Recent SEC Compliance Fines: What to Watch Out For

Four recent enforcement actions by the US Securities and Exchange Commission each highlight a different area of concern by the regulatory agency and each sends a loud and clear message in hefty fines and professional punishment. We think they offer valuable lessons to readers of FinOps Report on how to steer clear of legal landmines.

Conflict of Interest

In this case, everyone pays. The fund administrator, the board member and the auditor all have liability in what the SEC views as a failure of compliance with conflict-of-interest rules.

Fund administrator ALPS Fund Services has settled to pay a fine of US$45,000 for violating Rule 38a-1 of the Investment Company Act by not uncovering that Andrew Boynton, a trustee of the three closed-end funds it serviced, had a conflict of interest. In 2006 he was paid by Deloitte Consulting, an affiliate of the funds’ auditor Deloitte, for the intellectual property rights to a brainstorming business methodology and through 2011 received consulting fees to help implement the methodology with internal and external clients. The compensation occurred at the same time, Boynton served on the boards and audit committees of the three funds.

Denver-headquartered ALPS, a subsidiary of technology giant DST, was responsible for ensuring that the three funds followed federal securities laws. Rule 38a-1 requires each investment fund to adopt, with board approval, written policies and procedures to prevent violations of federal securities laws, which include mandating that auditors maintain a degree of independence from the clients whose financial books they review.

Alps initially circulated questionnaires asking trustees and officers of each fund to identify their principal occupations and other positions. In 2009, those T&O questionnaires went a step further in asking trustees and officers to reveal any direct or material indirect business relationships with the funds’ auditor. However, the SEC contends that the phrasing of the questionnaires was not clear enough to uncover whether a fund’s trustees and offers had any relationships with the fund auditor’s affiliates. According to the SEC, the three funds also did not have sufficient written policies and procedures to prevent other types of violations of auditor independence rules and did not provide board members with sufficient training to discharge their responsibilities related to auditor independence.

Legal experts tell FinOps Report that it is uncertain whether more clarity or training would have uncovered Boynton’s conflict of interest. In its settlement with ALPS, the SEC suggests that Boynton did not disclose his relationship with Deloitte Consulting because he thought it was a separate entity from Deloitte’s auditing business. Nonetheless, the regulatory agency imposed a strict interpretation of its compliance rule.

Boynton ended up paying a penalty of US$60,000 while Deloitte was hit with the highest penalty — more than US$1 million — for improper conduct in not following its own policies for ensuring auditor independence. Although Deloitte did ultimately catch wind of Boynton’s conflict of interest and voluntarily informed the agency in March 2012, it took five years to do so. during which time Deloitte claimed it followed auditor independence.

Expense Allocation

Here is another case in what’s starting to look like a wave of fees-and-expenses enforcements against private equity funds. The message from the SEC seems to be: get your compliance policies and procedures in place, inform the investors, and then just deal with complicated scenarios, like failed deals.

For the first time ever, the regulatory agency has fined a private equity fund adviser with misallocating “broken deal” expenses and held it liable for mistakes made even before it registered with the SEC. Kravis Kohlberg Roberts (KKR) has agreed to pay nearly US$30 million to settle the charge of breaching its fiduciary obligation under the Investment Advisers Act between 2006 and 2011. KKR failed to allocate a portion of broken-deal expenses to co-investing entities, including its own executives. KKR also violated the Act because it did not implement written compliance policies governing expense allocations until 2011 and did not disclose in its limited partnership agreements or related offering documents that it would not allocate broken deal expenses to co-investors.

Legal experts note that even though fee and expense allocations are subject to vagaries of timing and commitment, private equity advisers can at minimum address their compliance responsibilities with written policies and procedures to back-up their expense-allocation decisions and to clearly explain those decisions to investors. “The [SEC’s] action may not fully recognize that the allocation of broken deal fees and expenses in private equity can be nuanced and involve questions of judgement regarding costs associated with deals and potential co-investment,” writes Wilkie Farr & Gallagher in a communique to investors on the KKR case. “Early stage work with advisers typically begins before a co-investment strategy is in place and deals often die before potential investors are committed or before any co-investment vehicle is established.”

Custody Audit Performance

What does a custody auditor do if the client doesn’t cooperate with the need for internal records and assurances? Not, according to the SEC, sit around and wait for something to change. In this case of a fund administrator charged with fraud, the client went down hard but the accountant also did not emerge unscathed.

The SEC has just announced a settlement with Michael Wilson, principal of accounting firm Cotterman-Wilson. Wilson will pay $50,000 and be barred from servicing a registered company for three years because he failed to correctly complete “surprise custody exams” for which he was paid by Professional Investment Management (PIM), a third-party administrator and investment advisor to 15 retirement plans.

PIM, which held client funds and assets in omnibus accounts with three custodians, also provided investment advisory services for 25 individual clients for non-retirement accounts. PIM was Wilson’s only client registered as an investment adviser with the SEC. The owner of PIM, Douglas Cowgill, was the subject of a separate settlement last September related to accounting irregularities that resulted in his being barred from any professional activity in capital markets firms until the SEC accepts his application for reassociation.

