Category Archives: Regulatory Actions

Hedge fund performance fees – is it time to rethink the high watermark?

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There are many news stories out covering what may be a worst case scenario for many hedge funds – the distinct possibility of no performance fees this year.  This seems to be a major topic of conversation for many people within the industry and just yesterday I received the following comment with a link to a Wall Street Journal article discussing this issue.

The comment:

Regarding performance fees: the underlying hedge funds naturally also have high performance fees. But in the current climate, they aren’t making them. “Just one in 10 hedge funds is currently receiving performance fees from their funds.” See: http://blogs.wsj.com/deals/2008/09/22/fee-slump-hits-hedge-funds/

Unfortunately, with the current market conditions, many funds are going to be feeling the pressure of little to no performance fees at the end of the year.  For many hedge fund managers, the problem is compounded by the fact that their asset management fee is simply not enough to keep the business going.  Many managers cannot keep operations going with only the management fee.  Without performance fees, hedge fund managers may have their operations disrupted for a number of reasons, including the fact that for some, the traders will be expecting bonuses no matter the performance of the fund as a whole.  If these traders don’t receive bonuses, then some hedge funds could see talent drain, to the extent that such traders thought they could receive greater compensation at other firms or by starting their own fund.

Still worse, managers who have negative performance numbers at the end of the year will have another issue to deal with – the high watermark.  The high watermark is a concept designed as an investor-friendly provision that essentially prevents a manager from taking a performance fee on the same gains more than once.  The high watermark is a similar concept to the clawback provision in a private equity fund.

When a fund suffers a significant drawdown during a performance fee period, the high watermark will actually create a perverse incentive for the investment manager – either take extra risk to generate higher returns so that there will be a performance fee in the next performance fee period or close down the fund and start again.  Both of these potential actions would be taken to the detriment of the investor, and the investor may only have the choice of making a redemption or letting the investment ride. 

If the manager does shut his doors, the investor is going to have his assets at risk as the hedge fund wind-down takes place.  Depending on the hedge fund’s strategy, the wind-down could subject the fund to a fire sale of its assets which will reduce the value of the investment even further.  If such investor was to move into another hedge fund, he would step into the new fund with a high watermark equal to his investment and would be subject to performance fees on those assets anyway. Because such a turn of events is detrimental to such an investor, it might make sense for such investors to allow for some sort of modification of the high watermark.

Some potential alternatives to the standard hedge fund highwatermark might include the following:

No high watermark – this is probably not a viable solution as it would afford investors absolutely no protection from paying two sets of performance fees on the “same” gains.  Additionally, without the threat of the high watermark, there would be little deterrent for a manager to improperly manage risk.  Additionally, because the highwatermark provision is one of the most uniform provisions in the hedge fund industry, it is unlikely to simply disappear.  (Although I have seen a couple of funds which actually did not have the provision.)

Modified high watermark – I have seen all types of variations within the performance fee structure and the withdrawal structure, but the high watermark is one provision which is generally resistant to modification. The high watermark could potentially be modified in many ways including the following:

Reset to zero – under certain circumstances, that if stated in the offering documents prior to investment, the investment manager can be given the ability to reset the high-watermark to zero.

Amortization – one potential way could be to “amortize” the losses over a 2- or 3-year period so that some performance fees can be earned on a going forward basis.  Additionally, if the investor chose to withdraw before the end of the high watermark amortization period, there could be some sort of clawback.

Rolling – the high watermark can be taken under certain circumstances over a rolling period.  The concept is that the high watermark will be determined for a certain window so a drawdown would in essence be erased after a certain amount of time has elapsed.  This might work better for those funds that have a monthly or quarterly performance fee period.

Resetting to zero and an amortization reduction method could be both potentially valuable to investors as it will keep a manager in the game and it will reduce the incentive for a manager to abandon risk management procedures. Also, management companies may be willing to decrease fees if investors agree to keep their investment in the fund for a certain amount of time after the reset or amortization.

