Most advisory firms and fund managers end their fiscal year on December 31. Under the SEC Advisers Act Rule 0-4, you have 90 days to file your Form ADV update after the end of your fiscal year.

Last year that put the filing deadline on March 30 because it was a leap year. The next leap year does not come until in 2016.

This year that 90th day falls on March 31st. But that’s a Sunday. So we have one extra day this year. The filing deadline is April 1.

“Filings required to be made through the IARD on a day that the IARD is closed shall be considered timely filed with the Commission if filed with the IARD no later than the following business day.”

A Securities and Exchange Commission investigation found that two funds sponsored by Oppenheimer were involved in fraudulent valuations. Oppenheimer sent out misleading quarterly reports and marketing materials stating that the fund’s holdings of other private equity funds were valued “based on the underlying managers’ estimated values.” But that was not always true. The portfolio manager actually valued one of the fund’s largest investment at a significant increase over the underlying manager’s estimated value. That change that made the fund’s performance appear significantly better.

I don’t think the problem is that the fund of funds didn’t use the valuation provided by the underlying fund manager. The big problem is that the fund manager used a valuation method different than the one disclosed to investors. That problem was exacerbated by the result being an increase in valuation which led to better performance numbers in marketing materials.

Can a fund of fund use a valuation different than the one supplied by the underlying manager? I think so. But you would need to justify the difference.

One reason for using a different valuation would be timing. Given the time the underlying manager has to provide performance results, the fund of fund manager may have to start with stale information based on the prior quarter’s financial report. Then the manager could then increase or decrease the valuation based on estimated changes during the gap between the underlying manager’s report and the fund of fund manager’s report.

Another reason would be a perceived flaw in the underlying fund manager’s valuation. This change is one in which it is easier to justify a decrease rather than an increase. The fund of fund manager may find the valuation too aggressive or disagree with the underlying assumptions that went into the valuation.

Sources:

• SEC Charges New York-Based Private Equity Fund Advisers with Misleading Investors about Valuation and Performance
• SEC Order Against Oppenheimer Asset Management and Oppenheimer Alternative Investment Management (.pdf)

It was a case of math failure. Where exactly should that decimal place go? The Barthelemy Group of New York and New Jersey calculated assets under management as $26.28 million. But it looks like the decimal point was in the wrong place and the firm actually had $2.628 million under management.

Evens Barthelemy, the founder, sole owner, managing director, and chief compliance officer of the firm, wanted to be registered with the SEC and did so in June 2011. At the time, that meant having at least $25 million under management. Otherwise, the firm would have to register with the state regulators. (Unless the firm would have to register in at least 30 states, which would then allow the firm to register with the SEC instead of the states.)

On the firm’s Form ADV, Barthelemy stated that the firm had $26.5 million in assets under management and between seventy and ninety accounts. In the first four months after registration, the firm had no client assets that would qualify for AUM, never had more than $5 million in AUM, and only had about 30 clients at its peak.

This all fell apart during an SEC exam.

In response to an initial request from exam staff, Barthelemy provided an Excel spreadsheet listing all his clients and the assets he managed for each, which assets he totaled as $26.28 million. The exam staff later learned from BG’s independent custodian, however, that BG’s assets totaled only $2.6 million, and that the assets in BG’s spreadsheet were inflated ten-fold. Barthelemy had downloaded client account values from the custodian’s online platform, and then manually moved the decimal point for each client one place to the right.

That should be enough, but the SEC also had a laugh after looking at the compliance manual for BG. Barthelemy apparently prepared his firm’s 2010 written Compliance, Supervisory Procedures and Policies Manual by copying  a 2009 version he obtained from his prior employment at a registered broker-dealer. He merely substituted the term “investment adviser” for “registered representative” and substituted “client” for “customer.” That means he omitted most of the requirements under the Investment Advisers Act.

On one hand I feel bad for Barthelemy. I would guess that he was trying to switch his business model from a commission-based broker dealer to the AUM fee model as an investment adviser, better aligning his interests with his clients. But he clearly failed to seek out good advice on what he would need to legally do under this new business model.

