A Compilation of Enforcement and Non-Enforcement Actions

29 August 2013 Publication
Author(s): Terry D. Nelson Peter D. Fetzer

Legal News: Investment Management Update

Non-Enforcement Matters 

  • Private Fund Issuers’ Use of New SEC Rule 506(c) Hardly a “Slam Dunk”
  • Advisers Need to Revisit Their Business Continuity Plans  

Enforcement Matters 

  • Registered Adviser Sanctioned for Failure to Supervise Associated Person 
  • Adviser Subject to Enforcement Action for Misleading Fund’s Board 

Non-Enforcement Matters

Private Fund Issuers’ Use of New SEC Rule 506(c) Hardly a “Slam Dunk”

On July 10, 2013, the SEC lifted the prohibitions on general solicitation and advertising for a Rule 506 offering under Regulation D of the Securities Act of 1933 provided the issuer takes reasonable actions to verify that each of the purchasers in the offering are accredited investors as defined under Regulation D. A natural person is an accredited investor if, at the time of the purchase, he or she has a net worth, (exclusive of the value of the person’s principal residence) in excess of $1,000,000 or an annual income in each of the last two years, and reasonable expectation of having at least the same income for the current year, in excess of $200,000. The net worth calculation may include the assets of the person’s spouse and the net income calculation can also include the spouse’s annual income, provided that the joint annual income is in excess of $300,000 for all the relevant periods. The SEC was mandated by Congress under the JOBS Act of 2012 to lift the general solicitation and advertising prohibitions by regulation. New Rule 506(c) under Regulation D is in response to the congressional mandate and is effective on September 23, 2013.

The SEC’s recent action, long anticipated by issuers and securities counsel alike, may or may not be helpful to private fund issuers in attracting capital from investors. Private fund issuers are generally those issuers of an investment pool that is not registered under the Investment Company Act of 1940 because it relies upon an exclusion from the definition of an “investment company” under such Act. The immediate reaction by most observers to the issuance of new Rule 506(c) is that every issuer who does not have a ready targeted investment audience would want to utilize the new Rule and commence using general solicitation and advertising to attract potential investors as of the Rule’s effective date. But, the potential benefits of utilizing the new Rule must be weighed by the issuer against the additional risks that accompany the use of the Rule. One of those risks is that the issuer must take reasonable steps (or have a third party conduct such verifications that are deemed reasonable) to verify that each purchaser is an accredited investor. Sounds simple, but that verification process may prove to be problematic as many prospective investors may not want to divulge personal information necessary for the issuer or designated third party to fulfill the verification process.

The SEC provided the following examples within the Rule of a reasonable verification process that may be used: 

  • Review of two years of the prospective investor’s tax returns as filed with the IRS (all information other than annual income may be redacted) with a written statement from such investor of having a reasonable expectation of meeting the required income level for the current year 
  • Review of statements from a third party identifying the prospective investor’s assets and liabilities, which must be dated within 90 days, including a credit report from a national agency with a written statement from such investor that all liabilities have been disclosed 
  • Receipt of a written confirmation from a SEC-registered broker-dealer or investment adviser, a licensed attorney, or certified public accountant that after taking reasonable steps, has verified that, within the past 90 days, the prospective investor is accredited 
  • For an existing investor of the issuer who qualified as an accredited investor prior to the effective date of the new Rule 506(c), a written statement from the investor that the investor continues to qualify as an accredited investor

The main consideration for the issuer is to determine whether potential investors will provide the personal financial information sufficient to complete the verification process. Some investors are likely to shy away from an offering that is relying upon Rule 506(c) due to the requirement that his or her personal financial information will need to be provided to a person that the investor may not be familiar with. Some investors may provide the requested information if they are convinced that it will be safe-guarded and not shared with non-related persons. The issuer will need to provide prospective investors a pledge to protect the privacy of such information and be sure that it has a system in place to ensure that such a pledge will be fulfilled. Others may not invest in such offerings, instead relying on offerings under current Rule 506(b) which prohibits the use of general solicitation and advertising, but also allows investors, without more, to “self-certify” their accredited investor status by checking a box as to their required net worth or annual income.

Issuers will have to determine before deciding whether to use the new Rule, whether its targeted audience will generally be expected to provide the personal information required for verification. Issuers may also choose to use third parties such as accountants, lawyers, registered investment advisers, and broker-dealers to be the party who conducts the verification process and certifies to the issuer that it utilized a reasonable process for conducting the verification. Investors may have more comfort providing their personal financial information to such third parties with whom they probably already have an existing relationship and may have provided much of the financial information necessary for the third party to conduct the required verification. Regardless of the verification process utilized by the issuer, once the issuer goes down the Rule 506(c) route by utilizing general solicitation or advertising, there is no looking back. The issuer will not be able to “fall back” on the statutory exemption under Section 4(2) of the Securities Act of 1933 or transform a Rule 506(c) offering into a Rule 506(b) offering.