[HFLB note: any new investors coming into a fund during a performance fee period will have an initial high watermark that is equal to the initial investment value; depending on the time of the contribution and when the fund made its losses, there may be some performance fees paid even during a down year for such incoming investors.]

Further Resources

Another good article and some good comments on the article can be found here.

For an interesting academic paper on this subject, please click here. The paper is by William N. Goetzmann, Yale School of Management.  The abstract for the paper states:

Incentive or performance fees for money managers are frequently accompanied by high-water mark provisions which condition the payment of the performance fee upon exceeding the maximum achieved share value. In this paper, we show that hedge fund performance fees are valuable to money managers, and conversely represent a claim on a significant proportion of investor wealth. The high-water mark provisions in these contracts limit the value of the performance fees. We provide a closed-form solution to the high-water mark contract under certain conditions. This solution shows that managers have an incentive to take risks. Our results provide a framework for valuation of a hedge fund management company.

We conjecture that the existence of high-water mark compensation is due to decreasing returns to scale in the industry. Empirical evidence on the relationship between fund return and net money flows into and out of funds suggest that successful managers, and large fund managers are less willing to take new money than small fund managers.

Investment Advisor faces fine and injuction for unauthorized leverage

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As a hedge fund lawyer one of my most important jobs is to help keep the client out of any trouble and to help the manager deal with any potential issues before they become issues.

Below is a classic example of an investment manager who did not adequately describe his investment program (and the risks). One of the more important parts of the hedge fund start up process is to create an investment program which accurately describes the trading which the fund will engage in. While many offering documents include very broad language allowing a manager to make changes to the investment program, gross or wholesale changes should be communicated to the investor (potentially with the right to redeem the interests, depending on the hedge fund’s terms and structure). The highlighted language below emphasizes the point that descriptions of a hedge fund’s investment program should be accurate, as well as the point that hedge fund managers should never lie or intentionally mislead their clients.

The full release can be found here.

Release:

U.S. SECURITIES AND EXCHANGE COMMISSION
Litigation Release No. 20713 / September 11, 2008
SEC v. Mark D. Lay and MDL Capital Management, Inc., Civil Action No. 08-CV-1269 (DSC) (W.D. Pa.)
SEC Charges Mark D. Lay and MDL Capital Management, Inc. With Defrauding Ohio Bureau of Workers’ Compensation

The Securities and Exchange Commission announced that today it filed securities fraud charges in the United States District Court for the Western District of Pennsylvania against Mark D. Lay of Aliquippa, Pennsylvania, and MDL Capital Management, Inc. (“MDL Capital”), an investment adviser registered with the Commission and located in Pittsburgh, Pennsylvania. Lay was the Chairman, CEO and Chief Investment Strategist of MDL Capital and part-owner of MDL Capital. Without admitting or denying the allegations of the Complaint, Lay and MDL Capital have consented to the entry of a final judgment permanently enjoining them from engaging in the violations set forth below, and ordering other relief

The Commission’s Complaint alleges that, between February 2004 and November 2004, Lay and MDL Capital defrauded their advisory client, the Ohio Bureau of Workers’ Compensation, in connection with the Bureau’s investment of public money in the MDL Active Duration Fund, Ltd., a hedge fund affiliated with and managed by Lay and MDL Capital. The Bureau transferred approximately $200 million from its advisory account managed by MDL Capital and Lay to the hedge fund pursuant to an agreement that those assets would be conservatively leveraged.

The Complaint further alleges that MDL Capital and Lay exposed Bureau funds to unauthorized and undisclosed risk by substantially exceeding a 150% leverage guideline, at one point using leverage of over 21,000% in the hedge fund. As a result, the Bureau incurred losses of approximately $160 million. During the course of the fraud, Lay repeatedly lied to and misled the Bureau as to the reasons for and amount of the losses as well as the excessive leverage Lay was using.

In October 2007, based on these same facts, Lay was convicted in the Northern District of Ohio of criminal mail fraud, wire fraud and investment adviser fraud. Lay is currently serving a 12 year prison sentence.

