A Compilation of Enforcement and Non-Enforcement Actions

30 May 2014 Legal News: Investment Management Publication
Author(s): Terry D. Nelson Peter D. Fetzer

Legal News: Investment Management


  • Concerns Noted During Private Equity Adviser Exams
  • Employees of Mutual Fund’s Investment Adviser Have Whistleblower Protections
  • Succession Planning for Mutual Fund Boards


  • Registered Investment Adviser Faces Fraud Charges
  • Lifetime Bar Affirmed for Failure to Supervise


Concerns Noted During Private Equity Adviser Exams

Routine examinations by the SEC at advisory firms who manage the assets of private equity funds have uncovered some serious concerns about the way such advisers calculate fees and allocate expenses. According to Andrew J. Bowden, the director of the SEC’s Office of Compliance Inspections and Examinations (“OCIE”), recently reported on the results of examinations conducted to date by the OCIE of nearly 150 newly SEC registered private equity advisers.

According to Director Bowden, the private equity adviser model presents certain types of violations not usually associated with advisers who do not manage private equity funds. One example noted by the Director is that the limited partnership agreement for a private equity limited partnership oftentimes lacks specificity as to what expenses the fund will be responsible for versus the fund manager. Consequently, the staff of the OCIE oftentimes finds that the adviser is billing the fund for expenses that are typically the responsibility of the adviser. In addition, the private placement memorandum for the fund may not clearly itemize for prospective investors the expenses to be covered by the fund versus the adviser and also sometimes lacks a clear methodology of how assets will be valued by the adviser on behalf of the fund. The methodology for valuing the fund’s assets is important as the adviser’s management fee is generally a percentage of the asset value at the end of each quarter. The adviser may be receiving a higher advisory fee based on an inflated value of assets. The OCIE forewarns that such concerns result in violations of the “anti-fraud” provisions under the Investment Advisers Act of 1940.

Another common deficiency found by the staff according to Director Bowden is the expense of covering undisclosed third party fees that are typically charged to the fund and, of course, absorbed by the investors on a pro rata basis.

The examination results of the private equity advisers underlines the industry’s need to do a better job in disclosing accurately and fully to investors the coverage of expenses, calculations of fees, and methodologies for determining asset values. According to Director Bowden, a more robust compliance program is what is needed in the industry.  

Employees of Mutual Fund’s Investment Adviser Have Whistleblower Protections

Mutual fund boards should be aware that the U.S. Supreme Court has ruled that the employees of investment advisers and other mutual fund service providers are protected by the anti-retaliation provisions of the Sarbanes-Oxley Act of 2002. In light of this, as part of its ongoing oversight process, boards should reassess the funds’ whistleblower policies and procedures and those of the funds’ investment adviser. Boards should also ensure that the funds’ other service providers also have adequate whistleblower policies and procedures.

In reaching a conclusion that the funds’ investment adviser and other service providers have adequate whistleblower policies and procedures, boards may rely on the Chief Compliance Officer’s review of such policies and procedures. Boards should ensure that such review and due diligence is occurring, and that the Chief Compliance Officer reports back on such reviews.

Specifically, the U.S. Supreme Court ruled that the anti-retaliation provision of the Sarbanes-Oxley Act of 2002 protects employees of contractors and subcontractors to mutual funds and other public companies who engage in whistleblowing. Lawson v. FMR LLC, No. 12-3 (U.S. Mar. 4, 2014). Lower courts had split on the issue, with the U.S. Court of Appeals for the First Circuit ruling that the provision in question, 8 U.S.C. § 1514A, protects only employees of the public company and not employees of contractors and subcontractors.

Section 1514A provides that no public company, or any officer, employee, contractor, subcontractor, or agent of such company, may retaliate against “an employee” for whistleblowing. It has been an open question since the passage of the Sarbanes-Oxley Act whether the “employee” in question must be an employee of the public company, or could also be an employee of the contractor or subcontractor.

Even though mutual funds are public companies, they generally have no employees of their own. Instead, they rely on the employees of their investment adviser and other service providers. So, if the view of the First Circuit had prevailed, employees of investment advisers and other service providers would not have had whistleblower protections unless an adviser or service provider was publicly traded because such employees are not employees of the mutual funds.

In a plurality opinion by Justice Ginsburg, joined by Chief Justice Roberts and Justices Breyer and Kagan, the U.S. Supreme Court concluded that the statutory text, purposes and history show that the anti-retaliation provision shelters employees of private contractors and subcontractors, just as it shelters employees of the public company served by them. Among other considerations, the plurality placed special emphasis on the lot of outside lawyers and accountants, who would otherwise have no protection against retaliation for whistleblowing.

The U.S. Supreme Court was dismissive of the argument that mutual funds and investment advisers are separately regulated under the Investment Company Act of 1940 and the Investment Advisers Act of 1940, for nowhere else in these legislative measures are investment management employees afforded whistleblower protection.

