SEC Charges an Investment Adviser and a Portfolio Manager with Fraud and Causing a Money Market Fund to Violate Rule 2a-7

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The U.S. Securities and Exchange Commission (SEC) recently instituted public administrative and cease-and-desist proceedings against Ambassador Capital Management, LLC, a Detroit-based registered investment adviser (ACM), and one of its employees who served as the primary portfolio manager of the Ambassador Money Market Fund (Fund).1  The SEC alleges that ACM and the portfolio manager deceived the Fund’s board of trustees (Board) and caused the Fund to violate Rule 2a-7 under the Investment Company Act of 1940 (1940 Act), the rule governing money market fund investments and operations.

This OnPoint describes the role of the SEC’s Division of Investment Management (Division) in uncovering the alleged fraud through an analytical review of the Fund’s performance data and portfolio information.  It then discusses the alleged fraudulent conduct and other alleged violations of the federal securities laws.  Finally, the OnPoint suggests possible measures that can be taken to detect (and, perhaps, prevent) the types of conduct alleged by the SEC.

Enhanced Analysis of Money Market Fund Data by the SEC’s Division of Investment Management

According to the SEC press release, the enforcement action “stem[med] from an ongoing analysis of money market fund data by the SEC’s Division of Investment Management, in this case a review of gross yield of funds as a marker of risk.”  The Order stated that, as of October 2011, the return of the Fund “significantly exceeded” the returns for prime money market funds in its peer group.  Moreover, the Order noted that the Fund held, among other things, the securities of a non-U.S. issuer after it had been taken into receivership, as well as asset-backed commercial paper of a troubled German bank and two Italian issuers.  These concerns prompted further examination by the SEC’s Office of Compliance Inspections and Examinations (OCIE), which, after an on-site examination, referred the matter to the Asset Management Unit of the SEC’s Division of Enforcement.

The SEC’s press release credited the “ongoing quantitative and qualitative analysis of the asset management industry” by the Division’s Risk and Examinations Office as playing a “vital role” in this enforcement action.  Moreover, Norm Champ, the Division’s Director, stated that “this [enforcement action] is an excellent example of how [the SEC’s] investment in data analysis leads directly to investor protection.”

Formed in 2012, the Risk and Examinations Office was created, in part, to comply with the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.  This office provides the Division “with the capability to perform quantitative risk analysis”2 and, among other things, manages, monitors and analyzes the industry data the Division receives.  While the SEC Staff has long considered factors such as comparative fund performance when monitoring the money fund industry, the availability of these analytical tools, combined with the detailed data regarding the portfolio holdings of money market funds filed on Form N-MFP, has enhanced the ability of the SEC and its Staff to detect aberrational performance and to monitor the investments of money market funds and their compliance with Rule 2a-7.3

SEC’s Allegations Against ACM and the Portfolio Manager

Alleged Deception of the Fund’s Board

The SEC alleges that ACM and the portfolio manager violated the federal securities laws by repeatedly and knowingly making false or misleading statements to the Fund’s Board regarding (i) the level of credit risk of the Fund’s portfolio securities; (ii) the extent of the Fund’s exposure to asset-backed commercial paper potentially affected by the Eurozone crisis in 2011; and (iii) the diversification of the Fund's portfolio.4  Specifically, the SEC alleged that ACM had failed to disclose to the Fund’s Board that it had:

  1. regularly purchased securities for the Fund that exceeded ACM’s internal maturity restrictions, which had been imposed by the adviser in an attempt to limit the Fund’s exposure to the risks presented by certain investments;
  2. repeatedly purchased for the Fund portfolio securities without making the determination that the securities posed minimal credit risk,5 as required by Rule 2a-7 and ACM’s own Rule 2a-7 guidelines and procedures;6
  3. made false and misleading statements to the Fund’s Board regarding the Fund’s exposure to European issuers during the sovereign debt crisis, continuing to purchase and hold asset-backed commercial paper affiliated with a financially-troubled European country notwithstanding statements made to the Board that the Fund would have only limited or no exposure to that country; and
  4. provided false and misleading information to the Fund’s Board regarding the Fund’s diversification of portfolio securities, stating that, after a certain date, the Fund would have no more than 5% of its assets invested in any one issuer, while the Fund held securities of ten issuers after that date that exceeded 5%.7

As a result of the foregoing, the SEC alleged that ACM willfully violated, and the portfolio manager willfully aided and abetted and caused ACM’s violations of, Sections 206(1) and (2) of the Investment Advisers Act of 1940, the antifraud provisions under that Act.

Causing Violations of Rule 2a-7

The Order also alleged that ACM had caused the Fund to violate certain requirements under Rule 2a-7, in addition to the failure to make required determinations that portfolio securities present minimal credit risks.  These allegations included:

  1. causing the Fund to purchase securities of issuers that caused the Fund to exceed the issuer diversification limits of Rule 2a-7(c)(4)(i);
  2. failing to implement written procedures providing for stress testing of the Fund’s ability to maintain a stable net asset value per share in light of several hypothetical scenarios, as required by Rule 2a-7(c)(10)(v)(A); and
  3. failing on certain occasions to conduct stress testing that included hypothetical increases in redemptions of Fund shares8 and the impact of a downgrade of portfolio securities, as required by Rule 2a-7(c)(10)(v)(A).9