The Complaint alleges that Lay and MDL Capital violated Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and Sections 206(1) and 206(2) of the Investment Advisers Act of 1940. Subject to the Court’s approval, the final judgment imposes permanent injunctions against MDL Capital and Lay and orders them to pay $1,544,195 in disgorgement and prejudgment interest, but waives payment of these amounts, and does not impose civil penalties, based on the defendants’ sworn statements of financial condition.

SEC Charges Investment Adviser with Cherry-Picking

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So many of the investment advisory rules and regulations are based on common sense principles.  The story below is another example of a manager not using common sense with regard to the allocation of trades between different accounts.  Using a hedge fund’s assets to pay personal expenses is blatantly illegal.  Unfortunately there are too many of these cases out there and investors must do everything they can to protect themselves from such hedge fund frauds.  (One way to do this is through a hedge fund manager background check which is part of the hedge fund due diligence process.)

The article below can be found here.

SEC Charges Investment Adviser with Cherry-Picking

On September 9, the Commission charged James C. Dawson with securities fraud and investment adviser fraud, for orchestrating a cherry-picking scheme in which he allocated profitable trades to his personal account at the expense of his clients. Dawson is the investment adviser to a hedge fund, Victoria Investors, and individual clients.

The Commission’s complaint, filed in the U.S. District Court for the Southern District of New York, alleges that from April 2003 through October 2005, Dawson allocated profitable trades to his personal account by purchasing securities throughout the day in a single account and allocating the trades amongst his clients and his personal account after he saw whether the trades were profitable. The Commission’s complaint further alleges that Dawson used Victoria Investors’ funds to pay for personal and family expenses. Dawson did not tell his clients -Victoria Investors or his individual clients – about his cherry-picking scheme, and did not tell Victoria Investors that he was using fund assets for his personal expenses.

The Commission alleges that Dawson violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and Sections 206(1) and 206(2) of the Investment Advisers Act. The Commission seeks an order permanently enjoining Dawson from violating these provisions of the federal securities laws, and seeks disgorgement of ill-gotten gains and losses avoided, plus prejudgment interest, and civil penalties against Dawson. [SEC v. James C. Dawson, 08 Civ. 7841 (SDNY) (WCC)] (LR-20707)

CTA registration requirement and exemption

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Question: does my commodity/futures trading firm need to register as a CTA?

Answer: Generally Section 6m(1) of the Commodities Exchange Act (“CEA”) requires that any person (or firm) which falls within the definition of a CTA be registered as such. Section 6m(1) of the CEA states:

“It shall be unlawful for any commodity trading advisor or commodity pool operator, unless registered under this chapter, to make use of the mails or any means or instrumentality of interstate commerce in connection with his business as such commodity trading advisor or commodity pool operator”

The Commodities Exchange Act (“CEA”) specifically defines a Commodity Trading Adviser (“CTA”) as:

“any person who– (i) for compensation or profit, engages in the business of advising others, either directly or through publications, writings, or electronic media, as to the value of or the advisability of trading in– (I) any contract of sale of a commodity for future delivery made or to be made on or subject to the rules of a contract market or derivatives transaction execution facility; (II) any commodity option authorized under section 6c of [the CEA]; or (III) any leverage transaction authorized under section 23 of [the CEA]; or (ii) for compensation or profit, and as part of a regular business, issues or promulgates analyses or reports concerning any of the activities referred to in clause (i)”

Because the above definition is quite broad, Congress specifically excluded certain groups from the definition. These groups include:

  • any bank or trust company or any person acting as an employee thereof;
  • any news reporter, news columnist, or news editor of the print or electronic media, or any lawyer, accountant, or teacher;
  • any floor broker or futures commission merchant;
  • the publisher or producer of any print or electronic data of general and regular dissemination, including its employees;
  • the fiduciary of any defined benefit plan that is subject to the Employee Retirement Income Security Act of 1974 (29 U.S.C. 1001 et seq.);
  • any contract market or derivatives transaction execution facility; and
  • such other persons not within the intent of this paragraph as the Commission may specify by rule, regulation, or order.

