Category: Investment Advisers Act

Nabbing RIAs to Private Funds Who Do Not File Form PF

Private fund advisers managing $150 million or more of assets have been required to make annual filings on Form PF since 2012. (More often in some cases.) It’s really easy for the Securities and Exchange Commission to match the Form ADV data listing private funds to the Form PF filings for those funds. And it should be just as easy to find those firms who list private funds on Form ADV but didn’t file Form PF for those funds.

The SEC nabbed seven firms that failed to file Form PF for several years. The firms had to pay fines ranging from $90,000 to $150,000. It wasn’t clear why there was a relatively broad range of fines. Size of the firm? Size of the fund? There was no reason to find fraud or malice.

“The SEC uses information collected on Form PF in its regulatory programs, including examinations, investigations and investor protection efforts relating to private fund advisers.  The SEC publishes quarterly reports with aggregated information and statistics derived from Form PF data to inform the public about the private fund industry.  It also provides Form PF data to the Financial Stability Oversight Council to help it evaluate systemic risks posed by hedge funds and other private funds.”

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The One With $11 Trillion

There are a few different ways to calculate Assets Under Management. The SEC has prescribed ways to calculate Regulatory Assets Under Management. Often AUM and RAUM will differ depending on an adviser’s business model and client base.

But you can’t just make up RAUM.

Rubin Cedric Williams did so at his firm Vista Financial Advisors. He registered Vista Financial with the Securities and Exchange Commission in December 2021. He filed an update in April 2022 which listed the firm’s RAUM as $10 billion.

This large amount caught the attention of the SEC and started a “newly registered” exam with Vista Financial to kick the tires. During the exam Mr. Williams said his RAUM had grown to $180 billion and his sole client was a foreign trust. In April 2023, Vista Financial filed an updated Form ADV listing its RAUM as $11 trillion.

During the examination, Vista Financial produced a spreadsheet and delivered it to the SEC that was supposed to back up its claimed RAUM. One item was a bank account with 140 billion Euros. The SEC checked with the bank. That account never had more than $3500.

The spreadsheet listed $42 billion in a single issuance of US Treasury Bonds. That would have made the firm likely owning every bond in the issuance. Assuming the issuance was even that big. The SEC found no evidence that Vista Financial held any treasury bonds.

Then there is the fraud-ier stuff. Vista Financial purported to hold $3 billion in bonds from a corporation (unnamed in the filings). Vista Financial tried to open a brokerage account with a margin loan allowance using some of those bonds as collateral and citing Vista Financial’s registration with the SEC to support its legitimacy.

I was waiting to find some details behind this 2023 case hoping there would be some explanation for this craziness. Alas, the case has settled and no more detail have emerged. Mr. Williams agreed to be barred from any SEC registered firm.

Was Mr. Williams the scammer or was he being scammed? I was hoping to get an answer.

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State of the Registered Investment Adviser Community

Regulatory Compliance Watch compiled information from the 14,400 advisers who filed a revised Form ADV at the end of March. RCW Exclusive: An Industry Portrait Drawn From Form ADV Data. For those of you who do not subscribe, here a few pieces of data that caught my eye.

Registered investment advisers’ assets under management increased by 19% over the year to $121 trillion. It’s not clear if that is regulatory assets under management or some other AUM number from Form ADV. Of that, $43 trillion is in investment companies and $32 trillion is in pooled investment vehicles.

The average employee per firm was 62, while the median was 8 employees. To me that indicates that there is a big range of sizes in firms, with most being very small, while there are some enormous firms. Regulatory Compliance Watch did find a firm that had accidently said it had a million employees. When contacted, the firm realized it had made a mistake and that is should only be 130. The corrected data is in the average and median numbers.

Lots of other fascinating information in the story: RCW Exclusive: An Industry Portrait Drawn From Form ADV Data. (If you have a subscription)

Increases to the Qualified Client Standard

There are so many buckets for classifying clients and investors under the SEC regulatory standards. Lots of focus and discussion has been targeted at the “accredited investor” standard for private placements. The “Qualified Client” standard under the Investment Advisers Act seems to attract very little attention.

