A Compilation of Enforcement and Non-Enforcement Actions

Foley & Lardner LLP


  • Assets Under Management by Registered Investment Advisers Have Increased Substantially
  • Will “Accredited Investor” Definition Be Changed?
  • Excessive Fee Case Withstands Dismissal
  • SEC’s Continued Concern Over Alternative Mutual Funds


  • Altering a Document Results in SEC Enforcement Action Against RIA Compliance Officer
  • Repeated Custody Rule Violations Leads to SEC Enforcement Action


Assets Under Management by Registered Investment Advisers Have Increased Substantially

The amount of assets under management (AUM) by investment advisers registered with the SEC increased over the previous 12-month period (for period ending March 30, 2014) by an amount of 12 percent, according to various reports.

The increase in AUM was primarily a result of increased prices of stocks over that period. The information was obtained from a review by the Investment Adviser Association (IAA) of information reported on Form ADV by IA registrants with the SEC for the year ended December 31, 2013. Other noteworthy information from the review of the filings includes:

  • $61.7 trillion of assets under management versus $54.8 trillion as of the previous March 30, 2013;
  • The number of registered investment advisers increased slightly from 10,533 in April 2013 to 10,895 in April 2014. The number of persons employed by the registrants increased 9.3 percent to over 700,000 persons serving 28 million clients.
  • The number of advisers managing more than $100 billion of assets under management totaled 110 advisers, accounting for 52.6 percent of the total AUM.
  • The “typical” adviser has $331 million of AUM with nine employees and 100 client accounts.
  • Of the 11,000 registered advisers, about 1,500 reported disciplinary history (about 14 percent) while the remaining 86 percent of the advisers reported no disciplinary history.

Additional information from the report provided by the IAA can be found online.

Will “Accredited Investor” Definition Be Changed?

Investment advisers who manage “private funds” (i.e., funds that are not registered as an investment company under the Investment Company Act of 1940, instead relying upon one of two exclusions from the definition of an investment company by having not more than 100 equity investors or having only “qualified purchasers” and not conducting a public offering of its securities) should be aware that the SEC may, in the near future, change the definition of an “accredited investor” as defined under Rule 501 of Regulation D under the Securities Act of 1933.

Most private funds managed by investment advisers offer their securities exclusively to accredited investors. Any change to the definition of an accredited investor could have a material effect on who is qualified to become an investor in a private fund.

The current definition of an “accredited investor” under Rule 501 of Regulation D includes individuals who either have a net worth in excess of $1 million (not including value of principal residence) or had annual income in excess of $200,000 ($300,000 when coupled with the person’s spouse) for each of the previous two years and with a reasonable expectation of having at least the same income during the current year.

The Dodd-Frank Wall Street Reform and Consumer Protection Act requires the SEC to review the definition of an accredited investor by the end of this year and to conduct a review every four years thereafter. The current definition, which was enacted in 1983, has been for the most part, left unchanged. The SEC’s Investor Advisory Committee (the “Committee”) recently proposed changes to the definition of an accredited investor in order to assist the SEC in meeting its Dodd-Frank mandate.

The Committee, in effect, discounted the premise baked into the current definition that financial thresholds have anything to do with determining if an investor is equipped to understand the risks of an investment in a private offering of securities. In addition, the Committee believes that someone who does not meet the current thresholds may be experienced sufficiently in making investments that they should qualify as an accredited investor. The investment experience factor is not part of the current definition. The Committee also recommended the use of qualified third parties, instead of the issuer, to make the determination if an individual qualifies as an accredited investor. That dimension would, of course, add to the cost of the offering, either passed on to the investors or absorbed by the funds’ general partner, managing member or management company.

Whether the SEC adopts all or some of the Committee’s recommendations remains to be seen. What is clear is that the current definition of an accredited investor is likely to change and advisers to private funds need to stay on top of those changes, when adopted.

Excessive Fee Case Withstands Dismissal

A court recently allowed an excessive fee case to withstand a dismissal motion. While the case is specific to investment advisers to funds of funds, the case contains cautions for all mutual fund directors.