I have previously discussed how to register as a CTA in the article titled How to register as a CPO or CTA.

Question: are there any exemptions from CTA registration?

Answer: Yes. Section 6m(1) of the CEA states:

That the [registration] provisions of this section shall not apply to any commodity trading advisor who, during the course of the preceding twelve months, has not furnished commodity trading advice to more than fifteen persons and who does not hold himself out generally to the public as a commodity trading advisor. [emphasis added]

To fall within the above exemption, both elements must be met. That is, the CTA must

  • have less than 15 clients over the preceeding 12 months and
  • not hold himself out generally to the public as a CTA

The question then becomes what does “holding out” as a CTA entail?

The CFTC views “holding oneself out as a CTA” to include such conduct as promoting advisory services through mailings, directory listings, and stationery, or otherwise initiating contact with prospective clients. Thus, unless a CTA restricts his clients to family, friends, and existing business associates, a CTA generally will be viewed as holding himself out to the public as a CTA and would not be able to claim the exemption from registration in Section 6m(1).

The CFTC specifically gave such guidance in the following letter.

CFTC Letter No. 97-26
March 26, 1997
Division of Trading & Markets

Re: Section 4m(1): Exemption from CTA Registration

Dear [_______]:

This is in response to your letter dated January 29, 1997 to the Division of Trading and Markets (the “Division”) of the Commodity Futures Trading Commission (the “Commission”), whereby you inquire as to whether you may claim an exemption from registration as a commodity trading advisor (“CTA”) pursuant to Section 4m(1) [now 6m(1)] of the Commodity Exchange Act (the “Act”). *

Based on your letter, we understand the pertinent facts to be as follows. You intend to sell subscriptions to a fax service (the “Service”) entitled “A”, of which you are the sole designer. The Service will provide subscribers with buy and sell recommendations for Eurodollar futures and option contracts traded on “X”.

Section 4m(1) [now 6m(1)] of the Act generally requires that a person who provides commodity interest trading advice to the public must register as a CTA. Section 4m(1) does, however, provide an exemption from registration as a CTA for a person who satisfies two conditions: (1) during the course of the preceding twelve months, he has not furnished commodity trading advice to more than fifteen persons; and (2) he does not hold himself out generally to the public as a CTA. The Division views “holding oneself out as a CTA” to include such conduct as promoting advisory services through mailings, directory listings, and stationery, or otherwise initiating contact with prospective clients.** Thus, unless a CTA restricts his clients to family, friends, and existing business associates, a CTA generally will be viewed as holding himself out to the public as a CTA and would not be able to claim the exemption from registration in Section 4m(1) [now 6m(1)]. This is true whether or not the CTA is advising fifteen or fewer persons, since in order to qualify for the Section 4m(1) exemption, the CTA must satisfy both conditions. [Emphasis added]

Thus, if you plan to solicit clients other than immediate family members, friends, and business associates, you would be holding yourself out as a CTA and would be required to register as such prior to marketing the Service. You would also be required to comply with all other provisions of the Act and Commission’s regulations thereunder applicable to registered CTAs, including Section 4b and Section 4o,*** the antifraud provisions of the Act, Part 4 of the Commission’s regulations applicable to CTAs, and the reporting requirements for traders set forth in Parts 15, 18, and 19 of the Commission’s regulations.

The advice provided herein is based upon the representations that you have made to us. Any different, changed or omitted facts or conditions might require us to reach a different conclusion. In this connection, we request that you notify us immediately in the event your activities change in any way from those as represented to us.

If you have any questions concerning this correspondence, please feel free to contact me or Monica S. Amparo, an attorney on my staff, at (202) 418-5450.

Very truly yours,

Susan C. Ervin

Chief Counsel

* 7 U.S.C. §6m(1) (1994).

** Division of Trading and Markets Interpretative Letter 91-9, [1990-1992 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶ 25,189 (Dec. 30, 1991). We have enclosed a copy of this letter for your reference.

