Developments of Note
- FINRA Issues Further Guidance on Suitability Rule
- FRB Approves Final Rule Allowing SHCs to Elect to be Supervised by FRB
- SEC Settles Enforcement Proceeding Against Adviser over Improper Side-by-Side Management of Hedge Fund and Closed-End Fund
DEVELOPMENTS OF NOTE
FINRA Issues Further Guidance on Suitability Rule
FINRA has published Regulatory Notice 12-25 providing additional guidance (the "Guidance") on FINRA's customer suitability rule (FINRA Rule 2111 (the "Rule"). The implementation date for Rule 2111 is July 9, 2012. The Rule requires broker-dealers and their associated persons to "have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through reasonable diligence of the firm or associated person to ascertain the customer's investment profile." The Guidance is in response to industry questions and provides further clarification of Regulatory Notice 11-02. This article summarizes the Guidance, whose component questions and answers are referred to as Q1 - Q26.
General Solicitation Under The Jobs Act
Section 201(a) of the Jumpstart Our Business Startups Act (JOBS Act) requires the SEC to amend Rule 506 of Regulation D to eliminate the prohibition on general solicitations. However, according to the Guidance, the JOBS Act does not remove broker-dealer obligations under the Rule for private placements. FINRA explains that a broker-dealer's general solicitation of a private placement through the use or distribution of marketing or offering materials ordinarily would not, by itself, constitute a recommendation triggering application of the Rule. When a broker-dealer does make a "recommendation" within the meaning of existing guidance, however, the Rule will apply. (Q5)
Institutional Customers and Suitability Certificates
The Guidance states that FINRA has not approved or endorsed so-called "Institutional Suitability Certificates" created by third-party vendors to facilitate compliance with the new institutional-customer exemption under Rule 2111(b). Use of the "Institutional Suitability Certificates" does not constitute a safe harbor from the Rule. In adopting the Rule, FINRA modified the institutional-customer exemption by replacing the previous definition of "institutional customer" with the definition of "institutional account" used in FINRA's "books and records" rule under Rule 4512(c). "Institutional account" is defined as the account of a "bank, savings and loan association, insurance company, registered investment company, registered investment adviser or any other person (whether natural person, corporation, partnership, trust or otherwise) with total assets of at least $50 million." However, the institutional customer exemption, as distinct from the definition, contains two additional factors: (1) whether a broker "has a reasonable basis to believe the institutional customer is capable of evaluating investment risks independently, both in general and with regard to particular transactions and investment strategies involving a security or securities" (a factor used in the Rule's predecessor) and (2) whether "the institutional customer affirmatively indicates that it is exercising independent judgment" (a new requirement). A broker-dealer fulfills its customer-specific suitability obligation only if all of these conditions are satisfied. Institutional Suitability Certificates may not contain all of the information a broker needs to make a suitability determination with respect to the purchase of a particular security or class of securities, so brokers must make their own independent judgments based on information they deem relevant to the determination. (Q24 and Q25)
The Guidance advises that firms may use a risk-based approach to documenting suitability determinations for institutional customers. While the requirement to obtain an affirmative indication that an institutional customer intends to exercise independent judgment by definition cannot be satisfied with a non-response to a negative consent letter, the affirmative indication does not necessarily need to be in writing. Such an affirmative consent could, therefore, be given orally to the broker and memorialized by the broker in a written record. (Q26)
Definition of Customer. The Rule only applies to a broker's recommendation to a "customer." "Customer" is defined broadly as anyone who is not a "broker or dealer" and includes an individual or entity with whom a broker-dealer has a business relationship related to brokerage services. Even an informal business relationship with an individual or entity would constitute a broker-customer relationship. For example, recommendations to a potential investor, even if the investor does not have an account with the firm, will fall under the broker-customer relationship. (Q6)
Definition of Recommendation. The Rule does not define "recommendation"; however, FINRA directs member firms to the basic principles outlined in previous FINRA guidance and SEC cases and states that the prior guidance generally remains applicable. (Q2)
While the Rule now applies to hold recommendations, it does not apply to implicit hold recommendations. In order to trigger obligations under the Rule, the hold recommendation must be explicit; a broker's silence regarding security positions in an account does not implicate the Rule. (Q3) Advice from a firm's call center personnel to customers who want to know whether they may continue to maintain their investments at the firm if, for instance, they move positions from an employer-sponsored retirement account to an individual retirement account held at the firm would not constitute a hold recommendation if it relates only to account requirements and not to specific securities. (Q4)
If a customer transfers a security whose purchase the broker did not recommend into the broker's account, the broker would not be deemed to make a hold recommendation unless the broker made an explicit recommendation. In the event the broker does make a hold recommendation regarding such a transferred security, the level of documentation required to support the hold recommendation may be determined using a risk-based approach.