Key Take Away

When directors of a mutual fund are approving fees paid to the investment adviser, whether they are advisory fees or other fees, the directors must be certain that they fully understand the services that are being provided to the fund by the adviser, in order for the directors to be able to properly determine that the fee is reasonable. With regard to advisory fees, directors also need to be careful in assessing whether economies of scale are resulting in excess profits to the investment adviser by evaluating how advances in computing and communication technologies might offset the heightened workload and costs necessary to oversee more assets under management.


The investment advisers to the funds of funds charged the funds both an investment advisory fee and an acquired fund fee. The excessive fee case relates to the acquired fund fee, which the investor argued is a fee intended to compensate sub-advisers to the funds for day-to-day management of the underlying funds in the fund of funds structure. The investor noted that the investment adviser retained the majority of the acquired fund fee, and claimed that it was a breach of fiduciary duty by the investment advisers to retain any portion of this fee because no services not already compensated for by the investment advisory fee were provided in exchange for it.

In determining whether the claim would withstand dismissal, the court looked to the factors set forth in Gartenberg v. Merrill Lynch Asset Mgmt. Under this case, the investor is required to show that the acquired fund fee is “so disproportionately large that it bears no reasonable relationship to the services rendered in exchange for that fee and could not have been the product of arm’s-length bargaining.” The relevant factors, known as “Gartenberg factors,” include: (1) the nature and quality of the services provided to fund shareholders; (2) the profitability of the fund to the adviser-manager; (3) fall-out benefits; (4) economies of scale; (5) comparative fee structures; and (6) the independence and conscientiousness of the trustees.

Specifically, the investor alleged that the advisers’ costs of servicing the funds were nominal and that the fees therefore represent a nearly 100-percent profit for the advisers. The investor also alleged that the funds of funds experienced large economies of scale, charged fees higher than similar funds and were neither independent nor conscientiousness when they approved the acquired fund fees. With regard to economies of scale, the investor advanced the argument that the investment advisers experience large economies of scale in part due to advances in computing and communication technologies, with these advances offsetting the heightened workload and costs related to managing more assets under management.

SEC’s Continued Concern Over Alternative Mutual Funds

The SEC continues to express concern about alternative mutual funds. This seems a natural position for the agency, as these funds are still relatively new to the mutual fund scene, and the SEC and the industry are working to fully understand how these funds do and should function in the marketplace. While the focus is on alternative mutual funds, the guidance coming from the SEC is useful for all mutual funds.

Key Take Away

Directors of a mutual fund are responsible for ensuring that retail investors have the information they need to make informed investment decisions. If directors fail to ensure the information in a fund’s prospectus is clear to the average investor, then they can be held liable for such failure. So, it is important the directors ensure a fund’s prospectus is carefully reviewed each year to ensure it accurately portrays the fund’s principal investment strategies and the related risks. If the fund employs alternative investment strategies or complex investment strategies, then extra care needs to be taken to ensure that these strategies are explained in a simple, straightforward manner that the average investor can understand.


In recent remarks, Norm Champ of the SEC discussed the “challenges of appropriately disclosing the heightened risks of alternative mutual funds to retail investors.” He noted that alternative mutual funds “generally pursue strategies that seek to produce positive risk-adjusted returns (or alphas) that are not closely correlated to traditional investments or benchmarks.” As a result of the strategies that alternative mutual funds pursue, he believes that “several areas—such as valuation, liquidity, and leverage—present heightened risks” to investors in these funds.

He stated that “these heightened risks and the complex nature of the investment strategies employed by alternative mutual funds can make the goal of clear, concise disclosure more difficult to attain” because the “disclosure requirements of Form N-1A are intended to elicit information for an average or typical investor who may not be sophisticated in legal or financial matters.” The requirement that disclosure be clear to an average investor is the same for all mutual funds, and alternative investment funds are no exception.

