Tag: 206(2)

Failure to Adequately Oversee Service Providers

Citing what it called “wholly inadequate” oversight of a faraway subadviser, the Securities and Exchange Commission fined and ordered repayment of advisory fees by Morgan Stanley Investment Management. According to the settlement, Morgan Stanley will repay its client, the Malaysia Fund, $1.8 million for fees it paid from 1996-2007 for “research, intelligence, and advice” that  AMMB Consultant Sendirian Berhad of Malaysia, was to provide as subadviser.

AMMB served as a sub-adviser to the Fund from inception until it was terminated at the end of 2007. The Research and Advisory Agreement specified that AMMB would register with the SEC as an investment adviser under the Investment Advisers Act and furnish Morgan Stanley “such investment advice, research and assistance, as [Morgan Stanley] shall from time to time reasonably request.” AMMB did not exercise investment discretion or authority over any of the assets in the Fund. Morgan Stanley took responsibility for monitoring AMMB’s performance of services. The Fund would pay AMMB an escalating fee based on the fund’s assets. During the relevant time period, the Fund paid AMMB advisory fees totaling $1,845,000. As the fund administrator, Morgan Stanley facilitated the Fund’s payment of AMMB’s advisory fees.

Section 15(c) of the Investment Company Act requires an investment adviser of a registered investment company to furnish such information as may reasonably be necessary for such company’s directors to evaluate the terms of any contract whereby a person undertakes regularly to serve or act as investment adviser of the company.

It was an OCIE exam in 2008 that first questioned the arrangement between AMMB and Morgan Stanley. AMMB did not provide any of the services it and Morgan Stanley represented to the Fund’s Board. Instead, AMMB provided two monthly reports that Morgan Stanley neither requested nor used in its management of the Fund. The first was a two-page list of the market capitalization of the Kuala Lumpur Composite Index. The second was a two-page comparison of the monthly performance of the Fund against other Malaysian equity trusts. For twelve years, the fund’s Board relied on Morgan Stanley’s representations and submissions of information regarding AMMB’s services when it unanimously approved the continuation of AMMB’s advisory contracts. The SEC stated that even though Morgan Stanley took responsibility for monitoring AMMB’s services, its oversight and involvement with AMMB during the relevant time period were wholly inadequate.

The settlement calls on the RIA to devise written procedures, reimburse the fund and pay a fine of $1.5 million.

If you are charging a fund for services provided by a third, then there is an obligation to make sure the third party is providing those services.  The SEC stated a violation of Section 206(2) of the Investment Advisers Act that prohibits an investment adviser from engaging “in any transaction, practice or course of business which operates as a fraud or deceit upon any client or prospective client”. It also imposes on investment advisers a fiduciary duty to act in “utmost good faith,” to fully and fairly disclose all material facts, and to use reasonable care to avoid misleading clients. SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 191, 194 (1963). Morgan Stanley willfully violated Section 206(2) of the Investment Advisers Act by representing and providing information to the Fund’s Board that AMMB was providing advisory services for the benefit of the Fund, which it was not.

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Stealing Private Equity Investment Opportunities

Private equity transactions are not outside the scope of enforcement by the Securities and Exchange Commission. The SEC filed a case against a former principal of an investment adviser that manages private equity funds. The charge is that he “usurped …[a] lucrative investment opportunity in a private company.” At this point, the SEC has only filed for a cease and desist order and has not proven the allegations against Matthew Crisp.

Crisp worked for Adams Street Partners, a private equity firm registered with the SEC as an investment adviser. In 2006 and 2007, Adams Street was looking at investing in TicketsNow. Crisp was assigned as the lead sponsor of the possible investment. They decided to go ahead, but the investment was greater that their typical investment amount so Crisp decided to syndicate a portion of the committed investment.

Crisp decided to create his own investment fund and take a portion of the  syndication. Adams Street contends that Crisp was not authorized to syndicate the investment to his own fund. He also increased the size of his fund’s allocation.

The SEC contends that the resulting decrease in the size of the Adams Street’s collective investment in TicketsNow was a misappropriation of a lucrative investment opportunity that should have gone to Adams Street. The SEC alleges that Crisp did not disclose his involvement to Adams Street. That would include failing to report the involvement on his periodic compliance disclosures. Failure to disclose such information was a violation of the Adam Street’s fiduciary duties and of it’s policies.

