A Compilation of Enforcement and Non-Enforcement Actions

28 November 2011 Publication
Authors: Peter D. Fetzer Terry D. Nelson

Legal News: Investment Management Update

Non-Enforcement Matters

SEC Adopts Final Rule on Private Fund Reporting Requirements

On October 26, 2011, the SEC approved a final rule that requires SEC registered investment advisers to hedge funds and other private funds to report nonpublic information to regulators. The collection of such data was mandated by the Dodd-Frank Act. That Act, among other things, created the Financial Stability Oversight Council (FSOC) to assess and monitor the systemic risk posed by hedge funds and other private funds. The Act requires both the SEC and the CFTC to collect information from hedge and other private fund advisers to provide the FSOC with additional insight into private fund activities and assist with its risk-monitoring mission. The CFTC approved a final rule on October 31, 2011, requiring commodity advisers registered with the CFTC to report information regarding private funds managed by such advisers.

The information will be collected on new form (Form PF) which was adopted by both the SEC and CFTC. According to the SEC, Form PF was derived after consultations with, among other parties, foreign regulators who already collect such information from advisers to private funds. According to the SEC, Form PF, as initially proposed, was significantly modified by the SEC and CFTC after considering industry comments and suggestions.

The basic information to be provided via Form PF includes fund information such as amount of assets, performance data, borrowings, creditors, and ownership. Form PF will compliment the new Form ADV which requires registered and exempt investment advisers to provide additional information on private fund clients. Form ADV now requires information about a private fund’s size, managers, and the entities (or “gate keepers”) that provide certain services to the funds. Form PF is structured so that advisers to larger funds will be required to provide more information than advisers to funds of smaller size.

Advisers with less than $150 million under management for private funds will not be subject to filing Form PF. For purposes of determining the filing requirements, advisers are required to aggregate the amount of assets managed for other client accounts that pursue the same investment objective and strategy and invest in substantially the same positions as private funds managed by the adviser, along with assets of private funds managed by a related person of the adviser.

Heightened reporting will be required of advisers to hedge or other private funds with assets under management of at least $1.5 billion attributed to such funds. The SEC estimates that about 230 U.S.-based hedge fund advisers would be subject to the heightened reporting requirements.

U.S.-based private equity fund advisers that would be subject to the heightened private equity reporting requests are estimated to be about 155 U.S.-based advisers managing about $2 billion in private equity fund assets. The reporting requirements for advisers managing large private equity funds will be less than those for managers of the large hedge fund and other private fund advisers. That lesser requirement of reporting for the equity fund managers is the result of a lesser concern about private equity funds posing system risks versus hedge funds and other private funds.

The smaller private fund advisers (i.e., with $150 million or more of assets under management in hedge funds but less than $1.5 billion of such assets) will be required to file Form PF following the end of their fiscal year or fiscal quarter, as applicable, to end on or after December 31, 2012. Those advisers with $5 billion or more in private fund assets must begin filing Form PF six months prior to that date.

The information provided to the SEC and CFTC by advisers on Form PF will not be available to the public. The information will be shared with the FSOC and may be shared with other governmental regulatory services and self-regulatory organizations.

State Regulators Identify Most Common Investment Adviser Violations

As the state securities administrators gear up to assume the role as the “cop on the beat” to a larger number of registered investment advisers across the country, the North American Securities Administrators Association (NASAA) has provided a list of the most common violations state examiners have found during onsite examinations of investment advisers.

Starting early 2012, most investment advisers with assets under management of under $100 million will have to be registered with one or more state securities agencies. The switch from SEC registration to state registration for so-called “mid-sized” advisers is expected to affect thousands of such advisers. For those advisers, it will mean onsite examinations conducted by the state securities regulators rather than the SEC.

According to a recent report by NASAA, examinations conducted of 825 investment advisers by examiners of 45 states over a period of January 1 – June 30, 2011, uncovered more than 3,500 deficiencies in 13 separate compliance areas. The amount of deficiencies found is a significant increase over a similar period in 2009, although fewer investment advisers were examined in 2009 (458). The 2011 examinations were part of a coordinated effort by the states conducted under NASAA’s Investment Adviser Operations Project Group.