*** 7 U.S.C. §§ 6b and 6o (1994).

SEC fines adviser and revokes registration

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The SEC fined an investment adviser and revoked its registration because of willful refusal to follow simple investment adviser rules such as updating form ADV and submitting to a reasonable examination of its books and records.

From SEC website:

Commission Declares Decision as to Amaroq Asset Management, LLC and Dwight Andre Sean O’Neal Jones Final

The decision of an administrative law judge ordering Amaroq Asset Management, LLC, and Dwight Andree Sean O’Neal Jones to cease and desist from committing or causing any violations or future violations of Section 204 of the Investment Advisers Act of 1940 and Advisers Act Rule 204-1 has been declared final. The law judge further ordered that the registration of Amaroq Asset Management, LLC be revoked; that Dwight Andree Sean O’Neal Jones be barred from association with any investment adviser, with a right to apply for association after one year; and ordered that Jones pay a civil penalty in the amount of $15,000.

The law judge concluded that Jones willfully aided and abetted and was a cause of Amaroq’s failure to: (1) file annual amendments to Form ADV; (2) promptly update its Form ADV to reflect its current business address; (3) submit to a reasonable examination and failing to furnish copies of the required books and records in connection with the scheduled examination. The law judge found that Jones showed indifference and/or a series of broken promises, when Commission attorneys repeatedly and explicitly informed him of the law’s requirements, thereby demonstrating extreme recklessness. (Rel. IA-2770) Finality Order; File No. 3-12822)

For final decision, click here.

SEC to replace ancient EDGAR database

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Summary:

On Tuesday the SEC announced that a new company filing database which will be faster and easier to use than the current EDGAR system. The new system is called IDEA, short for Interactive Data Electronic Applications. With IDEA, investors will be able to instantly collate information from thousands of companies and forms, and create reports and analysis on the fly, in any way they choose.

Press Release:

SEC Announces Successor to EDGAR Database
“IDEA” Will Make Company and Fund Information Interactive
FOR IMMEDIATE RELEASE
2008-179

Washington, D.C., Aug. 19, 2008 — Securities and Exchange Commission Chairman Christopher Cox today unveiled the successor to the agency’s 1980s-era EDGAR database, which will give investors far faster and easier access to key financial information about public companies and mutual funds.

The new system is called IDEA, short for Interactive Data Electronic Applications. Based on a completely new architecture being built from the ground up, it will at first supplement and then eventually replace the EDGAR system. The decision to replace EDGAR marks the SEC’s transition from collecting forms and documents to making the information itself freely available to investors to give them better and more up-to-date financial disclosure in a form they can readily use.

Currently, most SEC filings are available only in government-prescribed forms through EDGAR. Investors looking for information must sift through one form at a time, and then re-keyboard the information — a painstaking task. With IDEA, investors will be able to instantly collate information from thousands of companies and forms, and create reports and analysis on the fly, in any way they choose.

IDEA will ensure that both the SEC and the investors who rely upon the financial reporting the agency demands are ready for the new world of financial disclosure that will soon arrive when financial information is presented in interactive data format. The SEC has formally proposed requiring U.S. companies to provide financial information using interactive data beginning as early as next year, and separately has proposed requiring mutual funds to submit their public filings using interactive data.

“IDEA will ensure that the SEC continues to stay ahead of the needs of investors,” said Chairman Cox. “This new SEC resource powered by interactive data will give investors far faster, more accurate, and more meaningful information about the companies and mutual funds they own. IDEA’s launch represents a fundamental change in the way the SEC collects and publishes company and fund information – and in the way that investors will be able to use it.”

Interactive data relies on computer “tags,” similar in function to bar codes, which identify individual items in a company’s financial disclosures. With every number on an income statement or balance sheet individually labeled, information about thousands of companies contained on thousands of forms could be easily searched on the Internet, downloaded into spreadsheets, reorganized in databases, and put to any number of other comparative and analytical uses by investors, analysts, journalists, and financial intermediaries.

The ease with which interactive data will make financial information available also is expected to generate many new Web-based services and products for investors.

