A seasoned investment banker established a hedge fund and solicited terminally ill patients to open brokerage accounts as joint tenants with rights of survivorship. The hedge fund used the brokerage accounts to purchase at a discount bonds and certificates of deposit (CDs) with a survivor's option feature. As readers of this publication know, a survivor's option is frequently found in many retail structured products, particularly structured CDs and certain "lightly structured" rate-linked notes.8 Upon the death of a terminally ill patient, the investment banker exercised the survivor's option by redeeming the relevant CDs or securities at par value, and assigned the profits to the hedge fund.
The Securities and Exchange Commission (SEC) filed charges against those behind this investment strategy for possible securities law violations. An SEC administrative law judge recently dismissed these charges, explaining that there was "nothing necessarily illegal about using, or even exploiting, a contractual loophole. There [was] also nothing illegal about profiting from the death of the terminally ill, even if some might view it as unsavory."9
As an update to our previous article,10 this article describes the investment strategy, explains the contractual loophole, underscores how the relevant SEC and FINRA11 rules were applied, and describes several potential survivor's option safeguards to issuers.
The Investment Strategy
Donald F. Lathen Jr.'s (Jay Lathen) novel investment strategy involved purchasing at a discount medium- and long-term bonds and CDs with a survivor's option, and exercising the option by redeeming these instruments upon their beneficial owner's death. A survivor's option, also known as a death put (or "estate option"), is "an optional redemption feature in a debt instrument that allows a beneficiary of a joint account to sell (or put) the instrument back to the issuer upon the death of a joint account owner. This feature requires the issuer ... to repay the full principal amount of the investment prior to maturity upon the death of a beneficial owner, so long as certain requirements are met."12
Since a holder had to die to activate the survivor's option, Lathen solicited terminally ill patients with six months or less to live ("Participants") from hospices and from referrals from social workers. He paid each Participant $10,000 in cash to sign a Participant Agreement ("PA") and agree to open a joint tenancy brokerage account that would be funded by various individual investors. Each Participant would also issue in Lathen's favor a limited power of attorney ("POA") to open and manage the account under a joint tenancy with right of survivorship arrangement. This meant that, upon the death of a Participant, the rights to the account would vest solely to Lathen and not to the Participant's estate. Lathen made sure to disclose the investment strategy to the Participants, and encouraged them to ask questions before signing the PAs.
To scale up the investment strategy, Lathen created the hedge fund Eden Arc Capital Partners, LP (the "Fund") as a financing vehicle, and Eden Arc Capital Management, LLC as investment adviser to the Fund (the "Fund Adviser"). Lathen and the Fund entered into a discretionary line agreement to finance the investment strategy, with Lathen executing a promissory note in favor of the Fund with the accounts as collateral. The investment strategy and its regulatory risks were disclosed to Fund investors through the Fund's private placement memorandum.
Lathen also collected additional funds through margin loans from brokerage firms. He used all of the funds he obtained to purchase CDs and bonds in the secondary market at a discount, and awaited the Participants' deaths to trigger the survivor's option. Once a Participant died, Lathen would exercise the survivor's option by filing a claim with the applicable brokerage firm to redeem the relevant CDs and bonds at par value. Meanwhile, Lathen used the POA to freely and frequently transfer CDs and bonds between accounts, especially if a Participant recovered from an illness or if his or her death was no longer imminent. This allowed Lathen to obtain profits by being able to redeem the instruments as early as possible. He did not make his redemption requests at periodic intervals, and did not attempt to avoid scrutiny by the relevant issuers. In fact, Lathen kept the brokerage firms fully aware of the investment strategy, and provided them with all relevant documents and information to substantiate his claims. The brokerage firms, however, merely provided the issuers with what was required pursuant to the issuers' offering documents. Since the offering documents did not specifically require information regarding funding sources and side agreements in connection with the survivor's option, none of this information was volunteered by the brokerage firms to the issuers. A diagram is provided below to help illustrate the investment strategy.
On August 15, 2016, the SEC instituted administrative and cease-and-desist proceedings against Lathen, the Fund, and the Fund Adviser ("Respondents") for possible securities law violations against the issuers of the securities. The SEC alleged that the Respondents defrauded the issuers by failing to disclose Lathen's side agreements with the Participants. If proven true, it would have the effect of misleading the issuers to believe that Lathen and the Participants were indeed legitimate owners of the bonds and CDs, and were entitled to exercise the survivor's option. A year later, SEC Administrative Law Judge Jason S. Patil dismissed all charges (the "SEC Ruling")13 primarily due to the Respondents' lack of intent to defraud, and effectively ruled in favor of the legality of Lathen's taking commercial advantage of the contractual provision.
Contractual "Loophole" on Issuers' Survivor's Option
The issuers' offering documents "did not specifically request information regarding sources of funding for the bonds, confirmation of access to brokerage accounts, evidence of future property interests in bond proceeds, or the existence of any side agreements between joint account holders with respect to the [bonds and CDs]."14 There was no required relationship between the deceased beneficial owners and the surviving owners making a redemption request. The bonds and CDs were offered for sale to retail investors, non-retail investors, and institutions alike.
Lathen was able to take advantage of this contractual loophole by working closely with, and revealing all details of the investment strategy to, his legal teams. Lathen was assured by his lawyers not only of his legal standing to exercise the survivor's option, but also that he had a legal basis for not being prevented from redeeming the bonds and CDs despite potential regulatory risks.
