A Compilation of Enforcement and Non-Enforcement Actions

27 September 2012 Publication
Authors: Terry D. Nelson Peter D. Fetzer

Legal News: Investment Management Update

Non-Enforcement Matters 

  • Lack of SEC Guidance With Revised Rule 506 Could Make the Rule Unusable 
  • State Securities Administrators List Top Broker-Dealer Compliance Problem Areas 
  • Hedge Fund Advisers and SEC Exams

Enforcement Matters 

  • SEC Initiates Enforcement Action Against Radio Host for Providing Misleading Information 
  • Enforcement Action Highlights the Need for Disclosure Regarding Conflicts of Interest 
  • Partner of Investment Adviser Sanctioned for Engaging in Conflict of Interest

Non-Enforcement Matters

Lack of SEC Guidance With Revised Rule 506 Could Make the Rule Unusable

As we have reported previously, on August 29, 2012, the SEC issued proposed revisions to Rule 506 under Regulation D of the Securities Act of 1933 (Rule) to accommodate the provisions under Title II of the Jumpstart Our Business Startups Act (JOBS Act). This legislation authorizes issuers to conduct general solicitation and advertising during a non-registered offering that will be sold exclusively to accredited investors.

In its proposal, the SEC failed to lay out how an issuer could comply with the Rule’s requirement to “take reasonable steps to verify” that each investor meets the accredited investor status at the time of purchase. According to some critics, the SEC’s failure to provide guidance or map out a “safe harbor” for the verification process will create uncertainty in the minds of issuers and regulators as to whether the verification process employed by the issuer was sufficient to meet the requirements of the revised Rule. Failure to comply with the verification requirement would likely result in the issuer violating the securities registration requirements under the Securities Act of 1933 and applicable state securities laws. Such failure would provide investors with a rescission right (i.e., require the issuer to buy back their securities at full purchase price plus interest from date of purchase at any time up to the applicable statute of limitations period) and provide securities regulators with a cause to bring enforcement action against the issuer, its principals, and other sellers of the securities.

This uncertainty, which is not expected by most observers to be addressed by the SEC in the final Rule, may cause issuers, who may have otherwise taken advantage of the elimination of the general solicitation and general provision prohibition, to continue under the existing Rule 506 until the ramifications of the verification uncertainty become more clear.

At their annual meeting in San Diego earlier this month, state securities regulators expressed reservations about the lack of SEC guidance within the revised Rule, and indicated they may quiz issuers who utilize general solicitation and general advertising and make a Form D filing with their states, to determine if the verification process utilized by the issuer was adequate. Without clear guidance from the SEC on the verification issue, what will likely result is a judgment call by each state securities regulator — and ultimately the courts — as to compliance with the verification requirement.

The uncertainty in this area also is likely to cause issuers to sell their offerings through registered broker-dealers who should already have policies and procedures in place to ensure that the investor meets the accredited investor standard. However, due to the shortage of registered broker-dealers who conduct private placement offerings, issuers may instead have to rely on advice from their legal counsel on what process should be implemented to protect against future claims that the verification process did not go far enough to meet the requirements under Title II of the JOBS Act. All in all, this uncertainty is not what Congress envisioned when it passed Title II of the JOBS Act.

State Securities Administrators List Top Broker-Dealer Compliance Problem Areas

The North American Securities Administrators Association, Inc. (NASAA) reported the results of a coordinated broker-dealer examination program conducted by state securities agencies over the period of January 1, 2012 through June 30, 2012. During those examinations, 236 examinations were conducted in 24 jurisdictions.

The examinations found 453 types of violations in five compliance areas. Those areas with the greatest frequency of violations were: 

  • Books and records (29 percent) 
  • Supervision (27 percent) 
  • Sales practices (24 percent) 
  • Registration and licensing (14 percent) 
  • Operations (6 percent)

The most common types of violations found were: failure to follow written supervisory policies and procedures, suitability, correspondence/e-mail, maintenance of customer background information and lack of or adequate internal audits.

According to former NASAA president, Jack E. Herstein, the purpose of the coordinated examination program and the release of its results is to provide broker-dealers with essential information in order to improve upon their compliance requirements and ultimately provide improved client services.

Hedge Fund Advisers and SEC Exams

Those SEC-registered investment advisers who provide advice to hedge funds and/or other private funds should expect to be examined by the SEC in the near future. There is no question that the SEC is under pressure from Congress to inspect advisers of private funds to help avoid the regulatory embarrassment and huge investor losses caused by Madoff and others like him as brought to light during the last five years. Accordingly, advisers to private funds (i.e., generally, funds not registered as an investment company under the Investment Company Act of 1940) should prepare for a visit from the staff of the SEC’s Office of Compliance Inspections and Examinations (OCIE) to conduct an examination of the books and records and trading practices of the fund and its adviser.

In a recent announcement by the OCIE, its staff is likely to conduct such exams with a somewhat narrow focus and be “risk-based.” The exam is likely to focus on the following areas: 

  • Marketing and advertising. The staff will examine the consistency between what the fund’s advisers convey to clients and what is actually done by the adviser. The staff is likely to review the private placement memorandum (PPM) and other offering materials to determine if the adviser is actually operating and managing the funds per the terms within the PPM, management agreement, investor side letters, and fund organizational documents. 
  • Fund trading and investments. The staff will focus on trade allocation to determine if investment opportunities are being fairly allocated among funds and other clients, and as disclosed to clients. 
  • Conflicts of interest. The staff will focus on sources of revenue for advisers, payments to finders, employees' outside business activities, and to determine if all material conflicts are disclosed to clients. 
  • Safety of client assets. The staff will focus on custody of assets and to determine if the adviser and fund have adequate policies and safeguards in place to protect fund and other client assets.