Documentation of a hold recommendation for a portfolio of blue-chip stocks may require less documentation than for complex or alternative investments, or where the customer has a highly concentrated position. (Q11)
Definition of "Investment Strategy". Under the Rule, "investment strategy" is intended to be interpreted broadly and covers such things as: (1) a recommended investment strategy regardless of whether the recommendation results in a securities transaction or mentions a specific security; (2) recommendations to invest in specific types of securities (e.g., Dogs of the Dow) or in a particular market sector; (3) recommendations to use a bond ladder or margin strategy involving securities regardless of whether the recommendation mentions a particular security; and (4) an explicit recommendation to hold a security or continue to use an investment strategy. Ultimately the Rule focuses on whether the recommendation was suitable when it was made. (Q7)
Safe Harbor. The Rule provides a safe harbor for the use of asset allocation models that are: (1) based on a generally accepted investment theory; (2) accompanied by disclosures of all material facts and assumptions that may affect a reasonable investor's assessment of the asset allocation model (or any reports); and (3) in compliance with the Requirements for the Use of Investment Analysis Tools, NASD IM-2210-6 (which will become new FINRA Rule 2214 when effective), if the asset allocation model is an investment analysis tool within the meaning of IM-2210-6. However, the narrower or more specific a recommendation becomes, the more it is likely to become a recommendation of a particular security and, thus, trigger obligations under the Rule. (Q8) Finally, the safe harbor provision under the Rule would apply to recommendations of a generic asset mix based on an asset allocation model. (Q9)
Security and Non-Security Investments. The Rule continues to cover a broker's recommendation of an investment strategy involving both securities and non-securities. Further, firms must establish a supervisory system which is reasonably designed to achieve compliance with applicable securities laws, regulations and FINRA rules as applied to investment strategies involving securities and non-securities. This may be done by setting up a system which identifies relevant red flags. For example, a broker's recommendation that a customer with limited means purchase a large position in a security should raise questions about the source of funds for the purchase. If the broker recommended that the customer raise money by putting a new mortgage on his or her primary residence (a non-security investment strategy), this would require a suitability analysis covering more than the securities purchase. (Q10)
Risk-Based Approach to Documenting Compliance
In General. There are no explicit documentation requirements under the Rule. The extent to which a firm needs to document its suitability analysis will depend on an assessment of the customer's investment profile and the complexity of the recommended security or investment strategy involving securities and the risks involved. For example, recommendation of a large-cap, value-oriented equity security would generally not require documentation. The Guidance advises firms to consult previous Regulatory Notices and cases discussing various types of complex or potentially risky securities and investment strategies for further guidance concerning recommendations requiring documentation. (Q12)
Documenting "Hold" Recommendations. Firms should pay particular attention to documenting hold recommendations of securities that by their nature or due to a particular circumstance could be viewed as having a shorter-term investment component. For example, leveraged ETFs, REITs, overly concentrated security positions, or securities that are inconsistent with the customer's investment profile. (Q13) The Guidance further provides that although the Rule does not prescribe the manner in which a firm must document "hold" recommendations, examples include hold tickets or other reasonable methods. Ultimately, firms may use a risk-based approach to documenting and supervising "hold" recommendations. (Q14)
Information-Gathering about Customer Suitability. The Rule requires broker-dealers to obtain and analyze customer-specific factors listed in the Rule when making a recommendation to the customer. A broker-dealer is not required to obtain all the customer-specific factors by the Rule's implementation date, but rather, a firm may obtain the factors when it makes new recommendations to customers (old and new). (Q15)
The Guidance provides that absent red flags indicating the information is inaccurate, a broker may exercise reasonable diligence and thus rely on a customer's responses to the factors listed in the Rule. However, there are situations in which a broker may not rely exclusively on a customer's responses including when a customer exhibits clear signs of diminished capacity. (Q16) Further, reasonable diligence does not include making assumptions about customer-specific factors when the customer declines to provide the information. Moreover, a firm must still consider whether it has sufficient understanding of the customer to properly evaluate the suitability of a recommendation when a customer refuses to provide customer-specific information. (Q17)
