United States: The Increasing Gatekeeper Liabilities Of Fund Administrators

Last Updated: August 16 2016
Article by Marc D. Powers

There is a noticeable trend in the fund services industry that is creating increased exposure and legal liability for fund administrators. More and more, fund administrators are now being looked to as gatekeepers in order to protect fund investors and monitor for compliance by fund managers. The SEC is increasingly holding fund administrators liable for the primary misconduct of others. Similarly, investors have been naming fund administrators in civil suits involving misconduct and fraud by fund managers. As such, fund administrators should be more sensitive to this exposure, and to their duties or alleged responsibilities. Several such cases are highlighted below.

In 2013, the SEC instituted a settled administrative proceeding against Northern Lights Compliance Services ("Northern Lights"),1 among others, in connection with certain alleged disclosure, reporting, recordkeeping and compliance violations. Under Section 15(c) of the Investment Company Act of 1940, before entering into or renewing an advisory contract, directors of registered investment companies are required to request information that is reasonably necessary to evaluate that contract. The directors are to evaluate the information and, under Rule 30e-1, disclose in detail the basis for approval or renewal of the contract in a shareholders report. Under Rule 31a-2, funds are also required to retain copies of the written materials used in the evaluations. Additionally, Rule 38a-1 requires funds to implement policies that are reasonably designed to prevent violations of federal securities laws. The SEC alleged that Northern Lights made disclosures in shareholder reports in relation to advisory contracts that were materially untrue or misleading. Northern Lights was also found to have violated Rule 38a-1 in failing to implement the proper systems and policies necessary to prevent violations of the law.

Gemini Fund Services, LLC ("Gemini"), the fund administrator, was additionally named as a respondent for its part in the alleged violations. According to the SEC, Gemini was contractually responsible for ensuring that the fund maintained the proper Section 15(c) files in compliance with Rule 31a-2. According to the SEC, these files were on many occasions incomplete, thereby failing to comply with the rule. Gemini was also responsible for preparing the shareholder reports. Those reports, however, were alleged to have been missing material information in relation to the advisory contract evaluation process. As such, the SEC found that Gemini caused the violations of Rules 31a-2 and 30a-1. Without admitting or denying the allegations, Gemini agreed to the cease-and-desist order, to hire an independent compliance consultant and to pay a civil penalty in the amount of $50,000.

Similarly, in 2015, the SEC instituted a settled administrative proceeding against Deloitte & Touche, LLP ("Deloitte"),2 arising from its alleged involvement in an independence-impairing relationship. According to the SEC, a Deloitte affiliate, Deloitte Consulting LLP, purchased intellectual property rights for a business methodology from Andrew Boynton and his business partners and hired Boynton as a consultant for the methodology for the purposes of training employees. Simultaneously, Boynton was serving on the boards of three funds for which Deloitte served as an outside auditor, which the SEC alleged caused a significant independence issue unbeknownst to any of the parties. Although Deloitte policies required an independence evaluation before entering into a new business relationship, the SEC alleged no such evaluation was performed. As a result, the SEC claimed that Deloitte violated Rule 2-02 of Regulation S-X, which requires independence from auditors, and Rule 102 of the Securities Exchange Act of 1934, which prohibits improper professional conduct. In addition, Deloitte was also found to have caused the three funds to violate Sections 30(a) and 20(a) of the Investment Company Act, both of which require independence.

ALPS Fund Services, Inc. ("ALPS"), the fund administrator for the three funds, was also charged. ALPS was contractually obligated to assist the three funds in complying with Rule 38a-1 of the Investment Company Act by implementing policies designed to prevent violations of federal securities laws. ALPS did draft policies for the funds, and developed questionnaires that were in part designed to detect independence issues. The SEC alleged, however, that the policies at all times were insufficient, constituting a Rule 31a-1 violation. It was further alleged that ALPS should have known that its conduct would cause a Rule 38a-1 violation. As part of a settlement, both Deloitte and ALPS agreed to cease and desist from future violations and to pay penalties in the amounts of $500,000 and $45,000, respectively, without admitting to or denying the allegations.

