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Rich College Student Misleads Outside Investors with Faulty Valuations

 

The SEC charged a private fund manager and its principals with using a non-standard valuation model to value structured notes, thereby inflating fund performance and fees.  The main principal launched his firm out of his college dorm room initially to invest his family’s fortune but ultimately marketed his fund to third-party investors.  Rather than value the underlying structured note investments pursuant to “fair value” as required by ASC 820, the firm used a proprietary valuation model that deviated significantly from industry norms, thereby inflating returns and fees.  The SEC asserts that the respondents lied to investors, the auditor, and the SEC staff about its valuation practices.  The SEC cites multiple violations of the Securities Act, the Exchange Act and the Advisers Act.

Although ASC 820 leaves some discretion to management, the inputs cannot consistently juice valuations and returns and must have some market-based support.  The SEC could preempt these types of practices by publishing more specific valuation guidance as previously promised

Adviser Recklessly Promised Investors that Third Party Capital was Coming

 

The principal of an adviser formed to manage private funds was barred from the industry and fined for misleading clients by touting a promised capital infusion.  According to the SEC, the respondent recklessly believed that a third party would invest a large amount of capital, thereby allowing the fund to expand investment activities.  Although the third party had executed a non-binding letter of intent, the transaction was never consummated.  Nevertheless, the respondent continued to promise investors that it had hundreds of millions in committed capital.  The SEC also charges the respondent with a series of related misrepresentations as well as lying on Form ADV and illegally registering with the SEC.

Don’t make promises based on a promise.  It appears that the respondent genuinely believed the money was coming, but, unfortunately, the third party never legally committed.  As the old saying goes, “If wishes were fishes, we’d all have a fry.”

Unregistered Adviser Barred From Industry for Marketing Misrepresentations

 

The SEC fined an unregistered investment adviser and barred its principal from the industry for making false representations in marketing materials primarily to professional athletes.  The SEC asserts that the adviser, which terminated its SEC registration in 2008 but continued to market its investment advisory services through 2018, baldly lied about its assets under management, clients, management, and employees.  The firm emailed its misleading brochure to over 80 prospects over a 12-month period and included a cover email that also included significant misrepresentations.  The SEC alleges violations of the Advisers Act’s antifraud rules.

Just because you do not register with the SEC does not mean that you are exempt from its antifraud rules.  Section 206 applies to any statement made by an investment adviser, whether registered or unregistered, that could defraud any client or prospective client.

Name-Dropping in Offering Materials Leads to Securities Fraud Charges

The Canadian-based principal of a company formed to invest in blockchain companies and digital assets was fined and censured by the SEC for making misrepresentations while soliciting capital. According to the SEC, the respondents used slide decks and other materials that falsely claimed that four prominent blockchain individuals served as advisors to the company. The respondents boasted “access to, and unparalleled relationships with, opinion-makers, the best entrepreneurs, and the highest profile figures in the blockchain community.” The SEC maintains that these false statements helped raise $16 Million in a convertible debenture offering. The Ontario Securities Commission imposed an additional $520,000 fine following a court order whereby the principal agreed to forego his $2 Million interest in the company.

Didn’t know that name-dropping could result in securities fraud? Any misstatement arguably relied upon by investors could give rise to Section 17(a)(2) charges of offering securities by means of an untrue statement of a material fact.

Fund Manager Barred for Lying About Investment Strategy

A private fund manager was barred from the industry for misleading potential investors about the success of his trading strategy.  The respondent claimed to invest in a diversified portfolio of publicly-traded securities with a proprietary algorithm to limit downside risk.  Instead, he pursued a highly risky unhedged options strategy that wiped out the fund’s assets.  The SEC alleges that the respondent hid his losses by sending out false account statements and tax forms.  The SEC charged the state-registered adviser with securities fraud.  The parties agreed to additional proceedings to determine penalties and disgorgement. 

This case should be read by any potential client/investor enticed by a too-good-to-be-true investment pitch.  It is unfortunate when legitimate investment managers have to compete for business against wrongdoers who outright lie about their performance. 

