Custody Crackdown

Earlier this year, the SEC’s Division of Examinations published its priorities for 2022. There was a significant focus area on private funds. In particular, looking at:

“compliance with the Advisers Act Custody Rule, including the “audit exception” to the surprise examination requirement and related reporting and updating of Form ADV regarding the audit and auditors that serve as important gate-keepers for private fund investors”.

Earlier today the SEC announced a swath of actions against firms for custody rule failures. The charged advisors advisers failed to have audits performed or to deliver audited financials to investors in private funds in a timely manner, thereby violating the Investment Advisers Act’s Custody Rule.

The SEC added on a technical filing violation as well.

Firms are strongly encouraged to ensure their compliance with the Custody Rule and the related Form ADV reporting and amending obligations. In particular, private fund advisers registered with the SEC are reminded that per the instructions to Form ADV, Part 1A, Schedule D, Section 7.B.23.(h), “If you check ‘Report Not Yet Received,’ you must promptly file an amendment to your Form ADV to update your response when the report is available.”

The Custody Rule for private funds have some bright lines, making it easy to comply with (if you ignore the costs of audits). It also makes failure to comply with the Custody Rule very obvious. You either deliver the audited financial statements on time or you don’t.

If you don’t deliver on time, the SEC is going to notice.

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The One with the Miscalculated Fees

The Securities and Exchange Commission has made it clear that one of its primary points of interest with private funds is fees and expenses. Some of that is well-deserved. Some private funds had a history of being opaque about fees and expenses.

A recent enforcement case by the Securities and Exchange Commission highlights mistakes that could easily be made by a fund manager if not paying attention to what the fund documents say. The case against Energy Innovation Capital Management, LLC is illustrative of items to pay attention to when checking management fee calculations.

The first thing to note is that Energy Innovation is a venture capital firm and is an exempt reporting adviser. Those types of firms are not subject to routine examination. I’m intrigued how the SEC came across the fee calculation problems at the firm.

As with most non-hedge private funds, the fund management fee calculation changes after the equity commitment period ends. During the commitment period, the fee is a percentage of committed capital while the fund deploys the capital. Once the commitment period ends, the fund is limited in its ability to make investments and the fee basis is reduced to an amount that generally equates to the amount of capital deployed.

In the Energy Innovation fund the commitment period ended in the first quarter of 2020. The firm changed the calculation as of the end of the quarter. That was inaccurate. The fee should have been pro-rated as of the actual date. Of course, by waiting until the end of the quarter the firm had a higher fee basis for a longer time.

The second problem was that the firm included accrued, but unpaid, interest attributed to certain individual portfolio company securities in the fee basis. Without the language of the fund agreement its hard to tell what went wrong. It may be that the fund documents did not specifically allow it to be included so the SEC took the position that it can’t be included.

The biggest problem is that the firm wrote down individual portfolio company securities and wrote off certain others for valuations, but did not incorporate any of these write-downs into its post-commitment period fee basis.

The final corollary issue was that the firm aggregated invested capital at the portfolio company level in fee basis, instead of at the individual portfolio company security level. The fund documents did not permit aggregation of invested capital at the portfolio company level. I assume this is tied to the treatment of write-downs.

The net result of these problems was that the firm earned $678,861 in excess management fees. Interestingly, the the order did not require repayment of those excess fees. The order notes that “the Commission considered remedial acts promptly undertaken.” I assume the firm had already repaid the excess fees during the examination.

This enforcement action is a warning to other firms that the SEC is laser focused on management fees.

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The One with the Fixing and Flipping

Angel Oak Capital Advisers sponsored a fund to securitize “Fix and Flip” loans. These loans were targeted at borrowers for the purpose of purchasing, renovating, and selling residential properties. It looks like Angel Oak didn’t get the underwriting correct. Angel Oak saw an unexpected increase in late mortgage payments delinquencies. The securitization had a covenant that required early amortization payments to investors in the securitization if there was a greater than 15% delinquency for two consecutive months.

