Private Placement Offering Failures

US FINRA recently fined Pacific Cornerstone Capital and its former CEO, Terry Roussel, a total of $750,000 for failing to include full and complete information in private placement offering documents and marketing material. FINRA also charged Pacific Cornerstone and Roussel with advertising violations and supervisory failures.

Pacific Cornerstone agreed to make corrective disclosures to investors and to submit advertising and sales literature to FINRA for pre-use review for one year. Roussel was suspended in all capacities for 20 business days and in a principal capacity for an additional three months.

From January 2004 to May 2009, Pacific Cornerstone sold private placements in two affiliated companies using offering documents and accompanying sales literature that contained targets as to when investors would receive the return of their principal investment and the yield on their investment. The offering documents included statements that the affiliated entities targeted returns of principal in two to four years and targeted a yield on a $100,000 investment in excess of 18%. FINRA found no reasonable basis for those statements.

Further, Pacific Cornerstone and Roussel continued to use a similar targeted time period for return of capital and rate of return in successive offering documents, although those targets were not supported by prior performance. The offering documents failed to disclose the complete financial condition of one or both of the companies.

Pacific Cornerstone also offered private placement units of the two affiliated entities, Cornerstone Industrial Properties, LLC and CIP Leveraged Fund Advisors, LLC, to other broker-dealers and investment advisors, which in turn sold the units to the investing public. A total of approximately $50 million worth of units were sold to approximately 950 accredited investors over a period of almost six years. Pacific Cornerstone continued to use the same targeted two-to-four year return of principal and 18% rate of return in successive offering documents, despite not having met those targets.

During the same period, Roussel periodically sent letters to the private placement investors to update them on the progress of their investment that painted a positive — but unrealistic — future, without providing required risk disclosures. Roussel's letters also failed to disclose the complete financial picture of the two companies.

In Hong Kong, we rarely witness that offering to private placement investors and professional investors are so adequately supervised by SFC.

Displaying Fictitious Trades and Misleading Customers

US SEC recently charged a US subsidiary of the world's largest inter-dealer broker, U.K.-based ICAP plc, with fraud for engaging in deceptive broking activity and making material misrepresentations to customers concerning its trading activities.

As an inter-dealer broker, ICAP Securities USA LLC (ICAP) matches buyers and sellers in OTC markets for various securities, such as US Treasuries and mortgage-backed securities, by posting trade information on computer screens accessed by its customers who make trading decisions based in part on such information. Inter-dealer brokers with greater trade activity on their screens often are better positioned to attract customer orders and earn more commissions than those whose screens reflect little or no trading activity.

SEC's enforcement action finds that ICAP, through its brokers on its U.S. Treasuries (UST) desks, displayed fictitious flash trades also known as "bird" trades on ICAP's screens and disseminated false trade information into the marketplace in order to attract customer attention to its screens and encourage actual trading by these customers. ICAP's customers believed the displayed fake trades to be real and relied on the phony information to make trading decisions.

ICAP agreed to settle SEC's charges by, among other things, paying $25 million in disgorgement and penalties. SEC additionally charged five ICAP brokers for aiding and abetting the firm's fraudulent conduct and two senior executives for failing reasonably to supervise the brokers. The individuals have each agreed to pay penalties to settle SEC's charges.

According to SEC's order, ICAP's UST brokers displayed thousands of fictitious flash trades to ICAP's customers between December 2004 and December 2005. ICAP represented to its off-the-run UST customers that its electronic trading system would follow certain workup protocols in handling customer orders. Such ICAP customers therefore expected that their orders, once entered onto ICAP's screens, would be filled according to the workup protocols. However, ICAP's brokers on the UST desks used manual tickets to bypass such protocols and close out of thousands of positions in their ICAP house accounts, thereby rendering ICAP's representations concerning the workup protocols false and misleading. In some instances, ICAP's customers' orders received different treatment than the customers expected pursuant to the workup protocols.

ICAP held itself out as a firm that did not engage in trading that subjected its own capital to risk. ICAP's regulatory filings routinely made this point, noting specifically in one instance that the firm "does not engage in proprietary trading." During the relevant period, however, two former ICAP brokers on the voice-brokered collateral pass-through mortgage-backed securities (MBS) desk routinely engaged in profit-seeking proprietary trading that rendered ICAP's representations regarding proprietary trading false and misleading. ICAP failed to make and keep certain required books and records on the UST desks and the MBS desk.

Many individual and institutional investors in HK incurred losses from buying the shares of Asian Citrus (73.hk) based on the misleading information in the listing document and SEHK's trading system. Could SFC do something for them?

