finra

FINRA

For Release:
Contacts:
Wednesday, January 9, 2008
Nancy Condon (202) 728-8379
Herb Perone (202) 728-8464

 


SMH Capital Fined $450,000 for Procedural Failures Regarding Soft Dollar Payments, Distributing Improper Hedge Fund Sales Materials

Washington, D.C. - The Financial Industry Regulatory Authority (FINRA) today announced that it has fined SMH Capital Inc. (f/k/a Sanders Morris Harris, Inc.) of Houston, TX, $450,000 for failing to adopt adequate supervisory procedures and systems designed to address its prime brokerage and soft dollar services to hedge funds. As a result, SMH made improper payments of $325,000 in soft dollars to a hedge fund manager.

The firm's failures also included drafting and distributing hedge fund sales materials that did not adequately disclose material investment risks to potential hedge fund investors. In addition, SMH entered into an improper compensation arrangement with two SMH brokers who also managed hedge funds, allowing them to share in commissions earned from fund trading contrary to representations made in the offering documents and a separate agreement.

In addition to the fine, SMH was ordered to retain an Independent Consultant to conduct a comprehensive review of the adequacy of the firm's policies, systems, procedures and training with regard to its hedge fund operation.

FINRA imposed $100,000 fines and 20-day suspensions on Michael S. Rosen and Jack D. Seibald, the two brokers who helped manage SMH's prime brokerage services business while at the same time serving as the managers of a hedge fund that executed trades at SMH. Rosen and Seibald improperly received compensation from a profit pool derived, in part, from commissions on trading by their fund. This was contrary to the fund's private placement memorandum (PPM) and a separate contractual agreement. FINRA also imposed a 10-day suspension and $15,000 fine on Anthony M. Gallo, an unregistered employee who engaged in activities that required securities industry registration.

"As broker-dealers increasingly provide services to hedge funds, they need to carefully tailor their supervisory systems and procedures to ensure they guard against conflicts of interest that result in securities law violations," said Susan L. Merrill, FINRA Executive Vice President and Chief of Enforcement. "SMH's inadequate procedures resulted in the firm making soft dollar payments without a reasonable inquiry into red flags indicating the payments were improper." FINRA found that SMH commenced its hedge fund services business in July 2000 and eventually established relationships with more than 15 different hedge funds, making the hedge fund business an important part of the firm's overall operations. SMH provided a platform of services to hedge fund managers including office space (complete with desks, computers, telephones and internet access), marketing assistance and capital introduction, with the fund managers paying for such services through commissions earned on trades directed to SMH.

The firm also operated soft dollar accounts for hedge funds that opted not to join SMH's prime brokerage services platform. These accounts collected a portion of the commissions earned when SMH executed trades for each fund. Fund managers could then submit, or cause to be submitted from third party service providers, invoices for products and services. SMH then paid the providers from the balances accumulated in the soft dollar accounts.

FINRA found that, by failing to have policies and procedures to police its soft dollar payments, SMH sent two improper soft dollar payments totaling $325,000 to a hedge fund manager. The manager had submitted an invoice to SMH requesting that SMH issue one check for $75,000 to an individual for "consulting services" and a second check for just under $250,000 to the manager for "research expense reimbursement." The invoice raised several red flags. It requested that SMH pay the hedge fund manager directly for expenses that had purportedly been provided by a third party; it did not describe what research had been provided to the manager or who had provided the research; and it failed to describe the "consulting services" the individual provided. The hedge fund manager did not provide SMH with any invoice or backup documentation from the individual consultant or from any research provider to support the invoice. The invoice was suspect on its face.

Despite the red flags, SMH took no steps to determine whether the manager was relying on the soft dollar safe harbor under Section 28(e) of the Securities Exchange Act and, if not, whether the manager had disclosed to its clients that it was operating outside the safe harbor. Had SMH taken such steps, it would have revealed the invoice should not have been paid.

FINRA also found that Rosen and Seibald were employed as SMH brokers while managing a hedge fund that operated on SMH's prime brokerage services platform. To eliminate the conflict that arose from their dual roles, the fund's PPM as well as an October 2001 agreement between SMH, Rosen, Seibald and an outside firm that marketed the brokers' hedge fund prohibited Rosen and Seibald from sharing, in whole or in part, in any commissions SMH earned from trading for the hedge fund. In April 2002, contrary to the PPM and the agreement, SMH, Rosen and Seibald negotiated a new arrangement that allowed the two brokers to receive bonuses from a "profit pool" derived in part from the hedge fund's trading commissions. Nevertheless, Rosen and Seibald continued to disseminate the fund's PPM that incorrectly stated the brokers would not share in whole or in part in the fund's trading commissions.

FINRA also found that, as part of SMH's marketing assistance for its hedge fund clients, the firm's employees prepared and disseminated hedge fund sales materials to potential investors that failed to adequately disclose the risks inherent in hedge fund investing. Furthermore, these sales materials were not approved by a registered principal or signed, dated, and maintained in SMH's files for three years, as required by FINRA rules.

FINRA further determined that SMH failed to retain and preserve certain e-mails and instant messages of firm employees between January 2003 and December 2004, as required by federal securities laws and FINRA Rules. SMH's failure to retain these communications hampered FINRA's ability to investigate the firm's activities.

In settling this matter, SMH, Rosen, Seibald and Gallo neither admitted nor denied the charges, but consented to the entry of FINRA's findings.

Investors can obtain more information about, and the disciplinary record of, any FINRA-registered broker or brokerage firm by using FINRA's BrokerCheck. FINRA makes BrokerCheck available at no charge. In 2007, members of the public used this service to conduct 6.7 million reviews of broker or firm records. Investors can access BrokerCheck at www.finra.org/brokercheck or by calling (800) 289-9999.

FINRA, the Financial Industry Regulatory Authority, is the largest non-governmental regulator for all securities firms doing business in the United States. Created in 2007 through the consolidation of NASD and NYSE Member Regulation, FINRA is dedicated to investor protection and market integrity through effective and efficient regulation and complementary compliance and technology-based services. FINRA touches virtually every aspect of the securities business - from registering and educating industry participants to examining securities firms; writing rules; enforcing those rules and the federal securities laws; informing and educating the investing public; providing trade reporting and other industry utilities; and administering the largest dispute resolution forum for investors and registered firms.

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