It turned out to be a good investment because TicketsNow was sold to a competitor a year later.The investment tripled their invested capital.

The SEC alleges that this was not a single instance of malfeasance. They claim that Crisp tried again with an investment in Sherman’s Travel. He took a syndication in that investment in his own investment fund.

Adams Street discovered the problem and, after conducting an internal investigation, terminated Crisp. Thy also took the next step and self-reported the matter to the SEC.

The SEC alleges that Crisp violated Sections 206(1), 206(2), and 206(4) of the Advisers Act. They extend this through Rule 206(4)-8 which prohibits fraudulent activity by advisers to pooled investment vehicles with respect to investors or prospective investors.

In the alternative, the SEC contends that Crisp aided and abetted Adams Street’s violation of Sections 206(1), 206(2), and 206(4) of the Advisers Act, extended through Rule 206(4)-8.

Further, the SEC alleges that pursuant to the actions outlined above, Crisp willfully violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder.

The cease and desist proceeding is being instituted to determine whether the allegations noted are true and what remedial action is appropriate. Crisp already returned a large portion of his returns to Adams Street.

As more private equity fund managers are going to be registered with SEC in the next six months, I found this case to be an interesting example of SEC enforcement in the industry. Assuming that Crisp actually did what the SEC alleges, such activity should be a violation of the firm’s conduct policy and a violation of it’s funds’ partnership agreements. Investors generally will impose a contractual obligation on the fund manager to not divert investment opportunities to employees and principals of the fund manager.

So how does SEC enforcement help in this area? I suppose it adds the scare factor of a government investigation on top of losing your job and professional reputation.

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Robbery Not Allowed is by Anders Sandberg

But the Computer Did It!

The Securities and Exchange Commission brought charges of securities fraud for concealing a significant error in the computer code of the quantitative investment model. I found this case to be interesting because it was not flawed human decisions, but flawed computer decisions. However, we still live in the age where computers do what we tell them to do. So, if the computer is doing something wrong, then a person is behind it.

Barr M. Rosenberg developed complex automated models and an “optimization” process to create and manage client portfolios. Barr Rosenberg Research Center LLC was the registered investment adviser. In April 2007, BRRC put into production a new version of the Risk Model, one component of its quantitative trading program. Two programmers linked the Risk Model to the Optimizer, a second component of the quantitative trading program. However, they made an error in the Optimizer’s computer code.

In June 2009, an employee noticed some unexpected results when comparing the new Risk Model to the existing one that was rolled out in April 2007. Some Risk Model components sent information to the Optimizer in decimals while other components reported information in percentages. That meant the Optimizer had to convert the decimal information to percentages in order to effectively consider all the information. That screwed up the inputs and the outputs resulting in the Optimizer not giving the intended weight to common factor risks.

As with most mistakes that lead to SEC action, the error caused the portfolios to underperform. The error impacted more than 600 client portfolios and caused approximately $217 million in losses. Obviously, this is a bad result.

The problems came, as they usually do, when someone tried to hide the problem. Mr. Rosenberg concealed the error and told his employees not to disclose the error to the investment officers or managers of the firm. That meant the firm was making material misrepresentations and omissions concerning the error to their clients, including:

(i) omitting to disclose the error and its impact on client performance,
(ii) attributing the Model’s underperformance to market volatility rather than the error, and
(iii) misrepresenting the Model’s ability to control risks.

The SEC charged Rosenberg with willful violations of  Sections 206(1) and 206(2) of the Investment Advisers Act. Section 206(1) prohibits any investment adviser from, directly or indirectly, “employing any device, scheme, or artifice to defraud any client or prospective client.” Section 206(2) prohibits any investment adviser from engaging in any “transaction, practice or course of business which operates as a fraud or deceit upon any client or prospective client.”

Rosenberg was aware of the problems, but did not disclose the error and directed others not to disclose. As a result, the firm misrepresented that the underperformance was attributable to factors other than the error and inaccurately stated that the model was functioning when in fact it was not. In addition, Rosenberg’s caused a delay in fixing the error leaving it uncorrected for several additional months. Rosenberg caused his clients to continue sustaining losses from an error that could have been promptly fixed.

Rosenberg has to pay the $2.5 million penalty fine and he received the ban from the SEC. He is barred from association with any broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization and prohibits him from serving as an officer, director or employee of a mutual fund.

Lesson learned. If the computer is broken, fix it right away. And don’t lie about it.

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