As he unveiled the new IDEA platform at a Washington news conference today, Chairman Cox announced that the IDEA logo will begin to appear immediately on the SEC’s Web site as the agency transitions to making IDEA the new primary source for all SEC filings. Companies’ interactive data filings are expected to be available through IDEA beginning late this year.

Investors and others who currently use EDGAR will be able to continue doing so for the indefinite future. During the transition to IDEA, investors will be able to take advantage of new interactive, IDEA-like features that will be grafted onto EDGAR in the short run. This will make it possible for investors to tap IDEA’s advanced search capabilities, and to use the information from EDGAR within spreadsheets and analytical software – something that was never possible with EDGAR. The EDGAR database also will continue to be available as an archive of company filings for past years.

“When Congress created the SEC, and even when EDGAR was launched, the markets worked on paper and by mail. Today, the marketplace works online and by e-mail,” explained disclosure and transparency expert Dr. William D. Lutz, who is leading the SEC’s 21st Century Disclosure Initiative. “Companies and investors alike compile, analyze, and produce information and reports electronically. With the move to an electronic data-based filing system, the SEC will not only keep pace with the markets, but will provide investors with a dynamic system they can use to get the information they need, rather than having to wade through an avalanche of paper forms, legalese, and doublespeak.”

David Blaszkowsky, Director of the SEC’s Office of Interactive Disclosure, added, “After 75 years of document-based static financial reporting, whether in paper documents or in electronic equivalents, it is exciting to see the SEC poised to cross the ‘data threshold’ and help investors receive financial information that is dynamic, usable and ready to go as they make their investment decisions. And when the investor wins, so does the public company, fund, or other filer who simultaneously benefits from greater transparency and trust in our markets. By tapping the power of interactive data to tear down barriers to quick and meaningful investment information, markets can become fairer and more efficient while investors can possess far better quality data than was ever possible before.”

SEC Release 2008-167: New SEC Commissioner Sworn In

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Troy Paredes Sworn In as SEC Commissioner

FOR IMMEDIATE RELEASE

2008-167

Washington, D.C., Aug. 1, 2008 — Troy A. Paredes was sworn in this afternoon as a Commissioner of the Securities and Exchange Commission by SEC Chairman Christopher Cox during a ceremony at the SEC’s Washington D.C. headquarters.

The ceremony was attended by his wife Laura Paredes, his parents Smiley and Hollie Paredes, his brother Randy Paredes, as well as other family members and friends. Other SEC commissioners and senior officials also attended.

Commissioner Paredes was appointed to the SEC by President George W. Bush on June 30, 2008. Prior to his appointment, Commissioner Paredes was teaching and researching in the areas of securities regulation and corporate governance as a professor at Washington University School of Law in St. Louis, Mo.

“Commissioner Paredes brings extensive knowledge of securities regulation and corporate governance that will be of enormous help to the Commission’s work to safeguard investors, maintain orderly markets, and encourage capital formation,” said SEC Chairman Christopher Cox. “I look forward to working with him and welcome his expertise as we move forward with a busy agenda at the SEC to help the American investor.”

Commissioner Paredes said, “I am deeply honored and humbled by the opportunity to join the Commission and to do my part in helping to advance the Commission’s vital mission of protecting investors, promoting capital formation, and ensuring that our country’s securities markets function effectively. I look forward to working with Chairman Cox, my fellow commissioners, and the SEC’s dedicated staff as we work together to serve the public interest at this very important time.”

Commissioner Paredes has pursued numerous research interests during his time in academia, including such pertinent topics as executive compensation, hedge funds, the allocation of control within firms, the impact of psychology on corporate decision making and investor behavior, and the development of corporate governance and securities law systems in emerging markets. Commissioner Paredes has authored articles on these topics and is a co-author of a leading multi-volume securities regulation treatise.

Before joining Washington University’s faculty in 2001, Commissioner Paredes practiced law, working on a variety of transactions and matters involving financings, mergers and acquisitions, and corporate governance.

