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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 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.”


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. 


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.


SEC Prosecutes Unregistered Fund Manager for Over $1 Million


An unregistered investment adviser/fund manager and its principals agreed to pay over $1 Million in disgorgement, fines and interest for engaging in conflicted transactions that were not properly disclosed.  The SEC accuses the respondents of using fund assets to invest in a company that the principals controlled and then buying out the ownership interest at a loss, all without consent of the limited partners or any relevant disclosure.  The SEC also asserts that the respondents engaged in undocumented personal loans and payment of overhead expenses in contravention of the fund’s disclosure documents and limited partnership agreement.  Although the firm (which had less than $25 Million in AUM) was not registered, the SEC argues that it engaged in investment advisory activities, owed the fund and its investors a fiduciary duty, and, therefore, violated the Advisers Act’s antifraud rules.

OUR TAKE: Just because you are not eligible (or fail) to register as an investment adviser, does not mean that the Advisers Act does not apply.  In fact, most of the antifraud provisions apply to unregistered and state-registered advisers, thereby allowing the SEC to assert its enforcement jurisdiction.


Adviser’s Multiple Roles Allowed Misappropriation of Client Funds

The SEC commenced proceedings against an investment adviser who allegedly used his position as trustee and executor of his client’s estate and president and co-trustee of the client’s foundation, to misappropriate funds.  According to the SEC, the adviser befriended the elderly widow of a longtime client and convinced her to appoint him as her executor and foundation president.  After she died, he used his position to move money from her foundation to her estate checking account and then transferred funds to his personal accounts.  The SEC asserts that the adviser made more than 200 unauthorized transfers totaling more than $9 Million over a 12-year period.  The Manhattan District Attorney has also brought criminal charges.

OUR TAKE: Whether or not this particular adviser engaged in the alleged illegal activity, one key lesson is that an adviser should never assume multiple conflicting roles as investment adviser, executor of a client’s estate, and president of the foundation.  The appearance of impropriety alone would be hard to defend if an interested family member second-guesses any transaction.


Lack of Compliance Infrastructure Costs Private Equity Firm and Principals

The SEC fined a private equity firm and its principals, and barred the former CFO/CCO from the industry, for engaging in multiple conflicts of interest transactions with the funds.  According to the SEC, prohibited transactions included (i) borrowing from the funds, (ii) failing to make capital contributions, and (iii) using false bookkeeping adjustments to hide transactions.  The transactions violated the LPA and were not properly disclosed in capital call notices or financial statements.  In addition to anti-fraud and books and records violations, the SEC charged violations of the compliance rule (206(4)-7) because the compliance manual did not address conflicts of interest including control by the two principals and related party transactions.  As part of the settlement, the firm hired a new CCO, a new general counsel, a new CFO, and an independent compliance consultant.

OUR TAKE: Hiring a competent CCO before the SEC arrived would likely have avoided the enforcement action and the resulting damage to the firm’s business and reputation.  It appears that the principals had no sensitivity to the regulatory environment in which they were operating.


Adviser Barred for Failing to Register as BD for Private Fund Sales

A financial adviser was barred from the industry and ordered to pay over $400,000 in disgorgement and interest for failing to register as a broker-dealer while selling interests in a private fund.  According to the SEC, the respondent identified investors, communicated with them (including in person), advised prospective investors on the merits of the investment, assisted handling funds, and collected transaction-based commissions.  The adviser sold notes issued by a third party fund that ultimately defaulted.  The SEC charges that the respondent’s activities violated Section 15(a)(1) of the Exchange Act, which requires registration as a broker-dealer to sell securities.

OUR TAKE: Over the last couple of years, the SEC has increased enforcement efforts to prosecute individuals and firms who sell private funds without registering as, or becoming affiliated with, a broker-dealer.