SDI Breach

In an article SDI breaches go dark at SFC dated 6 October 2009, David Webb voiced out that SFC has quietly stopped disclosing details of successful prosecutions for breaches of the securities disclosure-of-interests (SDI) provisions of SFO, including the name of the offender and the company whose shares are involved. Probably "alerted" by this article, SFC has recently resumed the practice of disclosing prosecution for SDI breaches.

On 26 November 2009, SFC announced that the High Court has dismissed an appeal by Mr Liu Su Ke against his conviction in June 2009 for failing to disclose his interest in shares in Warderly International Holdings Ltd (607.hk). Liu had earlier appealed against his conviction on two counts of failing to notify both SEHK and Warderly within three business days of becoming aware that he had acquired an interest in 231.8 million Warderly shares. Liu was convicted on 2 June 2009 in Eastern Magistracy on two summonses and fined the sum of $5,000 in respect of each summons.

On 28 December 2006 Liu received, from Mr Yeung Kui Wong, the chairman and an executive director of Warderly at the time, a deposit of certificates for 231.8 million Warderly shares together with share transfer documents as security for a loan of $6 million to a subsidiary of Warderly. As part of the arrangement, Liu obtained an irrevocable right to sell the shares to the extent of any failure by the subsidiary to repay the loan. On that basis, SFC contended and the Court found that Liu acquired a notifiable interest in the shares which he failed to disclose within three business days after becoming aware of his interest as required under SFO. Accordingly, the judge has dismissed the appeal and upheld the convictions.

In delivering the judgement, the judge considers a number of important legal issues concerning the enforcement of the obligation to disclose notifiable interests in listed securities including whether the absence of a reasonable excuse for not disclosing is an element of the offence, whether the offence is one of strict liability and the presumption of innocence.

SFC has successfully prosecuted 70 charges of failing to disclose a notifiable interest or change of interest so far this financial year against 11 individuals.

Email Supervision Failures

Last month US FINRA fined MetLife Securities and three of its affiliates a total of US$1.2 million for failing to establish an adequate supervisory system for the review of brokers' email correspondence with the public. The fine also resolves charges of failing to establish adequate supervisory procedures relating to broker participation in outside business activities and private securities transactions.

From March 1999 to December 2006, MetLife Securities and its affiliate broker-dealers had in place written supervisory procedures mandating that all securities-related emails of brokers be reviewed by a supervisor. However, the firms did not have a system in place that enabled supervisors to directly monitor the email communications of brokers. Instead, the firms relied on the brokers themselves to forward their emails to supervisors for review. To monitor compliance with the email-forwarding requirement, the firms encouraged — but did not require — managers to inspect brokers' computers for any emails that had not been forwarded as required. But brokers were able to delete their emails from their assigned computers, thus rendering spot-checks unreliable.

The firms also conducted annual branch audits, which were likewise ineffective because they did not allow for timely detection of email-forwarding failures. Moreover, the method employed by the auditors to identify email-forwarding deficiencies (prior to July 2005) was itself flawed, consisting mainly of a review of hard-copy files for any correspondence (including emails) that had not been forwarded. Brokers were therefore able to withhold emails without detection by the firm and conceal evidence or "red flags" of misconduct contained in their emails.

During the period from March 1999 through December 2006, two MetLife Securities brokers engaged in undisclosed outside business activities and private securities transactions without detection by the firm, although the misconduct was reflected in more than 100 separate emails that the brokers sent or received using their MetLife Securities email addresses. MetLife Securities did not discover the misconduct of either broker through supervisory review of emails because the brokers did not forward their emails to their respective supervisors.

MetLife Securities ultimately discovered that one of those brokers, Mark Salyer, stole nearly US$6 million from his customers in connection with his participation in numerous private securities transactions to raise capital for real estate development companies with which he had a relationship. In January 2009 SEC barred Salyer from association with any broker, dealer or investment adviser. FINRA's investigation of the misconduct of the other MetLife broker is continuing.

FINRA also found that the firms' inability to ensure compliance with the email-forwarding requirement meant they could not adequately enforce their own supervisory procedures relating to outside business activities and private securities transactions.

Monitoring of staff emails is not a simple matter. Apart from corporate email accounts, dealing malpractices may also be detected from webmail accounts. How could such monitoring be done without infringing privacy?

Concealment of Unauthorised Trading Losses

UK FSA recently fined UBS AG £8million for systems and controls failures that enabled employees to carry out unauthorised transactions involving customer money on at least 39 accounts.

The unauthorised activity, which took place between January 2006 and December 2007 at UBS' London-based wealth management business, only came to light when a whistleblower raised concerns internally.

Upon further investigation, it was discovered that UBS employees had taken part in the trading of foreign exchange and precious metals using customer money without authorisation and allocated losses to customers' accounts. An internal UBS investigation estimated that as many as 50 unauthorised transactions a day were taking place at the operation's peak.