Rule 205-3 under the Advisers Act exempts an investment adviser from the prohibition against charging a client performance fees when the client is a “qualified client.” The rule allows an adviser to charge performance fees for clients with a lot of money.

There are two ways to qualify as a “Qualified Client”:  

(1) “a natural person who, or a company that, immediately after entering into the contract has at least $1,000,000 under the management of the investment adviser” or

(2) “a natural person who, or a company that, the investment adviser entering into the contract (and any person acting on his behalf) reasonably believes, immediately prior to entering into the contract … has a net worth (together, in the case of a natural person, with assets held jointly with a spouse) of more than $2,000,000.

The Dodd-Frank Wall Street Reform and Consumer Protection Act amended section 205(e) of the Advisers Act to provide that every five years, the SEC has to adjust for the effects of inflation the dollar amount thresholds for a Qualified Client, rounded to the nearest multiple of $100,000. That five year mark has come around and the standards are increasing as of August 16, 2021.

Registered investment advisers entering into performance-based compensation arrangements with clients on or after Aug. 16, 2021 will have to make sure the client has assets under management of at least $1.1 million or have a net worth of at least $2.2 million.

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Form ADV FAQ Comes a Little Late

Most investment advisers filed their form ADVs last week, before the March 31 filing deadline. That didn’t stop the Securities and Exchange Commission from publishing a new FAQ about Form ADV on April 6. Hopefully you got it right.

There has been some questions about office locations that need to be disclosed on Form ADV during the pandemic. The general thought was that temporarily working from home during the pandemic didn’t need to be disclosed. Was that the right approach?

Let’s see…

Q: My firm has employees who are temporarily conducting investment advisory business from a temporary location other than their usual place of business (their homes, for example) as part of the firm’s business continuity plan due to circumstances related to coronavirus disease 2019 (COVID-19). Item 1.F of Part 1A requires information about a firm’s principal office and place of business. Section 1.F of Schedule D requires information about “each office, other than your principal office and place of business, at which you conduct investment advisory business.” Is my firm required to update either Item 1.F of Part 1A or Section 1.F of Schedule D in order to list the temporary teleworking addresses of its employees?

A: No. As long as the employees are temporarily teleworking as part of the firm’s business continuity plan due to circumstances related to coronavirus disease 2019 (COVID-19), staff would not recommend enforcement action if the firm does not update either Item 1.F of Part 1A or Section 1.F of Schedule D in order to list the temporary teleworking addresses. For purposes of this FAQ, “temporarily teleworking” includes prolonged plans to telework, provided that the firm maintains a physical office location. (Updated April 6, 2021)

The SEC Says Your Algorithm Is Not Good Enough

BlueCrest Capital was wildly successful as a hedge fund for many years. Its principals were wealthy enough that they could start a new fund with their own money and dedicate traders to running that new proprietary fund. That’s okay, even if the trading strategies between the new proprietary fund the existing hedge fund overlap. Compliance can manage the overlap. BlueCrest would need to properly disclose the conflict to investors.

The Securities and Exchange Commission said that BlueCrest failed to properly disclose. The parties agreed to a $170 million settlement.

The SEC order finds that BlueCrest made inadequate and misleading disclosures concerning existence of the proprietary fund, the movement of traders from the hedge fund to the proprietary fund, the use of the algorithm in hedge fund, and associated conflicts of interest.  According to the order, BlueCrest transferred a majority of its highest-performing traders from the hedge fund to the proprietary fund, and assigned many of its most promising newly hired traders to the proprietary fund.

What caught my attention in the order was that BlueCrest failed to disclose that it reallocated the transferred traders’ capital allocations in the hedge fund to a semi-systematic trading system, which was essentially a replication algorithm that tracked certain trading activity of a subset of BlueCrest’s live traders.

As you might expect, the algorithm underperformed the live traders. Why else would there be a SEC case? If the algorithm was better, the SEC would not have bothered. Actually, I bet BlueCrest would have used the algorithm on the proprietary fund if was outperforming the live traders.