Although there is no affirmative obligation to ask customers for additional information beyond what is listed as the customer-specific factors under the Rule, the best practice, according to the Guidance, is to obtain as much relevant information as possible about the customer prior to making a recommendation. (Q18) Additionally, if a customer chooses inconsistent investment objectives, the firm must make meaningful suitability determinations under an appropriate level of supervision. This may include clarifying the customer's intent and reconciling how it will handle the inconsistent investment objectives. (Q19)
Finally, when a third-party (i.e., trustee, custodian, or guardian) is managing an account, the investment experience of the third party should be considered. The firm must consider other factors such as the trust's investment objectives, time horizon, and risk tolerance in the suitability analysis. Importantly, when an institutional customer delegates decision-making authority to an agent (e.g., investment adviser, bank trust), the factors governing the institutional-customer exemption will apply to the agent. (Q20)
Reasonable Basis and Quantitative Suitability
Customer's Best Interests. Generally, a broker's recommendations must be consistent with the customer's "best interests." A broker may violate the Rule by placing his or her interests ahead of a customer's interests. For example, it has previously been held that a broker who recommended a product because of the potential for larger commissions violated the Rule. Likewise, a broker who recommended the purchase of promissory notes to use in his business violated the Rule. Despite these examples, the obligation to make recommendations consistent with a customer's best interests does not equate to recommending the least expensive security or investment strategy, as long as the recommendation is suitable and the broker does not place his or her interests above the customer's interest. Cost associated with a recommendation is only one of many important factors in the suitability analysis. (Q1)
Reasonable-Basis Suitability. The reasonable-basis obligation requires the broker to (1) perform reasonable diligence to understand the nature of the recommended security or investment strategy, the potential risks, and potential rewards; and (2) determine whether the recommendation is suitable for at least some investors based on the broker's understanding of the product. A broker will not meet his or her reasonable-basis obligation (or the customer-specific obligations) if the broker does not understand the securities and investment strategies being recommended. (Q22)
Portfolio Approach. Brokers may make recommendations based on a customer's overall portfolio -- that is, portfolios held with other financial institutions -- so long as the customer is in agreement with that approach. In fact, the Rule explicitly requires a broker to seek to obtain and analyze a customer's other investments. However, a broker may not use a portfolio approach in making a suitability analysis when (1) the customer wants individual recommendations to be consistent with the customer's investment profile or particular factors in that profile; (2) the broker is unaware of the customer's overall portfolio; or (3) red flags exist which indicate that the broker may have inaccurate information about the customer's other holdings. (Q21)
Quantitative Suitability. Quantitative suitability requires brokers who have actual or de facto control over a customer's account to have a reasonable basis for believing, in light of the customer's investment profile, that a series of recommended transactions is not excessive and unsuitable for the customer, even if suitable when viewed in isolation. The quantitative suitability obligation under the Rule essentially codifies the excessive trading line of cases under the previous rule and the general obligation of fair dealing. (Q23)
FRB Approves Final Rule Allowing SHCs to Elect to be Supervised by FRB
The FRB approved a final rule (the "Final Rule") setting forth the procedures for securities holding companies ("SHCs," and each an "SHC") to follow should they wish to elect (as permitted by Section 618 of the Dodd-Frank Act) to be supervised by the FRB. An SHC is a nonbank company that owns at least one registered securities broker or dealer. An SHC may elect to be supervised by the FRB if it wishes to meet requirements of a regulator in a foreign country that the company be subject to comprehensive consolidated supervision in the U.S. if the company wishes to operate in that foreign country. The Final Rule specifies the information that the SHC must provide to the FRB (including information concerning organizational structure, capital and financial condition) to be registered for FRB supervision. The Final Rule notes, however, that with respect to capital, the FRB may modify its capital rules to account for differences in activities and structure of SHCs and bank holding companies. An SHC supervised by the FRB will be supervised and regulated as if it were a bank holding company, but will not be subject to Bank Holding Company Act restrictions on nonbanking activities. The Final Rule will become effective on July 20, 2012.
