in prohibited principal transactions with affiliated broker-dealer C.L. King & Associates while trading on behalf of hedge fund client PCM Partners L.P. II. The SEC’s subsequent investigation found that Paradigm engaged in the trading strategy from at least 2009 to 2011 to reduce the tax liability of the firm’s hedge fund investors. As part of that strategy, Weir directed Paradigm’s traders to sell securities that had unrealized losses from the hedge fund to a proprietary trading account at C.L. King. The realized losses were used to offset the hedge fund’s realized gains. Paradigm engaged in at least 83 principal transactions by selling 47 securities positions from the hedge fund to C.L. King and then repurchasing 36 of those positions for the hedge fund.

According to the SEC’s order, since Weir had a conflicted role as owner of the brokerage firm in addition to advising the PCM Partners hedge fund, merely providing written disclosure to her as the hedge fund’s general partner and obtaining her consent was insufficient. Paradigm attempted to satisfy the written disclosure and consent requirements by establishing a conflicts committee to review and approve each of the principal transactions on behalf of the hedge fund.

The SEC’s order found that the conflicts committee itself, however, was conflicted. The committee consisted of two people: Paradigm’s chief financial officer and chief compliance officer – who each essentially reported to Weir. Furthermore, Paradigm’s CFO also served as C.L. King’s CFO, which placed him in a conflict. Specifically, there was a negative impact on C.L. King’s net capital each time the broker-dealer purchased securities from the hedge fund. The CFO’s obligation to monitor C.L. King’s net capital requirement was in conflict with his obligation to act in the best interests of the hedge fund as a member of the conflicts committee.

According to the SEC’s order, because the conflicts committee was conflicted, Paradigm failed to provide effective written disclosure to its hedge fund client and failed effectively to obtain the hedge fund’s consent prior to the completion of each principal transaction. The SEC’s order also finds that Paradigm’s Form ADV was materially misleading for failing to disclose the CFO’s conflict as a member of the conflicts committee.

“Paradigm’s use of a conflicted committee denied its hedge fund client the effective disclosure and consent to which it was entitled,” said Julie M. Riewe, co-chief of the SEC Enforcement Division’s Asset Management Unit. “Advisers to pooled investment vehicles need to ensure that any mechanism developed to address conflicts in principal transactions actually mitigates those conflicts.”

According to the SEC’s order, Paradigm’s former head trader made a whistleblower submission to the SEC that revealed the principal transactions between Paradigm and C.L. King. After learning that he had reported potential violations to the SEC, Paradigm immediately engaged in a series of retaliatory actions. Paradigm removed him from his head trader position, tasked him with investigating the very conduct he reported to the SEC, changed his job function from head trader to a full-time compliance assistant, stripped him of his supervisory responsibilities, and otherwise marginalized him.

Paradigm and Weir consented to the entry of the order finding that Paradigm violated Section 21F(h) of the Securities Exchange Act of 1934 and Sections 206(3) and 207 of the Investment Advisers Act of 1940. The order finds that Weir caused Paradigm’s violations of Section 206(3) of the Advisers Act. They each agreed to cease and desist from committing or causing future violations of these provisions without admitting or denying the findings in the order. Paradigm and Weir agreed to jointly and severally pay disgorgement of $1.7 million for distribution to current and former investors in the hedge fund, and pay prejudgment interest of $181,771 and a penalty of $300,000. Paradigm also agreed to retain an independent compliance consultant.