According to the order, the hedge fund algorithm basically made the same trades as the live traders in the proprietary fund, but did so the following day. The algorithm trades ended up being less profitable, resulted in more volatility and had more risk in its portfolio.

There is nothing wrong with this practice as long as it’s disclosed. The SEC order highlights some diligence questionnaires which the SEC found misleading in BlueCrest’s description of its trading strategies and use of algorithms.

The SEC thinks there is a big difference between live traders and algorithms and the use of algorithms needs to be disclosed.

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The One Who Was Bored at Work

We all have hobbies. Me?: Cycling, reading, kayaking. Some people have finance as a hobby. Sure you can spout off about finance. But, eventually you step into the world of financial regulation if your spouting off turns into financial advice.

Marcos Tamayo of Las Vegas was an airline baggage handler by day and, apparently, became an investment adviser by night. Tamayo learned about investing by taking classes at work and reading books during breaks at work. His fellow baggage handlers must have believed the financial advice he spewed forth on the tarmac and terminal. They gave him online access to their airline retirement accounts, which he used to select investments and make trades. He only charged a $300 annual fee.

Spot the issue? …. Correct, he was operating as an investment adviser and would have to register himself and his business.

He even had a name for the business: “Bored at Work”. But didn’t register.

Mr. Tamayo’s business took off in 2015 when he posted a doctored image purporting to be his account statement which showed a balance over $800,000. The fake image worked and sparked the interest of his fellow baggage handlers, seeking his investing acumen. By the end of 2016 he had over $110 million in client assets under management.

The Nevada Secretary of State got wind of his moonlighting as an investment adviser and brought a cease and desist order. The State wanted him to stop operations until he was properly licensed.

He may have actually tried to go legitimate at this point. He filed a Form ADV with the Securities and Exchange Commission. He even came up with a more conservative name for the business: BAW Retirement Services.

He made a fatal mistake in the filing. He checked the “no” box on Form ADV Items 11.D.(1)-(5) which ask whether there were prior investment-related actions, including by a state regulatory agency. That means he filed a registration that contained a material misrepresentation.

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New Guidance On Proxy Voting Responsibilities

Investment advisers are often stuck with voting of equity securities on behalf of their clients. This falls under the investment advisers’ duties of care and loyalty with respect to services undertaken on the client’s behalf, depending on the authority granted to the adviser. The Securities and Exchange Commission issued two sets of interpretive guidance last month on proxy voting: one targeted at proxy advisory firms under the proxy solicitation rules, and the other targeting investment advisers and their proxy voting responsibilities.

In the first, proxy voting advice provided by proxy advisory firms will generally constitute a “solicitation” under the federal proxy rules.

The second is guidance to Rule 206(4)-6.

[I]t is a fraudulent, deceptive, or manipulative act, practice or course of business within the meaning of section 206(4) of the Act (15 U.S.C. 80b-6(4)), for you to exercise voting authority with respect to client securities, unless you: (a) Adopt and implement written policies and procedures that are reasonably designed to ensure that you vote client securities in the best interest of clients …

According to the guidance, the Rule requires when an an investment adviser has assumed the authority to vote on behalf of its client, the investment adviser must have a reasonable understanding of the client’s objectives and must make voting determinations that are in the best interest of the client. Therefore, an investment adviser has to form a reasonable belief that its voting determinations are in the best interest of the client, by conducting an investigation reasonably designed to ensure that the voting determination is not based on materially inaccurate or incomplete information.

An investment adviser is not required to vote on every matter presented to stockholders.

Using proxy advisory firms, may mitigate an investment adviser’s potential conflict of interest, it does not relieve that investment adviser of (1) its obligation to make voting determinations in the client’s best interest, or (2) its obligation to provide full and fair disclosure of the conflicts of interest and obtain informed consent from its clients.

It’s worth noting that this is formal guidance from the Commission and not guidance from the Investment Management Division or other staff guidance. It’s also not a new rule. It’ formal guidance further explaining the Rule.

