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The Financial Industry Regulatory Authority (“FINRA”) fined and suspended Wells Fargo broker Eli Ungar (“Ungar”) for allegedly poaching client data from his former employer the Hong Kong and Shanghai Banking Corporation (“HSBC”). Mr. Ungar has been a registered broker since 2004, and was employed at HSBC from 2008 through 2016. In 2016, after Mr. Ungar’s transition to Wells Fargo, HSBC began a fraud investigation into Mr. Ungar’s activities, alleging that he took HSBC client data, and in doing so violated several investment-related statutes.

Many broker-dealers—including Wells Fargo—are signatories of the Protocol for Broker Recruiting (the “Protocol”), which establishes the type and quantity of client information brokers may transfer from one firm to the next when transitioning. Certain client contact information is allowed to be taken in transitions, however account balances and social security numbers are not, unless two broker-dealers have a specific onboarding relationship with each other that permits the transmission of such data. Regardless, HSBC is not a signatory to the Protocol, making Mr. Ungar’s alleged actions a possible violation of both FINRA rules and contractual obligations to HSBC. Mr. Ungar agreed to a $10,000 fine and 15-day suspension, according to the Settlement FINRA released.

Firms such as HSBC, who are not signatories to the Protocol, often actively try to prevent former employees from leaving with client information. Many brokers sign employment agreements including non-solicitation clauses or other restrictive covenants, thereby complicating their transition to other broker-dealers, especially if their former or future employer is not a member of the Protocol. In these instances, the firms they are leaving may go to court to file injunctions against the former employees, or their new firms, who attempt to utilize these previously acquired client books.

Merrill Lynch Wealth Management (“Merrill Lynch”) has, at the directive of its parent company Bank of America (“BOA”), rolled out a new broker recruiting program in an effort to trim costs, a move that falls in line with consolidation trends in the larger wealth management industry. Merrill Lynch is opting out of the expensive bidding wars between banks for experienced brokers with large client books. These recruiting initiatives, involving head hunters and recruiting agents, and six to seven-figure promissory note inducements to entice brokers with high-net worth client lists, are already being rolled back industry-wide.

At the same time Merrill Lynch is rolling back its recruitment of veteran brokers, it is aggressively expanding its wealth management division. Merrill Lynch is pursuing this strategy through a pilot program that involves hiring inexperienced, often new advisors—and paying them a salary with limited performance-based compensation inducements. Merrill Lynch appears to have made a risk reward calculation, and determined that paying veteran brokers sign-on bonuses in multiples of their yearly book revenue was no longer a viable investment.  Given the propensity for brokers to transition between banks in a race to the highest bidder, and an industry wide slowdown in active wealth management as assets move into lower cost exchange traded funds (“ETFs”), Merrill Lynch has opted for a lower-cost approach to its wealth management strategy. As of June 1^st, Merrill Lynch will no longer pay sign-on bonuses for brokers.

Given that the average age of wealth management advisors is close to 60, and the industry of active management is contracting, Merrill Lynch is looking to hire and train young, aggressive brokers to replace its more expensive and retiring veterans. The new compensation grid, which skewes towards base salary rather than performance-based bonuses, sets a precedent for lower compensation that reflects the challenges that the industry faces. BOA Chairman Brian Moynihan has stated that in regards to bank profits, “not every dollar is a good dollar,” which could be interpreted to mean that the risk of closely tying bonus packages to meeting recruiting goals is now outweighing the rewards, due to regulatory pushes and legal risks in the backdrop of active management contraction.

The United States Supreme Court has agreed to hear the case FTI Consulting, Inc. V. Merit MGMT. Grp. LP 16-784, that has the potential to make it easier for creditors to claw back cash that was paid out by a company for extended time periods before filing for bankruptcy. FTI Consulting, Inc. V. Merit MGMT. Grp. LP 16-784 involves a dispute on the outcome of a buyout of a horse racing track by Valley View Downs, an entity which is currently a debtor to FTI Consulting. FTI Consulting is Trustee to Centaur LLC, a litigation trust, that is the primary debtor to which Valley View Downs owes funds. Valley View Downs purchased another race track, Bedford Downs, by acquiring 100% of the stock of Bedford Downs in exchange for $55 million in cash. Merit Management Group was a 30% shareholder of Bedford Downs. After Valley View purchased Bedford Downs in a cash-for-stock transaction, similar to a leveraged buyout, Valley View was forced to file Chapter 11 due to an inability to secure a gambling license for the Bedford Downs race track. FTI Consulting, the Trustees to the entity Centaur LLC to which Valley View Downs owes funds, subsequently sued Merit for $16.5 million, which is to say the 30% stake Merit Management held in Bedford Downs stock for which it received a cash transfer in the buyout.

