New York – Soft dollars aren’t in the news much these days, so a recent headline that the US Financial Industry Regulatory Authority (FINRA) had fined a broker for soft dollar violations caught our attention. FINRA fined Terra Nova Financial Group $400,000 for making ‘improper’ soft dollar payments (payments for services with client commissions) involving five hedge fund managers. The action highlights a nuance of soft dollar regulation where hedge funds can be exempted from US soft dollar regulations if the policies are in the prospectus and disclosed to investors.
Terra Nova Financial Group is a small brokerage firm listed on the OTC Bulletin Board which provides prime brokerage and trading software targeted to small hedge funds. According to FINRA, Terra Nova set up soft dollar accounts, which allow investors to purchase services through trading commissions, for eight hedge funds in 2004. Over the next couple of years, Terra Nova made improper payments for five of the eight hedge funds, including:
- $13,700 for seven trips by a hedge fund manager to a “gentlemen’s club” in a two-week period (for those doing the math, that’s just under $2,000 per trip).
- $65,000 for credit card bills that contained charges for meals, clothing, auto repairs and parking tickets. Terra Nova made other payments for limousines, airline tickets and hotel stays.
- $145,000 for salaries and benefits of non-clerical employees when the fund documents only permitted payments for “clerical staff salaries and benefits.”
- $389,000 in payments for “consulting fees related to research” when the invoices requesting the payments did not sufficiently identify who provided the research or what research was being provided.
- More than $470,000 to one manager without any clear understanding of what expenses were being paid.
Interestingly, the issue here isn’t just that these payments violate US soft dollar regulations under Section 28(e) of the Securities Exchange Act of 1934, which require that client commissions be used only for the purchase of investment research. FINRA also had to establish that such payments also violate the policies laid out in the hedge funds’ prospectuses. As FINRA puts it, “… advisors may only use soft dollars to pay for personal expenses or other non-research or non-brokerage related expenses if those types of payments were previously disclosed to investors and if they are made in accordance with the terms of the fund’s organizing documents.”
So, in theory at least, hedge funds could be set up to use client commissions for the purchase of non-research expenses, and, if these expenses are permitted in the prospectus and are disclosed to investors, they are not subject to Section 28(e) regulation. In this particular case, ‘clerical staff salaries and benefits’ were permitted to be paid through client commissions by at least one of the funds. It is hard to conceive of hedge fund investors being comfortable with their commission dollars being used to fund trips to a ‘gentleman’s club’. More plausible might be quasi-research related expenses which used to be permissible before the regulations were tightened in 2006, such as mass-market publications or some trading and operational software (such as the trading software offered by Terra Nova.)
Many brokers will not process the payment for non 28(e) items even if disclosed because of reputational risk. (Note that the regulators go after the brokers not the hedge funds since the latter are unregulated.) Also, the violations cited by FINRA occurred five years ago, before the SEC guidance on soft dollars in 2006, which clarified US soft dollar regulations. Nevertheless, the possibility exists for hedge funds to legally flout Section 28(e), which in turn opens the door to ‘gentleman’s clubs’, dwarf tossing and other soft dollar abuses which would not bode well for Section 28(e) in the current reform-minded environment.
The full FINRA release follows:
FINRA Fines Terra Nova Financial $400,000; Firm Made Over $1 Million in Improper Soft Dollar Payments
Three Former Employees Also Sanctioned
Washington, DC — The Financial Industry Regulatory Authority (FINRA) today announced that it has fined Terra Nova Financial, LLC, of Chicago, $400,000 for making more than $1 million in improper soft dollar payments to or on behalf of five hedge fund managers, without following its own policies to ensure the payments were proper.
Terra Nova was also charged with failing to properly supervise its soft dollar program, failing to implement adequate supervisory procedures and failing to retain its business-related electronic instant messages. Terra Nova also failed to timely respond to FINRA’s requests for productions of various documents, including emails and instant messages, thus delaying FINRA’s investigation.
