SEC Enforcement Actions Impacting Private Fund Advisers for Fiscal Year 2020

11 November 2020 Foley Funds Legal Focus Blog
Authors: Stuart E. Fross Peter D. Fetzer Stephen M. Meli Margaret G. Nelson Thomas J. Krysa

On November 2, 2020, the SEC’s Division of Enforcement issued its 2020 Annual Report for the fiscal year ending September 30, 2020. While the Enforcement Division filed 405 standalone enforcement actions – the lowest total in the last six fiscal years, likely due to the impact of the COVID-19 pandemic – it still managed to obtain $4.680 billion in court-ordered disgorgement and civil penalties, marking its highest total in the last six fiscal years. 

Notably, the Division continued to be fairly active in the investment management space, filing 87 standalone enforcement actions, accounting for 21% of the standalone cases for the year. This note highlights the enforcement actions filed during fiscal year 2020 that impact private fund advisers (excluding cases involving obvious fraud), summarizing those we think are the most instructive for private fund managers registered as investment advisers or exempt reporting advisers. Although the cases cover a wide variety of fact patterns, they reflect the SEC’s continued focus on common violations of the Investment Advisers Act of 1940 (“Advisers Act”), such as negligent disclosure violations, custody rule violations, and the failure to properly implement policies and procedures.    

In the Matter of Cannell Capital, LLC (February 4, 2020, Rel. No. 5441) – Ineffective insider trading policies and procedures.

The SEC instituted settled administrative and cease and desist proceedings against Cannell Capital, LLC (“CCL”), a small investment adviser, for failure to implement and enforce written policies and procedures under Section 204A of the Advisers Act related to material, nonpublic information (“MNPI”). During the relevant period, CCL generally employed a strategy focused on trading securities of small market capitalization companies with little or no sell side analyst coverage. In determining whether to invest, CCL frequently communicated with issuer insiders and investment bankers often entering into nondisclosure agreements with issuers to gain access to potential inside information. Although CCL had an insider trading policy, the SEC alleged that the policy was not reasonably designed to prevent the misuse of material, nonpublic information and that CCL failed to maintain a restricted securities list as required by the policy that precluded trading when the firm was in possession of MNPI. Even in the absence of evidence of insider trading, the SEC alleged that CCL had violated Advisers Act Section 204A by failing to establish, maintain and enforce effective written policies and procedures to prevent insider trading, citing for example the CCO’s ineffective practice of updating the restricted list weekly rather than in real time and relying in part on self-reporting by recipients of MNPI which the SEC considered ineffective. In settlement, CCL agreed to a cease and desist order, a censure, and a civil penalty in the amount of $150,000.  In the settled order, the SEC acknowledged the remedial acts undertaken by CCL. 

Takeaway:  Insider trading policies must be periodically evaluated for effectiveness; it is not enough merely to have a policy in place.  Policies must have real time, independent MNPI determinations, a reasonably designed restricted list, and consistent communications to covered persons to alert them of restricted issuers. 

SEC v. Criterion Wealth Mgmt. Ins. Services, Inc. et al. (C.D. Cal., February 13, 2020, Rel. No. 24738) – Undisclosed side compensation arrangements.

The SEC filed a litigated district court action in the Central District of California against Criterion Wealth Management Insurance Services, Inc. (“Criterion”) and its co-owners Robert Gravette and Mark MacArthur for disclosure and compliance violations under Adviser Act Sections 206 and 207 and related rules, and against Gravette and MacArthur for aiding and abetting Criterion’s violations. The SEC’s complaint alleges that from 2014 to 2017 the defendants caused their advisory clients to invest more than $16 million in four private real estate funds without disclosing that the fund managers paid the defendants more than $1 million in side compensation in the form of recurring fees based on the amount of funds invested. This side compensation was on top of the management fee earned by Criterion. Because the side compensation was recurring, Criterion had an incentive to invest in the real estate funds rather than allocating fund capital elsewhere. The SEC alleges these fee arrangements constituted a “glaring” conflict of interest for the adviser. The complaint seeks permanent injunctions from future violations, disgorgement, prejudgment interest and civil penalties.  

Takeaway:  All fees, compensation and remuneration received by an adviser directly or indirectly in connection with fund investments must be sufficiently disclosed in offering documents. 

