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Category: conflict of interest

Hedge Fund Fined $5 Million for Weak Valuation Procedures

The SEC fined a hedge fund $5 Million, and its Chief Investment Officer another $250,000, for failing to properly value portfolio securities. The SEC maintains that the firm over-relied on the discretion of traders to value Level 3 mortgage-backed securities rather than use required observable market inputs. The SEC contends that the firm consistently undervalued bonds to maximize profit upon sale. The SEC faults the CIO for failing to properly review valuation decisions and ensure that the traders followed the firm’s valuation procedures. The SEC asserts violations of the compliance rule (206(4)-7) because the firm failed to implement reasonable policies and procedures to ensure fair valuation of portfolio securities. As part of the settlement, the firm hired an experienced Chief Compliance Officer rather than rely on its prior Risk Committee comprised of executives with limited regulatory and valuation experience.

Valuation is about process. Firms that buy Level 3 securities must create a consistent, documented and contemporaneous process based on objective criteria in order to defend pricing decisions. For compli-pros, one way to test valuation is to sample whether liquidation prices vary consistently (either always higher or lower) than the firm’s internal valuations before liquidation.

Chief Compliance Officer Stole Employee Information to Bid at Auctions

FINRA barred a Chief Compliance Officer for using his access to confidential employee records to create false online bidding accounts at auction houses. The respondent, who also served as the firm’s president, used his access as CCO to obtain employees’ driver’s license and passport information to impersonate those employees so that he could bid and acquire auction items. The auction houses had previously banned him because he successfully bid on items and did not pay for them.

The Chief Compliance Officer has extraordinary (and in some cases, unwarranted) access to employee records in addition to other confidential information such as executive meetings and emails. Firms should pursue enhanced background due diligence on potential CCO candidates, create information barriers so that the CCO does not have access to non-regulatory information, and implement a supervisory structure that ensures CCO accountability. Alternatively, consider outsourcing to a third-party firm that has limited access to firm systems as well as direct legal liability for breaches of confidentiality.

Dual-Hat Principal/CCO Caused Multiple Compliance Violations

The SEC charged an investment adviser’s principal, who also served as the firm’s Chief Compliance Officer, with multiple compliance violations. The SEC charges the respondent with (i) overcharging his client, (ii) overstating his assets under management, (iii) failing to disclose two client lawsuits, (iv) misrepresenting the reason he switched custodians, and (v) neglecting to maintain required books and records. The SEC also alleges that the principal aided and abetted violations of the compliance rule (206(4)-7) by purchasing a template compliance manual, omitting required policies and procedures, and failing to implement required procedures. The firm ultimately ceased operations, and the respondent agreed to pay over $500,000 in fines, disgorgement and interest.

The dual hat CCO model (i.e. a senior executive also serving as the Chief Compliance Officer) doesn’t work. The dual-hat CCO usually does not have the time, expertise, or interest to do the job properly. Also, a CCO must have enough independence from the business to properly enforce the applicable regulatory and compliance obligations.

Fund Manager Barred for Misusing Soft Dollar Credits

The principal of a hedge fund manager was fined and barred from the industry, and his firm’s registration was revoked, for misusing soft dollar credits and cherry-picking trades. According to the SEC, the fund manager misused over $1.1 Million in soft dollar credits to pay such expenses as alimony to his ex-wife, inflated rent to an affiliated company, salary to an employee, and timeshare expenses. The SEC notes that such payments contradicted disclosures in the PPMs and the Form ADV. The SEC also charges the firm with engaging in an illicit cherry-picking scheme to enrich certain hedge fund clients over other clients.

We are seeing a renewed SEC interest in how firms use soft dollar credits. Although the facts of this case date back several years, this action may portend future regulatory and enforcement initiatives.

Federal Court Says that Outside Advice is Not a “Get-Out-of-Jail-Free Card”

The United States Court of Appeals for the D.C. Circuit upheld the SEC’s decision that an investment adviser failed to fully disclose mutual fund revenue sharing even if it sought and relied on the advice of outside compliance consultants. The Court found that the adviser acted negligently by failing to fully disclose the conflict of interest inherent by receiving shareholder servicing payments for investing in certain funds offered by its broker/custodian. Although the record was unclear about whether the adviser sought or relied on an outside compliance consultant’s advice, the Court decided that it didn’t matter because “any reliance on such advice was objectively unreasonable because [the adviser] knew of their fiduciary duty to fully and fairly disclose the potential conflict of interest.” The Court did, however, throw out the SEC’s claim that the adviser intentionally filed a misleading Form ADV, because the SEC failed to show that the adviser acted with the requisite intent to deceive.

As we have previously reported, this case argues in favor of seeking outside advice because it will help defend against the claim that you acted with intent, which would draw more punitive penalties. However, the Court here makes clear that relying on outside advice, even though you (should) know otherwise, will not exonerate you from claims that you acted negligently.