If he felt he was better serving his clients, it’s very hard to justify the outright fraud of changing a spreadsheet and handing that lie to an SEC examiner.

Sources:

• SEC Sanctions Two Investment Advisers for Impeding Examinations
• SEC Order: Evens Barthelemy and Barthelemy Group LLC (.pdf)

The Securities Division of the Massachusetts’ Secretary of State’s office filed an administrative complaint against CCR Wealth Management. The complaint seeks to deny CCR Wealth Management registration as an investment adviser.

The secretary of state’s office said inspectors became suspicious when they noticed that CCR had reported static denominations over a period of time, even as its number of accounts fluctuated. According to the complaint, between 2007 and 2011, CCR reported exactly $25 million under management, even as its number of accounts fell from 350 to 250.

That $25 million number is the threshold between registration with the Securities and Exchange Commission and state level registration. With the transition from federal to state, a new set of eyes will be looking at the Form ADV filings and may have a different take on things.

What surprises me most about the story is that the Secretary of State noticed the issue and was able to act on it. I suppose we should credit an astute examiner in Massachusetts who compared the prior filings to the new state filing. I assume that person is overworked with a flood of new filings coming in this year.

It’s not clear what happened or that CCR did anything wrong. The company focuses on wealth management and estate planning. The SEC did impose a new and better defined method for calculating assets under management. The prior filings may have included items that are no longer included.

I find it strange that Massachusetts is seeking to prohibit CCR’s registration with the state. That seems like the nuclear option for something may merely be a misunderstanding rather than an intentional misdeed.

Sources:

• Galvin Charges Westborough Investment Adviser by Michael Gelbwasser
• State Seeks To Deny Registration For Westborough Firm by Matt Pilon in the Worcester Business Journal
• State issues securities complaint against Westboro wealth management firm by Donna Boynton in the Worcester Telegram
• IARD Filing for CCR Wealth Management

On Wednesday, the House Financial Services Committee held a hearing on the Investment Adviser Oversight Act. This bill would create a new self-regulatory organization for investment advisers.

Chairman Bachus opened up by offering to revise the list of exemptions. This worries me, since private funds are currently exempted.

My Congressman, Barney Frank, the ranking minority member of the Committee, pointed out that it is important not to leave state regulators out of the oversight mix. He pointed out that the entire budget of the SEC and CFTC  combined is less than J.P. Morgan’s derivative trading loss last month. The inadequate funding of the SEC is why the Committee is even considering a Self Regulatory Organization.

Congressman Barrett pulled out the Madoff failure as a complete indictment of the SEC. FINRA examined the broker-dealer side of Madoff several times and did a much more thorough job. (I will guess than “Madoff” will be mentioned many times today.)

Congressman Lynch raised concerns about the cost of an SRO on small advisers and the need to keep state regulators involved.

Congressman Scott thinks there is a big gap in investor protection because the SEC reviewed only 8% of the 12,000 registered advisers and compared this to FINRA’s 58% inspection rate in 2011.

Congressman McCarthy mentioned Madoff. She prefers the SEC but realizes the reality that Congress will not fully fund the SEC.

Current text of H.R. 4624, the “‘Investment Adviser Oversight Act of 2012″

WITNESS LIST

• Mr. Dale Brown, President and Chief Executive Officer, Financial Services Institute
• Mr. Thomas D. Currey, Past President, National Association of Insurance and Financial Advisors
• Mr. Chet Helck, Chief Operating Officer, Raymond James Financial Inc., on behalf of the Securities Industry and Financial Markets Association
• Mr. Richard Ketchum, Chairman and Chief Executive Officer, Financial Industry Regulatory Authority
• Mr. John Morgan, Securities Commissioner of Texas, on behalf of the North American Securities Administrators Association
• Mr. David Tittsworth, Executive Director and Executive Vice President, Investment Adviser Association

Mr. Brown supports the bill. “Consumers should not have to be regulatory experts to determine if they are being protected.” He cites data that 40% of investment advisers have never been examined. He endorses FINRA because they have the existing infrastructure.