The most recent SEC enforcement actions against a fund administrator were against Apex Fund Services (US), Inc. ("Apex"). The SEC instituted two separate administrative proceedings against Apex on the same day for its work with ClearPath Wealth Management, LLC ("ClearPath"),3 and EquityStar Capital Management, LLC ("EquityStar").4 In 2015, the SEC filed a civil complaint against ClearPath and its president Patrick Churchville for fraud violations related to the misappropriation of funds. ClearPath and Churchville allegedly had an elaborate, Ponzi-like scheme, whereby investor assets were misappropriated and distributed to unrelated investors or used to pay personal expenses. As a result of this conduct, the SEC alleged violations of Sections 206(2) and 206(4) of the Investment Advisers Act of 1940, among other violations. Section 206(2) prohibits investment advisers from engaging in business that operates as a fraud or deceit upon clients. Section 206(4) prohibits investment advisers to a pooled vehicle from engaging in any act that is fraudulent with respect to any investor in that pooled vehicle.

The SEC instituted an administrative proceeding against Apex in connection with this scheme because it claimed that Apex's conduct as fund administrator allowed for the alleged violations by ClearPath and Churchville. Apex was allegedly responsible for keeping accounts and records for the funds and preparing monthly and annual financial statements. The SEC alleged that Apex made it possible for ClearPath and Churchville's scheme to be successful by failing to separate fund assets properly into series and causing ClearPath and Churchville's use of assets to be reflected inaccurately in account statements. Apex also allegedly failed to detect or ignored red flags such as questionable margin loans and lines of credit. Because these red flags were not acknowledged, the questionable margin loans and lines of credit were not properly reflected in account statements. The SEC charged Apex with violations of Sections 206(2) and 206(4), making Apex liable. The case was settled by Apex's agreeing to retain an independent compliance consultant, to cease and desist from future violations, and to pay a disgorgement plus prejudgment interest and penalty in the amounts of $105,613 and $75,000, respectively, without admitting to or denying the allegations.

The second administrative proceeding involved Apex's administrative services to EquityStar. EquityStar and Steven Zoernack managed Global Partners Fund, LLC ("Global Partners"), and Momentum Growth Fund, LLC ("Momentum"). During their time as managers, EquityStar and Zoernack allegedly made false statements about investment returns for the funds in marketing materials and emails, and made undisclosed withdrawals from the funds of more than $1 million. The SEC also claimed that monies were often used by Zoernack for personal expenses or transferred into his personal bank account. The SEC brought proceedings against all relevant parties, including Apex, for violating Sections 206(2) and 206(4) of the Advisers Act.

The SEC alleged that Apex eventually became aware of Zoernack's withdrawals and questioned him. Zoernack told Apex the funds were being used to cover expenses and would be repaid. Relying on these statements, Apex allegedly designated the missing funds as "receivables" in the accounting statements. Receivables are considered assets on an accounting statement, which caused the assets of the funds to be materially overstated. Further, the SEC claimed Zoernack never repaid the receivables and Apex should have known Zoernack was unwilling or unable to repay the receivables. It was claimed that Apex thereby failed to account for the money properly, making the account statements sent to investors misleading. Because of these alleged deficiencies, the SEC found that Apex was a cause of Zoernack and EquityStar's violations of Sections 206(2) and 206(4). The case was settled and Apex agreed to a cease-and-desist order in which it retained an independent consultant and paid a disgorgement plus prejudgment interest and penalty in the amounts of $96,836 and $75,000, respectively, without admitting to or denying the allegations.

There have also been several investor civil actions against fund administrators. In Cromer Finance Ltd. v. Berger,5 investors in an offshore fund managed by Michael Berger brought suit against the fund's administrators and auditors. The suit arose out of Berger's fraudulent mismanagement of the fund, which created losses for the fund. In order to cover these losses from detection, Berger created fictitious monthly account statements that showed profitable performances. This was until 2000, when Berger admitted to the fraud and was subsequently criminally charged with securities fraud.

