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.
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.
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.
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.
OUR TAKE: Compli-pros face an enormous challenges in large, global institutions to ferret out multi-lateral business relationships and ensure that the firm adequately observes its fiduciary obligations.
OUR TAKE: Without proper disclosure and consent, a transaction that benefits the fund sponsor or its principals will violate the Advisers Act’s fiduciary duty whether or not the investors suffered any harm. This case also highlights the perils of the CCO dual-hat model whereby a senior executive with a pecuniary interest also serves as the Chief Compliance Officer, thereby avoiding independent scrutiny.
A portfolio manager of an activist investment firm failed to disclose a $3 Million personal loan to the CEO of a company in which he invested. The portfolio manager made the loan, according to the SEC, to secure the CEO’s support for his election to the Board as part of a broader initiative to exert control over the company. The SEC asserts that the portfolio manager violated his fiduciary duty to his clients by concealing his personal interest and that the investment manager failed to file a Schedule 13D (indicating more than passive investment). Also, the SEC faults the adviser for failing to implement a reasonable compliance program because the policies and procedures “did not discuss conflicts of interest more broadly in sufficient depth so as to capture and train employees to recognize other violative conduct not specifically identified.”
OUR TAKE: Because portfolio managers are often treated like the rock stars of investment management, compli-pros must implement heightened supervision to protect against reckless actions that will ultimately hurt the firm. Procedures should include reviews of investment decisions, due diligence about personal dealings, reviews of transactions outside the ordinary course, and training all employees how to identify unlawful activity.
OUR TAKE: Inter-company payments among affiliates raise the same regulatory conflict of interest concerns as payments received from non-affiliates. Compli-pros should follow the money to all of an adviser’s revenue sources in order to assess possible conflicts. Also, non-U.S. entities, perhaps less sensitive to the Adviser’s Act’s requirements, should hire qualified lawyers or compli-pros to avoid tripping over the regulatory wires.
A large mutual fund manager agreed to pay $3.6 Million in disgorgement, interest, and penalties for failing to disclose that affiliates would receive tax deductions that would deprive fund investors of securities lending income. The fund manager told investors and the Board that it would engage in discretionary securities lending and told the Board that affiliates could benefit from certain tax deductions. The SEC faults the respondent for failing to tell either investors or the Board that it might recall securities before the dividend record date, which allowed affiliates to take a dividend received deduction and deprived the fund and its shareholders of additional securities lending revenue. The SEC cites violations of the Advisers Act’s antifraud rules, acknowledging that proof of intent is not required and that such charges “may rest on a finding of simple negligence.”
OUR TAKE: This type of fraud charge based on simple negligence looks a lot like the type of “broken windows” enforcement cases that former SEC Chairman Mary Jo White championed. The SEC does not allege that fund investors would have made a different investment decision if it included the SEC’s enhanced disclosure. The conflict of interest makes the disclosure insufficient notwithstanding any effect on investors.