Bankruptcy law currently provides a ‘safe harbor’ to financial institutions that conduct securities transactions. The rationale behind this protection is to shield securities trades from creditor claims, thereby promoting stability in financial markets in the face of corporate restructuring that involves bankruptcy filings. The downside to these bankruptcy protections however is that they can provide protections for fraudsters, who use these transactions to trade funds out of a fraudulent entity, and then file for bankruptcy protection. Under the current law, it can be difficult to claw back these funds. The Supreme Court will consider whether these ‘safe harbor’ bankruptcy protections should apply to entities that acted merely as pass-through conduits for fraudulent financial transactions.

A federal appeals court in New York dismissed FTI Consulting, Inc. V. Merit MGMT. Grp. LP 16-784, citing ‘safe harbor’ protections, and ruling that the shareholders were except from clawback action. The Plaintiffs in the suit argued that the ‘safe harbor’ shield was designed to protect the banks who facilitated the transaction, not the shareholders who are being sued, and because they acted only as a conduit to facilitate the leveraged buyout, the protection should not extend to the shareholders in clawback actions.

Jesse Litvak, a former bond trader at Jeffries Global Investment Banking (“Jeffries”), was arrested and charged with securities fraud in 2013 for selling bonds to customers while lying about the price he himself had previously paid for the bonds. Litvak was initially convicted in 2014 for fraud and sentenced to two years in prison. However, after appealing, the Court decided that he should have the opportunity to explain his case to a jury. A federal jury in New Haven, Connecticut rendered a verdict on his case in January 2017, and he will be sentenced at the end of April.

Litvak sold bonds comprised of residential mortgage backed securities (“RMBS”) which are financial products comprised of pools of residential mortgage loans created by banks and packaged together based on different structuring of credit, prepayment risk, principle payment, and interest payment, and then packaged into securities and traded on the open market. When trading these bonds, Litvak habitually lied about when he had purchased the bonds and what prices he paid for them. For example, Litvak would tell a customer that he had bought bonds for $73.00 each earlier that day, and sell them to the customer for $73.25 the same day. In reality, Litvak had purchased the bonds for $71.00 several days prior, and had been shopping them around to institutional buyers to whom he could unload them for as high a price as possible.

Litvak’s defense is as follows: lying to his customers is not fraud, because fraud requires the lies be material, and lying about the price he paid for bonds is not material to the buyers’ pricing mechanisms in structuring a trade. Some analysts of the case have termed this defense a ‘used car salesman defense’ playing off the perception that used car salesmen bend the truth, and therefore assertions made about a cars previous condition and prices paid are not material to the buyer’s objective valuation of the car.

On April 5, 2017, the Securities and Exchange Commission (“SEC”) issued an Order (the “Order”) instituting Public Administrative and Cease-and-Desist Proceedings against Lawson Financial Corporation (“Lawson”) for failing to perform reasonable due diligence on bond underwritings for the renovation and development of senior living facilities. These bond offerings were made in connection with Atlanta-based business man Christopher F. Brogden (“Brogden”), who has been separately charged by the SEC and faces a court order to repay $85 million to investors. The SEC alleges that Lawson failed to protect investors from Brogden’s scheme by neglecting to ensure Brogden was in compliance with necessary disclosures, that under Sections 17(a)(2) and (3) of the Securities Act and Section 15(c)(2) of the Exchange Act and Rule 15c2-12 which require underwriters to receive annual financial and operating disclosures from any debt structured deal.

According to the SEC between 2010 and 2014, Lawson served as the underwriter for 13 separate Brogden bond offerings, through which approximately $87 million was raised. These funds were raised for the purpose of constructing, purchasing and renovating a variety of nursing homes, assisted living homes and senior development communities. While engaging in the underwriting of the bonds, Lawson failed to expose the persistent and continual material breaches, misrepresentations, and flouting of disclosure rules made by other Brogden-controlled companies. In addition to failing to uncover problems related to Brogden’s previous debt offerings, Lawson failed to perform its duties in obtaining annual financial disclosures from the projects underpinning Brogden’s bond offerings.

The SEC notes in its Order that by failing to continually obtain necessary financial disclosures while underwriting bonds for Brogden’s senior living development scheme, Lawson allowed the fraud to continue, thereby harming more investors. Andrew M. Calamari, Director of SEC’s Regional New York Office, stated: “Underwriters are critical gatekeepers relied upon by investors to ensure that accurate information is being provided in municipal bond offering documents.”