In the civil action in the United States District Court for the Southern District of New York, the plaintiffs claimed that the administrators used the fictitious statements that were created by Berger to prepare incorrect and overstated net asset value (NAV) calculations. The administrators initially prepared a correct NAV statement and were told to hold off on its issuance. Berger's false account statements were then used to revise the NAVs. The plaintiffs claimed this was in contradiction of the administrator's regular protocol, which required an examination of the asset holder's account statements. In addition, it was claimed that although Berger's fictitious account statements were "suspicious on their face," the administrators continued to use them in preparing the NAVs. Further, the plaintiffs claimed that the administrators did so despite receiving accurate statements from Bear Stearns, the fund's prime broker. The plaintiffs claimed that they relied on these incorrect NAV statements and would not have purchased or maintained shares in the fund if they knew the truth. As a result, the plaintiffs alleged aiding and abetting common law fraud and breach of fiduciary duty, violations of Section 10(b) of the Exchange Act, common law fraud, negligence, and professional malpractice. The parties eventually settled the dispute and the defendants agreed to pay $40.8 million.

In Jordan (Bermuda) Inc. Co. v. Hunter Green Investments LLC,6 Jordan (Bermuda) Inc. Co. ("JBIC"), an investor in a fund, sued in the United States District Court for the Southern District of New York several parties including the fund's administrator for fraud, breach of fiduciary duty, and aiding and abetting fraud or breach of fiduciary duty. JBIC invested in the Beacon fund after promises were made by John Schilling, a principal at Hunter Green Investments LLC and the fund manager. It was alleged that the parties agreed that if JBIC were to invest, JBIC monies would be maintained in a separate account than other investments, the JBIC monies would not be leveraged like other Beacon investments and Beacon would obtain approval by the JBIC trustee before allocating any fund portfolio securities to the Class J shares. As a result of these promises, JBIC agreed to purchase Class J shares of Beacon for a total of $5 million. The plaintiff alleged that in actuality, the Class J shares did not exist, the trust monies were subject to the claims and liens of Beacon's creditors, and Beacon was investing JBIC monies and utilizing leverage.

JBIC named the fund administrators, Investment Management Service, Inc. ("IMS"), and International Fund Services, Inc. ("IFSI"), as defendants for failing to disclose that Beacon was using JBIC monies to make investments and for preparing incorrect account statements. The plaintiff first asserted a claim of fraud against the administrators, JBIC moved for summary judgment, and the court held that the plaintiff failed to allege in its complaint that the administrators had knowledge that the Class J shares were not validly issued or that Class J share investments required prior written approval. As a result, the court dismissed the fraud claim. For the plaintiff's breach of fiduciary duty claim, the court articulated that New York courts have often focused on "whether one person has reposed trust or confidence in another." The court decided that the relationship between the administrators and JBIC was too attenuated to give rise to a fiduciary duty. It stated that IFSI had a relationship with Beacon and Hunter Green but little relationship with JBIC, which was at most "a client of a client." Similarly, IMS had no contact with JBIC and therefore no relationship. As a result, the breach of fiduciary duty claim was also dismissed. Finally, the aiding and abetting claims were dismissed because "actual knowledge" is an element, and it had already been established that the administrators did not have the required knowledge of the wrongdoings.

Similarly, Pension Committee of University of Montreal Pension Plan v. Banc of America Securities, LLC,7 involved a suit by investors in the United States District Court for the Southern District of New York in connection with their purchase of shares in the Lancer Funds. The Lancer Funds were managed by Lancer Management Group LLC and Michael Lauer. The funds were directed at sophisticated investors who understood that the investments would primarily be in small-cap companies, and that many of the investments would lack liquidity. However, when the funds began losing money, a scheme was allegedly devised by management to cover up the losses by making large investments in shell companies for "pennies per share," or sometimes for nothing at all. Then, before the end of the month, the fund would buy more shares of these companies at higher prices that would then be used to inflate the NAVs of the investments to increase management fees.

The plaintiffs asserted several claims against the fund administrator, Citco NV ("Citco"). Citco was responsible for the computation of the monthly NAVs and for sending them out to investors. As a result of the inflated NAVs computed by Citco, the plaintiffs asserted claims for violations of Section 10(b) of the Exchange Act, common law fraud, breach of fiduciary duty, and aiding and abetting, among other claims. The plaintiffs argued that the defendants were willfully blind or reckless to price manipulation that was readily detectable. The court, however, decided on a motion to dismiss that the Section 10(b) claims should be granted only with respect to purchases made after 2001, when Citco became aware of the issues. Of those claims, Section 10(b) claims survived for those investors who could prove they relied on the fraudulent NAVs. The same also applied to the common law fraud claims. The breach of fiduciary duty claim also survived because Citco did communicate with investors, particularly about the quality of its services, thereby accepting that it owed a fiduciary duty. However, the aiding and abetting claims were dismissed because the plaintiffs did not specifically allege that Citco had knowledge of the fraud. The case was scheduled for trial, but was promptly settled when the judge issued sanctions due to discovery failures by the plaintiffs.

