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«Advisers Practice Group(s): U.S. Government Enforcement Alert Government By Jon Eisenberg Enforcement Global Government According to the SEC’s most ...»

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SEC Enforcement Actions Against Investment

21 October 2015


Practice Group(s):

U.S. Government Enforcement Alert


By Jon Eisenberg


Global Government According to the SEC’s most recent financial report, as of August 2014, SEC-registered

Solutions investment advisers managed $62.3 trillion in assets. 1 Not surprisingly, investment advisers

attract a great deal of attention from the SEC’s Enforcement Division. The Division of Investment Management, Hedge Enforcement’s Asset Management Unit has 75 professionals spread across all 12 SEC Funds and offices. The group has developed strong industry expertise: it includes more than a halfAlternative dozen former industry professionals and works closely with the examination teams of the Investments Office of Compliance Inspections and Examinations, as well as with the Divisions of Hedge Fund and Investment Management and Economic and Risk Analysis. In the first 10 months of 2015, it Venture Funds brought over two dozen significant cases, resulting in over $190 million in settlements; nearly Securities a dozen cases are being litigated.

Enforcement The Investment Advisers Act of 1940 provides a powerful tool in the SEC’s enforcement arsenal. In SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963), the Supreme Court held that even though Section 206 of the Act nowhere mentions the word “fiduciary” and, instead, prohibits conduct that operates as a “fraud or deceit,” the Act “reflects a congressional recognition ‘of the delicate fiduciary nature of an investment advisory relationship,’ as well as a congressional intent to eliminate, or at least to expose, all conflicts of interest which might incline an investment adviser — consciously or unconsciously — to render advice which was not disinterested.” The Court added, “Courts have imposed on a fiduciary an affirmative duty of ‘utmost good faith, and full and fair disclosure of all material facts,’ as well as an affirmative obligation ‘to employ reasonable care to avoid misleading’ his clients.” Subsequent Supreme Court cases have construed Capital Gains as recognizing a federal fiduciary duty for investment advisers. Perhaps in deference to the “fraud or deceit” language in Section 206, however, the Commission almost always alleges that the breach was accompanied by inadequate disclosure.

Recent SEC enforcement actions

–  –  –

I. Receipt of Unauthorized or Inadequately Disclosed Fees Advisers are entitled to be paid for their services, but the fees they are paid should be consistent with any governing documents and clearly disclosed. The largest settlements in 2015 involved advisers who had received fees or expense reimbursements to which the Commission concluded they were not entitled In one of the largest settlements this year, three related investment advisers to private equity funds agreed to pay nearly $39 million largely because the SEC concluded that they had not disclosed their receipt of “accelerated monitoring fees.” 2 The advisers disclosed that they charged monitoring fees to each portfolio company owned by the funds, which covered advisory and consulting services to the portfolio companies (typically for a 10-year period).

The Commission concluded, however, that they did not adequately disclose that, before the private sale or initial public offering of certain portfolio companies, the adviser terminated the monitoring agreements and accelerated the payment of future monitoring fees. In announcing the settlement, the SEC enforcement staff stated, “Full transparency of fees and SEC Enforcement Actions Against Investment Advisers conflicts of interest is critical in the private equity industry and we will continue taking action against advisers that do not adequately disclose their fees and expenses.” The Commission brought the action and included a $10 million fine, even though it acknowledged a number of remedial steps that the advisers had taken. For example, it acknowledged that, prior to the SEC investigation, the advisers changed their practices and disclosed they would no longer accelerate monitoring fee payments when they exited a portfolio company through a private sale.

In a second case involving the receipt of fees, an investment adviser to collateralized debt obligation (CDO) clients agreed to pay $21 million because it retained “exchange fees” paid by issuers of securities held by the CDOs when the adviser recommended exchange transactions to CDO clients. 3 Exchanges are transactions in which the CDO returned the issuer’s securities to that issuer, in return for new securities and/or other consideration. The collateral management agreement authorized the adviser to take specific actions with respect to exchanges, but did not provide for the receipt of exchange fees by the adviser.

