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RIA/BD Failed to Disclose Mark-Ups and 12b-1 Fees

The SEC has commenced enforcement proceedings against a dually registered adviser/broker-dealer and its CEO/CCO principal for taking undisclosed commissions and 12b-1 fees on discretionary accounts.  The SEC’s complaint avers that the respondent sold inventory securities, acquired at a discount as part of the selling syndicate, to clients at a mark-up.  The SEC alleges that the firm never obtained the required informed consent.  The SEC also charges the firm for taking mutual fund 12b-1 fees without telling clients.

OUR TAKE:  A principal transaction with a client requires an adviser fiduciary to obtain specific client consent following disclosure of all relevant information.  The SEC continues its crackdown on any form of revenue sharing received by advisers with respect to their fiduciary clients.


Chief Accounting Officer Barred and Fined for Approving CEO Expenses

The SEC barred and fined a public company Chief Accounting Officer for approving undisclosed expense reimbursements for the company’s CEO.  The CEO ultimately repaid the $11.285 worth of perquisites incurred over a 5-year period for personal items such as private aircraft usage, cosmetic surgery, cash for tips, medical expenses, charitable donations, and personal travel expenses.  The SEC asserts that the CAO approved the expenses in violation of company policy and without appropriate backup documentation and then failed to disclose the reimbursements in the company proxy statements.  The SEC charges the CAO with causing the company to file false reports.

OUR TAKE: We wrote on Friday that the SEC is looking to hold financial executives accountable (see https://cipperman.com/2017/11/17/sec-enforcement-division-targets-financial-executives/).  In this case, the SEC doesn’t even allege that the CAO derived any personal benefit by approving his boss’s expenses.  Regardless, the SEC holds him accountable for allowing wrongdoing to occur.


SEC to Create Website of Bad Actors

In a recent speech, the SEC Chairman, Jay Clayton, announced that the SEC is creating a searchable website of those individuals that have been barred or suspended from the securities industry.  Mr. Clayton expressed concern that investors cannot uncover bad actors that have “shifted from the registered space…to the unregistered space.”  Mr. Clayton explained that the website “is intended to make the prior actions of repeat offenders and fraudsters more visible to investors.”

OUR TAKE: This “Scarlet Letter” approach to prevention ups the ante for those barred from the industry in civil enforcement actions.  It is unclear whether such a website will be any more or less effective than the CRD system, which reports disciplinary histories.


Private Company and CEO Misled Investors about Compliance Failures

A privately-held benefits consulting firm agreed to pay a $450,000 fine, and its former CEO agreed to pay over $500,000, for failing to disclose compliance failures during fundraising.  The SEC maintains that the firm evaded state insurance licensing laws by rigging online examination courses and allowing employees to sell insurance without required licenses.  The SEC charges that the firm violated the securities laws by failing to disclose the compliance failures when raising money from institutional investors during at least 3 financing rounds that raised over $500 Million.  The related stock purchase agreements included false representations that the company complied with applicable laws including licensing requirements.  The respondent has also faced regulatory actions by at least 40 states who have imposed more than $11 Million in sanctions.  As part of the SEC settlement, the company created a Chief Compliance Officer position.

OUR TAKE: Be very careful when claiming compliance with applicable laws in disclosure or fundraising documents.  You might want to ask your Chief Compliance Officer if any issues require more disclosure.  The SEC can use holes in your regulatory compliance as a predicate to an enforcement action for securities fraud.


Adviser’s Insider Loans Not Permissible Despite Lawyer’s Advice

A private fund manager was censured, fined, and ordered to hire an Independent Consultant in connection with undisclosed and unapproved loans he took from the fund.  The adviser arranged loans with the fund, rather than purchase securities, as a way to receive distributions.  Although his lawyer advised that the loans were permissible, the SEC faults the adviser for not obtaining investor consent and for disclosing the loans after they were made.  Additionally, the SEC faults the adviser for failing to explain the inherent conflicts of interest that the loans created.

OUR TAKE: A lawyer’s opinion is not a “get out of jail free” card.  If you violate your fiduciary obligations under the Advisers Act, the SEC will hold you accountable.  That is why it is important to implement a legitimate compliance program that avoids the regulatory gray areas.