Commissioner Paredes graduated from the University of California at Berkeley with a degree in economics in 1992, and graduated from Yale Law School in 1996.

CFTC Release 5527-08

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Release: 5527-08
For Release: July 31, 2008

Tampa Resident Edward J. Evors Ordered to Pay $904,000 in Restitution and Civil Monetary Penalties in CFTC Action Evors Permanently Prohibited from Engaging in Commodity Trading-Related Activities

Washington, DC – The U.S. Commodity Futures Trading Commission (CFTC) announced today that it obtained $452,000 in restitution and a $452,000 civil monetary penalty in a consent order against Edward J. Evors of Tampa, Florida. The order also permanently prohibits Evors, who has never been registered with the CFTC in any capacity, from engaging in any commodity trading-related activities.

The court also entered default judgment orders against two Nevada companies controlled by Evors, Bally Lines, Ltd. (Bally Lines) and GPS Fund, Ltd. (GPS), requiring them to disgorge funds received from Evors’ customers.

The orders were entered by the Honorable Richard A. Lazzara of the U.S. District Court for the Middle District of Florida. The consent order as to Evors resolves CFTC charges that he misappropriated customer funds that he solicited and received for the purpose of trading commodity futures contracts with Coyt E. Murray and Murray’s trading firm, Tech Traders, Inc. of North Carolina. Instead of investing customer funds with Tech Traders, Evors misappropriated the funds and concealed his theft by sending customers false account statements misrepresenting their investment. (See CFTC Press Release 5385-07, September 20, 2007.)

According to the CFTC’s September 2007 complaint, Evors instructed customers to send their funds to Bally Lines and GPS for placement with Tech Traders, but these firms actually provided no services and had no legitimate claim to any customer funds. As such, the complaint named Bally Lines and GPS as relief defendants and sought disgorgement from them.

Murray and Tech Traders were defendants in a previous CFTC enforcement action in which they and other defendants were ordered by the U.S. District Court of New Jersey to pay more than $30 million in sanctions (see CFTC Press Release 5357-07, July 23, 2007).

The following CFTC Division of Enforcement staff members are responsible for this matter: Elizabeth M. Streit, David A. Terrell, Joy H. McCormack, Scott R. Williamson, Rosemary Hollinger, and Richard Wagner.

SEC cracks down on lax AML implementation

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Yesterday the SEC ordered E*Trade to comply with the AML rules which requires brokers to know the identity of their clients. The order found that E*Trade did not verify the identities of 65,442 secondary accountholders. While this is a major breach of the AML rules, it also shows that the SEC is continuing to be vigilant in this time of economic uncertainty and market turmoil.

The full text can be found below and at: http://www.sec.gov/news/press/2008/2008-156.htm

SEC Orders E*Trade Brokerage Firms to Comply With Anti-Money Laundering Rule

FOR IMMEDIATE RELEASE
2008-156

Washington, D.C., July 30, 2008 — The Securities and Exchange Commission today charged E*Trade Clearing LLC and E*Trade Securities LLC (collectively, E*Trade) for failing to comply with an anti-money laundering rule that requires broker-dealers to verify the identities of their customers and document their procedures for doing so.

The SEC’s order finds that E*Trade failed to accurately document certain Customer Identification Program (CIP) practices and verify the identities of more than 65,000 of its customers as required by the USA PATRIOT Act and SEC rules. E*Trade agreed to settle the SEC’s enforcement action without admitting or denying the allegations, and will pay $1 million in financial penalties.

“E*Trade is one of the largest online brokerage firms in the world, and a compliance lapse of this type has the potential to undermine the nation’s anti-terrorism and anti-money laundering efforts,” said Linda Chatman Thomsen, Director of the SEC’s Division of Enforcement. “The penalty and undertakings imposed in today’s enforcement action reflect the critical nature of anti-money laundering rules, and will provide greater assurance that future compliance will be seriously and continuously monitored.”

