June 4, 2014

Folks often wonder why FINRA member firms aren't all that crazy about outside business activities and private securities transactions. Here's a FINRA regulatory settlement that delves into those issues with an added focus on the failure to supervise those activities. As a special added bonus, there's a mystery inside the mystery: Who is the registered person known only in the AWC by the codename "KH" ?

Case In Point

For the purpose of proposing a settlement of rule violations alleged by the Financial Industry Regulatory Authority ("FINRA"), without admitting or denying the findings, prior to a regulatory hearing, and without an adjudication of any issue, Sean M. McDermott submitted a Letter of Acceptance, Waiver and Consent ("AWC"), which FINRA accepted. In the Matter of Sean M. McDermott, Respondent (AWC 2013038645002, May 28, 2014).

McDermott first became registered with FINRA member firm Philadelphia Brokerage Corporation ("PBC") in 2001, where he was both an owner of that firm and its Chief Compliance Officer. The AWC asserts that McDermott had no prior formal disciplinary history with the Securities and Exchange Commission, any self-regulatory organization or any state securities regulator.

The Mysterious KH

Oddly, the FINRA AWC involving Respondent McDermott isn't so much about what he did but about the somewhat nefarious comings and goings of someone he was supervising -- a someone known in the McDermott AWC only by the ominous initials of "KH." 

Who is the mysterious KH? 
Why is his or her identity concealed in this AWC from the industry and public? 
Why are you asking all these questions at the beginning of this blog and keeping me from moving the story forward?

The 1031 Investment Fund

During the relevant period starting sometime around December 2010 through July 2013, KH was registered with PBC and Respondent McDermott was his supervisor.  Notably, KH was an owner and a controlling member of the General Partner for a limited partnership known as "1041," which he marketed as an investment fund.  Unfortunately, during the relevant period, 1041 didn't earn any revenues and the only two assets it listed on its balance sheet are characterized by the AWC as "illiquid" and "of questionable/unknown value."  The two dubious assets consisted of a collection of Philadelphia real estate and an ownership interest in a sports memorabilia company, neither of which investment had been professionally appraised or valued by an independent third party. 

Given that dubious pedigree, it was quite the quantum leap for KH to have solicited investments for this purported investment fund by claiming that it offered investors a "special opportunity." Yeah, quite the special deal.

The Old Misdirection Play

The McDermott AWC relates that three investors plopped down about $591,000 in this special opportunity of a deal during the relevant period:
  1. $200,000 in partnership units (Investor 1); 
  2. $91,000 in a debenture/note (Investor 2); and 
  3. $300,000 in four senior convertible notes (Investor 3). 
  • Investor 2 and Investor 3 were also PBC customers
Doesn't seem that those funds quite made it to where they were supposed to go because the AWC alleges that KH converted $350,000 of the three investors' fund for such personal uses as paying his daughter's wedding expenses and his children's college tuition. On top of that conversion, the AWC alleges that another $212,000 in funds were used to redeem partnership units from three prior investors, including $150,000 from KH's co-owner/associate's parents.

In tallying up the damage and misrepresentations, the McDermott AWC alleges that KH failed to disclose the Ponzi-like use of later investors' funds to redeem units of earlier investors. Moreover, the AWC alleges that KH's non-disclosure included 1041's lack of revenues and income - and the fact that the fund's continued existence apparently depended upon receipt of funding from new investors.  There are more examples of non-disclosure offered in the AWC but suffice it to say it's of the garden variety misdirection typically seen in these cases - suggestions that the investment was safe, sound, and secure; that there were audited financials; that profits were building up; etc.

Okay, you might ask (if not, please, go ahead and ask, otherwise I've got no place to go with this), what does all of this stuff about 1041 and KH have to do with Respondent McDermott and his FINRA AWC?

Hey, that's a great question! Thanks for asking!!

Red Flags

FINRA asserts that McDermott was aware of KH's involvement in 1041 during the relevant time and that the supervisor failed to address several red flags. Consequently, the McDermott AWC went into all that stuff about KH's shenanigans because FINRA argued that McDermott knew or should of known that KH was up to no good when he was pitching the 1041 deal.  For example, the AWC asserts that since McDermott allegedly approved wire requests involving hundreds of thousands of dollars of 1041 investor funds that KH deposited into 1041's PBC brokerage account and an outside bank account, that the supervisor was on notice that something might be amiss. More damning, is the allegation that McDermott was aware that KH had used some of those transferred funds to pay personal expenses.

You know, maybe it's me, and I appreciate that it often is, but given that this is a failure to supervise case that got settled at FINRA, how come the self regulator is going through all this crap about "KH" this and "KH" that? I mean, geez, what's the state secret with "KH's" name, particularly since FINRA is going to whack his supervisor McDermott?  I guess we will never know who KH because FINRA does such a great job of keeping secrets from the public and the industry. 