RIA Did Not Offer Lowest Share Class Available

An RIA was censured and agreed to pay disgorgement for failing to offer the lowest-fee mutual fund share classes available and failing to adequately disclose compensation paid to its affiliated broker-dealer.  The RIA recommended third party mutual funds to 403(b) and IRA clients, who directed the investments.  The SEC faults the respondent for recommending Class A shares that paid 12b-1 fess to its affiliated broker and failing to make available lower-fee institutional shares.  The SEC also cites the insufficiency of various disclosures that generally discussed payment of 12b-1 fees but failed to specifically explain that an affiliate would receive the trailers.  The SEC charges the RIA with violations of the compliance rule (206(4)-7) for failing to adopt and implement adequate policies and procedures around conflicts of interest, disclosure, and mutual fund share class selection.

OUR TAKE: We believe that the SEC wants advisers to offer the lowest share class available and refrain from accepting any form of revenue sharing compensation.  We think that the SEC will find inadequate even the most robust disclosures and procedures because of the inherent conflict of interest.


Large Custody Bank to Pay $32 Million for Undisclosed Transition Management Compensation

A large custody bank agreed to pay $32.3 Million to settle allegations that it charged undisclosed commissions and mark-ups as part of its transition management services to large plans and sovereign wealth funds.  According to the SEC, the respondent’s scheme involved bidding for transition management projects with artificially low commission schedules and then charging undisclosed mark-ups and concealing those mark-ups when reporting to clients.  The SEC’s investigation included emails and recorded conversations where internal employees (i) referred to such concealed mark-ups as a “rounding error,” (ii) committed to “make it work” internally when forced to bid at low commission rates, (iii) bragged that they would “back the truck up” when describing the undisclosed commissions, and (iv) vowed that “This can of works stays closed” when discussing their scheme.  A client’s consultant ultimately discovered the undisclosed commissions.

OUR TAKE: You do know that your emails are retained and your conversations are recorded?  Right?  The bad old ways of hoping you won’t get caught just have no place in the modern regulatory world where compliance officers, clients (and their consultants), and regulators all review sales activity and disclosure.


Adviser Charged with Defrauding Professional Athlete

The SEC has commenced enforcement proceedings against an adviser that it alleges lied to his professional athlete client about management fees.  The SEC asserts that the adviser told representatives of the client that the client paid between .15% and .20% of assets in management fees when the client actually paid 1.00%, resulting in significant payments to the adviser who received 60% of the revenue earned by his firm.  According to the SEC, the adviser misled the client and his representatives by using false account statements, forged documents, an impostor acting as a Schwab representative, and multiple misrepresentations in emails and meetings.    The client’s representatives ultimately contacted Schwab, who then informed his employer.  The adviser tried to convince the client to lie on his behalf to protect his job, although the client refused.

OUR TAKE: This type of case shows the problem with assuming that wealthy people are financially sophisticated.  Many wealthy people earn their income in fields (e.g. sports, medicine, technology) that would not necessarily make them qualified to make investment decisions.  Instead, these successful professionals rely on advisers who are supposed to act as fiduciaries and protect their clients’ interests.


Adviser Tried to Conceal Loans to Parent Company

A mortgage loan adviser and its two principals agreed to pay over $9 Million in disgorgement, interest, and fines for using funds it managed to make loans to the parent of its affiliated advisers and then using straw man transactions in an attempt to conceal the loans.  The SEC maintains that the respondent funneled money to the parent company through undocumented, undisclosed, and unlawful loans made by two private funds and a registered closed-end fund.  The respondent then tried to repay the loans by laundering mortgage assets through a straw man that bought mortgage loans from one fund and then transferred them to another fund.  The misconduct was uncovered when discrepancies arose between the registered fund’s collection account and its custody account.  The SEC asserts that the respondent misled the Board and investors, thereby violating the antifraud rules as well as the compliance rule.

OUR TAKE: Making the unauthorized loans was bad enough and would have resulted in breach of fiduciary duty charges.  Trying to conceal the loans through straw man transactions led to the fraud charges, which also could have carried criminal penalties if the U.S. Attorney decided to prosecute.


Hedge Fund Manager Used New Funds to Pay Expenses of Old Funds

A hedge fund manager agreed to pay $7.9 Million in disgorgement and a $5 Million fine for using the assets of newer funds to pay the expenses of older funds.  According to the SEC complaint, which was filed in 2010 and related to allocations made between 2005 and 2008, the respondent used assets from more recent funds to pay legal and administrative fees of older funds that could not raise cash because they held illiquid securities.  The SEC claims that the respondent replaced the cash with overvalued illiquid securities.  The SEC continues litigation with respect to charges that the hedge fund manager overvalued securities and made misrepresentations.

OUR TAKE:  The long arm of the law can reach back a long way.   The older funds began to have liquidity problems as far back as 2004, which caused the respondent to raise more assets to pay off old expenses.  And, the litigation continues.