Quick Case of Kickbacks and COI

We have a fresh example of kickbacks and conflicts of interest gone awry, thanks to a nifty case from the Securities and Exchange Commission this week that busted a rogue stock trader nicknamed “the Phantom.”

The Phantom’s real name is Brian Hirsch, 42. The SEC charged Hirsch and one of his customers, Joseph Spera, accusing them of a scheme where Hirsch improperly gave Spera the opportunity to purchase lucrative IPO stocks at low prices. Spera then sold those shares for a quick profit, and gave Hirsh a cut of the proceeds in cash.

According to the SEC’s complaint, Hirsch and Spera ran this operation from 2012 through 2015, while Hirsch worked at two “major” broker-dealer firms. Spera netted $4 million thanks to the inside access Hirsch gave him, and gave Hirsch roughly $1 million in kickbacks.

The kickbacks alone would violate Rule 10b-5 of the Exchange Act, and the U.S. attorney’s office is pursuing criminal charges against Hirsh. More interesting to the compliance community, however, is that broker-dealer firms have strict policies and procedures against the improper allocation of IPO shares — and Hirsch managed to evade those controls across two firms.

How’d that happen? Let’s take a look.

First, a lesson in IPOs for those who don’t work in financial services. When a company is preparing to go public, the shares it will sell on Wall Street are distributed to one or more broker-dealer firms. Agents at those firms (like Hirsch) then offer those shares to clients according to various criteria. For example, a long-time client of the broker-dealer with gobs of money might get the chance to buy 1,000 shares at the opening price; those with only small gobs of money might be offered 100 shares, or no shares at all.

So when you see a news article about Hot Company XYZ, which went public at $16 per share and promptly popped to $29 or something? Brokers like Hirsch get to decide which clients can buy at $16, while we mere peons placing orders on eTrade end up paying $28.97.

Normally a day trader like Spera would not have access to those opening price shares, especially if they are managed by large broker-dealers with deep-pocket investors as clients.

Unless, of course, a day trader like Spera worked with the Phantom.

Policies Ignored, Procedures Evaded

Both broker-dealer firms where Hirsch worked (Firm A was acquired by Firm B in December 2015) had extensive allocation policies. Both also prohibited employees from quid pro quo arrangements, which kickbacks would most certainly be.

The language in those policies was clear. At Firm A, for example, the policy expressed forbid an arrangement such as the broker-dealer offering lucrative IPO shares on one deal, in exchange for the investor also buying IPO shares of some other deal that wasn’t as popular. That was one arrangement Hirsch and Spera used multiple times, according to the complaint.

Firm B, meanwhile, said it “does not allocate a new issue as a means of obtaining a ‘kick back’ from the recipient in the form of excessive compensation for other services offered.” You can’t get any clearer than that — and still, Hirsch allegedly engaged in kickbacks.

In other words, we don’t have a policy failure from the broker-dealer firms. Their policies were solid. Both firms also required all employees to certify their compliance with those policies. Firm A required compliance attestations every quarter; Firm B required all new employees (Hirsch became one when when Firm B acquired Firm A) to fill out a questionnaire about possible conflicts.

The SEC says Hirsch simply lied on those attestation forms. So did Spera, when the broker-dealer firms performed their customer due diligence on him.

You get the picture. The firms had strong policies and certification requirements, and a failure happened because an employee lied.

What we don’t know from the complaint is how the SEC became aware of the Hirsch-Spera allegations. If Hirsch’s employers were indeed large Wall Street firms, presumably they have sophisticated surveillance mechanisms to monitor brokers’ email communications, financial status, and so forth. (They should, at least.)

When the SEC did catch up with Hirsch and Spera, it found that Spera had kept detailed records of all the improper allocations he received from Hirsch, plus all the improper proceeds Spera netted as a result. At the top of the records was a code name, “the Phantom.” (Documentation, people. Whether you have it or you don’t, it gets you every time.)

Perhaps an audit of Hirsch’s or Spera’s certifications found discrepancies; perhaps someone ratted them out to the SEC. We don’t yet know. And at a major broker-dealer, with thousands of employees who might commit these sorts of violations, we can’t even necessarily fault the firms. For all we know, they do enforce vigorous audits. You still might not catch that one rogue employee among the crowd.

We can say, however, that this is why vigorous testing of compliance matters. You can have the best policies in the world, and they will roll right off the back of an employee determined to commit misconduct.