SEC Settles Enforcement Proceeding Against Adviser over Improper Side-by-Side Management of Hedge Fund and Closed-End Fund
The SEC settled public administrative and cease and desist proceedings based on its findings of violations of a number of the anti-fraud, reporting, affiliated transaction and compliance provisions of the Investment Advisers Act of 1940, as amended (the "Advisers Act"), and the Investment Company Act of 1940, as amended ( the "1940 Act"), by two affiliated SEC-registered investment advisers ("Adviser 1" and "Adviser 2," collectively, the "Advisers") arising principally out of improper preferential treatment given a hedge fund client of one at the expense of a registered closed-end fund client of the other. This article describes the SEC's findings which the respondents have neither admitted nor denied.
Background. The Advisers are both part of a group of affiliated investment managers based out of the United Kingdom (the "Management Group"). Each is wholly-owned by the same parent. The Advisers operate from the same offices and share common employees. Adviser 1 serves as the investment adviser to a hedge fund (the "Hedge Fund"), and Adviser 2 serves as the investment adviser to a U.S. registered closed-end investment company (the "Closed-End Fund," together with the Hedge Fund, the "Funds"). Both the Hedge Fund and Closed-End Fund focused on investments in China and were managed by two portfolio managers ("Manager 1" and "Manager 2," collectively, the "Managers") who had entered into a profit sharing arrangement with the Management Group through a joint venture under which the Managers served as portfolio managers for the Hedge Fund, the Closed-End Fund and other accounts managed by the Management Group, and in return received a portion of the fees attributable to those accounts. The assets overseen by the Managers represented approximately one-third of the total assets under management of the Management Group. The SEC found that Manager 1, who played the leading role in the events giving rise to the proceeding, operated with very little supervision; he reported directly to the Management Group's Chief Executive Officer, bypassing the normal chain of command for investment managers at the Management Group.
The violations found by the SEC arise from the Funds' purchase of various securities issued by a Chinese company (the "Company") listed on the Hong Kong Stock Exchange and debt issued by a subsidiary of the Company.
Investments by the Hedge Fund in the Company. The Hedge Fund made investments in various parts of the Company's capital structure during the period 2003-2008. In May of 2003, the Hedge Fund purchased equity shares of the Company. In June 2007, Adviser 1 and Manager 1 caused the Hedge Fund to purchase $10 million of Company bonds maturing in 2010 with a coupon rate of 10% (the "10% Bonds"). The 10% Bonds were secured by equity shares of an indirect subsidiary of the Company (the "Indirect Subsidiary"), and also included detachable warrants that were convertible into shares of the Company.
In October 2008, Manager 1 and Adviser 1 caused the Hedge Fund to purchase an additional $4 million in bonds from the Company maturing in 2010 with a coupon rate of 15% (the "15% Bonds"). The purchase of the 15% Bonds increased the Hedge Fund's total investment in Company to $17 million, representing approximately 18.5% of the Hedge Fund's net assets. At that time, the Hedge Fund faced severe liquidity issues because of investor redemptions in response to market turmoil. Given the relative illiquidity of the 10% Bonds and the 15% Bonds, Adviser 1 sold other more liquid holdings to meet redemptions, resulting in an increasingly illiquid portfolio with even greater exposure to the Company. At the same time, the Company's financial condition had weakened, and it needed cash to make debt service payments to its various lenders and bondholders, including the Hedge Fund.
