A Compilation of Enforcement and Non-Enforcement Actions

30 October 2013 Publication
Author(s): Terry D. Nelson Peter D. Fetzer

Legal News: Investment Management Update

Non-Enforcement Matters

  • No Rush to Advertise by Hedge Funds  
  • Updated Guidance From the SEC 
  • Results of Dodd-Frank Legislation on Investment Adviser Registration Numbers

Enforcement Matters

  • Adviser’s Best Execution Failures Result in SEC Enforcement Action 
  • Failure to Correct Compliance Program Deficiencies Results in Enforcement Actions Against Three Investment Advisers

Non-Enforcement Matters

No Rush to Advertise by Hedge Funds

On September 23, 2013, all issuers of securities in the U.S. including hedge and other private funds could, for the first time, use general solicitation and advertising without registering their securities under the Securities Act of 1933 (the “Securities Act”). The Jumpstart Our Business Startups legislation (the JOBS Act) mandated the SEC to provide regulations that allow the use of general solicitation and advertising by an issuer under Rule 506(c) (the “Rule”) under the Securities Act provided the issuer took reasonable measures to verify that each of the investors in the offering was an accredited investor. Accredited investors include natural persons who have a personal net worth (or together with the person’s spouse) in excess of $1 million (not counting the value of the person’s principal residence) or has an annual income in excess of $200,000 over the course of the two previous years with a reasonable expectation of having at least that income over the current year (or $300,000 for the same periods when combined with the person’s spouse). But as predicted by some, most hedge or other private funds have not, to date, taken advantage of the new Rule to advertise their offerings. So, why the hesitation?

The main reason for not utilizing the new Rule by hedge and other private fund issuers appears to be the uncertainty over regulations proposed by the SEC to accompany the new Rule. Generally, the proposed regulations have been widely panned by both prospective issuers and some members of Congress as being heavy handed and contrary to what was intended by Congress by including the new exemption within the JOBS Act. Included in the proposed rules by the SEC are pre-offering filings with the SEC including the solicitation and advertising items to be utilized by such issuers. While some critics to the proposed regulations say they could probably live with the filing requirements, they strongly oppose the notion that a failure to make the filings within a set period of time would result in the loss of the exemption for the issuer. In addition, because it is believed that the filing of the general solicitation and advertising materials will not be reviewed by an already short-handed SEC staff, critics wonder what the point is of the filing requirement. Faced with a large number of comments in opposition to the proposed regulations, the SEC recently extended the period for public comments. The private fund industry is hopeful that the SEC will ultimately pull back and soften some of the proposed regulations with respect to the use of the new Rule before such regulations become law.

Also, adding to the hesitancy of private funds and other issuers to employ the new Rule is the lack of action by the Commodity Futures Trading Commission (CFTC) to adopt regulations that would allow sponsors of private commodity pools to use general solicitation or advertising. The CFTC has shown no signs at this point of “rushing” to implement provisions that would allow private commodity pools or funds that invest in commodities to take advantage of the new Rule.

Finally, some private fund issuers are uncertain about the appropriate verification process to employ so as not to lose the use of the exemption, and whether investors of such funds are going to be receptive to the verification process. Under Rule 506(b) of Regulation D (the old way of conducting a private placement without the use of general solicitation or advertising), investors in such offerings, typically “check a box” or self-certify as being an accredited investor. Under the new Rule, the verification process requires more than a self-certification by the investors. The process employed by the issuer to verify the investor’s status as being accredited is crucial if the issuer is going to avoid the loss of the exemption. Unlike under the old Rule 506(b) which allows up to 35 non-accredited investors, even if the issuer goes over that number, it may still be able to fallback on the statutory exemption under Sec. 4(2) of the Act (an exemption for an issuer conducting a non-public offering). Under the new Rule, there is no allowance for a sale to even one non accredited investor and there is no exemption for the issuer to fallback on if the new Rule exemption is not available after the use of general solicitation or advertising.

