Instinet $800,000 Settlement: Diligence Important Within Soft Dollar Arrangements
In August 2013, the U.S. Securities and Exchange Commission’s (SEC) charges against J.S. Oliver Capital Management, the firm’s co-founder and CEO Ian Mausner, and chief compliance officer Douglas Drennan over the misuse of soft dollars passed without attracting much attention, as the case only represented some of the harm caused to clients of the firm. With the late-December related charges and settlement with broker Instinet, LLC, the SEC has revealed that both parties of soft dollar arrangements may be held accountable for misconduct.
The original charges against J.S. Oliver over the misuse of client commissions totaled more than $1 million. According to the SEC’s order, the payments included:
- More than $300,000 that Mausner owed his ex-wife under their divorce agreement.
- More than $300,000 in “rent” for J.S. Oliver to conduct business at Mausner’s home. Most of this amount was funneled to Mausner’s personal bank account.
- Approximately $480,000 to Drennan’s company for outside research and analysis when in reality Drennan was an employee at J.S. Oliver.
- Nearly $40,000 in maintenance and other fees on Mausner’s personal timeshare in New York City.
J.S. Oliver cited Form ADV filings and offered documents for various J.S. Oliver-operated funds when requesting soft dollar repayments. The SEC charges citing the J.S. Oliver Concentrated Growth Fund memorandum included disclosure of allowed soft dollar usage for “evaluating potential investment opportunities (including travel, meals, and lodging related to such evaluation) and may even include such ‘overhead’ expenses as office rent, salaries, benefits, and other compensation of employees or of consultants to the Investment Manager.” While the initial aspects of the intended use may provide some benefits to clients, the latter portion appears to cover traditional operating costs for the firm. The outcome of the charges against J.S. Oliver, Mausner, and Drennan is pending with administrative proceedings held on 6 January in San Diego.
The charges against Instinet only related to about $430,000 of the total scheme, including payments to the ex-wife, rental fees, and maintenance on the timeshare. The SEC charges accused Instinet of overlooking potential red flags that J.S. Oliver was not upholding its obligations to clients. The requested amounts were paid by Instinet without first developing a reasonable basis that the activities were in the interest of the client. The SEC’s actions indicated that Instinet should have done more.
The CFA Institute Soft Dollar Standards could have provided Instinet with a useful set of principles for judging the requests of its counterparties. The Soft Dollar Standards seek to provide ethical guidance to investment professionals that engage in soft dollar practices. While primarily developed for those acting as investment managers, the Soft Dollar Standards provide brokers with a measuring gauge for allowable reimbursements.
Along with requiring that all soft dollar usage benefit the client and outlining effective disclosures, the Soft Dollar Standards also provide insights into determining whether an activity meets the basic characteristics of research. Research is defined in the Soft Dollar Standards as “services and/or products provided by a broker, the primary use of which must directly assist the investment manager in its investment decision-making process and not in the management of the investment firm.” It is not obvious how payments requested by J.S. Oliver for reimbursement for rental expenses, real estate maintenance expenses, and employee compensation benefit clients in the investment decision-making process. Expenses of this nature would typically fall under the operational expense of the firm for which the Soft Dollar Standards would not allow soft dollar reimbursement.
In an article in The Trade, Instinet is quoted: “The firm also is pleased that, following a lengthy and thorough investigation, the SEC did not find that Instinet engaged in any intentional misconduct.” While Instinet’s lack of diligence was not intentional, the firm, along with the fine, is required by the SEC order to engage an independent compliance consultant to review its soft dollar policies and procedures. Incorporating the Soft Dollar Standards into the review and future practices of the firm should assist in preventing future $800,000 unintended events.
As revised 15 January 2014.
Photo credit: iStockphoto.com/AndreyPopov