The “Fix and Flip” loans had escrow accounts to pay draws to borrowers after completion of renovations the properties. The securitization documents said these escrow accounts would be used for renovations and repairs. The documents did not specifically allow the use of the escrow to reduce delinquencies.

Angel Oak divert escrowed renovation funds to bring delinquent mortgage loans into current status and reduce delinquencies. According to the SEC complaint this was not consistent with disclosures made to investors in the certification. Angel Oak contacted delinquent borrowers and instructed them to make requests for escrow funds to reimburse for renovations, with the understanding that the funds would instead be used to pay off delinquent balances. There were email documenting the process with borrowers.

There are emails documenting the decision to seek the diversion of funds.

“We have to keep the 3 month average of 60+ dq [delinquencies] under 15% to avoid an early amortization trigger to trip. This trigger tripping would be extremely negative for our prospects of doing further securitizations and will also negatively impact our broader AOMT shelf.”

The additional problem you can see from that quote is that the early amortization would hurt effort to pull in investors for the next securitization. It’s not just a question of defrauding the current investors, but using the fraud to raise more capital.

As an additional conflict, Angel Oak held a junior position in the securitization. The early amortization trigger would have a substantial, negative impact on that junior position.

Blame was also placed on Ashish Negandhi, a loan portfolio manager responsible for purchasing loans to be securitized by Angel Oak as well as monitoring the securitizations’ performance after their sale to investors.

As a result of the SEC action, Angel Oak agreed to pay a $1.75 million penalty and Mr. Negandhi agreed to a $75,000 penalty.

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The One with Valuation Malfeasance

After a hiatus for the heat of the summer, here is a compliance case of valuation malfeasance. It comes from the biggest collapse of a private equity fund manager. The Abraaj Group and its CEO, Arif Naqvi, were vanguards in emerging markets investments. After some early success buying and transforming Inchcape Shipping Services and Jordanian Express Mail, Mr. Naqvi became a prolific fundraiser. The Abraaj Group at one point managed almost $14 billion, with holdings in health care, clean energy, and real estate across Africa, Asia, Latin America and Turkey.

The Abraaj fundraising was based on the purported success of the prior funds’ private company investments which were very illiquid. Mr. Naqvi also claimed that his investments were doing good for people while making money for the investors.

It turns out that wasn’t true. There are currently many pending actions against the Abraaj Group, Mr. Naqvi and the firm’s personnel in several countries.

The latest action is a case brought by the Securities and Exchange Commission against Mark Alan Bourgeois who was responsible globally for fundraising and investor relations and was a member of Abraaj’s Management Executive Committee. Mr. Bourgeois recommended that Abraaj not apply write-downs (or delay doing so) for investments made by prior funds to avoid the negative impact on the fundraising for its sixth fund. Abraaj did delay applying the write-downs. The result was that investors and potential investors in its sixth fund received an inflated performance track record while Abraaj and Mr. Bourgeois actively solicited investments for the sixth fund.

Mr. Bourgeois agreed to pay a $2 million fine in this case. Mr. Naqvi is currently free on bail in London while contesting extradition for financial fraud charges.

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The One With The CCO Illegally Selling Securities

Enforcement cases against a Chief Compliance Officer always catch my attention. The latest to catch my eye is against A.G. Morgan Financial Advisors, LLC (“AGM”) of Massapequa, New York, AGM’s owner Vincent J. Camarda, and AGM’s former Chief Compliance Officer James McArthur.

The SEC Commissioners and senior Division of Examination staff have usually stated three circumstances that lead to CCO liability:

  1. when the CCO is affirmatively involved in misconduct;
  2. when the CCO engages in efforts to obstruct or mislead the Commission; or
  3. when the CCO exhibits “a wholesale failure to carry out his or her responsibilities”

AGM, Mr. Camarda and Mr. McArthur got involved with an unregistered securities offering with a lending company called Complete Business Solutions Group, that was doing business as Par Funding. The company was making short term loans to small businesses that were supposed to be secured by receivables. Par Funding was raising capital by selling unregistered securities in the form of promissory notes. Nothing illegal as long as the firm and its agents are following the the private placement rules.