FINRA also sanctioned three individuals. Cleovan Jordan, the soft dollar administrator who managed Terra Nova’s relationship with its hedge fund clients, was suspended from associating in any capacity with a securities firm for 30 days and fined $20,000. Joshua Teuber, who supervised the soft dollar operation, was charged with failure to properly supervise, suspended from acting in a supervisory or principal capacity for 20 days and fined $15,000. David Persenaire, the firm’s Chief Compliance Officer until September 2009, was charged with failing to ensure the implementation of adequate written systems and procedures, suspended from acting in a supervisory or principal capacity for 10 days, fined $10,000 and required to take and pass a Compliance Official Qualification Exam.
As part of the settlement, Terra Nova is required to retain an independent consultant to review and enhance its policies, systems and procedures relating to its soft dollar operations.
“Broker-dealers that collect soft dollars and make payments for their hedge fund clients must possess and implement adequate procedures that govern their soft dollar practices,” said Susan Merrill, FINRA Executive Vice President and Chief of Enforcement. “Firms must not ignore red flags indicating the potential misuse of soft dollars that are generated from trading commissions. Soft dollars belong to the hedge fund investors and must be used for the benefit of the funds, or as permitted by the fund’s own disclosure documents.
“In this case, Terra Nova’s own policies required it to obtain and review a copy of the offering documents for its hedge fund clients.” Merrill said. “Terra Nova made numerous soft dollar payments that were improper because they were not authorized or clearly disclosed in those documents or because Terra Nova did not obtain sufficient documentation or conduct an adequate review. Therefore, Terra Nova knew, or with reasonable inquiry should have known, that the payments were inappropriate.”
FINRA found that starting in 2004, Terra Nova set up soft dollar accounts for eight hedge funds to encourage the funds to execute trades with the firm. Terra Nova collected a portion of the commissions generated by the funds’ trading in separate soft dollar accounts and from those accounts paid invoices from the fund managers or third parties for various services. Federal securities laws allow advisors to use soft dollars to pay for research or brokerage-related expenses. But advisors may only use soft dollars to pay for personal expenses or other non-research or non-brokerage related expenses if those types of payments were previously disclosed to investors and if they are made in accordance with the terms of the fund’s organizing documents.
FINRA found that in 2004 and 2005, Terra Nova made numerous improper soft dollar payments to or on behalf of five hedge fund advisors totaling more than $1 million. Some payments (for estate planning fees, administrative staff and accounting expenses) were not allowed by the fund documents. Other payments made directly to the funds’ managers were improper because Terra Nova did not receive written authorization from a third party evidencing that the payments were appropriate, as required by fund documents that the firm had or should have obtained under its own policies.
Terra Nova paid at least $1 million in expenses without receiving adequate documentation or conducting an adequate review to determine that the payments were for expenses authorized by fund documents. Those payments included:
- $13,700 for seven trips by a hedge fund manager to a “gentlemen’s club” in a two-week period.
- $65,000 for credit card bills that contained charges for meals, clothing, auto repairs and parking tickets. Terra Nova made other payments for limousines, airline tickets and hotel stays.
- $145,000 for salaries and benefits of non-clerical employees when the fund documents only permitted payments for “clerical staff salaries and benefits.”
- $389,000 in payments for “consulting fees related to research” when the invoices requesting the payments did not sufficiently identify who provided the research or what research was being provided.
- More than $470,000 to one manager based solely on the manager’s representation that soft dollars would be used to “fund expenses in conjunction with our documents” without any clear understanding of what expenses were being paid.
FINRA found that Terra Nova and Teuber failed to supervise the firm’s soft dollar operations by failing to respond adequately to red flags indicating hedge fund advisors were using soft dollars to pay for unallowable expenses. FINRA further found that Terra Nova and Persenaire failed to develop adequate systems and procedures in place to supervise its soft dollar group and that the firm failed to follow the policies it did have in place.
In settling this matter, Terra Nova, Jordan, Teuber and Persenaire neither admitted nor denied the charges, but consented to the entry of FINRA’s findings.