A Compilation of Enforcement and Non-Enforcement Actions

28 December 2012 Publication
Author(s): Terry D. Nelson Peter D. Fetzer

Legal News: Investment Management Update

Non-Enforcement Matters 

  • New SEC Registrants Under Dodd-Frank to Be Focus of SEC Examination Program 
  • FINRA Rule 5123 Revisited

Enforcement Matters 

  • SEC Accuses Hedge Fund Manager of “Cherry Picking” at the Expense of Clients’ Interests 
  • SEC Charges Funds’ Board of Directors Individually for Failure to Fulfill Their Fair Pricing Obligations to Fund Investors

Non-Enforcement Matters

New SEC Registrants Under Dodd-Frank to Be Focus of SEC Examination Program

Carlo V. di Florio, Director of the SEC’s Office of Compliance Inspections and Examinations (OCIE) recently announced the staff’s intention to examine, during the next two years, about 25 percent of the investment advisers required to register with the SEC subsequent to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank). This group of approximately 1,500 registrants primarily consists of investment advisers to hedge funds and private equity companies. Prior to the enactment of Dodd-Frank, such advisers were able to avoid SEC registration by reliance upon the 15-client, non-public adviser exemption under the Investment Advisers Act of 1940. That exemption from investment adviser registration was eliminated by the Dodd-Frank legislation.

The SEC announced the targeted examination program to such registered investment advisers by letter in October. The letter reportedly stated that the examinations will primarily focus on valuation, marketing, portfolio management, conflicts of interest, and asset verification. According to the SEC, initial OCIE examinations of hedge fund and private equity company advisers revealed significant concerns with respect to overstated management fees, improperly computed asset valuations, and conflicts of interests which were not properly disclosed to fund investors. Generally, the deficiencies noted within examinations of newly registered advisers consist of inadequate books and records and ineffective or non-existent supervisory controls.

Another purpose of this directed examination program according to the Director is to educate this class of investment advisers on what is expected of them as registrants under the Advisers Act.

Newly registered advisers subject to their first SEC examination are encouraged to fully cooperate and provide accurate and complete information requested by the OCIE. Such cooperation and the providing of accurate and complete information will help in maintaining a working relationship with the OCIE and possibly avoid enforcement action by the SEC against the registrant that can result when there is a lack of cooperation or failure to provide truthful responses.

According to the OCIE, the staff’s capabilities in examining this class of adviser registrants has been greatly assisted by the recent hiring of examiners from the private sector who have experience as hedge fund managers or as other specialists in the hedge fund industry. As the history of certain notorious hedge fund managers such as Bernie Madoff has proven, the OCIE’s examination program is only as good as its examiners. Having examiners who have been active in the operations of hedge fund managers should provide the OCIE with the ability to examine advisers of hedge fund and private equity companies in a more competent and efficient basis.

FINRA Rule 5123 Revisited

In our last edition of the Investment Management Update, we informed our readers that the SEC has approved Financial Industry Regulatory Authority, Inc.’s (FINRA) new Rule 5123. As we noted in that article, effective December 3, 2012, FINRA member firms that begin selling efforts related to private placement offerings are required to file the offering documents with FINRA or otherwise file a notice that no such documents were used. Recently, FINRA issued additional guidance regarding Rule 5123 in the form of frequently asked questions, discussed below.

Exemptions From Filing. FINRA addressed when offerings or sales were exempt from the filing requirements of Rule 5123. Specifically, sales of private placements sold solely to institutional accounts or solely to accredited investors that are not natural persons are exempt from the filing requirements. On the other hand, private placements that are sold to accredited investors who are natural persons are not exempt from the Rule’s filing requirements.

When Filing Requirements Begin. FINRA made clear that a member firm’s obligation to file offering documents begins on the first date of a sale of securities in the private placement. The member firm then has 15 days from the date of such sale to file the offering documents. Further, any document that sets forth the terms of the private placement, including a private placement memorandum, term sheet, or other document, must be filed. In addition, if there are any material changes to these documents, the member firm must file amended documents with FINRA.