In the Matter of Lone Star Value Mgmt. LLC et al. (February 24, 2020, Rel. No. 5448) – Undisclosed principal transactions.

The SEC instituted settled administrative and cease and desist proceedings against adviser Lone Star Value Management, LLC (“Lone Star”) for disclosure violations relating to unlawful principal trades under Section 206(3) and 206(4) of the Advisers Act and Rule 206(4)-7 thereunder, and against its founder Jeffrey Eberwein for causing such violations. Significantly, of the $150 million in assets under management Lone Star reported, $35 million reflected investments by Eberwein. In addition to being the founder, Eberwein was the sole managing member and CEO of Lone Star, and the portfolio manager for its funds. During 2014, Lone Star completed 19 interfund cross trades between 2 funds Lone Star managed, and in 2015, it completed 2 trades between a Lone Star fund and a separately managed account. Because Eberwein owned more than 35% of the funds at issue, the SEC alleged these trades were made on a principal basis, as if Eberwein or Lone Star was a counter party to relevant trades. Lone Star failed to disclose in writing that it had engaged in these principal transactions and it did not obtain client consent prior to the completion of the transactions in violation of Section 206(3). Lone Star also failed to implement written policies and procedures recently designed to prevent violations of the Advisers Act. In settlement, Lone Star and Eberwein agreed to cease and desist orders, Lone Star was censured, and Lone Star and Eberwein paid civil penalties of $100,000 and $25,000, respectively. 

Takeaway:  An adviser’s ownership interest in a fund can trigger Section 206(3) disclosure and consent requirements for certain fund transactions. 

In the Matter of Steven E. Fishman (February 27, 2020, Rel. No. 5450) – Custody rule violations from failing to meet audit exception.

The SEC instituted settled administrative and cease-and-desist proceedings again Steven E. Fishman for causing violations of the custody rule under Section 206(4) of the Advisers Act and Rule 206(4)-2 thereunder. Fishman is the cofounder and a principal of Formation Capital, a registered investment adviser based in Atlanta, Georgia. During the relevant period, Formation Capital’s investment strategy was to create single-purpose funds to acquire senior care properties and healthcare service providers. Under this strategy, the adviser managed 18 funds with approximately $6.1 billion in assets under management. Fishman and his cofounder agreed to invest their own capital into each fund in order to align their interests with those of their investors. These capital contributions were to be made through personal investment vehicles or PIVs. Fishman encountered personal financial difficulties and was unable to provide the necessary capital for his personal contributions to the funds. Instead, and unknown to the firm, he recruited investment capital from investors to meet his capital obligations. Fishman’s PIVs contributed more than $28 million to approximately 18 different sponsored funds. However, Fishman contributed only $2 million of this amount. Because the firm had custody of investor’s funds as defined under the custody rule, Formation Capital attempted to comply with the custody rule by having its financial statements audited annually and distributed to investors within 120 days of fiscal year end. However, because Fishman’s investors were unknown to the firm, his investors did not receive audited financial statements for the relevant funds on an annual basis causing the firm to violate the custody rule. In settlement, Fishman agreed to a cease and desist order, he was barred from the industry with the right to reapply after 5 years, and he paid a civil penalty of $50,000.  

Takeaway:  Custody rule violations are not considered by the SEC to be only technical in nature.  Rather, such violations continue to be taken seriously by the SEC twelve years after Madoff, and they can have serious ramifications, such as an industry ban. 

In the Matter of Sica Wealth Management, LLC, et al. (February 27, 2020, Rel. No. 5453) – Undisclosed adviser compensation. 

The SEC instituted settled administrative and cease-and-desist proceedings against adviser Sica Wealth Management, LLC (“SWM”) and its principal Jeffrey C. Sica for disclosure violations under Section 206(2) of the Advisers Act. From 2013 to 2015, Sica, SWM’s sole owner and managing member, recommended that SWM’s clients invest more than $30 million in securities in an enterprise known as Aequitas, which ultimately turned out to be a Ponzi scheme. In recommending these investments, Sica failed to disclose to the firm’s clients that Aequitas paid SWM and an affiliated adviser approximately $2 million pursuant to certain agreements. The SEC alleged that these agreements and the related compensation should have been disclosed so the clients could fairly evaluate potential conflicts of interest. In settlement, SWM and Sica agreed to cease-and-desist orders, censures, and pay civil penalties of $80,000 and $30,000, respectively.  Additionally SWM agreed to pay approximately $298,000 of disgorgement and prejudgment interest to provide notice to the relevant investors of the entry of the SEC’s order. 

