November 28, 2018 / 8:35 PM / 5 months ago

IMPACT ANALYSIS: SEC case signals support for compliance role, warns firms on resource shortfalls

NEW YORK(Thomson Reuters Regulatory Intelligence) - The risk of personal liability is an ever-present part of the job for senior managers in financial services, especially at investment advisers. So when a multi-million dollar fraud is discovered, the failures to detect and avoid such wrongdoing often lead to regulatory actions against higher-level managers of those involved in the fraud.

Businessmen walk past an electronic board displaying share prices outside a brokerage in Tokyo August 31, 2009.

A recent $179 million fraud involving fictitious U.S. government-backed loans or repurchase agreements (repos) originated by a Florida-based firm, and purchased by a Wisconsin-based investment adviser that looked past numerous red flags, led to enforcement actions against the adviser and its chief executive.

The perpetrators of the massive fraud were criminally convicted, but such frauds often have a ripple effect on counterparties. The U.S. Securities And Exchange Commission (SEC) announced last week two settled cases involving Pennant Management Inc(here), and its chief executive, Mark Elste(here), related to their failures to detect the fraud and more importantly, repeatedly refusing to allocate resources to compliance officers when they requested such while issuing warnings.

The SEC cases offer some solace to compliance officers who attempt to do the right thing while struggling in the face of management inattention and limited resources.

Below we review the fraud involving the Ponzi-like loans perpetrated by First Farmers Financial with an emphasis on the alleged management and compliance failures at Pennant Management where the chief compliance officer (CCO) raised questions and requested additional resources to no avail.


First Farmers Financial LLC held itself out as a U.S. Department of Agriculture approved non-traditional lender, and it originated loans pursuant to the USDA’s Rural Development Business and Industry program between 2010 and 2014.

Nikesh Patel was the firm's CEO, and Timothy Fisher was the firm's president and when they sold 26 non-existent loans to Pennant for $179 million. "All 26 loans were completely fabricated with no actual borrower, no pre-existing loan, and no government guarantee," according to the U.S. Department of Justice (DOJ){here}.

The DOJ said the company submitted documents to Pennant falsely creating the appearance that the loans were guaranteed by the federal government.

Pennant Management was founded by Mark Elste in 1995, who served as Pennant’s CEO and chairman until 2015. Elste also served as chief investment officer until 2013. Pennant’s most significant line of business was its repo program, which offered investment advisory clients the opportunity to purchase portions of loans intended to be guaranteed by either the U.S. Small Business Administration or the USDA.

Throughout 2013 and much of 2014 the adviser’s clients purchased repos from the firm despite a series of red flags. Pennant’s investments on behalf of its clients were sourced exclusively from one of four counterparties. By the end of 2013, clients had invested a total of almost $800 million in such loans based on Pennant’s advice, according to the SEC.

The SEC said that in September 2014 the USDA confirmed to Pennant Management that loans purchased from First Farmers were fraudulent. The adviser subsequently filed suit against First Farmers and the FBI arrested Patel.

Fisher and Patel were arrested in 2014 and plead guilty in December 2016 to various charges related to the fraud. While released on bond and awaiting sentencing, under the guise of attempting to recover funds for victims of the fraud and clean up the financial mess, Patel engaged in a new $19 million fraud, prosecutors charged. He was arrested again in January 2018, on the day he was to be sentenced, at a Florida airport where he was about to board a private jet to Ecuador.

Fisher and Patel were sentenced to 10 and 25 years respectively, in April 2018(here).


Pennant’s primary investments were in what the adviser marketed as high-yield alternatives to money market funds. Clients were told, and the adviser’s Form ADV Part 2A said, that “the firm conducted initial and ongoing due diligence and monitoring of repo counterparties.”

However, contrary to these representations, the firm’s due diligence procedures “were limited to a general practice and the use of a checklist of documents to be obtained as initial due diligence,” the SEC said.

According to the SEC order, Pennant’s CEO in January 2012 asked a portfolio manager to assume the role of interim chief compliance officer, or CCO. The unnamed individual had no prior compliance experience but accepted the position contingent upon having access to outside counsel and compliance consultants.

In March 2012 the compliance chief advised Elste and others that the firm’s compliance program was deficient and raised concerns. The compliance chief requested an outside resource “right now,” the SEC said. However, the firm failed to deliver, the order said.

In May 2012 the interim CCO notified the chief executive that Pennant had never completed a formal risk assessment and argued that one was necessary. Shortly thereafter, the risk assessment was completed by the interim CCO and the position was made permanent in August 2012.

Pennant hired a new president a year later, and the compliance chief reported to the new president and the chief legal officer of Pennant’s holding company, who reported to Pennant’s CEO. The new president also requested more compliance resources for 2014. Although the CEO approved the hiring of new business staff for 2014, the requested additional resources for compliance were not granted.


