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Large BD/IA Pays $2.2 Million for Recommending Wrong Mutual Fund Share Class

A large BD/IA agreed to pay $2.2 Million in remediation, interest and penalties for failing to recommend the lowest mutual fund share class available to retirement plan customers. Instead of recommending load-waived “A” shares, the respondent recommended other higher-cost share classes that resulted in compensation paid to the BD/IA.  The SEC faults the firm for failing to have adequate systems and controls in place to ensure that retirement clients benefitted from available discounts.   The SEC also asserts that the BD/IA omitted necessary disclosures about revenue sharing and the impact on overall investment returns.  An SEC Enforcement official warned that “these types of actions remains a priority for the Division” as evidenced by its recently-announced Share Class Selection Disclosure Initiative.

OUR TAKE: Firms must implement a system to ensure that eligible clients get the waivers to which they are entitled.  Compliance can’t rely on reps self-policing, especially when they receive higher compensation on certain share classes.


Adviser Failed to Stop Principals from Looting Client Accounts

The SEC censured an investment adviser and ordered it to pay $1.7 Million in fines, disgorgement, and interest for failing to implement a compliance program that would detect and prevent the looting of client accounts.  Two firm principals ultimate went to prison for using their positions as fiduciaries over trust accounts to steal funds.  The SEC faults the firm for (i) failing to adopt legitimate policies and procedures, (ii) neglecting to obtain the required surprise examinations, and (iii) preparing misleading Form ADVs.  In addition to charging violations of the Advisers Act fiduciary, custody and compliance rules, the SEC also cites violations of Section 10(b) and Rule 10b-5, which prohibit fraudulent conduct in the offer or sale of securities, presumably for misleading statements made in Form ADV.

OUR TAKE: Just because the principal wrongdoers went to jail doesn’t mean the firm is off the hook.  The SEC holds the adviser accountable for allowing the conduct to continue.  It is also significant that the SEC uses 10b-5 as a charge, which opens the door to more significant civil and criminal penalties.


Adviser Charged with Defrauding Professional Athlete

The SEC has commenced enforcement proceedings against an adviser that it alleges lied to his professional athlete client about management fees.  The SEC asserts that the adviser told representatives of the client that the client paid between .15% and .20% of assets in management fees when the client actually paid 1.00%, resulting in significant payments to the adviser who received 60% of the revenue earned by his firm.  According to the SEC, the adviser misled the client and his representatives by using false account statements, forged documents, an impostor acting as a Schwab representative, and multiple misrepresentations in emails and meetings.    The client’s representatives ultimately contacted Schwab, who then informed his employer.  The adviser tried to convince the client to lie on his behalf to protect his job, although the client refused.

OUR TAKE: This type of case shows the problem with assuming that wealthy people are financially sophisticated.  Many wealthy people earn their income in fields (e.g. sports, medicine, technology) that would not necessarily make them qualified to make investment decisions.  Instead, these successful professionals rely on advisers who are supposed to act as fiduciaries and protect their clients’ interests.


Longstanding Church Fund Violated Fiduciary Duty

The sponsor of a church fund agreed to pay over $2.25 Million in returned profits, disgorgement, interest and penalties for failing to properly disclose a reserve fund created to smooth returns.  According to the SEC, the Board of the fund, which was launched in 1973, created the reserve fund in 1993 as a vehicle to retain excess profits and ensure liquidity so that the fund could distribute consistent returns between 5% and 6.7%.  The SEC faults the fund sponsor for failing to fully disclose that it would charge fees on the reserve fund and that redeeming investors would not receive their pro rata amounts held in the reserve fund.  OCIE identified the fiduciary violations during a 2014 exam, which followed the sponsor’s registration in 2012.

OUR TAKE: The SEC appears to be most disturbed that the fund sponsor did not return client assets and double-dipped advisory fees by moving assets into the reserve fund.  Private fund firms that registered after 2012 as a result of Dodd-Frank, should audit their operations to determine whether longstanding business practices run afoul of their fiduciary duties.


Massachusetts Fines Large BD $1 Million for Sales Contest


The Massachusetts Securities Division fined a large broker-dealer $1 Million for compensating financial advisers to encourage clients to open securities-based lending accounts at an affiliated private bank.  The MSD asserts that the firm violated its own policies against sales contests and failed to quickly stop the program after Compliance raised objections.  The MSD cites statistics showing significant growth in securities-based lending associated with the program.  The MSD charges supervisory violations and failure to ensure “commercial honor and just and equitable principles of trade.”

