A Compilation of Enforcement and Non-Enforcement Actions

by Foley & Lardner LLP
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Non-Enforcement

  • SEC Looks to Step Up Oversight of the Fund Industry
  • SEC Provides Guidance on Key Employee Trusts Under the Family Office Rule

Enforcement

  • SEC Charges Advisory Firm and Its Two Co-Owners With Fraud in Connection With Statements Made to Clients to Induce Investments in Hedge Fund
  • False Performance Claims by Investment Management Firm Results in SEC Sanctions

Non-Enforcement

SEC Looks to Step Up Oversight of the Fund Industry

At a recent conference, Mary Jo White, SEC chairman, announced that the SEC will look to increase its scrutiny of the mutual fund asset management segment to ensure that appropriate risk controls by such investment managers are in place. According to Chairman White, it is not clear that the industry has implemented risk controls sufficient to meet the risks provided by new products and strategies.

According to Chairman White, in order for the SEC to evaluate and monitor this area, staff members will focus, during field examinations, on the “risks created by funds’ liquidity and use of derivatives.” The industry is required to conduct periodic stress tests per the provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The SEC will be stepping up its efforts to determine if such stress tests are being conducted and to provide guidance to the industry on how to most effectively test the risks and further implement the controls to monitor those risks by asset managers.


SEC Provides Guidance on Key Employee Trusts Under the Family Office Rule

The SEC Division of Investment Management has issued guidance regarding key employee trusts under the Family Office Rule. The Family Office Rule provides an exception from the Investment Advisers Act definition of investment adviser for families that are managing their own wealth, meaning, among other things, that they are providing advice solely to “family clients.” The guidance provides (1) that a key employee trust may qualify as a “family client” even if a non-key employee makes “non-investment” decisions for the trust; and (2) that a key employee trust may qualify as a “family client” even if the key employee who is authorized to make decisions with respect to that trust is not the key employee who contributed assets to the trust.

According to the SEC staff, recognizing the need for family offices to attract and retain talented investment professionals as employees, the Family Office Rule permits family offices to include as “family clients” certain non-family members, including those employees whose position and experience should enable them to protect themselves (key employees) and certain investment entities through which those key employees may invest in opportunities connected to the family office. Included in the category of key employee investment entities that would meet the definition of a family client is “[a]ny trust of which: each trustee or other person authorized to make decisions with respect to the trust is a key employee; and each settlor or other person who has contributed assets to the trust is a key employee or the key employee’s current and/or former spouse or spousal equivalent....”

The SEC staff believes it is within the intent of the Family Office Rule for a non-key employee to make administrative decisions for a trust, provided investment decisions are made by a key employee. The Investment Advisers Act does not contain a definition of “investment decision.” However, the SEC staff believes that, for example, the following generally are purely administrative duties and do not involve making “investment decisions”:

  • Preparing and filing taxes for the trust (however, advice on structuring a tax-favorable investment strategy would not be purely administrative)
  • Keeping records for the trust
  • Distributing periodic statements or disclosures to trust beneficiaries.

While these and other administrative duties may result in a non-key employee making certain decisions on behalf of the trust, the SEC staff would generally not consider such decisions to be “investment decisions.”

Additionally, the SEC staff believes it generally is consistent with the intent of the Family Office Rule for one key employee to make investment decisions on behalf of another key employee’s trust. The Family Office Rule requires that each trustee or other person authorized to make decisions with respect to the trust is a key employee. In this case, investment decisions would continue to be made solely by a key employee — individuals that the SEC staff has already concluded should have sufficient financial experience and sophistication to act without the protection provided by its regulations under the Investment Advisers Act.


Enforcement

SEC Charges Advisory Firm and Its Two Co-Owners With Fraud in Connection With Statements Made to Clients to Induce Investments in Hedge Fund

The SEC recently announced fraud charges against Reliance Financial Advisors, an SEC-registered investment advisory firm located in Buffalo, New York, and its two co-owners, Timothy S. Dembski and Walter F. Grenda, Jr. According to the SEC’s allegations, Messrs. Dembski and Grenda recommended to their clients to invest in a hedge fund managed by Scott M. Stephen. Stephen’s background and experience in managing the assets of a hedge fund were misrepresented and overstated to clients as prospective investors in the fund. Although Stephen had no prior experience or track record in managing assets of a hedge fund, the fund was pitched as an investment suitable for clients who were predominantly of retirement age. Although the fund’s trading strategy was supposed to be fully automated by an algorithm, it turned out that trades were placed manually by Stephen for the most part.

The fund’s investments turned out to be unsuccessful, and its investors lost all or a majority of their investments in the fund. Collectively, clients of Dembski and Grenda invested about $12 million in the fund.
In addition, the SEC alleges that Grenda borrowed $175,000 from two of his clients with the promise that the funds would be used to grow his investment advisory business. Instead, Grenda used those funds to pay for personal expenses.

The SEC’s complaint alleges that the advisory firm and its two co-owners violated the anti-fraud provisions of the Investment Advisers Act of 1940, the Securities Act of 1933, and the Securities Exchange Act of 1934 as they made fraudulent statements to induce clients to invest in the fund and to make personal loans to Grenda.

Separately, Stephen, the hedge fund manager also accused by the SEC of anti-fraud fund violations, has agreed to be permanently barred from the securities industry.


False Performance Claims by Investment Management Firm Results in SEC Sanctions

A Massachusetts-based investment management firm, F-Squared Investments, Inc., agreed to pay $35 million and admitted to wrong-doing based on SEC charges that it violated the anti-fraud provisions under the Investment Advisers Act by falsely reporting performance on its model portfolio. The firm’s CEO, Howard Present, was also charged by the SEC with making false and misleading statements to investors, but he has not agreed to a settlement with the SEC on those charges.

F-Squared is believed to be the nation’s largest marketer of index products using exchange-traded funds (ETFs). F-Squared created a model portfolio in 2008 based on trading signals received from a third party, which were based on an algorithm. The trading signals were for sector ETFs and were rebalanced from time to time as the signals changed. The new product, Alpha Sector, generally became the largest revenue producer for F-Squared and became the largest ETF strategy in the sector ETF market.

What got the firm in trouble is that it advertised the product as having a successful track record over seven years based on actual performance realized for client accounts. In reality, none of those statements were true, as the results in the strategy were over a lesser period, were “back tested,” and did not represent actual performance. In addition, the results reported were also inaccurate due to a substantial calculation error that resulted in an inflated number of about 350 percent.

According to the SEC, the firm’s CEO, Mr. Present, was responsible for the various false statements about the performance of the product over a period of about five years.

The firm, in settling the SEC’s allegations, admitted to violating the anti-fraud provisions of the Investment Advisers Act and caused violations of the Investment Company Act of 1940. In addition to paying the $35 million in disgorgement and penalties, the firm agreed to cease and desist from further violating the anti-fraud provisions and to retain an independent compliance consultant.

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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