Mr. Currey supports the bill and cites the same data as Mr. Brown.

Mr. Helck also supports the bill.

Mr. Ketchum supports the bill. (No surprise, since he is apparently hoping to expand the reach of FINRA.)

Mr. Morgan highlights the breadth and scope of oversight in Texas. He also pointed out the smaller income and scale of many advisers. He is concerned about the time and money a new SRO would impose on state registered advisers.

Mr. Titsworth is opposed and cites a long list of other organizations that are opposed to the SRO model and are critical of FINRA.  The cost of an SRO will greatly exceed the cost of just funding the SEC.

Chairman Bachus attacked the Boston Consulting group report on regulatory costs.

Mr. Morgan highlights some of the Constitutional concerns with requiring state regulators to report to an SRO.

The hearing turned into an attack on SROs and FINRA in particular. SROS are not required to submit to the cost-benefit analysis and FOIA requirements that an governmental regulator is subject to.

A Congressman asked why we think that creating another regulator will fix the problem. The Madoff failure was a regulator failure. (The SEC is hampered by a lack of funding.)

From the perspective of small advisers, the bill would subject state registered advisers to state regulatory oversight and SRO oversight.

Another pitch for FINRA came from the area of dual-registrants. They are already subject to FINRA on the broker-dealer side. By putting one organization in place as a regulator, you potentially fill a gap.

The panel’s score was 4 in favor, 2 against. Certainly, there is more to come.

Washington DC – Capitol Hill: United States Capitol  by Wally Gobetz
CC BY-NC-ND 2.0

Form ADV requires a registered investment adviser to state the firm’s assets under management. The new form changed the calculation and the term to “regulated assets under management”. At the same time, the threshold between state and federal registration has been increased from $25 million to $100 million.

I thought it would be useful to look back to 1997 when the regulation of investment advisers was first split at the $25 million level. Warwick Capital Management wanted to stay registered with the SEC and was accused of inflating its assets under management to maintain SEC registration. The main charge was a violation of Section 203A of the Investment Advisers Act. But the firm was also found to have violated section 207 by making an untrue statement of material fact in an SEC filing. Fraudulent intent is not required under Section 207. Even more, violations of Sections 206(1) and 206(2), by falsely representing Warwick’s assets under management and 2003 total performance returns to database services that published the misrepresentations to subscribers in the securities industry. Section 206 prohibits actions would operate as a fraud or deceit on a client.

In 1996 Warwick’s Form ADV listed $5 million of assets under management on a discretionary basis. In 1997 when the registration threshold increased, Warwick inflated assets under management to $26.55 million. That kept the firm under SEC registration and examination, instead of state-level.

Warwick also used inflated numbers in database services that acted as referral sources for Warwick. The amounts differed from those used in Form ADV and even differed from service to service.

Of course, you probably realize the importance of keeping the records that prove performance. Warwick did also. But they were destroyed in a fire, or a smoking chimney, or a flood. When asked by the SEC to make the records available, the firm used those series of excuses. The Administrative judge took the position that records never existed.

It probably comes as no surprise that in addition to inflating assets under management, Warwick inflated performance returns.

Sources:

• In the Matter of Warwick Capital Management (.pdf)

Inflating the Balloon by Terry Feuerborn

In my ongoing quest to distinguish what’s a security and what’s not a security, a new case came down from Missouri on the topic. Disgruntled purchasers of condominiums at the Branson Landing Hilton Promenade Boutique Hotel felt they got a bad deal and sued the seller/issuer to get their money back: Obester v. Boutique Hotel (.pdf)

The owners claim the seller/issuer represented that the condominiums would be rented out and they would receive a portion of the profits, generating substantial revenue. I assume the investment did not turn out to be a financial windfall. According to the claim, the hotel rented its inventory of unsold units at a discounted rate.

Fee simple ownership of the “bricks and mortar” of real estate is not a securities transaction. “The offer of real estate as such, without any collateral arrangements with the seller or others, does not involve the offer of a security.” As you move further away from that model, you move closer and closer to the ownership a security than the ownership of real estate. The line between the two is not a bright line.