This means that an alternative mutual fund must take extra care to ensure it describes its alternative investment strategies in a simple, straight-forward manner, and that the fund accurately portrays in its prospectus the alternative investment strategies that the fund actually employs, along with the related risks of these strategies. He noted that “in determining the appropriate disclosure, an alternative mutual fund generally should consider the degree of economic exposure the alternative investment strategy creates, in addition to the amount invested in that strategy.” For instance, he noted that “the staff believes that a small investment in some derivatives does not necessarily correlate with little effect on a fund's performance because of the impact of leverage.” On the other hand, he noted that “the staff has observed that a fund may have significant exposure to derivatives, but that exposure may not make the fund substantially riskier.”

He concluded by stating that a “fund generally should review its use of alternative investment strategies when it updates its registration statement annually, to assess whether it should revise the disclosures that describes its principal alternative investment strategies and risks.”


Altering a Document Results in SEC Enforcement Action Against RIA Compliance Officer

A former compliance officer of a registered investment advisory firm is the subject of a recently filed SEC enforcement action (In re Wolf, SEC, Admin. Proc. File No. 3-16195, 10/15/14) based on allegations she altered a document before submitting it to the SEC as part of its investigation in possible insider trading violations at the firm she worked for.

Judy K. Wolf, the compliance officer, was responsible for reviewing suspicious trading activities at the advisory firm for trades that may have been entered at the firm based on material nonpublic information. During the SEC’s investigation of insider trading violations by one of the firm’s registered representatives, the SEC determined that Ms. Wolf altered a document requested by the SEC, in an attempt by Ms. Wolf to reflect that she more closely reviewed the representative’s trading records than she had actually performed. The advisory firm terminated the employment of Ms. Wolf when the SEC questioned the authenticity of the document. Mr. Wolf at first denied altering the document but later admitted to the alteration.

The SEC in its lawsuit against Ms. Wolf, alleges that the altered document, caused her to aid and abet violations of the Securities Exchange Act of 1934 and the Investment Advisers Act of 1940. The advisory firm has settled its own enforcement matter with the SEC by admitting to having violated the books and records requirement under the Advisers Act, paying a $5 million fine and agreeing to engage an independent consultant to review its policies and procedures.

Repeated Custody Rule Violations Leads to SEC Enforcement Action

While an SEC registered investment adviser may be able to escape enforcement action if a violation of the SEC rules is a one-time event and immediate action is taken by the adviser to prevent the violation from reoccurring, it is clear that if such violations occur on a repeated basis and the adviser failed to take reasonable steps to prevent such violations, the SEC will take enforcement action.

In a recent enforcement proceeding (In the Matter of Sands Brothers Asset Management, LLC, Steven Sands, Martin Sands and Christopher Kelly, Investment Advisers Act of 1940 Release No. 3960/October 29, 2014) the SEC charged an SEC registered investment adviser and its three top officials for violating the custody rule (Rule 206(4)-2 under Section 206(4) of the Advisers Act) (the “Rule”), in spite of a previous SEC cease and desist order issued against the advisory firm in 2010 for similar violations. Accordingly, the SEC alleges that the adviser not only violated the Rule but also violated the previous order that ordered them to not further violate the Rule.

According to the SEC’s allegations the Rule was violated by the advisory firm for not timely providing audited financial statements to investors in the private funds managed by the advisory firm. According to the SEC, the firm was at least 40 days late in providing the audited financial statements to the investors in 10 private funds for the fiscal year ended December 31, 2010. In the following year, the statements were provided to investors anywhere from 6 to 8 months past the 120 day requirement under the Rule. In 2012, the statements continued to be provided late to investors by 3 months.

As advisers to private funds know, the auditors of the private funds are usually in their busy season (i.e., late Spring) and providing the audited financial statements within 120 days of the fiscal year end as required by the Rule can be a challenge. In this case, however, the adviser had been put on notice by the 2010 order that it needed to do a better job in working with the auditors to ensure that the statements were available for distribution to fund investors within the Rule’s requirements. The repeated tardiness of providing the audited financial statements to the investors since the 2010 order apparently demonstrated to the SEC that this adviser and its officials did not take seriously compliance with the provisions of the Order or the Rule. The Adviser’s officials were charged with aiding and abetting violations of the Rule.



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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