The coordinated examinations found:

  • The top registration deficiencies were inconsistencies between Parts I and II of Form ADV and failing to amend Form ADV in a timely manner
  • In the area of preparing and maintaining current and accurate books and records, the top deficiencies included not maintaining client suitability information, not properly safeguarding client records and data, and not backing up data
  • The leading unethical business practice deficiencies involved missing or no contracts and other contract-related issues, altered documentation, and signing blank documents
  • The most common supervision deficiencies were inadequate or no supervisory/compliance procedures, supervision over personal trades, and remote location supervision
  • Common advertising deficiencies included issues involving Web site, correspondence, business cards, and the misuse of “RIA” (registered investment adviser)

The most common deficiencies for hedge fund advisers were valuations of holdings, cross-trading, side letter and preferential treatment issues, securities registration exemptions for fund offerings, and failure to disclose conflicts of interest in fund offering documents. For all types of investment advisers, the most common areas of compliance issues centered on privacy, fee computations, and solicitors.

In order to help investment advisers registered or to be registered with state securities agencies to develop compliance policies and procedures, NASAA has provided the following “best practices”:

  • Review and revise Form ADV and disclosure brochure annually to reflect current and accurate information
  • Review and update all contracts
  • Prepare and maintain all required records, including financial records
  • Back up electronic data and protect records
  • Document all forwarded checks
  • Prepare and maintain client profiles
  • Prepare a written compliance and supervisory procedures manual relevant to the type of business to include business continuity plan
  • Prepare and distribute a privacy policy initially and annually
  • Keep accurate financials, and file them timely with the jurisdiction
  • Maintain surety bond, if required
  • Calculate and document fees correctly in accordance with contracts and Form ADV
  • Review all advertisements, including Web site and performance advertising, for accuracy
  • Implement appropriate custody safeguards, if applicable
  • Review solicitor agreements, disclosure, and delivery procedures

Enforcement Matters

State Securities Regulators Report on Enforcement Actions

Enforcement actions by state securities regulators in 2010 represented a 51-percent increase over the actions during the prior year period. According to a recent report by NASAA, state securities regulators conducted 7,063 investigations in 2010, which lead to 3,475 enforcement actions (up from 2,294 enforcement actions in 2009). Enforcement actions by state securities regulators can take the form of criminal, administrative, and civil, or a combination of all three.

According to the NASAA report, which was based on a NASAA survey conducted in early 2011 of some 45 state securities administrators who responded to the survey, the state enforcement actions resulted in the ordering of the return of $14.1 billion to investors. Of that amount, reportedly more than $12 billion was actually returned to investors. That amount was unusually high due to the spike in auction rate securities (ARS) enforcement actions in 2010.

During 2010, approximately 3,242 state broker-dealer, investment adviser, and agent registrations were denied, suspended, withdrawn, or issued conditional as a result of state enforcement actions. The states levied fines or penalties of $171 million and prison time resulting from state actions totaled 1,134 years.

According to NASAA, the majority of the enforcement cases involved the selling of unregistered and non exempt securities by unregistered and non exempt persons. The sale of Rule 506 Regulation D and real estate securities offerings were the most troublesome area of the securities products involved in the enforcement actions.

Adviser Sanctioned for Filing False Information on Form ADV and Failing to Disclose to Clients Its Precarious Financial Condition

LPB Capital d/b/a Family Office Group, LLC and Gary G. Pappas were the subject of a recent cease and desist order issued by the SEC. The adviser located in North Carolina, has been registered with the SEC since 2008.

The SEC, in its complaint, alleges that LPB Capital filed false information within its Form ADV with the SEC in connection with the amount of its assets under management. In order to “qualify” to register with the SEC, an investment adviser must have at least $25 million of assets under management. Apparently, in order to maintain its registration with the SEC and avoid investment adviser registration with its home state of North Carolina, LPB Capital indicated on Form ADV as filed with the SEC that it qualified to be registered with the SEC, citing assets under management in excess of $25 million when LPB Capital and Mr. Pappas knew that its assets under management at no time reached that amount. Such alleged false reporting to the SEC is a violation of Section 204 and Rule 204-2(e)(8) under the Advisers Act. In addition, for the fiscal year ended December 2009, LPB Capital had insufficient funds to cover its operating costs. However, LPB Capital failed to disclose it precarious financial condition to clients as required under Section 206(4) of the Advisers Act.

Mr. Pappas is cited in the SEC’s request for the cease and desist order as being responsible for filing the false information to the SEC. The staff of the SEC alleges in its complaint that the cease and desist order should be issued based upon the seriousness and number of violations alleged to have occurred.

Legal News is part of our ongoing commitment to providing legal insight to our clients and colleagues. If you have any questions about or would like to discuss these topics further, please contact your Foley attorney or any of the following individuals:

Terry D. Nelson
Madison, Wisconsin

Peter D. Fetzer
Milwaukee, Wisconsin

A. Michael Primo
Boston, Massachusetts