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Fund Manager to Pay $3.6 Million for Failing to Fully Disclose Securities Lending Benefits


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.


SEC Issues Cybersecurity Compliance and Disclosure Guidance

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.


Adviser Borrowed From Clients without Full Disclosure of Financial Condition

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.”


Managing Director used Prop Account to Trade Directly with Advisory 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.


SEC Fines and Bars Fund Manager in Series Trust

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.

OUR TAKE: The SEC has wrestled with the allocation of compliance responsibility between series trust sponsors and boards and the underlying managers.  In this case, the SEC targets the manager for failing to ensure proper disclosure.  It is unclear at this writing whether the SEC will also charge the series trust or its board.


SEC Prosecutes De-Registered Adviser for Prior Compliance Failures

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. 


Large Private Equity Firm to Pay $12.8 Million for Accelerated Portfolio Monitoring Fees

A large private equity firm agreed to pay over $12.8 Million in disgorgement, interest and fines for taking accelerated monitoring fees arising from the sale, IPO, and exit from portfolio companies.  The PE firm disclosed in the PPM that it would receive portfolio monitoring fees and disclosed in LP reports and the ADV that it received accelerated fees.  Nevertheless, the SEC faults the respondent for failing to disclose the accelerated fees before LPs committed capital and failed to submit the accelerated fees to the LP committee for approval.  The SEC accuses the firm of engaging in undisclosed conflicts of interest and failing to implement an adequate compliance program.

OUR TAKE: The SEC has attacked PE fees and expenses including portfolio monitoring fees, broken deal expenses, overhead costs, and consulting fees.  To avoid these issues, PE firms may want to re-think their business models and include all fees and expenses in a higher management fee and carried interest.


Dual-Hat Principal/CCO Ignored SEC’s Compliance Deficiencies

The SEC has commenced enforcement proceedings against a fund manager and its principal/CCO for ignoring exam deficiencies about its compliance program and other violations.  The SEC examined the respondents in 2010 and 2014 and noted several compliance deficiencies, which the SEC asserts the respondents ignored.  The SEC charges the dual-hatted principal with failing to perform any work on the compliance program, adopting a stock manual that was not properly tailored to the business, or conducting any compliance review.  The SEC also faults the respondents for charging compliance costs to the funds.  The SEC additionally charges undisclosed conflicts of interest, misrepresentations, and valuation issues.

OUR TAKE: The SEC doesn’t always give you a second chance to fix cited deficiencies.  But when they do and you don’t, expect an enforcement action.  Also, this is another example of the failure of the dual-hatted CCO model, where an executive ignored his compliance responsibilities.  Penny wise and pound foolish.


RIA/BD Failed to Disclose Mark-Ups and 12b-1 Fees

The SEC has commenced enforcement proceedings against a dually registered adviser/broker-dealer and its CEO/CCO principal for taking undisclosed commissions and 12b-1 fees on discretionary accounts.  The SEC’s complaint avers that the respondent sold inventory securities, acquired at a discount as part of the selling syndicate, to clients at a mark-up.  The SEC alleges that the firm never obtained the required informed consent.  The SEC also charges the firm for taking mutual fund 12b-1 fees without telling clients.

OUR TAKE:  A principal transaction with a client requires an adviser fiduciary to obtain specific client consent following disclosure of all relevant information.  The SEC continues its crackdown on any form of revenue sharing received by advisers with respect to their fiduciary clients.


Private Company and CEO Misled Investors about Compliance Failures

A privately-held benefits consulting firm agreed to pay a $450,000 fine, and its former CEO agreed to pay over $500,000, for failing to disclose compliance failures during fundraising.  The SEC maintains that the firm evaded state insurance licensing laws by rigging online examination courses and allowing employees to sell insurance without required licenses.  The SEC charges that the firm violated the securities laws by failing to disclose the compliance failures when raising money from institutional investors during at least 3 financing rounds that raised over $500 Million.  The related stock purchase agreements included false representations that the company complied with applicable laws including licensing requirements.  The respondent has also faced regulatory actions by at least 40 states who have imposed more than $11 Million in sanctions.  As part of the SEC settlement, the company created a Chief Compliance Officer position.

OUR TAKE: Be very careful when claiming compliance with applicable laws in disclosure or fundraising documents.  You might want to ask your Chief Compliance Officer if any issues require more disclosure.  The SEC can use holes in your regulatory compliance as a predicate to an enforcement action for securities fraud.