SEC to Fund Administrators: You Are Liable for Client Fraud (Updated)

(Editor’s Note: On July 25, 2016 Apex Fund Services announced two hires for compliance. It appointed Nitin Khanapurkar as global head of risk and compliance oversight. Apex’s Luxembourg unit tapped Sonja-Maria Hilkhuijsen as head of European compliance and data protection. Khanapurkar was previously senior partner at KPMG while Hilkhuijsen was chief compliance and data protection officer for State Street Bank Luxembourg).  

When you see something do something.

That is the message the US Securities and Exchange Commission is sending fund administrators. If they turn a blind eye to their clients violation of federal securities laws, they too will be held legally responsible for either causing the wrongdoing or aiding the fund manager customer in committing illegal acts.

Fund administrator Apex Fund Services must pay the SEC US$352,449 fine for allowing two of its fund manager clients — ClearPath Wealth Management and EquityStar Capital Management — to violate the Investment Advisers Act of 1940. The fund managers committed fraud and made false statements. The fund administrator itself didn’t violate any SEC rules, although its poor accounting, recordkeeping and disclosure procedures produced incorrect financial and investor statements. Of the US$352,449 paid, US$185,000 was in disgorgement — or loss of fees earned.  US$100,000 was in penalties, and the remainder was in interest.

Headquartered in Red Bank, New Jersey, Apex Fund Services is a subsidiary of Apex Fund Services Holdings, founded in Bermuda in 2003. The independent fund administrator has grown rapidly through a series of acquisitions since then with the most recent being the takeover of Pinnacle Fund Administration in March 2015. The purchase, which followed the appointment of former BNY Mellon managing director Dennis Westley as the new managing director for North America, raised Apex’s overall assets under administration at that time to US$40 billion. Of that figure 60 percent represented hedge funds and hedge funds of funds. Most of the US business, says a spokesperson for Apex, is serviced out of Charlotte, NC., where Pinnacle was headquartered.

The settlement with Apex reflects the SEC’s ongoing crackdown on service providers — such as fund administrators and accountants– for the wrongdoings of their clients. Last year, the agency fined ALPS Fund Services US$45,000 for not uncovering that Andrew Boynton, a trustee of three closed-end funds it serviced, had a conflict of interest. Deloitte Consulting was also hit with a fine of more than US$1 million for not following its own procedures for preventing conflicts of interest. Boynton was paid by Deloitte for the intellectual property rights to a brainstorming methodology and received consulting fees while serving as trustee. In 2013, Gemini Fund Services paid a US$50,000 fine for causing Northern Lights Fund Trust and Northern Lights Variable Trust to violate the recordkeeping and reporting rules of the Investment Company Act of 1940.

“Apex failed to live up to its gatekeeper responsibility and essentially enabled the schemes to persist at each of these advisory firms until the SEC stepped in,” said Andrew Ceresney, the SEC’s Director of Enforcement Action in a statement on the settlement. Apex never confirmed nor denied the SEC’s findings and in addition to paying a fine, hired a compliance consultant.

“We respect the SEC’s decision and have made every effort to accommodate any requests for information,” said Apex in a statement. “We are satisfied with the resolution of the investigation with a voluntary settlement amount of US$350,000 and remain fully committed to full compliance with all legal and regulatory requirements globally. We will continue to fully cooperate with regulators on any matter brought to our attention in any jurisdiction.”

What Went Wrong

The SEC’s settlement with Apex follows separate cases with Apex’s fund management customers and their top executives, which have yet to be resolved. In March 2016, the SEC accused Steven Zoernack — the owner of EquityStar Capital Management — of raising US$5.6 million from investors and secretly pocketing a total of more than US$1 million over a two year timetable, while trying to hide his shady past. Apex found out that Zoernack had started withdrawing cash from his fund as early as May 2012 and in early 2013 did confront him about paying back the amount owed at the time. However Apex did not change EquityStar’s accounting figures or disclosures in monthly statements to investors.

It was not until March 2014 that Apex first reflected the Zoernack’s receivable on investor statements and disclosed that a significant portion of the value of investor’s account included the receivables. By that time, Zoernack had withdrawn over US$1 million and Apex finally threatened Zoerneck it would dump his firm as a client unless he implemented a repayment plan. Zoernack subsequently fired Apex as his service provider. “Apex knew or should have known that Zoernack was unwilling or unable to repay the receivables and therefore it failed to properly account for them,” the SEC said. “In addition, Apex knew or should have known that the monthly account statements it sent to investors on behalf of Zoernack and EquityStar were materially misleading.”

If Zoernack’s continued inability to repay his US$1 million withdrawal weren’t enough to convince Apex it should have ended the relationship, Zoernack’s checkered past should have been. When Apex’s global compliance department discovered in March 2013 that Zoernack had a 2007 conviction for wire fraud, it left the decision on whether to retain his firm as a client to its US office.

Apex’s poor procedures were also evident in its dealings with ClearPath Wealth Management. In May 2015, the SEC accused ClearPath and its president Patrick Churchville of operating an elaborate accounting scam for four funds that caused investors to lose US$11 million. The SEC said that Apex knew about the firm’s undisclosed brokerage and bank accounts, undisclosed margin and loan agreements, and interseries and interfund cash transfers that violated customer investor agreements. However, Apex failed to report the activity to the SEC or fix accounting errors and produced false financial and investor statements.

“In setting up the fund accounting system for ClearPath’s funds, Apex did not take into account that the funds’ governing documents specified that each series was a subpartnership and that the assets and liabilities of each series cannot be commingled with any other series,” said the SEC in its settlement. As a result, the capital account statements that Apex generated for ClearPath to provide to fund investors did not accurately reflect ClearPath’s and Churchill’s use of series assets and made possible ClearPath and Churchill’s misappropriation and use of series assets for unauthorized investments.”

While the SEC’s critical stance toward Apex and other service providers should prompt fund administrators to beef up their monitoring of client activities, it remains unclear as to just how far the SEC thinks their responsibilities should go. The agency has never come up with any explicit rules or guidance but its settlement with Apex suggests that documenting the problem or simply confronting the client won’t be enough. Fund administrators may have to turn into whistleblowers and report their clients to the SEC or face regulatory fines and headline risk. Of course, dropping the client might also not be a bad idea.