Another consideration for private funds that invest in commodity futures, and rely on an exemption from commodity pool registration under the Commodity Exchange Act, is that such exemption is only available for a non-public offering by a commodity pool. Accordingly, unless, and until, the Commodity Futures Trading Commission provides a ruling that the commodity pool registration exemption is available for a Rule 506(c) offering, such issuer should not use the 506(c) exemption.

Private fund issuers oftentimes “self-distribute” the fund’s interests without the assistance of a placement agent. Such issuers, unless they believe their targeted investor audience will readily give up their personal financial information, may instead need to engage a placement agent to perform the verification process. Such engagement will, of course, add to the offering expense of anywhere from six to eight percent of the offering proceeds. Investors may balk at an offering where the placement agent fees are absorbed by the fund (i.e., pro rata by its investors). The managers of such funds may instead elect to cover such expenses.

Some critics of the SEC’s Rule 506(c) point to the examples of suggested verification process within the Rule (which are neither mandatory nor exclusive), to be unnecessarily intrusive for investors. They say that they will serve to dissuade issuers from utilizing general solicitation and advertising and thereby defeat the intent of Congress in including the new exemption under the JOBS Act.

Finally, the SEC’s proposed regulations for Rule 506(c), currently out for public comment, go even further (if implemented in their proposed form) by requiring issuers to file Form D with the SEC at least 15 days prior to the commencement of any general solicitation or advertising, provide certain legends and disclosures within the offering documents, require private fund issuers to conform to certain Investment Company Act performance requirements, and submit all general solicitation and advertising materials to the SEC. These requirements will further dissuade some issuers from utilizing the new Rule. It is possible that the SEC will ease some of these requirements under the proposed regulations after they receive public comments. Indeed, comments by a majority of Commission members at the SEC’s hearing on July 10, with respect to the proposed regulations, would appear to signal at least some pushback by the Commission members to the proposed rules.

Advisers Need to Revisit Their Business Continuity Plans

On August 27, 2013, the SEC and CFTC jointly issued a “Risk Alert” regarding their review of investment advisers’ business continuity plans (BCP). As the reader may recall, in 2012 Hurricane Sandy caused severe disruptions in business throughout the country because of its direct hit to the northeast region of the United States. In the wake of this natural disaster, the agencies sought information from advisers regarding their BCPs in order to assess investment advisers’ general approach to natural disasters and other occurrences that could affect an adviser’s ability to continue operations.

Among other practices, the agencies commended advisers to include the following practices and procedures:

  • Adopting and maintaining written BCP 
  • Distribution of the BCP throughout the organization, including requiring employees to certify receipt thereof 
  • Identification of contingency scenarios that would disrupt the adviser’s business and developing solutions ahead of time to mitigate the impact of such scenarios 
  • Testing of BCP and requiring vendors to do the same 
  • Switching to alternative locations or back-up sites in event of widespread business disruption, including sites on a separate power grid from the adviser’s principal location

In addition, the agencies further noted that some advisers had the following weaknesses in their BCP: 

  • Failure to address and anticipate widespread events that could disrupt business 
  • Lack of geographic diversity in office locations or staff 
  • Failure to ensure that vendors had appropriate BCP 
  • Failure to ensure that back-up computer systems, including systems maintained by vendors, functioned properly 
  • Lack of process in contacting and deploying employees if a widespread disruption event occurs

Advisers would be well-advised to review the Risk Alert on this topic and develop a detailed BCP that is tested by the adviser and disseminated among employees. Such BCP should address certain critical areas of the adviser’s operations, including: 

  • Chain of command among employees when a disruption event occurs 
  • Communication channels among employees 
  • Communication channels with clients 
  • Ability of vendors to assist the adviser in continuing to operate during a disruption event 
  • Availability of, and seamless transition to, back-up technology and alternate geographic locations

Enforcement Matters

Registered Adviser Sanctioned for Failure to Supervise Associated Person

The SEC recently announced (Investment Advisers Act 1940 Release No. 3636/July 29, 2013) the issuance of an administrative order instituting certain penalties against Comprehensive Capital Management, Inc., a registered investment adviser based in New Jersey, for failing to supervise the fraudulent activities of associated person, Timothy J. Roth.

While this particular SEC administrative action is newsworthy, the chief lesson that may be taken from this action is the apparent benefit of “self-reporting” the wrongdoing by the adviser to the SEC and other law enforcement officials. Although, the sanctions handed out in this matter against the registrant are significant, one cannot help but wonder what the punishment against the adviser would have been absent the “self-report.”

This SEC action against the investment adviser arose out of Mr. Roth’s activities during an astonishingly long eight-year period that included misappropriation of more than $16 million from client accounts managed by the adviser. According to the SEC’s complaint, Mr. Roth transferred client assets held at a custodian broker-dealer to a nominee account he controlled. Mr. Roth then used those assets to provide capital for certain companies he owned or controlled and to trade in securities for his own account. Mr. Roth apparently accomplished the transfer of clients’ assets to his own nominee account by falsifying client transfer authorization forms and by otherwise abusing the discretionary authority provided to him by such clients.