Hedge Fund's Limitation on Unlisted Securities. Shortly before the Hedge Fund was to close on its investment in the 10% Bonds, Adviser 1 realized that the acquisition of the 10% Bonds would cause the Hedge Fund to violate an investment restriction in its offering documents that limited to 5% the portion of its portfolio that could be invested in "unlisted" securities. Adviser 1 sought approval from the Hedge Fund's board to modify this limit. In presenting the matter to the Hedge Fund's board, representatives from Adviser 1 portrayed the restriction as ambiguous and unclear, and asserted that the 5% limit should not apply to all unlisted securities, but instead to only securities issued by companies whose stock was not publicly traded. (Under this definition the 10% Bonds would not be unlisted securities because the common shares of the Company are listed on a stock exchange.) The SEC found that the representatives from Adviser 1 who briefed the Hedge Fund's board in connection with the modification of the 5% unlisted securities limitation failed to raise certain important issues, including: (i) the risks of illiquid investments; (ii) the purpose of the original restriction; (iii) whether allowing greater exposure to illiquid investments was in the Hedge Fund's best interests; and (iv) whether the proposed modification was appropriate for the Hedge Fund and legally permissible.
Classification of the 10% Bonds as Cash. Following the Hedge Fund's purchase of the 10% Bonds, Manager 1 and Adviser 1 classified the bonds as cash in Adviser 1's risk management system and reported them as such to the Hedge Fund's investors in certain monthly reports. Manager 1 successfully requested that the investment be recorded as cash in the Adviser 1's risk management system arguing that Adviser 1's systems offered limited classifications and that cash best matched his investment rationale. The SEC found that, as a result, the 10% Bonds were improperly reported from November 2007 to December 2008 in monthly portfolio reports sent to the Hedge Fund's investors as cash and thereby excluded from the Hedge Fund's "Top 10 long holdings" and "net market exposure." The SEC also found that as a result of this misclassification, the liquidity and credit risks from the Hedge Fund's exposure to Company were not fully appreciated by the headquarters personnel of the Advisers until November 2008, after the Hedge Fund had purchased additional bonds issued by the Company.
Reducing the Hedge Fund's Exposure to the Company. In November 2008, personnel of Adviser 1 located in the United Kingdom became concerned about the Hedge Fund's illiquidity and overexposure to the Company. Adviser 1 subsequently informed the Hedge Fund's board of directors about the Hedge Fund's exposure to the Company. The Hedge Fund's directors promptly directed Adviser 1 to reduce the Hedge Fund's exposure to the Company by mid-February 2009.
By early December 2008, an internal working group at the Management Group (the "Working Group") was created to investigate options for reducing the Hedge Fund's exposure to the Company. Manager 1 was not a part of the group, and separately was negotiating a transaction (the "Original Transaction") in which an independent private equity fund would lead a group of investors in purchasing 100% of the equity of a direct subsidiary of the Company (the "Direct Subsidiary"). (The Indirect Subsidiary was a direct subsidiary of the Direct Subsidiary.) Pursuant to the terms of the Original Transaction, the Closed-End Fund would be a minority participant in the buyout group. As part of the Original Transaction, the proceeds from the sale of interests in the Direct Subsidiary would be used, in part, to repay the 10% Bonds held by the Hedge Fund. In addition, the Working Group reviewed the possibility of selling off the 10% Bonds, but concluded that there was no outside market for the 10% Bonds at that time. The Working Group also considered, but rejected, creating a "side pocket" for the illiquid securities and/or gating the Hedge Fund to limit redemptions.
The Working Group ultimately concluded that the Original Transaction was likely prohibited by the 1940 Act, and was otherwise improper because of the conflict of interest between the Hedge Fund and the Closed-End Fund. The Working Group then decided to focus on another client as a more suitable purchaser, but only if the investment's rationale and valuation were sound. After discussing the Original Transaction with Manager 1, the Working Group reversed its decision and decided to move forward with the Original Transaction, deciding that the Closed-End Fund could participate as long as its board of directors gave its approval through a conflict waiver.