Takeaway: The SEC requires express disclosure of adviser-related compensation arrangements and the potential conflicts of interest that could result. In cases involving failed investments, the Enforcement Division’s scrutiny of compensation-related disclosures increases substantially.    

In the Matter of Naya Ventures, LLC et al. (March 12, 2020, Rel. No. 5461) – Undisclosed compensation and failure to comply with partnership agreement provisions.

The SEC instituted settled cease-and-desist proceedings against Naya Ventures, LLC (“Naya”), an exempt reporting adviser, for disclosure violations under Section 206 the Advisers Act and Rule 206(4)-8 thereunder, and against co-founders Dayakar Puskoor and Prabhakar Reddy for causing such violations. Puskoor and Reddy co-founded Naya in 2012 as a venture capital fund, seeking to raise up to $50 million by selling limited partnership interests and invest such proceeds in mobile technology and Internet technology companies. By December 2014, the fund had received capital commitments totaling $12.5 million from 53 limited partner investors that included Puskoor and Reddy. The SEC alleged that Puskoor and Reddy failed to comply with the funds partnership agreement by (1) failing to establish an investor advisory committee as required, (2) failing to disclose to the fund and investors that they had failed contribute all of the capital to which they had committed and to exercise the default remedies provided by the agreement when other investors failed to meet their capital commitments, and (3) failing to secure audited financial statements for the fund. In addition, the two caused portfolio companies to enter into compensation arrangements with another portfolio company where Puskoor was Board Chairman and Reddy was CEO without disclosing these compensation arrangements to the fund’s investors. In settlement, Naya, Puskoor, and Reddy each agreed to cease and desist orders and to pay civil penalties of $40,000, $20,000 and $20,000, respectively.  Naya also agreed to certain undertakings, including providing notice of the SEC order to its investors. In the settled order, the SEC credited respondents with certain remedial actions promptly undertaken by them and for their cooperation with the SEC staff during the investigation. 

Takeaway:  The failure to observe and comply with fund governing documents, such as partnership agreements or operating agreements, can lead to an SEC enforcement action. Additionally, although it’s difficult to evaluate the impact of remediation and cooperation, it is always important to do both.

In the Matter of Old Ironsides Energy, LLC (April 17, 2020, Rel. No. 5478) – Misleading marketing materials regarding past performance.

The SEC instituted settled administrative and cease-and-desist proceedings against registered investment adviser Old Ironsides Energy, LLC (“Old Ironsides”) for failure to implement written policies and procedures under Section 206(4) of the Advisers Act and related rules. In 2014, Old Ironsides established a private equity fund to invest in the oil and gas industry through direct drilling investments (“DDIs”), private equity investments, and midstream assets such as pipelines. The fund received capital commitments of approximately $1.327 billion and, as of March 2019, had invested approximately $982 million of investor capital. Prior to the formation of Old Ironsides, its principals had managed a legacy portfolio of approximately 420 oil and gas investments that included DDIs. In marketing materials distributed to the Old Ironsides’ fund investors, it provided a track record related to its prior legacy portfolio, purporting to show the investment performance of early stage DDIs. When calculating the track record, however, Old Ironsides mischaracterized an investment as an early stage DDI when, in fact, the investment was a limited partnership interest in an investment managed by third-party. This particular investment had a significant return on investment of 10.9x, and, as a result, the inclusion of this investment significantly skewed the early stage DDI track record that was provided to investors. Due to this skewed track record, the SEC alleged that Old Ironsides failed to implement its existing policies and procedures preventing misleading marketing materials. In settlement, Old Ironsides agreed to a cease and desist order, a censure, and a civil penalty in the amount of $1 million. 

Takeaway: The use of past performance metrics in marketing materials to investors requires extra scrutiny. Assumptions and calculations must be evaluated to ensure that marketing materials do not present an overly rosy picture of past performance that is not supported by the complete performance data.

In the Matter of Monomoy Capital Mgmt., L.P. (April 22, 2020, Rel. No. 5485) – Insufficient disclosures regarding adviser-related fees for in-house services.