OUR TAKE: The MSD could not assert a suitability violation because the securities-based lending accounts are not securities.  Instead, the regulator employed the “equitable principles” catch-all doctrine, which looks very much like a fiduciary standard.  Even if the DoL rule dies and the SEC refuses to move on a fiduciary standard, watch out for the state regulators.


Unregistered Fund Manager Still Liable for Breach of Fiduciary Duty


The SEC fined and barred the principal of an unregistered private fund manager for breaching his fiduciary duty by failing to disclose that affiliate intermediaries profited from fund transactions.  The SEC alleges that the respondent used affiliate companies as intermediaries for the buying and selling oil and gas royalty interests and that the affiliates collected significant profits.  The SEC charges the firm with failing to disclose these transactions, instead telling investors that the fund would receive the best price possible and that any affiliate transaction would be conducted at arm’s length.  Even though the fund manager was not registered, the SEC accused him of violating the Advisers Act because he engaged in advisory activities and breached his fiduciary duty of full disclosure.

OUR TAKE: Private fund managers maintain accountability for alleged breaches of fiduciary duty even if not registered.  This includes conduct that pre-dates Dodd-Frank’s registration requirements.  Also, it is unclear how much disclosure is enough to allow affiliate transactions.


The Friday List: 10 Private Equity Practices that Cause Regulatory Problems

the list

The Friday List: 10 Private Equity Practices that Cause Regulatory Problems

Today, we offer our “Friday List,” an occasional feature summarizing a topic significant to investment management professionals interested in regulatory issues.  Our Friday Lists are an expanded “Our Take” on a particular subject, offering our unique (and sometimes controversial) perspective on an industry topic.

The private equity industry has seen increased SEC scrutiny and several significant enforcement actions since the adviser registration requirement went into effect in 2012.  In today’s list, we offer 10 PE practices that have caused regulatory problems for registered PE firms.


10 Private Equity Practices that Cause Regulatory Problems

  1. Direct transactions with portfolio companies. The SEC will highly scrutinize affiliate loans to portfolio companies, consulting arrangements with affiliates, and insiders serving as officers.
  2. Varying seniority rights for LPs. Giving preferential treatment to certain LPs (especially insider co-investors) will violate a fiduciary’s obligation to treat all clients equally.
  3. Mis-allocating co-investor expenses. Insider co-investors must bear the same expense allocations as outside LPs.
  4. Accelerating portfolio monitoring fees.  The SEC has brought at least 2 significant cases for failing to fully disclose how LPs will absorb accelerated portfolio monitoring fees incurred after a liquidation event.
  5. Charging broken deal expenses. The SEC views this practice as another way for a fiduciary to illegally line its own pockets at the expense of LPs.
  6. Legal fee discounts. Getting lower rates from your law firm (and other service providers) because they work on the funds violates your fiduciary duty.
  7. Overcharging overhead expenses. Several firms have been cited for taking overhead expenses out of the funds without adequate disclosure.
  8. Cross-portfolio transactions. Transactions between funds including interfund lending or cross-trading will violate the Advisers Act.
  9. Not registering as broker-dealer.  Investment banking activities for portfolio companies require broker-dealer registration.
  10. Weak compliance program.  Several PE firms failed to hire a competent and dedicated CCO to implement a specific Advisers Act compliance program.

Adviser Barred in Connection with Receiving Asset-Based Fees and Commissions


The SEC fined and barred the principal of an investment adviser for lying to clients about why he made investment recommendations and changed custodians.  According to the SEC, the respondent recommended that clients move assets to a proprietary fund from a third-party fund because he could no longer receive trail commissions from the third party fund.  The SEC also faults the respondent for failing to explain to clients that he had to change custodians because the incumbent custodian terminated its relationship due to a prior regulatory action.   The adviser failed to “disclose important facts to his clients so they could make their own informed decisions.”

OUR TAKE: An adviser walks a very treacherous regulatory path when it charges a client both asset-based fees and commissions.  It is possible that no amount of disclosure could cure this inherent conflict of interest that compromises an adviser’s fiduciary responsibility.