A Compilation of Enforcement and Non-Enforcement Actions

by Foley & Lardner LLP


  • State Securities Regulators Are Also Concerned About Cybersecurity Readiness
  • Know Your Affiliates


  • Portfolio Manager Sanctioned for Prohibited Act
  • Order Issued for Retaliation Against Dodd-Frank Whistleblower
  • Investment Advisers’ Affiliation Leads to Violation of Investment Adviser Registration Requirements

Non-Enforcement Matters

State Securities Regulators Are Also Concerned About Cybersecurity Readiness

As reported in the May 2014 edition of Legal News: Investment Management Update, the SEC has made cybersecurity readiness a high-priority item to review when it conducts examinations of registered broker-dealers and investment advisers. Some of the state securities regulators have also placed this item high on their checklists for surveying state-registered investment advisers.

Regulators from Massachusetts and Illinois are conducting a survey of state-registered investment advisers (900 in Massachusetts and 1,000 in Illinois) to determine the status of each registrant’s technology security procedures and whether the procedures need to be updated or enhanced. The three-page survey sent out by the state regulators to the registrants incudes questions about each investment adviser’s authentication procedures, use of encryption, electronic back-ups and third party vendors, and insurance coverage. Once the survey responses are compiled, the regulators believe they will be in a position to determine if additional regulations need to be put in place to ensure that such registrants take adequate procedures to prevent and detect the security of confidential personal information of their clients.

Know Your Affiliates

One aim of the Investment Company Act is to protect against fund insiders, or affiliated persons, using fund assets for their own purposes to the detriment of the fund and its shareholders. For example, Section 17 of the Act prohibits or restricts a wide range of affiliated transactions, and Section 10(f) limits a fund’s acquisition of securities from an underwriting syndicate containing certain affiliates. It is the duty of the board of directors to oversee compliance with these limitations and the various exemptions to such limitations on which a fund relies.

The importance of the board of directors maintaining proper oversight of affiliated persons is underscored by the recent guidance of the SEC’s Division of Investment Management regarding the issue. Specifically, the guidance reminds series investment companies to review their compliance policies and procedures to ensure proper identification of affiliated persons with respect to each of its series to prevent unlawful transactions.

Mutual funds typically operate as “series companies,” which is a single legal entity that offers investors choices among several different funds that are all series of the single legal entity. This structure provides for operational efficiencies while supplying options to address individualized investment objectives. While the Investment Company Act does not address all of the aspects of its application to series, the SEC and its staff have generally applied its requirements to each series as if it were a separate investment company.

The position regarding the application of the Investment Company Act to series is important in the context of affiliated transaction limitations because the definition of an affiliated person of another person includes any person who owns five percent or more of the outstanding voting securities of that person. This means that the five percent or more holder of a series is an affiliated person of the series, and is thus subject to the prohibitions on affiliated transactions. For example, Section 17(a) of the Act prohibits an affiliated person of a mutual fund (or an affiliated person of that person) from selling any security or property to the fund. In the case of a series investment company, the prohibition applies when a series is a party to the transaction, and the series is also relevant in determining whether the counterparty to the transaction is an “affiliated person.”

So, the guidance advises each mutual fund to review its compliance policies and procedures for the appropriate identification of “affiliated persons” with respect to each series for the purpose of preventing prohibited affiliate transactions.

To prevent violations of the Investment Company Act, this should include processes by which to identify those owning five percent or more of the outstanding voting securities of a series (as well as the series company as a whole).

Enforcement Matters

Portfolio Manager Sanctioned for Prohibited Act

Christopher B. Ruffle, portfolio manager of The China Fund, Inc., a fund registered under the Investment Company Act of 1940 was recently sanctioned by the SEC for orchestrating a securities transaction when he knew that the transaction raised affiliation concerns and was a prohibited joint transaction, in violation of Sec. 17(d) and Rule 17d-1 under the Investment Company Act. The SEC issued a cease and desist order, imposed a one-year bar on acting as an officer or director of a registered fund, and ordered Mr. Ruffle to pay a civil penalty of $150,000 (also see SEC Investment Company Act Release No. 31066).

As portfolio manager of The China Fund, Inc. (the “Fund”), Mr. Ruffle was principally involved in arranging for the Fund’s April 2009 purchase of convertible bonds from a private hedge fund, an affiliate of the Fund. The hedge fund affiliate had previously acquired the convertible bonds which were generally illiquid and needed cash to satisfy redemption requests from its investors. The Fund’s investment in the convertible bonds turned out to be a poor investment as eventually the bonds were sold in October 2010 for 55 percent of their face value. By structuring an investment for the Fund which directly benefitted an affiliate without first obtaining an order from the SEC, Mr. Ruffle violated the joint transaction provision under the Investment Company Act.