The SEC instituted settled administrative and cease-and-desist proceedings against registered adviser Monomoy Capital Management, L.P. (“Monomoy”) for disclosure violations under Section 206(2) of the Advisers Act. Monomoy manages certain private equity funds whose investors include pension funds, public employee retirement systems, charitable organizations, large institutional investors and high net worth individuals. With respect to three private equity funds, Monomoy earned a management fee on a semiannual basis. During the period at issue, Monomoy used its in-house operations group to provide certain services to the portfolio companies in the three funds. Monomoy had an established practice of billing fund portfolio companies separately for the costs associated with the in-house operations group, rather than covering these costs out of its management fees. Monomoy made certain disclosures in its offering materials related to the in-house operations group and the fact that certain types of fees could be borne by the fund portfolio companies. In addition, in March 2014, Monomoy filed a Form ADV that disclosed that “under specific circumstances, certain Monomoy operating professionals may provide services to portfolio companies that typically would otherwise be performed by third parties,” and that “Monomoy may be reimbursed” for costs related to such services. Despite these disclosures, the SEC alleged that the disclosures did not fully and fairly disclose the arrangement. In settlement, Monomoy agreed to a cease-and-desist order, a censure, and to pay disgorgement, prejudgment interest and civil penalties totaling approximately $1.9 million. The SEC noted Monomoy’s cooperation during the investigation in the settled order. 

Takeaway:  Disclosures regarding adviser-related fees and compensation arrangements will be scrutinized by the SEC.  In addition, the SEC will often take the position, as it did here, that disclosures using the term “may” or otherwise implying that fees “may be reimbursed” are insufficient if the fees are actually being charged by the adviser and are no longer a mere possibility.   

In the Matter of TSP Capital Mgmt. Group, LLC (May 22, 2020, Rel. No. 5508) – Custody rule violations due to failure to meet audit exception.

The SEC instituted settled administrative and cease-and-desist proceedings against TSP Capital Management Group, LLC (“TSP”) for custody rule violations under Section 206(4) and Rule 206(4)-2 thereunder, and for failing to implement written policies and procedures. TSP managed a $31.5 million fund that focused on private agricultural investments in Cameroon and had custody of the Cameroon fund assets. To comply with the custody rule, TSP relied on the audit exception. Although TSP engaged an audit firm to conduct annual audits, the audits were not completed until well after 120 days following the end of two fiscal years. Moreover, in subsequent years, TSP failed to secure audited financials. In settlement, TSP agreed to a cease-and-desist order, a censure, and to pay a civil penalty of $60,000. 

Takeaway: The SEC will bring Enforcement actions against advisers that fail to distribute audited financials to investors within the 120-day period following the close of the fiscal year in compliance with the custody rule. 

In the Matter of Rialto Capital Mgmt., LLC (August 7, 2020, Rel. No. 5558) – Misallocation of costs related to co-investments.

The SEC instituted settled administrative and cease-and-desist proceedings against registered adviser Rialto Capital Management, LLC (“Rialto”) for disclosure violations under Section 206(2) and 206(4) of the Advisers Act and Rule 206(4)-8 thereunder. The SEC found that, from 2012 to 2017, Rialto misallocated certain costs and expenses related to its performance of “third-party tasks” to two real estate private equity funds it managed that should have been allocated to certain co-investment vehicles that were also managed by Rialto. The third-party tasks included services for asset-level due diligence, accounting, valuation, and other similar services that are typically performed for funds by outside professionals. In marketing the funds, Rialto touted its ability to perform these third-party tasks in-house as a selling point. In addition, the SEC found that Rialto’s disclosures to one of the fund’s advisory committees did not state that Rialto failed to obtain updated information that the third-party fees and costs were at or below market rates, as required by the fund’s limited partnership agreements.  In settlement, Rialto agreed to a cease-and-desist order, a censure, and to pay a civil penalty of $350,000. The SEC noted Rialto’s cooperation in the settled order. 

Takeaway: The SEC is laser focused on the potential conflicts of interest arising from co-investments. Additionally, non-compliance with advisory committee governing provisions can be costly and serve as a basis for an SEC enforcement action.

In the Matter of Palmer Square Capital Mgmt., LLC (September 21, 2020, Rel. No. 5586) – Undisclosed principal trades and unlawful cross trades.