Closed-End Fund Board Waives Conflict to Allow Closed-End Fund to Participate in Group Buyout of Company Subsidiary. On December 4, 2008, Manager 2 and a client service director presented the Original Transaction on the Advisers' behalf to the Closed-End Fund's board of directors, which was holding a routine meeting. Prior to the board meeting, Manager 1 instructed Manager 2 as to which facts to disclose to the board of directors regarding the Original Transaction, and which to omit. Manager 1 advised Manager 2 to disclose that two clients of Adviser 1 held equity stakes in the Company, without mentioning that some of the proceeds of the Closed-End Fund's investment would be used to redeem the 10% Bonds held by the Hedge Fund. The Closed-End Fund's board of directors also reviewed a short report, authored by Manager 1, which described the Original Transaction, among other proposed transactions. Manager 1's memorandum stated that the Company would be using the investment proceeds for "working capital," and failed to disclose the redemption of the 10% Bonds held by the Hedge Fund. The Closed-End Fund's board approved the Original Transaction contingent on its approval by the Closed-End Fund's outside counsel ("Fund Counsel"), who had attended the board meeting. Although Fund Counsel received additional information on the Original Transaction, that information did not disclose that a portion of its proceeds would be used to redeem the Hedge Fund's 10% Bonds. Fund Counsel ultimately concluded that, based on the information provided, the Original Transaction was acceptable.
Group Buyout Abandoned - Closed-End Fund Alone to Purchase Company Subsidiary's Bonds. In January 2009, the Original Transaction was abandoned when the lead private equity fund investor withdrew. Manager 1 then negotiated a new transaction (the "New Transaction") in which the Closed-End Fund would invest alone and purchase bonds from the Direct Subsidiary which were convertible into common shares of the Direct Subsidiary, representing approximately 30% of the Direct Subsidiary (the "New Transaction Bonds"). As with the Original Transaction, the proceeds from the New Transaction would be used in part to redeem the Hedge Fund's 10% Bonds, with the remaining proceeds used by the Company for debt service payments and working capital.
In reviewing the New Transaction, the SEC found that Manager 1 and others at Adviser 2 failed to adequately consider whether the New Transaction was in the Closed-End Fund's best interests. In pricing the bonds and the equity conversion feature, Manager 1 relied on the valuation of the Direct Subsidiary that had been conducted for the Original Transaction eight months earlier, despite the fact that Company's and the Direct Subsidiary's financial condition had worsened significantly, especially in contrast to the forecasts used for Original Transaction. (In March 2009, Manager 1 learned that the Direct Subsidiary's year-end earnings for 2008 were 25% lower than the earnings estimates used for the Original Transaction.) Manager 1 did not conduct any new financial due diligence or credit risk analysis and instead relied solely on verbal assurances from the Company's management team.
The Advisers did not seek a conflict waiver from the board of directors of the Closed-End Fund with respect to the New Transaction. PM-1 attended the meeting at which the Closed-End Fund's board approved the escrow of funds for the New Transaction and provided the board and Fund Counsel with a memorandum that (a) described the proceeds of the New Transaction as providing working capital for business expansion and (b) explained that the Original Transaction had been abandoned because the Company's largest customer had also wished to acquire the business and thus opposed the transaction. The use of proceeds from the New Transaction to redeem the 10% Bonds and the withdrawal of the lead investor in the Original Transaction were not disclosed to the Closed-End Fund's board or to Fund Counsel.
New Transaction Closes. The New Transaction closed on April 6, 2009. The Closed-End Fund purchased the New Transaction Bonds for $22.8 million. The Direct Subsidiary loaned $10 million to its parent, the Company, which then redeemed at par the 10% Bonds held by the Hedge Fund. The remaining $12.8 million in proceeds was used by the Company to shore up its business and make debt service payments, including to the Hedge Fund.
Closed-End Fund's Valuation of the New Transaction Bonds. Pursuant to the policies and procedures of the Closed-End Fund, direct investments that were not traded on an exchange ("Direct Investments"), such as the New Transaction Bonds, were to be priced at "fair value" as determined in good faith by the Closed-End Fund's board of directors based on financial and other information supplied by Adviser 2. Prior to October 2009, Direct Investments were to be valued at cost unless the board, based on Adviser 2's advice, concluded that there was a material change in value. In October 2009, the Closed-End Fund amended its procedures to require Direct Investments to be valued at fair value at all times, rather than presumptively at cost in the absence of a material change.