According to the SEC compliant, Mr. McArthur was actively involved in the selling of the Par Funding securities to the AGM clients. This would put the nature of the SEC CCO action into the exception 1: affirmatively involved in the misconduct. (And still its CCO.)

In this case I’m not sure why Mr. McArthur is identified in the complaint as “its former Chief Compliance Officer”. There is no mention of him acting in a compliance role in the complaint. According to the firm’s website and the firm’s Form ADV filing, Mr. McArthur is also the firm’s president.

As for the alleged wrongdoing, AGM was also a client of Par Funding. The firm owed par as much as $750,000 at times and some which was personally guaranteed by Mr. Camarda. The Securities and Exchange Commission accuses AGM of telling investors that it was a safe investment, while failing to disclose that his company AGM was in debt to Par Funding and that Mr. Camarda was a guarantor on that debt to Par Funding. The SEC claims that existence of the debt was a material conflict that should have been disclosed to the AGM investors and failing to disclose the existence of the debt was a breach of fiduciary duty under the Investment Advisers Act. AGM was apparently paying down its debt to Par Funding by selling the promissory notes.

The SEC also claims that the sale of promissory notes did not fit any exemption from registration. It’s a little light on that claim. It at least three instances, the complaint notes that the respective investor had completed an “Accredited Investor Questionnaire.” It does reference a television commercial for the investment, so that could be a general advertisement in violation of the private placement rules.

Of course, the main problem was that the Par Funding investments were duds. Par Funding ended up in receivership. It’s under investigation for illegally selling securities. From news reports, Par Funding engaged in some shading lending practices, poor underwriting and had some shady characters under its employ. Investors lost money.

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The One With the Gambling Edge

Buying and selling securities is often equated with gambling. (The differences are that you can hold your securities and keep winning without making any bets.) Gamblers and investors are always looking for an edge to increase their odds of success. When it comes to investing, that edge can be the misuse of insider information.

The headline of SEC Charges Former Employee of Online Gambling Company with Insider Trading jumped out at me. Finally, the intersection of gambling and investing in an enforcement case.

It turns out to be a fairly standard insider trading case. David Roda worked at Penn Interactive Ventures, a subsidiary of Penn National Gaming, as a programmer for its online sportsbook application. He heard from a co-worker that Penn was working on an acquisition. Mr. Roda got himself added to the acquisition team and found out about the target.

According to the SEC complaint, Mr. Roda quickly acquired some call options on the target. Penn sent a message warning employees not violate the insider trading policy. That apparently spooked Mr. Roda so he sold those options. Or maybe it didn’t spook him, because he then bought more options on the target.

As you might expect, the trades looked suspicious. They were short duration options that were “out of the money.” Since the options were just above the current trading price with little time left for the price to rise, they were cheap. It would be very aggressive to buy these, unless you had a gambler’s edge. Or insider knowledge.

According to the SEC complaint, Mr. Roda’s $21,000 purchase of those options netted him over $580,000 in profits in less than two weeks. I’m sure that triggered warning lights for compliance at whatever firm he had used for the trading.

Obviously, this is just the government’s side of the case. The Department of Justice has stepped in with criminal charges as well. Mr. Roda may or may not be guilty.

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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)

SEC ALJs Violate the Right to a Jury Trial

Among the many, many, many legislative actions in Dodd-Frank, one section gave the Securities and Exchange Commission broader authorization to bring enforcement actions through its internal administrative law judges instead of through federal courts. The SEC decides which cases to bring to the ALJs and which it wishes to bring in federal court. In federal court you can have a jury trial. With the SEC’s ALJs you do not get a jury trial.

If you find this problematic, the Fifth Circuit Court of Appeals agrees with you. With its coverage of Texas, Louisiana and Mississippi, this Court fired a blistering attack on the SEC in the opinion.

