Tag: Rule 206(4)-8

Have You Disclosed Your Derivatives Positions?

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The Securities and Exchange Commission filed charges against a fund manager and its subadviser for their extensive use of derivatives. From April 2007 through October 2008, the Fiduciary/Claymore Dynamic Equity Fund engaged in derivative strategies to supplement the Fund’s primary investment strategy. But the Fund failed to include adequate disclosure about the risks to the Fund arising from the Fund’s use of derivatives, either in its annual report or in an amended Fund registration statement.

The Fund’s primary investment strategy was to invest in equities and write call options on a substantial portion of those equities. This covered call strategy trades upside potential in the equities held in the portfolio for current income from option premiums received.

Things changed in April 2007 when the Fund supplemented its income and returns by writing out-of-money S&P 500 put options. The Fund collected a premium from the purchaser of the option, and in exchange agreed to compensate the purchaser for any declines in the S&P 500 beyond the strike price of the option. Between April 2007 and August 2008, the Fund collected $9.6 million in premiums from written put options. For the six months ending May 31, 2008, written put options  added approximately 2.1% to the Fund’s return.

Then the financial markets collapsed in October 2008. The Fund lost  $45,396,878, or 45% of the Fund’s NAV in its undisclosed derivates strategy.

The Fund was a registered investment company so some of the violations stem from the failure to make proper disclosures under the Investment Company Act. The SEC also found violations under the anti-fraud provisions of the Investment Advisers Act, Section 206(4) and Rule 206(4)-8. Those provisions prohibit the making of any untrue statement of a material fact or the omission of a material fact necessary to make statements made not misleading, or to otherwise engage in any act, practice, or course of business that is fraudulent, deceptive, or manipulative with respect to any investor or prospective investor in a pooled investment vehicle.

If derivatives are substantial part of a fund’s portfolio, it sounds like the SEC expects you to disclose that fact to investors.

Sources:

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.

Sources:

Robbery Not Allowed is by Anders Sandberg

The SEC Continues to Investigate Side Pockets and Valuations

The SEC brought another case against a private investment fund for misuse of side pockets. Lawrence R. Goldfarb of Baystar Capital Management agreed to pay a hefty fine to settle claims brought by the Securities and Exchange Commission for misuse of his investment fund’s assets.

When used properly, a side pocket is a mechanism that a hedge fund uses to separate illiquid investments from the liquid investments. If a fund investor redeems their investment in a hedge fund with a side pocket, the investor cannot redeem the pro-rata portion of their investment allocated to the side pocket. That portion of the redemption is delayed until the asset is liquidated or is released from the side pocket. It’s a way to protect all of the investors when the fund has a big chunk of illiquid assets. A wave of redemptions would force the sale of liquid assets, leaving those who did not redeem with the illiquid assets.

The typical abuse is to hide under-performing assets from limited partner scrutiny. The manager still collects the management fee on the over-valued assets. Without recognizing the loss, partners are less likely to redeem their capital.

The SEC complaint alleges that Goldfarb acted even more egregiously than disguising valuations. He stole profits from the fund.

The complaint states that Goldfarb’s fund invested in a real estate partnership. Since that investment was likely a very illiquid asset it would typically end up in a side pocket. Shortly after the investment was made the real estate partnership started making cash distributions. Goldfarb has these distributions sent to him instead of the investment fund. He ended up transferring the whole interest to himself, using the side pocket to hide the asset and the distributions.

At first I thought this might be an interesting action to highlight Rule 206(4)-8. From the complaint, is sounds more like a case of blatant theft from the fund. This enforcement actions shows that the SEC is focusing on private funds, valuations, side pockets and affiliate transactions.

Without admitting or denying the SEC’s allegations, Goldfarb and Baystar Capital Management consented to permanent injunctions against violations of certain provisions of the federal securities laws and to pay disgorgement of $12,112,416 and prejudgment interest of $1,967,371, which will be distributed to the fund’s investors. Goldfarb also agreed to pay a $130,000 penalty, be barred from associating with any investment adviser or broker (with the right to reapply in five years), and be barred from participating in any offering of penny stock.

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Code of Ethics for an Investment Adviser

With the upcoming requirement that advisers to many private investment funds must register with the SEC, I figured it was time to look at some of the requirements that registration will impose.

Section 204A of the Investment Advisers Act requires registered investment advisers to

“establish, maintain, and enforce written policies and procedures reasonably designed, taking into consideration the nature of such investment adviser’s business, to prevent the misuse … of material, nonpublic information by such investment adviser or any person associated with such investment adviser.”

It also requires the SEC to adopt “adopt rules or regulations to require specific policies or procedures reasonably designed to prevent misuse.” That leads to the issuance of  Rule 204A-1 under the Investment Advisers Act of 1940

Rule 204A-1 has three key elements: Adoption, Reporting, IPOs.

