A Compilation of Enforcement and Non-Enforcement Actions

30 November 2012 Publication
Authors: Terry D. Nelson Peter D. Fetzer

Legal News: Investment Management Update

Non-Enforcement Matters 

  • SEC Approves New FINRA Rule on Private Placement Offerings 
  • Private Fund Advisers Come Into Compliance With Dodd-Frank Requirements

Enforcement Matters 

  • Investment Advisers Subject to Enforcement Actions for Impeding SEC Examinations 
  • Hedge Fund Advisory Firm Among Those Charged With $276 Million Insider Trading Violations

Non-Enforcement Matters

SEC Approves New FINRA Rule on Private Placement Offerings

Effective December 3, 2012, member firms of the Financial Industry Regulatory Authority, Inc. (FINRA) who commence selling efforts in private placement offerings on or after that date are required under new FINRA Rule 5123 to file offering documents in such offerings electronically with FINRA within 15 days of the date of the first sale in the offering, or inform FINRA that it did not use any offering documents in such offering. Also, member firms who sell their own securities in a private offering are required, effective December 3, 2012, to submit a filing about such offerings electronically with FINRA.

The new Rule is intended to compliment FINRA Rule 5122 which established standards on disclosure, use of proceeds, and a filing requirement for private placements where the member firm or a controlled entity of the member firm is the issuer of the securities.

The new Rule is a “leaner” version of the Rule first proposed by FINRA. In response to significant member firm opposition, FINRA dropped from the proposed Rule, the requirement to file prior to the commencement of the offering, and provided a number of exemptions from the filing requirement. The Rule even provides the option that no offering documents were used by the member firm in the offering, but the member firm still has to report to FINRA that no offering documents were used. FINRA expects that only a limited number of private placement offerings sold by member firms will result in reporting that no offering documents were utilized.

The Rule provides exemptions from the filing requirements for offerings to qualified purchasers, institutional purchasers, and other sophisticated investors, all as defined under the Rule. Offerings to individual accredited investors are not exempted from the Rule’s filing requirements.

The Rule is intended, in part, to keep FINRA informed as to the involvement of member firms in private placement offerings. Information filed in compliance with the Rule is afforded confidential treatment by FINRA.

Private Fund Advisers Come Into Compliance With Dodd-Frank Requirements

Recent changes to the Investment Advisers Act of 1940 codified in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) have resulted in significant changes in the mix of investment advisers registered with the SEC. Dodd-Frank eliminated the “15 client” exemption while adding in other narrower exemptions. Because of Dodd-Frank, the SEC also has added new reporting requirements for private advisers who are still exempt from registration.

As a result of Dodd-Frank, new SEC registrations of private fund investment advisers has risen sharply with 1,504 such new registrations since the enactment of Dodd-Frank. Of the 11,002 investment advisers now registered with the SEC, there are a total of 4,061 advisers who characterize themselves as advisers to private funds.

Private Fund Adviser Exemption. Before Dodd-Frank, private advisers were not subject to SEC registration so long as the adviser did not represent itself to the public as an investment adviser and had no more than 15 clients (each private fund counted as one client within the preceding 12-month period). The Private Fund Adviser Exemption is available if the adviser provides advice exclusively to so-called “private funds” and has less than $150 million in assets under management (AUM). An adviser managing between $25 million and $150 million in AUM is now required to register with the applicable state agency. Additionally, the SEC considers these advisers “exempt reporting advisers” that must file an annual report with the SEC on Form ADV. They also are subject to SEC examination but generally are not subject to provisions applicable to registered investment advisers.

In addition to the Private Fund Adviser Exemption, Dodd-Frank also created several other narrower exemptions. Two of the more prominent of these are the Foreign Private Adviser Exemption and the Venture Capital Adviser Exemption.

Foreign Private Adviser Exemption. A foreign adviser is exempt from state or SEC registration if the adviser: 1) has no place of business in the United States; 2) has, in total, fewer than 15 clients which number includes investors in the United States in private funds advised by the adviser; 3) has assets under management attributable to these clients and investors of less than $25 million; and 4) is not holding itself as an investment adviser to the public in the United States.

Venture Capital Adviser Exemption. This exemption is available to advisers that solely manage one or more venture capital funds. A venture capital fund is a private fund that: a) pursues a venture capital strategy; b) does not afford investors with redemption rights; c) holds at least 80 percent of its investment in cash, short-term holdings, and equity securities in private companies, and does not borrow against the investment to make fund distributions; and d) does not incur leverage in connection with more than 15 percent of the fund’s assets. Like the Private Fund Adviser Exemption, an adviser relying upon the Venture Capital Adviser Exemption must file an annual report on Form ADV with the SEC and is subject to SEC examination.

In addition to the jump in newly registered private advisers, the total assets under management of SEC-registered advisers has risen about 13 percent to $5.7 trillion. However, this increase in the AUM of registered advisers has likely occurred because of changes in the way AUM is measured under rules promulgated to implement Dodd-Frank in addition to the new registration requirements.