The Commission charged the adviser received exchange fees and sought to obscure them by referring to them as payment of “third-party costs.” It also charged that the fees were not disclosed to clients, directors of the CDO vehicles, or in reports from the CDO trustee to investors. The Commission also sanctioned a managing director of the adviser, who drafted language in exchange transaction documents that characterized the exchange fees as compensation for third-party costs; and the chief legal officer, who reviewed and approved the receipt of exchange fees. In announcing the settlement, the Commission’s enforcement staff stated, “CDO managers have an obligation to act in the best interests of their CDO clients and communicate fairly with them. [The adviser] secretly diverted funds owed to CDO clients, and concealed that diversion and the conflicts it created.” II. Use of Fund Assets to Pay for Expenses Advisers Should Have Borne Section 12(b) of the Investment Company Act makes it unlawful to use fund assets to pay for activities primarily intended to result in the sale of fund shares outside a written Rule 12b-1 plan approved by the board. In the first case brought under the SEC’s “Distribution-in-Guise Initiative” (focusing on whether advisers are being reimbursed for distribution expenses in the guise of something else), an investment adviser and fund distributor agreed to pay nearly $40 million to settle SEC charges that they unlawfully caused their funds to pay nearly $25 million for distribution-related services, rather than making the payments out of the firms’ assets. 4 Here, the payments were not covered by a written 12b-1 plan, and, while the respondents treated them as payments for “sub-TA [transfer agency] services,” the SEC concluded that they were payments for distribution expenses. In announcing the settlement, the enforcement staff stated that the respondents “inappropriately used money belonging to the shareholders of the funds to pay for services clearly intended to market the funds and distribute their shares. Unless part of a 12b-1 plan, the firm should bear those costs, not the shareholders.” The Commission also brought an action against a mutual fund adviser for directing brokerage transactions to a broker-dealer for promoting fund shares without complying with Rule 12b-1(h), which requires the implementation of policies and procedures reasonably designed to, among other things, ensure the selection of brokers for portfolio securities is not influenced by considerations about the sale of shares of the fund. 5 It stated the adviser failed to create and maintain an approved list of executing brokers for the funds, and failed to SEC Enforcement Actions Against Investment Advisers maintain documentation reflecting monitoring of the funds’ compliance with the Rule 12b-1(h) policies and procedures. The matter was settled for $50,000, which included both the directed brokerage and a separate custody violation.

An investment adviser to private equity funds and other institutional investors agreed to pay $28.5 million because the private equity funds had reimbursed a large portion of the brokendeal expenses, but other co-investors had not paid for broken-deal expenses.6 In that case, the adviser was permitted to allocate to the fund expenses that were incurred “by or on behalf of” the fund, but the SEC concluded that the funds had, in effect, also borne the broken-deal expenses of co-investors. In announcing the settlement, the SEC enforcement staff stated, “This is the first SEC case to charge a private equity adviser with misallocating broken deal expenses. Although [the respondent] raised billions of dollars of deal capital from co-investors, it unfairly required the funds to shoulder the cost for nearly all of the expenses incurred to explore potential investment opportunities that were pursued but ultimately not completed.” In a third case involving expense reimbursement, a hedge fund advisory firm was charged with improper allocation of fund assets to pay for the adviser’s operating expenses, including

office rent, employee salaries, and benefits. 7 The Commission’s order stated the payments:

1) were not clearly authorized under the funds’ operating documents and 2) were not accurately reflected in the funds’ financial statements as related-party transactions. In addition to charging the firm, the SEC charged two executives for their involvement in the improper allocations, and the accountant who conducted the outside audit of the financial statements sent to investors. In announcing the settlement, the SEC enforcement staff stated that the adviser “did not make the proper disclosures for clients to decipher that the funds were footing the bill for many of the firm’s operational expenses. Private fund managers must be fully transparent about the type and magnitude of expenses they allocate to the funds.” III. Improper Trade Allocations by “Cherry Picking” Favorable Trades In a case being litigated, the Commission charged that an investment firm advisor purchased options in an omnibus or master account, and then delayed allocation of the purchases to either his or his clients’ accounts until later in the day, after he saw whether or not the securities appreciated in value. According to the Commission’s order instituting proceedings, his trades had an average first-day positive return of 6.28%, while his clients’ trades had an average first-day loss of 5.05%. 8 In announcing the charges, the enforcement staff stated that the Division is engaged in a “data-driven initiative to identify potentially fraudulent trade allocations known as ‘cherry-picking,’ and this enforcement action is the first arising from that effort.” Further, “Cherry-picking schemes can be extremely difficult to detect without an investor astutely noticing that something may be amiss and coming to us with a complaint about the adviser. We devised this initiative to identify specific custodians providing services to investment advisers and their clients and leverage their trading records and other data to efficiently target preferential trade allocations occurring outside the detection of even the most observant client.”

SEC Enforcement Actions Against Investment Advisers

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