The SEC instituted settled administrative and cease and desist proceedings against registered investment adviser Palmer Square Capital Management, LLC (“Palmer Square”) for unlawful principal trades under Section 206(3) of the Advisers Act, for causing unlawful cross trades under Sections 17(a)(1) and 17(a)(2) of the Investment Company Act of 1940, and for failing to implement written policies and procedures. Palmer Square provided discretionary advisory services to five registered investment companies, several private funds, collateralized loan obligation vehicles, and numerous separately-managed accounts for institutions and high net worth individuals. The SEC alleged that during 2014 through 2016, Palmer Square effected 351 cross trades in securities between its client accounts, 13 of which were principal transactions. In so doing, Palmer Square failed to comply with the statutory provisions regarding unlawful cross trades between registered investment companies, failed to obtain an exemptive order from the SEC as required by Section 17(b) of the Investment Company Act, and did not comply with the requirements of Rule 17a-7 thereunder. In addition, the principal transactions were made without the required disclosures and client consent. In settlement, Palmer Square agreed to a cease and desist order, a censure, and a civil penalty of $450,000. The SEC noted Palmer Square’s remedial efforts and cooperation in the settled order. 

Takeaways: Interfund trades can be a trap for the unwary. Advisers must be mindful of the rules relating to principal trading and cross trades when executing interfund trades, trades between client accounts, or trades between registered investment companies. 

In the Matter of Finser Int’l Corp., et al. (September 24, 2020, Rel. No. 5593) – Improper performance fees and custody rule violations.

The SEC instituted settled administrative and cease and desist proceedings against small, registered adviser Finser International Corporation (“Finser”) and Andrew H. Jacobus for disclosure and custody rule violations under Section 206(2) and 206(4) of the Advisers Act and related rules. Finser’s advisory business included portfolio management, hedge fund management, and venture capital advisory services and had $79 million in assets under management. The SEC alleged that Finser charged $51,000 in improper fund performance fees when the fund in question did not meet high water mark requirements for the performance fees as stated in the fund’s private placement memorandum.  In addition, Finser failed to meet custody rule requirements by commingling fund assets in the personal brokerage account of Jacobus, Finser’s sole owner, president and chief compliance officer, and it failed to provide audited financial statements to fund investors. In the settled order, Finser and Jacobus agreed to cease and desist orders, a censure, to pay disgorgement and prejudgment interest totaling approximately $61,000, and a civil penalty of $70,000 on a joint and several basis. In the settled order, the SEC noted Finser’s remedial acts including retaining a compliance consultant to conduct a comprehensive review of Finser’s written compliance policies and procedures. 

Takeaway: This case is a reminder that the SEC will scrutinize adviser fee arrangements and such fees must be properly calculated.   

In the Matter of Meredith A. Simmons, Esq. (September 30, 2020, Rel. No. 5603) – Backdated document submitted in examination.

The SEC instituted settled administrative and cease and desist proceedings under Rule 102(e) of the rules of practice against Meredith A. Simmons for aiding and abetting an adviser’s violations of Rule 204(a) of the Advisers Act. Simmons was an attorney licensed in New York City who acted as the chief compliance officer of a registered investment adviser and its affiliated broker dealer. The SEC alleged that Simmons backdated a memorandum to file that evaluated the adviser’s acquisition of a company from a compliance perspective. The memorandum had been requested by Simmons’ supervisor shortly after the acquisition was publicly announced in October 2016. However, Simmons did not draft the memorandum until September 2017.  Simmons backdated the document to October 21, 2016, the day prior to the public announcement of the acquisition. In a subsequent examination by SEC staff, Simmons produced the memorandum, representing to the staff that it was “a contemporaneous memo to file” that documented her review of the acquisition. In addition to being backdated, the memorandum contained factual inaccuracies regarding the timeline and events in question. In response to exam requests, Simmons failed to produce other versions of the backdated memorandum and never corrected her statement that the document was a contemporaneous analysis. As a result, the SEC alleged that Simmons’ conduct substantially delayed and impeded the examination. In settlement, Simmons agreed to a cease and desist order, a censure, a bar from appearing or practicing before the SEC as an attorney for 12 months, and a $25,000 civil penalty. 

Takeaway: The SEC will not tolerate any interference with, or obstruction of, its examination processes.  As such, backdating a memorandum to file is never advisable and can lead to being barred from appearing or practicing before the SEC.   

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