Cheryl Scarboro, Associate Director in the SEC’s Division of Enforcement, added, “On several occasions, E*Trade personnel discovered and rediscovered its CIP deficiency. However, E*Trade did not initiate any corrective action until the problem resurfaced almost two years after the compliance deadline. E*Trade’s 20-month period of noncompliance clearly resulted from a disjunctive organizational structure and inadequate management of its CIP responsibilities.”

The SEC’s order finds that E*Trade established, documented and maintained a CIP that specified that it would verify all accountholders in a joint account. However, during a 20-month period, E*Trade failed to follow the verification procedures set forth in its CIP. The order finds that E*Trade did not verify the identities of secondary accountholders in newly opened joint accounts. Consequently, the order finds that E*Trade’s documented procedures differed materially from its actual procedures.

The SEC’s order specifically finds that, from October 2003 to June 2005, E*Trade did not verify the identities of 65,442 secondary accountholders in joint accounts as required by the CIP rule and its own procedures. The SEC’s order further finds that E*Trade’s compliance failure was systemic, resulting from lack of a cohesive organizational structure, lack of adequate management oversight, and miscommunications among personnel in several E*Trade business groups.

E*Trade consented to the issuance of an order instituting administrative and cease and desist proceedings for violations of Section 17(a) of the Securities Exchange Act of 1934 and Rule 17a-8 thereunder. In addition to the financial penalties, E*Trade agreed to a censure and to retain a qualified independent compliance consultant to verify the adequacy of its CIP rule compliance program.

In advance of settling this matter, E*Trade stated that it submitted the secondary accountholder information on joint accounts originally missed to its third-party vendor for verification. According to E*Trade, the verification process did not identify any joint accounts that should not have been opened.

CFTC Release 5525-08

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Release: 5525-08

For Release: July 30, 2008

California Resident Gilbert Philip Castillo, Jr. to Pay More Than $272,000 to Resolve CFTC Anti-Fraud Action

Washington, DC – The U.S. Commodity Futures Trading Commission (CFTC) announced today that Philip Castillo, Jr. of Walnut Creek, California, will pay $92,474.60 in restitution and a $180,000 civil monetary penalty to resolve CFTC charges that he committed fraud in connection with the trading of S&P 500 commodity futures and option contracts through three Internet websites.

The consent order, entered by the Honorable Thelton E. Henderson, U.S. District Court Judge for the Northern District of California, also permanently prohibits Castillo from engaging in any business activities related to commodity futures trading.

The order arises from a 2006 CFTC complaint against Castillo (see CFTC Press Release 5212-06). The complaint charged that Castillo and his company, Castle Enterprise Corporation (Castle) d/b/a WallStreetWar.com, CastilloResearch.com and Never-Lose.com (collectively, the Wall Street War websites), operated Internet websites from February 1999 through mid-2005 that made fraudulent representations to the general public regarding Castillo’s trading successes and the accuracy, profitability, and track record of Castle’s various commodity advisory services. During this time, Castle was purportedly acting as a Commodity Trading Advisor (CTA) without being registered with the CFTC, as required.

The order finds that Castillo violated the anti-fraud provisions of the Commodity Exchange Act by making false material representations through the Wall Street War websites. These representations included touting that the Wall Street War Advisory Service is “[p]roven to be the most accurate and profitable advisory available!”, and claiming that the system had a track record of 90 to 96 percent profitability, with “tremendous returns in different market conditions for six years!” that ranged “from 302% to 447%.” In fact, many of the advisory services offered to the public by Castillo and Castle never operated and clients were abandoned after purchasing trading systems or courses.

The order also finds Castillo liable as a controlling person of Castle and for being an unregistered Associated Person (AP) of Castle, which was operating as an unregistered CTA.

Previously, on February 5, 2007, the court entered a final default judgment against Castle, ordering it to pay $814,858.89 in disgorgement to be used for restitution to victims of its fraud and a $480,000 civil monetary penalty (see CFTC Press Release 5291-07).

The following CFTC Division of Enforcement staff members are responsible for this case: Timothy J. Mulreany, David Reed, Michael Amakor, Paul Hayeck, and Joan Manley.