Who Must File. In some cases, multiple firms may be required to file the offering documents for a private placement. Even if the firms have agreed that one party will be responsible for filing the requisite documents, each firm that is required to file such documents must confirm that the offering documents have been filed. Otherwise, the failure of the designated firm to file such documents will result in each of the firms being in violation of Rule 5123. Further, if a member firm is paid a fee for introducing a prospective investor to an issuer under a private placement, that member firm may have to file the offering documents with FINRA.

Finally, a member firm is entitled to engage legal counsel to assist with the review and filing of documents, and can even have legal counsel submit the documents on its behalf.

Enforcement Matters

SEC Accuses Hedge Fund Manager of “Cherry Picking” at the Expense of Clients’ Interests

The SEC recently accused a California-based hedge fund manager and his investment advisory firm of assigning profitable trades with its proprietary and other favored accounts and assigning losing trades with client accounts. This is a practice commonly known as “cherry picking.”

Peter J. Eichler, Jr., the CEO of Aletheia Research and Management, Inc. which is currently in bankruptcy under Chapter 11, is charged with allocating losing trades to two hedge funds managed by the investment advisory firm. According to the SEC, the transactions occurred over a two-year period ending in November 2011 and caused the two funds to lose $4.4 million. At that same time, the firm allocated winning trades to personal and favored accounts, resulting in $4.1 million in profits for such accounts. As an investment adviser, Mr. Eichler and his firm had a fiduciary obligation to treat all of the firm’s clients fairly. Instead, according to the SEC, Mr. Eichler and his firm treated certain clients, including proprietary accounts, favorably over the interests of the other client accounts.

In addition, according to the SEC, the firm failed to forewarn clients, as required under the Investment Advisers Act of 1940, of the firm’s precarious financial condition until just before filing for bankruptcy.

According to the SEC, the firm had knowledge of its precarious financial condition months before it advised clients of the situation.

The “cherry picking” transactions and the failure to timely alert clients about the firm’s dire financial situation are, according to the SEC, violations of the anti-fraud provisions under the Advisers Act and a breach of the firm’s fiduciary responsibilities to its clients.

The SEC is seeking permanent injunctions and disgorgement from Mr. Eichler and his firm.

SEC Charges Funds’ Board of Directors Individually for Failure to Fulfill Their Fair Pricing Obligations to Fund Investors

Persons who serve as directors of mutual funds are reminded of their obligations to the funds and the funds’ shareholders by a recent SEC enforcement filing against several individual fund directors whose allegedly ineffective governance activities caused violations under the Investment Company Act of 1940. The funds involved were RMK High Income Fund, RMK Multi-Sector High Income Fund, RMK Strategic Income Fund, RMK Advantage Income Fund, and Morgan Keegan Select Fund.

According to the SEC’s complaint filed recently against eight former members of the board of directors of five registered mutual funds based in Memphis, Tennessee, the directors delegated their responsibility to a valuation committee for determining the fair value of securities held by the funds which were not marketable. In each of these funds, a majority of the assets consisted of securities with no public market, making the determination of the fair value of such securities imperative if the funds’ net asset value was going to be a meaningful number in determining the value of the shares on an ongoing basis. According to the SEC’s complaint, the failure of the directors to adopt and implement appropriate fair valuation methodologies and procedures and having ineffective controls over financial reporting resulted in the funds’ violations of certain requirements under the Investment Company Act of 1940.

According to the SEC’s complaint, the funds’ net asset values were materially misstated for about a five-month period in 2007 due to the directors’ inaction and/or ineffective action. As a result, the prices for purchases and redemptions of the funds’ shares during the period were inaccurate.

The charges in this matter demonstrate the SEC’s concern with fair pricing methods employed for both publicly registered and private funds. Those persons who serve as directors of funds need to adopt effective and reasonable policies for determining fair value and then follow-up to ensure that the implemented policies have been administered. In addition, the directors need to review those policies periodically and fine-tune them as warranted, to ensure that the methodology utilized is effective in determining fair value of securities where no public market is present.

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