Legal Alerts

Select SEC Enforcement Cases and Developments Regarding Investment Advisors


The U.S. Securities and Exchange Commission (the “SEC”) continues to aggressively pursue enforcement actions against registered investment advisers and their associated persons and has identified investment advisers and investment companies as one of its examination priorities for 2013. This article highlights three significant enforcement cases brought by the SEC against investment advisers and investment companies during the fourth quarter of 2012. The enforcement cases touch on three priorities identified by the SEC as ongoing risk areas: fund governance, co-investment representations, and advertised performance.

Fund Governance; Fair Valuation Practices: 

It is not often that the SEC brings an enforcement action against independent directors for acts solely in their capacity as directors. So it was a notable event in December 2012 when the SEC filed an order instituting enforcement proceedings (“OIP”) against both the interested and the independent directors of five registered investment companies advised by Morgan Keegan alleging that the directors failed to properly carry out their duties with respect to overseeing the determination of the “fair value” of various structured products owned by four closed-end funds and three series of an open-end investment company (the “Funds”). 

During the period from January to August 2007, a large percentage of the securities owned by the Funds consisted of subordinated tranches of various structured products, including collateralized mortgage obligations and other asset-backed securities. Market quotations were not readily available for many of these securities and at times up to 60% of the portfolios of some Funds were required to be “fair valued” by the Funds’ Board in accordance with Section 2(a)(41)(B) of the Investment Company Act.

The OIP alleges that the directors were negligent in carrying out their statutory valuation duties in the following ways:

  • failing to provide the valuation committee with meaningful substantive guidance on how fair valuation decisions should be made;
  • making no meaningful effort to learn how fair values were being determined;
  • failing to receive sufficient information about the factors used in making fair value determinations; and
  • failing to obtain sufficient information explaining why particular fair values were assigned to specific portfolio securities.

In December 2012, the directors issued a statement vigorously denying the SEC’s allegations and noting several issues that would be subject to further litigation, including: the absence of any issues having been raised regarding the Funds’ valuations and procedures by the Funds’ independent auditors or the SEC’s examination staff; the absence of regulatory guidance on fair valuation procedures; and the unforeseen impact of the financial crisis. However, on March 27, 2013, the SEC and the directors announced that they had agreed in principle to a settlement on all major terms. The terms of the settlement have not been publicly announced.

Valuation issues continue to be a high priority concern of the SEC and Boards of registered funds may wish to consider taking stock of their fair valuation procedures. In particular, directors may want to seek input from counsel and from the advisers to their Funds with regard to the adequacy of their current oversight and compliance structures, the types of information they receive, the scope of their reliance on third-party experts, and the role of portfolio managers and other adviser personnel in the valuation process.

Co-Investment Representations:

The SEC is also focused on “skin in the game” representations by investment advisers who misstate the extent of their personal co-investment alongside outside investors. In December 2012, the SEC instituted and settled administrative proceedings against Aladdin Capital Management LLC (“Aladdin”), Aladdin Capital, and former executive Joseph Schlim for allegedly representing, from 2007 to 2010, that Aladdin was co-investing alongside clients in certain collateralized debt obligations, when, in fact, Aladdin did not make such investments. The SEC alleged that Aladdin’s representation concerning co-investment was a “key feature and selling point” to investors in its marketing message that the adviser’s interests were aligned with those of investors. As part of their settlement, Aladdin and Aladdin Capital agreed to pay $900,000 in disgorgement and a $450,000 penalty, and Schlim agreed to pay a $50,000 penalty.

Advisers that use the co-investment representation as a marketing feature must take action to ensure that such representations are accurate when they are made and that funds are reserved or allocated for any co-investments alongside clients.

Advertised Performance:

The SEC is also focused on investment advisers who distribute misleading advertisements regarding performance. In October 2012, the SEC instituted and settled administrative proceedings against BTS Asset Management, Inc., a registered investment adviser headquartered in Lexington, Massachusetts (“BTS”), for allegedly misrepresenting the performance of its high yield bond fund program (the “HYP”). 

From approximately 1990 to 2010, BTS’s advertisements for its HYP claimed that the program had experienced no down years since 1981. The advertisements based this claim on the performance of a model that applied BTS’s buy/sell signals to, at various times, a single high yield bond fund, a composite of six high yield bond funds, or a composite of five high yield bond funds. In 2005, BTS became aware that, in contrast to the model performance reflected in the advertisements, approximately half of the HYP clients would have experienced a down year in 2004 (with losses of up to 3.3%) based on the application of the HYP’s buy/sell signals to the funds known by BTS to be held by the clients in the program. The fact that, on this basis, a significant percentage of the HYP clients likely experienced investment results in 2004 that were materially different from the claims made in the advertisements BTS disseminated from 2005 to 2010 rendered those advertisements misleading in violation of the Investment Advisers Act. As part of its settlement, BTS agreed to pay a penalty of $200,000. Advisers must be very careful when advertising past performance.

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