The U.S. Securities and Exchange Commission (SEC) on December 26 sanctioned New York-based Instinet LLC for improperly making soft dollar commission payments in a negotiated settlement costing Instinet $813,000.
Last August, as we reported at the time, the SEC nailed a San Diego-based investment adviser, J.S. Oliver Capital Management, for misappropriating over $1million in soft dollar commissions, including divorce payments to the principal’s wife, illegal payments to the principal and for the principal’s apartment in New York City. The SEC claimed that there were ample signs for Instinet to realize that such payments were improper. As part of its settlement, Instinet neither admitted nor denied the SEC’s findings.
According to the SEC’s administrative order, Instinet ignored red flags while approving soft dollar payments to J.S. Oliver from January 2009 to July 2010:
- J.S. Oliver provided Instinet with inconsistent reasons for a payment of more than $329,000 to the principal’s ex-wife under the guise of employee compensation. The payment was actually related to the principal’s divorce. Instinet approved the payment despite a purported employment agreement provided by J.S. Oliver that, while significantly altered, still failed to indicate that the ex-wife had performed any work for J.S. Oliver after 2006.
- After J.S. Oliver had submitted invoices to Instinet indicating a monthly rent of $10,000 for all of 2009, the firm requested soft dollars in July 2009 for a 50 percent increase in rent to $15,000 per month. However, J.S. Oliver rented offices in the principal’s home, and Instinet knew that the principal owned the company to which the rent was paid. The increased rent payments were inflated for the principal’s personal benefit and not properly disclosed to J.S. Oliver clients. Nevertheless, Instinet approved $65,000 in soft dollar payments for the rent increase over a period of 13 months.
- J.S. Oliver again provided Instinet with inconsistent reasons for two requested soft dollar payments purportedly for the principal’s travel expenses related to evaluating “potential investment opportunities.” However, the expenses actually were for maintenance, taxes, and fees on the principal’s personal timeshare in New York City. Despite copies of timeshare bills that were clearly in the principal’s name indicating the payments would be for his own financial benefit, Instinet approved the soft dollar payments totaling more than $40,000.
According to the SEC, Instinet “willfully aided and abetted and caused JS Oliver’s violations of Sections 206(2) of the Advisers Act, which prohibits an investment adviser from engaging in any transaction, practice, or course of business which operates as a fraud or deceit upon a client or prospective client, and Section 206(4) of the Advisers Act and Rule 206(4) 8 thereunder, which prohibit fraudulent conduct by an investment adviser to pooled investment vehicles.”
Instinet agreed to pay a penalty of $375,000, disgorgement of $378,673.76, and prejudgment interest of $59,607.66. Instinet must hire an independent compliance consultant to review its policies, procedures, and practices related to soft dollar payments. The firm also consented to a censure and a cease-and-desist order.
Instinet’s disgorgement of $378,673.76 presumably relates to the commissions accruing to Instinet during the improper trades. Instinet generally agreed to give JS Oliver a soft dollar credit of $0.0225 for every $0.03 of brokerage commissions generated per share by JS Oliver clients’ equity trades, according to the SEC.
Conclusion: Although payment for employee compensation and rent is not typically permissible under Section 28(e) of the Securities Exchange Act of 1934, it is allowed if disclosed to investors in the offering documents. Effectively, the SEC is telling commission brokers that they must monitor the payment terms for each commission client and ensure that payments are consistent with those provisions. In the case of J.S. Oliver, the SEC found the violations egregious enough to throw the book at Instinet as well as the asset manager.
The more interesting question is whether this example of soft dollar abuse will incline the SEC to cooperate with their regulatory colleagues across the pond who are contemplating radical changes to the commission regime.