[ by Howard Haykin ]

A Seattle, WA, firm agreed to pay fines and disgorgement to settle FINRA charges that it failed to fulfill its obligations relating to the sale of interests in a hedge fund to customers by the firm and 2 of its brokers.  

Profile of Respondent.   KMS Financial Services, headquartered in Seattle, WA, has been a member of FINRA since 1969.  The firm engages in a general securities  business and operates pursuant to the (k)(2)(i) and (k)(2)(ii) exemptive  provisions of SEC Rule 15c3-3.   It has about 435 registered persons working out of some 304 branch offices.

Profile of Hedge Fund.   KMS placed several of its customers into Grifphon Alpha I Fund, L.P., a hedge fund.  Gritphon Holdings, the General Partner, is an investment company in Portland, OR, which has operated several hedge funds for institutional and individual investors.   Grifphon Alpha I, which commenced operations in 2004, is a multi-strategy global hedge fund that seeks to generate positive returns each calendar year through both domestic and international  investments in debt and equity instruments.  The fund was open to accredited individuals who invested at least $100,000 each.  Investments could be redeemed after 3 years. There was no management fee, and GrifPhon Holdings was to receive 20% of the fund's  profits as an annual incentive fee.  As of June 2006, GrifPhon Alpha I reportedly had $8.8mn in assets. 
$8,847,163.71  in assets.

FINRA Findings and Allegations.   From December 2006 until April 2008, KMS sold interests in the Grifphon Alpha I Fund, L.P.,  a hedge fund, to 12 customers for a total of $4.3 million.  KMS is being cited because it did not have reasonable grounds to believe that the hedge fund interests were suitable for any customer. 

FINRA alleges that KMS failed to:

• establish, maintain and enforce a supervisory system reasonably designed to achieve compliance with applicable securities laws and regulations and NASD Rules pertaining to Regulation D private placements. 

• conduct adequate due diligence of Grifphon Alpha I, relying on RRs' opinions and never trying to contact the HF's accounting firm to determine the nature of its services.

• confirm information the general partner provided.

• review a NYSE hearing panel decision sanctioning a founder of the hedge fund, who also was its portfolio manager.

At one point the firm requested financial statements for the hedge fund, but the partner would not provide them.   [red flag]  

• KMS later received an account reconciliation for its firm customers, that a different accounting firm prepared.  Yet, KMS did not inquire as to whether the partner had changed accounting firms.

• KMS then became aware of “red flags” regarding the hedge fund and based on the red flags, and as a result of its failure to conduct adequate due diligence, it did not have reasonable grounds to believe the hedge fund was a suitable investment for any customer.

FINRA further noted that KMS's WSPs did not adequately address due diligence of private placement offerings.  Surprisingly, a due diligence questionnaire was incorporated in the manual, but KMS failed to use it.

Determination of Violations, Sanctions.   FINRA charged KMS with violating NASD Conduct Rules 2310, 3010 and 2110.  The firm agreed to a $50K fine, which includes disgorgement of financial benefits received by the firm ($50,555.05 in incentive fees were received;  firm paid RRs $42, 827.92).  In making its determination, FINRA took  into account the fact that the firm paid $2.7 million to settle claims by customers who purchased interests in the hedge fund.

For further details, go to:   [FINRA AWC #2010024370301].  This case was taken from FINRA Disciplinary Actions for January, 2013.