As well as violating the requirement to reasonably supervise over the activities of its associated persons, the SEC cited the adviser for violations of the custody rule and certain books and records provisions of the Advisers Act, all related to Mr. Roth’s conduct.

The adviser, upon discovering Mr. Roth’s conduct, immediately notified law enforcement officials. Mr. Roth was criminally convicted of mail fraud and money laundering in October 2011 by the U.S. Attorney’s Office for the Central District of Illinois (See SEC v. Timothy J. Roth et al, 11-cv-02079 (C.D. Ill.)

Most, if not all, of the illegal conduct may have been thwarted, or at least detected at an earlier stage, by a more diligent chief compliance officer (CCO) for the adviser. The adviser’s CCO was charged within the adviser’s written policies and procedures to be responsible for developing, implementing, and enforcing all of the adviser’s supervisory and compliance policies and procedures. The adviser’s designated CCO accepted Mr. Roth’s explanations for various questionable practices, rather than probing the explanations, checking with third parties, and conducting an independent review of records. In addition to the CCO’s lack of diligence, Mr. Roth convinced several clients to give him signed blank letters of authorization and wire transfer requests which he then used to transfer client assets from the custody account to his nominee account. The fact that Mr. Roth controlled the nominee account to which client assets were transferred created a custody issue for the adviser. The CCO thought he took care of the custody issue by requiring Mr. Roth to transfer ownership of the nominee account to a person not associated with the adviser. However, the CCO never followed up to ensure that Mr. Roth was not directly or indirectly controlling the nominee account.

In addition to the custody rule violations, the CCO failed to supervise the transfer of assets out of client accounts. The SEC believes that the CCO could have discovered, if such transfers had been reviewed, the illegal transfer, on at least 15 occasions during about a six-year period, of cash from client accounts to Mr. Roth’s controlled nominee account. As part of the CCO’s responsibilities, he was required to review all daily transactions. If the CCO had done his job, Mr. Roth’s conduct could have been detected sooner and client losses would have been greatly reduced.

Finally, the CCO also knew that Mr. Roth communicated with clients using unauthorized email accounts although such email use was prohibited under the adviser’s written compliance policies and procedures. According to the SEC, Mr. Roth’s use of unauthorized email accounts occurred over a three-year period, with the CCO’s knowledge and no supervisory review over such emails. 

In order to resolve the SEC’s administrative action in the matter, the adviser agreed to the following:

  • Retain an independent compliance consultant to conduct a comprehensive review of the adviser’s compliance policies and procedures. 
  • To provide a report to the SEC of the consultant’s findings and to advise the SEC of the action it is taking to respond to each of the consultant’s recommendations. In addition, the consultant is to be engaged by the adviser for an additional two years. 
  • The adviser is subject to an SEC cease and desist order from committing any further violations of the custody rule, failure to supervise, and certain recordkeeping provisions. 
  • Pay a civil penalty of $120,000.

By this observer, it appears, although not stated within the Release, that the SEC gave credit to the adviser for self-reporting Mr. Roth’s conduct to law enforcement authorities. Such reporting may have saved the adviser from being the recipient of a registration suspension or termination.

Adviser Subject to Enforcement Action for Misleading Fund’s Board

In a recent action (Investment Advisers Act of 1940 Release No 3653/August 21, 2013), the SEC instituted cease and desist proceedings against Chariot Advisors, LLC and its sole owner, Elliot Shifman of North Carolina, for allegedly making misrepresentations and omissions of material facts about its proposed investment strategy and capabilities to the board of directors of a fund registered under the Investment Company Act of 1940. The adviser has been registered with the SEC since 2008.

Under Section 15(c) of the Investment Company Act, a registered fund’s board of directors is required annually to evaluate and approve of the fund’s investment adviser and investment advisory agreement and the adviser is required to provide the board with sufficient information to perform that annual evaluation. During that presentation according to the SEC, Mr. Shifman, on behalf of the adviser, misrepresented the adviser’s ability to implement a certain investment strategy proposed for the fund and the nature, extent, and quality of services that could be provided to the fund. Based, in part, upon the adviser’s misrepresentations and omissions of material fact, the board agreed to engage the adviser and retain the services of the adviser annually thereafter. Specifically, the adviser’s proposal was based on its ability to conduct algorithmic currency trading when it had not devised such a strategy or had any capability of engaging in currency trading. The adviser’s misrepresentations and omissions of material fact to the board resulted in the same misrepresentations and omissions in the fund’s registration statement and prospectus as filed with the SEC and provided to prospective investors. That conduct resulted in violations of the Investment Company Act (Sections 15(c) and 34(b)) and of the Investment Advisers Act of 1940 (Sections 206(1) and 206(2), 206(4) and 206(4)-8)).

This recent action by the SEC is also intended to determine what further administrative actions are necessary under the circumstances and to provide the adviser and its owner an opportunity to respond to the staff’s allegations.

This enforcement case is the most recent brought by the staff of the SEC’s Asset Management Unit over alleged violations of Section 15(c) of the Investment Company Act.

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