As a result of the alleged violations of Rule 2a-7, the SEC stated that the Fund was not entitled to rely on Rule 2a-7 to use the amortized cost valuation method to price its shares at $1.00 and should have calculated its net asset value per share under Rule 22c-1.  The SEC therefore alleged that ACM and the portfolio manager had caused the Fund to violate Rule 22c-1, as well as Sections 34(b) and 35(d) of the 1940 Act.10  The SEC also alleged that ACM had caused the Fund to fail to implement written compliance policies and procedures that were reasonably designed to prevent violations of the federal securities laws, including policies and procedures providing for oversight of compliance by the Fund’s investment adviser.11

Lessons for Money Market Fund Advisers and Boards

This enforcement action by the SEC clearly demonstrates what many in the industry had already realized – that the increased transparency of money market fund portfolios due to website posting and filings of Form N-MFP, combined with the enhanced ability of the SEC Staff to analyze portfolio data and monitor for aberrational Fund performance, has dramatically increased the effectiveness of the Staff’s oversight of money market funds.  As a result of this new level of efficiency (and to make sure that the SEC will not bring to their attention issues of which they are unaware), fund advisers may wish to review their compliance processes to assure themselves (and their funds’ Boards) that:

  1. any compliance issues that may arise under Rule 2a-7 will be identified and dealt with on a timely basis;
  2. any fund performance that is materially higher than that of similar funds is promptly reviewed to ensure that such outperformance is not the result of investments that do not comply with Rule 2a-7, the fund’s (and the adviser’s) procedures under that rule or the investment parameters disclosed in the fund’s prospectus and Statement of Additional Information (SAI); and
  3. any internal guidelines applied by the adviser when selecting investments for the fund are properly identified to the Board and that any exceptions made from such guidelines are properly reviewed and documented within the advisory organization. 

In addition, money market fund advisers may wish to consider having their money market fund portfolio management team meet with the fund’s Board to discuss the manner in which the fund is managed and the steps taken to assure that the fund is operated in compliance with Rule 2a-7.

Conclusion

Although this enforcement action has not been settled and is part of an ongoing proceeding, the allegations made by the SEC and the manner in which the investigation was commenced are illustrative of the enhanced effectiveness of the SEC’s ability to monitor the money market fund industry.  In light of this, advisers and Boards should consider reexamining their policies, procedures and practices to ensure that their funds are being operated in compliance with applicable law.

Footnotes

1. See In the Matter of Ambassador Capital Management, LLC, Investment Company Act Rel. No. 30809 (Nov. 26, 2013) (“Order”) (PDF); see also SEC Announces Fraud Charges Against Detroit-Based Money Market Fund Manager, U.S. Securities and Exchange Commission (Nov. 26, 2013).  This enforcement action has not been settled and is part of an ongoing investigation. Accordingly, the factual allegations described herein have not been agreed upon by the parties or adjudicated.

2. See OCIE Compliance Outreach Program, The Division of Investment Management’s Risk and Examinations Office, Recent Developments (Sept. 13, 2013) (PDF).

3. The use of these analytical tools is not limited to money market funds.  See SEC Charges Multiple Hedge Fund Managers with Fraud in Inquiry Targeting Suspicious Investment Returns, U.S. Securities and Exchange Commission (Dec. 1, 2011) (“Under the initiative — the Aberrational Performance Inquiry — the SEC Enforcement Division’s Asset Management Unit uses proprietary risk analytics to evaluate hedge fund returns.  Performance that appears inconsistent with a fund’s investment strategy or other benchmarks forms a basis for further scrutiny.”)

4. The Fund’s Board was not named in the Order.  Interestingly, although there have been several recent enforcement actions that have included claims against Chief Compliance Officers (“CCOs”), the Fund’s CCO also was not named in the Order. 

5. As used in Rule 2a-7, the concept of “minimal credit risk” is separate from the credit rating status of the security.  Records of this determination must be maintained for at least three years. See Rule 2a-7(c)(11)(iii).

6. In particular, the SEC alleged that ACM purchased securities that ACM identified as presenting “risk,” “some risk,” “moderate risk” and “slightly moderate risk.”  The SEC claimed that these securities had “significantly higher credit spreads and thus yield” than the securities for which ACM determined presented minimal credit risk.

7. It should be noted that these positions, which had apparently exceeded 5% of the Fund’s assets as a result of large redemptions of Fund shares, rather than due to purchases of additional securities, did not violate the diversification requirements under Rule 2a-7.  Rule 2a-7 requires money market funds to be diversified with respect to securities issuers, but compliance with those requirements is measured only immediately following a purchase or acquisition of securities.

8. As support for the importance of stress testing for increased Fund redemptions, the Order noted that a financially-distressed municipality was heavily invested in the Fund, and that the cash invested by this municipality fluctuated substantially. 

9. The Order noted that, since the Fund regularly purchased and held securities with exposure to the Eurozone crisis, the risk of downgrades should have been a part of the Fund’s stress testing.

10. Section 34(b) of the1940 Act prohibits a person from making any untrue statements of material fact in reports, accounts, records or other documents filed with the SEC under the 1940 Act.  Section 35(d) makes it unlawful for any registered fund to adopt as a part of its name any word or words that the SEC finds are materially deceptive or misleading.      

11. Among other things, the Order noted that the Fund had not amended its Rule 2a-7 procedures in the wake of the amendments to that rule in 2010. 

 

Topics:  Enforcement, Enforcement Actions, Fraud, Fund Managers, Investment Fraud, Investor Protection, OCIE, Portfolio Managers, Risk Assessment, Risk Management, SEC, Securities Fraud

Published In: Business Torts Updates, General Business Updates, Finance & Banking Updates, Securities Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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