As with the Hard Rock San Diego case still working its way through the federal courts in California, combining the sale of real estate with a management agreement starts making the real estate look like a security.

In the Boutique Hotel case, the court goes back to the Howey case and uses a four part test to determine if there is an investment contract, where there is

1. an investment of money,
2. a common enterprise,
3. a reasonable expectation of profits, and
4. a reliance on the entrepreneurial or managerial efforts of others.

The court draws a distinction between a vertical commonality and a horizontal commonality to create a common enterprise. Vertical looks at the relationship between the seller and the purchaser. Horizontal focuses on the pooling of interests among investors. It’s an interesting way to look at the analysis, but it ends up not being decisive to the court.

What kills the securities claim is that the owners were not required to participate in the rental program. An owner could chose to not rent out its condominium or rent it out on its own. That means the business arrangement did not have a reliance on the entrepreneurial or managerial efforts of others.

That distinguishes the arrangement from the one being contested in the Salameh / Hard Rock San Diego case. San Diego restricted the rental program to the one run by the seller/issuer. Under San Diego zoning, the units had to be sold for non-residential use and be managed as part of the hotel.

These cases do little to help me decide when an interest in a manager-managed limited liability company is a security. But it’s clear that there is still a big gray space between what is a security and what is not a security.

Sources:

• Obester v. Boutique Hotel (.pdf)
• Condo Rental Programs Are Not Investment Contracts by Ernest E. Badway in Fox Rothschild’s Securities Compliance Sentinel
• When is Real Estate a Security?
• What is a Security? Is Real Estate a Security?

Financial Services Committee Chairman Spencer Bachus and Rep. Carolyn McCarthy, a member of the Committee, introduced legislation that would create a Self Regulatory Organization for retail investment advisers. The legislation would amend the Investment Advisers Act of 1940 to provide for the creation of National Investment Adviser Associations (NIAAs), registered with and overseen by the SEC. Investment advisers that conduct business with retail customers would have to become members of a registered NIAA.

The bill exempt private fund managers from having to belong to a NIAA. It looks like it uses the current definition of “private fund” as a company exempt under Section 3(c)(1) or 3(c)(7) of the Investment Company Act. For real estate fund managers still wondering if the SEC cares about you, the bill also include those funds relying on the exemption under Section 3(c)(5)(C) of the Investment Company Act for real estate funds to be exempt from the NIAA requirement.

For investment advisers that have a combination of retail and fund management, the bill sets the the threshold at 90% fund management for the exemption.

The question for investment advisers is what organization will try to be a (the?) NIAA. FINRA is an obvious candidate and one that will upset many.

As for fund managers, presumably they would remain subject to SEC oversight and examination instead of NIAA oversight.

Sources:

• Chairman Bachus and Rep. McCarthy Propose Bipartisan Bill for More Effective Oversight of Investment Advisers
  
• Investment Adviser Oversight Act of 2012 (.pdf)
• Bachus bill backs SRO for RIAs— and it could be Finra by John Goff in Investment News

The SEC’s Division of Investment Management supplemented its Investment Management Staff Issues of Interest posting on the SEC website to include no-action relief for a newly registering adviser under Section 205(a)(2) and (3). Those include requirements that (1) an investment advisory contract not be assigned without consent and (2) that if the advisor is a partnership, the advisor will notify the client of any change in the membership of such partnership within a reasonable time after such change

The SEC has previously sought to minimize the disruption to the contracts of newly registering advisers when such contracts were permissible at the time they were entered into. For example, the SEC allowed performance fees for newly registered funds in Investment Advisers Act Release No. 2333 (Dec. 2, 2004)  More recently, the SEC permitted performance fees to formerly qualified clients after the SEC increased the threshold to be so qualified in  Investment Advisers Act Release No. 3372 (Feb. 15, 2011.