The adoption element lays out what needs to be in the advisers code of ethics:

  1. A standard of business conduct that you require which reflect the fiduciary obligations;
  2. Provisions requiring your supervised persons to comply with applicable federal securities laws;
  3. Provisions that require all of your access persons to report, and you to review, their personal securities transactions and holdings periodically;
  4. Provisions requiring supervised persons to report any violations of your code of ethics promptly; and
  5. Provisions requiring you to provide each of your supervised persons with a copy of your code of ethics and any amendments, and requiring your supervised persons to provide you with a written acknowledgment of their receipt of the code and any amendments.

Number five requires the standard delivery of the code and signature that they received the code. The prompt reporting is also standard for a code of conduct, as is the compliance with laws.

The fiduciary obligations may be a surprise for the advisers to private investment funds. Fund managers typically structure the funds as limited partnerships. The enabling statute impose a fiduciary duty on the general partner of a limited partnership, which for a private fund will be the investment adviser affiliate. Delaware limited partnership law allows a general partner to reduce its fiduciary obligations, but still must retain the implied contractual covenant of good faith and fair dealing. (see 17 Del Code §17-1101)

On the other hand, Section 206 of the Investment Advisers Act imposes fiduciary duties on investment advisers, regardless of whether or not they are registered with the SEC. This is a different body of law defining the obligations of an investment adviser as opposed to the general partner of a limited partnership.

The fiduciary obligation in 206 make its a violation to

  • employ any device, scheme, or artifice to defraud any client or prospective client;
  • engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client;
  • engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative;

Those are your conventional anti-fraud provisions. There is one more violation and it gets the most attention:

“Acting as principal for his own account, knowingly to sell any security to or purchase any security from a client, or acting as broker for a person other than such client, knowingly to effect any sale or purchase of any security for the account of such client, without disclosing to such client in writing before the completion of such transaction the capacity in which he is acting and obtaining the consent of the client to such transaction.”

The key here is that is a violation to if you don’t disclose the conflict prior to completion of the transaction.

Fora private fund, you will need to take a look at Rule 206(4)-8 because it lays out some additional fraud prohibitions for investment advisers to private investment funds.

If you run a private fund and don’t have written code of  ethics, it’s time to start thinking about putting one in place. Here are some examples of investment adviser code of ethics:

If you don’t have a code of conduct and are looking for a starting point. Those three are worth taking a look at. There are plenty of others out there and findable with an internet search.

Also keep in mind that you will have to revisit your code next year. Rule 206(4)-7 requires an annual review of your code of ethics.

Sources:

  • Section 204A of the Investment Adviser Act
  • Rule 204A-1 – Investment Adviser Code of Ethics
  • Investment Adviser Code of Ethics Rule by Shearman and Sterling
  • Section 206 of the Investment Advisers Act
  • Rule 206(4)-7
  • Rule 206(4)-8

Anti-Fraud Provision of the Investment Advisers Act

On September 10, 2007, the SEC Adopted Rule 206(4)-8. The SEC adopted this rule in response to the decision in Goldstein v. SEC, 451 F.3rd, 873 (in which the Court of Appeals for the District of Columbia ruled that the “client” of an investment adviser was the pool itself and not an investor in the pool).

Rule 206(4)-8 makes it clear that the SEC may prohibit fraudulent conduct of an investment adviser that impacts an investor in the investment pool, regardless of whether the investment adviser has registered with the SEC.

The rule does not create a private right of action.  It only provides the SEC with the authority to enforce the rule. But the SEC does have its broad authority to impose fines, sanctions bar individuals from the securities business and to seek criminal penalties.

The rule prohibits misleading statements and deceptive conduct and is not limited to “statements.” So,  the rule is applicable to non-written misstatements or omissions. The rule would include presentations at investor meetings and phone calls.

The bad act need not be made in connection with the sale of securities. Unlike 10b-5, this rule applies to regular disclosures and investor letters.

Unlike Rule 10b-5, there is no “in connection with” requirement and the SEC would not have to prove reliance or harm by any individual in an enforcement action. Also, Rule 206(4)-8 contains no scienter requirement, unlike Rule 10b-5.  The SEC need only prove that there was a misstatement or omission of a material fact.

The challenging piece is responding to requests for information from investors. If you are providing a piece of information to one investor and not providing it to others did you “omit to state a material fact”?

Although negligent conduct is proscribed, the SEC specifically stated that the rule does not create a fiduciary duty not otherwise imposed by law. This rule should not change the way an investment advisers perform their duties.  It merely removes the doubt regarding the scope of the SEC’s authority created by Goldstein.