Participants were aware of the investment strategy when they voluntarily entered into the PAs. Each Participant agreed with Lathen, as Fund nominee, to open an account under a joint tenancy with right of survivorship arrangement. Every Participant signed a POA to cede complete account control to Lathen. The POA permitted Lathen and the Fund Adviser to open, manage, handle and direct the account in the Participant's name, either individually or jointly; transfer funds and securities into and out of the account; buy, sell, exchange, convert, tender, trade, lend, and otherwise dispose of or acquire any securities in the account; pledge and grant a security interest in the joint accounts and the Participant's interest therein; execute agreements relating to the joint accounts on behalf of the Participant; and sign the Participant's name to any assignments in connection with the account.15 The POA enabled Lathen to buy bonds and CDs in the Participant's name and his name, without needing any prior consent from the Participant. Lathen could, and in fact did, sign on Participant's behalf to purchase bonds and CDs, open the account, transfer some or all of the account balances and assets as Lathen deemed appropriate. The PA basically vested legal standing in Lathen as joint tenant, and on a Participant's death, would make Lathen the owner of the account, because of his right of survivorship.
Application of SEC Rules
After analyzing the investment strategy, SEC ruled that the Respondents did not willfully violate the antifraud provisions of the Securities Act or the Exchange Act.
- The Exchange Act's Section 10(b) and Rule 10b-5 prohibit the use or employment of any manipulative or deceptive device in connection with the purchase or sale of any security. The prohibition includes "(1) employing any device, scheme, or artifice to defraud; (2) making material misstatements of fact or statements that omit material facts; or (3) engaging in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person."16
- The Securities Act's Section 17(a) prohibits, in the offer or sale of any securities, "(1) employing any device, scheme, or artifice to defraud; (2) obtaining money or property by means of material misstatement of fact or statements that omit material facts; or (3) engaging in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser."17
These provisions were applied in the SEC Ruling because the documents that Lathen submitted to brokerage firms to support the redemption were treated by the SEC as Lathen's indirect statements to the issuers. However, the SEC Ruling clarified that there would be no violation of these provisions, unless the misstatement or omission was material and with scienter (or intent to defraud).
- Lathen made no material misrepresentation of beneficial ownership. Lathen did not materially misrepresent the Participants' beneficial ownership over the bonds and CDs. According to the PAs, the Participants were to receive additional funds if Lathen predeceased them, and were not restricted to withdraw funds from the account.
- Lathen made no material misrepresentation on joint tenancy. A joint tenancy is "an estate held by two or more persons jointly, with equal rights to share in its enjoyment during their lives, and creating in each joint tenant a right of survivorship."18 Unless the PAs and Lathen's agreement with the Fund prevented the creation of joint tenancy, the presumption arising from the accounts under a joint tenancy with a right of survivorship arrangement remained effective.
- Lathen had no scienter. Lathen did not act with intent to defraud, because he fully disclosed the investment strategy to investors, Participants, and brokerage firms. His redemptions with the issuers were made in the ordinary course of business, without any intention to avoid any scrutiny.
The SEC likewise ruled that the Respondents did not violate the Advisers Act's custody provisions.19 The Advisers Act's Section 206(4) prohibits an investment adviser from "engag[ing] in any act, practice, or course of business which is fraudulent, deceptive, or manipulative."20 There was no violation because, although the Fund was entitled to profits from the accounts, the accounts themselves did not belong to the Fund, but were owned by Lathen and the Participants.
Application of FINRA Rules
On the other hand, in a separate but related case filed before FINRA, a respondent brokerage firm servicing the investment strategy (the "Broker"), and its anti-money laundering compliance officer, were penalized for negligent misrepresentations and omissions in connection with the investment strategy.21
- The Broker was negligent in describing Participants as joint tenants, and for not providing copies of the PAs to the issuers. FINRA Rule 2010 provides that "[a FINRA] member, in the conduct of its business, shall observe high standards of commercial honor and just and equitable principles of trade."22 FINRA ruled that the PAs were material in determining whether Participants had beneficial ownership of the accounts.23 The Broker should have provided copies of the PAs to the issuers, in order for the latter to make their own independent assessment as to whether the Participants were indeed beneficial owners of the bonds at the time of their deaths. Because of the Broker's representation and failure to provide copies of the PAs, the Broker was able to negligently redeem the bonds on behalf of Lathen and the Fund Advisor in violation of FINRA Rule 2010.24
- The Broker failed to establish and maintain a bond redemption supervisory system and procedures. FINRA Rule 3110(b) requires each FINRA member to "establish, maintain, and enforce written procedures to supervise the types of business in which it engages and the activities of its associated persons that are reasonably designed to achieve compliance with applicable securities laws and regulations, and with applicable FINRA rules."25 The Broker violated this rule when, despite having no experience in handling the novel investment strategy, it failed to establish or maintain any procedures in processing the redemption of bonds.
Practical Tips for Issuers
In order to avoid potential abuse of survivor's option provisions, issuers may wish to consider changes to the survivor's option provisions along the following lines:
- Define "beneficial ownership." The term "beneficial ownership" can go beyond distinguishing the real owner of the underlying interest in the security from the broker holding it.26 The account holder can be defined as a person who owns and will ultimately benefit from the instrument up to the point of death. The holder must have the right to receive the proceeds from the sale of the bond and from the principal of the instrument.
- Limit the survivor's option to initial issuances. An issuer may extend the survivor's option only to those who directly purchased the instrument in the initial offering, and not in the secondary market.
- Establish a longer holding period. An issuer should require a longer holding period (i.e., six months to one year) as a condition for the option's effectiveness. Extending this period will discourage to some extent the purchase of these instruments by an individual with an already short remaining life expectancy.
- Impose redemption conditions. An issuer should also stipulate that the survivor's option may only be exercised by the decedent's survivor or family members by blood or marriage.
- Maintain one standard survivor's option provision. With a standard survivor's option provision, an issuer may save on costs in enforcing it by setting up one process for all redemption requests. The conditions precedent in the exercise of the option will be uniform across all redemption requests.