The Closed-End Fund's board of directors relied on Adviser 2's expertise, judgment, and obligation to disclose factors, events, and other circumstances that were material to the fair valuation of Direct Investments. In May 2009, Manager 1 and Adviser 2 learned that the Direct Subsidiary's independent auditor issued a going concern warning in connection with its audit of that company's 2008 annual financial statements. In June 2009, Manager 1 and Adviser 2 became aware that the Company wanted to recast itself as a gold mining venture and that the Direct Subsidiary, whose printer cartridge business was failing because of competition and lack of working capital, faced an uncertain future. Beginning in September 2009, Manager 1 caused the Hedge Fund and a separate account that mirrored the Hedge Fund to begin selling all their equity holdings in the Company. None of the foregoing developments were communicated by Manager 1 or Adviser 2 to the Closed-End Fund's board.
In October 2010, Adviser 2 recommended that the Closed-End Fund's board of directors mark down the value of the New Transaction Bonds by 50% due to the Direct Subsidiary's poor financial condition; and the following month, on Adviser 2's recommendation, the Closed-End Fund's board of directors wrote down the investment again, this time to $0. (The Closed-End Fund subsequently sold the New Transaction Bonds for approximately 50% of their face value in April 2011.)
The SEC found that Adviser 2's actions deviated from the Closed-End Fund's valuation procedures and misled the board, and as a consequence, the Closed-End Fund held the New Transaction Bonds for many months at an insufficiently supported cost valuation. The SEC also concluded that Adviser 2's actions resulted in material misstatements in the Closed-End Fund's annual, semi-annual, and quarterly reports filed with the SEC on Forms N-CSR and N-Q, which were prepared by Adviser 2. The SEC found that the reports contained inaccurate valuations of the New Transaction Bonds and described policies for valuing the Closed-End Fund's direct investments that were not being followed.
Violations. The SEC found that Adviser 2 willfully violated the anti-fraud provisions of Sections 206(1) and 206(2) of the Advisers Act by (a) knowingly or recklessly advising the Closed-End Fund to make (and advising its board of directors to approve) the New Transaction on the basis of material misrepresentations and omissions concerning, among other things, the Hedge Fund's involvement, the investment rationale for the transaction and the initial pricing of the New Transaction Bonds, and (b) knowingly or recklessly deviating from the Closed-End Fund's valuation policies and procedures.
The SEC found that the Advisers willfully aided, abetted, and caused violations of Section 17(d) of the 1940 Act and Rule 17d-1 by causing the Hedge Fund, an affiliate of the Closed-End Fund, to participate in a joint arrangement (the New Transaction) with the Closed-End Fund without first obtaining an order pursuant to Rule 17d-1 from the SEC.
The SEC found that Adviser 2 willfully violated Section 34(b) of the 1940 Act by preparing annual, semi-annual and quarterly reports for the Closed-End Fund on Forms N-CSR and N-Q that reported valuations for the New Transaction Bonds that were not fully substantiated and that described valuation policies for direct investments that were not being followed.
The SEC found that Adviser 1 willfully violated Section 206(4) of the Advisers Act and Rule 206(4)-8 by misrepresenting the 10% Bonds as cash in monthly portfolio reports provided to Hedge Fund investors.
The SEC found that Adviser 2 willfully violated Section 206(4) of the Advisers Act and Rule 206(4)-7 by failing to maintain compliance policies and procedures reasonably designed to address: (i) the proper identification and full and fair disclosure of advisory and client conflicts of interest; (ii) the timeliness, accuracy, and completeness of its disclosures to the Closed-End Fund's board of directors; and (iii) accurate disclosure and valuation of portfolio securities.
Consideration of Management Group's Remedial Efforts. The terms of the settlement reflect the SEC's consideration of cooperation afforded the SEC staff and certain remedial measures undertaken by the Management Group, namely, that the Advisers: (i) compensated the Closed-End Fund for net losses arising from the New Transaction (plus associated legal, accounting and other expenses); (ii) refunded management fees incurred as a result of the New Transaction; (iii) severed relations with Manager 1; (iv) terminated, replaced, or disciplined certain other senior employees; (v) ceased new unlisted bond and private equity investments; (vi) undertook an investigation of the facts; and (vii) made enhancements to their policies, procedures, and controls governing compliance with the Advisers Act and the 1940 Act.
Sanctions. In addition to cease and desist orders and censure, the Advisers agreed to pay a civil penalty of $8.3 million to the SEC.
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