There have been over 2,000 FINRA arbitrations filed in Puerto Rico in regards to unsuitable leveraged investments in Puerto Rican bond funds, and over $226 million in awards so far. However, many of these cases settle. Some analysts have noted that while banks such as UBS have faced a large number of arbitration claims for investing clients’ funds in unsuitable high-risk leveraged Puerto Rican bond funds, bank of Santander was spared from most of these claims and is subject to only 200 filings. This lower number of claims stands in contrast to the fact that the Santander funds had higher leverage than UBS, and may have been marketed more aggressively to unsuitable clients.

Santander sold over 12 closed end funds and six open end funds in Puerto Rico; designated “First Puerto Rico Funds.” Santander marketed 11 of these funds to clients with conservative investment goals of “capital preservation,” yet these funds declined by 56% on average. In 2013, there were $3.4 billion in assets in these 11 closed end funds. By 2015, there were only $1.6 billion, with $1.8 billion in valuation vanishing as default rates rose on the bonds.

Most municipal bond funds are leveraged at a maximum of 20%, whereas Santander sold Puerto Rican municipal bond funds to conservative investors leveraged at 50% – 100%, doubling potential gains, but also doubling possible losses. Given that Puerto Rican municipal bonds were already paying coupons of between 5% to 6%, leveraging an already-risky bond in which the inflated yield is supposed to compensate for increased risk is unwise at best, according to some investment professionals.

Leading Plaintiffs Robert Colman (“Colman”) and Hillary Taubman-Dye (“Dye”) have filed a class action suit in the United States District Court for the Northern District of California against Theranos (“Theranos”) and founder Elizabeth Holmes (“Holmes”).  Theranos is a biotech company founded in 2003 on the premise of developing and producing cheap and rapid biomatter testing capabilities. It quickly became a highly sought after investment opportunity, rapidly reaching a nine-figure valuation, with investors predicting enormous demand for cheap, accurate, and portable home testing devices. However, it has since been the subject of numerous legal actions, both criminal and civil, alleging that its representations about an exclusive and proprietary blood testing technology were entirely fraudulent, and that no such revolutionary technology existed. Similarly, in their Complaint, Colman and Dye accuse Holmes of personally enriching herself while spinning a story that her revolutionary technology would both save millions of lives and cut costs: “the truth—there was no revolutionary technology” the Complaint alleges.

In its Answer, Theranos asserts that the Plaintiffs have no standing because they never invested directly in Theranos, rather they invested in venture capital firms, LVG XI and Celadon Technology Fund, which in turn invested in Theranos. Theranos further contends that Colman and Dye did not purchase fractionalized shares that would have given them traditional shareholder rights such as voting power or legal recourse. The analogy Theranos provides is that if an individual invested in an Exchange Traded Fund (“ETF”), and one of the companies in which that ETF had holdings committed fraud, the investor would have no grounds for claims against the company because the investor does not own the underlying securities, only rights to their collective valuation through the ETF.

The Plaintiffs argue that this analogy is misleading, given that the investments made in LVG XI and Celadon Technology Fund were placed exclusively for the opportunity of investing in Theranos, and that these venture capital firms are not at all similar to mutual funds or ETFs. Instead, they are vehicles for allowing investors to have access to private offerings of sought after companies, such as Theranos. The Plaintiffs further assert, these types of venture capital funds act more as an intermediary for investors who have the intention of investing in a specific company, yet lack the capital or connections to gain access to it–so use firms such as LVG XI or Celadon Technology Fund to facilitate this process. Plaintiffs are additionally seeking class action certification, as they believe there are many similarly situated individuals who incurred losses. The outcome of this case could set a precedent for future claims to arise in the venture capital and private offering sphere of the securities market.

According to analysts, private “tech unicorns” (tech companies with a valuation over $1 billion) have been recently engaging in unusual stock buyback activity in the private markets. For example, Uber Technologies Inc., in a recent announcement, said “those who work at the San Francisco company for at least four years can sell as much as 10 percent of their shares.” This sale highlights two emerging themes in the securities market: (1) multinational companies are able to raise billions in the private markets from both institutional and retail investors without the need to go public; and (2) the function of going public for these companies that have raised capital in private offerings is primarily to return money to shareholders who bought stock in private offerings.

For many tech companies, a significant portion of employee pay is in the form of preferred stock, varying from 5% – 30% of overall compensation. As industry analysts note, Uber’s private stock buyback program will help them retain talent, as employees anxious for the company to go public so as to liquidate stock options will be able to realize some of their compensation more immediately. However, some experts are worried, because Uber appears to be profiting off of this buyback, due to differing liquidity expectations of the buyers and sellers, and the subsequent wide spread between the bid and ask of these private stock offerings.