According to the OCIE, the exams are not intended to be a “top-to-bottom” exam as those exams take a considerable amount of time and expertise on behalf of the staff. Such exams will probably be put on the back burner for now unless the staff senses during the conduct of the focused exam that more time and scrutiny is warranted for a particular adviser.

Because the exam may be the first regulatory examination experienced by some of the private fund advisers, the OCIE staff will apparently use the opportunity to help educate the newly registered adviser as well as to note deficiencies.

Enforcement Matters

SEC Initiates Enforcement Action Against Radio Host for Providing Misleading Information

Raymond J. Lucia, a registered investment adviser and nationally syndicated radio personality, is the subject of formal charges made by the SEC on September 5, 2012 (see In the Matter of Raymond J. Lucia Cos., Inc., et al., admin. Proceeding no. 3-15006) for providing misleading information to his radio audience about his “Buckets of Money” strategy. Mr. Lucia, through his company, conducts investment seminars over the radio and in person across the country.

The SEC, in initiating a cease and desist proceeding against Mr. Lucia, maintains that he falsely stated during his radio program that his “Buckets of Money” strategy was extensively tested on historical data or “back-tested.” The term “back-tested” generally refers to a process involving the application of a strategy to historical data in order to calculate how the strategy would have performed had it been applied in a prior time period. According to the SEC, Mr. Lucia only conducted minimal testing and used an inaccurate hypothetical inflation rate, along with other flawed data during the back-tests. Mr. Lucia’s failure to disclose to prospective clients the fact that only minimal testing was conducted and applied flawed data is, according to the SEC, omissions of a material fact and violations of the “anti-fraud” provisions under the Investment Advisers Act of 1940. The SEC further maintains that Mr. Lucia failed to maintain records to support the performance representations being made during his client presentations, which is a violation of the recordkeeping requirements under the Advisers Act.

Apparently, Mr. Lucia admitted to the SEC that he performed only limited testing in the late 1990s to derive at the back-tested performance numbers and no longer had a record of the calculations. In addition, Mr. Lucia allegedly failed to use an inflation rate accurate to the time tested and failed to disclose the negative effect that the deduction of advisory fees would have in the back-tests.

In addition to a cease and desist order, the SEC is seeking financial penalties and other remedial action against Mr. Lucia and his investment advisory firms. In the meantime, Mr. Lucia’s counsel has stated that the SEC’s complaint contains no allegations of any investors losing money due to the alleged omissions and misstatements.

Enforcement Action Highlights the Need for Disclosure Regarding Conflicts of Interest

A recent SEC enforcement action against a registered investment adviser demonstrates the need for registrants to disclose to its clients in writing any and all conflicts of interest. In In re Focus Point Solutions, Inc., SEC Admin. Proc. File No. 3-15011, 9/6/1012, the SEC charged that the registered investment adviser failed to disclose to clients that the firm was receiving a percentage of revenues form a broker-dealer that managed mutual funds the adviser recommended for purchase by its clients. In addition, the SEC charged the investment adviser for the failure to inform clients of its conflict of interest before it voted on behalf of clients to add itself as a sub-adviser to a certain mutual fund.

This matter demonstrates the SEC’s recent focus to review and uncover undisclosed revenue-sharing arrangements between registered investment advisers and broker-dealers.
In order to settle the matter, the adviser agreed to return over $1 million in ill-gotten gains and pay penalties of $150,000.

Partner of Investment Adviser Sanctioned for Engaging in Conflict of Interest

In a recent action (In the Matter of Matthew Crisp, Investment Adviser Act Release No. 3451), a partner of a SEC-registered investment adviser based in Chicago, Illinois, was barred from association and from serving as an officer or director of an investment adviser for taking advantage of a conflict of interest for his own personal gain.

According to the SEC, Matthew Crisp, while working as a partner of Adams Street Partners, LLC, secretly formed a private partnership to take advantage of a particular investment that the investment advisory firm would have placed with one or more private fund clients managed by the investment advisory firm. The SEC further alleges that Mr. Crisp not only garnered the investment opportunity for his own private fund over the interests of the adviser’s other clients but also concealed the fact from the other clients and to the other partners in Adams Street Partners. In addition, the SEC asserts that Mr. Crisp enriched himself with a payment of $150,000 during a transaction involving his private partnership, although the payment should have gone to Adams Street Partners. In total, the SEC charges that Mr. Crisp personally benefited by more than $2 million from his conduct, all at the expense of the registered investment adviser’s private fund clients and the adviser itself.

After Adams Street discovered Mr. Crisp’s misconduct, he was terminated. Adams Street then self-reported the matter to the SEC. Mr. Crisp has since paid Adams Street approximately $2.3 million, roughly equaling the amount he was enriched by his exploitation of his firm’s partners and other clients. The conduct by Mr. Crisp, according to the SEC, violated the “anti-fraud” provisions under Section 206 of the Investment Advisers Act of 1940, Section 206(4)-8, which makes it unlawful to act fraudulently with respect to investors of private funds, and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder.

Mr. Crisp agreed to a bar from association with any broker, dealer, investment adviser, managed securities dealer, or adviser, and acting as an employee, officer, director, or member of an advisory board of an investment company or affiliated person of an investment adviser. Mr. Crisp has the right to apply for reentry into the industry after one year with the applicable self-regulatory organization or, if none, to the SEC. He also agreed to pay further disgorgement to Adams Street for distribution by Adams Street to certain of the private funds it manages.

Interestingly, Adams Street was not sanctioned either because the SEC found no wrongdoing on the part of Adams Street and/or that Adams Street self-reported the matter to the SEC. 


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
608.258.4215
tnelson@foley.com

Peter D. Fetzer
Milwaukee, Wisconsin
414.297.5596
pfetzer@foley.com

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