SEC's Sanction Against Royal Alliance For Failure to Detect Adviser's Ponzi Scheme Provides Valuable Lessons to Investors and Advisers

By James Eccleston

he SEC (Securities and Exchange Commission) has censured Royal Alliance Associates, Inc. and fined it $500,000 due to its failure to supervise one of its former advisers, David McMillan. From at least January, 1999 until December, 2004, McMillan was able to operate a Ponzi scheme and defraud no less than 28 investors "by lying about purchases and sales of securities, by misappropriating funds for his personal use, and by sending certain investors falsified statements relating to their investment accounts." Let's review how McMillan perpetrated this fraud and why the SEC severely has sanctioned Royal Alliance for failing to prevent and/or detect it.

Preliminarily, financial services firms have an obligation to supervise their advisers. The SEC has commented that effective supervision is a "critical component in the federal investor protection scheme." Firms must have "established procedures, and a system for applying such procedures, which would reasonably be expected to prevent and detect" securities law violations. Additionally, firms "must provide effective staffing, sufficient resources, and a system to follow up and review…." A firm's shortcomings in any of these areas may be found to constitute a failure reasonably to supervise.

McMillan worked for Royal Alliance from 1994 through 2004, before moving to another financial services firm from January, 2005 through October, 2005, until his fraud was uncovered. He operated a one-man satellite office in Bullhead City, Arizona, which was 200 miles from Phoenix, where his immediate supervisor, Brad Parish, was located. McMillan succeeded in bilking at least 28 investors out of no less than $3 million. According to the SEC, he accomplished this fraud "through the offer and sale of fictitious investments in annuities, fictitious loans to a real estate developer, and real estate loans that were to be secured by fraudulent first deeds of trust." McMillan told investors that their money would continue to be invested in securities, and he sent certain investors statements relating to their investments in the fraudulent securities. In truth, however, the SEC charged that McMillan had "misappropriated their funds either to repay other investors, for his own personal use, or to fund a new outside business activity."

The SEC filed a civil action seeking to enjoin McMillan from further violating the securities laws and for other relief. McMillan failed to answer and the court entered a default against him. Turning to Royal Alliance, the SEC found five separate problems with supervision. Royal Alliance neither admitted nor denied the SEC's findings but did consent to the SEC's sanctions.

The first of the five supervision problems that the SEC found was that Royal Alliance failed to establish adequate procedures for the review of operational bank records of satellite offices in 1999. Although Royal Alliance corrected this deficiency in 2000, the SEC notes that the firm likely could have prevented and/or detected McMillan's Ponzi scheme in 1999 had the firm had a written supervisory policy requiring review of bank records. That is because a review would have revealed customer transactions, for which customers' checks were being deposited into McMillan's own operating account!

Second, the SEC found that Royal Alliance failed to develop a reasonable system to implement its procedures for conducting exams in satellite offices. McMillan's supervisor, Brad Parish, did conduct the required annual review of McMillan's office, but he failed (in 2000) to review McMillan's bank records. Likewise, Parish was required to complete a workbook documenting various aspects of the branch exam. He did so, but left blank the section of the workbook relating to bank records! Royal Alliance failed to notice that blank section, and hence failed to detect the fact that Parish had not properly completed his branch exam.

Third, the SEC found that Royal Alliance failed to detect "red flags" during its exams of McMillan's branch office. The SEC noted that McMillan's commission income had dropped substantially from 2000 through 2004 ($149,000 in 2000, $93,000 in 2001, $40,000 in 2002, $71,000 in 2003, and $13,000 in 2004). During the same period, his expenses remained at roughly $90,000 per year, and he continued to employ two support staff. This raised a red flag. Additionally, the SEC faulted Royal Alliance for not questioning the two support staff relating to McMillan's declining commissions. Indeed, the SEC contended that the two support staff "were involved in many administrative aspects of these fraudulent investments from 1999-2004, although they did not know the investments were fraudulent." Still, the SEC observed that such questioning "would have likely prevented or detected the fraud."

Fourth, the SEC found that while Royal Alliance procedures required the first line supervisor "to investigate and respond to surveillance inquiries" related to its advisers, Royal Alliance failed to implement that procedure. Instead, Royal Alliance allowed the adviser - who was the subject of the inquiry - to be generally responsible for providing a response to the inquiry. For example, regarding one surveillance inquiry, Royal Alliance allowed McMillan to respond (falsely), and failed to require that Brad Parish respond or even follow up on the inquiry!

Fourth, regarding resources, Ms. Richards posed the question, "Does your compliance program have adequate resources to do the job?" This inquiry relates to recent warnings to firms that they should not trim costs associated with their compliance and legal functions if doing so will undercut their effectiveness. Ms. Richards states that "compliance policies and procedures should be designed to prevent violations from occurring, to detect violations that have occurred, and to correct promptly any violations that have occurred - and they must be adequate to this task." Should a firm's Chief Compliance Officer detect a lack of resources, he or she should document that fact in the annual report or review. Likewise, firms should consider "alternative ways to better target resources towards monitoring firm activities that pose the greatest risk for harm to investors." One approach is for firms to consider leveraging the work of other departments (such as internal audit and risk management).

Fifth, the SEC found that Royal Alliance procedures required the first line supervisor to monitor customer transactions by reviewing transaction reports. However, the SEC noted that Royal Alliance allowed advisers such as McMillan to manually enter transaction data. Of course, McMillan chose not to input several transactions - sales transactions generating cash proceeds - and then used those proceeds to invest in his fraudulent scheme! The SEC concluded that Royal Alliance failed to adequately implement its procedure requiring the reports to include all customer transactions.

The Royal Alliance sanction stands as an example of how clever, defrauding advisers can take advantage of a weak supervisory system. Investors as well as financial services firms should be thankful to the SEC for highlighting such supervisory deficiencies!

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About the Author: James J. Eccleston leads the Securities group at the Chicago law firm of Shaheen, Novoselsky, Staat, Filipowski & Eccleston, P.C., where he represents investors in recovering investment losses and financial services professionals in disciplinary, employment, and compliance matters. He has held numerous securities licenses and Chicago Bar Association leadership positions and serves as an arbitrator and mediator. He is a recipient of Martindale-Hubbell's highest rating (AV) for legal ability and ethics and is named to the Illinois Super Lawyer and Leading Lawyer lists.

JEccleston@snsfe-law.com, 312.621.4400, www.snsfe-law.com, www.financialcounsel.com