Before Dodd-Frank, investment advisers calculated their assets on a net basis. New SEC rules issued in conjunction with Dodd-Frank require that investment advisers calculate their AUM on a “gross” basis, rather than a net basis. As a result, advisers must calculate the fair value of their assets under Generally Accepted Accounting Principles without taking into account liabilities. Thus, it is likely that the increase in assets under management of SEC registered advisers partially resulted from this new valuation method for reporting purposes.

The foregoing changes are some of the more prominent changes instituted because of Dodd-Frank and its implementing regulations. Because of these changes private advisers must use the utmost diligence to ensure that they comply with SEC requirements, whether registered or properly exempted from the registration requirements.

Enforcement Matters

Investment Advisers Subject to Enforcement Actions for Impeding SEC Examinations

Two registered investment advisers were recently sanctioned by the SEC for impeding regulatory examinations. Evens Barthelemy and his firm, Barthelemy Group LLC located in New York, apparently misled SEC examiners about the adviser’s qualifications to be SEC registered. In a separate matter, Seth R. Freeman and his firm, EM Capital located near San Francisco, apparently impeded an SEC investigation by failing to produce books and records requested by the SEC over an 18-month period. Both firms have agreed to settle the SEC charges without contesting the staff’s allegations.

The enforcement actions in these matters demonstrates the SEC’s resolve to punish those advisers who materially impede their investigations. Advisers who are state-registered are reminded that they could be subject to similar enforcement actions by state securities administrators for materially impeding state examinations and investigations.

In the case of Mr. Barthelemy, the SEC asked the adviser for a list of client AUM to determine if the adviser’s reported AUM on its Form ADV was accurate. According to the SEC’s complaint, Mr. Barthelemy responded to the SEC’s request by fabricating the amount of its AUM to help support the statement that its AUM was sufficient to be registered with the SEC. At the time, an adviser must have at least $25 million of AUM to be registered with the SEC (which amount is now $100 million). Based on Mr. Barthelemy’s actions, the firm actually reported to the SEC AUM 10 times higher than what was actually the case. In order to resolve the SEC’s enforcement matter, Mr. Barthelemy agreed to be barred from the securities industry and from associating with an investment adviser. Mr. Barthelemy has the right to reapply after a two-year period. His firm was also censured, consented to a cease and desist order, and is required to, among other things, provide its clients with a copy of the proceeding and post it on the firm’s Web site.

As to Mr. Freeman and his firm, the SEC complaint alleged that Mr. Freeman’s firm failed to provide the SEC with requested books and records for a period of almost 18 months since the date of the SEC’s request. The records requested by the SEC consisted of financial statements, emails, and documents relating to the adviser’s management of a mutual fund client. The adviser did not comply with the records request until well after the SEC instituted enforcement action for the delay in responding. In order to resolve the SEC’s enforcement matter, Mr. Freeman and to his firm agreed to pay a combined penalty of $20,000 and to the issuance of a cease and desist order.

Hedge Fund Advisory Firm Among Those Charged With $276 Million Insider Trading Violations

This SEC enforcement matter serves to further demonstrate both the SEC’s resolve to more closely track the activities of hedge fund advisers and their employees and the adviser’s administrative liability when its employees trade on material non-public insider information.

CR Intrinsic Investors LLC, a Connecticut-based hedge fund adviser, was recently charged by the SEC, along with its former portfolio manager and a medical consultant for an expert networking firm, for their activities in connection with a $276 million insider trading scheme. The amount of alleged illegal gains in this matter makes it the largest insider trading case brought to date by the SEC.

The adviser’s portfolio manager was charged with using material non-public insider information obtained from the medical consultant involved in a clinical trial for an Alzheimer’s drug being developed by certain pharmaceutical companies. The consultant tipped the adviser’s portfolio manager with details about negative clinical results about the drug weeks before the news was made public in July 2008. Based on the non-public material information, the portfolio manager caused several hedge funds he managed to sell more than $960 million in securities of the affected pharmaceutical companies during a one-week period. After the news of the disappointing clinical trials was made public, shares of the companies declined by double digits. The hedge funds had liquidated their positions in the stocks before the news was made public of more than $700 million and went on to short the stocks resulting in $82 million in profits and the avoidance of more than $194 million in losses, resulting in $276 million in alleged illegal gains. Based primarily on the gains from the alleged illegal trades, the portfolio manager received a year-end bonus from the adviser at the end of 2008 of $9.3 million and the medical consultant was paid more than $100,000 by the advisers of the affected hedge funds.

The SEC’s complaint charges each of the defendants with violations of the “anti-fraud” provisions under the federal securities laws, and seeks a final judgment from the court ordering the defendants to disgorge the ill-gotten gains plus interest, pay financial penalties, and personally enjoining them from future violations of the anti-fraud provisions.

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

Michael G. Dana
Miami, Florida