A dissenting opinion by Justice Sotomayor, joined by Justices Kennedy and Alito, supported the defendants' view that only employees of a public company are protected. The dissent was particularly influenced by the possibility that employees of trustees and officers of mutual funds, such as gardeners and babysitters, will now have anti-retaliation rights. The plurality was dismissive of fears that its decision would open the floodgates, although it agreed that such employees would be entitled to protection.

Succession Planning for Mutual Fund Boards.

With the scrutiny of boards of trustees increasing, it has become more important that each board consider succession planning to ensure that a fully staffed and knowledgeable board is always in place. If a board member leaves the board, for whatever reason, it is in the best interest of the individual and the funds to ensure that the replacement is fully qualified.

The composition of mutual fund boards are subject to change, whether due to retirement, death, disability or another opportunity, and sometimes this change is unexpected. So, it makes sense to consider the need to have a succession plan. While the board may ultimately determine that a formal succession plan is not needed, it is a useful exercise to go through the process of making this determination.

The following discussion provides some insight and background into the process of selecting new trustees.

Identifying Candidates. Mutual fund boards should strive for balance and diversity when identifying a potential candidate. Diversity can be in the form of gender, race, age or experience. Depending on the needs of the funds and the composition of the board, it may make sense to select an individual with a great deal of experience and connections in the industry. On the other hand, circumstances might suggest that an individual with specific expertise, like expertise in derivatives or complex securities, might be a good addition to the board.

When bringing a new candidate onto the board, disinterested trustees must select and nominate any other disinterested trustees.

Vetting Candidates. When vetting an individual, the board will use a questionnaire to solicit information about the trustee candidate. This questionnaire may be bifurcated to speed up the process. First, a limited questionnaire is sent to the individual that is designed to quickly determine whether the candidate possess any disqualifying interest or relationship with the funds. Second, upon successful completion of the first part, the individual is sent a more lengthy questionnaire that solicits additional information that is needed to assess the individual’s candidacy.

Upon the candidate’s selection, there may be an opportunity for the candidate to transition onto the board. Overlapping service between the incumbent trustee and the newly selected trustee may provide the new trustee with a mentor and the ability to get up to speed without too much pressure. However, overlapping service is not always possible, and may not be desirable in some circumstances.


Registered Investment Adviser Faces Fraud Charges

The SEC filed fraud charges in a recent complaint filed in federal court against an Ohio-based investment advisory firm, Professional Investment Management (“PIM”) and its president and chief compliance officer, Douglas Cowgill, for allegedly concealing a shortfall of approximately $700,000 in client assets and then attempting to deceive the SEC’s examiners from detecting the shortfall.

During a routine examination by the SEC of the books and records of PIM, the SEC attempted to verify the existence of client assets. In account statements sent to clients by PIM, it was reported that PIM held about $7.7 million in a money market fund although only $7.0 million of client assets was actually documented as having been invested in the fund. During the SEC’s examination of the adviser, Cowgill attempted to disguise the shortfall by entering a fake trade in the firm’s account records. Cowgill falsified records he provided to the staff and apparently transferred funds from another account at a financial institution which also constituted client assets, to eliminate the shortfall in the money market account. The transfer of the shortfall amount between the accounts by Cowgill was meant to avoid detection by the staff. The SEC also asked the federal court to impose an asset freeze of the advisory firm in order to further protect client assets.

PIM currently has about 325 clients with $120 million of assets under management. It was registered with the SEC from 1978 until September, 2013 when it withdrew its SEC registration. The SEC’s examination was conducted, in part, because for the last four years, PIM had apparently not complied with the “custody rule” which required for each of those years, an independent verification of client assets.

The SEC’s complaint charges PIM and Cowgill with violating the anti-fraud, registration and custody provisions under the Investment Advisers Act of 1940. The motions made by the SEC included a request for the Court to issue a preliminary injunction.

Lifetime Bar Affirmed for Failure to Supervise

Carl M. Birkelbach, the founder and president of Birkelbach Investment Securities lost his appeal of a lifetime bar from the securities industry imposed by FINRA for failure to supervise over the trading activities of an associate at his firm. Primarily, Birkelbach based his appeal on the fact that the lifetime bar by FINRA was excessive.

A Seventh Circuit panel denied Birkelbach’s appeal in spite of Birkelbach’s arguments that FINRA’s bar was excessive which included a lifetime bar, six month suspension and $25,000 fine. The underlying conduct by the associate, who was directly supervised by Birkelbach, included trading without authorization in two customer accounts over a period of six years. During the period, FINRA ordered Birkelbach to place the associate under heightened supervision but he failed to do so. The conduct by the associate continued until 2008 when FINRA barred the associate for life from the industry and ordered him to pay disgorgement of nearly $600,000.

Birkelbach did not contest the charges of failure to supervise but argued that the lifetime bar was excessive as the punishment was not tailored to the offense. The panel disagreed citing that Birkelbach’s conduct was sufficiently egregious and that the sanction guidelines to the relevant rules contemplate a lifetime bar in all capacities in the industry.

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