Marylebone PCC Limited – Rose 2 Fund v. Millennium Global Investments, Ltd.8 involved a class action suit by investors of a UK hedge fund in the United States District Court for the Southern District of New York. The class action was asserted against Millennium Global Investments and its hedge fund manager, Michael Balboa. The fund was focused primarily on investing in sovereign and corporate debt instruments from emerging markets. However, from 2007 to 2008 the fund allegedly had experienced losses stemming from investments in "Nigerian and Uruguayan Warrants," so Balboa began artificially inflating the "market to market" quotes for the Nigerian Warrants, making the fund's value seem higher and misleading investors. The artificial inflation allegedly was used to cover losses from other investments. In addition, Balboa allegedly profited from this scheme by receiving increased compensation as the fund manager as a result of increased assets under management.

GlobeOp, the fund administrator, was also named as a defendant. GlobeOp was retained by Balboa to serve as the fund's "independent valuation agent." Under this title, like many fund administrators, GlobeOp was responsible for the calculation of the fund's NAVs. It was claimed that in undertaking this responsibility, GlobeOp generated fraudulent NAVs because, as part of its usual process, GlobeOp was supposed to retrieve market quotes from outside brokers for the warrants. GlobeOp allegedly questioned Balboa about the suspicious pricing, and he explained that he had local brokers who could verify the market quotes. The investors claimed GlobeOp accepted this explanation without any verification. GlobeOp then allegedly received market quotes from one of Balboa's co-conspirators and went on to generate incorrect NAVs.9 The plaintiffs claimed that they relied on these NAVs in making investment decisions, and therefore made claims for negligence, arguing that all the defendants had a duty of care to investors arising out of their contractual agreements. The plaintiffs also asserted a common law fraud claim against GlobeOp and an aiding and abetting breach of fiduciary duty claim. The plaintiffs argued that GlobeOp knew its actions would assist in breaches of fiduciary duty and it still continued to aid in the breach. The plaintiffs ultimately alleged a loss of $800 million for their lost investments, but the parties eventually settled for around $15 million.

In all, fund administrators are now more open to increased legal exposure. The SEC has held fund administrators responsible when they cause securities law violations by failing to perform their administrative functions. Fund administrators have also been held liable in private party actions for claims such as common law fraud and breach of fiduciary duty. This occurs when administrators knew or should have known about the misconduct, or had some duty to investors in carrying out their responsibilities as administrators. As such, fund administrators must remain aware of the conduct of their clients, as well as the information that passes through their hands. As the SEC considers them gatekeepers, they now have clearer responsibilities to detect misconduct and perform their duties assiduously. Administrators should be proactive when they notice an issue or misconduct, as they otherwise may be held liable for others' primary conduct.

Footnotes

1 In the Matter of N. Lights Compliance Serv., LLC, Exchange Act Release No. 30502 (May 2, 2013).

2 In the Matter of Deloitte & Touche, LLP, Exchange Act Release No. 75343 (July 1, 2015).

3 In the Matter of Apex Fund Serv., Inc., Advisers Act Release No. 4428 (June 16, 2016).

4 In the Matter of Apex Fund Serv., Inc., Advisers Act Release No. 4429 (June 16, 2016).

5 137 F.Supp.2d 452 (S.D.N.Y. 2001).

6 Jordan (Bermuda) Inv. Co., v. Hunter Green Inv., No. 00 Civ. 921, 2007 WL 2948115 (Oct. 3, 2007).

7 592 F.Supp.2d 608 (S.D.N.Y 2009).

8 Marylebone PCC Ltd. – Rose 2 Fund v. Millennium Glob. Inv., Ltd. (S.D.N.Y. 2012).

9 BakerHostetler represented one of the defendants in the action, an investment bank, where the co-conspirator worked.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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