Congress has given the Securities and Exchange Commission substantial power to enforce the nation’s securities laws. It often acts as both prosecutor and judge, and its decisions have broad consequences for personal liberty and property. But the Constitution constrains the SEC’s powers by protecting individual rights and the prerogatives of the other branches of government. This case is about the nature and extent of those constraints in securities fraud cases in which the SEC seeks penalties.

The case was launched by the SEC in 2011 against a fund manager for overvaluing fund assets to collect more in fees. The timing of the alleged fraud and SEC litigation is such that the fund manager was not required to be registered with the SEC as an investment adviser. I can’t find a provision in the opinion that talks about whether this distinction matters.

The biggest point in the opinion is that the fund manager was deprived of its constitutional right to a jury trial by the SEC bringing the vase through the administrative law process. The Court hangs its argument on its view that a case of fraud is traditional action of “suits at common law” described in the Seventh Amendment to the Constitution which can include “suits brought under a statute as long as the suit seeks common-law-like legal remedies.” (page 7) The Court points out that fraud prosecutions were regularly brought in English courts at common law. Even though the SEC brought non-monetary remedies against the fund manager that doesn’t invalidate the right to a jury trial.

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ESG Regulation is Coming to Investment Advisers

Maybe.

The Securities and Exchange Commission is going to propose standardization of environmental, social, and governance disclosures to investors and to the SEC. The vote happens at the SEC open meeting on May 25.

MATTERS TO BE CONSIDERED:

1. The Commission will consider whether to propose amendments to the rule under the Investment Company Act that addresses investment company names that are likely to mislead investors about an investment company’s investments and risks. The amendments the Commission will consider also include enhanced prospectus disclosure requirements for terminology used in investment company names, as well as public reporting regarding compliance with the new names-related requirements.
 

2. The Commission also will consider whether to propose amendments to rules and reporting forms for registered investment advisers, certain advisers exempt from registration, registered investment companies, and business development companies to provide standardized environmental, social, and governance (“ESG”) disclosure to investors and the Commission.

I assume the first item is to prohibit funds calling themselves “ESG funds” or “green” funds unless they meet some specific criteria.

The second is the new ESG Rule. What is it? It’s just a proposed rule so I would be guessing.

We could look to the proposed rule of Climate-Related Disclosures for Investors for public companies. That public company proposed rule is more focused on reporting greenhouse gas emissions and disclosure of climate-related risks. I don’t think its a great model for investment advisers and investment companies. I’m intrigued to find out what the SEC is trying to do with ESG.

Of course, this is yet another addition to a very busy regulatory agenda for the SEC.

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The One with the Missing Audits

The basic premise of the Custody Rule is that registered investment advisers who have custody of
client assets must implement specific safekeeping requirements to prevent loss, misuse, or misappropriation of those assets. (Rule 206(4)-2)

For non-fund managers, there is a surprise exam requirement. For fund managers, the usual route is through audited financial statements. The Custody Rule has a strict requirement that you deliver those audited financial statements to investors within 120 days of the end of the fund’s fiscal year. The audit has to be done by independent public accountant that is registered and subject to regular inspection by the Public Company Accounting Oversight Board, and in accordance with Regulation S-X.

Audits that meet those standards are expensive and take some time to perform. Let’s face the truth, if a fund manager is having trouble getting the fund audits done on time there is likely an underlying problem.

Spruce Investment Advisors acquired the management interest in about 100 private equity funds with about $182 million in regulatory assets under management and created two funds of funds on top of them.

As you might expect with the discussion about the Custody Rule, Spruce failed to meet the requirements of the Custody Rule. The firm didn’t get the audited financial statements out on time. Easy case for the SEC to win. Send the audited financial statements out on day 121 and you’ve violated the rule.

The SEC order pokes at some allocation of expenses issues that Spruce was encountering. It looks like Spruce was paying some expenses that should have been expenses of the funds. Re-jiggering the expenses delayed the audits for the financial statements. The re-allocation was another violation with the SEC piling on that Spruce didn’t have adequate policies and procedures in place regarding the allocation of expenses.

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