When selling investment products, you cannot merely disclose the good facts. In this case, the respondent may not (or may) have known the investments were Ponzi schemes, but he did have enough facts to suspect and should have warned potential investors.
Hire better service providers. Not every lawyer knows the Investment Company Act Board approval, disclosure, and reporting rules. Not every compliance person understands Rule 38a-1 and how to implement fund procedures and testing. Not all administrator/distributors understand the differences between private funds and registered funds. You wouldn’t hire a neurologist to perform surgery. You shouldn’t hire just any lawyer or compliance consultant to implement your registered fund regulatory program.
Lying to the regulators in public filings to qualify for exemptions will lead to big trouble. Ordering rescission is the Big Kahuna of enforcement penalties because it involves returning all proceeds with interest in addition to fines and usually an ongoing cease and desist order. Act deliberately when filing that Form D or making those Rule 144 representations.
The SEC Division of Investment Management’s Disclosure Review and Accounting Office has warned the fund industry to improve its fee and performance disclosure. In its most recent release, the DRAO highlighted “several issues” including failures to verify the accuracy of performance and fee information. In particular, the DRAO cites multiple funds that have failed to reflect the effect of sales loads in their average annual returns table, showing negative performance as positive performance, and transposing the performance of different fund classes and benchmarks. The DRAO also faults fund-of-funds for failing to show the expenses of underlying acquired funds. Funds also routinely make arithmetic errors and fail to properly use XBRL tags. The DRAO “encourage[s] funds to closely review their performance and fee disclosures prior to providing them to investors.”
Over the years, many fund firms have delegated the preparation of registration statements to low-cost service providers that may not have the necessary knowledge, staffing and/or systems to prepare correct filings. When hiring a vendor (administrator, lawyer, auditor), make sure that the firm has the experience and the resources to do your job right. The cheapest is never the best and could cost you in the long run with a rescission or enforcement order.
The SEC censured and fined an investment adviser for paying solicitors without complying with the solicitation rule (206(4)-3). The adviser had networking relationships with over 300 banks whereby the adviser paid the banks a substantial portion of the advisory fees received from clients referred to the adviser. The SEC asserts that the adviser did not comply with the solicitation rule, which requires separate disclosure about the solicitation relationship, the specific terms, and the compensation received. The adviser erroneously relied on a 1991 no-action letter, which stated that a bank need not register as investment adviser. The no-action letter did not hold that bank solicitors were exempt from the solicitation rule.
It’s always good to focus disclosure on the material issues. However, every SEC administration trumpets a goal of “improving disclosure.” This effort may be like putting a coat of paint on a structurally defective house to prepare it for sale. The issue for public companies is not how the lawyers should interpret Item 101, but the onerous compliance and regulatory obligations that may discourage private and non-U.S. companies from accessing the public markets.