Category: Investment Advisers Act

Beverly Hillbillies Ciphering for Assets Under Management

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.

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Another Danger of Overstating Assets

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.

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House Hearing on Investment Adviser Oversight Act

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

The Danger of Overstating Assets Under Management

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.

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Inflating the Balloon by Terry Feuerborn

Bill Backs SRO for RIAs

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.

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Advisory Contracts – Transition for Newly Registered Advisers

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]

Scalping as a Fraud


Today, it’s fairly well establish that an investment adviser should not be buying positions on their own behalf shortly before recommending that position to its clients. Fifty years ago, there was some question as whether the Securities and Exchange Commission could take steps to prevent this or require disclosure.

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.

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Image is The scalping of Josiah P. Wilbarger

This image is in the public domain in the United States. This applies to U.S. works where the copyright has expired, often because its first publication occurred prior to January 1, 1923.

Private Fund Advisers and State Registration

As a result of the shifting boundaries between state and federal regulation of investment advisers, NASAA created a model rule for Registration Exemption for Investment Advisers to Private Funds. The rule tracks the general parameters of the new federal rules for investment adviser registration for private fund advisers.

Massachusetts became the latest state to adopt its own regulations with such an exemption. A new private fund adviser exemption was adopted by the Massachusetts Securities Division, along with amendments to the “qualified institutional buyer” definition and IA custody requirements.

While the amendments took effect February 3, 2012, they will be not be enforced until August 3, 2012. You’ve got six months to get in compliance. The rules apply to adviser firms doing business in the Commonwealth, which generally means having a place of business in Massachusetts.

The new Massachusetts exemption is available to advisers to private funds that take money only from “qualified clients.” That definition carries over from Rule 205-3. Under that updated SEC rule,  “qualified clients” must have at least $1 million of assets under management with the adviser, up from $750,000, or a net worth of at least $2 million, up from $1 million.

Private funds using the Section 3(c)(7) exemption under the Investment Company should already meet this standards. Managers to section 3(c)1 funds will need to increase their threshold for investors from accredited investors to qualified clients.

The Massachusetts regulation tries to complement the SEC changes affecting private fund advisers under Dodd-Frank. So private fund advisers with between $25M-$150M in AUM, would have to file the exempt-reporting adviser sections of Form ADV. Those with more than $150M in AUM would have to notice file in the state as well as register with the SEC. Those private fund advisers with under $25M in AUM would also complete the exempt reporting sections of the form for Massachusetts.

States are still trying to catch up to the Dodd-Frank requirements:

They are well behind, leaving some uncertainty for managers of smaller private funds about their registration requirements.

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Middle Names and Form ADV

When filling out Form ADV, Schedule A and Schedule B require you to disclose control persons, owners, and significant indirect owners of the investment adviser. The instructions call for the full legal name: Last name, first name, and middle name.

And the SEC means it. They require full legal names (last, first, and middle name). If there is no middle name or only a middle initial, the information provided next to the name should reflect as such; (NMN) or (MI ONLY).

Unfortunately, FINRA’s system does not place one of those red stars next to the middle name field indicating that it’s a required field. Similarly, the online IARD filing system’s completeness check does not pick up a missing entry for a middle name.

Tighter Rules on Advisory Performance Fee Charges

Under the Investment Advisers Act, an adviser can only charge a performance fee if the client was a “qualified client”. The SEC equates net worth with sophistication, so a “qualified client” had to have a level assets to prove their financial sophistication. Those levels are now officially increased.

The original standard was that the client had to have at least $500,000 under management with the adviser immediately after entering into the advisory contract (“assets-under-management test”) or if the adviser reasonably believed the client had a net worth of more than $1 million at the time the contract was entered into (“net worth test”). Those levels were increased to $750,000 and $1.5 million in 1985 to adjust for inflation.

The Dodd-Frank Wall Street Reform and Consumer Protection Act called for Section 205(e) of the Advisers Act to adjust those levels for inflation and re-adjust the levels every five years. The SEC also decided to toss out the value of a person’s primary residence, just as they did with the new accredited investor standards.

The rule now requires “qualified clients” to have at least $1 million of assets under management with the adviser, up from $750,000, or a net worth of at least $2 million, up from $1 million.

The SEC is using the same primary residence calculation they used in the new accredited investor standard. So, if you owe more on your mortgage than the value of your house, then you need to treat the overage as a negative asset. As the SEC did with the accredited investor standard, the SEC requires certain mortgage refinancings to be counted against net worth. If the borrowing occurs in the 60 days preceding the purchase of securities in the exempt offering and is not in connection with the acquisition of the primary residence, the new increase in debt secured by the primary residence must be treated as a liability in the net worth calculation. This is intended to prevent manipulation of the net worth standard, by eliminating the ability of individuals to artificially inflate net worth under the new definition by borrowing against home equity shortly before participating in an exempt securities offering. Once again, owning a house can only be a negative for the SEC standards.

While I used the CPI-I standard as the benchmark for inflation, the SEC chose to use the Personal Consumption Expenditures Chain-Type Price Index (“PCE Index”), published by the Department of Commerce. One of the questions from the SEC in the proposed rule was whether the PCE index was the appropriate measure of inflation. They’ve decided to use this index and continue to benchmark it against the original test amounts. In five years, you will be able to predict what the new levels will be.

As for private  funds, Rule 205-3(b) requires a look -through from the fund to the investors in the fund. Each “equity owner … will be considered a client for purposes of the” limitation.  If the fund is relying on the 3(c)(7) exemption from the Investment Company Act then the fund’s investors should be “qualified purchasers”  and you won’t need to look much further. If the fund is using the 3(c)(1) exemption, then it will need to take a closer look at its investors to make sure that each is a qualified client.

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