hedge fund seeding platform created by a large asset manager agreed to pay over
$2.7 Million in disgorgement, interest and penalties for over-allocating
internal expenses. The respondent
created private equity funds to invest in third party hedge fund managers. The firm then created an internal group of
employees tasked with helping hedge fund managers in which the funds invested
to attract new capital, launch products and optimize operations. Pursuant to their organizational documents,
the funds would pay up to 50 basis points for these activities. The SEC charges that the respondent allocated
all the group’s compensation expenses to the funds even though they spent a
portion of their time on activities that benefitted the fund sponsor and
unrelated to the enumerated activities.
The SEC faults the firm for failing to implement appropriate compliance
policies and procedures and for making material misstatements.
Do not charge expenses to managed funds unless the organizational and disclosure documents are absolutely clear that the funds will bear the expenses. When doing internal expense allocations, always err to the side of benefitting the fund rather than the fund manager.
An investment adviser platform was fined and censured for receiving fund revenue sharing from a custodian and clearing firms it recommended without proper disclosure. The platform had more than 150 independent investment adviser representatives and 200 registered representatives working out of more than 100 offices. The SEC criticizes weak disclosure that failed to fully describe the conflict of interest when the firm recommended a custodian that kicked back 2 basis points on assets. The SEC also maintains that the firm violated disclosure, fiduciary and best execution obligations when it recommended mutual fund share classes that paid back 12b-1 fees to the firm and its reps when lower fee share classes were available. The firm did not meet its obligations with vague website disclosure that described how the firm “may” receive compensation but failed to fully inform all clients about how fees were paid or calculated.
OUR TAKE: The RIA platform business is extremely competitive, with many firms competing to recruit successful RIA teams. The real cost of an enforcement action like this is the reputational and competitive threat during the recruiting process. Also, as platforms compete for business and margins shrink, the incentives to accept (questionable) revenue sharing increases.
OUR TAKE: This case reads like a cautionary tale for large firms trying to quickly roll out a product. It appears that the portfolio management, marketing, legal, operations, and legal functions worked in silos, and, as a result, failed to properly vet or describe the products. We recommend that firms create a cross-functional product assessment team that can ask the hard questions before launching a product.
OUR TAKE: When it comes to cybersecurity incidents, time is not on your side. Because of the potential harm to clients and investors, it is better to provide immediate disclosure that will be followed up with additional information rather than waiting and thereby compounding the potential harm. Hacked firms must move quickly to investigate, assess, and remediate the harm to minimize damages.
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.
The SEC has issued cybersecurity guidance that directs public companies to adopt effective disclosure controls and procedures and overhaul their disclosure about incidents and threats. The SEC believes that public companies should adopt and implement cybersecurity risk management policies and procedures that ensure timely disclosure, internal reporting, processing of risks and incidents, and prevention of insider trading. The SEC also admonishes public companies to review all public disclosures including the materiality of incidents and security, risk factors, MD&A disclosure, business description, legal proceedings, financial statements, and board risk oversight. Firms should also consider disclosing past incidents “in order to place discussions of these risks in the appropriate context.” The SEC believes that “the importance of data management and technology to business is analogous to the importance of electricity and other forms of power in the past century.” The SEC said that it will be reviewing cybersecurity disclosures.
OUR TAKE: We expect institutional investors will add similar cybersecurity inquiries into their Operational Due Diligence processes before choosing an investment firm. So, even if you do not work for a public company, you should consider implementing the SEC’s recommendations.
The SEC censured and fined an investment adviser and its two principals for failing to disclose the firm’s weak financial condition to retail investors, including advisory clients, to whom it sold promissory notes. As far back as 2012, the advisory firm struggled financially as its inability to raise assets and earn fees failed to offset rising operating costs. To keep afloat, the firm issued short-term promissory notes to retail investors including its advisory clients. The SEC faults the firm for failing to disclose its weak financial position and the significant risk that it would not repay the notes (even though it did not default on any interest payment). The SEC cites violations of the Exchange Act’s and Advisers Act’s antifraud rules.
OUR TAKE: The SEC can assert regulatory violations even where there is no client or investor harm. Here, the SEC filed a settled enforcement action related to concerns about the notes even though the adviser never actually defaulted. Adviser should also note that Item 18.B. of Form ADV requires disclosure of any “financial condition that is reasonably likely to impair your ability to meet contractual commitments to clients.”
The Managing Director of an IA/BD was censured and order to pay disgorgement and a fine for trading with his advisory clients out of a proprietary account without advance notice and consent. The respondent arranged over 2,700 principal trades between his clients and a proprietary account over which he had trading authority. The SEC asserts that he knowingly failed to provide the required disclosure about the mark-ups received as well as obtain the advance consent to engage in principal transactions. FINRA previously barred his former firm from the industry in connection with churning allegations.
OUR TAKE: Although the regulators barred his firm, they did not stop there. The SEC will hold individuals accountable for their firms’ legal violations especially if they participated and benefited.
The SEC fined and barred the portfolio manager of a registered mutual fund for failing to disclose to the Board and shareholders significant changes in investment strategy. The fund operated as part of a platform series trust sponsored by a third party fund administrator that was responsible, along with the Board, for compliance oversight, although each adviser was responsible its own tailored compliance program. As the SEC alleged, the PM altered the fund’s strategy and began investing the vast majority of assets in derivatives, which ultimately led to the fund’s demise. Although the PM did ask for permission to invest in derivatives, he did not disclose that engaging in derivatives and short selling would become the principal investment strategy. The SEC also accuses the respondent with failing to properly disclose the changes in investment strategy in the prospectus and shareholder reports and for causing the series trust’s Investment Company Act violations.
The SEC fined a deregistered investment adviser and barred its former principal for multiple compliance failures involving double dipping, Form ADV disclosures, fee rebates, and misrepresentations. The respondents recommended that clients invest in private funds in which the principal held ownership and managerial interests. Although the SEC acknowledges that clients knew about the conflict, the firm failed to list and describe the conflicts on Form ADV. The SEC also charges the firm with multiple compliance program failures including inadequate policies and procedures and failing to conduct annual testing of the compliance program.
OUR TAKE: There is no such thing as declaring regulatory bankruptcy: the SEC’s long arm won’t let a firm engage in wrongdoing and then simply de-register to avoid consequences. Compli-pros should also note that disclosure alone will not always cure significant conflicts of interest, such as fee double dipping for advisory services along with underlying products.