Large Bank Lied about Hedge Fund Due Diligence Process

The SEC fined a large commercial bank for failing to disclose that it only recommended hedge funds that paid a portion of the management fee back to the bank.  The bank marketed a robust due diligence process conducted by a purportedly independent, in-house research group performing a multi-step due diligence process to select hedge funds from an “extremely large universe.”  In fact, the bank only recommended hedge funds that paid back management fees that it called “retrocessions.”  Although the bank disclosed that it might receive revenue sharing and the amount actually received from each hedge fund, the actual due diligence process did not comport with marketing promises.  The bank, which is not a registered adviser or broker-dealer, was charged with violating the Securities Act’s anti-fraud provisions (17(a)(2)).

Check the marketing team’s enthusiasm at the door.  The SEC doesn’t allow firms an exception from the securities laws for product hype, regardless of how clients/investors may perceive the statements.  Rather than caveat emptor (buyer beware), caveat venditor (seller beware) governs sales of securities products.  

Day Trader Lied About Track Record

The SEC charged an unregistered day trader for lying about his trading success and misappropriating client funds. The defendant convinced clients to hire him by asserting that that he had done very well as a day trader over several years and then promised over 50% annualized returns.  Once retained, the trader did very poorly and siphoned client assets for personal expenses.  According to the SEC, he then concealed his misconduct by delivering false account statements and implementing a microcap wash sale scheme.  The defendant also faces criminal charges brought by the U.S. Attorney’s Office for the Eastern District of New York.

Lying about your investment track record constitutes securities fraud, subjecting you to civil and criminal penalties.  Do not make performance claims unless you can affirmatively support your claims with hard data. 

SEC’s Blass Announces Plans to Modernize Adviser Marketing Rules

The SEC’s Investment Management Division Director, Dalia Blass, anticipates that the Division will soon recommend changes to the adviser marketing and solicitation rules.  In her annual speech to the Investment Company Institute membership, Ms. Blass also announced initiatives for a summary shareholder report, updates to the valuation guidance, modernization of the offering rules for business development companies and closed-end funds, and changes to the rules for funds’ use of derivatives.  Additionally, Ms. Blass wants the Division to finalize the proposed ETF and fund-of-funds rules.  She has also asked the staff to begin an outreach to small and mid-sized fund sponsors about regulatory barriers.  She announced that the Division is considering the formation of an asset management advisory committee to solicit diverse viewpoints on critical issues.

We applaud the reinvigorated Investment Management Division for tackling some of the thornier problems that have faced the industry for many years.  For instance, the marketing rules haven’t changed for decades despite revolutionary change in the financial services industry. 

Signal Provider Used Misleading Hypothetical, Backtested Performance

An index signal provider, who also managed assets, agreed to a fine, censure and an outside compliance consultant for utilizing misleading hypothetical backtested performance information.  The SEC alleges that the calculations of the hypothetical, backtested performance for one of its core strategies deviated significantly from the live data, failed to conform to the firm’s model rules, and utilized an unavailable commodity index.  The SEC also faults the firm for failing to properly supervise a third-party index provider hired to create the backtested performance.  The SEC charges violations of the Advisers Act’s antifraud provisions (206(2)), advertising rule (206(4)-1(a)(5)), and compliance rule (206(4)-7). 

This case against an index provider adds fuel to the fire started by Investment Management Director Dalia Blass who last year questioned whether index providers should be exempt from investment adviser registration.  Also, as we have said before, do not use hypothetical, backtested performance information in marketing and advertising. 

FINRA Allows Limited Use of Pre-Inception Index Performance Data with Intermediaries

FINRA has issued an interpretive letter allowing a broker-dealer to use pre-inception index performance data to market index-based registered funds to institutional investors including intermediaries.  To use pre-inception data, the index must be developed according to “pre-defined rules that cannot be altered” except under extraordinary conditions, and the member firm may only disseminate the data to institutional investors including intermediaries that will not use the information with their retail clients.  FINRA imposes several conditions including (i) the data includes no less than 10 years of performance information, (ii) the material shows the impact of the deduction of fees and expenses, (iii) the material includes actual fund performance, and (iv) the firm includes extensive disclosure including the reasons why the data would have differed from actual performance during the period.  FINRA previously allowed pre-inception performance data to institutional investors other than intermediaries with the same conditions.

The change here is allowing broker-dealers to provide the information to intermediary financial advisers and putting the burden on the intermediaries to prevent use directly with their retail clients.    Regardless, we recommend against using hypothetical backtested performance data because of SEC concerns as well as the significant regulatory and disclosure limitations.