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Category: conflict of interest

Trailer Fees Required Adviser to Register as Broker-Dealer

 The SEC fined an investment adviser and its two principals for failing to disclose compensation received for recommending a third-party investment fund and for not registering as a broker-dealer.  The adviser received a 1.25% up-front payment and trailing fee from the manager of a private fund that the respondents recommended.  The adviser did disclose that it would receive compensation but did not disclose the conflict of interest resulting because the fees received exceeded its customary 1.00% asset management fee, thereby creating a financial incentive to recommend the fund.  Because the compensation was transaction-based, the respondent was required to register as a broker-dealer, and the principals needed to obtain their relevant securities licenses.

The interesting twist here is that the SEC doesn’t really describe why the compensation should be characterized as transaction-based, triggering broker-dealer registration, rather than permissible asset-based compensation.  Instead, the SEC relies more on the source of the compensation (e.g. the product sponsor) rather than a direct fee charged to the client.  Could the firm have avoided the broker-dealer registration charges if it assessed the 1.25% fee on the client rather than collect it as revenue sharing from the product sponsor?  This may be an economic distinction without a difference, but the SEC will view it through a different regulatory lens.

REIT Manager Overpaid Itself When Calculating Incentive Fee

 A large REIT manager, together with its CEO and CFO, agreed to pay over $60 Million in disgorgement, interest and penalties for inflating incentive fees and taking reimbursement for significant expenses.  The SEC asserted that the defendants, contrary to disclosures and agreements, used their insider positions to calculate incentive fees in a manner that unjustly enriched themselves over the investors to whom they owed a fiduciary duty.  The SEC also charged the defendants with collecting millions in expense reimbursements as part of various merger transactions.  The SEC accused the defendants of securities fraud and falsifying books and records.

Firms should use some third party (e.g. fund administrator, LPA committee) to calculate, or at least confirm calculations, of fees collected from clients.  When management can exercise arithmetic discretion to pay itself, regulators will scrutinize the calculations.      

Adviser Benefited When Clients Invested in Its Lender

An investment adviser and its principal agreed to pay over $1.3 Million in disgorgement, interest and penalties for misleading clients about the adviser’s relationship with a lender. Following the action, the adviser was sold to another adviser, and the principal was barred from the industry. According to the SEC, the adviser, through the principal, advised clients to invest in the lender’s promissory notes without telling them that the loan’s repayment terms depended on the amount invested. The adviser characterized its relationship with the lender as a “strategic affiliation.” The SEC also maintains that the principal misled a client into investing in the adviser for the purpose of acquiring other advisers but the client’s investment was instead used to pay the principal’s personal expenses. The scheme was uncovered following the SEC’s action against the lender for fraudulent securities sales.

Don’t engage in direct transactions with your clients. We do not believe any amount of disclosure could adequately mitigate such a significant conflict of interest and resulting breach of fiduciary duty.

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.