Private Equity CEO Failed to Supervise CFO/CCO


A private equity firm, the firm’s CEO, and its CFO/CCO were each censured and fined for overcharging the fund, engaging in improper insider loans, and violating the custody rule.
According to the SEC, the CFO/CCO failed to properly allocate management fee offsets for certain deemed contributions, thereby overcharging the fund by about $1.4 Million. The CFO/CCO also arranged improper loans between the fund and the management company and overcharged for organizational expenses. The SEC also charges the firm with failing to deliver audited financial statements within the required 120-day period, in part because one of its auditors withdrew from the engagement. The SEC faults the CEO for failing to properly supervise the CFO/CCO as required by Section 203(e)(6) of the Advisers Act. The SEC alleges violations of the Advisers Act’s antifraud rule (206(4)-8) and the compliance rule (206(4)-7).

Senior leaders will not escape accountability by claiming reliance on subordinates. Also, private equity firms can’t use the funds they manage as their firm piggy banks. They need to implement policies and procedures about the withdrawal and use of funds.

PE Firm Bought Insurance Company Clients and Sold Them Over-Valued Illiquid Assets

The SEC barred and censured the principal of a private equity firm for using his position to mislead advisory clients, sell them over-valued assets, and loot the funds.  The SEC accuses the respondent of acquiring insurance companies, entering into investment management agreements, and then selling over-valued illiquid assets (e.g. paintings, private company venture interests) to the insurance companies to siphon off the general funds.  The respondents did not reveal that the valuation agent for the illiquid assets was an affiliated company controlled by the principals. 

This case has all the features of an advisory fraud: illiquid assets, conflicts of interest, an affiliated valuation agent, and individuals with questionable backgrounds.  It is a cautionary tale for investors, compli-pros, and regulators about how far wrongdoers will go to pursue their illicit intents. 

Direct Lending Platform Pays $5 Million to Settle Conflicts Charges

 

A direct lending platform agreed to pay a $4 Million fine and reimburse clients another $1 Million for allowing funds it managed to purchase loans in transactions that primarily benefited the parent company.  The SEC also barred and fined the firm’s CEO and fined the firm’s CFO.  The SEC asserts that the parent company used its controlling position on the Investment Policy Committee to force the funds to purchase loans outside its investment targets.  The SEC accuses the firm of using the buying funds as a liquidity source following the loss of two major institutional investors.  The SEC also maintains that the firm artificially inflated valuation and fund returns with undisclosed management adjustments.  The SEC did not charge the parent company because it self-reported and cooperated and engaged in significant remediation efforts including establishing a new independent governing board, outsourcing valuation, and retaining a third-party compliance consultant.

OUR TAKE: It is very difficult to cure the conflict of interest inherent in self-dealing transactions where an operating company depends on managed private funds for liquidity, and the funds source their assets only from the parent company.  This may be one of those conflicts that can’t be cured regardless of the disclosure.

Adviser Didn’t Fully Disclose Financial Incentive to Recommend Affiliated Wrap Program

 A bank-affiliated adviser agreed to reimburse clients over $600,000 and pay an additional $100,000 fine for failing to disclose that it had an incentive to recommend an affiliated wrap program.  The affiliated wrap program paid a 2% up-front incentive to the adviser if its investment counselor recommended the program.  If the client withdrew from the program within two years, the client would pay a termination fee.  Approximately 78% of client assets were directed to the affiliate program even though two other third-party wrap programs were available.  The SEC faults the firm’s disclosures for failing to fully describe the financial incentive to recommend the affiliate program and that the investment counsellor would retain the up-front incentive fee even if the client terminated.  Although the adviser was state (not SEC) registered, the SEC maintains that the respondent violated Section 206(2) of the Advisers Act, which prohibits an investment adviser from engaging in any transaction that operates as a fraud on any client or potential client.

OUR TAKE: Recommending proprietary products over third party products requires enhanced due diligence and disclosure because of the inherent conflicts of interest.  When the adviser recommends proprietary products that benefit the adviser to the direct detriment of the client, the arrangement will draw heightened scrutiny and will often result in an enforcement action.

 

Private Equity Manager Lowballed Purchase Offer to LPs

 The SEC censured and fined a private equity manager for lowballing the price offered to liquidate limited partnership interests.  The SEC asserts that the private equity manager, through its principal, offered to purchase remaining limited partnership interests at the December 2014 valuation.  The SEC faults the firm for failing to revise the price or fully disclose that it had received financial information indicating that the NAV had increased during the first quarter of 2015.  The SEC opines that the offer letter, termed “as an accommodation,” made it appear that the limited partners would receive full value for their interests.  The SEC charges violations of Rule 206(4)-8, the Advisers Act’s antifraud rule.

OUR TAKE: We generally advise against principal transactions with clients/investors/LPs.  Purchasing private interests directly from a client is so rife with conflicts that no amount of disclosure may be sufficient.