The advisor will need to meet three standards:

 (i) the advisory contract was entered into or last amended prior to the submission of the adviser’s application for registration;

(ii) any future amendment of the advisory contract will include the provisions required under Sections 205(a)(2) and (3);

(iii) the adviser undertakes to operate and perform under the advisory contract as if it contained the provisions specified in sections 205(a)(2) and (3)

Here is the text of the SEC language:

Advisory Contracts – Transition for Newly Registered and Registering Advisers

Sections 205(a)(2) and (3) of the Advisers Act generally prohibit registered advisers, and advisers required to be registered, from entering into, extending, renewing, or performing under an advisory contract that fails to include the provisions specified by those sections. In general, this means that an advisory contract must provide that (i) the contract may not be assigned by a registered adviser without the consent of the client and (ii) the registered adviser, if a partnership, will notify its clients of any change in membership within a reasonable time after such change.

As a result of the Dodd-Frank Act changes to the Advisers Act, previously exempt advisers are now required to register with the Commission. Nevertheless, newly registering advisers may be operating under existing advisory contracts that were entered into when such advisers were neither registered nor required to be registered with the Commission. As a result, these advisory contracts may fail to include the specified provisions of sections 205(a)(2) and (3). Advisers may need to seek the consent of their clients to amend the advisory contracts to include these provisions. Obtaining the consent of clients in a timely fashion to amend all existing advisory contracts, however, may be impracticable for some advisers.

The Commission has previously sought to minimize the disruption to the contracts of newly registering advisers when such contracts were permissible at the time they were entered into. See e.g., Investment Advisers Act Release No. 2333 (Dec. 2, 2004) (the Commission adopted rules to grandfather pre-existing contractual arrangements providing for performance-based compensation that were entered into when the adviser was exempt from registration) and Investment Advisers Act Release No. 3372 (Feb. 15, 2011) (the Commission adopted rules to grandfather pre- existing performance fee contractual arrangements that satisfied the requirements of the rule at the time that the contract was entered into ).

Accordingly, the staff would not recommend enforcement action to the Commission under sections 205(a)(2) and (3) of the Advisers Act if an adviser that has applied for registration but was not registered, nor required to be registered, when it entered into its advisory contracts, did not amend an advisory contract to include the provisions required by sections 205(a)(2) and (3), provided that: (i) the adviser undertakes to operate and perform under the advisory contract as if it contained the provisions specified in sections 205(a)(2) and (3), (ii) the adviser discloses such undertaking to the client and, in the case of a private fund client, each investor (or independent representative of the investors) in such client, (iii) the advisory contract was entered into or last amended prior to the submission of the adviser’s application for registration; and (iv) any future amendment of the advisory contract would include the statutory provisions set forth in sections 205(a)(2) and (3). [March 30, 2012]

The test case came against Capital Gains Research Bureau. The firm produced a monthly newsletter recommending securities. In 1960 the firm purchased securities before recommending them in its report for long-term investment. On each occasion, there was an increase in the market price and the volume of trading of the recommended security within a few days after the distribution of the Report. Immediately thereafter, the firm sold its position at a profit.

The SEC sought an injunction to stop that practice unless the firm disclosed that it may be trading in the securities mentioned in the report. The firm challenged the injunction by saying the SEC has to show an intent to injure clients or an actual loss of money. The trial court and the appellate court agreed with the firm. The SEC continued the fight and the case ended up in the hands of the Supreme Court.

The justices of the high court came to the rescue of the SEC.

The high standards of business morality exacted by our laws regulating
the securities industry do not permit an investment adviser to trade on the market effect of his own recommendations without fully and fairly revealing his personal interests in these recommendations to his clients.

Experience has shown that disclosure in such situations, while not onerous to the adviser, is needed to preserve the climate of fair dealing which is so essential to maintain public confidence in the securities industry and to preserve the economic health of the country.

And so, the SEC gained the ability to expand the types of activity that could be considered fraudulent, deceptive, or  manipulative. And to do so without having to show an intent to injure clients or an actual loss of money.

Sources:

• SEC v. Capital Gains Research Bureau, Inc. 375 U.S. 18 (December 9, 1963) (.pdf)
• SEC v. Capital Gains Research Bureau and the Investment Advisers Act of 1940 (.pdf) by Arthur B. Laby

Image is The scalping of Josiah P. Wilbarger

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