Consequently, Uber can purchase common stock from employees for 25% – 30% less than what it has sold the stock for in recent funding rounds. Given that Uber is not publicly traded, employees who want to unload their stock have few options due to the limited liquidity, and can sell primarily only to Uber. Investors who want to purchase shares in Uber, which is a private company whose stock offerings are scarce, are willing to pay a premium because it is difficult to access the stock. In this scenario, Uber is profiting off the bid-ask spread between what employees are willing to sell the stock for, and what investors are willing to pay for it.

On February 14, 2017, the Securities and Exchange Commission (“SEC”) instituted administrative and cease-and-desist proceedings pursuant to sections 203(e) and 203(k) of the Investment Advisors Act of 1940 (the “Order”), alleging that Morgan Stanley was responsible for the unsuitable solicitation and sale of inverse ETFs to clients.  Morgan Stanley has submitted a settlement Offer of $8 million (the “Offer”), and acknowledged wrongdoing in selling and marketing these inverse ETFs as a long-term investment strategy, when Morgan Stanley’s very own compliance policy procedures recommended such ETFs for only short term holds.

An ETF is a fund which owns underlying assets in a given sector (shares of a stock, bonds, foreign currency) and divides ownership of these assets into shares, which can be purchased by investors.  Investors do not have any direct claim to the underlying investments, but indirectly own them through the ETF shares.  ETFs can be sector specific (aerospace defense, semiconductors, uranium) or broad and track overall market performance.  According to the Order, the specific type of ETF Morgan Stanley was improperly selling to investors is an “inverse” ETF.  Nontraditional ETFs are generally inverse, leveraged, or inverse leveraged, although other more exotic types of ETFs such as different bundling’s of derivative options exist.  Inverse ETFs track an underlying package of securities; however, they are composed of various option derivatives that sell the underlying asset short.  This means that if the underlying assets go up, the inverse ETF goes down, and if the underlying assets go down in value, the inverse ETF rises in value.

Pursuant to FINRA Regulatory Notice 09-31, inverse ETFs are not suitable for long term holds for two reasons.  First, the most the ETF can appreciate is 100%, if all its underlying assets go to zero (highly improbable), whereas a long ETF can appreciate as much as its assets rise which could over the course of several decades lead to a doubling or tripling of your initial investment.  The second and most significant reason for why inverse ETFs are dangerous for a long-term hold, is that there is an underlying cost to hold them both in higher fees, and in inherent structural costs called “beta-slippage decay.”  The high fees associated with inverse ETFs, generally 1%, are due to the costs associated with purchasing “shorts,” or option derivatives on the underlying assets.  This makes inverse ETFs more expensive than regular ETFs, which simply purchase underlying assets rather than short options.  Beta-slippage decay is a mathematical term used to describe the costs associated with rebalancing on inverse or leveraged ETF.  In summary, if the underlying assets that the inverse ETF is pegged to do not change in valuation, the inverse ETF will slowly decline in value due to fees and rebalancing costs. This is why inverse ETFs are unsuitable for long term holding strategies, unless in rare cases they are part of a specific, documented hedging strategy where benefits outweigh these increased costs.

On January 25, 2017, the Securities and Exchange Commission (“SEC”) instituted public administrative cease and desist proceedings pursuant to Section 8A of the Securities Act of 1933 (“Securities Act”), Sections 15(b) and 21C of the Securities Exchange Act of 1934 (“Exchange Act”), and Section 9(b) of the Investment Company Act of 1940 (“Investment Company Act”) (the “Order”) against New York based brokerage firm Windsor Street Capital LLP, formerly known as Meyers Associates LLP (“Meyers”), and its former anti-money laundering officer John D. Telfer (collectively , “Respondents”). These enforcement actions were brought on the accusation that Windsor failed to file suspicious activity reports (“SARS”) on approximately $24.6 million in dubious transactions, and thereby enabled two financiers to run a “pump and dump” scheme while earning approximately $493,000 in commissions from facilitating these illegal penny stock sales.

These financiers, Raymond H. Barton and William G. Goode, were separately charged by the SEC with a pump and dump scheme.   Barton and Goode are accused of buying shares of sparsely traded shell companies for purported dietary supplement businesses, hyping them in “news” releases, and then dumping the shares at inflated prices.

A “pump and dump” scheme is a form of fraudulent market manipulation, in which a company (generally small, so called “microcap” companies) are promoted through false and misleading statements and mischaracterizations, in order to inflate or deflate the price of their stock.  These false messages can be spread through social media platforms, chat rooms, newsletters, or telemarketer phone calls, and are generally perpetrated either by paid promoters or company insiders.  Once these insiders “dump” their shares, the price of the stock typically falls, and investors lose money.  The reverse of this strategy is when fraudsters purposely try to deflate the price of a stock through fraudulent actions, so as to buy it on the cheap, however this is a more unusual scenario.