Despite a shortage of resources, the CCO had the difficult task of performing due diligence and ongoing monitoring the risk of the repo counterparties.

The due diligence showed that First Farmers told Pennant that it planned to originate $140 million in loans in 2013. This would have been more than twice the volume of the top USDA lender originations of 2011, and almost four times the lop lender originations of 2012, according to the SEC.

First Farmers also provided unaudited financials and claimed to be hiring a new auditor.

Pennant hired a private investigation firm to conduct background checks. The background checks showed that the First Farmers CEO had not graduated from college as he had represented and indicated a poor credit history. It also showed that First Farmer’s’ “CEO had pleaded no contest to assaulting a police officer, been convicted of two DUIs, and been sued multiple times for breach of contract,” the SEC said.

In May of 2013 Pennant’s investment committee approved First Farmers for repo investments with a limit of $75 million and raised the limit to $125 million three months later.

In April 2014 First Farmers provided a 2013 audited financial statement purportedly done by a new auditor. Despite Pennant’s inability to evidence the validity and qualifications of the new auditor, the firm continued investing and the investment committee raised the limit to $150 million. The limit was raised again in June to $200 million despite the concerns over the auditor.

After a July 2014 on-site visit to First Farmers’ offices an employee raised concerns with Pennant’s CEO. “As a result, Pennant’s CEO authorized additional due diligence by a private investigation firm on both First Farmers and the First Farmers Auditor,” the SEC said.

On August 28, 2014 several Pennant clients purchased an addition $5 million of First Farmers’ repos. Later that day the private investigators confirmed that it could not locate First Farmer’s auditor.

In September 2014 the private investigators could not locate the underlying borrowers for several of the loans and learned that the loans had not been provided USDA Certificates of Incumbency as had been recommended by legal counsel.

At this point Pennant contacted the USDA and law enforcement, and sued First Farmers, after which the FBI arrested the firm’s CEO on September 30, 2014.

Finally, Pennant informed clients about the fraud.

The SEC said, “During this time, Elste was aware that Pennant’s compliance program lacked sufficient resources but failed timely to address this deficiency, which contributed substantially to Pennant’s Compliance Rule violations.”

Additionally, the SEC said Pennant did not consistently follow its repo allocation policy disclosed in its Form ADV Part 2A and failed to maintain records related to repo client indications of interest and trade allocations.

The SEC Orders allege violations of Adviser Act sections 204, 206(2), 206(4) and 207(here To resolve the proceedings the adviser and Elste, without admitting or denying the findings, consented to the entry of cease and desist orders and to censures. The firm was fined $400,000 and Elste was fined $45,000.


Although Pennant may be viewed as a victim of the First Farmers fraud, as investment advisers, it had a responsibility to perform due diligence of counterparties and avoid such frauds. Management’s refusal to provide the resources requested by the CCO to perform the appropriate due diligence is noteworthy.

When such frauds occur, there is often a significant ripple-effect to other firms, particularly investors. Government documents detailed how Patel spent the stolen funds on a lavish lifestyle while also investing in other businesses, buying five hotels and other various real estate properties, all of which eventually had to be unwound or liquidated.

Significant losses were incurred by several of Pennant’s clients, particularly a handful of small banks and financial institutions. Illinois Metropolitan Investment Fund (IMET) lost more than $50 million, the University of Wisconsin Credit Union lost nearly $53 million and Harvard Savings Bank closed as a result of an $18 million loss.

Although IMET may recover much of its losses through insurance and recovery from the liquidation of Patel’s seized assets, the reputational damage can’t be undone. Newspapers reported that after the disclosure of the fraud one of IMET’s funds experienced significant investor redemptions in the following months, causing assets to decline from $1.8 billion to less than $500 million.

The Pennant and Elste cases send a message of personal accountability pointing out Elste’s decision to not provide the requested additional resources to conduct the necessary due diligence.

The cases also send a very strong signal to CCO’s to speak up and not be afraid to request additional resources. Furthermore, the documentation and denial of such requests, and the repeated warnings voiced by compliance, may have carried significant weight in the SEC’s decision not to include the CCO in the charges.

The SEC’s continued emphasis on personal accountability is evidenced in the charges against Elste. However, the lack of charges against the CCO also send a message that a CCO may avoid charges by trying to do the right thing and carry out their responsibilities even if their warnings or requests are ignored or denied by other senior managers.

(Todd Ehret is a Senior Regulatory Intelligence Expert for Thomson Reuters Regulatory Intelligence based in New York.)

This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on Nov. 19. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @thomsonreuters

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