The bar issued by the SEC against Mr. Ruffle in this matter includes, for a period of 12 months, serving as an employee, officer, director, member of an advisory board, investment adviser or depositor of, or principal underwriter for, a registered investment company or affiliated person of such investment adviser, depositor, or principal underwriter for a registered investment company.

Order Issued for Retaliation Against Dodd-Frank Whistleblower

Now that the SEC’s whistleblower program is in full operation, the enforcement action highlighted here may become more of a common occurrence. This enforcement action against Paradigm Capital Management, Inc. (“Paradigm”), an SEC registered investment adviser, and its principal owner, Candace King Weir, is based on their retaliation against a Paradigm employee who made a whistleblower submission to the SEC in 2012 regarding certain unlawful principal transactions conducted for a client by Paradigm.

The underlying conduct exposed by the whistleblower, who was Paradigm’s head trader at the time, involved the period of 2009 through 2011 and Paradigm’s engagement in principal transactions with C.L. King & Associates, Inc., an affiliated broker-dealer, without first disclosing to, or obtaining consent from, the client that purchased the securities involved in the transactions, which is a violation of Section 206(3) of the Investment Advisers Act of 1940. After discovering that the employee reported the violations to the SEC, Paradigm engaged in retaliatory actions that ultimately resulted in the employee’s resignation from the investment adviser in 2012. Paradigm, upon discovering that the employee had made the whistleblower submission to the SEC, removed the employee as head trader, changing his job function instead to “compliance assistant,” stripping him of any supervisory responsibilities, and “otherwise marginalized him.”

As a result of the retaliation, the SEC alleged that Paradigm violated Section 21F(h) of the Securities Exchange Act of 1934, which specifically prohibits retaliatory actions against a whistleblower. The SEC further alleges violations by Paradigm of Section 206(3), in connection with making principal transactions in a client’s account without obtaining the client’s prior consent, and Section 207 of the Advisers Act, which makes it unlawful to make any untrue statement of a material fact in any registration application or report filed with the SEC. As to the later allegation, the SEC alleges that Paradigm, in effect, had materially misstated within its Form ADV its treatment of principal transactions for client accounts.

Both Paradigm and Ms. Weir agreed to settle the SEC’s enforcement action by, among other things, agreeing jointly and severally, to distribute a total payment of $1,700,000 to compensate certain investors who had invested in the Fund during the time of the unlawful principal transactions, engage the services of an independent compliance consultant to conduct a comprehensive review of Paradigm’s supervisory, compliance and other policies and procedures designed to prevent and detect prohibited principal transactions, the issuance of the SEC’s cease and desist order, and the payment of a civil penalty in the amount of $300,000.

This enforcement action by the SEC demonstrates the protections afforded whistleblowers by Congress under the Dodd-Frank legislation and the conviction by the SEC to act forcefully against those persons who take retaliatory actions against whistleblowers.

Investment Advisers’ Affiliation Leads to Violation of Investment Adviser Registration Requirements

In a recent enforcement action, the SEC found that an investment adviser was in violation of the investment adviser registration requirements under Section 203(a) of the Investment Advisers Act of 1940 (In the Matter of Penn Mezzanine Partners Management, L.P., Release No. IA-3858). The adviser and a related non-registered investment adviser both claimed to be exempt from registration under the Advisers Act. However, the SEC determined that the two advisers were under common control, were not operationally independent of each other and, therefore, should be integrated as a single investment adviser to determine if registration was required. Applying the integration test, it was determined that neither the adviser nor its affiliate was exempt from registration. Prior to this, the adviser had filed as an exempt reporting adviser under Section 204(a) of the Advisers Act as its only clients were private funds with assets under management of less than $150 million. The affiliated adviser claimed that it was exempt from registration as its clients were solely venture capital funds. By applying the integration test, the advisers were deemed to be operationally integrated.

The SEC determined that the two advisers should be integrated for purposes of determining whether registration was required by noting that not only were the advisers under common control, but they had several overlapping employees and associated persons, including those persons who provided investment advice to clients on behalf of both advisers. In addition, the advisers had significant overlapping operations without policies and procedures designed to maintain separation between the operations for the two advisers. Finally, there were inadequate policies and procedures in place to protect client information from each other.

The advisers agreed to the issuance of the SEC’s cease and desist order and a censure and has already taken steps to reorganize operations and separate investment advisory functions between the two organizations.


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Foley & Lardner LLP

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