The FINRA Enigma Code Broken!

Oddly, there's a crack in FINRA's carefully constructed wall of secrecy designed to apparently protect KH's good name and to prevent us from knowing this wayward registered person's identity.  On Page 3 of the online posting as of June 4, 2014, of the McDermott AWC, we have this curious slip [Ed: highlighting supplied]:

During the Relevant Period, McDermott was KH's supervisor. While McDermott was aware of KH's involvement in 1041 activities, which if investigated, could have enabled him to detect Hamilton's violations . . .

Oops! Seems that FINRA's censors missed that breach of their codename non-disclosure protocol. Now we know that KH's last name is "Hamilton."

Being the good sport that I am, let's pretend that we haven't the foggiest notion as to KH's last name and just go along with the whole two initial thing. Wink, wink, nudge, nudge, say no more.

The AWC alleges that during the relevant period, McDermott knew that KH was soliciting on behalf of 1041 but the supervisor [Ed: highlighting supplied]:

did not, however, make any reasonable efforts to determine the extent of Hamilton's securities activity involving 1041, including the disposition of 1041 investors funds . . .

Oops, FINRA's wall of confidentiality has been breached yet again! Another "Hamilton" reference is found in the last paragraph on Page 3, as noted above.

The AWC asserts that not only did McDermott know that KH was maintaining and using a non-PBC email for his 1041 activities (emails that McDermott failed to review) but that [Ed: highlighting supplied]:

McDermott knew that Hamilton had deposited hundreds of thousands of dollars of 1041 investor funds into 1041's brokerage account at PBC and outside bank account. McDermott was also aware that KH was transferring investor funds from those 1041 accounts to his personal bank and brokerage accounts, as he approved several wire transactions initiated by Hamilton for this purpose. McDermott was further aware that KH had used some of those funds to pay personal expenses.

Yeah, I know, sort of like "Where's Waldo" at this point -- there were two more "Hamilton" sighting in that last quote. 

TOP SECRET Side Bar: Let us not downplay the significance of the breaking of FINRA's Enigma Code by an individual who is known only to the regulatory world by the initials "BS." This amazing yet modest hero tirelessly endeavored to break the code. His incredible work was purportedly furthered by the use of an old Enigma machine.


Concluding that McDermott had failed to adequately respond and investigate in the face of the cited red flags, the AWC asserts that he violated NASD Conduct Rule 3010 and FINRA Rule 2010. In accordance with the terms of the AWC, FINRA imposed upon McDermott a $15,000 fine, a 1 year suspension from association with any FINRA member in any and all Principal-only capacities, and a requalification as a General Securities Principal per passage of the Series 24 examination prior to resuming that capacity after the suspension.

Bill Singer's Comment Blog readers have come to view the blog's author (who hides behind the impenetrable code-name of "BS") as an inveterate investigator and fearless reporter. Although few have managed to pierce the identity of "BS" many are still trying to break that formidable code.

"BS" has uncovered the fascinating case of In the Matter of Kevin F. Hamilton, Respondent (AWC 2013038645001, May 28, 2014), in which FINRA asserts that Hamilton was first registered in 1983 with "PBC," where he was an owner. Apparently, Hamilton was "Permitted to Resign" from PBC on April 16, 2014, in order to "pursue employment." The AWC asserts that Hamilton had no prior formal disciplinary history with the Securities and Exchange Commission, any self-regulatory organization or any state securities regulator.

SIDE BAR: I'm going to go way, way, waaaay out on a limb here and guess that this Hamilton fellow in the "Kevin F. Hamilton, Respondent" AWC is likely the same "KH" referenced in the above McDermott AWC.  Among the compelling clues are that both AWCs were issued on May 28, 2014 -- now there's a coincidence! On top of that stunning revelation, we have the AWC numbers of 2013038645001 (Hamilton) and 2013038645002 (McDermott).

The Hamilton AWC asserts that Respondent Hamilton formed 1041 in 2001 and, thereafter, converted and/or misued about $522,000 from three investors. The rest of his AWC is pretty much what was noted above in the McDermott AWC. As such, if you dont mind: Blah, blah, blah, Yadda, yadda, yadda. All of which ended with allegations of violations of FINRA Rules 2150, 2020, and 2010; and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. In accordance with the terms of the AWC, FINRA imposed upon Hamilton a Bar from association with any FINRA member firm in all capacities. 

So . . . someone, anyone, how come FINRA insisted on referring to Kevin Hamilton as "KH" in McDermott's failure-to-supervise AWC?