Accordingly, for now, it appears that the majority of funds that sell their interests without registering under the Securities Act will continue to rely on the old Rule 506(b) exemption at least until the SEC finalizes regulations that are more user friendly and the CFTC enters the 21st century to accommodate the conduct of securities offerings under the new Rule.

Updated Guidance From the SEC

In October, the SEC issued updated guidance on two issues. The first guidance has to do when an entity that temporarily serves a fund “at cost” or for no compensation is an investment adviser under the Investment Company Act of 1940 (http://www.sec.gov/divisions/investment/guidance/im-guidance-2013-09.pdf). In this release, the SEC stated that no “assignment” of an investment advisory contract with a registered investment company may be at a time when an adviser would provide advisory services to a fund at cost or for no compensation. The SEC added that the providing of services by the adviser under the circumstances would not mean that it would be providing such services without coming under the definition of an “investment adviser.”

In a second recent guidance by the SEC (http://www.sec.gov/divisions/investment/imannouncements/im-info-2013-11.pdf), the Division of Investment Management updated its “frequently asked questions” with respect to SEC Form 13F. That Form is filed by institutional managers with at least $100 million in equity assets to report their securities holdings on a quarterly basis with the SEC. The updated information consists of recent staff interpretations about treatment of confidentiality requests for an ongoing program of acquisition or disposition of securities required to be reported on Form 13F.

Results of Dodd-Frank Legislation on Investment Adviser Registration Numbers

Under the Dodd-Frank legislation in 2011, investment advisers with assets under management between $25 million to $100 million were required to withdraw from SEC registration and to register with the states where they conducted business. At the same time, advisers exclusively to private funds with more than $150 million of assets under management were required to register with the SEC. Most such advisers, prior to Dodd-Frank, were exempt from SEC registration. The deadline for compliance with the Dodd-Frank requirements was June 2012.

Due to Dodd-Frank mandates, the number of registrants as reported by the SEC has stayed about the same for the most recent year (2013), 10,533 advisers as compared to 10,511 in 2012. In 2013, 619 new advisers became registered and 597 de-registered. In 2012 there was a large decrease in the number of SEC registrants due to the 2012 requirement for mid-sized advisers to de-register with the SEC and become registered with one or more states. In the meantime, the number of advisers registered with the states increased to about 17,000 advisers.

The SEC’s report as to assets under management by registered investment advisers is revealing. The overwhelming amount of total assets under management by SEC registered investment advisers (about $54.8 trillion) is managed by a few large advisers. In 2013, less than one percent of the total advisers (about 99 in number) together account for almost 51% of the total amount of assets under management. On the other hand, advisers who manage less than $1 billion in total assets under management of all SEC registered advisers, represent about 73% of all advisers and about 3.7% of all reported assets under management.

Enforcement Matters

Adviser’s Best Execution Failures Result in SEC Enforcement Action

In a recent action, the SEC instituted a cease and desist proceeding against Manarin Investment Counsel, Ltd., an SEC registered investment adviser located in Omaha, Nebraska (the “Adviser”), its affiliated broker-dealer, Manarin Securities Corp. and their founder, owner and President Roland R. Manarin (Investment Advisers Act of 1940 Release No. 3686, October 2, 2013). This enforcement action is based on violations under the Investment Advisers Act of 1940, the Investment Company Act of 1940 and the Securities Exchange Act of 1934 by the respondents in connection with, among other things, failure to ensure best execution of trades for various funds managed by the Adviser.

The SEC’s enforcement action is based on the SEC’s findings that the Adviser breached its fiduciary duties as investment adviser to the funds during the period of 2000-2010 by using the funds to purchase Class A shares of underlying mutual funds although the funds were eligible to purchase lower cost institutional shares of the same mutual funds. The result of this fiduciary failure by the Adviser was that the managed funds paid ongoing 12b-1 fees on their mutual fund holdings which were realized by the Adviser’s affiliated broker-dealer. In addition, the affiliated broker-dealer for a period of at least three years charged its affiliated mutual funds commissions that were in excess of the usual and customary broker’s commissions on transactions effected on a securities exchange.