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Regulation Best Interest, Form ADV Part 3 and the Fiduciary Standard

The Securities and Exchange Commission has been working on a way for consumers to better understand the difference between securities brokers and investment advisers. The Department of Labor made an attempt with respect to retirement plans, but that is a mess.

I’m not sure how much of a mess the new Regulation Best Interest is going be for private fund managers. The devil is in the details and the details are in the 524 page release for the new FORM CRS Relationship Summary and Amendments to Form ADV and the 771 pages of the Regulation Best Interest: The Broker-Dealer Standard of Conduct.

According to the press release, the SEC

“voted to adopt a package of rulemakings and interpretations designed to enhance the quality and transparency of retail investors’ relationships with investment advisers and broker-dealers, bringing the legal requirements and mandated disclosures in line with reasonable investor expectations, while preserving access (in terms of choice and cost) to a variety of investment services and products.  Specifically, these actions include new Regulation Best Interest, the new Form CRS Relationship Summary, and two separate interpretations under the Investment Advisers Act of 1940. “

The bigger burden is likely to be on broker-dealers. But changes are required for investment advisers and private fund managers.

One piece of good news is that Regulation BI attempts to clarify the fiduciary standard for investment advisers. That standard is not in the text of the Investment Advisers Act. It’s been developed through court cases.

The SEC published a new Commission Interpretation Regarding Standard of Conduct for Investment Advisers codifies an Investment Advisers’ Fiduciary Duty:

  • Duty of Loyalty
  • Duty of Care
    • Duty to Provide Advice that is in the best interest of the client
    • Duty to Seek Best Execution
    • Duty to Provide Advice and Monitoring over the course of the relationship

Get set for Form ADV Part 3. This new filing is directed at registered investment advisers that offer services to retail investors. Part 3 is the new relationship summary. New Rule 204-5 will require an investment adviser to deliver an electronic or paper version of the relationship summary to each retail investor before or at the time the adviser enters into an investment advisory contract with the retail investor. You’ll also need to post it to your website.

The deadline for compliance is June 30, 2020. We’ve got a year.

Where to turn to first? I’m diving into the Commission Interpretation Regarding Standard of Conduct for Investment Advisers.

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Pilfering? a Private Equity Fund

The Securities and Exchange Commission has made the industry very aware that it will look closely at the way private-equity firms handle fund expenses. The latest firm to get caught by the SEC for taking money from investors is Corinthian Capital.

Corinthian agreed to the order, but it contains the usual carve-out that Corinthian neither admits nor denies the findings in the order. Things may have actually happened different, but I’m accepting what’s in there as a warning for what the SEC does not like.

The first problem was related to improperly using a fee offset according to the the fund documents. The order does a poor job of explaining the operation of this particular offset. It seems like Corinthian affiliated limited partners are able not fund part of their capital commitments. The fund documents are silent on whether the offset can be applied retroactively. Corinthian applied it retroactively. Worse, the firm miscalculated the offset.

Compounding the miscalculation problem, Corinthian withdrew more than it was entitled to in fees from the fund to pay down the manager’s line of credit. Once that line was crossed, Corinthian transferred other cash from the fund to pay management expenses.

The second problem was charging the fund for organizational expenses that were not permitted by the fund documents. On problem is that the management company charged the fund for expected formation expenses. The SEC pointed out that this was improper because those expenses had not actually been incurred.

In addition, Corinthian misclassified some expenses as organizational expenses and ended up charging costs to the fund partners that should not have been charged to them. One item specifically reference is a placement agent fee.

“Corinthian also lacked policies and procedures with respect to charging CEF 2 for organizational expenses. Informal practices, dating from a former CFO, were put in place that gave great discretion to estimate and classify organizational expenses. While the CFO tracked and the investment committee determined the amount charged to CEF 2 for organizational expenses as referenced in Paragraph 12, no process was implemented to determine the accuracy of such estimates or whether expenses were properly classified. “

The third problem was that Corinthian’s auditor noticed these problems. The auditor chose to withdraw from the engagement and withdraw its opinion from the prior year’s financial statements. That left Corinthian not timely delivering audited financial statements and therefore in violation of the Custody Rule.

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