FSA investigation found that UBS had failed to:

• manage and control the key risks, and the level of risk, created by its international wealth management business model;
• implement effective remedial measures in response to several warning signs that suggested the business' systems and controls were inadequate; and
• provide an appropriate level of supervision over customer-facing employees.

Further details disclosed by FSA's Final Notice:

• The services UBS provides to its international wealth management customers in the UK include, amongst other things: bank account services, investment advisory, portfolio management, trade execution, and the safekeeping of documents and assets.
• International wealth management customers are typically non-UK resident individuals who have substantial assets to invest, and are sophisticated, active and performance-driven investors.
• The London Branch afforded the Desk Heads a high degree of autonomy and authority. Each Desk Head supervised the Client Advisers operating on that specific International Business Desk. Desk Heads’ responsibilities included preparing investment documentation, contributing to technical discussions and liaising with Legal, Compliance and ‘Back Office’ functions. Where appropriate, Desk Heads were also expected to meet clients with the Client Advisers.
• During the Relevant Period, UBS’ control framework was designed to operate on the basis of a ‘Three Lines of Defence’ model. The ‘First Line of Defence’ was the business itself (i.e. Client Advisers and Desk Heads). The ‘Second Line of Defence’ was UBS’ Risk and Compliance department, which, amongst other things, undertook monitoring and risk assessments. The ‘Third Line of Defence’ was the Group Internal Audit function and external auditors.
• On 31 December 2007, a UBS employee reported to UBS’ Money Laundering Reporting Officer a concern regarding a proposed transfer of funds from a customer’s account to a particular Desk Head’s (“Desk Head ‘A’”) personal account. As a result, the Risk & Compliance department announced it would undertake a review of the International Business Desk headed by Desk Head ‘A’ (“Desk X”). The announcement of this review prompted another employee on Desk X to escalate a concern regarding an unauthorised inter-customer transfer of a structured product at a non-market price.
• In response to these concerns, UBS suspended relevant employees on the Desk and conducted a comprehensive investigation. The investigation established that Desk Head ‘A’ and certain other employees on Desk X had engaged in and/or facilitated unauthorised FX and precious metals transactions by using certain customers’ money without their authorisation and allocating any resulting profit or loss to the affected customers’ accounts. There was a high volume of FX transactions during the Relevant Period; UBS’ investigation identified approximately 50 such trades per day during 2006, which continued (at a reduced rate) throughout 2007.
• UBS’ investigation established that losses arising from the Unauthorised Trades were allocated to the accounts of other affected customers on the same Desk by exploiting the following failings in the control environment: (a) FX transactions could be executed by providing UBS’ FX traders with only an identifier for the trade and the details of the amount and the currency to be traded. Full details of the transaction, including the account number, could be provided to UBS’ FX traders up to 24 hours later. This allowed the performance of the trade to be assessed before Desk Head ‘A’ decided how any losses (or profits) should be allocated; (b) FX trades that had already been executed and booked could be cancelled and then subsequently re-booked onto another customer’s account; and (c) FX trades made nominally on behalf of a number of customers could be consolidated into a single trade with an ‘averaged’ price, thereby hiding the number of deals and the patterns of price.
• UBS’ investigation identified that losses resulting from the Unauthorised Trades were concealed by Desk Head ‘A’ and certain other individuals on Desk X from UBS’ customers by adopting the following techniques: (a) unauthorised transactions were made on the accounts of customers on the Desk who utilised UBS’ ‘retained mail’ facility. Customers using the ‘retained mail’ facility did not receive timely statements and updates on their accounts; as such, it was less likely that such customers would discover in a timely way the unauthorised activities on their accounts in comparison to those customers receiving periodic statements; (b) customers with significant liquid funds in their accounts were persuaded by the Desk to “lend” funds to other customers on the Desk who had incurred losses as a result of the Unauthorised Trades. These “loans” were documented on UBS headed notepaper by way of purported ‘UBS Guarantee Letters’. This procedure was intended by the employees on Desk X to give the lending customers the impression that the loan had been approved by UBS; however, no such approval had been given; and (c)a number of internal transfers were routed inappropriately through one of UBS’ internal ‘suspense’ accounts. The use of the suspense account enabled the true origin of the funds to be concealed as the source would not be displayed on the customers’ statements.
• Desk Head ‘A’ and other individuals working on Desk X were able to deploy these techniques without effective challenge from UBS’ systems and controls.
• UBS reported the findings of its investigation to the FSA on 30 January 2008. In February 2008, UBS commissioned an independent third party to assist it in identifying those customers who had been affected by the Unauthorised Trades. This work identified that 39 clients of “Desk X” had been affected by the Unauthorised Trades.

This case again reveals the highly risky control environment of private banking.