Section 206 of the Advisers Act imposes on an investment adviser a fiduciary duty to act in the best interest of its clients. That duty includes the investment adviser’s obligation to seek best execution for transactions in client accounts. Best execution generally means seeking the most favorable terms under the circumstances. Because the Adviser in this case, caused the funds to purchase Class A shares rather than the available, institutional class shares, the funds, collectively, paid approximately $3.3 million more in 12b-1 fees during the period of 2000-2010. Those additional and avoidable fees were paid by the funds and passed through to its investors.

In addition, within the Adviser’s disclosure to investors in the funds, it caused disclosure to the effect that the funds would act to ensure best execution in trades for the funds. The Adviser’s Form ADV also disclosed to clients that it would be acting to obtain best execution at all times for its clients. Those material misrepresentations by the Adviser to fund investors, clients and prospective clients are violations of Section 206 under the Advisers Act.

The SEC’s actions to resolve the administrative matter, which were agreed to by the respondents, orders: the respondents to cease and desist from any further violations of the Advisers Act, Investment Company Act of 1940, and Section 17(a) of the Securities Act of 1933; the imposition of a censure on both the adviser and affiliated broker-dealer; such entities to pay collectively $685,006 in disgorgement with prejudgment interest of $267,741; and the Adviser to pay a civil penalty of $100,000.

Failure to Correct Compliance Program Deficiencies Results in Enforcement Actions Against Three Investment Advisers

On October 23, 2013, the SEC announced enforcement action against three registered investment advisers for repeatedly failing to adequately address compliance problems (http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370540008287).

The three firms, Modern Portfolio Management, Inc., Equitas Capital Advisers and Equitas Partners LLC all agreed to settle the SEC’s respective enforcement proceedings by each paying financial penalties and engage compliance consultants to help fix the compliance problems.

The action against the three firms are a result of the SEC’s Compliance Program Initiative which is geared to re-examination of registered advisers who have been previously advised by the SEC that they need to fix compliance programs. Upon re-examination, each of the three firms was found to have failed to adequately respond to the SEC’s prior warning about fixing the problems. The lesson learned is that advisers need to fix compliance deficiencies, especially after they have been advised by the SEC to do so.

Under Rule 206(4)-7 of the Investment Advisers Act of 1940, registered investment advisers are required to have written policies and procedures designed to prevent violations of the Advisers Act and relevant securities laws. In addition, such advisers are required to complete an annual inspection of the policies and procedures to ensure that they are kept up-to-date and are effective.

In the SEC’s order against Modern Portfolio Management and its owners, the SEC found that they failed to correct compliance deficiencies in spite of past warnings from the SEC examiners. They failed to complete the annual review of the firm’s compliance policies and procedures over several years and made material misstatements on its website and Form ADV Part 2 brochure. Among other things, the adviser’s website reported assets under management far greater than what was reported within its Form ADV. The adviser and its owners agreed to be censured by the SEC and pay penalties of $175,000. In addition, they agreed to replace their chief compliance officer and to engage an outside compliance consultant for a three year period.

In the SEC’s action against Equitas Capital Advisers and Equitas Partners and their owner and chief compliance officer, the SEC found that they failed to adopt adequate written policies and procedures and conduct annual compliance reviews over several years. In addition, it was found that they made false and misleading statements to clients and prospective clients about historical performance, compensation and conflicts of interest, and repeatedly overbilled (and even underbilled) clients. The firms agreed to reimburse all overcharged clients, pay a total of $225,000 in additional penalties, agreed to an order of censure and to hire independent compliance consultants. The firms are also required to inform clients about the SEC’s enforcement actions.

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