The regulatory agency says that Wilson violated custody rule 206(4)-2 of the Investment Advisers Act in 2009 by not filing Form ADV-E for any surprise custody exam conducted, and for signing off on a custody exam report that PIM had fulfilled its legal obligations despite his having discovered a shortfall in one of the custody accounts. In 2010 and 2011 Wilson neither completed the custody exam nor did he file the Form ADV-E report of any surprise exam of the custody accounts. .

The SEC requires registered investment advisers with custody of client funds or securities, as was the case with PIM, to ensure that client assets are protected from loss, misappropriation, misuse or the adviser’s insolvency. Its initial custody rule only called for registered investment advisers to make certain that custodians of the investment funds they service mail quarterly reports to each of their clients and for custodians to accept an annual surprise exam from an external auditor. The SEC’s custody rule governing investment advisers was upgraded in December 2009 to also require them to undergo annual surprise custody exams themselves.

According to the SEC, Wilson signed off on PIM’s 2009 custody exam, despite not receiving explanations from PIM for the shortall or an “attestation” from PIM’s management on the accuracy of information provided to him. PIM again didn’t answer Wilson’s questions for its 2010 report and in 2011. When Wilson finally did notify his client he couldn’t complete the 2010 report, he accepted the client’s instructions that he complete the work for the 2010 and 2011 reports concurrently.

Although Wilson never did the surprise custody exams or file Form ADV-E on PIM’s behalf for either 2010 or 2011, he invoiced PIM for work done and accepted compensation.  More important to the SEC, he never formally withdrew from the contract to perform those exams. It was not until January 2013, more than 15 months after Wilson submitted his last invoice to PIM, that he informed his client he could not accept any more assignments.

Bad Valuations

This tangled-web tale began with excessively optimistic valuations of exotic securities and ended with a huge fine, career repercussions and the closure of the hedge funds.

Greenwich, Conn-based AlphaBridge Capital and its two owners Thomas Kurzen and Michael Carino have settled to pay a combined US$5 million to settle the SEC’s charge that they violated the Investment Advisers Act of 1940 by inflating the valuations of unlisted thinly traded interest-only and inverse interest-only floaters. The Act prohibits registered investment fund advisers from making false statements and AlphaBridge did so by lying about how it priced those exotic securities. Registered investment fund advisers are supposed to ensure and disclose the validity of how they value non-exchange traded assets through an independent rigorous analysis of well-tuned models and inputs.

AlphaBridge and its majority owner Kurzen got censured while its minority-owner and chief compliance officer Carino, who used his own flawed methodology to overvalue the securities and persuaded others to play along, was barred from the industry for three years. Kurzen and Carino also were co-portfolio managers for AlphaBridge’s three funds which will be shut down after the fines are paid, says the SEC. Of the three funds, one was a master fixed-income fund and the other two were feeder funds.

AlphaBridge told investors and auditors that it obtained “independent” price-quotes from broker-dealers for those residential mortgage-backed securities when in fact it gave those same broker-dealers Carino’s own valuations as of 2008. The scam apparently started when Richard Evans, an independent broker-dealer in Houston, complained to Carino that traders in the broker-dealer firms he worked for as an independent representative were peeved it was taking them too long to price the exotic assets. Carino apparently decided to take matters into his own hands and told Evans he could provide him with the prices to forward to the funds’ administrator and auditor.

Although Evans was told by Carino that he was welcome to verify Carino’s prices, he never did, instead passing them along as his own. Naturally, the SEC alleges that Carino knew or should have known what Evans was doing. In fact, when Evans did raise some concerns in 2010 about the validity of Carino’s valuations, which didn’t match what he noticed from similar securities, Carino came with a plausible explanation — he was using a new better “long-term” valuation methodology instead of an accepted fair-value standard. Evans decided not to question that stance. Between 2000 and 2013 AlphaBridge was a lucrative customer, accounting for 60 percent of his commissions in 2011.

In its settlement with AlphaBridge, the SEC said that another broker-dealer identified as Person B also participated in AlphaBridge’s scam passing along Carino’s prices as his own but only until December 2012. Evans, identified as Person A, did so until April 2013. Person B was not identified in the settlement document.

When AlphaBridge’s auditor started worrying about whether the prices for the thinly-traded securities were legit during its 2011 year-end audit, Carino told the auditor to call Evans to verify their accuracy. According to the SEC’s account, Carino coached Evans before a telephone conversation with the auditor and then emailed the auditor’s questions to Evan with suggested answers, which Evans largely used to respond to the auditor. The same scenario took place for the 2012 audit, but by that time the auditor wasn’t buying the logic and in April 2013 suspended its work until AlphaBridge came up with a new methodology for how it valued the thinly-traded securities.

The inflated prices for those thinly-traded securities caused investors to overpay management and performance fees in 2011 and 2012. When AlphaBridge finally agreed to use a model-based approach to pricing, the truer value of the holdings in question finally became apparent. AlphaBridge was forced to write down the value of its funds from US$138 million to US$48 million in January 2014.

Evans cut a deal with the SEC in exchange for his cooperation and settled for a fine of only US$15,000 and a one-year ban from working in the securities industry. The SEC says that he has changed careers and is now working as a real estate agent in Texas.